Dollar Breaks Through Resistance

The dollar is once again showing signs of weakness after a brief respite. Until we can find a meaningful bottom in housing the Fed will continue to drop rates and the dollar will struggle to find its footing. If you can make a compelling argument for why the dollar should rebound in the near time I'd love the hear it. Until I am convinced otherwise I will continue to hedge against the increasing inflation risks that accompany a weak dollar. Commodities, TIPS, infrastructure assets and just about anything denominated in emerging market currencies is where I'll be at least for the near future.


The other inevitable effect of a weak dollar is the dollar's dethronement as the world's reserve currency. Slowly but surely it looks like the Euro is becoming the currency of choice for the world's reserves. Brad Setser however cautions us not to take the IMF data we rely on for these numbers to seriously:

I would caution against reading too much into the fall in the dollar's share of global reserves in the latest IMF COFER data release for two reasons:

First, most of the fall in q3 is explained by the rise in the dollar value of the world's existing holdings of euros and pounds. The euro rose from around 1.35 to a bit over 1.42 in the third quarter. The rise in the dollar value of the world's existing holdings of euros from currency moves explains at least $50b of the overall increase in euro holdings.

Second, the diversification that is taking place is coming from the world's advanced economies, not the world's emerging economies. After stripping out valuation gains, the advanced economies added $10.7b euros to their stockpile -- a far larger sum than the $3.1 billion increase in their dollar holdings. Either Japan diversified at the margin or a host of European countries continued to shift away from dollars. Those emerging economies that report data to the IMF, by contrast, bought three times as many dollars ($61.4b) as euros ($21.2b).

If emerging economies that do not report detailed data on the currency composition of their reserves acted like other emerging economies, dollar reserve growth remained very strong -- though not quite as strong as in q1 or q2. Central bank financing of the US hasn't ended.

So while the dollar hasn't fallen from grace just yet, we are surely testing the patience of many policymakers.

1 Gig Isn't What it Used to Be . . .

One gigabyte of computer storage (between 1 and 1.07 billion bytes depending on who you listen to) used to be a big deal (quite literally actually, see picture below). Nowadays flash disks do 1 Gig in about the size of your thumbnail and a single Blu-ray disc can hold 50 Gigs. Technological progress (in everything from transistor prices, processing speed, memory capacity, pixels per dollar etc.) is truly expanding in an exponential fashion. This is of course precisely what Intel co-founder Gordon Moore noted back in the 1960's when he noted that the number of transistors on integrated circuits was doubling every 2 years. The only limit to Moore's law will probably come when transistors reach the size of atoms, which could be in 15-20 years.


What does all this computing power mean? I love what Ray Kurzweil has to say:

"A $1000 of computing power is now somewhere between an insect and a mouse brain, it will intersect human intelligence in terms of capacity sometime in the 2020's . . . this is at an early stage, but you can show with the exponential growth in the amount of information about the brain and the exponential improvement in the resolution of brain scanning, we will succeed in reverse engineering the human brain sometime in the 2020's."

Scary huh?

Hat Tip: GagdetLite

It's Almost Election Season!

With primary season only a week away (yes, Iowa is on January 3rd!) I have begun doing a little more research on how the candidates are shaping up. I have been surprised with how little people know about the candidates when I bring up the election up in holiday conversation (I know, it is probably a faux pas). It seems that until the field has been whittled down a bit most people don't bother doing their research. So in an effort to kick start that effort, I have a linked to a quiz that helps voters identify the candidates that are the closest aligned to them on the big issues. It only takes 5 minutes and the candidates will probably surprise you! Just click the picture below:

Hat Tip: Swantz

Only Funny Because it's True

Hat Tip: Jim the Realtor

Looking for Oil?

Hmm. It looks like Saudi Arabia, Iran and Iraq control some 43% of proven oil reserves. . . maybe you should go ask them.

Hat Tip: Energy Bulletin

Is China Opening its Capital Accounts?

It seems China is going to take a different tack to avoid inflation:

Dec. 22 (Bloomberg) -- China will support international investment by companies next year as part of its effort to expand channels for such outbound ventures, said Wei Benhua, deputy director of the State Administration of Foreign Exchange.

China will also relax controls on individual overseas investment, Wei said today at a conference in Beijing.

``The move will help solve the problem of China's imbalance of international payments and the increase in currency reserves. It is also good timing for China to open its capital accounts,'' Sun Mingchun, an economist Lehman Brothers Holdings Inc. in Hong Kong, said today in a telephone interview.

A record trade surplus and inflows of speculative capital betting on faster yuan gains have pushed up China's foreign exchange reserves to about $1.4 trillion, fuelled asset bubbles and driven up inflation. China's top currency regulator, Hu Xiaolian, said Dec. 5 that China should expand channels for overseas investment and relax controls on capital outflows.

Relaxing controls on individual investment ``can help China's individual investors diversify risks from the local stock markets,'' Lehman's Sun said.

China Investment Corp., the country's sovereign wealth fund, may invest in China Petroleum & Chemical Corp. to help fund the oil company's investments abroad, China Business News reported yesterday, without saying where it got the information.

I am Long Antonio Cromartie

The Chargers have overcome a miserable 1-3 start to lock up the AFC West. One of the biggest stories of the year has been the rise of Antonio Cromartie, a second year defensive back who has really hit his stride. In his 11 starts he has ten interceptions, setting the single season interception mark for the Chargers. Perhaps more impressively, he has 3 more interceptions than any other player in the league and more interceptions than the entire Pittsburgh Steelers even though he has played 3 less games than everybody else. Part of that story is the amazing game Cromartie had against Peyton Manning, arguably one of the top 3 quarterbacks in the history of the NFL. In that game Cromartie had 3 interceptions in the first half, and had what is quite possibly the most athletic interception I have ever seen:


Despite being left off of the Pro Bowl ballot Cromartie was named to the Pro Bowl roster. All this from a guy who didn't play football for most of his last year in college due to a knee injury and as a result was largely unknown. Not too shabby . . . :

China Buys stake in Morgan Stanley

This time they bought a stake in JP Morgan after JP announced $9.4 billion worth of 4Q write-downs.

Morgan Stanley said Wednesday it is shoring up its capital with a $5 billion investment from China's sovereign wealth fund, after a $9.4 billion write-down related to mortgages pushed the bank into a deep loss for the fourth quarter.

