17 Captains and No Admiral

Or is it 17 European leaders and no central banker? Either way there appears to be a lack of true leadership and power to do what is necessary to solve EUR crisis.

One would think that after one of the biggest monthly rallies for equities since the ‘70s everything would be roses and smiles, but October’s rally was more symptomatic of a market that is under extreme stress than of long-term optimism. In large part, October's spectacular rally appears to be the result of traders (particularly hedge funds) reversing their negative bets on the euro and equity markets as rumors of an European deal slowly surfaced and US economic data came in stronger than expected. 

However, there are still major questions that need to be answered before the “new” European plan has any bite.  As a result, we continue to be positioned defensively across all of our portfolios and maintain that this was/is the right positioning given the current risks for two core reasons (among many): 

(1) European debt markets still suggest a negative outcome. Debt markets, which are generally dominated by sophisticated, professional investors and traders (as opposed to individual investors), are often better or “smarter” at predicting the outcome of economic events than equity markets. As illustrated in the chart below, European debt markets are flashing warning signals and actually suggest that Europe’s problems are getting worse rather than better.

This chart shows credit spreads relative to German bunds— the wider the spread, the more credit risk associated with that country’s bonds. A spread above 450 generally suggests trouble ahead. As can be seen, Italy, the 3rd largest EMU economy, is coming dangerously close to the 450 mark (at the time of this writing Italian spreads have passed 450). 

(2) The “new” bailout plan, while a step in the right direction, is still more bark than bite (see last month’s commentary "All Bark and No Bite") and is deficient in many ways:

• Where is the $1 trillion going to come from? European leaders seem to be assuming that China or the IMF will come to the rescue and serve as the monetary anchor for the plan. However, neither China (which has issues of its own) nor the IMF (which was not designed to rescue large, “developed” countries) is in a position to take on such a big responsibility. Instead, there needs to be greater fiscal unification across the 17 euro countries and the ECB needs to be authorized to serve as the central anchor and to issue “Eurobonds”. 
• How are the banks going to be recapitalized? It appears the new plan requires banks to seek private sources of funds for recapitalization first, then go to their home country, and then as a last resort go to the ECB or EFSF. In my opinion, this is flawed in that it exposes which banks and countries are too weak to raise money on their own at each step of the way. Exposing the weak will potentially have hugely negative destabilizing effects. 
• Finally, by forcing a “voluntary” 50% haircut on Greek debt, European leaders have prevented Greece from technically defaulting. However, in the process, they have made European sovereign debt CDS (insurance on European debt) virtually obsolete. Large investors use CDS to reduce exposure and risk in the event of a catastrophic failure (bankruptcy or default). Now that these investors are no longer able to rely on the insurance-like protection of European CDS, their appetite to buy European bonds, particularly of weaker countries, will be substantially reduced. This is the exact opposite of what is desired from a successful bailout plan.

Bottom line: While it was painful to sit on the sidelines for last month’s rally, we feel that it was the right decision given the risks currently inherent in the markets. If the bond markets are correct and Italy is the next country to require help, then the European equity markets, the euro and all risky assets will face significant downward pressure. Therefore, until there are more convincing signs that European leaders are containing the problem and the issues raised above are addressed, we will continue to maintain our defensive stance. 

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On a somewhat lighter, albeit slightly disturbing, note: This article sums up the Greek issue well: Fast cars and loose fiscal morals: there are more Porsches in Greece than taxpayers declaring 50,000 euro incomes

All Bark and No Bite

When it comes to euro crisis, European leaders, so far, are all bark and no bite. They seem to understand their dire situation, but have yet to really take decisive action (a “bailout” on the order of trillion(s) of EUR) to prevent and contain their predicament. The following quote from the June 25th issue of The Economist summarizes their options well: 

…the euro zone’s leaders will sooner or later face a choice between three options: massive transfers to Greece that would infuriate other Europeans; a disorderly default that destabilises markets and threatens the European project; or an orderly debt restructuring. This last option would entail a long period of external support for Greece, greater political union and a debate about the institutions Europe would then need. But it is the best way out for Greece and the euro. That option will not be available for much longer. Europe’s leaders must grab it while they can. Source: "The euro crisis: If Greece goes" | The Economist

The last two sentences are key and yet three months after the article was written, there is still no clarity on how European leaders are addressing and containing Greece’s insolvency. Worse still, their indecision has now led to other much larger more systemically important periphery European countries and more ominously banks and insurance companies to become intertwined in the mess (see last month’s post: “Griechenland Bezahl' Deine eigenen Rechnungen”).  This lack of clarity has led markets around the world to price in not only the possibility of the worst of the three options (a disorderly default) but the potential for a global recession as well (see chart below). 

12-Month Comparison: shows the 12-month performance of major global equities markets, as well as US Treasuries and Gold.  September 2010 = base year.

What may be surprising to some about this performance comparison is that despite all of the negative headlines, US equities have been relative out-performers when compared to their foreign counterparts. Even more surprising is that US Treasuries—the securities at the center of the S&P ratings downgrade—have been one of the year’s best performers.  The weakness in Emerging and Commodity Country markets and strength of US Treasuries suggests that many investors are expecting a global economic slowdown in the coming months/quarters.

Bottom line: With the 2007/08 mortgage crisis and extremely disorderly Lehman bankruptcy still fresh on investors’ minds, many investors have been quick on the sell trigger so as to not get burned again (ourselves included).  However, a Greek default should not have the same hugely negative market impact if it is properly contained.  We hope that European leaders will realize that their experiment—the EUR—has the potential to fail catastrophically and therefore will resist political gamesmanship and address the situation.  If they do (soon) then one of the major impediments to market and economic growth will be removed and we expect a significant buying opportunity as most markets have been sold to exceptionally cheap levels. 

Until then, we are positioned extremely defensively across all of our portfolios.  This means our portfolios are skewed more towards the possibility of a Greek default (orderly or disorderly) and a global slowdown, than to a satisfactory resolution to the crisis.  See table below for a quick and very basic scenario analysis:

Does the euro have a future? | The Great Debate

good read...

By George SorosThe opinions expressed are his own.

