Thursday, March 31, 2011

Re-branding the oil sands

The headline in the Globe and Mail blared Ottawa fights EU's dirty fuel label on the oil sands. Indeed, Canadians have been getting pressure from a number of quarters in the environmental movement over the issue of how oil is extracted from oil.

I've thinking that this label of "dirty oil" could be just a problem of re-branding. The environmental movement has done this very effectively in the past. Consider how:
  • The jungle (think hot, steamy and snake infested) has now become the rain forest.
  • Swamps (aligators and mosquito infested, etc.) are now wetlands.
I was at a lunch last week with some investment bankers when one suggested that the whole process is one giant environmental cleanup. We are cleaning up a natural environmental disaster and supplying the world with energy, a win-win proposition.

There is a federal election in Canada. Is anyone listening to this idea? Will anyone stand up for the country this way and become Kaptain Kanada (which incidentally is another re-branding effort)?

Tuesday, March 29, 2011

Does the Pentagon have a downward sloping demand curve?

Greg Mankiw amusingly blogged that Even terrorists have downward sloping demand curves, because AP reported that:
When an admitted al-Qaida operative planned his itinerary for a Christmas 2009 airline bombing, he considered launching the strike in the skies above Houston or Chicago, The Associated Press has learned. But tickets were too expensive, so he refocused the mission on a cheaper destination: Detroit.

In the current US federal budget debate about cutting expenditures, the attitude seems to be that the budget of the Pentagon and intelligence agencies is off-limits. Indeed Mankiw wrote a New York Times Op-Ed with what he believes to be a presidential address in 2016 with the news that the nation is bankrupt:
MY fellow Americans, I come to you today with a heavy heart. We have a crisis on our hands. It is one of our own making. And it is one that leaves us with no good choices.

For many years, our nation’s government has lived beyond its means. We have promised ourselves both low taxes and a generous social safety net. But we have not faced the hard reality of budget arithmetic.
He went on to state he (the president) returned from an IMF meeting in Beijing and secured a loan with onerous conditions and went on to detail his (Mankiw's) prescriptions of what must be cut, but conspicuous by its absence is military spending:
We have to cut Social Security immediately, especially for higher-income beneficiaries. Social Security will still keep the elderly out of poverty, but just barely.

We have to limit Medicare and Medicaid. These programs will still provide basic health care, but they will no longer cover many expensive treatments. Individuals will have to pay for these treatments on their own or, sadly, do without.

We have to cut health insurance subsidies to middle-income families. Health insurance will be less a right of citizenship and more a personal responsibility.

We have to eliminate inessential government functions, like subsidies for farming, ethanol production, public broadcasting, energy conservation and trade promotion.

We will raise taxes on all but the poorest Americans. We will do this primarily by broadening the tax base, eliminating deductions for mortgage interest and state and local taxes. Employer-provided health insurance will hereafter be taxable compensation.

We will increase the gasoline tax by $2 a gallon. This will not only increase revenue, but will also address various social ills, from global climate change to local traffic congestion
Notwithstanding the fact that America spends about 50% of the global military budget, is there something wrong with this picture? Consider this story about the Pentagon threw away $17 billion to fight roadside bombs with little success, or this rhetorical question about Operation Odyssey Dawn: How many teachers will 112 Tomahawk missiles buy you? (At $1.4 million a copy, 112 missiles will buy a LOT of teachers.)

Mankiw believes that terrorists have downward sloping demand curves. It is unclear whether Mankiw, or anyone else, believes that the Pentagon does as well.

Monday, March 28, 2011

A European Lost Decade?

Last week, I wrote that the ECB appears to be overly focused on inflation and was ignoring the fragility of their banking system in light of the economic risks of tightening monetary policy. Now HSBC's chief economist Stephen King has echoed my comments in this Bloomberg story:
European central bankers agitating for higher interest rates to quell inflation may be ignoring the lessons of Japan’s economic history.
As the European Central Bank and Bank of England consider tightening monetary policy, HSBC Holdings Plc and Fathom Financial Consulting warn officials risk misjudging the inflation threat and may end up hurting their recoveries. That’s what repeatedly happened in Japan in the past quarter century as policy makers constrained credit only to reverse within months when expansion faltered.
“The danger is of a policy mistake,” said Stephen King, HSBC’s London-based chief economist and a former U.K. Treasury official. “In an attempt to control inflation this year they could set the scene for more disappointing growth in the future as happened in Japan.”
Meanwhile, the Portguese government has collapsed over a proposed austerity package. It looks like it is in need of a bailout and its bond yields are blowing out. What's more Standard and Poor's reported that European banks would need another 250 billion of capital in a stress test scenario and the Irish Times reported that the ECB has planned an emergency €60 billion for Irish banks.

