Friday, May 29, 2009

Inflationary fears appear overblown

Yesterday on May 28, 2009, David Rosenberg, formerly of Merrill Lynch and now at Gluskin Sheff, put out a note entitled “Buying Opportunity of the Year in Bonds?” He gives several reasons for anticipating a bond rally, here is an excerpt of his most important ones[emphasis mine]:

The yield curve (2s/10s) has massively steepened to 275bps. This is unsustainable and is going to flatten but the question is how? Will it be by the Fed raising rates and taking away the carry? With the unemployment rate heading above 10%, hardly likely. The output gap is so big that the funds rate, in theory, should be closer to -5% than 0%. So which entity is going to be the one that starts to take advantage of this massive ‘carry trade’?

The banks, that’s who. They are the ones with the cash — over $1 trillion on the balance sheet, which is not only a record but more than triple what was considered a normal level in the past. At the same time, even with private sector borrowing on the decline, the commercial banks have not added anything — nada — to their cache of Treasury securities this year. But, it’s one thing to have the curve at 170bps as it was four months ago and the huge 275bps spread the market is offering today. The banks have never before had so much cash to be put to work in the most attractive carry trade in Treasuries in recorded history.

Inflationary expectations appear well-contained
Given Rosie’s comment, I analyzed the returns of gold and equities against the U.S. bond market. The chart below shows the relative total returns of gold (as an inflationary expectations indicator) and the S&P 500 (as an economic growth indicator) against the iShare Barclays Aggregate Bond Fund (AGG), which is representative of the returns of the U.S. bond market. When the line is rising, bonds are underperforming and when the line is falling, bonds are outperforming.

Despite the uproar over quantitative easing, credit concerns, etc., gold has been moving sideways against bonds since the end of 2007. During the same period, bonds have been in a relative bull and outperforming the S&P 500.

With gold in a basing pattern relative to bonds, it is suggestive that inflationary expectations are still under control. With sentiment readings overly bullish on gold (see here and here), which is contrarian bearish, it confirms my previous view that:

The day for a sustainable commodity bull and the commodity supercycle will come – but not yet.

Technically speaking, the behavior of AGG vs. the S&P 500 indicates that bonds are still in a relative bull against stocks and I have to give bonds the benefit of the doubt, for now. The alternative scenario is just not plausible: The U.S. consumer is coming back, we are starting a V-shaped recovery and investors should therefore get very long equities.

Rosenberg could be right - we may have another leg up in the U.S. bond market over the next few months.

Wednesday, May 27, 2009

Between a rock...

Poor Ben Bernanke! On April 14, 2009, he gave a speech stating that the Fed was well aware of inflationary concerns and was ready to act upon them at the appropriate time:

I can assure you that monetary policy makers are fully committed to acting as needed to withdraw on a timely basis the extraordinary support now being provided to the economy, and we are confident in our ability to do so.

On one hand, Tyler Durden at ZeroHedge is wondering about how the Fed may have to further expand its balance sheet to accommodate the pace of Treasury and Agency issuance.

On the other hand, John Taylor (of Taylor Rule fame) has voiced concerns over rising government debt. Scott Grannis at Calafia Beach Pundit is wondering if the Fed should *gasp* tighten as the steepness of the yield curve is signaling rising inflationary expectations.

We are all watching you, Ben
This video, which circulated at the time of Bernanke’s appointment, was hilarious at the time. Now, it doesn’t seem that funny anymore (though it’s unclear who would have done a significantly better job as the Fed chair).

Whatever the Fed does, the market isn’t going like the results. These circumstances can’t be bullish for equities.

Tuesday, May 26, 2009

Start of the Great Commodity Bull Market?

Back in January, I speculated that Pound Sterling could be the canary in the coal mine. America’s problems parallel those of Britain, but the UK does not have the flexibility to be the issuer of a major reserve currency. With last week’s warning by S&P of the UK’s potential problems, investors started to extrapolate British problems to American ones, sending the USD, along with fixed income and equity markets, into a sell-off. Not surprisingly, commodity prices advanced in the wake of this fear.

