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

Credit Suisse has a note out urging caution on Citigroup shares due to regulatory hurdles.  Their logic bears noting as it can be useful for other U.S.-based banks.

On Monday the CS analysts met with Citi management, who were somewhat cautious. The CS note indicates that regulatory changes in the U.S. are likely to mandate higher capital ratios and this necessarily will constrain returns on capital, not just at Citigroup but elsewhere in banking.

Another question involved deferred tax assets (DTAs), which I brought up last week. Citi said only $13 billion of the $38 billion in DTAs were counted against Tier 1 capital, meaning any writedowns to capital will have much less affect on Tier 1 capital. About $14 billion in DTAs were related to Citi’s burgeoning loan loss reserves; so the tax losses have not yet been triggered. This may give Citi time to earn money in order to use the DTAs. Again, the key with Citi’s DTAs has to do with how much it earns going forward. If it does not earn enough money, the deferred assets will have to be written down.

In general, banks are now entering a less favourable regulatory environment.  Moreover, in March, many bank stocks were trading below tangible book for the first time since 1990, at the height of the last major credit crunch in the U.S.. After a more than doubling in bank stocks from March lows, this is no longer the case and it will be harder to beat now elevated earnings estimates.

Meredith Whitney has said she expects the large cap bank stocks to underperform due to some of these hurdles and sees a relative value play in regionals.  However, a lot of CRE and loan construction exposure remains at regionals and the continued seizure of 3 or 4 banks every week by the FDIC points to distress.

I continue to believe upside in bank shares is limited all around.

Related posts:

• How well capitalized is Citigroup?
• How is Citi going to deal with $38 billion in deferred tax assets?
• The Citigroup Bailout: a blogosphere post-mortem
• Citigroup and Redecard: shedding international assets
• Rubin resigns from Citigroup

Below is a CNBC video with Meredith Whitney in which she joins Nouriel Roubini on the doom and gloom parade.  Over the summer, both Whitney and Roubini were fairly optimistic. In June I said:

Think of the consensus forecast as an anchor which restricts the outlook of any individual forecaster afraid of failing unconventionally.

In Roubini’s case – and this logic also applies to media darlings like Meredith Whitney – it does NOT pay to up the ante.  What Faber is saying is that they have already benefitted from the bold and unconventional contrarian market call they initially made.  There is little payoff and much risk from continuing on that path.

To wit, Whitney upgraded Goldman Sachs to a buy and by July she almost sounded bullish. But, things are vastly different now. The banking index is up some 136 percent, with many stocks doubling and tripling. Some are up nine times. This is way over the top.

In her interview with Maria Bartiromo, Whitney gives ample reason to expect significant headwinds in the financial services industry and the economy more generally. While I am less certain that we are presently seeing a secular move to consumer deleveraging yet as evidenced by recent retail sales and current account deficit numbers, there is no doubt that credit lines to small businesses and consumers have been cut as Whitney details. 

I have also been getting much gloomier about the prospect of a sustainable recovery as a result.

With fiscal belt-tightening on the agenda at states and municipalities and, now, federally, I expect a double dip in 2011 – a view Whitney shares.

The key question in financial services?

Maria Bartiromo: Do you think that the sector is adequately capitalized today?

Meredith Whitney: No way.

Maria Bartiromo: No way?

Meredith Whitney: No way.

She is bearish on bank stocks generally. As for relative value trades, Whitney says the trade was large cap banks over regionals until now. However, she says now is the time to reduce weight in large cap banks as the outperformance due to government backstops may be about to disappear.

A lot more in the video below. The interview with Whitney runs 11:47.

Related posts:

• Bill Miller and Meredith Whitney: The Bull and the Bear
• Meredith Whitney: “I would diversify out of financials here”
• Meredith Whitney seems onboard with the fake recovery
• Meredith Whitney: more bearish than ever, but…
• Is Meredith Whitney bullish now?

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”

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

I have really started to dislike municipal bonds as an asset class. They have seen a huge rally along with almost every other financial asset but the underlying fundamentals are weak because of financial distress at states and municipalities.

Last week, I wrote a first piece on this topic, based on some work by Philip Greenspun and Fred Sheehan. I also just wrote a piece about Ambac Financial’s likely bankruptcy, which will impact this market because of Ambac’s municipal bond guarantees. But, a Barron’s piece about Jim Chanos of Kynikos called “Short Seller: Dump Munis” piqued my interest and precipitated this particular article.

Chanos is bearish

The Barron’s piece by Tom Sullivan said:

James Chanos, the famed short seller who was among the first to foresee the collapse of Enron, recently sounded the alarm on the municipal-bond market — in the hallowed halls of the New York Historical Society, no less.

The "cracking of state and local municipalities is coming," he predicted at a recent meeting attended by Barron’s staffer Susan Witty, adding that he wouldn’t touch munis.

In a subsequent telephone interview with this columnist, Chanos said, "State and local municipal finance are a mess and going to get worse."

It’s not just the recession, which has reduced tax receipts. Rather, he says the poor economy "is masking real problems in municipal cost structures." The big problem, he says, is "the platinum-plated health-care and retirement benefits" given to state and local workers. "It’s all coming home to roost" as boomers start to retire.

California faces a $60 billion deficit, and the politicians there believe that in "a worst-case scenario, the federal government will bail them out," says Chanos. "If the feds do bail them out, as I believe they will," the state’s bonds will likely lose their federal tax exemption, he adds.

Sullivan went on to use New York and New Jersey as other examples of what is amiss for state bonds.

Revenue shortfalls

A New York Times article which I linked to this morning makes the situation in New York plain, ending with this:

The comptroller’s office numbers are more pessimistic than those from Mr. Paterson’s budget office. They project that the deficit for the remainder of the current fiscal year stands at $4.1 billion, with deficits of $7.8 billion and $15.7 billion in the succeeding years.

Mr. Ravitch, who helped steer New York City through its financial crisis in the 1970s, said, “The numbers are real and my own personal view is that they’re going to get worse.”

New York and New Jersey are suffering the same problems that California suffered, namely a huge fall in income and property tax revenue. This is true all over the country in places as far apart as Oklahoma, Hawaii, Texas, and Georgia.

Assets falling, liabilities ballooning

But, it’s not just about revenues versus outlays – the income statement. It’s also about assets and liabilities – the balance sheet. recently I spoke to Peter Schweich, a retired vice president of Boston University and founder of Boston University Academy, who had done some research on municipalities in Massachusetts and he explained that his research indicated that municipalities had seen a 30% fall in investment portfolio values during the credit crisis (much obviously gained back since). Even worse, he pointed me to enormous looming liabilities not reflected on balance sheet or considered by the ratings agencies.  In a recent Forbes article, he wrote:

While municipalities are able to raise property taxes to cover current salaries, not without considerable pain to the taxpayer, few of them, if any, are prepared for the future financial demands of their grossly underfunded or completely unfunded Other Post Employment Benefits (OPEB) obligation. OPEB obligations are primarily associated with health benefits for retirees.

