ETF Ingenuity in Copper and Rare Earths: Giving the Market What It Wants

Tuesday, November 2, 2010

Years ago, your editor was involved in a deep-water search & salvage operation off the coast of the Azores. Founded to locate a group of 16th century Portuguese cargo ships loaded with gold and silver, the company was decidedly low-tech even for the time. In fact, we relied on good old-fashioned Mark I eyeballs for our initial sea-floor search operations. This was possible – and effective – because we were anchored on a very simple yet highly effective premise, taught to us by a former Royal Navy diving officer: Nothing in nature goes in a straight line for very long. If we saw something on the ocean floor that went in a straight line, it meant that it was very likely man-made and potentially one of our target ships. This rule extends to the financial markets as well. In fact, one of the very first things fledging investors learn is that it applies to virtually any traded instrument. Moreover, it is true in all directions – up, down, and even sideways. In fact, even the most established trends experience reversals and corrections, some of which can shake even the most ardent strategist’s faith in his or her conviction. It is this type of correction that we have been experiencing in a number of markets, including commodities, over the past few weeks. And if you think the U.S. markets have been volatile, look at Germany, which is ground zero for the European debt crisis – its main equity index, the DAX, is on track for its fourth-straight week of moves of +/- 6% or more. A corollary to our self-named Straight Line theory of market moves is that the longer something has moved in the same direction, the sharper the inevitable correction. This is due to the very normal human tendency to take profits. Or, in the case of gold’s trading over the past few sessions, to raise cash when it looks like virtually every other asset class is in a deflationary spiral. One doesn’t have to agree with the market to understand what it is doing. Has the correction been sharper than we would have liked? Absolutely. Has it extended to instruments typically uncoupled from volatility in equity and fixed-income markets, like gold? Yes. And has it impacted commodity-linked currencies like the Brazilian real beyond what we feel the fundamentals warrant? You bet. But have the massive swings in these markets changed our long-term belief regarding precious metals, copper, commodities and commodity-leveraged currencies? Not in the least. The last several days have been the epitome of what Wall Street euphemistically calls whipsawing. It’s a term that describes violent swings up and down in price and hearkens back to the days when the push-pull action of a long saw made short work of timber. Whipsaws are most common when the markets are churning through conflicting signals and there is a broad lack of consensus regarding strategic direction. With economic data suggesting a looming recession, and twin debt crises threatening fundamental assumptions about fiscal policy in developed countries, it is not surprising to see even gold, the ultimate store of value, sold off as investors the world over have raised cash. This is especially true considering the handsome profits that were earned in precious metals over the last six months. Considering we’re about to enter the fourth quarter of a very difficult year, we’re sure more than a few fund managers have been keen to book a gain wherever one exists. The commodity correction has been a remarkable sight, but ultimately it is not something that changes our strategic outlook on resource investing. On the contrary, it is an opportunity to engage in these areas if you haven’t already, or to average down entry prices. Why? Because we’re convinced growth will eventually emerge, markets will stabilize (they may well have already begun) and commodities will resume their upward march. Copper under $3 per pound, for instance, is unlikely to last long given the simple mathematics of Chinese economics. Cash Cow’s Commodity Portfolio has been the hardest hit since our last issue, with price gains in eight of our 10 ETF positions wiped out by the correction. However, we strongly advise against being sucked into the reactionary trading that often seduces investors in highly volatile environments. Stay the course; remember that nothing goes in a straight line. Investors who sold at the first hint of trouble after the prior top in gold in 2008, the last time commodities went through a similarly wrenching reversal, ended up missing out on the best gains in a generation.

Years ago, your editor was involved in a deep-water search & salvage operation off the coast of the Azores. Founded to locate a group of 16th century Portuguese cargo ships loaded with gold and silver, the company was decidedly low-tech even for the time. In fact, we relied on good old-fashioned Mark I eyeballs for our initial sea-floor search operations. This was possible – and effective – because we were anchored on a very simple yet highly effective premise, taught to us by a former Royal Navy diving officer: Nothing in nature goes in a straight line for very long. If we saw something on the ocean floor that went in a straight line, it meant that it was very likely man-made and potentially one of our target ships. This rule extends to the financial markets as well. In fact, one of the very first things fledging investors learn is that it applies to virtually any traded instrument. Moreover, it is true in all directions – up, down, and even sideways. In fact, even the most established trends experience reversals and corrections, some of which can shake even the most ardent strategist’s faith in his or her conviction. It is this type of correction that we have been experiencing in a number of markets, including commodities, over the past few weeks. And if you think the U.S. markets have been volatile, look at Germany, which is ground zero for the European debt crisis – its main equity index, the DAX, is on track for its fourth-straight week of moves of +/- 6% or more. A corollary to our self-named Straight Line theory of market moves is that the longer something has moved in the same direction, the sharper the inevitable correction. This is due to the very normal human tendency to take profits. Or, in the case of gold’s trading over the past few sessions, to raise cash when it looks like virtually every other asset class is in a deflationary spiral. One doesn’t have to agree with the market to understand what it is doing. Has the correction been sharper than we would have liked? Absolutely. Has it extended to instruments typically uncoupled from volatility in equity and fixed-income markets, like gold? Yes. And has it impacted commodity-linked currencies like the Brazilian real beyond what we feel the fundamentals warrant? You bet. But have the massive swings in these markets changed our long-term belief regarding precious metals, copper, commodities and commodity-leveraged currencies? Not in the least. The last several days have been the epitome of what Wall Street euphemistically calls whipsawing. It’s a term that describes violent swings up and down in price and hearkens back to the days when the push-pull action of a long saw made short work of timber. Whipsaws are most common when the markets are churning through conflicting signals and there is a broad lack of consensus regarding strategic direction. With economic data suggesting a looming recession, and twin debt crises threatening fundamental assumptions about fiscal policy in developed countries, it is not surprising to see even gold, the ultimate store of value, sold off as investors the world over have raised cash. This is especially true considering the handsome profits that were earned in precious metals over the last six months. Considering we’re about to enter the fourth quarter of a very difficult year, we’re sure more than a few fund managers have been keen to book a gain wherever one exists. The commodity correction has been a remarkable sight, but ultimately it is not something that changes our strategic outlook on resource investing. On the contrary, it is an opportunity to engage in these areas if you haven’t already, or to average down entry prices. Why? Because we’re convinced growth will eventually emerge, markets will stabilize (they may well have already begun) and commodities will resume their upward march. Copper under $3 per pound, for instance, is unlikely to last long given the simple mathematics of Chinese economics. Cash Cow’s Commodity Portfolio has been the hardest hit since our last issue, with price gains in eight of our 10 ETF positions wiped out by the correction. However, we strongly advise against being sucked into the reactionary trading that often seduces investors in highly volatile environments. Stay the course; remember that nothing goes in a straight line. Investors who sold at the first hint of trouble after the prior top in gold in 2008, the last time commodities went through a similarly wrenching reversal, ended up missing out on the best gains in a generation.

President Obama has begun the arduous process of selling his jobs plan to the nation and a very skeptical Republican party, a process that will undoubtedly involve more soundbites than the original proposal did last week. The president is being extremely careful not to call the jobs plan “stimulus”, although that is exactly what it is, since the last two rounds of federal stimulus have resulted in little tangible impact.

This is not entirely the fault of policymakers. Based on political belief that the government can and should become the lender of last resort when an economy (and its citizens) roll into a crisis, the last three years have been replete with examples of governments essentially protecting citizens from themselves – or rather from the leverage and risk they created during the boom times. And from a moral perspective, it is also the policy choice easiest to defend – who can disagree with Obama’s sound bite yesterday rhetorically asking whether putting laid-off teachers back to work should take a back seat to tax breaks for private-equity fund managers?
 
But from an economic one, stimulus has rarely resulted in net positive growth in the past, even during garden-variety recessions. The economic dislocations from the financial crisis have been far beyond the “typical” recession, ensuring the recovery from them will be equally unique, and stimulus of any kind even less likely to work. At best, programs such as those proposed by Obama are stop-gap measures, important although tactical in nature. Work programs fixing roads and repairing schools are laudable and necessary, but they are not the same as long-term growth in private-sector hiring, and they do not bring the same benefits. Even the New Deal, praised for decades as the engine that drove the U.S. out of the Great Depression, is now considered by most economists to have actually extended it. Compassion aside, it was not the CCC or the TVA that got America growing again, but rather the hundreds of thousands of workers going to work in privately-held companies to equip the nation’s military.

The fundamental issue that continues to plague policymakers today, be they in Europe or Washington D.C., is that deleveraging continues apace. While businesses, consumers and even countries are focused on reducing their debt loads, they are not in a position to grow either consumption or credit. And that holds true whether it be by stimulus or any other means. And we have yet to fundamentally deal with the leverage issue in the first place; like in a shell game, we’ve merely moved it from the real-estate sector to the financial sector and now on to sovereign governments, where it must stop. The old maxim “every debt is either eventually repaid or defaulted upon” applies.
 
Commentators are bashing politicians around the world for a lack of political will in dealing with the “credit” crisis, but in fact it is a deleveraging crisis and political will exists in spades. Indeed, it is a resurgence of political will that is causing much of the consternation. In years past, stimulus plans and bank bailouts largely sailed through the political process – just look at the spending authorized in the U.S. during the two years when Democrats held both the White House and the majority in the U.S. Congress, or the cradle-to-grave social policies created in Greece, neither of which could be paid for with existing revenue sources. Today, however, politicians from Fresno to Frankfurt are balking at the prospect of digging even deeper fiscal holes, although they are simultaneously realizing that the policies needed to de-lever their national balance sheets also render them unelectable.
 
In the meantime, an extraordinary (but not unexpected) transformation is taking place. Quietly and without a lot of fanfare, China – the nation with the strongest balance sheet on earth – is stepping into the breach. Officials in Italy – the largest of the at-risk European nations and the only one still able to access international markets to any degree – recently discussed “potential investments in the country” with the Chinese. In clear text, this means the purchase of Italian bonds or privatized Italian assets. Spain, Portugal and Greece have already been down this road. Since the onset of the financial crisis,
China has increasingly become the world’s lender of last resort, and now that nations are involved, it is eclipsing the ECB, World Bank, and even the IMF.
 
We’re obviously not privy to the investment details, but in a world of 1.98% 10-year U.S. Treasury bonds, one can imagine that the Chinese are going to earn very attractive returns in exchange for investing into the sovereign equivalent of sub-prime mortgage assets. It’s a smart move and the national equivalent of buying when there is blood in the streets. Although the European problem is too large even for China to handle entirely alone, it may be enough to return some confidence to the bond markets of these countries. In any event, it is the largest backstop available. Let’s hope it holds.

 

Labor Day in the United States is an unofficial line in the sand for millions of people. Not only do most schools begin immediately after the holiday, but Congress returns to session and most businesses consider it to be the end of the summer vacation season. In other words, it’s when a vast swath of the American population gets back to work.

This year, the passing of Labor Day also ushers in an extremely busy week for the world’s central banks. Already this morning, the Swiss Central Bank took aggressive steps to halt the Swiss Franc’s ascent, while the central banks of Sweden, Japan, Canada, South Korea, Indonesia, Malaysia Australia and the Philippines all meet this week, as does the Bank of England and the European Central Bank. To cap it off, finance ministers of the G-7 meet at the end of the week in southern France, where it is assumed policy coordination is on the agenda.
 
For the Asian nations on the list, expectations are that they will err on the side of caution. They will either openly adopt more accommodative policies, or at least stop tightening. Indeed, Brazil’s central bank met last week and unexpectedly cut interest rates even in the face of higher reported price rises. Like most major high-growth exporters, Brazil has decided it would gladly trade an uptick in inflation if it means growth continues to hum along.
 
This applies to the U.S. as well, although you will never hear it mentioned by the Fed. We’re certain that Ben Bernanke (not to mention President Obama) would welcome a little inflation if it meant U.S. GDP growth returned to the 4%+ range. The problems faster growth would help to solve – unemployment, tax receipts, etc. – seem much more intractable at the moment, although from a macro-economic perspective policymakers should be careful what they wish for.
 
Meanwhile, it is the action of the Swiss Central Bank that has captivated our attention. We discussed the ascent of the Swiss Franc in our last issue, and have been watching it closely for an entry point ever since. It may have just arrived.
 
It has not been since the breaking of the British pound in the early 1990s that we have seen this kind of rhetoric coming from a country’s monetary authorities: “The Swiss National Bank (SNB)…will no longer tolerate a EUR/CHF exchange rate below the minimum rate of CHF 1.20. The SNB it will enforce this minimum rate with the utmost determination and is prepared to buy foreign currency in unlimited quantities". The SNB explained further that "the current massive overvaluation of the Swiss franc poses an acute threat to the Swiss economy and carries the risk of a deflationary development."
 
We’ve seen this movie before, and if past is prologue, the key phrases here are “unlimited amounts” and “utmost determination”. The SNB is aiming to set a line in the sand and show the markets that it is willing to do whatever is necessary to create conditions that result in a sustained and significant decline in the Swiss franc versus the Euro.
 
The kicker is that the Swiss national bank alone does not have the ammunition to defend its currency against global markets for any length of time. It had roughly $233 billion in foreign currency reserves as of 2010. Its gold reserves, which are significant, could in theory be sold off to generate foreign exchange, but that is an extremely drastic and unlikely step. This means the Swiss position has effectively no lasting teeth without the cooperation of other central banks in the world - notably the U.S. Fed and the ECB.
 
But we’d be surprised if either one is terribly inclined to support a strengthening of their currencies against the Swiss Franc. In the face of a potential double-dip recession, twin debt crises and the potential implosion of the European currency union, whether high exchange rates are squishing the Swiss economy is not going to be high on the list, and currency traders know it. Moreover, defending currencies is a horrendously expensive endeavor that history has shown only really works – if at all –over the shortest of terms. Short of outright currency controls of the sort practiced by China, South Africa in the 1990s, etc., there is very little reason at this point to believe the SNB’s peg will ultimately amount to anything other than rhetoric. As in the past, altering global currency flows is likely to be beyond the ability of any one small nation like Switzerland. Expect the Swiss Franc to trade sharply down on the news of the peg, stabilize, and then resume a tentative but consistent march back upwards.

The hurricane that swept up the East Coast over the past weekend reminded many people of the raw power contained in Mother Nature’s bag of tricks. A very large number of them had never dealt with a hurricane before, making the reminder more of an initiation that they will never forget. Like your first car, you never forget your first hurricane.

Despite a veritable army of experts and a national center dedicated solely to tracking, studying and predicting hurricanes, several exhaustively tested and extraordinarily sensitive models still failed to predict that the storm’s actual strength would be underwhelming when it hit New York City. Even in the modern age of supercomputers, there are simply too many variables at work. Some forces, it seems, are beyond man’s capacity to control, although we seem very capable of creating endless hype.

Markets often offer some of the same dynamic. Generations of analysts, economists, and money managers have tried, and failed, to consistently predict the market’s direction.

By definition and human nature, investors are no better suited to deal with once-in-a-generation financial events (such as the 2008 financial crisis) than Vermonters are used to dealing with hurricanes in their state. Rest assured, though, that just as younger Vermonters will remember Irene very far into the future, a whole generation of bankers and investors were forever branded by the financial crises and their aftermath. In both cases, the plans and philosophies of these younger folks will incorporate risk modeling not present in those that came immediately before them.

