Perception is Reality

Moving on Up Like George and Weezie

2008-12-30T11:58:00.002-05:00

Thanks to the continued and growing interest in Perception is Reality, I am moving the site to accommodate our expansion. The new address is http://perceptionisreality.kanundrum.com .

I have written a new book titled Blowing Bubbles: How to Identify and Profit from Market Bubbles. It can be downloaded at the new site on the Blowing Bubbles page

Also, I am now offering a subscription to the weekly newsletter and Market DNA reports. It can be found on the Subscribe to DNA reports page.

Thanks again for your support and I will see you on the new site!

Happy New Year!

Brian Kelly

Who is the Pilot on this Flight to Safety?

2008-12-15T13:20:00.007-05:00

If you are like me you have probably been asking yourself who would buy T-Bills with a 0% yield; it just does not make sense. The popular answer is "Treasuries are experiencing a flight to safety," but who is the pilot? The US Treasury released Treasury International Capital (TIC) data on Monday. The TIC data showed a disturbing trend for holders of long term US Treasury securities, while also explaining why short term Treasuries have been doing so well.

In October, foreigners sold $34 billion of long term treasury securities, while purchasing $92 billion of short term treasuries. The treasury has kept tabs on foreign purchases of US debt since 1978 and the amount of long term securities sold in October 2008 was second only to August of 2007 when foreigners sold $37 billion. But, foreigners bought short term securities so all is well, right?

It is no secret that foreign buyers of Treasury securities have been one reason the US has been able to sustain a large debt load. In fact, foreign buyers have kept up pace with the rate of change of debt issuance.

Even with the unprecedented run-up in outstanding US debt, foreign investors have not lost their appetite for T-bills, notes, and bonds. The chart illustrates the rate at which foreigners have bought new debt has outpaced the rate at which the US Treasury has issued debt. However, the gap appears to be narrowing and this could be cause for concern.

Despite the recent frenzied buying of short term securities, the percentage of US debt owned by foreigners has been declining since the start of the credit crisis in July 2007.

On aggregate, foreigners have been buying fewer Treasury securities as a percentage of all marketable debt outstanding. If the US plans on increasing its debt load then foreign investors must reverse this trend. The continued divergence of these two lines means only one thing: higher interest rates. Probably the easiest way to think of this chart is supply (outstanding debt) vs demand ( foreign ownership of debt). Econ 101 tells us that if demand falls and supply increases, then price decreases. In terms of US debt, lower prices mean higher interest rates. If another buyer steps into the market then higher interest rates are not inevitable.

In October, as part of the Emergency Economic Stabilization Act, the Congress approved a debt limit increase to $11.3 trillion. Currently the national debt stands at $10.6 trillion. If the US maxes out its credit line (a highly likely scenario) that would translate into a 7% increase in debt outstanding. Since foreigners are not the only buyers of US debt, someone will have to fill that gap, especially if the decline in foreign ownership continues. The trillion dollar question is, will the new buyer agree to the same 0% terms that the current buyers are receiving?

Disclosures: I am long US Treasury Bonds (for now).

Where is the Thank You for Oil Speculators?

2008-12-07T20:30:00.005-05:00

As the snow fell this weekend, my thoughts wandered to the balmy days of late June 2008. Oil prices were screaming higher and the US Congress took notice. In a series of painful hearings, oil executives were grilled about record profits and oil speculators were taken to the woodshed. Unfortunately, the speculators were not represented and could not defend themselves. This was fine with the Congress, since speculators were probably too busy manipulating oil prices to record highs. The Congress referenced the commitment of traders report (COT) as evidence that oil speculators were at work driving up oil prices; they showed charts that illustrated that as long positions increased, oil moved up almost 65%.

Indeed, looking at the COT data for 2008 it is easy to see that speculators increased their long positions ahead of the price spike in July. This was enough evidence for the Congress and even John McCain to publicly indict speculators without giving them the ability to defend themselves.

From October to November 2008, speculators once again increased their positions, except this time they were net short. During this time crude oil prices on the NYMEX decreased from $109 to below $50, over a 50% decline. The decline in oil prices may be the only bright spot in the current economic climate.

This leads me to my original question, where are the Congressional hearings thanking speculators for driving oil prices down?

Disclosures: none

Bubbles and Supply Shocks at the Commodity Investment World Conference

2008-12-04T08:20:00.007-05:00

I spent the last two days at the Commodity Investment World Conference in New York. The general theme and tone of the conference was that the world has changed dramatically and unprecedented market "anomalies" were occurring. In fact most of the presentations were compiled three weeks ago and were grossly out of date, so most presenters went off the cuff.
A simple look at the Dow Jones AIG commodity index illustrates the massive dislocations in the market.

The index peaked in July of 2008 and has since fallen 53%- the largest move in the shortest amount of time since the index began. If you have not looked at the news in 6 months this chart is a surprise, however, even a casual glance at the front page of any newspaper tells you the financial world is in turmoil. Deleveraging resulted in unprecedented correlations occurring between all asset classes, while institutional investors were making irrational decisions to pull money out of well performing funds.

As the conference got through the "Chicken Little" stage there was some blue sky. Thierry Wizman of Fortis spoke about hedge fund withdrawals coming to an end. I asked him for some detail and he told me that the numbers he has seen suggest that hedge funds have raised upwards of 80% of the cash they will need for year end redemptions . This follows the anecdotal evidence that I have gathered from friends and colleagues at large funds. Almost all have gone to cash and are waiting for the new year before they start to re-invest. In fact, many have told me that after this week they are done for the year.

I also chatted with one of the conference organizers and asked him how conference attendance has been overall. He told me that they had seen a surge in interest over the last few weeks as institutional investors were looking for opportunities for the new year.

Supply Shocks

The second general theme was that sometime in the next 6 months to 2 years there will be a substantial supply shock in many commodities, especially oil. The credit crunch has caused rigs to shut down, infrastructure improvements to stop and high cost supply to be unprofitable. The two examples examined were the tar sands of Canada and crack spreads.

In western Canada, the cost to pull a barrel of oil out the tar sands is roughly $70, the highest of all production methods. This does not include deep water Brazil which has yet to begin. In this environment, any company that is perceived to have exposure to oil is being punished and cut backs will lead to supply shortages.

Further, the refiners are losing money from negative gas crack spreads. The gas crack spread is a measure of how much money per barrel a refiner makes by "cracking"oil and producing gasoline.

Currently the gas crack spread is negative and has been that way since the end of October. Obviously refiners will not be able to stay in business for too long if they continue to lose money on the products they produce. This unsustainable trend will likely cause refiners to shut down production and lead to a supply shock.

All in, the take away from the conference was that while the world has changed rapidly, ultimately it will begin to normalize. Eventually, the unsustainable trends will be recognized by market participants and fundamentals will once again become relevant. However, as long as the credit crunch continues look for the insanity to continue.

Disclosure: I am short SLV.

The Governator, Munis and You

2008-12-02T10:48:00.008-05:00

The states are in trouble and the water is beginning to flow over the dam. Yesterday, the Governator - Arnold Schwarzenegger, declared a fiscal emergency in California claiming that the state could run out of money by February. As well, the National Conference of State Legislatures (NCSL) and National Governors Association (NGA) released a letter pleading for the Congress to pass a stimulus package. The NCSL reported that 30 states have shortfalls totaling $30 billion, while California already has a budget gap of $11 billion. Interestingly, municipal bond yields have not responded to these developments and that represents a juicy opportunity for investors.

Currently, 30 year Aaa bonds are yielding 5.6%%, while 30 year Baa bonds are yielding above 9%. In contrast, 30 year Aaa municipal bonds are yielding 5.3%. An historical look at Aaa and Baa corporate bonds reveals that the yields are near all time highs.

Furthermore, GE was re-affirmed as a Aaa credit rating today even though it announced weaker than expected earnings. The key of course is the earnings part, they still have some. However, California and 30 other states have an "earnings" shortfall.

