Bloomberg Story from another planet: Bond Yields Showing No Economic Spoils for Republicans in 2010

Posted on 22 August 2010 by Art

Trying out the WordPress app for my iPad. Came across the below story on Bloomberg. Not sure what to say. I try to keep objective but this story seems to be written to appear objective but is anything but the case.

I will go into this later, but the yield curve is steep because the low end is pinned down by the fed, and it has an extremely high chance of flattening. And if you follow the line of reasoning of the story, I think you have a decent chance of decreasing your net worth.

I continue to see evidence of an extremely unstable market with little volume. Stocks on a valuation basis don’t look so bad if we didn’t have serious deflationary factors. However we *do* in fact have serious deflationary factors as evidenced by the recent enormous flattening of the yield curve. Indeed one wonders if the writer of the story has looked at the recent price action on the five and ten year treasuries. Very unhealthy indeed!

Will try to update when I get time. In the meantime….

Try not to lose money.

Arthur O’Keefe, São Paulo Value

http://www.bloomberg.com/news/2010-08-22/bonds-showing-no-economy-spoils-for-republicans-as-rates-point-to-recovery.html

Bloomberg News, sent from my iPad.

Bond Yields Showing No Economic Spoils for Republicans in 2010

Aug. 23 (Bloomberg) — Former Republican House Speaker Newt Gingrich says Barack Obama’s policies are “artificially extending the recession.” Congressman John Boehner, the party’s leader in the House, says “stimulus policies aren’t working.” Republican Senator Jim Bunning calls Federal Reserve Chairman Ben S. Bernanke’s tenure “a failure.”

The U.S. bond market disagrees. The economy has never contracted with the difference between short- and long-term Treasury yields as wide as it is now. That gap, at 2.11 percentage points for 2- and 10-year notes, signals a 15.5 percent chance of a recession in the next year, according to the Federal Reserve Bank of Cleveland.

“Reports of the death of the recovery are greatly exaggerated,” said Andrew Busch, a public policy strategist at Bank of Montreal’s BMO Capital Markets in Chicago and former adviser to Republican presidential candidate John McCain and Treasury Secretary Timothy F. Geithner.

As politicians step up their rhetoric ahead of the November midterm elections, bond traders are watching the so-called yield curve for clues to the direction of the economy because before each of the last seven economic contractions, long-term yields fell below short-term debt. While that gap has narrowed since reaching a record 2.91 percentage points in February, it’s still almost double the average since 1990.

Though economists are paring their forecasts, they still predict growth in gross domestic product of 3 percent this year and 2.8 percent in 2011, according to the median of 66 estimates in a Bloomberg News survey. Goldman Sachs Group Inc. economists say most of the sectors that drag down an economy, including housing, employment and capital spending, have “already suffered big hits.”

No Double Dip

“As signs of slower U.S. growth have multiplied, market participants have become worried about the possibility of a double-dip recession,” the firm’s economists wrote in an Aug. 12 report. “The probability is unusually high – between 25 percent and 30 percent – but we do not see double dip as the base case.”

The yield on the two-year notes due in July 2012 fell to a record low of 0.4547 percent last week, as investors pushed the price of the security up 2/32, or 63 cents per $1,000 face amount, to 100 8/32. The yield on the benchmark 10-year note, a 2.625 percent security due in August 2020, declined to as low as 2.53 percent, the lowest since March 2009.

The $8.18 trillion market for Treasuries, which help determine the cost of funds for everything from mortgages to corporate bonds, has returned 8.05 percent this year, including reinvested interest, Bank of America Merrill Lynch index data show. They lost 3.7 percent in 2009.

‘Policies Aren’t Working’

Republicans, who lost control of the House of Representatives and Senate in 2006, are pointing to rising demand for bonds, falling yields and faltering stocks as a sure sign the economy is poised to contract. The Standard & Poor’s 500 index is down 3.9 percent this year.

It is time for Obama to “face up to the fact that his stimulus policies aren’t working,” Boehner of Ohio said Aug. 7, a day after the government reported the unemployment rate held at 9.5 percent in July.