This has two repercussions. First, the average investor – individual as well as institutional – has been a more risk-averse entity for the better part of two years. The hints of weakening economic growth sparked a wave of selling far out of proportion to what was actually being seen in the data partly because the memory of the carnage of 2008-2009 is still very fresh. It’s one of the reasons why stocks are selling for the lowest valuations in several decades. Indeed, for the S&P 500’s price/earnings ratio to reach its long-term historical average of 16.4 (from under 13 now), either earnings have to fall by over 20% - unlikely in even the worst-case scenario.

But just as the images of quaint covered bridges being swept away in southern Vermont are now seared in that state’s memory, the crisis seared fear of the downside into Wall Street’s collective psyche, biasing much of what happens now with a bearish tint. Negative data, usually of a lagging nature like this morning’s consumer confidence measure, is given great focus, while positive reports with leading tendencies – such as indications that the decline in housing prices may finally be over – are given scant attention. Financial stocks have been among the most shunned, with industrial ones not far behind.

Yet Ben Bernanke used his much-awaited Jackson Hole speech last week to basically say the economy was not deteriorating fast enough to warrant any additional stimulus. Aside from being warmly greeted by deficit hawks in Congress, this was correctly interpreted on Wall Street as a backhanded way of telling the markets that the Fed sees the economy indeed recovering six to nine months out. Remember, the Fed doesn’t manage monetary policy based on what it sees today, but rather for what it sees coming tomorrow.

The chance of a double-dip recession continues to weaken, much like Hurricane Irene did once it came into the Northeast. The evacuations ahead of the storm, based on the better-safe-than-sorry theory, seem to some in hindsight to have been an overkill. In a similar manner, the preparations for a double-dip, such as shaving over $2.3 trillion from the S&P’s market capitalization since July 22nd,, are the same thing – more a function of past experience and increasingly overblown given the reality on the ground.

Granted, there are legitimate reasons for concern. Slower-than-expected recoveries in housing and manufacturing, the ongoing European debt crisis, the debt-ceiling debacle and eventual U.S. credit downgrade were all significant in their own right, and coming all together over the same 8-week period made it seem like the world was ending - again.

But it didn’t, and it won’t. Our thinking is that equities are in for a good run this fall, primarily because the data won’t support a double-dip and there is tremendous buying pressure built up from cash parked on the sidelines. Commodities, too, will do well, as it becomes apparent that the global economy is not, after all, headed off the rails. Gold can pull back – too far, too fast is not something we’re used to seeing with precious metals, but gold needs a breather. Note, though, that our underlying premise with the yellow metal remains intact and that any correction should be used to your advantage.

This week brings the world’s central bankers, finance ministers and other titans of Wall Street together for a few days of meetings supposedly concentrated on out-of-the-box scenarios, sort of a TOPOFF-like exercise for the world’s monetary authorities. The seminal event of the conference will be a speech by Fed chairman Ben Bernanke this Friday.
 
Sponsored each year since 1978 by the Federal Reserve Bank of Kansas City, the original intent of the Jackson Hole meeting has long been eclipsed by its use as a policy podium. In fact, last year’s meeting was used by Fed Chairman Ben Bernanke as the setting for a speech in which he outlined the idea of a second round of quantitative easing (a.k.a. QE2). In the event, QE2 didn’t actually begin until November of 2010, although the markets went on a tear almost as soon as the microphones in Jackson Hole were turned off. Anticipating an unprecedented flood of liquidity into the markets (as well as a virtually riskless trade in Treasurys), everything headed north – stocks rose 18%, crude oil 22%, copper 31%, gold 15%, etc.
 
Fast forward 12 months, and there are many in the markets who believe Bernanke will hint at a renewed quantitative easing program this Friday. Despite a lot of commentary to the contrary, there are still some low-caliber weapons available to the Fed that would spur the economy, and in particular jobs, including focusing further debt monetization on the long end of the curve and thus forcing borrowing rates even further. This would serve to flatten the yield curve, but since short-term rates are already at zero and staying there for the foreseeable future, there would be little price to pay on that end beyond an already-tattered credibility.
 
It can also assist in getting the mortgage mess finally behind us, which in light of continued lethargy in the housing markets is probably one of the most leveraged options still available to the Fed. Foreclosures continue to haunt large banks, which are still highly reluctant to lend, and corporate credit creation remains at multi-decade lows. Bernanke could do worse than to use the Jackson Hole opportunity to lay out some options for mortgage refinancings, resets and other direct lending initiatives. At the end of the day, getting the American real estate market off its back is probably the most visible thing the Fed could do. In a period of extreme uncertainty, some clarity of action in a sector that touches virtually all adult American taxpayers would pay second- and third-tier benefits.
 
Granted, Congressional Republicans have not signaled a great deal of willingness to go along with any further quantitative easing measures. But that does not mean they are categorically ruled out. Indeed, with the debt-ceiling issue now punted until the early fall, there may be more room to maneuver on this topic than initially meets the eye.
 
But there is also a good chance that Bernanke uses the podium at Jackson Hole to merely outline his options, instead of advocating for specific measures. This would be reminiscent of pre-crisis meetings in which the greatest financial minds on earth tried to think outside of the proverbial box about long-term, strategic problems facing global finance. Issues that would obviously qualify for such thought would be the European sovereign debt crisis, the impact of China on the global economy, education & poverty eradication, etc. This would be a mistake; although he would be forgiven for taking a wait-and-see approach, the markets will be highly disappointed with a passive tone on Friday.
 
Either way, we don’t think much really changes Friday morning. Proactive or not, investors will not be willing to part with safe-haven choices – at the moment, Treasurys, gold and Swiss Franc – until they have a better comfort level about the security of their principal. The age-old argument over stimulus versus austerity will not be solved this week; expect the markets to continue to sell risk and park assets where they are least threatened. This will mean equities, which are oversold and will bounce over the next few weeks, will face selling pressure as they rally.

One of Wall Street’s most consistent tendencies through the years has been for companies that have reached a certain size to buy other companies in an attempt to goose their growth. The old saying goes that when you can’t get better, you get bigger.

It makes sense. Rapidly-growing companies can book impressive year-over-year numbers while they are still small, but it becomes increasingly difficult to post double-digit gains in sales and earnings once you’ve become a billion-dollar enterprise. Looking outside your own business to major competitors (i.e. buying growth through increased market share) or to companies that are related but tangential to one’s own (i.e. buying vendors, partners, customers, etc.) are the two most common ways in which this is done.

However, history tells us that such steps are fraught with peril. Major acquisitions by mega-cap stocks are usually overpriced and rarely go well for the acquiring company. Companies that have become very large have entrenched systems, personnel and mentalities that can be extremely difficult to modify, and it is common to see the merged entity rapidly lose highly experienced managers a year or two after the deal. There are numerous examples of this, but we’ll cite AOL’s merger with Time and Alcatel’s merger with Lucent as a two very good ones.

Google’s $12.5 billion decision to acquire Motorola’s mobility division, with which it works very closely on the Andriod mobile-phone operating system, is very telling in this regard. Having grown by leaps and bounds over the past five years primarily through search and advertising, Google’s management is under severe pressure to keep the music playing. Frankly, the deal has one of the hallmarks of a potential disaster – Google is paying a massive, 63%, premium to gain control over Motorola’s jewel in the crown, even though the deal is the result of an exclusive process in which Google was the only buyer.

Moreover, the deal puts Google squarely into a low-margin, high volume business that effectively puts it into competition with the 38+ other handset makers using Android, which is considered by many to be the best mobile OS. It has quietly amassed a dominant 43% of the mobile phone market, ahead of both Nokia and Apple, but it is generally considered poor form to directly compete with your customers. No amount of reassurance that Android licensing will still be managed by a “separate” division is going to placate rival firms who now see Google as a direct competitor.

Google has defended the acquisition in general and the price in particular by citing Motorola’s deep patent portfolio. There is some credibility to the claim, since owning the patents will provide a degree of legal protection from infringement lawsuits (as well as the legal standing to go after others), and there sure to be more than a few gee-whiz things in there that can be significantly monetized.

But the bottom line is that Google has grown up. It’s not the disruptive game-changing firm of 2005, but rather a very large, mature business with tons of cash that is buying innovation (this will be its 102nd acquisition). Steps like the Motorola acquisition and its recently launched Google+ social networking application suggest a me-too type of strategy, not the sort of thing that spawns sector-killer things like YouTube and Adsense.

In fact, Google now reminds us very much of Microsoft a few years ago. With lots of cash flow being generated from stable but slow-growing products like MS Office, Microsoft was long criticized for not acquiring growth through mergers, so it went out and snagged Skype in May in an ill-advised, non-core and overpriced acquisition that we feel will ultimately be seen as a major mistake.

Interestingly, Microsoft was quickly seen on Wall Street as a benefactor of the Google-Motorola deal. Not only does the acquisition instantly place other mobile OS makers, like Nokia and Research in Motion, on the block, but it may benefit the mobile Windows OS if, as mentioned, current Android partners defect. All told, Google’s move may look good on paper, but experience tells us that hindsight might deliver a different opinion.

Portfolio Alert: A quick note regarding the Internet Architecture (IAH) and Oil Service (OIH) positions in our Sector Select portfolio. Merrill Lynch, who came up with the HOLDR ETF type in the 1990s, is selling six of the funds to Van Eck and will liquidate the rest during the fourth quarter. OIH will go to Van Eck and be converted to a regular ETF, and we continue to recommend it. However, IAH will be closed down, and there is no reason to stick around until it is liquidated. We suggest selling IAH at current levels, and will likely re-engage the Internet sector via another ETF in an upcoming issue.

Much is being written about the ramifications of the U.S. debt rating downgrade, and equity markets have reacted largely as expected so far this week. A massive, although relatively orderly, selloff yesterday, a bounce today, and all sorts of talking heads extolling bullish factoids and soothing admonitions not to panic all have a familiar ring to them to anyone who went through the meltdown in 2008.
 
But this is not, nor will it become, a repeat of 2008. The degree of de-leveraging that has taken place, both within the financial system and on individual balance sheets, virtually assures we will not go through another credit-implosion spiral like we went through a few years ago. On the contrary, one of the ongoing consequences of 2008’s crisis is that banks have become vice-like in their unwillingness to lend, depriving the economy of one of its typical post-recession fuel sources.
 
And although S&P is getting pilloried by the press, Wall Street and just about everyone else, no one with half a brain can deny that their reasoning is sound, their warnings are spot on, and the value of shooting the messenger is questionable. As a blow to the collective American confidence, already battered by two years of an extremely meager “recovery”, S&P’s decision will be consequential. However, from an economic point of view, it says nothing we didn’t already know.
 
Ultimately, we think S&P’s downgrade – and the ones that will follow it if Congress doesn’t get its act together – will be seen as one of those moments in time when a national debate shifts from the margin to center stage. The vast majority of Americans understood little of the debt-ceiling negotiations, and many were frankly easy prey for partisan propaganda. But everyone who has ever bought a car or a house understands what it means when your credit rating is lowered, and having to live within your means. If we’re lucky, the downgrade will bring the fundamental imbalances in U.S. spending into the living rooms of millions of taxpayers, and provide the kind of common-sense rationality to the debate. Ironically, we can easily make the case that S&P’s step could be eventually be seen as a long-term positive.
 
Having forced a very difficult conversation to take place – one that the U.S. has needed to have for a long time – the fundamental disconnect with the way Congress authorizes and spends money is in a sharper focus than we have seen in decades. It is frankly an opportunity that we waste at our own peril. Thoughtful, structural and collective answers, not political games and paper-money parlor tricks, are what is needed. Perhaps the downgrade will remind American politicians that they are in Washington to serve their nation, not their political party or agenda.
 
The stock market will need some time to digest the volatility created since last week, and it is useful to remember the old saying about never trying to catch a falling knife. Generally, several weeks are needed before a sharp break within a larger trend can be digested; beyond a knee-jerk bounce this week, we’d expect a lot of back-and-fill base-building for the rest of the summer. However, the macro situation is not particularly bearish – interest rates are at record lows, corporate earnings and balance sheets are frankly in great shape, and equity valuations are rapidly approaching the generational lows we saw during the 2008 crisis. Until there is more specific evidence that the economy has slowed convincingly, the fundamental outlook for stocks is actually very encouraging.
 
In the meantime, gold and precious metals have rarely proven their hedge value as vividly as over the past three weeks. Given the inexorable growth in emerging markets and the continued debt problems in Europe (which, incidentally, will be much harder to solve, since political authority as well as will is so splintered), they remain the safe havens of choice.

 

It is perhaps not surprising that the world’s largest banks are having trouble shaking off the effects of the 2008 global financial crisis. Yet at the time, most experienced analysts would not have predicted that three years later, most major banks would be unable to convincingly deal with their lending problems and get back into the game. For some, bailed out by their respective governments, it is embarrassing how little taxpayers have to show for their capital. Financial stocks have participated the least in the equity market recovery since 2009, and have performed the worst of the 10 sectors in the S&P 500 so far this year.
 
Given the sheer scale of the balance sheet devastation wrought at the time, one could argue that a long period of stabilization will be necessary in order to unwind the damage. Moreover, there is increasing talk that a generational change might be necessary at these firms – the CEOs have resigned and the class-action lawsuits are winding their way towards settlements (class-actions are almost always settled out of court), but there is an entire phalanx of mid-tier managers who were on the front lines in 1998, and in many cases those folks are still trying to figure out what they did wrong. The unintended consequences of global money-center banking – foreseen at the time by critics of the Clinton-era decision to let banks participate in investment banking & prop trading – is the massively intertwined nature of their operations without the commensurate coordination of oversight. Yes, lending standards were dropped and questionable ratings given to even more questionable CMBO tranches, but generally speaking mid-level managers had no idea of the landmines they were laying. Add derivatives like swaps into the picture – invariably set by the trading desk, not the lending officer – and it is no wonder that these executives still stare blankly at their screens and wonder what really happened.
 
News that Bank of America lost the most money in a single quarter ($8.83 billion) since its founding was the latest sign that financial stocks remain the soft underbelly of the stock market. Moreover, BAC may need to raise $50 billion in additional capital (or sell Merrill Lynch) in order to meet new “stress tests” and the increased capital limits for those banks deemed too big to fail by regulators. Indeed, the international Basel II framework of banking standards, designed to provide a buffer against losses and a repeat of the financial crisis, will require an additional 2.5% in capital reserves to be set aside that would otherwise be deployed towards growth.
 
However, for investors with a little perspective, the situation is not entirely bleak. Considering the size of the financial dislocation that took place and the continued weakness in housing prices to which many of the problem mortgages are tied, it is not surprising to see major banks like BAC still struggling to get past the crisis. Yet at the same time, BAC has been steadily writing down busted loan portfolios and setting aside money for legal settlements. Operationally, they are actually improving; remove all the one-time write-offs from BAC’s quarter, for instance, and their quarterly profit was actually better than Wall Street expected. At other major banks, the situation is similar; Wells Fargo’s quarterly earnings rose 29% largely because of lower write-downs in the loan portfolio inherited when it acquired Wachovia during the height of the crisis.
 