The euro crisis is a direct consequence of the crash of 2008. When Lehman Brothers failed, the entire financial system started to collapse and had to be put on artificial life support. This took the form of substituting the sovereign credit of governments for the bank and other credit that had collapsed. At a memorable meeting of European finance ministers in November 2008, they guaranteed that no other financial institutions that are important to the workings of the financial system would be allowed to fail, and their example was followed by the United States.

Angela Merkel then declared that the guarantee should be exercised by each European state individually, not by the European Union or the eurozone acting as a whole. This sowed the seeds of the euro crisis because it revealed and activated a hidden weakness in the construction of the euro: the lack of a common treasury. The crisis itself erupted more than a year later, in 2010.

There is some similarity between the euro crisis and the subprime crisis that caused the crash of 2008. In each case a supposedly riskless asset—collateralized debt obligations (CDOs), based largely on mortgages, in 2008, and European government bonds now—lost some or all of their value.

To read more please see: Does the euro have a future? | The Great Debate

Griechenland Bezahl' Deine eigenen Rechnungen

This commentary is going out later than usual to coincide with the 3-year anniversary of one of the reasons I am living and working in the BVI — the Lehman Brothers bankruptcy … my beloved, albeit now infamous, former employer.  After the bankruptcy, I was fortunate enough to go on to Barclays Capital as part of their acquisition of Lehman; however, during the several weeks I had off while the two banks’ trading systems were being integrated, my friend, Steve, and I began to hatch a plan to sail the Caribbean. While we had no sailing experience, at the time, we thought getting out of the toxic atmosphere that was Manhattan was probably the healthier option (see Streak Freak below) Fast forward 3 years, and I am still in the Caribbean, Steve is married to a woman he met on Virgin Gorda and living back home in San Francisco, and the markets are once again in a similarly precarious position as to when I left.

Solvency issues that should have been contained to Greece and other periphery European countries are spreading and possibly metastasizing in some of Europe’s largest banks and insurance companies (see table below). As such we have shifted our base case scenario from the European crisis being successfully contained and minimal disruption to the European financial system to a base case where Greece defaults and possible one or multiple large European institutions need to be bailed out. 

Source: Financial Times

As a result, we have decided to ride out the current market uncertainty with a relatively conservative stance across all of our portfolios. This means we have been slightly more active over the past several months in terms of re-positioning our portfolios than we would generally like to be and have reduced high beta equities and commodities exposure, while maintaining or increasing our fixed income positions.  


Additionally we rolled our put hedges to the SPY Oct 2011 115/105 put spread and/or maintained our VXX position. (After initial success these put spreads have not produced much in terms of current returns however they have significantly reduced portfolio volatility and allowed us to sleep better knowing we are protected should the market make another big downside move.)  We expect to maintain this defensive stance until there is more clarity on how European banks will be supported in the event of a Greek default. 

We will be looking to buy again near this year’s lows (around 1100 in the S&P 500), as long as any combination of the following catalysts (with the last one being most important) are met: further stimulus from the US Fed (expected next week), the passing of Obama’s jobs bill (unlikely given the mess in Washington, but if a majority of the plan is passed then the market should rally), and Europe finally resolving their issues and insulating European banks from Greece and the other PIIGS (no longer our expected outcome).  If we get any combination of these, then we should see a huge buying opportunity possibly similar to March 2009.  Until then, we are willing to sit on the sidelines holding relatively conservative bonds and safe-haven commodities with little to no exposure to equities.  The obvious risk with this strategy is that if things are less worse than expected then the market could quickly rally higher and we will miss out on the upside.  For now, we are willing to accept this risk.

For the rest of this commentary I am going to defer to an excellent blog post from another investment manager that articulates the European dilemma much better than I can:

This week, the German Constitutional Court ruled that Germany’s role in supporting the EU’s periphery was not unlawful. The market’s knee-jerk reaction was to blast higher on the news, as the alternative would have been a total disaster. Upon closer inspection, it appears that smooth sailing into the future is far from certain. The court stressed that the decision was not a “blanket” approval for future bail-outs and demanded that the German Government “ask permission” of the Budget Committee before handing out any more cash to their southern neighbors. At the end of the day, this means that future bail-outs will be even more difficult to execute as the process is slowed further by administrative tape around afternoon siestas.

This is important. Time is quickly running out for the EU. The lack of a comprehensive solution after two years of “can kicking” means that the periphery’s disease has infected the core and the odds of a disorderly default have increased substantially. Rather than proactively addressing the challenges in the region – restructuring debt, recapitalizing banks, promoting growth, etc. – policymakers have waited for market’s to force their hand and only then, did they plug another hole in the periphery with their finger. With one year Greek debt within spitting distance of 100% yields, they are now running out of fingers. With Italian and Spanish yields back on the rise, the holes are getting too large to plug. Something’s gotta give.

To read more please go to http://www.viewfromtheblueridge.com/2011/09/09/you-lick-mine-first/

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On a final note: to read more about Lehman Brothers (and maybe a little more on why I considered the high seas as possibly safer than an investment bank trading desk) read Streak Freak, written by the former head of my ETF Trading desk, Jared Dillian.  

Just the Facts: S&P's $2 Trillion Mistake

Just the Facts: S&P's $2 Trillion Mistake: "In a document provided to Treasury on Friday afternoon, Standard and Poor’s (S&P) presented a judgment about the credit rating of the U.S. that was based on a $2 trillion mistake. After Treasury pointed out this error – a basic math error of significant consequence – S&P still chose to proceed with their flawed judgment by simply changing their principal rationale for their credit rating decision from an economic one to a political one.

S&P has said their decision to downgrade the U.S. was based in part on the fact that the Budget Control Act, which will reduce projected deficits by more than $2 trillion over the next 10 years, fell short of their $4 trillion expectation for deficit reduction. Clearly, in that context, S&P considers a $2 trillion change to projected deficits to be very significant. Yet, although S&P's math error understated the deficit reduction in the Budget Control Act by $2 trillion, they found this same sum insignificant in this instance."

“Just when I thought I was out … they pull me back in.”

