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8/8/2019 Poseidon Perspective No. 24 September 2010
1/20
THE POSEIDON
PERSPECTIVE
sound navigation through perilous cross currents
SEPTEMBER 2010 NUMBER 24
On approach toward shallow waters we have always found that the best preparation is a thorough review of the
appropriate charts. Hence, we embark on a reading of numerous graphics in an attempt to establish our position. Our focus is the equity markets, the soundness of the economic recovery, the myriad actions of the Federal Reserve, and
consideration of our bearings going forward. We believe this exercise is preparation for continued volatility in
markets, political change from November 2010 elections, and potential taxselling prior to year end. We begin with a review
of monthly returns year todate. In Table A we find that the frothy returns of March and July, and thus far in September, will bring equity returns into positive territory for the end of 3Q2010. However, we maintain that the returns on equity over
the past 3, 5, and 10year periods are not adequate compensation for the on going risk.
TABLE A Jan 10 Feb 10 Mar 10 Apr 10 May 10 Jun 10 Jul 10 Aug 10 YTD*
DJInd (3.46)% 2.56% 5.14% 1.40% (7.92)% (3.57)% 7.08% (4.32)% 4.15%S&P 500 (3.69)% 2.86% 5.88% 1.48% (8.20)% (5.39)% 6.88% (4.75)% 3.02%Nasdaq (5.38)% 4.24% 7.15% 2.63% (8.29)% (6.56)% 6.87% (6.21)% 4.95%S&P 600 (3.46)% 4.24% 7.65% 5.75% (7.27)% (7.16)% 6.25% (7.55)% 7.35%MSCI EAFE** (4.44)% (0.88)% 5.81% (2.10)% (12.1)% (1.16)% 9.41% (3.34)% 1.02%MSCI EM** (5.65)% 0.25% 7.95% 0.96% (9.18)% (0.91)% 8.00% (2.15)% 6.45%Gold (1.37)% 3.34% (0.39)% 5.93% 2.99% 2.31% (4.96)% 5.61% 18.24% *All returns are thru Sept. 24, 2010
**MSCI Barra Indexes
Additionally, most equity index returns
YTD have resulted from a September 2010 surge. We suspect that this has been in response to the frequent liquidity interventions by the Permanent Open
Market Operations (POMO) of the NY
Federal Reserve. We also note the appetite for risk as reflected in the returns to date of the S&P 600, a small cap index of higher risk US companies which exceeds the
8/8/2019 Poseidon Perspective No. 24 September 2010
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THE POSEIDON PERSPECTIVE SEPTEMBER 2010
MSCIEM, traditionally a higher risk, emerging market index. Finally, we
include Gold, the continuous futures contract, in this chart as a reminder that in most cases Gold prices lack a correlation with equity market returns. During March
and July when equity indexes were up substantially gold prices fell. Yet, Gold advanced strongly in May, June, and August when equities were subject to strong selling pressure. We will address the precious metals in more detail in the
October 2010 Perspective.
The equity markets appear to have reached a manic depressive stage. This increased
volatility may be in response to more emotive media hype about the economy, general noise with specious information value, and high frequency trading. The higher level of investor uncertainty is reflected in Chart 1 with the YTD pricing for VIX, the volatility index and Wall
Streets fear
gauge.
The
VIX
is
also
indicative of the insurance cost against a
price fall in the S&P 500. The VIX is back to its price level at the start of 2010 with substantial oscillations. We contend that some investors will sell the underlying
asset when the cost of insurance becomes a serious drag on returns. The spike in the VIX during May 2010 corresponds to the Euro crisis generated by sovereign debt
concerns in Greece, Spain, and Ireland. These economic imbalances have not been
corrected, only removed from the front page of media focus.
The bad news for the September 2010 rally
is that all those investors who bought S&P
puts as insurance during price volatility in May thru August are now out of the
money with the rise of the S&P 500. This may reduce annual returns. There is no free lunch.
CHART 1 DECLINING RISK ?
Source: PSI; StockCharts
Page 2
In conjunction with increased volatility in
index prices we look at Chart 2 for an assessment of investor sentiment. Based upon information from the Investment
Company Institute (ICI), www.ici.org/research, we see that Long Term Equity Mutual Funds have suffered a
steady stream of money outflows during the past five months. The figures are in $millions for domestic equity funds. In spite of this no vote from some investors
the S&P 500 continues its upward journey. Research from ICI also shows that total
fund net
out
flow
YTD
thru
September
22,
2010 was $61.2 billion. During the same
period Total Bond inflow was $618.8 billion. The point is relative value and direction. Quite clearly, not only has money been drawn out of equity funds, but new money is gushing into bonds.
8/8/2019 Poseidon Perspective No. 24 September 2010
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THE POSEIDON PERSPECTIVE SEPTEMBER 2010
CHART 2 LOSS OF FAITH OR NEED FOR SECURITY ?
