Has Anything Changed?

Gold at $980, silver at $20, oil at $102 and wheat at $15. In each of these markets, the pros might say that the prices don't reflect market fundamentals. While that may often be true for silver and gold, it makes little sense for other commodities. The asset allocation target of the times? I guess commodities go until they don't. All of my coffee buyers are dumbfounded by the market.

After a couple weeks of choppy upside action we took a big dump. While the small rally was nice with participation from the regulars - Metals, Ag, Energy - it was also a bit thin: I didn't seen any broader participation by big money, with big names like GE unch'd. There has not been a recent 90% up day in trading volumes but there have been many 90% down days. And we are still well over 20 on the VIX. I did see an interesting move by the natural gas plays; they seem to be moving out from the shadow of oil. We'll see.

The oil sell off and dollar rally from Jan and early Feb both faded quickly. The commodity rally seems to be sucking in assets worldwide and may be covering up real supply/demand changes, particularly in oil. The US consumer is making changes in their consumption patterns and the WW economy is slowing. But, it almost seems as if the traders think that whatever WW slowdown happens, it will be brief and shallow.

The move in the dollar suggests that the US recession is certain- at 1.52 E/$ and 102 $/Y, these are big moves signalling rates have further to drop. They may also be saying that rate changes are not going to generate much growth but will certainly push inflation. And that the US is headed for (or in) a recession.

Financials still have lots of issues to deal with in terms of asset quality, although the BCS and StandChart numbers and comments suggest some firms are clean, plus S&P has suspended the monoline downgrades for now. Having said that, CS said all was well only to come out a week later and reprice a whole lot of assets downwards, and the B/S of the insurers tells you there are no real current AAA ratings.

It appears as though there will be a few more quarters of mark to market on the down side, with leveraged loans, commercial mortgages and consumer credit jumping in the sand box for a bit of play time. Add in a poor earnings environment for Ibanks going forward and it's tough to see why you want to be there. Hedge funds continue to implode as corporate spreads widen and structured products run into their threshold limits forcing more unwinding and markdowns. The rally in the Yen can only accelerate this process as the carry trade shrinks. The spiraling downward cycle of credit unwind clearly has room to run.

The corporate spreads are the intriguing thing now; as reported in Bloomberg, "Last year, spreads on high-yield bonds were so low, that you could have expected to lose money if you purchased them, even if they defaulted at the lowest rate in history. This year, spreads are so high that you can expect to make money even if they default at the highest rate in history. That's one way to say that corporate bonds look like a good buy right now. If you think about it in terms of implied default probabilities, the analysis gets downright shocking."

"Looking at the iBoxx Dollar Liquid Investment Grade Index, (analysts) estimate that current spreads imply that 19 percent of five-year bonds in the index will default during the next five years. This is an unbelievably high rate. The highest default rate for these bonds was just 2.4 percent, and the average rate since 1970 was 0.8 percent. Current prices suggest that 21 percent of five-year bonds in the financial industry are expected to default during the next five years."

"This places financial bonds -- the debt of some of the bluest of blue-chip firms -- smack dab between single A- rated bonds (which have an implied expected default rate of 20 percent) and BBB-rated bonds (which have an implied expected default rate of 22 percent.) Those implied default rates are also way outside of historical experience. The highest five-year default rate for A- rated bonds was 2.5 percent. The most for BBB-rated bonds was 5.8 percent."

"The mayhem, of course, hasn't just affected five-year bonds. Longer maturities have even more extreme default scenarios priced in. Current prices suggest that 29 percent of corporate bonds will default over the next 10 years. That rate is six times higher than any 10-year period since 1970. It is worth noting that these default probabilities are probably somewhat inflated, as default risk isn't the sole consideration when looking at bond prices. Even so, the market is pricing in a bond-market catastrophe that's far worse than anything that has ever happened."

This is all happening while the same companies' stocks are holding up. This is vexing many who always seem to think the bond market is smarter than the equity market. Is the credit reset of the past year simply forcing rates back in line with risk, overshooting along the way from poor liquidity? Or is the implied default risk accurate?

This question of liquidity vs. solvency was hard enough to understand for the companies with truly risky assets on their balance sheets or those with too much leverage, but does that describe most corporate B/S's? If the bond prices are not accurate, then a bigger question arises: is all of the structured finance mark to market going too far? Are the underlying fixed income assets equally miss-priced? Again, Bloomberg: "Some analysts, such as Richard Bove of Punk Ziegel & Co., say the tools banks are using to value their assets "don't reflect the real world."

"This mark-to-market accounting forces banks to mark their portfolios against indexes that aren't representative of what's going on in the markets at all. " One index banks use "shows something like an 8 percent potential loss in commercial real estate in the United States,'' he said. "Do you know what the actual loss is right now? One quarter of 1 percent. In other words, banks are marking their securities against an index that suggests the losses will be 32 times worse than the actual loss experience."

The final word on what the bond and currency markets now seems to be saying about the US economy comes from the FT: "There was for a while an argument that debt's problems were down to liquidity problems in the debt market, and so stocks did not need to follow credit down. But now both the bond market and foreign exchange show acute concern for the US economy. Stocks may have no choice but to move lower."

