Monday, June 30, 2008

Bill Gross and Mohamed El-Erian : The PIMCO maestros.

Bill Gross is again out with a no holds barred punch at the administration and the current state of affairs. He predicts a trillion dollar deficit for the next administration, and a severe inflationary uptrend.

I had linked to his earlier excellent missive and CNBC appearance here. There’s also a discussion where I speculated that a mean reversion in the price-earnings multiple to ~12 could be the fat tail PIMCO is watching out for.

It’s good to see wide media coverage for both Bill Gross and Mohamed El-Erian. I'm generally a fan of fixed-income strategists. While Gross has a nice straightforward way of assessing things, El-Erian's measured tone makes him really interesting to watch or read.

I’m currently reading El-Erian’s "When Markets Collide", and it’s been a gripping read so far. His analysis on the current situation is really thought provoking. I think this is shaping up to be one of the must read books of the year, especially to understand the current situation and the shape of things to come. (Think Taleb’s Black Swan in 2007). You can read the reviews from this Amazon link to pique your interest:

You can also read the introduction to the book from PIMCO’s website.

An excerpt from the introduction follows:

A series of inconsistencies and anomalies, which will be detailed throughout the book, acted as early signals of the growing tension between what participants or actors on the global finance stage were pressing for and what could be reasonably and safely accommodated by the existing systems in order to minimize the risk of turmoil.

Market participants first become aware of transformations through what is commonly known as “noise.” This noise comes initially from the sudden emergence of anomalies to long-standing relationships that participants take for granted. Noise can matter in so far as it contains signals of fundamental changes that, as yet, are not captured by conventional monitoring tools.

For what seemed an eternity for investors (many of whom feel that a week is a long time), the U.S. bond market provided signals about the economy that conflicted with those coming out of the other most liquid market in the world, the U.S. equity market.

This inconsistency was accompanied by a rather peculiar situation among Fed watchers, that group of economists and analysts on Wall Street who make their living from predicting the course of the most influential interest rate in the world—the fed funds rate. In the middle of 2006, with the rate at 51⁄4 percent, the vast majority of Fed watchers fell into two distinct and opposite camps. One confidently predicted rate hikes—to 6 percent; the other equally confidently predicted cuts—to 4 percent. I remember noting several times that I could not recall such divergence in sign and size among such credible market observers.

Hmm.. Don’t we have a similar situation right now? Market strategists and economists seem divided between whether interest rates are headed up (read PIMCO's missive) or down(eg. Gary Shilling). There's even a divergence between countries cutting or raising interest rates. Is this signal telling us something? The current divergence could be hinting at the shape of things to come over the next year or so. It's all about observing signals in the noise.

My 2 cents is that yields would probably come down in the next year in a deflation scare, before treasuries enter a decade long bear market. Even Hussman extended bond duration a few weeks back. PIMCO’s investment thesis, while right in the long run, could underperform this year.

Full Disclosure: None

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The 2008 European Bear Parade

Over the past two weeks, the commentary from Europe has gotten decidedly bearish. And none of them are talking of a run of the mill bear market. The most cheerful of the lot is forecasting a 30% global equity markets correction; the others are warning of a once-in-a-century doomsday scenario. So without further ado, here’s the European bear market parade:

The parade really started with RBS coming out with a warning about a full-fledged global stock market crash. With a call for the worst bear market in the last century, Bob Janjuah warned us that "a very nasty period" was soon to be upon us.

Next up was Morgan Stanley strategist Teun Draaisma, the guy who called the market top in July 2007. His advise was to bugger off and go goose hunting. With a call for a 10% downside over the next 6-9 months, that certainly sounded appealing. He's also called this the best shorting period since 2002(with some short screen ideas). His thoughts on the evolution of a bear market can be found here.

Barclays chimed in with this: "We're in a nasty environment," said Tim Bond, the bank's chief equity strategist. "There is an inflation shock underway. This is going to be very negative for financial assets. We are going into tortoise mood and are retreating into our shell. Investors will do well if they can preserve their wealth." I found their recommendations on yield curve steepening, shorting Asian bonds and Indian currency interesting.

The ever cheerful pair of James Montier and Albert Edwards at Societe Generale called for a decline of over 70% in the indices. “The US is leading the way, diving into deep recession as a collapse in consumer confidence induces The Great Unwind. This asset-backed economic Ponzi scheme will finally crash to earth as debt revulsion leaves interest rates impotent.” Other forecasts include oil at $60 and US 10 year bond yields at 2% There’s an interesting inflation versus deflation debate shaping up between the various market strategists.

