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    MARKET EDGES

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“We are entering upon waters for which I have no charts and in which I therefore feel myself an utterly incompetent pilot.”
-James Warburg
 
When a 37-year old James Warburg made that comment, it was a similar time for the US currency market as the one you are witnessing today. With the critical clean cut difference being that FDR made his intentions to devalue the Dollar explicit. President Obama’s cast of politicized characters at both the Fed and the US Treasury do not have that Currency Credibility to serve up alongside fire-side chats.
 
James Warburg was the son of Paul Warburg (one of the founding fathers of the US Federal Reserve) and, at the time of this quote in 1933, he was the youngest chief executive on Wall Street. He was considered to be one of the “smartest” men in New York. That’s not always a good thing to be…
 
There was this other guy overseas who was Warburg’s age by the name of Keynes. The two men couldn’t be more different in their views of what a Burning Buck might mean for capital markets. Keynes wasn’t a banker – he was a currency trader who happened to be signed off on by Bank of England bankers.
 
The point of this historical contrast is that you can get emotional and enraged by the US Government Burning the Buck, or you can simply understand its implications and make money on them. Bringing your politics or emotions into your portfolio is going to do absolutely nothing but erode your returns. To date, the bottom line for 2009 has been that Dollar Down = almost everything priced in US Dollars up. That’s it.
 
In the long run, Sir Keynes will remind you where you’ll be – 6 feet under. In the immediate and intermediate term, you are best served trading the game that’s in front of you. Do you think for a second that the politicians in Washington or those at the NY Federal Reserve in Manhattan give a damn about the long term implications of US Dollar Devaluation? Of course they don’t; so neither should you.
 
Being patriotic in your portfolio won’t help you any more than your politics. So, roll up your sleeves this morning, like Keynes did in 1933 and make sure that you aren’t missing out on the easiest carry trade in the world. Being short the US Dollar and long anything priced in those dollars.
 
Theoretically, at a point, the US Federal Reserve should raise rates and end this Massive Macro Diversification trade away from US Dollars. Theory and some lip service about how you think things might play out in certain weather conditions might just render you a 59-0 loser like the Patriots made the Titans yesterday in Boston. So be aware of Practitioner’s Rules and re-read that Warburg 1933 conclusion before getting too theoretical about this…
 
Last week the Buck Burned to lower-lows, taking it down for the second consecutive week and eight out of the last ten. This morning, no matter where you go, there that Burning Buck is again, trading down another -0.21% at $75.44 and hanging on to hopes that another hedge fund manager doesn’t get YouTubed in Sri Lanka.
 
When any of the perpetually and willfully blind US Dollar bulls tells you that the marked-to-market price of the US Dollar isn’t what you see on the chart (testing a breakdown to its lowest levels in 38 years), ask them what they think the Credibility side of this US Dollar analysis looks like. Madoff, Stanford, Rajaratnam… the Transparency list of what it is that some American financiers have been doing for the last decade is getting longer…
 
If the Buck’s Bulls don’t see Credibility as a factor in the fundamental analysis of say the Chinese or Brazilians, maybe some of the following factors will help:
 
1.      The US Federal Reserve’s Balance Sheet went up another +$55B last week, with MBS buys being the highlight (up +10% week over week!)

2.      Bank of America and General Electric’s low quality levered earnings reports

3.      US Federal Reserve rhetoric being explicitly dovish again with weekly comments out of Donald Kohn (Vice Chairman)

 
At 11AM EST today, Ben Bernanke will have one more opportunity to prove the likes of Warburg and my long term monetarist understandings on inflation wrong. Reading the tea leaves, unfortunately, there is nothing but hope that Bernanke keeps the long run in mind. Hope is not an investment process…
 
Across durations, the US Dollar remains broken. Here are my risk management levels:
 
1.      TAIL (long term) =  82.39

2.      TREND (intermediate term) = $78.29

3.      TRADE (immediate term) = $76.54

 
Yes, maybe there is a hope that Bernanke being objective gets the US Dollar above the TRADE line. If it does, I suggest you keep all of your REFLATION shorts at just that – a trade. We don’t want to have to call ourselves “utterly incompetent pilots.”
 
Throughout last week, I took down my Asset Allocation to US Cash. What’s the point in being theoretical on the wrong duration (long term) when using Burning Bucks to buy things priced in bucks can make us right? My immediate term upside/downside risk management levels in the SP500 are now 1103 and 1074.
 
Best of luck out there this week,
KM

LONG ETFS
 
XLU – SPDR Utilities We bought low beta Utilities with a reasonable dividend yield on 10/13.

EWT – iShares Taiwan
With the introduction of “Panda Diplomacy” Taiwan has found itself growing closer to mainland China. Although the politics remain awkward, the business opportunities are massive and the private sector, now almost fully emerged from state dominance, has rushed to both service “the client” and to make capital investments there.  With an export industry base heavily weighted towards technology and communications equipment, Taiwanese companies are in the right place at the right time to catch the wave of increased consumer spending spurred by Beijing’s massive stimulus package.

EWG – iShares Germany Chancellor Angela Merkel won reelection with her pro-business coalition partners the Free Democrats. 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
 
FXB – CurrencyShares British Pound Sterling
The Pound is the only major currency that looks remotely as precarious as the US Dollar. We shorted the Pound into strength on 10/16.

XLP – SPDR Consumer Staples Strong day for Consumer Staples on 10/16, prompting a short versus our low beta long position in Utilities (XLU).

XHB – SPDR Homebuilders We were the bulls on a Q2 housing turn but, as the facts change so do we: now we are getting cautious on 1H 2010 US Housing. Rates up as access to capital tightens is not good for new home builders as we enter into a new year and series of potential catalysts for renewed pressure in the secondary market, including the expiration of the $8,000 tax credit.

USO – US OIL Fund WTIC Oil traded just north of our overbought line on 10/12. With the US Dollar hitting another higher-low, we shorted more of oil’s curve.

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.