Monday, July 21, 2008

The Moose Stays in Cash

By William Dirlam

JUL 18— The WallStreet Journal raised its newsstand price to two dollars this week. With Starbuck’s lattes going for five, the price of morning coffee and a paper, for those who want to be both trendy and in the financial know, is now seven dollars. Not Lira, not Pesos, not Yen… Dollars. Seven dollars for coffee and a newspaper! No doughnut. No OJ. No Russian Tea Room atmospherics. Just a stimulant made of beans and a depressant made of wood pulp.
All those government types who’ve been telling us that inflation from food and energy had not passed through to the general economy obviously drink instant and don’t read. Not that I know that much about Starbuck’s or favor the Journal myself. Frankly, I prepare my own coffee and get my written news off the internet. Sometimes the coffee is Starbuck’s, which I buy at Costco. Most times it’s just grocery store fare. I do grind the beans fresh each day now, which I admit to have considered effete when I was young enough to think coffee was hot tap water over a spoonful of Folgers Crystals.

In retrospect, my one visit to Starbuck’s was traumatic enough to make it my last. First off, there were a lot of truly wired people in the place, and their palpable nervousness seemed like it might be contagious. (Are fidget-cooties airborne? I didn’t know.) I also felt like a clueless tourist in Bhutan, entirely unfamiliar with the language and customs. So while I was trying to translate the Franco-Italianate menu and determine which of the hyperactive barristas I should talk to first, I was nearly trampled by a stampeding pack of caffeine-starved customers.
Let’s just say that I was clearly trying everyone’s impatience.

When my two-cup $8 order finally came (I’d gone there at a friend’s request) I nearly caused a fist-fight by accidentally picking up another guy’s coffee (which was sitting next to mine) and polluting it with sugar before he could hiss at me that they put all the orders on the counter at once in no particular sequence, and that I had ruined his life. Excuse me, but all the cups look the same on the outside, buddy. Since I’ve rendered your grande-black-quadruple-caff entirely undrinkable, Mr. Type A freakazoid, let me buy you another.

So I netted out at $12 and some serious stress for my two cups of Starbuck’s. Nowadays, I guess it would have been $15. I got off light. Even so, I’ve never gone back.

Given $5 coffees and $2 daily newspapers, it was somewhat comforting to see the latest consumer and producer price indices confirm what most of us have encountered in the real world for the last year. At least we no longer feel as if the govmint is lying to us. That was about the only comforting thing, however.

Inflation is not only alive and well, but, as we’ve noted here for some time, has been bulking up on the monetary steroids coach Ben has been pushing behind the Fed clubhouse. Wholesale prices are up 9% year-over-year, and consumer prices are up 5%. We’ve only just begun.
This week’s market action generally followed the post-bailout relief scenario outlined here last week. Once the Fed, the Treasury, and the SEC made guaranteed safety-net sounds over Fannie and Freddie on Tuesday and Wednesday, the relief sent recent history into reverse. Stocks rallied, interest rates rose, the Dollar gained, and gold backed off, all later in the week— all as predicted.

The only unexpected development was that non-precious metals commodities did not rally along with stocks. Normally stocks rise in anticipation of a stronger economy and this tends to push materials prices higher too. It didn’t happen that way this time (the divergence, in fact, was very stark), which suggests one of two possibilities.

Either the market considered commodities, especially oil (down 11%), short-term overbought going into options expiration and took profits, expecting to get back in synch with stocks in the coming weeks. Or the market saw the rally in stocks as a short-covering exercise instead of a prediction of an all clear in financials and stronger growth ahead, and sold commodities in anticipation of a global recession.

There is ample evidence that the sharp move in equities this week was a government orchestrated short-covering rally, particularly the historic surge in financial stocks. The SEC announced an emergency order banning naked short sales in the financials, and the most shorted sector responded brilliantly. Even though naked shorts were already illegal and have been for a long time, financials (XLF) rocketed 20% higher in three days. It was an historic move for a beaten-down sector, but it showed just how clueless the market remains, both about values in the sector, and about the impact the shifting rules (or confused jawboning) of an increasingly activist government may have on the trading process.

Still, when you look at comparative interest rates, the Fed Funds rate is about half the European rate and less than half Britain’s. Dollars are cheap, but once you own them and throw global inflation into the mix, you realize they are less than worthless. You get rid of them as quickly as you can by buying something, and since commodities are traded in Dollars, they have been a convenient haven. Once global growth slows, however, and you have less need to take delivery of commodities, you shift to precious metals, which are a more permanent store of value.
Fed Funds futures were all over the map this week— going from a 58% bet that the Fed would HIKE rates by 25 basis points before December to a bet that they would CUT rates by 50 basis points, to a bet that there would be no change. Whatever, the Dollar’s outlook is dicey. If anything, all pretense of an inflation-fighting Fed appeared to vanish in the face of an increasingly desperate financial situation.

