The “Stress Test” Challenge: Transparency & Intellectual Integrity

FDIC Chairman Shiela Bair said last week that the “stress test” would help the government determine how the big banks will fare in the event that the economy worsens. But before we get to any forward-looking measurements, the investing community deserves an update on the current status of the balance sheets of Wall Street’s once-elite financial institutions. As one critic of the banking stimulus plans in the UK questioned over the weekend, “how can the regulators decide whether the banks need to be nationalized or not without a publicly verifiable valuation methodology?” To which, this writer should add: Does anyone in authority have the audacity, since audacity is what is required now, to define a methodology, in written form, in the first place?

For all practical purposes, the stress test to be fully disclosed shortly, in one form or another, by Treasury Secretary Timothy Geithner will turn out to be a Trojan Horse, deflecting the market’s attention away from the factual reality of today to a set of “what-if” assumptions derived from forecasts on the domestic and global economy. The constituents of the stress on the financial system are well-known at this juncture: (1) a sharp deterioration in counterparty risk; (2) trillions of derivative contracts which defy any mark-to-market quantification; (3) collapsing asset values right across the investment spectrum; and (4) hopelessly inadequate loan-delinquency provisions. So what is required is comprehensive disclosure on the health of balance sheets within the context of facts as they present themselves today, not on the basis of what may or not happen in the future.

In fact, it is difficult to figure out how the Treasury, the Fed and the FDIC priced investments in and guarantees for troubled financial institutions in the first place. “It is impossible to find one document which clarifies, in mathematical terms, the fundamentals upon which regulators spent taxpayer dollars in buying common shares and preferred instruments in recent months,” said a trader who has been shorting banks for a New York hedge fund at the close of trading on Tuesday. “In the absence of details, why should anyone by buying Bank of America (BAC) and Citigroup (C) today?”

Tuesday’s buying of bank shares may well have been, in part, technical in nature. But, by all accounts, Wall Street is also hoping that Secretary Geithner’s announcements this week calm the nervous and set the stage for near-term stability in the financial sector. The problem is that, whatever that stress test turns out to be, the key systemic risk deeply embedded in the financial system, i.e. leverage, will not be addressed, let alone acknowledged. Because if leverage is fully recognized, shares in some of the major banks are actually worthless, and taxpayer funds are being spent on the back of serious, even irresponsible, over-valuations. What the future brings to the equation is an entirely different story altogether, a subject for another forum.

On a more significant note, it is apparent that financial journalists have been rendered ineffective in a climate where government spokesmen keep changing the rules of the game by the hour and attempt to bring a sense of false complexity to the situation. For example, nobody challenged Ms. Bair when she said that the “stress test will help policy makers to determine what type of additional capital investments the government may need to make.” What exactly have government officials been doing thus far? As another example, no member of the press pool appeared willing to push White House spokesman Robert Gibbs for specifics when he stated yesterday that the “Obama administration is going to help the banks through the crisis, but nobody imagines nationalizing banks.” If the members of the financial think-tank inside the Obama administration are still not sure about the results of the stress tests, how can they “imagine” anything at all–nationalization, partial nationalization or simply a partnership with private capital?

For many months, this writer has held the view that the bank rescue exercise is, in its entirety, a fatally-flawed, trial-and-error process lacking in transparency and devoid of an understanding of what a properly structured de-leveraging entails. Now the writer is convinced that it also lacks intellectual honesty.

At the risk of sounding repetitive, the stay-short-financials recommendation remains intact. Watch for rallies as long-term value investors find cause for optimism in the stress-test declaration later this morning, and in positive interpretations of that stress-test in forthcoming days.

US Government Recreating Leverage; Trade Windows Open

Fox News anchor Megan Kelly was visibly amused by two of her guest who predicted on this past week that the S&P 500 would fall below 600, but only after it rose by 30% from current levels during the course of this year. And, without doubt, many Fox viewers must have concluded that the bare assertions of the two asset managers border on insanity. But the Treasury and the Fed are on the verge of creating another leverage bubble and, as a result, the 700-to-900-to-600 scenario for the S&P 500 may not be as crazy as it sounds in the first instance.

The Obama Administration’s programmes to immediately engage the securitization market for a variety of consumer and small-business loans, and to force the restructuring of mortgages, are obviously designed to ensure that “credit flows through the system”. But in a climate where declining share prices and home values have caused a $13 trillion destruction in household wealth and where the jobless rate is severely curtailing family surpluses, the availability of additional (easy) credit, or the extension of contracts in default, is bound to generate new systemic risks within the American financial matrix. Credit apart, what the $1 trillion-plus which the government plans to inject into the consumer and housing market will certainly result in the flow of systemic risks right through the business spectrum.