Not to be left out, Fortis warned of a complete collapse of the US financial markets within a few days to weeks. "The situation in the US is much worse than we thought. There is starting to be a complete meltdown in the US. "

So there you have it, the great 2008 European Bear parade. It certainly seems like the unseasonal weather, massive asset write downs, and an economic slowdown has made the European strategists a moody lot. While US commentators like Louise Yamada, Grantham, Paul Desmonds and Hussman have cautioned on the stock markets, it's hard to beat the gloom and doom coming from Europe. It almost seems like a race to be out with the most bearish forecasts.

Their cheerful disposition is infectious indeed.

Full Disclosure: No positions. Wishing I was short Investment Banks back in July 2007.

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Thursday, June 26, 2008

In-Flight announcement - State of Economy (Parody)

(From an email)

Ladies and Gentlemen:

This is your Captain Ben Bernanke speaking. Welcome to the now-bankrupt U.S.A. Air, flight number 1929, non-stop service to Depressionville.

After reaching a cruising altitude of 5.25 %, we’ll steadily drop down to 2.0 % and hold it there for a long time before crash landing at Depressionville.

For your safety, please bundle-up Treasury Bills and stay in dollar. Federal law prohibits speculating in commodities.

Our in-flight entertainment will feature two Market Watch films, “2 Dollar Gas,” starring Rex Nutting as comedian, and “Bull Run,” starring Mark Hulbert.

In the unlikely event we loose cabin pressure, there will be a ten dollar surcharge to use the Oxygen mask.

After reaching the cruising altitude, we will be serving you complimentary doses of Prozak and Maylox.

If there is anything we can do to reduce your inflation pain, please do not hesitate to contact one of our flight attendants to receive a low CPI number.

Thank you for choosing U.S.A. air for your final destination, sit back and rest in peace.

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Did the IMF blow the emerging markets bubble?

Sometime in late 2007, a ‘new paradigm’ seemed to have emerged; that of fast-growing developing markets to trade at a premium to the developed world. I was in India in December 2007, and was often befuddled at some of the articles and conversations I came across. Indeed, brokerage houses pompously proclaimed the dawn of a new era in emerging markets. Investors, it seemed, would pay up for the faster growth, disregarding country risk, currency risk, inflation risk, home bias, etc. Truly, a ‘structural change’ seemed to have occurred.

Fast forward six months, and it’s a completely different cup of tea. A lot of ink has been spilled on the under performance in the emerging markets YTD. Some reasons discussed include:

-Increased risk aversion (flight to quality).
-Credit crunch induced liquidation of assets.
-Commodity inflation induced price shocks.
-Reversion to the mean in valuations.
-Reversion to the mean in profit margins.
-Decline in cost competitiveness due to commodity inflation, local currency appreciation and increasing labor costs.
-Debunking of the decoupling theory.
-Uncapitalistic regulatory and price control regimes.
-Political upheaval due to upcoming elections in India.
-*Insert favorite reason here*

Well, how about a new one?

In January 2008, IMF came out with a now forgotten report titled “Global Growth Estimates Trimmed After PPP Revisions”. The report trimmed the annual global growth estimates between 2002-2007 by 0.5% each year, definitely not a ‘rounding error’! More importantly, the contribution to the global output from China went down from 15.8% to 10.9%, and India's contribution was revised from 6.4% to 4.6%: a downward revision of almost 30%!!

Here's an interesting chart from the IMF report:

Quite interestingly, countries whose contributions held steady seem to have outperformed those who faced downward revisions.

If you look at the table above, India (INP) and China (FXI), two countries where the contribution percentages went down sharply, have underperformed in 2008. On the other hand, Japan (EWJ) and Brazil (EWZ), where contributions were (marginally) revised upwards, have held up rather well.

Is this merely a coincidence? While I don’t know the answer to the above question, it's certainly a good one to ask.

Parting thoughts: what are the possible implications of this 30% downward revision on the current commodity super cycle boom? A case maybe of going too far too fast?

Ticker symbols discussed: SPY, FXI, EWJ, EWZ, INP

Full Disclosure: None

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Monday, June 23, 2008

Weekend reading update..

Yet another update on my weekend reading. Last week, we had RBS issue a global stock and credit crash alert. Morgan Stanley chimed in with a warning on a “catastrophic event”.

I’ve read quite a few bearish European commentators talking of a sideways/upwards movement for the markets till early July, and downhill from then on till October. Here’s a few more links to whet your appetites!

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Thursday, June 19, 2008

Quotabale quotes on market direction.

It's always interesting to know what the smart money is saying. These have been culled from my readings over the last 7-10 days. Warning: Most of the commentators sounded bearish to me!