The White House hasn’t made much progress in selling the stimulus spending to voters. Asked how their opinion of the programs had changed in recent months, respondents to a Bloomberg National Poll were divided almost evenly among those who say they had become more supportive, those who are less supportive and those who haven’t changed their view.

‘We’ve Gotten Through’

A steep yield curve traditionally indicates economic growth as investors demand more compensation for the risk of faster inflation. A flatter yield curve signals contraction and little threat of inflation.

Though yields are hovering near record lows, the curve as measured by projections of the three-month Treasury bill rate to 10-year note yield suggest the economy will strengthen by about 1.14 percent over the next year, according to a July report from the Federal Reserve Bank of Cleveland.

“The growth trajectory in the economy is sluggish, but positive, with no contraction on the horizon” said Wan-Chong Kung, a money manager who helps invest $89 billion at FAF Advisors in Minneapolis. “We’ve gotten through a really tough downturn in the economy. It could have been much worse if we didn’t have the type of policy that was put in place on the fiscal and monetary front that.”

Inverted Yield Curve

There have been 33 official recessions since 1850, and only three times has the economy fallen back into negative growth within a year, according to data at the National Bureau of Economic Research.

The difference between 2- and 10-year yields is up from negative 0.19 percentage point in December 2006, just before the economy began to shrink.

An inverted yield curve has twice failed to predict a recession — in late 1966 and late 1998. The bears say bonds may be sending another “false positive.” With the Fed’s target rate for overnight loans between banks at a record low of zero to 0.25 percent, it may be impossible for long-term yields to fall below short-term debt.

“As long as the Fed continues with ultra easy policy the yield curve’s relative importance as an economic signal is diminished,” said Christopher Sullivan, who oversees $1.6 billion as chief investment officer at United Nations Federal Credit Union in New York.

A gradual recovery may not be enough to bolster Democrats in the November elections, BMO’s Busch said. “The number one thing on voters’ minds are still jobs, and we haven’t seen any significant progress on the employment front.”

Signs of Improvement

Since the stimulus legislation was approved in February 2009, the U.S. unemployment rate has climbed to 9.5 percent in July from 8.2 percent. The administration projects the jobless rate will average 9.7 percent for the year. Spending by consumers has slowed, with the savings rate rising to 6.4 percent in June, from 1.7 percent in August 2007.

There are signs of improvement, as production in the U.S. rose more than forecast in July. Production at factories, mines and utilities climbed 1 percent, twice the median forecast in a Bloomberg News survey, figures from the Fed showed last week.

Companies in the U.S. added workers in July for a seventh straight month as private payrolls that exclude government agencies rose by 71,000 after a June gain of 31,000, Labor Department figures showed. Corporate spending on equipment and software jumped at a 22 percent annual rate last quarter, the biggest increase since 1997, signaling confidence among company executives.

‘The Facts’

“There seems to be a doom and gloom out there,” Doug Oberhelman, chief executive officer of Peoria, Illinois-based Caterpillar Inc., the world’s largest maker of construction equipment, told analysts in a meeting at the New York Stock Exchange on Aug. 19. “We just don’t see it that way for lots of reasons. The facts aren’t bad in our business.”

The more than 75 percent of the companies in the S&P 500 that reported second-quarter profits exceeded the average analyst estimate since July 12, data compiled by Bloomberg show. Earnings will rise 36 percent this year, the most since 1988, forecasts show. Following the 2001 recession, income growth never exceeded 20 percent.

“The main difference between 2008 and now is that corporations are making money,” said Andrew Brenner, managing director at Guggenheim Capital Markets LLC, a New-York based brokerage for institutional investors.

Not Japan

As earnings rise, companies are cutting their interest expense. The 10 lowest-yielding U.S. corporate bond deals ever were sold in the past 14 months, according to Deutsche Bank AG. Armonk, New York-based International Business Machines Corp. issued $1.5 billion of 1 percent three-year notes on Aug. 2, the lowest coupon on record for that maturity.