If we look at the municipal bond yield curve for Aaa general obligation bonds, it is clear that the yields have not changed dramatically over the last six months, while economic conditions have deteriorated. In fact, the unemployment rate for the US as a whole is at the highest level in over 8 years.

Two of the most populous states and economically important are California and New York. Over the last year the unemployment rate in California has risen to all time highs. It is not difficult to deduce that the higher unemployment rate means people spend less and fewer taxes are collected. Throw in a legislative reluctance to raise taxes and voila, an economic crisis.

Great charts, but how do we make money from this?

The simple answer is to short municipal bonds and the easiest way to do that is to sell short the iShares National Municipal Bond ETF (MUB). This etf invests in primarily Aaa rated municipal bonds and over 30% of the portfolio is concentrated in issues from California and New York.

While investors have been running into the US government bond market they have ignored the municipal bond market and its inherent weakness. Once the market realizes that these Aaa rated muni bonds are less safe than both Aaa and Baa corporate bonds then the yield should increase while price decreases to reflect the new risk premium.

Disclosure: I am short MUB

The Tailwind in the Gold Market

2008-11-25T09:23:00.006-05:00

The global gold hedge book has seen dramatic changes as a result of gold producers systematically reducing hedges to take advantage of higher prices. Over the last year, gold producers have reduced hedges by over 40%, resulting in the lowest amount of gold hedges since 1987. GFMS and Societe Generale recently released their quarterly report on the hedge book, the following table summarizes the hedge book over the last year.

Composition of the Delta-Adjusted Global Hedge Book

Moz	Q2 07	Q3 07	Q4 07	Q1 08	Q2 08	Q3 08	YoY Change Q3 07 vs. Q3 08
Forwards & Gold Loans	23.58	20.20	18.26	14.92	13.44	11.92	-40.9%
Options	10.02	8.99	8.60	7.96	5.51	5.00	-44.4%
Total	33.60	29.19	26.86	22.88	18.95	16.92	-42.0%

Source: GFMS

Until recently, the preferred method of hedging was the use of forward contracts since they have a delta of 1 and provide a 1 to 1 hedge on production. However, as the price of gold increased, producers and shareholders were no longer satisfied with limited profits. Naturally, they wanted to take advantage of any upside in price, while also protecting against the downside. To accomplish this goal producers are now hedging downside risks with put options.

The reduction in forward contract hedging and the trend toward purchasing put options has radically changed the composition and sensitivity of the hedge book. As recently as the first quarter 2008 the hedge book was structured in such a way that in a rising price environment market makers would have to sell more gold to hedge their positions. When gold prices fell, market makers would have to buy more gold. As market makers adjusted their position they kept volatility low by selling into rallies and buying dips.

The following tables are based on data from GFMS and compiled by Societe Generale in the report "Global Hedge Book Analysis." These tables illustrate the changes in delta-adjusted volume during periods of different gold prices and volatility.

Sensitivity of Q1 08 Options Book as of March 31, 2008

Move in Volatility (%)			Move in Gold Price (US$/oz)
	-200	-100	0	100	200
4	7.59	7.78	7.96	8.07	8.12
3	7.59	7.79	7.96	8.07	8.13
2	7.59	7.79	7.97	8.08	8.13
1	7.60	7.79	7.98	8.09	8.14
0	7.60	7.79	7.98	8.09	8.15
-1	7.60	7.79	7.99	8.10	8.15
-2	7.60	7.80	8.00	8.11	8.16
-3	7.60	7.80	8.01	8.12	8.16
-4	7.60	7.80	8.01	8.12	8.16

Source:GFMS

The simplest explanation of the table is that the larger the numbers the more gold needs to be hedged. This hedging is undertaken by the banks and brokers (market makers) that are writing options to the gold mining companies.

For example, if a mining company purchases a put option the writer of that option will in effect be long gold. In gold hedge book terms this is called being long delta volume. Suppose the delta of the option written is +0.5 and the nominal value of the trade is 100,000 ounces, then the writer of the option (market maker) is exposed to being long 50,000 ounces of gold. Typically the market maker does not want to make a directional bet so they must offset the risk. The market maker will borrow 50,000 ounces of gold from a central bank and then sell that gold in the spot market, effectively eliminating directional risk. In this way, the hedging activities of the mining companies are reflected in the spot price of gold. This is why the sensitivity of the options hedge book is so important to gold prices.

For most of the current decade the delta-adjusted volume has increased as gold prices increased and decreased when the price of gold fell. This was primarily because the hedging activities were concentrated in forward contracts with a delta of 1 and resulted in a 1 to 1 offsetting trade. The following table illustrates the change that occurred in Q2 2008.

Sensitivity of Q2 2008 Options Book as of June 30, 2008

Move in Volatility (%)			Move in Gold Price (US$/oz)
	-200	-100	0	100	200
4	5.80	5.61	5.50	5.45	5.43
3	5.80	5.61	5.50	5.45	5.42
2	5.80	5.60	5.49	5.44	5.42
1	5.80	5.60	5.49	5.44	5.42
0	5.80	5.59	5.48	5.43	5.41
-1	5.80	5.59	5.47	5.43	5.41
-2	5.81	5.58	5.47	5.42	5.41
-3	5.81	5.57	5.46	5.42	5.41
-4	5.81	5.56	5.45	5.42	5.41

Source:GFMS

There are two striking observations about this table. First, the absolute amount of delta-adjusted volume has decreased, which makes sense in an environment of de-hedging activity. Second, and most importantly, the sensitivity has reversed. Now, as gold prices rise market makers will have to buy gold to offset directional exposure, while in a falling price environment market makers will have to sell gold.

The net outcome is that volatility has increased as market makers have essentially become momentum players buying and selling with the prevailing trend. Looking at the log change in prices of the SPDR Gold Trust (GLD) provides a standardized comparison of volatility.

It is clear that in the last 3 months the changes in the price of GLD have become more volatile and the volatility followed both up and down markets.

Sensitivity of Q3 2008 Options Book as of September 30, 2008

Move in Volatility (%)			Move in Gold Price (US$/oz)
	-400	-100	0	100	400
4	5.62	5.08	5.01	4.97	4.96
3	5.64	5.08	5.01	4.97	4.96
2	5.65	5.08	5.00	4.97	4.96
1	5.66	5.08	5.00	4.97	4.96
0	5.67	5.08	5.00	4.97	4.96
-1	5.68	5.07	5.00	4.97	4.96
-2	5.70	5.07	5.00	4.97	4.96
-3	5.71	5.07	4.99	4.96	4.97
-4	5.73	5.07	4.99	4.96	4.97

Source:GFMS

The most salient observations about this table is that once again the amount of hedging has decreased and the sensitivity of the book has decreased remarkably. In June 2008, a $100 decrease in the price of gold would result in the amount of gold sold as a result of offsetting hedges to increase by 0.11 million ounces. Now, a $100 decrease in the price of gold results in 0nly 0.08 million ounce increase in the amount of offsetting gold hedges. The prevalence of put options has had a large effect on the the price of gold.

The result of all these changes is that if the price of gold begins to trend up it no longer has the twin headwinds of the mining company hedgers and the market maker hedging activities. In fact, gold has an implicit tailwind built into the structure of the market.

Disclosure: I am long DGP and call options on GLD.

China's Greatest Trade...EVER - Part II

2008-11-19T08:04:00.003-05:00

On October 29th, 2008 I wrote "China's Greatest Trade EVER!" in which I suggested that if China were to diversify its foreign exchange reserves into gold they would overwhelm the market. Since they hold so many dollars and gold is priced in dollars, buying gold is a way for China to diversify without selling the dollar.

Lo and behold, The Economic Times reported today (11/19/08) that China is considering increasing gold reserves from 600 tons to 4,000 tons, as a way to diversify their foreign exchange holdings (Economic Times, "China to Increase Gold Reserves to Diversify Risks"). As per usual the People's Bank of China declined to comment on the report. As well, there was a discussion on ChinaDaily.com about what to do if the dollar crashes; curiously, that link has now been deleted, which should keep the conspiracy theorists busy all day.

