Drachmas, Dramas and Destruction Amidst the Summer Doldrums

The summer doldrums are finally here. This is newsworthy, in part because most of the summer has been marred by intense market jitters and volatility, and in part because it's taken an olympic effort to force market participants into finally enjoying summer. As we enjoy the final hedonistic days of IOC sponsored entertainment, here's a brief recap of the volatile usual suspects who're currently off stage.

First, there's the seemingly unending uncertainty over whether there'll be a new Greek Drachma. Despite strong indications that Greece is about to fire up their own printing presses (non-compliance with bail out terms, contracting economy, etc), the odds are that they'll stay in the union. If Greece "fails", market participants will increase their bets on "who's next", which will lead to Euro zone bailouts becoming increasingly more expensive (let's face it, even the ECB acting as a backstop is a bailout), and at some point this would be universally acknowledged as unsustainable. Once accepted, this would lead to the effective end of the Euro zone, the end of German exports to the Euro area, and a drastic decrease in German sales further afield - this will prove vastly more costly to Germany than a federalization of all Euro countries' debt issues; in fact, federalism will strongly support German industry (through a combination of a competitive global currency, and a large supportive "home market"). Recent German economic data strongly supports this view, but, of course, political interpretation could deviate. But, after the doldrums, the odds are for more barely-face-saving covert federal underwriting of the currency, unless... Unless Greek leftists manage to convince their electorate that the Euro is only a tool and extension of an imperialist pax-Germanica engineered to funnel all riches back to the fatherland, and that freedom, while not free, can only be bought by being a sovereign capable of printing.

On other stages other dramas are being rehersed. There's the US election (which, again, is earning its reputation as the "best entertainment money can buy" - provided you like a nice tragedy), the CHF is busy crippling segments of Switzerlands' non-diversified economy (while all banks continue to suffer and taxation initiatives continue to erode Swizerlands safe haven status), China desperately tries to both promote and control growth while giving the appearance of addressing issues of income inequality and access/corruption (recent high profile efforts would, in the parlance of the theater, surely be considered farcical), resource economies continue as two-speed economies (despite recent price pressures), and finally there's a moribund Japanese economy - escaping criticism only because no one has the energy left to criticize it.

For the most part people are optimists. US politicians continue to promise solutions. Chinese living in big cities will happily inform you that if you look straight up you can sometimes see that the sky is blue. Safe havens and resource economies (sometimes one and the same) while losing diversification and undermining their future prospects are universally envied. And, Japan's ever increasing debt burden is priced by the markets as sustainable. The obvious argument is, of course, that none of this is sustainable and we'll soon witness wealth destruction on a massive global scale. Frankly, there are too many scenarios to analyze, and, in some cases too little good quality data, so opinions proliferate while facts remain hard to find, but here's a takeaway:

The US 30 year bond, yields close to 2.8%, but if the US economy falters (more than it's already done), and if yields approach Japan's then the present value of the long bond will increase by around 25%. Odds are this won't happen, the USA is not Japan, but if Greek's decide on sovereignty then the long bond will destroy the market value of all in its path. So, in a low volatility environment, while the sheeple are captivated by the Olympic spectacle, it may be the right time to “cheaply” hedge some bets, and, feeling inspired by the gymnasts, perform some straddles – one thing is certain, volatility will be back.

Gold

Gold.  The utility of this precious metal rests on its ability to be a concentrated form of wealth. Its immutable nature gives it a permanent shine – not just now, but throughout human history. Unlike silver and platinum, whose fortunes wax and wane with their industrial applications, gold's value is independent of its utility. Unlike precious gems, which can be subjectively graded and valued, gold is a commodity – capable of being perfectly standardized and objectively valued at a myriad of transparent, liquid, and interconnected global markets. Gold is the preeminent sign of wealth all over the world. Gold, hoarded in government vaults, underwrites geopolitical power and imparts a sense of tangible value to currencies.

Adopting a contrarian perspective on the long term role of gold is futile. To argue that humanity will leave gold behind and focus on new Apple products as the ultimate sign of wealth is nonsense – the current crop of the spendthrift ultra-wealthy will be encasing their new high-tech gadgets in bejeweled gold cases, and spinning gold taps to brush their teeth, while ordinary mortals will continue to aspire to own a gold trinket or two. The combination of an increasing global population and affluence will continue to drive the demand for gold as a display of status and wealth, while economic uncertainties will guarantee its place in diversified investment portfolios.

Gold is proclaimed as the panacea for a wide array of troubles. In politically uncertain times, gold is a perfect hedge. Its high density and value means it can be easily transported and stored, which is good news both for desert nomads and central banks, and it's widely acknowledged that in an inflationary environment, gold is a hedge. This last decade, “gold bugs” have been well rewarded for their appreciation of the noble metal. During an extended period of falling interest rates, decreasing dividends, and equity markets struggling to regain lost ground, gold has more than doubled in value. As a “doomsday” investment it has shown greater resilience than reserve currencies and government bonds, and we are still waiting for it to take its starring role as the lead inflation fighter.

Now, let's have a look at price action. From a technical perspective, gold has obviously been in a multiyear bull trend, notable price action includes very strong performance during the last half of 2007 continuing into 2008, followed by a sell off combined with high volatility for the rest of 2008.  2009 marked the beginning of another leg in the bull rally, with gold prices going parabolic in August 2011 before a “blow off” top later that month, followed by a false continuation in September. Since topping gold has remained volatile, and, while its trading channel remains hard to define, it is narrowing. If the current consolidation in gold continues and gold conforms to a “standard” breakout from a lower volatility environment, then gold should be set for its next directional move towards the end of this summer.

