Category: Macroeconomics

A Brief Note on Tsakos Energy Navigation

A Brief Note on Tsakos Energy Navigation

Doing estimates of private market value is often difficult. Recently while reading through the annual report of Tsakos Energy Navaigation, the CEO mentioned how much the ships were worth on the open market compared to the value on the books. After running a few calculations, I came to the conclusion that the private market value of Tsakos was around $75/share, a premium to the current quote.

Now, what can go wrong here? A lot:

  1. Protectionism could erupt, and diminish the amount of oil shipped across our oceans.
  2. Too many new boats could be built, eroding the value of existing boats.
  3. I could have done the math wrong.
  4. The CEO may have overstated his case.

I like Tsakos from both a strategic and valuation standpoint, but it is not a risk free investment; like most cyclicals, it relies on the robustness of the global economy, and the willingness of economies to buy oil from overseas. Given the uneven distribution of oil across our world, I would expect that oil shippers will be in a good spot for a while, but one can never tell for sure.
Full disclosure: long TNP

?Note: this note has been edited to remove two material errors.? First, the word “discount” has been changed to “premium” in the first paragraph.? Second, my four points only indicate areas where my analysis could go wrong.? Point four has been clarified, because I meant that you can never tell with any CEO whether everything was stated correctly, not that I thought it was incorrect here.? Rather, I trust their representations.

PIMCO in Theory and Practice

PIMCO in Theory and Practice

There’s been a certain amount of chatter lately over some of the comments made by Bill Gross regarding the long end of the market.? Others have discussed that; I’d like to bring up a different point.

 

Leaving aside the rumors that Bill Gross talks his book in order to create better entry and exit positions (many in the bond market believe it, I’m not so sure), I have criticized his (and PIMCO’s) forecasting abilities in the past.

 

Fortunately for PIMCO clients, Mr. Gross does not depend on his Macro forecasting to earn returns. Sitting on my desk next to me is a copy of the September/October 2005 Financial Analysts Journal. In it Mr Gross has an article, “Consistent Alpha Generation Through Structure.” That article encapsulates the core of PIMCO’s franchise. Essentially, they write unlevered out-of the money options on a variety of fixed income instruments, go short volatility through residential mortgages, and try to take advantage of the carry trade through the cheap float that their strategies generate.

 

So there’s a free lunch here? Well, not exactly. In a scenario where rates move very rapidly up or down, PIMCO will be hurt. But the move would have to be severe and very rapid. Even then, unlike LTCM, which had many of these same trades on but in a levered fashion, a bad year for PIMCO would ruin their track record, but most of their clients would deem the losses mild in comparison with whatever happened to the rest of the asset markets during a crisis that moved interest rates so severely.

 

That is the genius of Bill Gross, and I mean that sincerely. As for what he says on the tube, well, that’s just to aid marketing of the funds. He’s an entertaining guy, and on TV, those that invite you don’t care so much that you are right or wrong; they care that you say interesting things that keep the ratings up.

 

So, ignore Gross and McCulley on macroeconomic predictions, but their funds are generally worthy investments (leave aside for a moment that they are having a tough time this year). That said, if I’m buying an open end bond fund, I go to Vanguard. Low expenses win with bond investing, and it is a more durable advantage than advanced quantitative strategies.

Convexity vs Overseas Money Flows vs Real Yields vs The Fed

Convexity vs Overseas Money Flows vs Real Yields vs The Fed

The move in the bond market today was pretty violent. I briefly wondered how notable the move was relative to history, and I found that we have seen much worse moves in the past. Examples:

  1. Early 2004, when the market realized that the FOMC was going to have to tighten.
  2. Summer 2003, when we got a self-sustaining selloff in the market when we realized that fed funds would not be 1% forever, and mortgage hedgers forced an overshoot.
  3. Spring 2003, when the FOMC hinted that it would cut to 1%, and actually did it.
  4. 2002, when the FOMC was aggressively cutting the fed funds rate.
  5. And more… I could go back a lot further, but moves of this level of violence occur about once a year on average. Since the start of the FOMC tightening cycle, things have been calm, and predictable, lulling investors into a false sense of security. That security has just gotten shaken.

