Archive for the ‘Economic Forcasting’ Category

*Reference to the ‘Dollar Smile’ theory (explained by Macro Man, coined by Morgan Stanley):

One possible explanation is an emerging school of thought that a US recession/quasi-recession is actually good for the dollar. According to the proponents of this theory, weak/negative US growth is both damaging to the rest of the world and a catalyst to encourage US investors to bring money back home. The upshot is that there is less demand for foreign assets/currencies and more demand for US assets/currency; hence, the dollar rallies.

By gauging the sentiment of news flow in the past week, the answer to the question of continued strength in the Dollar would seem to be no. First, a little history:

The dollar picked up steam back in December once the thesis that the world economy could “decouple” from the woes of the US fell apart — it became clear that the BRIC economies are less equipped to deal with fallout from the credit crisis, and are more likely to default on their own debts. As stated above, this led investors to unwind their investments in emerging markets, and bring them back into US cash (a more liquid asset). Since stocks were tanking, coupled with the Federal Reserve’s  intent to suppress interest rates with its various liquidity programs (TARP, TALF), many investors sought safety and bought US bonds — to at least yield some sort of return while on the sidelines. Since March 9th (the recent bottom in equities), there has been a departure from risk aversion, and more investors have sought the same risk they did last summer in commodities and emerging markets.

here’s a chart of the MSCI Brazil index (a basket of stocks which is representative of Brazil’s economy):


Here’s how the 10-year note has performed in the same time:

10 Note

Yields have gone up (which means people are selling) while emerging markets are simultaneously attracting new capital. The dollar has also weakened – although slightly – which raises the question of a weaker dollar going forward with rising inflation expectations. Tony Crescenzi has stated that the dollar may slowly relinquish the status of being the world’s leading currency, as the dollar is now 63% of the world’s reserve assets (compared to 70% back in 2002). However when considering alternatives (particularly China) he says:

China’s renminbi is ascending but not suitable for parking the world’s reserve assets because there is no bond market there. Moreover, the renminbi is not yet widely used for commerce and in contracts.

Well, Tony may have spoken too soon.

From the Financial Times:

Brazil and China will work towards using their own currencies in trade transactions rather than the US dollar, according to Brazil’s central bank and aides to Luiz Inácio Lula da Silva, Brazil’s president.

An official at Brazil’s central bank stressed that talks were at an early stage. He also said that what was under discussion was not a currency swap of the kind China recently agreed with Argentina and which the US had agreed with several countries, including Brazil.

“Currency swaps are not necessarily trade related,” the official said. “The funds can be drawn down for any use. What we are talking about now is Brazil paying for Chinese goods with reals and China paying for Brazilian goods with renminbi.” (Emphasis Added)

FT Brazil Exports China 5-19

The scale of the agreement wouldn’t be enough to dramatically affect the FX markets, but it could if this idea appeals to other foreign countries. Brazil has discussed selling 10 and 30 year bonds in International markets this year, which would add to the currency’s liquidity…which satisfies another trait of a desirable currency.

As many of the world’s economies embrace foreign investment (Malaysia’s FX market is currently closed to outsiders, for example), and as our domestic economy releverages money from this period of zero interest, the dollar may wear a frown sooner than expected.

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I just looked through my archives and discovered that I engage in some sort of market prognostication about every three months…The most recent one from January is a good place to pick up for this edition (if at all curious, here’s September and August).

US Treasury debt is an unreasonably low yielding investment, meaning this is where everyone is hiding from risk – which is a misconception, since the principal investment on a 10-year note is only protected by a 2.10% interest rate, meaning any indication of a sell off could drastically hurt a US debt holder. Should treasuries sell off, certain sectors within equities would be a logical home for this capital – the question is always when.

Well to answer this issue 3 months late, when could be now.

But first, some background on the FED’s role in buying treasuries.

The FED has been overreaching the bounds of their traditional policy tools i.e. setting interest rates through buying short-term government debt (1-3 month T-bills), and has entered the business of buying 5, 10, and even 30 year bonds in an effort to drive down the Mortgage Backed Securities pegged to government debt of longer maturities, which should lower the prices of adjustable rate mortgages and allow people to refinance a fixed mortgage.