Source: Investment Companies Institute via ZeroHedge.com
Chart 3 illustrates the price of the 10year
Treasury, thin black line, left scale, relative
to the
S&P
500.
While
the
ICI
flow
of
funds includes all manner of bonds, the 10year Treasury Note is a world of its own. This security is more than a bellwether; it is the risk free bedrock of bonds. Libors
importance notwithstanding, there is probably no more closely tracked credit instrument in the world than this
barometer of the US economy. Hence, the unusual high volatility over the past three
years points to uncertainty and equivocation. This in itself is a cause for concern. The rapid price escalation since April 2010 has crushed the 10year yield which has now fallen 2.62% from above 5% in June 2007, see Chart 13. This coexists
point (0.45%) return for purchasing the 2
year Treasury. These are the fruits of the
Federal Reserves
exceptionally
accommodative monetary policyZIRP. This is not sustainable; the last tithe 10year Treasury was above 125 was onMarch 20, 2009; at that time the S&P 500
was 768. Since traditional metrics and correlations have digressed long term securities, both stocks and bonds, face
increasing risk with limited upside retu
with the horrendous penalty of a 45 basis
and me
rns.
hart 3 reveals the turmoil in equity and
Treasury which was below 2.2%. Another
C
Page 3
Treasury markets during 200809. Yet, thechart does not clearly reveal a major point of transition in 4Q2008. At this time the dividend yield of the S&P 500 surpassed the yield to maturity of the 10year
8/8/2019 Poseidon Perspective No. 24 September 2010
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8/8/2019 Poseidon Perspective No. 24 September 2010
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THE POSEIDON PERSPECTIVE SEPTEMBER 2010
SOUNDINGS Willie Sutton w explaining
4 as
ions tore
at the
d this
close to 70% of GDP and consumption has
ity
to
.
HART 4 WHO HAS THE MONEY
as famous forthat he robbed banks because thats where the money was. We see Chartan introduction to some commentary on money and the continuing economic recovery. It appears that investors nolonger expect the banks to be the repository for cash flow. Expectatpoint to the major retailers as the new sof wealth. We premise this upon the
recent pricing for the Retail Holders ETF(RTH). We must deduce that the
investment community believes thconsumer is still king and retains
substantial spending power. We finpreposterous. Since consumption remains
been fueled by credit we believe that the consumer and the banking system are intimately linked to any future prosperor lack thereof. While the RTH has done extremely well in its rebound above 2007 price highs, banks as represented by the Bank Index (BKX), left scale, have remain below 50% of their 2007 peak. For the consumer the choice is consumption orsavings. Yet, the equity market appears have priced in a retail boom which will exceed the consumption binge of 200607
We believe that in the course of household deleveraging consumption will be quite muted relative to the 200607 period.
C
Page 5
Source: PSI; StockCharts
8/8/2019 Poseidon Perspective No. 24 September 2010
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THE POSEIDON PERSPECTIVE SEPTEMBER 2010
e look at consumer dynamics in greater
e is
Separations was 4.43 million. This
July.
f
over
CHART 5 LONG , HARD WINTER
Wdetail. The first, and we believe the most important, is employment. We begin our review of the employment situation with the measure of separations or those
leaving the private sector. This measurfrom the Bureau of Labor Statistics (BLS), www.bls.gov/jolts, job openings and laborturnover. The BLS reported that while the total number of job openings has increased and the Total Hires in June 2010 was 4.25
million, during the same period the Job
differential is expected to continue inThe sad fact about unemployment is that the private sector of the economy is not creating enough jobs to handle the rate oattrition. Secondly, the economy is not creating new jobs for the backlog of unemployed who have lost their jobs the past 3 years. So a rising increase in job hires does not offset the increasing rate (see Chart 5) of job separations.
Source: ShadowStats.com
We monitor John Williams ShadowStats
find his
includes the Bureau of Labor Statistics
of ordance
Page 6
(shadowstats.com) for numerous government statistics because we site timely and informative. Chart 5 is a recent summary of unemployment which
(BLS) U3 and U6. Additionally, Shadowstats produces its own measurealternative unemployment in accwith the traditional, versus the current,
8/8/2019 Poseidon Perspective No. 24 September 2010
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THE POSEIDON PERSPECTIVE SEPTEMBER 2010
metrics of the BLS. This is shown as the blue line. Whichever indicator one choothe current challenge of unemployment iindisputable. It is the biggest hurdle for economic growth. Many conservative prognosticators believe that current levelsof unemployment will continue for yeaputting great strains on the public sector. The impact on consumer spending will bea continuing cutback.
Next, we look at other
ses
s
rs
potential sources for
creased consumer spending. Credit
ing
D BORROWING
incards dont look like a good suspect. Chart
6 reveals the fall, nearly 17%, in RevolvCredit Outstanding.