On Wednesday 11/18/08 the World Gold Council (WGC) released its quarterly report "Gold Demand Trends." According to the WGC, gold demand in tonnage increased 18%, while in US dollar terms demand increased 51%, a record jump. Total supply fell by 10%, primarily due to lower central bank sales.

In 2007 total demand in tonnage was 3,518 tons and 2008 year to date demand is 2,599 tons. Total supply in 2007 was 3,497 tons and 2008 year to date supply is 2,492. It is clear to see that if China were to enter the market for an additional 3,400 tons they would need to purchase all the gold supplied in a given year. The gold market is already under supplied, any additional demand could have a major impact on price.

Disclosure: I am long DGP and GLD call options.

The Extremely Anxious Index

2008-11-17T12:14:00.004-05:00

The Philadelphia Federal Reserve Bank released its Survey of Professional Forecasters for the fourth quarter of 2008. As part of this survey the Philly Fed creates the Anxious Index. The Anxious Index is the forecasters probability of a recession occurring in the next quarter. The advantage this survey has over models based on the yield curve is the yield curve model assumes banks are borrowing short and lending long, thus stimulating the economy. This has not been the case recently and is a huge shortcoming of any yield curve forecasting model.

The Anxious Index for Q4 2008 came in at the highest reading in its history. Professional forecasters see a 74.78% chance that the economy will be in recession the next quarter. The last time the reading was this high was in the fourth quarter of 1974 when the index reached a high of 74.06%.

The Philly Fed also asked a few extra questions this quarter, in particular, they asked when the forecasters thought the recession had started and how long will it last. The forecasters believe that the recession started in April of 2008 and will last for 14 months. 31 of the 51 forecasters surveyed stated that the recession estimates included the potential for a new fiscal stimulus plan.

The following chart shows the Anxious Index since its inception in 1968 with recessions in red. Historically a reading above 40% probability has been a good indicator that a recession has begun. The Anxious Index reached 42.92% in the first quarter of 2008 which is consistent with the forecasters belief that the recession started in April of 2008.

Using the forecast of a 14 month recession would put the end of the recession coming in June 2009. The Anxious Index has been accurate in predicting recessions one quarter ahead, however, several Federal Reserve studies suggest that the accuracy significantly deteriorates after one quarter.

While this is useful information there are two shortcomings of this survey. First, the professional forecasters use the yield curve in their forecasts, therefore some of the inputs to the forecast are based on flawed assumptions. Second, this survey only goes back to 1968 and does not take into account forecasts during the Great Depression which are probably more applicable to the current economy.

The best way to use this survey may be to think of it as a map without road names. It may tell you where you are and what direction to go, but it will not give a directions to a specific address.

To that end, looking at the Dow Jones Industrial Average in 1974 one finds remarkable similarities. Coming into the fourth quarter of 1974 the DJIA was down over 30% for the year and the Anxious Index was above 70%. On December 13, 1974 the DJIA hit a low of 570.00 which turned out to be the absolute low of the bear market and the beginning of the bull market that lasted until 2000. Interestingly, the National Bureau of Economic Research (NBER) stated that the recession ended in March of 1975, one quarter after the Anxious Index hit an all time high.

Overlaying the DJIA in 1974 and 2008 illustrates the similarities between these years. A simple linear regression reveals the two markets had a correlation coefficient of 0.81 and an R Squared of .66. Perhaps not enough of a match to develop a tradable model, but the information can be used as a guide. Using the past as a guide (always a dangerous and thrilling assumption) we might expect the DJIA to retest the lows and then begin a bull move. If the retest occurs one quarter before the economy turns in June 2009 (according to the Philly Fed Survey) one might expect the DJIA to bottom around March 2009.

Looking further back in history, the Great Depression ended in March 1933 according to the NBER. The DJIA bottomed in July of 1932, two and half quarters before the depression ended. Comparing the twelve month period before the July 1932 bottom and 2008 reveals similar results to the 1974 comparison.

The correlation coefficient of .73 suggests that this period of time could be useful as a guide to the 2008-2009 market. Using 1932 as a guide (here we go assuming again) and a two quarter lead for the bottom of the DJIA, one might expect that the DJIA is currently in the bottoming process.

The point of this exercise is not to attempt to pinpoint a bottom, but to illustrate that the market turns before the economy and well before economic forecasts. In fact, the extreme readings of the perception of economic weakness could be used as a contrary indicator. This is a classic example of perception diverging from reality.

Disclosures: I am short SPY.

Update on Paulson's Speech and TARP Windfall

2008-11-12T11:31:00.003-05:00

A quick update on the recent post "Using the TARP as a Golden Parachute" with respect to Treasury Secretary Paulson's speech this morning. Secretary Paulson stated that the TARP would not be used to buy illiquid assets and that was decided once the bill was signed.

Regarding the windfall for banks that the TARP and other programs have created, it does not appear much has changed. While banks will not have the opportunity to sell the asset they acquire to the government, they will still have the opportunity insure these assets since section 102 of the Emergency Economic Stabilization Act requires that an insurance option be established.

Like much with the Act the details have yet to emerge, and thus it is impossible to evaluate the specific insurance options the banks may have. Comments for Section 102 were due by October 28th, however the extent of the guarantee is laid out in the original bill:

EXTENT OF GUARANTEE.—Upon request of a financial institution, the Secretary may guarantee the timely payment of principal of, and interest on, troubled assets in amounts not to exceed 100 percent of such payments. Such guarantee may be on such terms and conditions as are determined by the Secretary, provided that such terms and conditions are consistent with the purposes of this Act.

If the government ends up guaranteeing 100% of the payments and principle that is even better for the banks than an outright, presumably discounted, purchase. In theory, the insurance program could be designed to insure the assets at current market value, if that can even be determined. To be sure this will be complicated task and will likely be developed in real time much like every other program.

Disclosure: I am long RKH.

Using the TARP as a Golden Parachute

2008-11-11T18:00:00.010-05:00

At the insistence of House Republicans an optional guarantee program for troubled assets was inserted into the Emergency Economic Stabilization Act of 2008 (the "Act"). Section 102 of the Act allows the Treasury Secretary to establish an insurance program for any yet to be determined classes of troubled assets. At the SIFMA Summit of the TARP (Monday November 10, 2008) there was a brief discussion about this section and how many of the Act's conditions may not apply to this section. In particular, it was suggested that limits on executive compensation and corporate governance do not apply.

The law firm of Davis, Polk and Wardell released an analysis of the Act in which they stated

Interestingly, a number of the more general provisions of the Act that apply to TARP do not, by their terms, seem to apply to the Guarantee Program. This may be a result of the hasty drafting of the Act.

To clarify, Section 101 of the Act allows the Treasury Secretary to establish a Trouble Asset Relief Program ("TARP") to purchase troubled assets, while section 102 requires that the Treasury Secretary establish the insurance program. Section 102 states:

If the Secretary establishes the program authorized under section 101, then the Secretary shall establish a program to guarantee troubled assets originated or issued prior to March 14, 2008, including mortgage-backed securities.

By the language of the Act, now that the TARP has been established the guarantee option must be established.

Further in the Act the rules of executive compensation and corporate governance are established. Section 111 limits executive pay, includes a paragraph on bonus claw backs and prohibits golden parachutes. Presumably, these restrictions were intended to apply to any company that seeks assistance under the Act. Specifically, section 111 states

Where the Secretary determines that the purposes of this Act are best met through direct purchases of troubled assets from an individual financial institution where no bidding process or market prices are available, and the Secretary receives a meaningful equity or debt position in the financial institution as a result of the transaction, the Secretary shall require that the financial institution meet appropriate
standards for executive compensation and corporate governance. The standards required under this subsection shall be effective for the duration of the period that the Secretary holds an equity or debt position in the financial institution.

What the Act actually states is that the pay limits and corporate governance only apply if assets are purchased. There is no mention of section 102 or any assets that are guaranteed by the Treasury. This is a loophole that will likely be exploited. Instead of selling assets to the TARP a financial institution is better off having the asset guaranteed by the Treasury and then hold the asset to maturity. Not only will the financial institution benefit from the guarantee it will not have to limit executive compensation or tear up golden parachutes.

