Tradesense (a.k.a.Horse Sense)

This Blog was launched on 9th October 2008 just after the beginning of the worst financial crises the world is witnessing and fear seems to be reaching its peak.

Sixthsense investing appears to be the need of the time!! The intention is tickle it every week.


Monday, December 29, 2008

What is the behavior of gold price telling us?

I’ am no gold analyst but it has always interested & perplexed me. It is supposed be a hedge against inflation as also a savior in bad times – depression/deflation scenarios.

A Business Week report explains:

“It can be argued that gold's price spike to a record high of almost $1,030 an ounce last March had more to do with a surge of strength in commodities as a whole than anything specific to the yellow metal. Unable to buck the general sell-off in commodities since the summer, gold sank to a low of $680 in November before rebounding above $800 as the end of the year approached. Now that a new era for commodities seems to have begun—one likely to be characterized by greater price stability—any future gains by gold will have to come on its merits as a perceived safe-haven store of wealth, a hedge against inflation, and as a desirable component of jewelry.

…. cited questions he has received as to whether gold is still a safe haven asset—and if so, why the metal hasn't performed better during the recent economic tumult. Meger believes gold remains a safe haven asset and says it has weathered much smaller percentage decreases in price than have other commodities while avoiding the extreme volatility seen in other financial instruments. In fact, some of the selling pressure has been the direct result of gold's function as a store of wealth with easy liquidity, he points out.

...The true inflection point for gold, however, will come when concerns about deflation give way to inflation worries, Meger predicts.

…..Much like the stock market, which is way ahead of the economy, the price of gold is reflecting the market's belief that the worst of the recession is over, he says.” (all emphasis added)

So the import to me is that gold can be sold in times of chaos & disorder and hence one should invest in it if you expect a major deflation/unemployment/depression scenario. Also in case of expectations of inflation or high-inflation when the value of currency is falling rapidly gold can be a proxy as it is real as against a fiat money (fiat or order by the government that it should be accepted as a means of payment) where it is created out of thin air without any real asset backing it. As the trust in a given currency bursts gold increases in value as it is anticipated that gold can be used as currency for payment of goods & services if the currency fails.

Further this distrust on the fiat currency makes the governments and central banks jittery and more so in the case of US dollar which is a reserve currency for many countries/institutions. The fear that this reserve currency may now change to gold because of the lack of faith in US dollar has lead to manipulation theories where various central banks are supposed to have sold gold in a coordinated fashion to strengthen the US dollar and the spike from July in USD was as a result of this effort which also squeezed the dollar shorts. Gold in other words is an inverted dollar.

Source: gold-eagle.com

What I understand is that the current move up above $800 is due to the weakening of the dollar due to the Fed ratecut to zero levels. However it is expected that ECB and BOE will also follow with their own ZIRP (Zero interest policy) and it would be interesting to watch how US dollar and gold behave thereafter. Also the current geo-political situation in the Gaza-strip and Indo-Pak situation is supposed to have given it a further fillip.

Another point made by the Business Week article referred above is:

“Not everyone favors gold, even as a mere hedge against inflation. Historically, the returns on the physical commodity are miserable, although commodity futures are "somewhat more favorable as a diversifier,"….Those looking to gold as a store of wealth as part of a doomsday portfolio are better off holding gold coins, which they can keep in their physical possession,… "If the worst happens and you want gold because nothing else is worth anything, being able to say 'I have shares in this gold ETF' and going to the vault of a bank to get it out is unlikely to cut much ice…

…Prices of gold coins have spiked in the last six to seven weeks due to a shortage of supply and a jump in demand, even as gold futures prices have come down on the Comex division of the New York Mercantile Exchange. The American gold eagle, one of the three most popular gold coins, is now selling for the spot price of $845 plus a premium of $80 to $100, compared with the usual premium of 4.5% to 6.0%—or $38 to $51…

…That indicates small investors are moving more and more into gold because they're worried about the economy…" (all emphasis added)

So while physical demand has been strong the question that arises is why did gold fall to $680? Manipulation theory explained above has been given by many. It is a fact that paper gold market is 40 times the physical one and the former sets the price. The other reason is the deleveraging or forced selling due to the credit crisis.

So if gold prices are leading indicator what is it behavior telling us about the possible future economic conditions? It appears to be a ‘heads you win-tails you win’ asset class both in a potential inflationary (or hyperinflationary as some think) situation and deflationary or depression conditions – desire to hold gold should be pre-dominant in both situations. In such a situation should not gold prices be already at the levels they are projected to be - $2000+? Why this hesitancy? Is the behavior giving some other signal? Or am I missing something? I look forward to readers’ views and comments.

Disclosures – No Positions

Copyright © 2008 Tradesense

Sunday, December 28, 2008

Financial Crisis - A Humorous Recall

Doing my bit to cheer up after a horrendous 2008. The collection is from various sources on the Internet. Enjoy!






