Friday, February 4, 2011
- Change in Private Payrolls (Jan) M/M 50K vs. Exp. 145K (Prev. 113K)
- Change in Manufacturing Payrolls (Jan) M/M 49K vs. Exp. 10K (Prev. 10K)
- Seasonally adjusted U-6 underemployment 16.1% from 16.6% previously
- Much more importantly, Not-seasonally adjusted U-6 surged from 16.6% to 17.3%!
- The civilian labor force declined from 153,690 to 153,186
- Government workers: from 20,759K to 20,740K
- Labor force participation at 64.2%, the lowest since March March 1984
- Part-time workers for economic reasons: 8,407
- Part-time workers for non-economic reasons: 17,552
- Birth/Death adjustment: -339,000
Thursday, February 3, 2011
ISM Non-Manufacturing Price Paid Index hits highest level since Sept 2008
from Zero Hedge:
The January non-manufacturing ISM came at 59.4, higher than expectations of 57.2, and compared to 57.1 previously. From the report: "The Non-Manufacturing Business Activity Index increased 1.7 percentage points to 64.6 percent, reflecting growth for the 18th consecutive month and at a faster rate than in December. The New Orders Index increased 3.5 percentage points to 64.9 percent, and the Employment Index increased 1.9 percentage points to 54.5 percent, indicating growth in employment for the fifth consecutive month and at a faster rate. The Prices Index increased 2.6 percentage points to 72.1 percent, indicating that prices increased at a faster rate in January. According to the NMI, 13 non-manufacturing industries reported growth in January. Respondents' comments are mostly positive about business conditions; however, they still remain cautious about the sustainability." But why cautiousness- this is after all the 18 consecutive months of growth? Or is someone concerned what happens when Gen Ben closes the floodgates? With the dollar jumping on the results and stocks falling, it goes to show just how irrelevant economic data is for the bizarro stock market. And yes, prices paid jumped from 69.5 to 72.1, the highest since September 2008. Nothing to see here.
from The Economist:
It's a contentious issue whether or not pension liabilities should be included in state or sovereign debt measures, in addition to outstanding bonds. Despite America and Europe’s onerous entitlements, these promises are not included in their debt figures, though rating agencies claim to account for entitlements when they give sovereign debt ratings. But these promises are accounted for differently than other obligations because future entitlements are subject to revisions. Here's Moody’s, on how they factor different sources of debt into ratings:
How likely is the debt to rise abruptly due to a shock or crisis of some kind? The structure of the debt matters, especially from a liquidity risk standpoint. We attempt to differentiate between dangerous and benign debt structures. Dangerous debt structures are characterized by a lack of granularity (front-loaded debt, or a very uneven repayment schedule), and different types of indexation (to interest rates or exchange rates).Governments have the option of cutting back on pension or health benefits, and this partially justifies why entitlements usually aren't lumped with other promises. Benefit cuts are a form of default; it's perhaps not as damaging as missing a bond payment, but it is still not delivering on a promised payment. There's also a limit to how much benefits can be cut and taxes increased (most politicians will not leave their elderly population destitute), so at a certain point paying entitlements could mean other obligations are not paid. I am not sure exactly how entitlements should be included, but it seems they should be in some way
Likewise, debt can rise abruptly when, for instance, a government has to take the cost of a banking crisis onto its balance sheet. It is therefore important to assess the degree of conditionality of liabilities – actual financial debt obligations should be weighted much more heavily than contingent ones (such as the risk of a banking sector bail-out) or even more implicit, longer-term liabilities (such as unfunded pension liabilities). Indeed, contingent liabilities must be discounted by their likelihood of materialization – which is easier said than done – and future liabilities should be taken into account only in so far as we can appreciate their cash impact.
The point here is that we take into account implicit liabilities such as public pension system deficits only to the extent that they will materialize into an actual debt or payment obligation; governments have many ways to alter the net present value of pension liabilities, such as postponing retirement age, increasing contributions and lowering pensions.
But pension promises from American states should be in a different category than Social Security or Medicare. Pension and health benefits in many states are guaranteed by the state constitutions. That means reducing benefits is very difficult, if not impossible. According to Josh Rauh and Robert Novy-Marx that guarantee means that states may default on their municipal debt before they don't pay or reduce state benefits. It suggests that state pension obligations should not only be factored into ratings, but they should also be included when states calculate their outstanding debt.
from Zero Hedge:
It seems like so long ago that we noted that cotton was up over 17% year to date. Alas it was yesterday. Yet the time-lag effect is not surprising considering that less than 24 hours following our initial report cotton is now up 23% YTD, or a 5% pick up in one day! This was yet another limit up day for one of the world's most popular commodities, which closed at $169.72, a 150 year high. The reason, per Reuters, for the relentless surge in cotton's price is Asian mills: "It's basically mills panicking," said Lou Barbera, a cotton analyst for brokerage VIP Commodities. "Overseas mills are getting the ball rolling." In reality, mills are just one part of what is rapidly becoming a perfect storm for a commodity which will soon destroy margins for all mid-tier retailers: "Powerful cyclone Yasi in Australia also worried the market because it would hit prime cotton-growing areas. Losses there could further crimp supplies in Asian markets, dealers said. Sharon Johnson, senior cotton analyst at brokerage Penson Futures in Atlanta, said it is "possible there's a squeeze" in the U.S. cotton market."
And as if that was not enough, here are the catalysts for the immediate future, which may well continue pounding cotton limit up day after day:
On Thursday, the market will look at the U.S. Agriculture Department's weekly export sales report to gauge demand for U.S. cotton.No matter what the reason, we wonder how long before the Fed realizes that its CPI indicator is a complete joke when juxtaposed witch charts such as these:
The market will then turn its attention to industry group the National Cotton Council of America which will release its annual plantings survey for cotton at its annual meeting in San Antonio, Texas on Friday.
A Reuters survey at the Beltwide Cotton conference this month had forecast U.S. 2011 cotton plantings from 12.48 million to 12.53 million acres, a 5-year high and an increase of around 15 percent from last year's cotton sowings of 11.04 million acres.
Tuesday, February 1, 2011
This is good, but is a slight beating of expectations worth 17 points for the S&P 500?
The January ISM Manufacturing M/M 60.8 vs. Exp. 58.0 compared to the previous print of 58.5. Yet the key metric that everyone is focusing on is the surging Price Paid number, which hit a 2 year high 81.5 (73.5 expectations): the highest since July 31, 2008! The corporate margin collapse is about to cripple Q1 numbers, and at this point it is only a matter of time before even sell-side analysts are forced to aggressively lower their S&P EPS estimates.
Wow! There is tons of good material in this week's newsletter from John Mauldin:
Recent Predictions ...From time to time, it is our practice to take a look at our predictive hits and misses in an important market phase. I’ll try to keep it brief: how did our prognostication skill stand up to Pavlov’s bulls? Well, to be blunt, brilliantly on general principle; we foretold its broad outline in my 1Q 2009 Letter and warned repeatedly of the probable strength of Year 3. But we were quite disappointing in detail.
The Good News ...For someone who has been mostly bearish for the last 20 years (of admittedly generally overpriced markets), I got this rally more or less right at the macro level. In my 1Q 2009 Letter, I wrote, “I am parting company with many of my bearish allies for a while ... we could easily get a prodigious response to the greatest monetary and fiscal stimulus by far in U.S. history ... we are likely to have a remarkable stock rally, far in excess of anything justified by either long-term or short-term economic fundamentals ... [to] way beyond fair value [then 880] to the 1000-1100 level or so before the end of the year.” As a consequence, in traditional balanced accounts, we moved from an all-time low of 38% in global equities in October 2008 to 62% in March 2009. (If only that had been 72%, though, as, in hindsight, it probably should have been.) In the same Letter, I said of the economy, “The current stimulus is so extensive globally that surely it will kick up the economies of at least some of the larger countries, including the U.S. and China, by late this year ...”
