trades

Closed: ITB at $21.01 for 40%.

Opened: long AIG at $62.98.

ITB has been in the same basic $20-$22 range for a month or two now. The homebuilders are so oversold that every time there's bad news, like today's humongous price drop, the sharks come out and run the prices up. Fortunately, I got out ahead of the news, not after it.

AIG has the most subprime exposure of any insurance company. The AAA tranches are getting beaten with the ugly stick this month. Therefore, I think it's about time to short AAA MBS/CDO holders. Also, I expect that the greatest threat to insurance companies will not be losses from AAA MBS's, but losses from downgraded securities. The insurance companies are rated themselves, and the state regulators and insurance company raters (like AM Best) have no vested interest in painting lipstick on the subprime pig. AIG may have to sell downgraded MBS's just when they are worth the least. With the downgrades starting in the summer, I think AIG will show some exposure. Will it be a scratch or a bloodbath? Who knows, but I figure that I'm selling risk that is not paying for itself. I believe that a cut from the Fed's already priced in. In fact, the market will probably be driven down by the traders after the cut is announced. We shall find out November 7th, when AIG announces earnings.

Thoughts and trades...

Lost a lot of money on paper today, however, I made real money. I covered my DSL short early in the day for a 25% gain and sold CFC short @ $17.36 late in the day.

Here's what I'm thinking right now:
We're seeing a repeat of June or July. First, one or more bond indexes (ABX, LCDX, etc.) started imploding. Then the dollar fell through its support levels. Finally, panic came as fear caused a flight to quality (Treasuries) which rebounded the dollar (just a little) and caused an equity selloff. Don't let the disconnect fool you - the dollar drop is bullish for the DOW - until it (dollar) drops too much and rebounds. A little fear is bullish for the DOW; a lot of fear is bearish.

I think it is a good time to short AIG, which announces November 9th. It's down from $70 a couple weeks ago to close at $62.15. Their principle problem is that they have the most subprime exposure of all the insurance companies. The timing on the trade is that this is the first quarter that they are announcing after many, many downward ratings revisions. Just look at the ABX indexes to see what even a one-level drop does to prices. Now, they probably don't use the ABX indexes to price their portfolio, but they will have to take some sort of writedown in the event of a downgrade. This could hurt them a lot: insurance companies are not supposed to be volatile.

With the VIX under 20 again, I think sentiment is much to optimistic. I think that the DOW strength this week is a result of rate cut anticipation, and if the bears come out next week, they could sweep the field.

Trading Strategy

I'm waiting for bearish sentiment to manifest itself with a spike in the VIX to over 30. Then, I will cash in a few positions that have broken down since the last downturn. Then when sentiment swings back from fear to greed I'll have to jump back in.

DSL was the first to break down. After rebounding to almost $63, DSL broke down two weeks ago after its quarterly report revealed a spectacular rise in delinquencies. It closed today under $40.

CFC has also crumbled recently. After hanging around $20 for a few weeks, it closed today at $13.83.

Monday

DOW up 44. Actually, I was surprised it wasn't more, after the G7 meeting called for yuan appreciation. Translation: "we support a dollar slide, and we have joined forces to collectively devalue all our currencies against the yuan. We're not worried about inflation, because the yuan will suffer much more than we will." Then, the IMF said that the dollar is overvalued. Translation: "the dollar is dangerously overvalued, and we need to make sure the decline doesn't turn into a crash."

The traders took advantage of profit-taking in homebuilder shorts to try to squeeze them out. ITB was up 4%, led by the riskiest, BZH and SPF over 10%. I would have taken some profits at the open, but then I couldn't get back in, because the short ratio against them is so big. So, I will just wait. I expect to make everything back and more over the rest of this week with Existing home sales being reported Wed. The consensus calls for a 5% decline to 5.0 million. However, I see a 20-25% decline. Socal sales dropped 35% in August, and the national drop was 20%. September Socal sales came in at -49%. Divide that by half, and that's my number. If I take any profits, it will be in TOL, and it will be on Fri., perhaps.

Currency Trend

Inflation is rising in Brazil, and the CB may decline to lower rates today, according to Bloomberg. This continues to place downward pressure on the dollar. In India, market regulators placed restrictions on anonymous investments to stem the inflow of foreign capital into the stock market. They, too, are suffering increasing inflation. The dollar is under unbelievable pressure, and if it doesn't fall fast enough, there could be a major stock market correction.

A significant development...

reported by Bloomberg. It seems that foreigners unloaded US securities in August to the tune of a record $69 billion.

