How Markets Don’t Work!

It's funny how the markets work.  Everyone expects one thing, and the market does the exact opposite.

Case in point:  The US gets its national credit rating cut, and every US Dollar bond and US Dollar bear in the world figures that this is it... this is the big one... finally, interest rates are going to spike higher!

WRONG!

Since getting the credit rating cut from AAA to AA, we have seen the US Dollar remain fairly steady, and US Government bonds have rallied huge!  In fact, intraday on Tuesday 9^th August, 2011 we saw 10 year bond yields go below the 2008 low, all the way down to 2.036% - resulting in higher prices. WOW!

You have to think about this now -- why would bond yields go lower than the 2008 low? What could possibly be looming on the horizon that is so awful that bond yields would pierce the low set during the greatest market meltdown since 1929?

In a word, RECESSION.

The Fed pretty much came out and confirmed this thesis when they said that they would keep rates at ultra low levels until at least mid 2013!!  That’s almost two years away. WOW AGAIN!  Do you know how bad the internal data must be if the Fed is publicly acknowledging that they will not raise rates for 24 months?

So How Low Can Rates Go?

The irony was not lost when, after S&P announced that it was cutting US credit rating, China publicly blasted the US over its "bloated welfare costs".

Imagine that -- a communist country putting America down for being too socialist!

The funny thing is that, since the USA lost its AAA rating, bond prices have soared in value. In fact, over the last three days the Chinese have seen their Treasury holdings appreciate by tens of billions of dollars. (bond prices rise when relevant market interest rates drop)

For all their tough talk about how reckless the Fed was being when it announced QE2, they must have been secretly high-five-ing each other as their 1.16 trillion dollars worth of Treasuries appreciated in value by an estimated $100+ billion!!

Since QE2 was announced, we've seen 10 year yields drop from 4% to 2%, and we've seen much steeper declines in the 2-5 year duration, which is where China has MASSIVE exposure.  So that $100 billion gain guesstimate could be very conservative indeed.

Did QE2 Work?

It sure did!  Just not for you and I.

In fact, I know you have been asking yourself who benefited the most from QE2? After all, equity investors certainly didn't win... the average US worker didn't win.

You want to know who the winners were?

The only winners were Government and other bond holders.  And by the way, want to know who the two largest holders of US government bonds are?

YEP! It’s China and the Federal Reserve!

Want to know what's going on?  Just look around at who’s got the biggest slice of the pie.

It's no surprise that it was the Fed, and the US’s next single most important banker - the Chinese Government.  The US didn't break the 2008 yield lows on a fluke -- the market is telling us something.  It is shouting from the roof tops that we will almost certainly experience a recession in 2012.

While equity prices rebounded, after getting pounded so relentlessly again, I'll be looking to fade the rally and get short some more stock because unless we see a miraculous turn around in the employment and GDP figures we are going lower as far as equities are concerned anyway.

But we may go to 1,250 on the S&P 500 first before we see 1,050.  So, nimble traders: have fun.  Longer term traders: wait for the roll over, at which point you'll be able to short 'em all.

In the meanwhile, I’m getting longer on secured corporate bonds from entrepreneurial corporations in Asia. 

Is it time to buy the US Dollar?

There are riots in the streets of Greece, which now has the lowest credit rating of any sovereign nation on earth. Remarkably, the Euro Zone has managed to weather the storm quite well.  Whether it can continue is another matter.

The European Facade maybe Crumbling

A look at the US Dollar Index and the US dollar / euro exchange rate certainly points in that direction. As bad as things appear to be in the USA, Europe seems to be more worse off. 

The European Union is made up of 17 countries who speak different languages, have different customs and have varying degrees of work ethics and national productivity levels. 

As split as the US is between liberal and conservative views, the people are still all Americans - even if they come in all shades and shapes.  As such Americans have far more in common with one another than the 17 nation Europeans do.  If one of the states in the  USA gets into trouble, people won't be rioting in the streets if the Federal government decides to bail them out.

Now let’s consider it from the European point of view: If you are the German Chancellor, how do you defend the diverting of your national wealth to support a country such as Greece, when your electorate holds the firm view that the Greeks are neither as hard working nor as fiscally responsible as the average German? Correctly or not this appears to be the view reportedly held by much of the German public.

