Friday, December 11, 2009

Indicators point to a bounce in the USD

You say "But EVERYONE is short the US Dollar?"
So what. Is the USD worth zero? We already have lost 20% of the value of our currency in a year. That is a huge move. Let's look forward.

There are fundamental factors that could facilitate a rebound in the USD. A default of Greece, Russia, Hungary, Latvia, Mexico, or a major international bank all might cause a flight back to the USD. Also the completion or ending of the mortgage purchase program, Treasury purchase program, and declining effect of the stimulus all will have a deflationary effect on the USD.

In fact there are market indicators that show the USD could head higher from here in the short term.

The first is the possible break in the USD downward trendline. The euro is foretelling a break of that six month trend.

Second is the options action on the USD Jan 10 Option Chain (expressed through the UUP - USD Bullish ETF). At least one major hedge fund or active market participant has engaged in a bull call spread that will make money as UUP crosses $25.25 or so. Minimal action on the put side of the equation is a bad sign for anyone short the USD.

These positions could be just foolish bets from large accounts dumb money. But sometimes making positions in front of any trend where lots of money is moving in the same direction is the best place to be, smart or dumb.

Thursday, December 3, 2009

Time for a makeover!

Hi, this blog is going to get a makeover. Not just eyebrows and toes either. A whole new look!

If anyone has ideas for a motif, send them my way.

Unemployment peaking in 2011?

Good morning. I have had lots of family come and go over the past few weeks and it gave me a chance to take a breather from the market. Except for helping a friend out with some questions and stocking some gold, I have been pretty quiet.

News this morning... Goldman has released predictions that give us some food for thought for positions to take now.

"If Goldman Sachs is right, of course. Here is the firm’s 2011 forecast:

The key features of our 2011 outlook: (1) a strengthening in growth from 2.1% on average in 2010 to 2.4% in 2011, with real GDP rising at an above-potential 3½% pace in late 2011; (2) a peaking in unemployment in mid-2011 at about 10¾%; (3) extremely low inflation – close to zero on a core basis during 2011; and (4) a continuation of the Fed’s (near) zero interest rate policy (ZIRP) throughout 2011"

Let's examine each one and comment...

1) GDP growth of 2.1 % through 2010

From such a low base, this is just bouncing along the bottom

2) Unemployment peaking in mid-2011 at 10.75 %

Whoa. CalculatedRisk has noted that the Fed does not raise interest rates until "six months after peak unemployment". So monetary stimulus via the Fed will continue for at least another year. That means more downward pressure on the USD, and thus more upward pressure on commodity prices from domestic sources.

3) Extremely Low Inflation

If you think you can get a 6% yield over the next year with low risk of principal, I think you will have definitely beat S&P index returns and any low risk instrument. This is where you will sleep well.

4) Continuation of the ZIRP

The Fed will continue to create inflation to fight credit related deflation. Money, money, everywhere yet none of it to spend.

This blogger suggests buying Met Life A series at $20.90. Although all big insurers are suffering from investment losses and still holds significant exposures, Met Life must be gaining from the fall of it's biggest competitor in the marketplace.

This security will provide a solid yield while the Fed keeps rates low and includes protection if the Fed must quickly increase rates to address hyperinflation of any sort if it were to occur down the line. If the security is deemed by Met Life in the next few years, then the principal pop will provide an addtional 20%+ return over that time period (annualized rate will be lower).

"Met Life preferred A series securities at MetLife Inc., Floating Rating Non-Cumulative Preferred Stock, Series A, liquidation preference $25 per share, redeemable at the issuer's option on or after 9/15/2010 at $25 per share plus declared and unpaid dividends, with no stated maturity, and with non-cumulative floating rate distributions paid quarterly on 3/15, 6/15, 9/15 & 12/15 to holders of record on the 15th calendar day prior to the payment date or on the date fixed by the board, not more than 60 days or less than 10 days prior to the payment date. The floating rate will be the greater of 4.00% or 1.00% above the three month LIBOR rate. In regards to payment of dividends and upon liquidation, the preferred shares rank equally with other preferreds and senior to the common shares of the company."

Thursday, November 5, 2009

Ambac heading for default???

JP Morgan thinks so, in the near term...

Does anyone remember February 2008 when the monolines were first being reviewed for downgrade and the market went in a frenzy and the CEO of Ambac was on CNBC? Who remembers that and what did you think then?

"We do not agree with the models! We repeat we are at no risk of defaulting. We have over $1B in claims paying resources!" the CEO Callen pleaded over and over again live on CNBC. Two years later and after at least two capital raising activities, Ambac is now at the end of their rope.

Even as recent as this Sept 26, 2008 interview with the CEO Michael Callen shows he is unrepentent about the financial risks to his firm and the system in general. Even in Sept 2008 the CEO claims to have $12B in claims paying resources. Good thing the rating agencies did not allow them to just shirk their responsibilities by moving those assets into a new subsidiary to avoid the existing liabilities (a.k.a. the shell game plan).

Here is the link -> "Ambac Insurance Unit May Be Put in Receivership"

Just a year ago this would have shook the financial sector. But since we started handing out money and the Dow is up, "hey, no problem!"

No recommendations other than encouraging everyone to stay defensive in general.

FHA: Lending with a 20%+ default rate expectation

This blog has mentioned before that FHA is subprime in sheep's clothing. But how bad is it?

"Although the FHA has tightened credit standards, many of the 2007 and early 2008 mortgages are going bad. The agency expects defaults on 24% of all loans insured in 2007, and 20% of those backed in 2008. "The orders from Congress and us were clear: We want to save as many families as we can, recognizing that a lot of loans people were looking to refinance out of should never have been made in the first place," said Brian Montgomery, who served as the agency's commissioner for four years ending in July."(1)

Although there have been lots of assurances to the contrary, it looks like a bailout is now in the works.

"Two House Republicans warned that growing losses at the Federal Housing Administration could lead to a taxpayer-funded bailout and have asked the Department of Housing and Urban Development for data backing up the FHA’s assertion that it won’t need to ask Congress for any taxpayer money.

“Congress and HUD must take whatever steps are necessary to ensure that this program operates in a manner that does not expose the taxpayer to yet another bailout,” wrote Republicans Darrell Issa of California and Spencer Bachus of Alabama in a letter, dated Monday, to HUD Secretary Shaun Donovan."

Apparently news leaked that the stress tests used in the audit showed FHA is doomed at current capital levels.

Likelihood that a bailout will be avoided, I put it at 10%. But who cares, the DOW is up. Right?

(1) "FHA digs out after loans sour", WSJ, written by Nick Timiraos, Nov 4, 2009

(2) "FHA postpones release of audit as bailout worries mount" WSJ, written by Nick Timiraos, Nov 5, 2009

Tuesday, November 3, 2009

Is it time for the USD to show some muscle?

The US dollar has been kicked, spit on, and left for dead in 2009. Gold bugs, fiscal conservatives, and doomsayers all have abandoned the US currency in anticipation of economic meltdown due to the massive amount of debt spending to slow the crisis.

But have USD critics gotten ahead of themselves?

* Oil has overshot against the USD

Since March, USD has fallen less than 20% vs the Euro, but oil futures have increased 40% in anticipation of a collapse in the purchasing power of the USD. Yet that has not happened...

...and as time ticks by, the disparity between the increasing inventory of oil in the market and the demand on the exchanges becomes more and more peculiar.

* Even weaker currencies have gained 30% vs USD

Emerging market currencies such as the Colombian Peso, Brazilian Real, and Turkish Lira all have gained over 25% vs the USD in a just six months. Although their futures are bright, there are still significant political risk to emerging countries that is now disregarded in the purchase price.

* Lots of deflation on the horizon

The market has been bearish on the USD since March. But considering the wind down of stimulus in the next few months (Treasury purchases, MBS purchases, Cash for Clunkers) and also housing programs (HAMP, Housing Tax Credit), the deflation of reduced economic activity should be significantly bullish for the USD.

* USD is reaching historical support levels

Emerging economies need the USD propped up to maintain exports and keep the flow of hard currency into their country. This historical chart underscores the importance of the US economy to the world.