Another windfall for the banks in the Act is the prohibition against unjust enrichment. The intent of paragraph (e) of section 101 "Preventing Unjust Enrichment" is to make sure financial institutions do not take advantage of the American taxpayer. Specifically, the Act prevents the financial institution from selling assets to the government at a price above cost. However, this prohibition does not apply to assets acquired in a merger or acquisition. The Act states:

This subsection does not apply to troubled assets acquired in a merger or acquisition, or a purchase of assets from a financial institution in conservatorship or receivership, or that has initiated bankruptcy proceedings under title 11, United States Code.

Add this to a September change in the tax code and you have a bonanza for financial institutions.

On September 29, 2008 the IRS issued notice 2008-83 which amended section 382 of the tax code. Section 382 limited the losses a bank can use when those losses are "acquired" in a merger or acquisition. The intent of the rule was to prevent banks from buying up loss making companies solely as a tax shelter. IRS notice 2008-83 suspended those limits for banks purchasing other banks. It is this change that allowed Wells Fargo to acquire Wachovia without "government assistance", in fact, this change was announced 4 days before the Wells Fargo/ Wachovia deal.

The CFO of Wells Fargo estimated that Wachovia had $74 billion in losses on its loan portfolio, prior to the IRS rule change only about $1 billion could be used as a tax deduction. With the rule change it was estimated by tax expert Robert Willens in a Wall Street Journal article, that Wachovia losses would now be worth $20 billion to Wells Fargo, well above the purchase price of roughly $15 billion.

Once the deal is completed, Wells Fargo can sell those troubled assets to the TARP and use the tax deduction. Or better yet, use the guarantee option of the Act and keep the assets on the books. In this way Wells Fargo will pay a premium for insurance, but will be able to hold the assets to maturity as an insured investment.

The Act was written quickly and broadly which resulted in discrepancies. Coupled with other agency actions the unintended consequence is a windfall for healthy banks.....perhaps was intended?

Disclosures: I am long RKH and may purchase other financial positions.

Neel Kashkari at the SIFMA TARP Summit

2008-11-11T10:59:00.004-05:00

As part of SIFMA's Summit on the TARP, Neel Kashkari Interim Secretary for Financial Stability, gave an update on the TARP and the various programs that are up and running. He emphasized that TARP is one part of the combined government response to the financial crisis and that the main purpose of the TARP is to stabilize the financial system. Unfortunately this is the only guide we have as to how the money will be used. The program was designed with the flexibility to attempt to hit the moving target that is the global financial crisis. Or put another way, it can and will fight any fire that ignites.

The problem with fighting fires is it is reactive as opposed to proactive. Until there is clarity on the proactive steps to be taken the markets will languish in uncertainty.

The Capital Purchase Program

The Capital Purchase Program (CPP) is the program buying preferred shares in financial institutions. In keeping with the TARP's stated goals, the CPP's objective is to strengthen the financial system and increase the flow of financing to support the economy.

The structure of the CPP:

$250 billion of senior preferred shares will be purchased by the Treasury. The shares will pay a 5% dividend for the first five years and then increase to 9%.
The deadline for publicly traded banks to apply for the program is November 14, while private banks will get an extension since the terms are not final for the private banks.
Minimum subscription amount is 1% of risk-weighted assets and the maximum is the lesser of $25 billion or 3% of risk-weighted assets.
Participating companies are prohibited from increasing dividends for three years.
Share repurchases are restricted.
Executive compensation must meet the guidelines laid out in the Emergency Economic Stabilization Act of 2008.

A key point about the process is that while those who are approved to receive the money (healthy banks) will be announced, those who do not qualify (weak banks) will be "encouraged" to withdraw the application. If the Treasury "encourages" a bank to withdraw its application, the decision will not be announced.

The actual deployment of the money will take months as recipients of the money will have 30 days after Treasury approval to get shareholder approval and execute the three required documents: a stock purchase agreement, a certificate of designation, and a warrant purchase agreement.

During the question and answer session Assistant Secretary Kashkari was asked for a timeline on additional asset purchases. In particular, attendees wanted to know when and if the Treasury intended to purchase mortgage backed securities and other loans. Mr. Kashkari did not give a timeline and suggested that the Treasury was focused (read: swamped) by the sheer complexity of executing potentially thousands of purchase agreements.

The take-away from the speech is the Treasury is in "full execution mode" deploying the TARP money and that the program will morph into whatever is needed to promote financial stability. This means that there is considerable uncertainty as to the final form of the program. Continued uncertainty is not the financial markets friend.

Disclosures: None

Senator Charles Schumers's 6 Principles of Change from theTARP Summit

2008-11-11T09:05:00.006-05:00

I attended the Securities Industry and Financial Markets Association (SIFMA) Troubled Asset Relief Program (TARP) Summit in New York yesterday. SIFMA expected 350 people to attend, but over the weekend the registration swelled to over 600 people. The day was broken up into several sessions each with a plethora of information about the current state of the TARP, the future of the TARP and other uses for the TARP. In the key note address Senator Charles Schumer spoke.

Key Note Address - Charles Schumer, US Senator - New York

Senator Schumer took the first part of his speech to blame the laissez faire policies of the Bush administration for the current economic turmoil. He implied that the lack of regulation was the reason the mortgage markets, housing markets, and Wall Street became distorted . He then went on to outline his 6 principles of change:

1. Focus on Systematic Risk and Financial Stability - In the early stage of the economic crisis the most important thing for the government to focus on is systematic risk and financial market stability. Much like an emergency room doctor, first the patient must be stabilized and then the illness can be treated.

2. Unify and Simplify the Regulatory Structure - No surprise here, as one of the themes of conference was that an antiquated and often contradictory regulatory system exacerbated the current crisis.

Senator Schumer suggested that the new regulatory structure be modeled after the UK where one regulator oversees virtually all investment activities. He implied that the new single regulatory body would have the power to tell financial institutions when to cut back on risk and that if this regulatory body was in place perhaps Bear Stearns could have been saved.

While having an updated regulatory system is essential, Senator Schumer's assumption that a government agency may be more adept than investors at evaluating risk requires that the government understand the risk better - a colossal and flawed assumption.

3. We Need More Information on Complex and Opaque Financial Instruments - Again, not a shock given the current situation. This is a laudable goal as long as it can be accomplished without revealing proprietary and competitive information.

4. Recognize that the Global Financial System Needs Global Regulation - Senator Schumer's point was that if the US regulates the financial industry and activity moves to London or elsewhere then there really has been no progress or regulation. This is a complicated but essential goal in the new globalized world order.

5. Increasing Transparency Must be a Central Goal - Here Senator Schumer suggested that major players (read hedge funds, banks and insurance companies) must be required to disclose positions just like mutual funds.

Surprises have been fuel to fire over the last year. Now that the curtain has been pulled back everyone wants and deserves to understand how to avoid being deceived in the future.

6. Laissez Faire View that No Regulation is Good Must End - This brought him back to the beginning of the speech where he blamed the current administration for the economic collapse. He did make the point that over-regulation was not the answer either. He warned against regulating away innovation and the entrepreneurial spirit of America.

In general Senator Schumer's speech suggested what we already knew; the US and the world are in for a new era of increased financial regulation and transparency. It was encouraging that the Senator understood the genius of America is the ability to adapt, change, innovate and ultimately flourish. The US was built on flexibility and ingenuity and that is exactly what will move the country forward, it is essential to keep that spirit alive in any new regulatory structure.

Disclosures: none

When Will the Recession End?

2008-11-05T15:22:00.000-05:00

Now that the election is over, President-elect Obama has a tough economic road ahead. The advanced GDP report of -0.3% suggests that the US is in a recession. The $64,000 question is how long will the recession last. An examination of a few economic forecasting tools gives an approximation of when then recession began and likely end points.

