Links of Fury

Only the best for my readers.

Other Thoughts . . .
  • Is the eye-popping oil-natural gas spread exploitable? The obvious--too obvious--play is to be long NG, but I need to know what I'm missing. If you follow NG closely and have an opinion on this, drop me a line.
If you are one of my purely value-minded friends, please turn away from your computer right now so you don't vomit all over it . . .
  • I'm still short the financials, but I'm ready to be proven wrong. We'll probably pop back up to 34 or so in the next few weeks, but I have a moral obligation to be short this chart long-term. Prove me wrong, banks.
I'm not a nut for moving averages, but my own experience suggests that decisive crossovers (and retests, like we have here) of the 200-day are good for catching the beginnings and endings of very large, long-term trending moves. Here's the 5-year chart, which shows that we're below the 200-day while the average is declining for the first time in this bull market. Make of that what you will (also, notice the tremendous support around 30 that should keep this market from going straight down).



Because of the choppy market these days, I've recently been investing somewhat differently than usual.

Ideally, I'd like to have lots of money invested in companies that I hope will offer prospective long-term returns of somewhere north of 20-25 percent per annum. I don't see any right now, but I hope that within the next two years we may see enough of a decline (or at least a sideways market while earnings rise) that I can get some money into great companies that are deeply undervalued.

But because I don't want to be sitting on huge, moderately undervalued long positions in this fragile market environment (with the exception of extremely financially secure companies like Berkshire Hathaway and Johnson & Johnson), I've been playing "smallball" instead. I've been taking gains of 10-20 percent on both the long and the short side when they present themselves and then reverting some position that approximates neutral.

I think of this strategy as hitting singles rather than home runs. I'd like to be Barry Bonds, but the market isn't offering that chance, so Ichiro will have to suffice. As far as I'm concerned, it's just not longball time right now. Just as a matter of probability, home runs are going to be much rarer in the fifth year of a bull market than they would be in, say, 2002.

This smallball strategy is very conservative, and has forced me to leave money on the table at points. For example, I was heavily short Countrywide Financial (CFC) and D.R. Horton (DHI) during the August breakdown, but covered them far too quickly.

Still, I think that the ability to remain liquid while seizing the occasional opportunity has made up for these lost profits. The whole idea is to maintain my capital in real terms so that when it's time to play longball again (read: prospective long-term annualized returns of 20% or greater), I will have enough money left in my pockets to play.


What Keeps Me Up at Night

It's well past midnight here in Oklahoma, and I'm having some difficulty sleeping. I've been thinking and re-thinking my positions as we go into what is likely to be an eventful week in the markets.

I suppose I could have more serious problems keeping me up. Lady Macbeth (pictured) sleepwalked because of the guilt of having the King of Scotland's blood on her hands.

I suspect that my subconscious somehow knows when I've left myself overexposed, and won't let me relax until that exposure is dealt with. So I'm going to think through my positions yet again . . .

First, I worry that I could be overexposed against the dollar with my substantial gold position. I bought gold as it broke out above $700/oz, but as we run closer to gold's all-time nominal high reached in 1980 of $850, we should hit some pretty stout selling. Additionally, pessimism is rampant, and I'm not comfortable staying in a crowd that is this committed to one side of the trade.

I have to determine whether I'm going to be happy with a quick 20 percent or if I'm willing to put up with some turmoil in order to see gold through above $1000/oz, which I believe is on the way. My current stance is to stick it out and hang on, but that view will take a lot of stomach if a gold decline pulls back into the $600s. It isn't fun to see a perfectly good profit disappear on principle.

. . .

I'm also concerned about the very sizable short position I have against US financials as they appear to have started breaking down . . .

I've been bearish on financials for some time, and remain so. My research convinces me that the credit downturn has much further to go, and that people who think that banks can write down $300 billion in assets and then continue on their merry way frankly haven't done their homework.

Credit crises are crises of faith. When people stop believing in the value of an asset, whether it is the US dollar or the value of a mortgage derivative, they don't just begin believing again.

Particularly strange to me are the "value investors" who are piling into the financials they now call "bargains." I have no idea how these people, many of whom quote Warren Buffett and Ben Graham like scripture, have determined the asset values of these companies when even the companies themselves don't know what they're worth.

I would urge buyers of financial stocks right now to really think their purchases through. The analyst consensus for EPS growth at Citigroup (C), for example, is 8% over the next two years, just 2 points below the growth rate of the last five years.