It's a balance sheet recession
It appears that Richard Koo is right about balance sheet recessions. Not only America, but Europe is doomed for an endless loop of stimulus-tighten boom-bust cycles that we saw in Japan's Lost Decades.

Under this kind of economic backdrop, investors who use buy-and-hold approaches to portfolio construction are likely to see disappointing returns. I would advocate the use of models that trade these intermediate term swings like the Inflation-Deflation Timer Model.

Thursday, March 24, 2011

Back to the asset inflation trade

A week after the Inflation Deflation Timer Model moved from an "inflation" to a "neutral" reading, largely because commodity prices have rallied sufficiently for the model to return to an "inflation" reading.

As a reminder, the Timer Model relies on commodity prices as a barometer of global growth and asset inflationary expectations. Mark Thomas posted this chart at Economist's View that confirms our hypothesis.

These trend-following models have the unfortunate problem of occasional signals that whipsaw. Nevertheless, I must therefore respect the discipline of a well-defined investment process and re-orient the model portfolio to inflation hedge and growth vehicles, such as resource and emerging markets stocks.

Could this signal be a fake-out?
Deep down, I have some misgivings that this signal is a fake-out and a return to the risk trade is a just a product of reflex rally from a deeply oversold condition. The confirming indicators that generated the "neutral" reading last week remain in a neutral condition (see my previous comment here). Simply put, I believe that too much technical damage has been done for the markets to roar back to new highs.

As an example, the price of Dr. Copper has broke down from an uptrend and appears to actually be in a downtrend.

Similarly, the ratio of US Consumer Discretionary to Consumer Staple stocks as a measure of risk aversion also indicates that the relative uptrend remains broken.

Despite my personal reservations, I have found that the Timer Model's signals have in the past been better than my own opinion. Therefore I have opted to rely on the discipline of Timer Model instead. Were any additional risks were to arise, the risk control parameters of the model also allow me to define and limit portfolio risk.

Wednesday, March 23, 2011

A pending earthquake in Europe?

In the face of the earthquake in Japan, the BoJ acted to inject liquidity into the system. The Fed sounded somewhat dovish on inflationary expectations in its last FOMC statement.

By contrast, I wrote on March 3 that the ECB stated that it expected to rates to start rising as early as April. Since then, many analysts have pooh-poohed that statement by pointing out that the European periphery remains weak and the ECB couldn't possibly raise rates.

Trichet proved the analysts wrong when he stated that he "had nothing to add" to the March 3 statement that rates may rise as early as April, according to this Reuters report:
ECB President Jean-Claude Trichet said he had nothing to add on the bank's monetary policy stance to his comments at its last policy meeting on March 3, when he shocked financial markets by announcing that an April rate rise was possible.

Other European central bankers appeared equally hawkish:
Mario Draghi, who heads the Bank of Italy and is tipped as a possible successor to Trichet, said the ECB "remains prepared to act in a firm and timely way" to ensure inflationary risks do not materialise. Trichet's term as ECB chief expires in October.

In Austria, Executive Board member Gertrude Tumpel-Gugerell said the ECB was exercising "strong vigilance" on inflationary pressures -- repeating the phrase Trichet used on March 3 and which in the past signalled a rate rise was only a month away
Meanwhile, Portugal faces a crisis in April and Mish pointed out that the Portuguese government is on the verge of collapse. When I awoke on March 11 to the news of the devastating earthquake in Japan, what I found equally disturbing for the financial markets was that bond yields in the European periphery were blowing out.
If the ECB continues on their hawkish course, it risks destabilizing the financial system in Europe and set off another earthquake with aftershocks that could reverberate around the globe.

Monday, March 21, 2011

Poised for an oversold rally

I wrote about this trading model from Trader's Narrative before last week. The model, which uses the 50 and 150 day moving average in a rather unique fashion, moved to an oversold condition (ratio of 0.50 or less) and is in the process of rallying off that signal.

