Bits and Pieces

We are certainly living in interesting times. Lots of little bits of news out there.

Take this one, for example: "Critics Blast Brandeis Plan to Close Rose Museum, Sell Artworks." The college wants to raise $300 million "to preserve the university's education mission."

And how 'bout this one to scare the pants off you: "Dryships Shares Sink on Breach of Debt Covenants." What is the plan to fix this? Sell the farm to raise equity. How much? Well, they want $500 million. With a market cap of $400 mil after todays 25% decline, this will be tough.

In oil news, Russia's defense of the Ruble has failed. Foreign reserves are now down to $386 billion from a peak of $650. Which all goes to show that if you just look at what's above the surface, you don't have a clue to wha't really going on. I like to look for the shadows, and then find out what's making them. I also try not to be fooled by mirages. Why is this oil news? Because OPEC can cut all they want, Russia is the swing producer. Even with the OPEC "cuts," there is more supply than people know what to do with. How do we know? Because when oil is pumped out of the ground, it is either used or stored. Oil in storage is soaring. Why? The producers are pumping more than is being used.

Shipper Nobu Su is offering 20 supertankers to oil speculators. Maybe this is why Frontline is not up. There are already 40 tankers (at least) storing oil. Tanker prices are low considering this, which tells me that global oil consumption is extremely weak. However, I think that Frontline will announce very nice earnings for the quarter, and possibly a hefty dividend. Expectations are for $1.05 in earnings.

With the 30-year Treasury at 3.42%, these are tempting. However, I'm cautious because of huge oncoming supply and falling foreign reserves. For example, where has Russia's $264 billion in 50/50 Euro/US dollar gone? No one has said anything about this. I need to do some research here, or at least keep my ear open for any good explanations of this. Maybe I'll ask my professors about the exact actions that central banks take to deplete foreign reserves in defense of their currencies.

The Fed was a complete nothing yesterday.

Spain's cost of borrowing hit 1.23% higher than Germany's, the highest since they joined the Euro. I just learned that getting out of the Euro is extremely hard. How do you change currencies and devalue at the same time? Who would accept the new currency? No, once you're in, you're in.

Politics

Last Friday, President Obama's choice for Secretary of the Treasury signalled a startling shift in our relationship with China. Timothy Geithner said that China was "manipulating" the Yuan. This is a word that brought a strong reaction from China, and no wonder, no one in the Bush administration ever used the word "manipulate."

Obama is no stranger to reaching out to supposed enemies, as can be seen by the significance of his first TV interview, conducted on Arab TV.

Hmmm... something tells me that we're more likely to get a trade war with Obama than with Bush. And while a trade war will hurt China more than us, it will only make everyone poorer. While the media is focusing on who Obama is reaching out to, my contrarian sensitivities find who he's snubbing much more interesting and important.

"Test" or Smoke and Mirrors?

Bloomberg is reporting on the state of the commercial paper market. There is hope that the market is becoming less dependent on the Fed's CPFF. The market faces a "test" over this week and next, as $245 billion of government bought paper matures. Currently, the Fed is charging a punitive 2.24%. The market rate is 2.15%, but that has jumped from 0.28% on Janruary 8th, "as investors prepared to absorb" the oncoming supply. I also think the current earnings malaise might have something to do with this as well. Would you want to lend to a company with negative cash flow? Not me. I think investors will be very picky about who they lend to. And they should be. So who's been buying? "Assets in money-market funds reached a record high of $3.92 trillion on Jan. 14, according to the Investment Company Institute." Of course, they are backed by the MMIFF. This program is designed to buy assets from money market funds in the event of another paralysis of the market such as the one that occurred after the Lehman bankruptcy. This program is very confusing as can be seen by the Terms and Conditions. However, it seems to me to be a backup system that makes it safer for money market funds to buy commercial paper than it is for individual investors. Unfortunately, it is impossible for me to know what kind of effect it has on the buying habits of money market managers.

Trades

I did three trades today, as the market seems to be bottoming and I wanted to reduce my short exposure. My feeling is that either it heads back up to 9000 or it breaks below 7500. Here are my trades:

1. Closed QQQQ @ $29.15 for less than 1% gain. Why? QQQQ has a PE that's been beaten down to 13x, and most of the earnings were good so far this quarter. Also, these companies have tons of cash on the books. They can't go much lower unless there's another round of panic and deleveraging.

