Wednesday, April 7, 2010

Morning Note...

Futures ~30bps lower this morning as markets pause to catch a breath following the recent light volume, “melt up” action.  Further, Greek CDS spreads widened yesterday as concerns over debt default there resurface.  Additionally, Eurozone Q4 GDP was revised down to flat versus the prior +0.1% reading and UK Service PMI fell for the first time in five months.  Early on, markets this morning look likely to give back some of yesterday’s “post-ZIRP-for-some-time” FOMC minutes rally.  In corporate news, Family Dollar is trading higher on better-than-expected earnings and agricultural giant Monsanto is lower on profit concerns from weak Roundup sales.  NWS Chairman Rupert Murdoch is also back in the news, taking on GOOG and MSFT’s search engine for poaching news.  In geopolitical news, keep an eye on Thailand – they are back at it again, as Bangkok was declared a State of Emergency as protesters storm Parliament.  Overseas, speculation on yuan revaluation higher gathers momentum, as reports surface that “China has been alerting key exporters to potential risks and urging them to minimize their losses from a jump in the currency.”  Geithner is also due to meet with the Chinese Vice Premier on his way back from talks in India.  In Japan, the BofJ held key interest rates unchanged at 0.1%.  (Recall that Australia raised yesterday.)  The ten-year Treasury auction at 1pm today will be closely watched for weakness and levels of direct/indirect bidding (i.e. foreign participation).  Greenspan is on Capital Hill to testify before the Financial Crisis Inquiry Panel.  Incidentally, if you have not seen the April 4th NYT Op-Ed by Scion Capital’s Michael Burry (he of Michael Lewis & The Big Short fame) taking Greenspan to task for his past performance.  The subsequent response by Greenspan on ABC’s This Week is also an instant classic.  A google search for both is highly recommended.  Bernanke also testifies before Congress at 2:30pm today.  As for recent market commentary, ya gotta love Fred Hickey of the High Tech Strategist (also see Bill Gross’ recent thoughts in the quote section below):

The stock market is on another tear enabled by another round of Fed-supplied liquidity. As we know, easy money from the Fed drove the 1999-2000 tech bubble. The economy at the time appeared to be rocking and rolling. However, as I knew then, it was all a mirage. The manic stock market of 2000 eventually turned into the nightmare of 2000-2002 and the Fed stepped in once again, this time with their historically-low fed funds rate of 1%. The wonders of money printing, helped along by the government-urged elimination of virtually all credit standards created the real estate bubble, credit bubble and the decade's second stock market bubble.

Although the country continued to lose manufacturing jobs, a consumption-led boom fed by the trillions of dollars in real estate and stock market 'wealth" created by asset inflation drove service sector job growth (leisure and hospitality, finance, real estate, health care and government jobs). Consumers were able to extract trillions of dollars from their inflated home prices. At the peak, "cash-outs" through mortgage refinancings contributed nearly 10% of American's after-tax income. By the fourth quarter of 2005, 90% of the mortgage refinancings done by Freddie Mac increased the size of the original balances on the loans by 5% or more. At the end of 2009, U.S. household debt had soared to $13.5 trillion, more than double the level at the beginning of the decade. It was quite a party.

After the binge came the hangover, in the form of the asset bubble crashes and the worst recession since the Great Depression of the 1930s. All those asset-inflation inspired jobs evaporated. The past years' construction boom left a glut of unaffordable homes. There was no longer any need for all those realtors, appraisers, mortgage brokers and Wall Street CDO, CLO and other credit derivative peddlers. A record 8.4 million Americans lost their jobs. As we saw from last Friday's (March) employment report, 16.9% of the workforce remains unemployed or underemployed, with more than 6.5 million without a job for at least six months, an all-time high, according to the Labor Department. That's more than double the amount this time last year.

Out of necessity, Americans began to slow down their spending. The Federal Reserve reported last month that U.S. household debt fell 1.7% in 2009, the first annual decline since records have been kept (over sixty years).

To combat the deflationary effects of their blown asset bubbles, the Fed once again stepped into high gear, this time driving the Fed funds rate to 0% and taking the unprecedented step of printing up nearly $1.7 trillion of new money in order to buy an assortment of bonds (mostly mortgage bonds) and effectively monetizing the nation's deficit (for one year). More than offsetting the slight decline in U.S. household debt was an incredible 22.7% leap in U.S. federal government debt (to $7.8 trillion) last year, per the recently released Federal Reserve data.