Despite gold's recent price corrections, it remains in a major secular bull trend. Major areas of support have been breached and the trend is questioned – the first area has been breached (around 1600 – corresponding to around today's level of 155+ on the above ETF, NYSE:GLD), the second area of support is around 1300 (which, with GLD ETF costs will probably equate to close to 130, as opposed to 125). While it's possible to directly trade off these areas of support, the lowest risk strategy is probably to sell puts targeting these supports – incidentally, December GLD 150 contracts are trading at prices offering a sound entry and a 3.6% holding period return, or about 9% annualized.  This would never amount to a serious leveraged gold play, but as an "exposure to gold", or perhaps even as a commodity exposure this, or similar trades, deserve allocation.

In closing, some time ago, back in March (when I first thought that we were seeing a constructive consolidation price pattern begin to form) I had a conversation with a long time "gold bug" about miners' expense ratios.  I confessed that I could not understand how gold could trade at more than twice its "cost" (many miners report costs of just a little more than USD700).  The economic argument is simple: supply will ramp up until equilibrium is reached; lower grades will be exploited, higher fees will be paid etc etc.  While I knew that this equation was subject to externalities, such as government regulations, and political risks, to name just a few, it's still hard to accept gold's "premium".  To help overcome aversion to overpaying for gold (ignoring its historical roles as outlined above), the two major considerations are:

1. While miners are claiming low productions costs, supply remains inflexible due to the sector's inability to access capital (basically, investor trust was all but destroyed in the multi decade secular bear market that preceded the current bull market).  It's also natural to conclude that today's capital markets present huge barriers to entry for any speculative capital intensive company.

2. Most mining operations exist in politically challenging environments.  Whether it's a threat of nationalization, or simply permit risks; gold mining is a high risk venture and demands a big risk premium.

Establishing a long position in gold today implies that you're buying into these arguments (an adverse capital market, and risks galore - both political and environmental).

Short - But Not Sweet (for the record)

Today has been a real capitulation day on several fronts.  Equity markets are down, commodities are weak (oil and gas have collapsed), and most sovereign Euro bonds are diving.  The US Fed's Mini-Twist response fails to address the slew of issues revealed by yesterday's US economic releases.  The recent pledge to bail out Spanish banks has, in the mind of bond traders, already added €100B to Spain's impossible debt burden, and clearly demonstrated that German "style" initiatives are nothing but super sharp double edged swords.  As market participants wake up to today's reality, and to make sure that we all know where we are, US banks are subjected to another round of downgrades (at this moment this is only conjecture, but the markets are currently trying to price in this probable eventuality).

So, is there anything positive happening?  Yes, we're finally having a purge.  Basically, today's price action makes more sense (in the face of negative news), than previous market reactions.  Political issues have clouded sound judgement for too long, and today participants finally came to their senses and acted as they should have... a long time ago.  Now the question is, will they over do it, or will they wake up to find that another government trump is in their hands?  Today's capitulation will only be rewarding if there's a middle way.

Still Twisting and Turning

This is a "for-the-record" type post and picks up on the topic of the previous entry,  "Operation Twist Is Totally Skewed" of 22 March.

As an indicator for the long term US Treasury market, let's use NYSE:TLT, which was around 112 at the date of the article and has generated two (interest based) "dividend" payments for a combined $0.5735.  Today TLT looks set to open around 123.50.  Shorting TLT has resulted in a loss.  Writing puts against the short position has more than covered the dividends.  Provided short term, slightly out of the money puts were written the total loss on the position to date will have been around 4-6%.

NYSE:NLY, being the largest agency mortgage REIT (and the issue with the most actively traded options), is a reasonable indicator for the agency paper market.  NLY traded around $16.20 on the 22nd of March, has paid a dividend of $0.55 and looks set to open around$16.50.  Some additional income could have been generated by writing slightly out of the money covered calls.  


On balance, world bond markets are still awaiting the final act of the ongoing Greek tragedy (The Final Act of an Entertaining Greek Tragedy, 30 January, 2012), and this last act has caused US treasuries to spike - now is the time to increase the short position (always remembering to partially hedge and generate cash to cover "dividends").  As to NLY and its ilk, maintain current positions, look forward to continuing dividends and establish partial hedges by writing calls. 

Operation Twist Is Totally Skewed

This post should have been about gold, but instead it's another macro impact study of US government initiatives in the interest rate market - this is in part because the gold story has to remain in draft format until some "opinions" have been delivered, and in part because global concerns are yet again focusing attention on the US long term Treasuries.  These concerns include a Chinese property implosion and general economic slow down, oil "inflation", and Euro zone credit issues (inquiring minds and anyone prone to worrying about economic facts, might even want to know who is going to make good on the Greek CDS).


Without further ado:


Anyone remember the purpose of Operation Twist? Good - you may want to skip the rehash and start with the next paragraph. Now, for those who failed to obsess over yet another attempt by Bernanke to resurrect the US housing market, here's a brief synopsis: late September last year the US Federal Reserve initiated a program to buy longer dated paper in an attempt to drive down long term rates; specifically, $400 billion held in short term paper (less than 3 years to maturity) was to be reallocated to longer term Treasuries. The program is set to finish this June. Lower yields in longer dated paper, as a result of increased demand by the Fed, should, the theory goes, "twist" the yield curve in favor of long term borrowers - AKA mortgage borrowers. 


