Reflecting on Obscure late 19th and 20th Century Composers

I am a digital collector of classical music recordings.  I have many DVDs chock full of MP3s and Ogg Vorbis of recordings of everything I could get my hands.  I have any piece that’s been played with any regularity in the past 50 years, and usually have 4 or 5 different performances from different artists of each piece.  I had thought that I had a decent handle on musical history starting from the master himself (Bach).

After discovering a few dozen new composers in the last several weeks, boy was I wrong!  There was (and still is) so much great classical music that I hadn’t heard.

Most of what I had not heard was from Eastern Europe, where the composers were often displaced or suppressed by the formation of the USSR.

So, I will share some of my journey with you:

Anatoly Nikolayevich Alexandrov

Anatoly’s music is very archetypically Russian.  It’s emotive, and very similar to Rachmaninov.  The first of his 6 preludes, below, begins with a pretty thunderous statement.  To give context, it was written around the time when Russia withdrew (conceding much of its territory) from World War I, and the country was on the brink of civil war.

Borys Mykolayovych Lyatoshynsky

I am not a fan of atonal music.  Many atonal composers seem to have had a moment of epiphany where they have understood music well enough to compose atonally.  I wonder if listeners have the same epiphany?  His Mourning Prelude is one of the few atonal pieces which transcends my lack of understanding of music without tonal centering.  It’s a gripping piece that merges the slavic classical romanticism with atonality.

Sergei Mikhailovich Lyapunov

Lyapunov was a protoge of Liszt, and his music sounds like it!  Like Liszt, he trades off creativity in rhythm and thematic material for virtuosic texture.

Felix Blumenfeld

Blumenfeld commands wonderful virtuosic textures like Lyapunov in the style of Liszt, but he is a much more interesting crafter of thematic material.  His closest analogue is perhaps Rachmaninov. Although his name is not well known, he is certainly central to many names who are:  he was a pupil of Rimsky-Korsakov, and Vladimir Horowitz was a pupil of Blumenfeld.

Erich Wolfgang Korngold

His first sonata, below, is a mostly tonal (but not strictly) piece of considerable depth that is perhaps similar (though less-tonally centered) to Chopin.  He began its composition at 11 years old.

Arthur-Vincent Lourié

Born in Russia, Lourie’s music sounds very modern, and it’s very pretty.

Julius Reubke

Reubke, another Liszt protoge, only lived 24 years.  His work has broad, sweeping dynamics with incredible musical textures which are (like other Liszt pupils) traded off from theme & melodies.  This is an incredible work, especially from a 23 year-old.

Ján Levoslav Bella

Bella’s Piano Sonata in Bb Minor typifies the slavic romanticism with a Hungarian bend.  The piece is potent.

Gabriel Pierné

What a piece!  This is romantic period music at its best.  It’s very much like Rachmaninov.

Sergei Ivanovich Taneyev

The piece below is the second movement of his unfinished piano concerto, written at the age of 19.  This is very dark indeed.  Also, doesn’t he look like Andy Mckee?

Erno Dohnanyi

This is my favourite of the group.  I am a sucker for beautiful themes and melodies, and he incorporates them into a great package filled with deep textures and rich orchestration.

Finding this music was very eye-opening, and it’s led me on a path of musical discovery that I didn’t know existed.  I hope that you find something here that gives you a similar gift.

Happy holidays,

Matt

End of Year Strategy

We’re coming up to the traditional Santa Claus rally, and to quantify this, I’ve used Seasonalysis to examine the patterns.  Here are some interesting patterns about the S&P 500:

• Nov 25 through Dec 5, SPY has gained an average of 1.7%, going up 88.9% of the time
• Nov 21 through Dec 9, SPY has gained an average of 2.4%, going up 88.9% of the time
• Dec 4 through Jan 4, the S&P 500 has gained an average of 1.7%, going up 77.6% of the time – going back to 1960!

The bias towards the upside is clear, but the question that remains is whether the depression the United States is facing will provide the exceptional case.

What is the market telling us?  Let’s look at the big retailers. Confidence in holiday earnings looks very high.

Retailer	P/E Ratio
Wal-Mart	15.69
Amazon	76
Target	16.56
Costco	24.34
JC Penny	25.46

Those are strong multiples that imply strong growth.  For some time now, multiples have been growing, and earnings surprises have been consistent.  Forward multiples look to have a lot of value.  The question remains:  how realistic is forward earnings growth?

