David Darst - Robert Kessler - Interview Transcript (Feb. 19)

Sunday, February 28th, 2010

Connie Mack recently interviewed David Darst, chief investment strategist for Morgan Stanley Smith Barney, and Robert Kessler, head of Kessler Investment Advisors, which runs portfolios for institutional investors and governments around the world. This is a MUST view/read interview. The complete transcript follows.

CM: David Darst is known as a master of the art of asset allocation. He is the chief investment strategist for Morgan Stanley Smith Barney. David is also a teacher and prolific author, and his latest book is The Little Book that Saves Your Assets . And it’s great to have you both here. Thanks so much for joining us on WealthTrack.
Robert Kessler, U.S. Treasuries, you make your living in investing and managing portfolios of U.S. Treasuries, and as long as I’ve known you, they have been denigrated by most of the competition except in this most recent period when everyone rushed to Treasuries, but now the naysayers are back again. So why are they wrong again about Treasuries?

ROBERT KESSLER: It’s not a question of being wrong or right. A Treasury is really a benchmark to almost every other asset class. So as a benchmark, you can’t be wrong or right about a benchmark. It’s just simply matter of spread between what other asset classes are selling at. So in the Treasury market, we’re lucky enough to be able to have a choice of overnight Treasuries, which is cash, or longer-term Treasuries. And longer term Treasuries are really based on whether you believe inflation is going to be an issue or whether disinflation will be an issue.
So right now we’re in what we call a credit crisis. We’re in a credit recession. And during credit periods of time, you don’t want to own risk assets, and if you don’t want to own risk assets, you want to go to something that has very little risk, which is a Treasury. Now the question becomes: do you own Treasuries as bills overnight or do you really believe that rates are going to come down because there’s very little inflation in the world? So since we believe rates will come down because there is very little inflation, then Treasuries become very attractive.

CONSUELO MACK: All right. So let me stop you there and we’re going to follow up on that in a couple of minutes. David Darst, as a global strategist first and as an asset allocator second, how do you view this?

DAVID DARST: It’s a great point because really, inflation is a monetary phenomenon. We have a big war going on between this monetary phenomenon called inflation potential down the road.

CONSUELO MACK: Right.

DAVID DARST: And deflation is a credit phenomenon. And right now credit is contracting. The latest month figure for December showed it contracted, consumer credit, Consuelo, by $2.5 billion. That’s 11 months in a row the government has been keeping these numbers since 1943. It’s never contracted for 11 months in a row. So right now we have this epic, titanic struggle between the deflation phenomenon, credit contracting and the inflation phenomenon, which is the government attempting to pump up the money supply, add liquidity to the system, which people, makes them worry about inflation down the road. So we feel that maybe Treasury bonds, Treasury securities, you can have them in the portfolio right now, you need to have a little offense as well as a little defense. Treasury securities are a defensive investment in our opinion. Last two years ago they were up 20%. They were up 20% in 2008 when the stock market went down 37%. Last year, ten-year Treasuries lost 9.9% on a total return basis.
I’m very receptive. For a person basically to say stay away from Treasuries means they think interest rates are going to rise. That means the consumer is going to come back. That means that credit is going to stop contracting and we’re going to worry about inflation. But over the next 12 months, I’m not so sure those things are going to be an issue, Consuelo.

CONSUELO MACK: So short term at any rate, next 12 months, Treasuries are probably a good place to be defensive.

DAVID DARST: I think you can have some in the portfolio. We are underweight. We are underweight. Normal is 16%. We’re 7%. That’s our largest single underweight. We are very underweight because we’re worried about the health of sovereign credit finance about the condition of the U.S., the U.K., the European community and so forth, the condition of these finances. So much money has been issued.

CONSUELO MACK: Okay. How do you answer that argument because, in fact, as you know, that most people who are looking at U.S. Treasuries are saying, we’ve got a record deficit; we have to finance that record deficit. If we are basically having to sell a lot of Treasury bonds, that is going to mean that the value of the dollar of our securities is going to go down. And then, in fact, that means that it’s going to be inflationary for the U.S. So how do you respond to that argument? Why aren’t you worried about the size of the deficit and what we have to finance being inflationary?

ROBERT KESSLER: Let me answer two questions. The first question is this concept of the deficit. There is this constant talk of deficits lead to inflation. We don’t really have any indication that that’s true. In the Depression in the United States, we had huge deficits, of course, and we had no inflation. We had deflation. Japan has gone through 20 years now of deficits that are far, far higher than ours, and they have deflation. So we don’t know anything about the inflation side of it. What’s really important is that if people can’t raise prices and there’s an awful lot of excess capacity in the world and wages are going down and unemployment keeps staying kind of sticky at these very, very high levels, it’s very difficult to have inflation.
And so there is no inflation. That’s not our issue. The real issue is– television was interesting today because not only are we dealing with Greece, Greece is very interesting because we’re bailing out Greece and bailing out perhaps Portugal next, but we’re probably going to bail out New Jersey after that. Because New Jersey just announced today that they’re running into a huge deficit, too.

CONSUELO MACK: As are a lot of states.

ROBERT KESSLER: As are a lot of states. So we have states having problems, lowering wages, firing people; very, very difficult to raise prices and consequently, very difficult to have inflation.

CONSUELO MACK: All right. So you think we’re deflationary. You think the credit contraction you think which is extraordinary is actually, we’re in the beginning stages of it. You’re not thinking a year down the road, you’re thinking for inflation, you’re thinking, what three, four, five…

ROBERT KESSLER: It sounds like I’m being very pessimistic.

CONSUELO MACK: You’re a bond person.

ROBERT KESSLER: No, no but I don’t want to be pessimistic. We just got back from the Middle East. I have to tell you, not only is everything for rent in the Middle East, not only are buildings completely unoccupied, but banks, since we deal with banks, banks right now are doing one trade. They’re doing what we call a carry trade, meaning they’re buying their sovereign debt, either U.S. sovereign debt or their sovereign debt short term and they’re carrying it at very low cost.

CONSUELO MACK: Because they can borrow it at very low cost.

ROBERT KESSLER: Because they can borrow at very low cost, as is JP Morgan in the United States and as is Morgan Stanley and everyone else. So the fact of the matter is when people say we’re in a bear market in Treasuries, it’s ridiculous. Last year, even though David is correct, the ten-year Treasury was down 9%. The fact of the matter is we made more money last year in two-year Treasuries than any year I can think of because everyone was carrying a two-year Treasury at zero and getting a point. Now, in bank talk…

CONSUELO MACK: So they were borrowing at lower than 2% and then they were buying the two years… So they made?

ROBERT KESSLER: They do it at a very high leverage level because they don’t need to do very much with a capital question. So the fact of the matter is you have this bull market going on and yet everyone is saying, anything but Treasuries. Tell that to JP Morgan.

CONSUELO MACK: Right. So David, not to completely focus on Treasuries, but as far as asset allocation, you said that your biggest underweight is U.S. Treasuries right now.

DAVID DARST: It’s sovereign credit, Consuelo.

CONSUELO MACK: Across the board.

DAVID DARST: It would include U.K., it would include Canada, it would include Europe.

CONSUELO MACK: And the reason for that is what?

DAVID DARST: Well, the sovereign… we believe there’s so much issuance of sovereign debt; we do believe that the balance sheet of the Fed has ballooned from $900 billion to $2.2 trillion. We do see the deficits as being quite large on out into the future. And we do believe that these trillion dollar and trillion and a half dollar deficits are going to have to be bought and to entice people, which will cause higher interest rates. So that’s why Morgan Stanley’s economists have a big out-of-consensus call, which Robert is very familiar with. And by the way, the word Robert means bright fame. His name means bright fame. Now Robert is familiar with this- Morgan Stanley is expecting 5.5%. And every conversation I get into, I have to argue we think that inflation fears will be higher towards the end of 2011. We see all this slack. But there’s concern. Supply, which you mentioned, that is the excess issuance by the Treasury, and also the Fed, and I know there’s a lot of disagreement over this, we expect them to begin their exit strategy later this year, second half of this year.

CONSUELO MACK: And exit strategy could mean raising the federal funds rate?

DAVID DARST: Higher short-term interest rates, and that means we think higher long-term interest rates. We take a little bit of respectful issue with Robert Kessler’s brilliance over here. But we believe the essence of our underweight versus sovereign debt is because of enormous supply and people’s concern. Inflation is the biggest… The biggest inflations of all times have all come from fighting deflation. In the 1946 to 1949 period in Germany, in communist China, in the 1920s and 1923 period of Weimar Germany, the biggest inflations have all come from fighting deflation.

