Continued from Page 1

Where We Could Be Headed

In 2008 Outlook: I Don’t Know, I first talked about debt deflation, because in a world built on a mountain of debt, an economic slowdown could result in a tough recession and/or deflation. Then I said that perhaps it could lead to hyperinflation, because if the U.S. continues to print money at nearly 20% a year, surely the dollar must collapse and international investors might demand higher and higher rates to own U.S. bonds.

This has happened in other countries, notably Germany and Brazil, but is it unimaginable that it could happen in the U.S.? This question lead me to the idea that the situation that the U.S. finds itself in is so unique that perhaps it will define history as opposed to history being its guide? Is it possible that this is the ‘Great American Debt Experiment’ and that 20 years from now, we will look back and see that this was history? To be frank, this is the way I am leaning.

For the longest time, I couldn’t figure out why international investors (both foreign central banks and foreign institutions) kept buying U.S. bonds while the dollar kept plummeting. Under normal circumstances, the buyer would demand higher yields to compensate to the asset they own falling in price in their currency terms. To get an idea how many U.S. Treasuries they own, the number now stands at 51.7% of all marketable Treasuries, the highest on record. They have sailed through the magical 50% and now own the majority of U.S. Treasuries. Hardly enlightening, if you ask me.

Foreign Holdings of U.S. Treasury Securities

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Of particular interest to me is that the rate at which they are purchasing Treasuries has diminished when using a 12 month rolling calculation. What are they buying instead? Corporate bonds, loads of them, on the order of $600 bln in the last year. This is as spreads blow out. It seems that international investors simply have an insatiable appetite for U.S. assets. Why? Because America is on sale in their currencies.

Imagine you are from the Middle East and your currency is essentially oil and you are buying currencies in deflated currencies, namely dollars. And companies like Merrill Lynch (MER), Citigroup (C), Morgan Stanley (MS) and UBS (UBS) need capital to fight off writing off the values of the low quality assets on their balance sheets.

These investors gladly walk in (the Chinese government, Singapore government and Abu Dhabi Bank have all done this just in the last month) to own parts of great franchises at very low levels in their own currencies. And this trend, I am afraid, is just beginning. If I had asked you five years ago if it were possible for Singapore to bail out the Union Bank of Switzerland, would you have believed me? The U.S.' destiny is firmly now in the hands of international investors and they are buying and will likely keep buying. Wouldn’t you?

I have constructed a chart dating back that shows just how cheap the dollar is compared to the DXY, which, according to Bloomberg, "indicated the general international value of the U.S. dollar." In 1995, the ratio was approximately 0.1, meaning that the DXY was valued at 10x the value of a barrel of oil, but today a barrel of oil buys 1.3 units of DXY, a stunning 13-fold increase. Yes, America is on sale.

Barrel of Crude Oil divided by the DXY (U.S. Dollar Index)

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Shenzen Shanghai Exchange Value Divided by DXY Index

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Hong Kong Hang Seng Index Divided by DXY Index

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How Can We Profit from the Mistakes of Others?

For several years, I have been preaching to only take credit risk when you are paid to take credit risk. This concept really holds true for all sorts of asset classes including stocks and real estate. Generally speaking, buying into a parabolic move in prices in Japanese stocks, technology stocks, homebuilder stocks, real estate or Chinese stocks is a dicey proposition.

Like Twain said, "History doesn’t repeat itself but it does rhyme."

I have updated my 'bubble comparison chart’ that helped me avoid the tech fallout in 2000-2002, the real estate fallout (and other credit market fallouts associated with real estate) and now what looks like the newest bubble to burst: China.

Bubble Comparison Chart

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We are without a doubt within a nasty, yet necessary, unwinding of the massive credit bubble that began in earnest in 1995, courtesy of the Greenspan Fed and now the Bernanke Fed. There are bailouts galore but none seem to be working, and in my opinion, simply forestall the inevitable.

So what to do? There is a phrase that goes "Round and round she goes, where she stops, nobody knows." This is the key to understanding when to participate in the credit markets again. The credit market is like a top that was spinning, very balanced, but has begun to wobble. During this time, I have owned mostly Ginnie Mae, Freddie Mac (FRE), and Fannie Mae (FNM) securities. Ginnie Mae has the explicit backing of Uncle Sam while Fannie and Freddie have implicit backing. 

I have taken a position in preferred stock offered recently by Fannie and Freddie and while satisfied by the yields I am receiving relative to risk taken, they are a bit more volatile than I am used to (much of this, in my opinion, is due to year-end tax selling and balance sheet constraint issues by banks and broker/dealers).

Speaking of banks and broker/dealers, the main theme for the first part of 2008, I believe, is that the financial community will have to fess up to some uncomfortable write-offs and need yet more capital.

This is the ‘cockroach theory’ at its best. There is never just one and sometimes there are some large ones that you really don’t want to see. But something tells me this game is far from over and despite the fact that spreads have widened dramatically, an unwinding of an unprecedented credit bubble should be, well, unprecedented. So I will continue to wait and see, but what lies on the other side of caution is opportunity. I live by the age old adage of "Buy from the fearful and sell to the greedy."

Fear seems to be building but we are nowhere near capitulation. When I begin to sense capitulation, I intend to pounce on high quality securities on behalf of clients. The chart of the emotional roller coaster we call the financial markets is below and, I think, says it all.

Investor Emotion Chart

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I wish you and yours a Happy New Year and a Happy, Healthy and Prosperous 2008.


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