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Minyans in Manhattan Review, Hedgers, Slowing Economy and Inversion


The phrase 'the return of your capital rather than the return on your capital' will be rather accurate and important in the years ahead.

Having recently participated the inaugural Minyans in Manhattan event in New York City this past Friday, I came away with a couple of opinions. First off, I find myself truly humbled in being able to participate with the finest minds in the country like Steve Galbraith, former Chief Strategist at Morgan Stanley, John Succo, former head of equity derivatives at Lehman Brothers and now General Partner of Vicis Capital in New York and more. Others included Stephanie Pomboy of New York based Macro Mavens and Jonathan Golub, Chief Equity Strategist at J.P. Morgan Equity Asset Management and metals expert Greg Weldon of Weldon Financial. There are many others including fellow Minyanville colleagues Jeff Macke of CNBC's Fast Money and Todd Harrison. There were others whose intelligence was both impressive and daunting, like Jeff Bernstein of Keel Capital and Jeff Saut, Chief Strategist for Raymond James.

The list is long but one thing is for sure. Everyone (I hope myself included) had a good feel for the current environment and their specialty (I was there for my expertise in the land of bonds and asset allocation). What I was most impressed with was the fact that there was absolutely no acrimony, while we had diverse opinions to be sure about the future of the markets in 2007 and beyond. Below I will try to summarize my current feelings towards interest rates, equities and asset allocation in general as I presented them in New York. Special thanks go out to the many celebrities that donated their time for a great cause and to Michael Santoli, Senior Editor of Barron's for moderating the event. I have to say that playing Texas Hold Em with John Starks was a blast and watching my wife 'high-fiving' with ex Knick Patrick Ewing at the Blackjack table (for charity of course) made the evening event so special and helped raise tons of money for a couple of great causes. Now on to an early look at my views for 2007 and the current state of affairs of today's markets.

One common theme that was evident for most everyone at the conference was the amount of debt and derivatives in today's markets. Not everyone's take on the net result on these issues was the same, but no one denied that there are imbalances that indeed exist. Consider this. Merrill Lynch's Derivatives research area just announced what the current amount of notional value (underlying value) of derivatives contracts is outstanding. The amount, believe it or not, is $370,000,000,000,000 (yes trillion). Some people believe that all of these derivatives are somehow hedged, but I must admit that I have my doubts. In addition, we are all aware of the deficit issues that our country faces at present. But consider this. If one takes the next 75 years of expected deficits the US faces as a nation (mostly as a result of Social Security and Medicare), the net current present value of those deficits is $50,000,000,000,000 (yes, again, Trillion). Thanks to Ned Davis Research for that information. Incidentally, that $50 trillion, if the US had to pay for it today is roughly the entire net worth of the entire private sector at present.

So you can see why I am constantly cautious, particularly with OPM (other peoples' money). The imbalances are so large that I openly wonder what the impact would be if a financial accident were to occur. To be frank, I don't think anyone knows the answer, except that it is a frightening scenario and why I think we have been and are still 'whistling past the graveyard.' How long we go on like this is anyone's guess, but I continue to believe that it is a keg of dynamite with a fuse of unknown length. It is why the credit quality of my firm's portfolios is extremely high and when I do venture into the corporate bond market, I do so for short periods of time. I think the ultimate accident will take place in the debt markets. I have lived through several crashes and credit crunches and could fill pages with war stories of instances that most young portfolio managers likely believe can't occur. I am here to tell you, my friends, that they can and I think will eventually occur. Even though I am delighted with my firm's returns over the past 10 years, I look to the future with extreme caution, even if it means giving up a small amount of incremental performance on occasion. The phrase 'the return of your capital rather than the return on your capital' will be rather accurate and important in the years ahead. It reminds me of the ROTC fellow in the final scenes of the movie Animal House yelling 'ALL I S WELL!' only to get stampeded by a crowd.

My firm's 2007 forecast is rather simple. The economy, any way you slice it, is weakening. Nearly every economic metric I have reviewed the past few months are at best, sobering. Initial unemployment claims (which I will highlight in a chart of below) are rising sharply. GDP growth is grinding to a halt (two major Wall Street firms just revised their expectation for 4th quarter growth to be 0%). The Chicago Purchaser's Index is now in contraction territory (recession) mode as is ISM data. Housing is grinding to a halt as inventories swell. Hey, I know this is all sobering, but I am not paid to be an 'eternal optimist' like many talking heads in the media. My job is to assess when times are risky and position portfolios accordingly, recognizing that 'markets can remain irrational longer than one can remain solvent.' As such, I continue to believe that no matter how 'hawkish' the Fed talks about inflation (restrictive), they continue to act 'dovish' on inflation by growing the money supply at double digit rates.

