Wednesday, April 29, 2009

Dog off the leash!

As mentioned earlier, if the 10 yr treasury yield breaks 3.00% decisively the treasury bond has broken down. Today it did. Act accordingly.

John Barnyak

Where's the Debt?

This recession (call it what you will) is predicated on debt. Too much debt. I'm indebted, you're indebted, wouldn't you like to be indebted too?

The world is surely more interconnected than it was and as the makers of Tamiflu will tell you, when one of us sneezes we all get sick. But they will also tell you to stay away from sick people. It's not easy to isolate oneself, but we can try. So too is it with United States as a borrower. It's impossible to isolate us, but the rest of the world will try to stay out of sneeze distance if possible.

The U.S. currently has $3 Trillion of its debt in the form of Treasury securities around the world. The biggest as we all know is China, but there is plenty to go around. Given the state of the US economy, future liabilities and government policies it is a certainty that the rest of the world is trying to figure out how to let loose of the United States tarbaby. It likely will not happen quickly as such disruptions create problems globally, but it will happen. It IS happening.

The Chinese proposal of substituting the US Dollar with IMF Special Drawing Rights is a non-starter but it IS a warning. The world is looking. There is no alternative, yet. What keeps the US dollar up is every other currency being worse.
The Chinese have been hard at work to diversify a bit from the US dollar. They increased gold holdings significantly in the past year. They have been buying copper and hard asset productions. Whether with equity positions in mining companies or long term contracts for oil they've been on a shopping spree with a $3 trillion dollar line of credit.

What I have been watching is the action of the yields on treasuries and the policy moves. On March 18, the ten year bond was yielding 3.09% when trading opened. The Fed then announced it would buy $1.2 Trillion in treasuries. This tidal wave of impending demand pushed yields down immediately to under 2.50%. Today, the 10 year treasury yield is 3.02%. In other words the prospect of over a trillion dollars of buying has brought interest rates down, not at all. What happens when the Fed stops?

In the UK they experienced a failed auction of government debt. Not enough bidders showed up for the amount offered. In the US it is unlikely we would ever experience that as the Fed has taken it upon themselves to "monetize" the debt by being the buyer of last resort. Something has to give. The dollar? Inflation? Taxes?

Everyone seems to agree that shorting the treasury bond makes sense in this bubble. Usually I would think too many on the same side of the trade, but this might just be the mother of all bubbles, so be patient, but pay attention. The top of the 10 year rate has bounced off 3.00% repeatedly this year. When it doesn't bounce, the hound may have broken its leash. If you have all of your retirement money in bonds, pay CLOSE attention.

The quadrillion dollar question is which, what, and when.

John Barnyak

Tuesday, April 28, 2009

Bennie and the Feds

Amazing to think jazz pianists knew even before the recession was officially declared but not those running the ship of state. Enjoy.

Almost Midnight for Ken Lewis

Something is up. The trading cliche is that low volatility leads to high volatility. Well the market has been comatose since the beginning of April leaving us crystal ball gazers to shake it repeatedly just to make sure its working.

Since the equity markets seem to be, ahem, acting oddly, we look deeper to the Credit Default Swap market. The price of CDS for BOA/Merrill is way up today so bets are being placed on fireworks at tomorrows annual shareholder's meeting.

I for one am hoping he is escorted to the door and don't really care if it hits him in the ass. There are so many hands on the levers of power these days I'm just hoping, not betting.

Update: The powerful pension fund, CALPERS just stated they will be voting for his ouster. Wasn't one Kenny Boy enough?

John Barnyak

If you Squint you can see the light at the end of the tunnel

Good news folks! Monthly housing prices fell for less than a record amount for the first time since October 2007. Talk about your second derivative celebration! I concede it is better than a sharp stick in the eye but the chart below isn't exactly cause for exuberance. News like this makes short sellers slightly less aggressive but hardly reverse investment positions.

Maybe if a few thousand more homes are bulldozed prices will stablize and head north once again.

John Barnyak

Theater of the Absurd in Detroit

The Government proposal for General Motors may just be a watershed event. It is not that hard to understand and reveals who gains and loses fairly clearly. For American taxpayers, its not that good and when looking at the winners, joe sixpack might not be that happy.

If the deal goes through as currently proposed....

US taxpayers) would get stuck with 50% of GM's equity (currently worth $625 million) in exchange for forgiving about $10 billion in federal loans.

The UAW would get 39% of GM's equity (currently worth $488 million) in exchange for giving up $10 billion in health care benefits.

Corporate bondholders would get 10% equity (currently worth $125 million) in exchange for giving up $27 billion in bonds.

Under the above agreement there is still a missing $10 billion piece of the puzzle: "The government wants the union to accept company stock to finance half of G.M.’s $20 billion obligation for retiree health care as noted above."

What happens to the other $10 billion? Either it goes to the retired worker or to taxpayers via the Pension Benefit Guarantee Corporation.

Everybody loses but the credit default swap holders. Now who might that be? JPMorgan, Goldman Sachs, and/or Citigroup by any chance?

The decision to allow CDS to be an opaque, unregulated, casino might end up staining Bill Clinton's legacy even in the eyes of admirers.

The idea that Wall Street runs the country and not the elected or the electorate becoming clearer by the day.

As we saw with the Goldman Sachs/AIG counterparty party in which rolled the dice with AIG and taxpayers paid up, there seems no limit to our collective generosity.

John Barnyak

Starving Private Beasts Too

The rallying cry of the conservative movement in the 1990's was to, "starve the beast." As Grover Norquist said, "My goal is to cut government in half in twenty-five years, to get it down to the size where we can drown it in the bathtub." Well run the bath honey, GM is ready for a dip.

Following yesterday's announcements of additional plant closings, the demise of Pontiac and another 21,000 job eliminations, GM will be of a size even Mr. Norquist can handle. Employment will be 38,000, down from 395,000 in 1970. The company that once touted, "what's good for General Motors is good for the USA," seems on its way to irrelevance. Times, they are a changin.'

John Barnyak

Green Shoots of Recovery?

Over a year ago I listened to an interview with a real estate analyst from a major firm. His worst case scenario was the bulldozing of houses to bring supply and demand back into balance. This video indicates that in southern california at least, we're there.

The value of the houses to the banks that foreclosed has become negative with local zoning ordinances imposing fines on houses that are still unlivable but brand new.

I live near a big box strip mall that is now largely abandoned because of development problems followed by the developer's bankruptcy. I wonder how long before the municipality takes a similar route.

John Barnyak

Out of the box

I believe I have mentioned before the statement made by a speaker at a conference I attended that we cannot, “think outside the box. We are the box.” The current apparent thrashing about in search of the solution to the current banking crisis brings that statement to mind. Depending on the same people who created the environment that allowed the systemic problems to take root and then flourish to provide the solution has become part of the problem.

It is understandable to seek out expertise in a subject to provide guidance in all matters pertaining to that subject. Unfortunately it is also understandable that self preservation becomes the default mode. How can we expect the very people who insisted on repealing Glass-Steagall to now lead us back to similar regulation. How can we expect that those who wrote the legislation allowing banks to police their own capital levels to throw themselves on their swords or find the solution that is not within their view of the universe?