For some reason that quote by Michael Corleone from The Godfather: Part III keeps popping into my head. For the past several months, each time we get a glimpse of a reprieve from volatile markets, new (or old) issues surface. Just when I think we have blue sky ahead, new clouds appear …

Yesterday’s market action was extremely ugly. FX intervention by the Japanese Central Bank and the Swiss National Bank enacted to weaken the Yen and Franc forced investors out of their safe-haven holdings (Yen and Francs) and simultaneously to reduce their riskier holdings—equities, commodities, etc. Furthermore, this intervention combined with weak global economic data, particularly in the US, and signs that the European Debt Crisis is spreading to larger, systemically more important countries such-as Italy to produce near panic selling.

Fortunately, last week (Thursday, July 28), we hedged some of the equities exposure for our clients invested in our 5 Model Portfolios because of the politics that were taking place in Washington. These hedges act like an insurance contract, going up in value when the markets go down—therefore protecting our clients’ portfolios if/when the markets decline. For the hedges we used one of the following strategies:

• VXX: We used the VXX ETN, which was created by my trading desk while at Barclays Capital. (In fact, I was one of the first traders to ever trade the product in 2009.) VXX tends to go up when market volatility goes up and the markets go down. 
• Vertical Put Spread: For other portfolios, we used an option strategy known as a Vertical Put Spread. For this hedge we bought the SPY Aug 20, 2011 132 / 124 Put Spread (SPY was trading around 131 at the time), which provides downside protection below 132 in the SPY, an ETF that tracks the S&P 500. 

These hedges were our response to a unique short-term opportunity where we thought we could avoid unnecessary market turbulence associated with the debt ceiling debate—effectively canceling out some of the downside market movements. Initially, we intended to only hold these hedges through the resolution of the US debt deal, however given weak global economic data and the resurgence of Europe’s debt issues we decided to maintain the hedge, which has proved a wise decision.

Please do not hesitate to contact us to learn if your portfolio is properly diversified for the current economic environment or to learn more about the hedges described above.

Bottom Line: The likelihood of some sort of QE3-like action by the US Fed has significantly increased over the last several days. Furthermore, Jean-Claude Trichet, of the European Central Bank, will likely announce additional stimulus soon as well. If/when this occurs it should provide a lift to the markets and continue downward pressure on the US dollar. In the meantime, all markets (including commodity currencies which have performed extremely well despite the world’s economic woes) will continue to be volatile; meanwhile safe-haven assets such-as Treasures, gold and possibly even the US Dollar could outperform.

Finally, at the risk of sounding like a broken record, in times of market stress like we are experiencing now it is always important to remember that these market moves are relatively minor in the context of a long-term investment strategy. As always we will diligently take the steps that we feel are appropriate to protect your portfolio—currently this is via an equity hedge and through safe-haven assets such-as US Treasuries and Gold.

PRESS RELEASE: Offshore Investment Advisor and Josh Ungerman write a White Paper on ‘Accidental Americans’ and the Offshore Voluntary Disclosure Initiative

TORTOLA, BVI – July 19, 2010 – Offshore Investment Advisor, a Registered Investment Advisor in the Caribbean, in association with LGS & Associates, announced today that it has teamed with Josh Ungerman of Meadows, Collier, Reed, Cousins, Crouch & Ungerman, L.L.P., to raise awareness within the Caribbean community on some of the tax implications associated with being a dual citizen with a US passport or US birth certificate.

“We are pleased to have teamed with Josh Ungerman, as part of our new financial education campaign called ‘Raise Your Financial IQ’, to write this White Paper and educate individuals on the IRS’ new Offshore Voluntary Disclosure Initiative,” said James Bridgewater, principal of Offshore Investment Advisor. “At Offshore Investment Advisor we believe that wealth management is more than simply helping clients create and manage portfolios tailored to their unique financial needs.  It is as much about minimizing unnecessary losses due to penalties associated with improper tax reporting or relying on very conservative securities, such-as short-term CDs, that currently offer a negative real rate of return.” 

“It is not uncommon for residents of the Caribbean to travel to the United States, USVI or Puerto Rico and have a baby.  As a result, a relatively high percentage of Caribbean residents were born in a US territory and therefore are dual citizens of their home country and the US,” said Josh Ungerman, a former US IRS Chief Counsel Senior Attorney & US Department of Justice Tax Division Special Assistant US Attorney is one of the foremost experts assisting clients with US tax obligations.  “While there are many benefits of US citizenship, once an individual is subject to the US tax regime, the individual is taxed on his/her worldwide income.” 

Though this is shocking to some at first, it is not as onerous as it sounds because there are certain provisions in the new OVDI that allows for significantly reduced penalties provided that individuals take action before August 31, 2011.

This new White Paper educates individuals who have a US passport or birth certificate on the steps they need to take in order to meet their obligations to the US IRS.  In particular, it highlights the key requirements for an individual to be considered an ‘Accidental American’ and therefore qualify for significantly reduced penalties from 25% to 5% (or even 0%). 

“Ongoing financial education across the Caribbean is important to our ability to remain a vibrant, growing community and to evolve with the rapidly changing and increasingly complex offshore financial landscape,” said Lorna Smith, founder of LGS & Associates, a BVI-based consultant on international business and finance related matters.  “This White Paper will help individuals understand the new realities of this changing environment.”

Please visit http://www.offshoreinvestmentadvisor.com/Investor-Resources/white-papers to download the White Paper.

Media Contact:

James Bridgewater

Offshore Investment Advisor

james@offshoreinvestmentadvisor.com

284-495-4179

About Offshore Investment Advisor

Founded in 2005, Offshore Investment Advisor has established itself as a leading investment manager in the Caribbean by leveraging the strengths of TD Ameritrade Institutional, a globally recognized leader in brokerage and custodial services, as well as by working closely with our clients to understand their entire financial picture and then delivering on their specific financial needs and goals.  Headquartered on Tortola, BVI, we are a boutique provider of wealth and asset management to individuals, families, trusts and BVI employers.  Our services center on your unique requirements and include the following comprehensive solutions: Private Wealth Management & Retirement Plan Services. 