In free market economies, recessions are necessary in order to purge the excesses (especially debts). However, thanks to the anti-free market actions taken by our activist government, (bailing out the crony capitalists, bailing out the fiscally irresponsible binge-spending consumers, bailing out the bankrupt state governments, bailing out nearly everyone except the fiscally prudent), we've had a severe recession, but made no progress in purging our enormous debts. Indeed, our country's financial position is worse than ever.

Yesterday, the guys at Hedgeye took on a similar, cautious tone:

With all of the debts we have created, we are most certainly going to inflate a lot of things in our lives - not the least of which is hope that this US stock market's +75.6% gain from the March 9th low is going to sustain itself.

I shorted the SP500 on Thursday. So far that position has not worked. It has gone 0.64% against me. It doesn't make me happy. It doesn't make me sad. I understand where my risks are, and I will deal with them accordingly. If I see any SP500 price north of 1192 in the coming days, I will short it again. If it holds 1072, I'll probably cover the position. If it doesn't hold, and starts to break down like the US Treasury market has, well... that's not a risk I'll be bearing.

After you see market melt-ups like this, the most difficult thing to reconcile is that immediate term tops are processes, not points. The more hope you see in the Manic Media, the more careful you need to tread on the high-wire of making sales. Not unlike buying in April of 2009, selling here in April of 2010 is not for the faint of heart.

Wall Street is all about selling stories, not risk management. In early February, after the SP500 dropped -8% in a virtual straight line from its January 19th high, we acknowledged the selloff for what it was - Wall Street and Washington "Selling Fear" - and we got longer. Now, after a +12.3% monster rally from the February 8th low, the only fears that remain are those of either getting squeezed on the short side or missing the next bull market in hope.

RBS ups AIB, IRE.  BBI ~30% higher on news of agreements with Fox, Sony, and Warner.  DRI raised at COWN.  CKR up 5% on takeout proposal.  FDO beats by 3c.  GSCO ups KEY.  UBSS cuts LVS.  PRXL cut at WEFA.  TSCO higher on earnings.  VZ denies VDO merger.  MSCO ups FINL.  BARD ups CBR.  UBSS ups NOK.  BCAP cuts NFLX.  Janney cuts ESS.  BERN bullish on C. 

Asia mixed overnight.  Europe roughly 30bps lower across the board.  USD +37bps.  Oil -50bps.  Gold +45bps.

S&P 500 PreMarket 8:30am (last/% change prior close/volume): 
EXCEED CO LTD             11.00    +12.47%           270
FAMILY DOLLAR ST        39.65    +4.92%             366102
KEYCORP                       8.88      +4.84%             101071
EOG RESOURCES           99.69    +2.37%             57709
MASSEY ENERGY CO       47.41    -2.15%              125445
CARNIVAL CORP             38.60    -1.86%              5500

Today’s Trivia:  As of February data, list the top five U.S. companies by market cap. 
Yesterday's Answer:  Traditionally Polish areas of the country such as Chicago observe Easter Monday as “Dyngus Day.” In the United States, Dyngus Day celebrations are widespread and popular in Buffalo, New York, Wyandotte, Michigan, Hamtramck, Michigan, La Porte, Hanover, New Hampshire and South Bend, Indiana.
Best Quotes:  “Pimco's Bill Gross: Winning a different 'horse' race (April 5, 2010)

There once was a family who lived in a fine house on Main Street USA sometime in the 1980s. It was a handsome house with a big yard and a white picket fence, but something always seemed to be missing. There was never enough of this or that – a fancier car, another TV, it didn't seem to matter – there was never enough. And so, the house came to be haunted by an unspoken phrase, “there must be more money, there must be more money.” The walls seemed to whisper it in the middle of the night, and even during the day everyone heard it although no one dared say it aloud. The chair spoke, the bedroom armoire, and even five-year-old Billie's toy rocking horse would eerily demand almost in unison, “there must be more money, there must be more money.”

One day, sensing the family's distress, little Billie asked his father, “What is it that causes you to have money?” “Well, you go to school, get a good job, and get raises,” his Dad said, “but these days there just doesn't seem to be enough.” But Billie, being just a little boy didn't understand and so he went off to ride his rocking horse, searching for the “clue” to “more money.” The horse was a special toy because not only did it whisper like the walls and the living room chair, but it seemed to answer questions if you only rode it fast enough. And so Billie would sit on top of his horse when no one was looking, charging madly up and down, back and forth in a frenzied state to a place where only he and his pony could go. “Take me to where there is money,” he would command his steed.