The problems hatched by financial engineering and complexity beyond the understanding of even those who created it cannot be solved by adding yet more complexity engineered by the same persons. The response that a problem is so complex that it can only be addressed by those who created it is common. The problem needs to be deconstructed to a level at which mere mortals can provide simple coherent solutions.

Each time I hear a CEO of a failed, insolvent bank lament that compensation limits will mean they lose their best people I am surprised that the questioner does not follow up with, “and you don’t think that would be a good start?”

The solution to the banking problem would be fairly simple those without vested interests were not the ones looking for the perfect solution that supports the status quo. The holders of Citigroup and Bank of America bonds are not preponderantly widows and orphans. They are credit default swap wielding, monolithic investment banks. It is time that the private sector step up to the risk they took as sophisticated investors and lenders. The taxpayer is NOT the counterparty on poor judgment insurance.

If Mr. Geithner and Mr. Bernanke believe they are the protectors of the banks that has bought them lunches for the past decade they should be replaced. Since they can’t think out of the box they are in, we need a different box and they should move theirs from K street back to Wall St .

Stiglitz Lecture

Nobel Prize winner Joseph Stiglitz discussing the financial crisis and outlook. Nearly hour long discussion, slightly academic assessment of the current policy failures.

Monday, April 27, 2009

Charlie Rose Interview..state of the banking system


One of the most frustrating aspects of a secular bear market is the number of bear market rallies seemingly designed to pull in investors then swat them down just when hope begins to renew. The graph below shows the seven bear market rallies following 1929 and the accompanying seven failures to sustain them. From 1929 until 1933 there were ample opportunities to hope and croak.

Since the market high in October 2007 the S&P has paused three times for a bounce before resuming its downward path. In early spring of 2008 the S&P gained nearly 15% before collapsing again. The year end rally of last year saw a relief gain of over 27% and now again, the springtime sprigs have put on over 30% since the March low. None of the rebounds have been able to regain the level of the previous one. The pattern of lower highs and lower lows remains intact despite the green shoots of recovery the Washington policy makers wax poetic about.

Make no mistake, I know the siren call of a rally. No manager wants to miss a 30% move and I find myself taking very small scout positions just in case. The covered call strategy begins to look ugly when a minor time premium is exchanged for strike price that goes deeper into the money.

I once had an old jewish attorney whisper to me as I headed up to the witness stand in court, "sitzfleisch." What he was saying was, sit, shut up and be patient.

John Barnyak

Natural Gas Update

For all the Marcellus Shale aficionados in the area we offer this natural gas update. Today the price of the NYMEX continuous gas contract touched $3.37 and I confess to being sorely tempted. But there is more to the supply question than meets the eye of those of us who see drill rigs in the neighborhood.

While the analysis of rig count and demand gives me some confidence of higher prices later this year, an analysis of LNG availability presented by The Barricade blog puts an additional spin that many in this region don't consider. I think it best to let the money flow of natural gas show us when to put on a trade.

Commodities move with the underlying economy. My oil price call last year was dictated by macroeconomic conditions on the horizon and I expect despite the bleak outlook in the Barricade analysis, macroeconomic revival will provide some greater light for Natural gas prices in the coming year, but no need to catch a falling knife.

John Barnyak

The other side of the street

One of the challenges to investing is the matter of asymmetrical knowledge. What makes the concept fascinating to me is the continual pitchmen who talk their book to all of us. In a world in which salesmanship moves faster than accuracy, it is very easy to be caught up and caught out. Every grade school kid knows that when offered something in the cafeteria by a questionable friend the first question asked is, "what did you do to it?" Unfortunately it also seems the first question to ask years later when the tasty investment morsel may have longer term and less benign consequences.

Remember last summer when Goldman Sachs came out and clearly stated its view that oil was heading for $200/bbl? When an investor remembers that Goldman Sachs trades on behalf of itself the vast majority of the time, such advice might be taken with a grain of salt. Just because she knows the street, doesn't mean she's not about to give you more than you bargained for.

In the week before last, GS traded 84% of its program trades on the NSYE on behalf of Goldman Sachs. They also traded over half of the volume on the exchange. So how do we invest in a world that is working the other side of the street? Follow the money, not the advice of those with opposite interests.

The politicians would do well to also pay attention to the source of advice. Bank holding companies continue to put one hand out and another in the taxpayer's pocket but I am beginning to feel the complexity of the problems will not be tolerated for much longer. The simple solutions may well be finally allowed to rise to the surface and bank debt to equity swaps will be allowed to provide the elegant systemic answer to bank undercapitalization. The banking firms would rather keep hands in the deepest pockets in the world but its time to step up and create healthy banks from reluctant bondholders. Sorry Bill Gross, you're smart, you'll adapt.

John Barnyak

Fixed Income Strategy

Each year when I would attend annual metal commodity conferences part of ceremony was handing out the awards to those who had made the best predictions. Out of the several hundred guesses about the price development of several metals such a gold, aluminum and nickel, it was usual that the outliers were the ones that won. The distribution was the vast majority within several percentage points of the current price and a few nuts miles away. The winners were almost always the nuts.

Right now, the informed opinion is that long term bond prices are going to begin to fall any day. History has a way of making conventional wisdom look foolish. So slowly slowly and the more confident one is, the more slowly should be the entries.


John Barnyak

Friday, April 24, 2009

News so fast you'll freak!

Both my sons have at some time worked for a sandwich shop with the advertising, "sandwiches so fast you'll freak." Lately the news, and I mean BIG news just keeps coming. Often it is old before it is even released and reverses thinking on a dime.

This week as pundits spoke of the "green shoots" of economic recovery everyone seemed to grasp for positive spin on news, even selective spin.

Today March's durable good report was released and was just such a green shoot. While by no means great, orders fell by only half what was expected. But..uh, what about the news yesterday that General Motors will completely shut down for the balance of the second quarter? I think it might put a crimp in the next couple months' durable goods reports. Including parts suppliers this could be a reduction of payrolls of about 140,000 workers.

The U.S. economy needs approximately 100,000 new jobs per month to move the unemployment rate lower. By May we can expect to see 9% and 10% by June or July.

In other news, the Bernanke, Paulson, Bank of America saga looks about to get deeper, wider and more despairing. That laws were broken seems clear. That there will be consequences to any of them is less clear. But we're getting used to that.

The issue in question is that Mr. Lewis, BOA's CEO, wanted to step out of the deal to purchase Merrill Lynch as details came to light that the company was crumbling fast. Secretary of the Treasury Paulsen and Fed Chairman Bernanke threatened to remove Lewis and the board of BOA if the deal were not completed.

The bank had a fiduciary responsibility to alert shareholders of material events, such as the mounting losses at Merrill Lynch which would have given them the opportunity to stop the deal. Lewis told investigators, "it wasn't up to me."

It sure is up to you buddy. You don't work for the regulators you work for the shareholders. If your actions result in your removal from office by a regulator, tough. You followed the law.

Until consequences are felt at the HIGHEST levels, our system will grind ahead very slowly at best. With no clarity of policy or even law to guide commerce we are dead in the water. It's time to take a deep breath cut out the rot.

John Barnyak

Natural Gas

If there is one thing to learn about commodities, it is a phrase one hears often in energy trading. The answer to high prices is high prices. A cyclical industry, commodities are driven by supply and demand with greater speed and clarity than economic products higher up the food chain.

