Been There, Done That

Yes, I recognize the deja vu. About one year ago I began reallocating assets to reflect a more inflationary posture. That posture lasted only a few months. Last summer's debt ceiling debate coupled with the EU debacle squelched my incremental inflationary expectations, and I peeled off risk positions in favor of a more balanced posture.

Fast forward to now. Once again I find myself adding long exposure in lieu of a tape that seems to be taking the Fed's "0% till 2014" promise to heart.

Will this action once again prove temporary in a world that's drowning in a debt bubble that wants to deflate? Not sure, but currently my actions need to express a perceived uptick in the odds of Big Inflation on the horizon.

position in SPX

University Endowment Trends

This paper is somewhat dated (2008), but it still points out interesting trends in university endowments over a decade or so. Note big difference in endowment size between private (especially Ivy) and public. This really sticks out when examining endowment/student.

Asset allocation shows movement out of fixed income in favor of alternative assets. Some stats (medians):

2005 Overall

n = 726
endowment size = $72 million
return = 9%
AA equity = 59.6%
AA fixed income = 20.4%
AA alternative assets = 7.6%

Interestingly, Ivy League AA in 2005 was 38.1% equity/13.0% fixed income/37.1% asset allocation.

Of course, we now know that those increased allocations toward alternative assets were a source of pain during the credit meltdown of 2008-2009. Many alt investments, particularly illiquid ones, were crushed when bid/ask spreads fell thru the floor.

Still, the attractive characteristic of many alternative assets is that they can be less correlated with other asset classes, which makes them useful for diversification purposes.

position in SPX

The 'Risk Out' Scenario

Interesting proposition by Peter Atwater that the ultimate indicator that a secular bottom has arrived may not be one where individuals have moved out of more risky financial assets and into less risky assets. Instead, perhaps it will be a 'risk out' situation, where market participants flee securitized financial assets altogether.

There is, of course, a decent argument to be made that the probability is non-zero of a systemic meltdown that chases participants away. With systemic leverage thru the roof and issues of re-hypothecation raised by last year's blow-up of MF Global, it isn't that difficult to envision a scenario where the financial system ceases to function. Cascading bank failures, sovereign debt defaults, and other contagious events could bring the system to its knees.

Indeed, a good case for owning physical gold or other 'hard assets' is that they are tangible and outside the 'paper' financial system.

I'm going to keep Peter's proposal in mind. Perhaps the time to 'buy the list' is not when people are selling the list, but when both buyers and sellers have gone home en masse.

position in SPX

Why Wealthy People Own Gold

Straightforward explanation of why wealthy people own gold. The key point here is that the primary reason to own gold (in its physical form) is not to speculate in near term price moves.

Instead, wealthy people own gold to preserve their wealth against problems like inflation, bank collapses, and aggression.

Viewed thru this lens, owning gold is less of a 'buy-and-hold' investment strategy and more of a buy-and-will-to-the-next-generation family wealth preservation strategy.

More Gold Weakness

Action in precious metals continues ugly. New lows for the move today. Peering thru a longer time horizon lens, however, finds the yellow metal just now touching its multi-year uptrend line--a defined risk set-up for bullish traders.

One apparent takeaway from a macro perspective is that gold is not buying the thesis that the financial system is reliquifying--particularly w.r.t. the EU. Instead it is behaving like a wave of deleveraging, deflation in in the cards.

position in GLD

Euro Rumblings

Am continuing to pick up chatter like this that the situation in Europe is worse than appears. The EU version of TARP, the Long Term Refinancing Operations (LTRO), has seen a commensurate jump in bank funds with the ECB Deposit Facility to a record high half trillion euros.

The implication is that interbank lending in Euro is largely frozen. Banks are instead choosing to keep funds w/ the central bank.

Deja vu pangs here, as this is very reminiscent of the risk averse behavior we saw stateside in 2008.

Which probably shouldn't be surprising. After all, the situations are largely the same. Risk seeking behavior and easy credit ran up massive debt and leverage. Now risk appetites are waning. And price declines threaten leverage systems with insolvency.

position in SPX

Hyper Hypothecation

On top of hypothecation and re-hypothecation, there is also hyper-hypothecation. Hyper-hypothecation is basically the re-hypothecation process done multiple times between various trading partners.

HH creates systemic counter-party risk in a leveraged system. If one trading partner in a chain fails to make good on a contract, then the entire system freezes up because there is not enough capital to meet all the margin calls.

Conceivably, prices may be in error if participants fail to understand the counterparty risks that cascade thru a market system. Once those risks are understood, prices are likely to drop...significantly.

