Fundamental Trading Diary

Fundamental analysis of the capital markets

Bitumen & Bolts

Canada, the second largest country in the world by landmass, is home to 30 million people.  It’s the most economically comparable nation in the world to the United States: just at 1/10th scale.    After being more fiscally conservative than Americans — and rather smug about it, particularly after the 2008 credit crisis — a bi-polar economic structure has emerged which undermines the illusory Canadian prosperity.

Canada’s economic architecture is a two-headed beast:  it is a strong exporter of both raw materials & finished goods, most notably automobiles & military hardware (I’ll bet you didn’t know that).  The vast majority of trade is with the United States.

The durable goods manufacturing & export industry was reborn out a cheap Canadian currency, created out of the ashes of a tight monetary policy & populist anti-American political stance by Pierre Trudeau.  In the following years, fiscal & weak monetary policy crafted the Canadian economy as the first major manufacturing out-sourcing hub.  Canadian workers were as educated & productive as their

American counterparts, but cheaper, and their health benefits already paid for by the provinces. Coupled with strong government incentives, this ultimately made Canada very competitive.

The Canadian dollar has served as a proxy for basic materials, most notably oil.  This is a gross misestimation of the Canadian economy, and even just Canadian trade: the price of a commodity, whose gross sales at $70/bbl comprise of 3% of Canadian GDP has driven the currency.  Alberta, which produces 74% of Canadian oil, only shares 14% of Canada’s GDP.  In contrast, manufacturing driven Ontario comprises of more than 40%:  this is another demonstration of the relatively tiny size that oil production is relative to manufacturing.

When oil rises, two key things happen:  Americans buy fewer cars, and the Canadian dollar rises with it, making the much larger manufacturing sector less competitive.  This is what has catalysed the loss of more than 400,000 manufacturing jobs since 2002.

This creates a dichotomous system where the currency “sweet spot” for sustainable productivity across the country & throughout its industries is very narrow.  Current values are almost certainly too high, and this is made obvious by the continually falling industrial production.  Perhaps the most laissez-faire of major central banks, Bank of Canada is singularly mandated to fight inflation, which is performed almost entirely through rates.

The current economic expansionary cycle, which started several months before the American March of 2009 turnaround, was catalyzed by a very poorly covered bank bailout.  The Canadian people, who had been running a Federal budget surplus since 1996, suddenly find themselves with a $64 billion deficit:  the new item on tap is a $75 billion bailout (multiply this by 10x to compare it to the US programmes), which creates a massive — for Canada — $64 billion deficit.  What makes the Canadian bank bailout even more curious is how big it is relative to how few banks operate in Canada.  The banking spectrum is dominated by 5:  Toronto Dominion, Canadian Imperial Bank of Commerce, Royal Bank, Bank of Montreal & Bank of Nova Scotia.

Stephen Harper has sworn up and down at every opportunity that the Canadian banks weren’t bailed out, the Canadian banking system is the safest in the world, there is no sub-prime lending, and most recently against a co-ordinated global bank tax to pay for the bailouts.  The only problem is that it’s all untrue.

The Canadian federal government has long been captured.  Regulatory capture has killed financial competition & innovation, creating a system where retirement funds are funneled through a closed system.  As a customer of Canada’s largest bank, Royal Bank, you can expect to pay $28.95 per transaction, plus 2.5% currency fee if you buy American stocks!  The swift, uncontested & uncovered bailout neatly demonstrates the extent of the capture.

So – what does the Canadian economy, architected to sell expensive oil & cars to the United States, do when Americans can no longer afford either?  Spin up the FIRE economy, of course.  Open the credit spigots, lower the borrower requirements & quality, and spur domestic consumption.  This is how Canada’s mighty balance of trade fell from a surplus of 46.9 billion in 2008 (or 47.9 billion in 2007) to a deficit of 4.8 billion.

The position of the United States in trade has dominated global economics for decades.  The cycles of growth & decline of American consumption have driven a high degree of synchronicity in the global economy.  Because of this, most every tradeable asset is highly correlated, and perhaps more than two thirds of any trade is simply whether money is flowing in or out of risk-taking assets.  This is even more true for the Canadian economy, and Canadian assets:  as the largest exporter to the United States, the livelihoods of millions are very sensitive to what American consumers do.  Additionally, the quick federal government support to Canadian banks in late 2008 provided opportunities to scoop up American assets on the cheap, which they amply took advantage of.  This has increased the exposure of the Canadian economy to the American risk even more.