The bond market is saying that it may be years before the Fed raises rates to foster the recovery, said Carl Lantz, head of interest-rate strategy in New York at Credit Suisse Group AG, one of 18 primary dealers of U.S. government securities that trade with the central bank.

Slow, persistent growth will help stave off the fear that the U.S. is starting to look like Japan in the 1990s, when the Bank of Japan struggled to revive its economy amid a combination of deflation and recessions, he said.

“The economy is improving and the yield curve will stay steep as the market is pricing in a return to more normal rates further out the curve,” said Lantz. “It will feel like Japan for awhile, but ultimately we are not Japan. We are seeing subpar growth, and a muddling along that is not particularly satisfying, but we are on the path to an eventual return to normal growth.”

To contact the reporter on this story: Cordell Eddings in New York at ceddings@bloomberg.net

Find out more about Bloomberg for iPad: http://m.bloomberg.com/iphone

Sent from my iPad

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How do you invest in this environment? Invest in doing something real.

Posted on 15 August 2010 by Art

Quick tactical note of how I see things panning out in the US.

Having been an options trader and having invested for a while, I have a healthy appreciation and fear of the path of an investment’s returns. AIPC which was a great investment for me by any measure promptly lost half its value before eventually assuming a path that would result in it’s being purchased for over 6 times my first buy print on the stock. Great return, tricky path. At one point the “investment” showed a -50% return. Sticking with it yielded an awesome IRR.

Which brings me to the first half subject of this note…. Do we invest thinking that this is a deflationary envrionement (forget equities and stick to fixed income) or an inflationary environment (the opposite)? Indeed, I find valid arguments from both the deflationists and the inflationists and believe both are right. How is this possible? I suspect that we will have relatively bad deflation in the US before the currency finally weakens and then leads to inflation.

Why won’t we have inflation in the short term? The quick answer is that it would solve too many problems and make life too easy. Following the principal of maximum pain, then this scenario is unlikely. What problems would inflation solve? While I am worried about the budget deficit of the US, I think there are bigger problems in the short term with the various public pensions and entitlements – social security, medicare, state and local workers – as well as a debt overhang from the housing bubble with its associated overhang on banks balance sheets. In short everyone would benefit in a situation where pensions, benefits, and debt obligations are held constant in nominal terms while we experienced a large dose of inflation. The debt load would be alleviated, and everything would strengthen.

But isn’t the US operating like Zimbabwe, you might ask? Isn’t hyperinfation just around the corner due to a currency collapse? In short no. Zimbabwe had a number of things against it. First is that the state actively destroyed production capacity by breaking up and redistributing productive farmland. Second is that it was a small component of the global export market so its sudden competitiveness due to a currency devaluation would not be noticed. Third is that there was little history of rule of law. Forth is that it has no military. Fifth is that it has a limited population base and what it does have is limited in terms of global competitiveness. There are more, but you get the idea. The US, with a currency collapse, would suddenly become a force to be reckoned with. It was once a manufacturing powerhouse, and that can indeed return with the right forces. Furthermore, all its debts are local currency denominated. Yes the US is extremely dependent on oil and would suffer greatly in the short term with a currency crash, but it’s also resilient and would eventually adapt and compete. So bottom line is that while that may eventually happen, it’s just too convenient to happen in the very short term.

So what is likely in the short term? Deflation. The exact opposite of all of the above. Possibly with global competitive currency debasement leading to very little relative devaluation perhaps. States and local municipalities finding ways to cut pensions or perhaps even worse raising taxes on others to continue paying pensions. Either way someone is going to lose purchasing power. Same deal with entitlement programs. It doesn’t look good.

This brings me to the second half of the subject. In an environment like this, where you expect things to continue to deteriorate, there are no great passive investment returns to be made. Shorting (an inherently levered strategy) will get you killed in the long term as the market experiences increased volatility and periodic rallies for whatever sane or insane reason. In the meantime the general trend will be down. To get a feel for what this looks like, look at the graph of SDS: UltraShort S&P500 ProShares (SDS) via wikiinvest:

You got the direction right but still lost money. So what’s the answer? It’s actually not so surprising or depressing. The best thing to invest in when faced with these issues is in whatever is real that you can do to keep employed, keep relavent, and keep producing something of value (which should be rewarded with money if the product is in demand).

