Equity Bull Market?

Believe it or not, with this massive sell-off of the past weeks, we are actually in the middle of a bull rally. While it appears that there will be another more slow and painful downleg from here, a rally was not surprising given the amazingly oversold condition (I am no market timing expert but it was obvious how oversold things were getting). Now I don't think this is any reason to get excited about equities given that fundamental weakness will start showing up in earnings. Remember, it was not fundamentally a valuation bubble in equities we were sitting on, it was an earnings bubble.

Bonds seems to be interesting in this environment. There was an interesting article today about convertible bonds which seem to be pricing at levels last seen some 30 years ago.

http://online.wsj.com/article/SB122575841314895287.html

The one thing about bonds that frighten me is that they are still subject to inflationary pressures knocking around their yield. However, there are several bonds which are pricing at levels denoting distress, whereas the sales may have really been driven by forced selling more than anything. One of my favorite companies, Leucadia National, has bonds currently priced at 10% YTM. For what I consider an absolutely rock solid company, that is an excellent yield.

Election Day!

Pretty phenomenal that we are on the cusp of having an African American in the White House. It is even more astounding that he is a liberal from Chicago. I didn't think American politics had the capacity for this for at least another generation.

One thing that occurs to me is that this may be the death-knell for affirmative action. The hiring of a black president by the citizens of the United States of America seems to prove that even the highest glass ceiling can be busted through. That is not to say that minorities are well represented in all aspects of society, business and culture, but that those areas which were viewed as bastions of exclusion and male WASPiness may be possible of transformation and dynamism not expected by many.

It gives me hope that maybe the world is more egalatarian than I imagined. Even for a cynic like myself, it is an amazing expression of the power of the individual and of a truly free, democratic society. All in all, a pretty amazing time to be alive.

Scratch that if McCain wins.

Treasury Yield Discussion

Here is a letter from Vineer Bhansali at Pimco regarding his outlook for Treasuries.

http://www.pimco.com/LeftNav/Viewpoints/2008/Bhansali+Duration+Goodbye+Sept+2008.htm

Given the US government's rapid inflation exercise, which will likely have some sort of effect on currency depreciation, the Treasury yield should move out. If you look at the the long term bond yields in the chart linked above, you can clearly see that the Treasury market has experienced bouts of extreme volatility in the past. If you believe that there will be a massive contraction of liquidity on top of a general disenchanment with US Treasuries, then it is easy to envision how Treasury yields would blow out. Despite a lack of short-term volatility in the Treasury market, one can imagine that it would pick up to some increased level. What that level is is unclear.

So given that, it would seem that buying out-of-the-money puts on long dated Treasuries could turn out to be a fantastic play, particularly while the pricing on the bonds are high and the volatility is low. Still trying to figure out the specific mechanism for the trade. If anyone has ideas, please let me know.

Inflation in Foreign Countries

Given the massive flight to quality out of emerging markets and into the US Dollar and Japanese Yen, they must feel as if they can't catch a break. Given the strengthening of the US dollar, we are experiencing deflation here Stateside, but if you are sitting in a place like Australia or South Korea, the deflationary effects on import and commodity pricing haven't been anywhere near as strong given that your currency just fell by 30-40%. A fall of oil prices by 50% in US Dollar terms doesn't feel that dramatic to you. So if you were the central banks of one of those countries, I would imagine you would end up selling your dollar reserves, if you have any, or buying back Treasury-issued notes to try and prop up your currency. Won't this selling of dollars around the world end up putting back a ton of eurodollars back onto the market and weaken the dollar from its current position? The US would probably want a weaker US dollar so they would probably tacitly support USD selling.
http://www.straitstimes.com/Breaking%2BNews/Money/Story/STIStory_295370.html

Similarly, it sounds as if Japan is likely to start intervening to break the strengthening of their currency as it would and likely is massively impairing their export business.
http://www.straitstimes.com/Breaking%2BNews/Money/Story/STIStory_295371.html