The write-downs were primarily the result of a speculative trading bet that went bad, and their scale -- more than twice the size of the $3.7 billion hit the bank forecast on Nov. 7 -- raise questions about Chief Executive John Mack's consistent push to boost results by taking on more risk.

Mr. Mack's move to sell a stake of just under 10% to China Investment Corp. makes Morgan Stanley the latest damaged U.S. financial institution to seek help from cash-rich funds investing emerging-market government wealth.

CIC, officially launched on Sept. 29, is moving more quickly than expected to find higher returns for China's $200 billion of foreign exchange reserves. Just last month, Chairman Lou Jiwei said the fund would put its money mainly in index products and would set up an advisory board before plunging into big investments. In what has so far been a money loser, the fund paid $3 billion in May for just under 10% of private equity giant Blackstone Group, just before the leveraged buyout boom foundered amid a credit crunch.

I think one of the most intriguing side stories to the credit crunch is that at a time when much of Wall Street is looking for capital infusions Goldman Sachs is actually buying back its own shares at a rapid pace:
It looks like slowly but surely Goldman is planning on taking itself private.

Where Do Home Prices Go From Here?

The closest guess I have about home prices is what is assumed by the Chicago Mercantile Exchange (CME) housing futures market. Across the 10 major markets home prices are predicted to drop 8% in 2008 with no signs of stabilization. We are looking for home prices to form a bottom in 2009-2010. But, from there we don't expect significant appreciation. The bottom line is there is still no reason to be optimistic about home prices in the near term.


Hat Tip: Bespoke

Only Funny Because it's True

Country P/E Ratios and GDP Growth

Here is a telling chart courtesy of Bespoke. This ratio makes Sweden look expensive relative to China . . . who would have thought?

Don't Play Cat and Mouse with Big Ben

You can price in whatever you want but the Federal Reserve doesn't have to do anything. Ben Bernanke didn't actually say the previous sentence but he may as well have. After the Fed cut the fed funds and discount rates 25 bps today the market didn't react all that well. I guess Ben doesn't like being bullied around all that much:

Top 10 Things You May Not Have Known About the FOMC

10. The Fed exists to insure maximum employment, price stability and moderate long term rates. Their purpose is not to backstop speculators

9. 4.25% Funds rate very accommodative and historically low.

8. Between votes, Fed Governors make fun of BLS economists.

7. Overheard at FOMC meetings: “What would Greenspan do? Let’s do the opposite!”

6. Jealous that Jean Claude Trichet gets to hang out with Gisele Bundchen

5. Doesn’t give a rat’s ass what Cramer thinks.

4. "Then it's resolved, we print more money and we make more speeches . . ."

3. There is no Santa Clause -- just some guy with a beard named Ben.

2. Has been long Gold and short the Dollar since 2003.

and the #1 thing you may not have known about the FOMC:

1. “Hey, Wall Street: We’re not your Bitch anymore.”

A False Bottom in the Dollar?

I'm not big on currency speculation, but I do find it hard to believe that during the middle of a fed easing cycle and with massive concerns about the US housing market the dollar will form a meaningful bottom. That said, the dollar is up almost 2% off of its lows and is showing a little bit of life.


Hat Tip: Bespoke

How do I get Chuck Norris Approved?

Wow.

Global Food Prices on the Rise

We continue to receive validation from independent research that our firm's commitment to a secular overweight of commodities in general and agricultural commodities in particular is a sound asset allocation decision in light of the macroeconomic environment. My personal bet is that soybeans (pictured right), soymeal and soybean oil will be a particularly attractive place to park money over the next 6 months (and not just because of my personal edamame addiction). Here is the latest validation via Bloomberg:

Agricultural commodities may rise by as much as 50 percent next year because of crop shortages and demand from emerging Asian economies, Schroders Plc said.

Corn and palm oil will advance because of ``continued'' demand for ethanol and vegetable oils to make biofuels, while soybean and coffee may gain on smaller inventories, said Christopher Wyke, product manager at London-based Schroders, which manages $3 billion in commodities.

``The supply-demand balance for these commodities is very tight, which means they're vulnerable to any setbacks in production,'' he said in a telephone interview today. He declined to forecast prices.

Standard and Poor's GSCI Agriculture Index has advanced 32 percent this year as wheat rose to a record, while corn and soybeans climbed to multi-year highs. Commodities, which are outperforming stocks and bonds this year, may beat such asset classes in 2008 as the U.S. heads into a recession, Wyke said.

The UBS Bloomberg Constant Maturity Commodity Index of 28 futures contracts has returned 17 percent this year, compared with a 4.3 percent gain in the Standard & Poor's 500 Index of stocks. U.S. Treasuries have returned investors 8.9 percent, according to Merrill Lynch & Co. indexes.

On a side note, is anyone else feel relieved that oil is back under $88?

Web 2.0 Bubble?

Last week we posted a video of Peter Thiel saying that there is absolutely no bubble in technology. This week we offer the opposite view. We think you will enjoy this one . . .



Hat Tip: Ritholtz

The Post-Autistic Economics Movement

Greg Mankiw is the author of the most popular introductory Economics textbook on the planet. As such he is also the target of criticism from the left, the right and from the post-autistic economics (PAE) movement. I don't know much about "post-autistic economics" other than the fact that they are purportedly challenging the "mainstream"/"neo-classical" economics of which Mr. Mankiw is an easy target. I don't know that I agree with their use of the medical term "autism", by which they mean "closed-minded" or "self-absorbed" but I do think that some of the complaints raised by the co-founder of the movement are worthy of some careful thought. Anytime there is a legitimate concern that ideology is trumping true scientific inquiry I think it is only responsible to take a look a little bit deeper:

While Mankiw’s text is easy for professors to use, it oversimplifies economic theory and leaves out the ways in which markets can degrade human well-being, undermine societies, and threaten the planet. Each year, tens of thousands of students go out into the world, with Mankiw’s biases as a roadmap to the future. But we know that the neoliberal agenda is more and more disputed outside universities. And within universities, alternative textbooks are flourishing. One can thus hope that these new textbooks, with their greater relevance to real world problems – and their better acknowledgment of the diversity and complexity of economic thought – will soon out-compete Mankiw’s bible. As a believer in competition, Professor Mankiw could only consider this to be fair game.

This is the warning sign the PAE team proposes economics teachers should place on their textbooks.