Who wouldn’t want to buy IBM at 11.66, GS at 8.88, or MB at 1.66?  Quite clearly, the market doesn’t really have that much confidence in future earnings, and the good run-up we’ve had supported by a steady stream of earnings surprises has not really convinced buyers of a sustained recovery.

Let’s look at some key companies & sectors.

Technology

Technology is now the single largest sector in the United States.  The landscape is dominated by a small handful of hardware and software makers:  Microsoft, IBM, Apple, Google & Cisco.  Telecommunication giants AT&T and Verizon are generally included in this sector, but they have as much to do with technology as Circuit City;  they are utility companies with retail outlets.

Let’s compare their sales from the peak on October 2007 to now:

Symbol	October 2007 Price/Sales Ratio	October 2007 Total Trailing 12m Sales	November 2009 Price/Sales Ratio	November 2009 Total Trailing 12m Sales
IBM	1.7	$94.68B	1.746	$95.53B
MSFT	5.523	$51.12B	4.683	$56.3B
INTC	4.184	$35.97B	3.24	$32.78B
GOOG	14.257	$13.43B	7.966	$22.68B
AAPL	6.448	$22.63B	4.923	$36.54B
HPQ	1.355	$100.55B	1.012	$117.21

At present, these companies add up to $1.015 trillion dollars in market capitalisation, sitting on a foundation of $361.04 billion dollars in sales — a market cap to sales ratio of 2.81.

In 2007, these companies had a combined market capitalisation of $1.067 trillion dollars after $318.38 billion in sales — a market cap to sales ratio of 3.35.

The take-away is that these companies are collectively worth what they were at the peak in October of 2007, and have better sales by $42.66B.  Individually, the picture is interesting.  Google and Apple matured into earnings , and the modest commodity PC & office equipment maker Hewlett Packard has actually increased sales by close to 17%!

These companies have an ability to survive and thrive because they service the consumer, government, business, and export to foreign economies.  Apple does have more consumer exposure than the others, and they are now selling into the Chinese market, but piracy remains a real concern.  My take on the top six is that they remain a good hold as long as USD denominated asset inflation continues.

HPQ makes a case against bottom-up investing:  you could have predicted a $16.66B increase in sales & $0.52B increase in earnings, but you would have lost money buying it.

Financials

Without mark-to-market, the largest institutions in the world are a black box.  We can only imagine that reflation is good for these institutions.  The smaller banks are dropping like flies as Main Street fails to recover with Wall Street.  Forecasting these companies in aggregate boil down to liquidity flow & momentum with particular attention to detail to the debt markets.  Forecasting the largest banks obviously have the most importance due to market cap weighting in the indices.

The closed-end debt funds have had momentum slowing for longer than the equity markets.  Prior to the great collapse starting in July of 2007, closed-end debt funds had already began to sink, and I would expect the high-yield funds to drop first when the rug of reality is swiped from underneath the feet of equity pricing.  Total return (equity value adjusted for dividends from interest) of these funds have slowed, but it hasn’t (yet) experienced the kind of drop I’d expect before a roll-over of USD denominated asset inflation momentum.

I am watching the debt markets, as they likely will be the first to fall.  Their fortunes are pinned recursively with that of all USD denominated assets, and as reflation continues, the big boys will continue to do well.

Basic Materials

The major integrated oil companies like Exxon Mobil are disappointing based on weak demand.  As storage and hoarding become more difficult, oil prices are going to be under pressure for at least the rest of the year, and perhaps into the first quarter of 2010.  Buyers are betting on recovery and hoarding.  There are full tankers who will not sell at current prices because they’ve taken a bath.  The price of oil will be under significant supply pressure with little real demand for the conceivable future.  I am selling all of my American centric integrated oil & gas as a consequence.  They originally looked like deals, but the market was pricing in this pressure.

Conclusions

Based on the persistence of global returns (momentum), USD denominated asset inflation remains quite strong.  19 of 22 global equity indices are at or near their rally highs.  Out of the US sectors, only the utility group is lagging.  Gold is at all-time highs.  Silver is +117% since its Octobter 2008 lows.