For more information please visit: http://www.offshoreinvestmentadvisor.com/

About Josh O. Ungerman, Partner

Mr. Ungerman specializes in the resolution of tax matters.  He specializes in IRS voluntary disclosure and has extensive experience in the IRS 2009 VDI Program as well as the current IRS 2011 OVDI Program.  The tax matters in which Mr. Ungerman is involved are typically very complex from both a factual and legal perspective. These matters often require legal and accounting skills.  Mr. Ungerman is also a Certified Public Accountant.

Prior to joining private practice in 1994, he was a civil prosecutor for the Internal Revenue Service, Dallas District Counsel office. He was also a Special Assistant United States Attorney for the Department of Justice Tax Division in Dallas during his time as a civil prosecutor.  Prior to becoming an IRS attorney of a special assistant US attorney, he served as a law clerk to the Honorable Carolyn M. Parr at the United States Tax Court in Washington, D.C.

Mr. Ungerman is a past President of the Dallas Bar Association and a past Chair of the State Bar of Texas Tax Section Controversy Committee.  He is currently a Fellow of the American College of Tax Counsel and is currently a Vice Chair of the American Bar Association Tax Section Civil & Criminal Penalties Sub Committee.

Mr. Ungerman was admitted to practice in Texas in 1990.

For more information please visit: http://meadowscollier.com/attorneys/ungerman-josh-o/

Gold hits a new high but pound for pound this puppy is worth more!

Gold is hitting new all-time highs on possible QE3 and safe-haven protection as the European debt crisis and US debt ceiling talks heat up.



But at 50 pounds, this puppy is worth more than his weight in gold (and may offer more protection):

"A red Tibetan mastiff has become the priciest dog in the world after being sold for 10 million Chinese yuan, or £945,000...  Big Splash, or Hong Dong in Chinese, was bought by a coal baron from the north of China."  To read more please see Red Tibetan Mastiff: 'Most expensive' dog sold for nearly £1m | Mail Online

Prepare for a Sell-Off When the Debt Deal Is Struck - Seeking Alpha

Prediction markets, like Intrade, are by no means the be-all and end-all when anticipating the likely outcomes of future events. Many times they can be thinly traded or poorly designed, among other issues. However, prediction markets can be a very useful tool for gaining information on an unknown future event and provide an additional data point to fill in missing or unclear information. So with that said: What does Intrade predict for the timing of a U.S. debt ceiling increase?

To read more please read: Prepare for a Sell-Off When the Debt Deal Is Struck - Seeking Alpha

No Rest For The Weary

Well that was an interesting month. An interesting six months really!  I can’t remember a time when there were so many breathtaking, heartbreaking, earth-shattering headlines: Middle-East uprisings, Japanese catastrophes, bin Laden dead, European sovereign debt crises, US debt ceiling debates, floods, etc.  And to top it all off the sensational and controversial conclusion of the “OJ Simpson-like” murder trial of Casey Anthony.

While the 1^st half of the year has been disappointing, we expect the 2^nd half to provide a better environment for gains as there is resolution on Greece/Europe and the US debt ceiling, among other things.  Very similar to last year, May and June were tough months; however July 2010 through December 2010 produced a 20%+ rally in the S&P500.  2011 could be similar as negative headlines wane—case in point: markets having already staged a tremendous rally over the last week of June and into July.

In June, our focus was on Europe where it appears that Greece has been given a new (temporary) lease on life.  Despite agreement on the Greek bailout, there are still questions on how a debt roll-over will be treated by the ratings agencies, whether or not the Greeks will deliver on their austerity promises, not to mention the health of other periphery European countries (in particular Portugal whose debt rating was lowered to junk by Moody at the time of this writing).  Despite these hurdles it appears that many of the near-term major issues have or will be been resolved.

Now in July, our focus has shifted to US politics where political empowerment seems to be taking priority over common sense and the need for financial stability.  In our opinion, Republicans need to compromise and agree to some tax hikes and Democrats to significant budget cuts.  However, so far, Republicans have been unwilling to compromise and this has manifested itself in predictions for if/when the US debt ceiling will be raised.  According to predication markets leader, www.intrade.com, there is only 33% chance that debt ceiling will be raised above $15.1 trillion by July 31, 2011.  See figure 1 below.

Figure 1: The chart above shows the likelihood that Congress will approve an increase in the US debt ceiling to $15.1T or more before midnight ET 31 Jul 2011.  Source: www.intrade.com

If the debt ceiling is not raised before the August 2nd deadline, then the current rally that resumed at the end of June will be hindered.  Despite the importance being given to raising the debt ceiling, it is important to note that the US congress (Republican and Democrat controlled alike) has raised the debt ceiling 22 times since 1981—from $1 trillion to the current level of $14.3 trillion (source: Wikipedia).  So this is nothing new.  What is different this time is the extraordinary polarization of American politics, partially attributable to the Tea Party’s rise to power in the past election.  We are confident that a deal will made, however the timing is questionable.

On a final note, I apologize for so much gloom over the past several commentaries … I am usually a much more cheery person!  Sometime (hopefully soon) the tone of these commentaries will turn rosy again and we will be talking about how many gazillions of dollars people are making from social media stocks or some other extraordinarily positive news.

Bottom Line: No rest for the weary.  Although we are getting close to resolution on most outstanding issues, it is not time to head to the Soggy Dollar to sip Pain Killers during the summer slowdown quite yet.  The US debt stalemate is a huge issue, but, as history suggests, it is a resolvable one.  As such, we still consider corrections as buying opportunities in select markets.  As we have stated over the past several commentaries, with resolution we should see a substantial lift to the markets.  We saw it with Greece; now hopefully we will see it with the US debt ceiling.  Should the situation in Europe significantly deteriorate again or the US Congress prove unable to reach an agreement, then we will reassess our position.

A quick update on the situation in Greece

It seems I am writing these intra-month notes more often than hoped for.  However, I want to update you on the situation in Greece and reiterate our sentiment from last month's commentary that the current market activity, while volatile, still appears to be well within the normal range for a temporary market correction.  It is also important to note that our portfolios have little to no direct exposure to European equities and debt. 

