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Eye on Liquidity: Interbank Lending from Commercial Banks

The chart below dovetails with our view that credit markets are starting to loosen up, which on the margin is positive. On both on a week-over-week basis and year-over-year basis commercial banks are starting to lend to each other. In theory, commercial banks lending to one another should be the first step in credit trickling down to the broader economy and eventually to the consumer.

Interbank lending troughed at a decline of ~-30% y-o-y and in the most recent data lending is down ~-18% y-o-y. Yet on a week-over-week basis we are finally starting to see the first increase in lending between banks since the September time frame.

The caveat, of course, as the NY Times stated this weekend, is that “demand for interbank loans has been so low, the actual Fed rate has been close to zero for a month.” In essence, the Fed is inducing borrowing by lending money for close to nothing. Our view of inflation emerging in early 2009 is of course predicated on lending continuing to, as President Bush would say, become “unstuck”. We will have our “Eyes On” interbank lending as an important leading indicator of this non-trivial investment theme.

Daryl G. Jones
Managing Director

LIBOR and TED: You bet your Madoff credit is improving!

As we have been discussing our Morning Call (please call Jen White Kane or me at () if you have an interest in participating in the Morning Call), LIBOR doesn’t lie, people do.

We would have expected LIBOR to increase, particularly in light of the Madoff fraud ($50BN in assets gone!), but LIBOR continues to come in. As a measure of global counterparty risk, on balance, this is about as good as reference rates get (given Enron like fraud) and is a key unpinning of our bullish view on global equity markets in the immediate term.

In addition, the TED Spread continues to tighten as well and has narrowed to a level not seen since early September. This implies that the market is pricing in a much lower level of credit risk than in the past couple of months and that liquidity is improving sequentially.

Daryl G. Jones
Managing Director

Made-Up

The Depression came to be as a function of “the lack of honor of men in high places.”
-Franklin D. Roosevelt, at the DNC in 1932

In his famous Democratic National Convention speech that was ironically held in Chicago, Roosevelt also described these “men in high places” as “crooks”… and I guess that makes sense, because that’s what they were. I’d like to say that sometimes Wall Street’s narrative fallacy leads people to believe that everything that happens in this business is on the up and up… but, unfortunately, I have to say that most of the time it is not. It’s all about storytelling.

Our head of compliance, Moshe Silver, who joined Research Edge LLC after working with me at Carlyle’s hedge fund submitted the following observation: “We recognize that market manipulation is not an exact science. That being said, there are people out there who are recognized pros, and it would have made more sense to bring them in – the same line of reasoning that led FDR to appoint Joseph Kennedy to head the newly-created SEC.  We’d have been much more comfortable with Ace Greenberg or Jimmy Caine. Or, for that matter, Mike Milken or John Guttfreund, on the premise of Been There, Stole That…”

Moshe was expanding upon my ‘Weekend Edge’ “Quote of the Week” that ‘You Tubed’, Paulson’s “yes man”, Neel Kashkari, for saying “we’re not day traders, and we’re not looking for a return tomorrow.” Poor Paulson and his junior banker from Goldman (Kashkari) have t-minus a few weeks left until we get them off of team USA and back into the unemployment line where they belong. They’ve already lost almost $9B, or one-third of the value, of the “preferred investments” they’ve made in their favorite cronies banking schemes. Clearly, they weren’t proactively managing risk or “looking for a return” – we could have paid for this ridiculous big auto bailout with their trading losses.

These aren’t the only sell side bankers who have a hard time making money on the downside of the cycle. This week, we’ll have both Goldman Sachs and Morgan Stanley report their version of the numbers. “Ex” everything, be certain that there will be some serious storytelling on these conference calls. After putting an “outperform” on it somewhere close to $175/share in July, Goldman’s depleting research department is downgrading Apple this morning at $98/share. They apparently did some “channel checking” and set the table for their public parent’s finger pointing session on Tuesday – I’ll bet you a “Made-Off” buck that GS gets on that call and blames “the slowdown in the economy”… what’s a made up bet on a made up story with a made up buck anyway? Let’s roll the bones and lever up some bets!