The Treasury's reporting on long-term securities captures international purchases of U.S. government notes and bonds, stocks, corporate
debt and securities issued by U.S. agencies such as Fannie Mae and Freddie Mac, which buy mortgages.
Including short-term securities such as Treasury bills, foreigners sold a net $163 billion, compared with a gain in the previous month.

Could this be a preview of more to come? As foreign currencies suffer rapid inflation, they will step up their hoarding of hard assets. This has already created a vicious cycle.

In other news, homebuilders are still suffering terribly. Satyajit Das was precient when he stated a few weeks ago that the markets first overreact, and then underreact to bad news. The credit crunch is back, housing market news gets worse when it appears that it's as bad as it can possibly be, and corporate earnings are hit and miss. Because of the ABCP logjam, I see another rate cut at the end of this week. The dollar will slip further. Gold will go to $800 by the end of the month.

Local Economy

I was shocked and horrified when I picked up the local classifieds section this morning. It's Monday, which means that the Employment section has the most ads of the week, except for Sunday. The last time I flipped through it was a few months ago. There were about two and a half full-size pages of help wanted ads. Under the Legal Notices section, there were several foreclosure auction notices. This morning, the size of the sections was completely reversed. The employment section barely covered half a page. That's about an 80% drop. The foreclosure section has jumped from about three to 21, and covered almost two full pages.

Chinese...

trade surplus up 56% year over year. The question is: is Chinese inflation a self-reinforcing trend? Seems like it is. China prints money to keep Yuan undervalued, which causes accelerating inflation. That inflation is causing the rise of imports to China faster than exports from China. I believe that this policy is one that the Chinese government will pursue as long as they possibly can. The limiting factor(s) could be social unrest caused by inflation, a concerted effort by developed world central banks to raise rates enough to slow economies and kill China's trade surplus, or another unforseen factor.

Netflix...

Crap. I knew I should have bought NFLX for $16.00. It's at $23.55, and Blockbuster hasn't even folded yet. When they give up trying to take market share from Netflix, and Netflix gets it back, they'll be worth $30.

the higher order production fails as the lower order production (closer to
consumption) consumes most of what higher order production needs at any cost!!

(From last post) The conclustion is crystal clear: inflation will manifest itself in higher order production.

Is that what we see? Absolutely. Primary production i.e. iron ore is even more profitable than steelmakers, which are in turn more profitable than mining equipment makers. Then closer you get to final consumption, the more you get squeezed.

copied in its entirety...

from the Winterwatch comment board:

Bondbubble wrote:

