(Continued from Page 1)

The Potential for Re-Pricing of Credit Risk

If the scenario I mention above actually did unfold, the market that would be the most impacted, in my opinion, is the corporate bond market. All of the liquidity sloshing around the globe along with the yen carry trade has resulted in unnaturally low yields in corporate bonds. For example, I recently acquired 30-year Ginnie Mae 6% bonds and received a yield of 6.20%. Similar duration bonds like large banks, brokers, REITs and utilities routinely trade at yields 0.40% less than the Ginnie Mae, which possesses an explicit "full faith and credit" backing of Uncle Sam.

This is nonsensical to me, just as it is nonsensical for Private Equity firms buying companies with "cap rates" or returns of 4-5%. It is also why when we launch our new fund in August, we will look to profit from the eventual re-pricing of risk. To give you an idea of what can actually happen to corporate bond spreads during a "credit event" like 1990, 1998 or 2002, see the charts below. These pictures speak volumes. It is also why we are void of credit risk at this time and expect to remain in that position. Note to self: If you are not getting paid to take credit risk do not take credit risk.

Thanks to my friends at Ned Davis Research for the data.



Historical Bond Yields


Truthfully, I feel the re-pricing of risk is a matter of not if, but when and of what magnitude. Only time will tell, but I continue to be defensive, particularly in light of the fact that we are, strangely, I might add, getting paid more for not taking risk in the first place. I also am keeping duration in portfolios relatively low as long as the trend remains up in bond yields both here and abroad.


Smart Money Sells: What are the Implications?

I often refer to what the smart money commercial or "hedgers" are doing. When the market dipped, they bought the S&P, NASDAQ, DJIA and Russell 2000, both "big contracts" and electronic "e-mini" contracts, in near-record size. Well, they have sold that position into the recent rally, which I take note of. They are often early, but they are also often right. So I respect this and the fact that they are still net short the 10-year futures but long the 2-year note futures and also long the 30-year bond futures making them neutral from an "overall duration" perspective. See the charts here.

Combined Hedgers Positions in S&P Futures


10 Year Treasury Futures Position of Commercial Accounts



Homebuilder Update and the Effect on the Overall Economic Picture

I opined as early as late 2004 that there was a bubble brewing in housing and housing stocks. In retrospect, that is what we were experiencing and the aftermath we are experiencing is less than pleasant. Home prices are falling year after year for the first time since the 1930s and it is spreading to areas like "sub-prime" loans and offshoots of these loans, like ABX indexes and CDOs and CLOs. In my opinion, in the vote of "contained versus contagion", I have to confess to being in the ‘contagion’ camp and think this credit rot will eventually spread, and again, is why I am so cautiously positioned from a credit perspective. My goal is to be able to buy from the fearful when the market eventually adjusts. One only gets a couple of those chances every decade, in my experience, but I must indeed be properly positioned to benefit.

Below, please see an updated bubble chart that compares the bubble in Japan in the late 1980s, the NASDAQ bubble of the late 1990s and the broken bubble in housing stocks.

I think the decline is about to re-accelerate, unfortunately for those clinging to the hope that the industry has bottomed. I have reviewed the balance sheets of all of the major home builders and have come away believing that there will be at least one that bites the dust before it all ends. Actually, this is typical behavior for post-bubble periods and I believe the same hangover will be seen down the road from the bubble in Private Equity and LBOs. I have lived through too many episodes like this and I think I know when to play defense. This is just one of those times.

Bubble Comparison Chart


Just for grins, I dreamt up a bubble comparison comparing the NASDAQ bubble and the recent move in Chinese equities (the Shenzhen Shanghai Index in local terms) and one comes away with that similar feeling that says "here we go again". A picture tells 1,000 words, I guess.

NASDAQ vs. Shanghai Shenzhen Index



Conclusion—Why We Need To Stay On Our Toes

The picture I have laid out is admittedly sobering but what has me the most concerned (I am always a ‘worry wart’) is the mispricing of risk generally around the globe. Yes, the liquidity train rolls down the tracks unabated but one of these days it will derail, as it has a habit of doing. Will a yen carry unwind do it? Will it be global inflation fears? A couple of LBOs gone bad? A couple of large hedge funds wrapped up in all these illiquid "structured" products imploding? A continuation of the housing market downturn? Or a combination thereof?

I admit to not being sure from a timing perspective (the third years of presidential terms are notoriously positive for stocks while years ending in seven have had their share of financial accidents), only that I think it is out there sometime between now and 2009 or 2010. As for my positioning, I recently re-entered a few sectors, namely gold shares via GDX (Gold Miners ETF), SMH (Semiconductor ETF) and PPH (Pharmaceutical ETF). So I am not void of stocks, just being very careful which sectors should be represented in portfolios.

From a fixed income perspective, as previously stated, I continue to focus on short-term, high-quality bonds along with a smattering of Adjustable Rate Mortgages. Paradoxically, one sector that seems over valued is very short-term T Bills!

RETURN TO PAGE 1