On one part of the fundamentals we were, in contrast, completely wrong. On the topic of potential problems, I wrote, “Not the least of these will be downward pressure on profit margins that for 20 years had benefited from rising asset prices sneaking through into margins.” Why I was so wrong, I cannot say, because I still don’t understand how the U.S. could have massive numbers of unused labor and industrial capacity yet still have peak profit margins. This has never happened before. In fact, before Greenspan, there was a powerful positive correlation between profit margins and capacity in the expected direction. It is one of the reasons that we in asset allocation strongly suspect the bedrock on which these fat profits rest. We still expect margins to regress to more normal levels.
On the topic of resource prices, my long-term view was, and still is, very positive. Not that I don’t expect occasional vicious setbacks – that is the nature of the beast. I wrote in my 2Q 2009 Letter, “We are simply running out of everything at a dangerous rate ... We must prepare ourselves for waves of higher resource prices and periods of shortages unlike anything we have faced outside of wartime conditions.”
In homage to the Fed’s remarkable powers to move the market, I argued in successive quarters that the market’s “line of least resistance” was up – to the 1500 range on the S&P by October 2011. That outlook held if the market and economy could survive smaller possibilities of double-dips. On fundamentals, I still believe that the economies of the developed world will settle down to growth rates that are adequate, but lower than in the past, and that we are pecking our way through my “Seven Lean Years.” We face a triple threat in this regard: 1) the loss of wealth from housing, commercial real estate, and still, to some extent, the stock market, which stranded debt and resulted in a negative wealth effect; 2) the slowing growth rate of the working-age population; and 3) increasing commodity prices and periods of scarcity, to which weather extremes will contribute. To judge the accuracy of this forecast will take a while, but it is clear from the early phases that this is the worst-ever recovery from a major economic downturn, especially in terms of job creation.
And the Bad News ...We pointed out that quality stocks – the great franchise companies – were the cheapest stock group. Cheapness in any given year is often a frail reed to lean upon, and so it was in 2009 and again last year, resulting in about as bad a pasting for high quality as it has ever had. We have already confessed a few times to the crime of not being more open to the beauties of riskier stocks in a Fed-driven market. And in the name of value, we underperformed. Reviewing this experience, we feel that it would have been reasonable to have shifted to at least an increased percentage of risky investments after March 2009, because some of them, notably emerging market equities, did have estimates almost as high as quality. In fact, some were well within the range of our normal estimating error, although, of course, quality stocks were not only the least expensive, they were also the least risky, often a formidable combination. But even if we had made such a move at the lows, more extreme value discrepancies by early 2010 would have compelled us to move back to our present position – heavily overweight quality stocks – that we have carried for several years. Our sustained heavy overweight in quality stocks in 2009 was painful, intellectually and otherwise. Our pain in 2010 was more “business as usual,” waiting for the virtues of value to be revealed. The saving grace is that, although value is a weak force in any single year, it becomes a monster over several years. Like gravity, it slowly wears down the opposition.
The fundamentals have also worked against quality, with lower quality companies and small caps posting better earnings. They typically respond better to Fed-type stimulus. But like other components of value, profit margins always move remorselessly back to their long-term averages, or almost always.
January 2011So, where are we now? Although “quality” stocks are very cheap and small caps are very expensive (as are lower quality companies), we are in Year 3 of the Presidential Cycle, when risk – particularly high volatility, but including all of its risky cousins – typically does well and quality does poorly. Not exactly what we need! The mitigating feature once again is an extreme value discrepancy in our favor, but this never matters less than it does in a Year 3. This is the age-old value manager’s dilemma: we can more or less depend on quality winning over several years, but it may well underperform for a few more quarters. We have always felt we should lean more heavily on the longer-term higher confidence.
As a simple rule, the market will tend to rise as long as short rates are kept low. This seems likely to be the case for eight more months and, therefore, we have to be prepared for the market to rise and to have a risky bias. As such, we have been looking at the previous equity bubbles for, if the S&P rises to 1500, it would officially be the latest in the series of true bubbles. All of the famous bubbles broke, but only after short rates had started to rise, sometimes for quite a while. We have only found a couple of unimportant two-sigma 40-year bubbles that broke in the midst of declining rates, and that was nearly 50 years ago. The very famous, very large bubbles also often give another type of warning. Probably knowing they are dancing close to the cliff and yet reluctant to stop, late in bubbles investors often migrate to safer stocks, and risky stocks betray their high betas by underperforming. We can get into the details another time, but suffice it to say that there are usually warnings, sometimes several, before a bubble breaks. Overvaluation must be present to define a bubble, but it is not a useful warning in and of itself.
I fear that rising resource prices could cause serious inflation in some emerging countries this year. In theory, this could stop the progress of the bubble that is forming in U.S. equities. In practice, it is unlikely to stop our market until our rates have at least started to rise. Given the whiffs of deflation still lingering from lost asset values, the continued weak housing market, weak employment, and very contained labor costs, an inflationary scare in the U.S. seems a ways off.
Commodities, Weather, and MarketsClimate and weather are hard to separate. My recommendation is to ignore everything that is not off the charts and in the book of new records. The hottest days ever recorded were all over the place last year, with 2010 equaling 2005 as the warmest year globally on record. Russian heat and Pakistani floods, both records, were clearly related in the eyes of climatologists. Perhaps most remarkable, though, is what has been happening in Australia: after seven years of fierce drought, an area the size of Germany and France is several feet under water. This is so out of the range of experience that it has been described as “a flood of biblical proportions.” More to the investment point: Russian heat affects wheat prices and Australian floods interfere with both mining and crops. Weather-induced disappointment in crop yield seems to be becoming commonplace. This pattern of weather extremes is exactly what is predicted by the scientific establishment. Snow on Capitol Hill, although cannon fodder for some truly dopey and ill-informed Congressmen, is also perfectly compatible. Weather instability will always be the most immediately obvious side effect of global warming.
One last story, which is far from hard science, but to me at least intriguing; I support research being done by the New England Aquarium on the right whale (so called because it was just perfect for catching, killing, and turning into whale oil). We had lunch with the right whale expert one month ago – hot off the press! – and were informed of a new development. Three hundred and fifty or so right whales (out of the remaining population of some 500, down from at least hundreds of thousands), have always shown up in late summer for several weeks of feeding in the Bay of Fundy. This year, for the first time in the 30 years of the study, they were “no shows.” Calling up and down the coast, they were able to locate only 100 of them (all known by sight as individuals; none of which stayed more than a day or two anywhere). It is hoped that their food supply had simply moved to another location. The cause for this is unknown and may take years to be very confident of, but the most likely candidate is that extra cold fresh water run-off from melting ice, mainly Greenland, had shifted currents or interfered in other ways with the location of their food. If indeed the cause were accelerated run-off, then this would be completely compatible with another long-established hypothesis: that extra cold fresh water from Greenland might cool the Gulf Stream, the great conveyor of heat to Great Britain and Northern Europe. If this were in fact the case, then London would wake up and find itself feeling a lot more like Montreal – on the same latitude – than it is used to, producing, for example, the winter there that all travelers are reading about today.
You read it here first, and conservative scientists will perhaps be writing it up in a learned journal in two or more years. It is, though, a wonderfully simple example of how a warm winter in the Northern ice might have destabilized systems, ultimately resulting in a frigid Northern Europe.
Resource Limitation NoteFor my money, resource problems exacerbated by weather instability will be our biggest and most complicated investment problem for years to come. How should we prepare for it? First, we should all transfer more of our intellectual resources to the problem. Yes, we have already recommended forestry, agricultural land, and “stuff in the ground.” It would be nice to back this up with more detail. To this end, we are starting to look more closely at commodity cycles, both historically and currently. We will report back from time to time.
By the way, the good news is that our long-term bubble study, started in 1998, has become a monster. Formerly a study of the handfuls of famous, accepted investment bubbles, we are now well into a statistically rigorous review of primary, secondary, and possibly even tertiary bubbles, and now count a stunning 320 completed bubbles. For now, we do not intend to make our complete review generally available, but we will review some interesting “average” bubble behavior in a few months.
