China

The Chinese market plunged 6.8%, but the S&P broke it's 2000 record. Obviously, this is not the same story from the last time the Shanghai market dove in February. What's different? Nothing, except that nothing happened last time. Also, by resorting to a tax on trading, Chinese authorities did nothing to jeopardize even the appearance of a loss in liquidity from China. Instead of gaining on the news, the Yen was down against the dollar. So, there's another scary mask that's faded into the shadows.

I like the case the bears make; it's completely logical. However, the market is not logical, it's circularly logical and emotional.

illegal workers...

"Remittances grew at a 0.6 percent annual pace in March, down from a 27 percent rate in March 2006, according to the most recent Mexican central bank data" according to Bloomberg.

Ouch! That can't be good for the Mexican economy. As the article also points out, illegal workers are the first to lose their jobs. If this story is getting mainstream press, and you can be sure that Wall Street is miles away from Main Street, then it is probably time for the housing recession to start affecting the Dept. of Labor numbers. Let's see when the employment report comes out on Friday.

Currency continued...

Just a couple of notes to my last post.

I don't know why Japan doesn't show inflation, given that they have the weakest currency in the world.

Also, it is important to view the shift from bonds to equities that foreign central banks are embarking on is a slight shift in direction, not a reversal of global liquidity. It does indeed signal a more dangerous route, but that time is not upon us yet. In the mean time, it signals a global equity boom, for the time being. It will speed up the instability of the system because it shifts China's lending from benefiting consumers, (through lower mortgage rates) and therefore the US economy, to benefiting bankers and hedge funds (and hopefully your friendly blogger as well).

Right now, it seems that Japan is not feeling the strain of the system. They have been printing money willy nilly and they still have no inflation. They may make a token show of protecting the Yen from speculators, but that will be all.

China is a different story. They are under political pressure from the Democrats to appreciate their currency. A sharp revaluation could break the system; i.e., China might not be able to keep rates down if they don't have enough dollars coming in. A big pop in their stock market bubble could also shock the system, but probably not to the point of stopping the circle. In fact, liquidity is a three headed monster containing Japan, China, and OPEC.

Europe and Britain are keeping their currencies strong and raising rates, and they still have run-away inflation. What is the difference between them and us? China, OPEC, and Japan are throwing money our way, so we have lower rates. However, rates will go through the roof if that money ever stops.

Bernanke will probably see that coming, and eventually he'll raise rates. But in the meantime, he doesn't want to kill housing if he can help it.

Currency conundrum

Here's what I think about the current global macroeconomic backdrop.

China & Japan are keeping US yields low by lending us as much money as we care to borrow. China and Japan's purpose is to keep their currencies low against the dollar to promote their export business. OPEC also has amassed huge petrodollar reserves. However, their aim is different. They are seeking a higher return. Because of this, we see low yields financed by Asia, and a hedge fund/emerging market (EM)/stock market/buyout boom financed by OPEC. If the $ drops, OPEC will shift more investment away from the US, but Asia won't be deterred. They don't care if they lose money; their goal is to keep the money coming in.

The questions arises as to whether Asia can keep yields down if OPEC diversifies further. In fact, the Fed funds rate has been unchanged for almost a year. If we look back on the past five years we could hypothesize that while oil was going up in price, OPEC was pressuring yields upward. Since oil prices have been relatively steady in the past year, the trade deficit with China has ballooned and the upward pressure has been held in check.

Which forces will prevail remains to be seen, but even though this hypothesis does not predict which way rates will move next, it helps to give a framework with which to view future market developments. It will become crucial to monitor the trade deficit with China and Japan as opposed to OPEC.

The first set of opposing forces is that of OPEC and China. OPEC gets dollars and buys return-oriented products, and non-dollar products. Asia gets dollars and lends them back to us.

There is another struggle which I have observed: that between China and Japan. As devalued as China's currency is, Japan has lately succeeded in devaluing the Yen against the $, and therefore, the Yuan. China can't be happy about this, but because of US threats of tariffs and duties, inflation, an overheating economy, and a stock bubble in Shanghai, they have already lost. The question is, how much will Japan try to devalue their currency against the Yuan to make their exports competitive with China? Right now, Japan seems to have none of the problems listed above that China has. Japan has no inflation because they have no controls on investment capital leaving the country. Extra cash just flows into overseas investment. In contrast, in China, government controls on overseas investment keep all that extra money inside the border with few places to go except bubbles and price inflation.