2. Closed ITB @ $9.28 for a 17% gain. The Homebuilders index is trading at about 0.9X book value. It may go lower, but I'm keeping my short on KBH, which I believe is in worse shape than the index as a whole.

3. Closed EWW @ $28.34 for -7% return. I'm going to take a loss on this to reduce my exposure on international/emerging markets. Since Mexico hedged its oil revenue for 2009 @ $85/barrel, that kind of puts a floor under their economy through the first half of this year.

Blatant Lies from the National Association of Realtors

I just had to laugh when I read the news this morning. Home sales were up in December. (But only after the NAR revised November's sales numbers down.)
Here's how the NAR reports this tomfoolery:

Existing-home sales – including single-family, townhomes, condominiums and co-ops – jumped 6.5 percent to a seasonally adjusted annual rate of 4.74 million units in December from a downwardly revised pace of 4.45 million units in November, but are 3.5 percent below the 4.91 million-unit pace in December 2007.

Translation: "Home sales dropped 3.5% from a year ago, but we will report that they were up. When home sales drop next month, we will revise December sales down so that we can show an increase in Janruary."

The lesson to be learned is that we need to understand which data to trust and which to discount. Truthful data is essential to investing safely and wisely.

And in other news, Iceland's Government Topples Amid Financial Mess. Iceland has to pay $10's of billions back to European depositors who lost their money in Iceland's banks. Icelanders have discovered that they are not as wealthy as they thought they were.

Trades!

I closed EEM for a 2% profit today and EWZ for a 7% loss.

My ultrashorts (DUG, FXP, and SDS) have been surging lately. I wanted to take a some stuff off the table, as these positions get larger the more the market falls. Actual short positions get smaller when the market falls, meaning exposure decreases.

COF came out with earnings, oops, I mean losses. As one witty commentor said, "What's in your wallet? -Apparently not much." The subprime credit exploiter posted a loss of $3.74 compared with analyst expectations of $0.33 in profits. See Marketwatch. Crapital One is a terrible company. For years, they've exploited people with low credit and made all their money off fees.

The News is Worse

Much, much worse than it was when the market hit its lows on November 20th.

Singapore's GDP dropped at a 16.9% annual rate in Q4 '08.

South Korea's dropped 3.4% from a year earlier.

Japan's exports dropped 35% yoy in December. Imports dropped 20%. And exports to China were down 25%. I can't wait for the numbers to come out of China. Then we'll know how badly the official numbers lie about the real situation. My guess is that Chinese exports dropped 20-30% in December. What does this mean that exports are dropping faster then imports? It means that inventories are building and that raw materials still have a long way to fall. Demand is still coming down.

And it's not coming back any time soon. The credit crunch is worse than ever.

Spain's debt rating got cut from AAA to AA+. How does this affect American banks?

Portugal got cut from A+ to AA-.

Greece got cut.

Ireland will soon be next.

The Pound has now fallen $0.11 this week. Jim Rogers, who founded the Quantum Fund with George Soros says the UK is bankrupt. They can't afford to nationalize the 2.12X GDP debt of failing banks Lloyds, RBS, and Barclays because it would push overall debt levels to 4X GDP. And they have nothing to export. North Sea oil production has been falling for years, and prices will be low for years.

Treasury bonds are now falling on fears of dumping by panicked foreign central banks, pushing yields back up to 3.20%.

Bank of America needs another $80 billion says an analyst from FBR. And they just got $138 billion from the Fed last week.

Deleveraging continues. ML's Rosenberg says that hedge fund withdrawals hit $152 billion in Q4'08. "By way of contrast, hedge funds attracted an all-time high of $194bn over all of 2007."

The Fed is not printing. They are just transferring enough debt from insolvent entities to keep the whole system from collapsing.

Trade wars are coming: Obama Deems China ‘Manipulating’ Yuan, Geithner Says. If they're manipulating, then we have the option to do something about it, right? We can pick up a 4% boost to GDP just by eliminating the trade deficit. Paulson never labeled China a "manipulator." But what interests me is not the coming China - US trade war, but Chinese / Japanese relationships. Will there be a trade war? Probably. Will Japan try to protect itself, or will they attack China? Maybe.