Anyone can sit down in their year-end review and make things up. That’s what Wall Street does. Not all bankers are in on it – but Bruce Wasserstein knows a thing or two about banking, and he said that “accounting has now become an exercise in creative fiction… saying assets are worth a lot doesn’t make them worth a lot.” I think he was alluding to Steve Schwarzman’s argument for “marked to model” pricing of private equity investments, but heh, who’s keeping track of this stuff.

It wasn’t hard to keep track of how many shoes that Iraqi reporter gunned at ole Bushy’s head this weekend – both! If this wasn’t a metaphor for the bottom of the barrel of ‘You Tubing’ global confidence in the departing leadership of America, I don’t know what is. Between “Made-Off”, Bush, and Kashkari, I don’t think confidence in the American financial system can get worse. This is a very good thing.

Good thing? Yessir – very good. Stock market confidence isn’t built on nominal expectations – it’s built on what happens on the margin, relative to those expectations. Friday’s 500 basis point intraday rally from the thralls of the “made-up” Madoff lows was a significant one on this score. The ingenious bears who are figuring out things in the global economy are bad can choose to ignore it at their own risk. China just printed their slowest monthly Industrial Production growth number in a decade, and the Chinese stock market closed UP on the day. Markets don’t trade on yesterday’s news – they are leading indicators for tomorrow, and they don’t make stuff up!

In the USA, Friday’s University of Michigan consumer confidence report had me put up a note on the portal titled “Has American Confidence Bottomed” (see www.researchedgellc.com, under the North America tab). This report rhymed with the American confidence poll for the President elect moving to greater than 70%. You can call Obama “too young”, but he’s at least a good decade older than who Paulson, in his poor judgment, appointed to head up America’s “Financial Stability” program. Since Wall Street loves to compare performance on a relative basis, Obama and his team of Volcker and Summers are grey beards!

I am not into grey. I am more of a black and white guy, and as sure as I ran that NFL Sunday ball up the middle with our newly initiated long USA stock positioning on Friday morning is right back to where I am sitting here for you today.

I am here to stand on our investment process and be held accountable. There are many men and women “of honor” looking to lead in The New Reality, so let’s get the storytellers out the door and get on with it. I have an immediate term upside target for the SP500 of 916. And no, that number wasn’t just “Made-Up.”

Best of luck out there today,
KM

Long ETFs

SPY-S&P 500 Depository Receipts – CME front month contracts traded as low as 876.4 this morning before 7AM.

DIA –DIAMONDS Trust Series –CBOT front month contract traded as high as 8,756 early this morning before pulling back.

XLV Health Care Select Sector SPDR – Bristol-Myers Squibb (XLV: 4.07%) and Sanofi- Aventis won an appeals court ruling vs. Apotex  to block generic competition to the blood-thinner Plavix in the U.S. until 2011.

OIL iPath ETN Crude Oil –Front month NYMEX light sweet contracts traded as high as 49 before 7AM this morning as the market reacted to comments regarding production cuts from OPEC Secretary-General El-Badri  before the meeting scheduled in Oran this Wednesday.

EWG – iShares Germany – The DAX is trading up this morning 1.72% to 4743.42, a gained for the first time in three days as European Union regulators approved the country’s revised bank-rescue plan and on expectations for a swift US bailout for carmakers. Arcandor AG, the German retailer that controls tour operator Thomas Cook Group Plc, posted an annual net loss of €745.7 million ($1 billion), or €3.35 a share, in the year through September.

EWH –iShares Hong Kong –The Hang Seng closed up 288.56, or 1.96%, to 15046.95.

 FXI –iShares China – China’s industrial production grew at the weakest pace in almost a decade as export growth totaled 5.4% in November Y/Y as compared to 8.2% in October. CSI300 closed this morning up just slightly to 1975.03, or 0.75%.


Short ETFs

FXY – CurrencyShares Japanese Yen Trust –The Yen fell slightly to 90.9230 against the USD.

IFN The India Fund—India’s rupee rebounded more than 5% from a record low touched on Dec. 2 on speculation the US will bail out its automakers. India’s 10-year bonds rose for a sixth day, pushing yields to the lowest level since September 2004, on speculation the central bank will cut borrowing costs as economic growth and inflation slow.


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3Q INVENTORY = 4Q GROSS MARGIN SETUP

When it comes to inventories heading into holiday during a recession, less is definitely more. Here are the names with the biggest and least margin risk.

