Below is another great article from John Mauldin via his weekly newsletter.

John Mauldin, Best-Selling author and recognized financial expert, is also editor of the free Thoughts From the Frontline that goes to over 1 million readers each week. For more information on John or his FREE weekly economic letter go to:http://www.frontlinethoughts.com/learnmore

From ghoulies and ghosties
And long-leggedy beasties
And things that go bump in the night,
Good Lord, deliver us!

–Old Scottish Prayer

Where the Wild Things Are is a beloved children’s book and now a beautiful movie. But in the investment world there are really scary wild things lurking about in the hidden recesses of the economic landscape. Today we look at one of the unintended consequences of the Federal Reserve’s low interest rate policy.

For quite some time, I have been arguing that we are faced with no good choices, not just in the US but in the entire "developed" world. I see a low-growth, Muddle Through world over the next years (with a double-dip recession just to liven things up). However, that does not mean that we will lack for volatility. Things could get volatile rather quickly. Let’s quickly set the background.

It Is Not Just Japan

Let’s look at today’s interest rate picture. Yesterday, we had the bizarre occurrence of banks actually paying the government to hold their cash. Three-month treasuries yield a miniscule 0.01% in interest. If you opt to buy a one-year bill you get all of 0.26%. You can see the entire spectrum below.

Look at the graph of the yield curve below. It is as steep as we have seen it in a long time. But that is almost the point. Banks are essentially getting free money. If you are a banker and can’t make money in this environment, you need to quit and find meaningful employment.

And that is part of the rationale that the Fed espouses with its low interest rate regime. Not only does it allow banks to repair their balance sheets, it also encourages investors to put money into riskier assets in order to get some return on their investments. Over $260 billion has gone into bond funds this year, and just $2.6 billion into stock funds. However, you have to balance that with the fact that some $400 billion has left money market funds paying less than 0.2%. So there is some movement to capture yield.

But is it just banks that are getting cheap money? And is encouraging investors to find riskier assets a sound policy? Maybe not.

The Euro-Yen Cross and the Dollar Carry Trade

I wrote a great deal in the past few years about the strong correlation of the euro-yen cross to stock markets all over the world in general. (The euro-yen cross is the exchange rate of the euro and the Japanese yen.) This was a proxy for the Japanese carry trade. The stock markets of the world rose and fell in synchronization with the yen versus the euro.

A currency carry trade is a strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used.

The Japanese drove their rates down to essentially zero in the 1990s. By early 2007, it was estimated that the yen carry trade was over $1 trillion. But when the world credit crisis hit, the world wanted dollars. They paid back the yen and bought dollars, driving the yen higher and killing the yen carry trade. Who wants to borrow in a currency that continues to rise, even if the costs are low? And often, large leverage was used, so small movements in the currency could destroy outsized amounts of capital.

But now, there are some who are beginning to ask whether there is a dollar carry trade. In the last nine months, the correlation between the dollar and the stock market has gone to about 90%. If the dollar rises, the stock markets and other risk assets tend to fall, and vice-versa. It would appear that investors and funds are borrowing cheap dollars on a short-term basis and investing in all sorts of risk assets. Not only have stock markets risen, but so have high-yield bonds, commodities, and so on.

We have seen the steepest rise in US stock markets coming out of a recession since the end of the last world war. The market is "discounting" a 5% GDP next year and a profit rebound beyond anything in past experience. Depending on the quarter, operating earnings are expected to rise by anywhere from 30-40%. P/E ratios are back at 23, well above the 17 we saw in the summer of 2007 (I am using 4^th quarter 2009 estimates so as to not have to take into account the disastrous 4^th quarter of last year.)

Worrying about a dollar carry trade is not just a preoccupation of my friends Nouriel Roubini or David Rosenberg or Frank Veneroso. Look as this story from Bloomberg:

"China’s Liu Says U.S. Rates Cause Dollar Speculation

"Nov. 15 (Bloomberg) — The decline of the dollar and decisions in the U.S. not to raise interest rates have caused "huge" speculation in foreign exchange trading and seriously affected global asset prices, said Liu Mingkang, chairman of the China Banking Regulatory Commission."

"The continuous depreciation in the dollar, and the U.S. government’s indication, that in order to resume growth and maintain public confidence, it basically won’t raise interest rates for the coming 12 to 18 months, has led to massive dollar arbitrage speculation," he told reporters in Beijing today at the International Finance Forum.

"Liu said this has ’seriously affected global asset prices, fuelled speculation in stock and property markets, and created new, real and insurmountable risks to the recovery of the global economy, especially emerging-market economies.’

"His view echoes that of Donald Tsang, the chief executive of Hong Kong, who said the Federal Reserve’s policy of keeping interest rates near zero is fueling a wave of speculative capital that may cause the next global crisis."

"’I'm scared and leaders should look out,’ Tsang said in Singapore Nov. 13. ‘America is doing exactly what Japan did last time,’ he said, adding that Japan’s zero interest rate policy contributed to the 1997 Asian financial crisis and U.S. mortgage meltdown."

It is not just China. Brazil has moved to impose a tax (or tariff) on investment money coming into the country on a shorter-term basis, as they are worried about both a bubble in their markets and in their currency. Russia is openly considering similar policies.

I have been doing a lot of speaking in the last month. In almost every speech, I warn of the significant imbalance in the dollar. I walk to the very end of the stage to help illustrate that the world now has on a massive ABD trade. By that I mean Anything But Dollars. Everyone is now on the same side of the boat. They have borrowed dollars to buy other risk assets, assuming that the dollar, like the yen in the glory days of the yen carry trade, will continue to fall. Dollar bears are everywhere.

Explanations abound for why the dollar is a trash currency. It is Fed policy, or the Obama administration’s willingness to run massive deficits, or the trade deficit or our health-care policy or (pick any number of issues). But I wonder.

Global trade collapsed last year and well into this year. Global trade was essentially done in dollars. If global trade is down 20% or more, then there is less need for companies in various countries to hold dollars and more need for local currency because of the crisis. Thus, after a rush to safety in the credit crisis, there is a rational selling of dollars by business.

Look at the above chart. Notice that the dollar is roughly where it was 20 years ago. And notice the recent jump during the credit crisis. We are not even back to where we were before the crisis.

What happens if world trade picks back up, as it appears to be doing? Admittedly, it is not a robust recovery as yet, but it is rising. That means more need for dollars. And dollars which are being borrowed (and probably leveraged!) on the assumption the dollar will continue to fall.

And I agree that, over time, the case for the dollar is not as good as I would like. But in the meantime, we could have one very vicious dollar rally, which would take equity markets down worldwide, along with other risk assets. Why? Because it would be a major short squeeze.

Barron’s just did a survey. It revealed that the bullish sentiment on stocks is quite high and almost everyone hates US treasuries (graph courtesy of David Rosenberg of Gluskin, Sheff)

Whenever sentiment gets too strong in one way or the other, it is usually setting up the markets for a rally in the despised asset. Mr. Market like to do whatever he can to cause the most pain to the largest number of people.

I am not predicting a near-term crash or imminent precipitous bear, although in this environment anything can happen. I am merely noting that there is an imbalance in the system. The longer this imbalance goes on, the more likely it is that it will end in tears. And the irony is that a recovering world economy could be the catalyst.

The Wild Things? They may be hiding in a portfolio near you. Just food for thought. Stay nimble.

Source

Where the Wild Things Are – John Mauldin

Related posts:

• Chart of the day: Aussie – Yen cross
• Is the U.S. dollar carry trade replacing the one in Japanese yen?
• Japan’s easy money policy was the trigger for the tech wreck
• Mea culpa on the need for a new currency
• The dollar is rising against floating currencies

Morgan Stanley’s piece on Treasuries Priced for Perfection…for Now! is pretty bearish. The basic gist is that while the ten-year represents fair value today, because inflation expectations have become unanchored, Morgan Stanley expects the yield to rise from 3.3% to 5.5%. That’s a disaster of 1994 proportions. Obviously, given some of my recent comments, this is not what I expect to happen, but be well aware of the risk; in this economic environment, it would be fatal.