In our geographic area of southwestern Pennsylvania, last year there was group hysteria as every property owner I know was scurrying to confirm they owned the gas rights beneath their feet. Drilling lease rates went from little more than single digits per acre to thousands of dollars over the course of several years. It was marcellus shale fever! You could almost see their lips moving as they figured, "200 acres times $3000 equals...whoa. A really nice new pickup truck!" And that didn't even consider the gas price over $10/mcf, 20% royalty rates and well over a million cubic feet per day production on wells.

Combine a slowing economy with a massive new production supply and Adam Smith's invisible hand of capitalism comes into view. Today the price of natural gas is below $4/mcf and lease rates back to earth. Back to old pick-up, smaller crowds at meetings and life in the slow lane once more.

But for investors, the answer to low prices is low prices. The Natural gas prices show no sign yet of returning to last years lofty levels but the decreasing rig count is the seed of the next cycle. Investors may want to consider taking exploratory small positions in natural gas if they have a time horizon of beyond the next weeks or months. Looking at the ETF chart for natural gas tells the story.

A decline (collapse) of more than 80% in less than a year to levels below production costs in some cases begins to look interesting for the patient. As the graphic below shows trees don't grow to heaven, but they resprout in time.

John Barnyak

Thursday, April 23, 2009

Curiouser and Curiouser

Let me say first that this entry is not about the economy. The economic backdrop remains quite abysmal at every turn. Unemployment continues to rise, real estate foreclosures are soaring, states and local municipalities are starved for tax revenue. The policy makers have successfully shown great confusion and poor communication.

Having said all that, markets are discounting mechanisms which judge the future not the past or even the present. To make things even more difficult, one of the major market participants is now the US government. If that is true for the equity markets, as we know it is for the fixed income markets, US strategic activity may diverge completely from fundamental value in the markets.

The news flow is stunningly bad yet the market shrugs it off. The question is whether this is a matter of the market judging that valuation is reasonable or something more nefarious. Earlier this week traders seeking to short the S&P discovered they could not borrow shares as needed to sell short. This is unheard of. In an efficient market, the index of the 500 largest public companies in the country surely could not be cornered. Inconceivable, but for a short while true? Could someone's finger be on the scale? The conspiratorial thoughts run wild.

Technically the market is working off its overbought condition benignly. It appears that a few more days of flat trading days would poise the market again to move higher. If only news wasn't so damn bad.

In a market that is fundamentally unknowable, the only strategy is to follow the money.

John Barnyak

Wednesday, April 22, 2009

Freddie Mac Tragedy

Everyone knows that the stories of brokers throwing themselves from tall buildings in the Crash of 1929 are apocryphal urban legends. I think. While not yet clear why Mr. Kellermann, CFO of Freddie Mac, apparently chose to take his own life late last night, it is not hard to imagine. The despair that can overtake one in the midst of a personal and professional maelstrom can strip even the brightest and most outwardly successful of logic as well as hope.

No one else can be blamed for Mr. Kellermann's decision. We all make decisions daily under the guise professional responsibility, shareholder interest, orders from the top or even personal gain. We would all do well to remind ourselves that somewhere behind the paperwork, the policy and the profit, there are people.

The list of individuals who have taken their own lives because of reversals of fortune or because of shame grows as the current crisis continues. The asset manager in London, the real estate attorney in New York, the industrialist in Germany, the foreclosed widow in Toledo, all saw no way better way out.

Each of these is another reason to clean the system of the moral hazard that creates undue risky behaviour. Too often the consequence of ill considered actions is shifted. In some cases, it cannot be reversed. Even in death Mr. Kellermann left a wife and daughter to deal with them.

John Barnyak

It ain't over til it's over

You’ve probably seen the real estate advertisements recently. A beaming real estate agent handing the keys to a young couple as they begin life’s adventure as homeowners. It's idyllic and the opportunity won't last long. Or will it?

The voice over implores viewers to take advantage of this “never been a better time to buy a house.” I would agree there’s never been a better time to refinance a home with interest rates historically low. Assuming there is reasonable equity in the house, if they go lower still, refinancing should be possible. But the idea that housing costs are about to spin on their heels and head higher is hardly borne out by the evidence.

The fundamental part of the economy that pulled us into the mire is not ready to let go of our economic throats quite yet. In the past couple months lenders have paused in foreclosures at the behest of the President and it has certainly not been a hardship on the lenders since by all accounts they have already bitten off more than they can chew. Recently the banks have begun once more to begin foreclosures but I have to wonder why bother? They already have a huge shadow inventory.

RealtyTrac, which compiles real estate statistics, estimates 600,000 properties have been repossessed by lenders and not yet put on the market. The market simply cannot absorb so much supply without pressing housing prices even more dramatically lower.

A RealtyTrac survey found that only 30% of foreclosures were listed for sale in real estate listings. Much like the understating of unemployment because of workers having hours cut but still on the payroll, additional homes would be on the market if the homeowner thought there were any buyers. Discouraged workers do not show up in statistics, neither do discouraged sellers.

Normally there are about 160,000 homes a year in foreclosure sales. We are now seeing 80,000 a month, or six times normal levels, and rising.

Extend these actual physical homes to the securitized market of mortgage backed securities and the PPIP sounds like a pretty good deal, if you are a lender. In real terms, the PPIP program is meant to sell the taxpayer this real estate in a so called partnership. Is it any wonder the market values mortgage backed securities at about 35 cents on the dollar and the banks are champing at the bit to get them off the books in the PPIP at closer to 80 cents?

The mortgage issues alone make rolling the dice on financial company stocks a bit early I think unless you are a nimble trader ready to take profits and reload. There is still pain to come.

Last year the subprime market was hit with the maximum level of rate resets. Tens of billions of dollars of subprime adjustable rate mortgages came to market with results we have all seen. That pig is slowly moving through the python. As we move further through 2009 resets on prime, agency and Alt-A will surpass those of subprime. By 2010 sub-prime resets will be negligible. But there is trouble ahead in Option Adjustable Rate Mortgages.

If you can buy for less than you rent and be cash flow positive treating the house as effectively a rental property then it may be a go. But if you are hoping to get in before the real estate market takes off and leaves you behind, chill out. Keep saving, there is very likely an even better deal just over the horizon.
This 60 Minute video should help cool fevered real estate pitches.

John Barnyak

Monday, April 20, 2009

UIT's What's to Like?

I cannot count the number of times I look at a new client's old portfolio and say, "huh?" So often it is a collection of hot tips long since forgotten or a broker recommendation with the fingerprints of his manager's need to sell a new offering. This morning I found a Unit Investment Trust for Africa and the Middle East in a small client's portfolio that recently transferred in. Huh? I called to ask her why. Because he thought it was a good idea. Right. Put a middle aged american woman into a ten percent "horn of africa fund"? Sounds like a broker arbitration to me. Regardless, what was done was done.

But lets look at UIT's in general. What are they? What is their benefit? Unit Investment Trusts are unmanaged funds of a portfolio of stocks or bonds. There have been Dogs of the Dow UIT's, technology UIT's, healthcare UIT's. In principal that's not a bad thing. You get diversification. But are there other ways of achieving that for lower cost with better control and liquidity.

UIT's are created by a sponsor, in this case it was Claymore. They are not traded on any exchange and the constituent shares within the UIT must be physically delivered when sold. For that reason when I sold this morning the settlement date is seven days from now, with no price visibility and to add insult to injury, a deferred sales commission. In an investment Yemani qat production, consider a different method.