It's a good thing we live in an imaginary world with endless quantities of oil and other natural resources otherwise I would have to go back to college and learn "real" economics!

Great Interactive Oil Chart

For those looking to understand the flows of oil around the world, this chart is perhaps the best attempt I have seen to date at simplifying it.

Enjoy!

Peter Thiel: "There is Absolutely No Bubble in Technology"

Peter Thiel is one of the great stories of the last decade. He has an undergraduate degree in Philosophy and a law degree from Stanford and was running a small hedge fund when he bumped into tech whiz kid Max Levchin (now with Slide). Together Max and Peter co-founded PayPal, eventually taking the company to IPO and then sale to EBay. Now Peter runs a successful macro hedge fund - Clarium Capital Management - with over $2 billion in AUM. He also started the Founders Fund, a founder-friendly venture capital fund with significant investments in Facebook, Slide, Jaxtr etc.

The clip below is from Kara Swisher's interview with Peter earlier this month. In it Peter discusses the major trends in the media, how old media companies can and should adapt, how Web 2.0 companies can monetize their users, and perhaps most importantly whether Web 2.0 companies are overhyped. The answer (from a guy who is an early Facebook investor) is absolutely not. His argument on Facebook is the following: if the growth (of users I assume) continues for 2 years Facebook will be worth a factor of 10. If the revenue model works thats a nother factor of 10. Using simple math, if the company is successful on both fronts the company is worth a factor of 100. I'm not too worried about number 1. Facebook has been dead on in its user interface and ability to get users to consistently visit the site. But the monetization question is a big question, and without it Facebook may not even be worth $15 billion.

I do however like Peter's analysis of bubbles:

"I was here in 1999-2000 and it is not like this, even remotely . . . The other point is the history has just been . . we had a boom and a bust, and people remember the bust better than the boom. People are stilling dominated by fear not by greed, we are barely getting out of that. I don't think things are over-hyped. I don't think Facebook is over-hyped. I think almost none of these companies are. Some will turn out to be very valuable, some will turn out to be a lot less valuable. In aggregate I don't think there is a bubble at all. There is a bubble in housing, their is a bubble in China, there is probably a bubble in Private Equity funds and the finance industry but there is absolutely no bubble in technology."

(I apologize, the video is a little bit larger than the space I have here!)

The Case Against Decoupling, Part II

This is from the WSJ this morning. Those of you who have been generating strong returns by orienting your portfolio towards international and emerging markets should take a second to digest the effect a recoupling would have on your portfolios:

With worries over the fallout from the housing and credit markets deepening, the once-widespread view that Europe and Asia would pick up the slack and shield the global economy from the effects of a U.S. downturn is being put to the test.

Investors embraced the idea, shuttling money abroad and buying shares of companies with big overseas operations, like Wm. Wrigley Jr. Co. and 3M Co. -- until disappointing results from both sent their shares down. Technology companies, which as a group have the largest overseas-sales exposure, were another popular destination. After weathering the initial stages of the stock-market selloff in October, they have fallen sharply this month.

Less than two months ago, the International Monetary Fund offered a remarkably upbeat view that global economic growth would slow down just a smidge to 4.8% next year from an estimated 5.2% this year. But that no longer seems certain.

"It's quite clear that the downside risks to world growth have increased since we met about a month ago at the IMF," the governor of the Canadian central bank, David Dodge, said recently.

House prices have continued to fall in the U.S. and elsewhere, banks in the U.S. and Europe have announced billions of dollars in mortgage-related losses, stocks around the world have fallen sharply and an unrelenting reluctance by banks to lend -- even to one another -- has prompted the Federal Reserve and European Central Bank to act.

The notion that the rest of the world has "decoupled" from the U.S. came into vogue earlier this year, as overseas economies -- particularly emerging markets -- continued to post robust growth and Europe and Japan appeared to be enjoying a long-delayed upturn.

Policy makers joined the decoupling parade. In the spring, the IMF included a chapter in its April World Economic Outlook called "Decoupling the Train." The gist: The current weakness of the U.S. economy stems largely from housing woes -- and housing is less global than, say, computers and other parts of the U.S. economy. That is good news for the rest of the world.

But the U.S. is now flirting with something more severe than a mere slowdown. That -- along with rising oil prices and the specter of a global credit crunch -- is changing the picture.

The WSJ isn't the only one pointing out the risks of a recoupling. Toro has similar concerns and is considering adding Emerging Markets to his list of shorts:

I think the top is in and it is time to start shorting the emerging markets.

The central premise is that the world cannot and will not decouple from the United States. If the American economy is slowing or going to go into a recession, the reverberations will be felt around the world.

Not only is America slowing, Japan is as well. And Europe may be also slowing. I believe both Japan and Europe will follow the United States.

US equity markets are discounting a recession. The stock market is a notoriously poor predictor of recessions, however, and frankly, I have no idea if we are going into a recession or not. But I do know that risk is rising in the financial system, and even if we escape a recession, the secondary and tertiary after-shocks in American asset markets which are occurring now will be felt around the world. The idea that the emerging markets can escape the spreading contagion is nonsense, in my opinion.

As risk premiums rise, investors will pull back around the world, and will especially do so from emerging markets as emerging markets are the highest beta markets. Currently, spreads on emerging market bonds are 270 bps, up less than 100 bps off their lows several months ago. In 2002, spreads were 1000 bps. We may not hit a 10% premium over Treasuries again, but I am very, very confident that the peak of this cycle is not 2.7%.

There are also concerns about Cisco's slowing revenue growth in the emerging markets:

Morgan Stanley noted yesterday morning that in Cisco's F1Q08 quarterly filing, data for the emerging markets showed a significant deceleration in revenue growth. Specifically, emerging markets revenues grew 19% YoY in the October quarter, down from 35% YoY growth in the August quarter and 36% YoY growth in the same quarter a year ago. The firm said that while they remain confident in their Overweight-V rating and $38 price target, they would closely monitor this critical part of Cisco's growth story for signs of a rebound or further deterioration.

Hat Tip: WSJ, Toro, Seeking Alpha

Pandora is Cool

I've recently become addicted to internet radio site Pandora. If you haven't already checked it out you should go there now. It's a great way to find new music. My only warning is that it is a bit addicting. As usual all things in moderation.