Here’s an excerpt of what Manoj Pradhan had to say (emphasis added):

Fed Chairman Bernanke’s speech on Monday could not have been better tailored to keep bond markets happy. The commitment to keep policy rates "exceptionally low" for an "extended period" and the benign outlook for inflation were both very well received by bond markets, as well as other risky assets… Our proprietary model, MS FAYRE, shows a current fair value of 3.3% for the US 10-year Treasury yield – bang in line with actual yields…

Priced for perfection… MS FAYRE generates its fair value estimate using the real fed funds rate, 1-year ahead CPI inflation expectations from the SPF conducted by the Philadelphia Fed and the 5-year rolling standard deviation of inflation as a proxy for inflation volatility (for more details on the MS FAYRE model, see Fairy Tales of the US Bond Market, July 26, 2006). With the fed funds rate at 12.5bp, core PCE inflation tracking at 1.3% and the 4Q09 number for 1-year ahead CPI inflation expectations from the SPF coming in at 1.6%, MS FAYRE produces a fair value of 3.3% for 10-year bond yields, which is exactly where the 10-year yield is now (interested readers should contact us for a user-friendly spreadsheet for simulating the FAYRE model). Forward-looking bond markets thus seem to be pricing in altogether too rosy a scenario for the foreseeable future.

…for now: With actual bond yields bang in line with our fundamental fair value estimate, investors seem to be receiving no compensation for macroeconomic or fiscal risks..

Our forecasts look for bond yields to rise in 2010: Our US economics team expects bond yields to rise to 5.5% by the end of 2010 – an increase of 220bp that outstrips the 137bp increase in the fed funds rate expected over the same horizon (see Don’t Fear the Double-Dip, October 6, 2009). Our US interest rate strategy colleagues suggest that this bear steepening of the curve in 2010 may well be preceded by slightly lower 10-year yields in 2009 (see Liquidity Aplenty but Rising Sensitivity to Rates, October 22, 2009)…

Inflation expectations don’t seem to be anchored… The SPF measure of long-term CPI inflation expectations in the US has indeed remained stable, as claimed, since the median expectations have held steady for nearly a decade now. However…

…our conversations with clients also suggest a split into two fairly distinct camps. A smaller set of clients are bearish on the economic outlook and believe that inflation will be extremely low or even be outright negative for the next few years. The rest believe that inflation risks, and probably inflation itself, will rise within a year or so as the recovery becomes sustainable. The important point here is that it is difficult to find investors who believe that inflation over the medium-to-long run will be precisely in line with central bank targets. Both pieces of evidence do not support the argument that inflation expectations are anchored.

Obviously, Morgan Stanley is bullish on the economy because they are talking about a bear steepener across the Treasury curve. Their thinking on Treasuries is one reason you see Barack Obama talking about reeling in deficit spending. He obviously believes that an increase in interest rates would trigger a double dip recession.

My thinking goes more to bull flatteners where the two-year – ten-year spread decreases as expectations of a fed rate hike are countered by weak economic fundamentals.  This dichotomy points out some very real risks in the bond market right now.

Bill Gross his on the record expecting Treasuries to rally because he is cautious on the economic environment.

Gross has been talking about a “new normal” of deleveraging, deglobalization and reregulation. In his view, this means weak consumer demand counterbalanced only by heavier government intervention, leading to slow growth for the foreseeable future (See my post ‘Gross: The new normal for “the next 10 years and maybe even the next 20 years”’).  In essence, he sees a scenario that is bullish for bonds (especially longer duration types like the 10-year and the 30-year) but not particularly bullish for shares.

But we know that Gross loves to talk his book and he made billions from the Fannie/Freddie bailout doing so.  You have to make your own call here. It’s Morgan Stanley on one side of the trade and Pimco on the other.

Realistically, if rates spike to 5.5%, it would be a blood bath for insurers, and probably for pension funds (and hence municipalities as well). Mortgage rates would skyrocket and this would stop any housing recovery dead in its tracks. That sounds like double dip and depression to me; this is not an early 1990s economic environment. 

Ironically, 5.5% rates would sow the seeds of future 3.3% rates or lower. If you hold – and do not sell at the bottom – I don’t see how this induces a capital loss.

Related posts:

• Morgan Stanley: Recession will ‘end by mid-to-late summer’
• Morgan Stanley sees U.K. downturn worse than Great Depression
• Financial Alchemy at Morgan Stanley: Greywolf A3 CDOs now Aaa bonds
• Another take on the treasuries bubble
• Bill Gross: Fed on hold through 2010

I pick up Bill Gross where I left him on Friday.  He said in his monthly newsletter that the Fed is going to keep interest rates at zero percent through 2010. But, he is not willing to stick his neck out in a liquidity seeking return kind of way even though this is what reflation is all about. He advises lower risk assets over higher risk ones cognizant that this could mean under-performance.

What I found interesting is that Gross highlighted only two bits in his piece. That should lead you to believe these are the most important points he makes.  The first bit is the rationale behind why he thinks the Fed is on hold through 2010:

The Fed is trying to reflate the U.S. economy. The process of reflation involves lowering short-term rates to such a painful level that investors are forced or enticed to term out their short-term cash into higher-risk bonds or stocks. Once your cash has recapitalized and revitalized corporate America and homeowners, well, then the Fed will start to be concerned about inflation – not until.

This is what’s called an asset-based recovery and is exactly the same model we followed in 1992 and 2002. the Federal reserve lowers rates so much that the cash in your pocket burns a hole in it. Grandma may be stuffing her dollars in a mattress, but investors judged against an investment benchmark get fired if they don’t seek returns.  how did Chuck Prince put it: When the music’s playing…

If you are an insurance company, you have a ton of money invested expecting 6-7% nominal returns.  But, in a deflationary environment you have to be smoking something if you think you’ll get that return in low risk assets. So everyone is running the liquidity-seeking-return play. 

The Wall Street Journal mentioned this today:

Though insurers continue to buy bonds, the rally does "make it challenging in terms of getting yield," Steven Kandarian, chief investment officer at MetLife Inc., told analysts in an Oct. 30 earnings call.

Life insurers have long been one of the nation’s biggest bond buyers, currently holding about $1.78 trillion in corporate debt, or 16% of the total outstanding, according to industry group American Council of Life Insurers.

Their frustrations in finding investment opportunities signal how far and fast the bond market has recovered from the dark days when markets were frozen and insurers were diverting almost all incoming premiums and investment income into cash accounts.

But, it sounds like Gross is having none of this.  He asks a rhetorical question about overpriced assets in nearly every asset class:

Do you buy the investment grade bond market with its average yield of 3.75% (less than 3% after upfront fees and annual expenses at most run-of-the-mill bond funds)? Do you buy high yield bonds at 8% and assume the risk of default bullets whizzing at you? Or 2% yielding stocks that have already appreciated 65% from the recent bottom, which according to some estimates are now well above their long-term PE average on a cyclically adjusted basis?

Answering his own question is the only other part he highlights in his essay – one doubting the elevated price of risk assets. He says:

In a low growth environment, it seems to me that a company’s stock should yield more than its less risky debt, and many utilities provide just that opportunity.

Gross goes on to recommend high dividend safe stocks like utilities.  But, I did get the sense he was talking out of both sides of his mouth.  For months now, Gross has been advocating reflation as an economic policy. He has advocated massive deficit spending too.  Back in June of 2008, he was the first one I knew who was talking about deficits in the trillions. Yet, here he is cautioning us about inflated asset prices.  Well, zero rates and inflated asset prices go hand in hand. And I’m sure Bill Gross knows this.

