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The Elephant Is In The Room


What are the implications?


You are probably asking yourself if I had too much eggnog when I made this headline. But, seriously, the 'elephant in the room' is Wall Street parlance for who the big player is in the markets.

There are actually two elephants in the room at this time, private equity firms like KKR and Blackstone and the truly large elephant, foreign central banks. I am neither a bear nor a bull, but rather the one that has to review data provided to my firm in the marketplace and decide if the market is high risk or low risk. I had felt that the stock market was extremely high risk in 1999 but was not proven correct until 2000. That was a painful time as people told me 'I didn't get the new paradigm,' and that it was 'different this time.' I remained steadfastly negative until July 2002 and turned bullish in March 2003. My firm has been invested in stocks the whole way, but has now reduced exposure (a bit early, like 1999) as the market again feels high risk to me. And once again I am hearing 'it is different this time' from many bulls.

Maybe they are correct and I will under perform my peers in the months ahead, but as the manager of other people's hard-earned money, I must respect what I see in the marketplace.

What do I see? I see the United States stuck in a seemingly un-winnable war in Iraq (not a political statement, just an observation) and a monstrous trade deficit with much of the world. I also see the chasm between the wealthy and the poor widening. For example, the Wall Street Journal just published a report that the average CEO is paid 350 times the amount their average worker earns. I also see the chasm between reality (economic statistics) and perception (stock prices) widening. Why are they widening? Very simply, the elephant in the room is Foreign Central Bankers. See the chart below. It shows the trend of other countries buying US securities over the past 15 years or so. If that isn't a defined uptrend I don't know what is.

Foreign Purchases of U.S. Securities Since 1990 in Billions of Dollars Per Month

There is no question why they are buying in my opinion. The US creates a huge deficit with them and they simply take the proceeds and re-circulate them back into US securities. The key now is that they are buying around $1 trillion worth of US securities per year, as they crank up the printing presses of currency just as the US does. After all, the world is awash in debt at every level, and the US needs higher asset prices to sustain it. But see the chart below. At first, the bankers were buying out Treasuries. Then they started buying US equities and their buying peaked just as US markets peaked in 2000. Note that their trailing 12 month purchases are now at the same level as in 2000. They also missed the big move in stocks beginning in 2003 as their 12 month trailing purchases bottomed just as the US market bottomed. Hardly the best market timers, no?

Of even more importance is that they have now switched from buying US Treasuries to more risky asset classes, notably corporate bonds. In fact, over the past two months they have purchased no Treasury notes, but tons of equities and corporates. No wonder there seems to be an almost 'unnatural' bid to the market. And corporate bond spreads along with agency securities remain stubbornly tight. Basically, the Central Bankers are 'crowding out' the private sector and making jobs for prudent asset managers quite difficult. It almost seems like they want us to conform to their practices. It has also made many investors emboldened as if they can't lose money. In the Greenspan era they called it the 'moral hazard card' or 'Greenspan put.' Now, under Chairman Bernanke, it seems like there is a 'Central Bank put' where it doesn't matter if you overpay for something because the elephant in the room will be there to bail you out. Yes, it does ring of 'conspiracy theory' or like a chapter from 'Atlas Shrugged' where we are all expected to conform. But these are the facts, ladies and gentlemen like them or not.

For proof see the two charts below, one of which was released on December 15th and is courtesy of Bloomberg. The second chart shows foreign purchases on a 12 month trailing basis. Like they say, numbers don't lie, people do.

Purchases of U.S. Securities by Asset Class

12 Month Trailing Foreign Purchases of Treasuries, Corporates and Equities

This data, along with the US' monstrous money supply growth can explain why markets around the globe have a constant bid and why they are so coordinated. If you don't believe me, see the chart below of markets from around the globe. They are showing signs of stress, particularly in India, but there is no way to know if we will have a correction like in May or not. It 'feels' like it, but there's no way to predict it.

S&P 500 vs. Brazil, India and Malaysia (Emerging Markets)

I have talked often about the smart money hedging (commercial) accounts of late. They are usually correct, but usually early. They continue to be nearly record short S&P 500 (again, this is the combination of big, or open outcry, contracts and e-mini (electronic) futures netted out in big contract terms. It is hard to say if this is a 'directional' bet looking for a sharp correction or if they are actually hedging the gains they have harvested in this recent rally. In either case, it is one more cautious data point. See the chart below.

