Backpacking in South America and a Global Update

Investors,

   I spent January and February backpacking through Argentina, Chile, Peru, and Ecuador.  I wish I could write an analysis of the economies and societies as detailed as I did for China last year here, but I didn't gain comparable insight.  There are a few key themes worth briefly discussing, and a few specifics that I think you'll find interesting.  I'll then delve into a update on global markets.

South America: Most of South America is export driven with a focus on raw commodities.  China provides much of the marginal demand for commodities ranging from cattle to iron, so several South American countries are nearly a levered play on China.  Much of the continent faced intermittent civil war until just 35 years ago, so social institutions are weak and corruption is rampant.  

  Argentina is in the midst of a currency crisis, which will likely become a fiscal and political crisis in the next two years.  Wealthy Argentines are pulling their money out of the country as fast as they can circumvent the capital controls in place, and I wouldn't suggest fighting the smart herd.  One funny anecdote that highlights Argentine problems - the magazine ''The Economist'' publishes a ''Big Mac'' index, comparing the prices of McDonald's Big Mac across countries as a half-serious inflation index.  The government of Argentina ordered McDonald's to lower the price of its Big Mac in Argentina to make inflation appear lower.  McDonald's responded by lowering the price, but hiding the item from the menu.  If you walk into a McDonald's in Buenos Aires, you won't see the Big Mac advertised, but can request it and get a half-price meal.

  From a social perspective, Chile has a strong work ethic and social fabric, but is overly dependent on copper (42% of exports), and has a stifling bureaucracy; crossing the border from Mendoza into Santiago by bus required a 4 hour layover at border security where I had to stand in 3 separate lines to get various documents stamped.  Domestic service industries are nascent at best.  Peru and Ecuador lack the social institutions and infrastructure to support fast economic growth in the near future.  Of the four countries I visited, I'm most optimistic about Chile in the medium and long-term.

   Finally, one random point of interest about global real estate - I met an Argentine entrepreneur/investor named Jose who made the point that between 1965 and today, the population of the world doubled with plenty of population growth in the US, and even in Western Europe, so obviously there was strong demand for new homes and offices.  Today, the population of the western world is stagnant, and in many places shrinking.  Instead of a growing pie, we now have a shrinking pie in many areas.  For every new "hot spot" development, blocks of other homes must become abandoned.  Any time you see an underpopulated area that you think will prove a good investment, you need to ask yourself, where will the people come from to fill it and what other area must become underpopulated?  Real estate is fundamentally local, so there will certainly be areas of high growth and great returns to investment, but the secular trend is for stagnant demand.   Housing trends of the last century were supported by relatively consistent population growth that has now ended.  This argument even applies to much of the Eastern world.  China's population has stagnated and Japan is shrinking.  World population growth is coming almost entirely from India and Africa.  

Global Update: I recommended shorting the Yen in early 2012 and it's come down around 17%, with half that move coming in the last few months.  This is a big move for a currency and this trade has become a little crowded from a short-term technical perspective...but I still love the position and think it has a long ways to run.  I discussed the logic here; since then Japan has gained a new central bank head who was brought on specifically to print money and induce inflation.  This may end up looking like the best and most obvious trade of 2013 and 2014; I suggest selling on any pullbacks if you're not already in the trade.  

   Equities have continued their "stealth rally", a series of small winning days that have largely left the retail investor behind and many professionals too as people wait for significant but nonexistent dips to buy.  Retail investors stepped up their investments in mutual funds in the last three months, chasing recent moves as always, but more buying pressure has come as corporations buy back their own stock with cash on hand or newly issued debt.  It's perfectly sensible for companies to pursue these buybacks, but it has historically anticipated periods of poor equity returns for the market as a whole going forward.  

   The federal reserve is knee deep in the fourth round of quantitative easing with $85 billion in purchases of mortgage securities and treasury bonds each month.  I think they'll likely end the MBS purchases within the next 6 months since Fed officials have acknowledged they're ineffective; the MBS buying is just turned into profit for a handful of lenders and big banks and is having little effect on mortgage rates.  How long Fed bond purchases continue is anyone's guess.