With declining per-capita productivity (which is what you get with increasing unemployment), it’s not going to be easy. And I expect the returns for purely passive investments to decline – after all capacity utilization should decline in an environment like this, so what will “investing” pay? What investments are needed when there is steadily increasing capacity due to decline in demand? Bottom line is that it’s going to be tricky.

There’s always money to be made in dealing with short term capital crunches and by making markets where you are matching buyers and sellers, but it’s hard to make a living at that unless you are devoted to it full time. If that’s not your calling or edge, then find something that is your calling or edge that you can become an expert on and trade/get paid for other goods. Invest in yourself – your skills – and try to keep acquiring productive assets and growing your productive skill set.

This is the time for active investing – doing things like building businesses, streamlining production, and anticipating demand and meeting it.

Try not to lose money.

Arthur O’Keefe, São Paulo Value

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Tony Robbins – An Important Note of Caution

Posted on 15 August 2010 by Art

I know I have fallen off the planet for the last few months, but I have been very busy getting settled in São Paulo…. I remain super bullish long-term on Brazil and see enormous opportunities here. Some of those periodically consume a lot of my time.

In any case I continue to read and analyze what’s going on. Volume in the markets has been extremely light and conditions are pretty dangerous in my opinion. Very large moves on very small volume affect asset values of enormous scale. I call that a form a leverage in the system. In a way I think it would be better if the market just remained shut rather than have +/- 2+% days on less than 200mm shares changing hands on the SPY.

I advocate running very small direction either long or short (depends on what you own or are short I suppose) in this market and keeping gross leverage low as well (gross leverage is [ABS(longs) + ABS(shorts)]/[Net Equity] where ABS is absolute value).

If you’re dying to have a position, WMT is looking pretty cheap. HPQ is as well. But hedge out some of the Beta to the market in any positions (including these). Don’t stretch at all in this market and try to get some sort of seniority in the capital structure. I think the general direction continues down in the long term. Maybe some miracle happens and the market somehow rallies, but the risk is more weighted to the downside in my opinion.

So I will leave with this video warning on the state of the market that I came across from Tony Robbins. I am trying to figure out who’s he referring to in his opening (if I do I will post an update), as he never reveals his source. I don’t think, based on the numbers that he mentioned, that his client is Paul Tudor Jones, but it sounds like someone of equal stature. What’s significant is that I have to take Tony’s claim that he is well connected at face value given what I know of him. So if he felt strongly enough to go on the record with a warning saying that his best clients are worried, especially given that Tony doesn’t need to say any of this to gain credibility, it’s worth listening to and considering. It at least adds to the body of data to be analyzed.

Take a look at this video:

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Which Version of the iPad Should You Buy? My Perspective (Unrelated Post)

Posted on 24 July 2010 by Art

I have been working with my iPad for a few weeks now and have a perspective on the following:

Should I buy an iPad? And should I buy an iPad *now*?

It’s pretty clear from using the iPad that the future is moving towards tablet computing based on cloud computing. The general concept is that the instruments of consumption of the internet and of data in general will slowly be separated from the instruments of production of applications and manipulation of the data. In less technical terms it means that you don’t need a super powerful computer that is capable of creating applications and building reports to be able to use the applications and read the reports (even if the reports are interactive) because much less computing power and a much less sophisticated array of input devices are required for consumption as opposed to production.

So there is no doubt in my mind, we are going to see a continued trend to iPad-like devices.

Personally I think given the availability of bluetooth keyboards, VNC, and RDC (two specifications for working remotely) the laptop is dead in the long run. What you will have is personal servers that can keep data and run more sophisticated processes that iPad devices can make use of through cloud computing for low level tasks (like email). Additionally these devices can access a secure/private/VPN link and display server applications remotely for more sensitive data and more computationally intensive applications.