At first, Billie could not make the horse answer the way it had when he asked about Christmas presents or what kind of ice cream Mom would bring home from the store. Finding money seemed too hard of a question for a toy horse, but it made him try even harder. He would mount it again and again, whipping its head with the leather straps, forcing it faster and faster until it seemed its mouth would foam. “Where is the money, where is the money?” Billie would scream, and at last the horse in full gallop cried out, “borrow the money, borrow the money!”

At just that moment Billie's Mom came around the corner and into his room and his eyes blazed at her as he fell to the floor. She rushed to his side, but he was unconscious now, yet still whispering the horse's answer. He continued in that condition for the next 25 years, full grown, and confined comatose to his hospital bed. His family would visit, hoping for his revival, and then miraculously one day in 2008 he awoke with his father and mother at his side. “Did I find the money?” he asked, as if it were still the same afternoon. “Did you borrow it?” “We did,” his Dad answered, “but we borrowed too much.” Billie's eyes seemed to close at that very instant and he died the next night.
Even as he lay dead, his mother heard his father's voice saying to her, “My God, we became rich – or what we thought was rich – and we thought that was good, yet now we're poor and a lost soul of a son to the bad. But poor devil, poor devil, he's best gone out of a life where he rode to his doom in order to find a rocking horse winner.”
Adapted from a short story by D.H. Lawrence, “The Rocking Horse Winner”

For readers lost in the literative metaphor of another of my lengthy introductions to investment markets, let me connect the dots and suggest that it is symbolic of the perversion of American-style capitalism over the past 30 years – a belief that wealth was a function of printing, lending, and of course borrowing money in order to make more money. Our “horse” required more and more money every year in order to feed asset appreciation, its eventual securitization and the borrowing that both promoted. That horse, like Billie, however, died in 2008 and we face an uncertain and lower growth environment as a result. The uncertainty comes from a number of structural headwinds in PIMCO's analysis: deleveraging, reregulation, and the forces of deglobalization – most evident now in the markets' distrust of marginal sovereign credits such as Iceland, Ireland, Greece and a supporting cast of over-borrowed lookalikes. All of them now force bond and capital market vigilantes to make more measured choices when investing long-term monies. Even though the government's fist has been successful to date in steadying the destabilizing forces of a delevering private market, investors are now questioning the staying power of public monetary and fiscal policies. 2010 promises to be the year of choosing “which government” can most successfully substitute the governments' fist for Adam Smith's invisible hand and for how long? Can individual countries escape a debt crisis by creating even more debt and riding another rocking horse winner? Can the global economy?

The answer, from a vigilante's viewpoint is “yes,” but a conditional “yes.” There are many conditions and they vary from country to country, but basically it comes down to these:
Can a country issue its own currency and is it acceptable in global commerce?
Are a country's initial conditions (outstanding debt, structural deficit, growth rate, demographic balance) moderate and can it issue future public debt as a substitute for private credit?
Can a country's central bank be allowed to reflate via low or negative real interest rates without creating a currency crisis?

These three important conditions render an immediate negative answer when viewed from an investor's lens focused on Greece for instance: 1) Greece can't issue debt in its own currency, 2) its initial conditions and demographics are abominable, and 3) its central bank – The ECB – believes in positive, not negative, real interest rates. Greece therefore must extend a beggar's bowl to the European Union or the IMF because the private market vigilantes have simply had enough. Without guarantees or the promise of long-term assistance, Prime Minister Papandreou's promise of fiscal austerity falls on deaf ears. Similarly, the Southern European PIGS face a difficult future environment as its walls whisper “the house needs more money, the house needs more money.” It will not come easily, and if it does, it will come at increasingly higher cost, either in the form of higher interest rates, fiscal frugality, or both.