Is it time for the Great Inflation to begin?

Nowhere to run
By my reckoning, this is a false start. Firstly, there aren’t that many alternatives to monetary reserves for central bankers. For a central bank, the alternatives of any size are the U.S. Dollar, the Euro and, to a lesser extent, the Japanese Yen.

Brad Setser’s always insightful analysis has indicated that central banks haven't abandoned Dollar assets. What’s more, is the Euro a viable long-term alternative for reserves given the Eurozone’s very public problems?

As Johm Mauldin observed, the European banking system is a mess:

European banks are in far worse shape than their US counterparts. That is because they utilize far more leverage, on an average about 30 times leverage. How can that be, in what is supposed to be a conservative industry?

[The analyst team at Variant Perception wrote:] “European banks were only restricted on the basis of risk-weighted assets, unlike the US where it is the total leverage ratio that matters, so most European banks bought assets that were rated by Moody’s and S&P, who couldn’t rate their way out of a paper bag, and for anything that wasn’t highly rated, they bought credit default swaps or guarantees from AIG and MBIA. Because of that European banks were able to lever up a lot more than their US counterparties. Given the much higher leverage levels and general worsening of collateral values, we think that all the shoes in Europe have not dropped.”

European banks have assets of about 330% of their GDP, compared to US banking assets, which are about 50%. They have over $700 billion in loans to Asian businesses (which are watching their exports collapse) and $1.3 trillion in loans to Eastern Europe, which is in a very serious recession, and so many of those loans are simply not going to be worth anything. Simply put, there is going to be a need for massive amounts of money to bail out European banks, or we’ll watch their economies simply implode.
The IMF recently urged Europe to do more to tackle the recession (see story here). Yet, Europe is gripped by typical EU paralysis:

European Central Bank policy makers clashed over the bank’s asset-buying program and prospects for a recovery less than a week after President Jean-Claude Trichet engineered a truce…

“The ECB Governing Council looks like a battlefield,” said Laurent Bilke, a former ECB forecaster who now works for Nomura International in London. “It would be simply ridiculous if we weren’t already in the middle of the worst recession in postwar history. But now it has more dramatic consequences. Trichet will have to restore some order.”
Why should the Dollar fall against the Euro?

No signs of higher global inflation…yet
For U.S. based investors, the news of the UK’s potential credit disease could indeed be troubling if it migrated across the Atlantic. American commodity bulls of all stripes no doubt rejoiced last week, thinking that inflationary expectations is on the horizon.

There are a number of signs that this is a false dawn. Bespoke reports that gold analysts not expecting inflation this year. Moreover, if there was truly an outbreak of rising inflationary expectations, gold prices would be rising in other currencies, not just USD. A look at the price of gold in EUR, JPY, AUD and CAD show a very subdued rise, indicating that global inflationary expectations are well under control.

The Economist recently published a bullish view of oil prices [emphasis mine]:

As soon as the world economy starts growing again, the theory runs, demand for oil will once again outstrip the industry’s ability to supply it. The seemingly ample cushion of inventories and spare capacity will quickly be exhausted, sending prices soaring. In other words, the global recession has only interrupted the “supercycle” of which many analysts used to speak, during which the normal boom-and-bust cycle of oil and other commodities would give way to a protracted period of high prices, as ever-growing demand from emerging markets swallowed everything the extractive industries could produce. “The commodity supercycle is not over, just resting,” says Mr Blanch.
The key is economic growth. Until we get a global economic recovery, it’s too early to get excited about the inflation play.

The day for a the sustainable commodity bull and the commodity supercycle will come – but not yet. In the short term commodities may have some more upside, as Bill Luby of VIX and More points out. Moreover, investor sentiment for gold, crude oil, copper, the CRB Index, etc. show rising bullishness but readings are not excessively high indicating crowded longs.

For those who are interested, I am writing a free commodity/inflation watch e-mail newsletter for distribution. I won't spam you nor will I sell your email address to anyone. You may sign up for it here.

Friday, May 22, 2009

Another Children’s Crusade?