This pretty much describes our ponzi-esque condition...

The Infuence of Today's Events on Inflation

As noted in this morning's post, central banks got out the bazookas today in an attempt to blow away systemic deflationary forces that are driving Euro and US banks toward insolvency.

On the surface, the concerted central bank actions are clearly inflationary.

This post on zerohedge w/ Peter Schiff comments captures it well. The snippet at the end of the post REALLY captures it well:

"...this is merely the beginning as more and more inflationary actions have to be undertaken by central banks to save banks from being crushed by untenable debt loads. Whether they succeed in overturning the deflationary tsunami is unknown. What is certain is that they will bring fiat currencies to the [brink] of viability (and beyond) in trying."

As the snippet notes, the big question is whether this collective action will work. In late 2008, the Fed got out the fire hose of liquidity to stem the Lehman blowup. After a sharp relief rally on the news, however, markets resumed their downward path as the deflationary forces were not to be denied.

Hard not to wonder whether the same set up might not be in play here. Yes, the collective bazooka exceeds the power of the Fed's firehose. But the deflationary forces are more global in nature this time around.

Peter Schiff suggests that this is the time to load up on gold. That may turn out to be the case. Heck, gold popped 40 handles today.

But the other side of the trade is that the market forces pressing against the intervention are deflationary in nature.

And it's generally not nice to fool Mother Nature.

position in SPX, gold

Old Age and Sovereign Debt Default

Interesting discussion of the negative relationship between the age of a country's population and propensity for sovereign debt default. What many people don't understand about sovereign debt is that it is usually unsecured, meaning that there is no collateral for lenders to claim if the borrower defaults. This is unlike other debt instruments such as mortgages or corporate bonds which are typically backed by real assets.

As such, lending to countries is pretty much dependent on the creditor's assessment of the borrower's ability, or perhaps more importantly the borrower's willingness, to pay.

It is likely that old age reduces willingness to pay. Paying back debt might cut into entitlements that older segments of the population enjoy, such as State provided health care and retirement benefits. People may be less willing to forego those benefits in lieu of using those economic resources to pay back loans.

If the country is too leveraged, however, then the point may be moot. Socialistic systems require ever more economic resources to keep the wheels on the wagon. Credit will be cut off, either thru default or by bond market shut down.

This is the central message of Reinhart and Rogoff (2009).

Reference

Reinhart, C.M. & Rogoff, K.S. 2009. This time is different: Eight centuries of financial folly. Princeton, NJ: Princeton University Press.

Weak Jobs Number

Big miss in the jobs number this am. And it should be noted that the 54,000 number includes 206,000 estimated jobs created using the 'birth/death' model of the BLS.

Over the past 3 years, government has borrowed and spent $trillions, and printed and spent $trillions more largely in the name of 'creating jobs.' Yet, anemic employment persists despite the federal government's best efforts to paint the data pretty.

Will markets view this job report thru a glass half full or glass half empty lens? The bullish argument is that weak jobs data will require more government intervention (can you say 'QE3'?).

The bearish argument is that a weak employment situation persists in the face of $trillions of government intervention, suggesting that perhaps prolonged economic weakness is unavoidable.

Nasty Head Fake

Yesterday's nice move higher appears to have been a nasty head fake, as domestic equity markets were weak out of the gate today. They steadily ground lower and finished on the lows. The Dow was down about 280, which is the largest single day point drop in some time.

Am starting to wonder whether the major indexes might not have a date with their respective uptrend lines stretching from the Spring 2009 lows.

For the S&P, that would correspond to about SPX 1250 which is also where the 200 day moving average currently resides.

What in the fundamental or macro environment might drive weakness from here? There are many possibilities, cookie. But given how heavy the banks are trading (the BKX was down over 4% today), it 'feels' like markets may be worried about contagion from the ongoing Greece/Spain/etc EU saga.

Over the past couple of weeks, I've been selling strength to get more liquid. Cash level is now at 60%. Wouldn't mind more, as the market action is increasingly taking on a deflationary feel.

position in SH

Cash and Opportunity Cost

Jim Grant sees some value in large cap stocks like Cisco (CSCO) and Johnson & Johnson (JNJ). Generally, however, he sees most asset classes as richly priced.

He suggests that one investment strategy in the current environment is to simply hold cash, because the opportunity cost associated with not being in T-bills and other short term instruments is 'not much.' Although you make next to nothing on the cash, it is available when other asset classes become more attractively valued. Overvaluation, he observes, often 'passes in a thunderclap' and those who are liquid can 'get fully invested in a comfortable way.'