  • Rob Arnott: Stocks are likely to move lower in the next six months and will be in hibernation for years. For the long-term investor, stocks will offer single-digit returns over the next 10 to 20 years, though individual years could be far better or worse.

  • Michael Kahn: Technical analysis can be compared to a court of law where there is not one definitive proof that the trend has changed but a preponderance of evidence to say so. No bell has rung, but there is also no denying what is happening before our eyes. And until the evidence starts to pile up on the other side of the battle, we must act as if this is a bear market.

  • Jeff Saut (paraphrasing Ken Dupre): The market is cheap at a 16x P/E multiple (vs. 19 P/E a year ago) on depressed financial earnings, and there is a lot of cash on the sidelines. To me, this suggests a slow, rising, more volatile market. I am also a seasonal man and believe there are always bargains to be found in September/October, so having some cash today, or raising some this summer in rallies, should be useful this fall.

  • Prieur du Plessis: I would like to stress again that the emphasis at this juncture should be on the return of capital rather than the return on capital.

  • Nassim Taleb: “America is the greatest financial risk you can think of.”

    “Governments and policy makers don’t understand the world in which we live, so if somebody is going to destroy the world, it is the Bank of England saving Northern Rock. The biggest danger to human society comes from civil servants in an environment like this. In their attempt to control the ecology, they don’t understand that the link between action and consequences can be more vicious. Civil servants say they need to make forecasts, but it’s totally irresponsible to make people rely on you without telling them you’re incompetent.”

  • Larry McMillan: We have no buy signals from our indicators. However, we do have oversold conditions. Thus a short-lived and potentially powerful rally could spring up at any time. We think any such rallies should be sold.We think that this new down leg is strong enough that it will have to be resolved with a typical capitulation low -- involving a spike peak in $VIX and put-call ratio buy signals near the top of their charts. By the time all that happens, it would not be surprising to see $SPX in the neighborhood of the March lows. If so, it will be interesting to see whether or not a "retest" holds.

  • Eoin Treacy (Fullermoney): US government bonds in long-term bear market. Yields took 22-years to fall from their accelerated peak and may yet take as long again before they reach the highs of this secular move.
    This is a long-term cycle, and it will not be the same as the last bond bear market, but it will give context to almost every other asset class over the coming decades.

  • John Hussman: The prospect of 10-year total returns of just 4% in Treasury bonds is not particularly compelling on an investment basis, so the primary driver of bond returns will be speculation about economic weakness and a ‘flight to safety’ from credit concerns.

    Presently, deteriorating stock market internals suggest fresh skittishness among investors, which coupled with still-rich valuations (on the basis of normalized earnings) often results in particularly negative outcomes for stocks.

  • Richard Russell: The implications of the Lowry’s statement is clear enough. If there is no case of Lowry’s Buying Power making new lows many weeks after an important market bottom – then the fact that Lowry’s Buying Power is now making new lows indicates that the stock market has NOT yet put in an important bottom. In other words, we have not yet seen a bottom so far in 2008. If this is true, then the major averages and many, if not most, stocks are fated to break to new lows.

  • Brett Steenbarger: From housing to the dollar, banking to commodities, national debt to soaring Medicare and Social Security obligations: it's difficult to see the period since 2002 as anything other than one of profligacy and utter fiscal mismanagement. I am not a bear by nature, but when you consider the average debt of the average household and the concentration of household assets in housing, it's difficult to see happy retirements for many baby boomers.

  • David Rosenberg: The euphoria in the equity market has been breathtaking in the past few months. Are we believers that this is sustainable? The answer is no.

  • Gary Shilling: We think the unemployment would be going to 7.2% in the second quarter of next year, which we think would be the bottom of the recession. Brushing it aside is Fed's assertion that inflation is a concern not economic growth, but we don't agree with him. We are looking for the biggest decline in consumer spending of any recession since the 1930s.
    To make a bold prediction, I think towards the end of the year we'd be back to worrying about deflation and not inflation. We are long the Dollar against the Euro currency.

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Sunday, June 15, 2008

Weekend reading

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Saturday, June 14, 2008

On bond yields, treasuries and inflation

We’ve had Bill Gross coming out with a no holds barred scathing commentary on the US understating CPI. Other commentators have chimed in with a view that treasuries could be the most overvalued asset class in the world. (back in March)

I had an interesting email exchange which takes the opposite point of view(You should click the post link to view the emails). Here’s the email :

I have been a big proponent of the long-term US Treasury STRIPS. For the first ten years of their existence, 02/28/85-02/28/95, they were a far superior investment compared to S&P 500. Their total compounded annual return for the 10-year period was 15.3% compared to 14.14% for the S&P 500. Their beta was only 0.36 compared to the S&P 500.