The situation in Greece and periphery Europe has deteriorated over the past several days, and credit markets are pricing in a high likelihood of a Greek default.  With that said, we think there will be a last minute deal (as suggested yesterday by the EU Commissioner: Rehn Sees Markets Misreading EU Resolve).  If this does not happen, then Greece could default within the next several weeks.  While this will be a painful event, particularly for EUR denominated assets and EU banks, we maintain that it will not spread systemic risk as happened in 2007/08 (see Greece is Not Lehman).  If our thesis proves wrong over the next several days/weeks/months, then we have several options to ride out the storm.

(1) We can stay invested in equities, (2) we can exit or hedge (via options) our current positions and wait for calmer markets, or (3) we can go short and profit if the market enters a prolonged downturn.  As of today, despite weak performance, we have not seen outright sell signs that warrant exiting our long-term positions:

• The VIX Index, which is a measure of investor fear, has flashed the “fasten seatbelt” sign but investors are still far away from “jumping out of the plane”.
• Furthermore, by many metrics the market is oversold.  If/when any of the current issues are resolved (and all should be resolved within the next several months) markets should move higher as happened last year.

Additionally, while we do not think we will witness a widespread crisis, now is a good time to make sure your financial house is in order and double-check that your checking, saving/CD and brokerage accounts are insured against bank insolvency (i.e. provide the equivalent of FDIC/SIPC insurance).  This is particularly important for assets held at select European banks.

Finally, it is important to remember that as a long-term investor the current market volatility, while disconcerting, is just noise in the longer-term context of your portfolio’s returns.

IRS Loosens Aug. 31 Deadline for Offshore Tax Disclosures - Bloomberg

The Internal Revenue Service will let taxpayers with undeclared offshore accounts apply for a 90-day extension of the Aug. 31 deadline for coming forward.

The change, announced on the IRS website today, would let taxpayers seek the extension in writing by showing that they have made a “good-faith attempt” to meet the deadline and explain what information they are missing.

To read more please see: IRS Loosens Aug. 31 Deadline for Offshore Tax Disclosures - Bloomberg

How do you say Deja Vu in Greek?

The end of the search for Bin Laden and relatively dovish statements from Bernanke (meaning interest rates are going to stay low) should have provided a good start to May. However, negative headlines quickly outweighed positive ones and May 2011 turned into a near identical repeat of May 2010, which similarly witnessed concerns of over Greek debt and double-digit intra-month market swings. 

The euro’s slide and resulting USD strength, combined with what should have been a normal correction in an overheated commodities market, to form a wave of selling of across all markets several times greater than any single newsbyte warranted—a rogue wave of sorts. However, as mentioned last month we expect some positive swings in the USD over the short-term; over a longer-term horizon, however, we still maintain that the USD will remain relatively weak until interest rate differentials narrow. This should be positive for most commodities and non-USD assets.

As such, for new accounts, we used the corrections as buying opportunities in select markets that benefit from a weaker dollar and continued loose monetary policy in the US. For example:

After an initial sell-off in gold in USD terms, gold rallied to new highs in EUR terms and has provided relative stability against violent currency fluctuations. Gold remains a buy on pullbacks (more on this in a future article).

Furthermore, US Treasuries have proved their safe-haven characteristics, defying simple logic, and have rallied despite the imminent end of QE2. In fact, using history as our guide (see Figure 1 below), we think there is high likelihood that US rates will move lower (and bond prices higher), despite prevailing opinion that the end of the Fed’s buying will push rates higher (again more on this in a future article). 

Figure 1: With the Fed buying bonds in QE1 and QE2, one would expect rates to decrease. Instead the opposite occurred. Likewise, with the end of QE1 and QE2, one would expect rates to rise. QE1 proved differently. Will this be the same for the end of QE2?

Data Source: Federal Reserve

Bottom Line: Currently market activity, while volatile, appears to be well within the norm. For the most part, corrections are buying opportunities in select markets, rather than a reason to sell. Should this change and the markets show signs of prolonged deterioration, we will reduce exposure and then get re-invested as opportunities arise again in the future.

Greece is Not Lehman

Recently, there have been quite a few comparisons between a Greek default and the Lehman Brothers bankruptcy -- “Is Greece the 'next Lehman Brothers'?”, “Greek Restructuring Would Be 'Lehman Moment,' MIT's Johnson Says” and "Could Greece be the next Lehman Brothers? Yes - and potentially even worse" to cite a few. The comparisons, while tempting, are exaggerated and overstate Greece’s role in the European Union and more importantly in the global financial system. In short, it is our opinion that Greece’s debt issues alone do not pose the same threat that Lehman Brothers did in 2008. 

As such, while a Greek default would be extremely disruptive, the disruptive effect is not as much due to contagion and the spread of systemic risk, but more due to the disruption of the status quo—USD down / risk on. A Greek default will obviously be hugely painful, placing stress on EU relations, reducing confidence in the euro and generally decreasing risk appetite; however an all out freeze of the global financial system and movement of capital as experienced before, during and after Lehman’s collapse seems out of the question at this time. This is best illustrated by the Ted Spread, which still remains well within normal levels. See Figure 1 below.

Figure 1: The Ted Spread “represents the change between the three-month LIBOR rate and the three-month rate for U.S. Treasury bills. It is used to measure the amount of pressure on the credit markets. Generally, the spread has stayed under 50 basis points. The bigger the difference between the two, the more worry there is about the credit markets. Economists will look at this to determine how risk-averse banks and investors really are.” Source: Investopedia; Data Source: Federal Reserve

Lehman Brothers and the other now reincarnated investment banks were the pistons, gears and engine of the financial system. All were interlinked and as we ultimately learned the failure of one meant the virtual shutdown of all. The crisis of 2007/08, which I unfortunately had a front seat for as an ETF trader at Lehman, was a solvency crisis for investment banks and many commercial banks; it was a bubble bursting; it was a crisis of confidence; and importantly it was a liquidity crisis on a worldwide scale—money literally stopped moving. The spike in the TED Spread in 2007-2009 shows how capital movement virtually froze.