A widely used index of economic activity is the Chicago Fed National Activity Index (CFNAI). The index is released monthly and is a weighted average of 85 indicators of economic activity. Since the index is calculated using monthly data it can be used as a leading indicator for quarterly GDP. The foll0wing chart shows the CFNAI since 1967 with recessions in red.

The Chicago Fed produces two indexes, a monthly index and a 3 month moving average of the monthly index. The 3 month moving average index smooths any volatility in monthly numbers and is used for economic forecasting.

A zero value for the 3 month CFNAI indicates that the economy is expanding at rate of growth that is consistent with its historical trend. An index reading below -0.70 following a period of expansion indicates that a recession may have started. A reading above 0.70 two years into an economic expansion indicates increased probability that a sustained inflationary period has begun.

The 3 month CFNAI crossed below -0.70 in December of 2007 and is therefore the likely start date of the current recession. According to the NBER, since 1967 there have been6 recessions. The longest recessions lasted 16 months and occurred from November 1973 to March 1975 and July 1981 to November 1982. The shortest recession started in January 1980 and ended in July 1980, for a total of 6 months. The average recession lasted for 10.8 months.

Using the NBER figures and a start date of December 2007, the following recession window can be interpolated:

Recession Start Date: December 2007	Possible Recession End Dates
Long Recession: 16 months	April 2009
Short Recession: 6 months	May 2008
Average Recession: 10.8 months	mid-November 2008

From this table it is clear that the US will not experience a short recession since that would have been completed in May of 2008. The most recent advance GDP report of -0.3% suggests that the recession may not end in mid-November 2008. The only end date left is a long recession with a potential end date of April 2009.

The start date of the recession is consistent with Federal Reserve models of the probability of recession. In a 2006 report, Jonathan Wright a Fed researcher, developed a model for predicting the probability of a recession using the Treasury yield curve. The model developed used the 10 year - 3 month spread and the effective fed funds rate. The following chart is from Wright's paper and shows the probability of a recession since 1964 using his Model B. (Recessions in red)

Model B was found to be a good predictor of recessions within 12 months of a high probability reading. Interestingly, it appears that the critical probability level for predicting a recession is 50%. Once the indicator reaches this level there is high certainty that a recession will occur in the next 12 months.

Using Model B and current data yields the following results from 1997-2008.

This graph illustrates that the probability of a recession in the next 12 months reached the critical level of 50% in the first quarter of 2007. Within 12 months, the 3 month CFNAI crossed below -0.70 indicating a recession has begun. This provides more support for December 2007 as the start date for the current recession.

The Federal Reserve Bank of Philadelphia also publishes the probabilities of a recession in its Survey of Professional Forecasters (SPF) report. This data goes back to 1968 and shows the probability of a recession occurring in the next quarter. (Recession in red)

With this series it appears that 40% probability is the critical level in predicting a decline in GDP in the next quarter. Interestingly, the probabilities breached the 40% level in the first quarter of 2008. While not an exact match with Wright's Model B or the CFNAI data it is fairly close and can serve as additional evidence that the current recession began near the end of 2007 and the beginning of 2008.

After falling below 40% for one quarter, the Anxious Index breached the 40% probability mark again in the 3rd quarter of 2008. This suggests that forecasters are expecting a decline in GDP for at least one more quarter. This projection means that the recession will last until March 2009 which is consistent with the long recession projection of April 2009.

The next CFNAI report will be released on November 24th and could provide clues as to the duration of the economic malaise. As well, watching the 10 year - 3 month spread and effective rates will be of utmost importance.

Disclosure: I have no direct positions in any securities mentioned.

The Fed Sets A New Boundary for the Fed Funds Rate

2008-11-05T10:12:00.000-05:00

The Federal Reserve has had difficulty keeping the effective fed funds rate near the target rate of 1%. An effective fed funds rate that is below the target rate results in a de facto rate cut for banks. Since interbank lending is conducted at the effective rate, a low effective rate means that banks can borrow at rate lower than the Federal Reserve would like. In an effort to fight this the Federal Reserve began paying interest on required and excess reserves held at the Fed. This sets a theoretical lower bound to the effective rate as banks have no incentive to lend at an effective rate that is lower than the rate they can receive on reserves. Surprisingly, this action has still not resulted in an effective rate that is near the target rate. As a further combative measure the Federal Reserve announced today that they would increase the rate they pay on reserves. The Fed's announcement:

The Federal Reserve Board on Wednesday announced that it will alter the formulas used to determine the interest rates paid to depository institutions on required reserve balances and excess reserve balances.

Previously, the rate on required reserve balances had been set at the average target federal funds rate established by the Federal Open Market Committee (FOMC) over a reserves maintenance period minus 10 basis points. The rate on excess balances had been set as the lowest federal funds rate target in effect during a reserve maintenance period minus 35 basis points. Under the new formulas, the rate on required reserve balances will be set equal to the average target federal funds rate over the reserve maintenance period. The rate on excess balances will be set equal to the lowest FOMC target rate in effect during the reserve maintenance period. These changes will become effective for the maintenance periods beginning Thursday, November 6.

The Board judged that these changes would help foster trading in the funds market at rates closer to the FOMC's target federal funds rate.

The following chart illustrates the theoretical upper and lower bounds of the fed funds rate since October when the Fed began paying interest on reserves.

The lower bound is calculated using the Fed's formula while the upper bound is the discount rate. The discount rate is used as the upper bound since theoretically banks should not want to borrow at a rate that is higher than the discount rate. However, there is a stigma attached to using the discount window and therefore the upper bound is more likely to be breached.

It is clear that since October banks have been borrowing at rate well below the target rate, in fact the effective rate was as low as 0.22% on October 31. With this announcement the Fed is trying to implement its monetary policy, the fear is that the excess liquidity will lead to inflation. The fed funds market will be a key place to look for signs of a more normal financial system.

Disclosure: I have no position in the Fed Funds market; I am long RKH and BBT.

Can the Airline Index Rise as GDP Falls?

2008-11-03T12:37:00.000-05:00

The airline sector has performed well over the last 2 months, in fact, from July to August the AMEX Airline Index (symbol: $XAL) increased from $13.69 to $26.15, up 91%. To be sure, the index did not escape the market turmoil in September and October, but it did manage to remain above the July lows. This relative out-performance could be attributed to falling jet fuel prices.

In 2008, jet fuel prices and the AMEX airline index have had a correlation of -0.62. This implies that roughly 62% of the time that jet fuel prices fell the airline index rose. Over the last 2 months (September to October) jet fuel prices have fallen 35%, while the airline index has also fallen 6%. Based on inferences from the correlation analysis it appears that the last 2 months are part of the 38% of the time that the airline index does not trade inversely to jet fuel prices.

However, from October 10th, the airline index gained 49%, while jet fuel prices have fell 16%. A possible explanation is that the airline index was a victim of the market turmoil and is beginning to adjust to lower fuel prices.

The major airline company equity prices have held up well relative to the S&P 500 over the last six months. In fact, all except for Southwest Airlines (symbol: LUV) have positive relative strength vs. the S&P 500. Southwest Airlines aggressively hedges fuel costs and therefore the relative underperformance may be the result of its lack of sensitivity to falling fuel prices.

Relative Strength vs. the S&P 500

Symbol	4 wk	13 wk	26 wk	52 wk
AMR	25.38%	49.24%	58.86%	10.31%
CAL	41.34%	88.75%	46.95%	-10.93%
DAL	58.50%	85.51%	88.53%	-15.15%
JBLU	39.33%	37.26%	64.96%	-2.68%
LCC	77.28%	155.64%	69.70%	-41.17%
LUV	-0.54%	-3.07%	27.82%	33.21%
UAUA	103.71%	130.99%	33.73%	-51.84%
Source: TradeStation

The relative strength table illustrates that Southwest Airlines has underperformed the S&P 500 during the recent fall in jet fuel prices. The 52 week relative strength figures indicate that the rising jet fuel prices over the last year could have hurt the performance of airline stocks.

