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David Rosenberg, the former chief economist at Merrill Lynch (who recently jumped ship) had a follow up interview on CNBC about his bearish observations of the past month. Here are some points from Zero Hedge‘s thorough summary:

On the technicals, Rosie sees a possible break through all the way to 1,200: “That is an observation, not a forecast, by the way. Back when we hit that level last fall, it was a glass-half-empty feeling of being down 20% from the highs; this time around it is a cause for celebrating an 80% move off the lows!”

In the fund flow camp, he points out that after the sideways action for the past three weeks, the break out was precipitated by only the second net 2009 inflow in mutual funds of $12 billion. “The initial source of buying power in March was the dramatic short-covering and pension fund rebalancing.” Now, it is the retail investor keeping the rally alive, as he is transfixed by the cheerleading puppets on CNBC. The vicious cycle would pressure the predominantly bearish fund managers (60% seeing the move off the lows as a bear market rally, and 5% buying into the V-shaped recovery concept) to chase performance, implying high “odds of a further melt-up.”

Indeed, the market technicals make this chart of the S&P 500 look unstoppable:

S&P 500 6-2

The upswings since March have been on high volume (with the declines on relatively lower volume), and the index recently broke through the 200-day moving average, which has been a source of resistance since December 2007.

The market’s valuation on the other hand, is very overbought:

In a nutshell, David doesn’t see the S&P $75 earnings, based on a bond implied 12.5x multiple, as achievable until 2013 at the earliest. And he concludes “Look at this way — we are going to be hard-pressed to see operating EPS much better than $43 this year. A ‘normal’ first-year earnings bounce is 20%, and again this is being generous, but that would leave us with $52 EPS for 2010. We give that prospect very little chance of occurring, and we have some difficulty with the stock market going ahead and pricing in an earnings profile that is likely four or more years away from occurring.

Rationalizing the move upward is almost impossible, since this rally is founded on sentiment derived from the fear of being left behind…By institutional investors! From Minyanville:

Portfolio managers are evaluated based on their performance relative to their benchmark. Most institutional managers are still overweight cash and underweight equities…Perhaps even more importantly, virtually everybody that has cash right now is underperforming on a year-to-date basis. Remember that the S&P 500 started the year at 903…Most of these managers aren’t bullish on the market, but at this point, it doesn’t matter what they think. Getting long equities is a matter of job preservation.

That’s very well put…if they cashed out near the bottom, they have no choice but to chase the rally up. He goes on to point out that institutional fund managers (mutual funds, hedge funds, or general financial advisors) handle a great deal of money, and therefore cannot simply buy or sell all at once – it takes much longer to establish/unwind positions, making their operation less liquid. In essence, the shift in allocation from bonds to equities is moving the market due to the magnitude of the cash flow.

Finally, the long-term fundamentals illustrate a more precarious conviction, since the broader economy doesn’t point to the “green shoots” sprouting too quickly:

The much more ominous questions of unemployment and consumer savings are still on the table, and painting a much bleaker economic bleaker picture. In Rosie’s words: “The really big story is that the fiscal stimulus is assisting in the household balance sheet repair process, but is not really doing much to spur consumer spending — highlighted by the rise in the personal savings rate to a 15-year high of 5.7% from 4.5% in March and zero a year ago — never before has the savings rate risen so far over a 12-month span. Note that the post-WWII high in the savings rate is 14.6% and that is where I believe we are heading. Despite the conventional wisdom, this is highly deflationary.” As for unemployment: “Nothing is as important to the inflation backdrop as the labor market — wages/salaries/benefits are seven times more powerful in determining the corporate pricing structure.” And the labor market, at least until the latest batch of however adjusted data, is not showing any relief whatsoever.

A tug of war between market barometers indeed…

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Naked Short Sales

This chart from the NYT adds credibility to the SEC’s wild-goose chase from last year:

naked-short-sellingIn case you forgot, there were many people who blamed naked short sales – or shorting a stock without borrowing the shares – for the precipitous decline in shares of financial institutions this past fall. As the graph shows, there have been fewer failed trades since the temporary ban on short sales. Here’s why naked shorting is so controversial:

Naked short-selling can save a trader the costs of borrowing shares, or can make it possible to short a stock where borrowing is very difficult because so many others want to sell it short. A large number of fails does not prove naked short-selling, since there are other reasons for trades to fail, but such a number does indicate it is likely.

It looks like the trading arena is on the road to recovery. There’s an ideology developing where the SEC should tax trades to depress volatility — which would probably put a lot of people out of work.

