What to watch for.

Marc Faber says that when Goldman Sachs (GS) goes down, that will be th indication that the credit bubble is collapsing. He sees that credit will tighten when assets decline, rather than when central banks tighten.

Treasury yields and stocks...

I'm betting on a reversal of Treasury yields. The 10-yr. bill is at a 3 month high of 4.78%. This bet is easy with my practice Yahoo finance account. However, I don't have a futures account with real money. I am limited to stocks, so I will make my bet on yields going down with Novastar Financial (NFI), a sub-prime mortgage lender. John confirmed that mortgage lenders are inversely correlated to Treasury yields.

trades...

Bought 102'75 March 2-yr Treasury Bill call at 0'05

Orders:

Sell March 10-yr. Treasury 107'00 put at open. Take profits. Market sentiment can't go much further from an 86% chance of lower rates in March to only 50% chance of lower rates in September.

Short 2 MSCI Emerging Market index (EEM) at open. Hedge against "Doomsday Scenario."

Buy 5 Gafisa (GFSAY.PK) at open. Brazilian homebuilder. Play on mortgage rates coming down (since 2003, inflation is down from 12% to 3% but real rates are still at 10%) and an 8 million unit housing shortage.

Short 6 InnerWorkings (INWK) at open. Barron's says the man behind the scenes is a crook, and nobody's better at uncovering the crooks than Barron's.

The Doomsday Scenario

The Barron's roundtable issue came out this weekend. Putting together the various insights that were elucidated during the interview, I came up with a Doomsday Scenario. It's not something that I think will happen, but as a possibility, I should have a contingency plan, and I should throw a couple eggs in this basket to hedge against its possibility. It also jives with my view of the Dollar, so my currency bets are already 50% there. The other 50% consists of switching my bet against the Yen to against the Pound Sterling.

Here's the Doomsday Scenario in a nutshell. It's a massive correction in all financial markets and commodity prices. I'll lay out how it could happen this year, and then I'll examine the steps.

The Doomsday Scenario may have already started with plummeting oil prices. High oil prices have been the boon of financial markets, especially the bond markets. Scott Black of Delphi Management says that lower oil prices could eliminate $200-300 billion of inflows from OPEC nations. What about petrodollars from non-OPEC nations? Another $200-300 million? When the well dries up, the plants die. What I mean by this is that the financial markets need a continual source of money inflows to grow and flourish. They are much more affected by a loss of liquidity than by a temporary loss of asset values such as the $2 trillion correction in commodities and emerging markets last May. If liquidity starts drying up, then volatility will go up. In other words, the market will get choppier. If it gets choppy enough, and Japan raises rates, then the carry trade will end. That will further dry up liquidity. At this point it could become a vicious cycle. But, by this point, the Fed would probably have eased already. However, the global economy could stall if the flow of dollars reverses significantly. Right now, dollars flow from the U.S. to countries for oil, manufactured goods, and other commodities. If oil gets low enough, and volatility choppy enough, emerging markets will disintegrate (they had $140 billion in U.S. investor inflows last year) and all the money will come back here. Right now, only most of it does. A strong dollar is bad for the stock market, as is disinflation, as is volatility. These factors together would cause a flight to quality, namely, long-term Treasuries. If enough liquidity shrinks just when commodities plunge, emerging markets will be choked, further dropping commodity demand. If.... Lots of if's here, but these are some pretty big IF's, and these different scenarios could come together this year, which was impossible last year.

Here's the recap:

Oil down = liquidity down = volatility up = end of carry trade = Yen up, liquidity way down, dollar up = financial markets way down.

Despite this, I think the U.S. economy will escape a recession. GDP could still stay at 3-4%. But that doesn't necessarily mean that the stock market will go up. In fact, Bill Gross from Pimco says that if inflation goes to 1% and nominal GDP isn't greater than 3%, that will be deflationary for asset prices. He and Scott Black both see Bernanke lowering rates when inflation comes in abnormally low in the next few months.

Time to reverse my put option on 10-yr. Treasury bills tomorrow. I will close the put, and look for August calls over 112, or as far out and as high as I can go. They should be cheap. The Treasury bulls have fled the field and will take time to regroup.