In 2006, the Federal Reserve Bank of Chicago held a pension conference. In a short note, it reported that a "back of the envelope guess" for OPEB was $700 billion and that "other estimates suggest that OPEB exposure could range from five to 10 times current outlays for retiree health care."…

Cambridge, Mass., now known to most Americans as the city where a homeowner can be arrested for "breaking into" his own home, serves as a good example of the overwhelming burden residential and business property owners across the country are about to confront. Current and future Cambridge residents are now facing a completely unfunded OPEB obligation of $602 million. That figure, alone, is nearly one-and-a-half half times greater than the city’s entire 2009 budget. In addition, like most municipalities, the recent economic downturn has resulted in a significant loss to Cambridge’s regular pension fund: a 28.6% loss in 2008 in the amount of $225 million.

In addition, Cambridge has an unfunded liability for its regular pension fund (distinct from the OPEB fund) to the tune of nearly $70 million, and, of course, Cambridge also carries bond obligations, as do many municipalities. The Cambridge bond obligation exceeds $300 million. This means Cambridge, with approximately 75,000 permanent non-university student residents, one municipal employee for every 22 residents, and 22,000 taxable parcels, has current financial liabilities of nearly $1.2 billion…

Not surprisingly, the Cambridge city manager boasts of Cambridge’s financial stability each year in the introductory letter to his submitted budget. To bolster his claim, he proudly points to the Triple A bond ratings that Cambridge holds from Moody’s, Fitch and S&P. Cambridge, therefore, has 75,000 residents, 22,000 taxable parcels, $1.2 billion in financial liabilities–and a Triple A bond rating from Moody’s, S&P and Fitch.

These are circumstances that are being repeated across the United States. Expect scandals involving alleged improprieties to mount when financial distress hits. One notable example in the news is San Diego, where the top pension administrator is exiting after last year’s over 25% loss and where the fund is also being buffeted by two separate scandals: a conflict of interest scandal and a scandal where overtime pay was counted toward the formula in firefighters’ pension overtime. San Diego was also in the news a few years back because of a separate scandal where an alleged special pension benefit for the fire chief was under attack. See also San Diego’s Pension Scandal for Dummies from 2005, which details the conflict of interest case to that date.

Ratings agency problems

Then there are the rating agencies. Remember the whistleblower scandal from last month? It was all about municipal bonds and the Moody’s allegedly putting their revenue generating relationship with municipalities ahead of the rating function. If you recall, it was exactly this conflict of interest which led to Arthur Andersen’s downfall in the Enron scandal.

This is what Reuters said about the Moody’s whisteblower scandal last month:

Two former Moody’s executives — Scott McCleskey and Eric Kolchinsky — testified that senior managers were willing to silence employees who raised concerns about the ratings process or compliance efforts.

McCleskey said that while he was the head of compliance at Moody’s, he voiced concerns that the firm was not properly monitoring ratings on municipal debt. McCleskey, who was dismissed by Moody’s in 2008, said he was instructed not to mention the issue in e-mails or writing.

Kolchinsky, a Moody’s managing director who was recently suspended by the firm, said senior managers pushed revenue over ratings quality and were willing to fire employees who disagreed.

The two whistleblowers were flanked by Moody’s current chief credit officer, Richard Cantor. Cantor sat impassively, staring straight ahead as his former colleagues described their concerns to the lawmakers.

In his testimony, Cantor said Moody’s had recently hired an independent law firm to review Kolchinsky’s allegations.

That was criticized as an empty gesture by Chairman Towns, who said the law firm had no deadline and would not produce a written report.

Kolchinsky told lawmakers that Moody’s compliance group was understaffed and lacked independence. He also alleged Moody’s knowingly issued misleading ratings on complex securities and that analysts were "bullied" by managers, who overrode their decisions to protect revenue.  Kolchinsky said he would soon meet with the SEC to discuss his charges. SEC officials said the regulator had contacted Kolchinsky about his concerns in March 2009.

McCleskey, meanwhile, sent the SEC a letter in March 2009 warning about Moody’s weak compliance department and ratings process. He said Moody’s management had ignored his warnings that the company failed to properly monitor municipal bond ratings.

The company also spurned his suggestion to erect a firewall between the compliance department and its revenue-generating units, he said.

No doubt, there are those who are still recommending munis because of their tax-free status, as a recent WSJ article demonstrated. But, the fundamentals are weak and getting worse – both in terms of the income statement and the balance sheet. These governments are soon to lose their guarantees from Ambac (and eventually MBIA despite hiving off the muni business). To my surprise, these governments are getting no federal government backstop as the California situation has demonstrated. And the Fed and Treasury are on record as saying they will not guarantee any municipal bonds. Finally, I question whether one should rely on the ratings these bonds have to make an informed investment decision. Even the junk-bond king Michael Milken, a credit analyst of note, is now warning that credit ratings are inflated.

Municipal bonds are a clear case of buyer beware.

Related posts:

• The coming collapse of the municipal bond market
• MBIA and Ambac sued by LA
• Ambac may file bankruptcy soon
• California starts issuing IOUs as bankruptcy nears
• State and local government weighed down by housing

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?

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

Bill Gross has a must-read piece out for his monthly Investment Outlook called “Midnight Candles.” He begins the piece with allusions to his advancing years (Gross is now 65) and the mortality he feels because of it – pretty sobering stuff. gross then abruptly segues into his investment outlook, leaving one with the distinct impression he is suggesting there is something ephemeral in the global financial system’s status quo ante.

To solve the problem, Gross suggests continuing artificially low interest rates to maintain pumped up asset prices. This is a perverse conclusion I reject categorically. But his analysis leading up to this is right on the money. And the line he takes to make the transition to his thinking is right out of Credit Writedowns’ playbook.

I’ll jump straight into a discussion of why in a New Normal economy (1) almost all assets appear to be overvalued on a long-term basis, and, therefore, (2) policymakers need to maintain artificially low interest rates and supportive easing measures in order to keep economies on the “right side of the grass.”

Let me start out by summarizing a long-standing PIMCO thesis: The U.S. and most other G-7 economies have been significantly and artificially influenced by asset price appreciation for decades. Stock and home prices went up – then consumers liquefied and spent the capital gains either by borrowing against them or selling outright. Growth, in other words, was influenced on the upside by leverage, securitization, and the belief that wealth creation was a function of asset appreciation as opposed to the production of goods and services. American and other similarly addicted global citizens long ago learned to focus on markets as opposed to the economic foundation behind them. How many TV shots have you seen of people on the Times Square Jumbotron applauding the announcement of the latest GDP growth numbers or job creation? None, of course, but we see daily opening and closing market crescendos of jubilant capitalists on the NYSE and NASDAQ cheering the movement of markets – either up or down. My point: Asset prices are embedded not only in our psyche, but the actual growth rate of our economy. If they don’t go up – economies don’t do well, and when they go down, the economy can be horrid.