1995 also happens to be the time when stock market investments were heavily pushed by 401-Ks based on their 3, 5, and 10-year returns. Were STRIPS, with superior returns and lower risk, offered as a choice in any 401-K programs?

The UST STRIPS have also been a far superior investment to the S&P 500 during the last ten years. The UST STRIP bought for $1,000 on 02/28/85, when first available, would be worth more than $9,000 today. We know that inflation has only been up by a factor of 2. Even for the conspiracy theorists it has not been more than a factor of 3.

Here was the reply:

Going long STRIPS in mid 80s, and staying long through the period of "the great moderation" was obviously a great strategy in hindsight. Gary Shilling was a famous advocate of the "Long Bond" through these 20 odd years.. (You can check his chapter from John Mauldin's "Just one Thing" for a quick review)

Going long bonds/STRIPS at the ridiculously low yields you have today is plan hara kiri. We might be in for a 10+ year bear market in STRIPS. If the US is understating true inflation, why would you be advocating a long STRIPS strategy now?

Buying treasuries at historic low levels is a crap shoot at best – sure rates might go lower, we might get a Japanese style deflation. But even in the unlikely case that happens, your upside is limited while the risk of being wrong is high, and the opportunity cost higher. CPI showed inflation at over 7% annualized! Kind of sucks to be losing money as treasury yields rise to a negative real returns.

Counter reply :
It was in February 28, 1985, when UST STRIPS began (the Treasury dept started to deal with them directly). The inflation had peaked five years ago and the headline inflation rate had come down to 3.52%! For the next ten years the long-term UST STRIPS out-performed the S&P 500 with a beta of only 0.36.

$1,000 invested in long USTs in Sep 1981 and then converted into STRIPS in Feb 1985 would be worth $20,000 TODAY and I expect that to be $25,000 by 2010. That is good enough for me. The Yield on the 10-Year will go below 2% and long-term UST STRIPS would out-perform. Inflation is in the process of peaking and will collapse 12-15 months into the recession.

Hmm. Certainly food for thought! I think there is a strong case to be made for a second half treasury rally.

I also highly recommend checking out John Mauldin’s Just One Thing for this and other similar interesting ideas.

On the back of this exchange, here’s an interview with Mr. Long Bond himself (Gary Shilling). He seems to agree with this point of view.

(Note: I haven’t checked the authenticity of the exact numbers, but the general trend is indeed right)

Disclosure: None

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Wednesday, June 11, 2008

Nice chart.

Came across this interesting chart:

It seems Trichet’s comments caused a rally at the backend of the European curve. In my opinion, this could be implying a slowdown in the European economy, with lower yields going forward.

A flat yield curve in Europe, along with the negative news we've been hearing on the European names, could be implying a tough second half for the European banks.

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Monday, June 2, 2008

Revisiting the indicator review theme

Would you buy this chart?

Your opinion on this chart could very well determine your opinion on the market. The chart is the US Treasury ten year note yield.
  • If you think this breakout is sustainable and a long term one, then that's bad news for stocks . If this looks overbought on an intermediate term basis (and due for a correction), then that’s definitely a positive.

  • I personally think the ‘rising yields, rising inflation’ theme is a multi-year one. However, if things get rough for the remainder of the year, , the yields could very well go down and retest their March lows. (People could be underestimating the deflationary impact of declining home prices and any decline in monetary velocity)

  • The Fed has cut by more than 300 basis points over the past year. Yet, the change in the mortgage yields y-o-y is a paltry 40 basis points. The cuts are obviously not having their intended effect on the mortgage mess .

Here’s a look at the S&P500 chart:

  • The index briefly did a head fake by breaking out above the 200 day moving average, but quickly reversed direction and has now successfully tested the 50 day moving average, twice.

  • If we close below 1375 then of course all bullish bets are off.

  • The fact that this support has held, and looks to be forming a double bottom (notice the second retest is at a higher low), might imply a sideways-upwards pattern for the equity markets for the next 4-5 weeks.
I’ve also talked about the carry trade(dollar-Yen) as a proxy for investor risk appetites.
  • The carry trade is dead. Long live the carry-trade!

  • Yen is flirting with the 105 level, inspite of the 5% decline in the equity markets. Risk appetites and the ‘carry-trade’ is still very much alive.

  • The indicator review theme has consistently been the ‘reversion to the 200 day moving average’ one. Given that premise, we could very well see Yen close above 107 before the current upturn from March is in serious trouble.

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