American consumers are already leveraged. What is desperately needed now is a deliberate and structured de-leveraging, and a recognition that the state of the global economy is calling for a broad contraction in consumer demand. But, that said, this flow of credit may well support widespread upward revisions in corporate earnings in forthcoming weeks, and the predictions of the two Fox guests, as ridiculous as they sound when contextualized in fundamental terms, could start to gain currency. Another credit bubble is in the works, there is ample money sitting on the sidelines, stimulus spending is on the way and there are ample Wall Street analysts who are ready to advance the value-investing proposition with renewed vigour at the earliest opportunity.

From this writer’s perspective, a 30% increase in the major market indices (DIA, QQQQ, SPY) is almost unimaginable at this juncture, given that it is more than apparent that nobody in authority has been able to acquire a thorough grip on the banking crisis and given that neither Ben Bernanke nor Timothy Geithner displayed any grasp of the global nature of the problems confronting them at yesterday’s hearings on Capitol Hill. But the stage is indeed being set for some type of rally in the very foreseeable future, and the challenge will be to time both shorts and longs.

There is simply too much negative news still to unfold, both on the domestic and international front; so no rally can be sustained. The tension between the fundamentals on one hand and the short-term impact of government intervention on the other is offering new trading windows, not grounds for medium-term positioning by any measure. For example, gains in excess of 10% need to be sold into with the intention of covering shorts on periodic pullbacks. Gains in excess of 15% need to be sold into aggressively. Moderate longs are warranted if the indices drop by more than 10% from Friday’s closing levels.

What is important is discipline. In view of the fact that investors generally are unaware, and largely unprepared, for what lies in store in the months ahead, bouts of panic selling on bad news are inevitable; such bouts are going to be for limited periods and they must be used to cover shorts.

Arguably, the definition of “bad” is a relative one today. Investors are becoming almost immune to adverse economic data on the domestic economy and they will only rush for the exits in the face of substantive and significant events, e.g. Ukraine and Hungary defaulting on IMF commitments, a zero GDP growth confirmation from India or China, or a breakdown (for all practical purposes) of the European Union.

The writer’s bearish bias is intact, due to a number of well-founded reasons detailed in earlier articles posted by this writer However, the facts as they present themselves today are telling us that there is much more money to be made by trading the market from both sides in comparison to any medium or longer term strategy.

India’s Budget Stimulates Votes Amidst Negative Growth

For all practical purposes, India is in negative-growth mode. Industrial production is down for the first time in two decades. Exports fell by 20% last month. At least 1.5 million officially employed workers are expected to lose their jobs within this quarter; the comparative figure from the casual-labour sector will exceed 10 million, and another 12 million Indians will enter the workforce this year. In the diamond polishing industry alone, 14,000 factories have been shut down; another 10,000 will follow suit in forthcoming weeks. Thousands of small-scale outfits supporting textile and machinery exporters have entered bankruptcy. How, you may well wonder, are New Delhi spokesmen adamantly maintaining their target for 7.1% GDP growth in 2009?

“We have entered an extraordinary situation,” Finance Minister Pranab Mukherjee declared in the Indian parliament, referring to November’s terrorist attacks in Mumbai. “Extraordinary times call for extradition measures.” The Interim Budget announced by Mr. Mukherjee yesterday provided for a 35% increase in defence expenditures; for the full year, defence spending is targeted to rise by a remarkable 80%-plus.

A worried market analyst at the Bombay Stock Exchange who was looking for additional measures directed at stimulating the Indian economy questioned why “the government failed to incorporate any genuine economic stimulus in the Interim Budget, and why the focus was on defence and agriculture?”

She probably ignored the fact that the biggest challenge for the Congress-led government is to find a way to win the forthcoming general elections, due in April-May, not the Indian economy. That focus on votes was evident in the crop-price support mechanisms and farmer-debt write-offs in the Interim Budget. Indian National Congress strategists concede that winning over voters in India’s cities and townships has become a messy proposition, given the continuing (and sporadic) popularity of right-wing Hindu extremists, regional and caste-based parties, and of mainstream communist and socialists. So, as a prominent Congress cabinet minister concluded, “we must go back to our base, the farmers.”

