2009: Back to the '30's?

Common Sense Forecaster has one of the great blog posts of 2008. This is a MUST READ. And here is a teaser:

Shortly after President Hu Jintao said China is "losing competitive edge in the world market", we saw a move towards export subsidies for the steel industry and a dip in the yuan peg - even though China already has the world's biggest reserves ($2 trillion) and the biggest trade surplus ($40bn
a month).

So is the Communist Party mulling a 1930s "beggar-thy-neighbour" strategy of devaluation to export its way out of trouble? Such raw mercantilism can only draw a sharp retort from Washington and Brussels
in this climate.

"During a global slowdown, you can't have countries trying to take advantage of others by manipulating their currencies," said Frank Vargo
from the US National Association of Manufacturers. (This is what happened during the Great Depression.)

It is a view shared entirely by President-elect Barack Obama. "China must change its currency practices. Because it pegs its currency at an artificially low rate, China is running massive current account surpluses. This is not good for American firms and workers, not good for the world," he said in
October. The new intake of radical Democrats on Capitol Hill will hold him to it.

Chinese workers may lose 40,000,000 jobs.

Treasury Demand May Increase

Treasury demand may increase due to new Federal Reserve rules.

Demand for Treasuries is so great that investors are lending cash for next to nothing to obtain the securities as collateral through repurchase agreements, or so-called repos. The problem is market participants haven’t always delivered the bonds, causing “fails” to exceed $5 trillion at their peak, according to the New York Fed.

So, what's really going on here? The reason for the new rules is because some players are using Treasuries to gain leverage. It works like this (as far as I can surmise). Hedge funds buy Treasuries, and then borrow from the banks against them. They sign a repurchase agreement whereby the banks sell the Treasuries and agree to buy them back. However, they aren't always bought back; sometimes, they are just rolled over into a new agreement and the bonds don't change hands. So some enterprising managers have decided to sign repos with multiple banks in order to get free leverage. The Fed has decided to put a stop to it. A 3% penalty is high enough to stop this cold.

So, what are the implications? First, Treasury prices are likely to go even higher. Second, deleveraging of financial asset prices will continue. Third, this is deflationary for all assets except for Treasuries. Fourth, it will cut back on risk-taking.

These may sound like bad things, but they are not. I believe that this is a good and prudent rule from the Fed designed to instill confidence in contracts as well as force everyone to play by the same rules.

So, how does this change the way I view my portfolio? Not much. For the past month or so, the market has become much less volatile, government bailouts have neutralized some of the fear, there is some sort of consensus hope for an economic rebound in the second half of next year, new lows have not been made, and the market appears to have bottomed. Which makes me nervous because I'm so decidedly short against it, but at the same time, a change in sentiment back to bearishness will, I feel, provide a reward justifying the greater risk.

The bottom line is that deleveraging and deflation continue, and this is not a bullish macro environment for equities.

And now for another "bullish" story: "Clock Ticking on Benefits for Jobless SC Residents." Here's the setup:

A battle between South Carolina's governor and state officials over their unemployment fund threatens to cut benefits to about 77,000 jobless
residents as early as Thursday.

The state fund is set to run dry by the end of Wednesday unless they can settle on an agreement for the state to tap into a $146 million federal
loan. The loan would keep the benefits coming through March.

And here's the kicker:

The state's trust fund has been losing money for years as annual payments have exceeded the amount businesses pay in unemployment insurance taxes.

Of course this is "bullish"! Everyone knows that higher unemployment insurance taxes will come down the pike, increasing employment, making businesses more profitable, and generally contributing to an economic rebound. (smirk)

Dow 4000 in 2009.

Trades

Closed short on FXC (Canadian dollar ETF) @ 82.28 for +12%

I think this is a good profit here, I'm using a lot of leverage right now,
and I needed to make room for my next trade.

Buy 88 (10% position) FRO @ 28.38.

See "Arbitrage" below for story on this one.

