December 20, 2008

Another week of superlatives

Mr. Madoff and his $50 billion Ponzi Scheme
Speaking of superlatives, Mr. Madoff made the top spot at Wikipedia's list of largest trading losses:
As a good reference point, you may recall the infamous rogue trader Nick Leeson, who brought down Barings Bank in 1995 with a trading loss of about "only" $1.3bn.  He is currently number 10 on this list.
In fairness to Mr. Madoff, these numbers are probably somewhat distorted and assuming that his scheme was indeed a Ponzi scheme, then at least his early investors would have enjoyed many years of "guaranteed" or steady returns.  It's exactly those steady returns that should have raised massive red flags with investors and regulators.  Forget anything else you've learned about investing, but never ever ever forget this: No one can guarantee steady returns in financial markets, particularly not in equities.  Anytime someone offers you guaranteed and/or steady returns in the double digits, you're best advised to walk away from it. Use your common sense when investing and if something sounds too good to be true, it usually is…
On a similar note, you should also be highly critical of recommendations by brokers and financial advisors (including the ones I make).  Make sure you understand the role of the person who recommends, vets or rates any type of investment.  Conflicts of interest, albeit often disclosed, should awaken your senses and simply raise questions as to objectivity of any advice given.  When it comes to analysts and ratings agencies you generally have to discount their objectivity by varying degrees, often completely.  Do not forget that ratings agencies are paid by the companies they're supposed to rate.   
Along similar lines is an insight in today's Financial Times: "Who's afraid of thinking for themselves on investments?" By Aline van Duyn
Not only should you be fearless in terms of thinking for yourself when it comes to investing, it is your ultimate duty to do so.  Caveat emptor (buyer beware) is a concept that has been around for a couple of thousand years.  Despite incredible advances in technology and generally much higher sophistication, you, the buyer of an investment, service or advice have to use common sense and ultimate judgment when it comes to investing.  No guarantee for avoiding losses, but it can help you avoid painful surprises that are beyond the general market risk.
Oil futures prices hit a new low this year of $32.40 and closed today at $33.87.  This comes after the news that OPEC announced a record cut in production of 2.5 mn barrels per day.  So much for another example of (failed) attempts by organizations and governments to control market prices - it simply doesn't work!
Oil futures peaked on July 11 this year above $148. Compared with today's price of $33.87 we're looking at 77% decline in one of the most precious commodities of our times.  As much as I felt that there was no fundamental justification for oil trading above $100, we are now approaching a price level where we have to question whether the fundamentals are still intact at the other end of the price spectrum.  Last week, we reported that some analysts had predicted an oil price approaching $25 in the near future; this future is very near. At the same time and from a mere price and trading perspective, a major global commodity simply doesn't just loose nearly 80% of its value in 5 months without some form of take away in pricing.  From a technical point of view, this commodity is almost beyond "oversold" and some type of retracement has to ensue to balance the trades (the lower prices fall, the less speculative short selling occurs).  One could also argue that the oil price could theoretically approach levels below its production price.  However, in the absence of immediate energy alternatives and new technologies replacing all other petroleum based products (plastics etc.), the price of oil cannot approach zero.  As much as we like to be oil independent, we won't be next year, nor in the next decade.  In terms of energy production, solar power is forecasted to replace oil as the dominant energy component by the middle of this century.  I personally hope it happens sooner than that since we all have a vested interested in keeping our planet intact.

The "D" word continues to make headlines throughout the financial media.  Central bankers fear it and economists have been warning about deflation as if it was the beginning of the end; they basically don't know how to deal with it. I have a problem here in that I fail to see what is fundamentally wrong with lower prices?  Lower oil prices, lower energy prices as well as generally lower prices for goods and products should be good for consumers.  The money saved on general price declines is freed up investment or consumer capital that can be spent to purchase other products and services.  Having said that, can someone please tell me exactly how massive these deflationary pressures are?  Simply looking at asset prices (stocks, commodities) doesn't give us a true picture of "real" inflation.  For years, we've heard the Federal Reserve as well as politicians claim that inflation is benign.  CPI and PPI figures though have been "massaged" to give that impression and lead the general public to believe that we should basically ignore inflation.  And since the financial crisis, we're supposed to be fearful of deflation - hmmm…
Let's analyze our personal expenditures and see how we feel about de(in)flation.  Last week, I received a notice from my private medical insurance that the monthly premiums starting Jan-09 will go up by 14%, and they have gone up every year in the double digits for at least the past 7-8 years if not longer.  Housing prices have fallen, but the general public does not see a fall in monthly mortgage payments nor rents, at least not comparable to what we would call deflationary pressures.  Gasoline prices are much cheaper, but take a look at your grocery bill.  Do see massive savings?  All I can see from a personal perspective:  wages have been stagnant, but personal expenditures are not stagnant, they have been rising.  To me that sounds a lot like inflation…
In anticipation of lower US rates and with a surprise move by the Fed to lower overnight rates to essentially 0%, the US$ dropped throughout the week before retracing somewhat on profit taking.  Yesterday, the Euro rose to 1.4720 against the US$ essentially back to the same level it started in 2008.  We have witnessed a massive short term reversal of the recent Dollar strength and very much in line with last week's assessment, we have to view the Fed policies in terms of easing rates, increasing money supply as well as the continued and growing US budget deficit as a dilution of the US$ value.  As noted before, the major long term trend is still sloping upwards in favor of the Euro.  Although the US$ has gained backed some of the losses today (closing at 1.3900) and may gain back some more strength in the short to mid-term, the more likely scenario is that massive capital movements and carry trades could be next.  Carry trades would typically occur when rates in one country are significantly different from another country to such an extent that one could borrow at near 0% in US$ convert to a higher yielding currency with a positive interest rate differential (e.g. New Zealand or Australian $).  This has been long the case of Japanese Yen the prime example of the carry trade. But with US rates this low, it is a plausible trading strategy for larger institutions to such an extent that it can affect exchange rates in favor of the currency with higher yields.  Again, if you're looking at 2 very similar assets from a perspective of yields, all other things being equal, the trend has to be in favor of a higher yielding currency.
Central Bank Action
Central Banks continue with policies of easy money.  On Tuesday, the US Federal Reserve cut its target for overnight rates to 0- 0.25% percent.  Now that rates are effectively zero, the next tool for a central bank would be the so-called "Quantitative Easing" in which the central bank floods the banking system with masses of money to promote lending a.k.a. turn on the (money) printing press…

Japan has been tempering with a form of quantitative easing for over a decade and we have to seriously question whether this policy has much effect.  18 years after the Nikkei (Japanese Stock Index) hit its all time high of about 39,000, this index is currently at 8,588.52 - you do the math in terms of the decline… All things aren't equal between Japan and the US, but we have to be realistic in that rates alone cannot reverse fundamental business cycles.
Rates for major currencies are:  
NZD  5.00%
AUD  4.25%
EUR  2.50%
GBP  2.00%
CAD  1.50%
CHF  0.50%
USD  0.25%
JPY  0.10%

Good luck and good trading!

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