So, we do know some useful stuff about commodities. The complicating point is that in the recent few years, commodities seem to be making a paradigm shift. If this is so, it will be the most important paradigm shift to date. The bad news is that paradigm shifts cannot, by definition, be described well using history. It is all about judgment. Now there’s a real problem.
Looking Forward• Be prepared for a strong market and continued outperformance of everything risky.
• But be aware that you are living on borrowed time as a bull; on our data, the market is worth about 910 on the S&P 500, substantially less than current levels, and most risky components are even more overpriced.
• The speed with which you should pull back from the market as it advances into dangerously overpriced territory this year is more of an art than a science, but by October 1 you should probably be thinking much more conservatively.
• As before, in our opinion, U.S. quality stocks are the least overpriced equities.
• To make money in emerging markets from this point, animal sprits have to stay strong and not much can go wrong. This is possibly the last chapter in a 12-year love affair. Emerging equities seem to be in the early stages of the “Emerging, Emerging Bubble” that, 3½ years ago, I suggested would occur. How far a bubble expands is always anyone’s guess, but from now on, we must be more careful.
• For those of us in Asset Allocation, currencies are presently too iffy to choose between. Occasionally, in our opinion, one or more get far out of line. This is not one of those occasions.
• Resource stocks, as in “stuff in the ground,” are likely to be fine investments for the very long term. But short term, they can really ruin a quarter, and they have certainly moved a lot recently.
• We think forestry is still a good, safe, long-term play. Good agricultural land is as well.
• What to watch out for: commodity price rises in the next few months could be so large that governmental policies in emerging countries might just stop the global equity bull market. My guess, though, is that this is not the case in the U.S. just yet.
Things that Really Matter in 2011 and Beyond (in one person’s view) for Investments and Real Life• Resources running out, putting strong but intermittent pressure on commodity prices
• Global warming causing destabilized weather patterns, adding to agricultural price pressures
• Declining American educational standards relative to competitors
• Extraordinary income disparities and a lack of progress of American hourly wages
• Everything else.
SPECIAL TOPICJanuary 2011
Letters to the Investment Committee XVII
Speech at the Annual Benjamin Graham and David Dodd Breakfast (Columbia University, October 7, 2009), edited for reading.
Part 2: On the Importance of Asset Class Bubbles for Value Investors and Why They Occur
Moving on to asset bubbles and how they form brings us to Exhibit 1. It shows how I think the market works. Remember, when it comes to the workings of the market, Keynes really got it. Career risk drives the institutional world. Basically, everyone behaves as if their job description is “keep it.” Keynes explains perfectly how to keep your job: never, ever be wrong on your own. You can be wrong in company; that’s okay. For example, every single CEO of, say, the 30 largest financial companies failed to see the housing bust coming and the inevitable crisis that would follow it. Naturally enough, “Nobody saw it coming!” was their cry, although we knew 30 or so strategists, economists, letter writers, and so on who all saw it coming.
Exhibit 1. The Way the Investment World Goes Around: They Were Managing Their Careers, Not Their Clients’ Risk
But in general, those who danced off the cliff had enough company that, if they didn’t commit other large errors, they were safe; missing the pending crisis was far from a sufficient reason for getting fired, apparently. Keynes had it right: “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him.” So, what you have to do is look around and see what the other guy is doing and, if you want to be successful, just beat him to the draw. Be quicker and slicker. And if everyone is looking at everybody else to see what’s going on to minimize their career risk, then we are going to have herding. We are all going to surge in one direction, and then we are all going to surge in the other direction. We are going to generate substantial momentum, which is measurable in every financial asset class, and has been so forever. Sometimes the periodicity of the momentum shifts, but it’s always there. It’s the single largest inefficiency in the market. There are plenty of inefficiencies, probably hundreds. But the overwhelmingly biggest one is momentum (created through a perfectly rational reason, Paul Woolley would say): acting to keep your job is rational. But it doesn’t create an efficient market. In fact, in many ways this herding can be inefficient, even dysfunctional.
Keynes also had something to say on extrapolation, which is very central to the process of momentum. He said that extrapolation is a “convention” we adopt to deal with an uncertain world, even though we know from personal experience that such an exercise is far from stable. In other words, by definition, if you make a prediction of any kind, you are taking career risk. To deal with this risk, economists, for example, take pains to be conservative in their estimates until they see the other guy’s estimates. One can see how economists cluster together in their estimates and, even when the economy goes off the cliff, they will merely lower their estimates by 30 basis points each month, instead of whacking them down by 300 in month one. That way, they can see what the other guy is doing. So they go down 30, look around, go down another 30, and so on. And the market is gloriously inefficient because of this type of career-protecting gamesmanship.
But there is a central truth to the stock market: underneath it all, there is an economic reality. There is arbitrage around the replacement cost. If you can buy a polyethylene plant in the market for half the price of building one, you can imagine how many people will build one. Everybody stops building and buys their competitors’ plants via the stock market. You run out of polyethylene capacity, the price eventually rises and rises until you sharpen your pencil and find you can build a new plant, with a safety margin and a decent return, and the cycle ends. Conversely, if you can lay fiber-optic cable and have it valued in the marketplace at three times the price that it cost you to install, then you will sell a few shares and lay some more cable, until you drown in fiber-optic cable, which is exactly what happened in 2001 and 2002.
The problem is that some of these cycles happen really fast, and some happen very slowly. And the patience of the client is three point zero zero years. If you go over that time limit, you are imperiled, and some of these cycles do indeed exceed it. You lose scads of business, as GMO did in 1998 and 1999. This timing uncertainty is what creates career and business risk. This is really a synopsis of Keynes’ Chapter 12 without the elegance. Exhibit 1 also divides the process into the Keynes part and the Graham and Dodd part.
Another word about extrapolation. Extrapolation is another way of understanding the market. Exhibit 2 (Bond Market and Inflation) is my favorite extrapolation exhibit. It shows how the long Government Bond has traditionally extrapolated the short-term inflation rate into the distant future. You can see how inflation peaked at 13% in 1982. Now, with inflation at 13%, you would expect the T-bill to yield around 15%. It did. How about the 30-year Bond? It yielded 16%. The 30-year Bond took an extreme point in inflation (13%) that existed for all of about 20 minutes and extrapolated it for 30 years! Of course, with an added 3% for a real return. Volcker was snorting flames that he was going to crush inflation or die in the attempt, and they still extrapolated 13% for 30 years. Then, in 2003, infl ation was down to 2% and the 30-year Bond was down to 5%. 2% inflation plus three points of real return again. Oh, it was going to stay at 2% for 30 years this time? It’s incredibly naïve extrapolation, isn’t it? And, in a way, the stock market is even worse. Exhibit 3 shows the ebb and flow of P/E. In an efficient world, it would be far more stable. Andrew Lo of MIT said that the market has two phases: a lot of the time it is efficient and then – bang! – it will become crazy for a while. This is not at all how I see it. Every time the market crosses fair value, it’s efficient. For a few seconds every five or six or seven years, it’s efficient. The rest of the time, it is spiking up or spiking down, and is inefficient.