   Finally, there's currently a bank run going on in Cyprus, which creates a risk that Cyprus could leave the Eurozone and set a bad precedent for the PIGS.  The problem is that the ECB/EU organizations are reluctant to simply write a blank check to solve the problem, and Cyprus' debt is so great relative to its GDP that the only way to cover it may be to seize individual deposits from banks.  Still, the total problem is just $13 billion, a trivial sum in the scheme of Eurozone problems; this will likely be easily resolved soon, but there's a small risk that it will be the straw that breaks the overburdened camel's back.  

 

Ending corruption:  I promised Jose that I would ask for the input of my brightest friends and colleagues on ending Argentine corruption and that of other South American countries.  Jose has done his own research and estimates that the Argentine government accepts about $3 billion in bribes annually to dole out state construction contracts and similar projects.  This creates massive dislocations and inefficiencies.  Jose is looking for ways to make a difference, and exploring ideas like creating a Wikileaks type site to expose the corruption of individual politicians.  Some other ideas include creating an agreement with global financial institutions (either imposed from above like the Basel accords or as a voluntary organization), to stop funneling dirty money out of Argentina.  If politicians had no way to get sums larger than $1 million out of the country without anyone noticing, bribe taking would be greatly reduced.  We're looking for creative and practical ideas.  

Cheers,

Ari

Invest for Kids Conference 2012

Investors,

    I had the privilege of attending the “Invest for Kids 2012” conference today, where a dozen of the most talented hedge fund managers and financial analysts discussed their macro views and their favorite investments.  My thoughts in italics.

Frank Brosens of Taconic Capital Advisors

  Favorite Investment: GM.  Sales are up 40% over the last 2 years, with stock price stagnant.  With the election out of the way, the treasury will now sell their 32% stake, at which point management will pay out $20 billion of stale cash to shareholders.  Fantastic new management recently took the reigns.  Next year is the peak of the "refresh" cycle with many new products coming to market, which boosts sales and margins.  And, they're introducing many new trucks, which are particularly high margin.  There's general pent up demand for autos, with the average car age now at 11 years, vs 9 in 2008.  Even with valuation at current low levels, the stock price could rise 200% based purely on growing revenues, higher margins, and better cash allocation.

   Last year Marc Lasry pitched GM at the Invest for Kids conference; I was interested but skeptical and didn't pull the trigger.  Now I'm convinced.  I like the near-term catalysts and GM's sales in the last year are very supportive of a higher valuation.

Nelson Peltz of Trian Fund

  Focus on the income statement - if you find $1 on the balance sheet, it's worth $1, but that same $1 on the income statement is recurring so it's worth $10+.  

  Favorite Investment: Danone.  Food companies are currently trading at a 15% premium to the S&P 500 instead of their traditional 30%.  Danone is a health and wellness food company with most of its revenue from yogurt, water, and infant nutrition.  50% of revenue from emerging markets.  Free cash flow yield of 7%.  Trading at 9x forward looking.  Forecast 50% stock price appreciation over 2 years.  

Kyle Bass of Hayman Capital Management

   The US is monetizing our entire fiscal deficit every year.  Japan is monetizing 2/3 of theirs.  It's kind of a joke listening to central bankers talk monetary policy.  They're monetizing all the debt, plain and simple.

   Favorite Thesis:  Japan is on the brink of collapse.  We've passed the Rubicon. They sell more adult diapers than children's diapers.  The ultra rich are starting to pull their money out.  Starting to see net redemptions from Japanese pensions.  The currency will collapse.

   I fully believe in this thesis, but timing has always been the issue.  I think we've likely crossed the tipping point and collapse is likely any time now, but it's unlikely to take more than 3 years.