* Traders have moved to a net long position on the USD

In fact, it has been noted recently that traders have switched to a net bullish dollar position.(1)

* USD reversal could cause market mayhem

Many journalists remark on how the investment banks borrow from the Fed for free and invest in other currencies to obtain a spread. This is called a carry trade and it has helped banks such as Goldman Sachs, Morgan Stanley and JP Morgan book billions during this year. Roubini thinks an uptick in the US dollar will lead to a massive carry trade unwind.

“Everybody’s playing the same game and this game is becoming dangerous.”

The dollar has dropped 12 percent in the past year against a basket of six major currencies as the Federal Reserve, led by Chairman Ben S. Bernanke, cut interest rates to near zero in an effort to lift the U.S. economy out of its worst recession since the 1930s. Roubini said the dollar will eventually “bottom out” as the Fed raises borrowing costs and withdraws stimulus measures including purchases of government debt. That may force investors to reverse carry trades and “rush to the exit,” he said.

“The risk is that we are planting the seeds of the next financial crisis,” said Roubini, chairman of New York-based research and advisory service Roubini Global Economics. “This asset bubble is totally inconsistent with a weaker recovery of economic and financial fundamentals.”(2)

The author of this blog thinks it is time for the USD to correct, but that it is too risky to play for a major spike in the USD. In the case there were unforeseen banking issues in Europe or in a significant emerging market, a run to the USD could be damaging to US banks who are leveraging USD.

The author recommends buying SCO under $13 and exiting above $15.5

(1), "Stronger Buck Threatens Stocks And Commodities", Ryan Campbell, Nov 3, 2009

(2), "Roubini Says Carry Trades Fueling ‘Huge’ Asset Bubble", Michael Patterson, Oct 27, 2009

Tuesday, October 27, 2009

If this is a recovery...

If this is a "recovery", then I need to take high school english again. Recovery from an injury means regaining health and mobility. I see little health in the following stats considering the massive stimulus it took us to get there.

First of all, how do job loss trends like this...

...translate into increasing home prices?

It must be this...

...since I don't see a rebound in Buffet's favorit metric...

...or here in US daily oil consumption (even though the reported numbers are only until July)...

Bottom line. All I see is a little prop up, not recovery. Remember, my previous blog mentioned that we are now at the peak effect of the stimulus and that it will wear off from here. At least the headlines have toned down from the cheery "That was easy!" messages of two months ago. Let's see if they turn into "This is kinda hard?" in March when the Treasury stops buying agency debt.

Friday, October 23, 2009

Stimulus Watch: More evidence US at the peak

Previously this blog noted that not only has the whole world enjoyed a stimulus boost but that US is at the very peak of stimulus spending. To date, this is the amount of funds that have been dispersed.

Now Christina Romer, Chair, Council of Economic Advisers in Testimony before the Joint Economic Committee is confirming suspicions…

“In a report issued on September 10, the Council of Economic Advisers (CEA) provided estimates of the impact of the ARRA (American Recovery and Reinvestment Act) on GDP and employment. ...

These estimates suggest that the ARRA added two to three percentage points to real GDP growth in the second quarter and three to four percentage points to growth in the third quarter. This implies that much of the moderation of the decline in GDP growth in the second quarter and the anticipated rise in the third quarter is directly attributable to the ARRA.”

In fact, Romer’s assessment is that after Q3 2009, the stimulus will provide no boost to GDP growth.

“Fiscal stimulus has its greatest impact on growth around the quarters when it is increasing most strongly. When spending and tax cuts reach their maximum and level off, the contribution to growth returns to roughly zero. This does not mean that stimulus is no longer having an effect. Rather, it means that the effect is to keep GDP above the level it would be at in the absence of stimulus, not to raise growth further. Most analysts predict that the fiscal stimulus will have its greatest impact on growth in the second and third quarters of 2009.”

This might lead to an interesting confluence of events. Bank of America executives have said that there will be a spike in 4th quarter foreclosures as various State and Federal foreclosure moratoriums will wear off and mortgage modification programs are exhausted. “Cash for Clunkers” is now in the past. The home purchase tax credit, a dubious incentive itself, has been applied to maximum effect according to CalculatedRisk. also noted that despite extended benefits, 7000 people fall off of unemployment benefits a day.

But who is to say there will not be yet another stimulus program to compensate for this new situation? As long as the debt markets keep buying US debt, it seems that politicians will continue to find temporary solutions to draw out timelines for recapitalization of the financial system and consumers.

Thursday, October 22, 2009

Defensive Investing: Preparing for a currency war

Many people have been talking about how low interest rates and stimulus will devalue the USD. It is more interesting to talk about how long the Fed will apply pressure to the value of the USD and what to do about it.

Historical analysis that says that the Fed usually keeps rates low until 1 year after the peak of unemployment. Since we have not hit the peak of unemployment yet and do not expect it to occur until the beginning of 2010, the Fed will flood us with money until 2011. The USD has already lost 20% of it's value, and could lose another 10-20% more value in the next year.

But the economic policymakers outside the US are not naive. A low USD is like a tariff on imports for America. They know this and like to counteract the problem. On Tuesday Brazil put a 2% tax on all foreign investment into their country to devalue THEIR currency against all other currencies. The next day Turkey announced a similar proposal. Southeast Asian countries (Thailand, Indonesia, Hong Kong, Singapore, Malaysia) have started buying the USD to try to devalue their own currencies against the USD.

So what are we seeing, no one is going to take this lying down. It will turn into a currency war, with everyone racing to the bottom. Southeast Asia and Brazil can put in counter measures, but that only slows the progress. The USD will devalue, but at what price? The US has the biggest pump to flood the world with money, but it does not mean we will benefit the most from the flooding? Likely, but not necessarily.

What to do?: 100% of the known readers of this blog receive income in USD, have debt denominated in USD (if they have debt), and have over 90% of their available cash denominated in USD. A little diversity is a nice defensive measure and never hurt anyone.

As the USD devalues, emerging market currencies become more expensive and stocks in emerging markets equity prices rise. But in this environment owning equities is just like owning a lottery ticket. I think owning emerging market bond fund (EMB) or government debt of other countries (IGOV) in very small portion for a buy and hold scenario is a good step hedging step. Even better is just getting a CD denominated in currency in countries with 1) manageable deficits or no deficit 2) commodity exposure that is an Achilles heal to a devaluing USD (i.e. oil). Two safe choices for the next couple of years will be CDs denominated in the Brazilian Real or the Norwegian krone. Offered at with a minimum $10,000 deposit per CD, the CDs can be rolled every 3 months. The annual interest rate is 4.5% for the Brazilian real and .25% for Norwegian Krone. The money will be there and protected from the degradation of USD and is FDIC insured to boot.

Author recommends opening one rolling 3-month CD denominated in Brazilian Real and 3-month CD denominated in Norwegian Krone.

Tuesday, October 20, 2009

The Fed: Saving the system by any means necessary

I am not sure when the US market lost the concept of rule of law. The idea that there are winners and losers is a concept lost during our recent crisis. But whenever it did lose it's way and start rigging the markets so blatantly, it was a sad day.

"Oct. 20 (Bloomberg) -- Bank of America Corp. signed off on its government-assisted purchase of Merrill Lynch & Co. after U.S. regulators said the deal might boost the shares, e-mails from two executives showed. Instead, the stock collapsed.

The chairman of the Federal Reserve indicated it would be structured in a manner such that BAC stock should go up when announced,” Chief Financial Officer Joe Price said in a Dec. 29 e-mail to executives of the Charlotte, North Carolina-based bank, including Chief Executive Officer Kenneth D. Lewis."

The idea that the Federal Reserve is intervening to create the illusion of value in the purchase of an insolvant corporation strikes as market manipulation and the corruption of free markets. But who cares, the Dow is up, right?

Update on October 23rd: Apparently Mish Shedlock agrees with me...

Thursday, October 15, 2009

Emerging Markets: More in line with the US market than first meets the eye

I buy into the idea that the greatest opportunity for growth in the future will be outside the US. Even more immediately, I will show in this post that the decline of the dollar will make smart emerging market investments even more attractive in the coming deflationary correction.