In P&I there is an extensive discussion of the pros and cons of a core/satellite asset structure vs. a portable alpha structure for pension fund assets. My questions are:
  • Portable alpha overlaid on what benchmark?
  • How do you define core?

PBGC in trouble
In the meantime, I see in the news that the former head of the Pension Benefit Guaranty Corporation has refused to testify before the Senate and asserted his Fifth Amendment rights. He was to be questioned about his relationships with Wall Street firms and their relationships with PBGC.

By the way, PBGC's deficit has tripled to $33.5 billion.

What a mess.

A Children's Crusade?
As I indicated before, until pension funds have clearly benchmarked their liability structure and the factor sensitivities of that benchmark, the task of managing assets is may be as fruitful as the Children’s Crusade.

If you are not sure of where you are going, how will you know if you get there?

Wednesday, May 20, 2009

Higher inflation likely, but not hyper-inflation

Further to my recent post What if gold bugs’ fantasies came true, here is the latest comment from John Hussman [emphasis mine]:

The bottom line is that the attempt to save bank bondholders from losses – to provide monetary compensation without economic production – is not sound economic policy but is instead a grand monetary experiment that has never been tried in the developed world except in Germany circa 1921. This policy can only have one of two effects: either it will crowd out over $1 trillion of gross domestic investment that would otherwise have occurred if the appropriate losses had been wiped off the ledger (instead of making bank bondholders whole), or it will result in a stunning and durable increase in the quantity of base money, which will ultimately be accompanied not by a year or two of 5-6% inflation, but most probably by a near-doubling of the U.S. price level over the next decade. As I've noted previously, the growth rate of government spending is better correlated with subsequent inflation than even growth in money supply itself, particularly at 4-year intervals. Regardless of near-term deflation pressures from a continued mortgage crisis, our present course is consistent with double digit inflation once any incipient recovery emerges.

I concur with Hussman’s assessment that we will likely see elevated inflation levels. Weimar Republic or Zimbabwe style hyperinflation in triple or quadruple digits is unlikely at this point.

No free lunch
Milton Friedman famously said that there is no free lunch. It is encouraging that Obama has voiced concerns over the size of the deficit and its sustainability. It is also encouraging that he is getting close, but he hasn't uttered the word "sacrifice" yet. Meanwhile, the American electorate appears to be in denial over the sacrifices involved, which mean some combination of much higher taxes, fewer government services and lower Social Security and health care benefits.

Is California the future of America?
Down one road are the difficult adjustments that the U.S. and the world needs to make. Down the other road is inflation (most likely) and America going down the road of California's state of political paralysis. The Economist recently commented that [emphasis mine]:

California has a unique combination of features which, individually, are shared by other states but collectively cause dysfunction. These begin with the requirement that any budget pass both houses of the legislature with a two-thirds majority. Two other states, Rhode Island and Arkansas, have such a law. But California, where taxation and budgets are determined separately, also requires two-thirds majorities for any tax increase. Twelve other states demand this. Only California, however, has both requirements.

People want services and benefits, but they aren’t willing to pay for them. Something has to give (and the result is likely rising inflation). Here is a rant from David Merkel of Aleph Blog:

Those are trillions of dollars that we are looking at, and a 14% growth rate over the last eight years, significantly outpacing GDP growth...

We are viewing the slow failure of the US Government. It may not be for years or decades, but the lack of willingness of the current administration to address the growing shortfall shows that they are more similar to the Bush, Jr., administration, than different from it. After all, who ran the biggest deficits? Obama, by a long shot.

Watch this space. You may also want to sign up for my free inflation watch e-mail newsletter.

Tuesday, May 19, 2009

Do current incentive structures make sense?

On the weekend my family went to the new Star Trek movie. As I watched the film, I reflected on the effects that popular culture has on the incentive pay system, which has been a hot topic lately.

Should we looking for heroes?
The archetype of the hero in the movie is Kirk, the rebel and maverick who flouted the rules to get things done against the odds. He succeeded and became the captain of the ship. Playing against Kirk, we have the character of Spock, the logical and reasoned thinker (who will never become the captain of a starship). The Kirk hero archetype is a common feature in many Hollywood films and a common characteristic of heroes in American popular culture.