CHART 6 REDUCE
Source: St Louis Fed
Chart 7 provides a combintal consumer credit outstanding and its
e
.
r
ore
THE BURDEN OF DEBT
ed review of toyear over year change. The negative ratof change means that consumers are not
piling on more debt. Yet, while rate of change and direction are important, therehas been only a small decrease in Total Credit Outstanding, from $2.58 trillion in June 2008 to $2.42 trillion in August 2010The rate of deleveraging is 3.2%. At this
rate it will take another decade or more before the consumer has the spending strength of the late 1990s. The consumeis still massively over leveraged. The sources for consumer credit, better jobs with higher salaries, higher limits on mcredit cards, house equity as ATM, etc, have dried up. The retrenchment has
begun.
CHART 7
Source: ShadowStats.com
One way to measureecreasing credit expansion is to look at
nies. In ,
the impact of d
Page 7
the valuation of two finance compaChart 8 we display the prices for Visa (V)right scale, and MasterCard (MA), left scale. While both showed peaks in May 2008 they also revealed great strength in
8/8/2019 Poseidon Perspective No. 24 September 2010
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THE POSEIDON PERSPECTIVE SEPTEMBER 2010
Page 8
d e
HART 8 RETURNS ON REVOLVING CREDIT
April 2010. As leading indicators of the credit business they are not optimistic.
From its high of $306.51 on May 30, 2008 MA is down (33.8%) and V from a high of$96.29 on April 23, 2010 is down (27.8%). We interpret this as an indicator of a failing
recovery in consumer spending. Investor response reveals a very tenuous recovery.
Is there still confidence that dynamic money lending schemes, high fees, anextraordinarily interest rates will continuto drive greater profitability?
C
Source: PSI; StockCharts
We contend that the strong recovery in
ion
WEATHER WATCH We briefly a rest rates,
press releases, FOMC meeting minutes,
ation l
retail consumption and RTH prices from3Q2009 thru 1Q2010 is coming to an end. The recent weakness in V and MA indicates consumer exhaustion and
correlates with
the
10%
price
correctduring April June.
ddress inflation, intemoney supply, and Fed policy. We have been following the Fed through speeches,
Permanent Open Market Operations
(POMO), and the System Open Market Account (SOMA). Most of our informis taken from the web sites of the Federa
Reserve Board
of
Governors
and
the
twelve regional member banks of the system (ie, www.federalreserve.gov , www.newyorkfed.org, etc;).
The FOMC has undertaken several nconventional policies over the past 2 u
http://www.federalreserve.gov/http://www.federalreserve.gov/8/8/2019 Poseidon Perspective No. 24 September 2010
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THE POSEIDON PERSPECTIVE SEPTEMBER 2010
years to preclude the US economy frsliding into a deflationary spiral. This iscommonly referred to as reflating the economy. In Chart 9 we see the past 5 years of the CPI. The recent drop in consumer prices is the first substantial
decrease since the 1920s. A continuaof the 2008 decline is what the FOMC h been desperately attempting to avoid.
CHART 9 PRICE REFLATION
om
tion as
Source: St Louis Fed
The primary mechan ng flation is the control of interest rates and
s
r
e
ism for increasiinmoney supply through the Federal FundRate (FFR) and Open Market Operations.
Chart 10 shows the Federal Funds Rate, therate at which depository institutions lend balances to each other overnight. The range for the target FFR is established by
FOMC. It is currently 0.000.25%. Ovethe past 30 days it has ranged from 0.150.21%. The current target is the lowest in
over 60 years and, more importantly, weare approaching two years at this rate. Thlong term gyrations in this rate provide some indication of the severity of the boom bust cycles in the US economy.
CHART 10 INTEREST RATES
Source: St Louis Fed
resented both in aggregate and as annual wth of
rs
bt, given enough time, the
ility of the central bank through the
Finally, the money supply, M2, is pchange in Chart 11. Long term gromoney supply has been in the 4.57% range, thus the current 2+/% precludes any serious growth in GDP. Consumeare foregoing the available money in thesystem in a reversion to savings. The
current rate is border line for deflationaryexpectations.
We do not douab
Page 9
FOMC and New York Feds open market
http://research.stlouisfed.org/fred2/graph/?s%5b1%5d%5bid%5d=FEDFUNDShttp://research.stlouisfed.org/fred2/graph/?s%5b1%5d%5bid%5d=FEDFUNDShttp://research.stlouisfed.org/fred2/graph/?s%5b1%5d%5bid%5d=FEDFUNDShttp://research.stlouisfed.org/fred2/graph/?s%5b1%5d%5bid%5d=FEDFUNDShttp://research.stlouisfed.org/fred2/graph/?s%5b1%5d%5bid%5d=FEDFUNDShttp://research.stlouisfed.org/fred2/graph/?s%5b1%5d%5bid%5d=FEDFUNDShttp://research.stlouisfed.org/fred2/graph/?s%5b1%5d%5bid%5d=FEDFUNDShttp://research.stlouisfed.org/fred2/graph/?s%5b1%5d%5bid%5d=FEDFUNDShttp://research.stlouisfed.org/fred2/graph/?s%5b1%5d%5bid%5d=FEDFUNDShttp://research.stlouisfed.org/fred2/graph/?s%5b1%5d%5bid%5d=FEDFUNDShttp://research.stlouisfed.org/fred2/graph/?s%5b1%5d%5bid%5d=FEDFUNDShttp://research.stlouisfed.org/fred2/graph/?s%5b1%5d%5bid%5d=FEDFUNDS8/8/2019 Poseidon Perspective No. 24 September 2010
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THE POSEIDON PERSPECTIVE SEPTEMBER 2010
operations to radically boost the money supply.