Over at RealMoney, except for Tony Crescenzi, there aren’t many who know much about
bonds. A lot of the writers there are paying attention to bonds, but it is basically a black box, or a technical model to them. In this piece, I will try to explain the four factors playing tug of war with the long end of the bond market, and what the prevailing effect is likely to be over the short and intermediate terms.

Convexity

The largest component of the bond market is residential mortgage backed securities [RMBS]. Residential mortgages shorten when rates fall, because people refinance; when rates rise, fewer people than previously expected refinance, and people take longer to pay off their mortgages. A bunch of similar residential mortgages get gathered into a trust; participations in that RMBS trust are sold to institutional investors.RMBS is a complicated security to manage from an interest rate standpoint. Originators of the mortgages have to hedge them before they sell them off to investment banks who will turn them into RMBS. Many bond managers like to own RMBS for its high credit quality, liquidity, and attractive yields, but the problem is this: when interest rates move, the RMBS does what you don’t want to see happen. When rates fall, the bonds prepay, and you have to reinvest at lower rates. When rates rise the bonds pay slowly; you’d like to have more cash to reinvest at the higher rates, but the RMBS pays slowly.

This effect of shifting cash flows working against the owner of the mortgages or RMBS is called negative convexity. Basically, the owner has written a covered complicated bond call option. Anyone option writer receives a premium (extra yield), but must sell his investment if it goes into the money. If the investment stays out of the money he keeps the premium and the depreciated investment.
The mortgage originators and the RMBS holders want to limit the effect of the options that they have written, so they hedge. They can do that in three ways. I’ll use the example of hedging rising rates:

  1. Sell or short long Treasuries to lower overall exposure to rising rates.
  2. Sell RMBS that is lengthening, and replace it with RMBS that is less sensitive to rising rates.
  3. Enter into a swap where you pay a fixed rate for a number of years, and receive (floating) three month LIBOR over the same period.

Now, when rates rise or fall by a lot, mortgage hedging tends to reinforce the move, making falls and rises sharper. The effect depends on the configuration of the rates that people are paying on mortgages across the US. Negative convexity is highest on mortgages the are near the current mortgage rate for new loans. (At the money) At present, most prime mortgages are now below the current mortgage rate. I estimate that 20% are above and 80% below. What that implies in the current situation, is though mortgage hedging has had a big impact in the move so far, its effect should diminish dramatically from here, and almost disappear if the ten year gets up into the 5.50-6.00% range. Compare this to an era like 1994, where at the start of the move 10% of mortgages were below the current mortgage rate, and 90% above; it’s no wonder that move was so devastating. From the convexity effect, it should not be that bad here.

The Fed

We finally reached the fifth stage of grieving on the expected FOMC rate cut. The market has accepted that no cut is coming in 2007. This makes me edgy because that had been my view since December, and when the crowd crashes my lonely party, I have to ask, “Okay, now what? When and what is the next FOMC move? What is the crowd missing?”
Honestly, I don’t know, at least not yet. The FOMC is happily balanced between a variety of concerns, and I think it leaves them in a state of noisy inaction. Right now I think they will stand pat for as long as they can justify it. The effect on the bond market been to de-invert the curve, with the long end rising significantly. From here, though, unless the probability significantly increases that the FOMC will tighten, the effect on long rates is done here and now.
Overseas Money Flows

The current account deficit must be matched by a capital account surplus. The books have to balance! The only question is at what price (exchange rate) that the market clearing balancing will occur at. Partially due to the new view of FOMC policy, the dollar has strengthened over the last month, as foreign investors think that US rates will remain high for a while. But the varying currency policies of different countries will have an impact on the overall path of the dollar, and interest rates. Here are some bits of news affecting the question:

  1. South Korea continues to let the won rise, depressing the economy, but limiting local inflation. Also, they don’t have to buy as many US dollar assets.
  2. India has acted similarly with the rupee, which is having an effect on its competitiveness, but is reducing local inflation.
  3. Thailand had to let its currency appreciate against the US dollar because of rampant speculation.
  4. Other countries like Russia and some of the Gulf states are reducing exposure to the US dollar.
  5. Not everyone is reducing exposure to the US dollar, though. Most of the Gulf states still recycle petrodollars at the same rate as before, and China still uses the dollar as its linchpin in its currency system (which is just a dirty crawling peg). Now, this is leading to inflation in China, and a potential crisis, but so far, nothing is imminent, and that should continue to have a depressing effect on US interest rates, and retard the fall of the dollar.
  6. Growth is proceeding better outside of the US, which should put downward pressure on the dollar and upward pressure on rates.
  7. The two main carry trade currencies, the Japanese Yen and the Swiss Franc, are still at low levels, with low but increasing interest rates. There is atill a lot of speculative borrowing going on in both currencies, both locally and abroad, which is depressing the exchange rates. Eventually this will end with the Yen and the Swaissie rallying, but that could take a while.