The juxtaposition of real economic activity being at a crisis low and assets being at a crisis high isn’t lost on many people.  Corporate profits are coming from growth-less USD denominated asset inflation, cost-cutting, job-shedding and government bail-outs.  The steady stream of “surprises” has guided multiples higher, and a failure to meet expectations would likely to trigger a dramatic sell-off.  Some sectors, like energy, may already be there.

For now, I am modestly long.  Prices with the same denominator trade in sympathy, but debt, money & commodities will probably signal that it’s time for the exits before equities roll over.

Global Market Overview

S&P 500 as of November 1, 2009

Entering November, we’re facing a two-week slump that has the S&P 500 about -6% off its immediate high.  Anecdotally, bearish sentiment and calls for a top seem rampant amongst observers in the blogging & Twitter community.  Without taking a sentiment poll, and measuring the correlation with future returns, it’s tough to say what that means – if anything.

There is certainly no shortage of reasons to be pessimistic.  Last month’s cooked non-farm payroll surprised most people by reversing the trend of slowing job losses.  The deflationists ask themselves: if a $1.4T government deficit can’t create a single net job, what kind of future do we have?

Our future is likely one with increased volatility, growing currency imbalances, and a weakening American gravity, allowing the rest of the world to slip farther out of orbit.

These macro political & economic themes will dominate at least the next decade.  The effects of each impulse from each force have on global prices is far more difficult to understand and predict.  The highly leveraged structure of the dollar coupled with the USD being the most popular base for currency, commodity, bond & equity transactions make reading momentum an able forecasting mechanism.

Despite the weakness in US equities over the past several weeks, I don’t see the panic in global markets that I’m hearing from observers.  The NZX-50 & Shanghai have actually gained since the S&P 500 peaked.  Commodities are still strong.  The 10y yield gained (relatively) about 7.5% – from 3.16% to 3.39% in October.

Could we see some more weakness?  Sure.  Could this really be the top?  Also possible.  However, I look for outperformance in momentum because of the self-feeding nature of money creation and destruction.  I remain long in my equity holdings, and I’m using this opportunity to buy a few calls for a quick trade.

 

 

Themes & Forces for 4Q

I’ve been pretty quiet for the past several months, taking advantage of the momentum of global reflation.  With newly minted Federal Reserve displacing risk capital in government bonds and mortgages, they have forced many savers to speculate in equities.  This, combined with weak stimulus and low multiplier government spending, has led to earnings and valuations which would indicate a fairly regular economy.  Google’s P/E is 33.9.  Exxon Mobile’s is 10.99.  If you didn’t think we had a global depression hanging over our heads, the markets look pretty fairly valued.

None of this have helped the common man — at best, for the moment, it may have made it hurt less.  The October BLS non-farm payroll report surprised observers to the downside to the tune of 216,000 jobs.  Equities don’t care about the plight of the common man.  Inflation is generally good for large corporations who can more easily ring profit out of it at the expense of consumers.  The resultant imbalance is expressed in consumer debt.  The link between inflation and earnings is so strong that CXO Advisory bases their Real Earnings Yield Model on it.

The Federal Reserve is clearly trying to revive this inflate and borrow model.  Chris Martenson has calculated that the Federal Reserve is more than 100% of the 2009 mortgage market.  Why, then, also despite the $8,000 home-buyer tax credit, is the Case-Shiller Composite-20 only 3.6% off its recession lows?

Let’s first start by axing more than 20% of people who have mortgages beecause they are under water.  Next, let’s make them anxious about the economy by killing their retirement investments.  Finally, let’s shed 4,127,000 jobs – and not even make an argument about the overstatement of employment in government reporting.

If housing doesn’t start to move really soon, government obligations on their backstopping agreements are going to be measured in annual GDPs.

So, why am I still bullish on equities?

Liquidity, momentum & inflation.

This deflation has led to an inflationary pop as governments have responded to the threat.  Economist Marc Faber contends that this is actually good for equities, gold and inflation sensitive assets because the Federal Reserve will print more money as things get worse.

Most global equity markets are still trending strongly, consistently setting new highs.  The disturbing laggard is China, but after an index doubles in under a year, it’s not that damaging to the trend for a 20% pullback.  However, they really cannot slip back too much farther without putting the rest of the world at risk of dropping in sympathy.

Commodities are just shy of their recession highs.  Treasuries yields are suffering, but without a $1.75T bond purchase programme — and everything else considered equal — yields would probably be leading upwards rather than lagging.