As I don't have the exact figures for the signals and for the market. I eyeballed the charts for the past instances of rallies off an oversold condition, it appears that such conditions have been good for rallies of at least two weeks and the magnitude of the rallies for those two weeks have been in the 5-10% range.

Sentiment models also offer support for the bull case. Sentiment readings from different sources also indicate that investor bullishness has pulled back from excessively bullish extremes. In some cases, they are at or near "buy signal" territory.

To be sure, geopolitical events surrounding Libya and Bahrain are likely to add to near-term market volatility. Nothing goes straight up or down, but if this trading model is correct then equity prices will have an upward bias for about two weeks.

Friday, March 18, 2011

The importance of disaster plans

Earlier in the week Barry Ritholz wrote about the importance of having a plan in the case of a financial disaster. Asking someone "what should I do" after the roof has fallen in doesn't work:
The time to look for the emergency aisles and where the exits are located is before takeoff, not after the wings fall off the plane. You must have a plan in place to deal with unanticipated events, a just-in-case things head south scenario.

Ideally, you put this plan together when you are objective and unemotional and calmly contemplative — not when things are figuratively and literally melting down.
While disasters aren't necessarily specifically forseeable, we do know that they do happen. With the onset of QE2, I have seen too many people focus only on the upside (e.g. rare earths as the hot new story du jour) without thinking about the risks involved. When markets de-risk and investors head for the exits, those without a risk management plan in place often get trampled.

Personal disaster plans
Stratfor recently wrote about the importance of a personal plan, which is equally vital [emphasis added]:
Those caught in close proximity to such a disaster site have the best chance of escaping and reconnecting with loved ones if they have a personal contingency plan. While such planning is critically important for people who live and work overseas in high-threat locations, recent events have demonstrated that even people residing in places considered safe, like Cairo and Tokyo, can be caught in the vortex of a crisis. Taking this one step further, sudden disasters, such as tornadoes, earthquakes, school shootings or the derailment of train cars carrying chlorine, can strike almost anywhere. This means that everyone should have a personal contingency plan.

Emergency plans are vital not only for corporations and for schools but also for families and individuals. Such plans should be in place for each regular location — home, work and school — that an individual frequents and should cover what that person will do and where he or she will go should an evacuation be necessary. This means establishing meeting points for family members who might be split up — and backup points in case the first or second point also is affected by the disaster.
There are some other important points in the Stratfor essay that is well worth reading.

What's your disaster plan?
Living in Vancouver, I recognize that I am in an earthquake zone and we have a stash of emergency supplies, e.g. potable water, etc. Financially, I depend on the Inflation-Deflation Timer Model, which is designed to limit losses in the case of financial crisis but at the same time allow winners to run.
What's your plan?

Wednesday, March 16, 2011

Someone called the cops to the Fed's party

Regular readers know that I believe that the Fed has been throwing a party, in the form of QE2. Valuations are getting stretched, but in the short-term, neither valuation nor macroeconomic conditions matter. Only momentum and liquidity does.

The key for traders, therefore, is to enjoy the party but to keep an eye on the exit. Well, it seems that someone finally called the police to the Fed's party and the cops are on the way. The first clue was given by the Inflation-Deflation Timer Model, which recently moved from an "inflation" reading to a "neutral" reading - a signal that investors should shift from the high-beta trade to a more neutral stance. The Timer Model, uses commodity prices as a barometer of global growth and inflationary expectations. Commodities have begun to weaken and have broken down through the uptrend which began in September 2010.

Cyclically important commodities such as copper also show a pattern of a break from its price uptrend.

Similarly, measures of risk aversion, such as the ratio of Consumer Discretionary stocks to Consumer Staple stocks, are behaving the same way.

The effects of QE
The chart below from SocGen shows a remarkable correlation between the Fed's balance sheet and US equity returns, which reflect the effects of quantitative easing. If you look closely, there appears to be a 1-3 month lead between quantitative easing program and stock returns. Assuming that QE2 ends on time at the end of June and it is not followed by QE3, now is about the right time to head for the exits.

Time to sell on strength
Tactically, the market appears to be oversold on a short-term basis. This model, which uses the 50-day and 150-day moving averages in a rather unique way, just flashed a buy signal on stocks indicating a favorable near term risk-reward ratio.