So long as enough foreign entities are comfortable providing goods and services to the US, which taking back financial promises, there will continue to be downward pressure on rates, and the dollar will muddle. Woe betide us when they tire of giving us such nice treatment.
Yields and Real Yields

Having been a bond manager at a major insurance company I have experienced being a yield buyer. A yield buyer is willing to buy more bonds at higher yields, all other things equal. A real yield buyer is willing to but more bonds as the inflation-adjusted yield rises. Well, we are at levels on the ten year Treasury yield that we have not seen in five years. Yield buyers should become increasingly interested, which should moderate any increase in yields. Similarly, certain types of bond issuance should slow, as some projects will no longer justify paying the higher yield to finance the deal.
Real yields are another matter. As real yields rise, defined benefit pension plans and endowments buy more. But how much is inflation rising? It’s hard to say; our trade with developing nations decreases our inflation rate; some suggest that that might be coming to an end as inflation rises in the developing countries. My suspicion is that inflation is higher than the government says it is, but is not increasing much at present.

My upshot here is that up 0.25-1.0% in yield from here, assuming modest increases in inflation, we would see a lot of incremental buyers for bonds. We would also see fewer issuers.
Summary

Of my four effects, convexity is a spent force soon. The FOMC is likely on hold, so that effect is largely over, unless I am wrong. If rates rise, I expect yield and real yield buyers to arrive. The wild card is the foreign investors; if more countries revalue their currencies upward versus the dollar, reducing exports to the US, and reducing the need to buy our debt, then interest rates could easily rise by another percent. I don’t think that will happen, but it is the major risk here.

Absent negative foreign developments, I will get more bullish on the long end around 5.50% on the ten-year Treasury. Until them, I with with my positions, and clip the coupons; I don’t expect the rise to be severe, but will invest more on weakness.

Full disclosure: long TLT, FXF, FXY, and the rest of my bond portfolio is over at Stockpickr.com.

PS — It is not obvious to me that the current correlation between the stock and bond markets will maintain. I expect stocks to do better, relative to bonds, in the short term.

Updating My Thoughts of Two Years Ago

Updating My Thoughts of Two Years Ago

Two years ago in the RealMoney Columnist Conversation, I wrote the following:

Yield curve be nimble, yield curve be quick, yield curve go under limbo stick.Okay, no great allusion in the song there, but I sit watching the long end of the yield curve rally as the short end falls slightly. Is the FOMC back in play that fast after yesterday? I don’t think anything has shifted, but Mr. Market is manic.

It’s times like this that make me want to review the full set of reasons why the long end is rallying:

  1. The supply of long bonds is shrinking, and the Treasury hasn’t decided to reissue the 30-year bond yet.
  2. Pension Reform is happening in Europe, and some Europeans are buying long U.S. debt together with currency swaps.
  3. Pension reform might happen in the U.S. as well.
  4. The PBGC is buying long investment grade debt (it likes to immunize, because it’s risk-averse), particularly Treasuries and Agencies like a madman, and it just got a new slug of cash in with the takeover of the UAL (UALAQ:OTC BB) plans.
  5. Mortgage refinancing tends to depress rates as originators hedge.
  6. Speculators that were previously short longer bonds are now long. (uh oh)
  7. An aging population wants income and increasingly favors bonds.
  8. Neomercantilistic economies buy U.S. bonds because they can’t find anything better to do with their export earnings.
  9. Market players trust the FOMC (however misguidedly) to control inflation in the long run.
  10. There aren’t a lot of other places to get incremental yield, so extending maturities is a temptation for bond investors.
  11. The U.S. economy is anticipated to be growing at a slower rate.
  12. The marginal efficiency of new capital is falling because of the introduction (in principle) of 2 billion laborers to the global capitalist labor pool.