This puts Angela Merkel in quite a political situation. If the so-called PIIGS (Portugal, Ireland, Italy, Greece and Spain) follow Greece, it would be a miracle if the European Union survived intact. This fear is what has been behind the bull market we have seen in US bonds over the last six or so weeks, because, on a relative basis, US Treasuries still look like a much safer bet than EU Sovereign debt.

So, how can we benefit?

I know it's in vogue or even cool to be totally negative on the dollar, but to me, the dollar looks like it wants to rally. The US Dollar Index (DXY) is a basket of 6 currencies measured against the US dollar.  The biggest component by far is the euro, which makes up 58.6% of the index. Any drop in the euro will push up the value of the dollar, which in turn will drive the US Dollar Index higher.

If we get a real increase in Euro-related fear, we could easily see the US Dollar Index hit 80 - 81. Those looking to go long the dollar could do so by either buying the front month US Dollar Index futures contract (DXU11), or via the Bullish Dollar ETF, symbol UUP. 

So if I’m going long, I would use a break below 74.50 on the US Dollar Index as my stop point. In fact, if the US Dollar Index breaks that level, I'd be inclined to switch my entire strategy and look to going short for a  bit.  Anybody who tells you that they know with 100% conviction what the future will be is either fooling themselves or attempting to con you into something nasty.

Another way of playing a rising dollar is to take some bets directly against other currencies. One such currency is the Australian Dollar. I doubt if there is another developed country (except maybe Canada) that is more leveraged to the price of commodities. Remember, global commodities are priced in US Dollars -- if the value of the Dollar goes up, commodities typically go down. As commodities go down, the value of the Australian Dollar will typically decline as well. I would go short the Australian dollar in the futures market. The symbol on the front month contract is ADU11.  I'd use a move above 1.0730 as my stop if I’m short, with a price target of say 1.0275.  Alternatively, I could use the Australian Dollar currency ETF, symbol FXA.  If I’m using FXA to go short, I’d be sure to track the movement of the front month futures contract. I’d use the levels in the actual futures contract to trigger any profit taking and stop loss decisions in the ETF.

Remember, the whole world is looking for the US dollar to collapse into oblivion. I don’t consider it likely that everyone will be right. May the trend be with you always...

 

 

 

The Toughest Investing Question is When to Sell?

Here is an article first published on the RAOMABO (Research and Analysis of Merger and Buyout Opportunities) Website that I think is interesting and relevant in these times:-

We considered various issues and decided on five signals that will warrant a reason to sell a Stock if you owned it or even sell short if you don’t own it...

As the sage of Omaha - Warren Buffet puts it, it’s often, “easier to figure out the losers.”

Referring to the automobile industry, WB points out that although it was one of the the most important inventions of the 20th century, it was very hard to make money as an investor in the industry. Thousands of upstart automakers failed. So the easiest money to be made was on the short side…

Today, we’ll concentrate about individual “loser” i.e. companies that are likely have more downside ahead of them than upside. We’ll see how it is often easier to spot these than the next winners, specially in a market with so much head wind against it ... like today’s markets.

We’ll also look at selling some of your former winners. These are stocks that may have made you good money but are beginning to show signs that you’re better off selling them than holding on to them.

Essentially it all boils down to the most important question in investing: When to Sell?

We’ve found that there are some major red flags you can use to get out of a long position… and go short a stock you don’t own, as well…

Red Flag # 1: High Valuations without High Growth

If you had the foresight to buy a small coffee chain named after an obscure literary character, you would have rode through some fantastic profits. All through the 1990’s and even through the tech-bust, it seemed like Starbucks would never cease to open more stores.
Around that time a Starbucks started opening across the street from another Starbucks, though, it was time to get out. Their growth prospects have been hammered. Other coffee chains are after their alluring market share. Even fast food chains have entered the business.