In addition, Mark Hulbert, who monitors newsletter writer sentiment, noted that his sentiment readings are flashing bullish as of the close on Monday before Japan cratered by 10.5% [emphasis added]:
At the end of February, for example, the HSNSI stood at 58.2%. By last Thursday night, this benchmark had already dropped to 49.1% — and since then has dropped even further to 43%. This is a surprisingly big drop, given that the Dow — at least so far — is only about 3% below its bull-market high, hit in mid-February.

This fear factor is even more in evidence among market timers who focus on just the Nasdaq market — an arena where the mood among retail investors particularly predominates. The Hulbert Nasdaq Newsletter Sentiment Index (HNNSI) currently stands at just 20%, down from 73% on the date of the market’s mid-February high.

This retreat of the bulls is not what is normally seen at the beginning of a major decline. If the bull market had truly ended at its mid-February high, and sentiment adhered to the typical pattern, then the bulls would have stubbornly clung to their positions — if not actually increased them in the wake of the decline, treating the market’s weakness as a buying opportunity.
This is looking a lot like Lehman...
While my inner trader remains relatively sanguine and is ready to take some risk off the table on market strength, my inner investor is whispering, "This is starting to look a lot like Lehman..."
Valuation and macro risks are everywhere. The Tobin Q ratio, a measure of the market value of equities to replacement cost, shows the market to be immensely overvalued. Jeremy Grantham's estimate of fair value on the SPX is about 900, compared to the current level of about 1,300.
Then we have to contend with stories of unrest in Bahrain, Libya, Yemen and, the elephant in the room, Saudi Arabia. On top of that, we have the risk of European default and the possibility of another downleg in the US real estate market.
Then there is China. The most recent report of a trade deficit was shrugged off because of poor seasonality. Maybe it's true, maybe not. The weakness in copper and other commodity prices is worrying as there have been reports that the Chinese have been speculating in commodities on margin and possibly pyramiding their positions.
All these reassurances that everything is fine sounds a lot like Ben Bernanke's assurance in March 2007 that the subprime problems were well contained:
At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained. In particular, mortgages to prime borrowers and fixed-rate mortgages to all classes of borrowers continue to perform well, with low rates of delinquency.
Prolonged weakness in commodities could send not only commodity prices, but investor confidence, into freefall. If the Chinese had indeed been hoarding commodities on credit and prices turned down, any orderly retreat would easily turn into a panic and, in the words of Dennis Gartman, "a margin clerk market" where everything is liquidated to meet margin calls and the correlation of virtually all asset classes converge to 1.

Investors should re-calibrate their risk tolerances with care. Traders can try to catch the rally but don't forget to define their downside risk control parameters.

Tuesday, March 15, 2011

A test of the Bernanke Put

As I write this, the Nikkei was down 10.5% on the back of worsening news about its nuclear plants. The STOXX has cratered 3.5% and most global bourses are down 2-3%. Dow futures are off over 200 points. Meanwhile, the bond market is on a tear.

Today also happens to be the day of an FOMC meeting. Going into the meeting, there had been some speculation that the Fed may come out with a more hawkish statement in order to bolster its own inflation fighting credentials.

...but then there is a problem of that "explosion" in Japan. Assuming that the tendency is for the Fed to become more vigilant on the inflation front, how would the FOMC statement reflect those concerns in light of the market turmoil? Aren't central bankers genetically programmed to be financial fire fighters?

This is a real-time test of the Bernake Put. All eyes should be on the FOMC statement at 2:15 EST.

Addendum: The BoJ has already take steps to inject liquidity into the system. Is the FOMC watching headlines like Bank of Japan Fails to Contain Investor Panic as Nuclear Danger Escalates? Stay tuned.

Monday, March 14, 2011

Nuclear vs. financial disasters

Over the weekend, I have been pondering the potential problems at the two Japanese nuclear plants after the 8.9 earthquake on Friday. In the grand scheme of things, any problem seems to be contained and damage is likely to be relatively minor - though the Japanese are by no means out of the woods.

