The Fed Did the Right Thing

Not because they agreed with I posted yesterday, but because they told investors, as much as they can, what they are going to do going forward. They have rightly adjusted expectations while giving themselves flexibility.

Caveat Emptor

This is another in the series of pre-Fed postings, while we wait for some discussionable (is that a word?) news.

Last night, while cleaning up, I was flipping around the channels and I came across Jim Cramer and his Mad Money show. He was pounding the table, in a less-than-usual animated fashion, on Brazil, and specifically Banco Bradesco (BBD). He rattled off a whole host of reasons why you should buy Brazil, all of them valid. He stressed buying the ADRs, rather than the local (ordinary) shares, also sound advice, for the most part. He even admonished himself for a Brazilian pick earlier in the year, Bradesco vs. Itau.

What Cramer neglected is the history of investing in Brazil. Investors with little experience in Brazil and elsewhere in emerging markets don't realize how fast money can exit these markets. To be fair, I don't know what Mr. Cramer's experience is relative to Brazil. I do, however, know mine. I know that a good chunk of the gain is currency-related (Yes, ADRs have currency risk. You are buying a dollar-denominated proxy for the local shares. Even if the underlying shares don't move in price, the ADR value will fluctuate with change in value of the US dollar relative to the local currency) The BRL is up a ton this year vs. the USD; that probably won't happen again, at least to the same degree. It wasn't that long ago that the BRL was devalued in order to bail out the economy. This, among other things, helped push Argentina over the edge into bankruptcy, as they are large trading partners. Finally, Brazil is one of the most opaque markets in the world. The rules of normal business practice and laws to protect investors are nowhere near the level of transparency that you would find in a developed market. Locals control much of the business and information flow in Brazil, and that isn't going to change anytime soon. The bottom line here is also the title line: Caveat Emptor.

For The Record...

As is now customary, I will go on the the record about what I think the Fed will do tomorrow. So far, I'm 0-for-1, for those of you keeping score. The Fed will cut both rates 25bps, really for no other reason than they have primed the market with that feeling. Fifty basis points looks aggressive here, especially give equity prices, but, in fairness, I said that last time. Postponing a cut until December is inconsistent with Fed actions in general. Rarely does the Fed do one and done. What will be most important about tomorrow's announcement will be what they say going forward. The Fed needs to throw something to currency market, to at least keep the decline of the dollar steady. What would work would be a statement to the effect that the Fed is going to gauge the effectiveness of recent cuts on the economy, markets, etc. They can get away with this because it is generally accepted that it takes some time for these moves to filter through the economy. Then they throw in the boilerplate language about standing ready to act if necessary, yada, yada, yada, to keep equities from selling off 10%.

With one more meeting this year, the Fed is in a tough spot. They don't have as much room to maneuver. Next year, being an election year, the Fed will be more hesitant to act. There is no incumbent up for re-election, so it does give them more flexibility. They may not need to do much more anytime soon. However, the Fed need to telegraph its thoughts now that it can't solve the subprime crisis or bail out homeowners that bought more than they could afford by themselves; market-based solutions are what is needed in both cases. Otherwise, it will be a tough '08.

The Next CEO of Merrill Lynch Is...

Since there is a Fed meeting this week that has meaning and given the dearth of other news in the financial world (Riding on a plane with Warren Buffett on his trip to China does not qualify as breaking financial news, sorry CNBC), all eyes are focused on Stan O'Neal's departure from Merrill. Whether or not you think his exit is justified, his leaving has become a foregone conclusion now that he went behind the board's back, the same board that put him into that job over other, some would say, more qualified candidates. Merrill seems to go through these gut-wrenching fits every five years or so. They get into trouble when they stray too far away from what they do best, catering to the needs of private clients. That certainly what has happened here with these massive credit market exposure writedowns. It happened back in '98 after another fixed income blow up, Russia. Then, they exited a fixed income sector that I traded at a large competitor. I had one of the best months of my career, picking up Merrill's inventory on the cheap and having one less major competitor to deal with. For Merrill, this cycle is nothing new. What's different is that this time it goes all the way to the top. Stan O'Neal never enjoyed the unquestioned support of the 15,000 financial advisors as previous CEOs did. He wasn't one of them.