CHART 11 SLACK DEMAND ?
Source: ShadowStats
n 27 August 2010 Chairman Bernanke
ming.
the
ld
r. Bernanke
acknowledged
the
icy plays
ested
ent
as
ts
is
t in
is
r
York
es. s
Odelivered his widely anticipated addressfrom the Feds annual economic symposium in Jackson Hole, WyoSuch a spectacle is always well covered inthe press; yet, we must address his
comments. Chairman Bernanke andFOMC control the banking system and wield great power across the financial economy. Nothing they say or do shou be taken lightly. However, we struggled tofind the guiding spirit, the courage, or moral conviction in this important announcement.
Mprominent role that monetary polin promoting the economic recovery and, unfortunately, economic recoveryand repair remains far from complete.
His economic outlook is the common litany of concerns with the standard
caveats. While fiscal stimulus has arrthe economic decline growth in private
final demand notably, consumer spending and business fixed investmmust ultimately take the lead. The pace of growth dependent upon household
spending is dependent upon job growthwell as households repairing their financial positions. Also, housing pricesremain depressed. While large firms areable to tap public securities markets, small firms dependent upon banks are starved
for capital. In the face of a collapsing US$Chairman Bernanke blithely states that
the arithmetic contribution of net exporto growth in the gross domestic product
tends to be much closer to zero, and that likely to be the case in coming quarters. His policy outlook is restrained to the
Page 10
communications game coyly played outhe FOMC meeting minutes. After the institution of ZIRP in December 2008 thpolicy will continue. Regarding the Fed
oversized
balance
sheet
he
speaks
of
the
logic of the portfolio balance channel
and the stock view versus the flow view. Much verbiage is allotted to the justification of Committee actions. Hethen discusses Policy Options for FurtheEasing. What we hear is that the past is prologue. Fed policy is discussed and decided by a coterie of bankers and economists in Washington and Newprior to being foisted upon the markets. We will hear about the convoluted
justifications in later press releases, speeches, and FOMC meeting minutFinally, we note that his prognosis revealthat it is reasonable to expect some
pickup in growth in 2011 and in
http://www.shadowstats.com/charts/monetary-base-money-supplyhttp://www.shadowstats.com/charts/monetary-base-money-supplyhttp://www.shadowstats.com/charts/monetary-base-money-supplyhttp://www.shadowstats.com/charts/monetary-base-money-supplyhttp://www.shadowstats.com/charts/monetary-base-money-supplyhttp://www.shadowstats.com/charts/monetary-base-money-supplyhttp://www.shadowstats.com/charts/monetary-base-money-supplyhttp://www.shadowstats.com/charts/monetary-base-money-supplyhttp://www.shadowstats.com/charts/monetary-base-money-supplyhttp://www.shadowstats.com/charts/monetary-base-money-supplyhttp://www.shadowstats.com/charts/monetary-base-money-supplyhttp://www.shadowstats.com/charts/monetary-base-money-supplyhttp://www.shadowstats.com/charts/monetary-base-money-supply8/8/2019 Poseidon Perspective No. 24 September 2010
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THE POSEIDON PERSPECTIVE SEPTEMBER 2010
subsequent years. We expect a dangerouscontinuity of policy mistakes.
pon consideration Chairman Bernankes
ays
cord
the ly
etence
ked ?
ts.
order to provide a recent backdrop to
nths to a
10.
y tools
e
f the
he speech goes on to review the m
om
the
e
arket
banks to reduce excess reserves.