Ari Levy of Lakeview Investment Group

  Favorite short:  IOC interoil company is a fraud.  They've somehow gained an enterprise value of $3 billion through an incredible marketing effort, despite having basically nothing of value.  They own land in Papua New Guinea that probably does not produce meaningful oil or gas.  They routinely lie to investors about those assets.  6 companies have explored and given up on the exact same land.  

  This is a good short in theory, but the short interest is 23%.  That's a recipe for a short squeeze.

   

Steven Romick of First Pacific Advisors

  Real GDP growth has been collapsing for 40 years.  It was 5.5% in the 1940s, 3.5% in the 80s, and now it's 2%, and to get the shrinking growth, we're having to use more and more debt.  

   Favorite Pick:  Renault - cyclical exposure to unpopular Europe, but 50% of sales outside of western europe.  Buy Renault and sell Nissan and Volvo against it and you're getting a free stub.  Renault could sell off its assets and buy back all its stock and you'd be getting the core operating business for free.

Alex Klabin of Senator Investment Group

   Favorite pick: Rayonier.  It's a big timber player in the US and also makes high end fiber products.  They produce 35% of the global supply of certain fiber products; great margins.  Because of growth, the company will soon have to end their REIT structure for regulatory reasons, which will likely entail spinning off the fiber business.  The whole business is being priced as commodity timber with a low valuation, so spinoff should unlock value.  He expected EBITDA will go up 50% over 2 years.  Sees 30-60% stock upside over that time period.

Steve Mandel of Lone Pine Capital

  Favorite Pick:  Verisign (VRSN).  Registry operator.  Gets paid $8 per domain name.  6% annual growth in domain names.  They sign a contract with ICANN that gets confirmed by the department of commerce that dictates the prices they can charge.  Likely to continue being able to hike prices by 40% every 6 years.  Trading cheap given the certainty of cash flows.

Sam Zell, Real Estate Mogul

  Must be a contrarian, and the confidence to do that comes from finding deep value with bottom up analysis.  

   Current macro environment is terrible and uncertain.  Doesn't see value in equities or real estate.

  Volatility is underpriced.  Bet on black swan events.

Kelly Cardwell of Central Square Management

   Favorite Pick:  NXST - broadcaster pure play.  Being unfairly lumped together with newspapers.  They're a major content creator with good asset allocation.  They've cleaned up their balance sheet in the last 2 years and are prepared to make accretive acquisitions.

Jim Grant author of Grant's Interest Rate Observer

   Interest rates are cyclical, and despite the 31 year bull market, it won't last forever.  

   Favorite Picks:  Buy gold.  It's a moratorium on the market's faith in central bankers and fiat money.  Buy Metlife insurance equity.  Smart management (hedged against the falling interest rate yields), trading below tangible book value, powerful brand, diversified sales.

Cheers,

Ari

Whatever it takes

Investors,

   We remain in a central bank dominated market.  The German Bundesbank has given the go ahead to the European Central Bank (ECB) to buy up as many peripheral bonds as they want, and the ECB has loudly announced they stand ready to do whatever it takes to keep the European Union from falling apart.  In practice that means the ECB stands ready to buy as many Italian and Spanish bonds as investors want to sell.

   The US Federal Reserve announced similar intentions.  The Fed initiated a mortgage buying plan that entails purchasing $40 billion a month in mortgage backed securities (MBS).  About 90% of all mortgages in the US are turned into MBS and new issuance totals about $150 billion a month, although a good chunk of that is naturally amortized each month.  MBS analysts estimate this will have the Fed buying about 70% of all new US mortgages, in addition to their purchases of about 100% of all 30-year bond issuance.  

   This means that discussion of the fiscal deficit or debt to GDP ratio becomes almost silly.  The treasury issues new bonds to pay for government spending, which are then quickly bought by the Fed.  There's no legal limit to how much the Fed can buy, and now it appears there's no clear political limit either.  The point is that as much as at any time in the last few years, a bet on any asset is primarily a bet on the Fed.  If the Fed doesn't want the S&P 500 falling below 1400, they can buy up whatever assets are necessary to prop up equities.  The importance of the debt is almost entirely political.  We have a looming $600 billion "fiscal cliff" at year end, when spending cuts and tax hikes will automatically take effect without congressional action.  This leads into the need for another debt ceiling hike by April of next year; the exact timing is questionable since the treasury has some accounting slight of hand they can use to push the debt ceiling a couple months forward.  

