Archive for October, 2010

The SPDR Page

In an overall trendless market, you can still make money by trading the sub-sectors within a given market. This video shows you how we apply the Fund King System to the 15 Sector ETFs (and their underlying stocks) that make up the S&P500.

Watch this week’s Video Review to see what we are talking about. Click the full screen icon to the right of the volume controls if you want to see a larger version.

“China!”

Dog from the Disney movie UP

Source: YouTube – Disney Movie Trailers Channel

In the Disney movie “Up”, the dog is equipped with a collar that allows him to speak to our fearless adventurers. However, the dog interrupts himself mid-sentence to exclaim “Squirrel” (@ 1:28 of this 2:31 minute trailer), thus demonstrating that no amount of technology will improve upon the distracted dog brain that is behind the voice.

The markets around the world on Tuesday looked much the same as this “clever dog” in the picture above. The Chinese Central Bank decided to nudge the one year lending rate a massive 25 basis points (to 5.56%) and deposit rates to 2.5%. This was enough to clobber the Aussie dollar and impact markets around the world. And then, on the 20th, it was all over.

But is it really over?

The 25bp hike was a “Squirrel” moment because the global financial markets are overly sensitized to any change in interest rates.

First, the move itself won’t have much of an impact on Chinese demand, inflation or the “firehose of liquidity” that is pouring into China and the rest of Asia. It is a one-off “shot across the bow”. Don’t hold your breath for unilateral follow up.

Second, the larger issue is the brewing currency war between China and the US (see this and related FT articles). Simply stated, the US wants to depreciate the US dollar to pump up growth and inflation so as to transfer both short term and long term economic pain to the current account surplus countries. At the same time China, fearing an inflationary/hot money bubble, is unwilling to play along. For China, a revaluation of the RMB will transfer a healthy bulk of the US’s economic pain to its own export dependent economy while doing next to nothing to discourage hot money in the short to medium term. But it is not a two dog fight. The rest of the world (or at least the bit with trading currencies) is caught up in this dispute. Brazil’s finance minister, Guido Mantega, cancelled his trip to Seoul’s G20 meeting because he was too busy dealing with the forex situation in Brazil.

Will this result in another “Plaza Accord”? Probably yes and probably sooner than the finance ministers in Seoul realize. The US cannot afford to depreciate the dollar in a chaotic manner because it risks plunging the country into some very unpleasant economic circumstances. China will eventually sign on to some sort of deal because it can afford neither the inflation that has already started to bubble up nor a disruption in its biggest export market. The rest of the world will sign on just to keep the US from resorting to drastic capital and trade barrier tactics which threaten to nip the strong global recovery (at close to 4.5%) in the bud.

How should investors play a new “Plaza Accord”?

There is no question that the US dollar will get much cheaper but that does not automatically translate into Gold at $3,000 per ounce. Gold may rise further and certainly the Fund King System is positively disposed towards the yellow metal and the companies that extract it from the earth. However, much of the momentum on gold is tied to the uncertainty which has waxed and waned for the last decade. Once a level of multilateral certainty returns to the market, we may see the momentum behind gold leveling off at these lofty prices.

For US dollar based investors, it is a good time to evaluate your liabilities and see how much of your future expenditures are related to foreign currency. You might want to start rebalancing your investment portfolio to account for the 15%-20% forex exposure that wealth managers suggest is a “neutral weighting” for most middle and upper-middle class American families (“oh, you mean THAT BMW in my garage…”).

Once you have attended to the serious business of making sure that your assets will meet your future liabilities, it is time to look at some of the shorter term options.

The first option is UUP/UDN, which are the Bullish/Bearish US dollar ETNs offered by Powershares. That may not be exciting enough for some because it tracks the USDX Futures contract which is currently 57% Euro, 13.6% Yen and 11.9% British Pound. If you have a particular currency in mind, there are many choices (FXY, FXE, FXB, FXA, BZF…) in the ETF space to gain direct exposure to foreign exchange without having to learn what a pip is. If you want to play the RMB directly, CYB is far more liquid than CNY.