Who's next? Page C1 of today's Wall Street Journal has the pictures of the likely candidates: John Thain; Greg Fleming; Bob McCann; and Larry Fink. I'm going to shoot all of their candidacies down, knowing full well by the time I finish writing this one of them may have already accepted the job, and make my own suggestion. John Thain already was president of Goldman; why would he want the Merrill job? Besides, Thain wants Chuck Prince's job. Fleming knows the markets, but as far as the Merrill FAs are concerned, he's just another Stan O'Neal. He didn't come from their ranks and would not be acceptable to the FAs. Bob McCann would fit that description as far as Merrill's brokers are concerned, but he know little about that troubles the firm currently faces. Still, McCann would be the safe choice by placating the salesforce. That leaves Larry Fink. He certainly is the best all around candidate, but he has it pretty good over there at BlackRock. I'm not sure he wants to leave to take the Merrill job. It is also questionable how much of an outsider, which seems to be the consensus as to whom would be best for Merrill, Fink is , as Merrill owns 49% of BlackRock.

Having said all that, and not trying to be too self-serving, but I would like to put forth yours truly for the Merrill CEO position. I am definitely an outsider, certainly have the fixed income experience, and am very knowledgeable as to the workings of a large retail brokerage firm. So, if anyone on the Merrill board is reading this, except Stan O'Neal and Bob McCann of course, feel free to contact me at your convenience.

Foresight is 20/20

http://www.bloomberg.com/apps/news?pid=email_en&refer=rates&sid=axTqfaTiLf4I

Just a quick note on a Friday. The above link is to a Bloomberg article on Argentine debt. Surprise, surprise that the value of these securities are in question. This is an "I told you so". All I can say is caveat emptor. There can't much sympathy for those that bought these securities and the accompanying warrants given the bankruptcy, the lengthy restructuring, the hardball tactics, the opacity of the structures' valuations, the limited convertibility of the currency, and the headlong rush into the arms of the likes of Hugo Chavez. Well, greed can be blinding. Have a good weekend.

The Demise of the Bond Trader

The big losses being racked up by the banks and brokers these days can be directly attributable to one thing: the demise of the bond trader. More specifically, it is the demise of the art of bond trading in favor of the science of bond trading. Since the advent of widespread use of computers on Wall Street for valuation purposes, the art of bond trading has been pushed into slow but steady decline. Twenty years ago, the most sophisticated piece of equipment on a bond trader's desk was a Lane or Monroe bond calculator. It was the explosive growth of repackaged MBS pass-thrus (CMOs) that created the need for more sophisticated methods of determining value. Back then, the real prestige item for Wall Street firms was a Cray Supercomputer (do they even exist anymore?), used in calculating all the cash flows and other variables that went into structuring a CMO. The rest is history. There have been hiccups along the way, most notably in 1993-4 when the mortgage prepayment models didn't adapt to the changing interest rate/product environment and in 1998, when genius failed, as the book was so aptly titled, to account for reduced liquidity. It turns out, or perhaps more correctly, will turn out that 1998 was just a warmup for 2007. When the art of trading finally pushed back against the science, liquidity ran for the hills.

I'm no Luddite. My writing this blog should prove that. Nor am I suggesting that the world go back to writing prices and spreads down on little pieces of paper taped all over the desk. The problem comes about when a mathematical model completely supplants common sense. Management, for the most part, loved this because a model provides a definitive answer. Management could then take the model-derived answer and show it to the CEO, Board of Directors, major investors, regulators, etc. and say "See, here is our exposure, here is our risk, and here is what we've done to mitigate it. You may rest assured, now." As is publicly known now, and privately talked about for awhile, the inputs that were used to generate these model-derived values, particularly with regard to liquidity, were faulty to say the least. The models, generally very complex mathematical formulas taking into account a whole host of variables, are developed by some of the finest technical minds in the world, but have little practical market experience. Many are PhDs in the "hard" sciences, Physics and the like. Most of the people that use the models are not finest technical minds in the world, but have some or much practical market experience. Therein lies the disconnect. The consumers of information, always looking for better and faster ways to make money (a good thing, by the way), have become so reliant on the neat answers that models provide them that they ignored common sense and forgotten how to trade and the risks of trading.

If there is one lesson learned by all of this, it should be that the decision makers and risk takers need to get in touch with their trading roots and apply good old-fashioned common sense to the model equation. Securities that are packaged and repackaged and repackaged and repackaged again deserve more scrutiny, on all levels including rating, then they have received in the past. Values need to reflect all the risks, including the risk that the value may not be able to be determined. Maybe then, the trader's "bid out" would have happened sooner, sparing many the problems of the past few months. Probably not, but it is a wishful thought. The good news is that some happy medium will develop, new methods will arise, and the bond market will go on its merry way.

