Buy Treasuries

For a trade, that is. While my previous writings fixate on both what I've perceived as a US Dollar and Treasury bubble, especially in the face of mushrooming government budget deficits, the safer obvious position to take for the long term seems to be short treasuries and long precious metals. Simply put, government entitlement and debt obligations of the modern era necessitate inflation targeting policy, unlike the days of 1930s. The common gospel is that the money will eventually flood the system to remedy the gloom, and deflation will soon be a thing of the past.

OK. That's my "common view." Now for an interesting trade - the opposite approach. Treasuries might offer a good value here. With the 30 year Mar09 future trading in the high 126's, I can't help but perceive of the following factors being supportive in the near term, contrary to my previous view:

• The banking system is still broken and insolvent. Despite unmultiplied aggregates of money supply recently off the charts, the effective multiplier due to this insolvency is lower. M2 is relatively untouched. This won't last forever - but another 6-12 months is easily possible. Until either mark to market is abandoned or another trillion or two of cash is given to the banks, nothing will change. Fear and dread will continue.
• The Fed is saying they will buy long term treasuries. We're early in the game. They are done with $35B of agency purchases, out of a $500B total projection. The target is 4.5% mortgages (or below) for consumers out there. My intuition says they will not let the free market ruin their stated ambitions. In fact, a weaker currency exchange rate resulting from aggressive debt monetization might kill two birds with one stone: attaining lower mortgage rates while stimulating exports and increasing the overall price level (thus ending the deflationary trend).
• Decreased Trade Means Smaller Trade Deficit: Less aggregate demand, becoming somewhat inevitable due to likely too small government stimulus and effective enough remedy of the banking system. Smaller trade deficits are supportive of the US dollar and government debt assets. While demand for treasuries is smaller from trade partners, a strengthening dollar may incentivize them to hold tight. Where else to put assets? (Only so much gold...)
• Higher Savings: Likewise, larger anticipated government budget deficits (trillions per year for the next several years) may be financed in this environment with increased internal savings rates more than offsetting reduced debt purchases from the likes of China, Japan, and the mid-east. Look at Japan's treasury curve for an example of what high savings rates can do. Their 10 year is at 1.3% and 30 year at 1.94%. Smaller trade deficits equate to more capacity to save. Perhaps here is the seed of another idea: Japan's trade surplus will likely narrow, reducing their ability to fund government debt as effectively. US 30 year debt at 3.58% looks like a steal in comparison to Japan's. Might be a great spread trade, short Japanese 30 year debt to buy US government 30 year debt.
• Continued Deflation Prospects: The good old fundamental argument to buy treasuries. The long end of treasury curve is not far from 5% higher in price than the top of the range its been stuck for the better part of several years, even in the days of $147 crude and heightened inflation fears. There is a value here, especially concerning the environment going forward.
  

Conclusion: In the past, decreased savings rates were offset by increased trade deficits to provide a ready supply of funds to explain past treasury market strength. A future of the opposite, increased savings rates and likely smaller trade deficits, results in the same support - with a ready supply of money to bid on these instruments.

I've not abandoned my long precious metals stance, so perhaps long treasuries and long gold is a great approach here. And don't forget, Japanese bonds to carry into US long bonds.

A bubble in fear?

Credit Default Swaps spreads too wide?

Treasuries Credit Default Swaps at Record Highs, Yet Yields Record Lows?

These are two contrary readings. The 5 year US treasury yield is 1.47%, while the 'risk premium' determined by CDS prices to insure them is .695% (69.5 bp).

As much as the flight to quality has driven treasuries and the US dollar to recent highs, it is a peculiar point to consider that in the same environment of minimal counterparty trust that someone is willing to pay 69 basis points a year for insurance to likely a less viable counterparty than the US government. This is the same environment where banks still trust each other less 1 year out (1.86% 1 year LIBOR) than they trust the US government 5 years (1.47%). A 1 year treasury earns you a hefty .40% yield, apples to apples.

Maybe if these CDS were denominated in gold ounces or euros and collateralized by future earnings of the CDS writers' first born might they make any sense.

Blurry Expectations. Blurry Multiples. A Forecast.

Reading January 12th's John Mauldin's redistribution of a Cliff Draughn newsletter entitled 'Market Vertigo' today, I am struck by the following excerpt:

To all the Op-Ed pieces that have been written on President Barack Obama, I do not think I could add more commentary as to how one man will turn things around. He has instilled a sense of hope and a level of confidence not only to Wall Street but more importantly to Main Street. Hope and confidence are crucial to the eventual reversal of our current financial and economic woes, because they lead to the re-establishment of trust that is essential to the restoration of the global economy.

However, I caution anyone willing to place significant bets that Obama's "stimulus" plan will reverse the current recession tide any time soon, to simply examine the largess of issues confronting our economy...

The common knowledge is that the expectation for Obama's ability to solve all of our problems is high. But almost every allusion to Obama is filled the skepticism that the second paragraph illustrates. There is always a caveat, a second guess of his ability to please, usually cynically (or some would say realistically) concluding our problems are too deep for him to do anything about.