Source

Anything but .01% – Bill Gross, Pimco

Related posts:

• Bill Gross: Sell equities and buy Treasuries
• Bill Gross: the new normal means investors should shun risk
• High yield is back in business in Europe
• Another take on the treasuries bubble
• Bill Gross: “almost all assets appear to be overvalued on a long-term basis”

Marc Faber is in a bullish mindset, particularly on gold. In a wide-ranging interview with CNBC TV-18 in India, Faber talked about where he sees markets headed and why he thinks gold will never drop below $1,000 an ounce.

Private sector contracting while public sector expanding

This is the frame that Marc Faber puts on recent events post 2008 panic, namely that we are likely to see an era of increased government intervention. This is an echo of comments Bill Gross has been making for some time. We are seeing this stimulus on both the fiscal and monetary sides through fiscal stimulus programmes and quantitative easing worldwide.

The economy has not responded robustly given the size of stimulus, Faber says. Asset markets, on the other hand have. This sets up a clear dichotomy between ordinary citizens and those who benefit most from asset price appreciation on Wall Street and elsewhere in the financial sector. Moreover, the spill-over of asset price appreciation into commodity prices further constrains purchasing power for ordinary citizens.

Less certain about carry trade

Faber is less certain about the U.S. dollar carry trade. He sees a dollar overhang due to the enormous U.S. current account deficit and $7.7 trillion in U.S. dollar reserves as more the issue. Many are looking to sell these dollars and hedge their exposure in precious metals and other currencies.

Treasury bearish

The one area where Faber is bearish is U.S. treasuries. He says:

There is a risk that at some stage in 2010, the government bond markets (would) weaken considerably because I don’t understand why anyone who would now buy a 10-year US treasury at a yield of less than 3.5%. It’s a losing proposition. I also don’t understand why anyone could buy a 30-year US treasury at a yield of 4.4%. So I think that eventually yields will go up and this could disturb the stock market.

Not as bullish on equities

Given the huge uptick in share prices globally, Faber believes there is now limited upside going forward.  He says the risk/reward in equity markets at present is not favourable. Moreover, profit margins are cyclically high due to cost-cutting. Faber anticipates weakness in profits in 2010, causing earnings to disappoint and precipitating a correction.

Bullish on commodities and precious metals

His logic is as follows: cash is now trash with zero interest rates. So holding cash means underperforming.  Bonds present an unfavourable risk/reward.  Therefore, commodities and precious metals look attractive. One must also have equities exposure.

Interestingly, he makes a fairly explicit statement in favour of peak oil from about 1:40 in the second video below. The world is adding less in oil reserves than it consumes. That necessarily means a tighter supply/demand dynamic, especially given the demand in emerging economies for oil.

He uses a technical argument to make his money quote (in bold):

I believe that whereas in the past the USD 1000 per ounce level was kind of a resistance level, now it becomes a support level. I don’t think that you’ll see gold below a USD 1000 per ounce probably ever again.

So I’m actually quite positive. Maybe gold at this level is a better buy than it was at USD 300 per ounce in 2001.

Much, much more below.

(videos embedded below)

Marc Faber Interview: Part 1 (6:19)

Marc Faber Interview: Part 2 (5:42)

Sources

Gold will never fall below $1,000 an ounce: Faber – Live Mint

Gold won’t fall below $1000/oz level ever again: Marc Faber – Money Control

Related posts:

• Marc Faber says avoid financials and buy gold
• Marc Faber: I advise every American to hold his gold outside of the United States
• Marc Faber makes bullish comments on Bloomberg
• Marc Faber: “Monetary policy in the United States will stay expansionary”
• Marc Faber: “I am 100% sure that the U.S. will go into hyperinflation”

Bill Gross of Pimco spoke on Bloomberg with Tom Keene and Ken Prewitt. He thinks the U.S. is entering a new normal of low nominal GDP growth. However, financial bets have been made on 6-7 percent nominal GDP (think pension liabilities).  Unless we get 5-6% nominal GDP growth debt deflation and deleveraging dynamics (the D-process)will take hold, Gross says.

This is not a bullish scenario for equities as revenue growth is based on nominal GDP, meaning profit growth must come from trimming expenses and a secular increase in already high profit margins. Lower interest rates are the only other way to improve the net present value of future profit streams.

Pimco is dipping a toe into equities, however.  Gross remains cautious on high yield, which he sees as fully priced (buyer beware) a.k.a. overvalued. Mortgage backed securities are also overpriced in his view.  That leaves you emerging markets, corporates, and treasuries in the bond area.

So the Fed will be on hold because they need to see at least 4-5% steady nominal GDP growth, something unlikely to occur before the end of 2010, Gross says.

Video below.

Se also: Bill Gross Says Value Diminishing in Credit Markets – Bloomberg

Related posts:

• Gross isn’t buying corporates, high yield or equities even with zero rates
• Bill Gross: Sell equities and buy Treasuries
• Bill Gross: the new normal means investors should shun risk
• Bill Gross: Government intervention in markets will last
• The $1 trillion deficit: has Bill Gross gone crazy?

Just arrived in my inbox:

If you want to know what market momentum is all about, here you have it. Get in now to profit.

Sources

Bill Gross Calls High-Yield Corporate Debt `Overvalued’: Video (video here) – Bloomberg

Related posts:

• The market is moving. You should be too.
• Selling the good news does not a bull market make
• Richard Bernstein: Once a huge market bear, now a bull
• Jeremy Grantham: The market is 25% overvalued; 15% correction coming
• U.S. pre-market trading suggests a major selloff

Tilson is saying what I have been saying, namely that March saw an increased number of attractive buys, but most of these are now fully priced. As a result, he is selling equities – even building up his net short positions.

Unlike bear turned bull Richard Bernstein, Tilson says that after a huge 60%+ run up which saw a trebling or quintupling of some beaten up shares like Huntsman, you need to be cautious. Invest in high quality and low beta, he says – exactly the opposite of what Bernstein is now saying.

Despite some positive earnings reports from the likes of Toll Brothers, the sector he hates the most right now is home builders because of a 2-year inventory overhang.

Below Tilson talks to Bloomberg’s Carol Massar. The video runs just over 3 minutes.

Related posts:

• Whitney Tilson of T2 Partners, a new media darling, strikes a bullish tone
• Richard Bernstein: Once a huge market bear, now a bull
• Which homebuilder will go bankrupt next?
• Bernstein: What kind of recovery are we going to get?
• Are the markets set for a pullback?

This comes from the Guardian (hat tip Lee):

The world is much closer to running out of oil than official estimates admit, according to a whistleblower at the International Energy Agency who claims it has been deliberately underplaying a looming shortage for fear of triggering panic buying.

The senior official claims the US has played an influential role in encouraging the watchdog to underplay the rate of decline from existing oil fields while overplaying the chances of finding new reserves.

The allegations raise serious questions about the accuracy of the organisation’s latest World Energy Outlook on oil demand and supply to be published tomorrow – which is used by the British and many other governments to help guide their wider energy and climate change policies.

In particular they question the prediction in the last World Economic Outlook, believed to be repeated again this year, that oil production can be raised from its current level of 83m barrels a day to 105m barrels. External critics have frequently argued that this cannot be substantiated by firm evidence and say the world has already passed its peak in oil production.

Conspiracy theorists will love this one! But, we don’t need a conspiracy theory to see that the end of cheap oil is upon us. To find high quality oil deposits (I am not talking about Oil Sands in Alberta here) is becoming more and more expensive. And one oil field after another is hitting peak. We have seen it in Mexico, Russia, the North Sea, the Alaskan North Slope and elsewhere.  The only thing keeping us from realizing the peak is Saudi Arabia, the swing producer in OPEC.

In June of last year, I said:

There has been a lot of speculation of late regarding oil field production capacities declining. In particular, there are great worries regarding Russian and Saudi production capacities. The available data on Saudi production is especially opaque. Matthew Simmons, an expert oil investment banker, has written a book questioning the data the Saudis have provided regarding the proven reserves available for production and the production capacity of the Saudis major fields including Super Giant Ghawar, the largest oil field in the world. I recommend anyone interested in this debate read his book, “Twilight in the Desert.”