Recessions, Corrections and Bears (Oh My)

1. The probability of a US recession in 2008 continues to rise with Intrade putting the probability at 47%. Goldman puts those odds at between 40-45%.Meanwhile Former Secretary of the Treasury (and former Harvard President) Larry Summers thinks a recession is 'likely':
2. But, usually we don't know about a recession until after it is over:
3. The US market entered correction territory (10% downturn) for the first time since11/02-3/03:
4. The Shanghai stock market officially entered a bear market (20% downturn):
   

In such a market environment, having lower volatility assets in your portfolio is incredibly valuable. We continue to be optimistic about the growth story of some of our key stocks and about the fundamental value of an Endowment style asset allocation model.

Hat Tips: Bespoke, Ticker Sense

What to Make of Sovereign Wealth Funds

With sovereign funds becoming more and more active players in global financial markets we could see a variety of interesting "side effects":

1. Rising Protectionist Sentiment (especially for strategic assets).
   
2. A "sovereign wealth" premium: companies viewed as "strategic assets" will increasingly become targets of foreign governments, increasing their market value.
3. The line between between national and economic interests will be blurred even further, sparking many vigorous debates in economic journals and on the RGE Monitor.
   
4. Renewed vigor for running balanced budgets in the US (unlikely).
5. Renewed concerns about our addiction to oil. After all it is estimated that as long as oil is above $70/barrel, over $2 bln worth of petrodollars flows into financial markets every day.
   
6. Hank Paulson being reduced to tears as another foreign government rebuffs his pleadings to appreciate their currency.
7. Increased calls for transparency about the operation and holdings of SWF's. All of which will be rebuffed.
8. Much confusion about why we call these funds "Sovereign Wealth Funds."
9. Concerns that China plans to infiltrate the US using Stephen Schwarzman's "Skull and Bones" connections. Did you know that Schwarzman and George Bush were college roommates?
   
10. SWF's will become a huge issue in the presidential election after China, Singapore, Kuwait, or Abu Dhabi buys a US airline company, port or bank (oh wait . . . ).
    
11. Much overblown populist rhetoric that overextrapolates the growth of SWF's and is used to scare the American people into raising tariffs and enriching more American farmers.
12. Economists finally being able to explain the true cost of "mortgaging our future" to finance frivolous spending and frivolous wars. Yes, when you run deficits you are basically giving away a part of your country . . . its just that until now country's didn't take advantage of their power over us.
    
13. Very little rational, and realistic dialogue about what is likely to happen as we watch SWF's become the trendy thing to do with forex reserves (Thanks John):

The US has accumulated hundreds of billions of dollars in trade deficits in the past few years. Some of the deficit may be due to undervalued currencies, particularly the Chinese renminbi, but most of it would probably have occurred even if the renminbi was much stronger during this period. The truth is that the US has shifted a vast amount of its production abroad and must deal now with the resulting accumulation of external imbalances that are now being placed in sovereign wealth funds.

Clearly, the US can no longer be too picky on what kind of capital it will accept. For many decades, the US assumed that Asian countries would accumulate forex reserves and purchase Treasuries, as the ramifications of currency appreciation were as bad for them as a rout in the USD/Treasury market was for the US. The Bush administration even condoned Japan’s massive yen interventions in 2003-2004. But now that Asian SWFs are being created, they undoubtedly will be investing in equities soon; it is just a question of the timing and the method.

Many voices in the US government now say that this accumulation of reserves is illegitimate as it was caused by currency intervention, and that Asian governments should not be allowed to buy large portions of the US. While there are justifiable concerns about a communist country such as China owning controlling stakes in many “national interest” industries in the US, the general fear of Asian equity ownership is unfair and impractical. The US allowed this unbalanced system to develop and the natural consequence is for Asians, whether citizens or their governments, to own large portions of US assets, and not just Treasuries. With appreciating currencies, the Asian SWFs must seek higher risk assets such as high-yield bonds, equities and real estate in order to achieve acceptable returns.

The safest way to avoid an asset/trade war is to allow SWFs to invest passively in equities via indexed products or via external, long-only, diversified investment managers. Both sides should agree on a simple reporting system regarding such purchases, with restrictions that would be triggered if the overall SWF ownership level rises above 30 per cent.

If this is not achieved, Asian SWFs may rapidly diversify away from the dollar, with the euro bearing the greatest brunt of appreciation, and also likely causing a sharp rise in commodity prices. Trade protectionism and acrimony would certainly follow. While this has not yet occurred, China’s recent creation of its massive SWF and its growing influence in the world changes the rules. This trend will gain momentum very quickly, so it would be best to seek agreements on the above items as core principles of “SWF best practices” rather than wait for a long negotiation over a complete set of such principles.

If you have any thing to add to this list I encourage you to post.

A New Mortgage Reset Graph

I'm a big fan of mortgage reset graphs. They are a great way to end a discussion about the near future of housing prices because they are just so difficult to argue with. At any rate, here's the latest from the WSJ and Bank of America. I have also attached the other mortgage reset graphs from previous months:


This is from Credit Suisse. Please note that the red arrow denoting "You are Here" is now 3 months out of date. In December we will be at the peak of the first mountain:


And this is from the IMF:
I think this last graph really validates my prediction of a 2012 stabilization in home prices.

Happy Thanksgiving!!

Want to Buy a San Diego Condo? Take your Pick

I am so glad I don't own a condo in downtown San Diego. But from the looks of things now is not the time to start buying. I'm guessing late 2011- early 2012 should be just about right. Yes, you are seeing that correctly, that is 20+ lockboxes in the Grande. All told 7.5% of the building is on sale (33/442) and that is a building that is less than 1/3 owner-occupied. If that isn't a bearish indicator . . . . :


Hat Tip: Jim the Realtor

Intrade Predictions: Rate Cut, Hillary, Guiliani

The prediction market at Intrade is currently predicting another fed rate cut at the December 11th meeting of the Federal Open Market Committee:

Intrade is also still predicting that Hillary Clinton (71%) will face Rudy Guiliani (45%) in the presidential election . . . and win (49%-18%):


The only thing that scares me about these contracts on InTrade is that due to relatively thin trading their exists the possibility that these results could be manipulated by an overzealous campaign. The value of manipulating these numbers is very clear. Just go to Google News and type in Hillary and the word Intrade. You will find literally hundreds of articles from newspapers around the country referencing these figures. The value of that kind of PR could be huge for a campaign with an extra couple hundred thousand dollars in their coffers.