And that’s the good news. Eventually, all the problem assets related to the mortgage crisis will have been sold or written down. Models will be restructured to essentially assume the long-awaited rebound in housing prices is not going to come, providing enormous leverage when it eventually does. New regulations will be incorporated into these businesses, and dealt with accordingly. At the same time, operations at these banks will be as streamlined as humanly possible and probably the most efficient, from a capital return perspective, in their histories. Risk tolerance will be muted at best. All told, a pretty good launching pad.
 
Yet valuations in their stocks will be extraordinarily low. Even now, some of the numbers are intriguing; BAC’s price-earnings ratio, for instance, is a mere 5.8 on next year’s earnings estimates, while Wells Fargo’s is 7.9. Although taking longer than most analysts predicted, it is probably safe to say that the remaining effects of the housing crisis will, eventually, pass. When it does – and a little analysis into the quarterly reports of these banks suggests that point is not terribly far away – financial stocks will become the ones to beat.
 

 

Playing the Dollar’s Near-Term Rebound

One of the things that market observers, your editor among them, worried about back when the euro was being formulated was just how economic crises in Euro-member nations would be contained if they were all joined by a common currency. At the time, it seemed the so-called “soft” countries like Portugal and Italy were constantly teetering between crises, met more often than not by lax inflation discipline and devaluations. Once joined at the hip with the “hard” currency nations of Germany, France, etc., we were concerned that the problems of one would become the problems of many.

It may sound strange coming from folks in the finance & economics business, but there are times when we don’t really want to be right. This is one of them. What is happening in Europe was sadly predictable fifteen years ago; no one should be surprised that having effectively broken Greece, Italy, Portugal and Spain have now come into the sights of the global financial system. Remember, hedge funds and the like are not compassionate entities; altruism does not enter into their thinking. If there is money to be made from piling onto Italy like they piled onto Greece, they will do it. And then they will move onto the next-weakest link, until the opportunity is exhausted. Greece was the beginning, not the end.
 
If we learned anything from the Euro’s formative times, it is that the markets are infinitely more powerful than even the most dedicated government or central bank, especially when they smell blood in the water. With the Euro linking them almost inextricably together and the finances of Europe’s “soft” nations still an utter mess, there is still plenty of money to be made. And lest you think this is solely a European problem, it is only the U.S. dollar’s position as the reserve currency that has prevented what happened to Greece from happening here. From the looks of the insane game of chicken being played with our own debt levels in Washington, it still might.
 
Nonetheless, the realization that the euro’s problems do not stop with a temporary deal for Greece has lent strong support to the dollar. Having been in a downtrend for most of the last year, the dollar has been benefiting from a flight to safety out of the Euro, where the risk of a true default somewhere down the line still remains very high. As the European crisis has worsened, the dollar has stabilized and further downside risk seems limited – the markets continue to believe a debt deal will be reached in Washington in time for the ceiling to be lifted in early August, while recent economic weakness has been fully priced. Interest rate differentials continue to favor the euro over the dollar, but investors are voting with their feet.
 
As such, we think a good short-term trade in the dollar/euro exchange rate is shaping up. Our preferred way of playing this kind of trade, best suited for the more adventuresome among you, is the Proshares UltraShort Euro ETF (EUO). EUO is a leveraged ETF that uses swaps, options and futures contracts to generate twice the opposite of the move in the dollar/euro rate. In other words, if the euro drops 1%, EUO should go up 2%. We’ve used EUO before in Cash Cow and were initially very successful; our mistake was holding the trade too long.
 
Technically, EUO has made a strong base formation between $16 and $17, and a break over $18 – which may happen today – would signal room up to $20. With the exchange rate already dipping under 1.40 this morning, Spanish, Italian and Portuguese debt under siege, and Fed policy normalizing, we think the dollar may be entering a period of strength that could extend several months. However, this is a short-term trade; we will not hesitate to take gains when we have them. Conversely, we will not hold losses very long; we don’t foresee a significant worsening of the dollar’s economic background from here, but anything is possible and we admit the deadlocked nature of the debt negotiations in Washington is somewhat of a wild card. Either way, be on the lookout for an email closing this position.
 
On a side note, bear in mind that if we’re right and the dollar strengthens a bit through the summer, commodity prices will likely face continued pressure. This is to be expected as liquidity drains from the system following QE2, and should not impact the overall trend.

 

Today is an important milestone in the ongoing Greek debt saga, an issue we have been watching closely in Cash Cow. The current government is facing a historic no-confidence vote in the Greek parliament which effectively will determine whether austerity measures will either go forward, thus possibly paving the way forward on an end to the crisis, or the government of Greece will fall and the way forward will be even muddier than it already is.

 
Virtually every financial market is watching the outcome of the Greek negotiations very carefully – after all, global equities, bonds, gold, currencies, etc. have been dealing with various degrees of volatility, hand-wringing and general unease as a result of Greece’s predicament for the better part of a year now. Indeed, one of the major reasons why both the U.S. dollar and the Treasury market have been strong through the end of QE2 has been their safe-haven status away from the Euro, a currency that looks increasingly fragile under the weight of several concurrent member-nation debt crises.
 
Regardless of one’s beliefs about the immediate solutions available to Greece, the strategic outlook for the Euro is a real mess. A hard-line approach, favored by the Germans, is to force Greece to restructure its debt and thus its bondholders the pain. The problem there, however, is the Byzantine cross-holdings of that debt and its derivatives – Greek banks would be hammered, as would German, French and British ones. Moreover, a large number of U.S. financial institutions own swap contracts against that debt, which would be executed upon any default. Greece may seem like a local problem on the nightly news, but it is most assuredly a global one in terms of balance sheets.
 
While attractive in theory, the German approach risks another worldwide wave of capital markdowns in a financial industry barely off life support from the last one. Any restructuring of maturities – the favored option at the moment – would undoubtedly be treated as a default by capital markets, and very few within the financial system have sufficient incentive to push for such a move. A default, even one of a technical nature that modifies payment schedules & maturity dates, would kill Greek banks, accelerate payment clauses in derivative contracts and swiftly impact the investment ratings of more than a few global financial institutions. Indeed, while the German solution is the most correct one from the perspective of market theory and the “too-big-to-fail” syndrome, practically speaking, it is not the most likely one. If it is one thing we have learned in the markets, it is that fear is usually more powerful than greed, and rarely does the “greater good” come at the expense of profits and/or losses.
 
And issues of moral hazard abound in this discussion. The private sector was more than willing to cash in double-digit yields on Greek debt for years while the country was dragged along to prosperity through its inclusion in the Euro, and it should be the private sector that also pays the price of any default. However, as we saw ad nauseum during the U.S. financial crisis, even the bastion of free markets is not above bailing out an entire industry or three if the private sector is going to get it right between the eyes. But the alternative is equally unpalatable (and unpolitical), as the riots in Athens last week amply showed.
 
Ultimately, we think Greece will be bailed out. There is virtually no other choice. It will be horrendously expensive, very messy and, because of the involvement of the EU, the IMF, the World Bank, the Fed and the ECB, will take much, much longer than would be the case were financial markets driving the bus. Furthermore, the precedence value is huge - other European nations in the same boat as Greece (and also members of the Euro) such as Portugal and Spain are going to watch what happens very carefully, as are global bond investors.
 
One of the interesting ironies of all this is that historically, half-measures like bailouts and provisional measures usually don’t work. They merely delay the inevitable. Eventually, it is highly likely Greece defaults anyway, making any taxpayer-fed bailouts a waste of both money and time, two things of which Europe as whole has little to spare. Theoretically, Greece needs to devalue its currency and reissue new debt, but this avenue is unavailable so long as the country remains tied to the Euro. So, like any cash-strapped business trying to make a bank payment, the country is looking to sell assets, in its case airports and train lines to raise cash. To say the European Central Bank is in uncharted territory due to this mess is an understatement; one only has to look at Spanish and Portuguese bond spreads over German bunds to see how the global financial market views the situation.
 
Either way, the Greek vote of confidence today will be remembered as a departure point. If Papandreou survives, Greece will be the test case for a national bailout. If he doesn’t, it becomes highly likely that Greece will eventually be ejected from the Euro currency (which incidentally would result in a massive rally in the European currency). In either case, Greece is now a guinea pig in global finance, a position we do not envy. It’s no wonder, when one looks at the overall situation, why gold, silver and other hard assets have soared.

 

The S&P 500 peaked at 1363.61 back on April 29th, and since then, over $500 billion in market capitalization has been erased from U.S. stock market valuations. A disappointing May jobs report and continued apathy in housing are behind the market’s latest weakness, but when taken in total, we’ve simply been in a correction. Unfortunately for the bears out there, it really isn’t any more complicated.

The S&P 500 has had drops of 2% or more during broader bull markets 126 times since 1962, and each one undoubtedly trotted out all the folks convinced stocks were headed lower. The perennial problem with any major market move is whether it signals a shift in the overall trend or it is more a function of profit taking, hedging or other tactical trading strategy. And if we could choose among the myriad mistakes investors make on a consistent basis, mistaking the tactical for the trend goes to the head of the list.
 
Take the May jobs report. Yes, it was disappointing, and no, the current rate of job creation – 50,000-150,000 per month – is not large enough to support 3%+ annual growth in GDP. However, keep some perspective. Just two years ago we were seeing month after month of jobs numbers coming in at -700,000, -800,000, etc. The U.S. economy lost over 2.5 million jobs in under a year during the crisis, a pace not seen even during the Depression. So while the May number was not what economists had predicted and there is much work to be done to get more people back to work, not too long ago more than one economist feared the first seven-digit monthly job loss in U.S. history. All things considered, the trend is not what changed with the May jobs report, just our expectations about its speed.
 
This is a critical difference for investors. The recent correction that has gotten everyone nervous came after the S&P 500 laid on a whopping 30% from the end of August to the end of April. That’s a strong move in anyone’s book, and we’ve never known an investor that didn’t like taking a profit. But knowing that corrections can be swift and sharp is one thing; knowing that they can be created via seemingly innocuous data points or earnings releases is another. There is no telling what can set off counter-moves in a trend, but knowing that it is a correction, not a shift, is critical to keeping your wits about you when markets go the wrong way for a while. The adage that nothing goes in a straight line – in either direction – still applies well to Wall Street.
 
Take the last several weeks with a grain of salt. The market’s valuation held through a springtime filled with exploding oil prices, Middle East rebellions, and a tsunami-turned nuclear-disaster in one of the world’s anchor economies. Clearly, the U.S. economy is in better shape than the frenetic analysts on CNBC would have you believe. Indeed, even after taking the estimate revisions that occurred after the May numbers into account, the broader U.S. stock market is not very expensive when viewed historically. The S&P 500 trades for one of the cheapest valuations in the last two decades, a testament to rapidly recovering corporate earnings and a skittish investing public that has been loathe to push major sectors too far. And one thing is for sure – the mere fact that everyone is looking around for signs that the next crisis is upon us virtually guarantees that one isn’t. Unfortunately, this core truism of behaviorial finance – if everyone expects something, it almost certainly can’t happen because it will have been already priced – seems to be one of those lessons Wall Street is condemned to learn over and over again.
 
Stick to your guns. As we have written before, soft periods in trends best used to add to existing positions, or establish a position that may have eluded you beforehand. Above all, keep the broader trend in your mind when hearing the experts rant. You’ll sleep better, and your portfolio will be better off in the long run.

 

We have very little faith in the ability of general media to explain economics and markets correctly, or even close to correctly, on a consistent basis. Indeed, one of the goals of our commentary is to provide clear and thoughtful explanations and perspectives in areas that may desperately need them.
 
A good case in point has been the recent correction in commodities. Undoubtedly skewed by speculators (i.e. hedge funds the world over), and by extension the physical-asset ETFs that have sprung up in almost all commodity markets, there was no denying that a large swath of commodities was overpriced heading into the spring. We’re about as permanently bullish on commodities as you can be, and even we thought things might have been getting ahead of themselves.
 
However, it is also very typical of rapidly-growing sectors. Prices almost always reflect where the broader market believes an asset is going, not where it has been, which makes momentum such a powerful trading tool. There is no saying a stock or bond or option that went up today will do so again tomorrow, but historically the odds are pretty much in your favor. Where this gets tricky is when a few large positions are liquidated, either because of profit-taking, news, or because they were wrong in the first place. In highly visible over-extensions, like the one we just saw in commodities, just a couple such well-publicized moves are reported without any underlying explanation or strategic perspective, and the stampede begins. Investors are, after all, first and foremost a herd.
 
Broader media often picks up this sort of tactical looking glass. This is why headlines zooming across our terminals today ascribed the selloff in commodities to a slowing Chinese economy, crude oil’s to the decline in housing starts (a weak housing market can’t seriously be considered “news” to oil traders…) and stronger Treasury bonds were chalked up to weaker economic output last month (industrial production slipped as automakers dealt with Fukushima) and Greece. Greece? We would be shocked if much trading in the T-bond pit today had anything to do with Greece, and the economic impact of the Japanese disaster has already been priced. And even if Chinese inflation continued to tick up and policy there slowed growth to 7%-8%, it is unlikely in the extreme that commodity demand from China will be so dramatically impacted as to justify a 20% decline in some of these metals.
 
Our point is that short-term trading rarely has anything to do with the broader reasons often described in the financial press. Especially when a market has run strongly in one direction, there is no shortage of interests that will utilize the high price to take profits and run the price the other way. Having media outlets blame strategic factors for tactical trading decisions is misleading.
 
The bottom line is that the commodity drop of the last few days is a correction, not a crash. We’re riding it out, holding our commodity ETFs through what we believe, after analysis, will be a transitory period of weakness. As the broader picture hasn’t changed a great deal, we think new positions will be established and the trend will resume, just as it did in the fall of 2010 and 2008.

 

There is nothing like an over-valued acquisition to lift Wall Street’s spirits when the air starts to be let out of the proverbial balloon. Microsoft’s purchase of internet-telephone company Skype is one of those deals that must make Microsoft shareholders cringe and Skype’s dance for joy; Skype lost $7 million last year on $860 million in sales. This makes the $6 billion price tag MSFT agreed to pay justifiable only through some fancy assumptions about the marketing value of adding Skype’s user base of roughly 170 million people to Microsoft’s existing business lines.
 
Microsoft’s batting average when it comes to internet plays is not stellar. It has consistently floundered when trying to compete online, beginning with a lack of clear strategy and an unwillingness to abandon more than a few substandard but prolific sacred cows (Outlook, MS Explorer, etc.). There is little to show for the billions of dollars and years of effort Microsoft has put into tackling online search, combating the advent of cloud computing, and countering Apple’s resurgence. Only the most ardent optimist would see the Skype purchase in anything but a skeptical light.
 
More importantly, by agreeing to pay more than six times sales for a company that is losing money (in fact, has always lost money) and whose most popular products – by far – are free (member-to-member video calls and instant text messages), Microsoft has again fallen prey to the rarely-advisable tendency of mature companies to get bigger when they feel they can’t get better.
 
And while we’re sure an army of MBA’s has modeled the acquisition from every conceivable angle, we also can’t help but point out that with the NASDAQ at a better than ten-year high, seeing arguably the most successful technology company in history massively overpay for an asset that doesn’t have an immediately accretive effect on the bottom line brings back memories of the tech bubble. Indeed, M&A premium expansion is one of the more accurate leading indicators for short-term market tops, so we can’t help but wonder if this deal is another harbinger for equity weakness into the summer.
 