On the other hand, Greece and most of the periphery European countries, even the larger ones, are merely passengers of the financial system. They are not integral components to the continued viability and fluidity of the financial system. Spreads on Greek and some periphery European country debt have exploded relative to German Bunds, and yet we are not seeing the same general distrust amongst global banks that was so pervasive during the credit crisis.

Bottom Line: In some ways Greece’s relationship to Europe is like a tangled ball of yarn. Untangling the mess without serious disruption is possible but it will be difficult and at times painful. On the other hand, Lehman Brother’s relationship to the global financial system was somewhere between tangled yarn and a scrambled egg—maybe a tangled yarn dipped in egg. Untangling it was nearly impossible without serious blood, sweat and tears and despite best efforts by all everyone was left with a horrible mess on their hands. With that said, given the fragility of the global economic system, the possibility of a severe market downturn cannot completely be ruled out. As such, we are watching for warning signs that the above thesis is wrong—TED Spreads, Bund/Treasuries spreads, equity market volatility and credit spreads, among other things. So far all appear to be well within normal expectations.

Prepare for volatility and downward corrections but not outright collapse.

Rotary Club Sunrise welcomes presentation on personal finance « Virgin Islands News Online

ROAD TOWN, Tortola, VI- The Rotary Club Sunrise of Road Town welcomed James Bridgewater and Adam Stauffer of Offshore Investment Advisor, a Wealth Manager based on Tortola, on April 26, 2011.

According to Public Relations Director of the club Edwin Adams, James and Adam delivered an educational presentation on personal finance, including the effects that inflation, a declining US dollar and compounding returns have on an investor’s ability to save for retirement.

To read more: Rotary Club Sunrise welcomes presentation on personal finance « Virgin Islands News Online 

Dollar, Yuan, CDs and Silver

While the first several months of 2011 were dominated by non-market related events—the Middle-East uprising and the Japan catastrophes—April provided a month of nearly pure macroeconomic news. Despite the lack of sensational and heartbreaking headlines, these macroeconomic events will undoubtedly have implications on your money whether held in CDs or some of today’s favorite trades like gold and silver. Some of the more noteworthy news items include:

• The European Central Bank raised rates to 1.25% to tame inflation and despite struggling peripheral member countries. 
• Similarly, China increased banks’ reserve requirements to a record 20.5% less than two weeks after they raised interest rates; both desperate attempts to lock up cash and cool inflation. 
• Meanwhile, the US maintained QE2 and signaled prolonged loose monetary policy. 

The divergence in policies, which was confirmed in a late-April speech by Bernanke, means that the interest rate spreads between US Treasuries and other governments’ bonds are likely to continue to widen before they start to narrow—the forces driving the USD lower and gold/silver higher are going to get stronger before they get weaker. According to Bloomberg, “yields on Treasuries due in one to three years are 1 percentage point below that of government debt with similar maturities in the rest of the world on average, Bank of America Merrill Lynch indexes show. A year ago, there was no difference” (see here)

Bernanke’s speech combined with the technical breakdown in the USD solidified our convictions. We already had a substantial short USD position indirectly through international equities, which make up 50% of our total equities holdings, and international local currency bonds, as well as commodities like gold and silver, which historically have had a high negative correlation to the USD. However, in April we maxed out our non-USD holdings by initiating direct shorts against the USD—we moved excess cash in our clients’ portfolios to (1) a long position in the Chinese Yuan, which has been a “no brainer” trade that has gone nowhere for a long time, and (2) a basket of non-USD currencies.

Some may say we are late (and we are … by over three decades) and that everyone is already so bearish on the USD that now is the time to be a contrarian (which may prove true), but given Bernanke’s actions and the opposing actions of the world’s central bankers we are comfortable that over the medium-term the dollar will continue its slide.

Chinese Yuan - The Chinese have been very disciplined (or stubborn) in allowing the Yuan to appreciate relative to the USD. However, over the last several months it has become clear that China has an inflation problem and a wage inflation problem as well as possibly even a housing bubble. They have used rates and reserve requirement increases to try to alleviate their issues with relatively little success; now Governor Hu Xiaolian suggested on the central bank's website that The People's Bank of China plans to increase the Yuan's flexibility to cut the cost of imports and counter inflation. Yuan forwards traded at the biggest premium to the spot rate in more than five months, confirming speculation the central bank will allow faster currency gains (see here). Furthermore, the Yuan is making new multi-year highs—the Yuan strengthened beyond 6.5 per dollar for the first time since 1993 (see here)

The end result, we feel, is that the opportunity for a significant one-time jump in the Yuan is not only probable but could finally happen relatively soon.

Silver - On a different note, I spent much of Easter weekend looking at old Silver charts (get a life)—one of the more impressive ones is shown at right (March ’80).

Most of our clients hold silver, as well as gold, which have been great investments/trades recently. However now the concern becomes: when does it end?

Silver has a long history of making losers out of winners—rapid appreciation followed by extremely violent reversals means that most silver holdings fall back to cost or lower before the trader even knows what hit him. In the commodities market, and in particular silver, sentiment can shift very quickly with supply/demand dynamics changing over a matter of days or weeks rather than months or years.

With that said, we feel that silver likely still has some upside left given anticipated USD weakness. However, we are not initiating new positions until there is a significant pullback. It should be noted that given how volatile most commodities are, we follow a much quicker Risk Management process (see March 2011 Commentary) for commodities. This in theory should get us out of silver faster than most other investors. (Since the time of this writing margin requirements for silver have been raised twice by the CME which has had a deleterious effect on silver prices – see here)

To receive a PDF presentation on our Portfolio Construction Process and Dynamic Risk Management please contact us.

Bottom Line: On a daily/weekly basis the USD may correct upwards; however in the medium-term the USD will slide well beyond its 35+ year inflation-adjusted lows until the disparity across interest rates is eliminated and there is clarity on the US deficits and economic recovery. This means that already struggling savings and CDs accounts, will be doubly penalized—first by near-zero interest rates and second, and more importantly, by a weak and declining dollar combined with inflation. Cash held “safely” in USD-denominated savings and CD accounts are, and will continue to lose value. Which begs the question how do you define safe?