At the same time, Japan has ultra-low interest rates, which is more effective than China's currency peg. Japan is still in a stubborn deflationary benign circle. If anything in global economics today tends towards equilibrium today, this is it. As the Yen slides, more investment capital goes overseas, which is deflationary for prices in Japan. If the BoJ raises rates, the currency strengthens, and a strong currency keeps prices down. As long as there are no shocks to this system, Japan can slowly and safely devalue their currency against the Yuan.

No market understanding whatsoever

in this article. New home sales rose 16.2%. Prices dropped by 11.1% (10.9% yoy) The sales rebound is just temporary. When people hear that prices are dropping, they will wait to buy. Builders will get desperate in a few months and drop prices drastically again. Meanwhile, the new home market is pressuring the existing home market.

We ain't seen nothin' yet. Look out below!

Just saw this after writing the above blurb. Toll Bros. 2Q profit down 79%. They even managed to drop below analyst expectations by 12%.

Everyone's thrown in the towel on rate cuts. Chances of a cut by September fell from 51% to 9% from a week ago. Time to buy Treasury calls for my Yahoo account. However, I want December if possible because that gives me an extra month.

continued...

ADBE

1. Play on the market going up & continued liquidity
2. Flashplayer is everywhere. No matter what the limitations, quantity should trump quality.
3. They have new products coming out and strong growth.
4. They cost half as much as MSFT when valued according to growth.

Target: 45% yoy growth in Q3'07 = $52

ITB (short)

1. Housing is the classic George Soros definition of reflexivity in action: fundamentals which support a boom and then support a bust. Just as too-loose credit sparked an out-of-control housing boom, so will credit tightening cause a huge bust.
2. Housing is bad. If there's a recession or rates rise, it will be much worse.
3. They're still building houses faster than they're selling them.
4. UBS homebuilder analyst says "book value means nothing with the homebuilders."

Target: 20% under book value = $25

FXY

1. The only way to play a run on the Yen if the carry trade reverses.

Current holdings: reasons and targets

FRO

1. Dividend.
2. Management - John Fredriksen is continuing to funnel money to Seadrill. To do that, he's got to pay the maximum dividend.
3. Tankers are at record newbuilding prices. (Long-term plus.)
4. Imports of gasoline this year should keep tanker prices strong. (short-term plus)
5. Politics in Venezuela, Nigeria, and Iran is unstable.
6. Sale of equity in Sealift is worth $3/share for FRO.

Target: 15% dividend rate = $50

CFC (short)

1. Hedge against recession
2. 50% of income is from ARM's
3. 40% of $30 billion loan portfolio is in negative amortization ARM's. Most of these are in California.
4. Foreclosures totaled 8,099 worth $1.5 billion on 5/15. They are increasing 20% every month.
5. 10% of income is from increasing negative amortization booked as income
6. 37% of income in Q1'07 is from negative amortization booked as earnings.

Target: yearly low = $33

CNE

1. Dividend.
2. Play on Canadian currency.
3. Natural gas has phenomenol long-term growth potential
4. It was cheap after the overreaction to the termination of trust status in 2011.

Target: Price before trust termination = $18

PDC

1. Good management - sound expansion plan.
2. No debt
3. Long-term growth in natural gas
4. 4.3x cash flow

Target: 6x cash flow = $17.92

Interest rate outlook...

The Chinese Premier recently promised to let the Yuan to rise against the dollar. However, no one's been paying attention to this. I believe that this could significantly weaken the dollar. When the Chinese Central Bank (CCB) stops printing Yuan to buy dollars, the biggest source of demand for dollars will dry up.. Also, as the Yuan rises, Chinese imports will rise in price. This is inflationary.

Bottom line: short term, rates may fall, but long term, rates will surely increase.

Liquidity

I asked myself the other day: "Is liqidity reflexive right now?"