CONSUELO MACK: So what’s interesting is the common ground is here. Right now we are fighting deflation, which is actually positive at least for the next 12 months, possibly for…

DAVID DARST: Steroids, financial steroids. Mark McGuire has admitted to it and the Fed is taking financial steroids.

ROBERT KESSLER: Let me be a little contrary for a second.

CONSUELO MACK: For a second?

ROBERT KESSLER: All right, for 30 seconds. The fact of the matter is we talk about this exit strategy all the time about the Fed. I’m into the entrance strategy. I am trying to figure out how we’re going to help out 8.5 million people who don’t have jobs. It’s probably closer to 17 million because that’s really a more correct figure.

CONSUELO MACK: The ones who have been discouraged and not looking for jobs anymore.

ROBERT KESSLER: Why we’re talking about exit strategies is very, very disconcerting to me.

CONSUELO MACK: Because the Fed is actually. Bernanke is talking about it, right.

ROBERT KESSLER: What we’re talking about again is Wall Street and the banking industry. When you get to, excuse me, the middle of the United States, at least where I live.

DAVID DARST: Right, you live in Denver.

ROBERT KESSLER: In Denver. People don’t have a clue to what JP Morgan is doing or Morgan Stanley is doing. What they’re looking for is their job, and when someone says, excuse me, I think it will be a good idea to raise interest rates, they can’t even borrow money; not only can’t they borrow money, no one will lend them any money. So they’re really…

CONSUELO MACK: Like the credit contraction you were talking about.

ROBERT KESSLER: So the issue is why are we talking about exiting the strategy?

DAVID DARST: The reason we’re talking about exit strategy is psychological. It’s the use of Shakespearean language and words to try to divert people from worrying about the debasement of the currency, internally and externally. And that’s why he’s saying it. And I agree with you. I don’t see rates jacking way up very quickly. This is going to be gradual, but we went from $900 billion Fed balance sheet to $2.2 trillion. And it is very, very important.
Sarkozy, during the last four weeks– opening speech at the World Economic Forum said that in 2011 France is going to be head of the G7 and the G20 and he says his number-one agenda item is to create a new world monetary system, a new system without the United States dollar as the primary reserve currency. The reason they talk about exit strategy, Robert, is to keep people from going to this new currency.

CONSUELO MACK: So how concerned are you about the fact that the dollar could be replaced as the reserve currency?

ROBERT KESSLER: First of all, for a second I’m going to represent Main Street as opposed to Wall Street, and Main Street doesn’t have a clue to what we’re talking about.

CONSUELO MACK: Right.

ROBERT KESSLER: Believe me. This all gets very, very complicated to talk about.

CONSUELO MACK: And our viewers are investors.

ROBERT KESSLER: They’re investors, so my answer to all of this is the United States will continue to be the reserve currency. There’s nothing wrong with the dollar. Everyone will put money into the dollar, as we’re doing today. Today is a very, very good example. We had a 30-year auction today. What was exciting about it, even though it didn’t go over very big as an auction, didn’t go well, but what was exciting about it is 23% of the auction was bought by Americans. What we call direct investors.

CONSUELO MACK: We’ve seen a trend here where the direct investors, Americans are buying more and more of their Treasury securities.

ROBERT KESSLER: And so when you look at the American dollar, as you can look at the Japanese yen- the reason the yen has stayed strong for so long is because the Japanese support their own country.

DAVID DARST: Internal savings, financing.

ROBERT KESSLER: And in the United States, we are beginning to do the same thing. And so even though we have a deficit, if we’re willing to pay for it, then frankly there’s nothing so terrible about the deficit.

DAVID DARST: Your legion of viewers in the aggregate have 25% stocks, 25% their home and 7% bonds. That’s why, as you’ve pointed out on the show, Consuelo, over the nine months from March through December, they, we all put $315 billion net into bond funds and ETFs, $35 billion into non-U.S. stocks and minus $24 billion into U.S. stocks. So there has been this trend. 1982, the average baby boomer, the median age was 25 years old. Today it’s the reverse of the digits- 52 years old. People have been killed by the dot com meltdown, the housing price meltdown and the financial stock meltdown and that want to set aside some money. So your point is an excellent point, Robert. They want to put this money and maybe some of the buyers will be U.S. households.

ROBERT KESSLER: Let me add one more statistic.

CONSUELO MACK: Very quickly because we have to get to the One Investment.

ROBERT KESSLER: The statistic being, that if Americans begin to invest in Treasuries the way they have in the past, then there would be no deficit. There would be simply no deficit.

DAVID DARST: We’re sitting on $8 trillion of cash right now. And they need only $1.5 trillion, but we need higher rates, Robert, to entice us to take it out of the cookie jar and the mattress and put it in Treasuries.

CONSUELO MACK: So one quick question for you, David Darst, and this is put your asset allocation hat on again. What are you overweighting, in a minute or less?

DAVID DARST: We’re overweighting corporate credit to summarize quickly. That would be high yield bonds, and high grade bonds.

CONSUELO MACK: Because of the yield.

DAVID DARST: The yield is more attractive. We are overweight in real estate investment trust, which have a nice yield to them.

CONSUELO MACK: Right.

DAVID DARST: We’re overweight in emerging market stocks and Canadian stocks, Australian stocks, and in small cap stocks. They have basically taken a little gas in the first part of this year. We think that’s a pause, a healthy, needed correction that we will believe as the economies grow around the world- we just jacked up our China forecast to above 10% for this year- and we think probably world growth will surprise to the up side. Maybe that’s why yields will surprise to the up side, too. Interest rates.

CONSUELO MACK: Very interesting. And so let’s go to the One Investment for our investor viewers out there, and Robert Kessler, guess what you’re recommending.

ROBERT KESSLER: A quick comment.

CONSUELO MACK: Yes.

ROBERT KESSLER: A quick comment. I am so weary of people who wear white suits and recommend emerging markets. Now, David’s not.

DAVID DARST: White suits?

ROBERT KESSLER: White suits.

DAVID DARST: Tom Wolf.

ROBERT KESSLER: Right.

CONSUELO MACK: I don’t understand that.

ROBERT KESSLER: Consequently, what I’m saying is I think you want to be in everything that is risk-averse. And therefore I would suggest that a Treasury, whether it’s overnight money or it’s ten or a 30-year Treasury, I think the ten year will probably outperform everything this year, and that’s a way-out kind of a call, but I do think that rates are going to substantially come down, and they do usually the second or third year after a recession, and since we’re only a year into this, we have a long ways to go, and I think you’ll see the ten-year Treasury probably back at 2% range or lower. And that’s a big move.

CONSUELO MACK: Wow. And David Darst, you’re thinking defensive action, too.

DAVID DARST: I am, Consuelo. Procter & Gamble (PG), which I’ve recommended on the show before- they have 23 products with over $1 billion in annual sales, and they have 20 products in addition with over $500 million in annual sales. They just changed leaders. Robert McDonald takes over from A.G. Lafley. McDonald has been with them for 29 years. He sold Folgers Coffee. He’s selling off the pharma area to focus on personal care, on household products and human well-being, okay. We see three billion people every day out of six billion in the world that are touched by a Procter & Gamble product.

CONSUELO MACK: Wow.

DAVID DARST: He wants it to go up to four billion. Only 30% of their revenues are outside the U.S. and Europe. Stock sales are 14 times last year’s earnings. It yields 2.9%. They’ve not been buying stocks in a year and a half. They’ve just begun to buy stocks, and the last thing is it was only up 1% last year with its lag to market. It went down less than the market. It went down 14 in ‘08 when it went 37 down, up 1% last year. We think this is a company that’s been a defensive stock about to go on the offense.