The Canadian Mortgage & Housing Corporation (CMHC) is a crown corporation — fully owned by the state — which serves as an analogue to Fannie Mae or Freddie Mac.  From 2003 through 2007, they removed price ceilings (paving the way for what are called “jumbo loans” in the United States), added 40-year mortgages, removed the requirement of a down-payment, and opened itself up as a Mortgage Backed Securities marketplace (which has comprised more than 90% of the Canadian mortgage market since 2007).  In order to facilitate continually expanding housing prices, the borrowers obviously must grow progressively less qualified; in this capacity, the CMHC is actually riskier than Fannie or Freddie, who were merely over-leveraged, but not big players in the sub-prime markets.

The price-to-rent ratio has gone from less than even in 2001 to over 2.5:1 — at a peak level, after a small decline during the credit crisis.  The price-to-income ratio has gone from almost -2:1 to 1.5:1.  Canadian household debt has reached a record $42,000 a person, ranking Canadians as highest debt-to-income ratio in the developed world.

All of this adds up to a tremendous sensitivity to prices & confidence as in any classic example of a debt-fueled bubble.  Unless wages can quickly rise by 20-30% to cover the un-affordability introduced by credit expansion, or Canada invites an extra million-or-so wealthy immigrants from Taiwan, Canadian home sellers will quickly run out of greater fools.  There is evidence that this has already begun:  new home listings have once again reached an all-time peak, while sales have already leveled & declined from their highs.  At the same time, Canadian consumer insolvencies (bankrupcties & consumer proposals) are up 20% year-over-year.

None of this is good news for the Canadian banks — the top 4 of which own 169 billion in MBS, or foreign MBS owners like General Electric.  Additionally, it’s not good news for the loonie, whose cretinous investors’ distorted views of the Canadian economy has made it a proxy to oil.  Where will the loonie be after credit reverts to mean, and the Canadian government, which insures all of those MBSs, has to pony up from the losses these assets are certainly going to take?

The answer is much lower than it is now, and probably where it should have been all along.

Images, links & data: Mish1 Mish2 americaCanada


June 11, 2010 Posted by | Uncategorized | 4 Comments

What do new believers buy?

SMissed the train
Missed the train

When I look back at my writing, my estimation of the recession, recovery was flawed in two major ways:

  1. I underestimated the amount & duration the market would move against the Fed & the government during the panic phase
  2. I underestimated the amount & duration the market would move, responding to stimulus & recovery

Ultimately, of course, the stimulus & emergency measures taken by the Federal Reserve & government didn’t halt the decline;  it was the removal of mark-to-market accounting.  So:  the market knows what’s important…

The prevailing question to those like myself who are underweight equities:  the S&P 500 is up 75% from its cycle lows.  Have we missed the boat?

Has the pilot executed a perfect landing?

Nassim Taleb equated correctly tuning the economy for recovery to landing a 747 between the mountain & sea on a very short run-way.

Let’s consider our current economic context:


Non-farm Payroll Change m/m

Job losses have peaked, and we are once again heading into positive territory.  The rate of NFP change has been been historically very sticky to the prevailing trend.  Although I would not rule out a negative NFP in this cycle, I suspect that some very strong positive releases are coming in the next 6 months.  I even expect it to be strong enough to take the unemployment rate down – perhaps to 9% by the end of the year.

Corporate Earnings

2009 was still brutal for corporate earnings.  S&P 500 earnings require a +47% move to match their 2006 peak.  Consider a selection of multiples:

MSFT: 16.08
T: 12.41
AAPL: 23.27
JPM: 20.24
GS: 7.95
MRK: 6.96
JNJ: 14.86

Also, consider the companies still in the red:  BAC, C, BK, PNC, MET…

Valuations and earnings are all over the place.  As a whole, the largest stocks are positioned aggressively for growth, but many stocks could see a sharp earnings recovery & subsequent share price lift.  I would look for 2010 EPS for 70 or better – giving a forward P/E of 17.

This is already priced into many stocks, but probably not into many financial stocks in particular.

Working Thesis

So:  the great battle between inflationary and deflationary forces seems to have tipped over to the side of growth & risk.  Massive co-ordinated efforts globally by both government and central banks have saved the capital markets from a 1929-1933 style cliff-dive.