This, my friends, is the dreaded asset-based economy. It is the same financial model which has led us to mountains of debt and repeated bubbles and extreme financial instability.  I have said in the past that aggregate debt levels as measured by ratios like debt to nominal GDP should remain constant to the degree that the capital used to generate that growth is efficiently allocated. However, we have seen a ballooning in debt, which suggests that we need far more capital to generate a unit of growth than we did a generation ago.  Gross makes similar arguments, focusing instead on assets instead of debt (liabilities).

First of all, assets didn’t always appreciate faster than GDP. For the first several decades of this history, economic growth, not paper wealth, was king. We were getting richer by making things, not paper. Beginning in the 1980s, however, the cult of the markets, which included the development of financial derivatives and the increasing use of leverage, began to dominate. A long history marred only by negative givebacks during recessions in the early 1990s, 2001–2002, and 2008–2009, produced a persistent increase in asset prices vs. nominal GDP that led to an average overall 50-year appreciation advantage of 1.3% annually. That’s another way of saying you would have been far better off investing in paper than factories or machinery or the requisite components of an educated workforce. We, in effect, were hollowing out our productive future at the expense of worthless paper such as subprimes, dotcoms, or in part, blue chip stocks and investment grade/government bonds.

Again, these themes echo something i recently posted on, namely the hollowing out of America’s middle class from downsizing and outsourcing. See my post “A conversation with Stephen Roach on Charlie Rose “ in which the juxtaposition between a Stephen Roach interview circa 1996 and one from this past week makes plain the long-term problem.

Gross comes to a very different conclusion to all of this than I come to.  He says, faced with a potential collapse in nominal GDP growth, the answer is to feed the patient more of the asset price elixir to wean him off his drugs. Cold turkey would lead to depression (i.e. death – that makes the tie to his lead in plain).

This is where it gets tricky, however, because policymakers, (The Fed, the Treasury, the FDIC) recognize the predicament, maybe not with the same model or in the same magnitude, but they recognize that asset prices must be supported in order to generate positive future nominal GDP growth somewhere close to historical norms. The virus has infected far too many parts of the economy’s body, for far too long, to go cold turkey. The Japanese example over the past 15 years is an excellent historical reference point. Their quantitative easing and near-0% short-term interest rates eventually arrested equity and property market deflation but at much greater percentage losses, which produced an economy barely above the grass as opposed to buried six feet under. The current objective of global policymakers is to do likewise – keep the capitalistic patient alive through asset price support, but at an “old normal” pace if possible, six feet or 6% in U.S. nominal GDP terms above the grass.

My conclusion is different. I have said before that I also think cold turkey would lead to disaster (see my post “Confessions of an Austrian economist), but I am under no illusion that we need to keep supporting the asset-based economy indefinitely.  Our goal should be to use government stimulus as cover to eliminate malinvestments and downsize bloated sectors of the economy like financial services. This is one reason I am in favor of introducing a comprehensive too-big-to-fail (TBTF) resolution process to allow big banks to fail and breaking up TBTF financial institutions.

Going back to Gross, he concludes that his policy preference for maintaining is supportive of asset prices in the medium-term but not so supportive that we are going back to the gold rush of yesteryear.

If policy rates are artificially low then bond investors should recognize that artificial buyers of notes and bonds (quantitative easing programs and Chinese currency fixing) have compressed almost all interest rates. But while this may support asset prices – including Treasury paper across the front end and belly of the curve, at the same time it provides little reward in terms of future income. Investors, of course, notice this inevitable conclusion by referencing Treasury Bills at .15%, two-year Notes at less than 1%, and 10-year maturities at a paltry 3.40%. Absent deflationary momentum, this is all a Treasury investor can expect. What you see in the bond market is often what you get. Broadening the concept to the U.S. bond market as a whole (mortgages + investment grade corporates), the total bond market yields only 3.5%. To get more than that, high yield, distressed mortgages, and stocks beckon the investor increasingly beguiled by hopes of a V-shaped recovery and “old normal” market standards. Not likely, and the risks outweigh the rewards at this point.

While I disagree with Gross, his is a very good piece if you want to know which way the wind is blowing. I have linked to it below.

Enjoy.

Source

Midnight Candles – Bill Gross, Pimco

Related posts:

• Bill Gross: Fed on hold through 2010
• Gross isn’t buying corporates, high yield or equities even with zero rates
• Bill Gross: “Stop the decline in asset prices”
• Bill Gross: the new normal means investors should shun risk
• Bill Gross: “Staying Rich in the New Normal”

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

(H/T Prieur du Plessis)

Source

Walt Handelsman – Newsday

Related posts:

• Kass: Bearish on equities
• News from around the web: 2009-10-13
• Jobless claims back to 551,000; employment missing link to recovery
• News from around the web: 2009-07-31
• Average U.S. jobless claims top 600,000

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

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.

Related posts:

• The wisdom of crowds, the precision of models and going contrarian
• Marc Faber makes bullish comments on Bloomberg
• Regional banks: Zions falls
• Selling the good news does not a bull market make
• An amazing market rally. What’s next?

The following is a re-print of the latest monthly newsletter from Niels Jensen of Absolute Return Partners, published with the express permission of the author. Visit www.arpllp.com to learn more about Absolute Return Partners.  You can reach the firm  by email at info@arpllp.com.

The Absolute Return Letter

October 2009

A Country for Old Men and a Bit of Samba

The Man Card “Excuse me Sir, can I see your Man Card?” The stone-faced look of the security guard at Dallas Fort Worth Airport gave nothing away and, after two days of celebrating John Mauldin’s 60^th, my brain was probably operating somewhat below full capacity. “I need to see your Man Card Sir”. Couldn’t he just go away, I thought to myself, not really sure how to deal with the situation. Suddenly his face cracked wide open and in the broadest possible Texas drawl he said: “With those pink socks on Sir, I need to make sure you are a man”. Welcome to Dallas!

The highlight of the weekend was a two hour roundtable discussion on Saturday afternoon where John had asked 15 of his friends and business associates to share with the group what their fears and hopes were for the next 15-20 years. I duly noted that the issues on the minds of our American friends are not at all dissimilar to what we worry about in Europe – our children’s welfare, unemployment, immigration, racism, the impact of technology and the aging of our society to mention but a few.

This month’s letter is about demographics and is the second in our series about major trends defining the future of the world we live in. Last month I wrote about the energy outlook, and I had an unusually high number of emails commenting on the letter. Many of them made the point that the world is in better shape than I seem to think, even if oil supplies are dwindling, as natural gas reserves are ample. We just need to switch source. Whilst I don’t disagree that natural gas seems the way forward, one should not underestimate the task ahead of us. About 2/3 of all oil is used for transportation purposes and it is an enormous task to reduce our oil dependency. It will take many, many years and cost gigantic sums of money.