Arbitrage

The arbitrage opportunity in storing oil has not gone away. I'm surprised at how persistent it has been. This is despite a 20% increase in oil storage in the U.S. since September. China, as well, has been importing massive amounts of oil, which I expect is for storage, not consumption. Here are the future prices from Poten & Partners: (I had to delete all data except the last price)

CRUDE OIL Delayed Futures -09:40 - Monday, 22 December - [ Go to Daily Price Listing ]
Contract Last
January '09 ( CLF9 ) 33.87
February '09 ( CLG9 ) 41.85
March '09 ( CLH9 ) 44.62
April '09 ( CLJ9 ) 46.47
May '09 ( CLK9 ) 48.73
June '09 ( CLM9 ) 49.26
July '09 ( CLN9 ) 50.31
August '09 ( CLQ9 ) 52.06
September '09 ( CLU9 ) 51.87
October '09 ( CLV9 ) 52.91
November '09 ( CLX9 ) 54.50
December '09 ( CLZ9 ) 54.25
January '10 ( CLF0 ) 56.04

Look at Janruary 2009. $33.87. Now look at November 2009. $54.50. You can buy oil for delivery in Jan. and sell the same oil for delivery in November. All you have to do is store it. This would be a 60% profit instantly. How much does storage cost? Well, if you rent a VLCC for $50K/day (see Intertanko) and stuff it with 2,000,000 barrels from Jan through November, that costs $9/barrel. You can still make a 26% profit.

Today, we have been given a gift: Analysts Cut Oil Tanker Stocks. The guy might have something there with the new supply, but I think that FRO is worth a play as long as it pays to part oil in storage.

And one more thing: oil is going MUCH lower.

Trade

short 156 KBH @ 15.22.

this is wildly overpriced. book value is $12.65. Business won't come back for years, and they had negative cash flow last quarter. Everyone thinks they're ok because they don't have major debt due til 2011. But they're worthless even with no debt if they can't generate cash flow.

Withholding Taxes and Job Losses

Adapted from comment on Russ Winter's Winterwatch. I've added charts.


Russ,

I’m a little skeptical about your “orphaned money theory.” Yes, there is a lot of money that has “moved” into money markets, Treasuries, etc. However, I don’t see how you can count reserves at Fed, for example, as orphaned money. This is just a recapitalization scheme for the banks to earn money on Treasuries while the Fed holds down their borrowing rates.

Money markets? I believe that a lot of this is money that will never go into stocks because it’s institutional money that has restrictions on it.

As far as Treasuries goes, most of that move is repositioning from the agencies that the Fed is buying. Some of this, I believe is also reallocation to AAA from downgraded securities by insurance co’s, pension funds, etc.


Any orphaned money that the plutocratic class has left over is dwarfed by hedge fund losses. For example, margin debt has come way down in the past couple of months, but hasn’t changed as a % of market cap. Also, any hedge fund that has restricted redemptions is a fund that has something illiquid to sell. This caps any rally, in my mind.


One last thing. I looked at BLS chart of job losses. In the last cycle, they peaked in Q4′01.

Then I looked at the Withholding Taxes Chart.





It looks like there’s a one quarter lag on the withholdings. Q2′01 was the first negative job growth quarter, but the withholdings still grow at 3%+. Peak withholding losses lag peak job losses by 1Q, and recovery with positive job growth in Q3′03 shows negative withholding growth.

Bottom line: withholding taxes info lags job loss data.

Your wise thoughts/comments would be appreciated.

Strategy

Rule # 1. Prices are always wrong.

That's where I start. The next step is to look for the greatest price dislocations. Where is the price most wrong? This begs another question, which is, What should the price be? Price is relative, so sometimes a simple, "price should be higher," or "price should be lower," will suffice.

There are many ways to look for this. Some kind of arbitrage can be a useful thing to look for, however, they never last forever. If there's an arbitrage built on a lasting trend, that's a good thing.

Another thing to look for is when there is a mistunderstood financial mechanism that affects the fundamentals themselves, such as the mechanism of the housing bubble where lending raised collateral values. Which brings me to rule #2.

Rule # 2. Understand what's happening right NOW.

You can make all the future predictions you want, and be right about them, but if you don't understand the undercurrents of the market right now, you won't make a dime. A lot of this is understanding who will have to hedge what, and how they will do that.

Rule # 3. What? When? and How?

Even after the first two rules, it gets harder, not easier. There are three components of every trade. You need to get all three right to make money. WHAT is the big picture macro story? For example, are we in a bull or bear market? Will the economy rebound in the next six months? etc. WHEN do I buy and WHEN do I sell? You can get the big picture right, but you still need timing. Finally, there's HOW do I monetize my idea? The right security is crucial. Pick the wrong one, and you go nowhere, inspite of accurate forecasts and perfect timing.

I Knew Bernie Madoff Was Cheating, That's Why I Invested with Him

No further comment needed. The title says it all.

And another thing. My roommate from China told me that Chrysler and Volkswagon are shutting down factories in China. Chrysler I understand, but Volkswagon??? Things in China must be worse than the authorities are leaking in the official numbers.

Trade War coming. Who can devalue their money the fastest.

Bullish for gold.
Bearish for RMB, won, Taiwan dollar, Euro.