This isn’t sustainable.  A Keynesian response is leading to awful mal-investment from every sector:  governments (particularly the American government, pissing their productivity away with health-care, taxes & inflation, and spending their stimulus dollars on stemming the tide, maintaining the energy dependent status quo, and not building out new infrastructure for the future), central banks (liabilities taken on during the waterfall decline), people (buying new cars & houses they can barely afford) & investors (buying stocks & bonds at prices that ultimately will fall prey to deflation).

Generally, I think we can expect longer busts, and shorter booms.  We’re in a boom, until the awful foundation of mal-investment & energy structure pulls us back into the flames.

What’s left to buy?

I am overweight institutions that stand to gain the most from a recovery that haven’t quite seen the effects on their balance sheet yet.  Apart from the usual things I like, I think a possible list of candidates are:

  • Financial institutions in the red:  BAC, C, BK, PNC, MET
  • Natural gas
  • Short long treasury yields

I just want to make sure that I’m ready to jump off the train…

April 6, 2010 Posted by | Uncategorized | 1 Comment

Birth of the Perma-Bear

Although I didn’t place my first trade until a few years later, I wrote & backtested my first trading system some time around 1998.  My father & his three brothers were all actively trading the bubbling dot-com boom.  My father, the cynic, successfully forecasted the dot-com bust, and the subsequent crash in global equities.  In late 1999, my father & I went to our TD Bank financial advisor to liquidate the mutual funds my family had put away for my education.  The advisor not only attempted to convince us out of it, but recommended to my father that he re-mortgage his house, and invest the proceeds in the stock market.

As the market topped and came crashing down, my father bought Dow futures puts.  He cited many of the same concerns that we’ve heard more recently:  the spread between Eastern & Western/developing & developed standard of living was too wide, our outsourced manufacturing replaced with current account, government & private sector deficits, and the over financialisation of the economy.

He was right on every count.  His puts made a tonne of money.

Ultimately, my father thought that our Western economy was trapped in a death spiral, and that the stock market was going much lower.  He was probably right about the former, but he continued to hold his puts through the recovery, and negated the winnings he made on the way down.  That was his evolution into a perma-bear.

There are a couple of problems with the perma-bear scenario.  The principle arguments revolve around indebtness & the standard of living (perhaps around cars).  Here’s the thing:  if the equity markets gave a single greenish-brown floater about the plight of the common man, we’d be in a 40 year bear market.  Every facet of American life is inferior with the exception of technology:  the quality of our food, our disposable income, the cost of energy, our moral superiority, our economic prospects, the number of hours we work, our buying power…

How can all of those things decline — and in some cases, fall off a cliff — while the market posts 9% yearly returns?

The answer is that the economy changes.  Stock market prices are a simple combination of available capital, an appetite for risk, and corporate earnings.  Where the common man loses in quality of food, or disposable income, corporate earnings can gain.  As long as the central bank keeps printing money (which it does), there will never be a long shortages of capital.  This leaves us with the most important factor:  appetite for risk.  That’s all that really matters.

The conclusion isn’t that the equities are going to 0:  I think it’s more correct to say that our booms are getting shorter, and our busts are prolonged.

9 years after my father & I went to our TD Bank financial advisor to liquidate my mutual funds, I shorted stocks, and bought precious metals because everything I knew about the financial world was ending.  The spread between the developing & developed standard of livings had finally reached the tipping point.  The current account imbalances, debt balloon and financialisation of the economy had finally boiled over.  Our global currency system was irreparably broken.

My father has since reconciled with the up-side.  It took me until June of 2009 before I jumped back into equities.  Even now, my exposure is pretty low:  I own a few equities, but mostly write some options & wait for the chaos to return so I can do what is more intellectually comforting to me:  shorting the spread between the East and the West.  I have that nagging feeling, though:  am I now a perma-bear?  Like father like son?

Well, at least on the last part: definitely.

April 3, 2010 Posted by | Uncategorized | 1 Comment

Fundamental Playbook for 2010

After the -56% drop in equities between October of 2007 and March 2009, we find ourselves rebounded +64% after a recent -9% pullback.  There has essentially only been one trade:  you are either long or short risk.  Every day is a tug-of-war between reflationary and deflationary pressures:  the Federal Reserve furiously expanding monetary base while the Treasury promotes real-estate purchases through tax credits in an attempt to revive the wealth vessel that most American net-worth is held in:  houses.