It is the banks, Stupid! Back to this month’s topic – in the financial press, there has been no shortage of attempts to apportion blame for the credit crisis. Disregarding the more obvious finger-pointing (it is the banks, stupid!), there seems to be a growing acknowledgement that large imbalances in the global economy are to blame for the current mess.

Put differently, a large number of countries – mainly Anglo-Saxon in origin but also the majority of our Eastern European friends – became credit junkies and spent beyond their means, year-in year-out. Conversely countries with large current account surpluses (e.g. China, Japan and Germany) were only too happy to deliver the drug to the intoxicated.

It is therefore too simplistic to suggest that only the deficit countries are to blame. The suppliers of credit must accept that they carry no small part of the responsibility, just like the drug dealers do when supplying junkies. In the past, I have been critical of Ms. Merkel of Germany when she stated publicly that Germany should continue to do what Germany does best, and that is to export goods of high quality. The obvious point here is that if Germany pursues such a strategy, the world will be no more balanced ten years from now than it is today, and a crisis similar to the one we have just been through could happen again.

It should therefore be obvious that not only should the deficit nations become more disciplined (i.e. save more and spend less), but the large surplus nations should actually put measures in place to ensure that their citizens save less and spend more. In practice, however, that is easier said than done. Demographic forces have a much bigger say on spending and savings patterns than generally acknowledged.

The Life Cycle Hypothesis My story begins with Franco Modigliani. In 1985 he was awarded the Nobel Memorial Prize in Economic Sciences for his life cycle hypothesis which (somewhat simplified) states that spending and savings patterns are predictable and largely a function of demographics. When you are in your 20s and 30s, savings are low as much of your income is spent on establishing a family, buying and furnishing your home, putting the children through education, etc. Then comes a phase, from your early to mid 40s until just before you reach retirement age, where your savings grow significantly. The outgoings are smaller during this phase of your life as the kids have left home, and you focus on accumulating wealth to pay for your retirement. Eventually, when you retire, your savings rate turns negative as you begin to live on your life savings¹.

Empirical evidence has since shown that this is generally true both for the individual and for society at large. Obviously, you don’t win the Nobel Prize for pointing out something that can hardly be classified as original thinking, but Modigliani’s claim to fame was to demonstrate the effect this pattern has on the general economy as the population ages. Let me introduce you to a chart constructed by fellow Dane Claus Vistesen who is an economist and active blogger. He has made a solid attempt to graphically illustrate the consequences of Modigliani’s work (chart 1).

Chart 1:   Age’s Effect on the Current Account

Source: http://clausvistesen.squarespace.com

The blue line represents the current account – it is in surplus when above the red line and in deficit when below. As you can see, when a country’s population is relatively young, the country should (all other things being equal) run a current account deficit. As the population grows older, and the savings rate rises for the reasons described above, the deficit turns into a surplus until such time that the elderly begin to dominate the young at which point the surplus turns into a deficit yet again.

Our export dependency Why is all this important? Well, take another look at chart 1, but focus on the purple line instead, which represents the country’s export dependency. Translated into plain English, Modigliani’s work implies that a country with an ageing population must grow its exports aggressively in order not to build up an unsustainably large current account deficit. Unfortunately, as you can see from the shape of the curve, it is not a linear function. The problem gets progressively worse as the population ages.

Now, with most OECD countries fast approaching the danger zone where an uncomfortably large part of the population consists of old-age pensioners, how do we get out of this pickle? We can’t all export our way out of the problem. Somebody needs to buy our products. I will get back to answering this question later, but let’s take a quick look at the so-called dependency ratio first. If the ratio is, say, 30, it means that there are 30 people at the age of 65 or older for every 100 people between the age of 15 and 64 (which defines the working population).

Obviously, the higher the dependency ratio, the fewer working people there are to pay for the elderly. At some point the cost of supporting the elderly will reach a level which spells economic disaster, and some of the more exposed countries may quite simply be forced to abandon their welfare standards to cope. More about this later – let’s get some data points on the table. In chart 2 below, I have tried to keep things relatively simple. I have assumed, for example, that the fertility rate will remain unchanged going forward. This may or may not be a reasonable assumption. Only time can tell.

Chart 2:   Old Age Dependency Ratios for Selected Countries

Source: http://data.un.org/

A walk in the park The first thing that struck me when I produced this chart was how relatively benign the US outlook is. I read an awful lot of US centric macro economic research (my wife thinks too much!) and, more often than not, there is a reference to the bleak future for America given the fact that baby boomers in large numbers will be retiring over the next two decades. However, when you compare the US numbers (a dependency ratio of 19 today growing to 34 by 2050) to most other developed nations, the US demographic challenge suddenly looks like a walk in the park.

No other country is aging as quickly as Japan. Saddled with a large number of old age pensioners already (the dependency ratio is currently 35), the ratio will grow to an astonishing 76 over the next four decades. The Japanese economy has struggled to drag itself out of a slow growth environment for the past twenty years (give or take). The problems in Japan are well publicised and are often blamed on failed policy measures. I just wonder how big a role demographics have actually played in all of this and whether the Japanese mire is a sign of things to come for the rest of us?

Europe is toasted The outlook for Europe doesn’t make for pretty reading either. In fact, you can argue that we are worse off than Japan given our lower savings, and it raises some serious questions about the sustainability of our entire welfare model. The IMF has calculated that the cost of age-related spending in the average advanced G20 country will cause public debt-to-GDP to grow to over 400%, with Spain and Greece reaching over 600% unless the existing welfare model is cut back (see the April 2009 Absolute Return Letter here). For comparison, Japan has the highest public debt-to-GDP ratio today at about 225%.

As our business partner, John Mauldin, always reminds us, what cannot happen, will not. We may have to prohibit the use of condoms (not advisable for other reasons), import more labour from countries with higher birth rates (immensely unpopular) or simply reduce old-age benefits. The latter carries its own set of challenges as the political influence of the elderly is on the rise, and it won’t exactly become any easier over the next 20 years to pass draconian legislation to reduce old-age benefits. Frankly, I have no idea how we will find a way out of this pickle. But find a way we will.

BRICs versus PIGS As far as emerging economies are concerned, the outlook is considerably brighter (note the big difference between the BRICs and the PIGS in chart 2) but perhaps not as straightforward as you may think. Most investors seem to buy into the idea that, over the next few decades, emerging markets will offer better investment opportunities than more mature markets, as their economies are likely to grow much faster, and you don’t yet pay for the faster growth through higher P/E ratios. Whilst we wrestle with depressing issues such as how to pay for the credit crisis and how not to bankrupt ourselves as we age, emerging economies should benefit from a growing labour force. In fact, as you can see from chart 3, in the next few years less developed countries, which tend to have very young populations, will actually outgrow more developed countries in terms of the size of the working population relative to the total population (which is good for economic growth).