When we extrapolate those popular culture notions to how investment banks pay bonuses, does Kirk sound like the star producer and Spock is the risk manager?

This kind of thinking that as permeated not only American culture, which migrated across the Atlantic, has created a winner-take-all mentality. As a former colleague of mine once remarked, “It’s like an Olympics out there, if you’re not in the top three you are nothing.”

In support of this philosophy, Paul Kedrosky noted:

Well-timed conservatism is a fine thing, but there is something to be said for taking risks. Among the reasons why Bill Gates dropped out of university and started Microsoft and made billions when you know you're the same age as he is and you know he's not really that smart and Windows sucks and you can't stand the guy, is that he took a risk and you didn't. Elevating uber-conservatism into the highest virtue is no path to growth and wealth and all good things capitalism.
But do we really want to elevate the hero archetype that way? Is this the best way to incentivize everyone?

Sauce for the goose
Take the issue of compensation for government workers. Would Dwight Eisenhower have done a better job in World War II had he been given incentive bonuses to win the war? What about Norman Schwarzkopf during the Gulf War?

Do you get what you pay for?

Aldrich Ames turned over the CIA’s network of spies to the Soviets in exchange for a total of about $2 million. The initial payment that he received in 1985 was $50,000. Should the U.S. government be paying their people better? Had the CIA been giving people substantial incentive bonuses, could they have forestalled this intelligence disaster for roughly twice of what the CEO of Credit Suisse paid his ex-wife in interest in a divorce settlement?

Mediocre cavalry officers in charge of nuclear bombers
Dominic Connor, a headhunter, recently commented on the culture within banks [emphasis mine]:

A clear factor in the recent calamities has been the lack of expertise at the very top levels of banks. Reviewing the publicly available lists of board members at many firms, I observe that most of them not only have never taken an active role in trading, analysis or risk management, but that today few would even be accepted as a trainee in a less prestigious organisation than they ran into the ground. In effect we had mediocre cavalry officers in charge of nuclear bombers.

While it is important to create compensation and incentive structures so that originality and innovation are not stifled, we should not forget Paul Volcker’s comment that the most important financial innovation for most people years has been the automated teller machine.

Saturday, May 16, 2009

A new paradigm needed for pension management

In light of extremely weak returns for capital, there has been a spate of articles about how pension fund liabilities may be the next shoe to drop. Looking at the some of the sample headlines, the outlook appears dire:

Flying in a snowstorm without a map
Despite the trillions of pension fund assets around the world, what has puzzled me over the years is the utter lack of sophistication in the models used to model DB (defined benefit) pension liabilities. Until plans begin to better understand how their liabilities behave, we are likely to lurch from one crisis to the next.

Unless we understand how liabilities are likely to behave, investing the assets is like flying around in a snowstorm without a map.

A sample defined benefits plan
Typically, the pension plan has a board of trustees. The Board periodically undertakes an actuarial study of the liabilities of the plan. They may, at about the same time, conduct a study of the structure of the assets. At the end of the day, the Board compares the value of the assets to the value of the liabilities and pronounces the plan to be in surplus or deficit (and the value of the surplus or deficit).

A typical DB plan pays benefits based on some formula of final year(s) service, e.g. you get x% of the average of your last five year’s compensation. The amount may be subject to some inflation indexation, e.g. benefits will increase annually up to 60% of inflation, etc.

Total pension liability is the sum of the net present value (NPV) of currently retirees’ benefits, which is based on some mortality assumption of the retiree population, interest rates and inflation rate, and the NPV of the current workforce. The value of currently retirees is relatively simple to model, but I believe that current actuarial models do not accurately model the value or volatility of current workforce’s pension benefits.

To model the NPV of the current workforce’s pension benefits, the actuary looks at the age demographic of the working population and benefit formula. He then makes some assumptions about the workers’ annual salary increases and attrition rates (how many people die, get fired, leave their jobs, etc.) He then takes some interest rate and discounts those pension benefits back to a net present value to arrive at an answer.