This last point I covered in parts of the articles, “Implications of a Low-Nominal World,” and “The Economy, Seen From Many Angles.” When labor is abundant, more capital isn’t needed to produce a greater output, until labor is scarce again. The returns to the employment of additional capital fall, which leads market players to bid up the prices of fixed claims on the economic system, i.e., bonds, because they can’t find better places to assure a return for the future.

This also explains the increase in buybacks and debt reduction on the part of corporations, relative to increases in plant and equipment. That said, it’s a tough environment, but on the bright side, previously poor areas of the world are developing, and that bodes well for those countries, and the global economy 20 years out, once the labor that is new to the capitalist world is productively deployed.

What a difference two years makes. The above post was meant to justify low rates, and it did a fair job of making the case. Later I added a reason 13, that suggested that there was no other currency that could serve as the world’s reserve currency. Unless we move to a gold or commodity standard, that is probably still true.

So what among the above reasons are still valid? Let’s go through them:

  1. 30-year bonds are being issued now, though not in great abundance.
  2. Still a factor, but small because the initial surge has worn off.
  3. Only 40% complete in the US, but FASB may fix that within a year, which would intensify demand for long bonds as defined benefit plans attempt to match liability cash flows.
  4. The bankruptcy wave is past. Not a factor now.
  5. With rates higher, the mortgage hedging flows favor higher rates.
  6. Kind of a wash. Speculators are long the 10-year and short the 30-year. Not a factor on rates now.
  7. Still a factor. Yield seeking on the part of retirees is big, and Wall Street i catering to that search. (Hold onto your wallets.)
  8. Still true.
  9. Still true.
  10. False; can’t get much incremental yield at all through extension of durations now.
  11. True, but the degree of the slowdown is open to question, and foreign financial flows are a bigger factor.
  12. Still true, though the marginal effect at present is probably smaller.

So where does that leave us on interest rates? Muddled. Most of the big demographic and international effects on rates still favor lower rates. A new factor that was only partially understood by me two years ago has become a bigger factor: rising inflation in countries that fund the US current account deficit. That favors higher rates, both here and abroad. The question is whether foreign countries bite the bullet and allow their currencies to rise against the dollar or not. To the extent that they allow their currencies to rise, so will rates in the US. But if they keep their currencies artificially weak by buying US dollar bonds with their own currencies, it will continue to depress US long interest rates.

Human nature being what it is, I would expect that most countries continue their policies of buying US fixed income until a crisis forces them to change. Those don’t come on schedule, so I will not try to predict timing. I continue to keep a large portion of my fixed income investments in foreign currencies, which has not been a winner in the last month, but has served me well over the last two years.

What Credit Deterioration Looks Like Prior to Defaults

What Credit Deterioration Looks Like Prior to Defaults

There was a little stir over at RealMoney over an article printed in Friday’s Wall Street Journal regarding Leveraged Buy-out [LBO] quality. Both Jim Cramer (video) and The Business Press Maven, Marek Fuchs, disagreed with the premises of the article. So who was right? Let’s start with the case made by the Wall Street Journal. It can be summarized in three points:

  1. There are a few LBOs in trouble. This is notable because it is happening early in the tenures of the deals. There are unique things going wrong in the each of the four deals mentioned.
  2. Cash interest coverage ratios are at levels not seen since 1997.
  3. Some of the bonds and loans used to finance the deals are trading below par.

So what do Cramer and Fuchs do with this? They attack the weakest part of the argument, that there are only four deals mentioned to be in trouble out of thousand or more deals. Now, before any credit crisis hits, typically credit metrics have deteriorated, but few deals seem to be in trouble. Why? The companies in question are usually in good shape at the time a LBO takes place, and if not, the financing obtained typically has additional cash to re-liquefy the company.

Typically, it takes 3 years from the time that loans/bonds are sold before defaults start happening. In years 1 and 2, defaults are few, and notable because they look incredibly dumb in hindsight. Point one of the WSJ article does not of itself prove that a crisis is coming. But if they couldn’t point at some bad deals, there would be no article to write.