Back to August

Merrill Lynch announces a much larger than expected loss, coupled with weak home sales numbers and the pundits are coming out of the woodwork, falling all over themselves to demand that the Fed cuts rate 50bps next week. An analyst on CNBC went further this morning, saying that Hank Paulson's involvement in the creation of the SIV buying facility (designated M-LEC, or designated by me as BOSTONS-Buyers Of SIVs That Others Nevertheless Spurned) was really his way of begging the Fed to cut rates. Not surprisingly, Fed Funds futures are now leaning toward a 50 bp move. What is ironic about this is that the same people who were up in arms about the government (including the Fed) not acting fast enough are still up in arms or at least suspicious, about the government trying to help. Even with videotape and YouTube, TV has a short memory.

The bottom line here is that there are assets on the books of many firms that still have the valuation problems. At this point, that should have been worked out. When a valuation problem occurs, it is imperative to mark an asset to an appropriate level. Sometimes it is difficult what that level might be. At the end of the day, something is only worth what someone will pay for it. Too many times in my career did I come across the theoretical values guys out there, saying a security is worth X because the model says so. This Merrill announcement, and probably more to come from others, tells us that the model devotees are still holding sway. The value of Google stock is readily quantifiable, but the value of SIV-123abc isn't. When in doubt, mark it to a conservative level. When there is no real bid for an asset, the mark should represent the worse case scenario if that asset had to be sold. Clearly, the owners of these assets haven't gotten to that level yet. They are hoping the market bails them out, which is why they set up the M-LEC as a transitional facility until previous liquid market condition return. Then, M-LEC is a home run as it was able to pick up cheap assets.

In the end, it is the role of capitalism to punish entities that get valuation wrong. There is still a way to go, but the system will work and, in the end, economic growth will continue.

The Case For Sound Advice

'Sell all your mutual funds and stop being ripped off'.



Here is the link to this article http://www.marketwatch.com/news/story/sell-all-your-mutual-funds/story.aspx?guid=%7B4B8CD1AC%2DE5B4%2D46E0%2D9C24%2D03B45347A67F%7D

Basically, the author says that the fees they charge are not justified by returns. He also goes into a rehash of the mutual fund scandals of a few years back. He suggest index funds (ironically, offered by mutual funds) and ETFs. With these investments, the embedded fees are low (not including commissions charged at the point of sale). The case could be made that in these index-type investments, you get what you pay for. Owning an S & P 500 index fund maybe great for low expenses, but does it fit with your goals?

The point here is to get a hold of some sound advice. Work with an advisor and develop an investment policy statement, outlining your goals and objectives while taking into account your risk tolerances. Planners and advisors charge for the value of their information. If they do a good job, as defined by your investment policy statement, they should be compensated a fair amount. Mutual funds may be part of this mix, in some cases they may be the only way to get involved in certain sectors. However, take the time to understand the all the costs and loads involved.

Finally, mutual funds may be the best way to execute an investment policy. For example, if your total investable funds are only $50,000, you probably can't get financial planner for a reasonable fee (many have minimums). Putting together a diversified portfolio of investments may not be possible without use of mutual funds. Be mindful of the costs. If professional help is not practical, draw up your own honest and common sense-filled investment policy statement, delineating what you are trying to do and what you are willing to do (how much risk are you willing to take on) to get there. Stick with it, refer to it, and update it from time to time as needs goals, and risk tolerances change.

The Patron Saint of Bond Traders

Just a picture from the shrine of the patron saint of bond traders, Santoliquido.

What To Do, What To Do....?

The stock market goes up, then it goes down, then it goes up, and then it goes down. The main concept that needs to be remembered in this environment is the difference between being a trader and an investor. Although many of my friends are employed as traders, when it comes to their personal financial situation, they are investors, either voluntarily or by corporate mandate (you know who you are). While this is a great time to be a trader (if you know what you are doing, of course) as traders love volatility (the way to make money as a trader is to buy at one price and sell at a higher price in a relatively short period of time), it is an unsettling time to be an investor. With the amount of financial information and commentary available to people, a filter needs to be put in place to regulate what is really important. Here a just a few things to keep in mind, regardless of your situation. First, what is your time horizon for any given investment? If you are 43 and the money is in an IRA, you really shouldn't be concerned about day-to-day, week-to-week, or month-to-month moves, as long as you are comfortable with your investment plan. If it is money being used to buy a house in three months, that is a different story. Second, what is your risk tolerance? Some people are very comfortable to be invested 100% in equities and real estate. Others don't want to put there money in an FDIC-insured CD. Only you know your risk tolerance. A good financial advisor should be able to define and quantify that for you. Finally, what percentage is in what? Even you are the most conservative investor, you might 5% of your money in a hedge fund with massive sub-prime exposure. At the margin, this is your most risky asset. Are you prepared to lose it? Are you prepared for that investment to take ten years to rebound? Again, only you can answer that question.

While you are watching CNBC and the market is moving up and down, keep in mind who you are, what you are invested in, and what your time horizon is. These periods of volatility are good times to review strategies with your advisor to determine if you investments are properly positioned for your needs.