The inference that one may be tempted to draw is that prices of airline stocks should rise further if jet fuel falls further. However, there are two flaws in that line of thinking. First correlation does not necessarily imply predictive ability. In other words, it could just be a coincidence that jet fuel prices and the price of the airline stocks are correlated. Second, the economic environment must be taken into consideration. A falling GDP certainly cannot bode well for the prices of airline stocks. Performing a regression analysis will add an element of certainty to the inferences.

Beginning with jet fuel prices, the regression analysis can determine if the price of the airline index is a function of jet fuel prices. Analyzing the daily closing prices of jet fuel and the airline index from January 1995 to October 2008 yielded the following results:

Regression Results of AMEX Airline Index Price on Jet Fuel Price

	Coefficient	P-value
Jet Fuel	-0.38	0%

R Squared	.3931
Adj. R Squared	.3929

The analysis indicates that 39% (R Squared) of the movement in the AMEX airline index can be explained by movements in the price of jet fuel. Furthermore, the P-value of 0% indicates that there is virtually no chance that the price of jet fuel is unrelated to the price of the airline index.

Moving on to GDP quarterly data was used; the average daily close over the quarter was used for the quarterly price of the airline index.

Regression Results of AMEX Airline Index Price on Quarterly Change in GDP

	Coefficient	P-value
Qtr. Change in GDP	5.40	9.15%

R Squared	.0528
Adj. R Squared	.0349

The results of the GDP analysis suggest that only 5% (R squared) of the price change in the airline index can be explained by changes in GDP. Further, there is 9% chance that GDP has no relation to the price of the airline index. These results suggest that GDP growth, or lack thereof, should not be a concern to airline investors.

Combining the two variables (change in GDP and Jet Fuel Price) produces results that further question the relevance of GDP.

Regression Results of AMEX Airline Index Price on Quarterly Change in GDP and Jet Fuel Prices

	Coefficient	P-value
Qtr. Change in GDP	1.36	60.69%
Jet Fuel Prices	-.3792	0%

R Squared	.4021
Adj. R Squared	.3791

Using both variables, the results suggest there is a 60% chance that the price of the airline index is unrelated to the change in GDP. As well, the price of jet fuel does have a statistically significant role to play in the price of the airline index.

The results explain why airline stocks have been rising while GDP has been falling or has been expected to fall; GDP in fact has little to do with the price of airline stocks. While jet fuel prices are not the sole determinant of airline stock prices, they play an important role.

Disclosure: I am long CAL and JBLU

The Greatest Trade EVER!

2008-10-29T10:57:00.000-04:00

There has been a considerable uproar over a story in the overseas version of the Chinese newspaper The People’s Daily. The story suggested the Chinese are very unhappy with the low value of the US dollar. The most quoted line from the story is,

The United States has plundered global wealth by exploiting the dollar's dominance, and the world urgently needs other currencies to take its place.

Clearly the Chinese have a beef with the greenback and the way the US has treated it.

However, the Chinese anger seems misplaced, they are massive holders of US dollars and dollar denominated assets, why would they want to trash the dollar? Doing so would only hurt their dollar positions. I spent a good portion of yesterday pondering this exact question, and then, over a bowl of cookie dough ice cream it came to me….the Chinese have figured out the greatest trade EVER!

If the Chinese decide to transfer their dollars into another dollar denominated asset, besides US Treasury debt, they have a few choices. Several of these options include: US equities, private equity stakes, agricultural commodities, oil and gold.

If they choose gold they have a significant advantage. Since gold roughly trades inversely to the US dollar, the Chinese could buy gold with some of their dollar reserves and use the rest of the dollar reserves to keep a cap on a rising dollar. In this way they create the exact scenario that would cause the price of gold to rise, i.e., increased investment demand and a weak dollar. With this trade they could convert a depreciating asset into an appreciating asset and have some control over the appreciation. The Chinese government is one of the only sovereigns that have the resources to have a significant impact on both these markets.

Chinese dollar holdings are estimated to be more than $1 trillion. Using this figure as the estimated “dollar portfolio” we can get a little perspective on China’s ability to influence the gold market.

According to the World Gold Council, as of June 2008, the total amount of gold held in reserve was $894 billion or 29,813 tons. Immediately it is clear to see that, if it wanted to, China could buy all the gold in the world. Of course, that is all but impossible since the gold reserves are held by central banks and is not for sale.

A more realistic (and mathematically simple) scenario may be that China wants to spend $89 billion of its $1 trillion on gold, using the World Gold Council statistics that would buy China about 2900 tons. The following chart shows tonnage statistics for the last two years.

Gold Supply and Demand

In Tons

In tons	2006	2007
*Supply*
Mine Production	2485	2475
Central Bank Gold Sales	370	501
Total Gold Supply	3573	3496
*Demand*
Jewelry	2284	2400
Bar and Coin Investment	424	445
Total Demand	3405	3518

Source: World Gold Council

It is clear from the table that if China spent less than 10% of its dollar reserves to buy gold, they would overwhelm the market. They would be able to buy all the mine production and all the gold the central banks wanted to sell. They would also double the total demand for gold.

Of course I have no proof that the Chinese are doing this or are even contemplating buying gold with their dollars. But if I was running the dollar reserve portfolio and my bosses were talking tough about the dollar, I would look for alternative investments.

Disclosure: I am long GLD and DGP

Effective Fed Funds Rate Implies a De Facto Rate Cut

2008-10-27T13:17:00.000-04:00

During the market stress of the last two months the Federal Reserve placed saving the system above monetary policy. The result has been a de facto 50 bps rate cut since October 10th.

The Federal Reserve uses its Open Market desk to buy and sell government securities in the fed funds market in an effort to keep the effective fed funds rate at or near the target. The effective fed funds rate is the volume weighted average of trades between banks and represents a proxy for bank to bank borrowing costs.

Typically the Fed is very successful at keeping the effective rate close to the target and by extension implementing their desired monetary policy. However, as the Federal Reserve has pumped liquidity into the market they have not been able to control the effective fed funds rate and as a result the rate has dropped below target for over a month.

The following chart shows the effective fed funds rate superimposed on the target rate for 2008. The massive dislocation and volatility can easily be seen when looked at in relation to "normal" times.

A closer look at the last two months reveals that the effective fed funds rate has been below the target since October 10th, in fact it has remained at 1% or lower during this time. The impact on the market is that banks can borrow at a rate that is 50 bps below what the Fed is targeting.

Prior to October 6, 2008 the Federal Reserve did not have the tools to get the effective rate back to the target, the more liquidity they put in the system the lower the rate fell. The primary reason the effective rate fell below target was because banks had no incentive to hold excess reserves at the Fed. The Fed did not pay interest on bank reserves held at the Fed, therefore as banks received money they had incentive to immediately get rid of it.

Of course this is exactly what the Fed was trying to encourage since lending had all but seized up. The mantra was and still is - get the credit markets un-frozen.

The $700 billion bailout contained a clause that allowed the Federal Reserve to pay interest on reserves held at the Fed. Originally, this was supposed to occur in 2011, but the crisis forced the government to move that date up to October 1, 2008.

This is a critical development because it sets a theoretical or implied floor on the effective fed funds rate. Since the banks will now be getting interest on reserves they have an incentive to hold excess reserves. Prior to the change any excess reserves was simply offered in the fed funds market driving the effective rate down.

On October 6th, the Fed announced that they would pay 75 bps below the target rate on excess reserves. At that time the target rate was 2.00%, thus banks would earn 1.25% on any excess reserves. In theory any time the effective fed funds rate fell below 1.25% the banks would have an incentive to keep their excess reserves and not offer them in the fed funds market. On October 23rd the Fed adjusted the level to 35 bps below the target rate (1.15%). This now represents the theoretical lowest level the effective fed funds rate should trade.

The upper limit on effective fed funds is the discount rate. Since banks can borrow from the discount window, in theory, they would not want to borrow at an effective fed funds rate above the discount rate. This results in an implied or theoretical upper bound to the effective fed funds rate. Of course, theory and reality are two different things. There is a stigma attached to borrowing from the discount window, however it does provide a reasonable estimate of the maximum value at which fed funds should trade.