Today Starbuck’s balance sheet looks like a wreck. Let’s take a quick look. With a trailing P/E of 127, the company fails to pass an analyst’s first evaluation of a company’s value. The profit margin is less than 1% and the operating margin is 5%. Debt is three times cash. Return on equity, one of our preferred valuation measures, is 3.5%. Clearly, yesterday’s winners can become today’s losers.

Red Flag # 2: Technological Changes Taking Away a Former Competitive Advantage

Change is the only factor that’s constant in investing. Technological changes can make an entire company or industry’s products obsolete.

That doesn’t necessarily mean to go long the new technology. You should just avoid the obsolete one, or even short it as it dies off. Within the auto industry, we’ve seen technological changes that are partially responsible for the sad state of American automakers.

Toyota Motors was the first to market hybrid vehicles — namely its flagship Prius. The rest of the industry has been playing catch-up ever since. Sure, foresight is imperfect, and entrenched interests kept American automakers from fully adapting to this threat. But the solution wasn’t to go long Toyota; it was to stay away from General Motors, Ford, and Chrysler. Add in their uncompetitive cost structures, and it’s clear who the losers would be in this industry.

Red Flag # 3: The Company Begins to Use Questionable Accounting

Reading boring financial statements may tell you if you’re invested in the next Enron or Worldcom. Bad companies try to hide poor performance with financial gimmicks. One of the biggest things we’re looking at in the current investment environment includes companies reporting profits substantially in excess of reputed analyst expectations.

If such gains come from cutting costs, like firing employees, then the numbers being reported aren’t going to be sustainable over time. It’s the opposite of real sales growth and it’s a way of hiding a decline.

A lot of service-based companies are guilty on this count in recent quarters, from retailers to restaurateurs. Think of it as mold that people mistake for green shoots. It’s just too toxic to invest in.

The other major accounting areas to look at in this earnings environment are receivables and inventory. If Accounts Receivable is rising, there could be a problem with customer’s ability to repay... or there’s a problem with lax credit to customers to buy products. Either way, it’s one of the most obvious red flags you can see without. Eventually, toxic AR has to be written off. And the imaginary gains have to become real losses.

Rising inventories are even more problematic. A store offering this year’s fashions at 50% off may be able to post some good sales numbers, but over time it’s a recipe for disaster. Deeper and prolonged sales shorten the life of the business as lower margins choke off cash flow. Think Circuit City, Linens and Things, Mervyn’s and a host of other retailers. The retail industry’s problems are not over by a long shot.

Red Flag # 4: Divestiture to Meet a Cash Crunch or Burning the Furniture for Heat

Companies worth owning for the long- term don’t need to issue new debt right now. They certainly don’t need to go to the capital markets and issue stock to shore up reserves, either.

While this clearly applies to all the household-name financials, other companies have quietly been raising capital in the midst of this bear market rally as well. Any company that has to sell off assets or divisions right now is one worth reevaluating. Even in the absence of the worst credit crunch of all time, it would still be a very red flag.

Within this category insider selling is worth a mention. It’s a form of raising equity - only it benefits management and not the company. Certainly non insider the shareholders don’t benefit. Combined with other red flags, it’s the closest thing to a leading indicator we’ve seen that a stock is going to fall. Be especially aware of multiple insiders selling.

Red Flag # 5: Key Related Industries Are Suffering

There’s more than one way to make a profit. In investing, the term ‘pin action’, stolen from bowling, means that if one industry is on fire, related industries will share the heat as well. The same thing applies when it’s time to sell.

Watch the Flags...

Take a good hard look at the positions in your portfolio, and the major positions in any mutual funds you own. If your rationales for buying no longer apply or if any of the changes listed above are occurring, you might want to take some money off the table.

After a run-up, is the perfect time to re-balance your entire portfolio — to reduce risk by getting out of toxic assets and into better ones. When the market comes crashing down again, you’ll have more capital preserved to invest in companies that are innovative, growing, diverse, and ethical—and still have some left over to short the losers.

Latvia’s Unique Economic Cheer!

According to The Sovereign Society’s latest Offshore A-Letter, Latvia is facing the worst recession of all 27 EU members.

As a solution to cheer up its citizens, Latvia has come up with the First Annual Blonde Parade. The LINK to The Sovereign Society is http://www.sovereignsociety.com/