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.