Chart 3:   Working-Age Population as % of Total Population

Source: http://data.un.org/

The growing number of workers should, according to Modigliani, be followed by stronger economic growth and rising savings. If these savings can be invested into new productivity enhancing investments, emerging economies should enjoy much higher living standards in the years to come. You may raise a hand here and say “STOP – didn’t you just argue that countries with young populations should run current account deficits and hence low savings rates?”  It is indeed correct that ‘young’ countries should, according to Modigliani’s hypothesis, not be able to generate savings rates at the magnitude we have seen coming out of South East Asia in recent years.

Cheating is omnipresent But Modigliani didn’t take cheating into account. Virtually every country in Asia has artificially depressed its currency in recent years in order to export itself to prosperity. This cannot, and will not, go on forever. As living standards rise in these countries, and domestic demand fuels economic growth, expect their currencies to appreciate against the old world currencies.

At the same time, one should not ignore the fact that not all emerging economies have young populations. I have included the four BRIC countries in chart 2 in order to make this point clear. As you can see, by the middle of the century, China and Russia will actually both have a higher dependency ratio than the United Kingdom, whereas Brazil and in particular India should continue to benefit from relatively young populations.

In a recent research paper², BCA Research analysed a number of emerging economies and found that, broadly speaking, they can be divided into 3 categories – those where the working population is peaking just about now, those that will peak in the next 7-10 years and finally those where the peak is still 15-20 years away (chart 4).

Chart 4:   Demographic Profile of Emerging Economies

Source: BCA Research

It is clear from BCA Research’s work that some countries are in much better shape demographically than others. Most interestingly, China, which everybody (well, almost everybody) raves and rants about, does not look particularly attractive. Obviously you cannot judge the investment appeal based only on demographics, but if you add to that China’s fragile banking system and a construction boom which has left most new buildings half empty and led the Chinese authorities to block local access to hedge fund manager Hugh Hendry’s website, because he had the audacity to point out the insanity of many of the construction projects in China, then the Chinese investment story loses some of its glamour.

Too much of a good thing A great growth story like China will always attract plenty of capital but, in the case of China, you can actually argue that too much capital has been attracted. As I was taught at university, economic growth loses its momentum if capital spending outgrows labour because of the diminishing return on capital. BCA has illustrated this graphically (chart 5), and it is obvious that China is attracting too much capital for its own good. You want to invest where capital is scarce, not plentiful.

Chart 5:   Capital-to-Labour

Source: BCA Research

You are therefore likely to earn a higher return on investment by investing elsewhere in the universe of emerging economies. One such country is Brazil which does not attract nearly the amount of capital that China does. I have been keeping an eye on Brazil for some time now as I am intrigued about their fledgling oil industry, and the more I learn about this country, the more excited I get. The story has not gotten any worse in recent days after the International Olympic Committee’s decision to award the 2016 summer games to Rio de Janeiro. But that is an entirely different story which I may write more about another day.

Going back to the question I raised earlier, how do we get out of this pickle? As already stated, we cannot all become exporters as we grow older and domestic demand begins to fade. The only way out, if we want to maintain economic growth, is for the younger and more dynamic emerging economies to become net importers. This will require a sea change in policy, and attitude, in those countries. Most importantly, it will require the exchange rate cheating to stop once and for all. There is no alternative, unless you are prepared to accept negative GDP growth year-in year-out. And that is no fun.

Niels C. Jensen

© 2002-2009 Absolute Return Partners LLP. All rights reserved.

See other posts I have published referencing or presenting Niels’ analysis.

• The emerging markets crisis – Nov 2008
• Do BRICs (and Germans) Eat PIGS? – Feb 2009
• Europe on the ropes – Mar 2009
• The Fake Recovery - Apr 2009
• Green Shoots or Smoking Weed? – May 2009
• Make Sure You Get This One Right – Jul 2009
• The Hamster on the Wheel – Sep 2009

Related posts:

• Chart of the day: household debt vs. savings
• Chart of the day: Savings Rate
• Low savings, high debt and interest rate policy
• Savings in America hit 5%, up from nil last year
• Jim O’Neill on the Global Economy

In July, I blogged on an interesting take on how employment affects equity returns during cyclical recoveries by Van Hoisington and Lacy Hunt. Their thesis was that a recovery in which employment lags the overall upturn significantly is bearish for stocks. Since then, employment has indeed lagged other economic indicators.  Witness the most recent employment situation summary released earlier today.

Nonfarm payroll employment continued to decline in September (-263,000), and the unemployment rate (9.8 percent) continued to trend up, the U.S. Bureau of Labor Statistics reported today. The largest job losses were in construction, manufacturing, retail trade, and government.

Household Survey Data

Since the start of the recession in December 2007, the number of unemployed persons has increased by 7.6 million to 15.1 million, and the unemployment rate has doubled to 9.8 percent…

The civilian labor force participation rate declined by 0.3 percentage point in September to 65.2 percent. The employment-population ratio, at 58.8 percent, also declined over the month and has decreased by 3.9 percentage points since the recession began in December 2007.

Establishment Survey Data

Total nonfarm payroll employment declined by 263,000 in September. From May through September, job losses averaged 307,000 per month, compared with losses averaging 645,000 per month from November 2008 to April. Since the start of the recession in December 2007, payroll employment has fallen by 7.2 million.

In September, construction employment declined by 64,000. Monthly job losses averaged 66,000 from May through September, compared with an average of 117,000 per month from November to April. September job cuts were concentrated in the industry’s nonresidential components (-39,000) and in heavy construction (-12,000). Since December 2007, employment in construction has fallen by 1.5 million.

Employment in manufacturing fell by 51,000 in September. Over the past 3 months, job losses have averaged 53,000 per month, compared with an average monthly loss of 161,000 from October to June. Employment in manufacturing has contracted by 2.1 million since the onset of the recession.

In the service-providing sector, the number of jobs in retail trade fell by 39,000 in September. From April through September, retail employment has fallen by an average of 29,000 per month, compared with an average monthly loss of 68,000 for the prior 6-month period.

Government employment was down by 53,000 in September, with the largest decline occurring in the non-education component of local government (-24,000)…

In September, the average workweek for production and nonsupervisory workers on private nonfarm payrolls edged down by 0.1 hour to 33.0 hours. Both the manufacturing workweek and factory overtime decreased by 0.1 hour over the month, to 39.8 and 2.8 hours, respectively. (See table B-2.)

In September, average hourly earnings of production and nonsupervisory workers on private nonfarm payrolls edged up by 1 cent, or 0.1 percent, to $18.67. Over the past 12 months, average hourly earnings have risen by 2.5 percent, while average weekly earnings have risen by only 0.7 percent due to declines in the average workweek. (See table B-3.)