Back to reality. First, without trawling through a huge amount of data, how does a $400 billion "spend" on longer dated Treasuries stack up? Spread over up to ten months, in an uncertain global economic environment where liquidity in the multi trillion dollar Treasuries' market remains without compare, a spend of this magnitude is still important. Beyond its purchasing power, and of greater importance in the near term, there is the obvious headline power of a Fed program, and the "promise" that on-any-given-day contrarians can be "punished". 


Trying to establish the medium term expectations that the Fed had for Operation Twist remains a challenge, but the Reserve Bank of SF published a working paper in February that tempts the reader to accept that a relatively minor effect of 15 basis points on the 10 year equates to "success". Extrapolating from Fed working papers (especially one that's not specifically dealing with assessing the effects of the current Operation Twist, but focused on comparing JFK's 1960s Nudge/Twist to Bernanke's QE1) is problematic, but at least we're dealing with Fed thinking/analysis and rationalizations. This time the "nugget" is that the Fed aren't likely to measure their success in the same way as the markets, or, for that matter, your average house owner. The Fed is likely to declare a 15bps impact over almost a year on the "10 year" as a "victory" - the rest of us probably won't be quite as excited, and now, with the return of higher long term yields, the program's headline power seems to be fading.


So, is this the end game? The US interest rate environment remains a very intriguing study. Conditions for a recovery in the housing market appear to be present - apart from the fact that the securitization markets (CMOs) are still in the process of being unwound and MREITs are decreasing leverage. As to banks... well, their traditional role (since the early 90s) has been to originate and bundle loans - a business that's still mired in law suits, and, perhaps inadvertently, hamstrung by the decreased spread c/o Operation Twist. This really is the point in time, a few months before the proposed end of the Twist, when it's become abundantly clear that the current skewed interest rate curve will, barring a global calamity, continue to steepen. 


Take an interest rate curve reverting to "normal"; a deleveraging financial system; and a US Treasury keen to "profit" from low long term yields (playing along with Operation Twist will have restrained their ability to act - maybe now they'll even consider perps and 50s, like the UK), and it all adds up to... more of the same. That is, the economy has to do what is fundamentally important, which is to continue to write off and deleverage. Operation Twist gave us a temporary skew, some time to act, but it wasn't a victory (no matter what the Fed says).


In terms of positioning, as the yield curve becomes steeper and spreads widen, maintaining a positive cash flow short bias on the long bond continues to make sense. As long term yields continue to climb it becomes imperative to be paid to maintain this short to offset interest expenses. Targeting the increasing spread also allows for some interesting trades in the agency paper sector.  Global concerns may affect these strategies in the short run, but the fundamentals now dictate a wider spread and higher long term yields.

The Root of All Evil (Mk II)

This is not meant to be a third party "prop", but there's a lot of supposed data and statistics in the report linked below.  As the stats are bound to affect the thinking of some influential participants, it's worth having a look.  Of course, this report links in well with the Root of All Evil post of 25 January, but also ties in with the more recent Old Tricks and Future Headlines post of 22 February where it was mentioned that, "...some high profile hedge funds that have been investing [in housing] for the past couple of years are now coming out “talking their own positions” - which tells us that they've filled up with all the cheap housing they can afford and now are looking for the rest of us to give them a profit."  


The basic idea here is that a turnaround in the US housing market is not apparent, and maybe a "touch" fabricated.  Anyhow, have a look, keeping in mind that what you're looking at are "statistics".


http://www.corelogic.com/about-us/researchtrends/asset_upload_file360_14435.pdf
   

Fickle Market Sentiments

Every time I think about posting I promise myself to focus on being "concise", and, I admit, every time I fail.  The markets always offer up news that needs to be interpreted, and each new event demands to be encapsulated within a theoretical framework.  Anyhow, without further disclaimers:

This is the last week in February, and it's hardly started, but does anyone remember the positive market sentiment that marked the first week this month?  I suppose that we should all become chartists and technical analysts and rise above the grimy world of headlines - leaving the world of sentiment driven investing to the masses, but, apart from attaining a Zen like state of mind, would it serve us better than striving to develop a robust theoretical framework based on fundamentals?

In the midst of the current market chop, it would be great to give some space to competing market analyses, and I would especially welcome commentary by advocates of technical analysis.  Right now, US Treasuries are trading up while oil is down - which makes perfect sense since the IMF just managed to convince everyone, again, that it's in a muddle when it comes to sorting out some type of effective European stability fund.  But, from a macro perspective this is not news, IMF inaction is a "given", what's important, for the Euro area, is greater stability on the back of existing pledges coming online via the ECB this summer.  From a global macro perspective, sell the Treasuries on spikes and buy oil on dips - what do the chartists dictate?

Current weakness in European equity markets fits the global macro view, so today's action makes senses, but what about the lower futures for the US markets?  Current US taxation legislation proposed by Obama has given participants cause for concern.  The US is the home of many competitive, truly international companies (not just outsourcing one-trick-ponies like Apple), whose prospects would suffer if current double taxation provisions were changed (one day the media will wake up to the fact that this is what the recent discussions are actually about).  It is almost certain that market participants will lose focus and forget about the importance of such proposed taxation changes, so, for the short/medium term - buy the dip!  Unless, of course your charts tell you otherwise.