CONSUELO MACK: So we have a diversified portfolio right here between the two of you. Robert Kessler from Kessler Investment Advisors, thank you so much for coming in from Denver and from New York, it’s great to have you regardless, David Darst from Morgan Stanley Smith Barney, thanks so much for joining us.
At the conclusion of every WealthTrack, we tried to leave you with one action to take to build and protect your wealth over the long-term, as well. This week we’re revisiting a retirement income theme that we and many of our guests have emphasized over the years. This week’s Action Point is: lock in some retirement income for life.
How do you do that? The Obama administration recently came out in support of annuities as a tool to deliver a form of “guaranteed lifetime income.” Specifically, President Obama has called for a change in federal rules to allow adding annuities to 401(k) retirement plans.
Until that becomes a reality, one way to assure a stable flow of income that you can count on for life is to buy the simplest, plain vanilla version, an immediate fixed annuity, also known as a single premium immediate annuity. You turn over a one-time payment to an insurance company, and it in turn will provide you with a predictable and guaranteed monthly income as long as you live. To make sure it’s there, that it is as long as you live, only work with life insurance companies that have the highest credit ratings, and don’t put all your eggs in one basket.
The financial advisors we have talked to recommend investing only a portion, no more than one-third of your retirement assets, in annuity products, and also recommend consider staggering the amount you put in over a number of years, so you can adjust your income stream as you need it. To get an idea of what kind of monthly income a given amount will return, go to immediateannuities.com for a quote.
Now what troubles many people about these immediate fixed annuities is that you might die before you have recovered your investment, your heirs don’t get any benefit, and inflation can eat away at the value of the income stream. So the insurance industry, in its infinite wisdom, has responded with variations on immediate annuities that address these concerns. The tradeoff is the adjustments reduce the monthly income. Annuities are not right for everyone, but as a vehicle to create your own guaranteed pension plan for life, an immediate fixed annuity is definitely worth considering.
That concludes this edition of WealthTrack. Join us for one of our Great Investors series next week. I’ll sit down with Steven Romick, portfolio manager of the FPA Crescent Fund, a finalist for Morningstar’s Domestic Equity Fund Manager of the Decade award. In the meantime, to watch this program again, please go to our website, wealthtrack.com. Starting Monday, you can see it as streaming video or a podcast. Thank you for visiting with us. And make the week ahead a profitable and a productive one.

Source: Consuelo Mack, WealthTrack, February 19, 2010
http://www.wealthtrack.com/transcript_02-19-2010.php

Tags: Asset Allocation, asset class, Asset Classes, Bonds, Chief Investment Strategist, Connie Mack, Credit Crisis, David Darst, Disinflation, Institutional Investors, Interview Transcript, Kessler Investment Advisors, Morgan Stanley, Naysayers, Prolific Author, Recession, Robert Kessler, Smith Barney, Stanley Smith, Treasuries, Treasury Market
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As The Dollar Takes Off, The Dow Falters - Risk Appetite is Threatening Collapse

Friday, January 22nd, 2010

This article is a guest contribution by John Kicklighter, Currency Strategist for DailyFX.com.

Any doubts that the market has forged higher without the support of stable fundamentals should be completely dispelled after this week’s sharp reversal. Even if this recent slump in investor sentiment doesn’t ignite into a true reversal of capital flows; the simple fact that the markets retraced so aggressively and in tandem stands as testament to the fear that lies just beneath the surface.

•    The Dollar Takes Off and Dow Falters – Risk Appetite is on the Verge of Collapse
•    When Sentiment Falls Apart Correlations will Tighten and Momentum Increase
•    How Over Extended are the Market and What are Fair Fundamental Values?

Any doubts that the market has forged higher without the support of stable fundamentals should be completely dispelled after this week’s sharp reversal. Even if this recent slump in investor sentiment doesn’t ignite into a true reversal of capital flows; the simple fact that the markets retraced so aggressively and in tandem stands as testament to the fear that lies just beneath the surface. What’s more, there are plenty of fundamental reasons to be concerned about the state of the markets or more precisely the conviction of those participants that drove the supposed high-yield / high-return asset classes to their over inflated levels. Among the long line of fundamental concerns that have slowly eroded the foundation of the most aggressive influx of speculative capital in history, we have non-existent yields, government efforts to restrain capital interests and the withdrawal of vital stimulus among many other factors.

In gauging the threat of a significant retracement going forward, we need only pick our poison. Every major asset class has its own benchmark that is ready to suffer the ravages of risk aversion. In the Forex market, many prominent carry-based currency pairs have already marked critical breaks and reversals. The dollar has taken meaningful steps towards true recovery. Now, we await the clear break of the Carry Trade Index. The same conditions exist in more speculator-responsive markets. The Dow Jones Industrial Average broke out of a 300-point range for the first time in two months. In commodities, gold has overwhelmed a trend that has defined the metal’s bullish drive for more than five months now. These markets are at the very edge and require only the slightest gust of fundamental wind to transform a retracement into a true change of trend.

What could motivate investors to throw in the towel and either book profit or unwind failing positions? The most basic force at work will be fear itself. Should the more prominent benchmarks pitch into a clear downtrend, market participants will require little motivation to exit the market. Remember, it wasn’t long ago that the these markets suffered their worst crisis in modern history. While the collective memory of the markets is short; there is little doubt that traders will heed the warning signs and attempt to preserve any returns they have made over the past year. So, in these terms; all we need is a catalyst. There are plenty of sparks to push sentiment over the edge. The most recent threat to speculation comes in the form of government regulations and restrictions. These past two weeks, China has taken meaningful steps to limit leverage and aggressive speculation to prevent a potential bursting of an asset bubble.

There is no argument to be made against the overextended market. Raising the reserve ratios, tightening loan requirements and other steps are no doubt reasonable; but their effectiveness in this stage of the game is too little, too late. And, China (the objective of a sizable percentage of the market’s most speculative funds) isn’t the only country bearing down on the volatile capital markets. US President Obama recently announced proposals that would limit the size and risk profile of the nation’s largest banks. This is a reasonable and direct step for a country that has been rocked by the failure of ‘too-big-to-fail’ firms; but there is little doubt that the side effects of such policy would be to reduce leverage and liquidity. Furthermore, these steps are being taken at the exact same time that the world’s policy makers are withdrawing the stimulus that has been so essential to market’s recovery to this point. As it was, there were concerns that speculators would be able to stand on their own when stimulus and guarantees were removed. Now they are looking at restrictions.

Written by: John Kicklighter, Currency Strategist for DailyFX.com.
Questions? Comments? You can send them to John at jkicklighter@dailyfx.com.

Source: DailyFX - The Dollar Takes Off and Dow Falters – Risk Appetite is on the Verge of Collapse http://www.dailyfx.com/forex/fundamental/article/carry_trade_basket/2010-01-22-0657-The_Dollar_Takes_Off_and.html

Tags: asset class, Asset Classes, Capital Interests, China, Collapse, Commodities, Correlations, Currency Pairs, Currency Strategist, Emerging Markets, Falters, Forex Market, Fundamental Concerns, Fundamental Reasons, Fundamental Values, Gold, Government Efforts, Influx, Investor Sentiment, Retracement, Risk Appetite, Risk Aversion, Simple Fact, Speculative Capital, Vital Stimulus
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Chinese Stealth Treasury Purchasing Continues

Thursday, January 21st, 2010

This article is a guest post by Tyler Durden, of ZeroHedge.com.

A week ago we speculated that the mysterious “direct auction bidder” may be China, purchasing Treasuries  indirectly though offshore money centers. Yesterday’s Treasury International Capital data confirms that there is something strange happening with China treasury purchasing, and adds more fuel to the speculative fire that China is in fact acquiring Govvies through less than overt pathways.

The TIC data released yesterday showed a surge in Treasury buying, with foreigners purchasing $118.3 billion in Long-Term Securities (Bonds and Bills). As the chart below demonstrates, this was a record monthly purchase amount in the LTM period.

What was strange about this data point, is that European investors accounted for well over half of purchases, at $68.1 billion - also a record monthly amount. Of this, the UK accounted for a whopping $50.6 billion, and France also buying a sizable $11 billion. Accounting for all Bill sales in November, foreigners offloaded $18.9 billion in short-term securities yielding next to nothing, after selling $38.3 billion in October. Furthermore, as we speculated, paydowns added to run from short-dated securities: $134 billion in bills were paid down in October and $8 billion in November. While forigners no longer flock to Bills, their holdings of the low-yielding asset class is still elevated at well over pre-crisis levels:

On this backdrop, China was a purchaser of just $14.9 billion in Notes and Bonds, while at the same time it sold $24.2 billion in Bills, for a net outflow of $9.3 billion. This is confirmed by consolidated holdings data, which saw total Chinese holdings drop to $789.6 billion in November from $798.9 billion in October. China’s aversion to Bills is indicated in the chart below, yet it still has a long way to go before it reaches its 2007-2008 holdings of the short-end. In November China held $109 billion in Bills, down from $133 billion in October, and a peak of over $200 billion in May 2009. As the country’s Bill portfolio matures, we expect an accelerating reduction in China’s holding of Bills, especially if ongoing selling interest does not decline.

We will provide a more in-depth analysis of global fund flows in November later, although we are troubled by some odd revision to October data, particularly as pertains to short-term treasury holdings by the Channel Islands and the Isle of Man, which we are currently trying to reconcile.

Focusing back on China for the moment, among other things the country was a net seller of agency debt for the 17th month in a row, offloading $3.4 billion in the class. China also sold $146 million in corporate debt while buying $393 million in US corporate stocks: a token amount on both sides.