For example, let's refer to recent history regarding the behavior of the market during the crisis days of Nov 2008. At that time there was a tremendous flight to the USD dollar as investors sought safe investments during the crisis. During that time, the Brazilian Real lost 50% of it's value due to declining commodity purchases and concerns over the world economy.

One of the investments I find attractive in South America is Brazilian bank Banco Bradesco (BBD). I expect that banks will profit from the emergence of a new middle class in Brazil. BBD was trading at $10 in November. As of today the stock closed at $21.50, clearly outpacing the market as a whole. But this is not so simple, because since November the Brazilian Real has recovered 40%, the stock has only appreciated 60% in local currency. This only slightly outperforms the 53% returns of the S&P 500 index from March 2009 bottom. This is occurring not just for Brazil, but for Mexico and many other markets where currency appreciation has occurred against the USD. Many investment magazines and pundits have been pumping emerging markets as outperforming the US. Actually, performance is equivalent, it is just the currency basis that provides the advantage.

What do we gain from this observation?

1) When panic strikes, and there is a flight to the USD, emerging market companies become very cheap

2) If the US, in response to a panic, uses easing methods to address the downturn, this is bullish to US investors interested emerging market stocks simply because of the basis risk (or in this case reward) from monetary easing and a devaluing USD.

I have no positions to recommend at this time. But it is easy to foresee another stage in the crisis due to deflation that is addressed once again with huge floods of dollars. At that point, it will be important to recognize this pattern and take positions in companies like BBD, CETV, TLK, SBS, and GMK to reap benefits from this occasion.

Monday, September 21, 2009

Stimulus Watch: China stimulus effect declining

Commodities are the key sign for watching the effect of the stimulus program in China. Across the board, signs are starting to show that the largest stimulus program (as a percentage of GDP) is already starting to wane in effect. In the comments, let me know what other factors you are watching to track China's stimulus progress through the system.

(1) Oil consumption

Even though China recently became the #1 consumer of automobiles, oil consumption peaked in July and has been declining. "August seems to have brought a reality check for refiners in China," said Vandana Hari, Asia news director at Platts. "Domestic fuel demand has clearly been lagging their high processing rates, and storage space is finite."

(2) Copper demand

The large state sponsored infrastructure projects drove tremendous demand for copper and semi finished products. There were even reports of pig farmers stockpiling the metal as a speculative investment. But there is cracks in this demand too... "Traders say the market was worried that China, the world'slargest consumer of copper, may have overdone the stock building,which boosted prices in the first half of this year. Chinese copper and semi-fabricated imports fell 20 percent in August from July at just over 325,000 tonnes, and off 30 percent
from a record 476,000 tonnes in June."

(3) Iron Ore

Even iron ore, like copper, linked to China's massive development projects. "Cash prices for iron ore delivered to China from India have fallen 26 percent to $82 a ton since August, according to Metal Bulletin prices for the week ended Sept. 4. Iron ore from Australia has fallen 28 percent since Aug. 13 to $76.1 a ton yesterday, according to the Steel Index. Iron ore inventories at China’s major ports reached 76.5 million tons for the week ended Sept. 4, the highest level this year, according to data provided by Beijing Antaike Information Development Co."

(4) Lending

"The drop in new bank lending -- to an average of 383 billion yuan ($56 billion) in July and August compared with a monthly average of over 1.2 trillion yuan in the first half -- will also pull down transactions in the coming months, said Gao Shanwen, chief economist at Essence Securities."

(5) Constrained Lending -> Real Estate Asset Price Declines by End of Year

Policy tweaks and slower lending will probably be enough for now, analysts say, allowing Beijing to stop short of declaring a full-fledged campaign to stamp out property speculation similar to one in 2007. Ge projected that housing prices would drop toward the end of 2009 or early next year, by about 10 percent, much less than a 20-30 percent fall witnessed last year."

Clearly the world economy would suffer greatly if the program disapated in effect so quickly.

Let me know how you are preparing for the stimulus to wear off and when you expect the timing to occur.

Sunday, September 20, 2009

The TARP game is over, next step is an Uber Big "Bad Bank"

Obama's team came storming into office in the midst of the crisis with all the intent of saving the world financial system. They did it, temporarily at least. As it happened, the crack Obama team handed out cash to failing entities, abandoned accounting scrutiny, and finally provided a little transparency to balance sheets but no accountability for resolution. The markets gained faith in the new system, not because the banks had resolved their problems but because the government was credible and tangible in supporting all major market mechanisms.

This sunlight on the system gave the banks a chance to redeem themselves by opting out of government support by repaying the TARP money. To obtain this freedom, the banks announced their financial health based on increased capital and risk control measures. Was this actually done? No. Now the support programs (agency debt purchases, MBS purchases, T Bond purchases, money market funds(1), home purchase tax credits) are scheduled to lapse. Bloomberg reports "New York Fed President William Dudley, who is vice chairman of the FOMC, has sounded more cautious. "The market expects us to complete these programs,” he said Aug 31. “To contradict that market expectation is a pretty high hurdle.”(2)

What now?

The Obama team remedies addressed the symptoms, but the source was the undercapitalized American consumer and no remedy was found for their plight. As credit cards charge offs, unemployment rates, foreclosure statistics, and many other financial measures all zoom past stress test scenarios, the solvency of the banking system will be in question again by the Spring of 2010. At that point, balance sheets will have to be recapitalized again. Will the banks come back for TARP? No sane bank will risk the public anger of returning to the government as doctor after already claimed to be "cured" and going in for the same penicillin. The credibility of the stress tests will be demolished and the actual health of every bank that took the test will once again be on the table.

What will the government do in that situation? There is no way the Congress will hand out another $750B to the Executive Branch with no strings attached like last time. At least not if they care about holding their jobs come election time. The Executive Branch will have lost their opportunity to single handedly manage the crisis. Instead Congress will take center stage in bringing credibility back to the banking system the only way possible for a government entity. That will require complete nationatization of "bad bank assets" with the taxpayers footing the bill but banks taking a major equity hit in the process.

(1) "Treasury Announces Expiration of Guarantee Program for Money Market Funds" US Treasury Department Press Release, Sept 18, 2009
(2) "Housing Risking Relapse Confronts Bernanke Conundrum"By Kathleen M. Howley, Sept 21, 2009,

The author is long SKF at $25.

Tuesday, September 15, 2009

Stimulus Watch: I hope the Aussies are saving their pennies

Is Australia about to take shot on the chin? Currently the country is navigating the global downturn with exports of raw commodities to China. Is that about to turn?

Australia, which has benefited greatly from China's increased manufacturing consumption of iron ore. China has gone from consuming less than 20% of Australia's iron ore in 2000 to over 80% in 2008. (1) China has even continued to increase their copper imports during the downturn leading to a scenario where their economy exports less but still increases consumption. For Australia, this situations encourages projections based on artificial demand. For China, this indicates uncorrected inefficiencies in their domestic economies that have been papered over by stimulus plan.

There is evidence that the Chinese binge buying has abated...

"In recent months Chinese demand for iron ore -- the primary material in the manufacture of steel -- has dominated freight market activity while also adding to swings on the main index.Port congestion in China as well as off Australia's coast had previously tied up a large number of Capesize vessels, typically hauling 150,000 tonne cargoes such as iron ore and coal. But queues off China have eased.Brokers said reduced iron ore import activity in China in recent weeks was taking its toll." (2)

Considering the torrid pace of the last six months, this could be a breather or utter exhaustion. We will have to wait and look for more evidence before determining how to address the situation.

(1) "Australia finds fortunes ever more tied to China" Reuters, Aug 19, 2009, by Wayne Cole

(2) "Baltic index drifts lower, cargo enquiry light" Reuters, Sept 16, 2009

Monday, September 14, 2009

Stimulus Watch: China went overboard, do the Math

Now that the world economic situation has turned up many are looking for a sustainable environment to allocate investment. Yet is it really a meaningful recovery or just a meaningful temporary stimulus?

The total GDP of China $4.3T USD and the amount dispursed through loose credit policies through the first seven months of this year amounted to over $1T USD. This is equivalent to 25% of GDP lent to domestically to increase consumption.