And some India related


Wednesday, December 24, 2008

Japan's Marshall Plan - Write off US Treasury holdings

A Bloomberg report quoting Akio Mikuni president of the rating agency Mikuni &Co. provides a possible way out of the current mess. While he speaks paricularly with respect to Japan, his suggestions can be implemented by other countries which have a major dependence on US for its exports and are heavily invested in US treasuries. He says

1. Japan should waive or write-off US Treasury holdings as it is likely that US government will find it extremely difficult to service.

2. Given the size of its budget deficit and the potential amount of borrowing it needs to do will put tremendous pressure on the dollar which he sees at 50 to 60 Yen if such measures are not taken.

3. Japan also should invest in the infrastructure, roads and bridges that US plans to help create jobs and support personal spending.

4. Such 'out of the box approach' is only likely to save countries like Japan which are dependent on US consumers. In this sense it is a current sacrifice to protect the long term interest of the Japanese economy.

Sounds very interesting and if implemented could be challenging for Japan (it has $976.9 billion in foreign-exchange reserves). China may be better placed but given the political angle this may not be possible. The US it appears has to be 'doled out' while its government is busy ''bailing out'! Watch out, as any such move may bring life back to the markets.

Disclosure: No stocks discussed - No Positions

Copyright © 2008 Tradesense

Monday, December 22, 2008

FED@O, Bencopter takes off! Now What? Crash Land??

Welcome to ZIRPistan…the zero interest rate policy world - which promises that the Phoenix would rise from its ashes. Phoenix is

"A mythical bird that never dies, the phoenix flies far ahead to the front, always scanning the landscape and distant space. It represents our capacity for vision, for collecting sensory information about our environment and the events unfolding within it. The phoenix, with its great beauty, creates intense excitement and deathless inspiration." - The Feng Shui Handbook, feng shui Master Lam Kam Chuen

And Bencopter is set out to do a Phoenix.


And for the sake of completeness let me elaborate from the FED Playbook (2003) as to what this means:

“Usually, the Fed attacks weakness in the economy by conducting expansionary open market operations. In a typical open-market operation, the Fed purchases Treasury bills from bond traders in the New York securities market. The effect is to increase liquidity in the economy–cash and bank reserves rise while the number of Treasury bills held by the public falls–and to lower short-term interest rates. Lower interest rates encourage consumption and investment, and greater liquidity provides the means to finance the new expenditures.

Unfortunately, conventional open market operations lose their effectiveness as the yield on Treasury bills is driven to zero. At a zero interest rate, a Treasury bill is no different from vault cash or large-denomination currency. An open-market operation is like the Fed offering to exchange twenty $1 bills for one $20 bill: The increase in liquidity is negligible. Moreover, there is no way to achieve any further reduction in the interest rate. Why would anyone accept a negative return on Treasury bills when they have the option of holding cash, which offers a zero return? With no increase in liquidity and no reduction in the interest rate, there is no reason to expect an open-market operation to produce any increase in household or business spending.

….Policy-makers can find themselves in serious trouble if they come up against the zero interest-rate bound during a period of falling prices–that is, during a period of deflation. That’s because what ultimately matters to households and firms is the real cost of borrowing–what economists call the real interest rate. The real interest rate is the difference between the market, or “nominal,” interest rate and the rate of inflation. It is the prospect of a low real interest rate that makes current consumption and investment spending attractive.
The trouble is, even a zero nominal interest rate can produce an expected real interest rate that is too high if people expect a negative inflation rate.

For example, if prices fall at a 3 percent annual rate, then a zero nominal interest rate puts the real cost of borrowing at a positive 3 percent. The prospect of a 3-percent real interest rate might be just fine in a healthy, growing economy. It will be excessive, however, in an economy where the growth outlook is poor, or where fragile finances have led households and firms to become cautious about spending and banks to become cautious about lending.”

Explaining the various methods of tackling the situation the presentation further explains:

“We finally turn to the simplest strategy: buying other domestic securities. Even if the short risk less rate is equal to zero, other interest rates on other securities will generally be positive, and those securities could be targets for open market operations.

….it’s not necessarily desirable to have the Fed acting in markets for corporate debt or mortgages. Whatever benefits there might be from such actions would have to be weighed against the
cost of putting the Fed in the business of allocating private sector credit–a task for which the Fed has no particular expertise, and which would likely subject the Fed to unwelcome political pressures.

How, then, would this strategy work? Following this avenue, the Fed could purchase any government debt with positive yields–for example, longer-term Treasuries. In broad terms, reducing the supply of these securities forces the private sector to re-balance its portfolio. The yields on the securities whose supply has shrunk must fall, in order to make people content with holding less of them. The prices of these assets, which move in the opposite direction from yields, must rise.

For consumers, the lower yields reduce saving and spur consumption. For businesses, the lower yields can mean a lower cost of funds, while the rise in the assets’ prices can improve businesses’ balance sheets or give them more valuable collateral with which to secure financing.

This strategy, while indeed the simplest to implement, is not without problems:

First of all: No one, we believe, has a good quantitative sense of the mechanics of this strategy–that is, what size operations are needed to secure a given stimulus?