To conclude, feel free to throw some technical trading interpretations into the comments section - or make your own post!

Old Tricks and Future Headlines

We have lived through an era of revolutionary change. Everything is different now than it used to be. Examples are too obvious and plentiful to mention, but how about these future headlines: “US a net exporter of oil”, “Chinese property investments sound”, “US housing market recovers”, “Euro soars past Greek default”, “social media transforms markets”, and “inflation is not a threat”.

First, we can't have all this good news without making the last headline a lie. But it's this headline which ultimately is a the rallying cry for all market bulls; we hear everyone say that, “inflation is not a threat” and monetary policy confirms that, at the very least, inflation is not the number one concern (even China is easing again – while everyone thought they were tightening in an attempt to control a monstrous property bubble). Decreasing reliance by the US on foreign oil supplies will be held to support the low inflation argument, but the other headlines surely imply an inflow of funds into markets, the accounts of companies, and pockets of consumers, so, inflation is coming – watch out!

Not so fast, let's have a look at the likelihood of these headlines, and current assumptions and misconceptions. Is the US really going to be a net exporter of oil? The quick answer is no, in the last few years the US has decreased its oil consumption while increasing both gas and oil production. It's largely “new” cheap gas which has helped control the price of WTI, created banner years for the pipeline partnerships, and, combined with a weak economy, lowered the demand for oil. But, gassification is far from cheap, and a moderate rebound in the US economy will show everyone that the US is still very much addicted to oil, and confirm that the US is not going to be a net exporter.

Apparently, the Chinese government has decided to act with reckless abandon and puff up the property bubble even more. The official rationale presented for lowering bank margins goes along the lines that, since the bubble has not burst for a couple of years, there was no bubble to begin with. This rationale is pretty simple to follow, and, remember, we are living in an era of revolutionary change, and it's almost impossible to think of anything more revolutionary than the rapid rise of Chinese economic power combined with a rapidly liberalizing domestic market. While it's tempting to accept this argument and conclude that there's no property bubble, there's another way to look at the lowering of margin requirements in China – what if the Chinese banks are under pressure because their loan portfolios aren't performing? As property developers and buyers default, the banks only have two options, either carry the properties or sell them. The Chinese government is still facing the Herculean task of controlling the bubble, and decreasing margins will make it possible for the banks to not burst the bubble by flooding the market.

As we conclude that the Chinese property market is being doctored to prevent an implosion, perhaps it's natural to have a look at how the US market has fared after “operation twist”. Bernanke is used to being charged with being ineffectual when it comes to fixing the US housing market, but now there are signs of life in the US housing sector – could this be due to the Fed skewing the yield curve in favor of mortgage borrowers? While it's not possible to pass a final verdict, the fact is that current long term yields are the same as right before the “twist”. Lately, market participants have linked the yield curve more to European issues than Fed policies. As to the US housing market, some high profile hedge funds that have been investing for the past couple of years are now coming out “talking their own positions” - which tells us that they've filled up with all the cheap housing they can afford and now are looking for the rest of us to give them a profit. When you're a star fund manager this usually works, at least in the short run, and it sure looks like there's a causative relationship between some of these announcements/publicity and recent signs of life in housing market. Analyzing the situation on a different level, it seems there are added incentives for banks to allow “short sales” , this will lead to additional supply, but also additional demand, but on balance this is good for the housing market. Balancing this recent positive spin and increased liquidity, Ginnie, Fannie and Freddie are continuing to bundle foreclosed properties and attempting to sell them. In the end, these auctions combined with increasing short sales are all going to show up on the US tax payers' bills, but in the short run, yes, the housing market looks set to head up.

Talking about fixating on short term solutions and kicking the can down the road, Greece surrendered its sovereignty and was rewarded by another bailout. To talk about “'default” at this stage is very passe and best left for mainstream media – who in their right mind compares a 70% or more write-off to a “haircut” – imagine yourself 70% shorter than you are today, even sporting a 1970's afro wouldn't save your life! Anyhow, will the financial markets experience any more convulsions resulting from this Greek tragedy, and, specifically, will the Euro retain its valuation? Yes, there will be more convulsions, and, no, the Euro won't retain its valuation. The bond offerings by the rest of the PIIGS will now be even less attractive, leading to increased demands on the ECB which will directly result in Germany, and whichever other Euro area countries economists imagine might be fundamentally creditworthy, to provide more funds and bigger guarantees. The events unfolding are leading to a federal Europe, and Greece's surrender of sovereignty will prove the model. The EU is on its way to a unified tax code (pleasing the single market/level playing field adherents) – in the end, as the PIIGS agree to centralization and oversight, German rejection of the “European bond” will seem unfounded, after all, German demands are being met and these countries are no longer in control of their own economies. Anyone thinking that this may be a pyrrhic victory, as the creditworthiness of Germany et al is diluted, may be partially correct, but Germany would be much worse off with low interest rates, a strong Euro and crippled neighbors. Kicking the can down the road has been very costly, but considering the price paid by Greece, and everyone else in the Euro area, there's little chance that the can won't one day end up scoring a goal for the federalists.

Our last headline, will social media save the world? Without offering an argument for or against, here's our nominated indicator, NASDAQ:GSVC at $16 and change, after spiking above $20 after Facebook announced its IPO filing. Also, the company has done another secondary at $15 – which is roughly the same price as its IPO last April. Conclusion: institutional investors are hopeful, but, in a weak market, are able to drive a bargain. When it comes to social media, it's easy to agree that “hope” is nice but not a good guide.