It's The United States, Stupid

Well, it finally happened. CNBC, specifically Mark Haines, admitted this morning that they change their views more than daily depending on their guests' opinion. Today, amongst all the positive earnings from US industrial multi-nationals, they had a series of guests bashing the US economy. Guess what, the US economy is weak, led by housing. Foreign economies are showing signs of strength, but it is not the monolithic picture that it is made out to be. The worst guest of all, an American no less working for Credit Suisse in London, made a self proclaimed unpopular statement that the US is no longer the center of the universe, that it is the middle class of emerging markets driving the world economy. It is sad that CNBC puts people like this on without presenting a balanced view or asking the guest hard questions (they do, when it suits the host's personal agenda, on both sides of the spectrum).

There is only one question that needed to be asked of this analyst. Here it is: What created the conditions that allowed a middle class to form in these emerging markets, or the developed markets, for that matter? It's the United States, stupid. Is there really anyone sane out there that thinks the world's economic situation (or political) would be better off if the US hadn't acted the way it did over the past 60 years? Before I get 1000 posts, yes the US made mistakes along the way. The worldwide benefits of a global economy are starting to be realized, particularly since the fall of the Soviet Union. Emerging economies, sources of raw materials and cheap labor, starting from low bases are of course experiencing faster growth. The US created the conditions that allowed for this growth. The US continues to grow rapidly. There is no other country on Earth that approaches the size of the US that is as dynamic as it is here. Sure there is emerging market growth now, but what happens when these markets mature? Will they foster a spirit of openness and free trade? Will they resolve their massive domestic problems? When Brazil runs out of trees to cut down and iron ore to dig up, will the masses go back to accepting the massive wealth disparities that have and continue to exist there? When China runs out of cheap labor, brought on more quickly by a "one child" policy, will they retreat into another Cultural Revolution? Will Russians continue live with (or not) a declining life span and turn further back toward dictatorship? If the world is relying on any or all of these scenarios to take the place of the US in world leadership, it would be overly optimistic, to say the least.

As for the commentating world fretting about US domestic demand, that story plays well somewhere, however not CNBC's audience. If the US economy makes up 20% of the world's economy, then Caterpillar, Honeywell, etc. should be selling 80% of their products elsewhere. They can, thanks to the conditions created by the United States.

Just Walk Away...

It took longer than expected, but finally an article appeared about people walking away from real estate as their equity turned negative (Wall Street Journal, page D1). The story chronicles two people that got caught up in the real estate price frenzy, only now to consider defaulting in their mortgages and/or filing for bankruptcy. In many ways, it parallels the situation that occurred in the US in the late Eighties and early Nineties. In many ways, it doesn't. Before the various governments here start bailing everyone out, a few points need to be kept in mind.

The first is that, in many cases and certainly in the high growth bubble real estate, is that many of the "walkers" today are not owner-occupiers, but rather investors that got overextended. Fifteen, twenty years ago most people got in trouble were in their own homes, caught up in an extended downward move in real estate prices, exacerbated by over building. The market eventually worked its way out of that (helped in areas like Florida by Hurricane Andrew) but it took time. These days, with information flows much faster, the up and down cycles are shortening. There is a concern that these foreclosures and bankruptcies will force the renters in these investment properties out on the street. If the governments want to step in with moral suasion here (not legislation), go right ahead. Banks should be convinced kicking these people out on the street isn't in their best interest. At least they are receiving income while the market adjusts to new levels.

The second point is that all the new mortgage options coupled with reduced/ignored credit quality/issues has helped facilitate the problem. While the popular press has focused on the 89 year old homeowner duped into taking out the mortgage they didn't want or need, the reality is that most people, investors or homeowners, overextended into houses and mortgages they could not afford. If there is fraud involved, by all means go after them. If not, the parties involved need to take their lumps. Again, here is case where the moral suasion of government should be used to renegotiate the terms between mortgagor and mortgagee. Like the other credit issues in the market, there has to be an accounting and a reckoning of the risks taken, on both sides.

Score One For The President

Everyone knows, courtesy of Bill Murray, that the Dalai Lama is a big hitter, but the fuss being generated worldwide over the ceremony today is over the top. The Dalai Lama is being awarded the highest US civilian honor, the Congressional Gold Medal. The ruckus in Beijing over this is nothing short of ridiculous. The Chinese are starting to believe all the press written about themselves if they were under the delusion that the could order (yes, order) or threaten (yes, threaten) President Bush into not attending the ceremony.