Dynamic Risk Management

Unrest in the middle-east and a horrible series of disasters in Japan, among other things, have investors on edge. However, despite these events, there has been very little panic selling outside of the individual markets/regions that were directly affected. In fact, the VIX Index, which measures the equity market's expectation of near-term volatility (or risk), is trading near its 52-week lows (see chart at right). 

The VIX is a little like the flying in an airplane. Any spike higher in the VIX is similar to the fasten seat belt sign going on—99.99% of the time everything is fine. Even so, that little sign and the accompanying bumps raise your heart rate; fear levels go up. A spike above 30 or so is like the oxygen masks dropping down—the plane is not necessarily crashing but something frightening is happening; everything is not ok. Finally, any reading consistently above 35 or higher for more than several weeks is a sign that there is something systemically wrong—it is time to put the parachute on and exit the plane.

The reason I point this out is because many investors I have recently spoken with have expressed concern over the market. And, given recent events, some concern is warranted; however, the fasten seat belt came on only briefly over the last several months. Surprisingly the markets have shrugged off a series of horrible news and appear to want to go higher. (As explained in last month’s commentary, we believe this is in large part due to easy monetary policies in most developed countries.)

Regardless, given how unpredictable and uncertain the first three months of this year have been, the rest of this month’s commentary is dedicated to explaining our risk management process (i.e. when we strap on our parachutes).

There are two core components to our risk management strategy—strategic asset allocations and dynamic risk management. The combination of the two results in a portfolio with positively skewed monthly returns and significantly fewer negative months (see chart below).



Strategic Asset Allocation forms the “broad strokes” of our models and is based on our 3-5 Year Investment Outlook, as well as mean-variance optimization. Mean-variance optimization attempts to maximize portfolio return for a given amount of portfolio risk. The product of the two is a policy portfolio that balances investment opportunities across geographies and asset classes, and that serves as the reference portfolio off which we structure all of our models.

In theory, a well thought-out mixture of uncorrelated assets (equities, fixed income, commodities, currencies) should reduce overall risk and protect your portfolio against wild swings—when one asset zigs, the other zags—however, in practice, in times of severe disruption, all markets tend to move in the same direction at the same time.

Therefore, we have an added layer of risk management, Dynamic Risk Management, that acts as the “fine tuning” for our models and your portfolios. We follow a purely mechanical logic based on the current price level for any given security relative to its N-period simple moving average (SMA)—where N varies depending on certain preset parameters. Although, our process is slightly more complicated, at the most basic level when the monthly closing price for a security is above its SMA, we are invested; when it is below its SMA, we are in cash.

While not fail-safe, this mechanical system allows us to rapidly adjust our models to the prevailing trading environment and avoid making unwise investment decisions based solely on emotion. This in turn dramatically reduces the risk inherent in our clients’ portfolios (which is one of the key reasons many of our clients rely on us).

To receive a PDF presentation on our Portfolio Construction Process and Dynamic Risk Management please contact us.

Bottom Line: Despite the horrible toll on life, the recent events only temporarily raised the level of fear in the financial markets.

Mid-Month Update: A quick update on the implications of the situation in Japan

Tokyo Electric Power Co.’s nuclear power plant experienced two explosions today that significantly increase the chance of more radiation leaks. These leaks are not expected to be on the same level as Chernobyl however given recurring aftershocks it seems hard to rule anything out at this time.

This has direct implications on Japanese stock markets, of which we have little to no exposure to; it has indirect implications on global markets due to the size of Japan’s economy and the threat that a significant slowdown there could spread to other economies. Most non-Asian markets are down 1.5% to 2% (at the time of this writing), which does not qualify as an extreme move, but still warrants caution. The USD, CHF and JPY, as well as US Treasuries, are up on a flight to safety. Most commodities are down on global slowdown concerns; natural gas is up as this catastrophe represents a significant setback for nuclear power.

First and foremost, our hearts go out to everyone that has family or friends in Japan, or that is in anyway affected by the events in Japan. With that said, we are weighing our long-term investment philosophy versus the extremely unique and highly unpredictable nature of the current situation, and may decide to temporarily reduce our higher beta equities allocations, such-as emerging markets, as well as other allocations should the situation deteriorate further. As of this writing no action has been taken.

To be clear, we are invested for the long-term and do not let day-to-day or even month-to-month swings strongly influence our decisions (and neither should you). However given the unpredictable nature of this event, combined with the unprecedented (and possibly escalating) unrest in the Middle East, we may err on the side of being overly cautious, reduce some of our exposure and wait for more clarity on the global outlook.

If you have any questions/comments please do not hesitate to contact us.
To monitor the events in Japan in near real-time: http://live.reuters.com/Event/Japan_earthquake2


Sincerely,
James & Adam

A Note to US Taxpayers with Hidden Assets Offshore

For all US taxpayers that have an unreported offshore account (or that have a friend with one), the IRS has re-implemented a program to repatriate hidden offshore assets. It appears that the IRS is turning up the heat and progressively making it more difficult, if not impossible, to hide assets offshore.

“U.S. taxpayers with hidden offshore accounts have until Aug. 31 to decide whether to disclose their holdings to the government without being criminally prosecuted, the Internal Revenue Service said.” To read more see “IRS Giving Partial Amnesty to U.S. Taxpayers With Hidden Overseas Accounts”.

While we do not provide tax advice nor any tax-related services, we are here to help anyone that would like to learn more about their options or be put in touch with a tax specialist. Please do not hesitate to contact us.

Inflation Has Escaped

Despite the S&P 500 equities index setting a new 52-week high and finishing up nearly 3.5% for the month, February was a nerve-racking and at times sleepless month. But things could have been a lot worse.


Last month we spoke about how unrest in Egypt and Tunisia could spread to more strategically important oil producing countries and produce 1979-like inflation. Well the unrest spread and commodities prices rose– WTI crude oil topped $100; gold, cotton and food indices made all-time highs; silver multi-decade highs, etc., etc. (see CRB commodity index chart at right ). Despite widespread unrest and rapidly increasing energy prices, it appears that extraordinarily loose monetary policy led by Quantitative Easing in the US, but implemented by most developed countries’ Central Banks, has helped mitigate any negative impact on developed equity markets.