Global reflation chugs along.  It may have dangers, but how is that different from the past 8 months?  The framework and willingness to monetise debt is present like never before.  To conclude, I will leave you with some of my long ideas:

• EEM – iShares MSCI Emerging Markets Index.  The US economy isn’t going to grow in real terms any time in the conceivable future, but the emerging market economies already are again.
• AAPL – Apple.  The best run large company in the world.  AT&T made it worth while to get Apple to extend the exclusivity.  Great management, great technology, great consumers and great marketing.  Take whatever I say with a grain of salt, of course:  I dual-wield my iPhone 3GS and MacBook.
• DV – DeVry.  Recessions push the unemployed and underemployed to pursue new careers.
• COP – ConocoPhillips.  Big oils are very undervalued, and if you believe reflation will continue, you have got to believe that they will pick up.
• AEA – Advance America.  Cash advance is very lucrative business these days, and along with being long equities, I’m long American poverty.
• TTWO – Take-Two Interactive Software.  Among its properties are Rockstar Games (Grand Theft Auto), 2K Games and 2K Sports.  This should rock the 4Q.  Did I mention that Asians are huge gamers, too?  Slack in domestic demand will get replaced.

I am on this train while momentum carries it.  Then, I will jump off it.

Observations & VIX Interpretation

Fig 1: S&P 500, VIX, ATR(20), and ATR(20)-VIX Difference Histogram

The VIX is an indicator distributed by the CBOE which uses the out-of-the-money put and call prices for the front and next months to forecast implied volatility for the next calendar month.

The reality, however, is that it’s largely a reflection of the past calendar month.  This is demonstrated by plotting Wilder’s Average True Range (ATR) of the past 20 trading days (approximately one calendar month) against the VIX.  The shape of the two curves are almost exactly the same.  The divergences are in magnitude, and the apparent under-pricing of risk in 2000 and 2008 are very interesting.  Consequently, I’ve plotted a histogram of the difference between the two.

The VIX At Bottoms

Despite its most obvious usefulness more as a mirror rather than a crystal ball, the VIX has served as a bottoming indicator for both strong secular declines in the past decade.

2003 Bottom

2009 Bottom

Observe that in both instances, the VIX peaked before the ultimate bottoms in price & time.  Options writers are the most sophisticated of investors, and they clearly bet on the bottom.  Perhaps it was obvious to them what is obvious now:  oil, gold, silver and Asian equities were well off their ultimate November and December lows.

The other supporting theory is Max Pain Theory, which theorises that since options writers are the most sophisticated (and likely the largest) players, they will simply manipulate the market to make the most money.  Max Pain is the closing price at expiry of a security which gives the largest total payout to options writers.  I haven’t seen or conducted a study on the forecasting power of this, but I wouldn’t discount it as a vector of influence on equities;  the necessary supporting data that options writers make out like bandits was covered in depth by CXO Advisory.

State of the Global Markets

Macroeconomics

Macroeconomic data remains uniformly off its peak values.  Unemployment statistics see a slowing in declines, showing only 216,000 NFP jobs lost on Friday’s report, but other measures like withholding and discouraged workers continue to climb.  The market is viewing this surprise news positively, so green shoots are still in vogue.

Plenty of important new data is coming out this week around the world:  British manufacturing production, Canadian rate announcement, building permits & housing starts, Australian home loans & retail sales,  New Zealand’s central bank rate announcement, Chinese trade balance, and American unemployment claims & trade balance.  I would expect that the lessening negative momentum will continue, and that will be reacted to tepidly by global investors.

Global Market Momentum

China

Almost every stock market is channeling upwards.  It looks like China — a laggard in the past two months after 100% run-up since November — might be finished its correction.  The Chinese economy & stock market are largely credited for lifting the world out of recession, and it stands to reason that weakness in China would probably pull everyone else down into deflation oblivion again.  I would put the odds of that quite low:  central bank & governments around the world have demonstrated a relentless commitment to reflation, and the threat of more money printing & stimulus will likely temper any aggressive selling tendencies.  The danger is in the Chinese real-estate market toppling as China apparently tightens lending standards to curb urban inflation.  This is a real risk, but probably won’t introduce economic volatility for a few months.