Another way to play the upcoming events might be found in VXX, the ETN that tracks the S&P500 short term VIX volatility index. At a close of just under 13 on Friday, it is flashing a surprisingly comfortable indication to a market that is faced with mid-term elections in the US and a potential currency/trade war. Unless the agreement is already stitched up, it is safe to assume that we will hit some turbulence before the new “Plaza Accord” takes effect.

The markets are set for a period of heightened volatility. Now is a good time to do some portfolio cleaning to make sure that you are not dragging any deadweight assets along for this ride.

“New Normal” Returns

First promulgated by the smart folks over at PIMCO, the industry is slowly starting to embrace the concept of the “New Normal” age of investment returns. Simply stated, investors should expect single digit returns on average over the next few years while the developed economies dig their way out of the wreckage of the Global Financial Crisis. In a world of deleveraging, lower consumption growth, very low interest rates and maybe even a dash of deflation, investors are being told to ratchet down their expectations.

The elegance of the “New Normal” scenario is that it is self fulfilling. If one continues to invest like the 1990’s never ended, steady single digit returns are a very likely outcome. Buy and hold, quarterly rebalancing, broad diversification and closet indexing should give investors a pretty meager return if the overall economic pie doesn’t grow much. Unfortunately, this is precisely how most fund management, insurance and pension funds are designed to operate.

Why are we looking at crummy returns?

One need not look too far for the answer. While the global economy should experience some nice 4% plus growth over the next two years, the developed economies are not likely to enjoy anything approaching that level. Without several quarters of supercharged GDP growth, the US will be stuck with excess idle capacity and 10% unemployment. For investors who seek to get a broadly diversified exposure to the snail like growth of the US economy, it will be difficult to exceed the snail speed limits in terms of investment return.

How do we know that the US is in for more of the same?

The ECRI leading indicators are negative and while they are not deteriorating, they are not suggesting much in the way of growth either. Even the Mainstream Financial media is starting to figure out that neither more government stimulus nor Quantitative Easing 2 is going to be of much help. Without the private sector, the newly created money will cycle through the economy at a relatively slow rate, negating most of its stimulative properties. The Consumer Metrics Website is not painting a pretty picture either.

ECRI chart

Source: www.businesscycle.com

What can one do?

The answer lies in asset allocation. Just because a company is headquartered in the US does not mean that all of its revenues and profits come from the US. And just because the overall economy is due for a sluggish performance does not mean that there won’t be pockets of strength to exploit. For this week, take a look at the SPDR Materials ETF (ticker: XLB). The ETF itself is showing some reasonable strength for the medium term but if we were to construct a portfolio of the 31 constituent stocks and apply the Fund King System, we can see that a good 5 year return (over 100%) turns into a very strong 5 year return (holding only 5 of the 31 stocks at any one time).

SPDR Materials ETF

This same concept of selecting a portfolio universe and then investing in the most promising part while selling or avoiding the part of the universe which is not as promising can be applied to a wide variety of asset classes. For investors willing to consider investing part of their portfolios in Turkey, India, Asia or Emerging Markets in general, the prospects look much brighter than what US and European markets are likely to dish up in the medium term. Of course, when the tides of money shift direction, the Fund King System will be there to flash that inevitable signal as well.

Website Review – JohnMauldin.com

John Mauldin produces two free newsletters which are a must read. In this video, we introduce you to John Mauldin and tell you how to get on his mailing list. John Mauldin not only has great insights into the market himself but he also introduces us to alot of other useful content on the web.

Watch our Video Review of his website.

What’s Good for the Goose…

Everyone had a teacher who could see through the nonsense and zero in on behavior that was “just not acceptable”. Miss Tottenham (who later became an Anglican Bishop) did not have time for excuses and, perhaps because she was Canadian, she did not particularly care if our young egos were bruised by her corrective nostrums. The bruises healed but the lessons stuck.