John Barnyak

Then again.....

Maybe the Obama administration is just more patient than the rest of us. Last week the largest bank in Florida, United Bank of Coral Gables received a notice from the Office of Thrift Supervision. They have twenty days to either find a buyer or disappear. Will Coral Gables sink beneath the sea or will someone step up to purchase the bank? It will take a pretty big python to swallow this piglet and it will give us a reality check on money on the sidelines. If I would be thinking twice if I were holding trouble bank shares.

This bank is on par with IndyMac as far as size so could have intriguing repercussions. It also begs the question of how far on the hook would the FDIC be in a failure to sell or recapitalize? FDIC is not a bottomless it? Or will Goldman Sachs or Morgan Stanley, now banks, step in to acquire a deposit base?

John Barnyak

"You probably already know us here at BankUnited because we’re the largest bank headquartered in Florida. With more than $14.3 billion in assets, we’re a strong local presence, but we never forget our roots: Your community.

We’re proud to be your local bank and we’re proud to be your neighbors."

Brother can you spare a billion?

The White House has made a significant shift in approach to the banking fiasco over the weekend. I call it the Turducken Policy. Rather than speaking the name that should not be uttered, the administration has taken a, walks like a duck, quacks like a duck, must be a turkey, approach to bank nationalization.

By converting taxpayer bailout money to the major troubled banks into equity Citigroup and the other merry banksters will have their capital ratios raised, have the U.S. government as the largest owner, turn loans into capital, and keep out of the Congressional theater. The stomach for additional government aid for wall street is modest if not nonexistent.

I find it ironic that when Carl Icahn announces he has a 5% share of a company, things start to change. Heads roll, management groans and boards wince. When the US government owns effectively all of AIG and will own 30+ percent of the major troubled banking institutions, it seems business as usual. Even independent trustees of AIG work under a pall of apparent secrecy. They are neither company nor government, neither fish nor fowl.

It seems likely that the bank stress tests, which assume an economic worst case scenario (which we are already exceeding) will not be able to issue an all clear without some serious rejiggering of balance sheets. This closet nationalization continues to skirt the issue of the protected debt holders where the solution really exists. Rather than making use of the structures in place to default on bond holders and restructure in an orderly way, we continue to give the losses to the public and protect the private investors who should have known return on investment always entails risk in a capitalist system.

This continues to be crony capitalism and continues a saga of "responsibility" without consequence. As a social liberal and a fiscal conservative, I find the current path the worst possible. If policies would remove moral hazard and the increasingly oligopolistic system in place the entire world could breathe easier.

John Barnyak

Friday, April 17, 2009

Treasury Indecision

If one considers that the bond market is the best crystal ball of the investment climate, since February it's lips are sealed. After a chaotic flight to quality near the end of last year when investors cared more about return OF capital rather ON capital the Treasury bond market has been very quiet. With returns on treasuries pinned near zero it is hard to envision much room to rise unless inflation rates remain below zero for longer. During the height of the buying frenzy in treasury bonds at the end of December buyers of short term government bonds were accepting less than zero rates of return.

In the chart above, the blue line is TLT, the 20+ yr Treasury Bond ETF, while the red line its alter ego,TBT, the negative long treasury bond.

Yesterday the short term zero coupon return touched 0.01%, effectively nothing, yet at the same time stocks continued to rise. There is a disconnect here that I suspect will reveal itself shortly. The bond market is showing an extreme aversion to risk and the equity market storming ahead.

John Barnyak

I've got a bridge you might like

This morning the first financial news item that came across my screen was Citigroup's quarterly results beating expectations. Sounds good to me. Citigroup shareholders could use some good news. Then, I dug into the earnings report and admit to raising an eyebrow.

Income from continuing operations rebounded from a loss of $5.2 billion to a gain of $1.6 billion. Good stuff. Then we dug a little deeper. Global Cards division..ooh that one dropped a lot. Consumer banking? hmm...$1.2 billion in the red. Global Wealth Management? slight drop in a small part of the business. So where did the big advance come from? Institutional Clients Group which is their trading division. Wow, from a loss of $6.4 billion to a gain of $2.8B.

So if I understand this correctly, the American taxpayer gives Citi $45 billion in taxpayer funds and they manage to make $2.8 billion with a phone in each ear and yelling "buy!" , "sell!" across the room. Sounds like a long term strategy, if only they can keep those taxpayers priming the pump.

But I must say, my favorite part of the Citibank result is $2.5 billion they made just for being a lousy company. After Goldman Sachs misplaced the month of December in their recent results, Citi's accounting slight of hand seems almost normal. Because Citi debt has been justifiably savaged by the market it could buy back their own debt (taypayers need to step up again?) and book a $2.5 billion gain. Sounds like a nifty plan. Issue debt, run the company into the ground, say the debt is barely worth having and book a profit. Now if the financial system would just admit the mortgages they hold aren't worth what they say, wouldn't the national quarterly report look a lot better too? I know my P&L would.

John Barnyak

V=sqrt (2W/CdρA)

Investing at the geek level is full of greek letters and Newtonian concepts like inertia and momentum. For the past month the market seems thoroughly beguiled by the physics concept of terminal velocity. That moment when an object is no longer accelerating in its descent has captured the analysis of the talking heads.

What bothers me is the giddy tone. Falling no more rapidly does not by any stretch of the imagination mean the object in question is now flying. It is simply not going to hit the ground at any greater speed than present. A significant SPLAT! may still be in the cards. I agree we have decelerated our decline, but I am not yet prepared to accept that a reversal is going to be immediate and prolonged.

The term of art bandied about now is, “second derivative trade.” Objects do not fall at the same rate through the atmosphere and the stock market behaves similarly. Greater velocity occurs because of a number of factors and as these factors change, so too does acceleration. Weight is a factor, i.e. gravitational force. Surely the Dow at 8,000 weighs less than the Dow Industrial Average at 14,000. It makes sense. Gravitational pull is proportionately less.

Two other aspects of speed of decent are drag coefficient and gas density. We’re certainly lower in the atmosphere from the past lofty levels so air density should be greater and slow us down a bit. The final rate impacting factor, drag coefficient would be earnings. At the moment earnings are still coming in at a very streamlined level. In other words, there aren’t any. A few good earnings reports will be the parachute to truly slow the descent to a gentle landing.

Some investors are rushing to buy on the basis that the speed of decent has slowed. In the spirit of, “if you are in a hole the first thing to do is stop digging,” the market action is certainly positive, but caution is still called for. Investors should have been beginning to rebalance earlier this year when technical signs began to flicker green, but there is still a lot of work to do and no one needs to think they’ve missed it.

Thursday, April 16, 2009

Be a Zenful Investor

The single most important issue in positioning investments for future growth is to be correct on the question of inflation, more specifically unexpected inflation. Markets are discounting mechanisms based on infinite expectations. The trick is properly predicting the future. As Yogi Berra, the Yankee’s hall of fame catcher, so brilliantly declared many years ago, “it’s tough to make predictions, especially about the future.”

Right now there is a battle royal going on between the forces of deflation and inflation and today deflation is winning. Despite our personal inflation rate which tends to focus on the price increases, not the price decreases, deflation has the upper hand at the moment. But predicting the present does not provide much profit so we need to look further into the future.