Dr. Josef Oehman, research scientist at MIT, in a blog post comment, believes that "there was and will *not* be any significant release of radioactivity", largely because of the design philosophy:
When designing a nuclear power plant, engineers follow a philosophy called “Defense of Depth”. That means that you first build everything to withstand the worst catastrophe you can imagine, and then design the plant in such a way that it can still handle one system failure (that you thought could never happen) after the other. A tsunami taking out all backup power in one swift strike is such a scenario. The last line of defense is putting everything into the third containment (see above), that will keep everything, whatever the mess, control rods in our out, core molten or not, inside the reactor.
The whole comment is excellent, concise in explaining the fundamentals of the plant's design and what happened. It is well worth reading. Oehman went on to give kudos to Japanese engineering:
The earthquake that hit Japan was 5 times more powerful than the worst earthquake the nuclear power plant was built for (the Richter scale works logarithmically; the difference between the 8.2 that the plants were built for and the 8.9 that happened is 5 times, not 0.7). So the first hooray for Japanese engineering, everything held up.
The Japanese been expecting the "Big One" for decades so this earthquake was hardly a surprise. They have built much of their infrastructure with a major earthquake in mind. It is therefore a testament to their preparedness that a far more powerful earthquake (8.9) struck Japan and left it with a death toll in the tens of thousands (and much of that was from the tsunami and not the earthquake). By comparison, the 2010 Haiti earthquake was far less powerful (7.0) but produced a death toll of over 300,000.

What about financial earthquakes?
By contrast, the world went through a financial earthquake in 2008 when Bear Stearns and Lehman Brothers collapsed. So it was a shock when I saw Bloomberg report last week that an "International Monetary Fund report shows that regulators haven’t gone far enough in taming potential financial-market excesses since the economic crisis began."

The IMF report stated: "We are at the moment even less well-prepared than when the crisis erupted in 2007." [emphasis mine]

There are macro risks everywhere. Should another financial earthquake occur, it should not be a surprise to anyone.

Have we learned nothing? Where is the redundancy that is found in nuclear power plants? Where is the "defense of depth", or any defense?

Friday, March 11, 2011

A key technical test for the market

After yesterday's selloff, the 50-day moving average failed to halt the decline of the SPX, but the market is oversold on short-term measures.

The North American markets woke up this to two key pieces of news, which upon further reflection, may not be as bad as anticipated. First of all, global markets sold off on the news of the massive earthquake in Japan and there has been tsunami warnings issued all over the Pacific Rim.

Early indications are the tsunami has fizzled. Taiwan lifted its tsunami warning, as "the biggest waves that reached Taiwan after the earthquake were detected at Wushih,  in northeastern Taiwan's Yilan County, but they had a height of just 12 centimeters."

In addition, the much anticipated Saudi "Day of Rage" protest has fizzled because of a strong security presence.

Will the market continue to weaken or will these silver linings spark a rally? How the market reacts to news like this will be a key "tell" to the health of the bull.

Thursday, March 10, 2011

An optimistic view of MENA events

In a conversation with a friend, I was accused of being overly dark and pessimistic in tone in my writings. As a change of pace, I want to highlight a more optimistic view of the events in the Middle East-North Africa (MENA).

As we wait for Saudi Arabia's day of rage, which begin tomorrow, we could look over the valley of political unrest and look to Brazil and Latin America as a model of political transition, as per this report from Al Jazeera:
During Brazil's two decades of military dictatorship, it would have been unthinkable that a female former revolutionary would lead the country in the 21st century.

That transition, from autocracy to democracy, might offer some lessons for rebels across the Arab world, Brazil’s longest serving foreign minister told a forum organised by the Al Jazeera Centre for Studies in Doha, Qatar.

"Who would have thought an intellectual, a metal worker and a kind of revolutionary would follow a military dictatorship?" Celso Amorim, the former foreign minister and career diplomat, told a crowd on Thursday, speaking about Brazil’s former and current leaders.

"Whatever happens [rebellions across the Arab world] will create a new political situation in the Middle East. This is for certain," he said.
In a separate article that is well worth reading, Marwan Muasher, former foreign minister and deputy prime minister of Jordan, wrote that the recent unrest caught many observers by surprise (can anyone say "massive intelligence failure"?) and toppled many myths about Arab culture and economics (my comments in italics):
  • Arabs don't go into the street to protest
  • Economic liberalization should proceed political liberalization: Economic liberalization resulted in crony capitalism and a widening gap between rich and poor - a topic that I have written about extensively before.
  • Closed systems are necessary to prevent Islamists from taking power: Remember the Domino Theory in Southeast Asia?
  • Elections equal democracy: We learned that lesson when the Union Jack was taken down around the world after World War II. One man, one vote, once!
  • The international community has no role to play: Not sure if I agree with that. Too much foreign support, or meddling, robs a government of its legitmacy.
Enough optimism. After this rousing chorus of We Shall Overcome, back to your regular programming.