Yet what is most odd about China, as we pointed out previously when discussing Chinese FX reserves, is that while China grew its reserves by $55.7 billion in October and $60.5 billion in November, over the same period, it saw its net holdings of US debt decline by 9.3 billion: a $126 billion differential.

As has been widely speculated, China could simply be diversifying away from the dollar, although a $126 billion net purchasing of a UST alternative would likely have had much bigger repercussions on commodity prices globally in the October-November time period. Yet, as Market News points out, this fact does not explain the stability of the CNY, coupled with the ongoing positive trade surplus. Market News’ explanation:

First, it is possible that China is making purchases through other financial centers. The UK’s holdings of US Treasuries rose USD47.4bn in November, and Hong Kong’s holdings also ticked up. If a portion of those holdings can be attributed to China, that would explain part of the disparity between strong FX reserve growth and weak growth in Treasury holdings.

Second, Federal Reserve custodial data, which has a different coverage to the TIC data, shows a solid increase in US Treasuries held in custody for foreign official institutions in October and another smaller increase in November.

Zero Hedge will analyze Fed custodial account data shortly, to determine the nature of the noted discrepancies. Yet the original question does stand: if indeed China is accumulating Treasuries in a covert fashion that bypasses a “smoking gun” appearance on TIC data, why is it doing so? Who stands to benefit from this kind of indirect purchasing via “direct bidders”? The explanation that public and private bidders originating from the UK are accumulating US debt deserves much greater scrutiny: the buyer is certainly not the BOE, which has had its hands full monetizing its own gilts for the past several months (and yes, unlike the Fed, the BOE has no problems admitting it is directly monetizing). And Europe in general is now a funding basket case, exemplified by the events in Greece: the last thing European Central Banks will worry about is funding the U.S. exploding budget deficit when they have a ticking time bomb in their own back yard. So whether the U.K. is merely a hub for offshore purchases of US bonds, whether originating from China or Petrodollar countries, is unknown. If the buyer indeed is China, we raise the same question we did a week ago:

The Fed has now informally offloaded the Treasury portion of Quantitative Easing to China, which does so via the elusive Direct Bid. It also explains why the Fed has generically been much less worried about TSY purchases under Q.E. (a mere $300 billion out of a total $1.7 trillion in monetization). It does beg the question of just how much Chinese holdings of US Debt truly are, as this number is likely hundreds of billions higher than the disclosed $799 billion.

If true, this would imply that the UK “holdings” of $278 billion are highly suspect, as the country likely own a fraction of this total, with the balance held by Chinese and Petrodollar interests.

One thing is certain: if someone is trying to hide their purchases, this is never indicative of a good thing, and much more analysis must be performed to determine just why international fund flows need to be below the radar.

Tags: 1 Billion, asset class, Auction Bidder, Aversion, Backdrop, China, Commodities, Consolidated Holdings, Crisis Levels, Emerging Markets, European Investors, Flock, Foreigners, Money Centers, Offshore Money, Outflow, Pathways, Purchaser, Stealth, Tic, Treasuries, Treasury International Capital, Tyler Durden
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The Power of Conventional Wisdom

Thursday, December 31st, 2009

This article is a guest contribution by James Kwak, from Baseline Scenario.

The week between Christmas and New Year’s is probably a good time to throw out half-baked ideas on topics I don’t know much about.

First, there’s been a lot of talk about the “lost decade” for stocks. The S&P 500 is below where it was a decade ago. Dividend yields bring you back up to break-even (the Vanguard Total Stock Market Index Fund had average annual returns of 0.18% for the ten years through the end of November, and that’s after about 0.1% in expenses), but inflation sets you back a couple of percentage points per year. (Vanguard’s S&P 500 index fund, however, was negative over those ten years.) James Hamilton, drawing on data from Robert Shiller, has some thoughts on why the stock market did badly; the fundamentals were so-so, but the big factor was that valuations were at their historical peak at the beginning of the decade.

For me, the worrying thing about investing in stocks is not specifically the high price-earnings ratio. It’s the fact that in the 1990s, everyone started saying that stocks were the best long-term investment, because “over any thirty-year period ever stocks do better than any other asset class.” That’s not a direct quote, but I’m sure you can find hundreds that are virtually the same. There are two problems with this statement. The first is that it’s assuming the future will be like the past. But the bigger problem is this: if everyone thinks that X is the best long-term investment, then it probably isn’t, in part because enthusiasm about X will drive the price of it up. I believe people were saying roughly the opposite in the late 1970s, and look what happened in the next twenty years.

That said, I’m no investment genius, and I have a fair proportion of my money in equity index or near-index funds. But the general point is that when everyone agrees on an investment strategy, they are probably wrong.*

Second, there’s been a lot of China boosterism in the past year or so, as the Chinese economy has returned to growth and its stock market has soared. The Times had an article today on the topic. I’m far from an expert here, but wasn’t the government basically ordering state-owned banks to  lend money cheaply and without asking too many questions? Aren’t Chinese economic statistics so bad that economists use electricity consumption as a proxy for GDP? Haven’t we seen this movie before all over emerging markets around the world?

I think some of the U.S. press coverage of China reflects our pessimism about ourselves; in that sense, it reminds me of the idolization of Japan that took place in the 1980s. Of course, there are huge differences. The Chinese economy has nowhere to go but up, and with over 1.3 billion people its economy will surpass ours in gross output in my lifetime. (On a per capita basis, though, I don’t think that will happen in my daughter’s lifetime, even if there is a Chinese immersion charter school down the road here in Western Massachusetts.) But just as the United States is not on the brink of world-historical disaster, so everything is not perfect in China.

* What’s the right grammar here? I know “everyone” is singular, but are you really supposed to say “when everybody agrees on an investment strategy, he is probably wrong”?

James Kwak is a former McKinsey consultant, a co-founder of successful software company, and currently a student at the Yale Law School.  He is not, never has been, and never will be a member of the Yale Law Journal. However, on December 11, 2009, he was named Grand Heresiarch of the Ancient, Hermetic, and Occult Order of the Shrill by Brad DeLong. He is a co-founder of The Baseline Scenario.

Tags: asset class, Baseline Scenario, China, Conventional Wisdom, Dividend Yields, Emerging Markets, Equity Index, Half Baked, Index Fund, Index Funds, Investing In Stocks, Investment Strategy, James Hamilton, Kwak, Long Term Investment, Next Twenty Years, Percentage Points, Price Earnings Ratio, Robert Shiller, Stock Market Index, Valuations, Worrying Thing
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Gold Is The Decade’s Best

Sunday, December 27th, 2009

By Frank Holmes
CEO and Chief Investment Officer

Happy holidays wishes to all, with a special season’s greetings to the permanent gold skeptics.

The decade that ends next Thursday is on track to be the worst in recorded history for the U.S. stock market—worse than all of the many boom-and-bust cycles of the 19th century, worse than the Great Depression-era 1930s, worse than the recession-plagued 1970s.

The S&P 500 opened the decade at 1,469.25 on January 3, 2000. When the market closed on Christmas Eve, the S&P 500 stood at 1,125.46—with four trading days left in the decade, the index’s annual performance over that span is negative 2.6 percent. The Dow Jones Industrials has lost about 1 percent per year over the same period, and the Nasdaq Composite is down a whopping 5.9 percent annually. When adjusted for inflation, the 10-year returns for these indices are even lower.

Meanwhile, what about gold?

The chart above from Bloomberg tells the story—a $100 investment in gold when the market opened on January 3, 2000, was worth about $380 as of this week (data through December 21)—that’s a total return of 280 percent and an annualized return of 14.3 percent. Gold stocks (as measured by the XAU Index) have also had a good decade, climbing 9.4 percent annually.

Commodities (as measured by the S&P GSCI Enhanced Total Return Index) posted average gains of 13.6 percent per year over the period, driven mostly by rapid economic growth in Asia and elsewhere in the developing world.

There are many commentators out there who see no value in gold and who denounce it as an investment at every opportunity. They are certainly entitled to their opinions, but it’s hard to argue with the numbers over the past 10 years—investors on average would have been better off with a gold allocation than having no exposure.

We consider gold a legitimate asset class, and for that reason, we consistently suggest that investors consider a maximum 10 percent allocation to gold-related assets—half in bullion or bullion ETFs and the other half in gold equities—and that they rebalance each year to capture the swings.

What the next decade will bring for gold? Who knows. But we do know one thing—those who held gold for the past 10 years will have a happier New Year than those who listened to the perma-skeptics.

