Rottenness

“If stupidity got us into this mess, then why can’t it get us out?”
-Will Rogers
 
That’s the quote that leads off Chapter 17 of Liaquat Ahamed’s “Lords of Finance.” It is one of my favorite chapters in the book. It’s titled “Purging The Rottenness.”
 
In the rear-view mirror, was the American Financial system as we knew it rotten? You bet your Madoff it was. And it doesn’t stop with 2008 or with the Bernies (Bernie Marcus was the rotten rat who ran The Bank of the United States (BUS) ponzi scheme out of NYC in the 1920’s before it was went Lehman Light (under), causing most Americans to distrust the Wall Street system).
 
Versus the constant banking crises of the 1920’s and 1930’s, the really bad news is that now we have YouTube and the internet. Bad news for some of these CEO bankers that is…
 
But don’t worry, they get it. In the last 48 hours, after announcing he is stepping out of his CEO seat, we’ve had Morgan Stanley’s John Mack proclaim his mystery of faith that now we need a “Global Banking Regulator”; Kenny Lewis has resigned; and the Almighty Jaime Dimon has been rumored to be tee’ing up his exit stage left from the house that JP Morgan built.
 
To be willfully blind to the idea that these guys only know what they know as of yesterday’s P&L is one thing. To understand how they manage their career risk is entirely another. “If stupidity got us into this mess, then why can’t it get us out?” There are no more big checks waiting at the end of that rat tunnel folks. The Rottenness is being purged…
 
I’m still too young for most people to take my word for these lines of thoughts, so take Paul Volcker’s. I can’t stop rewinding the DVR of this Charlie Rose interview with the ex-Chairman of the US Federal Reserve. His clarity of thought on what caused the Rottenness is impressive. He basically calls the Fuld’s and the Mack’s and the Paulson’s (nope, it want just Dick!), the “financial engineers” who were paid to be willfully blind to the math.
 
No matter what career risk management moves these CEOs make in the coming years, history will remind us that they didn’t do the math associated with risk management outside the bell curve of shareholder probabilities. If you are depending on these guys to get us out, think again. Accountability will not be purged from this mess.
 
Back to the grind…
 
Yesterday, I was focused on The New Reality’s 3-Some (Warsh, Plosser, and Fisher). Bond yields were shooting up in the morning and, come the afternoon, the Fed’s Vice Chairman, Donald Kohn, was shooting them down…
 
You see, to be In De Fed Head Leadership Club, you need to tow the political line. Kohn is a veteran of this conflicted and compromised US Government institution, so don’t blame him for any of that Rottenness we’ve been talking about. He was just one of the guys who has been overseeing it!
 
Kohn came out intraday reiterating what Heli-Ben Bernanke said to take the US Dollar to its knees last Wednesday (the September 23rd intraday low of $75.80 for the US Dollar Index). Kohn said that “exceptionally low interest rates are likely to be warranted for an extended period…” To America’s Creditors (The Chinese), that surely sounded as rotten as it has for the last 6 months. The US Dollar started to tank and 2-year yields took an intraday swan dive, breaking my immediate term TRADE line of 0.97%.
 
Some traders clinged to that “exceptional” headline, but I found Kohn’s follow-on comments inflectionary. He said “we must begin to withdraw accommodation well before aggregate spending threatens to press against potential supply, and well before inflation as well as inflation expectations rise above levels consistent with price stability.” On the margin, that’s much more hawkish than the Vice Chairman has been. Take note.
 
Until the math changes, what matters to anything priced in US Dollars is Fed Policy. Rhetoric will signal the timing of the hike. If you wait until the day of the hike, you’ll be left behind. Markets move on expectations.
 
Both Dr. Copper and the Burning Buck are telling me that the timing of the 1st hike from ZERO is sooner than consensus thinks. For the first time last night, all of my quantitative studies were flashing lower-highs in everything REFLATION (copper, SP500, BAC, RIMM, etc…), and this morning, for the 3rd day in a row, my models are registering a higher-low for US Dollar price support.
 
On the margin, that is bearish for things priced in Dollars. No, I’m not a raging US stock market bear now. I’m simply calling out changes on the margin as I see them. Here are three other factors to consider:
 
1.      Volatility (VIX): breaking out above my immediate term TRADE line of resistance at $24.96 (bearish for stocks)

2.      Volume: the last 2 days in my broad US equity volume studies have shown 26% and 31% spikes. Combined with market down days, that’s bearish.

3.      Japan: trading down -1.5% last night makes it the first major equity market to break both my TRADE and TREND lines. It’s still the world’s 2nd largest economy.

 
Is the Rottenness in the Global Financial System still there this morning? You tell me. Remember, everything rotten has a time and a clearing price – if there’s anything we have learned in the last +56.4 percentage points from the SP500’s lows, that’s it. My immediate term support and resistance levels for the SP500 are now 1040 and 1076, respectively. Yes, for the SP500, that’s a lower-high. Lower-highs, on the margin, have some rottenness that I don’t have to buy into.
 
Best of luck out there today,
KM


LONG ETFS

EWG – iShares Germany
Chancellor Angela Merkel won reelection with her pro-business coalition partners the Free Democrats over the weekend. We expect to see continued leadership from her team with a focus on economic growth, including tax cuts. We believe that Germany’s powerful manufacturing capacity remains a primary structural advantage; with fundamentals improving in a low CPI/interest rate environment, we expect slow but steady economic improvement from Europe’s largest economy.

CAF – Morgan Stanley China Fund A closed-end fund providing exposure to the Shanghai A share market, we use CAF tactically to ride the more volatile domestic equity market instead of the shares listed in Hong Kong. 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. Although this process will inevitably come at a steep cost, we still see this as the best catalyst for economic growth globally and are long going into the celebration of the 60th Anniversary of the People’s Republic.

 

GLD – SPDR Gold We bought back our long standing bullish position on gold on a down day on 9/14 with the threat of US centric stagflation heightening.   

XLV – SPDR Healthcare We’re finally getting the correction we’ve been calling for in Healthcare. We like defensible growth with an M&A tailwind. Our Healthcare sector head Tom Tobin remains bullish on fading the “public plan” at a price.

CYB – WisdomTree Dreyfus Chinese Yuan The Yuan is a managed floating currency that trades inside a 0.5% band around the official PBOC mark versus a FX basket. Not quite pegged, not truly floating; the speculative interest in the Yuan/USD forward market has increased dramatically in recent years. We trade the ETN CYB to take exposure to this managed currency in a managed economy hoping to manage our risk as the stimulus led recovery in China dominates global 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. We believe that future inflation expectations are currently mispriced and that TIPS are a efficient way to own yield on an inflation protected basis, especially in the context of our re-flation thesis.

 
SHORT ETFS
 
USO – US OIL Fund We shorted oil on 9/30. The three Fed Heads just put rate hike rhetoric right on the table. If the Buck stops Burning, Reflation stops working.

XLP – SPDR Consumer Staples Looking for low-beta short exposure to US Consumer spending. Consumer Staples short interest is low, and the stocks are over-owned.  

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 that bonds will give some of that move back. Shorting ahead of Q4 cost of capital heightening as access to capital tightens.

DIA  – Diamonds Trust In the US, we want to be long the Nasdaq (liquidity) and short the Dow (financial leverage).

EWJ – iShares Japan While a sweeping victory for the Democratic Party of Japan has ended over 50 years of rule by the LDP bringing some hope to voters; the new leadership  appears, if anything, to have a less developed recovery plan than their predecessors. 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.

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. Yields are going to continue to make higher-highs and higher lows until consensus gets realistic.