Let's, for the moment, forget that the leaders of this Congress (the ones with single digit approval ratings) are giving the Dalai Lama this honor specifically to irk the Chinese and embarrass the President (why do you think it is happening during their five-year party congress?), this Dalai Lama isn't even advocating a separate state for Tibet, much to the consternation of many Tibetans. Why are the Chinese so upset? First, it take the focus away from their show. There isn't any real concern on their part about a Tibetan separatist movement or the US support of it. Second, and more important, it is the Chinese tit for tat regarding the US (and others now) constantly berating them about the value of the Yuan. Finally, as mentioned above, they think that because of their size everyone is going to back down. They go Mattel to apologize to them, unbelievably, why not the US government.

Fortunately, President Bush isn't going down that road. Instead, he took the high road, saying the honor is for the Lama's religious works and gave those who tried to back him into a corner nowhere to hide. On CNBC, the buzz was what this might to do US-Chinese trade relations. The answer is nothing. The Chinese aren't going down that road with the US. Without the 8-12% growth provided by exporting here, the Chinese government wouldn't last very long.

It Was Twenty Years Ago...Fri-day

Nothing to do with Sgt. Pepper or the Beatles, but Friday is the 20th anniversary of the '87 market crash. Back then, market professionals were huddled around their Quotron and Bunker-Ramo machines frantically hitting the Enter key to see how much the Dow dropped. The long bond traded up with 5 different handles as investors ran for cover. The NYSE's new electronic system, which could handle all of 95 messages per second, was quickly overwhelmed, not that it mattered as almost all trades were done by pencil and paper. The tape was hours behind. The specialist system was strained severely, but didn't break or collapse.

Over the past few weeks, the equity markets, ex NASDAQ, have traded to new highs. The last few days, reality has set in as stocks have weakened. The battle out there still continues over who is right on the economy, the stock or bond market. The answer depends on who you ask and when you ask it. For a couple of weeks, since the brokerage firms reported earnings, the market seems to have forgotten about housing/mortgage/sub-prime situation as those brokerage numbers came in at or above expectations. The euphoria has ended with the reality of the banks' earnings. It may change later this week as more tech earnings come out.

The real answer is that, ex housing, things are looking pretty good in the US. There is a lot of excesses that need to be worked out in that space. Individual companies may or may not do well in this environment. Certainly banks are having issues. Banks and brokerages make up most of the liquidity in fixed income markets. Other entities like hedge funds that might normally step in here are restrained by tighter credit, valuation problems, and redemption events. The real, meaning not Wall Street, economy must be kept in focus through the noise.

SMLEC

That isn't one of the easier acronyms to pronounce. Usually the financial geniuses come up with better names that roll off the tongue like REMIC, Iboxx, or ToPrs, the more complex the structure, the easier it is to pronounce. For example, the raison d'etre for SMLEC (or M-LEC if you read the Wall Street Journal) is to create a orderly (aka not free-falling, not unpriced) market for SIVs and SIVs-lite, which, as can be surmised, is easy to pronounce, yet all the kings horses and all the quants on Wall Street can't get a handle on their value. My thinking is that this came up so suddenly, that the marketing teams didn't have time to produce something catchier.

Just so no one trips over themselves, SIV stands for Structured Investment Vehicle and SMLEC means Single-Master Liquidity Enhancement Conduit. Personally, my choice would be BOSTONS-Buyer Of SIVs That Others Nevertheless Spurned. It is a little more accurate and definitely more descriptive. On the face of it, if this "buyer of last resort" helps liquidity in the front end of the market, it will be a success. The Wall Street Journal seemed to be somewhat in a snit that the Treasury was involved in this in some way. As long as they aren't putting up tax money to finance it, this is the kind of action they should be doing to get markets moving.

The other concern is that is just another way for the big banks to keep this stuff off balance sheet. This maybe true, but these items are already off balance sheet. I seriously doubt that J.P Morgan and B of A are going to create a fund for the sole purpose of bailing out Citi, the most heavily involved bank. It must kept in mind that this is a work in process. It also must be remembered that this isn't the RTC, the entity set up to restructure S & L's and their assets/liabilities. The very existence of this fund maybe enough to stabilize this market, without much of the fund being used. The should help the cream rise to the top, leaving SMLEC to unwind the rest, at a tidy profit for its investors.

$29 Billion

Yesterday, the Commerce Department released the trade deficit figures for August. Even though the number came in better than estimates at $57.6 billion, it is still a huge outflow that must be offset by capital account inflows. However, there are many positives to look at here. It could be much worse, given all negatives floating around. The most serious long-term negative is the increasing protectionist sentiment in Congress. They seem to be most insistent on pushing the US back to the economic glory days of the Jimmy Carter era, or worse by foisting upon us a Herbert Hoover-era, Smoot-Hawley-like, Depression-creating tariff. It shouldn't be surprising that Congress has an approval rating approaching the single digits. Maybe they should stick to censuring the current Turkish government for the ninety-year-old actions of the Ottoman Empire, but that is the subject of another post.