The more serious issues are loan pricing and interest coverage.WSJ Interest Coverage Interest coverage of 1.7 times cash flow is very low, and akin to what one gets on CCC-rated debt, except that the loans are typically secured by the assets of the company, which lessens the severity level of defaults. Further, for loans to trade below par when there is hot demand for loan collateral from Collateralized Loan Obligations, implies that something is amiss. Now, what do Cramer and Fuchs do with these issues? Not much. Cramer doesn’t deal with it, and Fuchs says:

For an article that implies a turn in the pace and fate of LBOs (did I mention the graph titled “Less Breathing Room”?) there needs to be more and better evidence. To make a point in journalism, you do not need the rigors of a scientific sample. Daily journalism simply has to move faster than that.

 

In short, he dismisses it without any significant comment.Now, I generally appreciate most of what Cramer and Fuchs write, but in this case, they didn’t seem to get the most significant points of the article (2 and 3 as I number them). That said, the WSJ emphasized point 1 the hardest, probably because they didn’t want to bore their audience, so perhaps they both can be excused.

Credit metrics deteriorate before defaults happen, and it takes three years afteer the peak of issuance to see how bad it will be. We are seeing record loan issuance combined with deteriorating fundamentals at present. It may be as late as 2010 before we see the bad results of this in full, but I would not cavalierly dismiss the problem simply because there are few distressed situations now. Within three years, we will have more than enough distress to overwhelm the sizable resources of vulture investors.

What Brings Maturity to a Market

What Brings Maturity to a Market

Some housekeeping before I start. My post yesterday was meant to be a “when the credit/liquidity cycle turns” post, not a “the sky is falling” post. Picking up on point number 4 from what could go wrong, I would refer you to today’s Wall Street Journal for two articles on LBOs that are not going so well, and the sustainability of private equity in the current changing environment. Please put on your peril-sensitive sunglasses before reviewing the credit metrics.

In the early 90s, as 401(k)s came onto the scene, savings options were the hot sellers to an unsophisticated marketplace. Because of the accounting rules, insurance contracts could be valued at book, not market, and so Guaranteed Investment Contracts [GICs] were sold to 401(k) and other DC plans.

The difficulty came when companies that issued contracts failed, like Executive Life, Mutual Benefit, Confederation, and The Equitable (well, almost). A market that treated all contracts equally was now exposed to the concept that there is such a thing as credit risk, and that the highest yielding contract is not necessarily the one that should be bought.

In the mid-90s, that was my first example of market maturation, and it was painful for me. I was running the Guaranteed Investment Contract desk at Provident Mutual, and making good money for the firm. We survived as other insurance companies went under or exited the business, but as more companies failed, the credit quality bar kept getting raised higher, until we were marginal to the market. Confederation’s failure was the last nail in my coffin. I asked my bosses whether I could synthetically enhance my GICs by giving a priority interest to the GIC-holders in an insolvency, but they turned me down, and I closed down an otherwise profitable line of business.
Failure brings maturity to markets, and market mechanisms. When a concept is new, the riskiness of it is not apparent until a series of defaults occurs, showing a difference between more risky and less risk ways of doing business. Let me give some more examples:

Stock Market Leverage: How much margin debt is too much, that it helps create systemic risk? In the 20s leverage could be 10x, and the volatility that that policy induced helped magnify the boom in the 20s, and the bust 1929-1932. Today the ability to lever up 2x (with some exceptions) is deemed reasonable. If it is not reasonable, another failure will teach us.

Dynamic Hedging: In the mid-80s, shorting stock futures to dynamically hedge stock portfolios was the rage. After all, wasn’t it a free way to replicate a costly put option?

When it was first thought up, it probably was cheap, but as it became more common the trading costs became visible. For small price changes, it worked well. Who could predict the magnitude of price changes it would be forced to try and unsuccessfully hedge? After Black Monday, the cost of a put option as an insurance policy was better appreciated.

Lending to Hedge Funds: I’m not convinced that this lesson has been learned, but if it has been learned, the crisis from LTCM started that process. After LTCM failed, counterparties insisted more closely on understanding the creditworthiness of those that they expected future payments from.

Negative Convexity: Through late 1993, structurers of residential mortgage securities were very creative, making tranches in mortgage securitizations that bore a disproportionate amount of risk, particularly compared to the yield received. In 1994 to early 1995, that illusion was destroyed as the bond market was dragged to higher yields by the Fed plus mortgage bond managers who tried to limit their interest rate risks individually, leading to a more general crisis. That created the worst bond market since 1926.
There are other examples, and if I had more time, I would list them all. What I want to finish with are a few areas today that have not experienced failure yet:

  1. the credit default swap market.
  2. the synthetic CDO market (related to #1, I know)
  3. nonprime commercial paper
  4. covenant-lite commercial loans, particularly to LBOs.