There are already some rumors circulating that Obama's poor performance on Intrade is due to an as yet undiscovered scandal.

Only Funny Because it's True

Hat Tip: Peattie and Taylor

The Case Against Decoupling

Many pundits have argued that foreign markets would remain strong during a US slowdown due to a decoupling of markets traditionally dependent on the US for growth. Nouriel Roubini take the opposite tack on his blog post "Global Recoupling Rather than Decoupling as the US heads toward a Recession":

For now it is clear that it is still the case that when the US sneezes the rest of the world gets the cold. And since the US will not just sneeze but is risking a serious case of protracted and severe pneumonia the rest of the world should start to worry about a serious viral contagion from this US sickness. Certainly credit and financial markets have already suffered from such contagion; the dollar weakness is sending shivers to non-US investors, policy makers and exporters; and daily shocks to US equities are transmitted to Asia and Europe. It will take only a little longer – once the US consumer falters – for the US real hard landing to affect the growth rate of Europe, Asia and emerging market economies. There was never real decoupling; the perceived “decoupling” was only a side effect of the modest slowdown of US growth; now that the slowdown is turning into a hard landing contagion and recoupling is reestablishing itself with a vengeance.

Sovereign Wealth Hunger

This is from the WSJ this morning:

China and the Gulf states are hungry, and they've just sat down for an American buffet. In the last few months alone, state-affiliated funds and companies have taken bites of American icons, picking up small stakes in Advanced Micro Devices, MGM Mirage, Nasdaq Stock Market, Blackstone Group and Bear Stearns.

The deals were designed to be small enough to avoid scrutiny from the U.S. government. This conveniently played into the hands of sellers, who were able to offload pricey positions while giving virtually nothing in return, such as board seats or veto rights.

But the mergers-and-acquisitions story of 2008 will be how these foreign sovereign funds -- sitting on an estimated $2 trillion to $3 trillion of reserves -- direct their appetites. Fattened by the U.S.'s own trade imbalances and encouraged by favorable currency rates, they aren't likely to stay so compliant for long. Further down the buffet line sit entire U.S. companies.

Seven sovereign funds, including those of Abu Dhabi, Kuwait, China, Singapore and Russia, now sit on piles greater than $100 billion. Outside the U.S., these funds have proven more adventuresome, with a Dubai company recently moving to take ownership of the airport in Auckland, New Zealand.

This foreshadows some uncomfortable economic and cultural reckonings for the U.S. The modern gamesmanship of corporate interests is beginning to look more like "The Great Game" of national interests, where capital, as much as armies, can be deployed for strategic effect. And on this field of play, the U.S. looks caught off guard -- not unlike the cocksure Olympic basketball squad, run out of the gym by ostensibly weaker teams.

"When governments act in this field, the motives are different," says Deszo J. Horvath, Dean of the Schulich School of Business at Canada's York University. "The motives are longer-term security issues, which can have nothing to do with current economics."

Sen. Evan Bayh captured the new concerns at a congressional hearing last Wednesday. "The definition of national security interest is broader than it used to be," he said. "[Y]ou'll see the Chinese going around the world acquiring what they view as strategic energy interests, and it is not impossible that financial positions might be used in a similar vein."

That's why this incoming wave of foreign money will reveal more about the U.S. than about countries initiating the deals. Laws overseeing foreign investments were just given a much-needed overhaul. But at its core, the issue is as much about emotion and pride as it is about process, says Ivan Schlager, a partner in the Washington, D.C., office of Skadden Arps, who handles cross-border transactions.

Foreign investments touch a nerve, especially when so much American economic power appears at the mercy of China, which holds U.S. Treasury bills, or the Gulf states, which have such a big say over U.S. energy costs. For 2007, foreign buyers have accounted for 20% of M&A in the U.S., according to Dealogic, the second-highest level since 1995.

"We have not fully grasped what is happening here, and we have no counterstrategy," said Patrick Mulloy, Washington representative of the Alfred P. Sloan Foundation, a group studying technology, business, and economics.

Can the U.S. accept the foreign investments as an essential element for lubricating a dynamic economy? Tighter economic ties create less incentive for war and terrorism. And below the radar, a recent series of foreign investments have closed without incident. "No one raised serious objections when Sabic [a state-owned Saudi Arabian company] bought GE Plastics in a competitive auction. Are we culturally ready? We're a very welcoming and open society," adds Mr. Schlager.

Until it's not. Already the country has proven touchy, famously fretting when a Japanese businessman overpaid for the Pebble Beach golf resort back in 1990, or when a Dubai-backed company looked to take over a series of U.S. ports in 2006, setting off a talk-radio furor that squelched the deal.

It's easy to find conspiracies in these governmental funds, in part because they have such little transparency. The Group of Seven leading nations recently called upon the International Monetary Fund and World Bank to study ways to improve disclosure and accountability.

With a weak dollar and the ever-enriched positions of petro-based economies, it's inevitable that the worries will continue to stew. And it's inevitable that they will one day interfere with a big sovereign-fund investment plan.

The irony is the U.S. is, in essence, funding its own potential takeover. In Wall Street parlance, they call it getting LBOed. "We're moving to a sharecropper economy," said Mr. Mulloy in an interview. "The other guys are going to be owning, and we're going to be working for them."

I think Mr. Mulloy takes it a little bit too far with his "sharecropper" idea, but I do think that this is an issue that many Americans could potentially get very angry about if we aren't careful.

Fed Update

The Fed is seeking to provide more transparency:

Federal Reserve officials will double the number of economic forecasts each year and extend their scope, offering what Chairman Ben S. Bernanke called a ``rough'' guide to the direction of interest rates.

Central bankers will also add predictions for a price gauge that includes food and energy costs and give a ``fuller discussion'' of members' projections, the Federal Open Market Committee said in a statement in Washington. In a related speech, Bernanke said the overhaul will give the public a better idea of the Fed's thinking on growth, prices and employment. ...

``The market is going to have to be on a steep learning curve on this one,'' said Diane Swonk, chief economist at Mesirow Financial Inc. in Chicago. ``This is a good move over time, as it will give markets more access to the decision-making process,'' though it may cause ``chaos'' next week because investors will need to digest a ``breadth of views'' among officials, she said.

Fed Minutes

Fed governors and district-bank presidents will release their quarterly forecasts in minutes of FOMC meetings in January, April, June and October. Outlooks will also continue to be a part of the central bank's semiannual reports to Congress in February and July. The publications will include commentary on officials' thoughts about the risks to their projections, Bernanke said. ...