Udissertations are like JellO, colorful, opaque, impossible to grasp, and alwless than filling. Fed policy has been ineffective except to support private interests at public expense. We must consider Chairman Bernankes past refor faulty judgment. He did not suspect or recognize the biggest housing bubble in US
history. He has not acknowledged the gargantuan costs of the continuing
banking crisis. He refuses to acceptimpotence of continuing ZIRP. He harshcriticized the Japanese for their monetary policy; but he is building upon the same folly. Yet, he is willing to gamble the economic future on a greater QE experiment. Such willful incompfrom the de facto head the US banking system is frightening. Why does the
Federal Reserve
continue
to
consider
mandates of unprecedented, both in
quantity and duration, liquidity and quantitative easing that have not worto overcome the current economic malaiseThis is an admission of failure. Why do we
continue to reward failure? It resembles the reckless surrender of oversight and regulation by Congress to the powerful and effective lobbying of the mega
financial and global banking interes
InChairman Bernankes excessive uncertainty we look back six mospeech given by Brian P. Sack, Executive
Vice President, Federal Reserve Bank of
New York and Manager, System Open Market Account (SOMA) on March 8, 20The title Preparing for a Smooth (Eventual) Exit reflected the policand strategy likely to be used by the Fed tounwind its bloated balance sheet. Unlike
previous tightening cycles the Fed is faced with three primary factors which areunique and unproven. The first is a policy decision which incorporates interest rates with balance sheet level and composition. The next considerations are the tools
utilized and the scale to which they aremployed. This strategic matrix is new inthis current cycle. Finally, Mr. Sack states that we will be operating in a framework
of interest rate reserves that has not been fully tested in U.S. markets. We appreciate his acknowledgement orisk.
T
Page 11
successful outcome from short ter
liquidity facilities
in
response
to
the
financial crisis and the smooth exit frthese arrangements. However, changes inmonetary policy will face some greater challenges. Unwinding the holdings in Feds balance sheet is a potential source of
disruption in markets due to its sheer size and the scale of activity. Hence, under anystrategy for policy change the Feds asset holding will remain elevated at the time
the FOMC wants to raise short term interest rates. The tools for change
include reverse repos which would bavailable to an expanded set of counterparties such as money mmutual funds and term deposits with
8/8/2019 Poseidon Perspective No. 24 September 2010
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THE POSEIDON PERSPECTIVE SEPTEMBER 2010
Finally, Mr. Sack addresses vulnerabilities. The two areas of concern
etplace which
ustness of
d st be
uld
operating in uncharted territory along r.
e
d
oenig, resident of the Kansas City Fed and
n
the
t
e pon one
terest
g
r. are far
y
t the
cause e
ig goes on to make several
portant points:
ile monthly data is tly
are: 1) Confusion in the markmight prompt volatility in asset prices. This can be mitigated with clear communication which includes direct and
valuable information. 2) The robrisky asset prices may not be sufficient towithstand a rising rate environment. This engenders the most concern among those who argue that the current low policy environment has fueled an
unsustainable rise in asset prices beyontheir fundamental values. We muincluded in this camp. The cure is seen to be a period of sustained, above trend
growth to absorb the substantial slack in place, which is an environment that sho be quite supportive of risky asset prices.
In conclusion we hear that the Fed is several dimensions. In particular M
Sack voiced
concern
about
impact
of
SOMA activities on the stock market. Threal conundrum is that this speech anpolicy propositions were made when the Fed was anticipating a shrinkage of its balance sheet. Now in September 2010 weface a FOMC that is considering an expansion of its balance sheet. We are flabbergasted but not surprised.
On August 13, 2010 Thomas M. HPdissenting member of the FOMC gave a speech called Hard Choices at a towhall meeting in Lincoln, Nebraska. We salute this outspoken opinion for two
reasons. The first is that dissent is a
necessary part of any rational, effectivediscussion since when everyone is ofsame opinion then there is not much grisfor the mental mill. Second, the current monetary paradigm and consul of leadership has continued to promote a
potential folly that is beyond our comprehension of risk management. W believe that Mr. Hoenig touches uof the most important but frequently overlooked aspects of current monetary policy. The fact that extended zero inrate policy (ZIRP) and quantitative easin(QE I and soon to be QE II) are high risk
experiments in which the technicians are unaware of the degree of risk which is
being undertaken. They either are not cognizant of or choose to ignore the seriously detrimental consequences. MHoenig states Economic conditions from satisfactory, unemployment is simpltoo high, and we want a stronger recovery. But as much as I want short term
improvement, I am
mindful
of
possible
longer term outcomes, I worry thaFOMC is inadvertently adding to uncertainty by taking such actions. Remember high interest rates did notthe financial crisis or the recession. Wapplaud this forthright analysis and concern.
Mr. Hoenim1) The trend data indicates a modestrecovery and, wh
Page 12
mixed, the overall picture is consistenpositive. While the recovery is not where we would like or expect it to be at
this stage, he astutely reveals that
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THE POSEIDON PERSPECTIVE SEPTEMBER 2010
volatile monthly data should not drive policy actions.
2) The financial collapse followed years too low interest
of rates, too high leverage,
primarily to e,
cing licy
s
e . The
celerate
f ZIRP; but they should not
from
.
ence that
ous
conclusion, Hoenig reiterates that the
ebt
ally, he
nfortunately, the FOMC brings a great
n
the
and too lax financial supervision as prescribed by deregulation from both
Democratic and Republican administrations. The economy had become so out of balance dueincreased debt, both public and privatthat reverting to a system of greater stability and strength will take time.