From Portfolio:

Such a tax could make the markets better. Financial markets raise capital for new enterprises. They help people exchange assets and information. But just because there is higher volume doesn’t mean these trades are expressing more views. Instead, all that is happening is that the bandwagon is speeding up. The faster it goes, the more people want to get on. Noise traders drive out the fundamental investors.

The full article brings up some good points.

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Berkshire Hathaway disclosed their holdings from late 2008 late Tuesday:

  • Sold half of his stake in Johnson & Johnson
  • Sold 9% (9.5 million shares) of Proctor & Gamble holdings
  • Sold entire stake in Budweiser, now InBev
  • Bought 19.9 million shares of Constellation Energy, and added 7.2 million to NRG (both are Utility companies)
  • And he increased his already monstrous position in Burlington Northern Santa Fe (railroad company) to 70 million shares.

Here’s the rest from Yahoo Finance:

Berkshire revealed several other changes in its holdings, including:

— Sold about 4 million shares of the nation’s third-largest oil company, ConocoPhillips, reducing its holdings to 79.9 million shares from 84 million.

–Sold about 5.4 million shares of Minneapolis-based US Bancorp, reducing its holdings to 67.6 million shares from 72.9 million.

— Increased its stake in industrial machinery maker Ingersoll-Rand Co. to 7.8 million shares from 5.6 million.

— Added shares of industrial equipment maker Eaton Corp. to 3.2 million shares, from 2.9 million.

— Reduced its holdings of auto dealership chain CarMax Inc., based in Richmond, Virginia, to 17.6 million shares from 18.4 million.

— Lowered its holdings of health insurer UnitedHealth Group Inc. of Minnetonka, Minnesota, by 79,900 shares, to 6.3 million.

This is a surprising amount of activity (or reshuffling) for a 3 month time frame – especially for someone like Warren Buffett…Consumer Staples stocks are clearly out of favor, as told by his sale of PG and JNJ, which contradicts his old adage “a man has to shave everyday, so I like to own the company which sells razors.” (that’s the general idea…)

Although the report doesn’t yet say, I would imagine that Berkshire increased its cash position after all of this activity. I think they’re taking some off of the table to “Buy American” for a later time.

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*As Advertised.

An insightful piece from Seeking Alpha prompted this post, as I’ve noticed deficiencies in the use of certain types of ETF’s:

  1. “USO” – which tracks the spot price of Crude Oil
  2. Any of the Proshares Leveraged ETF’s (short or long – SKF, UYG, SDS, SSO, DXD, DDM…)

I am certainly late to the party of pointing out the leveraged ETF’s, but nonetheless have a few things to say.

First, the explanation on USO from Seeking Alpha:

Here are the current prices for oil contracts with expirations in the next six months. Notice how every contract is more expensive than the one that preceded it. USO follows a simple strategy of buying the current contract and then rolling into the next contract before the current one expires.

March 2009 $40.42
April 2009 $46.22
May 2009 $48.88
June 2009 $50.45
July 2009 $51.28
August 2009 $52.70
Source: NYMEX. Data as of 2/9/08.

Until last Friday, USO owned the March 2009 contract. Specifically, it owned 84,378 March contracts, entitling it to 84.4 million barrels of oil.

But on Friday, it sold all those contracts and bought the April contract instead. But because the April contract cost $6/barrel more than the March contract, it couldn’t afford as many contracts. In fact, if you exclude new inflows into the fund, it could only buy 73,444 April contracts.

Whammo presto, the holders of USO lost 13.4% of their exposure to crude oil. They now control less oil. If the spot price stays near $40/barrel, the value of those April contracts will decay back to $40/barrel over the next month and investors will lose their shirts. If the price of oil jumps 15% in the next month—before USO rolls again into the May contract—investors will only break even.

Basically, because the price of Oil is upward sloping, the parent fund has to cost average-up at the beginning of every month – they have to reinvest all of the money from expiring contracts at a higher price – meaning there is less firepower behind the investment.

(The author makes reference to “contango,” which may sound complicated but isn’t…it’s just when the Oil futures price is above the spot (current) price).

The Leveraged ETF’s, on the other hand, aren’t flawed per se; it is our perception of how they should work which is flawed.

This concept was well covered by the Wall Street Journal, and by Jim Cramer, who through the powers of cognitive dissonance decided that the Ultrashort Financials ETF (SKF) brought down the bank stocks in January (The author of the Proshares article from thestreet.com provides analysis on how this is somewhat true).