Exactly where is all this growth going to come from, particularly since the i-banks are in the process of dismantling one of, if not the highest-growth areas, the packaging and selling of derivatives?

I believe that even 8 percent growth is too optimistic. Like the tech stocks in 2000 and like the homebuilders in 2006-2007, the financials' growth rates will not just slow, they will go negative. The investment banks are going to go into the red, and the 7 P/Es will, like those of the homebuilders, balloon out into double digits as the earnings denominator shrinks while the price numerator declines more slowly.

For these reasons, I've avoided financials for some time (Berkshire Hathaway being the main exception), but the apparent breakdown in the form of lower highs and lower lows is finally giving me reason to act against them aggressively.

However, as I look more closely at the chart, I realize that could have been more patient. I should have bought half of my position at current prices and then waited for the rally that should be here next week to retrace to 33 or so, where I could sell the rest short.

The volatility of this ride isn't going to be fun either, but I would be surprised to see the financials make new highs here.

That said, I accept that it could happen. If they begin a new uptrend, I'll get out.

Don't let the bedbugs bite.

The painting of Lady Macbeth is by Henry Fuseli, German-Swiss painter who was from Zurich.


James Grant Interview

James Grant of Grant's Interest Rate Observer has a view of the current financial situation that is very similar to my own.

Grant also sees an unusual problem created by simultaneous credit and currency troubles, and believes that we are right in the middle of what he calls an "Old Testament credit crisis." Wish I'd come up with that term . . .

Check it out.


Checkmate for the Fed?

For the first time since the 1970s, the United States is facing the potential of a serious banking crisis and a serious currency crisis at the same time.

So it appears that the stopped-clock permabears may be right, at least for the time being. Let me explain . . .

The Fed's customary solution to financial problems has, of course, been to pump money into the financial system when it is under strain. This strategy worked OK in 1987, after the Asian Crisis (despite creating the tech bubble), after the tech crash (despite creating the housing bubble and the current credit bubble), and during the first phase of the subprime crisis. Bears have each time proclaimed each crisis to be the end of the world, and their fears have always been overblown. And of course, the world won't end this time either.

But I believe that the current situation differs slightly from previous crises, for a single reason: today's Fed faces much steeper consequences for resorting to its favorite solution of credit injection.

Today's dollar market has stopped shrugging off injections of credit. Worried about the decline in the dollar, people now appear to believe that rate cuts and other forms of liquidity injection and preservation plans (the super-SIV plan) place enormous further downward pressure on the dollar. The Chinese, in particular, are reacting to worries about the weak dollar by dumping it and threatening to dump more, which is what most people paying attention have expected to happen for several years.

In many ways what we have is a financial crisis that is based in a crisis of belief. People around the world have stopped giving the dollar the benefit of the doubt simply because it is the dollar.

Notice how the gold ETF has continued to rise after the September surprise half-point rate cut, even while the bank index appears to have received little benefit from these cuts . . .

(Yahoo! Finance)

What does this mean? It means that the Fed's primary weapon of liquidity/credit injection has begun to backfire.

Further injections of liquidity, surprise or otherwise, will almost certainly endanger the dollar, to the point of sparking a free-for-all to escape from it among foreign holders. The Fed, in short, appears to be checkmated.

You have to make your own judgment about how you want to be positioned here, but I am currently positioned very short the money center banks via the Financial Select Sector SPDR (AMEX:XLF) and long gold (via GLD).

If the Fed chooses to try another bailout (the most likely development given its previous behavior), the run on the dollar could turn into a rout, driving gold past $1000/oz. If the last cuts are any indication, further bailouts shouldn't provide a great boost to the banks.

If the Fed opts not to bail out the banks, XLF will really be in for it, and gold should not suffer.

However, a dollar rally (way overdue) will decimate my gold position, so I will be very wary.

Additionally, my current sense from looking at the price action is that the "Smartest Guys in the Room" at the banks are trying desperately to get out of these stocks before everyone else realizes how bad the crisis really is.

Please remember that these are my opinions, and you must formulate your own investment strategies.

The Fed is full of smart people, and it will be quite interesting to see how and if they can escape from this pickle . . .


Dr. Doom Interview

There are only a handful of people you'll ever see on TV that are worth listening to on financial subjects.

Jim Rogers is one. To complement the other day's Rogers interview, here's an interview with Marc Faber, the Michael Jordan of bearish commentary.


Understanding Writedowns

This is a skill that's going to come in handy over the next year or so, particularly when evaluating financial companies.