``The changes will provide a more timely insight into the committee's outlook, will help households and businesses better understand and anticipate how our policy decisions respond to incoming information and will enhance our accountability for the decisions we make,'' Bernanke said today at the Cato Institute, a research group in Washington.

Rising inflation may keep the Fed from cutting rates in 2008:

U.S. inflation last month continued to accelerate at a pace that may limit the Federal Reserve's room to cut interest rates in 2008.

Consumer prices rose 0.3 percent in October, the Labor Department said today in Washington, matching economists' forecasts. Prices were 3.5 percent higher than a year earlier, the biggest 12-month increase since August 2006.

``There are no alarm bells going off today, but neither does it provide any wiggle room to cut rates,'' said Julia Coronado, a senior economist at Barclays Capital Inc. in New York, who correctly forecast the figures. Policy makers ``have to take the inflation threat seriously.''

Futures traders are almost certain the Fed will reduce its benchmark rate again in December, even though the central bank said on Oct. 31 that the risk of faster inflation and slacker growth are ``roughly'' equal. Crude oil prices punched through $90 a barrel in October and kept rallying this month, threatening to boost inflation and slow an economy already weakened by the housing recession and credit collapse.

Compared with 12 months ago, ``prices are uncomfortably high for the Fed,'' said Mark Vitner, a senior economist at Wachovia Corp. in Charlotte, North Carolina. ``It has to raise the question about the limits of how much the Fed will cut rates.''

The increase in total prices from September matched the median forecast of 79 economists in a Bloomberg News survey. Estimates ranged from gains of 0.1 percent to 0.5 percent. Excluding fuel and food, prices advanced 0.2 percent for a fifth month, also meeting the median prediction.

Hat Tip: Bloomberg

Only Funny Because it's True

Hat Tip: Barry Ritholtz

Rough Day for Materials and Energy

On any given day the worst sectors may underperform the broader market by 50 or 60 basis points. Today, materials and energy underperformed the broader market by roughly 450 basis points. If you have a good argument for why this happened I'd love to hear it.

Not Quite a Correction

A market correction is defined as a 10% drop. We haven't had a correction in any of the major indices for quite some time, but we are close right now.


At a decline of 8.31% we are 1 or 2 down days away from a correction. As a point of reference, a 20% decline is a bear market. Naturally along with the correction comes enhanced volatility. I've got a running bet with 3 to 1 odds that we'll hit 35 before the year is out. What do you think?


I think I told someone the other day that as sick as it sounds, buying Google now, even at $700 would probably look smart in 5 years. I won't back down from that statement, but I will say that buying Google on the dips is probably the best way to scoop up shares. If you look at the graph below I think you can make a strong argument that buying Google when it is within 5% of its 200 day exponential moving average is a safe bet. Even after the after market action today that left google at 627 the shares are still 16.5% above their 200 day EMA. In other words, you may want to wait another 50-60 points or so before you dive in.

Bill Miller's Market Commentary

Bill Miller's market commentary is a must read for investors looking for perspective on market events. You can read his commentary at the lmcm website. Bill gives a great synopsis of the current market environment and then follows it with his value equity commentary:

One of the enduring features of the findings in behavioral psychology as it applies to finance, a subject I have discussed many times over the years, is the almost complete inability of those who are aware of them to actually apply them. You can attend Richard Zeckhauser’s seminars at Harvard, read lots of articles and case studies, be reminded of how recency bias, or anchoring, or the representative fallacy, or myopic loss aversion impair clear thinking and skew decision making, and still fall prey to them and others of their ilk the moment you are confronted with real world situations.

The recent precipitous decline in financial stocks, especially those related to housing, which sent Countrywide Financial (CFC) to $12 last week, and led to 20 to 30% drops in financial guarantors in a day or so—after they had already dropped between 25 and 50% this year—is a case in point. After falling 20% in only a few days on no news, and this after being down 50% for the year, CFC rallied over 30% in one day once they reported their results and indicated they would be profitable for the 4th quarter and expect to earn a reasonable return on equity of 10-15% for all of 2008. The price action on both sides was driven by emotion – first fear, then relief – and was hardly the result of a careful analysis of Countrywide’s long term business value. That, by the way, we think is in the $40’s compared to its current price of about $14-15.

This is not unusual. Warren Buffett has often noted how any knowledgeable analyst would have pegged the value of the Washington Post at about 5x what it traded at in the 1974 bear market, yet no one wanted it at that price. The 2002 bear market saw some similarly amazing prices. AES traded under $1. It will generate over $1 of free cash flow this year and is up 20 times from the lows of 2002. Yet fear set its price, as it did those of Nextel, Tyco, Corning, Amazon, and a host of other companies at that time.

Today fear dominates the pricing of housing stocks, of mortgage related securities, of financials, and of many consumer stocks. Confidence and optimism underlay the pricing of energy, materials, industrials, and non-US stocks, especially those of emerging markets, and China in particular.

I am reminded once again of the quote that sits in the front of Ben Graham’s Security Analysis, from Horace’s Ars Poetica: “Many shall be restored that now are fallen and many shall fall that now are in honor.” (The quote does not say “all” by the way, just “many”).

So what do you think, is it time to start buying Citigroup and housing stocks?

Level 3 Asset Writedowns

Some market analysts are now expecting bank and brokerage writedowns to increase to between $100 and $500 billion, mostly due to the decline in value of Level 3 assets. Most of these writedowns will come as a result of a new FASB rule limiting the ability of companies to avoid valuing hard to value assets. According to the FASB terminology:

Level 1 means mark-to-market, where an asset's worth is based on a real price. Level 2 is mark-to- model, an estimate based on observable inputs and used when there aren't any quoted prices available. Level 3 values are based on ``unobservable'' inputs reflecting companies' ``own assumptions'' about the way assets would be priced.

Considering the sheer volume of Level 3 assets that most of the major US banks hold on their balance sheets and in off balance sheet entities, it seems shareholders would be very concerned about the degree to which banks can manipulate the value of those assets by changing their own assumptions. When banks finally reveal that those assets are truly as worthless as many of us assume, they will take even larger write-downs:

U.S. banks and brokers face as much as $100 billion of writedowns because of Level 3 accounting rules, in addition to the losses caused by the subprime credit slump, according to Royal Bank of Scotland Group Plc.