So long story short – you can join the trend now or later, but likely you will get tired of always carrying a laptop when you realize that you only use 10% (at best) of the functionality and can thus shed some weight by carrying an iPad instead.

So then the question is when to buy….

To me there is not a super pressing need to get the iPad if you are content with your laptop given the still developing state of many applications and the price of the top level iPads. So it depends on whether or not you really want to cut carrying weight now. To me the iPad becomes much more compelling after release of iOS4 -the OS of the new iPhone which is currently not released for the iPad yet. I’ve heard that this will come in September. Also many of the applications for the iPad are still buggy and many more are missing as developers are still working out how to best use the iPad’s features.

Should I buy the 3G or WiFi version of the iPad?

To me there is no debate on this given the current state of internet networks in the US and the world. Buy the 3G version (which inclides WiFi) if you don’t already have an iPhone. At some point you’ll make use of the 3G internet, and in any case it allows for more accurate positioning via GPS, which will also increasingly become important. The cost of the internet on the iPad for 1 month is basically equivalent to 1 day’s cost of internet at a hotel. So if you travel for work or leisure it’s worth it just for that.

If you do have an iPhone, then maybe it’s more debatable. My sense is that 3G for the iPad in this case becomes more of a luxury and a bet that in the future you will want to carry around your iPad and make use of advance internet features (beyond just Google Maps or email which you can do on your iPhone). I am pretty sure this will be the case… but the apps just aren’t there yet. There are some clear cases, I suppose when regardless you should get the dual band iPad. If you work in the real estate industry and need to look at land plots on Google Earth, get the 3G version without doubt as the full screen of the iPad is far superior to the iPhone for looking at plots. If you make use of RDC and VNC and want access wherever, then get the 3G version of the iPad. Etc. With time this argument will apply to more and more people as the apps become available.

What size iPad do I need – 16, 32, or 64 GB? 16 GB vs 32 GB vs 64GB

There are two important considerations – the size of your existing music collection and the size of potential videos. If you are not into music and will not watch videos – then the 16 GB will do. If you are a modest music lover and will not watch many videos then the 32GB will do. I have over 32GB of music alone and so there was no option – 64GB – if I want to keep everything on the iPad. In all fairness, I think that with time syncing between the computer and the iPad will get easier (and wireless) negating the need to carry everything and so probably 32GB is the right number. But if you want the luxury and longevity until the hi resolution iPad with a larger screen comes out in a few years, then consider splurging on the 64GB version.

Hope this helps! Now, back to the regularly scheduled programming….

Try not to lose money.

Arthur O’Keefe, São Paulo Value

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EUR – S&P Correlation Breaks Down

Posted on 20 July 2010 by Art

The above is the FXE Euro Trust Currency Shares vs the S&P Trust. As much as I am fundamentally bearish in today’s environment, the above is Bullish for equity valuations – at least relative to Europe. Why? The general environment continues to me heavily macro and volatility driven. From the strengthening of the Euro, and its recent breakaway/outperformance, we see that despite fundamental weakness, the world is settling down.

So there are a couple of options in this environment. Maintain shorts and try to find high quality that will rally and hopefully hold in the subsequent selloff or cut shorts and delever.

The technicals for the S&P remain fundamentally poor in the long term. My primary fear comes from the 60-120 SMA death cross which marked the Jan 2008 – March 2009 Bear Market as can be seen below:

I remember a paper a number of years ago speaking of the predictive power of the 60-120 cross. Personally I don’t care of its power in a purely academic sense – ie without other inputs is it a decent signal. We *have* other inputs – namely withdrawl of stimulus, massive delveraging, and implicit and explicit increases in taxes to name a few, all of which is deflationary and therefore inherently dangerous for equities. Witness the following from the most recent St. Louis Fed Monetary trendes showing the decline of credit:

So we have short term bullish and long term bearish = continued volatility. Actually I am starting to get excited with investment opportunities now that immediate crises are over (Greece and many state governments will default but not today). Volatility creates great trading opportunities – but they are that – trading opportunities. Money is made in this environment providing liquidity and then taking it back as it becomes plentiful. Said another way – buying low and selling high.