Not only does the agrarian hinterland offer the current government a valuable vote bank; with some luck, it might serve to boost the national GDP-growth number. The farm sector should contribute between 18 and 21 percent to India’s 2009 GDP. Over the last four years, agriculture grew at an average rate of 3.7%; while revised price support levels will no doubt underpin the size of the agricultural sector, Mr. Mukherjee and his colleagues must pray that the good weather continues. The flawed development in agricultural infrastructure since Indian independence in 1947 has ensured that the seasonal rainfall is the single largest component of farm output.

It does not take a genius to calculate that the final GDP product will depend, almost entirely, on defence spending and a favourable monsoon season; the former is a certainty, the latter is in the hand of the gods.

Obviously, those buying India in the belief that the 7.1% official growth target is highly impressive in the current global environment need to examine the contents of the Interim Budget in the requisite degree of detail. More specifically, it is important to note that a good part of the defence budget is now being allocated to fighting an insurgency led by the Communist Party of India (Maoist), which exercises varying degrees of influence in at least one-quarter of India’s villages. “If we cannot abolish poverty, we are certainly facing a Nepal-like scenario in the next year or two, at least in four states,” a Congress veteran conceded last week. In Nepal, a Maoist party is in control of the country’s parliament; the Nepalese communists are closely affiliated to their Indian counterparts.

As far as the threat from cross-border terrorism is concerned, it is difficult to see what India can do stem the tide. Two weeks ago, the Pakistani government was forced to make a peace deal with Taliban elements in the picturesque valley of Swat, a mere 150 km from the capital of Islamabad. Pakistan’s President Asif Zardari, who publicly announced that militant Islam is the biggest threat to his nation’s stability, is now asking the IMF for a further $5 billion worth of assistance to fight terrorism. And, according to reliable observers, the training camps run by radical Kashmiri jihadis along the Line of Control with India are still packed with recruits.

The conclusion: stay short India ETFs/ETNs (EPI, INP, PIN, ICN) and, if you do have access to the US$/Indian rupee far forward market, short the Indian rupee. The election results in May could present a profitable exit window.

The Geithner Dossier: There’s Money to be Made Now

Financials will rally whenever Obama Administration officials, Treasury Secretary Timothy Geithner in particular, are able to convince investors that the combination of the stimulus plans and bank bailouts will result in healthy balance bank sheets, in the very foreseeable future. But, in the absence of any identifiable specifics pertaining to the valuation of bank assets, rallies will be unsustainable. Therefore, trade the most vulnerable counters (BAC, C, JPM, MS, WFC) with a decidedly short bias.

                                                   

Financial Exchange-traded Funds (IYF, IYG, PFI, RYF, XLF) simply do not reflect the concentration required within the broader sector; from a trading perspective, the focus must remain on BofA, Citi, JPMorgan, Morgan Stanley and Wells Fargo, if the objective is to achieve periodic 10-20% gains through this quarter, for starters. (General Electric (GE), which is displaying all the characteristics of a financial stock, and Goldman Sachs (GS) are also interesting short-on-rally propositions, but their risk-reward profiles are substantively distinct from the five leading candidates cited).

 

This is not the time to analyze the Geithner Dossier; it defies cogent analysis anyway. Nobody in authority has the will or proven expertise to bring an asset valuation methodology into the public domain. Nobody appears keen to disclose the real risk on bank balance sheets, if such a risk determination has been made at all. And, lawmakers and regulators, almost without exception, (and President Barack Obama, for that matter), are totally sold on Ben Bernanke’s Depression-driven “finger-in-the-dyke” strategy, formally adopted by Fed and Treasury officials many months ago. So, trade accordingly; as necessary information, you should know that the tale of the brave Dutch boy, who supposedly put his finger in the dyke along the Dutch coastline, was a non-factual literary invention by a New York writer.

 

This writer will challenge the very fundamentals of the fallacious bet that an improving economy will allow the financial system to rectify itself in another article. For our present purposes, it is sufficient to realize that bank stocks will witness a daily tug-of-war, between bulls and bears. Depending upon the flow of news (and an abundance of spin), five- and ten-percent overnight moves will become a regular affair. In brief, this is the real money-making window today, with due respect to those interested in long-term value investing. All this writer sees in the medium term is chaos; there are no credible facts whatsoever upon which a longer term view can be founded.