A quick note on China’s April trade numbers released today. Exports surged to a new record while imports fell, pushing the trade surplus for the month to $11.43 billion. But that wasn’t what caught our eye. Rather, it was the fact that the average price of imported Chinese goods, after adjustment by a somewhat arbitrary “quality modifier”, rose 0.4% in April alone and is up nearly 3% year-over-year. Contrary to most conventional wisdom, China is rapidly turning into a contributor to global inflationary pressures instead of a kind of heat sink against them. In years past, demand-side inflation from the likes of the United States were dampened by ever-falling unit labor costs in Chinese manufacturing. This meant that the price of important Chinese goods was perennially flat or falling, effectively absorbing inflation from elsewhere.
 
As April’s numbers show, those days appear to be over – labor costs are surging in China anywhere from 10-30% per year, depending on the sector and location, while commodity input costs are impacting Chinese manufacturers as much as those in any other country. The result – unimaginable only a few years ago – is a broad trend toward higher prices for Chinese exports to the United States. Add a gradually increasing yuan, and it is no wonder that major global goods manufacturers are searching for the next low-cost nation.
 
Many economists estimate that the tipping point relative to China’s impact on global inflation is still several years out, but we’ve seen the financial community consistently get the timing of China’s economic rise wrong. Our Pacific Reach portfolio’s interest in nations like Vietnam, Malaysia, and Indonesia is partly based on the inevitable search for the next low-cost provider.
 
The bottom line is that China’s emergence as a major economic force has, predictably, been accompanying by the law of diminishing returns. It is logical that labor costs will begin to rise as incomes rise there. But the bigger question is how the world will react to an inflationary threat that is not longer being held in check by economic events, tight liquidity, high interest rates OR a massive low-cost, surplus labor force in the global manufacturing industry. We know one thing – it has been a long time since the developed world’s economic cycle had to contend with coordinated wage inflation in its low-cost manufacturing center, and we hope we’re not the only ones to see a looming problem ahead. The good news is that the markets are already telling us how to deal with it – commodities, energy and emerging markets.
One thing we have learned over the years is the propensity of investors to worry. In financial markets, particularly stocks, an interesting relationship exists between the degree of worry and return; generally speaking, the more people worry, the better stocks perform. This has given rise to the famous saying that “bull markets climb a wall of worry.”
 
And since, say, mid-2009, there has certainly been plenty about which to worry, culminating this year in the Arab revolts, housing’s doldrums, the budget mess, cash-strapped states and municipalities, a surging China, exploding commodities prices and near-record high gasoline, to name a few. In fact, there is probably more to keep your average investor up at night than any time in recent memory. Even the IMF has gotten into the act, declaring 2016 as the date the “Age of America” will come to an end.
 
Perhaps that’s why the S&P 500 and the Dow Jones Industrial Average both hit 2011 highs today. Based largely on strong earnings from large corporations, Wall Street is apparently more interested in strong corporate cash flow and an extremely accommodative Federal Reserve than in the various issues facing the markets. Increasingly, investor optimism seems rooted in where we are going instead of where we have been, which is as it should be.
 
It is worthwhile to note, however, that in late 2007/early 2008, we weren’t worrying about nearly as many things, and the root causes behind the financial crisis were on the radars of only a few very astute market observers, credit specialists, and perennial bears. And yet a crisis of monumental proportions ensued, so be careful tossing caution to the wind entirely. As a group, investors tend not to see the forest for the trees, which can lead to trouble at the tail ends of broader market moves.
 
Contributing to the general optimism has been, as we expected, a rising number of large U.S. corporations that are instituting or increasing their dividends on the heels of strong 2010 and first-quarter 2011 numbers, the most recent being IBM and Humana today. This trend reinforces the feeling that things are getting back to “normal” as well as increasing the attractiveness of these stocks to the legions of managers that are trying to survive on 3.5% 10-year Treasury yields which, despite all logic to the contrary, refuse to accommodate the “rising interest rates” crowd. Our Vanguard Dividend Appreciation ETF (VIG) position has duly reacted as hoped and we expect additional payout increases through the rest of this year.
 
Conversely, today was the first day we have seen silver come off in several weeks of trading. Typical of late-stage, “blow-off” moves, we have been watching the near-vertical ascent of silver (and to a lesser extent gold) with some alarm. Having re-entered a physical silver ETF in our last issue, we’re nervous about the degree of empty air underneath the Silver chart, but we also know a momentum trade when we see one and, given the fundamentals, recommend holding our silver ETF position, the iShares Silver Trust (SLV).
 
Meanwhile, the commodity run has continued to drive commodity-related currencies higher, and pushed our WisdomTree Commodity Currency ETF position to new highs. Here as well, we are watching the action closely, and note the record weakness of the U.S. dollar against a variety of both hard and soft currencies. With the Fed apparently in no rush to act and central banks around the world – especially commodity-oriented ones – already hiking rates relatively consistently, the interest-rate differentials between the dollar and commodity currencies should auger well for this position.
 
If anything, the lagging performance of our Pacific Reach portfolio continues to stand out to us as an anomaly. We’re as certain of the long-term prospects for this region as we are that the moon will follow the sun, yet the tactical trends in almost all markets in the area are flat to slightly down. We expect this will remain the case as long as interest rates are trending upwards; China took renewed steps outside of interest rates this week to cool inflation, hiking bank reserve requirements again. For most of this portfolio’s exposure, equity upside will likely only return in force once the extent of the rises is known. In the meantime, we’re content to remain engaged.

 

Normally, bond investors demand higher payment (i.e. yield) in return for taking on higher risk. When a company’s fortunes turn south to the point that it becomes questionable whether it will be able to pay the annual interest payments, repay the principal at maturity (or both), prices of the bonds understandably fall in the secondary markets. Since a bond’s price is inextricably linked with its coupon rate and the time remaining until its maturity, the market’s perception of risk to either one is immediately reflected in the bond’s price. As prices move lower, yields rise (and vice versa), meaning greater risk is almost always accompanied by higher yield. This makes intuitive sense; if you’re worried about getting your interest or principal back, you will insist on a higher return for your trouble than if one or the other is a sure thing. 

So it has been with more than a little interest that we have observed the trading in U.S. Treasury bonds this week. A relatively small group of rating agencies helps investors gauge how high the risks are, or perhaps more precisely, will be in the future, with Standard & Poors probably among the best known. S&P made some waves on Monday by downgrading their outlook for U.S. Treasury debt. Short of actually changing the rating on U.S. debt, lowering the outlook from “stable” to “negative” is seen as a warning shot to the subject company or country that it has to get its fiscal house in order. Considering the tumultuous budget negotiations of the past several weeks and the extraordinary expansion of U.S. debt levels over the past several years, S&P’s thinking cannot have come as a great surprise to anyone who pays attention to such things. The downgrade effectively means S&P’s analysts are looking at the whole situation and, for the first time, are beginning to be concerned enough to warrant lowering the AAA credit rating of the United States (one of only 19 sovereign nations with a triple-A rating, out of 127 rated countries).

Notably, it is not the absolute level of debt that necessarily worries S&P, but rather the lack of clarity about the path being taken to address it. In spite of significantly worse media coverage, nations like Germany, France, Canada and the U.K. have done more to address their crisis-related debt issues than has the U.S., and while Federal Reserve economists continue to predict rising GDP growth will eventually pull the U.S. back into line, the analysts at S&P are less optimistic.

In the aftermath of the downgrade, however, something extraordinary happened (and continued to happen today). Bond yields went down. On Monday, 10-year Treasury yields ended 14 basis points lower than they started, and today they fell another two. This goes against economic thinking in just about every conceivable fashion; if S&P is worried about U.S. credit quality and lowers its outlook, yields on U.S. debt should go up to reflect the increased risk. Yields on Portuguese and Greek bonds certainly didn’t go down as both S&P and other agencies slashed their ratings to below investment-grade – they exploded upwards. Yet in this case, T-bond yields went down. Why?

The answer is complicated but logical. If S&P is worried enough about the U.S. debt situation to publicly lower its outlook, what can it be thinking about the debt of other nations (like Greece and Portugal) that face much more serious problems? In a game of relativity, the U.S. actually comes out ahead since it’s bond markets are by far the most liquid and transparent the world. So, if you’re worried about bond quality, the S&P U.S. outlook downgrade didn’t necessarily make you love T-bonds more, but it may have made you like Greek bonds a lot less.

Another facet is the impact S&P’s decision may have on Washington. In a perverse way, some investors feel that the decision to lower the credit outlook on the world’s reserve currency may focus the attention of the budget negotiators in Congress, perhaps incentivizing them to sharpen their pencils a bit more and thus making T-bonds a buy right now, not a sell. We’re less optimistic about the ability of Congress to get the U.S. fiscal situation under control quickly, but we will admit a more candid discussion is taking place than at any time in recent memory.

For our part, we think it remains likely that a combination of higher inflation coupled with higher economic activity and increased commodities prices will push U.S. interest rates higher. But for the time being, S&P’s shot across the bow is not having the effect one would normally expect, meaning one of two things will happen – either aggressive U.S. spending and tax policies are put in place to attack the debt problem, or the beginning of the presidential election cycle next year will push the hard choices until after 2012. We’re betting on the latter – which in spite of the initial reaction to S&P’s move, means higher, not lower, interest rates.

We’re always amazed at how much Wall Street tends to live in the moment. As oil crested $113 intraday earlier this week, a few astute observers noted that supplies were actually pretty flush for this time of year, especially for West Texas Intermediate – the kind of oil that interests Americans the most – and even in light of the loss of Libyan production. In fact, some even braver souls have gone so far as to suggest that without speculation on the spread of Middle East unrest, oil should be trading in the mid-$80s per barrel. Then, earlier today, none other than Goldman Sachs came out with a research note that suggested oil might experience a pullback.
 
Obligingly, oil pulled back and was just over $106 as we wrote this update. But it is the headlines that make us chuckle. “OIL TUMBLES” reads the main story on one of the most popular financial web sites. “OIL CRUMBLES” reads another, although this one pegs it to higher prices slowing economic growth around the world – as if GDP impact nine months from now is the core reason why traders today decided to short crude oil. After nearly doubling in six months, a 3% move is not “crumbling” but good old-fashioned profit taking. It is almost painful to read. But then again, the financial press has never suffered from a lack of hyperbole. Don’t buy it – oil is neither crashing nor crumbling. It is pausing, with good reason.
 
Meanwhile, all the strategic reasons for rising oil and commodity prices have faded from the mainstream press. Yet China is still growing. India is still growing. A lot, especially relative to the West. And at this point, even the U.S. is growing – railroad shipping volume, one of Warren Buffett’s favorite economic indicators, rose 7.9% in the first quarter, the second-highest pace ever recorded in a first quarter. Unsurprisingly, there is a strong correlation between rail shipment growth and U.S. industrial production, which in turn is linked, with a delay, to economic growth. When the global economy is coordinated and firing on all cylinders, energy and other commodity prices rise. It isn’t rocket science.
 
And for the first time in seven years, China reported a trade deficit in the first quarter of just over $1 billion. This is a relatively big deal, since in the same period last year China reported a surplus of over $13 billion. Rapid growth in domestic demand as well as rising prices for food and – you guessed it – raw materials like commodities and energy were the reasons behind the $14 billion swing. Why does this matter? Because economists the world over point to China’s trade imbalances as a reason why the yuan should be allowed to float. By posting a deficit, China can say that they are not contributing to the problem, although this is pretty disingenuous – the volume of imports and exports are one thing, while the dollar value of them is another, depending on the currency rate. Nonetheless, the data suggests two things are happening – China’s domestic demand is rising, as we have predicted, and its consumption of energy and raw materials is following suit.
 
This is not to say commodities are bolted to a one-way escalator. Silver and gold are probably the most vulnerable, but most commodities have had stellar runs since this time last year, and we know from experience that this sector is cyclical and often self-correcting (when one crop does well, farmers cash in the first year, and plant more the second, which increases supply and thus lowers price). And the high cost of oil, for instance, will cause switching to natural gas, which is a subject of the latest issue of Cash Cow due out to you shortly. But generally speaking, when we take a step back and look at the overall strategic situation facing the commodities we follow, we still come back to a world that will need more of them – a lot more – in the next five years than it needed in the last five. This, above all else, is the foundation of our commodities thesis. Nimble traders may be able to game short-term breaks in many of these markets to good effect, but whenever you are thinking about the overall trend, just keep in mind the mental picture of a half-billion Chinese entering the middle class between now and the end of this decade.

 

One of the more interesting effects on Wall Street is its collective ability to turn belief into reality. Because most pricing, especially in the equity markets but also in commodities, is based on future expectations – of demand, supply, earnings, etc. – markets often discount these expectations long before they actually occur. Indeed, sometimes the events are so anticipated that the prices end up over-compensating for the expected occurrence, and actually move the other way once it takes place. This is the origin of the famous admonition to “buy on the rumor, and sell on the fact”.

This ability to turn belief into reality was on full display overnight as markets digested China’s latest interest rate hike of another 25 basis points. It was the sixth official move since October 2010, and comes in addition to a rash of non-monetary measures aimed at dampening inflationary pressures in the country. When the first of these six occurred last year, one would have been forgiven for thinking the financial world as we knew it was ending (again) – both equity and commodity markets sold off sharply and doomsayers predicted the end of the “Chinese miracle”. Today, however, both copper and oil closed up on the day, while U.S. stocks were largely unchanged. In other words, the hike was greeted by a yawn.

Why? Because China’s rate move was completely expected, and thus priced into the market. Since the start of the year, commodities and emerging market stocks have been correcting as China, India, Thailand and Brazil struggle to maneuver interest rates, bank reserves, currency controls and anything else they can think of to control inflation and appreciating currencies without killing their economies. Indeed, just since the start of 2011, central banks in China, Brazil, Poland, India, South Korea and Thailand have raised rates, and if the ECB is to be believed, the European Union is not far behind. In fact, from our point of view, the Chinese rate hike was another fully-telegraphed step towards gently reigning in some of the inflationary pressures brought about by recovering U.S. and European economies. It is not by chance that further relaxation of China’s yuan peg came just a few days before the hike.

And although initial data, from fixed-asset investment to property prices, suggests tighter policy is working, it is by no means finished. Food inflation, growing at double-digit rates, is still a major concern in a nation where the average worker spends half their monthly salary on food. Moreover, with the one-year lending rate now 6.3%, China still has some work to do before it will curtail the rampant credit creation underway there, which has been the primary source of overheating in the past.

As would be expected given the dynamic we just described, the markets immediately went about pricing the next Chinese rate hike. Swaps began pricing at least one more move hike this year almost immediately following last night’s move, and bonds moved lower. Yet it is worth noting that China’s Central Bank has been ahead of the curve for some time now – it was the first to loosen during the onset of the financial crisis, the first to institute stimulus when it was necessary, and it has been the first (and most aggressive) in tightening. In years past, it was the United States whose central bank moves were considered on the bleeding edge of economic policy, but China has become extremely important in this regard in a very short period of time. In fact, much like the United States and Europe twenty years ago, 2012 may see a situation in which the Chinese have stopped tightening before (or just as) the U.S. begins. That will be interesting, to say the least, and begs the question of when the U.S. stock market begins pricing the inevitable rise in rates headed our way.
From the point of view of folks watching the rise of incipient inflation around the world, the fact that it is now the Year of the Rabbit in China is pretty ironic. Other than their ears, rabbits are also known for two things – running fast, and jumping high. In the case of emerging markets, inflation is running at a pace not seen in several years (if ever), while interest rates around the region are jumping quickly and by large amounts. From this perspective, China’s rate hike overnight – its second in six weeks – makes the rabbit analogy almost too apt.
 