In comparison the US GDP is close to $14T USD and the stimulus program directly related to the federal budget amounted to $1T USD (Stimulus package + Cars for Clunkers + Chrysler Bailout + GM Bailout + TARP + AIG Bailout). This is a total of only 8% of GDP.

IMHO it is obvious that China has created malinvestment and guided resources into frivilous causes in fear. Considering the size of the error, it will only be a matter of time before this causes problems in their financial system.

Sunday, September 13, 2009

Now is the time for gold

This was originally written 9/13/2009

This blogger is now a gold bug. I tried to fight it, but now it makes too much sense. I even think gold is cheap.

Gold has been used as substitute currency at least since rhe Songhai king Mansa Musa flooded Western Civilization with the metal in the 1500s. In the first part of the 20th century, gold was used to back the government currency. The gold standard was abandoned in US but even today central banks and investors use the metal as a hard currency.

It is often stated that gold is an inflation hedge. It is not just sensitive to inflation. The value of gold rose significantly in real terms during The Great Depression, the most severe modern deflationary period. Gold actually rises in value during times of economic or geopolitical stress.(C) So whether it is the realization of trillions of losses by banks or the debasing of the US currency by massive borrowing by the US government, both scenarios contribute to stress and thus justify an increasing price of gold as a de facto currency.

Evidence of the upside of gold can be observed from many different sources.

(1) Miners

The world's largest gold producer, Barrick Gold, abandoned $3B in prices hedges to get long gold, you have to expect there is upside.(B)

(2) Short sellers

Greenlight Capital is long gold and cites due to emerging market central bank purchases. (D)

The author is long gold at $107.50.

(B) "Barrick Eliminates Hedges, Plans Offer", SF Gate, Sept 8, 2009, by Rob Gillies

(C) "Currency Trading and Intermarket Analysis" by Ashraf Laidi

(D) Greenlight Capital 2009 Q4 Newsletter

Friday, September 4, 2009

Green Mountain Coffee Roasters is piping hot!

The US consumer is currently tightening their belt, losing their jobs, and hunkering down to rebuild their retirement funds. Based on the numbers reported by Green Mountain Coffee Roasters (GMCR), buying a coffee machine seems to be the first step on the road to economic recovery for the American consumer.

As a budding short seller, this stock seemed like a prime candidate to profit from as expectations hit the rocks of reality. At first glance, GMCR holds all the initial signs of a momentum stock out of control. GMCR currently holds a $2.2B market cap and a 47 P/E ratio in a market with declining consumer spending across the board. Yet by the end of the analysis, GMCR looked a momentum stock with a full head of steam with more upside than downside. Here is why....

* GMCR products achieve great customer satisfaction

“During the quarter, we reconfirmed that consumers remained extraordinarily satisfied with the Keurig brewer system. Our quarterly research reconfirmed a top two box satisfaction score that exceeded 92% for all brewer models.”

“Our outlook for fiscal 2010 anticipates a net sales growth rate of 45% to 50%, shipments of system wide K-Cup portion packs to increase in the range of 65% to 70% and fully diluted GAAP EPS to be in the range of $1.70 to $1.80 per share.”(1)

* GMCR has solid organic growth

[Q3 2009]
“It certainly was another outstanding quarter for Green Mountain Coffee Roasters. Net sales totaled $190 million, up 51% over the last year with each business unit contributing strong sales growth. After inter-company elimination, the Keurig business unit net sales were up 97% to $90 million and the Specialty Coffee business unit net sales were up 39% to $100 million. ….
The primary driver of the increase in net sales is the continued growth in K-Cup sales which were up over 79% on a consolidated basis. Sales related to the Tully's brand represented approximately 5.5% of the 61% increase in consolidated net sales and are included in the Specialty Coffee business unit results for the first time.”(1)

* GMCR is rapidly developing new channels for growth and market penetration

“In our third quarter we announced two new licensing initiatives. We licensed Con-Air Corporation to launch a Cuisinart branded Keurig brewed coffee maker during the first half of 2010. We also licensed Jardan to launch a brewer under its Mr. Coffee brand expected during the second half of 2010.

These initiatives are consistent with our fundamental razor blade approach to growing the business which focuses on getting brewers into more households in part by providing consumers with more looks, features, brand choices and price points. Both product lines will be co-branded with Keurig and designed to work with the 200 varieties of gourmet coffee, tea and hot cocoa packaged in Keurig's patented K-Cup portion pack.

With Keurig, Cuisinart, Mr. Coffee all offering Keurig brewed technology, we are seeing to maximize the visibility of Keurig and expand choices for the consumer, thus accelerating the adoption of single cup brewing into homes across North America.”(1)

* GMCR signed deal to sell in Wal-Mart

Wal-Mart is a huge new retail relationship for GMCR to sell the Keurig systems. Although Wal-Mart has a track record of cutting margins on the units it sells, GMCR makes most of their money through the proprietary K-Cup they sell. The Keurig system requires using the K-Cup to function and the owner must keep a supply of cups on hand.

* GMCR has attracted hedge fund interest [Look out for the squeeze, short sellers!]

“In a 13G filed with the SEC, Stephen Mandel's hedge fund Lone Pine Capital has disclosed a brand new position in Green Mountain Coffee Roasters (GMCR). The filing was made due to activity on August 19th, 2009 and Lone Pine now shows an 8.3% ownership stake in the company with 3,603,364 shares.”

Finally, it is very difficult to estimate how much impact all of these new initiatives will have in total. But I am confident that GMCR will have ample opportunity to blow away current sales guidance. That is information that should make any short seller pack up and go home. Or just buy a few shares and go along for the ride.

(1) GMCR, Q3 2009 Results Conf Call Transcript

The author has an order to buy GMCR at $54/share.

FHA is subprime

When it was discovered that Fannie and Freddie were insolvent due to the poor performance of mortgages, Treasury Secretary Paulson, as a condition of guaranteeing the debt, mandated that Freddie and Fannie shrink their portfolios going forward.

The government need another agency to step into the gap and be the guarantor of mortgages so banks would not stop mortgage lending cold turkey. The agency given that charge was FHA and since then the government has become "the market" in mortgages.

"The FHA now insures $560 billion of mortgages—quadruple the amount in 2006. Among the FHA, Ginnie, Fannie and Freddie, nearly nine of every 10 new mortgages in America now carry a federal taxpayer guarantee."

As a house shopper I have been waiting for the strictest lending environment to achieve the best purchasing deal. Yet in the winter of 2007 my mortgage broker approached me at dinner (at the time he was moonlighting as a waiter) and said "Nothing has changed, FHA is the new subprime".

Since 2007 FHA has gone from single digits market share to providing over 25% of the mortgages in the US market. It was thought that the FHA full doc process would prevent the widespread fraud that underminded the ratings on securitized packages of mortgages. Although fraud has declined, I hear from mortgage brokers is still ways to game the FHA mortgage approval system.

Who will pay for the flaws of FHA? You will.

"Federal law says the FHA must maintain, after expected losses, reserves equal to at least 2% of the loans insured by the agency. The ratio last year was around 3%, down from 6.4% in 2007.
If its reserves fall short, the agency is obliged to notify Congress, which could spark a commotion over the extent to which the government is funding losses in the housing market. Some housing analysts have said losses might lead the FHA to pull back lending, which has helped boost flagging housing demand."(1)

This is a big problem. The agency has been the stop gap in the housing market, but now the stop gap is going insolvent. Officials think it could go insolvent by the end of this year.

...Officials said as recently as May that they didn't expect to fall below the 2% limit, but home-price declines have exceeded those used to model their expected losses. Given the pace of those declines, "there is no way they will make the 2%" if the current study follows last year's methodology, says Mr. Lawler."(1)

Although the problems is obvious, the solution is not. Congressional mid term elections are coming up and the Republicans would so much enjoy yelling "spendthrift" at Democrats for making another federal enterprise insolvent in two years. At the end of the day, another back door bailout including a relaxation of capital standards and additional borrowing capacity will probably occur. But the Republicans and Blue Dog Democrats may be able to extract a higher required down payment requirement for FHA loans going forward, or stricter payment to income ratios for borrowers.