 

Current short-selling targets: BofA above $6.50, Citi above $4.10, JPMorgan above $26.50, Morgan Stanley above $24 and Wells Fargo above $18.50. Look for sharp intra-week declines from those levels to exit short positions. With the passage of time, as the markets start realizing that the Geithner Dossier is replete with illogical imperatives, the short-selling targets need to be revised downward. At some point in the second or third quarter of this year, retail and institutional investors will finally recognize that private equity in these banks is worth zero. Those urging a blanket nationalization of banks today are not madmen; nationalization, in one form or another, is inevitable.

 

Secretary Geithner said yesterday that he will be unfolding details from his Dossier in stages, through the course of the next few weeks. But it is precisely that “unfolding” eventuality which is shaping this writer’s trading vision today. By all verifiable accounts, “unfolding” can only be interpreted to mean “trial-and-error” or, even worse, “we just don’t know”. What will certainly not unfold are comprehensive disclosures of risks, and asset valuation premises which can be subject to independent, qualified scrutiny.

 

Many on Wall Street were hoping that a $2 trillion commitment to the financial and credit marketplace would be accompanied by a “written document”, at the very least. But what they got were mere words, and much vagueness; the result was widespread selling. Watch for any number of similar failed-expectation scenarios in forthcoming days and weeks.

 

Disclosure: The writer has entered standing orders to sell BAC, C, JPM, MS and WFC at or above the targets indicated in this article.

 

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derivatives@shaw.ca

 

The Pfizer Deal: Taxpayer Dollars Chasing M&A Experimentation

In an effort to ward of accusations of using bailout funds to finance the $68 billion Pfizer (PFE) acquisition of Wyeth (WYE), a Citigroup spokesperson said on Friday that, since the lending consortium plans to sell down the loan to pension funds and money managers, “no TARP funds will be in play at any stage of the deal.” However, given the deal’s structure, there is no way to reasonably ascertain how much of the $22.5 billion one-year bridge loan will appeal to secondary participants by the time the transaction is ready for closing.

 

The consortium includes Citigroup (C), Bank of America (BAC), Goldman Sachs (GS) and JPMorgan Chase (JPM), all potential rescue targets in the forthcoming Bad Bank package. And there are concerns that adverse market conditions at closing, expected in the second half of this year, may force lenders to carry the Pfizer acquisition facility on their own books, amounting to a use of taxpayer dollars to fund a transaction whose immediate or near-term value-creation potential remains in doubt anyway.

 

At first glance, the yield (7-9%) for a superior credit (“AAA”) like Pfizer appears to take into account a rapidly deteriorating economic environment. But anybody pricing the bridge loan from the original syndicate will have to consider the potential downgrade of Pfizer’s credit rating, the chaotic nature of the rating-to-yield debt matrix in the foreseeable future and the lack of liquidity implicit on the purchase of a bridge-loan arrangement. In brief, while the bailout candidates will certainly be able to place the loan in the huge secondary market, there is no basis to assume that the placement exercise will be profitable or tidy.

 

More importantly, placement or otherwise, lawmakers and regulators need to ask themselves two very obvious questions. Could Wall Street banks have been in a position to provide Pfizer with a $22.5 billion commitment if they were not being propped up by taxpayer dollars? And, on a related note, is government backup encouraging an acquisition which will actually result in the shedding of jobs?

 

Pfizer publicly acknowledges that the combined company will shed 19,500 jobs. Pfizer has a 160-year history of terminating employee contracts, closing labs and shutting down production units after buying out smaller rivals, often without the creation of identifiable shareholder value. The Wyeth acquisition, health-care analysts suggest, is driven more by the eventuality that 38.5% of Pfizer’s 2007 sales will face generic competition by 2013, as an increasing number of patents expire. “With the real prospects of higher debt levels, of dividends being cut in half, and of revenues of the combined company declining by 17%, this is not a deal which has any meaningful inherent value at this juncture,” a merger-arbitrage specialist stated yesterday. “Moreover, the Pfizer-Wyeth deal is showing a 12% arbitrage return, a telling sign that the chances of the deal not going through are surprisingly high.”

 

That 12% return may be partly due to the fact that many of Wall Street’s significant merger-arbitrage specialists are no longer active. But, that said, the $22.5 billion commitment provided by Citi, BofA, Goldman and JP Morgan has set in motion a chain of events, besides merger arbitrage, whose consequences for the debt underwriting marketplace are highly uncertain. Firstly, Standard & Poor’s has put Pfizer on negative watch. Secondly, Wyeth stands to collect a whopping $4.5 billion in break-up fees, a recent record, if Pfizer’s ratings are cut and the banks don’t lend. Thirdly, if the yield on the bridge loan becomes a standard benchmark, junior credits can expect to pay no less than 12-15% on mezzanine funds—so much for credit flowing through the system at low interest rates. Finally, in their quest to gain fee income (total estimated to be $210 million), banks are willing to commit M&A funds at rates which are below those being paid on preferred instruments issued to the government.

