Creatively Destructing

"Learning without thought is labor lost."
-Confucius
 
After spending over a decade working in Manhattan, I've gotten used to observing people while they don't think I'm looking. Is there any other way to learn? Surely there is, but for me it's always been most effective to really just watch people and listen.
 
Call it coincidence or whatever it may be, but yesterday as I was walking out of 300 Park Avenue in New York, I brushed sleeves at the elevator bank with none other than the man I congratulated in yesterday's Early Look - Lloyd Blankfein...
 
Goldman's CEO probably doesn't care who I am or what I look like, and for that I am thankful. As my wife will attest, I'm not really into the social climbing thing. As I walked out onto the sidewalk I leaned over to my Partner, Daryl Jones, with a relatively large smile on my face and said " the guy seriously has no idea what's coming."
 
Mr. Blankfein's stock got pounded yesterday, closing down -12% on the day, leading both the Financials (XLF down -7% on the day) and the overall market lower into the close. Despite the one day selloff on the "news" that everyone with a pulse in this business saw coming, the good news for these horse and buggy whip Investment Banking Inc. execs is that they appear to have saved themselves to play another day.
 
Good news? For sure. Everyone needs a banker, at a price; and, provided that the XLF can hold its head above the $9.41 line, my risk management process still has the sector trading +4% above what I call the intermediate TREND line. TRENDs are hard to break. Goldman's TREND line support is all the way down at $90/share and Morgan Stanley's is closer to $20. Are these lower prices? Sure - but there's no stress associated with proactively being able to predict that stocks that have gone straight up will correct.
 
Keeping these horse and buggies alive and operating in this game is actually great news for the rest of us who are going to take market share from them. The American Financial system is undergoing an old school economic secular cleansing that is not unique - it has happened in virtually every other industry, and for Wall Street the time has finally come - Schumpeter called it "Creative Destruction."
 
Yes, as Creative Destruction takes hold, plenty of execs who are wearing horse blinders in these compromised and conflicted business models will be right stressed - as they should be. Ask the "Wealth Management" dudes at UBS how it felt seeing $20B (as in beeelion) in client assets just walk out the door. Learning that one's stress can become your economic reward, is a thought, that we can all respect as being far away from a Capitalist's labor lost.
 
Throughout the US stock market's 24% rally from the March 9th low, we have learned plenty. One of the main lessons learned is that the Three Horseman sectors that are NOT US Financials (XLF), Technology (XLK), Consumer Discretionary (XLY), and Basic Materials (XLB), can lead us higher as the US Financials deal with their own stresses. This, as the great American analyst, Tim Russert, would have said "is BIG."
 
Tech and Basic Materials are two of the things that The Client (China) needs. What we have observed in the last month is a very high inverse correlation between these two sectors and the US Dollar. If Bernanke, Obama, or the Chinese themselves can continue to Break The Buck, these American export businesses can start to crush their Western European and Japanese competition.
 
Competition? What's that? Aren't we trying to compromise and socialize America to smithereens? Thankfully, some will try to... and all the while, this will provide we men and women of American Capitalism Lost the ability to test and toil our new business models while the horse and buggy proprietors aren't looking.
 
One of my favorite quotes is from Henry Wadsworth Longfellow, and it's one that fits this idea of Creative Destruction like a glove: "Heights by great men reached and kept were not obtained by sudden flight but, while their companions slept, they were toiling upward in the night."
 
Now, I hardly consider myself a "great man" - nor do I buy into the notion that Wall Street's billionaire lever it up kings are either. However I do know that it takes a tremendous amount of trial and error to evolve. In The New Reality, where our entire industry is now being paid not to make any more mistakes, this is seemingly the best time to be taking measurable risks.
 
Risk? Yes, ask the short sellers if Squeezy The Shark has been giving them any of that to think about lately. Risk to the downside abates alongside declining volatility. Volatility in this market continues to hit lower lows. The Volatility Index (VIX) flashed no stress during yesterdays overdue US market correction. This remains a very trade-able range where the reward is starting to outstrip the risk on the long side.
 
Yes, if we break down and close through an SP500 level of 821 and the US Dollar starts to appreciate, the stock market will DEFLATE again... but until we see those facts on the front center of our screens, a better question remains - why am I not longer of US stocks?
 
In t-minus 2.5 hours, I'll be answering the opening bell on that question. I'm looking forward to buying from those who don't see me coming, as they creatively destruct.
 
Best of luck out there today,
KM
 

LONG ETFS

XLK - SPDR Technology - Technology looks positive on a TRADE and TREND basis. Fundamentally, the sector has shown signs of stabilization over the last six+ weeks.   As the world demand environment becomes more predictable, M&A should pick up given cash rich balance sheets in this sector (despite recent doubts about an IBM/JAVA deal being done).  The other big near-term factors to watch will be 1Q09 earnings - which is typically the toughest for tech, along with 2Q09 guide.  There are also preliminary signs that technology spending could be an early beneficiary of the stimulus plan.