Yeah, business stinks – we all know that. But it’s times like these that separate the winners from the losers. Let’s take a quick look at the standouts over the past quarter in managing inventories relative to sales. You don’t need to be a retail genius to know that a lean sales/inventory spread (sales growth > inventory growth) sets up for a positive gross margin event in 4Q – well needed in this climate. Lululemon, UnderArmour, Liz Claiborne, Timberland and Ralph Lauren are my favorites in that context. On the flip side, watch out for expectations to be in synch for names like Abercrombie, Volcom, Skechers, J Crew, DSW and Brown Shoe.

Eye On Leadership: Jack Bogle

“The motivations of those who seek the rewards earned by engaging in commerce and finance struck the imagination of no less a man than Adam Smith as something grand and beautiful and noble, well worth the toil and anxiety."
- Jack Bogle, Founder of Vanguard Group

“Good people do not need laws to tell them to act responsibly, while bad people will find a way around the laws.”
-Plato

Since we are located on the fringe of Yale’s campus in New Haven, CT, the Yale Daily News (“YDN”) tends to be one of the many daily newspapers our research team reads every week. It is the United States’ oldest college daily newspaper (although the Harvard Crimson disputes that claim) and has been the starting place for many successful journalistic careers, including Henry Luce, William F. Buckley, John Hersey, Pete Axthelm, and Dana Millbank, to name a few. From our perspective, it is worth reading because it offers a view into the current mindset of college students.

On December 4th, 2008, we picked up a copy of the YDN and a headline on the front page article read, “A Job on Wall Street: Are you Crazy?” The insinuation being that not only were jobs tougher to come by on Wall Street, but, and not surprisingly, the allure of such jobs had faded meaningfully. This was reinforced by a recent talk Keith gave to a group of students who were emphatic in their disdain for finance and the said “leaders” that run these major financial and investment banking firms. Smart, motivated graduating seniors want to be proud of their emerging careers and that pride begins with picking an industry that has integrity and respect.

The events last week relating to the fraud of Bernie Madoff’s hedge funds obviously even further tarnish the financial industry. We discussed Madoff this week on our portal, so won’t rehash the facts again, but the extent of the fraud is breathtaking and is estimated, in some reports, at over $50 billion. Ironically, while Madoff was not a household name, both he and his firm were considered long time leaders in the financial industry.

As a slight digression, not everyone bought into Madoff’s returns. We reread a May 2001 article from Mar/Hedge this weekend , which was entitled, “Madoff tops charts; skeptics ask how”. This is a major publication in the hedge fund industry and a must read for anyone allocating capital to hedge funds. According to the article, from June 1989 to February 2001 “it (Madoff’s fund) would rank as the best performing fund for the period on a risk adjusted basis, with a Sharpe ratio of 3.4 and a standard deviation of 3.0%.” The returns appeared to be too good to be true, and were.

As I reflected on Madoff this weekend (admittedly, many of the details are yet to come), I found it incredibly difficult to understand how a man could live his entire life under such a fraudulent scheme. Not only did he cheat his friends, close associates, but, ultimately, his own sons turned him in. In my mind, it would be better to be destitute and unknown than to live an entire life based on a lie, but, of course, Madoff thought otherwise.

The unfortunate implications of the Madoff fraud are that confidence in the “old boy” financial services industry will deteriorate further. While mistrust in the leadership of the industry is certainly well founded, I do think it is important for us to value the Madoff situation appropriately as his actions appear be an outlier, even for a terribly conflicted and compromised industry. While reading this morning, I a read article online by psychologist Juliann Mitchell about sociopaths and she wrote:

“It is typical for sociopaths to engage in illegal or deceitful behaviors. Compulsive lying is the norm. Guilt and remorse are not in their vocabulary. All sociopaths are incapable of feeling sorrow or sadness for their wrongdoings and destructive behaviors. Any tears you might see are for themselves. “I am crying because I got caught, not because I am sorry for anything I have said or done.”

Madoff was clearly a sociopath and, therefore, in a league of his own.

As the Madoff scandal and the failed leadership of Investment Banking Inc. are leading to a crisis of confidence in the financial industry and creating real doubts by our leaders of tomorrow, it becomes even more important to highlight that there are many great leaders in finance. These are people that have built long and successful careers on the pillars of integrity, transparency, and trust. One such person is Jack Bogle, the founder of the Vanguard Group.