The change in total nonfarm payroll employment for July was revised from -276,000 to -304,000, and the change for August was revised from -216,000 to -201,000.

A few points here:

1. Losing over 250,000 jobs per month nearly two years into recession is an indication of a still weak employment market.  This is 400,000 jobs per month below where we want to be.
2. Why is the labor force participation rate still falling? This is a sign of a deteriorating, not improving labor market.
3. Manufacturing is still shedding workers even though industrial production is rising. That demonstrates a weakness whose source is record low capacity utilization.
4. Local and state governments are cutting workforce and countering the stimulus provided by the Federal Government as I indicated in January they would.
5. The workweek is a record low and this is crimping earnings power.

Conclusion: the labor market is till weak, weaker than it should be at this point in a cyclical recovery. Unless this changes in the fall and winter, a double dip recession is going to be more likely. While the preceding points stress the negative, I should point out that my baseline view is for job losses to continue to diminish, albeit at a slow pace. I would anticipate job gains to appear by the end of the year or early in 2010.

That gets me back to Hunt and Hoisington and partial recovery. Even if we see job gains by Q1 2010, this will be a full 6 months after the manufacturing sector turned up. This must limit consumption because spending can only increase through higher employment and income or increased debt and leverage. As most of the cost-cutting and productivity gains inherent in those cuts is now behind us, the heavy lifting begins. Earnings growth is likely to be weak in this environment.

How a fully priced equity and corporate bond market continues to rally in the face of these factors is beyond me. I see government bonds as a better bet than either corporates or equities for the medium-term.

Update: I failed to mention the rather large (over 800,000 jobs) benchmark revision of prior unemployment data.  It’s this sort of thing which makes people not trust the numbers.  But, revisions are always necessary if you are going to do month-to-month measurements in an economy as large as the United States. 

Here’s what the BLS said:

Preliminary Estimates of Benchmark Revisions to the Establishment Survey

In accordance with usual practice, the U.S. Bureau of Labor Statistics is announcing its preliminary estimates of the upcoming annual benchmark revision to the establishment survey employment series. The final benchmark revision will be issued on February 5, 2010, with the publication of the January 2010 Employment Situation news release.

Each year, the Current Employment Statistics (CES) survey employment estimates are benchmarked to comprehensive counts of employment for the month of March. These counts are derived from state unemployment insurance tax records that nearly all employers are required to file. For national CES employment series, the annual benchmark revisions over the last 10 years have averaged plus or minus two-tenths of one percent of total nonfarm employment. The preliminary estimate of the benchmark revision indicates a downward adjustment to March 2009 total nonfarm employment of 824,000 (0.6 percent).

Related posts:

• US Unemployment shows 5.5%, net loss of 62,000 jobs
• Unemployment rate climbs to 9.4%
• U.S. unemployment rate 7.2%, 524,000 jobs lost
• 651,000 jobs lost but unemployment rate at 8.1% in U.S.
• 467,000 jobs lost in the U.S. in June 2009

This is how the famed investor and Chairman of Tiger Management began an interview with CNBC yesterday. Yes, the recession is probably over, he says.  But, in his view there is likely to be problems going forward because the U.S. has so much debt.

The money quote: “It’s almost Armageddon if the Chinese and Japanese don’t buy our debt.”

I am not sure I agree because a recession caused by a fall in the dollar’s value will almost certainly mean a reduction in imports and an increase in savings and domestic purchases of government bonds, something we are already witnessing.

As to inflation versus deflation, consider Robertson an inflationista. He is betting on inflation going higher in his investments. “We could easily see 15 to 20” percent inflation if the Chinese and Japanese go on strike, Robertson says.

Below are both the short video, which runs for the first eight minutes of his interview, and a longer full 30-minute version beneath it.

Related posts:

• China cuts holding of U.S. Treasury securities
• Japanese defend dollar’s status while China tears it down
• Mea culpa on the need for a new currency
• China sovereign wealth fund diversifies into a massive loss
• Faber: Gloom, Boom or Doom?

Mark Mobius is one of the most famous Emerging Markets investors and right now he is bullish on Emerging Markets despite a huge rally in shares from late last year. Mobius turned bullish right as shares troughed and has remained so ever since.

Mobius likes the so-called ‘Frontier’ Markets more than the well established BRICs.  He mentions Kazakhstan, Romania, Kenya and Vietnam as examples. Below is a video of Mobius from the Telegraph, explaining that investors need to take a five-year view and be prepared for lower liquidity and extreme volatility (20 or 30% corrections) to profit.

Note that his reasons to be bullish are:

1. Money printing globally will underpin shares (a view Marc Faber also holds)
2. “Derivatives are not dead. There are $600 trillion worth of derivatives out there,” according to Mobius. As a result, leverage will goose returns supplied by the money printing.

Both of these are technical factors that do not speak to the underlying fundamentals.  It does suggest that government action may be the dominant force in markets for some time to come, a view espoused by Pimco’s Bill Gross.

The video runs just over five minutes.

Related posts:

• Mobius: Emerging market stocks are breaking out
• Marc Faber makes bullish comments on Bloomberg
• Marc Faber on passing the baton to emerging economies
• Whitney Tilson of T2 Partners, a new media darling, strikes a bullish tone
• Fred Hickey: Gold starts secular bull, tech ends secular bear

How about all three. Faber released another provocative newsletter this month that has a little grist for investor of all stripes.

Boom. His short-term outlook is bullish because he believes money-printing will underpin the market even after the 60% increase in the S&P 500 from March 2009 lows. This puts him in the same camp with Rich Bernstein and Jim Grant. Interestingly, he says that a “very weak” economy is best for stocks because it will induce more money printing from central banks.

Gloom. However, he says this will only make matters worse over the longer-term as the U.S. government has no stomach for reigning in budget deficits expected to reach $2 trillion. It is merely underwriting the bankers’ mistakes. Down the line a point of debt revulsion will come.

Doom. In five to ten years, Faber sees major problems as a result.  In the September Gloom, Boom & Doom report he writes:

The future will be a total disaster, with a collapse of our capitalistic system as we know it today, wars, massive government debt defaults and the impoverishment of large segments of Western society.

Let’s call this Financial Armageddon. While he certainly presents a dire worst-case scenario, I sympathise with this view because, as I have warned in the past, unsustainable debt bubbles like the one we are now witnessing usually end in depression, war and strife.

Below are three videos of Faber on Bloomberg earlier today spinning his tale of waste and woe.  Pretty entertaining and they run twenty minutes in total.  Faber likes drug stocks.  He thinks that bonds and cash will be the worst long-term investments because of inflation.  Faber also would be overweight Asia as he believes emerging markets will grow faster than the West.  He has good things to say about Goldman. “They are really a smart group of people.”

See also Bullish Today, Marc Faber Is “Highly Confident” the Future Will Be Very Bleak and the attached video at Tech Ticker with Aaron Task. Faber gives another entertaining performance there as well.