This leads us to the Armageddon Scenario. Nuclear-armed nations like China, Russia, India and the United States are desperate to keep their standard of living up. As a result, with oil supplies dwindling, competition for oil supplies will increase. The risk of armed conflict to procure necessary supply increases as peak oil becomes apparent. The U.S. has invaded Iraq, has troops stationed in Saudi Arabia and is threatening Iran, all because of oil — and in Iran’s case, the possibility of another nuclear-armed nation entering the strategic quest for oil. This is a battle of extreme importance strategically for a number of countries. They may stop at nothing to achieve their ends should peak oil become a problem.

Of course, this is exactly why China is all over South America and Africa.

As for peak oil, the lower-48 United States peak of 1970 was not recognized until years later. The same will be true again for the global peak. High oil prices are not just a reflection of speculation, there are some very real supply demand imbalances building. Recession has suppressed these, but in a more normal economic environment, oil prices are going to rise.

Related posts:

• Peak oil: are we there yet?
• Drilling for oil
• What happened to peak oil?
• Peak oil: it’s all about the Saudis
• Iran finds huge billion barrel oil field

Why aren’t more municipal bonds being downgraded by the ratings agencies Fitch, Moody’s and S&P?  If you look at sovereign debt in revenue-constrained countries like Greece, Portugal or Ireland, the ratings agencies are issuing warnings. 

But, states and municipalities are suffering from the same revenue constraints. Tax revenues have plunged. Governments have shut down services to save cash. And they have cut staff. There are dozens of articles in the national press daily detailing the difficulties municipalities, cities and states are having.

You wouldn’t know that if you looked at the charts of some of the major municipal bond funds. Take a look at Nuveen Municipal Value Fund (NUV) for example.  It bottomed in December last year. Now, 11 months later it is up 31%. How about BlackRock’s MuniHoldings Insured Investment Fund (MFL). It bottomed in December as well. But is up over 70% since then. Pretty nice return. But, I don’t think it can last.

California’s summer struggles made it is the poster child of the distress in the finances of US states and municipalities. But, there are many states, cities and municipalities on the brink. That’s why I found the excerpt from the post “The Coming Collapse of the Municipal Bond Market” at Phillip Greenspun’s blog over at Harvard Law School interesting. Note the highlighted sections

A money manager friend showed me an interesting research report by Frederick J. Sheehan titled “Dark Vision: The Coming Collapse of the Municipal Bond Market. This is a product of weedenco.com and available only to subscribers, but I will summarize it here.

Sheehan starts off by noting that a lack of panic by the ratings and government agencies does not indicate health for a financial market. He cites the fact that the Fed did not anticipate how bad the subprime collapse was likely to be and obviously the Moody’s and Standard and Poor’s ratings were ridiculous.

Sheehan notes that “spending is rising and revenue is collapsing” for all levels of government. Pension fund losses will require governments to double their contributions to pension plans (see my blog posting on public employee pensions). Spending is rising, e.g., in New York City from an average of $65,401 in compensation per public employee in 2000 to $106,743 in 2009. The number of full-time employees in NYC grew as well, despite falling school enrollment. The number of state and local government workers grew from 4 million in 1955 to 20 million in 2008 (5x growth, against less than 2X growth in U.S. population). Those workers receive an average of 43 percent more pay and benefits than a private sector worker.

Municipalities dealt with the separation between taxes and expenses by borrowing. In the mid-1990s, states and cities were retiring as much debt as they were incurring. During the 2000s, though, they borrowed about $150 billion per year in aggregate, peaking at $215 billion in 2007 by which time $2.7 trillion in debt was outstanding, more than two years’ worth of tax receipts.

Barring some sort of miraculous boom in the economy and pension fund investment returns, state and local governments are headed for insolvency and default. This means that valuing a municipal bond becomes a matter for a legal expert rather than an accountant. Even for the legal expert, it is apparently tough to predict what will happen. Let’s start with the Wikipedia article on Chapter 9 bankruptcy: “Previous to the creation of Chapter 9 bankruptcy the only remedy when a municipality was unable to pay its creditors was for the creditors to pursue an action of mandamus, and compel the municipality to raise taxes. During the Great Depression this approach proved impossible so in 1934 the Bankruptcy Act was amended to extend to municipalities.”

Without bankruptcy protection, a city that couldn’t pay bondholders would be forced to raise taxes until it could. This happened to West Palm Beach, Florida in the Depression and property tax rates rose to 42.5 percent of assessed value. Potentially bondholders might demand that the city hand over real estate to satisfy its debts. With bankruptcy protection, it is unclear what happens. Vallejo, California went bankrupt 18 months ago and their obligations have not yet been resolved (story). If courts allow municipalities to walk away from debt they’ll have every incentive to declare bankruptcy and start afresh. There are no shareholders in a municipality to wipe out and therefore the only negative consequence of a bankruptcy filing would possibly be having to pay higher interest rates for future borrowing. If on the other hand, governments are not allowed to walk away from many of their obligations, they will simply run out of cash. Are bondholders senior to pension obligations or not? It may be up to the individual judge. This is “uncharted territory for investors” as my money manager put it (he does not buy U.S. muni bonds).

Municipal bonds are still perceived as almost risk-free by most investors and consequently offer a low yield, according to Sheehan. He points out that if the municipalities don’t default, the investor gets only a slightly better return than in Treasuries. Why take the risk if you’re not getting paid for it?

This ends my summary of Sheehan’s report. My own opinion is that the main lesson of subprime is that an investor cannot rely on the ratings agencies or the government to protect his or her interests.  The never-employed guy in Cleveland with the house in a crummy neighborhood and no down payment? The risk that he would never make a payment should have been apparent to any investor who dug underneath the asset-backed security. Similarly, an investor in muni bonds can look at the municipality. Does the state have a shrinking population, high public employee salaries, and a big pension obligation overhang from when the population was larger? They probably will eventually default. And if an insurance company was dumb enough to insure the bonds, they’ll probably be bankrupt too.

If you’re waiting until the ratings agencies give you a heads up, thinking this will happen before these problems get reflected in lower muni bond prices, you better think again.

Related posts:

• Chanos says dump munis as distress mounts and ratings attacked
• State and local government weighed down by housing
• Ambac may file bankruptcy soon
• MBIA and Ambac sued by LA
• State and local governments: budget cuts likely

Christopher Wood, the well-noted market strategist at CLSA and writer of the classic Japan crash warning book “The Bubble Economy,” is now warning of a market correction in the West.  According to CNBC India, Wood believes that the markets’ extreme upward move is increasing the chances of a major correction.

Wood is still cautious. He says there is some initial indication of a technical breakdown in the US. "The US market will be vulnerable early next year the US market. If it becomes clear, after this inventory cycle, that consumption, employment is not really recovering, then the market will go down. You will then get renewed stimulus in the US and measures trying to generate growth. The key variable in the West is government policy." CLSA’s best case scenario is 1,200 on the S&P 500 by year-end, he added.

I agree with Wood that underlying economic demand may indeed be weak and all we may be seeing is an inventory and stimulus induced cyclical upturn (see my July post “ISM: Is this the mother of all inventory corrections?”). Of course, the worry is about the employment cycle not turning up before these measures’ positive effect wears off.  This is the question for 2010. If this happens, we get  a double dip and a huge market-sell off. Even if the employment situation starts to improve slowly while stimulus and the inventory cycle recede, this will lead to a muddle-through scenario, again inducing a correction. This is the heart of Van Hoisington and Lacy Hunt’s call about partial recoveries and stock market weakness.

For those of you who want to believe and want to load up on junk, there’s a clap for that too, via bear turned bull Richard Bernstein:

Richard Bernstein of Richard Bernstein Capital Management is a lot more bullish. "Right now, there is a blurring between the secular issues and the cyclical ones. There are people, including me, who are concerned about the secular issues, but we can’t ignore the fact that the economy is getting better, employment is improving. When that happens you will see a cyclical rebound."