Second, if the short risk less rate is zero, but other rates are positive, those rates must be positive for reasons–to compensate the holders of those assets for some form of illiquidity or risk. Under this strategy, the Fed takes those risks onto its balance sheet.

This leads us to a third point: the
Fed is almost guaranteed to take a capital loss on its portfolio. If the strategy works, the economy picks up, interest rates go up, bond prices go down, and the value of the Fed’s holdings of longer-term Treasuries falls.

Finally, narrowing the yield spread between assets of long and short maturity can stress institutions, such as banks, that profit from that spread. On the other hand, it must be noted, a wave of deflation-induced loan defaults would no doubt also be stressful for banks.”

The document thus clearly spells out the motive, dynamics and the risks involved (all emphasis above is added). It clearly states that for the stimulus to work it has to be sizable and it has very little idea what this size could be. It also agrees that it’s crashing is also certain if the schema works. It is saved only if things do not work! So it appears that either the economy or the Fed has to go!! And if Fed does an open market operation on mortgages, corporate and other debt – where is the place to hide? Ashes are assured.

Incidentally through an array of lending programs, the Fed’s balance-sheet has soared from below $900 billion to more than $2 trillion, and is about to grow further.

The other point it makes is that consumers will spend as the rates are low to save. Even in 2003 the Fed was of the notion that US consumer saves! Given the consumer leverage in US and the pains they have suffered of late (see graphic) it is difficult to envisage that they will go on a spending binge. Credit at lower rates now will be used for refinancing thereby reducing the interest burden. Any surplus due to interest resets and lower prices of gas etc. is likely to be saved. If you thought develeveraging is done – watch when the consumer develeveraging accelerates.

And as regards the asset prices on balance sheets of business – the root cause of this crisis is that as no body knows the value of these assets. It is also clear that Fed had not envisioned that the this problem will involve bank assets in such large proportions that despite infusing substantial capital the tendency to hoard will be higher than to lend.

So while money supply has been added the willingness to lend is not perking up as the banks themselves are not too sure where the value of their assets stands now and more importantly what the value in future would be. They will require to fill future holes and hence the loss of appetite to lend. Therefore any addition to money base without the money flowing in the credit channel (velocity of money) is no good. On the other hand by not lending the banks are again creating potential holes in their traditional lending books as this will lead to businesses failing. Also the tightening of the credit norms is leading to further slowing of the money flow (see graphic).


In the context of Japanese experience I found this interesting snippet which is something one needs to watch out

“In Japan, these interventions have left the Postal Savings Fund insolvent as public money was used to support the JGB (Japanese government bond) market. Financial institutions were encouraged to hide their losses and even employees from the Ministry of Finance were installed in some cases engaging in loss postponing transactions of every kind. Major life companies were told not to hedge their risks for fear that this would make the markets decline even further…..”

In this sense the banks can find their balance sheets a little repaired as a result ZIRP. The MTM or mark to market losses on their debt portfolio will stand reduced or even show profits as interest rates fall across maturities and across many issuers. This will also help plug some pension fund holes with low discount rates. Remember this just a balance sheet date window dressing aided by Fed. Closely watch out as to how the pension funds handle the situation globally. From the reports I have been reading a sudden collapse cannot be ruled out. It also appears the pressure on banks to constantly raise capital to keep the capital adequacy ratios within acceptable limits is also going to be high.

Further are we at beginning of ‘carry trade V.2’? The pronouncement of ZIRP clearly provides such an opportunity especially with respect to emerging markets. In fact the foreign portfolio investment flow seems to have positive in December in markets like India mainly due to this factor and has propped up its market. As a result INR has also appreciated which is a double whammy for these traders. What it means for the future? We are already aware of the unwinding effects.

Imminent fallout of ZIRP is the depreciation of USD. Bernanke has espoused his thought very lucidly in early part of this century as to how deflation can be tackled in a “fool proof” manner using currency depreciation. (The dollar fell 3.9 percent to $1.3912 versus the euro on Friday from $1.3369 on Dec. 12, its fourth straight weekly drop. It slumped to a 12-week low of $1.4719 on Dec. 18. The dollar dropped 2.1 percent to 89.31 yen from 91.21, falling to 87.14 yen on Dec. 17, the lowest level since 1995. The euro increased 2 percent to 124.22 yen from 121.83).

“Even if the nominal interest rate is zero, a depreciation of the currency provides a powerful way to stimulate the economy out of the liquidity trap. A currency depreciation will stimulate an economy directly by giving a boost to export and import-competing sectors. More importantly, a currency depreciation and a peg of the currency rate at a depreciated rate serves as a conspicuous commitment to a higher price level in the future, in line with the optimal way to escape from a liquidity trap discussed above. An exchange-rate peg can induce private-sector expectations of a higher future price level and create the desirable long-term inflation expectations that are a crucial element of the optimal way to escape from the liquidity trap.