Commodities

The Dow Jones Commodity Index is up only +22% from its lows.  Oil has bumped its head repeatedly around the $70/bl mark.  I expected this, and expect this to continue as new supply becomes available from projects which become progressively more economically viable as energy prices increase.  Tepid growth and increased supply make oil a poor short and intermediate term investment, in my view.

Silver finally lifted off and rocketed past the $15 and $16 levels.  As was mentioned on Macro Hour on StockTwits.tv last night, the gold/silver ratio is a very heavily defended area that makes silver a very compelling purchase to the price-action inclined.  I’ve been buying silver since the sub-$9 levels based on the relative value, and it looks like taking profit might soon be an attractive option for me.

Natural gas continues to be a freak show, sporting a massive contango, production & development breakthroughs, storage challenges, and the destruction of American demand.

US Treasuries

The US treasury market tells a pretty different story to silver & equities.  Despite record borrowing this year, the 10y is still only 3.44%.  Yes, it is substantially off its insane low of 2.04%, but it is absurdly low in any growth scenario.  Either traders are pricing in a significant deflation risk not reflected elsewhere, or the debt monetisation is responsible.  Even the long end of the curve seems to be following a very consistent down-trend.  The likely scenario is a precarious balancing act by the Federal Reserve to keep mortgage rates down in an attempt to stimulate the economy despite money leaving for equities and commodities.

S&P 500

Financial valuations remain quite expansive (JPM at 132, BAC at 38.84, etc), while mainly traditional large cap technology growth stocks look like value stocks (MSFT at 15.2 and T at 12.63).  Priced for their forward earnings, almost everything looks like a value stock:  JPM at 14.02, BAC at 17.44, MSFT at 12.76 and T at 11.39.  Earnings day performance is all over the map.  If the surprises continue, we will get higher stock prices.  I think there are some great deals, especially in the seasonal consumer discretionary area as they traditionally bottom before Christmas.

Strategy

Reflation is continuing as planned.  I am fluent in good arguments which support a stronger September/October, but history & statistics are simply not indicative of much strength here.  I am still invested in things which have the best long-term prospects:  American poverty from a massive transfer of wealth to bank balance sheets, and the resource contention from a strong Asia.  I think there’s ultimately an expiry date on reflation, but there is a persistence of positively interpreted macro-economic data and asset returns, so while that train is moving up the mountain, I want to be on it.

Another Bounce To Buy

Top: S&P 500. Upper-mid: Birinyi OB/OS with linear regression slope. Bottom-mid: VIX. Bottom: Global indices with 2-week gain (+1) or loss (-1)

Employment

There were plenty of mixed signals to end the holiday-shortened trading week.  The most important, however, was the somehow unexpected non-farm payroll decrease of -465k and new unemployment claims of 614k.

	Unemployment Rate	NF Payroll Net Change	New Unemployment Claims
Forecast	9.6%	-360k	612k
Actual	9.5%	-467k	614k

Non-Farm Payroll: Actual, Forecast & Adjusted (from ForexFactory.com)

There is a serious cognitive dissonance in modeling and reporting of employment statistics.  Reality lost 107,000 more jobs than predicted, yet the unemployment rate was 0.1% better than expected, all while the new unemployment claims were essentially as forecasted.  Seriously?  The numbers are essentially meaningless on their own.  The forecasting bias has more economic and trading value.

Global Indices

10-day global index returns have turned positive.  Most markets were open on Friday.  European equities were mixed, but in Asia, they were mostly up.  The winners were the developing world, and the losers were the developed world.  Expect this trend to persist.

China continues its torrid pace of growth and recovery.  It is up +85% since its October low.  We’re going to need China to perform like this to drag us out of the abyss.

Still, since June the 1st, only 9 of 22 major global indices have posted positive results.  The results are top heavy, though:  the big gainers were a lot larger than the big losers (+15.74%, +8.23%, +3.14% vs -5.69%, -5.23%, -4.11%).  This is decoupling.  That said, decoupling won’t occur if the entire world is in the toilet – everyone will suffer in that case.   The process will be most evident when you compare performance over a long stretch of time.  Daily beta is still typically 1.0-1.5.

