Monday, December 15, 2008

Turn Yer Head For A Second And...

Just when you think it can't get worse. Madoff? Are you kidding me? $50b? That's about 1/2% of the US economy. The Mother of all ponzi's. Ponzi himself would be astonished. The good thing is the market is so used to bad news that it didn't really register much concern. What greater way could you come up with to point out the failings of the US capital markets? Capitalism needs an efficient and transparent market for capital. We don't have one.

We have a lot going on this week - OPEC meets, the Fed meets, GS and MS report - and I've been AWOL for a week, so there is a lot to catch up on. I've been in the bush on an outer island; I caught some waves, got bit by a dog, a regular solomon experience. on return, I have had a couple days to reflect on the changes in the last week and what seems clear is the following:

one, delevering has ways to go - this is a once in a century debacle and adjustment will take time; two, '09 will be a mess and growth will be moderate for years to come - no debt to fuel the fire anymore; three, the dollar must go down - massive debt issuances and low rates from quantitative easing will see to it; four, treasuries have almost bottomed - they may stay low for a long time, but looking on the short side is a good bet; five, high grade corporates have factored in a default rate worse than the 1930's and are the best bet for a rally in the next 3-6 months; and six, you can't slow the US consumer down without a corresponding impact in its manufacturing partner - Asia.

The short dollar call is the most interesting because of the recent rally in the Euro and Yen. It seems as though the market doesn't like the fact that the US current account deficit has expanded again, Madoff has dropped a $50b bomb and the Big Three might go bankrupt causing a massive round of CDS defaults. The jobless numbers didn't help and neither did the $500b-1t Obama fiscal plan making the rounds. These are the near term events.

Longer term, the market smells the '09 trillion dollar deficit and the massive treasury funding needs coming; it's looking at the expansion of the Fed's balance sheet with crappy assets and the likelihood of TARP 3 and TARP4 ; and it's looking at the current 0% yield on recent 30 day issuances. Growing risk matched by declining yield? Something has to give and it won't be interest rates - we can't afford that - so it must be the dollar. We can buy FXE or gold or the short dollar Profund.

Given that outlook, rates may not move up that much in the next 1-2 years, but we can be sure they can't fall much more. At a 0.5% Fed funds rate, money market funds are barely breaking even and that pretty much limits any move to 0%. That leaves the longer end of the yield curve, which has moved down aggressively over the past month to 2.60% for the 10 year. This move is a direct result of the quantitative easing policy of the Fed and can only be sustained by running the printing presses. At some stage of dollar weakness (and US inflation), the Fed will have to stop the game and rates will normalize. I wanted to be short T's a month ago, and would have burned, but the rationale is much better now. TBT is the ticker.

If you want to participate in a recovery rally in the US corporate sector, why not play at the high end of the balance sheet - high grade debt, instead of the least secure part of the balance sheet - common equity? At rates of 8%++ for high grade corporate credit with a potential for a serious rally in value, this seems like a sensible approach. I believe our endgame from this 50 year end-of-cycle carnage will place income above capital appreciation in the priorities of investors. That would mean you want a long term position in high grade bonds anyway. There must be some simple investment grade bond etf's to play. And you don't need to go too far out on the curve to get a decent yield or bounce on a rally.

What about gold? Well, if the dollar is going down in the longer term, and US inflation is headed up, seems that gold will perform well against the dollar for some time to come. As a hedge again Other Awful Things Happening, it seems helpful. Think about it: the largest economy in the world - by a factor of 3 - is taking a big gamble that the world will still hold its debt/currency despite a massive expansion in both. We live in a fiat currency world, and just 40 years ago the dollar was backed by gold. In a time of uncertainty, will we need to go back to a gold backing? Will we need to have all Fed currency liabilities backed by gold? Based on what we have in Ft Knox, that would price gold at $6-7,000/oz. You can own GLD, CEF, DGP or the gold stocks in GDX.

Finally, about Asia. They are more dependent than ever on exports, but their national and corporate balance sheets are strong and under-levered. They are flush with FX reserves. They will need them. If the US consumer contracts by 5% (a minimal guess), then China would need to expand its consumer spending by 40%. Not gonna happen. There is a very large export focused manufacturing base in Asia that will see a big chunck of business dissappear - some serious adjustments will be required. When those adjustments happen, this part of the world will be the Most Likely to Succeed.

As far as the expected equity rally goes, I'm getting bored waiting. The reports from Q4 and guidance for '09 will be nasty. The Obama fiscal plan has made the rounds and the market couldn't stay above 9,000. The hedge and mutual fund redemptions are still coming, so selling pressure remains. There is a lot of cash on the sidelines; what now will suck it into the market? I still own SSO for the trade and am underwater by only 15% now... Meanwhile some names have surged on the US infrastructure plans and look like good shorts. ACM comes to mind.


Blogger h tomlinson said...

What about LQD in the high grade bond category ... check out its holdings ... it has performed just as you are predicting

9:23 AM  
Blogger h tomlinson said...

What about LQD in the high grade bond category ... check out its holdings ... it has performed just as you are predicting

9:23 AM  

Post a Comment

<< Home