Perhaps surprisingly, some of the countries on PIMCO's “must to avoid” list are decently positioned to escape their individual debt crises. The U.K. comes immediately to mind. PIMCO would answer “yes” to all of the three primary conditions outlined earlier for the U.K. in contrast to Greece. We as a firm, however, remain underweight Gilts. The reason is that the debt the U.K. will increasingly issue in the future should lead to inflationary conditions and a depreciating currency relative to other countries, ultimately lowering the realized return on its bonds. If that view becomes consensus, then at some point the U.K. may fail to attain escape velocity from its debt trap. For now though, “crisis” does not describe their current predicament, yet that bed of nitroglycerine must be delicately handled. Avoid the U.K. – there are more attractive choices.
Could one of them be the United States? Well, yes, almost by default to use a poor, but somewhat ironic phrase, because a U.S. Treasury investor must satisfactorily answer “yes” to my three conditions as well, and the U.S. has more favorable demographics and a stronger growth potential than the U.K. – promising a greater chance at escape velocity. But remember – my three conditions just suggest that a country can get out of a debt crisis by creating more debt – they don't assert that the bonds will be a good investment. Simply comparing Greek or U.K. debt to U.S. Treasury bonds is not the golden ticket to alpha generation in investment markets. U.S. bonds may simply be a “less poor” choice of alternatives.

The reason is complicated, but at its core very simple. As a November IMF staff position note aptly pointed out, high fiscal deficits and higher outstanding debt lead to higher real interest rates and ultimately higher inflation, both trends which are bond market unfriendly. In the U.S. in addition to the 10% of GDP deficits and a growing stock of outstanding debt, an investor must be concerned with future unfunded entitlement commitments which portfolio managers almost always neglect, viewing them as so far off in the future that they don't matter. Yet should it concern an investor in 30-year Treasuries that the Congressional Budget Office estimates that the present value of unfunded future social insurance expenditures (Social Security and Medicare primarily) was $46 trillion as of 2009, a sum four times its current outstanding debt? Of course it should, and that may be a primary reason why 30-year bonds yield 4.6% whereas 2-year debt with the same guarantee yields less than 1%.

The trend promises to get worse, not better. The imminent passage of health care reform represents a continuing litany of entitlement legislation that will add, not subtract, to future deficits and unfunded liabilities. No investment vigilante worth their salt or outrageous annual bonus would dare argue that current legislation is a deficit reducer as asserted by Democrats and in fact the Congressional Budget Office. Common sense alone would suggest that extending health care benefits to 30 million people will cost a lot of money and that it is being “paid for” in the current bill with standard smoke, and all too familiar mirrors that have characterized such entitlement legislation for decades. An article by an ex-CBO director in The New York Times this past Sunday affirms these suspicions. “Fantasy in, fantasy out,” writes Douglas Holtz-Eakin who held the CBO Chair from 2003–2005. Front-end loaded revenues and back-end loaded expenses promote the fiction that a program that will cost $950 billion over the next 10 years actually reduces the deficit by $138 billion. After all the details are analyzed, Mr. Holtz-Eakin's numbers affirm a vigilante's suspicion – it will add $562 billion to the deficit over the next decade. Long-term bondholders beware.

So I'm on this rocking horse called PIMCO, a “co”-jockey appropriately named Billie, I suppose, and I'm whipping that horse in a frenzy, “The house needs more money, the house needs more money.” Hopefully my fate is not the same as the one created by D.H. Lawrence, nor is the horse's answer. Billie's rocking horse was a toy created in the 1980s and abused for two decades thereafter. Today's chastened pony cannot cry out “borrow money,” but simply the reverse – “lend prudently.” In today's marketplace, prudent lending must be directed not only towards sovereigns that can escape a debt trap, but ones that can do so with a minimum of reflationary consequences and currency devaluation – whether it be against other sovereigns or hard assets such as gold. Investment strategies should begin to reflect this preservation of capital principal by positioning bond portfolios on front-ends of selected sovereign yield curves subject to successful reflation (U.S., Brazil) and longer ends of yield curves that can withstand potential debt deflation (Germany, Core Europe). In addition, as increasing debt loads add impetus to higher real interest rates worldwide, a more “unicredit” bond market argues for high quality corporate spread risk as opposed to duration extension. In plain English, that means that a unit of quality credit spread will do better than a unit of duration. Rates face a future bear market as central banks eventually normalize QE policies and 0% yields if global reflation is successful. Spreads in appropriate sovereign and corporate credits are a better bet as long as global contagion is contained. If not, a rush to the safety of Treasury Bills lies ahead.

Above all, however, lend prudently, lend prudently if you want to be a rocking horse winner. And for you would be jockeys: be careful when you put your foot in the stirrups. Riding a thoroughbred can be a thrilling but risky proposition. Just look what happened to Billie – poor devil.

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