The federal government doesn’t help much in clearing the fog of prediction with statistics that seem to distort the past , the present, and the future. Whereas last year a benign Consumer Price Index seemed very much at odds with soaring food and energy prices and personal experience, we now see the reverse happening.
The most important component in the CPI calculation is what is called Owners Equivalent Rent. The OER is the governments estimate of what it would cost if owners were to rent the homes they own. It ignored housing prices for years and produced hugely understated inflation. Now, ignoring the fall in housing prices, the CPI is overstating inflation substantially. If we substitute the Case-Shiller housing index which more accurately tracks housing prices the CPI would show a negative 5.0% change in the index versus the government CPI of +0.2% . The government data show the housing component (approximately 25%) of the CPI rising 2.1% while more accurate housing data have prices falling 19.5%. Who is right?

With such a muddle of numbers which should be guiding us what can an investor do to avoid paralysis of analysis while bludgeoned with contradictory headlines daily? Be zenful and take the middle road. Let the market be your guide. In periods of trendless market action I often take small but opposite positions to act as canaries in the coal mine which I monitor closely until one keels over and the other sings.
Currently I am opening new positions in both long and short treasury bonds. In the past month the long treasury bond position is lower by slightly more than one percent and the short position is lower by about the same. However, in the past week the results are reversed. In other words, clients are hedged until we have clarity and can invest longer term with a clear bias. For now, the deflationary bias still has the edge despite the $trillions of stimulus flooding the market. I believe, in time as the economy begins to regain its footing the Fed will need to remove much of the newly printed money from the system. Historically it takes the better part of a year before the economy begins to feel the effect. But if history is a guide it likely won’t be pretty and investors should be placing their canaries before placing bigger bets.

John Barnyak

Wednesday, April 15, 2009

Dream a Dream

Today in the midst of tax day when cynicism runs deep and many wonder about the future I urge you to look at the video linked below of a dream probably long ago gone dormant. Embedding is disabled on the video but if you haven't had a dose of hope today, you must look at Susan Boyle's dream come true. Incredible and a bit tragic that it took so long.

John Barnyak

Tuesday, April 14, 2009

It's gone!

This morning when I read about the blow out, amazing, super duper wow results at Goldman Sachs I admit the cynic in me rose up. Your job, should you decide to accept it, will be to find the lie.

Analysts are flipping over rocks to look where slithery things lurk. Voila, a slippery creature seems to have been found! December is the month when most of us celebrate a major holiday. Gifts are exchanged, good cheer and fellowship reign. December tends to boost retail sales and waistlines. So it comes as a remarkable discovery that, rather like the Grinch, Goldman Sachs has canceled December!

That's right, gone. With the stroke of a pen, December has been banished from Goldman's results. If true, this is a Madoffian exhibition of chutzpah. Last year, along with Morgan Stanley, Goldman Sachs transformed itself into a card carrying, goverment supported, FDIC wallowing bank. There were many reasons for this with regard to capital raising issues. One reason I did not foresee was the new calendar. From Julian, to Gregorian, now to the Goldman calendar.

Goldman Sachs previously had a November ending Fiscal year end. When making the change to bank it took on a January to December fiscal year. In December Goldman apparently lost $2.15/share, but it fell into limbo between reporting periods. Add it to the first quarter results just announced and the performance is just a little below consensus expectations rather than far above.

Several weeks ago Citibank leaked a memo celebrating great results. Last week it was Wells Fargo's half story of earnings. Now Goldman Sachs. I must say, it is weakening. Is it any wonder Diogenes never found his honest man?

John Barnyak

No Trees Died in the Making of This Statement

"Another government report showed prices paid to U.S. producers unexpectedly fell in March after two months of gains, indicating the recession is keeping inflation under control."

This is one of today's Bloomberg headlines. The recession has provided us with an unexpected bonus, no inflation? We also save healthcare costs with every death. Inflation and deflation are simply opposite sides of the same coin. Will the pinnacle of reportage be, "Inflation crushed by government policy," which would be newspeak for "Depression raging!"

As the administration throws every possible reinflation tool at the recession, "inflation under control" has a benign and comforting feel? True it is much better than, "wages collapse" or "government begins subprime lending anew to stem foreclosures." But certainly both of those statements are implied in the Bloomberg headline.

Is it any wonder that for news and analysis people are increasingly going outside of the mainstream media?

John Barnyak

Monday, April 13, 2009

Birthday Thoughts

Time and again, the famous quote from the Pogo comic strip of years ago has been trotted out when appropriate. “We have met the enemy and he is us.” In this economic downturn my thoughts keep turning to the concept of moral hazard. I am sure most of us have had occasion to contemplate the benefits of our actions versus the consequences of something known to be at least close to the edge of propriety. In my own business career it began not long after getting my first job in the commodity trading business.

Selling various alloys to steel mills and foundries I recall one day quoting on a business inquiry and finding the material in our inventory was not precisely to the customer’s specification. “They can’t test for that,” was the answer I got when I asked what to do. And so it began. Over the years I saw such responses time and again from some of the most successful people in the business. When I moved to the investment world the comment became, “we wear a lot of hats,” and “sell the sizzle, not the steak.”

One can make a lot of money being clever. Make no mistake about it, the best on Wall Street are clever and now the entire nation is in the cross hairs of their moral hazard. If one’s behavior is dictated only by the chance of detection and then accountability, it is little wonder that the consequences are socialized. The cost of cleverness when divided by three hundred million is not so unpalatable and it is almost invisible on a personal level, of others.

I have little sympathy for the doyens of Wall Street or Congress or even Main Street who have forgotten that with great reward comes great responsibility. One hopes it transcends the quarterly balance sheet or the bi-annual election but that hope seems to have been misplaced lately.

I write this wistful screed today because my son is turning twenty-two, about to graduate from university and begin a career with a major bank as a credit analyst. It is much to consider for a young man who still looks out of place in a pinstripe suit. I have no doubt he will quickly learn about flexible decision making. But even at the lower rungs of a ladder which I am confident he will climb with great success, I hope he will remember to consider both the distant and invisible consequences of his actions and decisions and his own internal consequences.

Business ethics are a constant challenge and the measurements ever changing. He will have to find his own lines in the sand and inviolate rules to guide his behavior. No company statement of ethics will ever supplant personal integrity. I hope he will find his own personal words to place on his desk or mount on the wall but most importantly in his heart. Those will follow him from cubicle to corner office to executive suite. Have no regrets. Happy Birthday Son.

John Barnyak

Friday, April 10, 2009

Not Grapes of Wrath, but Getting There

The "Great Readjustment," looks every bit as bad as the Great Depression of the 1930's at the current time. When viewed on a global scale the economy is certainly giving that era a run for its money. Looking at some comparable pictures, what do we see and what our the conclusions? Clearly policy makers are not sitting idly. But are they doing more harm than good?

I. Global Industrial Output

The decline experienced in the past year is equal to the collapse in the comparable post 1929 period.

II. The World Stock Markets

Contrary to the belief that the 1930's collapse was far more dramatic, global markets have fallen faster than in the previous economic depression. The U.S. market has not fallen as dramatically as it did eighty years ago but globally by various measurements it is every bit as bad.