Tags: Annualized Return, asset class, Boom And Bust, Bust Cycles, Chief Investment Officer, Christmas Eve, Commentators, Commodities, Developing World, Dow Jones, Dow Jones Industrials, ETF, Frank Holmes, Gold, gold stocks, Great Depression, Gsci, Happy Holidays, Nasdaq Composite, Rapid Economic Growth, Skeptics, U S Stock Market, Xau Index
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Advisor Alert - November 27, 2009

Friday, November 27th, 2009

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Tags: asset class, Canada, Census Bureau, Chief Investment Officer, China, Commodities, Congressional Budget Office, Economic Trend, Emerging Markets, Federal Budget Deficit, Federal Budget Outlays, Federal Deficits, Frank Holmes, Global Investors, Gold, Gold Equities, India, Market Groups, Medicare Medicaid, National Debt Clock, oil, Reputable Sources, Social Security Benefits, Treasury Department, Trend Data, Unfunded Liabilities, War Efforts
Posted in Bonds, Emerging Markets, Gold, India, Markets, Outlook, US Stocks | No Comments »

David Rosenberg: Government Bonds are on Fire

Friday, November 27th, 2009

In today’s Breakfast with Dave, Gluskin Sheff’s Rosie says:

Government bonds are on fire. Yesterday we saw a 10bps slide in the German Bund and U.K. Gilt yields - they are consolidating today - and U.S. 10-year yields are now down about half that amount, to 3.22% - 2bps from taking out the October lows, so keep an eye here for a possible technical breakdown in yields. The Canadian bond market already did that yesterday with the yield on the 10-year GoC slipping below the October lows - we have news for you: this was a major technical move. We can understand that government bonds are the “enemy” to the bulls (not once were Treasuries even mentioned as an asset class during my two-hour stint on CNBC the other day). But there is no denying that somebody is buying these bonds because the 7-year Treasury note auction ahead of Thanksgiving had $88 billion of bids for the $22 billion offering. Go figure, some folks clearly still have deflation on their mind (as they should).

We went into this latest round of turbulence with tremendous complacency in the marketplace (I really sensed it during the two-hour stint on CNBC’s squawk box on Tuesday) - rallies were still light-volume in nature (only two sessions in the past three weeks with NYSE volume north of a billion shares), the VIX index had just receded to its low for the year, at 20.5 (down 60% since March!), the bull share and bear share of the sentiment surveys hit late-2007 levels, and with the trailing P/E ratio at 27x and the forward P/E on $65 of earnings of 17x. There is no margin for error in an overvalued equity market - one that is priced for nearly 5% GDP growth. Remember, it was in the fourth quarter of 1987, a quarter that saw 7% GDP growth and a 55% earnings trend, that the S&P 500 cratered 30%. So, it’s not just about the economic backdrop, it’s what is being priced in - that is the lesson. For a highly overvalued market, it does not take much - like an off-the-cuff remark from the Treasury Secretary on the Meet the Press - to entice a massive round of profit-taking.

Don’t look now but the Baltic Dry Index has just slipped for the fifth session in a row, and down 12% from the November 19 interim high. Not a constructive near-term signpost for the commodity complex. However, as we said above, we look forward to a correction that allows us another opportunity to build long-term positions in this segment of the market where there are secular positive dynamics at play. But as we highlighted last week, anything connected to the U.S. dollar-carry-trade - a very overcrowded trade - is due for a correction.

To reiterate, the Swiss, the Russians, the Brazilians and the Vietnamese have all taken actions to weaken their currencies in recent weeks (see Russia Launches Campaign to Weaken Ruble on page C2 of the WSJ).

If you would like to read more of this, subscribe to David Rosenberg’s newsletter by clicking on the link below:

Tags: asset class, Bear Share, Bond Market, Canada, Canadian Bond, Cnbc, Commodities, Complacency, David Rosenberg, Economic Backdrop, GDP Growth, German Bund, Gilt Yields, Gluskin Sheff, Government Bonds, Half That Amount, Light Volume, Lows, Nyse Volume, Squawk Box, Treasuries, Vix Index, Year Treasury Note
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Sprott: Beyond the Stimulus

Monday, August 24th, 2009

In the latest issue of his monthly newsletter, Eric Sprott, head of Sprott Asset Management, says that while the massive $2.8-trillion in cheques already written, which are part of a grand total of $11-trillion in total stimulus commitments, has been great for the stock market, it remains to be seen if indeed the positive effects will make it to “Main” Street.

Sprott discusses data that suggest this is as good as it gets - that the effects of the stimulus are already wearing off.

The majority of the Act (ARRA - American Recovery and Reinvestment Act of 2009)  consists of tax cuts and transfer payments to citizens, the impact of which was felt within the first two quarters of being received. By the end of September 2009 this stimulus will have worn off, and along with it will vanish the greatest marginal impact of the entire stimulus package itself. According to economic forecasters like Moody’s, by 2010 the net impact of the stimulus package to real GDP will be barely over 1%.

China’s $4-trillion yuan economic stimulus too has been unprecedented. It effectively represents 64% of China’s GDP, and it makes China the greatest stimulator of all. Beneath it all however, Sprott points out that it has resulted in 7.9% GDP growth increase for 2009, a mere $1-trillion return on a $9.37-trillion investment.

So if the money hasn’t generated GDP growth, where did it go? It’s  gone everywhere. Their government-induced liquidity flood has “soaked” virtually every speculative asset class in China. Copper, nickel, steel, Chinese equities, Chinese real estate - they’ve all appreciated in spite of the obvious and acknowledged weakness in the global economy.

What happened?

In our assessment of recent economic data, there are only two possible explanations for the recent market rally. Either  investors are discounting an incredible economic recovery that is just around the corner (hard to believe), or the extra  liquidity injected into the economy has found its way into the stock market. We’re leaning towards the latter alternative.

What’s next? Sprott says that a double dip recession is more likely now and investors should prepare for what is waiting beyond the stimulus, as there will nothing to replace all the artificially induced demand.

Read the whole letter here (pdf), or below:

Click on the top right hand corner of the reading pane to full screen the document.

Sprott Comment August 2009

Tags: Arra, asset class, China Copper, China Gdp, Copper Nickel, Economic Data, Economic Forecasters, Economic Recovery, Economic Stimulus, Eric Sprott, GDP Growth, Global Economy, Grand Total, Marginal Impact, Market Rally, Massive 2, Nickel Steel, Real Gdp, Reinvestment Act, Stimulus Package, Transfer Payments
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Hugh Hendry: June 2009 Letter

Thursday, June 18th, 2009

Here, below, in its entirety is Hugh Hendry’s latest letter to investors. Its both enlightening, and highly educational, as the outspoken and brash Hendry has a great handle on market history as well as the English language.

Hendry, founder of Eclectica Asset Management, is one of the hedge fund industry’s true luminaries, and often goes out of his way to argue his convictions as well as make his bets publicly known, and while his theses often get tested, as does his durability, he has yet to be proven wrong.

Hendry has made for some of the most incredible intellectual arguments as well as hilarious direct-attack moments regarding the markets and the ongoing inflation vs. deflation debate during European Squawk Box and Power Lunch gatherings. Here, here, and here (whaling moment of the year).

We got our hands on his hard-to-get letter thanks to Tyler Durden at Zero Hedge.

THE ECLECTICA FUND
Hugh Hendry, JUNE 2009

Warning, I am about to repeat myself.

I have been keeping a low profile and have reduced the length of my reports. There has been little to note: my favourite asset class is long duration bonds; not index linkers. These have performed poorly so far this year. I have not fought this trend aggressively. By March I had rebuilt a modest sized position owing to the severity of the weak economic data. However this was mostly eliminated by the first week of April out of respect for the formidable price correction that was ongoing. As a result the Fund is down modestly on the year to date following last year’s surge. However, with the long bond yield in America now not far off 5pc, it is my contention that the trend may be approaching another extreme. I therefore thought it appropriate to once more outline my thoughts: what if the trend in the charts below continues; what if this year is a re-run of last year?

The decision to reduce the book in April reflected an unpleasant seasonality in our preferred trade. The second quarter in four out of the last five years has simply not been kind to risk aversion. Furthermore, markets continue to swing from the binary outcomes of inflation and deflation. At this point last year inflation was in the ascendancy. Backwards, forwards, since July of last year the same investors had to adjust to profound deflationary forces as all risk asset classes fell precipitously. Can we be any more confident that the market has it right now?

Let’s swallow a frog

I do not have the requisite level of confidence to make such a commitment. Better I would contend to always have a vivid image of the worst that might happen in our uncertain future and have this shape our behaviour today. So let’s consider the “bad things” which might initiate another dramatic rotation towards deflation.