In order to understand how manipulation of the exchange rate can affect expectations of the future price level, it is useful to first review the exchange-rate consequences of the optimal policy to escape from a liquidity trap outlined above. That policy involves a commitment to a higher future price level and consequently current expectations of a higher future price level. A higher future price level would imply a correspondingly higher future exchange rate (when the exchange rate is measured as units of domestic currency per unit foreign currency, so a rise in the exchange rate is a depreciation, a fall in the value, of the domestic currency). Thus, current expectations of a higher future price level imply current expectations of a higher future exchange rate. But those expectations of a higher future exchange rate would imply a higher current exchange rate, a current depreciation of the currency. The reason is that, at a zero domestic interest rate, the exchange rate must be expected to fall (that is, the domestic currency must be expected to appreciate) over time approximately at the rate of the foreign interest rate.”

The depreciating currency helps the export sector and import-substitute sector while making imports expensive and hence adding to the inflationary pressure. It will also help those corporates with large overseas operations/profits to shore up profits in USD and their balance sheets with lower translation losses.

However a falling currency also makes the yield expectation higher. Can an economy that is essentially funded by foreigners afford flight of capital? Given last one year’s experience the US risk perception is not the same. What will be the country deleveraging effect? Given the level of quantitative easing/open market operations envisaged if and when the treasury bubble bursts – Fed could be bankrupt overnight.

Further such devaluation puts pressure on other countries to follow competitive devaluation policies and lower interest rates. Imagine all economies that matter at zero rates!! These competitive tendencies could lead to threat of protectionism. This more so for export oriented economies that apart from facing slower/lower demand have to face up to such currency volatility related issues. Local political pressures build up as jobs are lost and plants are shut. The temptation to throw trade barriers is very high. As Economist notes:

“Few fear a return to the punitive tariffs of the Depression, but Richard Baldwin, policy director of the Centre for Economic Policy Research, a research network, notes that during the Asian crisis in the late 1990s, some of the afflicted countries raised tariffs and rich countries responded with higher anti-dumping fees. It could be worse this time, he believes, because the crisis is more widespread. India, Russia and Vietnam have raised tariffs already this year. Trade litigation has also picked up. Mr Baldwin says the number of anti-dumping cases jumped by 40% in the first half of 2008.

Tariff increases may be the protectionist’s barrier of choice, despite limits agreed by members of the World Trade Organisation (WTO). This is because in the past decade many countries have unilaterally cut tariffs to well below those limits. They have plenty of room to raise them without breaking any rules.

If all countries were to raise tariffs to the maximum allowed, the average global rate of duty would be doubled, according to Antoine Bouet and David Laborde of the International Food Policy Research Institute in Washington, DC. The effect could shrink global trade by 7.7%.

There are other, more subtle, means of protection available. Marc Busch, a professor of trade policy at Georgetown University in Washington, DC, worries that health and safety standards and technical barriers to trade, such as licensing and certification requirements will be used aggressively to shield domestic industries as the global downturn drags on.”

So what is Fed trying to do? We have known that easy money and more debt did nothing but cause a greater problem down the road.

When you have a drug (Credit) addict you cannot withdraw as the withdrawal effects are violent & traumatic and could be fatal. So you keep administering the same drugs for some time as you talk through to make him/her mentally ready for the withdrawal trauma. And then you slowly start reducing the drug step by step. Obviously the ‘highs’ that were reached are now totally out of question. The process is painful and long. The cure too is uncertain. There will be lots of ups and downs. But if the addict has made up his mind to reform and is willing to withstand the agony, sure there is way – but it needs a lot of patience and very long term view.

Disclosure: No stocks discussed – No Positions

Copyright © 2008 Tradesense

Monday, December 15, 2008

Inverted Reasoning and Market Reversals & Bottoms

The market action last week was very encouraging and optimistic. The fact that it moved up ignoring all critical bad news has given a lot of hope to market players. Many believe that a reversal has happened and that we are on our way with a recovery rally – a rally that signifies that the bottom made in November ( in October in some markets like India) is now a significant long term bottom and that we shall now be moving on with a higher bottom kind of market movement.

I have here tried to think through this process of a market rally in the wake of significant bad news and, its interpretation that all major players who were to sell have done so. The bears therefore are now exhausted giving opportunity to the bulls to come out show their valor. But is there a case for inverted reasoning here? Let’s explore.

As the market tanks in value in a bear situation, after significant fall the scope for bears making money becomes lesser and lesser as the buyers become scarce and bids for reasonable volumes come at much lower prices than in normal situations. This increases the risk for bears and the expected risk- adjusted returns may not justify further activity. The bears at this time start to withdraw and start to give bulls a sort of psychological advantage. In the current situation, if we assume that the forced selling is more or less done then the bears have more reason to hold back as the risk-return equation is distorted even more. This means that the bears now need some reasonable up move for the risk-reward to shift in their favor.

But the question is if the forced selling is almost done what will give them the ammunition to fire? Just a technical position – overbought situations or is there something else? If the play for them till now was forced selling or deleveraging and if it has been done (which I’ am still not too comfortable assuming) then where will their deliverance come from? Well to me it is the economy! the global economy. As I see it even if the forced selling is discounted in the market, the state of emerging global economy is not. While one may argue that it was economic news that was overridden, the prime reason for its neglect appears more technical - the bears wanting better and more blood.