The Financial Accounting Standards Board's rule 157 will make it harder for companies to avoid putting market prices on securities considered hardest to value, known as Level 3 assets, Royal Bank's chief credit strategist Bob Janjuah in London wrote in a note today. The new rule is effective Nov. 15.

``This credit crisis, when all is out, will see $250 billion to $500 billion of losses,'' Janjuah said. ``The heat is on and it is inevitable that more players will have to revalue at least a decent portion'' of assets they currently value using ``mark- to-make believe.''

Wall Street's biggest firms have written down at least $40 billion as prices of mortgage-related assets dwindle because of record foreclosures. Morgan Stanley, the second-biggest U.S. securities firm, has 251 percent of its equity in Level 3 assets, making it the most vulnerable to writedowns, followed by Goldman Sachs Group Inc. at 185 percent, according to Janjuah.

The credit crunch is not over yet, and the worst may still be in front of us. If Wall Street is hurting this bad you have to imagine that we should see some more hedge fund blowups in the coming weeks. Hedge funds can hold off on valuing their assets longer, but eventually they will have to pay the piper.

Hat Tip: Bloomberg

Only Funny Because its True

Hat Tip: Barry Ritholtz

What Makes a Great Investor?

Greg Mankiw writes: "Hedge fund manager Mark Sellers tells Harvard business students the secrets to success as an investor. An excerpt:

As an investor, you need to perform calculations and have a logical investment thesis. This is your left brain working. But you also need to be able to do things such as judging a management team from subtle cues they give off. You need to be able to step back and take a big picture view of certain situations rather than analyzing them to death. You need to have a sense of humor and humility and common sense. And most important, I believe you need to be a good writer. Look at Buffett; he's one of the best writers ever in the business world. It's not a coincidence that he's also one of the best investors of all time. If you can't write clearly, it is my opinion that you don't think very clearly."

Google Telephony

Okay, so today's news about Google's entrance into the telecommunications world has been rumored for months if not years. But, today's announcement was still real news and represented what for many was a significant departure from the announcement they were expecting. Many thought Google would announce a GPhone, not unlike what you see to the right. What they got was an alliance of 33 companies attempting to rewrite the rules of the cell phone world. I won't get you my first impression here. Rather, I will shower you with links. It is a cop out, but I really can't do this story justice. If you read this in order it is better:

1) Andy Rubin: The Man Behind the Google Phone

The Google Phone — which, according to several reports, will be made by Google partners and will be available by the middle of 2008 — is likely to provide a stark contrast to the approaches of both Apple and Microsoft to the growing market for smartphones. Google, according to several people with direct knowledge of its efforts, will give away its software to hand-set makers and then use the Google Phone’s openness as an invitation for software developers and content distributors to design applications for it.

If the effort succeeds, it will be the most drastic challenge to date of the assertion by Microsoft — the godfather of the desktop PC — that Google and other members of the so-called open-source world can imitate but not innovate.

2) Google Phone Crunched

Reports started trickling out last week that Google is ready to announce its Gphone, or rather Gphones. It is more a reference design, than a single phone. Android-based phones will start to come out on the market in the latter half of 2008 (from HTC at minimum). One mobile startup CEO I know says he was contacted on Friday by Google and given the final go-ahead to port his app onto Android, which his company has not even started to work on yet. The software development kit will be available on November 12. Today’s announcement is just that. There is nothing concrete here in terms of products or services, but going mobile represents a major growth opportunity for Google, which wants to bring the Internet (along with search and contextual ads) to your phone.

3) Bloomberged

Spending on mobile-phone ads may jump to $11.4 billion worldwide by 2011 from $2.17 billion today, according to Informa Plc, a London-based research firm. Google, in Mountain View, California, gets 99 percent of its more than $10 billion in annual sales from advertising, mostly by selling text links next to search results on its own pages and partner sites.

Google shares passed $700 last week, gaining $100 in less than a month, on speculation the company would extend its lead in Internet advertising into wireless devices. Gene Munster, an analyst at Minneapolis-based Piper Jaffray & Co., predicted as early as August that Google was developing software to run mobile phones.

4) WSJ

Android is a bid to change how the wireless industry operates. Carriers traditionally have decided what applications most consumers see on their cellphones, setting rules and negotiating fees for software developers to gain access. Google has struggled at times in recent years to get its products -- including Google Maps, Gmail email and its search engine -- onto mobile phones in a way that's easy for people to use. With Android, software makers can theoretically write applications that run on any user's phone -- and consumers can freely browse the Web.

RMB Appreciation

As discussed last week, it appears the RMB is poised to appreciate rapidly. This is from China financial markets:

According to a Bloomberg article today, the RMB was up 0.56% last week, reaching 7.456 to the dollar. This may not sound like a lot if you trade dollar/euro, but it is easily the biggest one-week jump in the US dollar value of the currency since it was suddenly revalued by 2.1% in July, 2005. According to a Bloomberg article, RMB forward contracts imply a price of 7.38 by the end of this year and 7.25 by the end of the first quarter. The article did not list the contract expiration date or a more precise RMB value, so my calculations may be slightly off, but this implies a 6.4% annual appreciation between now and the end of the year and a 7.0% annual appreciation between now and the end of 2008’s first quarter. Implied annual appreciation during the first quarter of 2008 is 7.3%.

Two reasons are generally given for the increase in appreciation rate, and both probably are true. The first, and more cynical, reason is that there will be a meeting later this month between Chinese finance officials and their European counterparts, along with a meeting between France’s President Sarkozy and President Hu, and everyone expects the currency to be a very important topic of these meetings. As they often do before such discussions, the Chinese authorities may be allowing the currency to appreciate to help deflect some of the expected anger. One of the claims much beloved of journalists and China-watchers is that foreign pressure on Chinese authorities is almost always counterproductive, a claim about which I am extremely skeptical.

The second reason for the more rapid rise in the currency is that the inflation scare is ringing serious alarm bells in Zhongnanhai (the leadership compound), even while publicly the authorities still insist that inflation is a one-off temporary food thing. Given the anxiety, it is striking to me that fuel prices were raised by nearly 10% last week and that there are rumors that other controlled prices may also rise. This can’t help but feed into inflationary expectations. I think the only thing that can easily explain the timing of such rises must be that the costs of the subsidies must be higher than the authorities are willing to support, although perhaps there is also a sense that they should get all the bad news out of the way as quickly as possible.