How about stocks? Dividend stocks will do well if rates go down. Airlines should do well as slower growth would just further cement more than offsetting gains from falling oil. Companies with low debt will do better than leveraged ones. Financial companies will have a tough time. Staples, like the cigarette companies, will do well because their cash flow is safe.

On the flip side, there's this crazy guy in Iran who might stop pumping oil (although I think he's more likely to do that if he got a nuke), and emerging markets may be strong enough to stand on their own. (Do Chinese banks lose business if foreigners sell their stock?) In other words, could emerging markets keep chugging along even if their stock markets suffer a serious correction?

Forex

The Moore Inflation Predictor is forecasting disinflation and possibly deflation. This is good for the dollar, but bad for the markets. However, the Yen might strengthen this year if deflation erodes liquidity, raising volatility, and ending the carry trade. So, I'm switching my USD/JPY to USD/GB Pound.
EUR/USD $1.20502
GBP/USD $1.96449
USD/JPY $0.8309

Forex

The Moore Inflation Predictor is forecasting disinflation, and possibly even deflation. This is good for the Dollar. However, the Yen might come back this year, if deflation tightens liquidity, raising volatility, and ending the carry trade. So, I'm switching to USD/GB Pound.

consumer confidence...

... just came in at the highest level in a year. "This is a bullet through the heart of the doomsday crowd." --Stuart Hoffman, chief economist, PNC Financial Services. See Yahoo.

Currency...

Euro up, Pound down. The ECB kept rates flat, while hinting that they would raise again this quarter, reports Bloomberg. Meanwhile Germany's economy is growing by leaps and bounds. The new economies of Eastern Europe are injecting new life into Europe. The Euro fell half a cent to under $1.29 at $1.2890. The weekend after Thanksgiving, everyone was yelling about the Euro and now it's down from its high of 1.34.

Across the channel, inflation is over 3%, and the Bank of England raised rates, suprising 52 out of 52 analysts. See Bloomberg again. The Pound is up over 1.3 cents to $1.9447.

One more thing: a five cent swing doesn't sound like much, but it's a huge swing in the Forex market, where 100-1 leverage is common. It's more important to predict and take advantage of the six week 4% swing than to predict a one year, 10% swing.
I don't understand anyone being proud of such predictions. In the stock market, for example, people will say "invest for the long term." I see an investment as a failure if it loses 20% in six months even if it's up 100% five years later.

Allied Capital

Allied Capital (ALD) has been down as much as much as 15.7% in the past two days. Why? Because one of their investments, Business Loan Express (BLX), is in trouble. However, this is totally overblown. Even if they lose their entire stake, it's only 6.2% of Allied's portfolio, according to Allied's press release. Herb Greenberg thinks this justifies the shorts against Allied. Let's see if he's right. He says that he first wrote about BLX's fishy lending in 2003. Let's hope he shorted ALD in December of 2003 at it's yearly high of $28.74. If he covered it at the open today, at $27.79, that would be a 3% lower. Over 3 years! Wow. 1% a year. That's great Herb. What about dividends? They come to $3.58. Now you're talking about a loss of 9%. Well, if by justified, you mean losing money, here's to you Herb.

What this really is, is a golden opportunity to buy a $33 stock at $29.

follow up July 10th

Live cattle futures up from 88 to 94. Not nearly up as much as corn has been up.

2007 analysis.

2007. Let's ignore what I said two weeks ago and start over. The Moore Inflation Predictor from Fintrend.com predicts disappearing inflation this year. Every time I've been tempted to ignore it, it's come back to bite me in the ass. Here's the chart:The chart only tells half the story, however. The chart from August predicted that the Janruary spike in inflation would peak at 5.75%. Now it's at 2.75%. That's a serious downtrend.


My first prediction is falling oil. $40/barrel sometime this year. I've already taken advantage of this by buying United Airlines (UAUA). But what's next? As oil prices fall, we're now in a vicious cycle that's causing everyone to dump their oil before prices fall further. Who's buying? Refiners. Every year, gasoline spikes in the spring. Look for this year to be different. How about gas for a $1.50? (Right now Gasbuddy.com reports the average US price at $2.29.) That will help automakers, such as Ford (F).