This is also because I believe the forced selling is happening in different markets. For example it is reported that the sell-off in the leveraged loans market over the past month has been particularly bad.

“The primary draw of leveraged loans for the pros: When a company defaults on its debt, holders of bank loans, which have certain of the borrowers' assets and/or stock pledged as collateral, are higher up in the capital structure and generally get paid before holders of unsecured debt and equity holders. And these loans can be bought at sharply discounted prices, around 65 cents on the dollar on average, say fund managers.

That's the main reason for the dramatic drop in prices for bank loans, which are down 20% to 25% in the last 120 days, loss rates not seen in 25 years, he says. "It is not reality-based in terms of what I focus on," which is mostly companies' ability to repay their debt and, if they can't, what the reasonable chances are of the fund recouping most of its investment.

"If 100% of the companies in our portfolio went bankrupt tomorrow, our historic recovery would be 70%, which is above where they're currently trading," about 65¢ on the dollar, he says. There's nothing about the companies in his portfolio that warrants their trading 25% down from where they were last summer, he adds

One indication of the high level of risk involved in leveraged-loan investments: the growing possibility that a number of firms that go bankrupt will be liquidated instead of reorganized. (Emphasis added)

Hedge funds, which now hold more secured loans than banks, have less incentive to see a company whose debt they hold restructured, and are more likely to push a company that defaults on its debt into liquidation, says Martin Fridson, chief executive of New York-based Fridson Investment Advisors. Those odds are even greater if hedge funds have shorted the subordinated debt and stand to make more money from liquidation. Liquidations require the approval of all classes of shareholders and creditors, however, and unsecured bond holders could vote to block it, he adds.

But Standard & Poor's said in an Oct. 23 report that "liquidation is becoming more likely in default and recovery scenarios, with market conditions making the financing needed for companies to emerge from bankruptcy as going concerns increasingly scarce." S&P drew special attention to constraints on debtor-in-possession, or DIP, loans, which typically are used to pay vendors and cover a company's ongoing operating costs.”

Apart from the forced sales angle - this is really scary from an economic point of view – see the emphasized part of the excerpt above.

The current situation and the responses are unprecedented and much of what is theory is being tried out. I believe it is far too early for the market as a whole to be able to fathom the depth and possibility of outcomes of a series of measures being taken by various national governments/central banks and how these measures will interact to bring about global systemic changes. And there are quite a few pointers to this.

1. Given the enormity of global problems that the failure of the big 3 can be bring, more than the economic arguments it was the partisan north-south US politics played a greater role. This also brings out the uncertainty of the current political process to address other critical issues in a timely, focused and result oriented manner. And imagine this political behavior across all the countries!

2. This is further buttressed by the way the much touted US bail out package (TARP) is being handled. The incendiary report to congress has a lot to say.

“Is the Strategy Helping to Reduce Foreclosures? What steps has Treasury taken to reduce foreclosures? Have those steps been effective? Why has Treasury not generally required financial institutions to engage in specific mortgage foreclosure mitigation plans as a condition of receiving taxpayer funds? Why has Treasury required Citigroup to enact the FDIC mortgage modification program, but not required any other bank receiving TARP funds to do so? Is there a need for additional industry reporting on delinquency data, foreclosures, and loss mitigations efforts in a standard format, with appropriate analysis? Should Treasury be considering others models and more innovative uses of its new authority under the Act to avoid unnecessary foreclosures?”

The point being made is that people handling the bail out seem to have very little idea or strategy and are ad-hoc at best. How will the results be? Again imagine so many packages being executed all over the world!

And it is not easy to execute packages with so much moral dilemma. As Jim Roger says:

"What is outrageous economically and is outrageous morally is that normally in times like this, people who are competent and who saw it coming and who kept their powder dry go and take over the assets from the incompetent," he said. "What's happening this time is that the government is taking the assets from the competent people and giving them to the incompetent people and saying, now you can compete with the competent people? It is horrible economics."

3. Now coming to the issue that mothered the current crises – the US housing sector. According to a Reality Trac report:

“Foreclosure activity in November hit the lowest level we’ve seen since June thanks in part to recently enacted laws that have extended the foreclosure process in some states, along with more aggressive loan modification programs and self-imposed holiday foreclosure moratoriums introduced by some lenders,” said James J. Saccacio, chief executive officer of RealtyTrac. “There are several indications, however, that this lower activity is simply a temporary lull before another foreclosure storm hits in the coming months.

“Delinquencies on loans not yet in the foreclosure process jumped to nearly 7 percent in the third quarter, a record high, according to the Mortgage Bankers Association,” Saccacio continued. ”And more than half of the homeowners who received loan modifications to reduce monthly mortgage payments in the first half of 2008 are already delinquent on their loans again, according to the U.S. Office of Thrift Supervision. Many of these delinquencies could turn into foreclosures next year.”