China is relatively late to this game. Other central banks in the neighborhood began raising rates as early as late 2009, and the majority of them were well along this road by the spring of last year. Indeed, Thailand’s willingness to hike early and often has resulted in – so far – relatively stable inflation of just over 3%, leaving only the Philippines without a tightening bias in the region. China didn’t start raising official interest rates this cycle until last October and has been loathe to hike them too quickly, resorting to a whole series of quantitative measures like consistently higher bank reserve requirements to help cool things down without upsetting the apple cart. The speed with which this latest hike followed the last one suggests they aren’t entirely doing the trick, especially since it involved both the benchmark rate (upped 25 basis points to 3%) as well as one-year lending rates (upped 25 basis points to 6.06%). The lending rate boost was clearly aimed at China’s legendary savers as an inducement to avoid more speculative investments like real estate mortgages.
 
The move underscores how rapid increases in food, oil and raw materials have created vexing problems for China, which faces significant political ramifications if it moves too quickly. After extremely loose monetary policy during the financial crisis, which involved ample credit creation and massive public spending and is credited with helping China avoid the worst of the global meltdown, China is dealing with rising commodity prices precisely at the same point it is trying to mop up excess liquidity and maintain growth. Not an easy mission, particularly when one of the most useful tools for such things – a freely-floating currency – is unavailable. Whether China is behind the curve in fighting inflation remains to be seen, but we would expect the rhetoric to continue and additional hikes sooner rather than later. Either way, we also expect China will accomplish the majority of its growth-dampening activities via further quantitative methods and resort to rate hikes – something that has been likened to using a Sherman tank to attack an ant hill – only when absolutely necessary. If we see several raises in rapid succession, we will know China is trying to play catch-up.
 
Commodities have taken the tightening in Asia since last fall in stride, and today’s action was no different. The central bank has made it abundantly clear that rates are headed higher this year, making the news today more of a confirmation than a surprise. Copper hit another record high yesterday, silver is up another 4.2% this month and new data is out reinforcing the precarious nature of platinum’s dwindling supply. At some point, central bank actions in emerging markets will be sufficient to dampen growth in the region enough to impact commodity consumption, but we’re not there yet – and a U.S. economy growing at even average speed is more than enough to pick up the slack.
 
Meanwhile, JP Morgan’s decision to accept gold as collateral for securities lending and repurchase obligations is the most telling “sign of the times” to cross our desk in a quite a while. Previously, only exchanges allowed use of gold holdings as collateral. This means two things: first, JP Morgan’s large clients are using gold as an inflation hedge on their balance sheets and want the “capital” their gold represents to produce greater yield for them. Secondly, it means JP Morgan feels sufficiently confident about the direction of gold prices (or their stability at present levels) to accept the metal as security against cash obligations. As with so much in life, we think the timing is interesting – could the riots in the Middle East and rampant inflation in Asia be part of the reason why JP Morgan’s clients are clamoring to mortgage their gold holdings? Think of the contrasts behind gold, which is secure, borderless and an unassailable store of value, in any number of national currencies, and the answer is pretty clear.

 

In academia, a lot of time is spent exploring the difference between causality and correlation. The former describes a relationship in which A plays a direct role in causing B to happen, whereas the latter simply says that B followed A, or the two took place together. Take the example between churches and hospitals. There is a strong correlation between the number of churches in a city and the number of hospitals – as cities grow, so do the number of churches and the number of hospitals. But that growth does not mean going to church gets you sick, or going to the hospital leads to greater piousness. They may be correlated, but that does not mean they have a causal relationship.

Correlations abound in finance. However, it is causality that interests us analysts the most. Finding out that when one thing happens, it causes another to occur is a holy grail in this business, since such relationships basically give the investor an ability to see, at least partially, the future.

When it comes to oil and the U.S. dollar, it has long been a maxim on Wall Street that a very strong correlation exists between the two, but that causality was much harder to pin down. The perception is out there that a weaker dollar is accompanied by higher oil prices, and vice versa. Which one leads the other is a matter of huge debate and far more complicated than we can get into here, but suffice it to say that recent events have proven this old adage once again.
 
The geopolitical meltdown occurring in the Middle East is obviously enough to send oil prices northwards, and considering the potential contagion effects into Saudi Arabia, Oman and Iran, we’re frankly surprised oil isn’t higher. At the same time, the U.S. dollar has been weakening against the Euro far more than the economic data coming out of Washington would normally suggest. Turned around, the Euro has been stronger – far stronger - than you would expect given the economic data as well as Europe’s still-unresolved debt issues. While oil’s correlation with the U.S. dollar seems to be greater with the Canadian and Australian dollar exchange rates, the fact that the Euro is up at the same time oil is up has not been lost on traders.
 
There are competing theories as to why this correlation exists. One holds that the dollar will weaken on an oil shock because high oil prices will have a disproportionate impact on the U.S. economy. Another holds that since oil is priced in dollars, nations that export it earn more dollars as the price goes up and allocate that additional revenue into other currencies. This latter theory would at least partly explain why the Euro seems to benefit – the Euro is increasingly held as a reserve currency by oil-exporting OPEC nations. Add to this latter theory the ongoing liquidation of long-dated U.S. Treasury positions (as evidenced by rising 10- and 30-year yields) despite QE2 and further diversification out of dollars is probably going on as we speak.
 
We think oil will continue to be firmer as long as the political upheavals in the Middle East are in the news, and Libyan production remains shut in. Iran will be the next big one to watch – a reform movement already exists there, although bloodied. Saudi Arabia’s government, although perhaps among the most in need of reform, is very likely to escape the kind of existential moment faced by Mubarak and Qaddafi. If the correlation we described above continues to hold, this does not bode well for the dollar over the short term.
 
For our ProShares UltraShort Euro ETF (EUO) position, this theory is bad news. Originally taken as a quick trade at the end of last year on rising tensions in South Korea, the position moved to a 20% gain quickly. We should have taken it right then and there, but we looked at the U.S. and European economies and used the disparities between them to justify turning a tactical trade into a strategic holding. It was not a smart move – the dollar’s weakness since the start of this year has evaporated our gains, and turned EUO, which is leveraged 2:1 against moves in the Euro, into a small loss. We suggest closing EUO before we lose any more ground; we still think the dollar will outperform the Euro, on balance, in 2011, so if we sense the dollar will resume its upward trend, we’ll re-enter the position.

 

Since the U.S. economy began to drag itself out of the mud in late 2009, one critical sector has been notably shakier than all others: housing. While intuitive, since housing (or more specifically, sub-prime financing for housing) was at the core of the financial crisis that preceded the last recession, pundits and investors alike have been surprised at how arduous housing’s recovery has been.

This morning, we received news via S&P’s Case-Shiller Housing Index that residential home prices are falling again in most major cities, with the average price in four of them now at their lowest point in eleven years. Prices fell for the sixth month a row, and when viewed in aggregate, the average home price in the U.S is now back to summer 2003 levels. While there were pockets of good news – Las Vegas, for instance, has stopped falling – a few areas are seeing double-digit declines on a three-month annualized basis. If extrapolated forward for any length of time, housing in cities like Detroit will be free in under a year. And in a telling sign of the times, the only major metro area to see house prices rise in January 2011 was Washington DC, and Washington is the only one of twenty major areas to have weathered the housing storm with any degree of success.
 
Housing is an interesting sector from an investment point of view since it has so many concentric influences. For instance, overbuilding and high inventory of unsold houses would normally be rectified as prices went lower, which at some level of equilibrium would result in higher consumption. But foreclosures continue to put new supply into the market at rock-bottom prices, while tighter lending standards are preventing buyers from entering. Housing has become the heaviest drag on an economic picture that is otherwise relatively bright, and with over 1 million people actively involved in housing construction at the peak in 2008, the sector’s sluggishness is also playing a major role in continued employment and consumer confidence weakness.
 
Since the start of Cash Cow, we’ve been in the camp that thinks Housing’s remaining risk is low compared to the sector’s potential in a recovery. In other words, we’re closer to the bottom than the top, regardless of month-to-month data. Yet so far, our guarded optimism has been in vain – the numbers speak for themselves, as does the flat performance of our Vanguard REIT ETF in Sector Sense. Some experts, including Robert Shiller, think that the housing trough will be so long and so deep so as to fundamentally alter the public’s perception of the entire asset class, similar to what happened in Japan following their housing bust in the late 1980s/early 1990s, after which urban land prices declined for 20 years. We’re not as pessimistic – when viewed on a chart, the declines since the peak have retraced roughly 50% of the move from 1987, which would be typical in a trend shift of this magnitude, and secondly, the aggregate rate of change in the pricing moves, although negative, is small when compared to the middle of the crisis. We certainly don’t want to paint the housing picture in a positive light, since the data unequivocally suggests the sector is going nowhere fast, but we’re also fairly certain a return to the April 2009 lows is not in the cards.
 
Obviously, a lot of this sector’s fortunes will hinge on the future direction of interest rates. As of now, there is little chance of another QE program, and while the Fed may not raise rates soon, the bias will undoubtedly be higher in the months ahead. Indeed, we’d wager that one of the only reasons to keep interest rates low for the rest of this year is the weak housing market.
 
The bottom line is that Americans continue to be faced with the relatively unique prospect of having the prices for just about everything – fuel, food, Chinese imports, technology, etc. – going upward while the largest real asset many of them will ever own continues to decline in value. It is a squeeze that will continue to impact the real economy for quite some time. Yet we tend to look at the markets for guidance when the severity of a trend is in question, and we see REITs and housing stocks not far from where they were late last year. The market has not yet voted with its feet regarding this sector, and we’re inclined to think the recovery is of a more gradual and intermittent than doomed. For now, we’re sticking with our REIT recommendation, and suggest you do the same.

 

Traders are generally thought to be rash, emotional types that foam at the mouth and fly off the handle at a moment’s notice. In our experience, however, the successful ones are nothing of the sort. While a good trader can make decisions very quickly based usually on a mix of imperfect information and gut instinct, consistently good traders are anything but rash. They do what they do based on very sound, methodical interpretations of the world around them.
 
Many novice market observers voiced surprise when the tumult in Egypt did not spill over into the oil pits very much, thinking the typical trader would have gone bananas with what was happening there. But to us it made sense; although Egypt produces oil, it does not produce very much and is otherwise resource-poor, and it did not take very long for traders to understand that both Egypt’s famous canal and its less well-known but equally important oil pipeline were not at serious risk regardless who eventually won out in Tahir Square. Accordingly, the events there were a non-event as far as oil prices were concerned, and they barely moved.
 
From the oil trader’s perspective, the far more important question has been (and remains) whether what began in Egypt would spread to other countries with greater impact on global oil prices. As we have noted in the past, commodities traders are pretty ambivalent whether democracy blossoms or not – they care first and foremost about supply and demand influences, and any situation that may impact one or both of them.
 
Libya is a case and point. Traders may have been able to take Egypt’s turmoil in stride, but Libya is another story altogether. News of bloodshed, air strikes, closed ports, defecting fighter pilots (suggesting open rebellion by parts of the military), and a wholly belligerent Moammar Qaddafi sent oil prices up over 8% on Tuesday. Libya’s 1.2 million barrels of oil per day make it the world’s 15th largest exporter, and that production may be at risk should the country plunge into a much more violent version of what happened in Egypt - or worse, an all-out civil war. Three major international oil firms – ENI, BP and Repsol, suspended production on Tuesday and began evacuating staff.
 
But the current risk to production is not only what has spooked traders. Rather, it is the fact that Libya holds the largest reserves of any nation in Africa (and the ninth largest in the world) at over 41 billion barrels. Saudi Arabia immediately said it would be able to “compensate” for any shortage in international oil supplies, but the trading Tuesday clearly illustrates how crucial a relatively small swing producer like Libya can box more than its weight due to what it still has in the ground. A prolonged civil war between East and West in Libya – between Benghazi and Tripoli – would call in into question the massive exploration and production plans put in place over the past several years to access Libyan reserves and help assuage the growing imbalance between the oil we consume and the oil we produce. In addition to the very real tactical disruptions to supply, it is this longer-term threat to new oil supplies that has spooked traders.
 
Furthermore, it goes without saying that all eyes in the oil pits have begun to focus on Saudi Arabia. The fear that the “jasmine revolution” could spread to the linchpin of global petroleum production, while still unlikely, has moved to a new level in light of the events in Libya. It won’t take much in terms of upheaval there – or frankly, just the perception of it – to generate further major upticks in global oil markets.
 
It also goes without saying that the economy is in a particularly fragile state to withstand any kind of oil shock. Back when oil spiked to $150 per barrel in 2008, the U.S. economy was coming off a relatively long period of at least perceived prosperity. This time, any possible oil spike would be taking place right as it is just emerging from the deepest recession in three generations. It is no wonder the equity markets today reacted as they did – a rapid rise in oil right now could easily put the recovery into jeopardy.
 
Interestingly, agricultural commodities spiked downwards along with equity markets on Tuesday. Corn, wheat, rice and soybeans all fell “limit down” in Chicago, while copper also fell. There was plenty of air underneath each of these commodities, though, so we don’t suggest reading much into one day’s trading. Nonetheless, the overall sensitivity to a single move in the oil price is worth noting.

 

Like any business, economic forecasting is pretty small circle once you get to a certain level. The same names appear across various issues, and particularly with economics, commentators and pundits tend to come down either as generally positive, upbeat folks who tend to see the glasses half full, or as more cautious types reminiscent of Eeyore in A.A. Milne’s Winnie The Pooh.

Gary Shilling, whom we have followed for the better part of twenty years and who we consider to be among the best economists in the U.S., tends to see glasses half empty. His latest prediction is for a veritable crash in commodities prices predicated on a Chinese economic slowdown. Obviously, with what has gone on with commodity prices since 2009, the media has gotten a hold of Gary’s commentary with a vengeance, and has exacerbated a stance that was already more sensational than Gary probably intended.

Gary’s musings are always thought-provoking, and we don’t disagree with his theory that high inflation pressures may force the Chinese to tighten further, harder and longer than they would like. This risks an overshoot that could dampen growth, and with food inflation in China . And we grant Gary’s core premise that lower Chinese GDP growth of, say, 6% - characterized as a hard landing by Shilling - would be considered slow by their standards. An impact on commodities prices would be certain.
 
Where we disagree with Shilling is the depth of the “crash” he expects. Commodities, especially base metals, are obviously buoyed by emerging market growth, and China is the 800-lb gorilla when it comes to emerging market demand. Yet while a China growing at 6% annually is not one growing at 8%, there is no doubt in our minds that it will still draw enormous amounts of commodities nonetheless. For minerals like copper, which are already at supply-demand parity or worse (and that with the U.S. just emerging from recession), we think it is unlikely in the extreme to expect the situation to suddenly flip and go back to having a massive excess of copper stockpiled around the world. Granted, a hard landing as Shilling describes may pull some froth out of prices, but the strategic picture is simply too powerful to believe a drop will be anything but transitory. In fact, the numbers speak for themselves – all those Chinese are not going to go back to riding bicycles.