 

Once again, the argument being presented to the street by syndicate members is that they will finally end up holding only a limited portion of the Pfizer transaction, if at all, on their own books, and that the $22.5 billion commitment should be viewed more as an underwriting facility than a direct loan. But this type of bet on the shape of the future makes sense only when “stand-alone” balance sheets justify the assumption of the associated risks, not when a $2 trillion Bad Bank law is in the works today. In fact, the entire business of underwriting must now be conditioned by rigid capital adequacy ratios on one hand and by measurable pricing methodologies for both debt and equity on the other. Otherwise, history will repeat itself: lucrative fee-income considerations will trump prudence and technical integrity.

 

 

 

Netting Derivatives: Slippery Slope Marred by Opaqueness

If those in command of disclosure had their way, the average investor would be left with the impression that the total derivatives exposure of financial institutions (AIG, BAC, BCS, C, CS, DB, GS, UBS, JPM) is only a fraction of the notional value of outstanding contracts. “We are looking at risk levels to the tune of about 3%, post-netting,” a guest on CNBC said yesterday. In actual fact, given the opaqueness surrounding the open positions in credit default swaps, collateral debt obligations, structured notes, put options, currency swaps and far-forward transactions, there is no logical methodology which provides any acceptable risk indicator at all.

                                              

Perhaps in an effort to limit any adverse impact on share prices, and even on the financial system at large, the word “netting” has gained widespread popularity since the collapse of Lehman Brothers. But those who are assuming that netted exposure is a finite dimension of net risk are sorely mistaken. Even when netting is undertaken on the basis of sold and bought contracts with the same counterparty (with the same reference instrument, currencies or interest rates) realistic calculations of residual risk need to take into account variations in maturity dates (mismatches) and potential conflicts in the underlying contractual obligations; in other words, netted amounts shown in financial statements may never be netted in practice.

 

Of course, when netting is a consequence of fully-matched hedging (i.e. buying of risk from one entity and selling an exactly similar risk to another entity), counterparty credit considerations come into play, particularly in the case of longer-dated maturities. For example, risk may have been bought from an “AAA” credit and sold to an unrated name. Or, for example, one counterparty may be located in a country where government intervention (in favour of domestic exporters presently carrying negative derivatives positions) may result in the transformation of a supposedly fully-matched deal into an open risk transaction.

 

None of the bigger derivatives players (AIG, Citigroup, CS, DB and UBS) are known to have bought political risk insurance; therefore, the use of the term netting may be highly misleading in the context of developing-world-linked contracts. This political risk is further compounded by the fact that the most profitable emerging market deals were made for far-forward maturities, in the midst of illiquid and undeveloped markets and in the absence of verifiable benchmark rates. So any mark-to-market assessments are simply not applicable, specifically (for example) in the case of five-year-plus swaps with one leg denominated in currencies like the Indian rupee, the Russian ruble, the Turkish lira, the Brazilian real and the Chinese yuan.

 

Finally, and from the perspective of the overwhelming majority of retail and institutional investors, it is important to point out that netting in standard currency and interest rate swaps contracts is an entirely different affair from netting insurance-type transactions. A currency swap, for instance, may be evaluated via short-term interest rate differentials, leaving the widening or the narrowing of the differentials in the future as the key component of pricing risk. A credit default swap, on the other hand, is primarily guided by counterparty credit ratings available both at the point of execution and on a midstream basis; the proposition that there is a credible process through which a profitable credit default swap or a collateralized debt obligation can be netted against a matching contract is almost invalid, a myth without any technical foundations whatsoever. The unending sequence of “credit events” alone in 2008 must cast serious doubts on the integrity of the netting announcements being made periodically by the Depository Trust & Credit Corporation (DTCC) and by other monitoring bodies.

 

As traditional insurance actuaries will confirm, the pricing of insurance risk (life and non-life) is predicated on mathematical conclusions derived from historically proven, numerically substantive and heavily population data matrices.  There is not even a remote equivalent of such tools in the hands of CDS and CDO providers; on the contrary, bond default risk is still commonly being quoted by utilizing option- and probability-driven computer models!