However, loose monetary policy is proving to be a double-edged sword and inflation is on the precipice of spiraling out of control. Not necessarily because central bankers have pushed it too far or because the US dollar is in a downward death-spiral as many doomsayers predict, but because of wildly unpredictable factors beyond the control of central bankers and government officials alike.


Which makes me think of Jurassic Park. Bear with me...


Jurassic Park, a novel by Michael Crichton and movie by Steven Spielberg, is “often considered a cautionary tale on unconsidered biological tinkering. [Jurassic Park] uses the mathematical concept of chaos theory and its philosophical implications to explain the collapse of an amusement park showcasing genetically recreated dinosaurs.” (http://en.wikipedia.org/wiki/Jurassic_Park)


Rearrange some of the characters and you could be talking about our current predicament: inflation (the dinosaurs), quantitative easing (biological—read economic—tinkering) and unrest in the Middle East (chaos). Central bankers have successfully engineered inflation designed to stimulate growth, reduce unemployment and increase consumption. However, now that they have succeeded, their creation appears to have taken on a life of its own; chaos has set in; the beast has escaped from the park!


With that said, our portfolios are now firmly biased toward inflation risk. As recently as mid to late-2010 we were on the fence between deflation/inflation and our portfolios reflected our lack of conviction. Starting in late 2010, we progressively began adding and/or increasing allocations to securities that should outperform in an inflationary environment (and the resulting rising interest rates)—TIPS, precious metals, energy, agriculture, infrastructure, and floating rate bank loans.


Furthermore, we are closely watching the USD index for a clear break below its long-term resistance (see chart below). While we already have significant non-USD exposure through non-US equities, should the dollar index make a significant move lower we will move excess cash and cash-equivalents into a basket of non-USD currencies.


Bottom Line: Inflation is a major and growing risk. The rapid accent of energy prices has the potential to reverse economic progress made since ‘08/09, which will be negative for equities, however positive for most real assets as long as the rise is orderly.

US Interest Rates - BVI Property Guide

Rising US Interest Rates - BVI Property Guide
by Adam Stauffer, CFA, Chief Investment Officer at Offshore Investment Advisor

In the last months of 2010, US Treasury rates—or the interest on US government debt—started to climb from near historic lows.

The combination of a second round of quantitative easing by the Federal Reserve and an extension of former US President George W. Bush-era tax cuts sparked a rally in 10-year Treasury rates from a low of 2.45% in early October to around 3.5% at the time of this writing.

While the prospect of rising rates is welcome news for investors in CDs, many of whom have realised negative real rates of return over the last several years due to near zero percent interest rates, the impact on short-term CDs will be muted. In fact, the benchmark three-month CD rate only increased to 0.29% from 0.27%. Instead, the primary impact will be felt in mortgage rates and more generally across an investor’s portfolio.

When does 50 cents equal $5 million?

When you are a rapper named 50 Cent and you use Twitter to promote stocks in your portfolio: “Sales of the penny stock [ticker: HNHI] increased by 290 percent following the endorsement [by 50 Cent], resulting in a paper profit of almost $5.2 million for the rapper, who owns 7.5 million shares in the company...” To read the full article see “Is 50 Cent Using Twitter to 'Pump and Dump' Stock?”


Maybe James and I should hire 50 Cent to write this commentary …

Party Like Its 1999?

In some ways it sure seems like it. Equities appear to be unstoppable and some names like YOKU and DANG have had IPOs that have skyrocketed in their first several days of trading similar to dot-coms in ‘99. In reality, 1979 may be more like it. But let’s hope it is neither!


What is happening in Egypt has some similarities to Iran in the late 70’s. In 1979, amid massive protests in Iran, the Shah fled and the anti-western Ayatollah Khomeini took over leadership. This set up the Arab oil embargo of the US and its western allies and set off an inflationary cycle in everything oil-related, from gasoline to food. The price of Saudi crude more than doubled to around $34 a barrel at the end of 1980 from $14 two years earlier. A similar disruption in the Middle East could send WTI crude oil, which currently trades around $90, well above its previous high of $145 in 2008 (see chart).


However, it is unlikely that Egypt will be the cause of a massive spike (at least directly), since the country does not produce much oil. Egypt does control the Suez Canal, which sees more than 5% of the world's oil pass through it, however even this is unlikely to set off an inflationary spike.


In my opinion, the bigger concern is how quickly these disturbances are spreading from country to country. According to Business Insider, what started in Tunisia “partially due to food price inflation and unemployment, but also because of WikiLeaks,” has spread to Egypt, Morocco, and Algeria, among other countries. If a serious disruption were to spread to a significant producer of oil then runaway inflation—starting in oil-related products then spreading to other commodities—could be an issue.


Coincidently, if you have been reading our past couple of Commentaries there is a scary, albeit loose and lucky, similarity between what we spoke about and what is going on. Specifically, in November, we mentioned:

“To cap off the negative tone for the month, Wikileaks has thrown a wrench into closed door politics and, in my opinion, has turned a nearly impossible situation in the Middle East into an impossible one…” Read more here.

Then in December we spoke tongue in cheek about Armageddon and commodities inflation:

“I am not an “Armageddon is coming” type person, but It is easy to let your mind get carried away when you think of how much food, energy, water, etc. 7 billion people need…” Read more here.

Bottom line: The current turmoil in the Egypt is not Armageddon (although if you live in the region then it may feel like it). However, food prices have been rising dramatically in the Middle East, as well as other parts of the world. According to the UN, the food price index is at the highest level ever recorded. This food inflation has the possibility of creating global social unrest (particularly developing markets), which generally speaking will have negative implications for stocks which tend to decrease in value during times of uncertainty and positive implications for supply constrained things like commodities. Furthermore, it appears that risks are starting skew in favor of holding developed equities vs. developing.


For more information on the linkages between the Mid-East unrest and Wikileaks and Food Inflation see here and here.