My greatest angst is reserved for the four-fold rise in private sector, non-financial, leverage in America. In just 60 years, the private sector increased its debt from 43pc of GDP to 175pc. To put this into perspective, the UK is on the verge of having its formidable tax raising franchise downgraded because its debt may reach 100pc in two years time. And yet, until last year, there was little hand wringing about the private sector having borrowed more than 4x the public sector’s then debt.

Don’t get me wrong, I am sympathetic to the plight of America’s debtors. I understand why they came to believe that they were invincible. In truth, something without precedent occurred earlier this decade. Fearing the fall out from the tech bubble, businesses across all sectors of the economy set about cutting costs and laying staff off to prepare for the impending deep recession. Unemployed workers should have cut back on spending and rebuilt their savings. Instead they leveraged themselves against appreciating home prices to maintain their spending habits. Corporate revenues should have fallen. Instead, with disposable income boosted by home equity extraction, sales rose and profits boomed like no time before.

Today, by comparison, the corporate sector is threatened not so much by its own debt but rather by the loss of spending in the economy from the debt laden workers it has fired. Businesses are slashing costs and letting staff go. American unemployment is at a 26 year high of 9.4pc and total nominal wage payments have fallen for the first time in at least 50 years. This time around the economic orthodoxy is reasserting itself. Companies are discovering that in their quest to contain costs (by firing the economy’s consumers), they are suffering from a loss of revenue in future quarters; because of this I am wary of most prospective profit forecasts and not tempted by trailing 10 year earnings multiples.

My second concern relates to the willingness of governments to use their own leverage as a remedy for asset deflation. Policy makers seem to believe that the only way to reverse the tide in asset prices is to issue vast sums of ‘money-like pieces of paper’, aka government bonds. In doing so they are mimicking the previous decade when investment banks were able to boost the housing market by issuing trillions of dollars of mortgage backed paper, or the 1990s when it was new internet share issuance which drove the TMT bubble and so on back to John Law and his endless printing of Banque Générale certificates which financed the Mississippi stock bubble.

However there is a glaring flaw. Government debt is very visible; certainly more so than the paper previously issued by investment banks. Increase the issuance of mortgage backed securities, from $0.5trn in 1996 to $3.2trn in 2003, and no one bats an eyelid; house prices boom. Suggest issuing a corresponding amount of Treasuries and the bond market quickly fears inflation and frets over who will possibly buy all these bonds. Today bond prices are falling and there is the possibility that economic activity may be subdued by the rising cost of money. US mortgages are now dearer than at the end of last year.

Stimulus, what stimulus?

So prices are falling on the high street, total nominal wages are in retreat and yet the sovereign debt markets are in open revolt on the premise that “inflation is always and everywhere a monetary phenomenon”. Panic has taken over. Marc Faber is asserting that the US will definitely have hyper-inflation, one investment manager recommends an 89pc balanced fund allocation to inflation-proof Treasuries and CLSA’s Christopher Wood is recommending that US pension funds hold 40pc of their portfolio in gold. In other words people are convinced that inflation is the future.

What is less certain is when rising government bond yields begin to remove credit from the mortgage market and so close the door on the exit route of cheaper refinancing; today this is still seen as a distant prospect. The other pertinent question is whether “deficit nations” like the US and UK will be forced to moderate their ambitious spending targets. No one likes criticism and the reprobation of the German Chancellor and the Governor of the Bank of China must produce some soul searching; after all, central bankers are not renowned for their non consensual habits.

I keep thinking that it would be ironic if history were to show that US policy makers were right to fear the prospects of a $54 trillion debt deflation and that they should have been more ambitious in their monetary expansion. The bond vigilantes believe that the double dip deflation of the 1930s will ensure that the Fed will be slow to raise interest rates this time around. But what if the economy stalls because the credit markets are premature in tightening monetary policy for them?

I am beginning to sense another paradoxical twist. What if the Fed is right and Angela Merkel, Zhou Xiaochuan, Warren Buffet and James Grant are wrong? And that contrary to their inclinations the American authorities are forced to moderate their monetary expansion in order not to undermine the confidence of the international community. Whilst at the same time the bond market pushes long rates higher.

Under such a scenario the debt reduction efforts of the private sector would usurp the government’s attempts at stimulus; the economy would falter once more. Back in 1931 the same thing happened. Bond prices dropped and yields rose to the level that had prevailed for the previous ten years; a feeble economy lapsed back into a deflationary spiral. Perhaps if this were to happen again, and we were once more confronted by a truly dire economic outcome, then it is conceivable that the authorities could gain the vital legitimacy necessary to engage in an unquestionably large monetary response which finally purges the system of deflation. That is when I would choose to let rip on buying commodities and cheap equities.

The key is the economy’s sensitivity to bond yields. Russell Napier argues that it would require ten-year yields of 6pc (vs. 4pc today) to knock the economy and stock market from their perch and reassert the deflationary trend. But he bases his assertion on observations taken since the early 1960s. My quibble is that today’s leverage is unprecedented and prices are falling. May’s American CPI is forecast to contract by 0.9pc YoY; they fell in April. We never had falling prices in the 1960s, 70s, 80s or 90s. I therefore maintain that it is feasible that some unquantifiable but certainly lower nominal rate could choke the economy.

Regardless, it is my contention that many are investing in risk once more almost oblivious to the notion that a heavily indebted economy is confronted by a very real tightening of monetary policy. It is not inconceivable that the macro compass could swing violently towards deflation and wrong foot them again.

Will it happen? As I suggested at the beginning, it really comes down to whether we are trading in a groundhog version of last year. By last summer, oil had been bid up to $147 per barrel and markets were anticipating that central bankers like the Bank of England would be forced to raise (not cut!) rates by 200 basis points. The pressure was intense. I recall philosophical conversations regarding short sterling; what did it really represent? And with oil spiking I was taking my gross long position down but replacing it with $200 call option premium; not $50 put strikes. As Robert Prechter reminds his readers, “the news at turning points is just too strong for most people to act contrarily to it…fundamentals so intensely support the continuation of a trend just when it is ready to reverse”; mea culpa.

I have had cause to think long and hard about what caused the turnaround last July in the commodity spectrum. I believe the persistent and government approved appreciation of the Yuan played a prominent role. Forget quantitative easing, I believe this was the printing press that propelled risk asset prices higher. Chinese speculators could borrow in dollars knowing that their loans could be repaid for less in their local currency. And when the US entered the global recession first, and began cutting rates, the Chinese were emboldened to ramp up their overseas borrowing further; they had to buy something and as we know oil went parabolic. But then the Yuan stopped appreciating. Perhaps the central planners didn’t like spending so much on commodities? I suspect it was more that they became fearful of their competitive position vis-à-vis the Koreans and other mercantilist trading countries. Whatever the reason, it is clear that since last July their currency stopped appreciating vs. the dollar. This provoked an immediate response: speculators rushed to reverse their trade and we immediately went from inflation to deflation.

Since early March the price of risk assets has again risen considerably; the Yuan has gone sideways. Perhaps the Chinese don’t want to re-price their scarce exports amidst the economic weakness? I see this as a non-confirmation of the move in equities and commodities and it reinforces my bearish slant on the year. However, I happily contend that should the Yuan begin to appreciate once more and establish a new high vs. the dollar then I am just plain wrong with risk aversion and I will change the Fund’s posture; but so far it has been almost a year and nothing.

Rapidly Decreasing Pessimism?

I have been very fearful of fighting this stock market rally, taking the view that we could see something vigorous enough to convince the majority that we were in a new bull market. I did not expect anything like new absolute highs; more like 1930 when the Dow Jones rallied 52pc from its 1929 bottom. I was therefore heartened to hear, “History says fill your boots, sell your wife, dive in…” from David Schwartz, the self styled stock market historian, in an article from The London Times on the 9th of May, one day after the European stock futures had completed a 50pc rally from their intra day lows back in March. Furthermore, it was taken from a piece entitled, “Investors bet that worst of recession is over and predict new bull market”. These are early days but clearly the process of social herding and higher prices is succeeding in tempting many investors to risk their capital again.

I have written previously of life imitating art and continue to take inspiration from Will Self’s collection of short stories, “The Quantity Theory of Insanity”. In one tale a plucky undergraduate succeeds in locating his missing college professor by determining a pattern from a collection of integers copied from homosexual graffiti lifted from the cubicles of London lavatories. But it’s just a lucky coincidence. This got me thinking about Soros and Paul Tudor Jones plotting where the Dow might trade in 1987 from the entrails of the Dow in 1929. They thought the “great crash” of 2008 was due in 1987. They were wrong. But their pattern of integers, by coincidence, matched perfectly and Tudor Jones made 50pc in October 1987. In this business it doesn’t matter if you get lucky; just stay lucky.