Since the February 6 post calling for market consolidation, the Dow has added about a hundred points, the Footsie a little less, and the All Ordinaries are flat, while the Nikkei is up 600 points and the Hang Seng is up an impressive 800 points. Along the way there have been consolidations and the outlook is for a bullish continuation as fund managers buy the dips in an attempt to catch up to the markets, all the while shouting for all to hear that inflation is not a threat.   

The Real Fundamental (Rant Alert)

Whatever your strategy and however you analyze opportunities, nothing is more important than position management.  Whether you prefer to think of this in terms of risk management, money management, or some slavish compliance with an asset allocation model imbedded in an obscure black box, doesn't matter - in the end, it's all about position management.

Thankfully, for most of us it's hard to come up with a series of real day-to-day risks negatvely impacting our ability to manage our positions.  Robust markets pride themselves on providing liquidity and managing counter party risks, and participants quickly flee issues, markets and counter parties that don't perform.  Fundamentally, if these risks can't be managed we can't place our bets.

Now, how many of us have scrutinized our contracts with the clearing houses and examined all the exceptional provisions, and exclusions?  Thought so.  Well, as a public service I'd like to draw your attention to the fact that the US SEC specifically prevents the punishment of lenders facilitating short positions who decide not to perform.  This "held harmless" clause results in all short sales surviving at the mercy of counter parties who've been given the right, by the relevant regulators, to manipulate the market.  If we examine the situation we'll quickly see how broken the system is:

1. you borrow from someone who's long and wants a bit of fee income,
2. you effect strategies based on your short position,
3. your clearing bank earns commissions all the way around,
4. the lender decides to pump up demand and, in effect, announces that all borrowers are subject to a buy in,
5. buy ins occur at the opening of the market the next day,
6. following the buy ins everyone is exposed on their hedges and the markets experience a huge "unwind" manufactured by a few longs.

Not being able to hold your clearer to an obligation, for which you're paying and prepared to keep paying, because any and all regulatory provisions trump normal business practice (in this case with an "held harmless" clause), incentivizes market manipulation and makes even the most fundamental position management involving short positions an unreasonable challenge.  To conclude, I suppose it's now "incumbent upon us" to add the manipulated short squeeze to the margin short squeeze plays.

As an addendum, the short I was denied was in long term US Treasuries via NYSE:TLT; the hedge was a rolling short 2-3 month put.  This was a core position which I'd maintained to profit from option premiums while also earning a little from a decline in long term Treasuries.  With the disappearance of the short position I had to cover the puts.  This coming week we'll get to see the full effect of this manipulated short squeeze (which started Friday morning) - the following week (Feb 20th), I'll likely re-establish this position.  If I'm handed mark-to-market returns again then I'll have to flee from this manipulated ETF issue and seek solace in shorting the underlying.

Reconciling Irreconcilable Differences: Printing Presses and Inflation

Intentionally, the title of this post brings to mind the challenges of a marriage on the brink of divorce.  The marriage, in this instance, is the one between the "Money Supply" and "Low Inflation Environment".   In dark corners of the market, persistent rumors can still be heard about how this couple have some serious issues...

Before pointing to the empirical evidence and simply dismissing the rumors, try to recollect the hordes of inflationistas, when Bernanke first pressed the green button, screaming that crippling inflation was "right around the corner."  Fine, now that the inflationistas have been deprived of media coverage and are standing on shabby soap boxes in dark forgotten corners of the market, perhaps it's time to revisit their argument, incorporate the new data, and proceed to demolish their flawed theories and declare the marriage of MS and LIE a blessed union.

First, acceptance of basic economic theory would make inflationistas out of all of us.  It's obvious, if more money is around, then people will be able to spend more.  Equally obvious is the fact that as people have the capacity to spend more, both the demand and prices for goods and services increase, which, obviously, means we'll end up with inflation.  In turn, central banks wake up and crank up rates to control everyone's profligate spending.  It would be fair to say that pre-2008 economists would, as an aside, throw in a few caveats, they might talk about  "increased productivity", "velocity", and "liquidity" - they might even talk about how hard it is to actually quantify the various forms of money supply, but it's not credible to claim that anyone would have called for low inflation year after year even as the presses run short of paper.  How unimaginable the current situation is, is clearly demonstrated by the round of higher rates imposed by central banks after the first round of easing - to combat the "inevitable" threat of inflation.  

So, what went wrong with the inflation theory, or, from the perspective of the MS and LIE union, what went right?  The consensus is that the "caveats" grabbed their chance of stardom and stepped into the spotlight: in China, Apple have indeed made some new stuff which translates into "increased productivity" (if we look really hard we may find other examples of increased productivity too); and money really did not go very far or fast despite the red hot printing presses, emergency central bank and interbank facilities.  Basel, in its various national incarnations crippled leverage and transformed banks from conduits into sponges, and, by the way, since your company is not Apple and able to point to "increased productivity", you can't, under any circumstances, borrow any of the money.  Economists can now declare victory, pointing to the combined impact of decreased velocity and a liquidity trap of truly historical proportions.  This victory preserves MS and LIE while burying the inflationistas and their simplistic theory in a grave simply marked, "Beware the Caveats".