Readers of my past work know that I track overall inflation, not 'core' inflation that arbitrarily excludes volatile food and energy. I have done a study (see the chart below) that tracks the overall year-over-year rates of inflation in terms of both Consumer Prices and Producer Prices. Please note the nearly 100% correlation with the Federal Funds rate. Year-over-year PPI is now squarely in negative territory and CPI isn't far behind. It is one of the main reasons why I feel the Fed will lower rates in 2007, perhaps more aggressively than most think, perhaps to 3.5% or so. Another reason I think the Fed will lower rates is in response to the so-called Presidential Cycle. Think of it this way. What every first-term President wants is second term and what every second term President wants is a good legacy and/or his party to be re-elected. With the Republicans having just lost both Houses to the Democrats, I fully expect the Fed and administration to push rates lower to reinvigorate a sluggish economy. And don't be surprised if we see some other stimulus like changes to Social Security accounts and relaxed margin requirements. Anyway, here is the chart.

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

As for the overall call on interest rates, it is a more dicey call. My firm is currently challenging an important multi-year trend line in the 10 year note at a time when hedging accounts are stubbornly short the 10 year future. So we are at a rather interesting inflection point, one that will likely get tested this coming Friday with the release of the November Employment report. See the chart here.

Continuous 10 Year Note Future vs. Smart Money Hedgers

But what about the hedging accounts' overall activity in bonds? Weeks ago, I developed a concept that blended together the overall positions of hedging accounts including the 2 year, 5 year, 10 year and 30 year futures adjusted for duration (longer term bonds have longer durations and more volatility than short-term bonds). Interestingly, they were net short the market before the rally and have been 'squeezed' lately into a neutral position. We never can know if they are hedged with some other instruments to be honest, but I still find the information important. It also stresses the point that while their bets are usually early and correct they are not infallible.

Overall Hedgers Position in Bonds vs. 10 Year Notes

What about unemployment claims? See the chart below. They have begun to spike which I suspect is a result of slowness in housing and automobiles. I have overlaid the claims number over the current yield curve inversion (Federal funds rate minus 10 year note yields) and you can see why the curve is so inverted. The bond market is clearly sensing a slowing economy and rate decreases in 2007, a view I have been harping on for months now.

Initial Unemployment Claims vs. Yield Curve Inversion

Now let's take a look at the stock market. One of the themes mentioned often at Minyans in Manhattan was the view of emerging markets. Mike Santoli of Barron's posed a question to the panel I was on was if the U.S. was the 'best house in a bad neighborhood.' I have to say that I humbly answer the question with a 'yes' answer. Just take a look at the chart below. It shows three major 'emerging market' indices against the tech bubble of 1999-2000. The similarities are striking, no? Not only are they similar, but the correlation between the different emerging markets looks like 100 percent to me. So when the fuse does hit the keg of dynamite someday, the blast will be loud.

Emerging Markets vs. NASDAQ Bubble

How about the position of smart money hedger's against the S&P 500? They have been leaning hard short against the markets rise in recent weeks and this week shows no real changes in their position. They continue near record short S&P futures (the combination of big contracts (open outcry) and e-mini (electronic) futures). They are also stubbornly short the Dow Jones Industrial Average and are now net sort NASDAQ futures (they sold into the recent rally) and are still modestly long Russell 2000 (small cap) futures. But their overall position is one of pessimism. Basically, my firm sees smart money selling to speculators and private equity funds and insiders selling at unprecedented levels. See these charts below.

S&P 500 vs. Net Hedgers Position S&P Futures

Dow Jones Industrial Average vs. Hedgers in Dow Futures

NASDAQ 100 vs. Hedgers in NDX Futures

Russell 2000 vs. Russell 2000 Hedgers in Futures

One last comment about the inverted yield curve and stocks. I was recently interviewed by Bloomberg and was asked about my thoughts on inversions and stock market performance in the future. Incidentally asked me the same thing. There is where it gets both interesting and humorous. My thought is (and history backs me up I think) that when inversions (Fed Funds minus 10 year yields) go on for extended periods and head towards 100 basis points, the stock market and economy both do poorly in the quarters ahead. The funny thing is that the other day, former Fed Chairman Alan Greenspan, aka 'Elmer' or 'Maestro,' declared that inverted yield curves are no longer a good predictor of future economic growth. Well, I have to admit that it is hard to disagree with Elmer in a public forum but I am doing so anyhow. I just don't believe it is 'different this time.' I never have and never will. I guess the only way I believe it is different this time is in a sobering, negative sense. I just don't like the way the US is taking on so much debt and mortgaging our future. This brings me to my last point.

There has been much talk about the falling dollar of late. I opined in New York that part of my forecast for 2007 includes that of a rising dollar. I say this for two reasons. First, it feels to me that the most 'crowded trade' at present is to be negative about the dollar, and crowds are rarely successful on Wall Street. Secondly, the third year of a Presidential Cycle is usually the best for the dollar as fiscal and/or monetary stimulus is applied. It is also the best for stocks incidentally of all four years. So I expect some weakness in equities in the early part of 2007 followed by strength in the second half. Most of my firm's indicators are aligned that way at present and we will adjust accordingly. 2008 and beyond is where it gets more dicey. One wild card could be if the Democrats win the Presidency in 2008 and control the House. While not a political call, it would likely lead to higher capital gains tax and repeal of the capital gains tax on dividends, which for a while would be a negative for stocks as people look to lock in gains at a low tax bracket.

As always, I hope this finds you well and will keep you updated as market conditions change.
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