John Clifton “Jack” Bogle was born on May 8, 1929 in Verona, New Jersey. Bogle went to Princeton University and while at Princeton happened upon an article in Fortune about the emerging mutual fund industry. Eager to write a thesis about a topic that had not been widely studied, Bogle wrote a successful thesis about the industry and was awarded with a job at Wellington Management, where he worked for the next 23 years and ultimately became CEO. Bogle left Wellington in 1973 and founded Vanguard in 1974.

The rest, as they say, is history. Vanguard today manages over $1.3 trillion and is the largest pure no-load mutual fund company in the world.

In a 2003 speech at the Harvard Club of Boston, Bogle said:
“The extensive study of the industry (in his 1951 senior thesis at Princeton) that followed led me to four conclusions: One, that mutual funds should be managed in the most “efficient, honest, and economical way possible: and that fund sales charges and management should be reduced. Two, mutual funds should not lead the public to the “expectation of miracles from management,” since funds could “make no claim to superiority over the (unmanaged) market averages.” Three, that the “principal function (of funds) is the management of their investment portfolios” – the trusteeship of investor assets-focusing on the performance of the corporation . . . (not on) the short-term public appraisal of the value of the share (of stock).” And four, that “the prime responsibility” of funds “must be to their shareholders”, to serve the individual investor and the institutional investor alike.”

These are fairly basic principles that embody transparency, accountability, and putting the client first. Bogle developed these principles as a senior at Princeton over 50 years ago and has managed his businesses based on them ever since.

The quotes from Plato and Bogle at the start are meant to emphasize two points. First, capitalism and the pursuit of profits can very much be a noble endeavor. Secondly, bad people exist and they will find ways around our laws. Careers like Bogle’s tell me one thing, incredible profits and success can be found within the framework ethical conduct and, in fact, and a long term legacy is almost impossible without that ethical foundation. We need to encourage our leaders of tomorrow to study the careers of people like Bogle, so they will realize that there is much to be proud of in the investment management industry.
Biographer Richard Slater described Bogle’s life as “evolutionary, iconoclastic and uncompromisingly committed to the founding principles of putting the interests of the investor first . . .” There is clearly a vacuum of leadership in the financial and money management industry at the moment. While the lack of credible role models justifiably concerns the leaders of tomorrow, this leadership vacuum will also create opportunities for people to lead themselves, to define “The New Reality”, and to aspire to become the next generation’s Jack Bogles.

Daryl G. Jones
Managing Director
RESEARCH EDGE, LLC
111 Whitney Avenue
New Haven, CT 06

www.ResearchEdgellc.com

Eye On The Energy Threat: Ukraine’s Geopolitical Impact

A recent top business story in the Russian Times included a short article on Ukraine’s failure to pay state-owned Russian gas giant Gazprom $2.4 billion in debt.

This impasse between Ukraine and Russia is nothing new, yet there are multiple contributing factors that make Ukraine an important country in our global macro dialogue, including: (1.) the geographic significance of a major Russian gas pipeline running through the country that services Europe, (2.) the politically divided Ukraine with recent signs of EU-centric orientation, and (3.) heightened policy between “The West” and Russia, including measures by the European community to reduce its dependence on Russian energy.

Ukraine’s geographic location is an important one that plays into its geopolitical influence. It’s situated with Belarus to the north as a strategic land buffer between Russia and Europe. While increasingly more pipelines are being built to service oil and gas from Russia and the Caucasus to Europe that don’t directly cross Ukrainian or Bulgarian territory (e.g. under the Black and Baltic Seas), currently the Russian pipeline Druzhba (or “Friendship”) running across Ukraine services 80% of the gas the EU receives from Russia. This is a considerable number, especially with context—Russia exports about a quarter of the EU’s gas.

For years, Ukraine enjoyed cheap gas prices as part of the Soviet legacy. That changed in 2005 when Ukraine decided to switch to market prices for transit through the country. Gazprom, the largest extractor of natural gas in the world, was all too happy to accommodate Ukraine and consequently drove up the price of gas. Ukraine’s first refusal to pay higher prices resulted in Gazprom shutting off supply on January 1, 2006. Hoping to circumvent the action, Kiev decided to siphon off gas from the pipeline, which resulted in the disruption of gas deliveries to Europe.

