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Posts Tagged ‘Inflation’

Two must read articles today; The first is an Op-Ed piece from Warren Buffett in the New York Times.

Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

The second piece is an interview with contrarian investor Eric Janszen, founder of investment site itulip:

There have been warnings about how precarious it is for the $63 trillion credit-derivatives market to be bigger than the “world economy.” What are people talking about when they bring up this figure?

  • Credit-default swaps (CDSs) have been described as insurance policies taken out between two parties. One party agrees to insure against the default of a bond; the other party agrees either to pay out the insured amount if the default happens during the term of the contract or to keep the premium if it doesn’t. But CDSs are not exactly like insurance policies–you do not have to own the asset in order to take out insurance against it. So the CDS market is like thousands of gamblers taking out hundreds of fire-insurance policies of various terms–say, averaging five years–against hundreds of houses. The total value of the insurance premiums of all of the contacts may be $4 trillion (known as the gross market-replacement value) while the total liability of all of the counterparties may be $63 trillion (notional value) if all of the houses were to burn down. The gigantic notional value of CDS market is often covered by financial journalists with alarm. But the chances that all of the houses are going to burn down in five years is close to zero. The actual liability is somewhere between the gross replacement value of $4 trillion and the notional value of $63 trillion.If the “statistically correct” thing happens and only one of the several hundred houses burns down in five years, then the total amount that all the counterparties owe together is manageable. But if many of the CDS contract writers are using the same or similar risk models and they happen to be substantially off, then the total cost of the insurance payouts may exceed the insurers’ ability to pay. The insurers will be forced to default on the default insurance.The risks are: 1) that a few such defaults will lead to others, causing a panic; 2) that in a panic that the CDS market cannot be bailed out by the Fed because the market is based on of thousands of handwritten contacts enforced by novation, the weakest form of contact settlement–which means there is no central clearinghouse where parties can be brought together to work out problems; and 3) that there is a considerable concentration of CDS liabilities among a small number of financial firms. That is why Bear Stearns, for example, was bailed out, and why Lehman should have been bailed out, from the perspective of financial system stability.

Both are very credible sources, but Janszen comes up with much more meaningful qualitative data; I hate to criticize Buffett, because he’s mostly right about everything (except Solomon Brothers). Also, the assumption that the common investor should be buying is a bit unfounded; Buffett can afford to sustain a 30% loss, because he’d still be one of the richest men alive. Finally, his whole argument is predicated on the past. Most of the news we hear today carries no parallels to the past: bailouts being 7% of our GDP, we have a housing crisis which we thought was bottoming out, but is intensifying.

I do agree that in the long term, cash is a bad place to be because it is a depreciating asset, but the crisis in our financial markets has not yet been digested in the real economy, the driver of our future economic prosperity.

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September 6th – UPDATED

Until the true details come out about the treasury’s bailout plan, we will only have speculation. The leak of the bailout finally materializing was taken as great news in Friday’s after-hour trading, for all financial institutions, except Fannie and Freddie for obvious reasons. If it hasn’t been said yet, the common and preferred share holders will receive next to nothing for their equity.

The thing that I am still grappling with is how the market will respond to this come Monday…will we have another bottom like we saw after the Bear Stearns rescue? Or will we see the market rejoice on this seeming messiah-like bailout of our mortgage markets….I like to see what the guys on Fast Money have to say on issues like this, as they usually give a pretty accurate pulse of the market. Here’s a recap courtesy of Thestreet.com:

Melissa Lee hosted CNBC’s “Fast Money” Friday night. She started the show with a discussion on late-breaking news that the Treasury is planning to backstop Fannie Mae and Freddie Mac. The plan would include changes to senior management. Steve Liesman, senior economics commentator for CNBC, joined the traders to discuss the plan by the Treasury to inject capital into the two companies. He said the rumors on the Street are that the Treasury will offer a convertible preferred or a warrant offering. Guy Adami asked Liesman if the stocks are going to zero. Liesman said he was unsure and said we’re back to where we were before on these equities.