So, it's worse than before. Time to start thinking about taking profits. This time, I will take a different approach than the last cycle. I am going to take profits on the less volatile and stronger positions and hold the more volatile positions longer. As the market becomes more unstable, the more volatile positions grow riskier, but the profit potential rises as well.

Closing my short in COF is a possible profit taking trade, but I want to wait until earnings come out after market close today. If they're good, I'll close it and wait for a few months for a bounce. If it's bad, I'll keep it short for now.

Brazil (EWZ) just cut their benchmark rate from 13.75% to 12.75%. They have a lot of room. They've engineered a middle class in their country over the last 10 years. They don't manipulate their currency. Oil is down, and they have high corporate debt levels, but they are also energy self sufficient. I am looking to close this position.

Mexico (EWW) has hedged all their oil production at $85/barrel. This should enable them to hang in there, although they are extremely dependent on the US.

EEM - emerging market index. I'm just waiting for it to hit new 52-wk lows on a big down day.

Housing - looking at book value, they are not even close to what I think they're really worth. Book value is still getting written down by the billions every quarter, yet ITB trades at 0.93X book. I want this ratio to drop to about 0.7X book. Same with KBH.

Gold - looking better and better: now we have deflation with longer term Treasury rates edging up. Keep OZN, IAG, and IAU. Consider NG > $1.50.

QQQQ - tech is getting hammered, and people are still hiding there. Apple beat expectations, by growing earnings by a measly 1.5%. If Apple can't grow, nobody can.

And finally, oil. My DUG ultrashort is way under water, at $26 with a cost basis of $34. But I'm just going to wait and see what happens. I still think oil keeps falling, although it might all be future prices.

FRO - the contango is still there. Currently 40+ tankers are being used for storage. Rates are high. I think they pay out a big dividend or announce something big.

Big Picture for 2009

Here's the big picture: the credit crunch is still devouring the "real" economy like a pack of famished piranhas. Think of a locust swarm or army ants. Rosenberg says lending data show an increase in the severity of the credit crunch with bank lending dropping 16% annualized over the last four weeks.

The government has had to step in with new bailouts, both here and in the UK. Spain's debt rating was cut from AAA to AA+. Ireland, Greece, Portugal, and Italy are next. Why? Nobody wants to borrow except those who have too much debt already, and nobody in their right minds wants to lend to those people in this type of economy.

There's still plenty of debate between inflation and deflation. Deflation is winning hands down. Companies are cutting pay for existing workers. When was the last time that happened? Surely not in my lifetime.

The Fed is not inflating, in my mind. They are assuming bad debts that have made the US banking system insolvent. Credit is not growing. In fact, credit is still shrinking, because the Fed has not even covered all the deflation in debt markets, equity markets, and real estate markets. The Fed and the Treasury have assumed enough of the losses in the banking system to prevent a full-scale meltdown, but they
haven't been able to prevent further cutbacks in credit and lending.

Going forward through the first half of this year, equities face hurricane force headwinds. If equity is leveraged debt, and debt is in doubt of being paid off, equities will be under severe pressure. Deflation is also extremely bearish for corporate profits. My big picture strategy is therefore to leverage cash by selling short. At this point in time, I am getting close to taking some profits as the market retests the November lows. If the market drops through, I will continue to take more. I believe that the market is still in bear market mode, as today's 150-point drop on the messiah's inauguration indicates selling on good news. Gold is the only thing I want to be long right now.

Deflation Setting In

Bank of America received $118 billion in guarantees and $20 billion in preferred equity (8%) investment from the Fed.

BAC's market cap is $27 billion. Is there any doubt that equity is negative? The Fed will be taking losses on this for years and years and years.

And inflation is dead. Done. Deader than a doornail. CPI for last year was 0.1%, the lowest since 1955, according to Bloomberg.

Prices will plunge next year.

As far as market behavior, the market rallied 250 points off yesterday's low on the BAC bailout news. But something doesn't make sense. BAC was down 18% yesterday, and is down another 11% today. I was thinking of taking some chips off the table with the markets close to testing the lows, but now I'm going to wait. It just feels like we drop right through support like butter.

I was thinking of taking some profits on gold, but it has actually rallied against the market pullback. In addition, with negative CPI today, gold is up 4%. Finally, gold has rallied in the face of 10-yr Treasury yields from 2.07% to 2.5% earlier this month. So, I am going to hold on to gold here, and I'm almost tempted to buy some NG at $1.50.