Tuesday, March 8, 2011

Crowded trades = Rising risk levels

Reuters reports that the latest Commitment of Traders report from the CFTC shows a crowded short in the US Dollar:
The value of the dollar's net short position rose to $34.9 billion in the week ended March 1 from $22.36 billion a week earlier, according to CFTC and Reuters calculations. It was the largest net short dollar position for which Reuters has data, dating back to June 2008.
The other side of the coin of the short USD trade has been the skyrocketing commodity price. Maryann Bartels of BoA-Merrill Lynch aggregated the COT positions for large speculators in the CRB Index and found that large speculators (read: hedge funds) are in a crowded long position in commodities.

In the short term, the news from Libya has also served to push up oil and gold prices. We are also seeing strong momentum and funds flows from traders continuing to pile into the cyclical or reflation trade. Despite the 3% drubbing taken by Dr. Copper yesterday, the CRB Index continues to rally to new recovery highs.

Nevertheless, this kind of sentiment backdrop represent high risk conditions for the stock and commodity markets. For traders who want to stay long, I advise a high degree of risk control in order to define the level of losses you are willing to bear. Meanwhile, enjoy the party.

What I am watching for: There have been rumors circulating that Qaddafi is negotiating the terms of his resignation. If that were to happen, oil and gold prices will crater and that will remove the geopolitical noise from commodity prices.

In the event that the Libyan risk premium contracts from recent levels, what I am watching more carefully is the price reaction of the entire commodity price complex to the market environment. It's not just energy and precious metals, but how the softs, agricultural and industrial commodities react for a sign of how market expectations of global growth and inflation are developing.

Monday, March 7, 2011

Tunisia, Egypt, Libya...Pakistan?

Tunisia, Egypt and now Libya. Now the markets are watching Yemen, Bahrain, Oman and Saudi Arabia for signs of emerging geopolitical risk.

Could the Davis Affair blow up the emerging markets risk trade?
Good investors know that one way to make money is to find a story on page 12 that eventually get on page 1. While I am concerned about the consequences of further unrest in the aforementioned countries, the page 12 story that I am watching is the potentially explosive nature of the Raymond Davis Affair* and the potential fallout on the emerging markets risk-on trade. The New York Times recaps the episode:
According to Pakistani police accounts, Mr. Davis was driving a white rental car on the congested Jail Road in Lahore on Thursday when two men on a motorcycle tried to rob him.

The American shot the two men, police officials said. Police accounts initially differed on whether the two assailants were armed, but according to the official police report released Friday, the police found weapons on the dead men. Mr. Davis did not have a license to carry a weapon, the law minister said.

Mr. Davis called the consulate for help during the episode, and a four-wheel-drive vehicle that tried to come to his aid hit and killed a third man, said a senior police official, Faisal Rana.
This seems to be the story of a caper gone wrong. Raymond Davis appears to be an intelligence operative who shot two Pakistanis, who are believed to be working for ISI, Pakistan's intelligence service. The backup team on the way to the rescue hit and killed an innocent bystander, panicked and left the scene.
The dispute between the US and Pakistani government is whether Davis had diplomatic immunity and could stand trial for murder in Pakistan. There is a further dispute whether Davis was acting in self-defense as some accounts indicate that he was not being robbed and in fact had shot one of the victims in the back while the victim was fleeing.

Here is the convential inside the Beltway view of the Davis Affair from Stratfor:
Pakistani officials have corroborated Davis’ version of events and, according to their preliminary report, Davis appears to have acted in self-defense. From a tactical perspective, the incident appears to have been (in tactical security parlance) a “good shoot,” but the matter has been taken out of the tactical realm and has become mired in transnational politics and Pakistani public sentiment. Whether the shooting was justified or not, Davis has now become a pawn in a larger game being played out between the United States and Pakistan.

When one considers the way similar periods of tension between the Pakistanis and Americans have unfolded in the past, it is not unreasonable to conclude that as this current period plays out, it could have larger consequences for Davis and for American diplomatic facilities and commercial interests in Pakistan. Unless the Pakistani government is willing and able to defuse the situation, the case could indeed provoke violent protests against the United States, and U.S. citizens and businesses in Pakistan should be prepared for this backlash.
In a separate comment, Stratfor wrote that operating in places in Pakistan is dangerous and therefore security officers like Davis are needed to run intelligence operations. Moreover, foreign intelligence services are not to be trusted in their entirety:
It is important to remember that in the intelligence world there is no such thing as a friendly intelligence service. While services will cooperate on issues of mutual interest, they will always serve their own national interests first, even when that places them at odds with an intelligence service they are coordinating with.
Remember Johnthan Pollard?

