A Changed Market

In my last post I argued that it was a great time to short the market. My timing ended up being wrong. Stock prices have risen further, making them even more overvalued now (and therefore better to short). I'm not alone in having made this mistake. We have seen dozens of fund managers (publicly and privately) make the similar predictions in the past year and losing money. The worse aspect of this situation is that high-quality blue chips are not moving much while low-quality speculative growth stocks (such as the "cloud computing" sector, Netflix and Chipotle) are soaring and most overvalued. This looks a bit like the 1999 bubble, just not as extreme.

The market is also more difficult to decipher. Increasingly dominated by high-frequency trading, momentum chasers and Fed stimulus, the very nature of this market has changed. When one examines the market's internal structure, a disturbing but unsurprising conclusion emerges: big banks getting favors from government and the government itself are dominating. Many great fund managers have complained and elaborated on this point in recent months. We have seen various hedge funds and trading operations close their doors recently (big ones, small ones, profitable ones, money-losing ones) because they simply cannot figure out the market. Previously reliable patterns - both technical and fundamental - are breaking down.

This is very hard to take because Wall Street has historically rewarded the talented. Now it rewards the well-connected. In this annoying situation, the right thing to do is stand aside and let others do battle with each other. Taking myself as an example: I find myself unable to short stocks in any significant size - not because I doubt that they're ridiculously overvalued but because my previous methods for recognizing markets peaks have stopped working

But Hope Is Not Lost...

I am still optimistic. I believe that the patterns will return one day and that methods previously used by talented people will work, for two reasons: (1) I believe that real capitalism will eventually prevail, that the government will stop its policy of boosting stock prices and that big banks will lose their unfair advantage. (2) I believe that when the government bond bubble bursts, anything that depends on this bubble will collapse too, including the stock market. This means that I predict that interest rates will rise, we will enter a new recession and stocks & bonds will decline.

In summary, I am on the sidelines and watching developments in the U.S. treasury market. When the U.S. starts having trouble financing their deficit, it'll be time to short stocks.

A Historical Opportunity to Short

Today is election day and tomorrow is QE2 day, an event which has been over-anticipated for the past two months, in what has been, until and including today, a very tough time for those shorting the market.

Since my last post a lot has taken place. A market scared of a double-dip recession quickly reversed into a market confident that there won't be a double-dip, and one that has traded based on this acronym that everyone has learned "QE2" (which stands for: round 2 of the quantitative easing policy).

A lot has been written about the U.S. stock market, its economy, and how they are broken. This post is intended to be a summary of everything I believe is happening and will happen:

State of the U.S. Economy and Markets

- After 24 straight weeks of retail investor withdrawals, clearly only institutions are participating in this rally.
- High Frequency Traders were responsible for the May 6th flash crash. Another flash crash will happen if regulators don't act vigorously enough.
- The Fed is boxed in, its policies are ever-more political. It is not politically independent as it was designed to be. Its purchase of MBS, its QE2 policy, and its asking banks for input on policy are the proof.
- QE2 is not going to meaningfully: lower rates, boost GDP, boost any component of GDP, boost anything that matter. Funds may be channeled into speculation, and more so abroad or into commodities, not in U.S. business.
- The economy is skirting on recession, though still growing a little bit. It may or may not double-dip, but it for sure will not sustainably grow much above 2% any time soon.
- Fiscal policy and anything else that Congress or the White House have tried doing is not meaningful and there is no political support for any major action.
- The only meaningful policy that will matter at this point is if the U.S. government stops supporting Fannie, Freddie and the big banks (Citigroup, Bank Of America, JPMorgan Chase, Wells Fargo) and figures out a long-term liquidation plan for their assets and their liabilities, along with FASB re-instituting mark-to-market methodology. This will hurt in the short run, and be beneficial in the long run.
- Home prices have now started a new downtrend and at some point the foreclosure/mortgage mess that is unfolding will only make it worse.
- Bonds are expensive, overvalued investments.
- Stocks are also overvalued, trading at a normalized P/E of 22, as high as it was in 1929, in 1987, and in 2008

What Will Happen

- Stocks will go down by 30-50% from current levels
- Bonds will go down (i.e. bond yields will rise)
- Employment and GDP growth will not improve
- The market will realize that the Fed cannot do anything about this situation, and therefore whatever is left of confidence that government can fix things will evaporate
- This new pessimism will lead the stocks markets and bond markets even lower. Precious metals will continue to outperform
- It will also lead to a questioning of U.S. sovereign credit, and maybe about the use of U.S. dollars as the reserve currency.
- At some point the Chinese construction bubble will implode, which will worsen the situation and lead to a decline in commodities prices
- At some point, stress in Europe will grow again and questions about whether the Euro can continue to exist will resurface.