Also, a great article from the WSJ regarding the reason for Bretton Woods in 1944. Much of it was due to battling currency devaluations between exporting countries. Although not quite the same here, massive disruptions in currency markets should lead to some form of international resolution around these issues. As the article states, China's participation, nee leadership, seems to be critical.
http://online.wsj.com/article/SB122489333798168777.html

Jim Rogers on Agriculture Commodities and Inflation

http://www.youtube.com/watch?v=mBVC3H8Pgc4

From Bob Prechter - The Deflation Counterargument

"Believers in perpetual inflation think that the government can keep assuming others’ bad debts infinitely. But it can’t. The only reason that Congress has gotten away with issuing this latest blizzard of new IOUs is that society is still near the top of a Grand Supercycle, so optimism and confidence still have the upper hand. But as pessimism and skepticism continue to wax and the economy contracts, the bond market will figure out that the Treasury will be unable to fund all these obligations with tax collections. Then Treasury bond prices will begin falling as if they were sub-prime mortgages. A collapsing bond market is deflation; it is a contraction of the outstanding credit supply. Recent bailout schemes will not reverse the deflationary freight train. They will serve only to confuse the marketplace and hinder the efficient retirement of bad debts, thus exacerbating the crisis and aggravating investors’ uncertainties and thereby falling right in line with the declining trend of social mood."

I think it is an important perspective and certainly viable. There is one investment move that seems to be a winner in both an inflation and deflation scenario. That scenario is short long US Treasuries. As Bob states above and we have stated in previous posts, the question hinges truly on whether or not the US government can overwhelm the massive credit deflation in the market. If yes, then you will get inflation which will cause Treasury yields to rise. If no, then as Bob states above, Treasury yields will blow out because of perceptions of US credit and the ability of the government to pay these debts.

For retail investors, an interesting way to play this would be buy TBT, the ultrashort 20+ year Treasury index. They charge a 1% fee but if the direction is correct the returns should overwhelm those fees. Just look at what happens to bond prices if Treasury yields move from 4% to 8%. It gets sliced in half. That is a significant move.

How Prices Inflate: Lessons from Germany

In the case that we have inflation, it is a fair question to ask how exactly prices inflate? It seems to be much taken for granted that inflation would cause general rise in the price level. However, it is really not that straightforward. First of all, most people confuse monetary inflation (which is the technical definition of inflation) with price inflation (which is how it is commonly used).

In any case, when the system is flooded with additional dollars, how does this end up getting translated into prices, and furthermore, which prices does it end up getting translated into? Probably the best source to figure this out would be to see what happened during the most famous case of inflation that ever existed - Germany during the Weimar Republic in the early 1920s.

In Germany, the most immediate effect on a huge influx of additional currency in the system served primarily to drive down the exchange rate on the currency vis-a-vis other currencies. This was driven partially by true supply-demand imbalances but also on speculative activity. Given a drop in the exchange rate, the prices for imported goods would therefore rise, including the price of inputs, such as raw commodities. Given the US's massive reliance on foreign-produced goods, this would be a major impact.

While at first, internal prices would remain relatively stable and provide something of an anchor for the exhange rate, at some point if the government persists in printing dollars, internal domestic prices will ultimately rise, as will wages and other items. But that is an effect of persistent monetary inflation, and not short-term inflation. This does not mean that inflation will ultimately be persistent in nature? While the German mark was on a major devaluation trend, there were periods of stabilization and even currency strengthening that led to lower import prices during that interim period. Also during a major inflation, credit creation becomes massive which further increases the money supply.

Clearly there are differences between the US today and the Weimar Republic then. But history may be rhyming. The big difference today is the debt deflation happening. If you think inflation is coming strong, best to get back into, as Jim Rogers says, "unimpaired" commodities as they will once again feel the surest impact of this inflationary boom and dollar devaluation.