There are core positions to be held, but exposures likely should be “traded around”. Underexposed net as things take off, and overexposed in the worst of times. It’s not an easy business.

Finally just for the record, I mentioned AIPC – American Italian Pasta Company – in a few posts. The company was bought out marking one of my most successful and interesting investments. I started getting into the stock at $9.00 after which is rather promptly went to $5.00 before starting it’s long and rewarding journey to $53.00. All of this occurred during a period of some of the worst returns of the S&P in history. Indeed in 2009 I believe AIPC was the 5th best performing stock in the market.

The point is that not all volatility is warranted and sometimes it takes the market a long times to see things – good and bad.

Try not to lose money.

Arthur O’Keefe, São Paulo Value

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Update your RSS Feeds. Return to Blogging – Shift to WordPress 3. New Site

Posted on 19 July 2010 by Art

Quick announcement. Please update your RSS feeds by coming to http://www.spvalue.com and resubscribing to the RSS feed. Having returned from traveling as well as having finally dealt with a few pressing issues, I found time to rebuild the site including transferring to a more professional and scalable setup with WordPress 3.

I have to say that I am pretty impressed with the software. It wasn’t super easy to install, but it also wasn’t super difficult, and the tools that it gives are very strong.

I will have to write more about this general theme later, but basically I am coming to the conclusion across various levels – professional and personal- that knowing and expressing what to do should be separated from the tedious execution. For instance in this case, one does not need to know how to program to write a Blog. And actually they aren’t necessarily complementary. The best programmers may not write interesting Blogs, and the best Bloggers are probably to busy reading and writing to keep their programming skills up to speed.

Looking forward to starting up again. Lots to discuss.

Try not to lose money.

Arthur O’Keefe, São Paulo Value

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EURUSD is still the Key. Keep your eye on currencies

Posted on 30 May 2010 by Art

The above is EURUSD as seen through Oanda’s fxTrade platform. Oanda’s platform is free and is an excellent tool. From what I can figure out, I think it shares the same back end as UBS’s professional currency trading platform – so it is of institutional quality.

Below is the FXE (EURUSD ETF) vs S&P:

Last week saw a head-fake that looked at first like EUR was going to outperform the S&P (how is that even possible??? – note sell any outperformance of EUR to the S&P) and then a couple of instances where it looked like the S&P was going to break away from EUR but failed. I think S&P will eventually strip away from EUR, but probably not while North Korea may go to war or while people are discussing dropping a nuclear weapon on the seabed of the Gulf of Mexico to stop an oil leak.

So not much to report. Value has showed up again in small cap high cash flow companies – names like AIPC, RKT, RSH as well as high quality companies – you’ve basically gotten 6 months of growth in WMT for free at the price it is today, but there is some severe deflationary events (sovereign defaults in Europe) and horrible technicals (is there any retail investment left in the stock market and will it ever come back with this volatility?) that it’s quite possible that “good deals” can persist for a while and get even better.

Thus, this is not the environment to stretch or lever up. Buy “high quality” shorter dated high yield (Brazilian USD denominated debt is interesting at these levels) and nibble at high cash flow stocks using existing cash flow from other sources (dividends, coupons, and operational businesses/personal income) to add slowly. High quality companies should prove to be a hedge when inflation eventually comes back (looks like it will be 2 years away minimum at this point).

In my opinion, this is an incredibly challenging environment to invest in. As the title suggests, keep your eye on currencies to understand what’s happening. That is the driving risk factor right now from every number that I’ve looked at. The equity and debt markets are responding to currency/capital flows and liquidity constraints driven by these flows. So until we see stability in the currency markets (and we are not seeing that yet) we will not see a bull market in my opinion.

So to close, here are some interesting thoughts from the St. Louis Fed Monetary Trends June edition:

First the Title: “Why Do People Dislike Inflation?”
- Can there be any debate of the Fed’s wishes with a question like that?

Nevertheless, looking at the aggregate stats I don’t think they are successful or are likely to be successful in the near term:

I see signs of recovery but that’s expected given the large amount of stimulus pumped into the economy. Considering this and the huge amount of slack between employment and capacity utilization, I don’t see how we can have inflation.