(three videos embedded)

Related posts:

• Marc Faber: “A huge move is coming in the dollar, in bonds and in equities” but…
• Marc Faber: “Monetary policy in the United States will stay expansionary”
• Marc Faber: China’s numbers are fake
• Marc Faber: “I am 100% sure that the U.S. will go into hyperinflation”
• Mobius: Still bullish on Emerging Markets

Bill Gross is a bond man.  In fact, he is often called the “Bond King” because Pimco, the organization where he is founder and Co-Chief Investment Officer, is the largest bond fund in the world. In Bondland, what Gross says has a lot of weight.

And 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, Gross is also reducing risk.  There has been a huge run-up in corporate bonds, especially in high yield bonds. And Gross believes now is the time to take profits and reduce exposure to riskier assets, a view he first put forth in his monthly newsletter at the beginning of July (see my post, “Bill Gross: the new normal means investors should shun risk”).  And Gross is re-balancing his portfolio quite heavily to reflect this “glass half-empty” bias. His portfolio has its heaviest concentration in five years of Treasuries, considered the U.S.’s risk-free financial assets.

Below is a video of Gross talking on CNBC along with two other market experts, Bob Doll and Dan Tishman, regarding their view of the economy and financial markets. Gross goes as far as to say point blank that one should sell equities and other riskier assets like high-yield bonds.

Before you watch the video, be aware that two other formerly bearish analysts, Richard Bernstein and Jim Grant, have flipped to bullish recently.  Gross mentions Grant by name and disagrees with his take on the economy, calling it “disingenuous.” Articles by or on Bernstein and Grant’s view’s are below the video.

This is the third in a series of posts about reducing risk. See also:

• Sell equities
• Way too much risk in the equity market

Related articles
From Bear to Bull: James Grant on Recession and Recovery – Jim Grant, WSJ.com
Bernstein: Best Value In Junky Names – CNBC.com

Related posts:

• Bill Gross: Fed on hold through 2010
• Sell equities
• Gross isn’t buying corporates, high yield or equities even with zero rates
• Bill Gross: the new normal means investors should shun risk
• Marc Faber: "I don’t think that you’ll see gold below $1,000 per ounce probably ever"

The following post appeared on Wednesday at Rick Bookstaber’s new blog. Bookstaber is a market veteran who has long and storied history of achievement. He worked at Bridgewater Associates, ran the Quantitative Equity Fund at FrontPoint Partners and was in charge of risk management at Moore Capital Management amongst other things.

Of particular relevance here, Bookstaber was the director in charge of firm-wide risk management at Salomon Brothers and was a member of Salomon’s powerful Risk Management Committee. He also spent ten years at Morgan Stanley, first designing and marketing derivative instruments, then as a proprietary trader, and eventually as Morgan Stanley’s first market risk manager.

Basically, the man knows risk. He has testified before Congress about Value at Risk models, most recently this month. And to top it off he wrote a killer book, “A Demon of Our Own Design,” which I recommend.  Below are his latest thoughts on regulation and capitalism from a risk perspective.

Enjoy.

Will regulation hobble capitalism? I think the opposite is true. Properly done, government regulation of the financial industry will move the industry closer to the capitalist ideal. By capitalism, I mean where those who take the risks and put up the money get the fruits of their labor. And, importantly, where those who take the risks and put up the money actually do take the risks, bearing the full costs of failure as well as success.

Capitalism means bearing the costs
I sometimes miss the rugged beauty of Utah, where I spent some of my pre-Wall Street years. From my house on the foothills of the Wasatch mountains, I could see the cliffs of Mount Nebo to the south, nearly fifty miles away. Ten miles north, the western face of Mt. Timpanogas, capped with snow into early summer. To the west, the sun reflecting on Utah Lake. Oh, and on the eastern shore of the lake, the black smoke billowing out the stacks of Geneva Steel.

Geneva Steel was built to produce steel during the war effort, and kept in operation until seven years ago. It teetered at the edge – and at least two times over the edge – of bankruptcy, closing for good in 2002. Left behind were assorted furnaces, presses and scrap metal sold to a Chinese steel producer, and a giant pond of toxic sludge.

Fortunately, we’ve learned a thing or two about toxic sludge in steel production. The steel producer, in this case the original parent of the Geneva plant, U.S. Steel, has to set aside a fund to pay for the clean-up. The sludge is part of the production process, and the clean-up is a cost of production, even though it is a cost that is not realized until many years down the road. As a result, steel costs are a little higher and the shareholders fare a little worse than if this longer-term expense were not forced onto the producers. The regulation that requires setting aside funds for the clean-up might be considered intrusive to the core values of capitalism. But it is the contrary. It is forcing the steel mills to recognize all of their costs rather than leave society to foot part of their bill.

Wall Street’s toxic sludge
Wall Street has its own forms of toxic sludge, longer-term costs and negative externalities from products and strategies: The increase in the risk of crisis that comes from the opacity of complex derivatives; the fat tail risk of positions that are short credit or liquidity; negative gamma trading strategies, strategies that in various guises are like naked call writing, making money most of the time, but on occasion failing spectacularly; the forced deleveraging and liquidity crises that come from high leverage.

These costs are easy for the Wall Street capitalist to ignore, because unlike the sludge pond behind the steel mill, they are not visible until they finally hit. Indeed, they are not even deterministic. They might hit or they might not – so what we have in financial markets is invisible and probabilistic toxic sludge. Which makes sludge-producing strategies all the more popular with banks and traders, because if you can do things where you don’t have to bear some of the costs, the odds are better you will turn an apparent profit.

The limited liability assault on capitalism
The banks and trading firms don’t have to bear these costs because of the widespread use of limited liability. Limited liability creates a ‘heads I win tails you lose’ relationship. The template for limited liability is the corporation, a template that has been copied to create the trader’s option and short-term compensation, paid out before the full costs of a product or strategy are manifest.

If I want to get the most value out of limited liability, I will gravitate toward fat tailed and complex businesses, where most of the time I pump money out with regularity, but face some prospect of a catastrophic loss. How catastrophic? The bigger, the better. It doesn’t matter to me how bad things get once they have passed my liability limit. And the larger that catastrophic case, the more costs I am passing on, and thus if a general risk-return relationship holds, the more return I will get as long as the catastrophe is kept at bay.

Put in other terms, I will look for businesses and strategies that produce the highest level of costs that I can slough off, that will be unrecognized by others. Is this the direction Wall Street has gravitated? Are the exposures of traders and banks biased toward taking credit risk, being short liquidity risk, and short gamma? Do they prefer the complex to the simple? Do they push leverage as far as regulation allows?