Now for something completely different, how about we decide to forget about the inflationistas, economists, and central banks - let's walk into the nearest public drinking establishment and try to convince people to invest.  OK, this might not be very professional, but in terms of discovering what people think about investing its better than listening to the news or economists - remember, these fellow drinkers are your primary sources, and if you listen they'll tell you what they think (sometimes they won't stop... but that's another issue).  At the end of the night, or several nights (depending on the value you place on your liver versus statistical significance), you might conclude that people are more afraid than greedy.  

If the markets are driven by supply and demand, fear and greed, and if the average person has somehow managed to influence politicians, regulators and investment managers - then the lack of market speculation can solely be attributed to "fear".  People don't want to lose again, and they've learned that no one is to be trusted.  Markets suffer as pension plans become defensive, and money is withdrawn and more sensibly spent at the bar.  Of course, there are indicators that deal with consumer sentiment, but they are statistics (remember, we've learned that no one is to be trusted).  

So what is the conclusion?  Well, the MS and LIE relationship clearly shows us the power of the basic market components, fear and greed.  The inflationistas were wrong simply because people were afraid and stopped spending and gambling (the economic theory caveats played second fiddle).  No doubt, experts, especially economists and media pundits, will turn away from this Occam's Razor inspired explanation and come up with more complex stories, or seek to incorporate this fear into some complex economic theory, but there really is no need for complexity when there's a perfectly good common sense explanation.

And, by the way, irreconcilable differences do lead to divorce.  When inertia ceases to define the trend we'll move in a new direction, and the LIE will cease to be and MS will misbehave.  Now, let's do some research and attempt to predict a change in direction.

Option Reminder or Primer: Comments for the Week Ahead

Just a brief post to make a couple of obvious points - why bother you might ask?  First, what's obvious to some might not be to others - so feel free to debate the validity of the statements.  Second, it's always a good idea to have a look at the mile markers as you drive along... and this market has passed a few in the last month.

Global equity markets have rallied since the end of last year leaving many participants on the sidelines.  It's been notable that this has, on balance, been a low volume rally with commodities left behind while the materials sector (companies) have joined in the rally.  Low interest rates, increasing access to capital (both debt and equity, and M & A activity) could justify the divergence. 

Managers booking gains have found a strong market, and they have been incentivized to continue to hunt for bargains.  With a very average earnings season, bargains have become harder to find and the indexes stabilized towards the end of January, before continuing to trend upwards.  This latest move up is now showing signs of exhaustion with markets failing to string together daily gains.  While there are other signs of exhaustion it's worth noting that long term US government debt has recently traded down; also worth noting its very high volatility further supporting the "exhaustion argument".

Psychologically, bullish managers have been blessed with good performance this year, and an increasing IPO pipeline (leading to excitement, discounts and fees in all the "right" places), but now they are faced with having to "pay up" to maintain their market exposures - which quickly leads to a feeling of "chasing the market".  To conclude this brief market analysis, a contrarian perspective can account for the flattening of the short term trend at the end of January, while basic human greed probably accounts for last week's continuing moves higher (as managers started to worry more about "missing out" than "chasing the market").

So, we're overbought again!  Getting all the indicators to tell us that we're overbought and still seeing markets trend higher is a sign of a bull market, but the highest probability trade now is consolidation.  Reflecting on the nature of secular bear markets, it's also a good idea to keep in mind that while we take the "stairs" up we like taking the "elevator" down!

Now for the options' reminder/primer.  Consider selecting issues that have shown solid strength, but which are not - under any circumstances - takeover candidates.  Sell a straddle (put and option) for a combined premium that gives a nice technical entry price for the underlying.  Technicals for most issues should now provide good short term support in a deteriorating market, and global headline risks ought to prevent an outright bull rush.  It may be tempting to have a look at ETFs (mostly to develop strategic industry/sector/country exposure while avoiding the risk of being bankrupted by a takeover), but please view ETF technicals with a high degree of scepticism.

Perspective

Grand prognostications are always problematic, but the November issue of Scientific American had an article by David H Freedman, A Formula for Economic Calamity, which, inadvertently, highlighted some critical problems with basic analysis. To summarize, the article contends that the 2008 crash was largely brought about by inadequate mathematical models which failed to correctly assess market risks and protect participants.  Specifically, current models are both insufficiently sophisticated and missing relevant data. Considering the source of the article, Scientific American, it's acceptable that there's a “science can fix it" bent to the argument, but the most important lesson to take away from the article is that Freedman, and probably the vast majority of readers, clearly view the financial markets as a natural ecosystem and expect science to one day find the correct model. 


Financial markets are always being compared to “nature”, and the attempt to transpose robust scientific models to the field of financial analysis is a temptation that neither Goldman Sachs or regulators are able to ignore. Fundamental to this quest is an implicit acceptance that the markets are “natural”.   As is pointed out in the article, it may be that the data available to us is insufficient and current models aren't up to the task; this leaves us with the assumption that one day we'll have all the data and a model capable of handling the task.

Critics of financial modeling, black box trading algorithms, and even the dismal science of economics, tend to unite in announcing that the quantity and complexity of the data will always surpass our ability to both gather the relevant data and arrive at robust models capable of accurate predictions. With economies and markets booming and busting, hedge funds imploding, bank bailouts, and a slew of other unpredicted events occurring on a daily basis, the anecdotal evidence obviously seems to support the view of the critics. And, even the most ardent believer, has to accept that we currently live in a world without access to the right formula.