This strategy has made sense to me for some time. I find it interesting coming out of Jim Grant's mouth because of his inclination toward inflationary macro scenarios. What he is describing his more consistent with what happens in a deflationary situation. After all, why hold cash if you think its value will be inflated away.

Currently my cash level is just over 50%. I wouldn't mind bumping this to the 60-70% range, and will be looking to sell strength to do so.

positions in CSCO, JNJ

Deflation Definition

During his CFA speech, Grant offered a definition of deflation that I had not quite considered before. He argues that deflation is not simply falling prices. After all, prices are likely to fall in unhampered markets as productivity increases. Higher productivity means greater abundance. More supply of economic resources per monetary unit means lower prices.

Stated differently, lower prices are natural outcomes of free markets.

Instead, Grant suggests that deflation is 'too little income chasing too much debt. It is a disorder of lending and borrowing.'

He notes that in a credit crisis, inventories (whether they be hard goods or securities) cannot be financed and therefore are thrown on the market. Prices broadly fall as a consequence.

Deflation, therefore, is not the Wal-Marts (WMT) and tech hardware industries of the world getting more efficient. Rather, deflation is excess credit leaving the system.

What's particularly new and vivid to me about Grant's explanation is the notion of inventories of all sorts being thrown on the market because they cannot be financed.

When you hear market watchers gasp that 'they're selling anything that isn't nailed down,' deflation is likely at hand.

no positions

China's Banks

Jim Grant is one of my favorite reads. His newsletter, Grant's Interest Rate Observer, is a bit out of my price range but I'm fortunate to score an issue every now and then.

His May 20th newsletter discusses troubles under the hood w/ China's banking system. While China's markets and massive growth have been all the rage, people seem to forget that a socialist regime oversees the country. Central planners control capital allocation on a macro scale. When bureaucrats sitting in a room are deciding how to allocate capital, they are likely to make more mistakes of longer duration than individuals making decisions in unhampered markets.

Grant suggests that Chinese banks are holding gobs of non-performing loans--loans that banks were required to take on per govt officials. These loans are currently not marked anywhere close to market.

This situation, of course, is reminscent of the credit crunch faced by banks in the US. Grant suspects that, because the Chinese system is so opaque, the potential exists for big problems if things start to go bad.

His 'new working hypothesis is that the banks of the People's Republic...will execute the greatest belly flop in the history of paper money.'

Should this come to pass, there is no way that the problem would be contained to China.

Low Bond Yields in an Inflationary World?

One phenomenon that is perplexing many who believe in the Big Inflation thesis is the behavior of bond markets--particularly government bond markets. Theory says that yields should go up with inflationary expectations. People should be selling bonds today out of worries that the real value of their bonds will go down as their coupons get paid back in dollars that are lower in value.

That theory has not been working out well in practice. Despite the $trillions created by the Federal Reserve over the past couple of years, and commodity prices screaming higher, long bond yields have not gone to the moon as many inflationistas have forecast.

Perhaps the theory doesn not account well for the dynamics of transitionary periods.

For more than two decades, central  banks have been suppressing interest rates and offering credit on the cheap. This credit has gone into all kinds of risky assets--stocks, commodities, real estate, plants and equipment. Bonds are also a risky asset class although they are often perceived as less risky than other categories. This is particularly true of bonds issued by the US government.

The easy credit spawned a secular boom in leveraged risk taking. Individuals, organizations, and governments have all borrowed at low interest rates and invested in assets deemed to return something more than the cost of carrying the loan. This behavior is also known as the carry trade.

Leverage magnifies returns when prices are going in your direction. A few years back people could buy a $500,000 house with little money down and low interest rate, and flip that house a year or two later for $750,000, generating an enormous return over the cost of carry.

As many have discovered over the past couple of years, leverage magnifies losses as well. When firms like Bears Stearns and Fannie Mae (FNMA) were levered 30:1 or higher in mortgage related derivatives, it did not take much decline in home prices before their assets were less than liabilities, creating conditions of insolvency.

In leveraged systems, falling prices motivate many to close out their carry trades. Risky assets are sold, dollars are bought back, and loans are paid off. We saw, and continue to see, a lot of this since 2007-2008.

But not all carry trades are taken off. Some leveraged investors, rather than totally getting out of risk, merely substitute less risky assets. Thus, rather than using credit to buy stocks, carry traders buy bonds instead. Leverage is still in the system, but it is located in assets classes deemes 'less risky.'