Here's a good primer.


Macro Reflections

Although my basic outlook on the market is value-based, I frequently like to commit the Grahamian sin of thinking through the major economic factors affecting asset classes in order to determine what markets I want to be in. Quantitative analysis only gets you so far.

I do this is by framing hypotheses about the main story in each asset class. Once I have formulated these, I sit and wait. Over time, the markets either prove or disprove them, and I adjust my stance accordingly.

I discard the hypotheses for two reasons. Either 1) They are proved wrong or 2) They have been proven so completely that they are common knowledge, and are therefore fully valued.

An example of the first was my belief at Google's IPO that it was overvalued, and that it would be dangerous to buy a company trading at 50X earnings. So I opted to sit it out. This is obviously a decision I regret, and it has forced me to accept that a few extraordinary companies are worth paying up for.

An example of the second was my belief this year that U.S. financials were extremely weak and quite vulnerable to the problems of rising interest rates. This view was proved correct, and so I reduced my bets against financials . . . although I still do expect this situation to worsen considerably.

Here are the hypotheses I currently subscribe to:

The world is in a period of accelerating inflation which still remains largely unrecognized, fueled both by 1) decades of underinvestment in commodities (creating the current supply-side problems) as well as 2) loose credit from the world's central banks (demand pulling prices up).

Money supply in many areas worldwide is growing at double digits . . . and the arguments of individuals who defend the CPI calculations leave me pretty blank. To understand why the Fed understates inflation, you have to think about the Fed's motivations as people rather than as an institution. They are afraid of economic slowdowns, but also of wage inflation.

The moment that the average person begins to realize that his or her cash is being destroyed, they demand higher wages, which pushes prices higher, and so on (the wage-price spiral). "Fixing" the CPI to understate inflation is a way to avoid this extremely unpleasant outcome.

Stocks (which should continue to rise until people realize that inflation has been driving the bull market)
Hard Assets (which I will begin to buy once wage inflation begins)

This is obviously something that everybody and his grandma are worried about. So I agree with Jim Rogers that a rally--probably a huge one--is in the offing soon.

Still, the dollar is in for still more hurt over the long term in my view. As George Soros explains in The Alchemy of Finance, because so much of a currency's value is collateral value, the decline in a currency tends to picks up speed as it goes.

This applies especially well to the US dollar right now. The dollar is valuable throughout much of the world because, as the world's reserve currency, it is seen as a store of wealth. But each decline in the dollar further erodes its value as a safe haven, thus prompting more selling. So the selling spiral is likely to accelerate until there is a crisis.

Add to this the fact that there is no real constituency inside the Fed or outside of it that wants to see the dollar defended, and it looks like the path of least resistance is down.

This hypothesis has been very profitable so far, although there is likely to be some turbulence soon with the coming dollar rally.

Swiss Franc (FXF; an excellent currency)
Berkshire Hathaway (Large overseas currency holdings as well as increasing commitment to finding earnings streams in overseas companies, such as the Iscar purchase)


I discussed this point before.

Prepare to go short in these areas at signs that credit is drying up. Emerging market banks will be especially vulnerable . . . as their loan portfolios go bad, they will go under.

I have been long oil for some time for the simple reason that I can't see how oil prices are going to decline when the global credit boom (described above) is throwing so much money into the pockets of the industrializing world for capital expenditures and personal consumptions (cars, specifically).

I'm not a "peak oil" believer, per se, but I think some of their arguments are great, such as the fact that OPEC member nations are incentivized to overstate their reserves, allowing them to ramp up output. This means, of course, that worldwide crude stocks are vastly understated.

This has worked well so far, but I'm beginning to worry that a bullish consensus is forming on oil . . .

As part of this outlook, I also like oil exploration companies. If you look at the bull market in oil stocks over the last several years, the market has gone up almost entirely because of higher earnings. P/Es haven't expanded. I believe that if the bull market in oil stocks is like every other bull market in history, eventually P/Es will rise to reflect the growth these companies have shown, and we could see these stocks double very quickly.

Right now, you can buy the iShares Oil and Gas Exploration Index for 5.6 times cash flow. It's likely to do well even if oil prices collapse, and you have no company risk.

Oil (USO)
Companies that are leveraged to higher oil prices (IEO)

Note: I currently hold the following securities mentioned in this article: BRKB, GLD, IEO. I will try to remember to include these disclosures, though you have my word that I am not using this blog to try to move the world gold price in my favor.