Here’s the WSJ excerpt:

The issue is that these funds are designed to double the index’s return — or double the inverse of that return — on a daily basis. The compounding of those daily moves can result in longer-term returns that have a very different relationship to the longer-term returns of the underlying index.

For example, take a double-leveraged fund with a net asset value of $100. It tracks an index that starts at 100 and that goes up 5% one day and then falls 10% the next day. Over that two-day period, the index falls 5.5% (climbing to 105, and then falling to 94.5). While an investor might expect the fund to fall by twice as much, or 11%, over that two-day period, it actually falls further — 12%.

Here’s why: On the first day, doubling the index’s 5% gain pushes the fund’s NAV to $110. Then, the next day, when the index falls 10%, the fund NAV drops 20%, to $88.

The funds themselves are tricky, but if you understand that making 10% is different than losing 10%, then this should make perfect sense.

End Lesson: These are instruments made for day traders, not long term investors.

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“Dating back to work on the random walk hypothesis by French economist Louis Bachelier (1870-1946), the efficient market hypothesis asserts that stock market prices are the best available estimates of the real value of shares since the market has taken account of all available information on an individual stock.”

Economy Professor

Now from New York Times Magazine, which had an interesting 10 page spread about Risk valuation last Saturday:

VaR is often measured daily and rarely extends beyond a few weeks, and because it is a very short-term measure, it assumes that tomorrow will be more or less like today. Even what’s called “historical VaR” — a variation of standard VaR that measures potential portfolio risk a year or two out, only uses the previous few years as its benchmark. As the risk consultant Marc Groz puts it, “The years 2005-2006,” which were the culmination of the housing bubble, “aren’t a very good universe for predicting what happened in 2007-2008.”

How are these two phenomena related? The risk models our world of finance has been relying upon for several years are grounded in the Efficient Market Hypothesis; VaR models – or models which price risk – would not function without the corollary of the underlying asset being priced properly. We took comfort in this convenient theory, that everything is priced appropriately, all the time.

The counter to this argument is not another theory, but a series of real life outliers. If markets are efficient, How does George Soros continually compound his fortune by trading according to his boom/bust empiricism (like shorting the British Pound)? Warren Buffet also acknowledges fault with this theory: “I would be a bum on the street with a tin cup if the markets were always efficient.”

Every theory has shortcomings, and the admitted shortcoming of the Efficient Market Hypothesis is one of “black swans”, or in economic terms, exogenous shocks. These are events which cannot be predicted, ones which are often described as lying outside a 99% confidence interval, and ones which continually disprove the efficiency of market pricing – especially during times of panic.

The second glaring shortcoming is one which lies about the applications of the EMH, or one of our perception. One assumption of the hypothesis, like an assumption in micro-economic theory, is that the participants are completely rational (much like human calculators). This assumption has proven to hold under times of tranquility – like the times LTCM succeeded in making money – but during times of deception and opacity, many of us are hopelessly irrational.

To quote Michael Lewis’s most recent book, Panic!, on the pricing of Bear Stearns:

“If the market got the value of Bear Stearns so wrong, how can it possibly believe it knows even the approximate value of any Wall Street firm?” (P. 342)

The pillar of the EMH that comes tumbling down in times like today is “known information”…On the surface, who is to say that Bear’s balance sheet was all that bad? I’d like to believe we could extrapolate everything from the footnotes (never mind having everyone read them), but the population of people who called for the failure of Bear Stearns in 2006 lie far outside the depths of the “normal distribution.” Furthermore, here’s a real life example: how could the Nasdaq be accurately priced at 1,400 in 1997; at 5,000 in 2000; and back at 1,400 in 2002?

All of this is to argue that the notion of efficient markets, which we have taken shelter in for much of our modern financial history, stands paralyzed in times of uncertainty; this would provide insight into why panic ensues at the very signal that we are “in the dark” concerning anything (this could also be a reflection of our poor sentiment; the constant belief that we will be disappointed by Wall Street is becoming a part of our psychology). This would also provide an explanation for our dependence on models as a “crutch”, to grant us what has turned out to be a false sense of security by quantifying risk with numerical values.

The fallout of the sub-prime mortgage crisis has uncovered many of the issues with deriving models after this hypothesis – the only problem is, we haven’t come up with anything better. VaR were used heavily in the late 1990’s by none other than LTCM, but as the NYT article points out:

Firms viewed it as a human failure rather than a failure of risk modeling. The collapse only amplified the feeling on Wall Street that firms needed to be able to understand their risks for the entire firm. Only VaR could do that. (Page 7)

We then reverted back to their use.