Where Did the Madoff Money Go?

FEES! Hedge fund fees, that is, according to Bloomberg. I think someone's going to get sued. Investors will want their fees back, as they were based on fraudulent returns. Ouch! Long-term, I can think of nothing better for my own future as an investment manager than to have the house cleaned out before I get out of school. I'm so glad I won't be competing against so many frauds and incompetents who have been eliminated.

Frontline

Here is some interesting news about oil tankers, contango arbitrage, and Frontline from Reggie Middleton on Seeking Alpha.

Key data is that Frontline has already leased 20-25 tankers for oil storage, and arbitrageurs are seeking 5-10 more. What did I tell you?

The amounts of oil being put into storage are going to reach ridiculous, historical proportions. It's so silly. Is the oil really worth that much more out of the ground? No, but there is a vast ocean between current prices and future prices, which have a mid-year recovery priced in. Recovery or not, the amount of oil in storage will depress future prices either way. I see oil at $30 some time this year. Long term prices have a long way to fall.

Trade

Sold FCX (all shares) at $28.85 for a 30% profit.

I think this rally since Nov. 20th is getting long in the tooth. The most bullish scenario I see over the next month or two is that the DOW tests the lows of around 7500. If things get worse enough, look out below!

2009 Debt Rollovers Due

From David Rosenberg, chief economist at Merrill Lynch:

Bond Refinancing Risk in Emerging Market-land as Well

We saw from the December 29th FT that emerging market governments and corporates face a whopper of a $6.9 trillion debt rollover calendar in 2009 (Brazil with $205 bln; Russia with $605 bln; India with $257 bln; China with $2.4 trillion).

Hmmm... Something doesn't look right to me. The conventional wisdom is that China's reserves make it a rich nation. Doesn't look like the reserves will cover the bill to me. They're only $1.9 trillion. Unlike China, the US can repatriate capital from around the world through strong dollar and protectionist policy. With China, capital flight will be the big story. Still sticking with FXP and bearish on China.

But what if China starts to dump reserves to pay debt, forcing up US Treasury yields? If anything, this would be more deflationary and dollar bullish. I don't think that the US needs to borrow anything from China. The government can get all it needs right here at home. Until this is apparent, however, I would not be surprised to see the 30-yr head back up over 3%. If it does, I will look for a good buying opportunity and probably start with a 50% equity position. In the meantime, with FCX over $28, I am thinking of booking a nice little profit on that one.

Hamas

Thousands Protest in Europe at Gaza Offensive

Why am I not surprised that no one has protested the rocket attacks by Hamas? Clearly there is a double standard here. These cowards always hide behind the "disproportionate action" argument. Israel needs to take any action necessary to defend its citizens.

And why is there no problem in the West Bank? No Hamas, no problem. Unfortunately, Hamas will not be eradicated by a ground war. Hamas wants a ground war. They want a bad guy to blame. That's why they provoked Israel in the first place. Without war, they have no way of keeping power.

Keynesianism

Mish rails against Keynesianism in this blog post: How "Something For Nothing" Ideas Become Policy. I won't copy the entire thing. Although it's worth reading, it's too long for easy commenting.

First, the title. I don't see "something for nothing" in fiscal stimulus, at least not in a quantitative sense. If the government spends money, the amount, or at least the value comes from somewhere. Either it comes from taxes, or it is borrowed from investors, or it is printed. In the last case, the value of the printed money comes at the expense of the devaluation of the rest of the money supply. Thus far, I agree with Mish about "something for nothing." However, I am about to fork off onto another path. What Mish does not see, and what Keynes did, is that the distribution, and not the amount is what becomes important when money no longer moves, trust breaks down, and investors would rather accept 2.5% on government bonds than 20% on corporate bonds. Quality trumps quantity. When monetary policy, equivalent to pushing money into the economy stagnates, fiscal policy, which pulls money through the economy is the common sense alternative.

Germany has voiced the strongest principled objections to large-scale fiscal stimulus packages. Peer Steinbrück, the finance minister, has complained about the "crass Keynesianism" pursued by Mr Brown, accusing him of
"tossing around billions" and saddling a generation with having to pay off
British debt.