Amongst her many admonishments was the old saying: “What’s good for the goose is good for the gander”. The term is meant as a reminder that the two sexes should not be subjected to different standards and it was often used in that context. However, she was fond of extending the saying to other areas (comparative religious studies in particular).

How does this apply to the markets today?

As the mainstream financial media beat the drums for the next round of quantitative easing, one can’t help but notice that policy makers in the US have one set of recommendations for developing countries going through a financial crisis and another set for G-7 countries.

Like my old teacher, the markets do not suffer fools lightly. The question is: who are the fools today? And why are they acting foolishly?

Let’s start with the mainstream financial media, which was born and raised in New York and London.

The reason I pick on the media and not Treasury Secretary Geithner is because I do not have regular access to the latter whereas it is hard to avoid the former. Whatever Mr. Geithner, Mr. Bernanke, Mr. King, Mr. Trichet and Mr. Shirakawa are thinking, saying and doing, I am confident that the Financial MSM will be there to parse each datapoint for the rest of us.

But all of that analysis and commentary, which have tremendous impact on intraday trading, is largely irrelevant given the direction in which these esteemed gentlemen and their institutions are heading. Instead of learning lessons from the recent crises that have plagued the world outside of the mainstream media’s immediate focus, the leading economies in general and the US in particular have decided to validate Santayana’s famous quote: “Those who cannot remember the past are condemned to repeat it.”

What past am I referring to? How about the Asian Financial Crisis? The Swedish Banking Crisis? The Japanese Stagnation? Or even the S&L Crisis?

Rather than detail the lessons missed, let’s start with why they were missed. The primary reason is an extension of the NIMBY attitude which ensures for example that the US perennially lacks adequate refining capacity (haven’t heard about that one lately? Just wait until the US unemployment rate heads back to 6% and all those new workers drive to work). These crisis events did not take place in the backyard of the policy makers who are tasked with designing a recovery. Therefore, until now, no one was building a policy response. And, after years of doling out harsh advice through the IMF, no one is seriously proposing the same draconian measures for developed economies.

Not everyone failed to learn from the recent slew of crises. Let’s start with the Asian Crisis. Who learned what lessons? All the countries involved, including China, recognized that a banking system run amok could torpedo decades’ worth of economic growth in very short order. China, Korea, Taiwan, Hong Kong, Singapore, Malaysia and Indonesia faced severe challenges. So did Thailand (patient zero of the Asian Financial Pandemic) but that country has been too busy with internal politics over the past decade to worry much about economic development.

What was the response? They learned that keeping banks on a tight leash, stacking up piles of foreign exchange at the Central Bank, keeping currencies stable and current account/budgetary balances under control were all needed to stave off the next crisis. What assistance did the countries receive from the G-7? Not much. As a result, banks failed or were merged, property markets took hits and some of the cowboy financing was curtailed.

Therefore, one shouldn’t really be surprised when China doesn’t respond to every US Treasury lecture or Congressional resolution. Chinese officials know that a revaluation of the RMB is not going to change the structural nature of trade between China and the US anytime soon. Furthermore, while it will not instantly transform China into a modern service and consumption based economy, a revaluation will hand the Chinese an “instant loss” on the pile of US dollar denominated assets which backstop the RMB. With the Asian Crisis experience fresh in their minds, is there any wonder that we are hearing “What’s good for the goose is good for the gander” statements from Chinese officials.

What can Japan teach us?

If you look through a second hand book store, you are bound to find copies of books declaring “Japan as #1”. These books all date from the peak of the Japanese property bubble in the late 1980’s. In the intervening two decades, Japan’s economy has stagnated while its government has accumulated a peacetime pile of debt that is staggering. How did this happen? Two words: gullible stooges.

Who were the “gullible stooges”?