The author purchased SDS at $44.5.

(1) Wall Street Journal, Sept 4, 2009, "Loan Losses Spark Concern Over FHA" by Nick Timiraos

(2) "FHA ready to join Fannie and Freddie"

(3) Wall Street Journal, Aug 11, 2009, "The Next Fannie Mae"

Thursday, September 3, 2009

At the top of the hill on the stimulus: What's Next???

This is the peak of the stimulus...

Whatever money that has been made available has been spent...

* The "quantitative easing" performed with $300B of Fed spending will end in October. Will 10y Treasury Rates (which dictate mortgage rates offered by lenders) stay low???

* Over $800B of the $1.25T of mortgage debt to be bought this year has already been purchased to lubricate the housing market. Has housing bottomed???

* 3/4 of the $232 tax cut of the Obama administration has been doled out to the American consumer. Has retail rebounded???

* 1/2 of the $550B in "shovel ready projects" have been paid out

Banks have made their bed...

* Banks are expected to write off another $1T by the end of 2010

* The accounting rule grace period has ended and banks will need to bring $700B of off balance sheet assets on balance sheet

* The banks have paid back the TARP explaining that they are not in need of assistence. Can they go back to the government for another loan if the writedowns are enforced by conscientious auditors? What do you think the regulators will do this time when they come in for money? I think there will be at least one "accelerated wind down" scenario to play out.

* The banks paid back TARP, not because they want more freedom to lend to business in this difficult economic period, but instead because they wanted to freedom to curtail lending and preserve capital during this tough period.

* A non-TARP company loves to see a TARP trapped bank oblige the government and give out loans to the broader market because it means distressed assets to buy at a discount with less hassle later.

* The foreclosure moratoriums have all expired and all the mortgage modification programs have expended tremendous amounts of effort to offer reprieve to the overextended to minimal effect

* A wall of unprocessed foreclosures are mounting and the forecasted peak of homeowners entering the foreclosure process has not even topped out

Obama is facing a challenge to prove his metal...

* What more can Obama do? Better yet, what more can Obama and Congress push through without a revolt? Obama has already moved the public opinion needle from "Fearless change agent" to "Soft on big business". It would be a popularity killer to let opinion turn even further to point to "In Pocket".

" rates are very dependent on the Fed's purchases of $300 billion in Treasury debt that will expire in October and $1.25 trillion in mortgage bond purchases that will expire at year-end. Unless the economy stumbles, we're likely to see higher rates in the fourth quarter."

Government orgs to keep housing afloat are reaching limits

* Fannie and Freddie have a mandate to wind down operations

* FHA has so many deliquent loans that it will not achieve the federally mandated 2% capitalization requirement and thus will require a bailout

In Conclusion...

So what does this mean... is all downhill from here...

The author is long SDS at $44.5.

Tuesday, August 25, 2009

This really scares me

Just one year out from a major financial disaster, some of the most leveraged banks that recently lost billions of shareholder value are now looking to expand their trading operations again. What did we learn from the deleveraging debacle? Nothing.

Apparently even more banks than Goldman Sachs and Morgan Stanley want to get into commodities speculation. Soc Gen and Bank of America hardly seem like the type, but the opportunity to squeeze retail investors out of their nickels may be too great. In case, traders know that the place to make big money is where the volatility is. So I guess if you are down tens of billions of dollars you will be tempted to enter a market a lot of zig and zag.

Aug 31 Update: It looks like Citigroup does not want to be left out and is diving in head first too.

Friday, August 14, 2009

Stimulus Watch: Has China closed the spigot already???

As I have mentioned before, the massive stimulus program in China is driving much of the revival of exports in across the global, particularly in regional partners like Japan and South Korea and commodity producers like Brazil.

But has the Chinese government started to close the spigot of easy money already???

"The benchmark Shanghai Composite Index fell to 3112.72, as data showing a 77% decline in bank lending in July from June raised fears that banks may make fewer loans following record disbursals during the first half. The Shenzhen Composite Index fell 4.4% to 1052.51.

"Even though the Chinese government insists it'll keep a loose monetary policy, the reality may be that some credit tightening measures have already been implemented," said Ben Kwong, chief operating officer at KGI Asia. "The market is worried that a significant slowdown in lending means less liquidity and investors are taking profits."(1)

The evidence of the change might be represented by the recent turn in the Baltic Dry Bulk Index. The index is largely driven by the movement of raw commodities in international trade, and the recent surging demand from China provided a major boost to the index from January's historic lows.

There is still too little data to substantiate a change in the economic climate. But many estimates made by Brazil and even use manufacturers like Alcoa hinge on the sustained growth in China to offset economic stagnation elsewhere. It will be interesting to observe over the next few months if China will be able to maintain it's momentum with or without easy money policies.

(1) "Drop in Bank Lending Spooks Investors; a Fall Back Below 3000?", WSJ, August 14, 2009 by V. Phani Kumar

Sunday, August 2, 2009

The whole world is on Viagra

Last night I heard a story about a friend who looks after his 91 year old grandfather. My friend has a dilemma that even though his grandfather's health is failing because his advanced years, he continues to live the lifestyle of someone younger and more spry. In fact on more than one occasion he has found his dear old grandpa passed out in various areas of the house from overdoses of Viagra.

The global economy is experiencing a similar circumstance.

With US port traffic down...

Retail sales down...

imports and exports are down...

There is little sign of virility to the economic situation. Yet the global markets stay excited over the prospects of a turnaround in the face of this information. Why?

Artificial stimulation from bailouts and stimulus plans, of course.

Only $230B of the $787B US stimulus package has been spent to date. But US is far along ($700B) with the housing market stimulus executed with the 1.25T allocation to purchase agency debt. The US is also stimulating the housing market with $500B in purchases of securitized mortgage debt in the open market at exaggerated prices. Without this support, mortgage rates would rise and provide an additional disincentive for the anemic rate of home sales.

There are auto purchasing incentive programs in the US, South Korea, China, and Brazil. The U.S. , the last to adopt an auto purchase incentive program, "Cars for Clunkers" program has been expended from $1B to $3B in funding. The government rebate will be used in an estimated 500,000 car transactions this year in the US. It has been shown before that such stimulus only pulls forward future purchases. Maybe this time will be different...

In the U.K. the government continues to use quantitative easing to support the yield curve and keep mortgage rates down. The U.K. recently extended their quantitive easing program by authorizing another $50B in funds to attempt artificially depress interest rates.

China also is in the process of executing a $586B spending package to maintain economic growth. But this pales in comparison to the loose monetary policy underwritten by the Chinese government. In the first half of 2009, over a $1T in loans has been made, a 1000% increase over the previous year.

The overall stimulus in China has been massive. “They opted for a very quick fix,” said Stephen Roach, an economist and chairman of Morgan Stanley Asia. “Surging investment, fueled by the most rapid bank lending in history, accounted for nearly 90 percent of China’s G.D.P. growth in the first half of this year. And that is worrisome.”

Overall, with Japan, France, Germany, China and soon the US reporting Q3 growth and no top line growth across the whole bunch, it looks like ailing economy is dependent on special pills to stay in the game. Let's hope we don't over exert ourselves in the process.

Friday, July 31, 2009

Party on! The bill is on China!

Keep Rockin'!

In the US, Wyeth, JNJ, Time Warner, Conoco Philips, Alcoa, Intel and host of other companies all beat revised earnings with negligible top line growth and extensive spending reductions. So behind the glitter of good earning reports lie a litter of disgarded workers who are victims of CEOs trying to prove they can make their financial targets.

On one hand, employment numbers are being interpreted as showing that unemployment is easing. But it could just as easily be interpreted as not improving because people are falling off the unemployment rolls.

So what is the cause for optimism? The CEO of Alcoa pointed to surprising resilience in the China market driving sales growth in that region. Catepillar also noted an uptick in sales due to large capital expeditures for infrastructure projects in the Middle Kingdom. The world's largest exporter expanding raw material consumption and investment spending in the face of the largest decline in imports across the global economy in decades? Sounds strange.