I believe all of these will happen within the next two years, roughly in the order that I have written them.

It is possible that at some point, a lack of confidence in the USD and/or the Euro and/or the Yen will lead to a panic in currency markets and that people will chase commodities as a replacement. Under that scenario, commodities will not go down so much.

What Will Happen Real Soon

I believe that the U.S. stock market will crash by 10-30% within the next 4 months, at the most, and very possibly within this month. I highly recommend the work of John Hussman as a source of some of the reasoning behind this. These things are always hard to predict but I think it makes a lot of sense. And so now it's time to see if my predictions are right, and it all starts with political theater of the next 24 hours.

Radio Interview on the Global Economy

On July 14th I gave the following 1-hour radio interview about the state of the global economy and how to balance one's portfolio from a macro perspective. The issues discussed include the whether or not the U.S. will go into a double dip, the housing market, Fed policy and the may 6th "Flash Crash". The interview was on Radio Shalom's Money and Business show hosted by Sam Ezerzer.

Enjoy!

Summer Thoughts After a Volatile Spring

The markets have been through a lot since I posted my thoughts last July. After declining to 12-year lows amidst fears that the U.S. banking system would collapse, the government-engineered rebound (taking short-term interest rates below 0.25%, printing money to buy mortgage paper, allowing liberal accounting methods, creating incentives for people to buy houses and cars, large stimulus package) has surprised most observers.

Stocks rallied 80%, taking them almost to pre-Lehman levels. GDP grew 4%, the housing market rebounded slightly (and in some areas, significantly), corporate bonds traded back up and capital markets regained confidence. Many companies raised funds and reduced debt loads. Things improved overseas as well: China’s massive stimulus package led to a construction boom, which in turn drove up commodity prices; this led to sharp economic rebounds in Canada, Australia and Brazil. Europe also looked good...for a while...


But since the new year we’ve seen fissures in this recovery.

There are three important points to make here: (i) analysts with a notably precise forecasts agree that the rebound is mostly due to government interventions and that if those interventions were removed, it would send the economy back into recession (ii) The recovery's strength was still weak considering it followed such a deep recession. (iii) the big problem today is dropping confidence in government finances, which translates into political pressure to pass austerity measures.

The recent troubles began in Dubai and quickly spread to Greece, Spain, Portugal, and the rest of Europe. The ECB’s trillion-dollar response is not foolproof: Germans aren’t happy about it; the IMF commitments can be canceled for countries with rising debt costs; the plan is to take funds from Peter’s pocket and putting them into Paul’s; the market is relying on the ECB to keep buying Greek and Portuguese bonds and private investors are therefore more absent than ever. Furthermore, the ECB isn't perfectly sterilizing its bond purchases as it promised to. The banking system is also in trouble as European banks don’t trust each other and would rather borrow money directly from the ECB. Spain looks extremely vulnerable (houses there are still about 40% overvalued and ‘cajas’ are very poorly capitalized). Longer-term, the continent's debt problems can linger on. As observed in Ireland, austerity plans can backfire because sometimes they crush GDP to the point where the debt/GDP ratio ends up rising instead of falling.

Over the longer term, government bond markets are bound to get volatile in the U.K., Japan and the U.S. as well. This will be resolved with a combination of more spending cuts, tax hikes and inflation. In other words, all developed economies are going to have to accept little or no growth for the next 5-10 years and residents of these countries will have to get used to more difficulties.

Another variable to watch is the popping of the Chinese construction bubble, which I think will lead a dramatic decline in raw materials prices. Chinese exports will also slow down. Every country wants to export right now, therefore they must all share the burden of reduced consumption.

I’m still a long-term bull on commodities, precious metals and commodity-linked currencies like the AUD & CAD but in the short-medium term I am bearish on all of these, except perhaps precious metals. My favorite way to bet on China’s slowdown is shorting the Australian Dollar. The Chinese stock market has declined already but the AUD has not.

The U.S. stock market is also a great short as it is not pricing in these circumstances. As a matter of fact, up until recently, most on Wall Street predicted a V-shaped recovery. In addition to the jitters in Europe, over the past month data in the U.S. has pointed to a slowdown and maybe a double dip. The housing market as a standalone will go through a double-dip for sure. Even after the recent decline in stocks the S&P 500 remains approximately 20% overvalued based on historical standards. Therefore, although I’m not sure that stocks will revisit March 2009 lows or that the economy will reenter recession, I believe the April top is solid. I also think that Gold will outperform stocks over the next 5 years even if both go down. So overall I’d short stocks and commodities and go long gold until the point where stock valuations are more fair. Then there will be time to reenter commodity plays. That bottom is not necessarily close; I think a more volatile ride lies ahead...

