February 13, 2010

Market Insights - 13 February 2010

Dear Friends & Fellow Investors

Here is the latest issue of Market Insights. As always, please email any questions to: . 

To our Chinese Readers: Kung Hei Fat Choi – Happy Chinese New Year!

In This Week's Issue
• Weekly Snapshot
• Charts Of The Week
• Weekly Barometers 
• Euro 2.0 
• Recommended Video 
• More On ETFs 
• How The Big Banks Make The Big Bucks 

Weekly Snapshot
• US retail sales in January increased 0.5% from December, to $355.8 billion (ESA)
• China said for the second time in a month it would force banks to increase their reserve levels (Reuters)
• Germany's GDP flat and Italy went into reverse in the final quarter of 2009 (Reuters)
• Industrial production down by 1.7% in Euro area (Eurostat)
• Eurozone GDP grew by only 0.1% in the last three months of 2009 (AP)
• European leaders have reached a deal to provide aid to Greece (Reuters)
• One in five US mortgages are underwater (Zillow/Reuters)
• Chinese exports in January rose 21% from the previous year (FT)
• China's imports jumped a record 85.5% in January from the year before (FT)
• US Trade Deficit increases to $40.2 Billion in December (Bloomberg)
• Traders and hedge funds have bet more than 40,000 contracts ($7.6bn) against the Euro (FT)
• CDS spreads on PIIGS sovereign bonds continue to rise during the week (Eurointelligence)

Charts Of The Week (click on chart for larger image
On the left below, please consider this nice chart from Serge Perreault, courtesy of Dshort.com.  We have added a version of the same viewpoint and included the Fibonacci retracement levels (blue horizontal lines).  For technicians, please note the upside momentum still needed to break above the more important green downtrend resistance. The Fibonacci levels indicate a level of 965 for the S&P as a first initial stop.

Serge-Perreault-100212  SPX-2010-0213

Weekly Barometers  (click on chart for larger image)

Stocks-2010-0212   FX-2010-0212

Euro 2.0  
As reported by various news channels, European leaders have reached a deal to provide aid to Greece in order to help overcome its debt crisis.  The pledge of support by European leaders though has been vague and no detailed plans are yet available.  Further, as reported by Reuters in Greek Debt Profile:

Total borrowing need in 2010 is 53.2 billion Euros or 21.8 percent of GDP. This is down by 13 billion from 2009 and includes 12.95 billion in interest payments, a primary deficit of 10 billion Euros and redemptions of 30.23 billion.

"Peanuts" compared to the financing needs of some US States one would think... Then why is Greece so important and such a fear factor for the Europeans, and what are the prospects that the Eurozone will return to a path towards recovery?

This is an oversimplification of things but hopefully it illustrates one of the core issues within the Eurozone: 

The EU sort of “put the cart before the horse” by embarking on a common currency prior to common fiscal and legal environment among the member states.  It is particularly evident in the current PIIGS (Portugal, Italy, Ireland, Greece & Spain) crisis that the common currency has taken away a natural escape valve, i.e. individual country currency which, unlike monetary and fiscal policy, can be a faster and more effective escape valve adjusting economic imbalances through market forces.  In the absence of a domestic Greek currency (previously the Greek Drachma), the Euro is the adjusting mechanism and the result is a weaker Euro.

All things considered however, a weaker Euro may not be such a bad outcome after all.  It will enable the more export-driven economic powerhouses in Europe to tackle an ongoing and Europe-wide recession (technically not a recession anymore but a measly 0.1% growth rate for Europe in 2009 which still feels like a recession). 

As we noted last week, the default of any of the PIIGS countries would have a devastating effect on Europe’s economy and on the Euro. But Greece’s potential default may be the easiest one to absorb within the European Union.  Some other countries, notably Spain and Portugal, pose a much bigger threat to the stability of the European economy and its monetary union.  I'm afraid, until individual countries get their internal finances in order, prospects for the Euro will be much murkier than one might have expected in previous years.  And until such time, a common fiscal policy, one of the long-term objectives of the EU, may be increasingly difficult to implement.

In terms of possible scenarios going forward, I can think of a two-tiered approach towards common policies among all member states similar to the approach applied to the creation of Monetary Union within the European Union. Several EU member states, most notably the UK, have opted not to join the monetary union and chose not to adopt the Euro.  They did so for the very reasons that are currently making life more difficult for the member states and equally so for the European Central Bank in terms of steering through the crisis.