The alternative view
For some alternative views of the Davis Affair, consider this account from FB Ali (Brigadier, Pakistan Army, retired):
The facts of the incident that sparked all this are now fairly clear. Davis, in a rental car, was driving around in Lahore in areas where foreigners scarcely ever venture, tailed by two ISI auxiliaries on a motorbike. After an hour or more of trying to shake them off, they both came abreast at a stoplight. He pulled out a gun and, firing through his windscreen, shot them both. Accounts differ as to whether they made any threatening gesture, but one was killed as he was trying to run away.

The backup van that Davis called for came roaring up the wrong way on a one-way street, ran over a cyclist, killing him, then turned around and roared off. Davis was arrested, and weapons, ammo and other paraphernalia were found in the car. On his cell phone were numbers that were later traced to phones in the tribal belt where the Taliban operate, while his camera had pictures of religious schools and military sites.
For more analysis and discussion of the Davis Affair, see blog posts at Fabius Maximus here, here and here.

Why the Davis Affair matters
It appears that the Pakistani government would love to find a face saving way to let Davis go home, but the incident has become a cause celebre in Pakistan and has the potential to become a spark for unrest much like the Mohamed Bouazizi story did in Tunisia. In the book of analysts, Pakistan is at serious risk of becoming another Egypt as food price inflation rampages through their economy.

Should the Pakistani street go up in flames, what happens? How will it affect investor perception of India next door, a mainstay of the BRIC economies and emerging markets?

Could it be the spark for investors to de-risk their emerging market exposure? Stay tuned.

* Consider this following thought experiment. How would Americans have reacted if a British intelligence operative had been caught shooting FBI auxiliaries on the streets of Boston during the height of The Troubles on a mission against Provisional IRA terrorists? Would the State Department allow the British to claim diplomatic status retroactively for the intelligence officer? How much leeway should Americans allow the intelligence services of staunch allies to operate on thier own soil?

Friday, March 4, 2011

Managing extreme tail-risk market events

Are you worried about losing money in the market but don't want to miss the rally? That's the conundrum posed by my post Thinking bearishly, trading bullishly. In that post, I outlined my concerns about the market, namely:
  • Chinese slowdown
  • European sovereign risk
  • US municipal bond implosion
  • Further weakness from US real estate
On the other hand, my inner trader was staying bullish in the face of these risks because of bullish technical and sentiment readings. However, I remained highly aware of these extreme tail-risk events which could derail the markets.

CXO Advisory wrote a timely piece entitled Overview of Research on Asset Allocation in the Face of Disaster and they concluded that current asset allocation practices didn't have a clue of what to do in the face of these extreme events:
[E]vidence from surveys of relevant research indicates that academia has made little progress in finding practical ways for investors to protect even diversified portfolios from extreme events (crashes).

Market timing: Avoid extreme risk, but allowing winners to run
Under these kinds of volatile market conditions, allocating some funds into market timing strategies makes sense. Abnormal Returns also discussed different approaches to market timing, of which the Inflation Deflation Timer Model is one of the variants.

I know that the term "market timing" is a four-lettered word in some quarters, but given the current environment where extreme tail-events are more likely, buy-and-hold strategies are likely to lead to sub-optimal results.

Thursday, March 3, 2011

Get ready for rates to rise

The latest Beige Book report shows improving conditions and scattered instances of better pricing power [emphasis added]:
Manufacturing and retail contacts across Districts reported rising input costs. Manufacturers in many Districts conveyed that they were passing through higher input costs to customers or planned to do so in the near future. Homebuilders in the Cleveland and Atlanta Districts noted rising material costs, but acknowledged little ability to pass through the costs to buyers. Retailers in some Districts mentioned they had implemented price increases or were anticipating such action in the next few months. There is little evidence of wage pressures across Districts. Wages remained steady in the Boston, Philadelphia, Cleveland, Kansas City, and Dallas Districts, while moderate wage pressures were reported in the Chicago, Minneapolis and San Francisco Districts. Philadelphia, Dallas, and San Francisco noted that most wage increases were for workers with specialized skills.