Wall Street's Grip

Yves Smith has an excellent post on the grip that Wall Street has on our society. The gist of it is that even the 'good' parts of Wall Street are not necessary for our society and shouldn't be making much money at all. I did not foresee Wall Street having so much political power that they'd still get their way after the downturn of 2007-2008. The discussion in the comments is just as interesting as the post. I recommend this article to anyone. This piece inspires me to contribute to change in America but how exactly to do it is the tricky part.

One year after Obama's election I fear greatly for America's future. The president came in with a massive amount of political capital and wasted it in two ways: compromises with bankers, and now, a health care bill. Instead he should have forced Wall Street down to the mat. He could have done it, especially with his sophisticated Internet-campaign apparatus. No one will convince me otherwise. Obama made a mistake and now power is in the hands of a congress which is funded by Wall Street and other "to big to push around" corporate interests such as big pharma, big oil and health "insurers".

The problem is not so bad though: America is in fact opposed to Wall Street in a big way, even if for the wrong reasons. This is discussed in Yves' post. But we need to take down this block of society using responsible intelligent leaders who will carry the masses with them while preventing those masses from being too violent. I think it's still doable.

Krispy Kreme Puts - again

Guess what I shorted this morning?
KKD has recently shot up on strong volume for no apparent reason. Trading at 14x a stable EBITDA, it surely is overvalued. It may be that a sale of the company or other event is in the works, and people in the know have purchased the stock ahead of the crowd. Or, it could be just a head fake. I put a small sum into this trade so if they get bought out at $5 it's no biggie. Recently the company has closed some of its stores and expanded their commitment to the small-store concept. Still, EBITDA will not double magically.

This is my first post in 3 months and I haven't much else to say. On the right side of this blog is the Volcker article from 2005. I suggest reading it again four and half years later. I am impressed with its relevance.

What I'm Doing These Days

I haven't posted anything in half a year. When I opened this blog I promised silence in case I've got nothing to say. Still, my portfolio and thoughts have evolved during the spring/summer. So here's a summary of what I've done, what I think, and what I plan for the future.

Recent Portfolio Activity

After shorting Citi and a few other stocks in February, I took it easy until I saw the potential for a rise in stocks. The combination of widespread panic and impending good news (PPIP, stress tests, mark-to-market changes) made me think a bottom is close, which I played by buying calls on OXM. The market turned a few days later. I also purchased some calls on banks which I thought would pass the stress tests and a variety of stocks. I made some profits but sold out almost all my earnings-valuation-based long positions by the end of May. So I've missed out on the rest of the rally but that's ok - chasing short-term performance is not my game.

What Now...

So now my portfolio consists mostly of a few special situations and small put option positions that expire in January (HE, COF, APOL, SPG and a few smaller ones). What do I see macro-wise? First of all, I'm refraining from low-PE stocks (or EV/EBITDA stocks) because I just don't believe we can tell the normalized earning power of most companies. The American economy seems to continue its slide toward a concentration of wealth in the hands of a few very large dominant players who, in turn, are increasingly connected to government and lobbyists. There isn't enough of a free market and America could fall behind if we continue of this path of government intervention and politically-motivated decisions. Furthermore, various other risks remain, most of which are connected with confidence in government.

Treasury Bonds and Interest Rates

So what's the deal with confidence in government? Personally, I have now become a gold bug. I believe that the entire world has embarked on a politically addictive adventure of printing money and that this must end in a crash of government bond markets, a rise in interest rates and inflation in commodity prices (especially Gold and Silver). Further, I believe there's a chance that central banking as we know it will end and that we'll see social unrest in some parts of the globe. The U.S. has a fiscal problem, Japan has a fiscal problem, Europe has a fiscal problem too. I understand the argument for deflation: banks hoarding money... cheap Chinese labour... a lost decade is what they call it. I don't buy that argument. When we talk about "banks" hoarding money, it's really depositors hoarding money. Depositors place their funds in the banks, who then proceed to hoard those funds. But if the economy stagnates for a very long time, eventually people will slowly withdraw their deposits in order to buy essentials such as food and energy. This would push up commodity prices. And no one else will replace these depositors because on a net basis the world economy is stagnating and as a global economy we will need to spend more than we produce. In other words, whether we have a recovery or not, I believe we're headed towards a day when people start to essentially trade away their cash for commodities. And just to point out something that isn't discussed elsewhere: China seems to be experiencing a reflation-bubble of the sort that the U.S. experienced in 2003-2007.

What's Next?

I will try to post to this blog, especially if I have a good idea about a specific stock. right now my best idea is for investors to take a significant portion of their cash and invest it either in investments connected with silver/gold or a diversified basket of resources-related investments. My predictions for the rest of 2009: an acceleration of pain in credit cards, in commercial real estate and in Eastern Europe. For 2010 I wouldn't be surprised to see a double-dip recession.