3) In order to accommodate a rebalanof the economy a move to a tight poon interest rates is not yet required. However, a clear path forward which
includes a policy of increasing rates inecessary. This would allow the continuation of slow deleveraging whilaccommodating economic growthrebalancing of the US economy, consumers, businesses, and government will take time but the attempt to ac
this transition
through
ZIRP
brings
its
own unintended consequences and
uncertainty. 4) Market participants are the great beneficiaries odirect policy. They will cry for an
indefinite ZIRP because They are earning a guaranteed return on free moneythe Fed by lending it back to the government through securities purchasesHoenig states that I find no eviddeflation is the most serious threat to
recovery today. The Fed continues to use the fear of deflation to mask a dangergamble.
Inrecent financial crisis and recession was
not caused by high interest rates but by low rates that contributed to excessive dand leverage among consumers, businesses, and government. Finreminds us that there is no short cut.
Udeal of uncertainty into the securities markets. Many investors, proprietarytrading desks, and hedge funds hang oevery word that emanates from their sacrosanct meetings and operations.
According to the Monthly Report onCredit and Liquidity Programs and the
Balance Sheet dated July 28, 2010 on www.frb.gov , the Feds Total Assets w$2,329 billions while Total Capital is $58 billion. Thus, the cynical evaluation is ththe System Open Market Account (SOMA) is leveraged at 40 times and thus operates as the mother of all hedge funds.
ere
at
e contend that the probability of
at a
wed
oil
s we noted above Mr. Hoenig clearly
its
Wsubstantial QE II is very high and thshort period of deflationary pressure during the next 12 months will be follo by a rapid surge of inflationary pressures
which will put immense pressure on interest rates. In the midst of this turmthe trillion $ question is what happens tothe US currency?
A
Page 13
described the banking arbitrage which allows them to generate continuing proffrom the Feds ZIRP.
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THE POSEIDON PERSPECTIVE SEPTEMBER 2010
Page 14
CHART 12 GRINDING FINER
Source: PSI; StockCharts
The collapsing spread between the 10year Treasury and the FFR makes it harder for banks to grind out the free money for the rebuilding of their balance sheets. As
recently as April 2010 the banks borrowed at the FFR, zero to 0.25%, and bought Treasuries yielding more than 3.75%, see
Chart 12. Now they have lost more than 100bps as the rush into Treasuries shrinks their yield but has increased their capital
gains. When, not if, they decide to move on to greater risk and more robust returns the Treasury market could be in for a very
rude surprise.
Chairman Bernankes Fed has been operating as if the increased liquidity and
bank reserves will stave off further recession. We find this proposition
questionable. The
Austrian
school
of
economics would argue that GDP growth
creates the demand for money which will be met by increased supply. The obverse is not true, increased supply of money will not create greater demand for production.
Asset values, stocks, bonds, derivatives, etc are climbing in value on the threat by the
FOMC to buy anything and everything in a new round of quantitative easing. Even housing is showing some price gains in hot markets like New York and
Washington.
PROVISIONING During the 4Q2010 we expect continuing volatility in global markets. In addition to pertinent information and media noise the US financial markets will have to wrestle
with greater central bank market activity,
Treasury Dept. refinancing with increasing innovation, regulatory mandates (ie, SEC, CFTC, etc), continued high frequency trading (HFT), and accounting (FASB, GAAP) changes. As a result, markets will not reflect fundamentals as we have measured them in the past. We surmise that asset price correlations will continue
to converge with market uncertainty. The
massive movement
of
funds
out
of
US
equities and into bonds and foreign markets is a reflection of the growing
stretch for yield and changing perception of risk. Since we are not in a trading mode we have refrained from any serious allocation to the equity markets. Our preference for a longer time frame, 35 years, means that we will have to forgo
potential short term trading profits. Undoubtedly, the time will come when equity prices again present good investment value. In the meantime we
must watch macro economic factors for indications of trend reversals.
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CHART 13 RELATIVE TO WHAT
Source: PSI; StockCharts
Page 15
Chart 13 exemplifies our concerns. The sharp decline of the US$, right scale, and
the resumption of diminishing yield on the
10year Treasury, left scale, display two fundamental patterns of weakness. The
currency and its bond are mutually dependent yet may trade within a spread which oscillates widely. These movements may appear to be random in character.