This is not to say there is zero risk in commodity-based investments right now. Commodities are famous for boom-bust cycles, and although we see a bright future for virtually anything China (and other emerging markets) needs in order to modernize its economy, volatility will be inherent in the sector precisely because expectations eventually outstrip reality. But with the U.S. economy just beginning to ramp up speed (which suggests Europe will likely follow), we think it is unlikely commodity prices will “crash”. And if they do, it will be a buying opportunity, not a change in trend.
Emerging markets are not famous for their political or financial stability, a fact that many investors tend to forget when things go well. Indeed, the outsized gains seen in many emerging markets in the past few years has encouraged many investors to engage them without accurately considering the risk inherent in nations whose financial markets are fragmented, illiquid and subject to government interference across the board. Yet emerging markets are increasingly crucial for both global businesses – American companies generating over half their sales overseas will grow revenue four percent faster than those that do not, according to Thomson Reuters – and, as Cash Cow readers know, they are crucial in your investment strategy as well.
 
The problem comes when good returns cause investors to throw caution to the wind. We are often amazed at how much baggage can be overlooked if the alpha – i.e. return over a particular benchmark, like the S&P 500 – is there. Indeed, since they were first described in the 1970s, emerging markets have periodically bitten investors lulled into complacency by periods of stable returns. From this perspective, the recent events in Egypt remind reminds us of the Las Vegas entertainer who was badly mauled a few years ago by his pet tiger. The animal had been docile for years, but was obviously still able of biting someone with very little warning. It was a docile as a housecat right up until it decided to rip the entertainer’s head off.
 
Emerging markets are similar in a way - they can do very well for a period of time, but they are always subject to unique risks and volatility that can befall even the most carefully analyzed investment. Officially categorized as an “emerging” rather than a “frontier” market by MSCI, Egypt was the largest and fastest-growing market in North Africa until last week, when demonstrations closed the stock exchange. As of this writing, it had not yet reopened.
 
When things like this happen in emerging markets, they do so extremely quickly, and investors are thus usually taken by surprise. More often than not, sell-offs ensue. But is important to look at the depth of the event and the true threat to the market it represents. In Egypt’s case, the current turmoil is of great interest to global investors because it is both an oil-producing nation (albeit a small one) and it controls the Suez Canal, through which over a million barrels of oil per day flow. In our view, only the most pessimistic scenario for Egypt involves any real threat to either one, and the markets tend to agree. Oil has reacted relatively cautiously so far, gold is actually down since the unrest began, and equity markets are generally firmer around the world. Interestingly, even the dollar, traditionally a sure-fire play whenever emerging markets got crazy, has been relatively unfazed.
 
However, Egyptian stocks have been taken to the woodshed, losing 21% since the start of the year through last week. While understandable, the sell-off may be an over-reaction. Unrest in Egypt may result in a secular democratic regime, or it may result in something else of a full liberal democracy. Either way, Egypt’s comparatively robust rule of law, business infrastructure, intellectual leanings and demographics (the majority of the population is under 30) suggest that business in Egypt is not threatened. Indeed, IMF data shows Egypt’s national finances, with gross external debt at just 17% of annual GDP, in better shape than some members of the European Union.
 
Our contrarian instincts are thus suitably awakened, and since Cash Cow is an ETF-oriented service, our gaze has naturally turned to the one ETF that is 100% invested in Egypt. Van Eck’s Global Market Vectors Egypt Index Fund (EGPT) is down well north of 20% so far this year, and dropped 13% just last week. However, assets in the fund have jumped from $11.65 million last Friday to $24 million yesterday. Granted, with the Egyptian market closed, most of this new capital is sitting in cash, and the net asset value of the ETF’s holdings is frankly anyone’s guess at this point. But it is up over 6% today on volume of over 800,000 shares, more than 100 times its average daily volume. We’re not recommending EGPT (yet), but some investors clearly sense a bounce is possible when the market reopens, and we’re inclined to agree. Such is the nature of emerging market investing - Risk, reward, but above all else, volatility.

 

It is sometimes worthwhile to take a step back and consider things from the perspective of where we were in the past compared to where we are today. Useful around times of birthdays, anniversaries and (for some) court dates, we often find ourselves thinking this way whenever an index like the Dow Jones Industrial Average nears a major round-number hurdle. In this case, the Dow is within spitting distance of 12,000, a level it has not seen since the middle of June 2008. In other words, shortly before the wheels came off the financial world.
 
The market teetered back and forth that summer, bouncing around between 11,000 and 12,000 on the Dow until the end of September, when Lehman failed. At that point, all bets were off and the Dow fell to just above 6,600 by March of 2009. Like many traumatic events, only those active in the markets during that time can truly understand what it was like to see the U.S.’s main equity index lose almost half its value in less than six months. It was a useful demonstration of the old maxim – made famous during other Wall Street bloodlettings a century ago – that at the end of the day, fear is actually far more powerful than greed.
 
How quickly they forget. With the Dow now scratching 12,000, optimism now abounds, which always makes us nervous on some level. Having anticipated stronger economic activity last fall, now that it is here we naturally worry to what degree it is priced, whether ultimately housing will prove the ball-and-chain of this recovery, etc. We expect President Obama’s State of the Union speech tonight to be full of anecdotes about how we’ve turned the corner economically, and by many measures (including those of September 2008) we have. Moreover, it is no secret that a humming economy is crucial to Obama’s re-election chances in 2012 – it isn’t for nothing that the third year of a president’s term is a traditionally a very strong one for stocks. And judging from the earnings reports we’re seeing, he is on the right track.
 
However, we are rapidly approaching the point when we will have to be careful what we wish for. U.S. interest rates have already backed up in response to accelerating economic performance, and while inflation remains muted in the U.S. and Europe, it is already a serious concern in emerging markets around the world. Following similar steps in Brazil and China, India’s hiked interest rates by 25 basis points again today, the seventh such hike since the beginning of 2010 and pushing its benchmark rate to a two-year high. The obvious question is how long it will be until massive price increases in basic commodities comes home to roost in the developed as well as the developing economies. As we’ve noted in the past, monetary authorities are between a rock and a hard place when it comes to this situation. Spur consumer demand via rock-bottom interest rates, quantitative easing, currency debasement, etc., and inflation will rise. Don’t spur it, and the recovery is at risk. For now, we think similar hawkish moves are still 6-9 months away in the United States, and even further out in Europe depending on to what degree the debt crisis there has truly stabilized. But they’re coming, that’s for sure.
 
In the meantime, strong cyclical trends within the U.S. economy are now firmly in place, returning us to a more traditional, positive trajectory for most equities. Although commodity prices will continue taking a breather while the more aggressive monetary policy stances are digested, we’re pretty sure they won’t collapse. Although nations like China, Brazil and India are taking aggressive steps to dampen inflationary tendencies in their fast-growing economies, basic supply-demand economics will still be at work in commodities whether India’s lending rates tick up 25 basis points or not.

 

As if on cue, Alcoa launched the U.S. earnings season today with results that confirmed the economic impulse visible in a bevy of government statistics. As well as traditionally being the first company to report each quarter, Alcoa – the third-largest producer of aluminum in the world and active in 31 nations – is also a terrific indicator for the health of the global industrial sector. Because it is involved in all facets of primary metal production – technology, mining, refining, smelting, fabrication and recycling – the company’s results often suggest increasing manufacturing activity in industries like automobiles, packaging and construction long before it is visible in downstream activity measures tracked by economists.
 
Alcoa posted its biggest profits in over two years in the fourth quarter of 2010. It booked net losses in 2008 and 2009 as the financial crisis hit, forcing the company to lay off some 20,000 workers and shutter plants worldwide. It is the latest in a string of companies to specifically include attainment of pre-crisis revenue and profit levels as a reporting benchmark in their financial discussions, suggesting that a return to pre-Lehman levels of activity is an accomplishment in itself.  
 
However, Alcoa’s report also contained a confirmation of another sort. Since the tail end of last year, concerns about surging inflation in emerging nations like China and India (and the steps necessary to combat it), driven largely by explosive increases in commodity prices across the board, have been central to weakness in these markets since the new year. For its part, Alcoa’s report confirms these headwinds exist and that efforts made to contain growth in China are having an effect. The company thinks that Chinese aluminum consumption is expected to grow 15% in 2011 versus 21% in 2010, while end-markets like autos will grow 10-15% this year against a whopping 32% gain in 2010. It is important to note that the company also expects aluminum prices to remain firm.
 
Alcoa’s comments are useful to investors as an education in perspective. Twenty years ago, if Alcoa had predicted the largest aluminum market in the world was going to grow 15%, the stock would have skyrocketed. Back then, gains of 5-6% per year were considered breaking news for stodgy companies like Alcoa. The predictions for next year seem weak only when compared against truly extraordinary numbers last year. Now, with virtually all major economies in the Asia-Pacific region showing a tightening bias as they try to reign in the effects of both rising commodities and rapidly rising currencies, the numbers will understandably cool off. In contrast to Wall Street’s reaction to Alcoa’s report, which was the typical “throw the baby out with the bathwater” selloff, the more stable growth rates are actually much better for the health of the broader strategic trend. Rest assured, Chinese auto sales, construction, retail consumption, etc. are all going in one direction. They will all continue to grow, although perhaps at a slower rates than that which was seen in 2010. This basic fact is undeniably bullish for commodities and the companies that mine, process or fabricate them whether the rate is 15% or 30%.
 
The core message is that while both commodities and emerging markets have backpedaled a little bit since January 1, the underlying growth trend is NOT in danger. On the contrary, it is wholly intact. China, India and other countries’ efforts to dampen growth are a natural response to the basic macro-economic situation that evolved over the past two years, and are very likely to be successful.
 
In the meantime, one of last year’s darker trends – the slow-motion implosion of the European sovereign debt market – may have faded from the front page lately, but it is by no means gone. Indeed, the likelihood of another bailout, this time for Portugal, grows by the day, driving renewed safe-haven activity in T-Bonds and gold, and we think odds are now pretty even that some kind of European equivalent to Brady bonds will be seen sooner rather than later. Both the Chinese and Japanese central banks have pledged active support to European sovereign debt auctions in the past week, leading some to think bonds issued by European bailout entities are a foregone conclusion. This area merits particularly close attention, as the first quarter may be setting the tone for the rest of the year.

 

It never ceases to amaze us how breathlessly the start of a new trading year is reported upon by the financial media. It is as if stocks and the economy know the difference between the last week of December and the first week of January. While we, as sentient beings, may be glad to put a given year into the history books, rest assured the stocks you own really couldn’t care less. Indeed, equally amusing is the amazement that often greets a positive start to each New Year, when in fact most such “calendar” trading patterns are simply the result of money flows - institutional money free of performance baggage, bumps in IRA/401k contributions (or the anticipation of them) from year-end bonuses, etc. It happens pretty much every year.
 
Obviously, what matters more than the roll of any calendar digit is the direction of the trend in the first place. While it is now relatively easy to find cautiously optimistic opinions about the U.S. economic recovery in the business press, it was not so back in the early fall when we began publishing Cash Cow. On the contrary, there was much hand wringing about a possible “double-dip” recession, and employment was easily the most prevalent concern in spite of early signs that the U.S. economy was finding its feet. Yet if anything, we’re more concerned about possible slippage now than we were then – consumers’ staying (i.e. purchasing) power is extremely fragile, we don’t like the persistent weakness in the housing industry (which ultimately affects one in three workers in the U.S.) and the structural implications of the debt load the U.S. just put upon itself are just now becoming more fully understood (they’re not good).
 
Granted, we agree that 2011 is starting out on better economic footing than any year since 2007, and strength in the equity markets is reflecting the belief that it is solid enough to support 3.5%-4% GDP growth. But it is worth remembering that much of this growth is coming from nothing more than pent-up demand; two full years of belt-tightening and downsizing have left everything from cars to web servers in need of repair, refurbishment or replacement. It is amazing what record cash levels at U.S. corporations and two years and little or no capital expenditures will do to order books, inventory levels and production. The question for folks like us is what happens after the catch-up honeymoon is over.
 
In the meantime, the core underlying trends that we believe are actually more important than things like monthly U.S. jobless claims –commodity consumption, China, the Eurozone crisis, etc. – continue apace, and will remain the primary drivers of long-term portfolio performance. Copper hit another high yesterday, at $4.4470 per pound, after rising 33% in 2010 and a whopping 139% in 2009. And prices are likely to continue rising; the International Copper Study Group forecasts a copper deficit of some 435,000 tons in 2011, following three years of more or less balanced supply and demand, and little new supply on the immediate horizon. Perhaps even more important for copper prices, though, is the imminent arrival of a physical-copper ETF later this year. If the experiences with other metals are any guide, a copper ETF will provide significant support to prices.
 
In the background remains China, the 800-lb gorilla of the world economy. An interesting chart that crossed our desks earlier this week from Credit Suisse shows that as far as GDP goes, China is roughly where the U.S. was back in 1966. However, when discussing consumer demand, the picture is a lot more complicated. While in absolute numbers China’s domestic demand for things like TVs is approaching that of the U.S., in relative terms it is still far below U.S. consumption. For instance, demand for things like cars, air travel, restaurants and other service enterprises are decades behind that of the U.S. (but catching up quickly). On the other hand, it is nearly on par with America in terms of things like steel consumption, mobile phone penetration and, interestingly, bank loans. The rise of the domestic Chinese consumer is easily the next big chapter in the Chinese growth saga, and Cash Cow’s portfolios will continue to reflect it.
 
Finally, we’re looking closely at another potential tactical trend that may have big implications to the U.S. economy (and our portfolios, if we play it right) in the second half of 2011. Fully 75% of all United States municipalities are facing cash crunches this year, beset by bloated public-sector obligations and lower-than-expected tax revenues. Barring an economic miracle, some of these states and cities will either default on their bonds (unlikely) or restructure them, but either way the opportunity may exist to snap up municipal-bond ETFs at bargain prices. If our research pans out, we’ll discuss this idea at length in our next issue. Stay tuned.

 

The week between Christmas and New Year’s is traditionally very quiet on Wall Street, which means it is usually a period in which both volume and volatility are usually low. This year, things were even quieter than usual – the good old-fashioned Nor’easter that walloped New York with two feet of snow yesterday left many trading desks empty or half-staffed. Indeed, as this update went to press, only 9 of the stocks in the S&P 100 had moved more than 1% on the day – there’s quiet, and then there is outright dull. Nonetheless, one can often learn a lot from how markets react to events during this period, since the lack of normal “noise” highlights things that would otherwise fly under the radar.
 
And then there is China, which apparently has a hard time flying under the radar even when it tries. Considering their propensity to be as stealthy as bulls in a china shop (pun intended) when it comes to such things, it didn’t come as a surprise to see the Chinese choose December 25th – Christmas – to raise their interest rates by 25 basis points. Inflation has been running higher than virtually all the reported statistics suggested for much of 2010, and several earlier interim steps, like six hikes in bank reserve ratios this year alone, have been ineffective in curbing price rises. Apparently, the Chinese thought that with U.S. and European markets closed on Saturday and Hong Kong markets closed Monday, the impact of the hike would be lessened. Of course, virtually anyone watching China since their last hike in October already knew it was coming - “unofficial” sources started hinting to it as early as the first week of December – and most markets that would be affected by such a move had already priced it in. In the event, the rate hike was basically greeted with a yawn.
 