Yen will probably continue to be the strongest, with the U.S. dollar second. But Japan can't be happy with RMB devaluations, and unlike the U.S., they have no qualms about currency wars. In fact, they invented the game. Their rates are almost 0%, so they can't cut much. If they try novel devaluation tricks, there may be some opportunities there.

Auto Bailout

Oh, and by the way, how much is left of the TARP?

Isn't it only $10 billion?

GM looks like it's done.

And Honda, which doesn't have the debt overhang or the millstone of union wages around its neck is cutting production by 120,000 next quarter.


The good news about deflation is that lower prices, especially gasoline and food, will put about $1,500 per person back into consumers' wallets over the next year.

The bad news is that 1,900,000 jobs lost has already taken out $300, and $7 trillion in lost wealth has amounted to $23,000 per person.

Ouch!

Fraud and Bailouts

First, bailout news. GM is shutting down half the company for at least the month of Janruary. This is extremely deflationary. How many car parts won't be ordered from China? How much steel and copper and aluminum won't be needed? Look out below!

And next, fraud. Bernard Madoff supposedly lost billions for investors in a giant Ponzi scheme. The warning signs were everywhere. First of all, the returns worked like clockwork, which means they were too good to be true. Second, Madoff also owned a market-making firm, or brokerage. Here's how he described it, according to the Wall Street Journal:

On Friday, Maxam Capital Management LLC reported a combined loss of $280 million on funds they had invested with Mr. Madoff.

"I'm wiped out," said Sandra Manzke, Maxam's founder and chairman. The Darien, Conn., fund of hedge funds will have to close as a result of the losses, she said.

"He was a low-key guy," Ms. Manzke of says. "He would say, 'Look, I'm a market-maker, and I don't want anyone to know I'm running money.'
It was always for select people. He was always closed, he wasn't taking new
money."

"I'm a market-maker and I don't want anyone to know I'm running money." Translation: "I'm making you money by taking advantage of the conflict of interest inherent in trading for investors and being a market-maker. I'm using inside information from my market-making firm to make money for you on the side." In plain English: "I'm cheating my market-maker clients for your benefit, so don't tell anyone."

That's the sleaziest sales pitch I've ever heard in my life. Anyone with half a brain could read between the lines.

Lesson: Never trust someone who says he will cheat others to make you money.

Now, I don't think many of the wealthy individual investors got that sales pitch. However, this can't be good for re-establishing trust in the financial system. And considering the level of sophistication of the con scheme, I think this one, as big as it sounds at $50 billion, will probably be even bigger. Hedge fund selling, here it comes!

Eurozone Crumbles, China Exports Fall

Greece is in flames. The Eurozone is crumbling. Greece lied about deficits to get into the Euro. The IMF estimates unemployment in Spain hits 15% next summer. France has problems as well. I think it's abouut time to buy some EOU, ultrashort Euro.

And Chinese exports went from + 20% yoy in October to -1% yo in November.

Have I been aggressive enough?

Trades from yesterday:

short PXE (oil + gas exploration) @ 13.65.
long FXC (Freeport-McMoran Copper and Gold @ 22.27
long FXP (Ultrashort FXI, Shanghai 25 index) @ 33.12

FXP is now trading at 15% UNDER net asset value. So is DUG. They are both screaming bargains here, but I am afraid to be too aggressive. First, I have been wrong before, and second, I already have large exposure to both of these.

The Shanghai 25 index has now rallied 50% and the Hang Seng 25%. This is with Chinas exports DOWN yoy in November for the first time in years and years. At the same time, there are reports of multi-billion dollar bets on the Renminbi. China may not devalue the RMB, but I think they will reverse its course of appreciation against the dollar. The price is most definitely wrong, and I sense a huge opportunity here.

I'm wondering whether or not to cut my losses on GM... It's looking more and more like the bailout won't happen or it will just be a temporary bridge to bankruptcy. I wish I knew how to value the bonds.

Next trade, PXE. This has bounced 25% off the lows. Oil exploration is leveraged to the price, as new exploration is not very feasible at $40 a barrel. There are two reasons why I think oil will go a little lower and stay there. First, in the past couple of months, 5 days' global supply of oil has been stored on tankers. How much has that propped up the price of oil? Oil has fallen during that time. If this supply overhang keeps up, that's about an 8-10% oversupply margin. Huge. Humongous. Ginormous. Whatever. OPEC can cut by 4 million barrels/day and oil could still go down over the next six months. Second reason is from Bloomberg. Trade deficit? Is this the right link? Yes. Ignore the title, it tells us nothing about oil. Go to the third to last paragraph:

Rather than helping shrink the trade gap last month, as most economists predicted, oil contributed to the deterioration. A record $15.56 drop in the price of imported crude in October was swamped by a 70.9 million-barrel
jump in purchases that was also the biggest ever, the report showed. Excluding petroleum, the trade gap was little changed at $24.5 billion.