Just in September, Bernstein was saying America “practically invites another catastrophe.” What happened to that guy? He better be right on his bullish turn or he is going to have a lot of egg all over his face.

Source

Chances of a deeper correction are rising: Chris Wood – CNBC TV18 India

Related posts:

• Whitney Tilson: "A pullback of some sort is likely"
• Richard Bernstein: Once a huge market bear, now a bull
• Bill Gross: Sell equities and buy Treasuries
• Marc Faber: “Monetary policy in the United States will stay expansionary”
• Partial recovery will mean new lows for stocks

This is the second straight month that the RBA has raised interest rates. From the Sydney Morning Herald:

The Reserve Bank has lifted its key interest rate for a second month in a row as it attempts to keep Australia’s economy on track for sustained growth.

Today’s widely tipped 25-basis-point increase raises the central bank’s cash rate to 3.5 per cent, marking the first back-to-back monthly increase by the RBA board since March last year when rates peaked at 7.25 per cent.

I remember seeing data showing that once central banks start raising rates, they continue to do so for months. They do not raise rates one month, then lower them the next and then reverse course. Does anyone have the data? This makes me suspect that rates are due to go higher globally rather than lower.

If you think this rate increase will lead to a global double dip because of underlying economic weakness, you should expect the yield curve to flatten. Operation Twist anyone?

Related posts:

• Norway makes three
• Interest rates, the pound and good news for Brits
• Credit markets are easing again
• RBA hikes rates 25 basis points in Australia
• Australia is set for a slowdown

Here’s another bullet point in our ongoing tally of reflation indicators. It’s the return of risk in the form of start-up hedge funds (John Meriwether included).

From the FT:

Hedge fund launches are growing in size and number after months of subdued activity in the wake of the collapse of Lehman Brothers last year.

The revival of fund start-ups is one of the clearest signs yet that the $1,400bn global hedge fund industry is starting to return to better times.

London-based Tyrus Capital on Monday became the largest fund to launch so far this year. According to people close to the company, investors placed about $800m with it before the cut-off for initial subscriptions closed. The fund is expected to raise a further $300m before the end of the year.

Theleme Partners, set up by Patrick Degorce, the co-founder of The Children’s Investment Fund, also launched on Monday with an estimated $200m under management. In the US, Greenwich-based Pia Capital, set up by ex-Moore Capital trader Christopher Pia, launched with an estimated $300m under management in June.

Related posts:

• Hedge Fund Panic
• Hedge Funds: the bell tolls for Ospraie
• Hedge funds collapsing
• Corporate defaults mean more hedge fund blow-ups
• John Meriwether is back, risk must be too

Yesterday, Moody’s cut the outlook for the sovereign debt of Portugal and put Greece on negative watch for a downgrade, signaling growing concern over spiraling debts. Just as with Spain and Ireland which I discussed yesterday, Portugal and Greece are smaller countries within the Eurozone with large fiscal problems due to the recession. For example, the Wall Street Journal says that Greece expects a budget deficit of 12.5% of GDP this year – that’s more than 4 times larger than the limit set by the Maastricht treaty.

Bonds sold off on the news. The Wall Street Journal reports:

The news spooked investors in government bond markets. The yield spread between 10-year Greek government bonds and comparable German government bonds, or bunds, widened to 1.42 percentage points from 1.36 points. The impact was milder on Portuguese yield spreads, which widened to 0.56 point from 0.54 point against German bunds, because a possible downgrade appeared less imminent.

Moody’s said it hoped to complete the review process promptly, and within three months in the case of Greece. It added that it might keep Greece on a negative outlook even if it decides upon a downgrade.

Standard & Poor’s downgraded both Portugal and Greece in January, while Fitch downgraded Greece last week and revised its outlook on Portugal to negative in September.

And we should certainly expect these downgrades to continue. Back in January, when Portugal was downgraded, the spread to German Bunds moved out to a 12-year high of 146 bps. We are now only 4 beeps lower than that. So, that sounds bearish for their bonds. However, their is a silver lining as Peter Schaffrik of Commerzbank explains in the video below.  Bond investors are incredibly starved for yield and that means there is a good bid for these sovereign issues as they offer relatively more yield pickup than German Bunds.

On the other hand, Chris Wyllie of Iveagh says he is zero weight in bonds now because even these bonds and corporate issues simply do not have enough yield to make them attractive.

You should see this as further evidence that stocks are being artificially buoyed by an increased risk appetite driven by low interest rates.

Related posts:

• Spain can’t sell its bonds
• More trouble in the Baltics as S&P downgrades
• Treasury yields go below zero
• Baltics: Fitch downgrade and more downgrades to come
• Corporate defaults mean more hedge fund blow-ups

This is a guest post from our newest contributor, Charles D. Bull.

Greetings Writedowners,

Ed has gone to bed already. This is Charles D. Bull speaking.

You know, my wife told me yesterday that the local shopping area already has the Christmas tree up and is all geared up to drum up holiday season sales.  Shoppers were out, the sun was shining and the place was really looking pretty, she said. It warmed my heart. I was so excited for the holidays. I couldn’t wait.

Then, I wake up this morning and along comes this guy, what’s his name, David Rosenberg — with his tales of doom and gloom like the Grinch who stole Christmas. Forget about Nouriel Roubini, this guy makes him look like Mary Poppins.

Check this out:

BULL RUN MAY BE REVERSING
The S&P 500 is riding a four-day losing streak. And while we have seen these corrections turn around before during this massive bear market rally that started last March, the difference this time is that the uptrend line from the lows has been violated across a fairly broad front, including the S&P 500, Nasdaq and the Russell 2000. When trend lines get violated, and when this happens on high volume, it usually, though not always, signals something big.
So many people are deluding themselves that we have some sort of durable recovery on our hands and yet consumer confidence, at 47.7 in October, is unbelievable — the lowest this every got in the 2001 recession, which included the 9-11 terrorist attacks, was 84.9. Think about that for a second. If the equity market is catching on to the view that we could be in for some slowing in the data, then a significant correction after a 60% surge is very likely. This is a time to be raising cash if you haven’t done so already — valuation, technicals, fund flows and fundamentals at this juncture are all near-term obstacles.

In terms of valuation, we said yesterday that the P/E ratio on the S&P 500 on a normalized 10-year basis is 20x and the long-turn norm is 16x. Just to go back to the norm, let alone compress to a level commensurate with an unusually high level of economic and financial uncertainty, would suggest that we would see the S&P correct down towards 875.

ONLY ECONOMISTS SEE THE RECESSION AS BEING OVER
The man on the street sees it a little differently, perhaps less enthused by the fact that a lower rate of inventory destocking is arithmetically underpinning GDP growth at this time. Put simply, a Wall Street Journal/NBC News poll just found that 58% of the public believe the economic recession still has a ways to go — and that is up from 52% in September and means that the private investor, unlike the hedge fund manager, is not interested in adding risk to the portfolio even after a 60% surge in the equity market.

Only 29% of those polled believe the economy has hit bottom — imagine having that psychology with nearly zero interest rates, a bloated Fed balance sheet and unprecedented fiscal deficits (poll was taken from October 23-25). Nearly two in three (64%) said the rally in the stock market (still a bear market rally — not the onset of a new bull market) has not swayed their view (or ours for that matter). There is going to be some very tough slogging ahead as far as the economy is concerned.

OK. Enough already. I think Dave needs to take a few happy pills.  Dave, did you see that rally today? Dow up 200. S&P up 23. Now, that’s what a bull market rally looks like, my friends: stocks way up, bonds way down, lower dollar, lower gold prices.  That’s what I’m talking about!

As for you shorts out there, you’re probably grabbing your ankles, crying “thank you, sir. May I have another?” Serves you right. In the ‘real’ America, we’re doing just fine, thank you.