Yet, we believe there are numerous forces at work which command patterns. The financial panic in 4Q2008 was preceded by a strong demand and surge in forex rates for the US$. Three months later the demand for a risk free asset resulted in a
collapse in the yield of US Treasuries. There are numerous explanations for the dramatic price fluctuations; however, during this period of turmoil the dynamics
and the time lag are significant. Again, the US$ made a substantial rise early in
1Q2010 prior to and coincident with a
Euro financial crisis. We then saw a 30% drop, during April thru September, in the
10year Treasury yield. Since May 2010 the US$ and the yield have been declining in tandem. The instability of US$ rates over the past three years is detrimental and
costly to efficient markets and global trade. This inefficiency means major exporting countries attempt market interventions for economic support to maintain any potential trade advantage thru foreign exchange rates. One result is a large
accumulation of US$ denominated reserve assets. As a spring is coiled more tightly it develops the potential for a sudden and powerful unwinding. The unwinding of
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major bets in the currency markets could mean massive reversals in foreign stocks,
bonds, real estate, and/or commodities. Just as important, volatility in the US bond market is a major drag on world financial markets.
We believe that two of the most important indicators to watch are the bond yield and forex rate for the US$ as they are the harbingers of inflation. The failing strength of the US$ may reveal diminished support
for FOMC. If the US$ continues its slide below the 80level a strong signal is being
sent. As any further correction in the US$ would put great pressure on inflationary
drivers including the price of oil and other commodities.
Bonds are currently expensive unless one believes in a Japanese experience for the
US economy. So, we suspect that investors have priced into the bond and Treasury markets the expectations of deflation. An economic consequence noted frequently by
the FOMC. Thus, as contrarians we must believe that that there is a serious opportunity here. One trade is to be investing at the long end of the interest rate curve with duration of 1020 years depending upon risk appetite. This allows
for a 1015% gain over the next 12 months as interest rates continue their path down.
The trick will be to get out before the inevitable reversal begins. Otherwise, wait
with cash.
CHART 14 BEARING POINT , SHIFT TO THE EAST
Page 16
Source: PSI; StockCharts
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THE POSEIDON PERSPECTIVE SEPTEMBER 2010
Chart 14 which depicts the Japanese Yen
(JPY or XJP), right scale, and the US$ over the past decade. Unfortunately, we cannot include the last great move of the Yen, the 50% appreciation during 19851987. This
was terminated in less than 2 years with the collapse of both real estate and equity bubbles. We may now be building toward a similar dnouement.
The JPY has appreciated 45% over a 3year
period as the carry trade players have paid off yen denominated debt, buying JPY, and
taken on US$ funding by selling US$s. Thus, one consequence of ZIRP is the US$
replacing the JPY as the basis for a global carry trade. We believe this is the precursor to more serious US$ devaluation which began in June 2010. The central banks of Asia and the petro producers have supported the US$ in their recycling of trade generated currency into US
government and
agency
debt.
The
rise
of
the JPY may also result from foreign
central bank purchases, especially China, as a means to diversify their reserves away from US$s.
The global financial system rolls from crisis to crisis without any dramatic restructuring in the banking system, derivative swaps, or foreign exchange
commitments. There exist a number of
strategies for the US Treasury and Federal
Reserve to enforce a reflation of the US economy. However, upon reflation we question the discipline of government and central bankers to increase interest rates
high enough and quickly enough to prevent rapidly escalating inflationary expectations. At that time bond markets will be bloodied.
In a world of closely correlated asset
returns, diversification can prove to be an expensive form of insurance. Hence, we
summarize our current strategy for asset allocation.
1) Bonds are expensive. Yields are grossly inadequate. Yet, some potential capital appreciation is available over the short term. 2) Stocks are overvalued; we await lower prices and higher dividend yields. 3) Cash is costly to hold due to negative
real rates
but
we
view
security
and
availability to take advantage of new
opportunities as worth the penalty. 4) Gold is a strong performer in a continuing bull market subject to corrections. We look to accumulate on
weakness. The same is true for silver.
Investing demands patience. Rashness reveals a lack of character.
It was a restless summer which seems to have quickly slipped into history. However, there was a series of events whose implications continue to resonate with shifting tonality. The circumstances and prospects involve Hayabusa, Tokai/Sharp, Senkaku, Qixiong, and the rare earth elements. We will explain.
Page 17
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Page 18
Hayabusa, Japanese for peregrine falcon, is the name of an unmanned spacecraft which
PHOTO 1 ROCK SOLID
returned to Earth on June 13, 2010. It was launched on May 9, 2003. The Project Manager Junichiro Kawaguchi called
Hayabusa a High tech Space Ship as its key technologies, a plasma reactor that supports cutting edge industries, robot technology with visibility, development of heat resistance, and power saving technology are expected to be applied to various other
fields. Its mission was to bring back samples from an asteroid and investigate the
mysteries of the birth of the solar system. Source: JAXA
The craft contained a separate landing vehicle, the MINERVA, a 10cm by 12cm robot mini lander designed to depart from the main craft, gather asteroid material samples, and return to the mother ship. This amazing execution of nano type technologies unfortunately failed in part of its operational phase. Yet, the true success of this mission was the advancement of aerospace engineering concepts, operational testing of cutting edge technologies, continuing leadership in the development of composite materials, the record setting time for ion engine
operation, and
increased
progress
in
solar
power.