Exhibit 2. Long-Term Bond Yields – Extrapolation at its Best
Source: GMO As of 9/30/04
Exhibit 3 – P/Es and Profit Margins: Double-Counting at its Worst (Why Shiller Is Right)
Source: GMO, Standard & Poor’s As of 6/30/07
Now, the market should equal replacement cost, which means the correlation between profit margins and P/Es should be −1. Or, putting it in simpler terms, if you had a huge profit margin for the whole economy, capitalism being what it is, you would want to multiply it by a low P/E because you know high returns will suck in competition, more capital, and bid down the returns (conversely at the low end). But what actually happens? Instead of having a correlation of −1, our research shows it has a correlation of +.32. The market can’t even get the sign right! High profit margins receive high P/Es and vice versa, and the correlation is much greater than +.32 at the peaks and the troughs. Right at the peak in 1929, we had record profit margins and record P/Es. In 1965, there were new record profit margins and record P/Es (21 times). Now, think about 2000. We had a new high in stated profit margins and decided to multiply it by 35 times earnings, a level so much higher than anything that had preceded it. In complete contrast, in 1982 we had half-normal profits times half-normal P/Es (8 times). I mean, give me a break. We were getting nearly one-third of replacement cost at the low, and almost three times replacement cost at the high in 2000. This double counting is, for me, the great driver of market volatility and, basically, it makes no sense. Once profit margins start to roll, investors look around at the competition, who are all going along for the ride, and we get overpricing as a result. It is a classic fallacy of composition. For an individual company, having an exceptional profit margin deserves a premium P/E against its competitors. But for the market as a whole, for which profit margins are beautifully mean reverting, it is exactly the reverse. This apparent paradox seems to fool the market persistently.
The process we’ve been looking at – career risk, herding momentum, extrapolation, and double counting – allows, even facilitates, the process of asset class bubbles forming. But asset bubbles don’t spring out of the ground entirely randomly. They usually get started based on something real – something new and exciting or impressive, like unusually strong sales, GDP, or profits, which allow the imagination to take flight. Then, when the market is off and running, momentum and double counting (among other factors) allow for an upward spiral far above that justified by the fundamentals. There is only one other requirement for a bubble to form, and that is a generous supply of money. When you have these two factors – a strong, ideally nearly perfect economy and generous money – you are nearly certain to have a bubble form.
Forecasting bubbles, though, is problematic. It is hard work and involves predictions and career risk. Whether bubbles will break, though, is an entirely different matter. Their breaking is certain or very nearly certain, and that sort of prognosticating is much more appealing to me as a job description. Any value manager worth his salt can measure when there is a large bubble. To avoid exploiting bubbles is intellectual laziness or pure chickenry and is a common failing, in my opinion, in otherwise sensible and suitably brave Graham and Doddites.
I unabashedly worship bubbles. One of the very early ones – the famous South Sea Bubble – is shown in Exhibit 4. It’s beautiful, isn’t it? The shape is perfect. The average of all of the bubbles we have studied, by the way, is that they go up in three and a half years, and down in three. Let me just say a word about that: 34 bubbles is not a surprising number to an efficient market believer. Randomly, one would expect some outliers. So, we have a nice little body of 34 to study. But here’s the problem: in the efficient market view, when a bubble forms, it is seen as a paradigm shift – a genuine shift in the very long-term value of an asset class or an industry. If that were the reason – a fundamental change, not the package of basically behavioral factors we’ve described – then what would happen following these peaks in an efficient world? Why, the prices would wander off on an infinite variety of flight paths, half of them upwards and half downwards with, I suppose, one or two nearly sideways. What happens exactly in our inconvenient real world? All of them go back to the original trend, the trend that was in place before the bubble formed. Take the U.S. housing bubble, for example. Based on its previous history of price and volatility, it was a three-sigma, 100-year bubble. What were the odds that it would be followed by a beautiful-looking bust of equal and opposite form? Why, 1 in 100, of course. So a three-sigma bubble should form randomly and burst every 100 x 100 years, or every 10,000 years, like clockwork. And the more frequent two-sigma, 40-year completed bubbles would occur every 1,600 years. Yet we have had 34 out of 34 complete bubble cycles, which would allow several universes to grow cold before occurring randomly.
Exhibit 4 – Isaac Newton’s Nightmare
South Sea Stock December 1718 – December 1721
Marc Faber, Editor and Publisher of “The Gloom, Boom & Doom Report.”
This is one of the many reasons that I am wildly enthusiastic about both rational expectations and the efficient market hypothesis. (Yes, I know we are still waiting for the aberrant U.K. and Aussie housing bubbles to break. And one day they will. Even with their variable rate mortgages to support them in bad times as the rates drop. I recently met a Brit paying ¾ of 1%. No kidding.)
Exhibit 4 also tells you a little bit about Isaac Newton, which may be true and, in any case, is a great story. Newton had the great good luck to get into the South Sea Bubble early. He made a really decent investment and a very quick killing, which mattered to him. It was enough to count. He then got out, and suffered the most painful experience that can happen in investing: he watched all of his friends getting disgustingly rich. He lost his cool and got back in, but to make up for lost time, he got back in with a whole lot more (some of it borrowed), nicely caught the decline, and was totally wiped out. And he is reported to have said something like, “I can calculate the movement of heavenly bodies but not the madness of men.”
Exhibit 5 shows six bubbles from 2000. You can see how perfect they are. My favorite is not the NASDAQ, even though it went up two and a half times in three years and down all the way in two and a half years. My favorite is the Neuer Markt in Germany, which went up twelve times in three years, and lost every penny of it in two and a half years. That is pretty impressive. It’s even better than the South Sea Bubble. Whatever we English could do, the Germans could do better...
Exhibit 5 – Perfect Bubbles of 2000
Source: GMO, Datastream As of 9/30/02
Exhibit 6 is the U.S. housing bubble. We were showing this exhibit (cross my heart and hope to die) half way up that steep ascent. One reason we were so impressed with it is that there had never been a housing bubble in American history, as Robert Shiller pointed out and was clear in the data. Previously, Chicago would boom, but Florida would bust. There was always enough diversification. It took Greenspan. It took zero interest rates. It took an amazing repackaging of mortgage instruments. It took people begging other people to take equity out of their houses to buy another one down in Florida. (We had neighbors who ended up with three...) It was doomed, but, right at the peak (October 2006), Bernanke said, “The U.S. housing market largely reflects a strong U.S. economy ... the U.S. housing market has never declined.” (Meaning, of course, that it never would.) What the hell was he thinking?! This is the
Exhibit 6 – U.S. Housing Bubble Has Burst
Source: National Association of Realtors, U.S. Census Bureau, GMO As of 6/30/10
guy who got reappointed. Surrounded by statisticians, he could not see a three-sigma housing bubble in a market that previously had never had one lousy bubble at all. I say it is akin to the Chicago story where two economics professors cross the quadrangle, pass a $10 bill on the ground, and don’t pick it up because they know, in an efficient world, it wouldn’t be there since it would already have been picked up. Bernanke couldn’t see a housing bubble because he knew we don’t have housing bubbles – bubbles don’t exist in big asset classes because the market is efficient. As Kindleberger, the well-regarded economics historian said, the efficient market people (like Fama, French, Cochrane, Lucas, and Malkiel) “ignore the data in defense of a theory.”
The twelve famous bubbles we always list are shown in Exhibit 7. The top row shows various stock markets: 1929, 1965, Japan, and 2000. Regarding 2000, we can see that, until 2008, the U.S. market did not get to trend. It has an interesting shape, including a wonderful several-year rally. I am pleased to say that in 2004 and 2005, I described the market’s ascent as “the greatest sucker rally in history,” so I was very relieved that it wiped out and completed the bubble cycle by bursting in 2009, with interest, as shown in Exhibit 8. So, in the end, Uncle Alan and his interest rate heroics only postponed the inevitable. Perhaps it will be the same again. The surge of bailout money certainly prevented the market from going as low this time as would have been justified by the severity of the crisis. Based on history, an appropriate decline would have been into the 400s or 500s on the S&P.
Note: For S&P charts, trend is 2% real price appreciation per year.
* Detrended Real Price is the price index divided by CPI+2%, since the long-term trend increase in the price of the S&P 500 has been on the order of 2% real.
Source: GMO As of 10/10/08
Exhibit 8 – The 2000 S&P 500 Bubble Finally Breaks!
Note: Trend is 2% real price appreciation per year.
* Detrended Real Price is the price index divided by CPI+2%, since the long-term trend increase in the price of the S&P 500 has been on the order of 2% real.