Based on initiation of the China stimulus package, in the Q1 of 2009 China increased lending 1000%. Within three months, there were more cars sold in China than in the US for the first time ever. Commodity prices took off as manufacturers in China replenished inventories to prepare for the domestic recovery. The optimism is reflected in the Baltic Dry Index chart.

Yet the amount of goods moved within the US declined to 20% YOY levels. It is probable that this indicates a significant decrease in China's exports to the US.

Moreover, the world economy overall is so bad oil demand is very weak and no amount of stimulus has been able to change that.

On the other hand, even domesticly, China's economic strength looks suspect. China claims growth is at nearly 7% annualized. But electrical output, the most reliable measure of industrial capacity utilization, is down 5% annualized and indicates that there is less production occurring.

Better yet, China's new lending spree that is authorized by the central government is executed at the local level and according to reports is carrying up to $4T in debt. I do not dare speculate how that burden come to bear on the markets. But it is bound to have an effect some time.

For now, we can just enjoy the party. In fact the Chinese are opening 4000 retail stock market accounts a day. Over the past month IPOs have been white hot at offering. Sounds like 1999, I like the music, I even might do a jigg or two. But my money is staying on the sideline so this party will not end up left with part of the tab.

Wednesday, July 22, 2009

Economic recovery around the corner?

So much talk of a recovery...I decided to check some vital signals to verify the prognosis.

Forward indicators like the Baltic Dry Bulk index definitely show a slight recovery. I was caught short when I was read articles stating that all port traffic into and out of China had virtually stopped and shipping rates to China dropped to zero for the first time. Since then, demand has snapped back and the trend is clearly upward. This is a positive sign regarding international trade, but could just be a bounce due to the artificial support programs being implemented for the credit markets that allowed trade to occur that could not move due lack of supply of Letters of Credit in the market during the 4Q 08 and 1Q 09.

Next I looked at Warren Buffett's favorite indicator, rail car traffic. Across all indicators point to ~20% YOY decrease in traffic with no major upturn in product to be moved in sight. I think we can draw from this consistent 20% margin is that the consumer demand is not returning yet, and that retailers see no need to restock to previous inventory levels. This may also indicate that the upbeat earnings reports were achieved through extended cost reductions rather than top line gains or profit margin increases.

Finally, I looked at Conference Board LEI index to get a broader view of the issue. It seems that there is a significant pick up in economic activity that is not translating to consumer spending. The distorting factor with this index is that two of the leading components are stock market prices and interest rate spreads. Both of these components have been benefiting from significant government intervention in the banking sector and auto sectors. For the sake of the economy let's hope that government facilitation of the credit markets translates into real economic demand to make this uptick sustainable. Normally, those two events happen in the other order.

Overall, there has been a marked change in business environment, even if it is not evidenced in actual economic activity. The alleviation of fear is the first step to moving to a normal economic environment. Yet for Obama and Bernanke, it may serve more to bolster confidence based on perception rather than emphasize the facts and the sober reality.

Thursday, June 25, 2009

HSBC: Live by the accounting gimmick, die by the ....

In the first quarter, many banks announced surprised profits in-line with YOY profit returns. Unfortunately, in Q3 accounting tricks will cause sizable losses that will need to be covered by operating profits.

For Q1, HSBC reported ".. a jump in trading income, strong performance in Asia and a $6.6 billion gain on the falling value of the bank's own debt, which helped HSBC earn a pretax profit "well ahead" of the same period last year, the bank said in a trading update."

With the artificial support programs of the Federal Reserve coming online slowly and the credit crisis in full swing, the market value of HSBC debt liabilities dropped $6.6B in the quarter. Accounting rules allow companies with a decrease in value of the debt they issue to claim the decrease in value as a decrease in liabilities and thus claim a paper increase in profit on the decline, and HSBC took full advantage of it.

But did HSBC catch the spirit of this rule when it included is event as earnings? The catch to this rule is that it assumes that the 1) the decrease in the value of the debt does not correlate to the credit impairment and/or possible impairment of the ability of the company to service their debt 2) that the company is able to free the capital to retire the debt in the open market. HSBC generates a huge amount of cashflow, so their ability to service their debt threatened at this point. But considering their effort to maintain capitalization levels in the face of consumer finance losses, whether or not the company is in the position to retire the debt in the open market is entirely debatable.

Since HSBC reported their 1st quarter results, high yield corporate bonds and corporate bonds in general have been on a tear. Some high yield corporate bonds, particularly of financial services companies, have seen increases in value of over 50% since March lows. The junk bond rebound is evidenced by the performance of HYG since March, returning close to 20% return in three months.

In addition, HSBC will face additional losses due to accounting treatment of stockholder gains related to their Q2 rights offering.


Accounting gimmicks are paper gains and losses, but just as they glossed over Q1 pain they may cause additional strain when the losses are reported in unison with the consumer banking problems evidenced by home price declines, and increases in credit card default rates. HSBC should be expected to announce similar losses to the previous quarter in this lending area. But when the overall earnings are measured, accounting strategies will prove to be a double edged sword.

The author is short HBC at this time but has not chosen a short position to recommend.

(1) Breaking Views, July 21, 2009, "Loss in Translation" by John Foley

Wednesday, June 24, 2009

Commodity prices a "tell" for China's economy

Recently China has been viewed as a stand out in a horrible global economic situation. It has been peculiar that the world's biggest exporter has been able 7% rate of growth while other major exporting economies, Taiwan, Japan, Hong Kong, and South Korea, all suffered negative growth rates and negative annual growth targets. In response to this environment, Chinese government has mandated lending in the face of a massive drop in exports revenue.

Unfortunately, in traditional heavy handed approach by the Chinese governmenet, the lending has been indiscrimminately applied. Initial observations suggest that manufacturers have used the additional capital to build up raw material inventories without actual demand to produce for.

"The international media has been following reports of record commodity imports by China. The surge is being portrayed as reflecting China's recovering economy. Indeed, the international financial market is portraying China's perceived recovery as a harbinger for global recovery. It is a major factor pushing up stock prices around the world.

But China's imports are mostly for speculative inventories. Bank loans were so cheap and easy to get that many commodity distributors used financing for speculation. The first wave of purchases was to arbitrage the difference between spot and futures prices. That was smart. But now that price curves have flattened for most commodities, these imports are based on speculation that prices will increase. Demand from China's army of speculators is driving up prices, making their expectations self-fulfilling in the short term...."

Although I do not have the information resources to support this, I would be curious to know if Chinese companies were actually given incentives to borrow money based on their purchases of commodities, and took advantage of the situation to "arbitrage" the purchase domesticly with other market consumers. If anyone has any insight to how the Chinese stimulous package is being administered, chime in. But back to story...

The impact of this rash spending has been evident in the meteoric rise of the Baltic Dry Bulk Index since January even while shipping rates renewed their fall and exports are projected to continue to languish. Chinese firms are importing raw materials, even on decade low export levels. This situation led the CEO of Alcoa to point to China as the demand factor to turnaround abysmal aluminum sales for that company.

But there is evidence that Chinese firms, and foreign firms operating in China, are not planning to import as much as to speculate on the prices.

"And even though foreigners technically can't trade commodity futures in China, some of the world's biggest trading houses have found indirect ways to trade through local brokers. Non-Chinese firms are emerging as influential players on the country's four exchanges, including in soybean futures. "They are trading large volumes," says one bank analyst who follows the sector."

If China is speculating with stimulous money expecting renewed global demand, by the second half of 2009, it may not come. Surveys show that shipping rates could actually decline because of reduced purchases by Chinese manufacturers in late 2009. Moreover, just a technical or market mover related adjustment in commodity prices due to lack of real end user demand could cause significant pain or even unloading of commodity futures contracts if balance sheet issues arise at these speculating firms.

In any case, commodity prices appear to be a solid "tell" over the next six months regarding the effect of the Chinese stimulous and the Chinese economic growth story as scenario to end the global recession.

The author has taken no positions related to this post at this point.

(1) The world market for digging equipment will contract by more than a third in the first half of the business year

Thursday, June 18, 2009

Too early to turn to this TIP

Everybody is screaming about inflation and how it will destroy what little value we have left in our currency. I don't buy it. Unemployment is rising and houses are still only affordable to heavily leveraged or liquid rich guys.