 

All this is not to suggest that the huge quantum of derivatives on the books of financial institutions will ultimately generate more-than-significant losses. The problem lies in the lack of transparency; in brief, we just don’t know. One can only hope that somebody in the Fed or the Treasury has access to all the necessary information and has made a considered finding on the systemic risk posed by the derivatives complex today. Or is one hoping in vain?

 

 www.quoteplatform.com

 

 

 

 

 

 

Gold: “Recycling” Threatens Demand-Supply Equation

More than 25% of gold’s annual supply flows originate in the recycling of scrap. The global recession has now generated another recycling process altogether: the purchase and sale of jewellery items and gold bars entering the marketplace due to declining household wealth.

 

Gold bugs should take cognizance of the alarming pre-weekend announcement by the Bombay Bullion Association that gold imports into India, the world’s biggest gold consumer, fell 81% year-on-year in December 2008, as purchase orders through the complex gold chain (village-to-city) virtually came to a standstill. Indian gold imports for 2008 as a whole are estimated to have fallen by 47%.

 

Israel’s offensive in Gaza has caused a spike in gold prices over the weekend. But, unless there is conclusive evidence that the Gaza crisis will spread to Lebanon, any moves beyond $910 per ounce should be used to short gold via Exchange-traded notes (DGZ, DZZ) or, depending upon liquidity and market-sensitivity considerations, via Exchange-traded funds (e.g. UBG and SBUL.LSE). Thus far, Dubai gold shops confirm that aggressive statements from Tel Aviv have not resulted in panic buying; moreover, major gold traders in the Mumbai (Bombay) bullion market are ready to unload excess inventories around $910-935, given that nobody there believes that Hamas has the ability to extend the Gaza ground war beyond a few days.

 

Of course, the more fundamental argument in favour of higher gold prices (with some calling for $2,000-plus) is rooted in the safe-haven dogma. “With assets being devalued across the globe, central banks, money managers and even individuals will increase the gold allocation in their portfolios throughout the new year,” a spokesperson for the Bombay Bullion Association emphasized yesterday. “Demand will pick up in the second half of January since it is not considered auspicious to buy gold until the 14^th.”

 

But small-scale gold outlets in the Indian interior are pointing out that, as opposed to any inferences derived from a reading of the stars (i.e. numerology), what is really inauspicious about the Indian gold matrix is the increasing poverty levels in the countryside, and in the dramatic erosion in the wealth of lower-middle-class families in towns and junior cities. The last marriage and festival seasons saw an unprecedented trend towards minimal and selective purchases of jewellery; in fact, a record number of households are actually pawning or selling gold and silver possessions merely to survive. Almost two-thirds of physical gold purchases in India originate outside big cities like Mumbai, New Delhi, Chennai and Kolkata.

 

East Asia, the Indian sub-continent and the Middle East account for roughly 72% of world demand; 55% of world demand is attributable to just five countries: India, China, the US, Turkey and Italy. While Chinese demand rose by 24% in 2007, late-2008 statistics are expected to show a sharp decline. How many jobless workers returning to their villages from the once-booming industrial zones have pawned or sold their gold-denominated savings is still the subject of speculation in the Hong Kong media; but the manager of a gold dealing window in Guangzhau (formerly Canton) confirmed in a television show that sales of gold bars had slowed down to a trickle despite the Christmas shopping season. “The Chinese New Year may bring better news,” she hoped.

 

Gold’s reputation as an alternative store of value is only sustainable if the early-2008 demand-supply equation can be sustained; that demand-supply equation is now completely reliant on the equilibrium shift between those fleeing financial assets to invest in physical gold (not in futures and options) and those actually selling (or pledging) gold assets in order to survive. As far as gold production is concerned, there are enough mines and enough proven reserves (in South America, Africa, Central Asia and Russia) which evidence a solid base of supply. Furthermore, despite regional variations, production costs continue to justify maximum mining-capacity utilization even with gold in the $550-600 range

 

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Great Depression & Wrong Lessons: Doomed to Repeat History

All the ingredients for another major downside move (below 700) in the S&P 500 are now in place. A slew of economic data over the holidays proves that the world’s emerging markets have finally entered a decisive contraction phase, which means significantly lower asset valuations and collapsing consumer demand throughout the developing world. And, as far as the domestic environment is concerned, rather than focusing on systemic risks, the Fed and the Treasury have embarked on a series of monetary policy and bailout decisions which are almost entirely predicated on the hope that the US economy will take a turn for the better in late 2009 or early 2010.