Source: GMO As of 10/10/08
Stock market sectors have also bubbled unfailingly – growth stocks, value stocks, Japanese growth stocks, etc. In fact, they’ve been very dependable. To ignore them, I believe, is to avoid one of the best, easiest ways of making money. At Batterymarch we invested in small cap value in 1972-73 because we had created a chart of the ebb and flow of the relative performance of small cap that went back to 1925, and we could see this big cycle of small caps. We saw the same ebbing and flowing with value. We made a ton of dough: in just eight years, Batterymarch went from $45 million under management in late 1974 to being one of the largest, if not the largest, independent counseling firm by 1982. It did so mostly without my help, since I left in 1977, although I did bequeath my best-ever idea – small cap value. Small cap value didn’t merely win; it won by over 200 percentage points. Small cap itself won by over 100 points (+322% versus +204%). Batterymarch and GMO, which continued that tradition, won by over 100 points. But we didn’t keep up with small cap value, and that has been a lesson that has echoed through my life: we hit the most mammoth of home runs, and yet couldn’t beat the small cap value benchmark. (One reason was that we were picking higher quality stocks – the real survivors. From its bottom in 1974, the index was supercharged by a small army of tiny stocks selling at, say, $1-⅞ a share. These stocks, which were ticketed for bankruptcy if the world stayed bad for two more quarters, instead quadrupled in price in the six months following the market turn.) Picking the right sector was, in that case, more powerful than individual stock picking. Such themes are very, very hard to beat.
Let me end by emphasizing that responding to the ebbs and flows of major cycles and saving your big bets for the outlying extremes is, in my opinion, easily the best way for a large pool of money to add value and reduce risk. In comparison, waiting on the railroad tracks as the “Bubble Express” comes barreling toward you is a very painful way to show your disdain for macro concepts and a blind devotion to your central skill of stock picking. The really major bubbles will wash away big slices of even the best Graham and Dodd portfolios. Ignoring them is not a good idea.
Monday, January 31, 2011
Chicago PMI Surges again, hitting 68.8 on expectations of 64.5, compared to the lower revised 66.8. And as recently has become trading, the only indicator everyone is looking at is the Price Paid (i.e., the margin collapse metric) which came at 81.7 compared to 78 previously. The key comment from the survey panel: "Steel prices are going crazy."
Dallas Fed Misses Expectations, prints at 10.9 versus 15.0 consensus
But Inflation Climbs:
"Prices climbed again in January. The raw materials price index jumped from 43 to 62, reaching its highest level since mid-2008. The share of manufacturers who saw an increase in input costs surged to 64 percent, compared with only 2 percent who saw a decrease. Finished goods prices rose for the third month in a row, although the great majority of respondents continued to note no change. Sixty percent of respondents anticipate further increases in raw materials prices over the next six months, while 40 percent expect higher finished goods prices."
Hey Ben, wasn't your glorious strategy supposed to prevent this?
Home values are falling at an accelerating rate in many cities across the U.S.
The Wall Street Journal's latest quarterly survey of housing-market conditions found that prices declined in all of the 28 major metropolitan areas tracked during the fourth quarter when compared to a year earlier.
The size of the year-to-year price declines was greater than the previous quarter's in all but three of the markets, the latest indication that the housing market faces considerable challenges.
Inventory levels, meanwhile, are rising in many markets as the number of unsold homes piles up.
Home values dropped the most in cities that have already been hard-hit by the housing bust, including Miami, Orlando, Atlanta, and Chicago, according to data from real-estate website Zillow.com. But price declines also intensified in several markets that so far have escaped the brunt of the downturn, including Seattle and Portland, Ore.
Falling prices are a reflection of weak demand and tight credit conditions that reduce the number of potential buyers.
"There are just not a lot of renters with confidence, with a down payment, with good credit, and without a lot of additional debt," said John Burns, a homebuilder consultant in Irvine, Calif.
On the inventory front, New York's Long Island had enough homes on the market at the end of December to last 15 months at the average sales pace. The supply of unsold homes stood at 14 months in Charlotte, N.C., and Nashville, Tenn., and at nearly 13 months for northern New Jersey.
Markets are generally considered balanced when the supply is around six months.
A few markets, including Sacramento and San Diego, are seeing inventories fall to healthier levels as low prices spur interest from first-time buyers and investors, while others, such as Washington, D.C., and Boston, have been cushioned by more stable economies.
"We're still running at half speed," said Jeffrey Otteau, president of Otteau Valuation Group, an East Brunswick, N.J., appraisal firm. "Sales are below year-ago levels and inventory is higher than it was a year ago." Far-flung suburbs continue to fare worse than homes located closer to core metro centers, he says.
Economists say that the biggest risk to the housing market is that job growth doesn't pick up. "Without improvement in unemployment, confidence stays low. Purchasing stays low," says Stan Humphries, chief economist at Zillow.
Market conditions could get worse in the months ahead. Millions of homeowners are in some stage of foreclosure or are seriously delinquent on their mortgages, and millions more owe more than their homes are worth.
Real-estate agents are bracing for an uptick in distressed properties hitting the market, including foreclosures being sold by banks and homes sold by owners via a short sale, in which banks agree to a sale for less than the amount owed.
Sales of foreclosed homes are partly responsible for reducing home values because banks tend to reduce prices quickly to sell the homes. Sales of foreclosures slowed in some markets at the end of last year as document-handling problems raised questions about the integrity of their foreclosure processes. But that could change as banks pick up the pace of foreclosures.
Real-estate agents say that the threat of future price declines has led to a months-long standoff between buyers and sellers.
Sellers spurn what they see as low-ball offers, while buyers are demanding discounts because they are "convinced prices will drop further, and they don't want to feel like suckers six months later," says Glenn Kelman, chief executive of Redfin Corp., a Seattle-based real-estate brokerage that operates in nine states. The result is that "it's high noon at the O.K. Corral on every single transaction."
Agents say that sluggish housing markets are requiring sellers to become much more realistic about setting prices that will spur dealsthe prices they set.
After receiving no offers on a three-bedroom home in Oceanside, Calif., during the first week on the market, real-estate agent Jim Klinge convinced the seller to slash $30,000 from the price, to $420,000.
That drew two full-price offers, and the home sold last week in an all-cash deal. "The drop in price was critical to reignite urgency for buyers," said Mr. Klinge.
Some sellers have opted to pull their homes from the market rather than lower their prices, either because they believe values will improve or because cutting the price would mean selling for less than the amount owed to the bank.
"I know so many people here who are unwilling landlords," said Mr. Kelman. "They're now spending their Friday nights fixing leaky faucets for the tenants they've brought into their house."
Sunday, January 30, 2011
from Zero Hedge:
With all the hoopla over Egypt some have forgotten that this is merely a geopolitical event (one of those that absolutely nobody, with a few exceptions, was talking about less a month ago, so in many ways this is a mainstream media black swan which once again exposes the entire punditry for the pseudo-sophist hacks they are), and that the actual mines embedded within the financial system continue to float just below the surface. Below we present the five key fat tail concerns that keep SocGen strategist Dylan Grice up at night, which happen to be: i) long-term deflation, ii) a bond market blow-up, iii) a Chinese hard-landing, iv) an inflation pick-up, and v) an Emerging Markets bubble. Far more importantly, Grice provides the most comprehensive basket of trades to put on as a hedge against all five of these, while also pocketing a premium associated with simple market beta in a world in which the Central Banks continue to successfully defy gravity and economic cycles. For all those who continue to trade as brainless lemmings, seeking comfort in numbers, no matter how wrong the "numbers" of the groupthink herd are, we urge you to establish at least some of the recommended trades in advance of what will inevitably be a greater crash than anything the markets experienced during the depths of the 2008 near-cataclysm.
But before we get into the meat of the piece, we were delighted to find that Zero Hedge is not the only entity that believes that providing traditional annual forward looking forecasts is nothing more than an exercise in vanity (and more often than usual, error).