Investment Strategy

So here I am in June 2009. My favourite asset class is down over 20pc on the year and is popularly derided. But I am feeling lucky. My gut feeling is that this year could follow last year. If I am right then it is time to re-engage tentatively with deflationary trades. Remember, I am fearful that the next few months could still contain further euphoric moments. My preference is therefore to start modestly and go for low delta but big pay-off option trades.

Such opportunities are rare today. However, over the last couple of weeks we began purchasing out of the money call options on the current 30 year US Treasury bond. Do not be too concerned, we have only used about 20 basis points of the Fund’s NAV on such option premium so far. However it is our intention to add to this amount should the elevated levels of fixed income volatility subside. Given the capacity of this market to thrash around from extremes, it is not unrealistic to imagine that yields could match their lows of just six months ago. Should this happen before the year end, our options would payout 14 times our investment.

Similar asymmetric payouts are achievable in the short sterling interest rate market where investors are pricing in a 2pc hike in Bank of England base rate by the end of 2010. This is eerily like this time last year when they were expecting a 2pc hike for the second half of the year. If this time around the market again reverses its opinion by December, and takes the view that this is unlikely to happen, then our option package could payout over 10 times our money.

I also like German sovereign CDS at this level: an annual fee, paid quarterly, of just $30k (a total outlay of $150k if held for 5 years) to insure $10m of notional debt should something truly calamitous happen to the finances of the German Republic. Could it happen? No. However, those who underwrite credit default swaps today can only see Germany’s formidable strengths and laud it for its high savings, fiscal prudence and large trade surplus. But as I wrote to you previously, I fear the “surplus” nations of China, Japan and Germany have been duped by the West’s borrowing binge.

I fear they have over-estimated the global economy’s demand and are confronted with huge pools of surplus marginal capacity. A prolonged and feeble recovery in America’s nominal GDP would have especially dire consequences for such economies; Germany is already on course to contract by 5pc this year. It could be that with a moribund export market (traditionally two-thirds of economic growth) and the likelihood that politicians change the constitution to ban state and local deficit spending, investors might prove willing to pay more for their German bond insurance. Remember it only has to trade at the highs of earlier this year and I would double our money.

Sovereign defaults are today priced as black swan events despite the fact that more than half of all governments defaulted on their external debt back in the 1930s. Already in this decade we have seen both Argentina and Ecuador default. In both cases the recovery rate was 25pc. This is low; historically 40pc is more typical. Perhaps 25 is the new 40? Today it seems likely that Latvia will join them. Their sovereign CDSs trade at €750k per €10m of notional protection. What this means is that should Latvia default tomorrow, or within the next 12 months, you would receive €10m minus the assumption of recovery (25pc) and minus any CDS payments incurred; or 10x your money. I own Hungarian protection which is priced at €340k per €10m of equivalent sovereign protection. Again, assuming a 25pc recovery, a default this year would return us 22x our money, 11x if it is next year, 7x in 3 years and so on.

Lastly, in an effort to help fund the cost of carrying these risk-averse trades, I have been selectively buying corporate bonds in the tobacco, agriculture, and utility pipeline industries. This portfolio has an average yield of 8pc and I would be happy to take you through its finer details on request.

Here is hoping that I get lucky.

(Legal)

This document is being issued by Eclectica Asset Management LLP (”EAM”), which is authorised and regulated by the Financial Services Authority. The information contained in this document relates to the promotion of shares in one or more collective investment schemes managed by EAM (the “Funds”). The promotion of the Funds and the distribution of this document in the United Kingdom is restricted by law. This document is being issued by EAM to and/or is directed at persons of a kind to whom the Funds may lawfully be promoted. No recipient of this document may distribute it to any other person. No representation, warranty or undertaking, express or implied, is given as to the accuracy or completeness of, and no liability is accepted for, the information or opinions contained in this document by any of EAM, any of the funds managed by EAM or their respective directors. This does not exclude or restrict any duty or liability that EAM has to its customers under the UK regulatory system. This document does not constitute or form part of any offer to issue or sell, or any solicitation of any offer to subscribe or purchase, any securities mentioned herein nor shall it or the fact of its distribution form the basis of, or be relied on in connection with, any contract therefor. Recipients of this document who intend to apply for securities are reminded that any such application may be made solely on the basis of the information and opinions contained in the relevant prospectus which may be different from the information and opinions contained in this document. The value of all investments and the income derived therefrom can decrease as well as increase. This may be partly due to exchange rate fluctuations in investments that have an exposure to currencies other than the base currency of the relevant fund. Historic performance is not a guide to future performance. All charts are sourced from Eclectica Asset Management LLP. Net Asset Values are as at the date of the document. © 2005-09 Eclectica Asset Management LLP; Registration No. OC312442; registered office at 6 Salem Road, London, W2 4BU.

Tags: Ascendancy, asset class, Asset Classes, Asset Management, Aversion, Bond Yield, Contention, Deflationary Forces, Durability, Eclectica, Economic Data, Hedge Fund, Hugh Hendry, Inflation And Deflation, Letter Thanks, Low Profile, Luminaries, Lunch Gatherings, Market History, oil, Power Lunch, Preferred Trade, Seasonality, Severity, Squawk Box, Theses, Tyler Durden, Whaling
Posted in Gold, Markets | 1 Comment »

Rogers on commodities (Newsweek)

Monday, April 20th, 2009

“Jim Rogers, the legendary American investor, financial commentator and, along with George Soros, founder of the Quantum Fund, is the ultimate commodities bull. More than 10 years ago, he started the Rogers International Commodities Index, and in 2005 he wrote ‘Hot Commodities: How Anyone Can Invest Profitably in the World’s Best Market’. Below, he explains to Newsweek’s Rana Foroohar why oil is still black gold.

Foroohar: Inflation-adjusted, oil is the same price that it was in 1976, and in 1870. So why are you still a bull?
Rogers: It doesn’t matter. It’s also true that just about any stock you can think about is at or below where it was in the 1970s right now. So what? There are still 15- to 20-year periods when commodities, stocks and any other asset class goes up a great deal. In 1987 stocks collapsed by 40-80%. But people who were smart enough to stay in them made 1,000% returns in the next decade. The point is to take advantage of those periods and make some money.

What’s the fundamental case for commodities right now?
Supply is declining. There’s been 35 years of low investment in production capacity. The last lead smelter in the US was built in 1969! There’s been no major oilfield discovery in 40 years. Oil is in decline. According to the International Energy Agency, oil reserves are declining significantly. At this rate, in 20 years, there will be no oil left. The only people to make money in the next 20 years will make it in commodities. It’s the only asset class where the fundamentals are improving. I mean, look at Citigroup, look at GM. Those fundamentals are not improving.

Do you see commodities as an inflation hedge?
Absolutely. This is only time in history where you’ve got every central bank in the world printing money at the same time. Consumer prices are going to go way up. The public is already getting out of paper money, which is why you’re seeing gold go up.

Does the future growth of China factor into your bullishness?
China is tiny in comparison to the US economy. Anyone who thinks that the commodities story is driven by China needs to do more homework. In the 1970s, everyone was in recession, and you still had declining supply [in oil] and higher prices. Asia wasn’t even in the game then. China was run by Mao. But now, of course, there are those 3 billion people in Asia who are in the game. It’s just another factor.”

Click here for the full article.

Source: Rana Foroohar, Newsweek, April 11, 2009.

Hat tip: Investment Postcards

Tags: American Investor, asset class, Black Gold, China Factor, Financial Commentator, George Soros, Growth Of China, Hot Commodities, International Commodities Index, International Energy Agency, Jim Rogers, Lead Smelter, Oil Reserves, Paper Money, Printing Money, Quantum Fund, Rogers International Commodities Index, Time Consumer, Time In History, World Printing
Posted in Commodities, Gold | No Comments »

Crispin Odey: No Recovery Until Consumers Unwind Debt

Thursday, March 5th, 2009

Crispin Odey, CIO, Founder of Odey Asset Management, in the UK, released his outlook for 2009 in his 2008 year-end letter to shareholders. Odey, a high profile hedge fund manager, and Hugh Hendry’s (Eclectica AM) former mentor, made a fortune last year shorting UK banks, shares some of his insights and observations on last year and the coming year. Here is an excerpt from that letter:

“2008 was a difficult year. As our shareholders remarked, it was not the year of the rat for nothing. If something could go wrong it did go wrong. No asset class rose but some currencies fell. Stock markets on average fell by 50% in US dollars. Commodities fell by 70% from their highs in June, admittedly after rising by 30% in the first five months. Hedge funds saw on average redemptions of 40%”.