The result over the last week has been a slow return to more normal levels. Although still below the target rate, the effective fed funds rate has begun to creep back towards the target rate.

While the media focuses on the FOMC meeting and the likely outcome, the reality of lower rates has been with us for some time. A rate cut this week may be good for sentiment, but structurally it may have little impact. As the banks and the Fed get used to this new structure, expect the effective rate and the target rate to converge once again.

Disclosure: I do not have any position in the securities mentioned.

PNC and NCC Deal Could Signal More Bank Mergers

2008-10-24T11:33:00.000-04:00

Among the mess that is the global financial markets this morning there is some very positive and indicative news. PNC Financial Services (NYSE:PNC) agreed to purchase National City Corp (NYSE:NCC) in a stock deal. Along with the merger announcement PNC revealed that it will issue $7.7 billion in preferred stock to the US Treasury under the TARP.

This deal makes PNC one of the first banks to choose to participate in the TARP and could provide a model for how banks intend to use the program. Instead of making loans with the money, PNC has elected to purchase a weaker rival and increase its capital base. This is a first step in repairing the global financial markets and will likely be followed by other deals.

In fact, the government may actually encourage more mergers. A Wall Street Journal report on October 21, 2008 (“US Rescue Fund is Likely to Foster Bank Takeovers,” WSJ 10/21/08) quoted a government official saying, “If a healthy institution is making an acquisition, we would look very favorably on that.”

This government encouragement and available capital has not been lost on healthy bank CEO’s. On BB&T Corp’s (NYSE:BBT) Q3 earnings conference call, the CEO John Allison said in reference to the TARP, “We think there are going to be some acquisition opportunities, either now or in the future, and this is a relatively inexpensive way to raise capital.”

The market has rewarded PNC for this move, as it is one of the only financials that is up on the day. Again, a very interesting occurrence as acquirers usually fall on the deal announcement and the acquiree rises. The PNC bid for NCC was 7% below yesterday’s close, which explains the sell off in NCC. However, the rise in PNC is a canary in the coal mine that may signal that in this wave of bank mergers the acquirer will be rewarded.

There are two ways to play this theme of bank consolidation. First, one can sift through every regional bank and determine weak and strong. Typically the value player would look to buy the potential acquiree, however, based on the pricing of this deal and on how the market reacted it makes sense to purchase the stronger banks.

The second and more efficient way to play the theme is to purchase the Regional Bank HOLDRS ETF (AMEX:RKH). This ETF holds both the strong and the weak banks and provides an opportunity to participate in any deal among these players.

Regional Bank HOLDRs Composition

Company	Symbol	Current Weighting
Bank of America	BAC	7.17%
BB&T Corporation	BBT	3.59%
Bank of New York	BK	4.72%
Comerica	CMA	1.46%
Fifth Third Bancorp	FITB	1.61%
JPMorgan Chase	JPM	18.98%
KeyCorp	KEY	1.52%
Marshall & Ilsley	MI	1.13%
National City	NCC	0.46%
Northern Trust	NTRS	4.02%
PiperJaffray	PJC	0.21%
PNC Financial	PNC	6.18%
Regions Financial	RF	1.08%
Synovus Financial	SNV	0.81%
SunTrust Banks	STI	3.66%
State Street Corp	STT	4.36%
US Bancorp	USB	19.00%
Wachovia	WB	2.76%
Wells Fargo	WFC	17.27%

Source: www.holdrs.com

Since the components are market weighted the stronger banks will have a higher weighting as market players sift through the ruble and bid up the stronger companies.

The price action of the ETF suggests that market participants have similar thoughts. Earlier this month, during the equity market sell-off, RKH did not make a new low. This is significant given the fact it is loaded with financials and several of the companies reported substantial losses. Even with futures limit down this morning the ETF held above the October 10 low.

Source: BigCharts

The market weakness is providing one of those rare low risk entry points into RKH. As the weeks progress we will most likely see more mergers and more uses of the TARP in this manner.

Disclosure: I have a long position in RKH.

Hank the Plumber

2008-10-19T18:27:00.000-04:00

While the world was focused on Joe the Plumber, his brethren Hank the Plumber, a.k.a. Treasury Secretary Henry Paulson, went to work fixing the global financial plumbing.

The global financial crisis may not be over, but there are a few signs that things are changing. It is helpful to break down the structure of the crisis in three basic elements. These three components need to be addressed before we can declare the crisis over:

1. Financial Institution Solvency, a.k.a. The “blockage” in the commode

2. Interbank Lending, a.k.a. The Plumbing

3. Real Economic Spillover, a.k.a. The Bathroom Floor

Financial institution solvency has been the biggest reason behind the global fear based liquidation. Investors have been afraid that any investment, whether it is equity or debt, would result in a loss because the company they invested in was insolvent. Truth became irrelevant, simply the perception of insolvency lead to investor withdrawal and ultimately resulted in actual insolvency. Both Lehman Brothers and AIG are perfect examples; once they were perceived to be weak they both experienced a “run on the bank” event.

The hope that this week offered on the financial institution solvency front is the direct investment in banks by the US government under the TARP plan. The government has accomplished two goals with this use of the money. First, they have taken the fear of insolvency away by providing much needed capital and an implicit government backing. Second, they have provided capital directly to the system where, if used properly, can begin to repair the economy.

The intended outcome of this action was to restore some faith in the financial institutions. We saw the result of that restoration in the interbank lending market on Friday when both JP Morgan and Citibank reported lending in the market. This is critical to getting the financial plumbing back in working order. In terms that Joe the Plumber would relate to: Direct TARP investment in the banks is the Draino and lending in the interbank market is the toilet beginning to flush.

Now we have to deal with the spillover into the real economy. Just like a plumbing back-up some “stuff” has spilled over the bowl. At this point we have been so concentrated on unplugging the plumbing that we have no idea how bad the real economy is damaged. On Friday, the University of Michigan consumer confidence survey dropped from 70.3 in September to 57.5 in October, this is the lowest level the since the survey started in 1978. The unanswered question is how long and by how much the American consumer will retract. Based on consumer sentiment, people are still not willing to use the bathroom.

US Equity Markets

The Rule of 11 has proven useful again(see last week's post). The US equity markets had a roller coaster week but were able to hold the lows made the prior week. Warren Buffet made his debut as JP Morgan, circa 1909, when he announced in the New York Times that he was spending his own money to buy US equities. This is classic discovery period behavior, and Buffet is the classic investor during this period, central casting could not have done a better job.

Mr. Buffet wrote that markets typically bottom before the economy turns and suggested that “if you wait for the robins, you may miss the spring.” I have never much liked the storms and mud the spring brings and my boots are not as high as Mr. Buffet’s. Therefore my style is to wait until I see the nest being built in preparation for the robin’s eggs.

US Treasuries

Yields ticked higher this week and resulted in a bit of flattening to the curve. However, Friday’s action in the interbank market may be more important than Treasury yields. LIBOR did come down as the credit markets began to thaw. I am still on the sidelines of this market until I get a clearer picture on the real economy.

Gold

Last week I mentioned that gold was probably my favorite market right now. There have been some dramatic changes in this market that could lead to demand outstripping supply.

In brief, a change in the global gold hedging book, strong investment demand and a resumption of interbank lending all are positive signs for gold.

Dollar

The dollar did not do much this week as I think most investors are like me and are waiting for some more definitive economic news. However, the consumer sentiment number does not bode well for the economy and eventually I believe the flight to quality bid in the dollar will recede. And as the saying goes, when the tide goes out, we can see who was swimming naked.

Oil

New lows in oil this week caused panic in the OPEC nations. So much so that they have decided to push their meeting up and “discuss” cutting output. My inclination is that a cut in output is all but inevitable. OPEC nations have built up considerable wealth and power as they reaped the profits from high oil prices. I do not think they are willing to give up their position, especially when they control the spout.