For
example,
the
Autonomous
Navigation
System enables the probe to approach a far away asteroid without human guidance. The
ion engine ionizes a propellant, Xenon gas, and then electrically accelerates and emits the ions to propel itself forward. This and more information on technological developments is available from the Japanese Aerospace and Exploration Agency (JAXA), the website is www.jaxa.jp/projects/sat.
Tokai Universitys solar car, the Tokai Challenger, is powered by Sharps compound solar cells developed for outer space applications. Their cell conversion efficiency is 30%, the highest in the world. Sharp is the only manufacturer whose solar cells are approved for use
by the Japanese Aerospace Exploration Agency. In 2009 the Tokai Challenger won the 3,000 km, Australian Global Green Challenge. This summer it entered the grueling South
African Solar Challenge 2010 with very high expectations. We believe that currently Japan is pursuing the some of the greatest advances in technology at this stage of the 21st century. The research and development utilizing advanced engineering spans motors, magnets, materials, biotechnologies, robotics, optics, miniaturization, and artificial intelligence.
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Page 19
PHOTO 2 SPEED FROM LIGHT
Meanwhile on September 7, 2010 the Japanese Navy captured a Chinese fishing trawler off the Senkaku Islands, known as the Diaoyu islands in China. The ownership of these rocky
outcroppings is contested among Japan, China, and Taiwan. There are potentially huge oil
and gas
reserves
in
the
area.
While
the
Japanese
released
the
boat
and
its
crew,
authorities
detained and arrested the captain, Zhan Qixiong. The Chinese response to this grave situation was forceful and immediate. The NY Times reported on September 23, 2010 that
the Chinese government had blocked the exports of rare earth elements to Japan. If true, this would be in violation of World Trade Organization agreements. We view the threat as more indicative as a show of force. However, any confrontation in Asia is inherently risky as at any stage one party may be forced to avoid a loss of face. Hence, rapid escalation breeds uncertain and outsized responses.
Rare earths are not really rare at all; they are found throughout the earths crust. They are found in almost all massive rock formations. However, they are concentrated in two minerals ores, bastnaesite and monazite. Rare earth elements Samarium, Erbium, and Promethium are necessary for current uses in magnets, lasers, nuclear batteries and active
ions. They are essential in the production of cell phones, laptop computers, cruise missiles, radar systems, wind turbines, solar cells, hybrid vehicles, and industrial catalysts. Rare earths are an indispensible factor and resource in the development and advancement of clean
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energy technology. Estimates of Chinese reserves are in the range of 57% and China currently produces 93% of the metals according to NY Times. Needless to say, rare earths
are an integral part of Japans continuing advances in an ultra tech economy.
There are at least two implications from this geopolitical and economic confrontation. The first is that trade issues which include currency exchange rates will be utilized in the pursuit
of political ends. Secondly, probably more importantly, China has once again shown its ability to cut quickly to the heart of any major confrontation. Chinese politics is not adept with the scalpel but is quick to use the cleaver. This attempt to coerce the outcome of a minor altercation by withholding resources critical to Japans economic advancement is an indication of serious friction. The activities, timing, and responses combine to reveal the current political tensions and intense economic competition in East Asia.
Concurrently, the currency wars have begun and they will be intense. The economics of a
competitive currency in relation to the US$ is a keystone for countries dependent upon exports. The recent declines of the Euro and the US$ have exacerbated this competition. In
this arena China is exerting the power of its monetary reserves. Recently, China began buying JPY driving up the value of the JPY. In order to protect its export machine the Japanese central bank begins a regime to increase purchases of the US$. The end result is China exchanges US$ for JPY, a nice move for diversification away from a falling currency while avoiding any yuan appreciation.
So whats the point? While Japan has suffered a 20year battle with deflation and lost its
place as
the
worlds
Number
2 economy,
this
is
not
a
second
rate
nation.
This
is
not
an
economy built on low tech, low margin basic manufacturing. Do not underestimate the
power of advanced education, hard work, solidarity, and savings. The hardball tactics and geo economic ploys will get much more complex as the economic battles escalate. The theater of rising development and power has shifted and many battles will be fought in Asia, both East and South. Is the worlds largest economy becoming an ineffective policeman and
a consumer sideshow?
Brian E. Shean, CFA POSEIDON STRATEGIC INVESTMENTS _________________________________________________________________________________
The views expressed in this commentary are those of the author at the time of composition. The assumptions, analysis, and conclusions are subject to change in conjunction with changes in the securities markets or discovery of additional or conflicting information. All information conveyed herein has been deduced, compiled or quantified from sources thought to be consistently reliable. This informational report is produced for general circulation and is not to be construed as a solicitation to buy or sell securities, financial instruments, or investment products. Prior to entering any transactions for investment products please consult a competent financial adviser and undertake proper due diligence. AMDG