Below is an interesting link to Chinese monetary policy
thinking:http://www.smh.com.au/news/business/inflation-in-china-builds-up-steam/2007/09/23/1190486137178.html
Essentially, the Chinese (and the rest of the world) prefer inflation(and
hoping that this will translate into wage increase for all in Chindia and
hencepush the cost of exports and hope this will balance the trade for China).
As an economist mentions, this will create more Brazil Americans in China, India, etc. Also, notice that, the view seems to allude that, because Japan and Taipei choseto deflate the inflation in the early 1990s, they got hit very badly and those nations thatdid not choose to deflate that much in the 1990s (as in US) prospered and benefited fromJapanese deflation i.e could create more credit easily!! For this reason, every nation now wants to avoid arresting the inflationary tendencies. May be China is hoping, US will crap first which will lower the demand world wide and they can pump credit merrrily after the US deflation….
When would the game end? Hayek says, the higher order production
fails as the lower order production (closer to consumption) consumes most of what higher order production needs at any cost!! This is why CBs fight
inflation!! Not because USD/Yuan is losing value or there is some social unrest. Let me explain this concept and we are seeing this in spades right now: The main industrial beneficiary of lower interest rates in all countries including US is exports!! So I would watch for these exports in all nations creating shortages in individual nations. For example, US would start exporting more grains (China seems to be avoiding importation of grains for now) and hence consume more farm equipment and fertilizers/oil. Note that, in the US, nitrogenous fertilizers are completely outsourced in the last 3-4 years because it uses natural gas and natural gas has more than doubled in price. For this reason, you should be seeing lot of slack in natural gas usage (not mentioned in the media). So, US is importing more and more nitrogenous fertilizers and this is causing fertilizer to raise everywhere in the world!! i.e Inspite of outsourcing nitrogenous fertilizer (higher order goods industry being killed in US), net Natural gas
consumption continues to increase because of lower order industry (for heating homes etc)!!! I dont deny that Natural gases are used in higher order goods (like in electricity going to machine tool making etc) - but you want to watch for the lower order goods manufacturing consuming the Natural gas (like houses consuming electricity!!).
Another classis example of the lower order industry killing higer order industry:You are already seeing that there are about 20% less rigs in the Gulf of Mexico than 2 years ago - inspite of oil price spike!! Why? the mainstream media does not mention that - oil exploration demands lot of
steel (drill bits has to be continously replaced etc). And when Katrina hit the gulf, the insurance companies saw their payment soar and hence when the renewal for insurance came up, they spiked it - as they probably watched the steel prices etc soaring!! Inspite of rising oil prices, the Gulf of MExico rigs can NOT afford the insurance premiums!! So, they are increasing the rig count inland - where the insurance is low!!
Similar thing is happening in Canadian oil sands!! Few years ago, oil sands were claimed to solve the world oil problem at $60/barrel!! Today oil is at $80 but you have stopped hearing oil sands!! Why? Look out for farm equipment industry now demanding more steel and competing with oil companies (and other higher order goods industries)!!!
So, I would say, watch for higher order industries dying (like oil refiners are having low margins inspite of gas price at more than double the amount in 5 years!!) and lower order industry (like car companies in Chindia, unused toy ports build for the Chinese politicians to “play”) cannibalising the higher order industry!!!
This is what creates the shortages!!! This is what CBs will fight!! Any increased money makes lower order guys thrive at the expense of higher order guys!!
Another happening: All the states avoided electricty price spike by cutting down on new plant development and avoiding maintanence!! Now the consumption industry (like malls and houses) are taking so much energy,
States have reached the limit where they have to build new plants ALL in ONE shot (as opposed to doing it gradually over the years). The fast printing of money has created faster demand than the State officials past calculation!! Hence, AZ which has 50% of the cost than CA for electricity (9cents vs 16 cents) - is now being forced to supply to CA and increasing demand in AZ. They expect the cost to double in AZ (and the price hikes are coming into GA etc). But nobody expects CA electricity prices to fall just because it is being sourced from cheaper AZ!!! Obviosly all these excess capacity are being built for a deflationary bust. But while they build, they will consume more steel, copper - killing the higher order industry!!!
Hayek says production is complex. You only mentioned one of the aspect of iron ore price increase - because China is building toy ports. But there is another aspect which you completely overlooked. The Brazil folks who mine iron ore, collect their salary in real and just to support the current production (and not expansion), iron prices have to increase in USD (as Real appreciates). On top of that, the miners have to increase production (to meet the increased demand). I dont think the miners are going to
make lot of profit in Real terms (but in USD, certainly yes). This should push for more increase in ore price or shortages of iron ore…. I would bet that shortages are what makes Fed to raise rates!!

BRILLIANT! This will be a comment to study, reread, ponder, and understand.

capital flight

We've already seen it happen: a flight from the dollar. Things that will accelerate the trend will be: economic weakness, lower interest rates, defaults in US $ debt, etc. This trend is self-reinforcing because a lower dollar will cause more US debt to default, and also will engender more capital flight. On top of domestic dollar flight, there will be international flight. Where will they put the money? Anywhere except US dollar debt. Treasuries yield nothing, and anything else may never be paid back.
The flight from the dollar will fuel emerging markets, commodities, etc. Since we have an import economy, commodities will skyrocket (we haven't seen anything yet).

This is a dramatic shift from what I've been thinking recently, but it's the only way I see to explain what I see happening in the global economy.

Strategy for this view will be to move to a 50-50 weighting of short domestic and long non-US dollar positions over the next couple of months. Watch/wish list: MO, TCK, RIO, SFD, ABX, OZN, SU.

Only one way to test the hypothesis: act on it. If I'm wrong, at least I believed in myself. If I'm right, believing in myself pays off. Hopefully, either way, I'll learn to be a better economist.

What is the strength behind commodities?

I've been rethinking my stance on commodities lately. With the U.S. dollar plunging, inflation in China will soon get out of control. In anticipation of this, I have done an about face on RIO from short to long. What kept me from this play before was the spectre of U.S. recession starting sometime over the next six months.

My thinking was that a U.S. recession would hammer stocks like RIO. However, I now believe that the dollar will drop even more. Why? Because China refuses to break their dollar peg. This means that they will continue printing money. A recession here will further exacerbate inflation in China. As the dollar weakens further on the back of the slumping U.S. economy, China's economy will continue to get proportionately stronger, fueling the run into commodities even faster.

When will this pressure subside? Possibly only when the dollar peg is broken, and China decides to export their inflation through a rising Yuan.

The money has to go somewhere, and I think I've just understood where it's been going. The question is whether or not it will continue, and I think it will, as long as there's pressure on the Yuan to go up.