A two-tiered approach might give birth to Euro 2.0 a new and higher-rated core currency similar to an A-share of a company's stock.  The core countries would have a fast-track route towards a common fiscal and economic policy as well as a uniform legal framework. The B-share might then include countries with less rigid economic policies and obviously much higher interest rates and financing costs and a longer route towards entering overall common laws and policies. Incidentally, the core countries appear to be located in the center of Europe whereas the B-share Eurozone countries are located among its geographic outliers. The EU and the Eurozone countries are certainly facing an interesting dilemma which is not swept away by the quasi bail-out of Greece.  There are many other problems lurking beneath the surface.

Why should US investors worry? To quote a passage from John Mauldin’s most recent newsletter:

Whether it is Japan or Portugal or the US or (pick a country), the body of evidence clearly shows that there is a limit to the amount of debt a sovereign country can handle without a crisis developing. That limit is different for each country, but there is a limit that the bond market will impose. And there are many countries in the developed world that are approaching that limit.

For those of us who have a vested interest in the future and longevity of the EU and the Euro, let us hope that the rigidity and the constraints imposed by the overall EU framework will not be its downfall.  Instead, the constraints might be the catalyst for an innovative approach; as often when faced with a sheer insurmountable problem, a visionary and innovator will look at this problem as an opportunity.  How about asking Steve Jobs to come up with the framework for Euro 2.0?

Recommended Video
Please consider this enlightening video: http://2010.therussiaforum.com/news/session-video3/

At one hour, the panel discussion is a bit lengthy but very well worth your time. This rather illustrious and intelligent group of market participants and hedge fund managers expressed their various viewpoints with much gusto and conviction.  Kudos to Hugh Hendry for an outstanding and very passionate debate, giving me at least a few sleepless nights in terms of re-assessing portfolio strategies.  But I'm also taking away two very simple and fundamentally important reminders:

  • Although not a realistic representation of the entire universe of market participants, this group gives an indication of the many different opinions people have on various subjects and how they express those opinions with their wallet.  More importantly, one can see even in this small group that there is almost always a buyer for every seller and vice versa...the only real debatable metric is the price.*
  • Fascinating discussion about risk.  We could argue about the notion of risk and relationship towards risk as well as debating what is considered a risky or riskier asset class.  One could further debate whether the developed world of today was a more risky asset class/region than the developing world.  But I prefer to remind myself that widely held believe in asset allocation and diversification, the supreme mantras of modern finance (until 2008), did not achieve truly diversified portfolios and did not entirely balance risk and reward.  Even the most sophisticated models turned out to have the erroneous assumption that all risk could be diversified away.  As we are all painfully aware by now, diversification doesn't always work and when it doesn't, the effects can be devastating. (see charts below).

diversification-success  diversification-failure

* Ed. Note: In terms of the Greek crisis, something fundamentally important also seems out of balance i.e. the price and conversely the yield on those Greek sovereign bonds.  Considering the amount of negative coverage and the very real possibility of a default, why aren’t the yields on these Bonds in the double digits?  Let us assume that you had those $100M that Marc Faber so generously dished out to his panel members, would you invest in Greek Bonds yielding just about 3% above German Bonds?  Otherwise stated, assuming that a price is a true reflection of all information available to all market participants, then perhaps the Greek crisis isn’t nearly that much of a tragedy.

More On ETFs 
In our ongoing quest to shed some light on Exchange Traded Funds (ETFs), here is some useful information on an a currency ETF, CurrencyShares Australian Dollar Trust, ticker symbol: FXA

But before we delve into a more detailed discussions, we want to refer to our disclaimer at the end of this newsletter.  As always, you should read the full prospectus if you are considering any trades or investments in this ETF or any other ETF or Mutual Fund for that matter.  You can download their prospectus here.   If you don’t fully understand all the risks in an investment you should consult your financial advisor. 

The Australian Dollar was one of the winners of 2009, outpacing most other major currencies with a 28% gain against the US$.  After the market turnaround in March ‘09, the Aussie Dollar showed a high degree of correlation to commodities, in particular to Gold.