Regulation and capitalism
Regulation that exposes these costs and forces the trader or bank to absorb them makes the markets more true to capitalist ideals. Capitalist regulation forces the producers to recognize all of their costs. It undoes the harm to capitalism that comes from limited liability and its kissing cousins, the trader’s option and short term compensation deals. The flip side is that with capitalist regulation, no one can take on more risk than they are capable of absorbing. Which means requiring higher levels of capital on the one hand, restricting leverage on the other, which in turn means reduced capacity to generate high returns.

The aspiring capitalists among us will decry such regulation because it invariably makes our lives harder; we can’t make as much money. But if the reason is that the regulation is now forcing us to bear all of the costs of our enterprise, then we are feeling the pain of having the socialist trappings removed, and entering into a more robust capitalist regime.

This post is re-published with consent of the author, Rick Bookstaber.

Related posts:

• Rick Bookstaber to join SEC
• Guest post: Why do bankers make so much money?
• On so-called bureaucrats in Washington and the morality of capitalism
• Guest Post: Did Gordon Gekko inspire Wall Street or the other way around?
• Madoff as a signal to go for “regulation heavy”

Following up on my “Sell equities” post, I want to highlight a factoid from today’s David Rosenberg’s Breakfast with Dave distribution.

Never before has the S&P 500 rallied 60% from a low in such a short time frame as six months. And never before have we seen the S&P 500 rally 60% over an interval in which there were 2.5 million job losses. What is normal is that we see more than two million jobs being created during a rally as large as this.

In fact, what is normal is for the market to rally 20% from the trough to the time the recession ends. By the time we are up 60%, the economy is typically well into the third year of recovery; we are not usually engaged in a debate as to what month the recession ended. In other words, we are witnessing a market event that is outside the distribution curve.

I had been pretty bullish in March and April.  But almost immediately, this rally just went straight up in a moon-shot kind of way that makes someone like me who is more oriented toward fundamentals a bit nervous. After months of wondering how long this thing could last, I’ve finally said sell.

I’m not saying that the rally can’t continue (after a correction).  That depends in part on the economy and reflation. What I am saying is that a two- or three-sigma move should have you asking yourself a lot of questions. And since this is a two- or three-sigma move to the upside, you should be taking profits, not chasing that last dollar.

The video below from 7 Sep with Cazenove’s Robin Griffiths gives one the bigger picture.  Going into treasuries is a flight to safety. Going into gold is the same. Notice that Griffiths dispels the notion that Gold is an inflation hedge alone.  In reality, it is a paper money hedge and its rise represents a fiat currency rejection as much as a portend of inflation.

Source

Breakfast with Dave, 18 Sep 2009 (PDF) – David Rosenberg, Gluskin Sheff

Related posts:

• Rosenberg thinks U.S. market may Test March lows
• Sell equities
• Overbought?
• Rosenberg: Market rally is just multiple expansion
• Rosenberg: Still a bear market rally

In late August, I wrote a post called “Getting bearish again” in which I said that the bear market rally I had anticipated back in March was long in the tooth.  At the time, I mentioned 1026 on the S&P 500 as a sell signal.  With the S&P 500 now well over 1060 and gains of well over 50% from those March lows, it’s definitely time to sell.

And when I say sell, I’m not talking about going overweight bonds or commodities by putting additional new money disproportionately in other asset classes – which is what you should have been doing in August.  I am talking about lightening up on equities and selling existing positions. 

Now, if you missed the rally, I’m sorry but, now is not the time to get in. And if you have been there from the start, remember, bulls make money, bears make money but pigs get slaughtered.

David Rosenberg sums up the logic.

The S&P 500 is now up more than 60% from the lows, which is truly amazing and kudos to those who called it. But the question is whether the fundamentals will ever catch up to this level of valuation — usually after a 60% rally, we are fully entrenched in the next business cycle. Never before have we seen the stock market rise so much off a low over such a short time period, and usually at this state, the economy has already created over one million new jobs — during this extremely flashy move, the U.S. has shed 2.5 million jobs (as may as were lost in the entire 2001 recession).

Do you really think there’s huge upside here? After a 60% run to the upside?  Laszlo Birinyi does and sees 1200 before year end. I’d rather sit this one out. The downside is a lot greater at these levels than the upside. I would say lighten up on risk all around. High quality over low quality. Low beta over high. Consumer staples over discretionary.

But, if you are not going to run with the liquidity-seeking-return crowd and chase high beta and low quality stocks or high yield bonds, where do you put funds?  After all, Bernanke and company have made sure cash is trash by lowering rates to zero. 

Here are three ideas.

Government Bonds

Has anyone noticed the yield on treasuries?  It’s falling. For example, a month before Labor Day on 7 Aug the 30-year yielded 4.61, the 10-year was yielding 3.89 and the 5-year got you 2.84 (see 2009 data here).  Today, we are looking at 4.18, 3.40 and 2.38 (data here).

Meanwhile the dollar is getting crushed – approaching parity with the Swiss Franc. Everyone is shouting “recovery, recovery,” as if that’s the reason that the U.S. Dollar is falling. So then, why are government bond yields exploding to the downside even while the U.S. government budget deficit spirals upward?  It doesn’t sound like the bond market is expecting a very robust recovery. Pimco, the world’s largest bond fund, is already in this trade. They have been loading up on treasuries of late – bringing them to their highest relative weight in 5 years.

Gold (or platinum)

As I see it, the U.S. is likely to use the U.S dollar as an escape hatch for a very intractable debt problem.  That is dollar bearish, but not necessarily bearish for U.S.-based treasury investors.  A scenario in which the Dollar tanks and there is a flight to safety in Treasuries is also one in which Gold could outperform at the same time. And Gold has also been surging as well, last trading well over $1000 at $1015.  If you like precious metals as a hedge against a dollar run, then platinum is a good bet as well as it has outperformed gold.

Out of the money puts

If you think this cyclical bull market (aka bear market rally) has legs like Laszlo Birinyi does, why not do a Taleb Black Swan trade via out of the money puts on Spiders (SPX) or QQQQs or some other broad market ETF?  This would be a hedge – and that’s all. The benefit of such a trade is that you don’t have to sell outright. And it is de minimis in cost right now. The VIX, a broader market volatility index, is at a one-year low. So, this insurance bet will cost you less.  But, the decrease in the VIX should also be treated as a contrarian indicator.

Sources

Breakfast with Dave, 17 Sep 2009 – David Rosenberg, Gluskin Sheff

Update: I just noticed that Barry Ritholtz has a post out discussing why he thinks markets can and will go higher. See his comments here.  He makes valid points  – based more on technicals than fundamentals.  On a fundamental basis, the market is overvalued. To the degree you hold Barry’s view that the rally will continue because of liquidity, then you would want to employ the Black Swan strategy I mentioned as a hedge against downside risk.

Related posts:

• Bill Gross: Sell equities and buy Treasuries
• Way too much risk in the equity market
• Treasurys are getting killed again
• Kass: Bearish on equities
• Marc Faber: "I don’t think that you’ll see gold below $1,000 per ounce probably ever"