Wednesday, February 22, 2012

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.   

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