It doesn’t work, of course.  Unlike China, but very much like Japan, you cannot force a snake-bitten financial sector that doesn’t want to make loans (where 5% of their existing loans are 90-days delinquent) to lend money to the even less credit-worthy.  In fact, trying to force banks to lend by feeding them newly printed money is a lot like pushing on a string:  financial institutions will hoard their cash for their self-fulfilled rainy day prophecy, and only sparingly invest the money into extra liquid assets like stocks, treasuries & commodities.

This leads us to an environment with a 10y which has surpassed 4% & oil which has surpassed $80 at the same time that unemployment is 10.6% (seasonally unadjusted;  9.7% if adjusted, or 21% if you revert back some of the lies the BLS has introduced since 1994).  The last time oil was $80/barrel, headline unemployment was less than 5%.  A combination of inflation, Chinese hoarding and long-term decline of oil supply — peak oil — has essentially doubled the economic cost in unemployment of oil.

High energy costs & interest rates combine to create a scenario Gregor Macdonald calls the Double Overhead Crush.  As complacency from the liquid risk asset market rally sets in, global political solidarity for reflation is beginning to crumble as the Chinese and Europeans engage in gigantic games of macro-economic chicken.

My conclusion to all of this is that risk of real economic activity materially growing in 2010 is low.

What are the risks of real economic growth in 2010?

Stimulus Spending

The most substantial risk of real economic growth in 2010 is that 77% of the $787B stimulus package has yet to be spent.  My principal counterpoint is that the vast majority of stimulus is tax cuts, state aid, unemployment programmes & health-care.  Other than tax cuts, these measures only stem some of the bleeding.  There is no great productivity or efficiency project:  no Tennessee Valley Authority or Hoover Dam.  Most states are quickly running out of (or already have run out of) unemployment insurance money, and are not far away from mass layoffs and wage slashes.  The remainder of the stimulus will treat the bleeding first – and likely not much more.

My second counterpoint is that if we actually did undertake large efficiency project (like solar/nuclear build-outs, or mass transit in a serious way), $80 oil would be a wistfully pleasant number of the past – much like $15 oil is today.

Housing Prices Gaining Traction

Existing home sales volume has been crushed – it is near cycle trough, and the median price has set a new trough low.  38% of existing home sales were distressed.  New home sales have been falling every month since the small rebound peaked in July of 2009.  The only thing holding up the low-end is massive government government support.  With the tax credits expiring for first-time home buyers, and without further action, we’re going to see lower real estate values.

I’m unsure if Obama or the Democrats have the political capital left to pull off much here.

Record low (<20%) home equity reinforce the inelasticity of wages.  As global competitive pressure is put on inelastic wages, this will continue to crush housing.

The final negative pressure is housing inventory, which sits at 3.27 million houses – a 7.8 month supply.

There may be one final push to move houses as spring arrives, and before the first-time credit expires.

US Equities

The S&P 500 P/E is sitting at a very average 20.33.  The earnings multiple curve remains steep.  This is typical in an early business cycle, but we seem to have already passed a tipping point where consecutive earnings surprises have turned into disappointments.  Look at earnings day performance for many of the biggest companies in the S&P 500:

  • Microsoft: -3.34%
  • Google: -5.66%
  • QCOM: -14%
  • JP Morgan: -2.26%
  • Goldman Sachs: -4.12%
  • Pfizer: -2.31%

It’s becoming more difficult to beat expectations, and companies will have to engage in earnings management to meet or beat moving forward.  This would imply that they could likely continue to beat on paper for some time, but that’s very negative for GDP out a few quarters.

This should at least mute stock performance for the next few months.  As a consequence, I’m writing vertical call spreads on SPY to earn some income while I wait for something more interesting to happen.  Given the macro environment, I’ll be shorting ES futures directly on the 200×50 MA cross.  I will reconsider my options and ES shorting strategy if we see a meaningful improvement in unemployment and housing prices without corresponding yield & oil hikes.

My suspicion is that we will see the down-draft in the 2nd half of 2010, after earnings management becomes more difficult, high energy & rate input costs, and the European debt crisis comes to a head.

Until then, I am going long periodically on the RSI-2 mean reversion as long as my risk index remains positive.

Canadian Dollar:  A Tale of Two Economies

For many years, the Canadian economy has been a strong exporter.  The nation’s productivity is reflected in the numbers: over the past decade, Canada has a net surplus of 531 billion dollars – more than twice what Revenue Canada takes in income tax every year.  In 2007, exports comprised of 35% of Canada’s GDP.  Canada’s economy is clearly inexorably dependent on it, and any decline is keenly felt around the country.  This mighty aggregate savings has driven demand for the Canadian dollar.  At the same time, more than 400,000 manufacturing jobs have disappeared since 2002 largely because Canadian dollar strength has made it too expensive to manufacture in or buy from Canada.