I will end with a phrase which has time and again been a sure way to see oneself proven wrong – Maybe this time it’s different.

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Bill Gross wrote an interesting piece about being one step ahead of government policy on Seekingalpha today. He sees two vehicles to accomplish this:

  1. Municipal Bonds, since a default in New York or California is “unthinkable”…here’s a list of the most recent New York issuance. Gross’s logic being that a 5.00% coupon municipal bond is better than a 2.5% treasury bond (after tax considerations, the muni is more like a 6.75% coupon), since default risk isn’t one of his assumptions.
  2. TIPS, or Treasury Inflation-Protected Securities. Here’s how they work

Treasury Inflation-Protected Securities (TIPS) are marketable securities whose principal is adjusted by changes in the Consumer Price Index. With inflation (a rise in the index), the principal increases. With a deflation (a drop in the index), the principal decreases.

And Gross’s logic:

2½% real yields cannot possibly be maintained unless deflation as opposed to inflation becomes the odds-on favorite. What bond investors know as “breakeven inflation rates” are currently signaling a future where the U.S. CPI averages -1% for the next 10 years. Possible, but not likely.

Since interest rates are zero-bound, barring excessive demand at auction (like we saw with 3 month T-bills), there is low risk of principal depreciation – since deflation is already being accounted for in interest rates…we have a ZIRP for crying out loud. Our government is doing everything in its power to avert a period of deflation, and will happily substitute inflation (this can be extrapolated from our government running  a $1 trillion budget deficit, and the Federal Reserve relentlessly expanding the money supply).

Personally, I think this gets too complicated when you’re relying on the precision of our CPI (which is how TIPS value themselves) to emcompass all facits of inflation. Also, if the value of an inflation protected bond increases only with the value of inflation, you’re not really making money; not to mention that this increase in “principal” is treated as a capital gain, which is subject to federal tax.

Here’s a yield table for TIPS and Notes:

tips

Those yields aren’t very impressive…I’ll take my chances with equities.

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Rhymes of 2003

Sorry for the absence of posts; I was in a foreign country without computer access.

We have an interesting start to the year, as there has been broad based anticipation for a good start to 2009 – but not to the extent to jinx a prolonged rally.

Via Bloomberg:

“Wall Street is starting a new year, and there’s always more money at the beginning of the year,” said James Swanson, chief investment strategist at Boston-based MFS Investment Management, which oversees $160 billion. “The markets will see beyond the current bad economic data and begin a broad-based move upward in the next three or four months.”

It is worrisome to a contrarian to see everyone so cheery when we’re on a very similar path to that of the 2003 tech bubble:

2003-double-bottomNotice the strong start to 2003, as the DJIA started off up 500 points in 3 days of trading (this was uncommon back then…). More importantly, notice the “triple top” formation at 8,800 which acted as a form of resistance, where the index proceeded to plummet to the real bottom (the one nobody expected).

Let’s now look at the Dow Jones of today:

dow-2009After the November lows, we now see a similar triple top formation, at 8,900. We just broke through that level today, but it was done on light volume…

Reasons to be Negative

I don’t find it inconceivable to follow the path of 2003, where the luster of unfounded confidence wears off, and people of the present day realize that Russia will probably default (due to decreased oil revenues, leading to decreased tax receipts), and commercial real estate will bear an atomic bomb on mortgage lenders, who are already at a tipping point (the liquidation sales we saw during Christmas? That’s probably indicative of trouble for many retailers).

Reasons to be Positive

  • The Financial Times reported that Mutual Funds suffered a $320 billion outflow, the likes of which have never been seen (this does not include money market funds, which saw a cash inflow of $422 billion – since people were selling stock, this is a logical place to stash money in a brokerage account to get a reasonable yield).
  • US Treasury debt is an unreasonably low yielding investment, meaning this is where everyone is hiding from risk – which is a misconception, since the principle 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.

It is clear that investors have allocated their savings out of equities and into low-yielding US treasuries and Money Market funds, in return for safety, which is a bullish indicator for the future (since equities have historically outperformed bonds, barring periods of severe inflation), and since we will always seek good returns on investment; unless severely discounted, bonds typically don’t meet this criterion.

Therefore, I would personally wait for either of those negitives to unfold, then re-evaluate the positives as a corollary to invest on the long side in the future.

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