This quote comes from the Financial Times. Again, there is a technical manner in which Mish and the German finance minister could be viewed as right: British taxpayers will have to pay of the debt eventually. What they miss is that most of the government debt is not new debt. (If if was, you'd see interest rates on government debt increase, not decrease.) This is just a transfer of debt from the private sector to the public sector. In fact, I would argue that net debt has contracted. A sign of this is US consumer debt in November shrinking for the first time since the Great Depression. Another sign is bank lending contracting by 55% in the US in 2008. The increase in government debt worldwide has not expanded enough to offset the shrinkage in non-government debt due to repayment, writeoffs, defaults, etc.

Mish further argues that

the stagflationary 70's killed (or rather I say should have killed), Keynesian theory given that the "impossible" happened (rising unemployment and rising inflation).

I would say that had Keynes been alive, he may have recognized that the policies which got us out of the Depression would not solve the inflation of the 70's. It is unfortunate that his followers misapplied his theories. I am probably treading on thin ice here as I have not studied the economics of the 1970's in great detail. However, my guess is that inflation was so bad that it was causing consumption to fall, therefore causing unemployment to rise. When Mish explains how the Philips curve does not apply to a deflationary period, then maybe I'll reconsider a Keynsian solution.

Here's what Mish says about Keynesianism in Japan:

Japan pumped massive amounts of money into the economy and went on a spending spree and it did no good. Did Japan learn from this? Of course not.

How does Mish know it didn't help? Japanese asset values collapsed 70-90% in the 1990's, the same as the US in the 1930's. The difference was in GDP. Japan's GDP never fell, while US GDP fell by over 30%. My conclusion is that it depends on what you're looking at. If you look at stock and real estate values, it didn't help. If you look at GDP, it did.

Mish offers no solution: "There is only one way to defeat deflation and that is to not let the conditions that foster it to build up in the first place."

If the government had not stabilized the financial system earlier this year, there would have been a run on the entire banking system, ATM's would not have worked, and we might be facing roving bands of hungry looters and martial law. Doing nothing is not a solution. When Mish has a solution, then I will start to believe he understands the problem.

And a last word. I read Mish every day. He has a lot of great analysis, and he may be right. I tend to comment when I disagree, which may make it seem as if I believe that Mish is not one of the most intelligent economists in the world today. Mish may even be right; it would not be the first time I am wrong. This is just the way I see things to the best of my understanding today. I reserve the right to change my mind and declare myself wrong at any point in the future.

China

I can't remember where I saw it, but at least two separate articles have mentioned an amazing statistic: China's internal economy is only 25% of its economy. That means that 75% is export based. Ten years ago, the share was 40% internal/60% external.

Chinese officials have expressed wishes that the Chinese economy returns to this more sustainable (although still extreme) model. My prediction is that their wish will be fulfilled, although not in the way they expect. The easiest and most likely way for this to happen is for exports to shrink by 50%. This will be a minimum figure for 2009, as the whole pie of the global economy shrinks by record amounts.

And now for something more hopeful, albeit speculative. I've been pondering the question, "Where has the global economy gone wrong?" It seems to me that the first problem here is an imbalance of debt and production. The countries that were borrowing (US, UK, Iceland, parts of Eurozone, deficit countries in general) were not the ones increasing production. Production was increasing most notably in China. The problem that resulted, loosely speaking, from this is that the wrong goods were being produced. Too much capital, labor, and raw materials went to goods that benefited too few people (borrowers). Production was geared towards inefficient goods with negative externalities (econo-speak for McMansions and gas-guzzling suv's) instead of efficiency and return on investment. This is just a loose train of thought here so I won't develop it any further at this time. I will move onto the second problem which I see.

The second problem is perhaps an offshoot or a microeconomic version of the first. The problem is that too much wealth got concentrated in too few hands. For a few years, the middle class was able to borrow to sustain their spending spree, but that is now over. They will be saving for years to make up the wealth they have lost due to shrinking asset prices. When wealth is concentrated in too few hands, the value of that wealth will plunge, as the amount of productive capacity of the capital far outweighs the consumptive capacity of the overall population. The more concentrated capital is, the greater its productive capacity, while the more spread out capital is, the greater the consumptive demand. For example, one rich man can build a steel mill. However, he would be hard pressed to make anything useful if he tried to use all of its capacity just for himself. This is where I will leave this discussion. Perhaps later, I will work on the implications of these problems and possible government or non-government solutions.