Due to this agenda, the Federal Reserve has been a huge buyer at all of the recent treasury auctions (the same ones which finance our $1.5 trillion deficit), and have successfully suppressed bond yields…until today:

From Bloomberg:

Benchmark indexes turned negative at about 2 p.m. after an auction of $34 billion in five-year Treasury notes drew a larger-than-forecast yield of 1.849 percent, spurring concern that government attempts to lower interest rates won’t work.

Treasuries declined for a fifth day following the auction and the failure of a U.K. government debt sale. The last time the U.K. was unable to attract enough investors was in 2002.

This situation is paradoxical; on one hand, as I wrote in January, the disinterest in treasuries could be a indication that investors are beginning to trust equities again – a notion which is supported by the 1,200 point rally in the past 10 days.


On the other, we could have a situation where the free markets counter the aims of the FED by selling off treasuries – when buyers cease to exist, yields will go up, and so will rates on mortgages indirectly pegged to treasuries.

With that, here’s the rest of what I’ve been thinking:

Reasons to be Positive:

  • I think the Dow has temporarily bottomed at 6,500 – for different reasons than Doug Kass – because we will need to see if the effects of the recent government action actually work. More specifically, in order to drop below 6,500 we would need a scenario discernibly worse than a nationalization of our financial system, since that was what a DJIA of 6,500 was pricing in. Besides that, all of the logistics which traders look for are coming into favor: there’s heavier volume to the upside on up days, oil has rebounded (which suggests an antipication of increasing global demand), investor confidence is rising, and home prices/sales are looking more optimistic.

Reasons to be Negative:

  • Citi, BofA, and JP Morgan have all indicated that they were profitable for the first 2 months of 2009, but this was accomplished in a system with free money. What will happen to profitability when Bernanke inevitably raises rates?
  • Do I need to worry about the omnipotence of vacant stores, or is commercial real estate implicitly apart of the same set of issues we’ve been dealing with for the past 2 years?

I never thought I’d run out of negative things to say…I may add in some other points if nothing else interesting happens in the meantime.

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I have a terrible string of exams coming up, so I won’t be writing about very much until December 16th (when they’re all over).

Here are my thoughts on the market, since I won’t be able to embed silver linings (or black clouds) into anything for a while:

  • This is not “the” bottom. Volatility remains far too high, meaning the market is still changing its mind too much. This also tells us that there are simply too many unknowns for the market to price itself properly; Will GM and Ford go bankrupt? Are there any other banks which will need a Government intervention? Will $120 billion be enough for AIG (probably not)?
  • The yields in treasuries have dropped to 50 year lows, and most T-bills are at/near or even below zero. This means people are overweight in their allocation to government debt, and are unwilling to invest in equities. What better indication of confidence than this? Investors are on the sidelines, and little good will come for the Dow Jones and S&P until we see mass participation.
  • Most stocks are not cheap. If a company’s forward P/E ratio is at 6, it’s probably because the market expects their earnings to come down – forward P/E is only an indication of a company’s guidance, which is subject to revision. See FedEx and Texas Instruments.
  • Oh yeah, and what about commercial real estate? That was the driver of the housing recession in the 90’s, and we are only beginning to feel it now – It’s not even being talked about on the news yet…

So what’s to keep the market going higher into the new year? Respected investors calling bottoms? Obama announcing more cabinet members? That euphoria is short lived since it does not necessarily translate into an ultimate fix. That’s why I’m more concerned about the earnings forecasts, which many companies are preannouncing earlier than planned.

All of that said, I think that the time is approaching  in the next 6 – 8 months (once the lows are retested, and not after a 1,300 point rally in the Dow) to buy selected stocks for the long haul. It is better to be early to the market than late, because once the light at the end of the tunnel is not perceived to be an oncoming train, all of the money in the bond market will flood the equity market and it will be too late to catch the upswing.

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Via TheBigPicture:


Time should be kept in perspective; we can argue that we are 1 year into this bear market, with the fate of the big 3 unresolved, 4 banks (B of A, JP Morgan, Goldman Sachs & Morgan Stanley) left without a government back stop like Citi received, and unemployment still relatively low in comparison to the economic crises in the chart above, at 6.5%.

So when everyone starts talking about a bottom, think about how long it took to manufacture bottoms in the past, and then think about the relative severity of each recession.

