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What the Markets Know Isn't Worth Knowing: Part III


...a chart is nothing more than a representation of the opinions of the public-at-large and their position on a particular index or security.

Click here to return to What the Markets Know Isn't Worth Knowing: Part II

The Fate of the Greenback-Have We Lost Control of Its Fate?

In addition to the fundamental data we are bombarded with, there are many types of graphs and technical jargon that we all use in our daily work. One of the most used technical patterns is that of a "flag," either a "bear flag" or a "bull flag."

Charts can be used on an hourly, daily, weekly or monthly basis, but how about a multi-decade chart? Surely that would have significance. After all, a chart is nothing more than a representation of the opinions of the public-at-large and their position on a particular index or security. In this case, I focus on a multi-decade bear flag of the U.S. Dollar Index (DXY). See the chart below. A bear flag typically contains both a down trend line and long base. It is believed that once the base is broken, the down trend takes over and then all of those that bought above the support line are now in a losing position. Consider this when viewing this sobering chart. If the support line in the 80 area is broken on a monthly basis, all buyers from the year 1967 forward will effectively be in a losing position. Hence, they become sources of supply as previous supply now becomes resistance as they all try to "break even."

Further, have you ever considered what has happened to the purchasing power of the not-so-almighty buck over the past couple of centuries? Well, I stumbled across this website (after getting the idea from my good friend Jeff Saut, Chief Market Strategist of Raymond James), It outlines the 90+% decline in the purchasing power of the dollar. Please note that the chart below is in "log" or logarithmic terms, as are most charts with lengthy time and range.

Why do I think that there is an inevitable move lower in the dollar? Well it seems simple to me. Foreigners control over half of US debt securities and have been accelerating their move towards corporate securities and away from the purchase of additional Government bonds. Why? Well, foreigners already own more than 50% of US Government bonds and routinely buy half of new agency offerings from Fannie Mae (FNM) and Freddie Mac (FRE). This gives non-US investors free rein to eventually tell the US what yields they wish to receive and if the US does not comply, they simply unload their holdings.

This represents the potential for a hyper-inflationary event, yet another reason for my firm's holdings in gold shares. See the chart below of foreign (both Central Bankers and Private Foreign) holdings on a 12 month trailing basis. Clearly, foreigners are firmly in control of the US' destiny.

Bond Yields and Seasonality and the Smart Money Hedgers

I have remarked numerous times over the years that my firm follows the positioning of so-called "smart money" hedging accounts positioning in all sorts of asset classes. These players are typically early in their calls and tend to take the other side of the momentum crowd's (hedge funds mostly) trades. Due to a couple of mainly technical supply/demand imbalances, seasonality is usually weak in the first five months of the year. Note that, post-Thanksgiving, the new issue calendar tends to be light and then picks up as the New Year begins. Supply stays relatively high until the summer months, as investment bankers vacation in the Hamptons on Long Island. Add to that the large amount of interest paid around June 1 and July 1, and you can see how we have a recipe for a seasonal low around Memorial Day.

In fact the worst three months of the year, according to are March, April and May. My firm is positioned for this with just 20% or so of our holdings longer term and the rest short term, high coupon "cushioned" securities, mainly backed by Ginnie Mae or Treasury Bills. Note the chart below of the net position of the hedgers versus the 10 year continuous note future. They are decidedly negative at this time. I expect they will become buyers soon and I envision buying alongside them, either in intermediate term Treasuries or longer-term Ginnie Mae backed Collateralized Mortgage Obligations (CMO's).

Summary: Why We Should Focus On Absolute Returns Going Forward

I realize that I have laid out a sobering viewpoint of the US economy, currency and markets, but I had to answer the question. What I have witnessed and continue to witness is that markets around the world are becoming more correlated than ever before. As that happens and as money is created so freely, there is too much cash chasing too little volatility and too few ideas. Just look at the prices that private equity firms are paying for public companies. Returns on the order of 5% internal rates of return, 1% less than I can get buying simple Ginnie Mae pools. Hedge fund after hedge fund are being created along with "funds of funds" trying to further minimize risk and volatility while maintaining high relative returns. Let's take a look at the arithmetic at play in these vehicles. Let's say that you are a brilliant "fund of funds manager" that has assembled a list of equally brilliant fund managers. The underlying managers charge the traditional "2 and 20," or 2% management fee and 20% of profits. Further, as the manager of managers, you charge an additional "1 and 10"' or a 1% annual fee and 10% performance incentive fee.

The math goes as follows:

20% gross return - 2% fee = 18%, less (20% of 18%) = 14.4%.
14.4% - 1% fee = 13.4% less (10% of 13.4%)
= net return of 12.06%.

So, even if you are lucky enough (doubtful) to have every manager earn a gross 20% return, the investor ends up with 12.06%. In my opinion, this is not worth the lack of transparency, lack of liquidity and financial leverage usually employed.

While there are many, many excellent hedge fund managers, registered investment advisors and mutual fund managers out there, the field of superstars is shrinking. As we go forward over the next 5 to 10 years, I think absolute rates of return with low levels of volatility and "drawdown" or losses will be the key. Consider an index that falls by 20% and a money manager saying that they are a good manager because they were "only down 15%" and performed well from a relative perspective.
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Position in FNMA, FHLMC, GNMA, Treasuries

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