If the government wipes out the preferred holders, it will create other problems in the banking sector, he added. Pete Najarian said the problem is that we don’t have enough clarity on what this means for the Freddie and Fannie shareholders. Jeff Macke added that both stocks are screaming sells, along with the Financial Select, SectorSPDR Trust.

Adami mentioned that if the backstop of Fannie and Freddie can lower mortgage rates, the entire problem could begin to unwind itself. Karen Finerman said the plan is bad for the Treasury and bad for the U.S. dollar.

The one thing which should be clear, is that this will not be cheap; someone (by that I mean the taxpayers) will have to finance this operation. If it turns out that Paulson doesn’t plan for the taxpayers to cover everything in one hefty dose (~$1 trillion divided by 340 million people), then we will need to print more dollars and dilute our currency…after all, what would you do if you didn’t have enough money to cover the losses? Simply print more money!

Since everyone else is guessing about what’s going to happen, I’ll give it a shot…

Friday’s trading leads me to believe it’s entirely possible that we have a pretty big rally, but I think any rational person who reads into the repercussions of this bailout will not be so optimistic in the longer term.

1) Suddenly, the prospects of serious inflation are back; this time, not driven by expensive commodities, but by high rates of growth in the money supply…Think of the market for the dollar like a stock: the value of the dollar is driven by factors of supply and demand. However, what happens when a company holds another stock offering…Using Merrill Lynch as an example, they dilute their shares and make each share in the company worth less than before. Adding more dollars into the economy would effectively be the same as a company diluting their share base. When there is more of something, it does not have the same purchasing power/value as before.

2) Personally, I do not think this directly translates into good news for financial institutions, because we shouldn’t forget that they (big and small banks) hold much of Fannie and Freddie’s paper, whether its equity or debt. The good news, which is an indirect byproduct of the bailout, is that any exposure pertaining to mortgages may finally have a price floor in place, since now they are essentially insured by our government. Maybe the treasury could employ some trickery to allow people to make their mortgage payments, which could calm the housing slowdown.

Here are some places to find good literature on Fannie and Freddie in the coming days (not newspapers, as they’re afraid to be controversial enough to write anything good):

The Big Picture, (He’s usually the best…)

Macro Man, (if he posts anything on the issue, it will be good)

Nouriel Roubini, (if he has anything to say, it’s a must read)

Naked Capitalism, often has good insights.

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August 28th:

Besides the fact that these numbers are almost always revised, we are seeing asymmetric analysis via Jim Cramer and Barry Ritholz:

First, the quote from the much more trustworthy, Barry Ritholz:

GDP is out, ticking higher to 3.3% rather than 2.7%

And if you believe that data, I also have a bridge for sale in Brooklyn.

Why the beat on the headline figure? Aside from the usual inflation nonsense, there were two other factors: Exports, which rose to 13.2% (versus earlier reported 9.2%) and Inventories, which also played a part in the apparent strength.

Now for Cramer, concerning the impact of the numbers on trading today:

And the markup will be made easy today, because you can interpret the GDP number as growth without inflation — ideal for buying financials and techs!

Cramer’s nonsense doesn’t even bother me anymore, because he lost credibility in my book a long time ago (specifically, when he recommended selling First Solar, when it was trading at $60 a share last spring. It traded around $300 for most of the summer). Secondly, he just affirmed my belief that he’s on crack in saying now is “ideal for buying financials.”

Our government could not discount inflation on a GDP reading, especially since they use core-inflation (which excludes food and energy, two of the most important/expensive things we as consumers spend our money on). If that doesn’t do it for you, think of it in very basic terms: You are a bread distributor. Because of increasing costs of wheat and the like, you now have to spend more money on inputs, including the heat for the bread oven, which results in the need to raise your price to maintain your profit margin. If you think it stops there, it doesn’t. Then the guy at the deli, who buys his Kaiser rolls from you, isn’t going to take the loss, so he also has to raise his prices to account for the increase in costs.

In accounting terms, however, we see growth due to increased consumer spending, not inflation.

Long story short, all of that is just my way of saying that Jim Cramer is an a**hole.

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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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