At this time of the year we’re supposed to give our predictions for what’s in store for the year ahead. The problem is I don’t have any. Not because making forecasts is difficult. It isn’t. It’s just pointless. Instead, I suggest getting in touch with our inner Kevin Keegan, the hapless former England football manager who, facing the sack after a bad run of results famously lamented “I know what’s around the corner, I just don’t know where the corner is.” The more people construct portfolios on the assumption that they can see the future, the greater the opportunity for those building portfolios which are robust to the reality that we can’t.That said, no matter how ridiculous the act of Oracular vanity ends up being, those who charge an arm and a leg for their "financial services" continue to do it, only to be among the first carted out head first when reality is imposed upon them and their blind belief that this time is different and the crowd is actually right. Few are willing to accept and recognize the humility that they really know little if anything about how a non-linear, chaotic system evolves. Which is once again why we believe that Grice is among the best strategists out there: in his attempt to hedge the stupidity of the crowd, he has coined a term that may well be the term that defines 21st century finance and economics: instead of foresight, Grice believes the far more correct term to explain the process of prognostication should be one based on foreblindness.
In financial markets, craziness creates opportunity. It affects only prices, not values. And one of the craziest afflictions I know of is our faith in our ability to see the future. Indeed, there isn't even an appropriate opposite to the word "foresight" in the English language. So I'?m going to make one up. And rather than build a portfolio based on the pretense we have foresight, let's explore some ideas for building one that is robust to our foreblindness.This is the kind of insight that one will never find from a TBTF "strategist"... And one wonders where all those softdollars go.
So now that we know that unlike the traditional cadre of sell side idiots who are always wrong in the long-run, Grice actually admits that he has no clue what will happen, which is precisely the reason to listen far more carefully to what he has to say.
Let's dig in:
Here are some things I think are true:Let's take a look at the five fat tails in detail:
Here are some things I know are true:
- developed economy governments are insolvent
- Japan is the highest risk developed market (DM) to an inflation crisis (though it might be Greece)
- there is too much debt around
- China?s economic model is biased towards misallocating resources
- every country which has industrialized has experienced nasty bumps on the way
- China and the US are in the early stages of an arms race
- demographic trends suggest more conflict in the oil rich regions of the world
- bottlenecks are developing in key commodity markets
- the only thing central banks are good at is blowing the bubbles that cause the crashes which are used to justify their existence
- market prices only reflect fair value by accident and in passing
- most people don't think these things are important
- they might be right.
What to do? To my mind, the ideal is not to make huge bets on particular events happening because failure of the expected event to materialize will materially endanger your capital. Instead, the ideal is purchase insurance at a price which won't materially pressure the returns from your core portfolio of investments if the event fail to materialize, but will protect capital from significant impairment if it does.
- perceived uncertainty causes emotional discomfort which isn't conducive to good decision making
- all the above situations have the potential to cause significant asset price volatility
- I have no idea when.
Is such an ideal attainable? By evaluating insurance and using the same valuation discipline you'd apply to anything else, I think it is. So what follows is not a list of recommendations here, or even any suggestions. Everyone should do their own homework. What follows is an illustration of why I think the macro research we've been doing is relevant and can be used to lower portfolio risk. The insurable risks I'm most worried about at the moment are:
The first thing you?'ll notice is that these aren't all consistent with one another. It's difficult to get a Chinese hard landing and an EM bubble at the same time, for example. But internal consistency is overrated. It's only relevant for point-in-time forecasts, and the assumption underlying this entire exercise is that I haven't a clue if/when any of what follows is going to happen. At the risk of repetition, I'm interested in the possibility of building a profitable portfolio which is robust to my ignorance.
- long-term deflation
- a bond market blow-up
- a Chinese hard-landing
- an inflation pick-up
- an EM bubble
Not surprisingly, Grice gives the least amount of weight to the one thing most troubling to such economic disgraces as Ben Bernanke and Paul Krugman. Yet it should not be avoided. After all there are many deflationists out there, who believe that the Fed, which has now clearly telegraphed it is all in on reflating (or after the Fed, the monetary collapse deluge) may actually succumb to what has been ailing Japan for two decades.
According to economists the primary risk faced by economies is that a huge deleveraging spiral becomes self-fulfilling: deleveraging reduces demand, which lowers prices, which further lowers demand, and so on. The idea was first developed by Irvine Fisher in the 1930s to describe the great depression, and has been used to explain the ?First Great Depression? of the 1870s and Japan since the early 1990s.We couldn't have said it better ourselves.
Paul Krugman says everything has changed because we?re in a liquidity trap. The fear of prolonged deflation is what keeps poor old Ben Bernanke awake at night. And maybe that's the clue. At our London conference this year, James Montier said that Bernanke as the worst economist of all time. Now, I'm not sure I agree with James on this one because I can't make up my mind, sometimes I think it's the Bernanke, other times I think it's the Krugman. But usually I think nearly all economists to be the joint worst economists of all time. So I have a lot of sympathy with the idea that if the consensus macroeconomic opinion is worried about something, it probably isn't worth worrying about. In fact, if they worry about deflation, I'm going to worry about inflation.
So how does one trade deflation insurance?
More importantly though, deflation insurance is expensive. The following chart shows the price of 5y 0% US CPI floors to be trading for just under 200bps. The way these floors work is that they provide the owner of the contract with the right to payments equal to the rate of deflation. Since the floors in the chart have a five-year maturity, they entitle the owner to five annual payments. For example, if inflation was -1% in year one, the owner would receive 100bps of the notional value of the contract. If inflation was -1% in year two, he'd receive another 100bps. And if the rate of deflation remained at -1% for years three, four and five, he'd receive 100bp cash flow for each of those annual payments so that over the life of the contract he'd have received a total cash flow of 500bps. So if you're worried by the prospect of CPI deflation, this is the product for you.Chinese Hard Landing
And skeptical though I am of the debt deflation hypothesis, Western demographics worry me. Although we don?t know what aging economies look like, we know that the glimpse into the future provided by Japan isn't encouraging. So I do take the scenario seriously and would be happy to put the hedge on at the right price. The problem is, I don't think the price is right. I think this insurance should be sold, not bought.
While Grice is obviously far less worried about a systemic deflation scenario arising out of events in the US, what may happen in China is obviously a far riskier proposition, and one that could generate deflation out of the proverbial "Hard Landing." Luckily there is an instrument with some wonderfully convex properties to hedge this...
Albert calls China a ‘freak economy.’ Certainly, running with an investment to GDP ratio of over 50% doesn't seem normal. Neither does keeping interest rates at 5% when the economy is growing by 15% in nominal terms each year. Such lax monetary conditions have helped land prices rise by 800% in the last seven years, according to NBER economists. And when you come to think of it, more recent examples of real estate inflation fueled by negative real interest rates: Ireland, Spain, the US didn't end too well. Jim Chanos says China is a shortseller's dream and that there's not one company he's looked at that passes the accounting sniff test. And if Jim Chanos, who built a very successful business around spotting accounting gimmickry says something like that, my guess is he's right.What happens if and when the inevitable crash happens? One word - Australia. Another word(s): 10x-20x payout.
Taking a step back though, as far as I?m aware all industrialized countries have experienced financial crashes. It seems a part of the maturing process. Why should China be any different? A credit crisis wouldn't necessarily mean the end of the China story any more than the panic of 1873 meant the end of America's, (though US demographic prospects were considerably more favorable at the end of the 18th century than China's are today). For the record, I think the Chinese have a bright future. My son is learning Mandarin. But when I look at the numbers I can't help but think there's going to be a crash and that it's going to be quite unpleasant. It's just that my guess as to when it's going to happen is as good as Kevin Keegan's.
When it does happen though, the Australian economy will be toast and its government bond yields will collapse. During the panic of 2008, AUD 10y swap rates fell around 3% to 4.40%.Asset Bubbles
The panic of 2008 was a "good crisis" for Australia though. A Chinese crash would be more serious.