I will continue to not argue with China.  Its price has been riding at the edge of 2 stdevs, and it has now closed twice in a row above its 2 stdev bollinger band.  This means that China’s gains in the past few days are even more rapid than what is normal in the contemporary.  The question is:  can we expect China to maintain this?  I suspect not, but the answer likely is in liquidity theory.  It probably explains the performance difference between China (+15.74%) and the Dow Industrials (-2.91%) since June 1.  I cannot easily verify this, as I can’t find Chinese equity supply on a cursory search.   Think about it like this:  money base globally has been skyrocketing.  As all of the dollars, yen, yuan and euros try to find homes for themselves, if they went into global equities equally — ignoring everything else — prices would go up as a function of supply.  Equities world-wide boomed.  As the developed world banks needed to raise cash, they added a tremendous amount of new supply with new stock issuance and competed with the demand by new bond issuance.

Trimtabs founder & CEO Charles Biderman says that sideline cash seems to be nearly exhausted.  What about in Asia?  The massive saving rates in China and Japan, they theoretically could maintain very significant demand on their equities.  This trifecta of extreme savings, rapidly developing economy and favourable supply conditions make China the place you want to park your money while it is on the up-swing (which will likely be the majority of the next 10 years).  On the same token, I really doubt the Chinese economy and stock market will continue to boom if the developed world is completely falling off a cliff.

My prognostication is that China is a great momentum play on both sides, and right now, they’ve got upward momentum.  Maybe they’ve got a little too much for the moment given that nobody else does.  Watch this carefully, and be ready to jump off the train.

Volatility

Implied volatility as measured by the VIX is now 27.95 while the S&P 500 is at 896.42.  Consider that it was 32.68 while 911.97.  Options participants clearly think that equities pose less of a risk than they did on June 16th.  They’re usually right.  Max pain on SPY is at $92.00.  These things make me modestly bullish about the very near-term.

Answer Unclear; Try Again

Building upon my arguments on Saturday, global markets have become even more opaque for me.  Despite cash gaining against assets all around the board yesterday, the number of global indices with a positive 2-week return has turned positive (the first time since the 15th).  That said, this is not a short-term timing indicator — rather, it is measure of momentum globally.  It also does a much better job of predicting high-beta markets than US stocks.

Volatility indicators outright are telling us to buy.  I discount the VIX for past movement, however, and the reality is that we still have a very large risk overhanging priced into options.  Additionally, as I mentioned in my previous article, the VIX is at the same level it was just before the Lehman and Bear collapses.  No-one knew what was going to happen, and volatility measured at tops is always massively understated.

S&P 500, VIX & Birinyi OB/OS

The Birinyi OB/OS indicator, which measures how many S&P 500 stocks are more than one standard deviation above or below their 50-day moving average, started June at +413.  In the past few days, it’s gotten as low as +5, but it snapped back yesterday to +275.

Charles Biderman, the founder of Trimtabs, had a great interview on NBC on June 18.  His statement was that insider selling and corporate actions were all adding a glut of new supply to the market.  At the same time, sideline cash seems to be close to exhausted.

That we have had a pause in the market is no real surprise, as a consequence.  Reggie Jackson wrote this morning in his fantastic newsletter about the growing influence of programme trading.  The people left holding the bag are almost always retail investors, and the market seems to have been given enough bid support to be kept high to get them in on the action.  Now that they are committed, add in the new supply, and we are trading on very thin bid support.

Prices are set at the margin, but when the bid depth at the margin is very thin — which it is — things can move very quickly.  Momentum has dried up on the upside, and the bid support seems largely maintained by — as Zero Hedge likes to put it — some SPARCstations in the closet of some investment banks.

I leave you with some Oscar Peterson.

Late June Review

American, Chinese, Indian and Japanese Stocks

The past several weeks have marked a divergence in the path of global indices.  With most of them actually down (21 out of the 23 I measure), Shanghai (+6.72%) and Taiwan (+0.24%) contrast with London (-4.52%) and Germany (-5.78%).  Starting from the 15th, and extending through Friday’s close, this marked the first time the number of global indices with 2 week gains had fallen negatively sustained for more than 2 days since the up-turn.  There were some shorting and convergence arbitrage opportunities, specifically in Malaysia earlier on in the divergent down-turn.  I suspect that ship has now sailed.  There are probably, however, convergence arbitrage opportunities in China (short) and Germany (long).

A look at volatility

My long-term volatility model — which takes the VIX value and discounts it for recent price movement — is still very pessimistic about future prices.