The case for short equity positions (ADRE, DIA, EEM, QQQQ, SPY, XLF) could not be stronger and is, in fact, fortified by the fact that the very concept of systemic risk is either horribly misunderstood or simply ignored. One component of systemic risk is public confidence that failing banks will not wipe out family savings. The other is the guarantee that essential day-to-day business (exchange of food and essential commodities) can be conducted under logical assessments of counterparty risk, as opposed to a virtual standstill in the credit markets. The third, and perhaps most important, component of systemic risk is the ratio of productive and non-productive (e.g. financially engineered products) assets within a particular economic matrix.

Drawing from studies of the Great Depression, policy-makers like Ben Bernanke are convinced that if the apparently vital constituents of the economy (AIG, C, GE, GM, GS and now GMAC) are kept alive long enough, a sustained uptrend in asset valuations, household wealth and home prices at some point in the future will return those constituents to health and prosperity. The difference between the 1929-1933 period and today, however, is stark. Shortly after the First World War, debt was mainly being incurred by industry to finance expansion. Over the previous two decades, a huge proportion of total outstanding debt has been incurred to promote financial activity bearing no relationship whatsoever to identifiable industrial or agricultural growth.

In 1982, financial institutions accounted for 5% of total corporate profits; that number rose to 41% by 2007. In 1995, the face value of asset-backed securities stood at $108 billion; within the following decade, that number had risen to $1.24 trillion. The notional value of bond default-related insurance products, which were hardly known in the early 1990s, reached $250 trillion-plus by the first quarter of this year. The Bank for International Settlements estimated that the underlying amount of over-the-counter derivatives exceeded $685 trillion as of the end of June. The daily turnover in the foreign exchange market was almost $2 trillion prior to the start of the credit crunch.

Quite clearly, policy-makers needed to distinguish between the systemic mechanisms which threatened the viability of the domestic economy, and the global economy in certain instances, on one hand and the risks posed by the largely non-productive debt and derivatives bubble on the other. The critical “systemic challenges” of protecting savings and moving credit to the engines which drive an economy cannot be confused with bailouts, many of which have been undertaken for failed business models or for business models which are evolving with each passing day.

What the equity markets are now confronted with in forthcoming months is a real contraction in business activity, further erosions in asset values, a huge downsizing of balance sheets in the banking and finance sector, a conclusive decline (and adjustment) in corporate earnings in line with the new business reality and dwindling household wealth. A cyclical bottom-picking approach is without foundation. Investors need to position themselves accordingly.

What Corporate Yield Spreads Are Telling Us About Equities

Despite the government’s best and varied efforts to address the credit crunch, the average yield spread on medium-grade (“Baa” or “BBB”) debt obligations stands at a record high of 642 basis points against a comparable (1962-2008) average of 188 bps. Have corporate bond spreads peaked? And, must bond spreads peak, and trend decisively towards the 40-year average, before a bottom in equities can be called with a degree of conviction?

 

According to a brief analysis issued by the Bespoke Investment Group on Wednesday, there are at least three instances (in 1971, 1974 and 1982) when the S&P 500 bottomed well before bond spreads peaked. The Bespoke analysis cites one example (late 2002) when bond “spreads peaked at the same time as the S&P 500 made its low”.

 

But history provides no guidance in today’s unique and unprecedented financial and economic environment. There is every reason to believe that, this time around, corporate bond yield spreads will not approach anything close to the 188 bps average at all. In fact, this writer’s bearish call on equities (DIA, QQQQ and SPY) is, in good part, based on the assumption that the very sustainability of the historically high spreads is eroding the foundation of equity valuations.

 

For starters, the quality of the benchmarks themselves is now in question, as credit default swap spreads for 5-year and 10-year US treasuries settle above 60 bps, in preparation for a move into the 80s as the $8 trillion-plus bailout saga unfolds over the next two months. Secondly, it is obvious from the post-September behaviour of the CDX and iTraxx high-yield indexes that the average yield spreads on corporate bonds today would be closer to 850-900 bps if it were not for systemic-risk-offset actions taken by the Treasury and the Fed.

 

Thirdly, sophisticated lenders are now rationalizing yields after taking into consideration the cost of default insurance on institutional and corporate borrowers; in this regard, before on gets to the corporate spectrum, it should be noted that CDS spreads even for government bailout targets in the US and in Europe are at levels nobody could forecast a few short months ago. For better of for worse, CDS spreads for ex-blue-chip names like Goldman Sachs (340 bps), Morgan Stanley (440 bps), Citigroup (250 bps), UBS (205 bps), Credit Suisse (185 bps) and Deutsche Bank (140 bps) are having a direct impact on determining corporate bond spreads.