There have been some misdirected cries by unions to curtail investment in tarsands oil projects, which strengthen the Canadian dollar as oil demand grows.  That would be like trading a position of strength for a position of weakness.  It does illustrate that Canada is a Tale of Two Economies.  The economies in the Eastern half of the country are driven by manufacturing and exporting durable goods — cars, in particular — to the United States.  For this to be effective, the Canadian dollar needs to be closer to 77 cents than parity.  In contrast, the economies of the West require high oil prices for the tar-sands projects to be economical.

Beloved Canadian Prime Minister Pierre Trudeau led Canada the last time the Canadian dollar flirted with parity.  He was driven out office when he let the currency appreciate, and the US manufacturers left for more competitively priced labour.  Canadians are once again close to the same point.  Speculators have treated the Canadian dollar like a developing world resource currency — a currency proxy to oil.  There are some serious problems with this thesis – mainly that Canada is an advanced manufacturing economy which is dependent on exporting durable goods to the USA using cheaper labour as a competitive advantage.

This Tale of Two Economies provide fairly hard limits on the upside and downside of the Canadian dollar:  the longer as the Canadian dollar is near parity, the more Canadian economic data will deteriorate as Canadians lose their well paid manufacturing (& services to manufacturing labour) jobs.

At the same time, a Canadian housing bubble is brewing.  Yes:  Canadians are mimicking the same conversion of productivity into debt that their American cousins did between 2004-2007.  I’m not willing to short this directly, yet:  a bubble can stay longer than I can stay solvent.  The chief reason I believe that this bubble will be more short-lived than the American analogue is the state of the economy as it relates to currency strength (and corresponding manufacturing weakness), as well as the structural limits imposed by interest rates & energy inputs on its biggest trading partner, the United States.  Except in Alberta — and only short-lived there — these conditions will not support the wage growth necessary to sustain housing price inflation.

This leads us to complete our Canadian economic trifecta of doom:  much like the mid-late stages of the US housing bubble, prices are supported by credit growth.

The great myth is that Canadian banks are better regulated than their American counter-parts.  This is largely bullshit.  There are some differences:  Canadian banks did not engage in the kind of securitisation & poor quality lending that is largely blamed for the American credit crisis.  The problem is that the small fraction of US mortgages that sub-prime comprised of didn’t take out the US economy:  they were merely the canary in the coal-mine.  On the other side, Canadian banks have something even scarier:  no fractional reserve limit, and poorer reporting requirements.  We really won’t know how many skeletons are in Canadian banking closets until they would need to raise more capital than is largely suspected they need.  Follow the interactions between the Canadian banks and the credit markets to track this issue.  This will potentially be aggravated with a housing bubble — in its final stages, supported by credit growth — popping.  There could be a lot of skeletons here.

There isn’t a trade against banks, yet, but I’ll be watching closely, and probably shorting Canadian banks on something simple like the 100d MA.  The Canadian dollar is a different story:  I’m writing options against parity, and shorting it on 100d MA crosses.  The principle risks associated with shorting the Canadian dollar are higher oil prices, and the Bank of Canada raising interest rates prematurely to snuff the housing bubble.  I don’t think either are likely, but I am still mostly comfortable with the resulting economic changes:  anything higher than $80 oil will have long-term demand destruction, and a housing bubble murdering rate-hike will take the rest of the economy — and almost certainly the banks — with it.

February 27, 2010 Posted by | Uncategorized | 1 Comment

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,


December 26, 2009 Posted by | Uncategorized | 1 Comment

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?

S&P 500 Forward P/E For Nov 20, 2009

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 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.


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.


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.

November 23, 2009 Posted by | Uncategorized | Leave a comment

Global Market Overview

S&P 500 as of November 1, 2009

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.



November 2, 2009 Posted by | Uncategorized | Leave a comment

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.

October 5, 2009 Posted by | Uncategorized | Leave a comment

Observations & VIX Interpretation

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

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

2003 Bottom

2009 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.

September 12, 2009 Posted by | Uncategorized | 1 Comment

State of the Global Markets


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


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.


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 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.


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.

September 7, 2009 Posted by | Uncategorized | Leave a comment