Now we have something. Future oil prices are still much too high. That pays people to store oil. The U.S. uses 14.7 million barrels/day, and imports about 10 million/day. 71 million extra barrels in one month is pretty huge. All those extra stocks of oil are putting pressure on future prices.

Last trade: FXC. Did I buy it for the copper in the ground at $0.08/lb? No, I bought it for the gold in the ground at $185/oz. and got the copper for free. Sweet. The plunge in Treasury yields is bullish for gold. And the rate cuts around the world keep coming. Korea cut from 3% to 2%. Taiwan cut from 2.75% to 2%. Three-month U.S. Treasuries are negative. Soon money market funds will be too. GoldMoney will store your gold in a vault for 0.18%. That storage cost is looking better and better against negative yields.

And today's news: IAMGOLD is buying out Orezone's two producing mines for $140 million, or about $0.36 and spinning off the exploratory properties as New Orezone. A quick check of IAMGOLD shows no debt, $150 mil in cash, and a cost of $130/oz in the ground at $550 recovery cost (including Orezone). I will hold onto this and take the IAMGOLD offer of 0.08 shares/share of Orezone.

Maybe I'll even buy more of IAMGOLD. Now, the question is, should I cash out of NG, up 65% today to $0.80? It's a nice jump, but in the big picture of the whole portfolio, it's only worth 1% of my portfolio. Hmmmm... I could trade it in for more IAG. I think I will do that. Done. Sold NG @ 0.70 for +52%. Bought IAG @ 4.85 (5% position).

Discrepancy Explained

For the past few months, I have been searching for an answer. Commodities such as copper, coal, and iron ore have plunged in price. The Baltic Dry Index, not surprisingly has fallen as well. Oil is now down 72% from the peak. But oil tanker charter rates, while down from absurd levels have rebounded to normal.

The question is, "Why is there this discrepancy between dry shipping and tankers?" The economy is not doing well. However, the normal price of tankers left me with a nagging doubt as to whether the BDI or tanker rates was a better sign of current economic conditions.

I just got my answer from Bloomberg:

In the worst year ever for oil, investors can lock in the biggest profits in a decade by storing crude.

Traders who bought oil at the $40.81 a barrel on Dec. 5 could sell futures contracts for delivery next December at $54.65, a 34 percent gain.

Royal Dutch Shell Plc sees so much potential in the strategy that it anchored a supertanker holding as much as $80 million of oil off the U.K. to take advantage of higher prices for future delivery. The ship is one of as many as 16 booked for potential storage instead of transporting crude, said
Johnny Plumbe, chief executive officer of London shipbroker ACM shipping Group Plc.

Oil Storage

The tankers, if full, hold about 26 million barrels worth about $1 billion, more than the 22.9 million barrels sitting in Cushing, Oklahoma, where oil is stored for delivery against Nymex contracts. U.S. crude inventories rose
11 percent this year to 320.4 million barrels, according to the Energy Department.

Problem solved! The demand for oil use is not there. It's just that the futures market still does not believe that the global economy is as bad as it is.

Trades

Short ITB @ $11.30, 10% position

Short QQQQ @ $28.80, added 10% to a 4% position

ITB is trading at 95% of book value, which is absurdly high for a money-losing industry with bubble-year land values. I think it goes back to $8 after Bernanke gets mortgage rates down to 4.5% and it doesn't help much.

QQQQ is at a P/E of 17. That's way too high heading into a deep recession or depression. 20% of QQQQ is AAPL, MSFT, and QCOM. Apple will have a tough time maintaining growth, Microsoft will get slammed by a strong dollar, and Qualcomm will lose big time as emerging market cell phone sales plummet. I think QQQQ goes to $17-18 range, or around a P/E of 10 as most of these companies report earnings contractions over the next couple of quarters.

Lots of News

Merrill Lynch has an analyst who says that oil is going down to $25.

Really? What about gas falling to $2/gallon? The truth is, it doesn't seem to be helping, as the latest figures on fuel consumption in the U.S. shows a 6.2% yoy drop for the four weeks ended Nov. 28th (Bloomberg).

David Rosenberg says that gold does well during a global trade war, the seeds of which are being sown as China starts devaluing the Renminbi.