Before I get flames and hate emails, I recognize that this is a gross simplification. Nevertheless there are a number of problems with this approach.

The model has few inputs: In classical economics, the three standard factors of production are capital, labor and rent. Workers’ wages are mostly a function of the relative demand for and productivity of labor and capital. Where is the productivity factor in this model?

The model is highly interest rate sensitive: Once you’ve assumed that wage increases are based on some standard formula, the only serious input into the equation is the discount rate and the inflation rate. Interest rates and inflation rates are highly correlated as inflationary expectations is a driver of long rates.

Are pension liabilities just interest rate sensitive?
Because of the assumptions built into these liability models, many pension plans that adopt an asset liability management (ALM) framework wind up with a very high fixed income allocation.

Are pension liabilities just interest rate sensitive?

If so, there would be little need for equities or other asset classes in a pension plan. I believe that pension liabilities are modeled incorrectly. This creates problems not only with the valuation of pensions, but with understanding their volatility and sensitivity to changes in economic conditions. Moreover, it lessens the effects that pension plan sponsors have played using differing return and discount rate assumptions to manage the stated value of pension fund shortfalls.

How not to fix the pension time bomb
If I am right, here are some ways of not fixing the pension plan time bomb:

Asset liability management: The principles of ALM have great merit – which is to model and manage the asset-liability surplus or shortfall. But how can you create an ALM framework when your liability model is broken?

Change from a defined benefits plan to a defined contributions plan: While changing from a DB to a DC plan gets future pension liabilities off the balance sheet of the organization, it doesn’t solve the macro problem if we don’t understand how pension liabilities behave. How do you advise individuals on how to manage their retirement assets if you don’t have the proper framework for modeling their pension liabilities? Is a 60/40 asset mix appropriate? Are life cycle funds even the right paradigm? If not, then will these potential pension shortfalls come back to bite us as a society when retirees wind up on social assistance?

These are all thought provoking issues. I would be interested to hear from any pension fund and actuarial professional who believe that I’ve gone off the deep on this. Please email me your comments at cam at hbhinvestments dot com.

Addendum: While we are on the topic of pensions, David Merkel at Aleph Blog has some interesting, though politically unpalatable, solutions for Social Security and Medicare. These are issues that need to be raised.

Friday, May 15, 2009

What if gold bugs' fantasies came true?

There have been a number recent of very bullish analysis on gold, with a target price in the $5,000 to $10,000/oz. range (for examples, see this, this and this).

I would like to explore the question of what happens if every gold bug’s fantasy came true. The endgame would not be a happy one and the roads ahead are arduous, even if you owned lots of the yellow metal.

Happily ever after?
Modern children’s fairy tales end with “and they lived happily ever after.” Unfortunately, real life isn’t like that.

Even if the price of gold were to go to the aforementioned stratospheric levels, there are several questions that a commodity bull has to answer before he can truly live happily ever after:
  • Does it even matter?
  • Will you get to keep it?
  • What happens afterwards?

Does it matter?
If you were long gold and gold went from $900/oz. to $9,000/oz. or more, does that make you rich?

The traditional reason to hold gold is that it is an insurance policy against inflation and the erosion of purchasing power from the debasement of paper currency. Gold is the constant in defining value. If everything else goes down, does that make you rich? What have you gained?

Gold is just inflation insurance. If your house burned down, would you hold a party and dance on the front lawn because you have fire insurance?

Do you get to keep it?
A skyrocketing gold price implies hyperinflation. Hyperinflation is often accompanied by political turmoil. Would political circumstances allow you to keep that wealth?

During these times of economic dislocation, society would be split between haves and have-nots. There would be searches for scapegoats under a populist government. When lynch mobs form, anything can happen.

Could you become a scapegoat?