III. World Trade Flow

Early on as the world slowed rapidly in 2008, the leaders of the G-20 crossed their hearts and swore to keep international trade flowing. The chart above suggests their fingers were crossed as well? Certainly the globalization and specific trade flow makes this less clearly comparable. The volume of oil trade alone and the rapid fall in price and demand of petroleum may mean this chart is less than meets the eye.

Verdict? If we use the metrics of Industrial Production, Equity Prices and Global Trade the term "recession" may just be semantics.

That is what has happened. The bigger question is what have we done about it? What have the policy actions been to deal with the crisis?

I. Money Supply

In periods of economic slow down there is a very clear correlation between money supply and increasing economic activity. The lag is a substantial six to nine months. In the immediate post 1929 years the money supply collapsed and did not reverse until 1933 when Roosevelt removed the dollar from the gold standard. Current policy has injected massive money supply through quantitative easing and the purchase by the Federal Reserve Bank of treasury bonds and mortgage backed securities in particular.

II. We're all Keynesians Now

The final picture in the series is the most contentious. Honestly, economists and political agendists are still debating whether or not Roosevelt's fiscal stimulus of the 1930's was the saving grace or misguided policy. Keynesians, montarists, Austrian school economists each has compelling arguments to support their thesis. What is more agreed upon is that if you lay all the world's economists end to end they would still not reach a conclusion.

What is also clear is this this administration is willing to create a much larger deficit in pursuit of economic recovery. I fear that it will not be either easy or quick. And, like that 1930's event others may debate forever whether the eventual recovery came (as it will) because or in spite of government action. The intervention of World War II means that the answer will never be conclusively known. Let's hope that we are not confronted with such a global event simply to keep the debate alive forever.

In any event the current situation requires more active participation by investors since they may be sailing upwind for a while and must be alert for the shoals of unintended consequences.

John Barnyak

Baltic Dry Index

Following yet another hijacking of a ship by Somali pirates I began to think whether just maybe ship owners, while distraught over danger to crew, might not be thinking the event to be a minor economic positive. Years ago when I would groan that I had a shipload of cargo heading to the United States as the market fell, more than once I muttered, "if it sinks, it's sold." Having insured the cargo there were times in difficult market conditions when total loss would have been the best outcome. It never happened by the way.

One of the most revealing indicators of global economic health is the Baltic Dry Index which tracks shipping rates. When global commerce is vibrant, rates rise as shippers clamor for quick transport in a buoyant market for commodities. At the moment, ship owners are struggling mightily.

Global shipping rates are set to collapse by 74 per cent this year as commodity demand continues to fall in Asia and the massive glut of vessels ordered during the boom years finally takes to the seas. The seeds of despair are always sown in the best of times and vice versa.

The expected collapse in rates, which could push dozens of shipowners close to bankruptcy, comes after a 92 per cent decline in the Baltic Dry Index (BDI) of shipping rates over the course of last year. Any rebound in the index looks to be a year or more away.

At the beginning of the current global downturn the world's nations pledged to remain solidly behind free trade as they recalled the devastating results of protectionism during the 1930's. All those promises has been torn up and binned as countries around the world struggle to satisfy domestic needs in any way they can, even with a policy of beggar thy neighbor.

The closely watched gauge of world trade in iron ore, coal and other bulk cargoes has fallen for 19 consecutive days, the same rate of decline that occurred after the collapse of Lehman Brothers, the investment bank, and the catastrophic freezing of trade finance.

Fleet owners are canceling orders for new ships and a record number of vessels are being put into storage. A ship out of service AND collecting insurance may be the best deal out there, though admittedly a terribly cynical view when it comes to the Somali situation.

Yet these measures, however drastic, may not be enough to fight further alarming declines in freight rates. Even if 40 per cent of worldwide order books were canceled this year, analysts say, the slump in global demand and the sharp rise in Chinese inventories of iron ore and coal suggest that the worst is yet to come.

Chinese imports of iron ore are falling because, despite Beijing's promise of massive infrastructure spending as part of the country's vast $586 billion stimulus package, the pace of construction has slowed dramatically. Iron ore inventories at dockside at Chinese ports are thought to have swollen by about eight million tonnes during February, while the country's exports of finished goods — the sort that used to fill container ships bound for the United States and Europe — continue to fall.

About 10 per cent of the world's 10,650 in-service container ships and bulk carriers are sitting empty and at anchor waiting for cargoes that will not appear until the recession creaks to an end.

John Barnyak

Double Helix Thinking

Each day I become more incredulous regarding the solutions being presented by the administration and begin increasingly convinced that the issue is being approached backwards. The issue and problem is not simply to stumble upon the solution. Rather, it is to discover the problem. Thus far the approach seems to be to address a seemingly intractable problem with an equally complex and convoluted solution. The solutions thus far are to scatter the dragons teeth while hoping they do not grow into new monsters. I think they are failing thus far.

The large and insolvent banks are being allowed to remain a drag on the economy, and an impediment to market price discovery for bad assets. In the process the rot is spreading. The recently announced Private Public Investment Program creates a convoluted solution that obscures both problem and solution with complexity. Why the FDIC, an program specifically created to protect small depositors of member banks has now been pressed into service to provide multimillion dollar investment firms with guarantees of more than one trillion dollars is a solution by recreating the problem of massively integrated financial firms.

The FDIC will guarantee 85% of the debt so that a select group of private investment firms can acquire the toxic assets. It is questionable that by compressing the market to find the correct prices for these assets the process will be efficient.

Through an act of accounting legerdemain in order to circumvent congressional approval the FDIC will by far exceed its own charter limits which limit obligations to $30 Billion. So just how does one turn $30 Billion into over $1 Trillion you may ask. The obligation will be calculated not as a monetary obligation, but rather as a contingent liability which FDIC head Sheila Bair (a very competent and forthright manager I thought)now estimates as zero. From the Trillions of dollars of deeply impaired loans which they will guarantee the FDIC estimates losses in the future to be zip, nada, nothing, not one thin dime. That is how one keeps under the $30 Billion cap.

This Washington-Wall Street corridor sleight of hand keeps the bond holders
intact while transferring the risk straight to the taxpayer. How it is the taxpayer's obligation to underwrite the risks taken by poorly managed investment firms eludes me. Why taxpayer funds were transferred to Goldman Sachs to pay AIG's credit default swap obligation baffles me.

There are legal systems that have worked for many years for failed business entities. First there is an attempt to reorganize under the chapter 11 bankruptcy code. Failing that, chapter 7 liquidation would sell the profitable or recoverable segments of the business to others. The FDIC was created precisely to deal with insolvent banks. To suggest that the complexities of breaking up these failed banks exceeds those of trying to act as if humpty dumpty can be put together again is misguided.

It was moral hazard that got us into this mess, it sure isn't going to get us out.

John Barnyak

Holes don't go to China, nor do mortgage rates

This entry goes into the "news you can use," class. Manipulated markets always snap back. The the Tulip bulb market of 1637, silver market of the late 1970's, and now, the mortgage market of 2009.

The U.S. home mortgage system has been a nightmare for some borrowers recently. But setting aside the questionable, if not illegal, actions of banks, investment firms, and mortgage charlatans, the American system of locking in a long term rate while having the option of refinancing if rates fall has made US home mortgages one of the more appealing borrowing structures in the world.