GDP should be much higher with inflation down. Last quarter it was 2%. Inflation was at 2% and housing took away 1.2%. Add in a point for inflation, half of housing, and a bounce of 0.6% and you have 4.2% growth next year. Compare this to the consensus of about 2.5%.


Let's put strong GDP and low inflation together. We get steady to slightly higher interest rates. I predict 5.5% at the end of the year. This will be bad for dividend stocks. Last year, they gained 21.6% without dividends! Allied Capital (ALD), for example, went from $27 to $33 from August to December.

What about the dollar? If rates are up, the dollar will be up. Add a strong economy on top of this. Also, Europe will probably stop raising ratesA strong dollar plus falling commodity prices means that emerging markets will be pummelled.

Falling inflation is, however, bad for the stock market. A good economy should limit the downside. A higher dollar is bad for the market. What the market will do is actually pretty foggy for me. Is there enough liquidity to raise the market? Earnings growth from a good economy doesn't raise the market without liquidity flowing in. My guess is that the market will be pretty flat, maybe a single digit gain this year.


Gold will fall back to around $500. A strong dollar and a strong economy are bad for gold. On the upside, however, gold production is unexpectedly down, and the world could easily become less stable and more dangerous.

Housing? Should keep sliding, albeit at a slower rate. I don't see any big bounce in housing any time soon, especially if rates increase. I think the market won't be terrible, just mediocre.

Tanker stocks

Last quarter, tankers stocks such as Frontline (FRO) suffered from below average rates. This quarter looks weak so far as well. Why so weak when the fourth quarter is traditionally the year's strongest? Falling oil prices? I don't think so. I think this has more to do with oil stockpiles than oil prices. Lets look at this chart from the Energy Department. During the third quarter, stockpiles grew greater and greater than the five year average. When oil prices started dropping, there was no incentive to stockpile oil. Instead of importing oil, the stockpiles were opened. I believe that tanker rates will rebound when oil stockpiles return to five-year average levels. If they don't I'll have to look for another hypothesis to explain and predict rates.

Thank God for Hugo Chavez!

If you want oil to go lower (I own United Airlines), then you must be a huge Hugo Chavez fan. With his new plan to nationalize "everything that was privatized" (Bloomberg), the Venezuelan market is down 22%. Now, I know that everyone's first reaction is that this might disrupt oil supplies. Absolutely not. Hugo Chavez is addicted to oil. Addicted to selling it, ever since he generated record deficits for his country last year in a desperate bid to get re-elected by bribing the people with social programs. Even as he chases foreign investment out of his country, oil becomes more and more important to him. Why doesn't anyone take OPEC seriously? Because Chavez will pump more oil the lower the price goes. I, for one, applaud his efforts. I want to see gas under $2.00 again, and I will.

Viva Chavez!

How cheap is Sprint?

Sprint (S) is down 10% today on forecasts of flat revenue for this year. On top of that, Sprint lost 300,000+ customers in the fourth quarter of last year. Ouch. Further concerns include the fact that the company is too big too turn around fast. But it's worth looking at when it makes the Bloomberg headlines.

Verdict: at 10x leveraged free cash flow with $21 billion in debt, I give it thumbs down.

Getting Hot!

The adult stem cell market is getting hot! Bloomberg reports on the American companies, but I still like Mesoblast best. I'm going to still with this one for a while.

Follow up post of June 3rd

Market: right for 3rd quarter, wrong for 4th
Commodities: wrong on oil, right on metals
Housing: perfect
Good thing I didn't buy Newmont Mining (NEM) at $53. It's now at $44.
Adult stem cell companies: Mesoblast (MSB.AX) is up 51%.

Ooops...

Spoke too soon on what's different. I don't think the Fed will be lowering rates in the next 6 months. The economy will be fine. However, I think the Fed is very wrong on inflation. I think that this year will almost disappear, and because of that, GDP should come in at 3%.

Let me summarize my views on what to invest in for 2007: any companies that are users, not producers of commodities.

Economy

Good news all around on the economy. Almost everything was good: oil down, manufacturing strong, Wal-Mart showing strong sales, and consumer strength. The only downside was seen in auto sales and housing construction. What's different today is that the market has dropped it's fear that a strong economy will cause the Fed to hold rates steady.