And similar to Gold, it can be a very volatile trade, hence one should keep in mind that additional considerations towards risk are in place.  Having said that, this currency was the ideal carry-trade component for financing in US$ or Japanese Yen while taking advantage of the more than 3% interest rate differential in favor of the Aussie Dollar.  That worked beautifully until the end of 2009 when the major players started getting out of risk currencies and commodities and returning to the illusive safe havens, the US Dollar and Japanese Yen and turning their profits into government debt.  In recent weeks, there was another immensely profitable currency trade i.e. buy the Australian dollar versus the Euro.  But that also goes into the realm of Spot currency trading, which is not for everyone.  Email me however, if you wish to have some info on cross currency trades such as this one.

In terms of taking advantage of the interest rate differential between the US and the Australian deposit rates, and short of opening a savings account “down under”, the FXA represents an easy to establish currency position.  Unlike trading Spot currencies or Futures which is really the realm of day-traders, trading the currency via an ETF makes more sense for the medium to long-term investor, depending on your outlook and risk tolerance.  Because of the interest rate differential and the way this ETF is structured, an investor can expect a small distribution which reflects that rate differential between the Aussie$ and US$.



FXA Price

Annualized Return

















































In 2009, total distributions were $2.09 per share at an average return of about 2.4%.  Not much, but better than most deposits currently available in US$ terms.  And it is a bit of a teaser with regard to the ETF’s expense ratio of 0.4% (below most Mutual Funds but still higher than the traditional Index Trackers) which is one of the major downsides to owning some of the more complex ETFs.

A few caveats: The distributions should not be the main consideration for this trade as possible fluctuations in currency prices could easily exceed those distributions. In volatile market sessions, this could happen within one day - Know your risk!  In terms of the taxation of these distributions, they are not considered qualified dividends and therefore do not have the favorable tax treatments for US investors – Consult your CPA. 

Nevertheless, if one has any concern about the long-term viability of the US$, despite the recent consensus for a flight to safety, this is one way to diversify and it can be done as easy as trading shares. 

How The Big Banks Make The Big Bucks
In view of the upcoming Valentine’s Day, Marketplace’s Senior Editor Paddy Hirsch puts some family values into money making.  Enjoy this wonderful illustration of how the big guns make money.

How the big banks make the big bucks from Marketplace on Vimeo.

Neither the information nor any opinion contained in this communication constitutes a solicitation or offer by us to buy or to sell any securities, futures, options or other financial instruments or to provide any investment advice or service. Each decision by you to do any investment transactions and each decision whether a particular investment is appropriate or proper for you is an independent decision to be taken by you. In no event should the content of this communication be construed as an express or an implied promise, guarantee or implication by or from us that you will profit or that losses can or will be limited in any manner whatsoever. Past results are no indication of future performance.


Guy Haselmann said...

As you state, the euro is certainly a release value for the PIIGS problems. However there is much more to the story. In joining the EMU, countries agree to live by the rules in exchange for a union central bank providing them with a stable currency and low inflation. In return, member states are required to keep their fiscal houses in order by maintaining strict budget and debt guidelines. Greece was not only reckless, spending wildly, especially during the low interest rate and boom year. They even lied about it in their economic reporting and concealed it further with the Goldman Sachs swap. Do you really think that the German and French taxpayors, those who acted most responsibly and prudent, will be willing to bailout out Greece. The ECB's "agreement" to help was vague and without any substance. It was given merely to calm markets. Most importantly, the ECB CANNOT agree to bailout Greece and give subsidies because it is clearly violates the laws of the Union. Furthermore, if they did it would open up a Moral Hazard can of worms and set a subsidy precedent for all other member states. The solution, therefore, resides within Greece, who has very few good options. They will either have to drop out of the Union, default on their debt, or make such drastic decision that rioting in the streets become a daily event. Regards, Guy Haselmann

info@fxistrategies.com said...

Dear Guy

Thanks for your comment - much appreciated. You have raised some valid points. The story is of course quite complex and there are no easy answers and no perfect solutions for Greece or the EU.

One main point I was trying to make, and no offense to the Greek community here, Greece has enjoyed many of the advantages of being part of the Eurozone countries. One huge advantage has been the low financing cost simply through default of being a Eurozone member. Thinking of this episode in terms of free market behavior, if buyers of Greek debt had done their homework right, Greek treasury purchases would have either been avoided or much higher yields should have been demanded. Particularly the hedge funds that have often innovative ways of assessing risk should have been in a position to truly assess whether the Greek government was upfront about their finances.

While it is unclear if and how the Greek government will be bailed out, I find it hard to believe that Greek yields aren’t in the double digits when the possibility of a default is still very real.

Best regards - Clemens