Thursday, October 2, 2008

The Bailout Plan

People have asked me about the "Bailout Plan" and I wanted to describe what is really going on.

The issue with the “financial crisis” is simply this – banks are insolvent and lying about the price of the assets they hold on their books.

Credit is created by banks lending back and forth to one another. Banks know that other banks are lying about their assets and are afraid that if they lend to another bank, they may not get their money back. So banks aren’t lending to each other right now. They are hording US Treasuries.

The Paulson Plan
How does the Paulson Plan fix things?
The goal of the Paulson Plan is to give the US Treasury a $700 billion pool with which to buy securities. They want this power so that they can fix prices at artificially high levels.

Why?
Say Bank A has a $1 Billion Mortgage Backed Security. Say that this bank is pricing that asset at 20 cents on the Dollar, or $200 million in paper value. Other banks know that the bond is really worth something like 6 cents on the Dollar, or $60 million in paper value. The US Treasury wants to be able to go to that bank and buy a small portion of their holdings in this bond at some fantasy price well in excess of the current “price" or actual value of the bond, say 40 cents on the Dollar.

That will allow Bank A to increase the value of the bond on their balance sheet and declare a $200 million PROFIT for the quarter! This “repricing” will result in banks becoming flush with “capital” and they will be able to start lending again.

That’s the Paulson Plan. Buy overpriced assets with taxpayer money so that the banks can lie about the value of their holdings. Does that sound like a good plan? It sounds highly illegal and unethical to me.

Plan B
When the Congress voted No to the Paulson Plan, the SEC (Securities and Exchange Commission) decided to investigate a Plan B for how to artificially inflate prices of the holdings on the balance sheets of banks.

The SEC Plan
The day after the Paulson was voted down, the SEC went to FASB and asked them to change the rules for how bonds are priced. The role of FASB (http://www.fasb.org/) is to develop the Generally Accepted Accounting Practices (GAAP) within the United States.

FASB 157 is the rule for determining how corporations price the assets they hold. The intent of the rule is to have prices set based on the actual prices being paid in the market for the security or for a security of similar quality and maturity.

The SEC asked the FASB to change the rule, so that companies could now price their assets based not on the current going price, but on some fantasy estimate of the hypothetical maturity value of the security.

At this point I just throw my hand up in the air. The SEC is supposed to enforce the laws to protect the public from transgressions by companies which hurt the public.

The SEC is now instructing companies to lie about the value of their holdings
The credit markets are now frozen because nobody trusts the guy on the other side of the trade
US Treasuries are being horded at the expense of new corporate debt creation
The stock market is imploding because nobody wants to hold rigged assets
The US Government wants to give $700 billion to the US Treasury to further rig the prices of bonds

We are in deep doo doo.

Tuesday, September 30, 2008

Market Roadmap

I know that I am rehashing things, but it is the start of a new quarter, so I wanted to review my Roadmap. This is the chart of the Standard & Poors 500 Index (S&P 500). The S&P 500 ($SPX) is a composite which tracks the performance of the 500 largest companies which trade on US Stock exchanges. As this index goes, so goes the economy. It is a Leading Economic Indicator.

I consider this chart my Bull Market / Bear Market Roadmap, because it makes it easy to see whether we are in a Bull Market and you should be focusing on making money or in a Bear Market and you should be focusing on protecting your money.

Very simply, if the bars are above the Red and Blue Lines, then you should be buying pullbacks into the Red and Blue Lines. If the bars are below the Red and Blue lines, then you should be shorting bounces into the Red and Blue Lines. Pretty simple, huh?

We are now below the lines, so you should not be holding stocks. If you want to try and make money, then you should be shorting rallies into the lines. If you don’t want to risk money, then sit in cash and wait for the next economic expansion.


In January 2008, I alerted clients that the markets had broken down and it was time to get defensive. Those who were late in reacting were advised to sell the first bounce into the Red and Blue Lines.

I made it very clear on a number of occasions this year that I think we are replaying the 2000-2003 Bear Market. This is the second crash since the late 2007 top. The 2000-2003 Bear Market had four crashes. I am not sure if we have two crashes or ten in this Bear Market. But I do know that I will be ready to buy when the Bear Market ends.

I also know that I have avoided the majority of the carnage of 2008. Even with today’s monster rally, the S&P 500 was down 9.21% for the month of September! Yikes!!

In my opinion, you had better know how to play offense AND defense, or you should find somebody who can do it for you.

Currencies

I was asked about Foreign Currencies and I wanted to address the issue. I have written about this topic a lot this year, but again I have not been able to get the information out to everybody and that is why I started the blog, to aggregate all of the information I send out to people.

Here is the historic chart of the US Dollar ($USD) relative to a basket of foreign currencies. As you can see, the Dollar was able to hold support at 80 on several occasions (1991, 1992, 1995 and 2005). The Dollar broke down in September 2007, after the Fed decided to use its balance sheet to rescue the US Financial Sector. Foreigners took the August 2007 emergency rate cut as their cue to abandon their holdings in the US Dollar.

The Dollar is now rallying up into the old breakdown point. That is an extremely Bearish pattern. Normally a security will break support, then rally back into the breakdown level to “kiss it goodbye” and then implode.