There is nothing new under the sun. Human behavior, including fear and greed, do not change. In order to stay safe in one’s investments, one must understand where undue risk is being taken, and avoid those investments. You will make more money in the long run avoiding foolish risks, than through cleverness in taking obscure risks ordinarily. Risk control triumphs over cleverness in the long run.

Thinking About What Might Blow Up

Thinking About What Might Blow Up

The credit cycle is kind of like a Monty Python skit where the humor has reached a point of diminishing marginal returns. At that point, they might blow something up, and move onto the next skit. Credit cycles end with a bang, not a whimper. Take a spin down the last few cycles:

  • 2000 — Nasdaq, dot-coms
  • 1997-98 — Asia/Russia/LTCM
  • 1994 — Mortgages/Mexico
  • 1989 — Banks/Commercial Real Estate
  • 1987 — Stock Market
  • 1984 — Continental Illinois
  • Early ’80s — LDC debt crisis

In each case, we had assets that were weakly financed.? When liquidity began to become scarce, the entities that were weakly financed faced sharply rising borrowing costs, and many defaulted.? The purpose of this piece is to muse about what entities in our world today are reliant on the presence of favorable financing, and would suffer if that financing ceased to exist.? Here’s my initial list.? Can you give me some more ideas?

  1. Too obvious: CCC-rated bond issuers.? We’ve had a lot of them issue debt over over the past three years.? Those that have not shored up their balance sheets and paid down debt will suffer if they need additional financing.
  2. Yield-seeking hedge funds.? When the credit cycle turns, yield becomes poison.? Those holding the equity of Collateralized Debt Obligations, and other levered forms of credit will have a rough time, particularly if their investors ask for their money back.
  3. Dodgy mortgages.? We’ve already seen the beginning with subprime mortgages, but there are more loans that will hit resets over the next twelve months.? The troubles with Alt-A lending will be more spread out, but it really hurts to have your financing rate jacked up at a time that the asset financed is experiencing weakness in price.
  4. Private equity over-borrowing.? Much of private equity relies on the idea that they can have an easy liquidity event five years from now.? What if interest rate are three percent higher then?? P/E and EV/EBITDA multiples will be lower, not higher, and then what do you do with all of the debt used to finance the purchase?
  5. Overly indebted cyclicals, and mergers that increase leverage.? Companies that presumed too much about the future get killed when the cycle turns.? The mergers and recapitalizations that looked so promising are horrid when the willingness to take risk drops.
  6. Mis-hedged investment banks.? This is a little more speculative, but in a credit crisis, investment banks without adequate liquidity are in the soup.? Lehman Brothers barely survived 1998; in a more severe crisis, who would get harmed?
  7. Sovereign nations with large current account deficits.? This is the most controversial category.? I am not talking about the main emerging markets here; I am talking about developed countries that lack discipline, like Iceland, New Zealand, and the United States.? The large emerging markets are in better shape than the derelict nations that they fund.? If the debt is in their own currency, the nation has more options than merely defaulting.? They can inflate, or create a two-tier currency system to give foreigners the short end of the stick.? (Think of Argentina, or South Africa back in the 80s.)


These are the weak entities that I can think of. ?There are more, I am sure, particularly as the demographic crises emerge over the next decade, but for now, if liquidity becomes scarce, these are the entities?that will suffer.

What Three Months Can Do

What Three Months Can Do

Three months ago, the global financial markets were at their short-term nadir, but few knew it at the time.? Long term bond yields bottomed then as well, which should be no surprise in hindsight.? Since that time, the average 10-year swap rate (what a AA-rated bank can borrow at) for the 10 nations that I track (USA, Germany, Japan, Britain, Switzerland, Canada, Australia, New Zealand, Norway, and Sweden) have risen 53 basis points (0.53%).? Equity markets have rallied, and implied volatilities and corporate bond spreads have fallen.

The correlated change in the global bond markets is significant, and if it runs another one percent or so, could derail the equity markets.? Bond yields would then be fair relative to equity yields, assuming that the current high operating profitability continues, which is not guaranteed, though I think it will persist long enough to embarrass those who say it must mean-revert imminently.