“Whatever they might still say all clients started to view cash as their benchmark. Noted individuals were badly caught out. Joe Lewis, a legendary currency trader, lost a billion dollars in Bear Stearns. Kirk Kerkorian famously declared that he should have died a year ago and he would have saved both his fortune and his reputation”.

“So what does 2009 promise? Firstly it has to be said that governments, institutions and regulators have been slow to understand the credit cycle. At each turn they have believed that it was not part of anything greater. What was nothing more than a problem in the interbank market became a lending problem for the major banks and in September caused a slump in the economic activity worldwide”.

“The numbers are now so bad that they are not worth repeating. In January 2009, Japan’s exports were down 40% year on year. A combination of not understanding the credit cycle and no interest in history has served our leaders poorly. As John Train recently remarked “just as Keynes said that leaders thinking they were acting in good sense were in fact slaves to some defunct economist, so today these politicians have been slaves to Keynes.”

“Even if they could find solutions to the problems we have, we cannot now escape the most painful recession post-war. However, there is also no consensus over the solution necessary. What is true is that politicians will not stand by whilst unemployment rises and activity dwindles and that is precisely the outlook we face with current policies. Current policies are helping to contain the worst effects”.

But his main point is that there will no recovery until consumers start to unwind their indebtedness, which is going to take time and pain. “There will be a rise in prices in those countries that have devalued, despite current widespread belief to the contrary, which will be felt when companies re-order. We may be in recession in the UK, but a 25% fall in our currency will result in a 10% rise in prices at some point. It is the fact that no economy is remotely in the recovery position which makes me still quite depressed for this year. I am happy to buy when faced with irrational fear, but the fear that I see around me today appears reasonably rational”.

Hat Tip: Jonathan Davis, Independent Investor

Tags: Array, asset class, Bear Stearns, Billion Dollars, Crispin Odey, Currency Trader, Defunct Economist, Eclectica, Economic Activity, Five Months, Good Sense, Hedge Fund Manager, Hedge Funds, Hugh Hendry, Interbank Market, Joe Lewis, John Train, Keynes, Kirk Kerkorian, Legendary Currency, Letter To Shareholders, Post War, Redemptions, Stock Markets, Uk Banks, Year Of The Rat
Posted in Commodities, Credit Markets, Economy, Markets, Outlook | No Comments »

Jim O’Neill Discusses World, BRICs

Wednesday, January 14th, 2009

Jim O’Neill, Chief Economist, Goldman Sachs , who invented the “BRICs” asset class is interviewed by FT.com’s David Oakley regarding world markets, BRICs and Emerging Markets. Click on the image to watch Part I (the player will automatically play all three segments:

Click here for the second video on the BRIC economies.

And click here for his view on investment in emerging markets.

Here is a synopsis of the interview, which is worth watching:

Part I: World Markets

• I suspect [2009] its not going to be as bad as 2008.
• The worst quarter for the world economy may very well be the 4^th quarter of 2008.
• In some ways it was extremely bad, with -4-5% GDP growth annualized drop.
• Indicators suggest that there’s been a huge improvement since November.
• In the first 5 days of the year there was a slight gain in the S&P500, and those of us who look at that believe that as goes the first 5 days so goes the year.
• 80% of our clients are very negative about the world economy.
• Markets are markets, and if that is truly representative, then aren’t that many more who can get negative and improvements in anything will be a surprise.
• In think its possible for the US to have a similar outcome as Japan, and because of the Japanese experience, US policymakers have learned from their mistakes, and I don’t think that’s going to the case in America.
• After all the financial shocks that we got last year, especially during September and October, where it was one every two or three days at one point, which were so demanding. I’m assuming we got all the surprise shocks; if there is another surprise shock at this stage, then I would be once again concerned, that would be extremely worrying, it would force me to have a different view.

Part II: Regarding the BRICs (O’Neills favourite subject)

• Manchester United is actually Jim O’Neill’s favourite subject.
• BRICs come close to favourite.
• If you look at last year in the context of where its come from, its pretty obvious that in the midst of a major slump in the developed markets the BRICs would be affected.
• At the beginning of 2008, the BRICs, at least India and China, were trading at 2X the valuation of the US market. There’s no way they could cope with a 20-30% drop in a major markets with that valuation and slowing.
• When we started this thing [BRICs] the idea that these markets would go up every year forever was something we never believed.
• If you actually look at the returns, they’re still showing over 120% total returns since we started 7 years ago, and the S&P 500 is down 25% over the same period.
• Anybody who thinks the BRICs thing is over because of last year is living in a dream world, its just because they may have gotten in late.
• I think Russia is the independent weak link and the Russian story is by and large an oil price story, plus some political view as well.
• I’ve always believed for the last 3 years that we needed to see commodity prices dropping in order to see what would happen to Brazil and Russia who are very dependent on commodities.
• Clearly with the price of oil going down, that was not good for Russia. What you need to see there is a quicker changes about policy, or for oil prices to go up otherwise they’re going to have another tough year.
• One of my favourite ideas across the board, not just for the BRIC, is investing in Chinese domestic demand.
• Look at the fiscal and monetary policy response in China. It’s huge. There is some evidence already of monetary growth is already picking up in China. The freight indices such as the Baltic Dry Index and others have started to turn around again. I suspect that is a sign of Chinese demand already starting to turn for commodities which ultimately is going to be good for places like Russia (and Brazil); at its worst it will take a while; Russia will look like it’s in a recession, but the idea that Russia is finished is risky in itself.
• I’m surprised at the attention the bad Chinese export numbers are getting, given what’s happened to the US economy; obviously Chinese exports are going to be weak given that at one point China was exporting up to 10% of its GDP to the US.
• What you need to do is look at what’s happening going forward with China’s domestic demand policy, and on that score, I am very optimistic.

Pat III: Looking at opportunities in Sub-Saharan Africa

• I don’t think of BRICs as emerging markets, in the traditional sense. I think of them as the lynchpin of the modern globalized economy, because they’re all so big in terms of population.
• I do think it’s a different question to ask about emerging markets beyond the BRICs.
• If what I said about some recovery in some of the world’s major equity markets doesn’t happen then I think that a lot of emerging markets will struggle, but if I’m right and we do see some shoots of recovery in major markets, I would guess even some of the riskier ones will end up surprising people by showing strong returns.
• By and large, EM will be at the riskier end of the spectrum, so when things go down, they tend to suffer the most, and when things go up they tend to do the best.
• Recovery in the emerging markets will depend on the risk appetites of foreign investors.
• If things continue poorly in the US, I think that there are a number of places such as Eastern Europe that could become a really big problem, some parts of Asia and Latin America with large external deficits, would have major problems attracting funding.
• Outside of the BRICs where I spend most of my time, I’m very intrigued about Africa.
  • We have (Jacob) Zuma coming on the scene in South Africa, and that could be a very big issue. Zuma could do a Lula, and surprises people positively, that he’s not some kind of raving lunatic, keeps sensible economic policies and South Africa does better than people think.
  • Obviously Zimbabwe. That’s been a mess. Will that change, and if it does, that will be another source of positive surprise for the continent in general.
  • The last one, which is the biggest in many ways, Nigeria. People started to warm to Nigeria, the past couple of years. It ended up struggling, there seems to be perennial problems about certain areas of geography about Nigeria and the politics. If that carries on then Nigeria might become a source of disappointment. On the flipside of that, if you get the governance on side, then maybe Nigeria’s the place to look at.
  • I have a bit of my money in Africa, I wouldn’t put too much of my safe money there, but its the one that I’m most excited about in terms of where I’m willing to take risk.
• I think its time to take a bit of risk. We started by talking about how cautious people are, and that’s a good sign. Last year at the same time, there weren’t many people cautious, and when we got all the bad news we were all vulnerable to it. Now, people all over the world are scared, paranoid. Now, we’re going to climb a wall of worry, I suspect, so long as policy is helpful.

Tags: asset class, BRIC, BRICs, Case In America, Chief Economist, David Oakley, Days Of The Year, Emerging Markets, Financial Shocks, GDP, GDP Growth, Goldman Sachs, India, Japanese Experience, Manchester United, Midst, O Neill, P500, S David, Segments, Th Quarter, World Economy, World Markets
Posted in Commodities, Economy, Emerging Markets, Gold, India, Markets, Oil and Gas | No Comments »