If market assumptions are correct and the RMB does begin to appreciate at 7.3%, with bank deposits yielding 3.8% you can earn 11.4% in US dollars if you can smuggle money into China and deposit it in a bank. Even the most intrepid of my hedge fund friends in New York wouldn’t sniff at those kinds of returns, especially since the biggest risk is upside risk – a sudden maxi-revaluation. There’s the problem – an obvious danger of speeding up the appreciation rate is that it might set off another wave of speculative inflows, thus pushing monetary conditions even more out of whack. Poor PBoC – dammed if they do, damned if they don’t.

The "Bailout and Justify" Fed

I can't think of a Halloween in recent memory that fell on a day with such a heavy dose of economic news. Not only are we getting some of the standard fare -- ADP private payrolls, construction expenditures, the employment cost index etc. -- we are also getting some real substance with the FOMC meeting and the third quarter advance GDP figures. The end result, if this year carries on as it has thus far will probably be bad economic news followed by a great rally. Allow me to explain.


As you can see above, the market has priced in a 25 bip rate cut heading into FOMC day. I personally think the Fed could, and may try to "justify" another 50 bip cut. How would they do that? Well for starters they could point out that market conditions haven't stabilized enough to cushion the blow from an accelerating housing market decline. After all that resilient American consumer is only as resilient as the credit officer who signs off on his/her HELOC's and credit card applications.

The Fed's second "justification" option is to just point at the graph above and use dramatic works like "crisis" and "carnage" to describe the credit spreads. Surely there is something in that chart to scare the weak-hearted and spin a 50 bip cut!

The reason I emphasize the Fed's need for justification is to point out how closely Bernanke's Fed seems to be following Greenspan's basic policy, as summed up in the following Greenspan quote from September of 2004 (and pulled from Jeremy Grantham's most recent newsletter): "For the Fed to interfere in security speculation is neither desirable nor feasible," but "if a sudden correction in asset prices did occur the Fed's first responsibility is to protect . . . to provide ample liquidity until the crisis is past." In plain English, Greenspan's stance is that you can't stop speculation, but you must bail out the speculators before they hurt everybody else. The real key of course is to bail out the speculators, but justify your bailout to market participants in such a way that they don't increase their inflation expectations. While this "bailout and justify" policy seems to be the preferred option for Greenspan and Bernanke, it does have a fatal flaw; it is quite simply not the type of policy that will force market participants to accurately price risk and thus prevent future speculation (moral hazard).

Now I want to make it clear that I don't think these moral hazard problems are necessarily Greenspan or Bernanke's fault. I think that the Fed Chairman's incentives, at least during this little slice of history, are just not in line with staying hawkish on inflation during market corrections. Indulge me on this for a moment. Back in early September Martin Feldstein suggested at the Fed's Jackson Hole Symposium that a 100-bip cut in the Fed Funds rate could be rationally justified. When reading the quote below from Feldstein's speech try to imagine yourself as the Fed Chairman listening to this speech and slowly letting your scholarly inclination to "stay hawkish on inflation and tough on speculators" slowly drift away and start thinking more about how posterity will view you if you precipitated a painful recession:

The Fed could adopt the risk-based "decision theory" approach in responding to the current economic environment. If the triple threat from the housing sector materializes with full force, the economy could suffer a very serious downturn. A sharp reduction in the interest rate – in addition to a vigorous lender of last resort policy – would attenuate that very bad outcome.

But what if the outcome in the absence of a substantial rate cut would be more benign and yet the Fed nevertheless cuts the federal funds rate? The result would be a stronger economy with higher inflation than the Fed desires, an unwelcome outcome but the lesser of two evils. If that happens, the Fed would have to engineer a longer period of slower growth to bring the inflation rate back to its desired level. How well it would succeed in doing this will depend on its ability to persuade the market that a risk-based approach in the current context is not an abrogation of its fundamental pursuit of price stability.

Wait a minute, hold the presses, since when did "Decision Theory" replace the Taylor Rule as the key factor in the Fed's decision making? While I don't think Marty was trying to illustrate the amazing power incentives have in encouraging moral hazard in Central Banking, he did a fairly good job of it. The acute pain of a recession is a far bigger and more salient pock mark on the track record of a central banker than that of a "longer period of slower growth." Just think, if you were Bernanke looking at the current state of the economy, and I was God and I offered you stability today followed by a "longer period of slower growth" or a 50% chance of a sharp recession that would likely be blamed on you, which option would you take? That's what I thought.

Following this line of thinking to its natural conclusion, it would also behoove an incentive-led central banker to underestimate the true inflation rate in the economy in order to provide more flexibility to cut rates in times of distress. And now we are at the truly scary part of all of this discussion. More and more scholars are starting to question whether the Fed's preferred inflation measures are truly capturing all the inflation out there in the economy. Jeremy Grantham -- a man who seems perenially worries about the market -- has not once been concerned about inflation for the past 20 years, that is until now:

For the first time in 20 years I am slightly worried about inflation. . . By the way, like many others I have an increasing distrust in the official inflation numbers.
For example, we have rising commodity prices and a very large deficit combined with a very weak currency, yet we have a decreasing inflation rate and one that is lower than that of many European countries with strong currencies. Very odd indeed.

Makes you wonder what exactly goes into the inflation calculation doesn't it? I'll tell you what. With what little I know about incentives it just seems to me that the Fed is more likely to cut big now and seek to justify than it is to rediscover its distate of inflation. I just hope all of you who have made it this far in this post have moved out of the dollar into commodities and emerging market stocks.

Sidenote: Just the other day Jim Rogers was quoted as saying: "It's the official policy of the central bank and the U.S. to debase the currency." While I think he was being a bit dramatic, I think he may have a very good point. China dropped its 'official' dollar peg 26 months ago and has allowed its currency to appreciate just 10% over that stretch. Now China is facing a serious problem: they are raising rates to fight rising inflation (6.2% in September, October numbers due in 2 weeks) and they are watching as the US lower rates (today) to fend off a recession. If the US is at 4.5% and China sees rates rise closer to 3.5 or 4% it won't be long before China's Central bank will actually be losing money if it continues to sterilize capital inflows. With the Fed in "decision theory" mode I might just follow Jim Rogers advice and start moving all of my assets into Renminbi . . .