Volatility-Discount Model

Implied volatility itself gives us two tells.  The first is that we are at a crisis low.  Despite this past week’s global stock markets drifting down, implied volatility still crept lower.  This, in conjunction with a strong China, is what led me to tweet “If I were a more active trader, I’d be buying equities for a bounce right now” on the evening of June 22nd after the market had lost -6.78% from the June 11 highs.  A fortunate call, but I’d be more lucky if I were a more active trader….

Implied volatility in context

On the flip side, volatility is also at the stage where the market was before it really collapsed in September of 2008.  The market had a lot of uncertainty, but it underestimated the carnage which would follow.  Given that we’re at the same implied volatility as we were in August, just -9% off all-time highs, is it possible that future volatility is understated yet again?

One thing which we haven’t yet considered is the psychology effect on voltility premiums.  Options writers are the most sophisticated sub-group of investors, and they are also the only type of investor who actually have a historic edge over the market.  That said, they may write options to generate income for their bonuses now, and worry about the ramifictions/unwinding their positions later.

Implied volatility is also a far more reliable indicator at bottoms than it is at the top.  My conclusion is that volatility is understated.  Now is the time to buy volatility for the mid-term.  The macro-economics at play — chiefly the mortgage reset schedule — are going to return to the foreground.  In the very short term, I suspect the markets won’t do a whole lot, and this is probably a good time to scope out inflation sensitive assets which have been inordinately beaten down recently.

Fixed income taking away risk dollars

Stocks/Bonds Relative Strength Index

My bullish argument to explain the past few weeks of weakness is that the yield on bonds had become more attractive than domestic equities.  The risk chasing dollars haven’t receded so much as shift asset classes.  Wilfred Hahn made part of this compelling argument in his fantastic Global Chart Panorama (100 pages of nothing but charts you need to see).

There are major risks associated with various interest rates, however.  The Federal Reserve has allowed the Fed Funds rate to hit their target of 0.25%.  The recovery has shifted the structure of the lending market so that the US government is the source of all lending.  The balance sheet is providing the bid support for everything from government securities, mortgage backed securities to simply giving banks newly created money in the form of reserves to encourage them to lend.  (Note that this was tried in every crisis like this – namely Japan and the Great Depression, and it didn’t work either time).  Despite this, yields have been pushed higher, signalling that foreign investors, global soverign wealth managers, pension funds, and other very large long-term players don’t think they’re attractively priced.

At the same time, residential housing prices haven’t even hit their median prices for lows, and interest rates are fast threatening to derail the extremely modest recovery attempted there.

Equity valuation modestly improving

P/E and Future Return

There are actually people in academia who disbelieve the idea that there are secular bear and secular bull markets.  Surprisingly, Professor Shiller is one of them.  He certainly has implied a belief that exist in other asset classes (like real estate).

The Big Picture wrote an article back in June of 2006 that had a 100 year chart showing that secular markets in equities were identifiable through the consistent expansion or contraction of the earnings multiple.  I tend to agree.  It is now obvious that the markets priced the S&P 500’s earnings very cautiously.

S&P 500 P/E Bottomed Out

The P/E multiple has bottomed out for the moment.  It’s important to note that the mark of a new bull market, if indeed this is one, does not necessarily mean that stocks — particularly domestic — are a great asset to exchange your cash for.  In the most in the most optimistic of economic projections, US equities are going to trail emerging markets and commodities.  The financial sector, which recently accounted for half of corporate profits, is in the process of being neutered.  Asian banks, on the other hand, didn’t recently suffer from the leverage gluttony, so they have plenty of reserves, margin and limited regulation.

The conclusion I come to is that this is the rising tide of inflation where everyone goes up, but there are certainly better boats to park your cash.

Conclusion

Bullish:

• Chinese equities didn’t participate in the pause
• Risk premium search still appears active in other asset classes than stocks
• P/E multiples have, at least temporarily, bottomed
• Implied volatility is lowest since Bear and Lehman collapsed

Bearish:

• Implied volatility is the lowest since Bear and Lehman collapsed:  it mispriced the risk then, so is it now?
• Macro hasn’t stopped falling off a cliff
• Mortgage resets
• 21 of 23 largest global indices have had negative 2-week returns since June 15

Holdings

Overview

My holdings represent the belief that foreign economies (particularly Asia) will grow faster than the domestic, US assets will continue to drop in value and are in fact in a bear market rally, and PPI inflation will run high.