Commercial Hedging Accounts Positions in S&P 500

What about the hedgers' position in bonds? Well they are still short there too. We sold the majority of our preferred stocks and long term Treasuries and agencies right around the low yield of 4.41% in 10's. For the moment my firm is content to sit short-term 'cushioned' mortgage backed and agency securities. Of note also is the channel that is evident in the 2-year note. A move through 4.75% would be a definite negative for bonds and would tell us that the 'dis-inversion' trade is on. It seems to me that this is the likely outcome. After all, if foreigners stop buying US Treasuries (they only bought 12% of the recent 10-year auction - which is well below the recent norm), supply will overtake demand. So it seems to me they are selling gold, selling Treasuries and buying agencies, corporates and stocks. Basically, they are taking on more risk just as the market makes highs. Buy high, sell higher anyone? Central Bankers are now momentum investors! At any rate, see the two charts below of the 2-year note yield channel and the 10-year note vs. the commercial accounts.

2-Year Treasury Note Yield Channel

10 Year Notes vs. Commercial Accounts

What about the Fed? They say they are concerned about inflation and talk 'hawkish.' But they print money like crazy and act easy or 'dovish.' We track year-over-year overall PPI and CPI versus the federal funds rate, the overnight lending rate set by the FOMC. The overall index includes the volatile food and energy components. Note that whenever overall year-over-year PPI and CPI plunge like they are now, the Fed cuts rates. My firm expects them to do so in 2007 as is typical for a third year of a Presidential term. See that chart below. That would also lead to a flatter curve or even a steep curve by late 2007. This could point to early weakness in stocks in the early part of 2007 followed by a strong rally into the end of the year. This is normal behavior for the third year of a Presidential Cycle.

Overall Year-Over-Year CPI and PPI vs. Federal Funds Rate

Why would they cut rates? My firm still thinks it's due to a weak housing market. Even the Fed acknowledged in their statement this week that there is a 'substantial' slowdown in housing. Well, I still think it is a busted bubble. See the chart below which compares the bubble in Japanese stock prices that blew apart in 1989 (their economy had a huge real estate problem as well) with the S&P Super Composite Homebuilders Index. Pretty convincing. A picture tells 1,000 words, you might say.

Japan vs. S&P Super Composite Homebuilders Index

One last point about the elephant in the room. The dollar has plummeted over the last several years as gold has shined. Notice the nearly perfect inverse correlation between gold and the U.S. Dollar index (measured against a basket of foreign currencies). You would think that as in their currency's terms they would tire of watching the dollar based securities get crushed. But, no, they just keep buying. It is as if they don't care if they lose money. Do you know why they don't care? It is because central banks don't have a 'P&L' like you and I. If they lose money, they just print more. See the chart of the dollar and gold below.

Dollar Index vs. Physical Gold Per Troy Ounce

I happen to think that the dollar will rally early in 2007 as is a seasonal pattern, particularly early in the third year of a Presidential cycle. The longer term picture for the greenback, in my humble opinion, is grim. I find it curious that the Treasury Department has stated that the US has a 'strong dollar policy' as the greenback falls 40 percent. But they need the currency weak to make US products sell-able abroad. Yep, more conspiracy theory. But see the chart below of the S&P 500 in Euro terms. Hardly inspiring. It really makes one wonder why they would keep buying. I really am starting to think it so they make the US buy too. But this cannot last forever, but for now, is simply a fact that we have to deal with. The real key to US markets having a serious correction is if they stop buying and the money supply growth contracts. These are the data points that I will be tracking very closely in the days and months ahead.

S&P 500 in Euro Terms

In summation, I admit that despite the elephant being in the room with an infinite bid without a care for what they pay (remember, they have no P&L), I remain cautious, but not bearish. I will be tracking the hedgers and paying particular attention to the yield in 2-year notes as well as the shape of the yield curve. My firm has sold the majority of our municipal bonds as they seem woefully overvalued compared to Treasuries and agencies. And the credit quality of our portfolios is extremely high. There could eventually a financial accident as in 1998 in my opinion.

I hope that you find this information interesting and valuable. I have to admit that if you would have asked me in 1982 as I was graduating from Rutgers University with a degree in Economics that I would ever write an article like this one, I would have said 'no way.' The markets have kind of a surreal tone to them lately. For the longest time, I saw the action, but couldn't explain it. My reason for writing this piece was to bring it to everyone's attention. The elephants are here. And they are in charge. Stay Tuned.

We wish you and yours a Happy, Healthy and Prosperous Holiday and New Year.

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Positions in treasuries, agnecies, S&P, munis

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