As an example, not everyone suffered during the hyperinflationary days of the Weimar Republic. The holders of capital made out like bandits, while savers and suppliers of labor suffered. Those very painful market adjustments contributed to the rise of Nazism and Hitler. They had to find scapegoats. It just so happened that Jews formed much of the business class. In more recent memory, Malaysian prime minister Mahathir railed against evil foreign currency speculators during the Asian crisis.

If you think that populism and authoritarianism are unlikely to happen here, then consider this. In the wake of the controversy of prosecuting former Bush Administration officials over torture, the Fabius Maximus blog reports that many Americans are supportive of these officials and support some form of torture. What was more surprising is that in the wake of the My Lai massacre in 1972, the author notes that: “[i]n the twenty-four hours after the military court declared Calley’s guilt, the White House received more than 5,000 telegrams and 1,500 phone calls. The messages ran 100:1 in Calley’s favor.”

Put it another way. If you were the owner of a food and grocery store in New Orleans in the aftermath of Hurricane Katrina, did it make you rich? Would your inventory be worth a lot more in light of the shortages? The answer is “yes”. But if the mobs were at the door and windows, would you be able to realize your windfall profit?

Unless you are willing to hole up in the metaphorical compound in the wilds of Idaho, stocked with food, fuel, water and surrounded by razor wire and claymore mines, you may not be able to stick around long enough to enjoy your wealth under these circumstances.

Is this the lifestyle change you really want if gold goes from $900 to $9,000?

What happens afterwards?
Even if we were to assume that society doesn’t totally disintegrate, such a massive revaluation in the gold price would cause incredible economic dislocation. There would be a gargantuan number of bankruptcies and business failures, which will result in widespread unemployment.

Consider the case of GM and Chrysler. The reason why the U.S. government tried to step in was because of the substantial employment effects if these companies were to be shuttered. It’s not just about the direct employment of GM and Chrysler. If these car companies went down, such an event would also affect all the car parts manufacturers and their employees. Car plants and parts plants are located in specific parts of the country. That’s not all. Car dealers, which are located in every city and town in the country, would also be forced to close and lay off staff.

Multiply those car manufacturer employment effects by five to ten and you start to get the idea of the implications of a skyrocketing gold price.

It would cause a gigantic deflationary collapse.

As an investor, you would have to be nimble enough to sell out your gold holdings at the top and move into cash or other deflation hedge vehicles. Are you that good a market timer? Even Jesse Livermore, who was prescient enough to be short and profit from the market crash in 1929, lost his fortune by going long too soon afterwards.

An arduous road ahead
For gold bugs, a tenfold increase or more in the price of gold is the end of the road. It isn’t. The road beyond is incredibly treacherous.

Out of control inflation is likely to be followed by an episode of deflationary collapse. Be prepared.

This is an excerpt from my free commodity newsletter. I have posted it here at the urging of some readers. If you are interested in getting on the email list, please sign up here.

Wednesday, May 13, 2009

Are those “green shoots” growing?

Now that the equity market seems to be on teeter totter as it ponders its next move, I recently wrote that:

Now that prevailing sentiment has moved from “Armageddon is around the corner” to “green shoots”, the next turning point will likely occur when the fast money ponders the question of what happens next, now that we seem to have stabilized.

The next test
Certainly the macro picture is improving. There are sporadic signs of green shoots here and there. In addition to the US data, Brad Setser reports that there are also tentative signs of recovery in East Asia as the Korean data, which is the most timely, is pointing to recovery. After the close, we saw Intel, which is an economically sensitive semiconductor company, making positive noises about its 2Q outlook.

On the other hand, the Pragmatic Capitalist indicates that there is no sign of recovery in US rail traffic data. Moreover, Obama’s tax proposals could significantly diminish investors’ risk appetite (but then, someone has to pay for those enormous deficits).

The market has a way of saying “what have you done for me lately?” Now that a recovery is getting built into investor expectations, these negative fundamentals could prove to be a nasty surprise in the near term.

Watch out for the downside.