    Many of the smartest investors I follow believe the deflationary and deleveraging pressures of the credit crisis fallout will continue to outweigh the inflationary pressure of the Fed's printing press for the foreseeable future - in other words, they think the Fed's money printing won't result in significant inflation in the next 2 years.    Additionally, the next political phase in the US is one of fiscal austerity, which is naturally deflationary.  This leaves investors in a tough spot.  It's hard to love shorting any asset when the Fed stands ready to buy with an infinite bankroll, but the fundamentals are bearish.  My positioning is unchanged with long commodity-related equity exposure and short equities in general.

   Finally, I'll leave you with some random insight from the best value investor you've never heard of.  Li Lu is a hedge fund manager and Warren Buffet's pick for one of the top 3 investors alive.  In 1989 he was a student leader of the Tiananmen Square protests in China before studying at Columbia.  Here is an interview he gave and here are notes from a lecture he gave at Columbia.  Lu makes use of traditional value investor metrics like price to earnings and price to book, but describes his role more as a journalist with insatiable curiosity who, on rare occasion, stumbles across an interesting story.  Before investing, he wants to understand the business behind the stock as thoroughly as though he owned 100% of it.  He suggests gaining a similar depth of understanding of the company's industry.  

   

Cheers,

Ari

Key Themes

Investors,

   First, Obama and Merkel have tremendous incentive to keep the world from falling apart before their respective re-elections, so expect any bad news to be met with swift if vague promises of action (e.g.the hints we're currently getting out of Europe of a rate cap).  The Federal Reserve is 60%+ to launch a third round of quantitative easing before the November presidential election; if equities sell off sharply, this possibility becomes certainty, so equity downside is constrained for the next couple months, but then things get ugly.   


   The key themes of the next 3 years are:

- Austerity in the US.  After the November presidential election, the winner will have no choice but to implement austerity and will likely want to get it out of the way as soon as possible.  This austerity will decrease aggregate demand which will sharply lower corporate profit margins and therefore earnings ,and impose strong downward pressure on US equities.  

-Continued brinksmanship out of Europe that will most likely continue to unfold as it has been - a combination of monetization and effective default of periphery debt.  I don't know whether the monetization or deleveraging forces will have a greater impact.  There remains a significant risk of a disorderly breakup, but I think it is less than 30%. 

-Global stagnation.  Even without a severe drop in US demand, there simply isn't an engine for global growth over the next 3 years.  China will be working through excess capacity for the next few years, which means less demand for steel and concrete; this hurts a variety of commodity exporters, most notably Brazil.  This theme will seem to contradict the longer term theme of resource scarcity that I'm about to discuss, but as we've seen over the last 4 years, global demand for many commodities is continuing to grow even without real GDP growth.  Basically, commodities tied to infrastructure like steel, copper, iron, and concrete probably won't be strongly bid amidst weak global growth.

 - I can't call it a 3-year theme because of my general pessimism about global growth and my uncertainty of the timing, so I'll just call it a general theme - growing resource scarcity.  Jeremy Grantham of GMO has another nice write up on the long-term trend of rising agriculture and energy prices (you must sign up to read it, but it's free).  They predict that within a decade it will lead to widespread famine and social unrest, but timing is difficult.  For a long-term investor, the best approach is to gradually scale into long commodity exposure, saving plenty of ammunition in case we get a severe recession that provides very attractive prices.  