At the end of October 2008, Gazprom and Ukraine’s state-controlled Naftogaz Ukrainy signed a long-term agreement for direct gas supplies from Russia to Ukraine with the abolishment of the intermediary company RosUkrEnergo, which is 50% owned by Gazprom. While the agreement did not set out the volumes of gas Ukraine would buy from Gazprom in 2009 and beyond, nor a price or pricing mechanism, the signing of the deal was seen as a positive step in Ukrainian-Russian relations. Yet this relationship has soured in recent months due to Ukraine’s failure (or as some see it inability) to pay off its debt of $2.4 billion in gas back payments to Gazprom on behalf of RosUkrEnergo.

Now that the holiday season and colder temperatures have arrived, observers speculate that Gazprom may have another stand-off with Ukraine, which could have repercussions in European supply.
It is Ukraine’s geographic location that makes it of such political importance for both the European Union (The West) and Russia (The East). Ukraine’s political trend-line has been gradually changing towards a pro-EU orientation, with pro-Western parties and coalitions coming to power, as demonstrated by the victory of President Viktor Yushchenko’s Orange Revolution five years ago. Yet still, observers struggle to qualify the “democratic” nature of the country’s leadership. After entering office, President Yushchenko banned Ukrainian cable companies from showing Russia’s Channel One to limit the Kremlin’s voice, demanded Ukrainian language instruction from kindergarten to university level, and instituted a remembrance holiday to acknowledge the genocide of Ukrainians by Russian commissars during the famines in the 1930s. Such measures didn’t go over so well with all Ukrainians, for a larger percentage of eastern Ukrainians still strongly identify with Russia.

Both the EU and Russia have made attempts to reign in on Ukraine. While Russia has exercised its influence through leveraging its energy price, the EU has made a number of concerted efforts. Just last week NATO foreign ministers met in Brussels to discuss whether Ukraine and Georgia should be allowed into the military alliance. Ultimately Western Europeans, led by Germany and France, blocked US efforts to offer Ukraine and Georgia membership, yet the discussion furthered the debate to recognize Ukraine as a “Western” country.

In another EU gesture to extend its hand to Ukraine, European Commission President Jose Manuel Barroso unveiled an Eastern Partnership package last week to give Ukraine and five other former Soviet states access to €350 million of financial aid, free-trade pacts, and hassle-free visas. In addition Ukraine has already received more than a quarter of the $16.4 billion rescue loan from the IMF. This comes at a time when its currency, the hryvnia, has deeply devalued to historic lows against the dollar.

Russia, on the other hand, has done little to repair its reputation with Ukraine. Ukraine officially denounced Russia’s invasion of Georgia. In fact its aggression further confirmed to many Ukrainians that when it comes to political and economic issues, they trust Europe more. Even the politically significant balance of power between Washington and Moscow over such controversial issues as the US proposed missile defense shield in Poland and the Czech Republic has Ukraine leaning westward.

Yet the icing on the cake to disrupt the political significance of Russia may result solely from its oil-levered economy. Oil prices from a high of $147/barrel in July are down 70% today. Further, the EU is taking steps to limit its dependence on energy imports, including gas. In November, the European Commission convened and came up with The New Energy Policy, a plan by 2020 to reduce carbon dioxide emissions and total demand for energy by 20% and to increase the share of renewable energy sources.

While the plan didn’t explicitly aimed to reduce the EU’s dependence on energy sources from Russia, the implication was understood. Irrespective of the EU’s ability to meet The New Energy Policy, Russia’s bottom line will be affected. Investment is already being made by many European countries in liquefied natural gas (LNG) facilities that would allow gas to be transported via ship. LNG benefits would include the ability to store reserves for times of shortage, and rely on the world’s natural gas reserves rather than solely Russia’s.

While the European Union is not ready to extend membership to Ukraine, it has taken numerous measures to placate the country. With oil’s global demand destruction, Russia’s energy “authority” will be vulnerable, especially if the EU becomes less dependent on Russia for its supply. Ukraine remains an important country that can tip the East-West balance of powers. We’ll be following this global macro event as it plays out.

Matthew Hedrick
Analyst

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