The message is that the markets do not entirely believe a 25-basis-point hike in lending rates will do much to slow growth in China, which a colleague of ours recently termed the “greatest game in town”. Growth remains off the charts, which in turn means China is importing massive amounts of two things: commodities and capital. From a macro perspective, high growth countries like China and Brazil are far more interested in maintaining high GDP growth rates than fighting inflation, and the markets know they have traditionally favored the former when formulating policy. Tactically, though, they are increasingly taking steps that signal the opposite to the markets; credibility is everything in this business, and early moves in China’s benchmark rates are clearly intended to set expectations.
 
Of course, one can’t help but remind the Chinese that simply letting the yuan appreciate would be a fabulous way to accomplish much the same thing. It would be far less complicated, since it would reduce the cost of imported goods and raw materials without dampening domestic demand. The unwillingness to let its currency do some of the inflation-fighting heavy lifting means China will eventually have to basically choose between draconian currency controls, which have never worked for any appreciable length of time, or sky-high interest rates.
 
From our perspective, China’s rate hike (regardless of when it was timed) illustrates something far more important. The world’s economic path is splitting in two as its center of gravity shifts from West to East. While Europe and the United States are almost certain to keep their benchmark interest rates low next year, it is highly likely that emerging economic nations like China and Brazil will be raising them. In fact, a recent research note by Morgan Stanley predicts that 17 of the 23 emerging markets covered by their international economics team will raise rates in 2011, while the ECB, the U.S. Fed and the Bank of Japan leave their rates more or less unchanged and the Fed spends billions it doesn’t have monetizing Treasury debt. Cash Cow’s portfolios have been built with this strategic environment in mind, aiming to balance exposure between these two paths as they diverge in the coming year. So far, so good...

 

Contagion is a word that has lately been condemned to over-use by uninformed observers. Beginning in earnest back during the Asian financial crisis of 1997, in which currency volatility in Thailand, sparked by the government’s decision to float the baht, rapidly spread to most other Asian “tigers”, the word has been evoked to mean the effects of volatility in one market or geographic area spilling over into another. Rarely is it used in its original meaning, which hails from medicine and basically means catching a contagious disease through direct or indirect contact.
 
In most cases, we think the word is a misnomer when used in finance. Markets are so inter-connected now that developments in one instantaneously appear in another, especially in areas that are heavily prone to derivative creation, and such volatility is rarely indicative of a disease.
 
However, there are times when we think the shoe fits, and a recent article by intelligence service StratFor reminded us that the unfolding European crisis is clearly one of them. Interestingly, it is also rooted in an overvalued currency and foreign debt levels that make up a large proportion of GDP. Indeed, back in 1997, markets were aghast at foreign-debt to GDP levels over 75%, and they were ruthless in marking down such currencies. Fast forward to the present day, and such debt levels are again undermining the health of a currency – albeit in this case, a single one representing a large group of discrete economies.
 
Although you would never know it from the financial press, the Euro crisis is not just limited to fiscal basket cases like Ireland and Greece. Unfortunately, several “core” Euro nations are dealing with many of the same problems, to a surprisingly similar degree, and thus make the risk of true contagion very real. These states share the characteristics that have been the PIIGS household names in global finance for all the wrong reasons – large (and largely popped) asset bubbles, high budget deficits, extraordinary debt levels and an inability to force austerity measures onto very spoiled populations. In this case, it is not the disease itself that is contagious, but rather the interpretation of it - financial markets being what they are, it is wholly reasonable to expect the pricing pressures that have pushed Ireland and Greece – and by extension the Euro – to the precipice will eventually shift to over to these more established countries. And who is most likely to be next? Belgium.
 
Belgium has never been as solid as its location between the hard-currency nations of France and Germany suggests, even back in the pre-Euro days. Almost alone among Western European countries, it has a surprising lack of political stability, and has suffered through three complete government shifts in just the past three years. The country now boasts government debt of 96% of GDP, far worse than Spain and Portugal’s. If the conventional financial and economic wisdom holds that Portugal is next on the ECB bailout list, then Belgium surely cannot be far behind. One of the new benchmarks of the Euro’s valuation criteria is the degree to which fiscal austerity is realistic, and without a stable political front it becomes even more likely that the financial Valkyries turn their attention to Belguim’s sovereign debt.
 
Moreover, like Ireland, Greece, Portugal et. al., Belgium is beholden to the international capital markets to finance its external debt (much like, it is worth noting, the United States). This distinction is paramount, however, since investors in those markets can suddenly demand a higher risk premium on debt that a small nation may be able to bear. This “rush for the exits” is relatively commonplace and has resulted in the devaluation of more than one developing nation’s currency. However, locked at the hip to the other nations of the Euro, Belgium – although it is an advanced, western nation with an established, free-market economy – has no such flexibility. As far as contagion goes, the pressures on the Euro since the dawn of the Greek tragedy last June will pale in comparison to that which will greet the ECB should investors realize, en masse, that the very same problems facing the PIIGS exist deep within the Euro’s core.

As of last week, Belgian 10-year bond yields were trading at a relatively slight premium of 110 basis points over comparable German bunds (considered the benchmark for European sovereign debt) while those for Ireland and Portugal were at 520 and 320 basis points, respectively. If the markets begin to price true contagion of the Euro crisis from the periphery of the Eurozone to the foundation, these spreads will widen, perhaps rapidly. We don’t think Belgian debt will become as toxic as that of Greece, but we doubt the ECB will be able to stabilize the situation rapidly enough to prevent a spillover into the Euro. All things considered, contagion is not a word we tend to use lightly. In this case, however, we think it is only a matter of time before Belgium comes into the sights of the bond markets, and the ECB will not be powerful enough to stop it. The consequences for the Euro will be sharp and steep – stay short the European currency via our ProShares UltraShort Euro position.
 
 

 

We wrote last time that the period between now and Christmas would be an unsettled one, and that such uncertainty would auger well for the dollar, U.S. interest rates, and equity portfolios carrying strong U.S. and commodity exposure. Our position remains the same – ripples in the water coming from geopolitical events, such as from Korean artillery duels and Wikileaks scandals, or economic ones like another European sovereign bailout, are serving a useful purpose from our perspective – they have arrested corrections in commodity markets and breathed some life into the U.S. dollar, both of which have helped move Cash Cow’s portfolios even further into the green.
 
Granted, continued evidence of a gradual acceleration underway in the U.S. economy doesn’t hurt. Early data from the Thanksgiving weekend suggests shoppers were out in force both physically and via their keyboards this year, employment numbers are finally going the right direction (although there is a long way to go before we reach levels typically associated with recoveries) and various upstream indicators like confidence, production and other leading indicators suggest a momentum that has been elusive this time around. Taken in context of the last two years, even a steepening of the yield curve, in which 30-year yields have risen while 5-10-year maturities have fallen, suggests a normalization of the economic recovery process is underway. Indeed, economic recoveries tend to gather the most steam when the yield curve is steep or steepening, so this is unabashedly good.
 
Incidentally, the insider trading scandal that has riveted much of Wall Street since just before the Thanksgiving holiday reminds us of an old and unscientific maxim taught by a mentor whose career in finance spanned three wars and eight presidents. In his long experience, turning points in major market cycles are usually marked by mega-scandals. In this case, the Madoff scandal broke as the full enormity of the financial crisis was becoming clear, and perhaps it will be the insider trading one (of which there is still very little public information) that will serve as the demarcation point for a return to “normal” growth. We continue to see this more of a story about a story, and not something that will fundamentally impact the equity markets – even capital that exits implicated funds are unlikely to exit stocks entirely, choosing instead to head for cleaner pastures – but it would fit with this long-standing tendency.
 
As for the ongoing European debt crisis and the bailouts that seem to be merely kicking the proverbial can down the road, the biggest impact will continue be felt in the Euro. As we’ve written before, the bailout offered to Ireland earlier this week (and the Greek one six months ago) exemplifies the typical European mistake of putting the urgent ahead of the important. Bondholders who would normally share in the burden and financial loss associated with any default or workout of sovereign debt issues are again being virtually exempted from it. Instead, European taxpayers, who in this case mean citizens in Germany, France, Holland and any other hard-currency Euro nation, are paying the price, and it is getting extremely expensive to do so. Indeed, the whole thing reminds us of what it must be like to watch a train wreck unfold in slow-motion - it is fundamentally impossible to keep economically disparate nations locked at the hip via common currency when that currency does not also encompass common financial systems, fiscal policies, or budgetary processes.
 
The bottom line is that the markets are beginning to smell blood in the water with the Euro, and they’re right. Accordingly, we’re content to keep our Proshares UltraShort Euro Fund (EUO) position open; EUOis doing very well for us, up 10.8% since we took the position only three weeks ago. There are more gains to be had here – no central bank or consortium of bailout programs will be able to prevent further devaluation in the Euro once the market decides that sovereign default risk in Ireland, Greece, Portugal and Spain is simply too high. Indeed, in the “old” days, nations such as Greece and Ireland would have simply devalued their currencies by 25% to 30% and been done with it, making all participants share equally in the pain of correcting past excesses and mistakes. Those of us old enough can recall happened to the Bank of England when the markets (i.e. George Soros) decided certain currency trading bands in Europe were too narrow…
 
Vis-à-vis the U.S. dollar, all of this means a stronger exchange rate, and thus stronger commodity prices across the board. For the time being, the tactical developments in currencies, equities and politics are all in synch with out strategic theories on emerging markets and commodities, and all them favor continued strength in Cash Cow’s portfolios.

 

The days leading up to major holidays are always good for two things in financial markets, and American financial markets in particular – they are usually lighter in volume than regular days, and for whatever reason, they usually contain extraordinary events that, because of the lighter volume, have outsized impacts on the markets. And so it has been so far this week – word of a massive insider-trading investigation involving some of the biggest names in hedge funds and a North Korean attack on South Korea would unnerve markets in the middle of June. Two days before Thanksgiving, they sent it for a tailspin.

Of the two, we’re more worried about Korean situation. It will come as very little surprise, following scandals of the size and complexity of a Madoff, to learn that a cadre of Wall Street fund managers used sector and industry experts as private fountains of information. While it might ensnare a number of brand-name funds and high-profile investors, we don’t expect any major market-wide repercussions beyond capital flight from the funds affected and, potentially, additional regulation on how such experts share their knowledge. Neither troubles us very much.
 
On the other hand, the Korean situation is one that could become strategically very problematic. Starting with the sinking of a South Korean corvette earlier this year, allegedly by a North Korean concussion torpedo and culminating with attack this morning on a disputed island near the DMZ between South and North Korea, North Korea’s actions and rhetoric signal a major shift in how it views its role in the region and the world. We also note that the timing of the attack was not arbitrary; it came a day after North Korea unveiled yet another uranium processing facility, effectively giving the U.S., China, Russia and Europe the collective finger.
 
Beyond the military and geopolitical ramifications of North Korea’s belligerence lies our concern with the economic ones. Following the financial crisis, the world has pulled out most of the stops in terms of policy measures – there is not much ammunition left in fiscal or monetary steps that can be taken to push the global economy further towards recovery, and as the ongoing Eurodebt crisis shows, sovereign defaults by Ireland, Greece, Portugal and Spain are no longer fanciful speculation but real possibilities. A major geopolitical event is the last thing the global economy needs right now, and it would have significant adverse impact on global growth were the two Koreas – and by extension Japan, China, Russia and the U.S. – to get into a major open conflict.
 
One upside of all this volatility has been the stabilization in the commodity markets, which had been correcting heading into this week, and continued weakness in the Euro. In fact, the Euro is at its weakest levels since September, pushing our tactical position in the Proshares UltraShort Euro Fund (EUO) to its best levels since the same time. Although we’re up strongly on the position, we anticipate the Eurodebt situation will get worse before it gets better, pushing down the Euro, while the situation in North Korea is pushing the dollar upwards. There are more gains to be earned here - continue to hold for now.
 
In the meantime, there is a quick trade in defense stocks due to the heightened tensions in Asia. Although they typically rise and fall with the U.S. defense budget, aerospace and defense stocks will find some footing as sabers continue to be rattled overseas, adding to the stabilization seen when the Republicans swept the midterm elections. For this speculation, we like the iShares Dow Jones US Aerospace & Defense (ITA) ETF, trading for around $55.50 today and up from a low of around $49 back in September. Although not leveraged like our short Euro speculation, the iShares fund is more engaged in some of the technology and intelligence companies we think will be favored going forward, as opposed to the more traditional “heavy iron” defense makers. And like EUO, we may not hold this one very long, so stay tuned for a possible close out by email.
 
If we’re right, the period between now and Christmas may be unsettled indeed. This bodes well for several of Cash Cow’s main pillars – commodities, a stronger dollar, lower U.S. interest rates, and specific sectors like Defense. And as for the insider trading investigations, at least we’ll all have something interesting to read over the holidays.

 

If there is a common theme among investors in all asset types, it is the anticipatory nature of their trading. From Microsoft to cotton futures, investors universally buy ahead of whatever they think is going to happen, not what has already happened and is printed on the tape today, last week or last month. With perhaps the lone exception of purely technical traders, who buy and sell based on signals generated by a dizzying variety of price- and momentum-based theories, this type of tendency results in the development in question – whatever it may be – being at least partially priced before it actually comes to pass. There may be few constants in the markets, but “buy on the rumor, sell on the fact” is one of them – being a bit predictive and contrarian in your thinking is one of the foundations of a successful fundamental trading strategy.

So with this in mind, we’ve been viewing the U.S. dollar with renewed interest. It has been shunned for most of this year, especially during September and October, and has lost ground against virtually all major developed-nation currencies. It has lost even more against commodity-rich developing ones. Yet following the Republican victory in the midterm elections and the Fed’s infamous QE2 round of quantitative easing (in the form of $600 billion newly-printed dollars), the dollar has held up reasonably well. This means two things; QE2 is already priced, and in fact was being priced during the fall as the markets speculated exactly how large it would be. Secondly, the markets are likely to start looking past QE2 in short order and begin pricing the dollar for higher inflation rates and a rebounding economy. Indeed, the G-20 meeting this week will see a chorus of international criticism against QE2, but we doubt any appreciable downward movement in the dollar.
 
Note that our long-term concerns about the dollar remain – the Fed’s desire to create “a little” inflation runs the risk of permanently debasing the world’s reserve currency against virtually every major resource-rich, exporting nation in the world except China, who refuses to let its currency move to where it should be. But we see a good trade shaping up here in which we capture a dollar rebound that coincides with continued economic progress heading into 2011. The big question: against which currency will the dollar appreciate the most?
 
From our viewpoint, the answer is the euro. Assuming the market has indeed discounted all the bad news relative to the dollar and it will react well to improving economic news, Europe’s problems are likely to return to center stage. The problems highlighted by Greece last summer have not gone away, they were merely overshadowed; it has been fundamental Euro-zone strength that pushed the euro from $1.26 in late August to $1.39 today, but rather dollar weakness. Meanwhile, Germany has categorically refused to even discuss further bailouts while the budgetary problems in Portugal, Spain, Ireland and Italy remain extremely severe. It seems unlikely that the ECB will move on interest rates until at least the second half of 2011, and if the downward pressure on the dollar subsides, the euro should be vulnerable to a multi-cent decline against the dollar.
 
