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Eye On China: Keeping The Money At Home

Keeping money at home

China's total foreign currency reserve increased by 418 billion USD in 2008, 44.1 Billion less than the increase in 2007 -with an increase of just 45 billion in Q4. Make no mistake - the stack of chips in front of China may be growing at a slower rate, but they are still the big money at the poker table and can still splash the pot at will.

As the pace of the stimulus measures picks up pace however, they may become more selective in the places they choose to hold their capital –with yesterday’s M2 figures released by PBOC saw broad money supply increased by 17.8% year-over-year with a 62% increase in new Yuan denominated loans and no signs of slowing pace, FX reserve growth rates could go negative in the coming quarters.

For now, China is still financing two separate stimulus packages, one at home and one in the US. As the “new normal” takes effect, the question of who calls the shots in international economic policy may well change. Creditors have a nasty habit of expecting to get their way.

Andrew Barber

Eye on Europe: Grinding To The November Halt

Eurozone Industrial Production continues to decline

November Eurozone Industrial Production came in lower than expected today at -7.7% Y/Y versus consensus of -6.1%. We’re cognizant that a November number is stale, but the slowdown trend is clearly showing no signs of bottoming yet. The impact of the slowdown is being felt harder in some places than others, Italy reported a -12.32% Y/Y production number today for instance, and that divergence creates the possibility of discord among the EU member countries as they plot a course for recovery.

The big factors to watch remain the same:

1. The outcome of Europe’s €200 BN joint stimulus package to jump-start the economy (€50 BN of which Germany committed this week): We’ve written much about Obama’s US stimulus package over the past several weeks. The risk that Europe’s package (along with tax cuts and fiscal policy changes) will fail to increase consumer spending and create jobs sufficiently and require a second round of heavy spending. Back in October Germany and France issued bank rescue packages to the tune of €500 BN and €360 billion respectively, yet today Deutsche Bank made headlines that its Q4 ’08 loss totaled €4.8 BN and HSBC is expected to require an additional $30 BN cash infusion. Another trip to the well will be painful (particularly for EU members that have a higher cost of funding like Greece, which will likely see it’s relatively high cost of borrowing increase further in the wake of today’s ratings cut by S&P).

2. Rate Cut Impact: Tomorrow the ECB will all but certainly cut interest rates, with consensus estimating a -50bps cut, yet will this be enough to accomplish anything? Additionally as ECB interest rates change we’ll be watching its affect on the Euro-USD currency exchange. Should the Euro continue to rise against the dollar, it will put further pressure on European exports. If this should be the case you’ll see exports decline along with PPI and CPI numbers on deflationary pressures.

For all of 2009, we have been short the UK via the EWU exchange traded fund. We covered that position today. Booking gains on the short side continues to be what we do. We will look to re-short EWU on an up day.

Matthew Hedrick

Need A Level? SP500 Levels Refreshed...

Suffice to say, after the SP500 has been hammered for a 100 point, -11% move, since we we’re calling it as overbought last week, the math in my macro model has changed!

Last week I said the VIX could have a +27% squeeze to the upside and nothing will have changed its fundamentally negative intermediate “Trend.” This is not October/November 2008; if you are managing risk around those same levels of risk/volatility assumptions, I think you’re going to miss the next move. The VIX is +18% today, and it is waking people up because it should… too many people are long the same catalyst – Obama’s inauguration. As a result, the big move in volatility (off the bottom) is now a historical event. Unless I see the VIX close > 54.65, I think it continues to make lower 3-mth cycle highs on rallies. The SP500 can then be traded on the long side from its newly developing range of support.

The next move is to respect the math associated with that new range - I have outlined it below: SP500 836-889 – that’s a 6% range; its going to be very tradable with pending PPI and CPI reports here in the US on Thursday/Friday, then Obama after the market comes back from the long weekend.

Make no mistake, that breakdown of the SP500 “Trend” line at 889 remains today’s reality. Unless we can close above that line, any rally towards it is to be traded with an immediate term defensive bias. Any freak-out selloff testing 836 is where I first cover shorts (like I just did in NKE and EWU), and then consider buying longs.