But assuming we are headed for a time when housing bottoms, employment picks up, consumption upticks, and commodities prices come roaring back, are TIPS the best way to prepare ahead of time?

TIPS are treasury debt instruments sold to the public that designed to protect the buyer from problems of owning fixed income securities when inflation is eating away at yield returns. TIPS are just like treasuries, with a fixed yield for a fixed period of time. TIPS protect the owner by providing an adjusted interest payment based on the fixed rate by multiplying the inflation adjusted principal amount by the fixed interest rate. The amount of inflation adjustment is determined by semiannual adjustments (inflation adjusted principal = ((semiannual CPI + 1) * previous principal amount)). Thus as inflation adjusted principal grows, the fixed interest rate coupon paid by the TIPS security increases. (Details here)

How do you get into a TIPS position? There are two easy choices regarding buying TIPS. You can buy them individual issues directly from the Treasury at or buy the iShares Barclays TIP ETF (NYSE: TIP). Current TIPS issues track against the 10 year treasury. The TIP ETF is more attractive because it comprises of all the TIP issues outstanding. This gives a higher yield from the combination of securities than current issues sold from the Treasury. Also, with an average duration of 9.3 years to the TIPS issues held in the fund, investors will see significant protection over the next few years without siginficant volatility due to security rollovers to rebalance the fund.

Should you run out and buy TIPS now? The World Bank indicates that growth should be contracting through 2012. The world's largest container company, Maersk, indicates that the amount of containers moved has dropped tremendously due to decreases in consumer spending and that they do not expect the amount of consumer goods traffic to recover until 2015. With that perspective in mind, the threat of inflation is still a little premature and the need for protection from a security like TIPS may be muted for the next couple of years at least. But when prices start to move upward, it should be a core holding. Since CPI is a lagging indicator, there is an inherent lag in the adjustment of TIPS to the inflation incurred, giving the investor time. This advantage from the lagging indicator might be mitigated by increased demand at the TIPS auction because it is known across the market.

Ultimately, whether or not to buy TIPS depends on when you feel that inflation will become a key driver in the economy. Otherwise, in a deflationary scenario, it might be safer to stick with the paltry returns of the comparable 10-yr Treasury and enjoy the predictable yields.

To view current prices of the most recent TIPS auction results to find out what is available.

The author current does not have any position related to TIPS but expects to go long TIPS sooner rather than later.

Monday, June 8, 2009

To anyone who wants to retire soon...

Dear Uncle, Aunt or any Baby Boomer,

As a amatuer speculator/investor I am often looking for potential investments to suit all different tastes and situations. Since you have begun to transition to retirement I have been looking particularly at conservative, well managed investments that will give you comfort that your money is safe while you focus on service activities and other more actualize pursuits outside of the rat race.

As your unofficial, self appointed portfolio manager, I have two objectives for you.

First, maintain a steady, secure income.

To do this you must find securities with a high margin of safety.

Second, you must prepare for a high probability of massive inflation.

Unfortunately, finding a security that meets the first criteria puts you at risk for the second criteria. So a combination of securities can be assembled in the 20% of your portfolio that is speculative that may put you ahead of the game.

Since the first objective is more important than the second, I have assembled a list of securities that will benefit over the next year from the short term deflation of the asset unwind.

The following securities are all issued by companies with solid fundamentals that could withstand major downturns in the market for an extended period of time.

Ticker List
NYSE:JZL - Kraft debt
NYSE:JZT - Boeing debt
NYSE:KTH - Philadelphia Gas & Electric (Regulated Utility)
NYSE:XFR - Bristol Myers Squib debt
NYSE:JBI - Sempra Energy debt
NYSE:WRS - Westar Electric mortgage debt (Utility)

Thursday, May 14, 2009

Arsonists at the restructuring table and GM is burning

On May 13th Geithner finally put forward a plan to regulate the credit default swap market. Everyone knew it was coming, there was no surprise in the government extending their reach. But what it did not address is the new dynamic created by the CDS industry.

Recently Financial Times has reported that of the 34B USD in GM debt, a large majority of it has been hedged away by the bondholders using CDS and possibly other derivative instruments. Thus, it has been noted, that most bondholders currently feel there is a possibility of higher return collecting on their CDS protection than restructuring and hoping for a turnaround. This is the equivalent of not calling the fire department when your house is on fire because you feel that you can return more on insurance than the value of saving the home. Good math, bad corporate citizenship. There is a lot at stake with many families, corporate partners, and local government entities that rely on this industry to generate commerce. Thus when the government holds debt restructure talks coming later in May to achieve 90% committment from the bondholders, the wrong people will be at the table.

Instead, as a part of the new regulations for CDS, the contracts should also carry the voting privileges of the underlying instrument. Thus if you are a bondholder, and also long CDS to achieve a net short debt position, you should not have the right to vote in any restructuring event regarding the company you will profit from in default. Your debtholder rights should be transferred in percentage allocation to the notional value of your debt position hedged to all of those counterparies that have absorbed the risk of the default of the instrument. This will require a strong regulator body and a more sophisticated clearing system, or just strong legal punitive measures for non-compliance. But providing this transfer of rights is a necessary way to ensure you don't have arsonists buy a seat at the table when you vote whether or not to save a burning house. In this case, the burning house is GM.

Tuesday, March 31, 2009

OCD Stock Pick #3: TLK

This is the third in a series of stock picks for the stock pickers suffering from OCD who MUST go long in the world's most dangerous bear market...

As an OCD investor, to protect yourself from your ways, your only chance is purchasing at the correct time. In this time of economic turmoil, for an investor, OCD or otherwise, not to demand a discount due to unforeseen events is reckless.

Thus the author recommends previous pick that can be recycled for the OCD amongst us.

The author previously bought at $20.12 on November 20th, 2008 and recently sold at $26.55. Since that time, there is absolutely no significant news related to the company, positive or negative. The stock has risen and fallen with general market swings.

In the previous analysis the risk factors were the following:

1) Global market conditions
2) Currency risk

Since that time the IDR (Indonesian Rupiah) has actually strengthend 5% versus the USD. The oil prices have stablized, which probably provides a significant amount of support for the IDR.

The author recommends buying TLK again at a value discount of $19/share (9.34B market cap) and 11.1x FY2008 cashflow. (9.34B / .84B = 11.1)

Monday, March 30, 2009

OCD Stock Pick #2: ICE

This is the second in a series of stock picks for the stock pickers suffering from OCD who MUST go long in the world's most dangerous bear market...

The Intercontinental Exchange is a futures exchange regulated by the New York Federal Reserve that intends to become the premier clearinghouse for credit default swaps. Thus as unregulated insurance contracts decimate the financial landscape, the investor can benefit from the push to bring to transparency to this bidding process. ICE is even owned by a few of the major CDS brokers (i.e. JP Morgan and Goldman Sachs) giving it instant leverage in this new market.

Over the course of the year, there will be steady increase in business as the new regulatory framework is created for this financial instrument. Regardless of the red tape, there are huge market drivers pushing for CDS to be handled in the open market. First of all, no other instrument is available to hedge a fixed income instrument as credit default swaps. Considering the amount of fixed income securities outstanding the need for big banks to mitigate risk, the institution of this marketplace is a win-win for business and government.

With revenue growth near 50% YOY, ICE is benefiting from increased electronic trading. Even at this early stage for the market, ICE produces a free cashflow of $250m annually on 800m in revenue. The company holds net long term debt of only $300m after backing out $12B of cash and $12B of maturing liabilities.

In previous markets, this stock would be evaluated based on it’s growth potential at a high P/E ratio. The OCD investor needs to be defensive in their investment to receive desired feedback loop, thus purchase price needs to be evaluated as a measure of cashflow growth. ICE cashflow growth has been decelerating over the past few years from 60% growth from 2006 to 2007, and 25% from 2007 to 2008. Assuming only a 10% increase in cashflow growth this year, valuing ICE at 11x FY2009 cashflow yields a $3.6B market cap. Based on the market cap today of $5.4B at ($75/share), the OCD investor should place an order for ICE at $50/share. This price is also at technical support point and thus provides a likelihood for being executed and providing immediate positive feedback.