Beyond Rationality

2008-10-13T10:26:00.000-04:00

Perception certainly had a profound effect on reality this week. In fact, the two were so intertwined they were hardly distinguishable. A global liquidation of unprecedented proportions is underway. Last week I wrote that hedge fund liquidation could be occurring because large investors wanted their money back. It turns out that it was worse, large investors needed their money back. This week not only Russian oligarchs were forced to sell to meet margin calls, but corporate executives in our own backyard were forced into margin selling.

Sumner Redstone was forced to sell holdings in both CBS and Viacom to meet loan covenants, John Malone sold stock in Liberty Capital to meet margin calls and the CEO of Chesapeake Energy was forced to sell all of his holdings. But wait, there is more…a director of Coca-Cola Enterprises surrendered 18.6 million shares to JPMorgan and several officers at General Growth Properties were forced to liquidate holdings.

As the uber-wealthy cut back on champagne and caviar lunches, the forced selling turned into a panic. This panic pushed many asset prices beyond what a rational investor would consider value. For example, Continental Airlines (NYSE:CAL) has over $3 billion in cash as of June 30, 2008, but as of Friday had a market cap of $1.25 billion. A rational investor could buy every share of the company, pay herself back with the cash on hand and still have $1.75 billion in the bank.

Of course, in rational times this would spark a nice buyout boom, but these are not rational times. The prevailing perception and reality is that companies need every bit of that cash to fund operations and that by the time any deal closed that cash could be gone.

As the credit markets unfreeze, companies that still have plenty of cash should be the beneficiaries of any rally. However, we have stiff economic headwinds and I can still see no reason to buy US equities. We may have pushed past rationality, but that does not necessary mean the worst is over.

The Rule of 11

So much damage has been done to the economy that the probability of a sustained bull market in US equities is close to zero any time in the near future. However, there are some structural elements to the action in the S&P 500 that suggest Friday has a high probability of being a short term bottom in the market.

The bull market of the last 4 years began on October 10, 2002, including this date there have been 30 major peaks and troughs. These peaks and troughs have tended to occur on or around the 11^th of the month. In fact, 53% of the time the market peaked or bottomed within 3 trading days of the 11^th, 90% of the time the market peaked or bottomed within 7 days of the 11^th. The following table shows the date of every major peak and trough since October 10, 2002 and the amount of trading days since the 11^th of the month.

This week is prime time for a market bottom based on the historical pattern. I have been short the S&P 500 since September 4^th, 2008. I will be covering at least 1/3 of my position on any meaningful rally this week. If the rally is strong enough I will cover another 1/3 and leave 1/3 to take advantage of any further weakness.

Trading Days from 11th	0	1	2	3	4	5	6	7	8	9	10
*Peak*	10/11/07			10/6/04	6/17/03	2/4/08	1/3/05	12/2/02
	12/11/07			5/8/06	3/5/04		8/3/05	2/22/07
	8/11/08			7/26/07	3/7/05		5/19/08



*Trough*		10/10/02	8/13/04	8/6/03				4/20/05	1/24/08	11/26/07	10/25/07
		3/12/03	10/13/05	8/16/07				1/23/08
			6/14/06	3/17/08
			3/14/07
			7/15/08


Total			*3 days*	*53%*	*5 days*	*67%*	*7 Days*	*90%*

The Kanundrum Model of Markets

The following is a description of the major global financial markets and their current position within the Kanundrum Model of Markets. An explanation of the Kanundrum Model can be found at www.kanundrum.com.

US Equities

Current Stage: Belief and Proof – Stage 3

Current Market Condition: Bear

We have seen both the belief and proof that the world is in a tough place manifest itself in the equity markets last week. It is possible that last week was the climax of this stage and we could be entering Complacency – Stage 4.

The key will be the strength and length of any rally. A choppy, low volume rally would suggest the sellers are simply using the rally to get better prices. A high volume, long rally may indicate that this belief and proof stage has also encompassed the Mom and Pop stage.

US Treasuries

Current Stage: Mom and Pop – Stage 5

Current Market Condition: Bull

The market for US treasury securities is less clear to me than other financial markets. My hypothesis is that we are in the final stages of the bull market. The past week saw investors chasing after yields near 0%, which suggests that safety trumped rational thought. Irrational behavior is common at market tops.

The wild card in this scenario is the Federal Reserve; I cannot construct a scenario where the Fed raises interest rates in a slowing economy. Therefore, the only thing that should take rates higher is market demand for better yields. If foreign investors refuse to fund the US deficit at near zero real rates then the market will take rates to an acceptable level.

Gold

Current Stage: Disbelief/Confusion – Stage 2

Current Market Condition: Bull

There is a very good possibility that we are at the beginning of a major bull market in gold. There are too many factors to discuss in this short format, so I plan to write more about this in a separate report.

In brief, the global financial panic has resulted in tremendous demand for gold; if the dollar begins to slide the result could be a massive rally in gold.

Dollar

Current Stage: Disbelief/Confusion – Stage 2

Current Market Condition: Bear

Although the dollar has had a significant rally in the last few months I still consider this a corrective rally in a bear market. Until the fundamental picture for the dollar changes I cannot in good conscience suggest that there is a bull market in the dollar.

Most of the action has been technical and mechanical in nature. The credit crunch caused tremendous demand for dollars to fund dollar denominated liabilities. As banks hoarded cash, those dollars became hard to come by and those in need were forced to pay higher prices for the dollars.

Oil

Current Stage: Unclear

Current Market Condition: Unclear

Oil is trading on the perception of a global economic slowdown. This perception is quickly turning into a reality. However, I am still not completely clear or convinced that the bull market in oil has ended or even that a bear market has begun. Until I get some clarity I am staying on the sidelines of this market.

Prevailing Perception October 5, 2008

2008-10-05T15:48:00.000-04:00

The sentiment in the global financial markets is decidedly negative, particularly after the passing of the bail-out bill did not result in any meaningful change in the markets. Credit markets are still frozen, banks are hoarding cash and non-financial companies are wondering if they will ever get a line of credit again.

The prevailing perception among lenders is that any loan they make will turn out to be a bad loan. The speed at which financial companies are imploding is breathtaking. The perception that any loan will turn out to be a bad loan is creating tremendous demand for cash. As cash is hoarded, fewer banks are able to get the capital they need, which in turn makes them weaker and an even worse credit risk. As the bank becomes a greater credit risk it needs to raise more capital, which it can't get, and thus any loan made to the bank becomes a bad loan.

We are truly in a period where perception is influencing reality.

US Equities: Strategic investors cutting sweetheart deals shows the amount of panic in the market. While having Warren Buffett put some money to work can be perceived as a vote of confidence in the US equity market, the reality is he is protected by 10% yields and warrants.

The other reality in the marketplace is that many hedge funds are facing redemptions. Many big funds are down over 20% on the year and large investors want their money back.

US Treasuries: The flight to quality trade continues, although it seems ridiculous. The fear sweeping the global financial markets has investors flocking to US government debt with almost zero yield and in some cases negative real rates of return. The trade is not about return on capital it is about return of capital.

Oil: It is amazing how quickly oil's star has faded. As the global slowdown trade takes hold the influence of oil is just not what it used to be. At this point, I would perceive a rally in oil as a positive. A rally may suggest that the global economy has found its footing and may be on the rebound.

Gold: Gold is probably one of the most interesting markets these days. Despite a rising dollar, fear has boosted the metal. I suspect that as investors flee other currencies in favor of the dollar they are searching for places to stash their cash. For now, gold is perceived to be better than a bank.

As we wade through this financial crisis, the perceived quality of the dollar could change, once investors begin to focus on the deteriorating financial condition of the US government. A falling dollar coupled with fearful investors could spark a nice rally in gold, I will be buying on a pullback.

Dollar: The perception that the dollar is the least worst option among global currencies has lead to a rally in the greenback. Again, this is a matter of return of capital vs. return on capital. If a suitable alternative to the dollar emerges, the focus will return to the US deficit and the extra $700 billion the government must finance. The fundamental story for the dollar has not improved, if anything it has become worse.