Which brings me to $29 billion. The figure represents the total value of petroleum products that the US imported in August. I'm no mathematics expert, but that works out to about $1 billion a day. That number also works out to almost exactly one-half of the trade deficit number. Given that the price of oil has moved higher at a fairly regular pace over the past few years, that deficit number has grown. None of that part of the deficit is with China; they make up a large part of the other half. The biggest single recipient, surprisingly or not, is Canada, which explains the 30-year high in the C$. The rest of it goes to the usual suspects in no particular order: Saudi Arabia; Mexico; Venezuela; etc. Every time the price of oil goes up, the deficit will get worse, despite all of the Chinese-bashing tariff that can be put in place. The weaker dollar contributes too (even though commodities are priced in dollars, as the dollar weakens, producers adjust their prices accordingly to make up for the reduced purchasing power), although it is far less significant and is probably more than offset by increasing exports.

It is this side, the energy side, of the trade deficit that is the real problem. It is the one that needs to be addressed, not the politically expedient goods side that gets all the attention. Of course there are problems with the goods deficit that need to be addressed, but the discussions need to be limited to the high value goods that can be profitably competitive with area of the world that have unlimited supply of cheap labor. Let them make the cheap stuff (And don't apologize to them when they are in error, call them out on it. This means you, Mattel). As stated in previous posts in this forum, $80 dollar a barrel oil opens up many opportunities for alternatives in the US that weren't feasible at $30/barrel. Conservation, cleaner coal, oil shale, solar, the list goes on and on. The US government should embrace this opportunity and lead the nation into the post-imported oil epoch.

Another Follow-Up

Long-time readers here know that several posts on the blog have been devoted to the relative price movements between oil and gasoline. Oil has skyrocketed while gasoline hasn't moved this year. This relationship is beginning to manifest itself in lower earnings for domestic suppliers and refiners. If the cost of raw materials (crude oil) goes up and the finished product (gasoline) stays the same, margins get squeezed. Yesterday in the Wall Street Journal there was an article on whether the next move for oil is $100 or $50. While this is obviously important, it is really the price of the finished product (gasoline) that really matters.

Here's why I think oil should be capped around this level (barring some external shock). First is slower US growth. While the rest of the world seems to be doing well, the US still makes up a large percentage of the world economy. Second, with oil sustained around the $80 level, more supply will come on line. This takes time however. The longer the price stays up here, the greater the chance for increased supply. While the Saudis will want to push the price down to a level where they can keep this additional supply off the market as their cost is below $10/barrel, it won't get to that level soon. The good thing is that much of this new supply will be domestically produced. Similar to oil sands of Alberta, the Western US has huge reserves of oil, although much of it is trapped inside of shale. At $80/barrel, this can be produced profitably and without the externally generated political risks. The third point is that at these price levels, substitutes, primarily ethanol, are attractive and coming on line in an increasing rate. If the government lifted the 52 cent/gallon tariff on imported ethanol, its price would come down and use increase. The last point, plus the expansion of domestic refineries (finally), will help keep gasoline prices down.

In The Short Memory Department (Redux)

Well, look at the stock market now. For example, on Aug 15, Goldman Sachs' shares could have been had for roughly $165/share; yesterday the stock closed above $239/share. I pick Goldman for two reasons. The first is that being a financial powerhouse, it was in the center of the credit market maelstrom. The second is that as a well-run organization, Goldman has weathered the storm. A 75 point move, or 45%, in less than two months is nothing short of spectacular. Critics would state that Goldman was down almost that much before the credit market crisis, which is true. Most financial firms were down, and many have not come back. It is not worth listing them; you know who they are. The same critics would also say that Goldman is really a hedge fund, not a Merrill Lynch or Lehman. That may also be true, and they may take on more risk than their competitors. Goldman also seems to manage it much better than their competitors. At 9+ times earnings, it is certainly not out of line with these same competitors.

The bottom line here is a theme that has been stressed many times here, don't panic in times of crisis. During these times, there are always winners and losers. If you are a long-term investor, this kind of event is going to happen periodically. If it works, stick with your plan and adjust it if necessary. Try to rise above the noise. Step back from the constant stream of financial information if it helps you focus on what is important.

