"I'm trained in weapons, demolition, and unarmed combat. I'm a sniper, and I'm the platoon medic. But most of all, I'm an American."
-Marcus Lutrell, US Navy SEAL
For Memorial Day weekend, I re-read "Lone Survivor." If you're looking for a reminder as to what it takes to face real adversity for your country, that would be the required reading.
What we've had to deal with on a day-to-day basis in financial markets is not even in the same solar system as what Marcus Lutrell overcame in Afghanistan. To the lost heroes of SEAL Team 10, and all those who watch over this country while our families sleep - we can never Thank You enough. We get to wake-up and play this game every day because of you.
This game of REFLATION that I have been riding in the US stock market for the better part of 2009 became a materially riskier one to be invested in last week. I think the BIG move in the REFLATION trade is behind us, so I'm starting to get out.
What was the inflection point? That's simple - going from a proactively predictable exercise of Breaking The Buck, to crashing it. As the US Dollar broke what I consider emergency support (at the $81.48 line on the US Dollar Index), I opted to cut my Asset Allocation to US Equities and Commodities to 27% and 12% of my max exposures, respectively. Additionally, I made 20 consecutive sales in our virtual stock portfolio. I now have 18 long positions and 12 short positions.
What Tim Geithner and his boss have labeled a "Stress Test" pales in comparison to what lies in front of them if this US currency crisis starts to trend sustainably in its current direction. Amplifying this international economic problem is The New Reality that America's enemies (North Korea, Iran, the Taliban, etc...) are more than willing to use the weaponry of market-timing to their advantage.
Market timing? Who does that? I do - and apparently "they" do too. Does anyone in Washington think for one second that the timing of missile testing and insurgencies doesn't incorporate some level of marked-to-market sophistication?
C'mon guys, let's seriously wake-up and smell the Robusta beans this morning. Our enemies are more than happy to inaugurate President Obama into the real global macro stress testing that was always pending. Markets are where people in this world get paid. Geopolitical risk is a monetize-able weapon of considerable destruction.
These aren't my politics. This is my investment process. I'm trained in real-time market prices. But most of all, I am a Risk Manager. If you want to try and tell the guy sitting next to you that there is no basis for these concerns, ask him to pull up a live quote. Market's don't lie folks; people do.
Oil prices shot up +9% last week to $62/barrel. Gold prices were up another +3%, taking its 3-week cumulative run to +8%. Yields on 10-year US Treasuries busted out to new YTD highs at 3.45%. Treasury Bonds on the long end of the curve got smoked alongside the US Dollar. Yes, the aforementioned commodities are priced in Dollars. Yes, both of these commodities always reflect a level of implied geopolitical risk.
All the while last week, some of my favorite contrarian indicators (sell side strategists and economists) are explaining that this is the beginning of a bullish move, and that "reflation isn't inflation" - thanks for the revisionist memos from the national history society guys.
I have been talking about credit markets improving, on the margin, for almost 6 months. This morning, I am going to start talking about them looking too good. The slope of the US Treasury yield curve hasn't looked better. At almost 260 basis points, the spread between 10 and 2 year US Treasury yields is exceptionally wide. And the TED Spread (3month Treasuries, minus 3month LIBOR) is as narrow as it has been in a long time.
So what do we do? Do we parrot consensus and jump into the US Equity REFLATION trade with both feet? C'mon. Let's get as serious as this currency situation has become. It's time to get very serious about the risks that have mounted over the course of the last week. The US stock market, while up last week, is down for 4 consecutive days for plenty of reasons - and I think I have called out some big ones here this morning. A market that rallies to lower-highs is as bearish as a market making higher-lows is bullish.
Where do we go from here? With the VIX (Volatility Index) down -60% from its October/November highs, and the TED Spread collapsing 400 basis points from that same time of real-world economic stress, my answer is not to higher-highs anymore. It's time to manage risk through the new game of Survivor that's developing, real-time.
In "Lone Survivor", Marcus Lutrell reflects on a veteran of six SEAL combat platoons, Eric Hall's, code of American conduct (Hall was one of Lutrell's instructors and stated to his prospective SEALs), "We don't put up with people who feel sorry for themselves... anyone lies, cheats, or steals, you're done, because that's not tolerated here. Just so we're clear gentlemen."
Just so we're clear, President Obama - it's time to step up and show the world what "I am an American" really means. Your country's currency is begging for leadership.
Best of luck out there this week,
KM
LONG ETFS
XLE - SPDR Energy- We bought Energy on 5/13 with the dollar up. We think it works higher if the Buck breaks down. Bullish TRADE and TREND remain.
CAF - Morgan Stanley China Fund- A close end fund providing exposure to the Shanghai A share market, we use CAF tactically to ride the wave of returning confidence among domestic Chinese investors fed by the stimulus package. To date the Chinese have shown leadership and a proactive response to the global recession, and now their number one priority is to offset contracting external demand with domestic growth.
EWD - iShares Sweden-We bought Sweden on 5/11 with the etf down on the day and as a hedge against our Swiss short position. From a fundamental setup, we're bullish on Sweden. The country issued a large stimulus package to combat its economic downturn and the central bank has effectively used interest rate cuts to manage its economy. Sweden's sovereign debt holds a strong AAA rating despite Swedish banks being primary lenders to the Baltic states. We expect Sweden to benefit from export demand as global economies heat up.
XLV - SPDR Healthcare-Healthcare looks positive from a TRADE and TREND duration. We've been on the sidelines for the last few months, but bought XLV on a down day on 5/11 to get long the safety trade.
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.
GLD - SPDR GOLD -We bought more gold on 5/5. The inflation protection is what we're long here looking ahead 6-9 months. In the intermediate term, we like the safety trade too.
SHORT ETFS
XLU - SPDR Utilities - We shorted Utilities on 5/22 as it is trading below the TREND line. As long term bond yields breakout to the upside, Utility investments are the relative yield loser.
EWJ - iShares Japan -We re-shorted the Japanese equity market via EWJ on 5/20. We view Japan as something of a Ponzi Economy -with a population maintaining very high savings rate whose nest eggs allow the government to borrow at ultra low interest levels in order to execute stimulus programs designed to encourage people to save less. This cycle of internal public debt accumulation (now hovering at close to 200% of GDP) is anchored to a vicious demographic curve that leaves the Japanese economy in the long-term position of a man treading water with a bowling ball in his hands.
EWW - iShares Mexico- We're short Mexico due in part to the repercussions of the media's manic Swine flu fear. The country's dependence on export revenues is decidedly bearish due to volatility of crude prices and when considering that the country's main oil producer, PEMEX, has substantial debt to pay down and its production capacity has declined since 2004. Additionally, the potential geo-political risks associated with the burgeoning power of regional drug lords signals that the country's economy is under serious duress.
IFN -The India Fund-We have had a consistently negative bias on Indian equities since we launched the firm early last year. Despite recent election results likely proving to be a positive catalyst, long-term we believe the growth story of "Chindia" is dead. We contest that the Indian population, grappling with rampant poverty, a class divide, and poor health and education services, will not be able to sustain internal consumption levels sufficient to meet targeted growth level. Other negative trends we've followed include: the reversal of foreign investment, the decrease in equity issuance, and a massive national deficit.
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%.
EWL - iShares Switzerland - We 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.
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