The mirror image of the US Dollar is the Australian Dollar. I think this is because Australia is a commodity-based economy selling into the Asian economic expansion. The Australian Dollar ($XAD) broke out above historic resistance and has now pulled back into massive support – potentially very Bullish.

The ETF (Exchange Traded Fund) which tracks the Australian Dollar (FXA) is now yielding 6.87% and appears to have little downside from here. I will be looking to see if good entry points show up in FXA. I love the yield and the potential for appreciation as a US Dollar hedge.

The Euro ($XEU) is also pulling back into long term support. This is also Bullish and may set up as a great hedge against a falling Dollar.

The Japanese Yen ($XJY) has been sitting in a trading range for 12 year. This has been the result of Japan keeping interest rates artificially low (basically zero) to allow investors to borrow cheaply in Yen and buy the Nikki (part of the mystical “Yen Carry Trade”). At some point, Japan will get their interest rates back in line with reality, and when they do, the currency should break out of this trading range.

The bottom line is that the chart of the US Dollar is extremely Bearish and the charts of the Yen, Euro and Australian Dollar are extremely Bullish. That is not good news for you if the majority of your assets (your house, your 401k, your savings accounts) are priced in US Dollars. So, going forward you may need to focus on hedging your US Dollar-based holdings relative to other currencies or a basket of real assets (commodities like foods and metals).

Monday, September 29, 2008

Bond Market Crash

Corporate bonds crashed the last two weeks. Here is the chart of the high quality stuff – The Investment Grade Corporate Bond Fund (LQD). This is the little old lady portfolio where you are supposed to be able to hide your money when all you want is income and little price volatility.
This index has fallen 24 percent this year. 24 PERCENT!!
Grandma is going to get her statement at then end of the month and keel over...

Compare the performance of Corporate Bond to the performance of short-term US Treasury Bills (SHY), which are at their highs for the year!

I have been hiding is short-term Treasuries and CDs for over a year. Sure, the yields have stunk. But I have been more concerned about return of my money, rather than return on my money. I appreciate the patients of clients during the last 12 months of low yields, but the hand writing was on the wall for this disaster since at least 2006.

I want to look at a couple of popular strategies for capturing higher yields. These strategies are Bull Market strategies that use leverage to build portfolios of bonds that benefit from rising short-term interest rates. The biggest of these is the
Van Kampen Senior Income Fund (VVR), with $2.3 billion in assets. VVR was only down --10.45%. TODAY!!

The PIMCO Corporate Opportunity Fund (PTY) also uses leverage to buy lower-quality bonds in order to get enormous yields. It only fell -9.02% this week, but is down -30.9% from its high for the year. I am now looking out my window a couple times a day to make sure that nobody from PIMCO has jumped from the building...

Again, these are Bull Market strategies that borrow money to buy Junk Bonds (now called “High Yield”) to try and generate big yields. High yield bonds get crushed during recessions as their default rates go from an average of 1% to 6% in a two year period. During recessions, Junk Bonds end up yielding 10% more than US Treasuries as investors sell them and their prices crater.

Even the bonds of other governments are not immune to the carnage in bond land this year. The debt issued by Emerging Market countries has fallen hard, as the Alliance World Dollar Government Fund II (AWF) illustrates.

If you think I am cherry picking bad charts to prove a point, then go to http://www.cefa.com/ and you will see that these charts are indicative of the performance of these asset classes.

My big concern is that bond prices are not just falling because of deteriorating economic fundaments and massive unwinding of leverage. My fear is that long term bonds are finally starting to price in the reality that interest rates are going to go through the roof as the government prints trillions of new dollars, resulting in massive inflation.

I know the numbers for inflation are relatively low in the US, but I think the numbers for our CPI are fake (a topic for future discussion). Here is a chart of the combined CPI for nine major industrialized countries. As you can see, their rate of inflation is twice what ours is. So either they are not buying the same stuff as us (exotic stuff like food and gas), or our numbers are artificially low compared to reality.


I am afraid that the pain in Bonds is just starting. Heed my warning, do not go out an buy a portfolio of long-term bonds because the yields are attractive relative to money market rates.

Yields on the 30-year US Treasury are at historic lows, and do not have far to go until they reach zero. They have been kept low by design to stimulate consumption. At some point they will need to be brought to extremely high levels to crush the inflation wave which is inevitable. That is where bond prices will get crushed and you will lose a lot of money if you hold a portfolio of long term bonds.

Here is the yield on the 30-year US Treasury Bond ($TYX = 30-year yield x 10).

Here is the price of the 30-year US Treasury Bond ($USB). Prices are approaching an unbreakable ceiling as rates approach zero.

To summarize, Corporate Bonds have been annihilated this year, while US Treasury Bonds and Bills have continued to new highs as people buy them up in a flight to quality.

There will be a time in the next 12 months where the Bond Markets begin to price in economic growth and the trend will reverse. At that point, I will be looking to buy Corporate Bonds and sell short-term US Treasury holdings. Moreover, I will be looking to abandon Long Term Bonds and buy inflation-adjusted short and intermediate term bonds to protect myself from the ravages of what seems to be certain, significant future inflation.