And you can get pretty attractive odds on AUD rates collapsing. The following chart shows the payout available using AUD receiver swaptions prices with a three-year maturity, based on the 10y swap rate. Effectively, these are put options that pay out when rates fall below the strike price. The prices I've used here are from Bloomberg based on the swaptions striking at about 5.5% (i.e. 100bp below the current rate of 6.50%). What's interesting is that at current prices, if Australian swaps were to break their 2008 lows, you'd be making about 10x your premium (for the record, these swaptions are priced at about 120bps, or 40bps per year over three years, which is about the same as the annualized revenue you'd get if you sold the CPI floors discussed above). If swap rates fell by 300bps as they did during the panic of 2008 the rate would fall to 3.5% and you'd make nearly 15x your premium. To repeat the point I made earlier, this isn't a recommendation. It's just a starting point (my guess is that you'd find more attractive payouts as you went further out of the money with the strike price, and that capital structures of Australian banks, property companies and levered resource stocks would be worth looking into too).
Grice provides one of the best and most succinct explanations of bubble mentality we have read to date:
For reasons I won't go into now, but which are probably obvious from what I just wrote about China, I think EM is riskier than it seems. I'm not even sure I feel comfortable valuing EMs yet. So should EMs bubble up, the risk for investors sharing my concern is that they'll be faced with quite a nasty dilemma: do they buy something they don't feel sure is cheap because everyone else is and they're scared of underperforming, or do they stick to their principles and prepare themselves to take on the business and career risk of underperforming their competitors, seeing clients withdraw their funds, and possibly finding themselves out of work?Regardless of the psychology behind each and every bubble, the good thing is that there is a good way to hedge this risk outright.
And the sad reality is that ultimately nearly everyone gets hurt during a bubble. Sceptics get hurt as it inflates, believers get hurt when it bursts. George Soros says when he sees bubbles he buys them. He?'s been pretty good at selling them at the right time too. But most of us aren't so clever.
One way to hedge the inflation of a bubble, rather than its bursting, is to buy out of the money call options on the equity indices. Calls are usually cheaper than puts ? I think because fear is a more powerful emotion than greed and the tails in equity markets tend to be on the downside. But the following chart shows that that difference (or skew, the difference in implied volatilities between puts and calls) is close to unprecedented highs, at around 4.5 vol points (the chart shows skew for the S&P500 though other equity indices show a similar picture).Hyperinflation
In other words, the upside is close to unprecedentedly cheap relative to the downside. If you could get two year call options 30-35% out of the money for 130bps per year you?'d be getting good value (of course you could make this zero cost, or even ve cost by selling puts to fund the purchase, and you could do it in such a way that your downside risk would be similar to that of holding stock, but I'm no derivatives strategist- as usual, if you want to talk about this stuff to people who know more than I do, speak to your SG derivatives salesman, or ask me and I?'ll put you in touch).
A topic near and dear to many. Luckily, once again, one which can be hedged proximally in a form that generates massive returns should it transpire there where it most needed: no, not the US. Japan. In fact, if Grice is right about Japan, his proposed trade takes the returns generated by Paulson in shorting subprime... And magnifies them by about a million.
Historically, bankrupt governments have used inflation to alleviate their indebtedness. I doubt things will ultimately be different this time. And as regular readers know, I think Japan is the country closest to the edge. All DM governments have the same problems: they've made promises to their electorates which they're unlikely to be able to keep. But while there's time for European and US governments to fix the problem, for Japan I think it's already too late. John Mauldin says the Japanese government debt position is a “bug in search of a windshield”. I agree with him.Bond Market Blow-up
I've already written too much this week, so I don't want to rehash all the stuff I've already written on Japan and which regular readers will be familiar with. But if you chart past episodes of extreme inflations with how stock markets behaved during the episodes, you invariably find something similar to what happened to Israel in the 1980s.
In Steven Drobny's excellent “Hedge Funds Off the Record” (which I consider a must read - almost every interview oozes with profound risk-management wisdom), Steve Leitner talks about buying out of the money call options to hedge against such a hyperinflation. Buying 40,000 strike Nikkei calls with a ten- year maturity, with a payout in a strong currency can be done for around 40bps per year. And to give you an idea of how explosive that asymmetry might be, if Japan was to follow the Israeli experience from here, the Nikkei- currently 10,500 would trade at around 60,000,000 (sixty million). So putting even one-tenth of your notional into that kind of hedge would cost 4bp per year (for reference, the Nikkei currently offers in excess of a 2% annual yield, while some JREITS offer in excess of 4% - I'd argue that 40bp is a bearable burden, and 4bps certainly is).
When a few weeks ago we presented Sean Corrigan's chart which we dubbed the Great Regime Change, few put two and two together, and realized the vast trading implications of this chart. And they are profound. As Grice rightfully observes, they stand at the base of nothing less than the hedge against that most critical of fat-tail events: a bond market blow up, one which is getting increasingly more probable with every single $X0 billion UST bond auctions (the bulk of which is now monetized directly by the Fed).
One obvious way to hedge against a bond market blow-up is to use the swaptions market as we did in the Australian market to hedge a Chinese crash, only this time buying payer swaps, which are effectively call options on rates. But I thought I'd show you something I think is a bit more interesting: the correlation between the S&P500 and bond yields.For all those who figured this out based on the Corrigan chart, congratulations. This could well be the holy grail of the biggest black swan insurance trade of all. For those who haven't quite grasped it, here is some more from Grice:
Bonds represent poor value in my opinion, with little margin of safety to protect against the very real risk that governments try to inflate away their debts. But one good reason to continue holding them is that they protect risk asset positions during the '?tails'?. The following chart shows that over the last ten years the correlation has been volatile, but positive: when equities have fallen so have bond yields, offsetting losses in the equity portfolio as bonds benefit during "risk-off" events.
When inflation expectations were (probably) around zero (before the 1960s) the correlation between bonds and equities was zero too. But look what happened during the 1960s when inflation expectations broke (this was during the Vietnam war, as the Bretton-Woods system was coming under pressure and as the bear market in bonds was getting into full swing). The chart shows that the correlation went negative. When bond yields rose equities fell because government bonds were reflecting the same tensions that were pulling down equity valuations (fear of ever-higher inflation).
As the bond bear market reached its climax in the early 1980s, the correlation remained negative. But as the worm turned, and central banks across the developed world made new and credible commitments to stop printing money, a bond market rally was born. And as inflation expectations began to fall, what was good for the bond market was good for the equity market. Now, falling yields coincided with rising equity prices and so the correlation remained negative. But during the last ten years, inflation expectations have been roughly stable and, if anything, slightly biased towards the deflationary side. So what?s been good for bonds hasn't been good for equities, and the correlation between yields and equity prices has been positive to reflect that.
The point is this: if governments are insolvent, and the government bond market becomes a source of risk once again (as opposed to the nonsensical "risk-free" description it has somehow obtained in recent years) what's bad for the bond market will be bad for risk assets too. As yields rise, risk assets will fall. The correlation will go negative. Bonds will provide less protection against the tail events than they have done in recent years because they will be a source of the tail event.
This correlation is tradeable. Any bank with a derivatives operation must have an implicit correlation exposure between products they've sold options on. So for derivatives houses, correlation is a by-product in much the same way that molybdenum is a by-product of copper miners. and correlations like this trade in the IDM market. And sometimes that means you can get it for a very good price. I recently heard of a correlation trade between the S&P500 and the US 10y swap rate done at 40 correlation points, which seems a decent enough price to me (of course, selling at 50 points would give you even more margin of safety), although current pricing is at around 30 I believe. Pricing can be volatile though and waiting to sell in the 40-50 range seems sensible to me. It would hedge risk positions against a regime in which government bonds were seen as the source of risk, rather than the reliever of it.Finalizing the Black Swan Insurance basket.
Let's add it all up and see how much it would cost to insure our portfolio. If we were to sell the 5y US CPI floors for 200bps (40bps annualized); buy the 3yr AUD receiver swaption for 120bps (-40bps annualized); buy 2yr 30% S&P500 calls for around 130bps (-65bps annualized) and bought one tenth of our notional on NKY calls for 40bps (-4bps annualised) the net upfront cost would be 90bps (200bps-120bps-130bps-40bps). If we wanted to hedge the risk of bond market turbulence with a correlation product, this would cost nothing upfront because it would be done on a swap basis with the bank. On a roughly annualized basis our cost would be 69bps each year.The bottom line, and the reason why we think this is a great basket trade, is that it makes money in a normal environment while at the same time, providing great positional hedges to those 5 events which sooner or later are bound to happen.