Monday, May 11, 2009

We are all socialists now

Richard Nixon once famously said “We are all Keynesians now.” Within a decade of that comment, Keynesian ideas had become largely discredited. Now, the world is turning Left after a long period of embracing free market ideas. Avner Mandelman noted with some indignation on this Leftward lurch:

What did Mr. Obama say? He said he stands with the unions against Wall Street, and vehemently faulted hedge fund bond investors for insisting on their legal rights in a bankruptcy.

I am not sure if you grasp how momentous this is. A U.S. president effectively said the law be damned, the sanctity of commercial contracts be damned, if such constructs cause pain to unions.

Indeed, the Economist recently commented that:

Rather than challenge dirigisme, the British and Americans are busy following it: Gordon Brown is ushering in new financial rules and higher taxes, and Barack Obama is suggesting that America could copy some things from France…

Is America that much a bastion of the free market? Barry Ritholz wryly made these observations about the differences between Europe and the US and asked "Who is the Welfare State":

-Europe has cradle to grave health care plans, generous unemployment benefits, and free or subsidized college costs.

-The US gives away public assets (oil, gas, mineral rights) for pennies on the dollar, has huge subsidies and tax breaks, and bails out reckless speculators.

Is the free market system, as it’s set up, broken? Tyler Durden over at Zero Hedge, claims to have found an article by Deepak Moorjani, formerly of Deutsche Bank, who wrote on the socialization of risk:

Our asymmetric incentive structure is fundamental to our problems. The question remains: Do we maintain the status quo and naively hope for better results, or do we begin to implement structural reforms in order to align the incentives? If taxpayers are forced to pay for the losses from bad trades, this socialization of risk adds to the moral hazard problem. This socialization of risk actually encourages more aggressive behavior in the future.

The call-option bonus structure has led to the ascendency of sales over risk management. Maintaining the status quo is not a smart bet, and we cannot afford to ignore the fundamental issues of structure and compensation.

I have written before on how to fix the asymmetry problem – bring back the partnership investment bank. Meanwhile, nothing changes on Wall Street. Paul Krugman recently commented:

Does anyone remember the case of H. Rodgin Cohen, a prominent New York lawyer whom The Times has described as a “Wall Street éminence grise”? He briefly made the news in March when he reportedly withdrew his name after being considered a top pick for deputy Treasury secretary.

Well, earlier this week, Mr. Cohen told an audience that the future of Wall Street won’t be very different from its recent past, declaring, “I am far from convinced there was something inherently wrong with the system.”

For too long, the Right hid behind the principles of the free market when it was to their advantage and now the chickens have come home to roost. This wave of socialization will pass in time. In the meantime, please stand and join in a singing of Internationale.

Thursday, May 7, 2009

Weak leadership imperils market advance

Further to my last post entitled Respect this market rally, there are further data points that point to a high risk environment for this equity market.

It is sometimes instructive to analyze market relative charts to see who the market leaders are and how the leadership is behaving. Technology had been standouts in the past few months. As the chart of the Technology Select SPDR ETF (XLK) relative to the S&P 500 below shows, the sector has been plummeting against the market and has broken down below a support zone.

Technolgy vs. S&P 500

The Financials had taken up the leadership mantle since the March bottom, but as the chart below of the XLF relative to the S&P 500 shows, the sector may be running into relative overhead resistance soon.

Financials vs. S&P 500

The best relative performers since 3Q 2008 has been emerging market stocks. The chart below of the iShare MSCI Emerging Market ETF (EEM) relative to the S&P 500 shows that it, too, is likely to encounter relative overhead resistance soon.

Emerging Markets vs. S&P 500

These pictures of faltering leadership and relative overhead resistance for recent leaders point to limited near-term upside potential for equities here.

Wednesday, May 6, 2009

Respect this bear market rally

The market action of this equity advance screams bear market rally, but I believe that traders need to respect the momentum inherent in this upswing.

Bear market rally!
I have characterized this move as a bear market rally before and I remain convinced that this advance does not represent the start of a new bull. There are many reasons for this.
  • In late April, Mish writing at his Global Economic Analysis blog outlined a number of technical indicators that suggest caution in the face of this advance.
  • Insiders are selling like crazy (see story here).
  • Market internals remain weak. Marty Chenard at his site, indicated that the number of new highs are surprisingly low considering the magnitude of this rally:

New Highs vs. S&P 500

  • Mark Hulbert’s newsletter writer sentiment indicators also show that sentiment has gotten bullish much too quickly – a contrarian bearish sign.

