Tuesday, February 26, 2008

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.


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