Stop listening to those clowns Ed Harrison and Marshall Auerback, writing here about depressions and pulling the rug from under our trusted banks. Earth to Ed: we are going into a V-shaped r-e-c-o-v-e-r-y, not depression. Our banks need to be bigger, not smaller. And, um, Eddie, take off the blinders. I don’t know if you noticed it, but we just printed 3.5% on GDP. So, me, I AM popping the cork on the Moet. In fact, I’m sipping it right now.

I don’t know what Ed and Marshall are smoking, but don’t pass it around.

See, I’m an optimist. I knew we would pull out of this one. My motto? Remember, there’s always a bull market somewhere. You just need to know where to look.

You’ve probably been sitting there wondering, "What is The Secret?" I’ll tell you, it’s called positive thinking.

Anyway, I’m sure you pessimists are going to try to bring me down in the comments: aitrader, Lavrenti, kbob, Vangel, you know I’m talking to you – you too Wadsworth. I can take it. As my boy Nails would say, “I love it, baby… Pile it on, bro.”

Charlie has left the building.

Charles D. Bull is a pseudonym. He has been loosed on this site to post purely for your amusement… and ridicule.

Related posts:

• Rosenberg: Market rally is just multiple expansion
• Overbought?
• An amazing market rally. What’s next?
• Rosenberg thinks U.S. market may Test March lows
• Back to the future: Rosenberg says it’s like the crisis never happened

This comes via the FT:

Saudi Arabia on Wednesday decided to drop the widely used West Texas Intermediate oil contract as the benchmark for pricing its oil, dealing a serious blow to the New York Mercantile Exchange.

The decision by the world’s biggest oil exporter could encourage other producers to abandon the benchmark and threatens the dominance of the world’s most heavily traded oil futures contract. It is the main contract traded on Nymex.

Before anyone tries to spin this as an anti-dollar move, you should read what else the FT article says:

In January, WTI, which usually trades at a premium of $1-$2 a barrel to Brent, fell sharply, leaving it at a discount of almost $12 – a record gap. This dislocation in the market continued well into the summer. 

From January, Saudi Arabia will base the price of oil for its US customers on a new index developed by Argus, the London-based oil pricing company.

The Argus Sour Crude Index will track the price in the physical market of a basket of US Gulf Coast crudes, including Mars, Poseidon and Southern Green Canyon.

The point of this move is not to undermine the dollar but to get away from the WTI contract where prices have been artificially inflated due to storage shortages at Cushing.

A friend familiar with this market also indicated that big bank punters active in this market will like this move as well as it helps them evade the position limits and regulation of the CFTC. He says, “In fact, the lack of transparency and regulation on the Dubai Merc was one of the reasons why you had such successful speculation in the oil market during the spring of 2008.”

I see a spike in oil prices as a risk to any sustained recovery. Anyone with more insight into why the Saudis made this move, do comment.

Related posts:

• Peak oil: it’s all about the Saudis
• Blame Bernanke, the dollar and oil
• Evidence that governments are underplaying peak oil
• Abu Dhabi sovereign wealth fund loses $125 billion
• Oil price rise is accelerating

Jeremy Grantham is out with his much anticipated Quarterly Letter and it’s a good one. “Just Deserts and Markets Being Silly Again” is a cutting, snarling, and sarcastic rejection of the prevailing V-shaped recovery bull market view.  But Grantham is far from ultra-bearish, giving a more nuanced and realistic assessment for the medium and longer-term.

He starts his letter with sarcastic allusion to Obama’s Nobel Prize, titling the section “Just Deserts.”

I can’t tell you how surprised, even embarrassed I was to get the Nobel Prize in chemistry. Yes, I had passed the dreaded chemistry A-level for 18-year-olds back in England in 1958. But did they realize it was my third attempt? And, yes, I will take this honor as encouragement to do some serious thinking on the topic. I will also invest the award to help save the planet. Perhaps that was really the Nobel Committee’s sneaky motive, since there are regrettably no green awards yet. Still, all in all, it didn’t seem deserved. And then it occurred to me. Isn’t that the point these days: that rewards do not at all reflect our just deserts? Let’s review some of the more obvious examples.

But, he is just warming up, as he goes on to heap vitriol on 13 groups he feels are equally undeserving of rewards in a scathing condemnation of status quo ante in the economic and financial establishment.

They are:

1. Ben Bernanke
2. Larry Summers and Tim Geithner
3. Mortgage Brokers
4. Homebuilders
5. Over-spenders and under-savers
6. Too-big-to-fail banks
7. Over-bonused financial types
8. Overpaid large company CEOs
9. Stock holders of overleveraged Corporations
10. The U.S. Auto Industry
11. Over-vehicled America
12. Stock options
13. And, of course, Sir Alan Greenspan

This letter is a polemic against the financial elites of a ferocity the likes of which I have never seen from a major fund manager. I see it as a must-read.

As for the markets, he is not all doom and gloom.  But the point that certainly jumped out at me was this:

Corporate ex-financials profit margins remain above average and, if I am right about the coming seven lean years, we will soon enough look back nostalgically at such high profits. Price/earnings ratios, adjusted for even normal margins, are also significantly above fair value after the rally. Fair value on the S&P is now about 860 (fair value has declined steadily as the accounting smoke clears from the wreckage and there are still, perhaps, some smoldering embers). This places today’s market (October 19) at almost 25% overpriced, and on a seven-year horizon would move our normal forecast of 5.7% real down by more than 3% a year.

Translation: the market is so overvalued now that you should expect pretty meager long-term returns in equities.  Does that mean a crash is right around the corner? Not necessarily – but a brutal correction is probably in the offing. Grantham says:

I would still guess (a well-informed guess, I hope) that before next year is out, the market will drop painfully from current levels. “Painfully” is arbitrarily deemed by me to start at -15%. My guess, though, is that the U.S. market will drop below fair value, which is a 22% decline (from the S&P 500 level of 1098 on October 19). 

Unlike the really tough bears, though, I see no need for a new low. I think the history books will be happy enough with the 666 of last February.

The bottom line here is this: the market is significantly overvalued at present levels because of a technical rally super-charged by stimulus. This necessarily means lower returns over a longer-term horizon. The possibility of a major correction is high.

Update: the full letter with a lot more detail, market history and asset allocation recommendations is now linked below instead of embedded due to copyright restrictions.

One other thing: a GMO representative reminded me you that can register with their site and subscribe to the letter and receive it automatically as well.

Source

Jeremy Grantham’s 3Q 2009 letter – GMO website

(the link to the GMO splash page above will guide you to registration in order to view the letter – and to subscribe to future letters)

Related posts:

• More bullishness from Jeremy Grantham
• Jeremy Grantham: “Pull the trigger”
• Jeremy Grantham: “Keep telling yourself… you’re a long-term investor”
• Jeremy Grantham: “Many shares priced for… economic collapse”
• Jeremy Grantham: Overheating in China, speculative rallies and fair value

I used to be a European High Yield guy. I was there when the market first took off in the late 1990s on the back of telecom plays like NTL or Telewest. I was also there when the Russian devaluation and default shut down the market. And I remember how the market tanked when the Tech Bubble burst and those 7 and 8 times EBITDA and 0.9x coverage ratios were not met, defaults skyrocketed, and investors lost their shirts.

So I know what happens to markets when easy money comes to town and people are ready to leverage up.  It’s called “reaching for yield.” And this is what is happening in European markets right now. The Guardian reports:

Investors are in turn flocking to the more risky high-yield market because of the low returns offered elsewhere with interest rates at historic lows. They are attracted to returns of about 7 or 8%, compared with the 3% they get from a more regular loan.

However, Standard & Poor’s, another ratings agency, warned that the rush back into junk products could be dangerous. "Are memories in the capital markets getting shorter? The global markets have just experienced one of the worst liquidity and credit dislocations since the Great Depression … We believe that investors might want to consider the benefits of maintaining discipline in structuring, pricing, and distributing high-yield bond transactions," the company said.