It would seem to be because it comes from the carry trade. The carry trade is reflexive because the carry trade depresses the Yen further and builds up the Euro, Pound, New Zealand Dollar, etc.

The carry trade will continue until the central banks have to break the pegs for political reasons. Right now the BOJ is ok, but the Chinese Central Bank is under pressure. The sentiment in China is that the authorities won't risk any downturns before the Olympics in 2008, so everyone is fearless over there.

OPX...

I bought OPX today at the open for $4.02.

Why?

• They were at 40% of book value because of liabilities in their subprime business. Now that they've sold off those liabilities, they're still 23% below. That makes them cheap.
• If the yield curve steepens, spreads will move from 30-40 bips to 100-200 and they'll make 3-4 times what they're making now.
• They're a good hedge against a recession, because rates will be lowered.
• They pay a 5% dividend.

My target price is book value, of $5.24. When they get to that point, I'll look at interest rates to see if the outlook for lower rates warrants a premium over book.

This is why...

... I read Jim Jubak's articles every week. I agree with him 100%. When the fundamentals are irrationally based, but still make people money, the market will follow the money, not the safety. "But it's not safe!" the Bears complain. Well, neither is coming out of hibernation in the middle of winter.

Uh, Oh...

I'm not worried a wit about the market's boo-boo today. My shorts on ITB and Countrywide hedged me just fine. Actually up $1.09. Nor do the dismal retail numbers worry me. However, I can't help taking a second look at this juicy quote I got from the Winter Watch.

Merrill’s David Rosenberg: “A point to note: fulltime jobs, the key generator of personal income growth, plunged by 687,000 in April. That was the largest slide since the economy was knee-deep in recession in August 2001. Such a decline has
only occurred three times in the history of the Household Survey going back to
1968.”
Posted on 10-May-07 at 11:34 am

678,000 is a lot. Also, "barely junk" bond spreads have blown out from Libor +1.4% to +2%, a 40% increase in spread. Not to mention, buyout rumors are more prevalent than the real thing now. It's safer to short the pop than bet on a LBO. Hmmm... maybe my idea of a stock market run is running out of steam already. But where else will liquidity go? Into the market or... Pop?... just don't know.

Here's a fascinating paragraph from Bloomberg.

`Trade-Up Purchases'
First-time home buyers are more likely to be subprime borrowers. Every purchase of an existing house by a first-time buyer triggers four other sales in the housing market, said Jeffrey Otteau, president of Otteau Valuation Group in East Brunswick, New Jersey.
``They are largely trade-up purchases,'' Otteau said. ``The buyer of the $300,000 house enables the seller of that home to buy a $450,000 house, and up the line until you get to a luxury home. None of that can happen unless the first-time buyer makes the purchase.''

There are several conclusions we can draw from this. First, this explains how the subprime credit crunch will further weaken the whole housing market. 'Subprime' is not a separate part of the market. Second, we can predict that the housing market won't recover until first-time buyers find homes more affordable. Since most first-time buyers compare prices with renting, we're looking at a long way down. In addition, this also suggests that any recovery will take a long time, as the recovery starts with first-time buyers, and spreads through the market.

Alleluia!

Sold CFC short today at $41.28. Sweet! I was hoping a crazy buyout rumor would come along, I just never thought it would come this soon and bump CFC up so high.

The naked calls I sold in the Yahoo account got killed today, but I'm not worried. In fact, I loaded up on the $45 calls at $0.50 (up from $0.05).

Seadrill

Seadrill has a market cap of $6.86 billion. Their current contract backlog is $5.6 billion. They have 3 ultra-deepwater rigs under construction that aren't yet under contract. That's worth $3 billion in contracts. They own $500 million in Akers Drilling. Total $9.1 billion, or $22.75 per share.

I will buy with real money as soon as I get the $5000 minimim required for overseas orders. I am willing to sell FRO, ADBE, and CNE.

15,000

When bubbles get squeezed at one end, they seldom pop. Instead, the liquidity just flows somewhere else. What's been the safest investment in the last year and a half? The stock market of course! DOW 15,000 by year end.