Writer’s Block, Low Interest Rates and Baby Boomers

With the Euro Crisis continuing to dominate financial markets I have struggled to find a topic to write about other than the crisis. However, there is one area of the market where something very peculiar is happening—interest rates.

It is no secret that since 2007/08 interest rates on everything from CDs to AAA rated government debt, and even mortgages, have been low and steadily declining. This is largely due to central banks trying to stimulate growth through cheap capital by setting short-term rates at or near 0% and lowering long-term rates through quantitative easing.

However, over the last several months, nominal interest rates (or the interest rate before accounting for inflation) on bonds issued by Germany, Finland, Denmark, Switzerland, the Netherlands and Austria have all gone negative. Negative nominal rates mean that investors are literally paying the issuing country to hold their money:

“Germany sold two-year bonds at a negative yield for the first time on record on Wednesday, as the borrowing costs of Europe’s more creditworthy nations were driven even lower by investors seeking safety.” Source: Financial Times

Figure 1: Negative nominal rates on the 2-Year Swiss Bond; source: Bloomberg  

Negative yields are nothing new. Whenever the rate of inflation is greater than the interest rate on a bond or CD, the “real” rate of return on that bond is negative. For example, if you own a bond that pays an annual coupon of 2.5% and the annual rate of inflation is 3.0%, then the real rate is -0.5%—every year the value of the payment received is less than the amount that inflation has eroded. However, what is new is that for the first time ever nominal rates across multiple countries and maturities are negative.

So why would any rational investor pay a country to lock in a guaranteed loss? It doesn’t make sense, unless…

1. Investors are more concerned about the return (preservation) of their capital than the return on their capital and are therefore willing to accept extremely low rates to “guarantee” that their cash is for the most part protected.
2. Investors are using safe-haven bonds as a hedge and are counting on bond appreciation as rates go down to offset losses in other areas of their portfolio.
3. Investors expect deflation in the future, where the future value of cash is greater (i.e. buys more goods and services) than its current value. 

All of the above are possibilities:

• Greek and Spanish investors are in a situation where they are uncertain of which currency their cash will be valued in the future should their country exit the EZ. For example, if Greece goes back to the drachma, then Greeks should be willing to pay to ensure that their cash stays in Euros rather than being converted into a significantly devalued “new” Drachma.
• Other investors may be using the negative correlation to equities historically associated with bonds from AAA-rated “safe-haven” counties as a way to hedge risky assets in their portfolio. As rates decline in times of market stress, the price of their bond holdings increase (as bond yields go down, bond prices go up). By not holding the bond until it reaches maturity these investor can trade in and out of their position and lock in profits as their bond holdings appreciate.
• Finally, others may be worried that the world is entering a prolonged period of stagnant global growth similar to what Japan has experienced over the last several decades, and therefore are betting on deflation and prolonged low rates. 

Record setting low nominal yields are likely the result of a combination of the above depending on who the investor is and where he/she is domiciled. As long there is uncertainty over the EUR and global growth the trend should remain in place (particularly if Japanese-style deflation turns out to be the correct thesis). However, in theory, at some point investors, particularly income-sensitive investors such-as pension funds, retirees and banks/insurance companies, that rely on income from their investments to survive, will shift out of low yielding safe haven bonds into higher yielding securities like dividend paying stocks, such-as utilities and telecoms, and high-yield bonds.

This is particularly true given that over the next decade or so Baby Boomers will be retiring at an accelerating pace. In what may be one of the Boomers’ last rebellions against the status quo, they may stray from tradition, which would have them switching from equities to bonds as they enter retirement, and instead do the opposite in search of return and yield that offers the regular payments required to live without a steady paycheck. 

Figure 2: Investors are shifting out of equity funds into bond funds. We will be watching for this trend to reverse and for interest rates to rise as a signal that investors are reversing their conservative stance. Source: Morningstar 

Bottom Line: While very low to negative nominal rates work for a short period of time as a strategy for parking money, it is not an effective long-term strategy for many investors unless there is outright deflation. Furthermore, if/when rates increase, investors will be in for a rude awakening as their bond holdings decrease in value (interest rates up --> bond prices down). As a result, we are watching fund flows (see figure 2 above) as well as interest rates for signs that investors are tiring of playing it safe and are willing to accept more risk in order to meet their income and return objectives.