Don’t get gored by the bull
Nevertheless, it is important not to get overly enthusiastic on the bearish side.

Positive price action in the face of bad news is a bullish sign. Consider the whopping 17% advance by Bank of America’s common shares as news broke that it may need an additional $34b in capital.

There is a lot of fiscal and monetary stimulus that has gone to lift this market. Michael Feroli, a senior economist at JPMorgan Chase recently cautioned that:

It was a 2.2% uptick in consumer spending that prevented economic troubles in the U.S. from getting worse in the first quarter of this year. However, the consumer economy's apparent strength is misleading because it was fueled by lower taxes and transfer payments from the government.

His conclusions are correct in the longer run but incorrect in the short term. The chart below shows the increase in MZM in 4Q 2008. All that stimulus has to go somewhere…and it’s showing up now.

Todd Harrison of Minyanville sums up my sentiment best:

We must remember that a cornered animal has little to lose. The Federal Reserve and Treasury Department have thrown a lot at this market and seem intent on inventing mechanisms, printing currency and further diluting the definition of free-market capitalism. I learned the hard way in 2003 to respect those agendas, and it's a lesson I carry with me to this day.

What happens next?
Now that prevailing sentiment has moved from “Armageddon is around the corner” to “green shoots”, the next turning point will likely occur when the fast money ponders the question of what happens next, now that we seem to have stabilized.

Traders who are long should maintain tight stops, as this market could roll over any time. Traders who are in cash should probably stay in cash and not chase this market.

Sunday, May 3, 2009

Inflation watch linkfest

Fiscal trouble ahead?
From the FT:

The developed economies will continue to be confronted with huge national budget deficits, despite the fact that stimulus spending is likely to taper off, the International Monetary Fund says. The overall budget deficit of the Group of 20 nations next year will be 6.5% of GDP, only slightly below this year's 6.6%. Next year the budget deficit will be 8.8% in the U.S. and 9.8% in the U.K., the agency said.

Morgan Stanley upgrades their Chinese growth forecast
Morgan Stanley is upgrading their Chinese growth forecast from 5.5% to 7.0% for 2009(see here). This should be supportive of commodity demand.

Deflation risk is receding
Scott Grannis, who blogs at Calafia Beach Pundit, points out that inflationary expectations are rising again.

More on Simon Johnson
Here is a discussion of a left vs. right brain analysis of Simon Johnson’s analysis about the financial elites dominating policy. The logical (left brained) analysis says that there is no evidence of collusion by the oligarchs, or financial elite. The right brained argument is that this is a conspiracy – and conspiracies are set up to not leave any smoking gun evidence. You have to come to your conclusions by inference.

No signs of social backlash
I wrote before that we should watch for social signs of a backlash against Wall Street. The New York Magazine reports a quote from a Citibank executive as an illustration of the culture of entitlement:

No offense to Middle America, but if someone went to Columbia or Wharton, [even if] their company is a fumbling, mismanaged bank, why should they all of a sudden be paid the same as the guy down the block who delivers restaurant supplies for Sysco out of a huge, shiny truck?

Ryan Avent responds:

[W]hen you have a few people taking home billions, that’s a sign of either very good luck or some brilliant new strategy. When you have a lot of people in finance taking home billions, then something has gone badly wrong. Either something unsustainable is building, or there are some serious inefficiencies in the market.

So far, the populist backlash doesn’t seem to be gaining any momentum. So it looks like we will see another round of going into debt to reflate economy and sustain these imbalances.

Free newsletter for Inflation bulls
I reiterate my offer: I have begun a longer email list for inflation bulls. There is no cost and I will keep your email address to myself. Drop me a line and sign up here.

Friday, May 1, 2009


Light blogging in the next few days. I am moving and also busy with another project...

Back soon.