It would be easy to join the critics and conclude that the only defensible perspective is that markets are unpredictable and nothing can be modeled, yet this is simply an excuse to stop thinking and analyzing data.  Also, active participants recognize that there are models which work dependent on “market conditions”.  Concluding that we're having a bull run in a secular bear market turns high P/E ratios into red flags for fundamental analysts. If market conditions change, and the most widely held view is that we're in a bull market, then the same analysts will largely ignore P/E and look at other indicators – perhaps revenue growth and market share become the new favorites. Technical analysts are happy to accept that a chart formation in one type of market is a sell signal, while the same signal in a different market, or perhaps just a different security, can be a buy signal. To market participants it's clear: the nature of markets and securities dictates which models are useful/correct, and it's futile to apply one grand unifying model and attempt to reconcile these differences. As we have witnessed: it's no good to say that book values of 1:1 makes for safe investing; it's no good to say that when volatility increases the markets are about to correct (up or down); and “broken” correlations shout out that markets and asset classes don't have the cozy causative relationships we wish they had.

So, back to the Scientific American article, the belief that the markets are a natural system and that it is worthwhile pursuing a “correct” model is the main problem. Clearly, markets trade based on the actions of its participants, and market participants (whether they are central banks or day traders) act in accordance with their chosen models – so let's adopt a fresh perspective. Let's forget about attempting to develop a master theory that allows us to model all financial markets.  Let's turn our analysis up-side-down and assess which models are in the ascendancy and predict where these models will lead the markets. Let's maintain that the fluctuations of financial markets are not the behavior of natural ecosystems, but, merely, natural outcomes of the dictates of fit (from an evolutionary stand point – remember, we're trying to “borrow” from hard science here) financial models (which exist in an ecosystem of ideas attempting to gain supremacy and followers).  Models rule – markets follow.

An easy example: in a world where generally accepted models tell us Japanese government debt is a safe haven investment, this prediction leads to high demand and the models are “correct”, but in a world where our models tell us that Japan is hopelessly indebted and in risk of default – capital flees, and Japanese debt becomes junk. 

Interlude

Global equity markets have risen dramatically these last couple of months and many active fund managers have already logged greater returns than they did all of last year. The markets have overcome the fear that decreased liquidity in China would collapse their speculative property markets and cause an economic implosion; ramifications of a troubled Euro zone, perhaps even a Greece in default, was “priced in” last October; US employment data continues to improve; central banks are telling us that interest rates will stay low forever; and, to top it all off, the imminent launch of Face Book, at an astronomical valuation, confirms that we're all ready to start huffing and puffing and inflating another internet bubble, AKA “social media”. So, are all conceivable negatives “priced in” and we're forced to participate in the social media bubble or forgo any chance of gain?

Surprisingly, there are a couple of “old school” indicators confirming that the markets are solidly in the ascendency: first, US and German government debt is trading at levels indicating that participants are already highly risk averse (supporting the argument that much risk capital is sitting on the sidelines); and during the last two months there has been a narrowing spread between German and other Euro area yields, indicating a greater degree of confidence in the peripheral economies. Before concluding that the markets are about to enter another “virtuous cycle” it's worth having a look at commodities, which have been left on the sidelines (and this includes gold) these past couple of months. The latest rounds of QE, and promises of more to come, might also change the way government spreads should be analyzed – after all, who has been instrumental in narrowing that spread?

Finally, there's a $100 million company called GSV Capital Corp (NASDAQ:GSVC) that might indicate the importance and fate of the new social media industry. This company has several non-listed sector investments; traded around $14 for the last half year and popped up to $18 once the Face Book IPO surfaced (now it's back to $17 and change). Seems logical to contend that if GSVC triumphs it will be because risk capital is flowing into the market – now, let's see if Treasuries and Bunds roll over and commodities trade up – confirming the advent of a new virtuous cycle and an end to the current market interlude.

The Final Act of an Entertaining Greek Tragedy

The Greek bailout/default story continues to be a solid crowd pleaser with an easily recognizable list of characters and ability to be serialized.  Germany, the fiscally conservative powerhouse of the EU, in its role as the tragic hero, has said and done all the "right" things to no avail.  In fact, Germany's prescription of fiscal austerity has well and truly finished off the Greek economy, and our hero now realizes that the only way out is to jettison its principles and turn its back on history - AKA, "back Greece and print Euros".


For the international media this Greek tragedy has been a bonanza.  First, we've been presented with the shocking expose of how Greece cheated and lied to join the Euro (everyone knew this, but nothing beats simply republishing old material); second, we're brought the amazing story of how Greeks don't like austerity (really, who does?) complete with images of rioting in the streets (nice footage); third, the media happily brings us the news that government pledges turn out to be nothing but empty rhetoric (we are all shocked); and so on and so forth.  Together these episodes in this latest Greek tragedy are entertaining while adding to the audience's sense of inevitable doom.  Now, as the curtain rises for the final act, the audience sits in rapt suspense.


It is this rapt attention and suspense which is, in fact, the biggest tragedy.  From the very beginning, the main storyline has been the possible, probable, perhaps almost "certain" Greek default, but even in the first act in 2010 it became obvious that there was nothing uncertain about a Greek default - unless someone credible wrote a blank check.  In the process of presenting this tragedy the politicians and the media have managed the improbable - they have manipulated the audience to such an extent that the very meaning of the word "default" has become a topic of debate.  Everyone knows that if you don't service your loan and don't pay back the agreed upon final amount at the agreed time, there's a default (even rating agencies and issuers of CDS actually recognize this as a fact and not a topic of debate).  It really is tragic that there still is a sense of suspense; ask yourself, when was the last time anyone thought Greece could afford to service its national debt and raise new loans in the open market?  