This will help support the dollar, which apparently is bearish for the stock market (empirically), so no rush. Good deals should persist and cash flow is a must in my opinion.

Try not to lose money.

Arthur O’Keefe, São Paulo Value
http://www.spvalue.com

http://www.scribd.com/doc/32312831/Keep-Your-Eye-on-Currencies-EURUSD-is-Still-the-Key

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EURUSD is the Key and Desperation to Avoid Painful Adjustments as a Near Term Catalyst

Posted on 19 May 2010 by Art

The above is EURUSD as seen through FXE. It is compared with XLF and the S&P 500 index.

I continue to learn. I admit, my call to cover shorts was premature (and wrong). Obviously one “Fading Near Term Catalyst” I neglected to consider was that politicians would not even recognize that there is a crisis of confidence in their ability to lead and instead would attack the markets as the cause of the EUR crisis instead of a reflection of the judgement of the participants.

Witness: Merkel Pushes Extra EU Rules, Seeks to Widen Short-Selling Ban

The issue is not really the naked short selling ban, which is more or less a ban on counterfeiting and not a bad thing. Rather it’s the following:

“Merkel said Germany will lobby governments to introduce a tax on financial markets, and for ratings companies to come under European supervision so governments regain “primacy” over markets.”

Who knows where this goes… and governments regaining “primacy” over markets sure sounds a lot like not having functional markets. Is the government going to ban downticks? These measures have an extremely high risk of increasing the risk premium required to participate in the market thereby lowering prices.

In my view, there still remains no incentive to own any EUR denominated asset as at this rate, EUR is headed lower still. And it could get worse. My fear is that even the Europeans might not want to own EUR denominated assets.

Seems like Europe will be the first forced to address imbalances, and at this rate they are on the road to addressing imbalances in a non-coordinated way… as separate countries eventually with separate currencies.

If Europe doesn’t print money in mass, then it will suffer a debt driven deflationary depression as governments cut spending to reduce deficits and are then stymied by declining GDP. If it does print money, then EUR denominated debt will be dumped for dollars and reserves will be depleted.

The link to the S&P would be that the dollar value of european revenues of large companies would decline with the economies of europe. And so equity prices would decline is my guess.

I more than suspect that these swings have caused long term damage to retail investors confidence in the functioning of the equity market which removes an important price stabilizer from the market. Expect volatility to remain elevated for a while – weeks or months.

And until there is a base found in EURUSD, volatility will continue and asset prices will head lower.

Therefore, still not adding positions and have cut things that I am not super comfortable owning for years, but I admit that I also trimmed some shorts a bit which in hindsight was super premature.

So…. Low bids are likely to be hit in the coming weeks.

Still trying not to lose money.

Arthur O’Keefe, São Paulo Value
http://www.spvalue.com

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Correlation is Higher Than You Think. Covering Shorts, Flattening Risk on Fading Near Term Catalysts

Posted on 18 May 2010 by Art

I spend a lot of time on analyzing and understanding risks, especially the concept of risk factors. I don’t try to explicitly name or quantify risk factors between investments, rather I just try to understand the major driving risk factors in a portfolio. Then I try to understand when or if the influence of common risk factors may change.

Above is S&P, EURUSD, XLF, RKT, and AIPC. First I would note the correlated indicies – S&P, EURUSD, and XLF. It may not be intuitive, but being long the EUR was to be long the S&P and the XLF for the last month. So to be bearish on the EUR was to be bearish on the other two as well.

If there is declining confidence in EUR, I eventually expect that link to break as assets flow to the USD denominated assets. Additionally, structurally, I think the US is stronger than Europe.

By now, as well, European leaders are on notice, and there is a high risk that more drastic action is taken. I don’t think it will be terribly effective in the long term, but there is an increased risk of volatility out of this, and in my opinion volatility should only be borne with a proper compensation for having to lose sleep dealing with it.

So I think it’s worth it to cut USD based shorts being used to hedge EUR risks.