As we stated in our last commentary: “Everyone knows that Greece is in trouble. What is unknown is how individuals and banks in more economically significant countries will react to Greece’s eventual exit.” Now we can add everyone knows that Spain is in trouble, and it appears that we are getting a better idea of how investors are preparing for a possible Greek or Spanish exit—they are parking cash in traditional safe havens despite the costs.

Until there is more clarity on how Europe is going to resolve the Euro crisis, we continue to maintain our conservative stance, which underperformed in the first quarter of the year as markets ignored Europe’s troubles, but is now outperforming as market uncertainty rises once again. This means we are:

• Avoiding European markets 
• Fully invested in safe-haven fixed income assets like US treasuries, as well bonds that will benefit from further quantitative easing like mortgage REITs 
• Underweight equities by investing in ‘safer’ large, dividend paying US equities, while shorting more risky emerging market equities, which will be negatively impacted by slowing global growth 
• Underweight commodities that will be negatively impacted by slowing global growth (energy and materials) 
• Short EUR versus long USD, and at the same time long Gold as a hedge against rapid appreciation of the EUR in the event that the US Fed eases further or the EUR crisis is quickly resolved 
• Adjusting risk exposure as needed by going long or short volatility products like VXX--long volatility protects against sharp moves downward while short volatility increases exposure

To learn more about bonds read “Everything You Need to Know About Bonds” by PIMCO.

“Angela, we’re going to need a bigger hose…”

“Policy makers don’t understand that they are not in control. It’s not that speculators are in control, either, but rather that fundamentals actually matter.” – interview with Colm O’Shea, “Hedge Fund Market Wizards”, Jack D. Schwager, 2012

With recent elections across Europe going to anti-austerity/anti-bailout parties and Greek bank runs, individuals—who largely have been silent throughout the crisis (aside from the occasional protest or riot in Greece)—are reacting to the deteriorating fundamentals of the Euro Zone and are forcing change one vote and one (large) ATM withdrawal at a time.

The entrance of individuals as active players in the European crisis is a sign that the crisis has entered a new and critical stage. To date central bankers and politicians have been able to prevent flare ups from turning into full blown wildfire through policies and rhetoric that bought time, but did nothing to address the true structural issues associated with the Euro. However, over the last several weeks, European citizens’ actions at polling stations and ATMs have reignited the crisis and reversed nearly all of the stabilization policies put in place over the last 6-12 months.

As a result, the Euro is trading near its 2010 low (see Figure 1) and the odds that a country (Greece) will leave the Euro before the end of 2013 have increased significantly (see Figure 1): 

Figure 1 – The Euro is down over 7% from its recent local maximum at the end of February. Source: http://www.barchart.com 

Figure 2 – According to intrade.com there is a 57.6% chance that a country currently using the Euro will announce intention to drop it before midnight ET 31 Dec 2013. Source: http://www.intrade.com/ 

But, a Greek exit from the Euro in and of itself does not need to be a catastrophe for the entire Euro Zone and signal an end to the Euro. In theory investors have had more than enough time to prepare for Greece’s exit — most private investors (including European banks) have already realized significant losses on their Greek debt holdings due to the private sector debt swap earlier in the year.  This means that the direct financial impact of a Greek exit on European banks should be relatively contained because they have already taken the hit.

Policy makers now need to shift their focus to policies that actually address the true structural flaws in the EZ — i.e. that a one size fits all monetary policy for the whole EZ does not work without greater fiscal unity and economic burden sharing across strong and weak countries — and that mitigates the growing threat of contagion and bank runs, which have already started in Greece and to a lesser extent in Spain:

According to the Financial Times, “Shares in Bankia, the Spanish bank which was part-nationalised last week, plunged by over a quarter on Thursday morning, after a report that customers had withdrawn €1bn from the bank over the past week.”

Specifically, the threat of bank runs could be significantly reduced by providing some sort of assurance that bank deposits are not only insured against bank failure but also guaranteed against adverse currency conversion should the banks' home country abandon the Euro for a weaker currency.