 

Finally, there is this rather complex issue of rating downgrades in a climate where it is evident that the leading rating agencies are overwhelmed by the task at hand. As was more than obvious in this week’s downgrades for Goldman Sachs and Morgan Stanley, and rating cuts for a number of sovereign issues, the best the rating agencies can do now is to follow the news. Since, early warnings, as opposed to after-the-fact announcements, are now well in the past, uncertainties surrounding the fate of certified credit quality are also playing a significant role in keeping bond yield averages at 40-year highs.

 

In summary, this writer’s stance is that the bond-yield-spread matrix has undergone an irreversible transformation; despite some excellent analysis on yield-to-equity correlations and breakouts being provided by Bespoke in recent weeks, history is certainly not repeating itself. On the contrary, what the matrix is telling us is that when fundamental cost-of-capital and debt-equity relationship considerations are applied to the corporate spectrum, a significant decline (20%) in equities is overdue.

 

Perhaps we may have to wait (a) for the market to acknowledge the limited effectiveness of the stimulus packages being proposed by the new administration before we see the S&P 500 at 700 and lower, and (b) for investors to realize that the finger-in-the-dyke Dutch legend, which Ben Bernanke and Hank Paulson are currently applying to systemic risks, was actually an all-American literary invention, not historical fact.

 

 

 

 

 

 

Why State Capitalism Creates Zero Value For Small Investors

Do Washington’s bailouts and rescues simply amount to an intervention in the American free market system on behalf of elite institutions and big capital, against the interests of the American consumer? And is there a fundamental disconnect between the principles guiding such intervention and the shape of the global economy?

 

If the answer to both questions is “yes”, retail investors are best advised to forego bullishness and to use all significant rallies in the S&P 500 to sell (QQQQ, SPY) aggressively, and to buy put options when such rallies are accompanied by record implied volatility. After the sharp fall in equity markets on Monday, a number of mutual fund managers continue to espouse the longer term view in one television appearance after another, despite the fact that economic data on the domestic and global front is clearly telling us that the deleveraging process is certain to have painful repercussions for asset valuations and for consumer loan delinquencies through 2009 and beyond.

 

In a classic free-market capitalist society, financial institutions and corporations are not protected from market forces. The $8 trillion government program involving both cash outlays and guarantees is not only destroying the dynamics of private capital; it is also creating new systemic risks, while claiming to remove underlying threats to the process of capital accumulation and to mainstream deposit and lending mechanisms. The biggest system risk being established today pertains to the qualitative deterioration in the “full faith and credit” of the US government.

 

Of more immediate concern to retail investors should be the alarming inability of rescue targets to bring any post-rescue credible business models into the public domain. American International Group (AIG), Goldman Sachs (GS) and Citigroup (C), for example, remain in semi-permanent restructuring mode. Others accessing government funds and guarantees are still refraining from identifying the full extent of asset depreciations; General Electric (GE), for example, needs to restate its emerging market assets (given the turmoil in India, Thailand, Turkey, Brazil and the Middle East) before anyone can figure out how its stock should be valued. This week the focus will be on Detroit, and there is every reason to believe that aid in the face of a failed business model will be termed a medium-term loan.

 

In the absence of any detailed business plans from the bailout targets, it is best not be misguided by the rather vague argument that, in time, the American tax-payer will actually benefit from concerted and widespread government intervention. On the contrary, the targets will simply drift along, in the hope that either the domestic stimulus packages will result in a sustainable improvement in household balance sheets and overall credit quality, or the stimulus packages in Europe, China, India, Brazil or Russia will lead the world out of this deep-rooted recession.

 

The Obama administration has been touting the recently-announced stimulus package (expected to reach $800 billion) as being friendly to the American worker. History does not support that proposition. The fact remains state capitalism has always been about the control of the means of production and the related financial superstructure by the state; the evidence shows that, even in instances where the state (e.g. Russia and China) claims to represent workers and peasants, it is the political elites who control the ebbs and flows of capital, and the fate of the population at large. So check who controls or directs Washington’s lawmakers before executing any long-term bullish trades.

 

This short call is premised on the ideological assumption that state capitalism, at its roots, is bad for the retail investor, near-term or long-term. For a profound analysis of the state capitalism phenomenon, study the post-WW II analysis of the Soviet Union by Tony Cliff and Raya Dunayevskaya at your leisure. Both writers were of the view that America’s Cold War enemy was not a communist state in the first place!

 

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