My mental calculator tells me 1-1.5 more years of recession, followed by 2.5-3 years of recovery until the next expansion.

When you have low expectations, its a nice surprise if/when they are exceeded.

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While I find much of our financial and economic news inspiring, It is not very often that I find something that really resonates with me from a moral perspective.

While it is bothersome on many levels that [Bear Stearns, Fannie & Freddie, Indy Mac, and probably Lehman Brothers/Washington Mutual/AIG] have failed in our free market system, the thought of people giving money to “experts” to invest in these companies and the broader market is far more unpalatable.

Barron’s published an article in this weekend’s edition which deals with this very issue. I think this installment is worth reading if only to illustrate that it’s not safe to be invested in most equities in this environment. Typical recessions of the past have lasted 2-3 years, but they did not witness the evaporation of billions of dollars in write downs, and perhaps up to 1 trillion in taxpayer support for our Government Sponsored Enterprises. The main point which is continually disregarded by the media, is that many of our market’s participants are not Hedge funds and Proprietary trading desks. There are REAL people who think now is a good time to buy certain stocks like Warren Buffet would…We cannot rely on the media pointing this out, because that is not their job. We cannot rely on a source when they have an ulterior motive; in their case, it’s getting viewers.

  1. we are in year 1 of a recession; one in which there is unanimous agreement that it is unlike anything anyone has ever seen. What good will come out of entering right now? You will not miss anything until bank stocks are in single digits…
  2. Unfortunately, this one is not restricted to the equity markets (like the tech bubble of 2000-2003) in which investors felt the most pain. Our American consumer, one which has been indestructible in the past, is now faced with asset deflation (houses, cars, and would not rule out dollars as a deflationary asset just yet) and commodity inflation (while gasoline has come back from $4 a gallon, it is no longer $2, and food still costs more than last year). Because these notions are so negative (believe me, I feel pain when I see peoples’ reactions to this cynicism) we have been trained to brush it off and say “we’ve gotten through this before. It’s part of the business cycle” This is certainly true. Maybe I just haven’t thought enough about this, but I can’t remember a time where 70% of our GDP (consumer spending) was weakening, while we underwent credit, mortgage, and energy crises simultaneously.
  3. Honestly, what is there to lose by keeping mostly in cash, and if one must invest, can it be in companies which have A LOT of cash, and pay big dividends? An individual is not flaunting his/her financial performance like a Mutual Fund or a Hedge Fund, one which would be ecstatic to say “I only lost 8% in this market when the S&P lost 20%…That makes me better than the average!” Money managers try to manipulate statistics and mask the reality of relativity: is losing 8% really good? A checking account would have made you 2.5%…that sounds better than the mutual fund’s rate of annualized return…

Finally and most importantly, If you wonder how some of CNBC’s programs can be so optimistic in an “intermediate horizon”, maybe its because their parent company is General Electric. They would rather have your money in stocks than savings accounts, because the run-of-the mill investor is unlikely to short the market. But can we trust our source of information? is this advice founded on objective analysis of the market, or are they more concerned about their GE stock options? (CNBC is actually very neutral when it comes to talking about their parent company, though).

Finally, One has to approach investing as a risk manager; what can I win? What am I likely to lose? If the trend is down for 2 years, and sideways for another 3 years, is it smart to invest in broad based indexes with no dividends?

All of this is not to say that all investment opportunities have vanished forever, it is just that we will not miss the bus for a while, and it is very foolish to lie below a falling knife.

I promise not to write about anything this negative again, I just felt the need to offer a concession, and the hope that this post could stop someone from watching a 10% loss grow to a 30% loss in lieu of what is coming our way.

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August 13th:

I’ll be starting class again soon, so I’m not sure how much blogging I’ll do going forward (barring anything fun to write about).

This will be one of my last posts before school, and I think this is a good time to write what I’ve been feeling about the markets for a while.

Well, the Olympics have begun and oil is down 22% from its all time high. (The timing of my prediction was right, but my reasoning was incorrect…I guess its better to be lucky than good)

As one would expect, this was welcomed with open arms (the consumer may be saved from demand destruction, the Fed can keep rates at 2%). The rotation out of all things pertaining to commodities (oil, agriculture, metals) have provided an interesting situation: there is now nowhere left to hide, and there is nothing which is untouchable from the downward trend of the broader market. In other words, there are no bullish “momentum” stocks to park your money in, as all of those have gone into free fall at one point or another, and have since stabilized at a lower price. At the same time however, because of the fall in oil, there have been some unfounded gains in certain places (chiefly anything financial), until today!

