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Hedgers Press Their Bets, REITs in Silly Season, 2007 Ease?

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...it is not possible to be 'over disciplined.'

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I have been writing much about a slowing economy for the past few months. Housing is slowing, retail is slowing, inflation is ebbing (towards deflation-more on that later). I have also harped on the persistent inversion of the yield curve (short-term rates are higher than long-term rates) which I will highlight as well.

In a recent www.WSJ.com interview, I opined that the economy could continue to slide and the inflationary fears would turn to deflationary fears. Below I will highlight two charts that are very important to me as it regards both the Treasury market as well as the stock market. The first chart I will feature shows the yield curve which continues to invert using the Fed Funds rate (the rate the Fed charges for overnight loans) versus the 10 year Treasury note yield. The direction is rather clear. All I know is that excluding 1995 (which was coincidentally the time the money supply growth began accelerating and the great bubble of the late 90's began), persistent curve inversions usually spell future economic weakness and stock market weakness. See the chart below.



Next, see the chart below. It shows the year over year change in both overall inflation of both the Consumer Price Index and Producer Price Index. I have always used overall inflation rather than 'core' inflation that excludes food and energy. Food and energy, while admittedly volatile, are important in my book. Obviously you are free to disagree, which is what makes markets, but as I write this in the car ride from Daufuskie Island to my home in Orlando, the price of fuel and food are probably rather important to the zillions of folks we are stuck in traffic with. At any rate, the chart depicts the Federal Funds Rate when overlaid upon year over year inflation. Note the rather sharp and decisive move down. The year over year PPI is now firmly in negative territory and the CPI is not far behind. In past instances, the Fed Funds rate has fallen along with it. So while the Fed talks tough on inflation, they print money like crazy and act dovish (easy policy). Throw in the fact that we are entering the all important third year of a Presidential Cycle (when fiscal and monetary policy is usually loose), I would bet on Fed eases in 2007. When you consider the Republicans have lost control of both Houses, they probably want to avoid losing the Presidency as well. More ammo for Fed easing in 2007. Anyway, here is the chart.



If this plays out as I suspect, the economy might find itself persistently weak, profit margins could come under pressure as producers lose pricing power and GDP growth continues to cool. Perhaps this is why the hedging accounts continue to short S&P futures in record size in the face of a stubbornly strong stock market. I am sure that they, like most of us know that we are entering the strongest seasonal time of the year. I use Bloomberg and CFTC data to get a 'combined' view of the S&P contracts in 'big contract terms.' Big contracts are the ones you see people in the pits on TV screaming about (open outcry) and e-mini contracts are electronically traded and have 20% of the value of each 'big' contract. So my firm nets them out to get a true picture of their picture. And they are leaning hard against the speculators (the rest of the world?-yes that is sarcasm…). See that chart below.

Combined S&P 500 Hedgers v.s the S&P 500


What about other sectors? As I have mentioned over the past few weeks, I have noted the big boys stubbornly short the Dow Jones Industrial Average, liquidating tech stocks into strength (they are now short actually) and have remained long the small cap sector, a bet they made when they were lower in the summer months. See these three charts below. Note that these charts also combine the e-mini contracts and open outcry contracts into big contracts as well.

Hedgers vs. NASDAQ 100


Hedgers vs. Dow Jones Industrial Average


Hedgers vs. Russell 2000 (Small Cap Stocks)


The hedgers' positions in bonds haven't changed much during the recent inversion and bond market rally. My firm has added preferred stocks in companies lately at yields in the 6.50-6.6% range in companies like Citigroup (C), Florida Power and Light, IBM (IBM), Morgan Stanley (MS) and General Electric (GE). While not wildly bullish about corporate bonds, the spreads attained over Treasuries is now sufficient enough (175-200 basis points) to own them. I actually should stress that my firm is 'renting them' rather than investing for the very long term. This is due to the fact that we believe that corporate bond spreads will eventually widen out, particularly junk and emerging market debt. See the charts below on the positions in 10's and also the overall yield curve (duration weighted for the 2 year, 5 year, 10 year and 30 year contracts).

Hedgers vs. the 10-Year Treasury Note


Hedgers Overall Duration Weighted Position vs. 10-Year Treasury Note


Every Monday morning I seem to wake up to $100 billion in private equity deals, mergers or LBO's. It eerily reminds me of my days at Drexel Burnham Lambert in the 1980's. Recall Mike Milken and the Beverly Hills gang buying everything in sight with borrowed money. At first, the deals were solid, like Safeway (SWY) and Beatrice Foods. But once the good deals (with good interest coverage ratios) are gobbled up, capital chases deals at too high a price. I note that last Monday, Sam Zell, one of the savviest real estate players on the planet, sold $20 billion of REIT's to a private equity group. This strikes me as a watershed event that could signal the 'smart money selling to those that have to buy.' I am not criticizing the buyers as they are smart folks to be sure, but their job is to buy things. Otherwise, investors will demand their capital back. So I dreamed a new chart that shows the Bloomberg REIT Index versus the 10 year Treasury. I also threw in a ratio of the REIT Index versus treasuries. I would note that this deal takes place after a gigantic run and that REIT's routinely trade at 7x book value. Unprecedented territory and yet another troublesome data point.

Bloomberg REIT Index vs. 10-Year Note and Ratio


Lastly, I would like to drag out my 'bubble comparison chart' that I have been featuring for the better part of a year and half. Homebuilders' shares have been on the rise lately as there is talk that they are cheap and could be takeover targets. I must tell you that although there could be deals done in this space, the fact that they would be prudent transactions makes me giggle. The homebuilders have been reducing earnings and sales estimates at an alarming rate. This is occurring as their balance sheets are bloated with overvalued homes and land. They are also bloated with long-term debt that financed all of the over-building in the first place. But as I noted on the chart, the homebuilders (S&P Super Composite) is tracking Japan more than the NASDAQ. This may be coincidence or may be due to the fact that the post-bubble experience in Japan was real estate led.

Bubble Comparison Chart


In conclusion, I have been cautious on stocks, perhaps overly so the past few percent, but am neither a bull nor a bear. I simply look to overweight asset classes when I feel there is a 'low risk entry point.' This goes for stocks and bonds as well as sub sectors such as industries or indices like growth and value. If and when the risk/reward ration points heavily to reward rather than risk, we will take more risk. In the meantime, we will attempt to generate 'equity-like' returns with assets like the aforementioned preferred stocks. This is not market timing, simply an assessment of risk. My firm has four distinct goals for our clients.

  • Protect hard earned capital.
  • Consistent returns with low standard of deviation.
  • A high stream of income.
  • Capital Gains.


While not always popular, and also not stubborn, my firm must never lose our objectivity. Granted, this reduces returns in the near-term sometimes, it serves us well over the long term. I do not think it is possible to be 'over disciplined.'

I hope that you and your family had a joyous Thanksgiving. I know that I am thankful for the family, friends and wonderful clients that I have.

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Positions in treasuries, preferreds, agencies, S&P 500

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