Secondly, observe RKT and AIPC. Both were influenced somewhat by the crisis in that their individual volatilities increased (10% swings in the value of RKT is abnormal) but ultimately their value held – so for now (and I think going forward as well) they are not tied to the EUR which gives confidence that they can be in a portfolio as outsized positions.

I don’t want to be one to flip sentiments on a dime – but trying to make money in a choppy market is a bit like this…. I have long term and short term views. Long term, I expect riots in Europe as the ramifications of austerity measures becomes clear. The measures may or may not hold. Even if they take place, they may not be effective as GDP gets crushed from the withdrawal of government spending (look at the case of Ireland right now). So long term, I am still very scared and very worried for Europe. There has been little done to address imbalances in the banking sector there as well, and I continue to think that there is real risk of continued bad news.

But I don’t expect Europe to bring down the US. From my perspective here in São Paulo, things are booming in Brazil, and I suspect the rest of Latin America, ex Venezuela, is hanging in there as well. I am mildly bullish on the US in that it’s still the technology king of the world, and its people (my people) are amazingly adaptive. Growing up in Louisiana, I’ve seen my share of busts – oil price fluctuations in the 80’s caused a mini-boom accompanied with a property boom that then crashed when oil prices crashed. It took a number of years, but eventually the state recovered. Seeing the after effects of Katrina as well gave some understanding of the power of government stimulus and trials and tribulations to rehabilitate an area. It’s possible that New Orleans is better now than it has ever been on a number of measurements.

So we’ll see. I have little interest in owning anything Euro right now until I understand where this process goes, but I also suspect the link between S&P (and XLF) and EUR will weaken going forward, and so action should be taken in concordance with this view. I’m covering my shorts (which is not to say that I am going 100% allocated), as like most value investors, I don’t really like being short for the long term nor do I try to make money in downturns….

I just try not to lose money.

Arthur O’Keefe, São Paulo Value
http://www.spvalue.com

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Can Things Get Worse? Risk is that Greece is the Start and not the End. Volcano Returns, Euro Imploding, Banks Attacked, Random Selloffs

Posted on 17 May 2010 by Art

The above, of course, is EURUSD.

People should be scared as this is not the currency of a Banana Republic and it is *not* being attacked from outside. The currency is falling from within and this will be very difficult to stop. What we are witnessing is a crisis of confidence from *within* the Eurozone.

Rational people are pulling money out of weak banks and shifting to stronger ones. Similarly people are selling questionable bonds to buy stronger paper. Who’s taking the other side?The lender and buyer of last resort is apparently the ECB which means that debt liquidation/monetization looking like a certainty.

But this doesn’t occur in a vacuum. Europe, possessing lots of quick-thinking and history-studying people, is seeing it’s own inhabitants front-run the ECB by selling Euros and buying gold. This creates a vicious cycle that will be extremely difficult to stop and can go to levels vastly beyond what the mainstream is talking about.

The tricky thing about crisis of confidences is how they can get out of hand very quickly. If all of Europe starts to run, we can see the Euro go to 10 cents. Of course it won’t get there with a European Union intact – stronger countries will be forced to pull out to protect the lifestyles and purchasing powers of their inhabitants.

One thing is for certain, there are some banks already broken in Europe and we haven’t heard anything about it and no one is discussing it. So likely more surprises ahead.

Anyway, my 3 warnings here turned out to be rather timely… and I still don’t see much change. In addition to the debacle of the Euro, the Volcano is back, liquidity has disappeared while the market behaves like a rigged slot machine, and banks are being investigated for various dubious acts during the last excessive lending period.

This is the time to only own things that you are comfortable not selling for a few years – as the market could very well indeed shut down for all purposes.

Do not add risk needlessly in this environment in my opinion. Deflation is back. Use cash to pay down any debts as deflation should continue and any excess should be used only to buy low cost producers on the bid (or below). Low bids are likely to be hit in the coming weeks.

Try not to lose money.

Arthur O’Keefe, São Paulo Value
http://www.spvalue.com

Posted in Currencies | Leave a comment