All over I see major minds, liberal and conservative alike, chipping away at the hope and dream we all have for success of the best outcome. Paul Krugman's recent analyses pointing to weaknesses in stimulus proposals, particularly their possibly ineffective size, are a good example of this. Here he details the stimulus will likely fall a few hundred billion short on an annual basis to aggressively solve our woes:

I’d guess that the CBO estimate, which has unemployment averaging 8.3 percent in 2009 and 9 percent in 2010, is actually too optimistic (see 3, below), but even so it puts the Obama plan in perspective: a 3% of GDP plan, with a significant share going to ineffective tax cuts, to fill an 8% or more gap.

We could go much further, but the point here is really quite simple; Expectations are actually very low. Most references to the 'great hope' (or negatively tinged 'great hype') end with a seemingly pragmatic conclusion saying not to expect too much. There is a mood of somber realism, if not outright cynicism, that has permeated the mainstream collective psyche. We are in the middle of a dark storm. With this negative attitude underlying our outlook, it is very difficult to look forward and see the other side.

As I've alluded before in my now former position that the US dollar was at a long term bottom and thus a buy, I perceive the herd always tends to incorrectly perceive the most recent trend as a paradigm shift, rather than what it usually is: a part of mean reverting cycle. Deflation is the current new or revisited paradigm; Inflation trend was the new paradigm of six months ago. Markets are just as fickle as the events that drive these trends.

In the end, the reality is that nothing is static, and most of us can agree with equal certainty that not even the most well respected gurus amongst us are worth listening to for their predictions for other than entertainment purposes. This is simply because there are constant surprises that undermine the value of even the most academically-credited forecasting.

As an example, the fall 2008 Lehman bankruptcy unexpectedly catalyzed the revaluation of most the world's equity markets by a mere 50%. Had a few key decision makers behaved differently that mid-September weekend, the path and outcome of price of all global markets would have been unarguable different. This is truely independent of the actual level of fundamental insolvency on Lehman's balance sheet, especially since fundamentals quickly change, often self-reinforcing their own trends. One decision made under uncertainty would have realistically meant a possible 30-40% difference in global equity valuations across the board.

This is a perfect example of why I fundamentally see forecasting is generally a tool only useful for solving economic problems in a blunt fashion. We need some methodology after all to help us design stimulus proposals. Even so, just one improbable paradigm changing event can invalidate even the most thorough of analyses. The impact of outliers and need to fit forecasts into tidy standard distributions are contrary forces, but the likes of Taleb cover this quite effectively already.

It all comes back to how we perceive the collective state of the markets. Where expectations are high, risk is likewise high. Where there are none, the opposite may be true in a relative sense. Right now it is particularly difficult to gauge what expectations actually are. The range bound holding pattern we are observing indicates that expectations are suspended until the status of a possible congressional stalemate passes with regards to successfully pushing a stimulus through. A pervasive belief that less than necessary than will get done is perhaps depressing a market multiple going forward (or even the earnings estimate component). With no other major unexpected exogenous forces, that points to possible significant upward adjustment of the fundamentals very soon after decisions are made, assuming something actually gets done.



On the S&P, latest Standard and Poors forecasts call for 2009 top-down operating earnings estimates just shy of $60. But what multiple do we put on that? A 30 year bond trades at a 33 multiple. A ten year treasury even higher (100/2.3% = 43.5 multiple). Historic mean for S&P over the last 125 years is 16.36, which puts us at a 981 S&P valuation. But why should we settle for historic mean when the 10 year yield is above a 40 multiple? Doesn't this justify us to take more risk, especially in the face of Fed governors who thoroughly understand their ability to expand money supply? Some argue for a 10 or under multiple. Why is that justifiable? Isn't risk highest when price and earnings are trending highest above mean. That is simply not the case today.

It is important to realize those depressed early 1980s multiples were justified by 15%+ earnings yields on risk free fixed income instruments. So according to this relative valuation methodology, the S&P is worth somewhere between 600 (10) and 1800 (30 multiple). It doesn't end there. Stocks do not just entitle you to 2009 earnings, but also perpetuity. So what year is the worthwhile estimate appropriate for? 2009? 2010? 2012? The first half of 2009? The second half of 2009? Should we be bottom up, top down? Operating or reported? I could make an argument operating earnings may be more worthwhile, since they tell the story without factoring in one time events. What about book value? A successful global coordinated money printing spree combined with higher wage levels sustained with higher disposal income levels could easily result in a common view of earnings trending upward without imminent barriers. This gives substantial upside to future reported earnings way above operating baseline numbers.

Common knowledge says financial leverage is out and regulation is in. This means anemic earnings growth, thus we shouldn't get excited about stocks going anywhere. A sustained period of positivity after the once in a lifetime flush we've just witnessed could result in a substantial positive readjustment of asset prices and thus book values, especially considering central banks and governments are targeting asset inflation.

One could even positively spin the slow growth view is bullish for company valuations, as it reduces the need for a substantial amount of risk premium (that ends up depressing a multiple). So what you lose in earnings and growth you gain in the multiple. If you need evidence the markets work like this, look at PEG ratios of consumer staple stocks. 20-25 PE stocks can easily exist when annual growth rates are an anemic-appearing 5% if there is a perception that the earnings streams are reliable and insusceptible to another blowup. Look to pre-blowup pricing of KO, PG, and GIS for proof of this. On a PEG basis, these companies always seem to be expensive. Their reduced cyclical exposure to cashflow risk keep them this way.

So here goes for a useless but honest and likely correct forecast: Just as probably the S&P could hit 600 this year, it could hit 1800 in 2 years. It all depends on what variables you consider or accidently ignore.