Why so many re-defaults? The questions being asked are:

“Is it because the modifications did not reduce monthly payments enough to be truly affordable to the borrowers? Is it because consumers replaced lower mortgage payments with increased credit card debt? Is it because the mortgages were so badly underwritten that the borrowers simply could not afford them, even with reduced monthly payments? Or is it a combination of these and other factors?”

That question “has important ramifications for the foreclosure crisis and how policymakers should address loan modifications, as they surely will in the coming weeks and months….”

4. Further it looks like the beach communities are likely to join the party soon with Jumbo Defaults. To quote:

”Jumbo Prime are high-leverage programs that allowed borrowers to buy much more home than they should have. Because Jumbo Prime borrowers had better credit overall, banks were very easy on the qualifying.

…It goes hand in hand with the Moody’s downgrade of many Bank of America Jumbo Prime deals citing a 13% delinquency rate. This represents a total meltdown in the sector happening right now that nobody is reporting.

…..Now that the raters are reporting such massive default rates, I am going to officially say that the ‘Jumbo Implosion’ is upon us. The sad part is (ex-Countrywide) BofA was one of the better lenders during the bubble years. In my opinion, it was much more conservative than Wells Fargo, Citi, Chase, Wachovia or WaMu.

These programs offered by most of our nations largest banks allowed a considerable amount of leverage when purchasing or refinancing. These are the ultimate ‘walk away’ loan, as a household income of $85k per year could legitimately buy a $650k home with 5% down during the bubble years. With stated, no ratio and no doc available at a slightly higher rate, many didn’t even need $85k. Now that home is worth 25-70% less and borrowers are making the wise decision to walk away given most their after-tax income is going towards this massively depreciating asset.

Analysts are not taking into consideration how much trouble the American economy will be in across the nation when those middle to upper class home owners all over the nation see their prices fall as much as the lower end has. This will happen - it has to.”

Looks like the key problem still remains and if these have been discounted today’s prices is anybody’s guess.

5. Talking about collateral damages I don’t know how many have figured this out. Says one report:

“In its quarterly report, the BIS warned the US Federal Reserve, the Bank of England and other central banks that near-zero interest rates and emergency monetary stimulus may come at a cost.

By opening the cash spigot, the authorities risk displacing the money markets and may "discourage banks from lending to other banks".

The money markets are a crucial lubricant for the financial system, but they cannot function if rates fall too low. The sector can wither away, as Japan discovered during its "Lost Decade".
…worldwide issuance of bonds and securities has also gone into freefall, plummeting 77pc from over a trillion dollars to $247bn in the third quarter…

The collapse in bond issuance reflects the near-total closure of the capital markets in the late summer as credit spreads surged. Bonds issued in Euros dropped by 94pc from $466bn to $28bn over the quarter."

6. The fact that Fed is likely to issue its own bonds has its own collateral ramifications. Would the price start reflecting the way Fed is performing? Would it be a call on its policies, execution capabilities and the risk in the assets it purchases using the proceeds? If this happens and if the past track record of Fed performance is any indication it would be a grand stage to watch.

Government backing may help but as seen now the yield on government backed issues of banks are higher than the Treasury securities.

7. China is emerging as bigger joker in the pack than was previously imagined. According to this informed article:

“But veteran Hong Kong economist Jim Walker, the director of the Asianomics research firm, believes investment cycles don't slow -- they disintegrate. Although Beijing will try to keep building public infrastructure, Walker's research indicates that a steep decline in private-sector demand from Europe and the U.S. will lop 7.5 percentage points off gross domestic product growth in 2009.

Walker thinks a crash in domestic consumption will lop an additional 2.5 percentage points off GDP growth. Thus Walker's best-case scenario is in the 0%-to-4.5% range, and he puts 30% odds on a contraction. "There has been an outrageous over-investment in property and factories, and much will be unwound," he says. The economist also believes that the growth in Chinese domestic consumption has been overblown and that despite a 50% decline this year, the Chinese stock market remains grossly overvalued. “

Russia too is hearing the D word according a Business Week report. According to it “In comments cited in The Moscow Times, leading Russian economist Evgeny Gavrilenkov warns that if the latest government figures are accurate, they mean that Russia is now heading into a “severe depression”.

8. Are we looking at the death of OPEC. Many of the governments in these countries and those like Russia had national budgets at oil prices well above the current levels and are in deep trouble. It can only balance its current accounts and budget at around $70, according to its finance minister’s own estimates. Further highlights:

“Politicians in oil-producing countries have gotten used to oil revenue providing the bulk of the national budget, enabling them to keep taxes low and expand services. In Iran, for example, oil revenue provides between 40% and 80% of the national budget, depending on which oil industry analyst you believe. In Nigeria, oil and natural-gas revenues account for 85% of government revenue.

According to PFC Energy a consulting firm the United Arab Emirates, Algeria and Qatar would be the only OPEC nations able to balance their accounts in 2009 with oil below $50. Saudi Arabia would need oil prices just over $30 a barrel, according to Merrill Lynch, or slightly more than $50 a barrel, according to PFC Energy.