Position Breakdown

Ordinarily, I would say that if one major economy index did not confirm the other in a bull market, the action was a bear market rally.  What I believe to be happening is the long process of grand decoupling.  This picture is being obscured by monetary inflation.

Monetary inflation does make things more difficult to price, and if the professionals and well informed amateurs do not do a good job of out-performing the broad indices (which we don’t – there are only a handful of people in the world who can claim multi-decade outperformance), this spells an even greater trouble for the financial planning of the common household.

Further aggravating this is the sinking quality of economic reporting by government agencies.  The Federal Reserve removed the M3 (the broadest measure of money) statistic in 2007, and is now involved in a scandle involving billions of dollars in off-balance sheet transactions.  The US government has been consistently revising labour and inflation statistics for decades.  Economist John Williams’s site is an excellent resource to understand this better.

The end result is poorer financial decisions by consumers, governments and businesses made with less overall financial resources using consistently poorer information.

The end result is poorer financial decisions by consumers, governments and businesses made with less overall financial resources using consistently poorer information.

Holdings

Asian Bank Spreads:  The Asian economies have been growing at a much higher pace relative to the West.  Their banks are stronger, better capitalised, and their economies are becoming less regulated — not more encumbered with government intervention.  I started out long 33% SKF (ProShares UltraShort Financial), 22% KB (KB Financial Group), 22% HDB (HDFC Bank) and 22% MTU (Mitsubishi UFJ Financial Group).  Since then, I have done some rebalancing, but the positions have run into needing to be rebalanced once again – especially since I think we are likely ready for some sort of correction.

US Equities: My US equity exposure is limited to three companies:  GS (Goldman Sachs), AEA (Advance America) and DV (DeVry).  Goldman Sachs is the most well connected company on the planet.  Alumni occupy many important government and central bank positions in the world.  Even the most naive interpretation of this has extreme implications.

AEA is a cash advance company which operates in the USA, UK and Canada.  I selected it because of its attractive valuation.  Initially, I took a fairly hard hit on this position, but it’s rewarded me for my patience with a present gain of 39%.  Trading at 7 times earnings, I still believe this to have some room.

DeVry is on of the largest vocational colleges in the United States.  My treatise on investing here was that recessions provided a catalyst for people to ‘upgrade their skills’ and make career changes.  DeVry is one institution primed to take advantage of it, and this was confirmed a few months ago with their highest enrollment rate ever.  It still hasn’t recovered very much ($43.57 from a low of $38.19 from a previous high of $64.69), and I think there will be positive surprises as earnings news comes through for this stock.

Commodities: Marc Faber says that he is 100% certain that the US will experience hyper-inflation, and that buying agricultural commodities will be like investing in the oil sector in 2001 and 2002.  With the monetary base more than doubling in the last year, the only alternative I see is more vicious deflation.  The gold market put much stock in the deflation theme — at the worst of it, it was down -13% from peak in 2008.  It’s a few bucks away from all-time highs now.  Even bonds don’t believe it.  The 10y rate has gone from 2% to 3.8% in less than 6 months.  Government spending in both absolute and relative terms is pushing new records every day.  Any gain and any rally in USD is ultimately temporary.

That isn’t to say that there aren’t valid shorter term reasons for commodities to fall against the dollar.  There is so much oil supply, and so much potential supply in paused production that I doubt we’ll see oil pushing $100 for perhaps years.  Deflation is another reason.  Inflation and deflation is and will simply happen at the same time in different assets.  The cost of food to the consumer hasn’t had a single decrease throughout this recession, yet the average metro home price has fallen -20%.  This is one faucet of the grand decoupling.

This is implemented by long positions in OIL, DBC (Deutche Bank Commodity Index ETF) and DAG (Duetche Bank Agricultural Commodities ETF).

Any gain and any rally in USD is ultimately temporary.

Net Short US Assets: I am short industrials via SIJ, and I am about to make a lot of money on it as GM goes into bankruptcy tomorrow.  Additionally, I am short US housing via SRS.  My belief is that the US housing market hasn’t even corrected to mean, and it has at least 10% farther to go.

The Other Stuff: I am long volatility through the wonderful ETF VXX.  This is a liquid ETF which correlates extremely well with the theoretical index.  I also have positions in Chinese real estate (TAO), and roughly 17% cash.