Better pricing power is a precursor to inflation - though the reported acknowledged that wages pressures was relatively weak. If we continue to get reports like this and oil prices back off so that they don't create a recession risk, then QE3 is likely off the table in 2H.
Meanwhile, across the Atlantic, the ECB may be getting ready to raise rates as early as 2Q, barring a revolt by the new Irish government that causes a crisis:
A distant alarm bell may be starting to ring at the European Central Bank after data showed the euro zone's inflation rate is rising, manufacturing is powering ahead, unemployment is easing and the economic recovery is spreading to countries at the heart of the currency area's debt crisis.
Bill Gross of Pimco has called June 30, 2011 (the end of QE2) the new D-Day:  
Investors should view June 30th, 2011 not as political historians view November 11th, 1918 (Armistice Day – a day of reconciliation and healing) but more like June 6th, 1944 (D-Day – a day fraught with hope for victory, but fueled with immediate uncertainty and fear as to what would happen in the short term). Bond yields and stock prices are resting on an artificial foundation of QE II credit that may or may not lead to a successful private market handoff and stability in currency and financial markets. 15% gratuities may lie ahead, but more than likely there is a negative two-bit or even eight-bit tip lying on the investment table. Like I did 45 years ago, PIMCO’s not sticking around to see the waitress’s reaction.
For now, momentum is positive but risks are rising at the Fed's party. My inner investor is saying goodbye to the host is on his way out the door. My inner trader is having another drink, but edging away from the bar and moving closer to the exit.

Be aware of the rising risk level.

Wednesday, March 2, 2011

China gets it, when will America?

I have written about social inequality and the risks it poses to the social fabric and stability before (see recent examples here and here), Andy Xie recently commented about the wave of unrest sweeping North Africa and threatening the Middle East. His comments could be generalized to the rest of the developed world, largely because the fruits of globalization have not been distributed evenly [emphasis added]:
A large share of the global population, including low-income groups in the developed economies, have not benefited from globalization but are suffering from inflation. Their reaction will put global stability in jeopardy. The major central banks may change their attitude toward loose money only when the riots happen in their own countries.
The current wave of commodity inflation has rewarded the rich and hurt the poor:
Inflation is redistributive, usually unfairly. First, low-income people tend not to have debt, because they are usually not qualified to borrow from banks. When inflation surges, as it is happening now, their bank deposits erode in real value. Where do their losses go? The people who have debt and real assets, like property speculators, gain the same amount. Inflation essentially robs the poor and gives to the rich.

Second, low-income people tend to have insecure jobs and cannot bargain wages up along with inflation, especially when inflation surges like now. The reduced purchasing power for their wages pushes them into an unsustainable situation. They simply cannot make ends meet.
Recall that during the hyper-inflation days of the Weimar Republic, there was a roaring stock market where the suppliers of capital profited while the suppliers of labor got squeezed. We know what happened next.
Andy Xie thinks that America isn't immune to the risks of social instability:
In 2009, 14.3% of Americans lived in poverty, according to the U.S. Census. Including ones that have given up looking for a job, one-sixth of American workers are underemployed or unemployed. A huge chunk of American people have no cushion against massive increases in the cost of food and energy. In addition, the prices of imported consumer goods that low-income Americans depend on are rising and are likely to rise much more, later in the year. Fifty million Americans are not so different from Egyptians in their economic plight. Riots could come to American cities.

A contrast in policy response
Consider the contrast in policy response between China and America. In a recent interview, Chinese Premier Wen Jiabao said that rising inequality is threatening social stability: "We will roll out measures in all these aspects, including tax policies, to make China a country of equality and justice where each citizen lives within the security net."
Meanwhile in America, the Fed is focused on QE2, which is a policy designed to raise asset prices to benefit the suppliers of capital in hopes that the wealth effect boosts economic growth. Meanwhile, the suppliers of labor will have to bear the brunt of the adjustments. Notwithstanding the events in Wisconsin, Moody's estimates that the GOP plan to cut the deficit would cost 700K jobs and slice 0.5% off GDP growth.

China gets the social risks of rising inequality. When will America?

Investment response: My inner investor is highly mindful of these risks, but my inner trader tells me to enjoy the party that the Fed is throwing but to stay near the exit.