I’m certainly in no position to second-guess the wisdom of the Fed. I can’t even navigate a Starbucks. I’ve been evaluating the Fed Check, however, for some time now, and it’s forecasting ability still appears robust. If anything, this Fed’s propensity to do the opposite of what the commodity and bond markets are telling it has reinforced my theories about what happens when they act that way. To tell the truth, this Fed has kind of hit us over the head with it.

In retrospect, the Fed missed a chance to cut rates in 2006, and by standing pat, flattened the yield curve, which curbs bank profitability. While that didn’t create the sub-prime banking crisis a year later (Greenspan’s far larger miscues did that), it certainly didn’t strengthen the banks going forward. Then, once the crisis hit, the Fed ignored strong inflation signals in late 2007, and chose to cut rates to protect a weakened banking system. In fairness, it was a damned if you do, damned if you don’t call, but it has led to increasing inflationary pressures, which, if theory holds, won’t be peaking until a year after the cuts stopped— i.e., next spring. Thus, commodities and gold still probably have legs.

There are a couple of ironies in all this that should be mentioned. One is the most obvious, which is that the more government screws up, the more power it feels it needs to rectify the situation. I mean, do we really need to give Bozo bigger, redder shoes? Two days of Congress, Fed, Treasury, and SEC on the tube was an ego boost for them, I’m sure, and for me too (although it was an “eyes-glaze-over” type e.g.o. thing for me). But apart from face-time in an election year, what did they accomplish? I’m still waiting.

The second irony is mostly hypothetical. If the Fed acted in concert with bond and commodity markets to dampen swings, instead of in opposition, it would be more effective in stabilizing growth and inflation. That would reduce market volatility, but make both forecasting and trading more difficult. So while the American in me would like to see them get it right, the Moose in me isn’t so sure. If they weren’t messing up the markets so obviously all the time, I might not know what to make of it.

Trading aside, I do think a more compliant Fed would bring back investing. This past week alone is ample evidence that the investor has fled our markets. Stocks plunging 20% one Friday, and then surging 20% by the next is more like manic depression than planning for the future, which is what investing is supposed to be all about. There are enough exogenous forces (weather, terrorism, war, cartels, earthquakes, etc.) pumping uncertainty into our markets without our government magnifying their impact.

As for this week’s signal, several very perceptive Moosaholics have asked why, with cash in first place and GLD in second, given that GLD is POS short and medium term, that it is not the current choice. The reason is author discretion, and indecision. (If you think you hear a feint “puck, puck, puck”, that is the chicken on my keyboard.) Let me explain.
When I first developed the model, there was no gold (GLD), only gold shares (ASA), which behave very differently from bullion-- more like stocks than a commodity. So when the Fed Check, as it does now, said “avoid equities”, I would avoid gold shares. No brainer.

When I substituted bullion for gold shares a couple of years ago, although I did not have enough back data to check my assumption, I reasoned that GLD should be exempt from the Fed Check's occasional blanket aversion to stocks and bonds (promises) because it was a hard asset (reality).
As it turned out, bullion has occasionally gone down (25% of the time) when the Fed Check was predicting paper would. It seems that when stocks go to hell in a hand-basket, people sometimes sell the good stuff to cover or raise cash. The baby can get thrown out with the bathwater. That said, GLD recently gave the Moose a preliminary buy signal (three weeks ago), pre-banking crisis. Longer term, it should be headed up.

The model generates a “confidence number” for each asset, however, based on the tape, the market, and the Fed, and GLD’s remains just below a “Confirmed Buy”. Now I'm waiting for a price pullback since, as the Bear Stearns case suggested, gold retreats once a "crisis" is averted. I'm not sure this latest Fannie-Freddie credit crisis has been averted, but if the market thinks it has, gold should correct as stocks rally. In a week or two, GLD may be a buy.

There’s a reason the banking crisis broke a year ago. It’s because this is when the banks release their quarterly statements after the spring real estate mortgage season, when all the 1, 3 and 5 year ARMs roll over, or as we’ve seen lately, go belly-up. This year, we’ve gotten some numbers that stink, but our noses expected worse. We still have another week, though. The better the banks report next week, the stiffer the correction in gold. Since Citibank got a standing O for “only” losing 2.5 billion this week, the bar defining success is obviously set pretty low (underground). Might as well wait.

The thing is, when I get too fancy (and the above reasoning is fancier than a gigolo in room full of dowager aunts), I usually find I’ve been too smart by half.

Nevertheless, another week in cash. Worst that can happen is we miss out on the chaos. In my view, a small price to keep one’s pants dry.

Some of the funniest commentary from Bill yet. The gigolo analogy is classic. I have commented on Bill's methodology & website previously and reiterate that it is one of the best. Thank you Bill for all that you do.