   As we head into the November elections and enjoy the recent moderate equity rally, I am growing more bearish.  I am now net short of equities and will continue to leg into a moderate position as we approach US and German elections.  I am long a few specific commodity-related equities including fertilizer producers, and crude and nat gas drillers.  I will soon be looking to expand my commodity investments to other arenas like pipeline and energy equipment manufacturers, and possibly agricultural research firms.  I still have my moderate short Yen and short US treasury positions and expect to hold both for up to a decade.  I will use selloffs in equity markets to establish long-term equity longs in china and other emerging markets.  While I still think European equities provide some value, I'd prefer to wait for a panic to entice me into that market.  I haven't yet found any specific European names that are obviously deep value investments.  

Cheers,

Ari

Europe faces reality

Investors,

   Last week, many headlines blared: "Europe finally faces reality."  There is now consensus that either the Eurozone will dissolve or Europe will finally form a true fiscal union.  Just about everyone agrees the latter is preferable, but Germany insists it will not back eurobonds or deposit insurance unless countries cede control of their budgets to a central European authority.  Most other eurozone countries (including France most importantly) are refusing to give up sovereignty.  Investors are optimistic that Eurozone leaders will quickly lay out a plan and the ECB will plug any gaps in the mean time.  To make it clear just how dire things are in Europe - both Italy and Spain will begin defaulting on debt within 4 months without additional aid.  This week, Spanish ministers began openly begging the ECB for aid for its banks, announcing that the market is refusing to finance Spanish debt. 
    I can't handicap this game and I think Europe's problems are probably fairly priced in the market.  If Eurozone leaders get their act together in time, equities will pop, otherwise they'll plummet.  There's probably no value in us betting on the outcome at this point.  I covered the last of my short euro position.
    While the world watches Europe, my concern remains the US.  Most data out of the US last week was dismal, ranging from increasing unemployment to worsening PMI indexes.  I remain very concerned that early in the next president's term we'll get fiscal tightening and the austerity will have dire effects.  Additionally, the market is now pricing in some form of additional quantitative easing, but I expect that a basic extension of "operation twist" and even large mortgage purchases will be met with an equity sell off.  Without something more aggressive, investors will rightly wonder what difference another 30 basis points in lower yields will make when 10-year notes are already at 1.6% and 30-year mortgages are at 3.8%.  Anything short of outright money printing is just "pushing on a string." 
     Back in 2008, I was convinced by my study of economic history that the collapse would likely come in two waves.  First we had a very sharp collapse followed by a sharp rebound.  Then I expected a second wave down after which equities would simply sit near their lows for an extended period, probably several years.  The first rebound happened sooner and was sharper than I expected because of the unprecedented quantitative easing.  I don't expect to time the second wave any better, but I remain confident in the general pattern.  So, I'm in no rush to get long equities in general.  Don't worry about repeating 2009's mistakes and missing the rebound.  Still, I'm a value investor, and I'm always on the lookout for specific value opportunities.  Today that means I want to find the most hated stocks so I'm looking in Europe, and in the beaten down energy sector.  My schedule as a trader and MBA student keeps me busy and makes value hunting difficult, so if anyone has any specific picks in these sectors, I welcome suggestions.  One last point - given the strong rally in treasuries and sell off in risk assets and the constant talk of Europe, it feels like the risk is for a continuation of the trend - more bad news, deflation, and "risk off."  The opposite is true.  Anyone with more than a 6 month time horizon should be far more concerned about inflation.  The market is already pricing in global recession with some small chance of global depression.  That's why investors are accepting yields of below 0% on short-term Bunds, and below 2% on 10-year Japanese, German, and US bonds.  To sleep soundly at night, we should be confident that our portfolios will withstand the surge in inflation that is very likely to start sometime in the next 5 years.    

Cheers,
Ari

Economic Commentary: A political and possibly a monetary turning point

Investors,

   The big news of the last few weeks has been out of Europe.   For the past 4 years we've had loose monetary and fiscal policy in the US and relatively tight monetary and fiscal policy in Europe.  I believe that is about to switch.  Now is a good time to identify attractive European equities and European assets that will benefit from increased spending in the near future.
- France just elected the Socialist Francois Hollande; I think he's a moderate at heart but will reverse the relatively extreme austerity that Sarkozy was championing.
- In the past week, Greece roiled markets as voters gave support to parties that are declaring all debt agreements void.
- The unsustainable debt and unemployment situations in Spain and Italy have led to increasing bond yields and growing concern, highlighted by a major bank bailout in Spain announced last week.