I am in cash and gold, following the instructions of Dear Leader (RR). I have small positions in natural gas with ME and CHK, and oil services with HAL . I am looking at junk bond funds, and am ready to jump back into fertilizer (AGU, MOS, TNH) and shipping (DSX, DRYS) and size up my position in natural gas. I have missed the metals off their bottom, but I am looking at FCX and NUE. As always, the big US export plays are still probably the safest bet and pay the biggest dividends.

There is a line of thought that says in our current high productivity, lean economy, growth has led to fewer job gains in the past few years and therefore recession will lead to fewer job cuts that typical. I want to be short retail, but I am so out of touch with US consumer attitudes that I can't get much conviction. But even if there is not a significant change in the unemployment rate, consumer spending pull-backs alone should impact more retailers over the coming quarters. I am still looking at BBY and ANF short.

Interestingly, the real bears on this global market, folks like Roubini and Faber, continue to see the US equity market as the most interesting place and consider Asian decoupling a myth. I am still unsure on this point; I do notice that Thailand seems unshaken by the recent down draft.

It's Not Your Daddy's Olds

S&P comes over the wire with the quote, "history failed us". It's always impressive how corporate managers are able to blame others for their mistakes. History? Who's that? Is it really possible that the analysts at S&P had no idea how much the mortgage market had changed in the past five to ten years? I guess so. They're as lazy and greedy as the rest of 'em.

Didn't they notice that banks had been disintermediated by the originators, warehousers, I banks and so on? Owners of mortgages have never been more removed from the creditor. The Time Life telemarketers have taken over for the old timey, suspender-strapped, close cropped banker. Did they really base their ratings on the 1990's and prior history of sub prime mortgage behavior? I guess so, $200B plus plus plus later.

Just as I congratulate RR on the bear call, he starts hedging his ass off. Every pundit is pretty mistified. Do we pay attention to the Q3 GDP growth, increases in disposable income, BIG rate cuts and low unemployment rate? Or do we focus on the thousands of broken charts, high volitility, overlevered consumer, macabre housing market and stunned credit market?

Lowry's says selling pressure abates little during the rallies, Yamada says WW charts are in death spirals, oil drops daily. The oil charts look aweful and none of the names are bouncing in the rallies. The pyramid of absolute strength is dissapating into a shaky base of relative strength in the "early cyclicals" and defensive names.

The oldsters are looking for low PE's before they do anything crazy. The PE's have been cut in half since the '00 peak, but as Mr. Maudlin reminds us, in all past market cycles, "there has never been a time when valuations dropped to the mean and then went up without visiting much lower valuations. Never."

Is it possible to separate the consumer economy strength from the crash in housing and credit? The shortage of bank capital is a short term issue, but the change in lending standards is a longer term issue. It seems as though we have peaked on all measures of the credit cycle and can only grow through earnings strength. That leaves the US consumer on a very fine edge, supported somewhat by the lowering of rates. Recession or no, there is a big slowdown that will likely be around for a while.

So the market has a delayed but strong response to the rate cuts, and clearly expects a lot more. But it doesnt seem like the currency markets do. The dollar is in full rally mode as the UK bank drops rates but the Euro bank holds. Traders are saying it's because the focus in currency markets is shifting towards a premium on growth and not rates. I'm still trying to figure that one out. Maybe it's because the US is early on this move and will be the first one out.

There are clearly more cockroaches to come from the banks, and the consumer appears to be coming to a dead stop. What to do? At some point the SWF's will stop reaching for the falling knife. Byron Wein says oil is going way up, as is gold, and the US $ is still in drop mode. In other words, no changes in trends even with a US recession. In his world, the ags, solars, and all oil related stories continue to lead.

I played a couple bounce names - BAC, AGU - but I was on the road and couldn't focus. I'm now holding a ANF short, a HAL long and a few small odds and ends. I want to get short more financials, but I'm scared of a bond insurance bail out. And it really seems to a be no-mans land market - right in the middle of the trenches where you get mowed down by machine guns, the short and long ones.

A few things I am sure of: inflation in Asia is growing like a festering carbuncle; oil is suggesting at least a slowdown and a drop in prices (at least the stocks are saying it); metals are moving back into contango as the heat comes off of the spot markets and inventory projections build; the weather is freaking me out weekly which is good for ag prices; the credit crunch is still in force and banks have lots of overpriced assets on their books (Macquarie...); gold is holding like a rock as the US $ rallies - the decoupling no one is looking for - and the 10 year looks overbought.

I sold the MU for a good quick gain, got stopped out on IBKR for a small gain, AGU for two big gains, and ACM for a unstopped modest loss. My discipline is getting better. For the moment, Gold is holding up well as the correllation among assets seems to be changing around a bit. At the moment they all seem to be correlated, but I assume they will begin to diverge in new ways. I am looking for gold through any correction (ABX is the clear leader).

I'm staying long DBA and looking for re-entry in the ag stocks, which have clean charts (the pure play nitro's like TNH/MOS), and waiting for rallies to sell more financials. I'd like to short the 10 yr. Any retailer that's not been ravaged, I think I want to get short. The Baltic Dry is still a focus, and I missed the huge DRYS rally, shamefully.

I find it hard to believe that China would let the market do anything but go up through the olympics. There is no question they have a plunge protecion team inplace. I'm not concerned with whether this is a bull or bear, secular or cyclical. I'm just waiting for a trend or severe overeaction.