In contrast, Iran needs a price of $90 to $100 a barrel to break even in 2009. And because of President Hugo Chavez’s soaring spending on social programs, Venezuela needs an oil price somewhere between $60 and $120 a barrel; the consensus seems to be somewhere around $90. On Nov. 24, Chavez told a news conference that $80 to $100 a barrel would be a fair price.”

Makes you wonder if in the current economic turmoil if the countries concerned will be able to reduce or cut expenditure when the call of the day is to increase it like never before. So the question then is how long before oil prices catch up for these countries to balance budgets - a 2mn. barrel per day cut could not help stem the prices (It is well known that the compliance of these cuts by OPEC members is low). Or will middle-east countries see taxation become an important tool? The internal dynamics of OPEC is changing rapidly.

And as far oil demand and off take is concerned, Bloomberg reports that storage of oil in land is very tight and that producers are hiring tankers to store them.

9. As a fall out of the economic crisis and the mistrust the financial system and its guardians have created, Nassim Taleb the celebrated author of the book Black Swan talks of Capitalism 2 in which societies will not depend upon asset values any more!! As one commentator to this talk points out:

“Mr. Taleb has his mind around this present market morality play presented by the usual cast of self proclaimed financial charlatans... This tragedy Taleb correctly points out is another in a series of blow ups brought to us since he first experienced the 1987 incarnation of financial magical thinking in London...The Salmon Bros blow up that Warren Buffett helped mitigate at great personal risk seemed to be a remake or at least a knock off of 87 ... a ludicrous estimation of risk by people with PhD’s and fuzzy models... This same group of mathematical elves marched Hi Ho Hi Ho right into LTCM with the same lame theories Greek lettered disastrous result... Now a recent set of variants of that same sort of magical thinking has produced CDO's CDS's and a host of other alphabet soup sows ears... These seem have the potential of marching us all toward living in caves and bartering with loaves and fishes...”

The import I believe is that the in future risk will be profiled giving a lot of weight to distrust on corporate reporting, assets and cash flow values which when factored-in through PE multiples or discount rates are not going to be very comparable to historical averages.

Disclosure: No stocks discussed - No Positions


Copyright © 2008 Tradesense

Monday, December 8, 2008

Has the market discounted all bad news? - A reality check

Optimism is back! US market last week claimed victory of sorts - except for Monday it was a winning streak on all days despite weak economic data and corporate news. And the icing on the cake was on Friday when despite a horrible employment data the markets shed its losses and gained substantially. Friday did not see the kind of panic one would have expected given the margin of surprise and the change of mind happened quicker than one would have expected. It was as if to indicate that the pressure on the government/s to do more and fast is going to so high that they will start delivering sooner than later. Market watchers are interpreting last week’s market behavior despite a slew of bad news clearly as an indicator that most bad news is in the market.

We also have UBS & Goldman providing upbeat reports with sizeable market rally expected by the second half of 2009, albeit according to them the markets may see some downside before doing that. According to Goldman the investors are likely to price-in a short deflation before the market moves up by second half. A downside of 20 to 30% is also seen as possibility as investors price it in.

This to me appears to be a conspiracy of optimism. Have the markets really discounted all possible bad news? Does the market have enough information today to discount even a possible deflation – short-lived or otherwise? And that all such bad news will be discounted in the next six months to see a low by then and then see the up move coming?

Given that US markets are setting the tone for all other markets lets take a closer look.

While I do not have the resources and tools to make this kind of judgment (which some of these institutions probably have) I explored available public information to check if this may be a possibility. This list of by no means is exhaustive. The judgment, if the implication of these have been discounted or is likely to be discounted in the next six months – I leave it to you.

1. The NYT notes the bad employment numbers do not include people who are under-employed or who have simply stopped looking for work. Counting those folks would nearly double the November unemployment tally, putting it at 12.5 percent instead of 6.7 percent. President-elect Barack Obama called for public spending to solve the crisis, but the Times says Obama's vague plan to create 2.5 million jobs would "barely recover the jobs that have disappeared over the last year," given the accelerating losses.

2. The big (little!) three may ultimately require $75 to $125bn. If the government does not help they would file for Chapter 11, a restructuring, but it would likely turn into a Chapter 7, a liquidation. Their factories and other operations would be shut down and their assets sold to pay creditors – Mark Zandi of Economy.Com in his testimony to senate banking committee.

3. A record one in 10 American homeowners with a mortgage were either at least a month behind on their payments or in foreclosure at the end of September as the source of housing market pressure shifted from risky loans to the crumbling U.S. economy. The jump has been steep – from 7.3 percent to 9.2 – year on year for the quarter ended June 08 as per reports. Is there a redemption to this problem in the near term is the question.

4. According to a news letter that I receive – an analyst from Oppenheimer and Co. stated that...

We expect available consumer liquidity in the form of credit-card lines to decline by 45 percent. The credit card market will be 18 months behind the mortgage market and will begin to shrink by mid-2010”. This translates into $2 trillion cut from consumer credit card accounts alone. More on credit cards here.