This assumes the borrower could afford to borrow in the first place and is not victim of his own over reaching with some of the teaser hybrid loans that brought the system to its knees. Today, plain vanilla is the best flavor.

Right now, the panic of continually degenerating economic news in housing and its knock on effects on banks has put money on sale if one has steady income, and reasonable credit history.

Rates are changing daily, even hourly, so work with a knowledgeable and trustworthy broker. In the words of one analyst, "shop the broker, not the rate." A sharp broker working for you can lock in a rate on a dip that you would never see over the course of casual rate shopping. We have worked with several in Pennsylvania, so they do exist.

Rates will vary and move based on individual issues such as FICO score and buydown points. Doing homework ahead of time can pay dividends for an opportunistic borrower whether a first mortgage or a refinance.

These rates are extremely attractive. But they are skewed. For example, interest only loans are close to 6.25% while 30 year rates are as much as 2% lower. This spread is unprecedented, as are 30 year rates at 4.25-4.5%.

Rates are low and people should take advantage of them while they can. But it's important to understand why rates are low.

Fannie Mae debt is on a tear. Remember that yield and price move in inverse fashion. Thus a price rally in bonds equates to lower yields. Yesterday the Fannie Mae 30/60 (thirty year term/sixty day delivery) was at 4.46% The massive government buying of mortgage backed securities is driving the prices up and the rates down.

However, these prices are artificial. The government is buying Fannie Mae and Freddie Mac debt to force down yields and stabilize home prices. Could it reach still lower? 3.50%? Perhaps. But if it does it will likely be of extremely short duration as suddenly every mortgage in America will benefit from refinancing. If you haven't done your homework you will likely miss it. So do your homework, be prudent and conservative. If you plan in remaining in your home for more than a few years, this could be a windfall moment when you look back.

John Barnyak

Thursday, April 9, 2009

Passive Investing 101

For years we've heard about buy and hold and long term returns. Just how long does one have to fiddle while Rome burns? By no means do I wish to turn long term investors into Cramer crazed traders but paying attention wouldn't hurt. Whether that is done by oneself or with a interest aligned advisor there are tools to help keep investor's heads above water.

I remain a strong believer in using technical charts. These are not magical tea leaves to be read to predict the next day or week but rather depictions of market movement and the canaries in the coal mine. Long before we can absorb the nuances of market fundamentals charts can alert an investor to a trend change.

Rebalancing is probably the most important and one of the least implemented market strategies. If an investor has sufficiently diversified, rebalancing will provide the discipline to buy low and sell high. Without diversification and rebalancing an investor must be prepared to closely monitor and decisively act.

Employing an S&P index buy and hold strategy, including reinvested dividends, over the past ten years an investor would have lost 44% after inflation adjustment.

It is said that ninety percent of life is just showing up. Well, 90% of investing is just paying attention.

John Barnyak

If it walks like a duck......

As the market rises on a wave of feel good pronouncements, something just doesn't quite feel right. I've been expecting a bottoming process for a couple months, but this? Is it because of the large amounts of cash in portfolios? Spring weather in the air? It sure can't be because a bank ceo declares they are making lots of money (but offers very little in the way of proof), can it?

Mark to market accounting rules have been ...well have been, not really anything, but lots of news is announcing that nasty mean spirited accounting standard gone, along with the clarity it is meant to provide.

Wells Fargo has provided a much lower level of loan loss provision than might be expected since the underlying collateral of loans continues to decay. Residential and commercial markets are by no means buoyant, and that is after all the underlying value of the loans.

This delightful market rally is on volume of about 35% less than the 65 Day average volume. Big rally, low volume, holiday weekend with shorts covering financial stocks in advance. Turning this ship is going to take more than a bear market rally.

Having said that, maybe that is the classic climbing on a wall of worry.

John Barnyak

How Credit Default Swaps Work (CDS)

The linked story from NPR's Planet Money series is one of the clearest explanations I've seen of the unregulated derivative market that has brought the economy to its knees.

Planet Money link to How Credit Default Swaps work.

You Own AIG! Pay attention!

We endured eight years of "responsibility" with no consequence to the Deciders. More and more it seems the only additional protection the investment banks and their creditors should be given is protective custody.


(The following is a reformatted version of a letter to the Office of the Special Inspector General Barofsky for the Troubled Assets Relief Program from 27 members of Congress.

March 25, 2009

The Honorable Neil M. Barofsky Office of the Special Inspector General for the Troubled Assets Relief Program 1500 Pennsylvania Avenue, NW, Suite 1064 Washington, DC 20220

Dear Inspector General Barofsky:

After reviewing the documents released by American International Group, Inc. (“AIG”) regarding the identity of counterparties to certain transactions who received taxpayer “bailout funds,” we find that they raised more questions than they answered.

Congress and the American people were told that the AIG bailout was necessary to limit systemic risk across the global economy. Using bailout funds, AIG in turn paid various debts to the counterparties to its various transactions. Apparently, all claims were paid at 100 percent of face value, including swap-related claims.

We would like to know if assessments were made of the health and total exposure risks of counterparties, such as Goldman Sachs (which, for example, claimed it had no material exposure to AIG), Barclays, Deutsche Bank and others. If such assessments were made, by whom were they made and what were the criteria guiding the assessments?

Further, was any attempt made to renegotiate and close out these contracts with “haircuts?” If not, why not? What was the benefit of the decision to pay 100 percent of face value to the American taxpayers who provided the bailout funds and how did it support the goal of ensuring the stability of the economic system?

In essence, we would like to know if the AIG counterparty payments, as made, were in the best interests of the taxpayers who provided the funding and in the best interests of re-establishing long-term economic stability.

SIGTARP was created to investigate the uses of TARP funding, and AIG is among the largest recipients of TARP funding, and the largest recipient of government aid during the crisis. We believe that an investigation into the AIG counterparty payments is a critical component of the oversight effort. As the holder of nearly 80% of the equity in AIG, the U.S. government has a fiduciary obligation to manage this investment in a prudent manner, and your role is crucial to the protection of the taxpayers’ rights as AIG’s “shareholders.” We look forward to your response to the above questions.


Elijah E. Cummings, et al.

John Barnyak

Wednesday, April 8, 2009

The Continuing Case for Emerging Markets

A curious state of affairs is unfolding, a reversal of roles so to speak. After many years of Emerging Markets on life support provided by the International Monetary Fund as debtor nations, the so called Emerging Markets have made tremendous strides politically and economically.

On an aggregate basis emerging markets have become more stable than ever. As beneficiaries of a recent boom (prior to the bust) in commodities, they shored up foreign reserves and balanced budgets. Their banks and economies are less leveraged than our own.

To make a sweeping generalization is usually dangerous, but in general the lesser developed countries have moved to more stable governments, increasingly structured legal systems, more balanced economies and a growing middle class while keeping the long term economic driver of youthful demographics.

The following simple facts should induce investors to look more seriously at emerging market investments in the coming years:

* Recently and for the next few years, emerging market economies are expected to contribute 50% of all global growth.

* Emerging markets comprise 20% of Global GDP, but only 10% of investment market cap

* 85% of the world's population lives in emerging market nations.

The diversity within the emerging markets suggests that diversifying across the sector is a prudent way to participate in what looks to be one of the more vibrant investment opportunities in coming years. It is because of the greater risk and internal market inefficiencies that greater returns can be anticipated. But that with that return higher volatility should be expected.