From an ETF perspective there are two ways to play this idea. The first would be to simply short the shares of a basic long-euro ETF such as the Rydex CurrencyShares Euro Trust (FXE). However, shorting stock is not for everyone, so another option would be to use a leveraged futures ETF to accomplish the same thing to a greater degree. We have been hesitant to recommend any of the leveraged ETFs in Cash Cow because of their volatility. However, for a trade like this one, which we expect to be relatively short-lived, we think an ETF with 2-to-1 leverage makes sense. We suggest using the Proshares Ultra Short Euro Holdings (EUO) ETF here, a highly liquid fund geared to return double the inverse of any corresponding move in the euro/dollar exchange rate. EUO has fallen from over $26 back in June to just over $19 now and has started to recover. It has significant technical support at $17.
 
Therefore, for the adventuresome among you, we suggest taking a speculative position in EUO at prices no higher than $19.50. At the same time, we recommending placing a stop order at $16.50, to be on the safe side, and suggest keeping a sharp eye out for emails on this position. We will not hesitate to take profits or close out if need be.
The relationship between bond markets and stock markets can be a tricky one, to say the least. And generally stock markets care more about the direction of bonds than the other way around. Indeed, any length of time in this business will teach you that the folks in the bond pits generally have a very good grip on the state of the economy right now, whereas equity traders may have a much better handle on what it will look like in six to twelve months. Right now, this makes stock traders generally an optimistic bunch; bond traders less so.
 
So it should come as little surprise that while equity markets have turned up lately in anticipation of an accelerated economic recovery, bonds (as measured by U.S. Treasury yields) remain at levels that reflect the sum of several fears – inflation, deflation, currency wars, safe havens, etc. And while we’re generally optimistic that the stock market may do decently well over the short- to medium-term due to superficially strong earnings and easy comparisons, the longer-term picture is much more complicated – and that’s what has the bond traders so concerned.
 
Indeed, one of the smartest bond players on the planet, Mohamed A. El-Erian of PIMCO, is being quoted this week as saying additional Federal Reserve purchases of Treasury debt – also known as quantitative easing – will lead to faster global inflation and will not have the desired effects on structural issues in the U.S. economy like unemployment. While the immediate goal – keep borrowing costs low without officially cutting interest rates – is theoretically sound, it is likely to come at the price of significantly higher commodity prices and continued weakness in the U.S. dollar. And while the Fed frets deflation, the markets are beginning to see El-Erian’s point – an auction Monday morning of 5-year inflation-protected Treasury notes (TIPS) sold at a negative yield for the first time, meaning investors are seriously concerned about inflation between now and the notes’ maturity date. Although 5-year TIPS have been trading on the secondary market for negative yields for several weeks, this was the first time such yields were seen at an auction. With the break-even inflation rate on TIPS running roughly 1.6%, the TIPS auction was a clear signal that investors believe inflation will run higher than Treasury yields. As confirmation, an auction today for 2-year regular Treasury notes were also sold at a record low yield of only 0.4%, underscoring the bond market’s expectation that inflation is on its way.
 
From our point of view, the adage about being careful what you wish for comes to mind. The Fed may be desperately trying to get some growth (i.e. inflation) into the system, but that is the kind of genie that is sometimes left inside the bottle. You’re already seeing the effects of high inflation expectations on commodities and the dollar. Indeed, a quick check this morning saw copper at a 27-month high, cotton at a record, wheat up the most in two weeks, gold within $50/ounce of another record, coffee at a 13-year high, sugar at levels not seen since 1981, and silver at 30-year highs. The trend is pretty unmistakable, and we think it has much further to run. And judging from the number of metals-related ETFs that are coming to market (including a physical-copper one from JP Morgan), we’re not alone.
 
Frankly, the Fed might be barking up the wrong tree. Quantitative easing, regardless of size, does little to address structural challenges facing the U.S. economy. China, for instance, is unlikely to enjoy bidding against the Fed for U.S. paper under a massive “QE2” scenario, while a revaluation of the Chinese yuan would likely do more to improve the jobs situation in the U.S. than any amount of debt monetization. Indeed, Paul Tudor Jones, as much a titan in the equity markets as El-Erian is in bonds, has calculated that a 30% revaluation in the yuan would be equivalent, on a trade-weighted basis, to an 8.5% depreciation in the dollar that would lead to as many as three million jobs and a drop in the unemployment rate of 1.5% by 2014.
 
Regardless of how next week’s election shapes up, President Obama will be looking for a foreign policy success in order to anchor his party’s platform. Perhaps putting the full-court press on the Chinese currency reform would be the place to start. Either way, we think the handwriting is on the wall – higher inflation is on the way.
 

 

Don’t look now, but despite chaos in Washington, uncertainty about regulation affecting roughly half the economy, record gold prices and rock-bottom interest rates, American businesses are starting to peer out of their collective foxholes.
 
The Institute for Supply Management’s September survey of the non-manufacturing (i.e. services) sector came in better than expected today, at 53.2%. With ISM survey’s any reading over 50 usually signals expansion; under 50 – contraction. Today’s number was the ninth straight 50+ number for the services sector. Better yet, employment in the sector also improved, likewise edging up over 50 and giving the third positive reading in five months.
 
Coming off the best single September in the stock markets in two generations, investors have been looking for this kind of economic foundation to support a bullish hypothesis, and there has been real concern of late that weaker-than-expected economic figures would take the wind out of any market rally that started. But on the other hand, if ever the old adage that bull markets climb a wall of worry would hold true, it would be now. Indeed, we’ve been so worried for so long that it is very easy to envision a situation in which a stealth bull market develops while everyone is still complaining about what they see in the rear-view mirror.
 
Granted, we’re not ragingly bullish. There are still serious political issues to tackle, gold is saying (yelling, actually) that the market is strategically on a very precarious foundation, and there are major risks with both inflation and deflation. Nonetheless, September’s gain is not without merit; the last six times September racked up gains of 5% or more, the markets were positive for the fourth quarter and for the year, averaging 7.4% and 23.2%, respectively. Indeed, the lowest quarterly gain was 2.44%, in 1997, and the best was a 20.8% bump in 1998. Incidentally, the weakest annual tally following a 5%+ September was 20.26% in 1996, and the best was a whopping 45% run in 1954. At least historically, the strong showing in September 2010 should be a precursor to a more sustained tactical move upwards.
 
Meanwhile, the Fed’s dangerous policy of quantitative easing is beginning to have serious international repercussions, and it is from this angle that we see potential icebergs ahead. As the Fed floods the system with dollars, the dollar naturally weakens versus other currencies, which while perhaps in the interest of the United States is an event rarely welcomed by export-oriented nations like Germany and China. Amidst talk of a “global currency war” on trade desks around the world, Japan’s central bank unexpectedly cut interest rates today and sent an unmistakable signal that it will do whatever it can to keep the record-high yen in check. Elsewhere, commodity-rich nations like Brazil and Indonesia have taken steps to control the “fast money” moving in and out of their currencies as massive amounts of investment capital flow in their direction, while “hot” emerging markets like South Korea have done the same. Such reactions are understandable, although perhaps unadvisable; as a veteran of both the breaking of the British pound by George Soros and the draconian currency controls in South Africa, your editor can attest to the slippery slope on which these nations are beginning to tread.
 
Ultimately, it will be sustained economic growth that removes the need for the Fed to provide additional easing in any form. At that point, currency pressures will subside. Until then, expect to see demand for emerging markets and commodities – and, for better or worse, the appropriate currencies – remain extraordinarily strong.
 
Finally, we’re putting together the next Cash Cow issue, and will be bringing you several new portfolios aimed at Asian emerging markets, commodity currencies and commodities themselves. We’ll also be adding additional recommendations in specific U.S. market sectors in light of the stronger market we see potentially developing over the next several months.
 

 

Markets have been volatile since our last update, with commodities correcting across the board and the market’s reaction to the Fed’s QE2 program getting fully priced into everything from interest rates to equities. Specific moves to curb speculation in commodities markets recently have included comments from the EU financial services commissioner, higher margin requirements by the CME for silver, and rumors that China’s steps to combat inflation will include price limits on food and increased penalties for commodity speculation. Taken together with the Fed’s dubious QE2 and the stratospheric levels at which some commodities have been trading, these steps have taken some of the zest out of the markets. Indeed, things like corn, soybeans, precious metals, oil and copper have corrected as it has become clear China will take some sort of action in the near future. In fact, the Thomson Reuters/Jefferies CRB Index, which is comprised of 19 raw materials, has fallen to its lowest levels in a month. Accordingly, many of our commodity-related ETF recommendations in Cash Cow have come off their highs.

 
This was not unexpected. If we have learned anything from nearly 20 years in this business, it is that markets do not go in straight lines, and markets that have gone in one direction for any extended period are susceptible to short, sharp corrections. The commodity rally that began nearly two years ago has been a one-way street for a relatively long time, and began generated the dreaded “bubble” moniker in press reports. We don’t think commodities are in a bubble, mostly because the rise in prices has been predicated on fundamental demand strength from recovering developed economies and growing emerging ones. Corrections such as this one typically wash out tactical money, i.e. investors who are playing momentum more than strategy and short-term trades versus long-term potential. We’re not concerned; as long as the fundamental supply/demand dynamics of commodities remains intact, and nothing on the horizon suggests they will be otherwise, commodities will figure large in our investment theses.
 
The commodity correction is also impacting emerging markets, since the equity markets of many of them have been riding the commodity wave upwards. In these markets, stock performance through 2010 has been primarily focused on companies exposed to either developing markets or commodity prices, so the correction in some of these materials is bound to have an impact on equity prices
 
In the meantime, our speculation on a falling Euro is bearing a little fruit. Recommended in last week’s update, our position in the Proshares UltraShort Euro ETF (EUO) is back over $20, up about 5.2% since the recommendation on the 9th of November. Leveraged 2-to-1 on moves in the Euro/Dollar exchange rate, EUO’s performance has been on a drop in the Euro from roughly $1.37 to $1.35. While we took this position as a short-term trade, we think there is more downside for the euro directly ahead, so we’re keeping the position open for now. As we’ve written, however, this may change quickly, so keep your eyes open for an email from us closing the EUO position.
 
Interestingly, behind the scenes through all of this has been rising Treasury yields – precisely the opposite of that which was intended by the Fed’s QE2 program and what the vast majority of the proponents for quantitative easing expected. And as we’ve written in the past, we’re more apt to trust the folks in the bond pits than the current crop of Fed governors – bond traders rightly fear a massive onset of inflation and are selling debt as a result. In the meantime, Europe’s debt problems may have receded from the front pages during the fall, but they are anything but solved – debt spreads for Greek and Irish debt are widening again and Austria has threatened to block the next tranche of bailout funds to Greece until the government there gets a bona-fide deficit reduction plan in place. As before, we’re skeptical the Euro can remain intact through next year without some kind of modifications.
 
In the meantime, signs continue to mount that the U.S. economy may be doing better than a lot of people think. The dollar is a six-week high, jobless numbers have stabilized, corporate profits are very strong (although due more to cost cutting than higher revenue), and things like the GM IPO and Reynolds 2-for-1 stock split have us thinking the market is returning to something that could be considered normal.
 
For now, we’re content to let the commodity/emerging market correction run, which will have some spillover effects into the Sectors and Currency portfolios in Cash Cow. Ultimately, these corrections will be healthy for the long-term trends we see impacting all of the markets we currently follow. Strategically, we’re more troubled by the debt issues enveloping the developed markets than we are in relatively small retracements within very established bull markets in commodities and emerging markets.

One of the benefits of the ETF industry is that new products can be created extremely quickly (at least relative to other financial products), enabling Wall Street to craft exactly what is needed to address whatever demand may be simmering at any given time. A case in point is the new Rare Earth/Strategic Metals ETF (REMX) from Van Eck, launched last week. We’re still doing the research on the fund and whether it will fit into our philosophy at Cash Cow, but we can tell you this: the commodity super-trend to which we continually return is illustrated in few better ways than the Chinese headlock on the global rare-earth metal supplies. The specific companies that make up Van Eck’s ETF look to be, at least in some cases, somewhat tangential to the rare-earth industry itself, but remember that rare-earths are used in a large variety of decidedly high-tech industries and products – i.e. wind turbines, industrial electronics, super magnets, cell phones, jet engines, etc. And while their supply is not in question globally, the fact that the Chinese effectively control that supply makes the whole rare-earth complex very much a commodity play.

 
Moreover, Van Eck’s ETF – or any collection of rare-earth plays for that matter – is also a play on another consistent Cash Cow theme: Asian markets. The underlying index upon which REMX is based presently allocated across roughly 25 constituent positions weighted with 24% in Australian equities and 15% in Chinese H shares (i.e. those available to foreigners). We don’t expect the discussion on China’s rare-earths to let up anytime soon, since it is clear the subject has become part of a political dance related to China’s currency and trade policies as much as a supply/demand question. In fact, we think it is a pretty fair bet that additional Chinese rare-earth equities will become available on either the U.S. pink-sheet market heavily favored by Chinese small-capitalization companies or as H-shares in China. Either way, a key advantage of ETFs in this kind of situation is that as the index’s investable universe expands, so does the ETF’s position base. Especially when trying to capitalize on trends heavily populated by small-cap stocks in faraway markets, this sort of made-to-order diversification is critical.
 
Along the same lines, we can’t help but take notice of BlackRock & J.P. Morgan’s plans to list a physical-copper ETFs. Emboldened by the success of other hard-commodity, physically backed, ETFs in gold, oil, silver and platinum, both houses clearly think enough of copper’s long-term investment prospects that they think filing for an ETF makes sense. From our perspective, they’re spot on – and if either (or both) ETFs actually come to pass, they will add significant investment demand for physical copper above and beyond that for industrial usage.
 
With the supply-demand situation already extraordinarily tight and prices at multi-year highs, a physical copper ETF would remove metal from the market (in contrast to futures contracts, which while implying physical delivery rarely actually do so) and lock up supply, exacerbating the market’s tightness and putting even greater upward pressure on copper prices. Indeed, the advent of such ETFs for gold and silver contributed significantly to the start of multi-year bull markets in both, and neither has the dramatic industrial demand of copper. Bloomsbury, a highly regarded London-based metals research house, wrote in October that “ETFs, on the other hand, can immediately take metal out of the market, potentially leading to physical scarcity. If investment in ETFs proves to be highly responsive to news, such as an earthquake in Chile for example, a relatively modest supply disruption could turn into a much larger one, directly impacting on the ability of consumers to buy the red metal.”
 
And note that Bloomsbury anticipates a whopping 80,000 tons of physical copper will be held by ETFs by the end of next year, adding to an overall supply deficit of 500,000 tons. The effect of this shortfall on price should be pretty obvious. Meanwhile, we think it is safe to assume both BlackRock and J.P. Morgan have learned from the mistakes made by early physically backed ETFs related to allocations and net asset value, any potential copper ETF even more attractive to institutional buyers.
 

We will be taking a much harder look at both ETF ideas in the upcoming issue of Cash Cow. In the meantime, our point is simple: Commodities should be the one of the fundamental anchors of your investment strategy, and several of Cash Cow’s various ETF portfolios reflect our belief that a strategic uptrend is underway in commodities prices. While volatility will remain – and will be exacerbated by things like the planned copper ETFs – to us, the trend is as clear as it could be.