This newsletter further makes a good point: “We had the dot-com bust. There was a recession, but consumers didn’t really stop spending. They didn’t need to. The value of their homes started moving higher. And that’s when they figured out that they could use a line of credit on their home, and spend more. In the end, the boom we had after the 2001 recession was due to an expansion of credit, not to an increase in wages. The proof is in the pudding, adjusted for inflation, wages are down since the year 2000.”

That is future spending power for you –more job losses, falling wages & no or very less credit. Would interest rate matter unless you are saver? Actually deflation will help.

5. For those who are more analysis oriented - John Mauldin provides support to point 2 above with some excellent graphs in his analysis ‘The Velocity Factor’ which if correct says a lot. While details are available in his report I have taken the liberty of showing some of them.

Notice that the velocity of money fell during the Great Depression. And from 1953 to 1980 the velocity of money was almost exactly the average for the last 100 years. Also, Lacy pointed out, in a conversation which helped me immensely in writing this letter, that the velocity of money is mean reverting over long periods of time. That means one would expect the velocity of money to fall over time back to the mean or average. Some would make the argument that we should use the mean from more modern times since World War II, but even then mean reversion would mean a slowing of the velocity of money (V), and mean reversion implies that V would go below (overcorrect) the mean. However you look at it, the clear implication is that V is going to drop. In a few paragraphs, we will see why that is the case from a practical standpoint.”

Explaining the concept of velocity of money he says:

“Basically, this is the average frequency with which a unit of money is spent. Let's assume a very small economy of just you and me, which has a money supply of $100. I have the $100 and spend it to buy $100 worth of flowers from you. You in turn spend the $100 to buy books from me. We have created $200 of our "gross domestic product" from a money supply of just $100. If we do that transaction every month, in a year we would have $2400 of "GDP" from our $100 monetary base.”

Explaining why the velocity will fall he says:

“…that the Fed will soon move rates close to zero. For all intents and purposes, the markets have already moved there. But is it having an effect on the willingness of banks to lend? Not hardly. Standards for lending are tightening every week. Look at the graphs below. The willingness of banks to make consumer loans is dropping to a 28-year low. And they are tightening standards on all sorts of business loans.”


From an implication point of view it would be impossible for any on make a judgment as to how far this mean reversion could go and how long will it take. The background to this is that banks have already taken a $1trn. hit and more is likely to come. Also, that many of the global big players are now to be run by government and/or their representatives. Proof is here.

6. The scramble for treasury securities is high given the recessionary fear factor and the safe haven it is supposed to provide. The US government has committed itself to more that $7trn. in the form of various packages.

But there is a catch…a dangerous one. Staying on with treasuries will make sense only if you feel that the rescue package/s will not work. If they do than then appetite for risk may come back and may see treasury prices sliding. With yields new zero for 3 month papers and low for longer papers this is at best a capital protection plan if the package/s do not work or are prolonged. But will it protect capital in which case? If the rescue plans do not work the loss of confidence in the government may lead to panic selling. A treasury bubble seems to be in the offing!!

7. And what is the consequence of lower interest rates? Says Macro Man:

“While lower long-term rates may be seen as a boon to spending, they also substantially increase the net present value of pension fund liabilities. Coming at a time when declining asset performance has left a hole in pension funds' balance sheets, lower long term rates make the asset-liability mismatch even worse. Among those funds most adversely affected include, quelle surprise, the defined-benefit plans of the Big 3, who themselves are lobbying for fresh government bailouts.”

Now these are the collateral damages I have mentioned in my previous posts. Market needs to know and understand all such possible future consequences.

8. The geo-political risks worldwide have increased since the Mumbai attacks. According to NYT report - “… by the time the crisis finally ends, foreign policy experts say, the fallout may have expanded to include the United States, NATO, Afghanistan and Iran.”

This a point I have made in my previous posts already and the dimension of this seems to expanding.

9. One writer has the following to say when telling folks that it is time to buy:

But before you rush to write checks, please remember that you shouldn't put money into stocks or houses or other investments unless you can do it while adhering to the three eternal verities of financial survival. They are: Live within your means or below them; shun credit card debt like the plague it is and don't borrow except for an education, a home or a car; and use your house as a place to live, not as a cash machine or a get-rich-quick scheme.

In addition, don't start investing until you've accumulated an adequate reserve fund. To me, that means enough to cover your bills for at least three months if you (and any other employed people in your household) lose your job (or jobs).

You need to have staying power. Don't borrow to buy stocks. Don't use your eating money or next year's college tuition money to buy stocks. Don't bet on having a much better year financially than you're having now unless there are special circumstances, such as being a medical resident about to become a practicing physician. Invest only money that you can afford to tie up for years, if not decades, and that you can afford to lose.”

After what you have gone through in the last 12 - 18 months how many will have the surplus after providing for all of the above, without stretching yourself and have the psyche for tying up money for years?

The next true up move will happen when the proportion of those who can do so increases substantially. When? Your guess is as good as mine.

Disclosure: No stocks discussed – No Positions


Copyright © 2008 Tradesense