Will gold be the next bubble? Could happen, but I'm really on shaky ground here. I feel much more confident on my call of a new asian/emerging market currency crisis. There are just a lot of little reasons I like gold. Here's another one: low interest rates make the opportunity cost of owning gold really low.

Smartest and stupidest trade of the year all in one: Treasuries. I caught the first one third of the greatest rally in history perfectly, but got out with only one third of the profits. This week, I've seen three versions of "Are Treasuries a bubble?" in the news already, which means that the best part is probably over.

Now with half a million job losses, there is no doubt in my mind that the market will plunge again. There are a couple things I'm thinking about. The first is the Fed's Grand Poobah Two-Day PowWow. Expectations are very high, but who knows what Bernanke will pull out of his hat. I'd rather wait and see what happens before I lever up any more. Actually, since learning about Mexico's oil hedging program, EWW will be the first emerging market short I will cover. But I want to pay $25 or less.

Another thing I'm looking at is the homebuilder's index (ITB) again. As a short, of course! They've bounced from $6.50 to almost $11 yesterday. That looks like a great short, however, it's only 0.85X book value. I will short this if I see it go to $12, which would be 1.00X book value. Otherwise, I need to wait and see what Bernanke pulls out of his hat on 12/17.

Asian stocks are reported to be rallying on the hope that the drop in oil will reduce costs, according to Bloomberg. I remember when this happened in the U.S. earlier this year.

And I haven't said anything about retail lately, but here's a telling quote from Vanity Fair, "I was at Michael’s yesterday and was thinking, Oh, Manolo’s … But then I thought, Why? Why do that? It just doesn’t feel good." This shopper is right. Even if you have the money, it doesn't feel good to throw money away when you're friends are suffering.

“I ran into a couple I always see at the antiques show,” one Upper East Side woman recounts of her visit to the Armory show on Park Avenue. “They always buy something fairly grand. ‘What have you bought this time?’ I asked. ‘Oh, nothing!’ they said. ‘We’d feel … ashamed.’”

It used to be cool to buy stuff. Now it's not. Look out below!

And another really cool statistic. According to the Bureau of Labor Statistics, unemployment for 1930 was only 8.9%. This was after the crash. Maybe the Great Depression was not so bad after all.

Oh, wait, unemployment did reach 24.9% in 1933. I don't know if things are that bad, but I've also been bullish (compared to the market) for most of the past two years.

Trade

Trade

I bought a 1% position in NovaGold. The good news is they are a gold exploration company with 15 million oz.'s of reserves. They have a 50% partnership with Barrick at a mine called Donlin Creek. They also have some other stuff. That's the good news. The bad news is that they have a liquidity crisis. They've breached loan convenants and one or more of their mines might be foreclosed on. They may have to liquidate, which would make the stock worthless. They also have a management problem, as Barrick offered a $16/share buyout earlier this year, which they turned down.

But at $0.46, their gold in the ground costs $3 an ounce. Barrick costs $190/oz in the ground. Goldcorp costs $395/oz in the ground.

Does cost per oz in the ground mean anything? I just made it up, so probably not. But at $0.46, I'm willing to gamble. If they survive, it will be a home run.

What Next

First of all, here's a story from the FT about Mexico punking the hedge funds. They bought their puts for $1.5 billion in July. Look at the current commitment of traders.
Their puts are now worth $12.5 billion, effectively hedging all of Mexico's 2009 production at $85/barrel.

And Paulson is telling China to let the RMB appreciate. However, the RMB is now dropping for the first time in three years.

Does this signal a trade war with China?

Will the U.S. counter by devaluing the dollar?

How?

Where's the next bubble? Gold?

One thing's for sure: Chinese equity markets have more pain ahead.

Outlook

This Financial Times article prompted a question: "Why are relatively good hedge funds in trouble?"



Easy answer: rich people who put money into these funds now need it back. What started as a collapse of toxic assets has now dragged the good down as well. Which begs another question: "When does it come back?" Not sure, but it seems to me that the crash phase of the Credit Bubble is now passed. First the guillotine, then the sandpaper, as Russ Winter says.



If we are in a sandpaper, or jagged-shaped downtrend, I need to trade more quickly. Take profits more quickly, as well as look for some opportunities to bottom-fish. I'll probably look at more high-yield bonds, maybe an ETF. Some of these are so low that they offer equity-like capital appreciation opportunities, while paying much juicier income streams than the typical dividend.

However, my macro view continues to be extremely pessimistic for the world economy. Chinese manufacturing has collapsed, and there is now talk of a DEVALUATION of the Renminbi. I had this one spot on a month ago, but CNY and
CYB are not marginable.