On the surface individuals moving their money to ‘safer places’ like Britain, Switzerland, and Germany does not seem as bad as an entire country defaulting; however, bank runs can be incredibly insidious 

Figure 3 – 'Gross' anatomy of a EZ bank run. 

because once they start they are difficult to stop. This problem is further magnified in Europe where most banks hold a significant portion of their assets in their home country’s debt. When the bank is forced to sell assets in order to raise cash to meet withdrawals, they have to sell their country's bonds, which further destabilizes the country’s credit and in turn the bank’s (see Figure 3).

Without currency conversion protection, bank runs will become the most significant challenge that the EZ has faced since the crisis began.

Bottom Line: Everyone knows that Greece is in trouble. What is unknown is how individuals and banks in more economically significant countries will react to Greece’s eventual exit and to devaluation threats from currency conversion.  To date European policy makers have been putting out flare-ups with buckets and a garden hose on a country by country basis, but have done little address the threat of a widespread wildfire.

Consequently, despite the temptation to buy into the rally in the first half of the year, we largely maintained our conservative stance. This conservative, slightly bearish stance means that our portfolios underperformed as the markets moved higher earlier in the year; however is now providing the protection that we desire as the crisis once again is front and center in investors’ minds and as contagion risks rise. This means we are:

• Avoiding everything European (equities, bonds, EUR, bank accounts, insurance, etc.) 
• Fully invested in safe-haven Fixed Income assets like US treasuries and other relatively safe bonds 
• Underweight Equities by investing in ‘safer’ large, dividend paying US equities, while shorting more risky emerging market equities, which will be negatively impacted by slowing global growth 
• Underweight Commodities that will be negatively impacted by slowing global growth (energy and materials) and that are inversely correlated to the strengthening US Dollar (gold) 
• Short EUR versus long USD 

Policy makers' actions and elections results (Greece is holding more in June) over the next several weeks will guide our positioning.  If we see signs that policy makers are addressing bank run concerns, or a renewed coordinated program by central banks around the world then we will selectively increase exposure. Until then, despite possible market moves higher, uncertainty remains too high for us to move significantly away from our conservative positioning.

Pessimism Exhaustion

I am going to keep this month’s note short given that I am sure you are exhausted of hearing me go on about the European Crisis which has produced more back and forth moaning and groaning than a Williams/Sharapova match. 

Unfortunately despite recent headlines claiming the 2nd Greek bailout is done, the tragedy is not over. Digging a little deeper into the new requirements imposed on Greece:

“European creditor countries are demanding 38 specific changes in Greek tax, spending and wage policies by the end of this month and have laid out extra reforms that amount to micromanaging the country’s government for two years” – "Athens told to change spending and taxes”, Financial Times

It is difficult to envision how a country that couldn’t meet its original significantly less painful targets (over a span of two years!), will successfully meet these draconian, completely eviscerating, new demands in a few short weeks. However, according to Angela Merkel, these demands (and high private sector participation in the Greek bond swap which as we pointed out last month is far from certain) must be met in order to receive the new aid.

And yet, despite these long odds, markets have rallied like its 1999, ignoring the difficult road ahead for Greece and Europe. This leaves me, along with many other managers that have not fully bought into the recent rally, in the unenviable position of having to decide to: (1) chase the market higher, ignoring inherent risks and warning signals coming out of Europe, or (2) wait for the market to come back in as it is repriced to the real risks associated with the Greek bailout.

While not an easy decision given the swiftness of the rally, we are not chasing this market higher for several reasons:

1. We do not feel the Greek solution is a done deal. 
2. Crude and gas prices are surging due to worries in Iran; if sustained these higher prices could negatively affect global growth. 
3. Finally, the rally has been on extremely light volume—a sign that big investors do not have conviction in the current move (see chart below)

As evidence for point 3:

“Last January (2011) the average number of stocks traded on the NYSE per day was 891mm shares vs 661mm for this January (a 26% drop YoY!) and this is down an incredible 59% from January 2008.” 