Little Montenegro down on the Adriatic Sea

To begin with, anyone that guesses what book the title of this post came from gets extra credit. The EU's finance ministers warned Montenegro not to unilaterally "Euro-ize" as it is incompatible with EU law. In order to adopt the Euro, countries must meet certain financial criteria, although the EU has bent the rules before. When Montenegro split from Serbia last year and became independent, using the Euro was the most effecient and expedient thing to do rather than create its own currency. In fairness, the warning was less directed at Montenegro than at EU member states that may try to backdoor their way into using the Euro without meeting the criteria.

On the other hand, it would be thought that the EU would happy, nay thrilled, to have some legitimate entity wanted to use their currency. Until now, only rogue states (Saddam Hussein, Iran, Venezuela, etc.) looking to thumb their nose at the US and criminals (the 500 Euro note, being highest value, widely circulated paper currency in the world) looking for portability of assets were only ones voluntarily adopting the Euro.

For all of Europe's talk about becoming the world's next reserve currency, this is just another point, along with an underdeveloped bond market, showing they have a way to go. If Montenegro wants to use someone else's currency, they should try the US dollar. They would be welcomed with open arms.

reader update

Yesterday, this blog received it 500th hit, which may not seem like much but it puts it in the top 2% of blogs worldwide. I've had readers from as far away as Europe and Asia, but the vast majority have been from the US. For those of you that are regular readers, thank you. Finally, for those of you that think I'm getting rich off of this, Google tells me that this blog has generated $3.80 in ad revenue over the past two months. They don't pay out until it reaches $100. I always thought Google was overvalued, but maybe I was wrong. With all of this blog ad cash they are sitting on, perhaps the stock deserves to be at $600/share.

Told You So...

Instant analysis. This is a textbook example of why not to look at these month to month headline numbers. A minus-4 to a plus 89? You don't want to know what that difference is on a percentage basis (In fact, it can't be calculated). The trend over 2007 of about 100k job gains per month is probably weak enough to give the Fed cover to cut 25 bps on Halloween, especially with the dollar moving higher. On the other hand, they might go back to worrying about inflation and take a wait and see attitude. I'm inclined to think the former, as the Fed doesn't want to appear as being too indecisive, given their last statement, lurching from number to number. Have a good weekend.

Another Month, Another Employment Number

Here we go again. Just by observing some anecdotal, very unscientific evidence, the 100k gain in jobs the consensus is looking for seems to be too high (I have a lot of time these days to conduct these surveys). Add in the announced job cuts and factor in that new home construction has fallen off the map, the number should be weak. Yet, who knows? Those of you who know me or have been regular readers (I got a page hit from Qatar yesterday, goin' global) know my feelings on the employment numbers. In a nutshell, in and of themselves, employment numbers are next to nonsense. We are relying on the 50 state bureaucracies, plus assorted commonwealths, territories, and districts, to provide timely and accurate information to be complied by another bureaucracy. Any number where the revision gets as much attention as the headline has to suspect. In the aggregate, looking over months of data, employment figures become useful in spotting trends.

The bond market thinks it is going to be weak, judging by the recent move in rates, all but assuring future cuts. The equity market isn't so sure. After taking the major averages, ex NASDAQ, back to their recent highs, the rally stalled. A weak number probably means further Fed rate cuts, especially since this is the last monthly number before the next meeting. It also means slower growth, at least domestically, capping further earnings gains. What a conundrum!

How, in general, should you play these numbers? Investors should basically ignore them, using them only to determine the direction of long-term trends. Trying to trade the bond market based on the hot number of the month, whatever it is, will most likely give you whiplash. Let the professionals lose money in the half-hour after the number (although it is a zero-sum game, somebody wins). If a number (or revision) prints that few expect, there will be wild swings in prices, exacerbated by the lower, albeit increasing, levels of liquidity in the fixed income market. The hour after a big number can be irrational. Trader's years can be made or broken during that time. By the time the equity market opens at 9:30, instant analysis has been completed and the direction for the rest of the day can usually be figured out, unless there is another big number tomorrow. Happy employment Friday to all, and to all a good night.

The Dollar's Falling, The Dollar's Falling!!!

If I had a dollar for every time since 1980 I read or was told about how it was all over for the US dollar, I could permanently retire with all those greenbacks, despite their fluctuating value. Given its current level, you would have to be blind and deaf to not be aware of the demise of the currency. Today, there is a piece on page C1 of the Wall Street Journal regarding this topic. The columnist tries to inject as fear and doom and gloom as possible right off the bat with the title, “Why the Dollar Won’t Regain Its Past Strength”. He quotes professors from Harvard and Berkeley and trots out some model they developed saying the dollar has 20% more to go. If that is case, then I suggest you call your broker immediately and buy some short-term, non-dollar government bonds. They make it sound like it is a no-brainer, and, who really knows, maybe it is. It can’t hurt to have that kind of exposure and diversification in a portfolio generally.