In effect, everyone knows that Greece will default unless Germany agrees to write a blank check.  This conclusion rests on simple assumptions: first, the EU will need to continue to bail out Greece (the Greek economy simply can't service the interest payments and make the principal repayments); second, the debt markets are pricing Greek risk at a level which makes it impossible to refinance; third, out of all the Euro countries only Germany has the financial strength to write the required blank check.  If Germany does not write the check, Greece defaults.  If Greece leaves the Euro, Greece defaults.  And tragically, if Germany ignores its own lessons and writes the check, it'll scupper all appearances of EU fiscal responsibility and be inflationary.


On the way out from this Greek tragedy, it's tempting to place all bets on an inflationary spiral, but keep in mind the competing (not "competitive") nature of credit markets, and the "race to the bottom" by the world's leading currencies - after all, everything is relative.  Finally, who wrote all those CDS?

Feel Free to Comment

Feel free to comment - anyone can now comment. 

It turns out that restricting who can post comments caused some problems.  If there's too much spam then we'll look at ways to restrict who can comment.  For now, spam and "horribly" off topic comments will simply be removed.  Anyone having problems either posting or commenting please contact alloptstrat@gmail.com.

The Root of All Evil

The Fed now promises low rates well into the future. After the 24/25 Jan FOMC meeting Bernanke added more than a year to their previous “low rate” pledge. Ostensibly this is good news for everyone (unless you happen to hate gambling and would rather get some nice interest on some bonds, a CD, or perhaps your bank savings), but I'd wager that this is mostly another attempt to resurrect the atrocious US housing market, and provide the right conditions for government to address the negative equity trap - the post 2008 “root of all evil”. 


Every week I'm getting offers to buy houses in the Atlanta, Georgia area (single family units with a garage, a lawn and so forth) for around $50,000 – this is cheap by all standards and certainly cheap compared to the pre-foreclosure prices of the properties (which were typically $100,000 to $200,000). The fact is, before foreclosure owners pay what they can in the hope of getting out of the trap, and after foreclosure they're denied credit. I'd like to credit Bernanke with some basic human compassion and a sincere desire to ease the pain of those caught in the trap; from an economic perspective the global economy needs the return of its number one consumer and if the Fed can be instrumental in turning the US housing market around it would be a major victory. 


If it was easy to administer and trade a portfolio of Atlanta houses I'd make an allocation and take a gamble on a return to a period of “safe as houses” (aided by low interest rates courtesy of the Fed), but the complications and costs involved in transfers, tenancies and various filings makes this an unreasonable proposition. Looking at alternatives brings me to the mortgage REIT companies. The MREITs profit from low interest rates and provide some participation in the potential comeback story. There are complications, in fact there are quite a few potential problems on the horizon for these companies, to highlight a few: Freddie and Ginnie are under review and any changes to these participants will impact everyone; the Fed's buying and financing the purchase of mortgages – effectively competing for business and driving down the yield for mortgage investors, while low interest rates encourage refinancings (also decreasing the value of MREIT portfolios); and there are regulatory concerns which may result in MREITs being treated as investment companies and not simply another way to invest in property. All these issues warrant attention, but provided the MREITs continue to be able to finance their operations and maintain their leverage it's tough to ignore their double digit dividend payouts. 


Just in case this round of Fed “easing” is effective at getting to the root of it all – how about picking up some Annaly (NYSE:NLY) at around $15.80... or if it never gets there (towards the close today it's trading around $16.80) write an appropriate March put option and get in line for a dividend – provided dividends aren't cut that should equate to about a 14% annual payout - or simply collect the premium. 


 All for now, have a good weekend!

Welcome to the site!

As the site is new, please feel free to comment on the layout, content, etc.  Does the background make the site hard to read?  Do the "gadgets" make the site load too slowly - are they a waste of space?  Should we ditch Blogger and look for a better home?

With time we'll hopefully have some topical posts deserving of comments.  Here are some recent "big" issues I've tried to come to terms with (they should give some ideas for contributions):

1. The Euro vs USD debate.  The value of the Euro tells us that it's not important that Greece defaults, and that the ECB prints its way out of trouble - how can this be?

2. The Japanese Yen and Swiss Franc are viewed as safe havens, but aren't both economies fundamentally unsound?  Japan is supposed to be an export economy, but how can this happen/continue with such a strong Yen (and there's surely a government debt time bomb ticking away as well)?  Isn't the entire "safe-haven" economy of Switzerland undermined by a combination of EU/USA anti tax evasion initiatives, while its export/research sector crumbles due to the high CHF?

3. Corzine bankrupted MF Global with a bet on Portugal.  Back when Long Term Capital flopped they made a series of badly timed bets which ultimately paid off, and now it looks like some Lehman creditors are being made whole by cashing in their collateral.  This last week, US long term government bonds have fallen about 3%, is this the beginning of a narrowing of spreads in the government bond markets?

4. With earnings season well under way... why are the stock markets rallying, when all that is happening is that companies are, on balance, meeting their previously lowered earnings estimates while providing even lower guidance for the future?

These are big topics, and I'll probably mostly post on individual stocks, currency pairs, bonds, commodities, and trading strategies, but any and all efforts to tackle the big issues would be welcome.  Examining the macro environment and highlighting the next round of "probable" headlines will give us the edge and profitably lead us to safer shores.