There is a change going on here, and as for my balanced mandates, I think it means that I toss out my long bonds [TLT] for a small loss, and keep my duration short.? As for my equities, no action for now, aside from ordinary rebalancing activity.? Don’t panic, but be vigilant, and use your ordinary risk control methods.

Full disclosure: long TLT, but not much

Going Through the Research Stack

Going Through the Research Stack

Once every two months or so, I go through my “research stack” and look at the broad themes that have been affecting the markets. Here is what I found over vacation:

Inflation

  1. Commodity prices are still hot, as are Baltic freight rates, though they have come off a bit recently. Lumber is declining in the US due to housing, but metals are still hot due to global demand. Agriculture prices are rising as well, partly due to increased demand, and partly due to the diversion of some of the corn supply into ethanol.
  2. While the ISM seemingly does better, a great deal of the increase comes from price increases. On another note, the Implicit Price Deflator from the GDP report continues to rise slowly.
  3. Interest rates are low everywhere, at a time when goods price inflation is rising. Is it possible that we are getting close to a global demographic tipping point where excess cash finally moves from savings/investment to consumption?
  4. At present, broad money is outpacing narrow money globally. The difference between the two is credit (loosely speaking), and that credit is at present heading into the asset markets. Three risks: first, if the credit ignites more inflation in the goods markets which may be happening in developing markets now, and second, a credit crisis, where lenders have to pull back to protect themselves. Third, we have a large number of novice central banks with a lot of influence, like China. What errors might they make?
  5. The increase in Owners Equivalent Rent seems to have topped out.

International

  1. Global economy strong, US is not shrinking , but is muddling along. US should do better in the second half of the year.
  2. The US is diminishing in importance in the global economy. The emerging markets are now 29% of the global economy, while the US is only 25%.
  3. Every dollar reserve held by foreigners is a debt of the US in our own currency. Wait till they learn the meaning of sovereign risk.
  4. Europe has many of the problems that the US does, but its debts are self-funded.
  5. The Japanese recovery is still problematic, and the carry trade continues.
  6. Few central banks are loosening at present. Most are tightening or holding.
  7. There is pressure on many Asian currencies to appreciate against the dollar rather than buy more dollar denominated debt, which expands their monetary bases, and helps fuel inflation. India, Thailand, and China are examples here.

Economic Strength/Weakness

  1. We have not reached the end of mortgage equity withdrawal yet, but the force is diminishing.
  2. State tax receipts are still rising; borrowing at the states is down for now, but defined benefit pension promises may come back to bite on that issue.
  3. Autos and housing are providing no help at present.

Speculation, Etc.

  1. When are we going to get some big IPOs to sop up some of this liquidity?
  2. Private bond issuers are rated one notch lower in 2007 vs 2000. Private borrowers in 2007 are rated two notches lower than public borrowers, on average. Second lien debt is making up a larger portion of the borrowing base.
  3. Because of the LBOs and buybacks, we remain in a value market for now.
  4. Volatility remains low ? haven?t had a 2% gain in the DJIA in two years.
  5. Hedge funds are running at high gross and net exposures at present.
  6. Slowing earnings growth often leads to P/E multiple expansion, because bond rates offer less competition.
  7. Sell-side analysts are more bearish now in terms of average rating than the ever have been.
  8. There are many ?securities? in the structured securities markets that are mispriced and mis-rated. There are not enough transactions to truly validate the proper price levels for many mezzanine and subordinate securities.

Comments to this? Ask below, and I’ll see if I can’t flesh out answers.

The Premature Return of Equity REITs?

The Premature Return of Equity REITs?

Ugh. After the purchase of EOP, I felt that equity REITs had reached valuation levels that not only discounted the lifetime of my children, but eternity as well. With the purchases of Archstone Smith and the Pennsylvania REIT, we are at valuation levels near those at the EOP purchase. My metric is equity REIT dividend yields versus the 10-year treasury yield. When one has to give up 1.2% in yield to move from safe Treasuries to risky REIT equity, there is something amiss. The valuation levels embed significant assumptions for growth in rents, which is particularly dangerous when the bull cycle in commercial real estate is so extended.


As a side note, before the purchases were announced, REITs looked the worst from a technical standpoint in the financial space. Now they are the best. So much for the utility of technical analysis.

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