TIP - iShares TIPS- The iShares etf, TIP, which is 90% invested in the inflation protected sector of the US Treasury Market currently offers a compelling yield on TTM basis of 5.89%.  We believe that future inflation expectations are currently mispriced and that TIPS are a compelling way to own yield on an inflation protected basis, especially in the context of our re-flation thesis.

XLB - SPDR Materials -If the USD goes up, XLB deflates. It's a bull on both a TREND and TRADE duration. The Materials sector is, obviously, a key beneficiary of our re-flation thesis.  Domestically, materials equities should also benefit as the stimulus plan begins to move into action.

USO - Oil Fund-We bought oil on 3/25 for a TRADE and are positive on the commodity from a TREND perspective. With the uptick of volatility in the contango, we're buying the curve with USO rather than the front month contract.  

EWC - iShares Canada-We bought Canada on 3/20 into the selloff. We want to own what THE client (China) needs, namely commodities, as China builds out its infrastructure. Canada will benefit from commodity reflation, especially as the USD breaks down. We're net positive Harper's leadership, which diverges from Canada's large government recent history, and believe next year's Olympics in resource rich Vancouver should provide a positive catalyst for investors to get long the country.   

DJP - iPath Dow Jones-AIG Commodity -With the USD breaking down we want to be long commodity re-flation. DJP broadens our asset class allocation beyond oil and gold.
 
GLD - SPDR Gold-We bought more gold on 4/02. We believe gold will re-assert its bullish TREND as the yellow metal continues to be a hedge against future inflation expectations.

DVY - Dow Jones Select Dividend -We like DVY's high dividend yield of 5.85%.


SHORT ETFS

LQD  - iShares Corporate Bonds- Corporate bonds have had a huge move off their 2008 lows and we expect with the eventual rising of interest rates in the back half of 2009 that bonds will give some of that move back. Moody's estimates US corporate bond default rates to climb to 15.1% in 2009, up from a previous 2009 estimate of 10.4%.

SHY - iShares 1-3 Year Treasury Bonds- If you pull up a three year chart of 2-Year Treasuries you'll see the massive macro Trend of interest rates starting to move in the opposite direction. We call this chart the "Queen Mary" and its new-found positive slope means that America's cost of capital will start to go up, implying that access to capital will tighten. Yield is inversely correlated to bond price, so the rising yield is bearish for Treasuries.

EWU - iShares UK - We shorted the UK on 4/08. We're bearish on the country because of a number of macro factors. From a monetary standpoint we believe the Central Bank has done "too little too late" to manage the interest rate and now it is running out of room to cut. The benchmark currently stands at 0.50% after a 50bps reduction on 3/5. While the Central Bank is printing money and buying government Treasuries to help capitalize its increasingly nationalized banks, the country has a considerable ways to go to attain its 2% inflation target as inflation has slowed considerably. GDP declined 1.5% in Q1, unemployment  is on the rise, housing prices continue to fall, and the trade deficit continues to steepen month-over-month.

EWL - iShares Switzerland - We shorted Switzerland on 4/07 and believe the country offers a good opportunity to get in on the short side of Western Europe, and in particular European financials.  Switzerland has nearly run out of room to cut its interest rate and due to the country's reliance on the financial sector is in a favorable trading range. Increasingly Swiss banks are being forced by governments to reveal their customers, thereby reducing the incentive of Switzerland as a tax-free haven.

UUP - U.S. Dollar Index -We believe that the US Dollar is the leading indicator for the US stock market. In the immediate term, what is bad for the US Dollar should be good for the stock market. The Euro is down versus the USD at $1.3247. The USD is up versus the Yen at 99.1040 and down versus the Pound at $1.4932 as of 6am today.

EWJ - iShares Japan -We re-shorted the Japanese equity market rally via EWJ. This is a tactical short; we expect the market there to pull back when reality sinks in over the coming weeks. Japan has experienced major GDP contraction-it dropped 3.2% in Q4 '08 on a quarterly basis, and we see no catalyst for growth to return this year. We believe the BOJ's recent program to provide $10 Billion in loans to repair banks' capital ratios and a plan to combat rising yields by buying treasuries are at best a "band aid".

XLP - SPDR Consumer Staples- Consumer Staples continues to look negative as a TREND. This group is low beta and won't perform like Tech and Basic Materials do on market up days. There is a lot of currency and demand risk embedded in the P&L's of some of the large consumer staple multi-nationals; particularly in Latin America, Europe, and Japan.