A high-yield conference in London last week saw about 200 bankers, investors and corporate treasurers gather to cheer the return of a market that still represents a small fraction of the funds raised by European companies.

Traditionally, businesses in Europe have relied more on bank loans built on longstanding relationships and local contacts. But banks are still shoring up their books in the wake of the credit crunch and have turned down some of their traditional clients. Slowly, the European high-yield market is turning more towards a US model, more reliant on institutional investors, such as pension or hedge funds. The US, with an economy similar to Europe’s, has a junk bond market which is about four times bigger.

Now, to be fair, the last comment about the European High Yield market is on the money.  There is huge potential for Mittelstand companies in Germany, for example, whose loans are saddling bank balance sheets to use the high yield market as an alternative source of capital. I certainly expect Europe to be a key area for the expansion of the global high yield market. 

Nevertheless, from the investing side, risks are now being taken that have as much to do with artificially low yields as with the attractiveness of high yield bonds.  I can’t help but think I have seen this movie before and it does not have a happy end.

Related posts:

• Fridson Says Junk Debt Is ‘Extraordinary Opportunity’
• Gross isn’t buying corporates, high yield or equities even with zero rates
• Corporate defaults mean more hedge fund blow-ups
• Bloomberg talks Eastern Europe as Latvia downgraded
• Market risk is high

Richard Bernstein has done a huge reversal in the last few months from touting low-risk stocks to high-beta ones. He has gone from a preference for consumer staples to one for consumer cyclicals (XLY). And he has gone from lugubrious doubter of a sustainable recovery to an almost V-shaped optimism. 

What is remarkable about the transformation is the dichotomy between his views and his former Merrill Lynch colleague David Rosenberg’s. The two were tied at the hip at Merrill, producing research that was out of step with the bullish consensus yet painstakingly substantiated.

Just five months ago, back in May, I caught Bernstein on Bloomberg and he was questioning whether we would get any recovery at all.  I wrote then:

Richard Bernstein asks a very good question in a wide-ranging interview with Bloomberg.  Now that the so-called green shoots are dominating the news coverage and the S&P 500 is up a massive 34% from its March lows, one might think we are due for a pretty Robust V-shaped recovery.  Is that what the future holds?

Bernstein doesn’t think so.  He thinks the recovery will be more muted than most people think.  For this recovery to have any legs Bernstein believes we need to move away from the “credit-induced” dynamic of the previous 5 to 15 years.  This necessarily means that financials will not be leaders in a sustainable bull market because we will have a lot less leverage in the system. This also means that the core earnings power in the sector is a lot less than people think. Bernstein thinks the financial sector has gotten way ahead of itself – a view I am beginning to share after today’s junk rally.

Bernstein went on to say that there was still huge overcapacity in financial services and that we needed to shed this capacity if we wanted to see a good return on investments in the sector. At the time, I was more bullish on the financial sector (although I also worried expectations were getting ahead of themselves; I am now bearish). I saw upside because the overcapacity coupled with low interest rates was an invitation to seek risk, a view that has been borne out in recent months.

As to the bailouts and the government plan, Bernstein believes that the government is attempting to keep the excess capacity in the financial sector alive.  His basic point is that bubbles create overcapacity (think tech stocks).  This is the case in finance.  The sector must shrink.  In my own, there are only two ways a sector in over-capacity can perform.  They can have poor earnings (Bernstein’s first point) or they can seek heavy risk taking and reach for yield.

Just as I am switching the other way, so too is Bernstein.  Witness the latest Bernstein appearance on CNBC last week.

It seems even the most bearish market mavens can’t fight the bullish momentum in this stock market. Wait until you find out who’s now a buyer of stocks.

Richard Bernstein, the former Merrill Lynch chief investment strategist, and one of the biggest bears we know is changing his tune.

People like me have underestimated the rebound, Bernstein says. What’s made him a believer?

You might remember the last time Bernstein was on Fast Money he told the traders – at the foundation of the stock market and the recovery is  jobs. The market can’t sustain itself unless people are brining home the bacon.

And although the unemployment rate continues to rise Bernstein is more focused on initial jobless claims which he and many others consider a leading indicator. And that number has started to decline.

In fact, when they were reported last week new jobless claims dropped to the lowest level since January. And that trend combined with low inflation likely means Americans will regain their appetite for spending.

Another way of saying that is – the economy is slowly getting better. “if you believe in the recovery this is the prime time to be a value investor.”

Bernstein added that one wants to load up on risk now if one believes in the recovery. Junky names are the best as they have more leverage to a rebound.  This is certainly the play right now (but I think it has more to do with interest rates than recovery). I had seen Bernstein saying exactly this last month, but he was not yet confident that the jobs picture had turned. Apparently, he is now and recommends going all-in, a recommendation I would view with skepticism.

Related posts:

• Bernstein: What kind of recovery are we going to get?
• Wood warns of correction, says “key variable in the West is government policy”
• David Rosenberg and Richard Bernstein to leave BOA
• Are the markets set for a pullback?
• Bill Gross: Sell equities and buy Treasuries

In today’s morning with Dave article, Gluskin Sheff’s Chief Economist and Strategist says the macro environment makes it look like 2007 all over again – as if the crisis never happened.

It’s like 2008 and early 2009 never happened. Hong Kong’s Hang Seng index just hit a 14-month high as the island benefits from Chinese growth, U.S, interest rates and competitively supercharged currency link. In fact, the entire MSCI Asia-Pac index added 1.0% today, with broad-based gains and taking the index to its highest level since September 1, 2008.

The VIX index, at 21.49, is back to where it was on September 3, 2008, when most economists didn’t even know we were knee deep in recession, strategists believed we were only in for a mild correction and the Fed still thought it was fighting a liquidity battle as opposed to a credit contraction. In fact, to show just how complacent the market is now regarding that dirty, but now forgotten four letter word called “risk”, the VIX index is flirting near levels we saw back in October 2007, when the S&P 500 was just coming off its all-time high of 1,565 and market pundits were dreaming up new ways to redefine ‘global liquidity’.

Meanwhile, the DXY (USD index) is still recovering a bit but still on very shaky ground (Japan reiterated that it will not intervene in the FX market) and the commodity complex is bid with copper enjoying a nice session yesterday (though off a tad this morning) and oil heading for $80/bbl. It is amazing that the surge in oil prices and the challenge to the economic outlook isn’t making front page news, but it is arguably very tough to push Dow 10,000 off the front pages of the morning papers. The market seems to like Apple’s earnings — my kids sure love its products — and Texas Instrument’s too with futures up and the tech sector on a big roll right now — the Nasdaq is up 38% so far for the year!

Corporate bond spreads have continued to tighten (even in the face of a massive supply boom, a record $1 trillion of new U.S. issuance has hit the market this year) and the “undervaluation gap” in this once-very-cheap sector has now closed given that it is de facto discounting 2.5% U.S. economic growth in the coming year (equities now are close to 5% — not far off from what they were pricing back at the October 2007 peak). Question that still must be asked is that if we are into some big reflationary trade here, why are U.S. Treasuries not getting absolutely smoked? In the last couple of sessions, they have rallied (10-year T-note yield at 3.38%) and being led lower by real rates, which is generally not consistent with pro-growth cyclical beta performance.

It’s what’s called reflation!  And it will end in a very bad way.

More here.

Related posts:

• Rosenberg: The Grinch who stole Christmas
• Rosenberg: Market rally is just multiple expansion
• One on One with David Rosenberg, Chief North American Economist at Merrill Lynch
• UK real wages falling
• Rosenberg: Still a bear market rally

Below are two videos from Marc Faber’s recent interview on Asia Confidential.  In it, he takes questions from user emails in regards to the U.S. dollar, economic decline in the U.S. and gold as an investment.

He sees a need for the U.S. to borrow increasing amounts of money going forward – not less. As a result, what was a crisis in finance in 2008, resulting in the nationalization of Fannie Mae and Freddie Mac will become a national bankruptcy. The U.S. will borrow and print money. The dollar will fall precipitously. Then, “next station is when the U.S. government goes bust.”