Keith R. McCullough
CEO & Chief Investment Officer

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Big Broker

Big Broker - asset allocation011409

“Few people are capable of expressing with equanimity opinions which differ from the prejudices of their social environment.”
-Albert Einstein

Groupthink is not good, particularly when it becomes your culture. If you are not allowed to challenge the received wisdom of your bosses, and you are a financial services firm living in The New Reality, you are going to have a serious problem. Yesterday while I was taking Q&A on a panel at the AQR conference in New York City, I couldn’t shake these thoughts out of my head.

While I was on yesterday’s panel, Barry Hurewitz, whose title is “COO of Investment Research” at Morgan Stanley, made a statement, then asked me a question. Sorry Barry – you’re getting You Tubed. I will paraphrase his statement because it was a bit long winded, but Barry proclaimed the mystery of his “clients” faith in saying “what our clients really want from our analysts is insights – you know, like the conversations.”

Herein lies THE difference between the horse and buggy whip brokerage model that is going away and my vision of the future. Having been a Morgan Stanley prime brokerage client, I think THE client has always expected “insights”, but what they really want today is for your research calls to be right. That’s it Barry – make the call, put a time stamp on it and a price – and be accountable. If the accuracy rates of your compromised and conflicted “calls” are too low to show the world, then I guess the only thing to conclude is that clients want you to talk to your analysts on the phone and have you set up conference meetings for them.

The pundit patrol is going to be all over the manic media today with their view of Barry’s firm merging its brokerage unit with Smith Barney. Now it’s going to be called “Morgan Stanley Smith Barney” and there is nothing that scares me more than Merrill’s “thundering herd” than a team of consensus that’s even larger! Instead of 16,000 Bank of Americans strong, the client gets a 20,000 man team of brokers selling “Investment Research” tied to a groupthink culture.  This is The New Reality – if you dont think THE client wants you to have a process and stand up every morning and make a call that’s grounded in that process, I’ll be standing on the other side of that Trade.

Suffice to say, the US stock market has weakened in the last week in the face of a hard earned “Crisis In Credibility” (see www.researchedgellc.com Early Look from 1/7/09). The US brokerage stocks don’t lie, people do. With 3-month LIBOR hitting a new low this morning at 1.09% and the TED Spread (3mth LIBOR minus 3mth Treasuries) as narrow as it has been in well over 3 months, many a supermarket brokerage house strategist is confusing last year’s liquidity crisis with the crisis in the credibility of their employer. We do not have anything in the area code of the liquidity crisis we had in October-November. What we have is a crisis in the structure of the US brokerage model – like Big Auto… Big Broker is creatively self destructing in painfully slow motion.

Brokerage businesses are still ran by starting with a revenue number and trying to understand the cost structure needed to support those revenues. These are compensation structures, not businesses that can stand the test of economic cycles. There are great talents at Morgan Stanley (I have hired 3 of their former horses). Today, this is how they attempt to compensate their best people: 1. with cash bonuses (begging the government for that cash if need be), 2. with options that have ultimately proved worthless, and 3. by promising their “smartest” group thinkers titles, like “COO of Investment Research”.

No one at Morgan Stanley is empowered to be a capitalist right here and now. As I said, they have some great people working there, but they are afraid. I guess that begs the question as to whether you can empower people with fear of economic insecurity.  Where I come from, that creates situations where colleagues start looking after themselves instead of the team. There are two T’s in Morgan Stanley Smith Barney. Neither of them stand for Team. Its sad.

So are Deutsche Bank’s numbers this morning  - they printed a loss of over $6 Billion and shook European equity markets to the core of the matter, the credibility crisis at hand. The #1 and #2 stories on Bloomberg this morning are about Deutsche and Citigroup. This isn’t a surprise – it’s just really all turning out to be what it is – sad.

It is sad to think that the people running these firms tell the client what they need them to want. Let me tell you what they don’t want: THE client doesn’t want you trading prop ahead of them; THE client doesn’t want an investment banking disclosure on your “Overweight” recommendation; and THE client doesn’t want you to lose their money. THE client simply wants to be put ahead of house’s revenue “expectation”, and for THE house to be right.

Both Asian and European stock markets are breaking down now, and they probably should. Their crisis in confidence has no clear path of resolution. In America, the SP500 has broken it’s 889 support line, and while hope is not an investment process, at least we have a catalyst of change in Obama.