In Japan, they were the middle class who were happy to plow a significant amount of their savings into government bonds or institutions which primarily bought government bonds. With such a bountiful supply of willing buyers, the government was able to funnel that savings into zombie companies, zombie banks and infrastructure projects that make the famous “Bridge to Nowhere” look like a sensible project. The whole process was contained largely within the borders of Japan because the Japanese had the resources to squander that allowed them to overlook the consequences. The only outsiders who might have noticed were academics and a few foreign bond traders. The price and yield of JGBs were largely uncorrelated to the rest of the world. The only outside effect was the “carry trade” (borrowing cheaply in Yen to invest dearly in other currencies) which drove massive fund flows to high yielding currencies and helped to drive down rates globally. So, what did the rest of the world learn about the Japanese situation? Almost nothing. After all, the problem was contained in a stable democracy and all those Quantitative Easing Yen were flowing into Australia, New Zealand, Canada and the US, lowering interest rates, easing lending conditions (by boosting wholesale funding supply) and indirectly boosting consumption and property prices.

Now, with 20/20 hindsight, we can see that there were important lessons in the Japanese experience that no one was willing or perhaps even able to comprehend at the time.

When it comes to the US property bubble triggered Financial Crisis, most learned observers point out that conditions are very different in the US than they were in Japan in 1989. Oh really? Property prices and lending standards that had lost touch with reality? Government funding for zombie companies (AIG, GM, Chrysler)? Government support for zombie banks (Citibank, Goldman Sachs, Bank of America, Morgan Stanley…)? Massive stimulus packages funded by public debt? A peacetime record level of public debt? Raising taxes? Ah, but you might say, there is a difference. The American Middle Class did not have the savings to become “gullible stooges” like the Japanese Middle Class. And that is correct. The “gullible stooges” were governments and banks around the world which used US Treasuries and Agency paper as well as more exotic derivatives as their asset base. That’s how Japan’s lost decades have remained largely a domestic issue while the US Subprime disaster morphed so quickly into the Global Financial Crisis. So, while Japan has tried to squander the wealth of its middle class, the US is busy trying to squander the reserve status of the US dollar.

How does that help us as investors?

When we look forward over the next two years, we need to build investment scenarios that accommodate reality the way it is unfolding rather than clinging to historical relationships that may no longer be valid. The economic balance of power is shifting as China overtakes Japan to become the second largest economy (it earlier overtook Germany’s top export position).

With the US largely in denial (the political mood is heading towards “Carter malaise” levels), the profitable investment opportunities are probably not going to come by buying and holding a wide slice of “blue chip” companies with the S&P500 trading on a high teens forward P/Es. Unless something changes dramatically, the US will stay in a bear market (which can be defined as a secular fall in P/E ratings). Asia and Latin America’s painful financial crisis experiences appear to have served both regions well. Africa is growing economically for the first time in decades (with South Africa leading). The Middle East has opportunities that a country like Turkey is trying to capture. And Europe, led by Germany, is starting to deslot from the fiscal and monetary policies advocated by Japan, the US and the UK. Resource rich and legally/politically stable Canada and Australia are also areas that deserve a closer look.

The world survived the stagnation of its previous world beater, Japan, in the 1990’s and it will no doubt forge ahead while the US spends the next few years putting its affairs back in order. Even a crisis in China will have to be put in the context of improving fundamentals in Brazil, India, South Africa, Indonesia and Turkey.

This is not idle speculation. The IMF is forecasting global growth in excess of the 4% as the rest of the world recovers from the effects of the Global Financial Crisis. But that number hides big gaps between the developed and developing worlds. Companies that are poised to take advantage of the growth will benefit while companies that are depending on the US consumer are not likely to grow as quickly.

That doesn’t mean that there won’t be opportunities along the way in the US Equities Markets. It does however mean that a Buy and Hold approach to the markets is probably not the right method.
As a result, the Fund King System is starting to show growing momentum in equities, particularly in emerging markets. The previous leaders, US Governments and Precious Metals, are still holding up with Silver playing some catch up to Gold.

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