Edward here. This might make for good headlines on Bloomberg, but it is patently false.  The United States is not now or ever going bust. A sovereign government which borrows in its own currency in a fiat currency system can never go bust. An entity which borrows and prints its own money does not have the same constraints that, say, California or Ireland have. How prices are affected is another issue altogether.

That’s where gold comes into the picture. Here, there are many questions.

• Is it overvalued?
• Is it a good inflation hedge?
• How does gold perform in deflationary environments?
• How does it perform against equities over the longer run?
• What about silver?

Faber takes on all of these.

On the whole, he is an inflationista and does not believe the U.S. will suffer deflation. When asked how gold might perform in a significant deflationary environment, he responds “first of all, I would like to make a very clear statement. I will believe in deflation once we have a significant period of U.S. dollar strength. U.S. dollar weakness is a symptom of inflation in the system.”

He goes on to say that gold outperforms other asset classes in a deflationary environment and is therefore a good hedge against fiat currency revulsion whether one expects deflation or inflation.

My own view is similar. However, I would differentiate between consumer price inflation, which will remain non-existent while industrial capacity and employment levels are at depressionary levels.  The inflation in the system will manifest itself first in asset prices – with industrial and food commodities or oil being the transmission mechanism into consumer prices.  Secular consumer price inflation will not return until the slack in the system is purged. 

I would add that this is one principal reason that the Great Moderation occurred despite enormous money printing in Japan and extraordinarily loose monetary policy in the U.S.  After China, India and Eastern Europe joined the capitalist system, the enormous increase in labor – both skilled and unskilled – acted as a check on inflation of the consumer price variety.

Alan Greenspan was fooled by this and kept monetary policy too loose. The result was asset bubbles again and again.  Going forward, it would comforting to see central banks target asset prices not just to gain policy traction through reflation but in order to cool the economy through deflation.

Related posts:

• China to diversify out of U.S. dollars
• Quote of the day: William White and inflation
• The inflation – deflation debate redux
• Morgan Stanley warns of a new inflationary period
• Bernanke is responsible for the market meltdown

There is an enormous dichotomy in foreign exchange markets that has wide-ranging implications for the global economy.  In Europe, most currencies float freely against the U.S. dollar. In Asia and the Mideast, most do not.

What this has meant in practice is two things. First, as the U.S. dollar has weakened, it has done so only against those currencies which are free floating. This has meant the lion’s share of any adjustments in global imbalances have fallen on the likes of Japan and Germany. Second, those countries which are pegged have had to resort to currency intervention and a massive build-up of foreign reserves to stop their currencies from appreciating.  This is inflationary for those countries, and is one reason there is a housing and equities boom in Asia right now.

But, as the dollar continues to weaken, those countries with pegs will be under pressure to drop their peg or to revalue their pegs higher.  The Bloomberg video linked below explains. The dichotomy whereby the adjustment process is done only through free-floating currencies is inherently unstable – and invites a nationalistic response.

A busted peg in any major U.S. trading partner’s currency is likely to have a very negative psychological impact on currency markets and severe knock-on effects.  These are what I call digital events.  It’s all or nothing, on or off. Either the peg is revalued enormously or there will be continuing pressure.

As an example, look back to 1998 when the Russians attempted to devalue the ruble.  The immediate effect was a sense that the ruble was not devalued enough, leading to an all-out assault on the currency and a much more massive devaluation which in turn triggered default.

I would anticipate a similar albeit less pronounced dynamic were the Chinese or the Saudis to revalue significantly.  There would be tremendous downward pressure on the greenback globally, more pressure on the busted pegs and increasing pressure on other pegged currencies to revalue. The result, of course, would be higher interest rates in the United States and a likely double dip.

Busted pegs are not something I necessarily expect. However, this is the type of exogenous shock that is a clear downside risk to my more benign muddle through baseline scenario – and one reason to prefer gold over bonds in reducing exposure to equities.

Currencies Pegged to Dollar May Abandon Greenback: Video – You Tube

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That was the title of an e-mail I received from my bank today. Here is what the e-mail looked like:

This is what happens when markets go up. I don’t recall getting anything like this when the market was tanking. Obviously, there are a lot of people depending on you to invest in order to put food on the table.

I wonder if this is a contrarian indicator though.

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In my last post, I presented you with a bunch of data on debt levels broken down by sector of the economy (see “A brief look at the Asset-Based Economy at economic turns”).  I found it interesting that a secular pattern seemed to be at play when looking at the household debt charts.

Notice the three areas boxed in red on the chart to the right.

The chart measures the differential between the year-on-year change in household debt and nominal GDP.

The three areas show three distinct periods of household debt accumulation.

1. 1951-1966. The first shows household debt changes generally outstripping nominal GDP by a wide but decreasing margin. This period coincided with a secular bull market in equities.
2. 1966-1982. This second period is more volatile, but with the overall numbers lower.  In general, debt was accumulated less rapidly compared to the growth in nominal GDP. And when recession hit in 1970, 1974 and 1980, it induced a retrenchment (at least relative to nominal GDP growth). This period coincided with a secular bear market in shares.
3. 1982-?. This last period shows an enormous increase in debt growth relative to GDP growth during the 1980s followed by minor retrenchment after the 1990-91 recession and strangely also in 1997 (could this be a butterfly effect to the Asian Crisis?). But after that it was off to the races right through the 2001 recession until mid-2007.  This period coincided with a secular bull market in equities.

The pattern seems to indicate that there is a relationship between debt build-up in the household sector and stock prices.  The build-up in debt relative to nominal GDP troughed in Q3 2008 at -0.4%. As of Q2 2009, the number was +1.2%.

I see this as evidence of the so-called Wealth Effect. The data suggest that the secular bear market may not have begun in 1998 or 2000 as I have generally believed. And they also suggest that, despite the recent rise in shares, a new secular bear market may have just started in 2007. I will be curious to see what the data look like for the second-half of 2009.

Source

Z1 Data Series – Federal Reserve

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Gold hit a record high of $1,044.30 an ounce, beating the previous record of $1,032.35 set back in March and up a monster $26 on the day. The impetus is the crashing dollar, brought down by a report (later denied) that OPEC states and the Chinese were organizing a secret abandonment of the US dollar (see story here).

It is still rising.  In fact all commodities are rising sharply against the dollar. WTI Crude is up 2%, oat futures are up 3%, wheat futures are up 4 1/2%,  and corn futures are up almost 7%. And, we are seeing parabolic moves in silver (up almost 6%) and copper (up over 3%) as well.

But, of course, the Dow is up over 160 points despite this news of dollar revulsion. A little gallows humor over at Zero Hedge captures the mood amongst the shorts (hat tip Scott). This rally is absolutely turbo-charged. Can nothing take it down?

Sources

Spot gold – Kitco

Commodity futures – Bloomberg

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The Reserve Bank of Australia unexpectedly raised rates by 25 basis points to cool down its economy. It will “gradually reduce stimulus” in anticipation of sustained recovery. Australia has probably been the major economy least affected by the global economic slowdown, so one would expect the RBA to be the first major central bank to increase rates. However, the question now is whether other central banks will follow.

In the U.S., Donald Kohn and Richard Fisher have made fairly hawkish statements suggesting that the Federal Reserve is going to be more anti-inflation now than in the Greenspan era.  However, New York Federal Reserve Chairman William Dudley obviously didn’t get the memo about jawboning the market in a hawkish way.  Yesterday, he indicated that the U.S. Federal Reserve is likely to keep rates very low for a prolonged period for fear of choking off a tenuous recovery.

So while the RBA is raising rates, the Fed and the ECB may not follow anytime soon. That is certainly supportive of the Australian dollar.

Below is a CNBC video that gives you a chance to see the real-time reaction to the RBA’s decision and another with some commentary on the Aussie dollar.

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