The only change I can hope for in the brokerage model of accepted compromises past, is for it to go away in as orderly a fashion as Americans can tolerate. It’s time for change. It’s time for Big Government to manage Big Broker, and let American Capitalists rebuild THE client’s trust.

Best of luck out there today.

Big Broker - etfs011409

EYE on themes - Meet the “New Normal”

A recent NY Times article expands on our “New Reality” theme as it relates to Investment Banking Inc. and broadens the theme to the auto industry, calling December’s declining sales trends the “New Normal.” The article says that the historic collapse of the new-car market raises questions about whether the auto industry will ever again see the pace of sales it did a few years ago. The easy answer is no, but Detroit will adjust and move. The “New Normal” theme goes beyond auto, however, and touches just about every industry. More importantly, the death of the consumer credit cycle will mean that there is a “New Normal” for nearly everyone.

The “New Normal” refers to the fact that the world has changed forever and those companies that are reluctant to change are doomed to fail. Those companies that do not adjust to the “New Normal” will be in purgatory for an extended period of time. Reducing capacity and capital spending are the order of the day and those that try to convince you that “we can grow” through the cycle are not in tune with the “New Normal.” Our “New Reality” is closely aligned to the debacle on Wall Street and the end of Investment Banking Inc. as we know it. The “New Normal” is closely aligned to the permanent shift in every aspect of consumer behavior. The most recent example of the “New Normal” comes from Lee Scott, the CEO of Wal-Mart, who believes that recent economic activity has caused a permanent and fundamental change in the behavior of the consumer in that the consumer will not have as aggressive a desire for consumption and debt. The question that remains unanswerable as it relates to consumer spending is what level of spending is the “New Normal?”

As far as the investment community is concerned, the “New Normal” is not levered long, and does not include concentrated, activist investing. Traditional Hedge funds and Fund of Funds are not part of the “New Normal.” Business models that provide leadership, accountability and trust will be part of the “New Normal” within the investment community. The game is changing every day and we are here to play. Welcome to the “New Normal.”

Ironically, in 2004, Roger McNamee authored a book called ‘The New Normal.’ At the time, he said The New Normal is a time of risk and uncertainty, but it also offers unprecedented rewards for the bold. He also says that back in the 40s, 50s, and 60s, it was fairly easy to plan for a secure future. People picked a career, a spouse, and a place to live, and those basic decisions put them on a predictable course for the rest of their lives, especially if they were lucky enough to land at a big corporation with great benefits and smart enough to buy stocks. In the 1990s and early 2000s, technology and global competition transformed the world, and the bull market lulled people into thinking they were in control of their lives.

Today, the new normal of the 40s, 50s and 60s is looking like a great place to be. The “New Normal” of 2009 is nothing like we have ever seen.

Eye on Oil: Futures Curve Continues to Indicate Oversupply

We are not of the mind to make front running calls on economic data points, particular as it relates to releases from the Department of Energy, but we did want to highlight the current futures curve for Oil in advance of the 10:30am Weekly Petroleum Status report tomorrow. The curve is sharply in contango. The implications of this are that producers, and those who own physical oil, are overwhelming being paid to store crude. Just by rolling the futures, they can gain a nice profit.

The chart below outlines the steepness and deeply contango nature of the curve, which is supported by ample open interest liquidity. More specifically, the table below quantifies the profit to be made by storing and rolling over a futures contract on a monthly basis. Just three months ago, there was literally no profit to be made by storing and rolling over the contract. Currently, based on the curve, there is a ~14% gain to be made in one month and ~35% gain to be made for four months.

This shape of the futures curve is only one factor in our multi-factor Oil model, but it is currently painting a bearish picture for the balance of Oil’s supply and demand. The implications of the curve are, in effect, that in the short term the world is awash in Oil. Obviously, a number of factors can alter this oversupply picture very quickly, such as an OPEC that sticks to its production cuts or a reacceleration of global growth in H1 2009.

This data suggest that the DOE report for tomorrow should be decidedly bearish. If the report is not bearish, then as Keith would say look for Oil to “pop out of its hole” . . . in a big way.

Daryl Jones
Managing Director