Source: ZeroHedge.com, Chart: Bloomberg  

With that said, there are reasons to be bullish including the unprecedented amount of liquidity from central banks and relatively strong US economic data.  As a result we have added some lower risk US equities positions over the last month or so in attempt to capture some of the rally; however, until Greece either (1) makes their March 20 payment or (2) defaults, we will maintain a neutral to slightly negative stance across all portfolios based on our hypothesis that the Greek solution will be more messy than the market is currently pricing in (i.e. CDS triggered, policy errors, and renewed loss in confidence in the EZ). We feel this positioning will protect our portfolios regardless of the outcome in Greece.

Bottom Line: Like a 4am drunk, happy and full of confidence one minute, angry and sloppy the next, global markets are not on firm footing. Should there be successful resolution in Europe, we will shift away from our defensive stance by increasing equities exposure in developed and developing markets. Until then we remain defensive, which means we have:

• nearly full allocations to fixed income skewed towards bonds that should perform better in a down market (treasuries and muni bonds) versus bonds that should rally along with risk (corporate, high yield and emerging market bonds) 
• hedged positions in equities (lower beta (lower risk) US equities versus higher beta emerging market equities and volatility) 
• partial allocations to commodities skewed slightly long 
• short EUR/USD

If You Can't Find The Fish At The Table

There is a saying in poker “if you can't find the fish at the table, then you're it.” And right now, when it comes to the Euro Crisis, no one thinks they are the fish. 

The amount of brinksmanship taking place in global financial markets has reached a fevered pitch more akin to the Word Series of Poker than the implementation of global economic policy. Depending on whom you listen to (or want to believe): 

1. the Euro crisis has been contained and financial markets are on the verge of a renewed bull market because of improving economic data and the amount of cash sitting on the sidelines, or 
2. Europe is staring into the abyss and heading for the next great depression because of the increasingly complicated financial trickery in Europe and the impending hard default of Greece

The reality, of course, is that both cannot be correct and odds are expectations will continue to oscillate wildly between the two outcomes over the next several months and quarters as the stresses in Europe eventually work themselves out. 

The most obvious place where this game is being played is in Greece where negotiations between the Greek government, the Troika (European Central Bank, European Union and International Monetary Fund), and European banks have been ongoing for months. Simply:

• Greece needs money for interest payments due in March so they have agreed to draconian austerity measures
• The Troika needs the EU to remain stable, so they have agreed to give Greece money even though Greece is a bottomless pit
• Banks do not want the EU crisis to deteriorate further, so they have agreed (in principal) to forgive a significant portion of Greece’s debt 

On the surface, this is THE main event—the stakes are high and all sides appear to be playing to win. 

However, in the last several months, a fourth player has shown up that no one has paid attention to who has the ability to significantly affect the outcome of the game. This player, small yet cutthroat, may be the real shark at the table. 

It appears that a handful of hedge funds have been buying Greek sovereign debt at distressed prices in amounts sufficient to influence the outcome of the restructuring negotiations. While their exact motive is unclear, it is likely they are attempting to engineer one of the following outcomes: 

1. These funds may simply want to force the hand of the Troika by blocking a Greek restructuring until new, more favorable terms are put in place for a quick profit (while the math is significantly more tricky, at the most basic level these funds probably paid around 20 to 30 cents for Greek bonds while they push for a restructured "new" price closer to 50 cents). 
2. The other, more insidious (albeit less likely), motive may be to exert enough pressure that Greece is forced into technical default. By buying CDS (insurance on bonds) that pay out when a country defaults, these funds may be gearing for a much larger win that pays off when Greece defaults (and contagion spreads to other periphery countries). 

Bottom line:  At the risk of remaining overly pessimistic for too long on Europe’s ability to contain the crisis we continue to maintain our negative positioning on the market.  We are prepared to adjust this stance once the details of Greece’s imminent restructuring are clear.

However, in our opinion, as it currently stands, the entrance of hedge funds into the Greek debt negotiations process significantly increases the likelihood that Greece and the Troika will make a policy mistake that will trigger a technical default and more importantly reduce investor appetite for other, more systemically important, European country bonds. 

Case in point, this morning there are rumors that “Greece Nears Deal With Creditors on Haircuts” that would pay only 32 cents on the euro for Greek bonds.  Forcing such a steep loss on all private investors, while good for Greece, may trigger credit default swap payments and at the same time inadvertently scare investors away from other high risk European countries like Portugal, Spain and Italy given the severity of the forced loss.

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.