John Barnyak

More than a Money Pit

In our effort to add a bit (a very little bit) of perspective to the economic debate.

John Barnyak

Shufflin' Off to South Dakota

How did the country end up with the a financial system too big to fail? As part of the current economic discourse everyone has a favorite guilty party. Barney Frank, George Bush and Alan Greenspan all have had their moments in the crosshairs. Perhaps it goes back even further.

During the 1970's one of the oldest legal constructs was dismantled during the Carter administration. The concept of usury laws goes back thousands of years even to Babylonian code and biblical passages. The link to Democracy Now with Amy Goodman's interview with Thomas Geoghegan gives food for thought. Societies have long held that excessive interest rates on borrowing was immoral, but is it more? Was it a public policy decision gone awry?

In 1978 the U.S. Supreme Court found, in the case Marquette National Bank v. First of Omaha Service Corporation, that states could not regulate interest rates on interstate credit transactions based on prior federal law signed by Abraham Lincoln. In that decision lay the basis for the financial industry to become far and away the dominant sector of american commerce. Where industry and manufacturing might produce competitive returns of 5 or 6% the profit found in shuffling paper far surpassed other endeavors. Companies like General Motors (GMAC) and General Electric (GE Capital) opened finance companies to provide profits far in excess of their manufacturing activities. The sky was the legal limit.

Companies loaned aggressively, put the loans on the balance sheet as assets and grew enormously. While a bank writing a loan at 6% would scrupulously underwrite the credit worthiness of the borrower with the expectation of return of its capital, the credit card lender at 18% was much less interested in the loan being paid off as long as the loan was serviced.

Adam Smith in his The Wealth of Nations and John Maynard Keynes in his, The General Theory of Employment, Interest and Money cautioned again excess interest rates.

The moral hazard implicit in excessively high real rates of interest has the dual effect of shifting capital to non-productive activity from manufacturing or other service sectors. It also accumulates assets on the balance sheets of the financing companies without due diligence and strict underwriting procedures. Focus on transactional income has results we now see. Borrowers are excessively burdened by interest and unable to pursue more economic activities, and lenders accumulate poor quality assets until economic conditions force writedowns and capital impairment.

When two human natures, greed and hope meet, the ensuing mix has public policy results that are now expressing themselves to our collective detriment.

John Barnyak

Tuesday, April 7, 2009

SELL! I mean BUY, No, I mean, turn off CNBC!

I don't know when it happened but sometime in the 1980's America became obsessed with the price of something somewhere all the time. When I moved back to the U.S. after a number of years living in Europe, I recall sitting down to watch television one evening only to have the program interrupted with the news of the closing price of gold in Zurich. What the hell? At the time I was a metals commodity trader but I remember thinking, they care about that in Iowa?! And so it began. America's love affair with 401k's. Not simply how much we'd managed to sock away in the past year, but how we did between 9:30 and lunch!

Jon Stewart in his inimitable way laments the stock market's obvious vote on the new president.

The Daily Show With Jon StewartM - Th 11p / 10c
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But wait! He's loved again! Check out the Dow Industrials poll beginning the day of that comedic interlude. Obviously, the country has changed its mind overnight on the immediate glorious ascendancy back to prosperity.

Holy P/E Ratio! The Prez is back! Up 20% in a month? Why that's a whole year's performance in four weeks. Take that you 'publicans.

(The other side of the aisle gets there turn again next month I suspect. Fox News, get ready to rumble!)

Look for the big picture and the economic themes and try the Food Channel for the important news.

John Barnyak

Spring Lamb Market

My son just informed me that the snow we are having is too near the birthday of a spring lamb like himself. I hate to remind him that such young creatures often end up with mint sauce on the side at Easter. The cavorting market of the past month may meet a similar fate. I also am optimistic (hopeful) that the worst of the stock market may be behind us but not without some testing.

The 25% rally in three weeks certainly felt good. But to expect that it presages the beginning of a V-shaped recovery simply is wishful thinking.

The market has suddenly priced in significant rebound in earnings that are unlikely to emerge for some time. What I find most troubling is the sectors that have climbed the highest and fastest. Leisure/accomodation has gained 35%, homebuilders, 40% and retail stocks up 30%.

These consumer driven sectors may have presented some good short covering opportunities, but to expect consumer driven industries to drive the recovery flies in the face of sober reality. Increased consumer spending and tight credit means game over for many of the business models built on ever expanding consumption.

There have been a few comparable gains in such a short period.

* December 1929
* June 1931
* August 1932
* May 1933
* July 1938
* September 1982

Only in September 1982 and in May 1933 was it the beginning of a prolonged bull market. In 1982 the markets were coming off of extremely high interest rate levels and beginning a secular decline in interest rates that was to last 25 years. 1933 and in 1933 Franklin Roosevelt was inaugurated and took the United States off the gold standard unleashing a wave of monetary stimulus.

Clearly the 1982 event does not contain a background comparable to today. The 1933 change of administration and radical departures from practices that mired the nation in depression may have similarities that only history will determine. However, I think we can expect a retracement of much of the recent gains and hopefully followed by a successful test of the recent market lows. The only thing worst than being late to the party is being arrested by the cops before you even finished your first drink. We suggest cautious sipping.

The charts still show a definite intact downtrend, albeit a few hopeful sprigs. But like the snow covered flowers in our garden, they may not all make it. Don't count your tulips before they are bloomed.

The technically overbought condition, the beginning of quarterly earnings reports and historical "outlier" characteristic of this lovely four week run makes me willing to protect some of the recent profits while remaining hopeful that spring is perhaps near at hand.

John Barnyak

Monday, April 6, 2009


The concept of diversification has been so oversold and underdelivered in recent years. For many, the pig's breakfast of various collected stocks and mutual funds has provided little more than a dangerous delusion. Chasing performance from one stock to another or one stock theme to another does not provide the basis for a diversified portfolio. Over the past few years I lamented that "nothing" seemed cheap and with good cause. Nothing was cheap.

Diversification should mean that the performance correlation is negative or uncorrelated. In other words, when one zigs, the other zags or just pays no attention at all. As interest rates fell, treasury bonds and the stock market we actually somewhat correlated although for different reasons.

Bonds rose as interest rates fell over years, but stocks rose on easy credit excess leverage. In 2007 as the first shots were fired in the subprime mortgage debacle that linkage began to fail as investors began to move away from risk to security with the US Treasury bond the ultimate security.

Lets look at the performance of asset classes over the past few years. The first chart is a look at how ineffectively the US/International diversification worked.

Not at all. The effects of globalization are seen clearly as a connected world provided an efficient (if not effective)interconnection of equity performance worldwide. As Warren Buffet says, it is only when the tide goes out that we see who's standing naked in the water.

The truly diversified market shows the effective non-correlated comparative performance of Treasury Bonds, Rydex Managed Futures and the S&P 500. In the worst financial melt down of our lifetime the diversified portfolio would have weathered the storm reasonably well.

The conclusion is that one should not mix diversification with performance seeking. The decision OF the asset class is more important than what is IN the asset class.
Within our model currently we are weighting domestic stocks more than foreign, technology more than manufacturing, but the true proof of a good portfolio will be the weighting of fixed income (and various durations therein) versus equity.

John Barnyak