If you notice from the chart, financials have sort of, drifted higher recently. The rally which occurred after the bottom on July 15th was sustained because of the simultaneous drop in oil…The only thing is that, some day oil will also stop falling, and will stabilize. Many say that will happen at $110/barrel. I think that is a sound prediction, but believe that it can be around $85-$95 through the winter. Winter is 4 months away though, and once oil stabilizes, the hot money has to go somewhere. More importantly, there won’t be anything fueling the rally in financial services, because they are still in horrendous shape.

Finally, the prediction….

I think the saying “markets do not repeat themselves, but they rhyme.” applies to our current situation. In case you have repressed this information (I did, until today) the last sell off in financials was sparked by none other than a series of downgrades…on Tuesday, we had another round of downgrades and cuts in earnings estimates (Goldman, JP Morgan, Morgan Stanley).

While we do not have as negative a catalyst such as rising oil prices, we do have, what I believe to be a drying pipeline for good news now that commodities have dropped big. This also means that Financials are in the spotlight because they can no longer share the blame of a bad environment with high oil prices. TO TOP IT OFF, a more severe catalyst for financial services can emerge, and that is the deterioration of banks like JP Morgan, which have been virtually unscathed…until Tuesday. If they were believed to be the fortress from this whole mess, and they come out in bad shape through 2009 (which was picked up by their press release, hence the biggest drop in 6 years) we can see a serious sell off.

Finally, by now we must know that the news of Merrill Lynch selling their CDO’s was a bad sign, not good, and John Thain might go down as one of the worst CEO’s in finance history because of it. Not only did he sell the pre-2006/2007 CDO’s – which represent the better quality basket simply because debt from that time frame is more likely to get paid back – but the good CDO’s within that tranche were undoubtedly cherry-picked by the guys who bought them. (Honestly: if you were spending billions of dollars on such a toxic investment, wouldn’t you make sure you got the best ones?)

The inevitable realization of losses in Level-3 assets/off balance sheet assets, coupled with instability amongst the bulge bracket banks, will result in another sell off, and another bottom (no one can really say if it will be worse than the last one, and I surely won’t begin to speculate)

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August 5th:

Rates are kept at 2%, all sectors but oil and commodities rally, and the dollar gets stronger. *did I read the wrong headline, because based on that information I thought rates would be at 2.25%*

CNBC was rather amusing, as the crew was trying to diagnose the market’s behavior: they concluded that the traders didn’t buy the Fed’s “hawkish” tone towards inflation, which means that they could possibly be overplaying the prospect of inflation, and will be able to keep rates where they are. What’s also of note, is that news from the Fed, good only on a relative basis, always impacts the markets. Despite my complaining, I think that this boost was needed. Nothing goes in only one direction, we can extrapolate what we want from the data, it all depends on the mood of the market.

I wouldn’t be surprised to see this behavior continue for another month or so (people seemed pretty cheery on television), simply because oil doesn’t have any buyers right now; the short term prospects of inflation are evaporating. Oil goes down when there’s a hurricane (which must mean that a catastrophic disruption was priced in), and the latest thing is “demand destruction”, which holds some credence, but now has gotten to the point where it is contradicting the fundamentals of most companies in the sector. There are companies which have actually reported real, tangible earnings in this environment (believe it or not), including almost any energy company or miner of basic materials.

The market, however, is tired of the story. It’s like a little kid who has a short attention span. People love the newest thing, but eventually it gets old or boring. This, I suppose, is a part of the cyclical nature of markets…if it weren’t, when would we have such buying opportunities? Take Brazil as an example: people couldn’t get enough of their prospects going into the summer, but now that people have become more risk averse, they think back 10 years and relate it to crises such as Russia’s default, times of hyperinflation, and a volatile currency (the last characteristic is still true). As a result, some of the best stocks are down 25%-30%.

My take on all of this, is that while this is a nice sigh of relief, its an even nicer time to establish a short position in financial services.

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