Of course, we'd have a maturity mismatch because our hedges would have different time horizons. So we'd have to adjust them from year to year. We'd also be more vulnerable to deflation because we don't think the deflationary hedges offer value. So our portfolio wouldn't quite be bullet-proof because it would be tilted towards inflationary outcomes. But we'd have insurance against deflation with the Australian receiver swaption. And since the correlation swap hedges us against any bond market blow-up which also blows up the equity market, we can feel more comfortable allocating some capital towards bonds we think might offer good value (not that there are many, I'd say maybe about 20-30% in Australian and New Zealand bonds).
I'd put 10% in gold. I'll explain more in another note but for now, although I've said I'm not a fan of plain commodities as investment vehicles because buying commodities was equivalent to selling human ingenuity, I exclude gold from that logic. I prefer to see buying gold as buying into the stupidity of governments, policy-makers and economists, and I'm comfortable doing that.
With the exception of Japan (which we'd be hedged against anyway) I'm not so worried about "traditional" CPI inflation any time soon. At the moment, I think the first signpost on the way to that kind of crisis will be via the bond market, which the correlation swap should protect us against. That and my gold holdings would make me comfortable allocating 20%-25% cash. I still think risk assets are generally overvalued and cash is the simplest insurance "option", whose relative value rises proportionate to the decline in other assets. So let's say I'm 20% in cash,10% in gold, and 20% in mainly Australian and New Zealand government bonds. That leaves just under 50% of my capital for me to put into the equity market (the 69bps per year for my insurance bucket to be precise).
Which equities? I've always thought investing in index funds to be crazy, but nearly everyone does it and it's a part of the craziness we can use to our advantage. The EMH says that market prices are always broadly efficient because all market participants respond to all available information. But around 10% of the market is explicitly passive and probably another 50% is benchmarked and therefore implicitly passive. In other words, the overriding variable for the majority of equity investors is a company's weight in the index! Intuitively therefore, the prices can't fairly reflect fundamental value, which means that at any point in time, there will be lots of stocks which are mispriced.
The following chart shows two lines. The red line shows the cumulative return to buying stocks in the cheapest decile, while shorting stocks in the most expensive decile (I define value as the discount relative to the estimated intrinsic value - a methodology I've been meaning to write up in detail for several months now but which I will definitely do within the next few weeks). Using a monthly rebalance, the annualized return is 750bps. This shows that there is meaningful alpha in identifying and owning those stocks trading at a discount to intrinsic value. The black line shows the relative outperformance of the top decile against our wider stock universe. (In passing, note that this value strategy underperformed in the late 1990s during the tech bubble, and remember that this is the reason our hypothetical portfolio has out of the money call options.)
The relative outperformance of this long-only basket has been 330bps. If I expect a stock market return of 5% per year over the coming years, that 330bps outperformance is highly significant. It means we only need to put 60% of our capital into that basket of stocks to generate the same incremental return as a market portfolio would generate. So owning 50% isn't as cautious as it sounds.
In the sort of world in which everything is normally distributed, well behaved, and in which our insurance expires worthless (i.e. the sort of world most economists forecast), we'd still be making decent returns. And while there's no such thing as a truly bullet proof portfolio, we'd have done so with far less embedded risk. Because if any of the scenarios I've explored here come to pass we'd be in a much better position to take advantage of the distressed selling of others.That said, and as Dylan would be the first to acknowledge, if and when everyone is positioned with precisely this hedge on their books, it will be something totally different that will cause the next great financial wipeout. But until then, those who step in first, will benefit from appreciating prices precisely on their hedges. At that point it will be up to the principal to decide whether to take profits or to hold off until the bitter end. The problem, however, at least the way we see it, is that should any of these five black swans occur, any currency that one generates as a result of a successful trade, no matter the P&I, will probably not be all that useful for the world that materializes at T+1.
Here's just one more dot to connect: the Fed's disastrous monetary policy is the partial cause of food inflation, and thus a trigger for food riots all over the developing world!
by Ambrose Evans-Pritchard
The surge in global food prices since the summer – since Ben Bernanke signalled a fresh dollar blitz, as it happens – is not the underlying cause of Arab revolt, any more than bad harvests in 1788 were the cause of the French Revolution.
Yet they are the trigger, and have set off a vicious circle. Vulnerable governments are scrambling to lock up world supplies of grain while they can. Algeria bought 800,000 tonnes of wheat last week, and Indonesia has ordered 800,000 tonnes of rice, both greatly exceeding their normal pace of purchases. Saudi Arabia, Libya, and Bangladesh, are trying to secure extra grain supplies.
The UN’s Food and Agriculture Organization (FAO) said its global food index has surpassed the all-time high of 2008, both in nominal and real terms. The cereals index has risen 39pc in the last year, the oil and fats index 55pc.
The FAO implored goverments to avoid panic responses that “aggravate the situation”. If you are Hosni Mubarak hanging on in Cairo’s presidential palace, do care about such niceties?
France’s Nicolas Sarkozy blames the commodity spike on hedge funds, speculators, and the derivatives market (largely in London). He vowed to use his G20 presidency to smash the racket, but then Mr Sarkozy has a penchant for witchhunts against easy targets.
The European Commission has been hunting for proof to support his claims, without success. Its draft report – to be released last Wednesday, but withdrawn under pressure from Paris – reached exactly the same conclusion as investigators from the IMF, and US and British regulators.
“There is little evidence that the price formation process on commodity markets has changed in recent years with the growing importance of derivatives markets”, it said.
As Jeff Currie from Goldman Sachs tirelessly points out, future contracts are neutral. For every trader making money by going long on wheat, sugar, pork bellies, zinc, or crude oil, there is a trader losing money on the other side. It is a paper transfer between financial players.
You have to buy and hoard the vast amounts of these bulk commodities to have much impact on the price, which is costly and difficult to do, though people do park crude on floating tankers sometimes, and Chinese firms allegedly stashed copper in warehouses last year.
But that is not what commodity index funds with $150bn are actually doing with food, base metals, and energy. Only governments have strategic petroleum and grain reserves big enough to make a difference.
The immediate cause of this food spike was the worst drought in Russia and the Black Sea region for 130 years, lasting long enough to damage winter planting as well as the summer harvest. Russia imposed an export ban on grains. This was compounded by late rains in Canada, Nina disruptions in Argentina, and a series of acreage downgrades in the US. The world’s stocks-to-use ratio for corn is nearing a 30-year low of 12.8pc, according to Rabobank.
The deeper causes are well-known: an annual rise in global population by 73m; the “exhaustion” of the Green Revolution as the gains in crop yields fade, to cite the World Bank; diet shifts in Asia as the rising middle class switch to animal-protein diets, requiring 3-5 kilos of grain feed for every kilo of meat produced; the biofuel mandates that have diverted a third of the US corn crop into ethanol for cars.
Add the loss of farmland to Asia’s urban sprawl, and the depletion of the non-renewable acquivers for irrigation of North China’s plains, and the geopolitics of global food supply starts to look neuralgic.
Can the world head off mass famine? Yes, with leadership. The regions of the ex-Soviet Union farm 30m hectares less today than in the Khrushchev era, and yields are half western levels.
There are tapped hinterlands in Brazil, and in Africa where land titles and access to credit could unleash a great leap forward. The global reservoir of unforested cropland is 445m hectares, compared to 1.5 billion in production. But the low-lying fruit has already gone, and the vast investment needed will not come soon enough to avoid a menacing shift in the terms of trade between the land and the urban poor.
We are on a thinner margin of food security, as North Africa is discovering painfully, and China understands all too well. Perhaps it is a little too early to write off farm-rich Europe and America.