There have been several posts in this forum regarding this subject. The biggest risk to a weak dollar is inflation. If inflation gets too high, we have problem, and so does most of the rest of the world. There are benefits to a weaker dollar, which are detailed in previous posts. If I had to bet on the US adapting to a weak dollar or the rest of the world having to adjust to stronger dollar, I think everyone knows where I stand. Already, the Europeans are screaming for currency relief.

The other points of the piece are somewhat dubious. The rest of world catching up in productivity isn’t a real surprise as they chuck their electric typewriters for PCs. There doesn’t seem to be any lack of demand for US Treasuries, judging by where they are trading. Finally, the point regarding EM spreads doesn’t mention the supply and demand issues in that market, and it remains to be seen whether EM doesn’t suffer the fate as the rest of the credit market.

Finally, after an informal and unscientific poll of traders, I have yet to find anyone that read this “required” reading on Wall Street desks.

Remain Calm, All Is Well

That was Kevin Bacon's character's line from Animal House just before he was stampeded by the crowd into a two-dimensional figure. It was also the general point this blog was trying to make during the market's nadir in August. Certainly the equity market has taken it to heart. If you had been out of touch for the last three months and looked at the current level of the stock averages, you would think that the market just went into the summer doldrums and was just now beginning to emerge. Technicians will tell you that the stock market is a leading indicator of economic performance. Based on that, we can expect a sharp economic downturn, followed by an almost as sharp economic boom. It seems hard to believe that the housing market in general is going to turn around quickly, given the nature of the market (the transaction costs and time involved are radically different) and the amount of excesses that need to be worked out, although some depressed local markets, Florida for example, could be helped by the weak dollar bringing in foreign buyers. Likewise, the fixed income markets sustained significant damage in the recent turmoil. Banks are starting to disclose the effects of the past three months, taking their lumps and hoping that liquidity flows back in. Like in the housing market, it is hard to believe that appropriate valuations now exist for all these credit and structured products that no one had a clue on a month ago (the only real appropriate valuation is what someone is willing to pay for x or y, not what some model says it is worth). It will take some time for the bond crowd build up their appetite for risk again.

The bottom line is that in this instance, hindsight will be 20/20. If the economy goes into a general (one not limited to housing and related sectors) recession, then the bond guys were right. If not, then the equity guys were right. As a life-long bond guy, I'm inclined to believe the equity guys. The events that occurred in the bond markets over the past few months were strange, to say the least, pushed forward by a blind ignorance of credit risk and the resulting liquidity risk, and aided by the absence of key players during the usual summer slowdown.

Follow Up

No one guessed what those two lines on the graph are. One is the USD/CAD relationship and the other is the USD/BRL relationship. Notice, as the quant guys would say, how they have a high degree of R-squared.

Let Someone Else Worry About The Dollar

As stated many times in this forum, the biggest risk to a weak US dollar is the resulting inflation. It's the Fed's job to figure that out. Let's say that doesn't happen. So, what's the problem? The mass media will tell you about how expensive to go to Europe on vacation. There are three ways to solve that: don't go; economize; or be prepared to spend more. Is this really a problem. Of course not! Here's a better idea, go on vacation in the United States. The money stays here, helps employ people here, and you don't have to go through the hassle of getting a passport, a real problem these days. Foreign tourists, spurred on by a weak dollar, are coming here in droves despite all the complaints about security, visas, etc. They are spending money too, buying things here that are cheaper even without the currency adjustment. If you need immediate evidence of this, take a look inside any book jacket and see the difference between the US and Canadian price. Hop in your car and drive up to the Woodbury Common Outlets north of New York City and watch the busloads of Asian tourists disembarking on shopping junkets (For further proof, the local airport there is gearing up to accept international charter flights specifically for this purpose).

Some of the above is tongue-in-cheek, but in all seriousness, let someone else worry about the dollar. For decades, the world benefited from a strong dollar, exporting anything and everything to the US. These countries decry the low US savings rate despite the fact it is the main driver of their export-based economies. Export growth is triple the rate of import growth. This is occurring without a strong national policy championing exports as exists in other countries. There is even serious talk of exporting ethanol from the US now until domestic distribution infrastructure catches up with supply increases. (As an aside, the price of ethanol has dropped 40% from its peak. This will help the inflation numbers going forward, not so much on the energy side but on the food side as production costs, farmers a big users of ethanol, and supplies balance out).

These foreign countries should push to spur domestic demand rather than rely on weak currencies to bail them out. The US dollar is weaker than it was, but there isn't anyone seriously stating that it is undervalued at this point. In fact, against dollar-pegged currencies, like China, it has a ways to go.

Have a happy Fourth Quarter, 2007.