One explanation as to why bond yields have not yet backed up is that much leverage remains in the system. Carry traders are content to earn the spread between nearly 0% borrowing cost from the Fed and ten year T-notes paying 3.1%.

But this is a transitory situation. Huge amounts of leverage cannot last forever. Central banks can seek to force spreads open but over time they must collapse as resources borrowed from the future are paid back (or defaulted upon). Short rates will rise and/or returns on risky assets will fall and the carry trade spread will be crushed--regardless of government intervention to the contrary.

At some point, then, we may witness another counterintuitive situation as markets rebalance. It does not seem out of the realm of possibility that bonds could sell off big-time as more and more leverage leaves the system.

position in SH

The Gold Confiscation Order of 1933

Did you know that private ownership of gold was outlawed in the 1930s? FDR ordered that gold be confiscated so that he could devalue the dollar in attempt to inflate the country out of the Depression.

The formal ban on gold ownership lasted over 40 years until President Ford lifted the law in 1975.

Here's an interesting review of the relationship between the banks runs of 1932 and FDR's ban on gold. One insight is that the bank runs were people seeking to front run the US going off the gold standard--something that FDR had publicly hinted in the months leading up to his inauguration.

In 1933 a NYC lawyer with unsurrendered gold holdings challenged the confiscation order. A Federal judge upheld the order, saying that the government was justified in compelling individuals to surrender their gold, and declared 'the right of the government to take private property of any kind when it is deemed necessary by the appropriate authority for the public good.'

Scary words for those who believe in liberty and property rights...

In any event, a bit of economic history that has some connection to what is going on right now.

position in gold

Japan Earthquake Effects

Death tolls from last Friday's catastrophic earthquake in northern Japan have now topped 10,000--a number that is almost certain to rise significantly higher. The country is now working to stave off additional disasters at a couple of nuclear power plants that have experienced reactor damage.

Last night the Nikkei sold off more than 6%. The Bank of Japan (BOJ) injected  $200+ billlion billion of 'liquidity' into the financial system in the form of short term money market credit, and asset (bond and ETF) purchases.

In the midst of the BOJ's money printing, the yen actually rallied last nite. As explained here, one reason for this is that there is an immediate need for cash in Japan. People who have have purchases risky assets with yen borrowed at uber cheap BOJ rates (a.k.a. 'the yen carry trade) are now looking buy those yen back to shed risk and whether the economic storm.

Stateside, there has been some fear that Japan might start unwinding its huge stash of US Treasury debt in order to raise more cash. Thus far, the aggressive BOJ monetary actions appears to have stemmed any predilection to liquidate US bonds.

This is a dynamic situation that requires careful watching.

position in TLT

Is Inflation Priced In?

David Rosenberg of Gluskin Sheff thinks that inflation expectations may be pretty well priced in by the markets. He offers some interesting evidence to support his thesis.

As we have noted in class, when consensus builds on a subject that has helped to trend markets, then a trend reversal may be pending...

US Consumer Credit Breakdown

Wondering about the composition of consumer debt in the US? The below graph shows a breakdown. Mortgage debt is by far and away the largest.

Many observers like the fact that credit card debt has been ticking higher (squint and you may actually see it!)--which suggest more spending on the horizon.

The other side of the trade is that more consumer credit is the last thing we need given the degree of leverage in the system...

A Primary Macro Issue

Richard Russell writes Dow Theory Letters, the longest running investment newsletter service in existence (he's been at it since the 1950s). I've subscribed to his service in the past and it has helped shape my thought process.

Snippets from RR's nightly missive occasionally appear in the public domain. This one provides a nice example of a 'macro' market issue. In fact, it may be the primary 'macro' issue facing the US (and the world, for that matter): government spending and debt.

Russell suggests that debt levels have risen past the point of no return, and that there is little political will to reverse course. He sees two possible endgames to this situation. One is for the US to default on its debt. Big debt default is akin to deflation. To many, including Russell, this seems unlikely. However, sovereign debt defaults, even among 'leading countries,' have marked world history. Investors, in my view, should not dismiss this scenario entirely because of the potential market consequences should it come to pass.

The other likely scenario suggested by Russell is for the US to debase the currency (i.e., print money) and to pay back debts in depreciated dollars. This, of course, is inflationary. Indeed, one could argue that this strategy is already underway via various Federal Reserve monetary policies. RR thinks that this scenario is far more likely because it is more palatable to politicians and to the public.

You may not agree with RR's thought process. But in the interest of 'seeing all sides of the trade,' prudent risk managers should be factoring such macro scenarios into their spectrums of possibility.

position in TLT