OCD Stock Pick #1: ADP

This is the first in a series of stock picks for the stock pickers suffering from OCD who MUST go long in the world's most dangerous bear market...

ADP is a payroll processor with long standing relationships and an excellent business track record. With the downgrade of GM, ADP is one of the only four industrial companies retaining AAA credit rating. The company generates $1.2B in annual profit and $1.5B in free cash flow with a $18B market cap ($36/share). Due to the high cashflow, the 3.6% yield is safe assuming no cataclysmic economic events occur.

ADP is a company that can be called “an original outsource outfit”. Companies often hand over their payroll responsibilities to ADP to make sure their employees are paid appropriately and on time. Therefore growth of the payroll business is directly correlated to the amount of people employed across industries. Considering the downside risks to the economy, a healthy margin of safety is necessary to avoid having an autistic tantrum if market turmoil makes this sleepy stock more volatile than what you are looking for.

The author recommends that those suffering from OCD to buy the stock at 12x a deep recession level free cash flow of $1.1B/year, producing a 13.2B market capitalization or $26/share.

Stocks for OCD investors

Stocks for those with Obsessive-compulsive disorder (OCD).

OCD, according to Wikipedia, is a mental disorder characterized by intrusive thoughts resulting in compulsive behaviors and mental acts that the person feels driven to perform, according to rules that must be applied rigidly, aimed at reducing anxiety by preventing some imagined dreaded event.”

Most people I know who invest in the stock market demonstrate the behaviors of obsessive-compulsive disorder.

The conversation between them and a ‘normal’ person goes something like this…

“Rough Market, eh?”

“Rough market” I reply.

“I bought XYZ at the last dip. I am upset. It went up a little but now it is lower than before I bought it. I am thinking of getting out.”

“Sure, definitely more downside possible.” I say.

“There could be some more downside, what do you think?” clearly nervous about the short term prospects.

“Sure, has been accelerating the unwind of the world’s previously biggest car company, previously biggest bank by assets under management, and biggest private insurer. I think that could cause more downside to the market.”

“What are you looking at buying?” OCD person asks.

Blank stare response.

The financial media, mutual funds, and maybe our mothers have conditioned us as investors to obsessively search for the next buy and hold opportunity. Millions of investors across the globe, like slaves to the financial system, scour the markets for the perfectly controlled positive feedback loop. Their stock purchase may come from a broker report, or a tip, or maybe individual research. They buy 100 shares of stock and if it goes up, then they buy 100 more. Then, if the stock goes up again, they repeat the cycle. If the stock goes down, they panic and exit. No entrance strategy, no exit strategy, and very edgy on the trigger.

Thus it is no wonder why so many people get so angry during bear markets. The behavior of the market is not meeting their expectations for a positive feedback loop, frustrating the desire of the regular fix to satisfy their obsessive compulsive desire for control of their environment.

The author does not recommend going long with a traditional buy and hold at this point. But lots of stock market investors just cannot wrap their mind around shorting or waiting for the demise of the automakers and most of the financials.

So as a community service for those with OCD who have no plans for correcting this portfolio- debilitating disorder, the author has chosen a series of stocks that should best benefit from current market conditions. Thus to address the impaired amongst us, I will recommend a few stocks, if purchased with a measure of discipline, that should provide a controlled positive feedback more often than not over the next year.

Author note: This post is not meant to insult those with Obsessive Compulsive Disorder but intended to insult those without the disorder who still mimic the traits in the stock market.

Author note #2: Stocks chosen for the OCD portfolio will not be included in the authors performance tracking because of the high risk of going long in the current market.

Wednesday, March 4, 2009

JP Morgan - Counting AIG Bailout Money as a Profit

If you are worried about where your TARP or any other bailout money is going, this press article on JP Morgan may provide a hint.

The opening of the article leaves out one huge product segment of the Fixed Income Derivatives product group, Credit Default Swaps (CDS). In fact this is a huge oversight, the OCC source shows that banks have a 87T OTC derivative exposure which includes fixed income derivatives and states that of the 16.1T of outstanding credit derivatives 99% are CDS. Why did Bloomberg not come out and be forthright about 20% of the derivatives market?

Moreover, over 40% of reported trading revenues derived from this segment of the derivatives market.

The bailout money for AIG CDS positions no sooner hit AIG's account before it was transferred to AIG's counterparties to settle collateral requirements for it's positions. With AIG posting $60B losses from CDS in the last quarter, there had to be someone on the other side of those trades who would claim a commeasurate gain.

As of Q3 of 2008, according to the Office of the Controller of the Currency (OCC), there are only 5 major CDS brokers amongst the US banks who hold 87% of the outstanding notional credit exposure. JP Morgan is largest one of those five.

Thus when the government provided $60B capital to AIG in order to meet collateral requirements for it’s counterparty positions, one can infer that the ultimate recipient was JP Morgan, and other major CDS dealers. This is the fallacy of the whole market. The government is providing AIG with funds not just to keep AIG afloat, but to support all of AIG’s counterparties from the systemic risk of not getting paid. But in providing this liquidity, the government is allowing JP Morgan to mark profits from bailout money originating at another firm while they hold on to the TARP money they received from the government.

What is to be learned from this? The systemic risk of the “Shadow Banking System” is being balanced by the US taxpayer. But it is not being communicated how many counterparties are also being saved by the single bailout of AIG and other major lenders. What astounds is that the market makers continue to perform solid business in the very instruments that could at any moment cause their demise if the government withdrew it’s support of the losing counterparties. This evidence underscores how dysfunctional the whole banking system is currently and how much more needs to be done to wean the banks with most CDS exposure from government funded settlements.

The author is long puts in JP Morgan.

Wednesday, February 25, 2009

Lessons from Benjamin Graham, Part #1

In the classic book, Security Analysis, Benjamin Graham presents an in depth thesis on how the "margin of safety" determines the attractiveness of an investment. Graham wrote the book based on a thorough analysis of one of the most severe investing environments of this country, the Great Depression from 1929 – 1939.

Currently our security market is on a downward trend comparable to that historic time. Looking at the historical data regarding the fall of earnings of the industrial companies during the Great Depression, you can see why there was a 90% drop in market cap from peak to trough.

But the analogy to emphasize is that the market is not near the end of the current cycle. In comparison, over 1929 to 1932, the Dow had equivalent to three consecutive 50% drops in value. The value of the Dow fell from par value of 10, 5, 2.5, 1.2. With this in mind 2009 may not drop by as much points wise, but the percentage loss will be equivalent to last year. In any case, the market is still very much on track to match the largest fall ever recorded.

So what to do?

To learn how to handle a potential future depression, it is wise to learn from the last one. When Benjamin Graham wrote Security Analysis, he did so to provide text to support most secure methods of investing based the test cases of the Great Depression. Benjamin Graham wrote…

The economy today involves faster business cycles due to technology, but still contains industries which hold promise to meet Grahams criteria of a stable enterprise. Using Graham’s profit data over the course of the Great Depression, it is observed that regulated utilities held 66% of their pre-Depression earnings. This is a quite impressive feat compared to 99% reduction of industrial company earnings in aggregate, and 100% loss of earnings for railroad companies on aggregate.

What is wisdom to be passed to the wise retail investor? Whereas the broader industrial sectors suffered seriously from decreased consumer consumption and capital spending associated with major downturns, the earnings of regulated utility industry remained relatively insulated. Although not very attractive for an equity investment where growth of profits is required for returns on a stock, this situation underlines the large "margin of safety" risk-reward propositions for fixed income investors of regulated utilities for the next five to ten years. As profits slide with the general economy, equity holdings for all companies will be comprised. But the debt holder of a regulated utility is not as concerned about a fluctuation in profitability as the ability of the issuer to continue to be current on existing claims. Thus, in these humble times, the prudent will buying securities in preparation for years of lean corporate profits, one place Benjamin Graham has told us this can be found is in debt and preferred shares of regulated utilities. (To be continued in Part #2)