- Germany's bundesbank may finally be throwing in the towel on inflation and we may get another major money printing operation from the ECB soon.

  First on Hollande - the markets view him as a big question mark. He's advocating "growth" policies as opposed to Sarkozy's austerity, but no one knows the specifics.  My own take is that Hollande is really a moderate and will not make any radical changes.  Analysts are suggesting that his election and that of Greece mark a political turning point.  Voters are rejecting austerity programs that are ostensibly in the service of foreign debt holders.  However, France has no printing press.  Hollande can increase government spending, but I doubt this will have much of an impact.  French banks have little in the way of excess reserves, so just about every euro that Hollande spends will effectively cause a decrease in private sector spending of a similar amount since banks will have to buy the additional sovereign debt instead of lending; in contrast, banks in the US have lots of cash sitting under the mattress so an increase in government spending would likely increase total consumption.  Hollande might want to be profligate, but in the short-term it won't matter since France's total consumption will change little.  The key is the pressure Hollande is likely to put on the ECB to print Euros.  More on this shortly.

    I don't know what will happen with Greece, but at this point if they leave the Eurozone or default on the bulk of their debt it will be neither shocking nor particularly important to global markets.  Greece's stock market is down 90% from its highs and much of their sovereign debt has already been written off by investors.  The focus is rightly on Spain.

    Last week the Bank of Spain announced a partial nationalization of the large institution "Bankia."  The announcement included a rough outline for a plan requiring all Spanish banks to set aside more reserves, which will further reduce lending to the private sector.  I've said it before and I'll say it again - austerity has never succeeded in getting a country out of a deflationary recession in the history of the world.  Spain will either slide into crisis, or the EU will have to embark on a radical change in direction with a money printing scheme.  With Spanish youth unemployment at 55%, I'll be surprised if we don't see major social turmoil in the next year. 

    The ECB created a trillion euros as part of the ongoing peripheral Eurozone bailout...and it's clear that was no where near enough.  Spain needs more money ASAP and France will likely be demanding easing soon.  Murmurings from Germany's bundesbank suggest they will soon give in and allow further monetization of the sovereign debt.  Back in 2008, the US Federal Reserve doubled the money supply and yet deflationary forces were stronger than the money printing.  I don't know which force will prevail in the coming year in Europe, but the looser monetary policy will likely generate a bid in real assets.  I continue to favor energy commodities and related equities.  

  

    My positions are unchanged - very small short euro position, short yen, I'm continuing to gradually ease into a long-term short treasury note position, and I'm long energy related equities.  With the exception of the small euro positions, I'm viewing these positions on a 3-10 year time frame.  I want to increase my energy equity investments so if you have any particular ideas or analysis, I'd love to see it.  I also want to invest in European assets - they're incredibly unpopular and the wave of fiscal and monetary easing will provide a tailwind - and would appreciate suggestions.

Cheers,

Ari

A Global Bond Bubble - Alpha

1. OVERVIEW - WHY BONDS ARE BAD AND DANGEROUS OVER 5-10 YEARS

Within the US, UK, and Europe, there is likely a bond bubble going on currently with artificially low yields due to central bank intervention and asset purchases in bond markets. A sluggish economic environment combined with further quantitative easing and uncertainty surrounding the European debt crisis will most likely weigh on long-term yields. With unemployment high and inflation low, the Federal Reserve is likely to continue to maintain extreme monetary policies, thus depressing US Treasury yields. I expect long-duration bonds will fare the worst, while sectors of the fixed income market with credit risk outperform as risk appetite returns. Only professionals who can go long and short bonds with duration and derivative instruments (PIMCO, Doubleline, etc.) can play in the bond space today.

My general advice to passive investors: AVOID ALL BONDS TODAY. Or stick to low maturity cash-like options from countries like Canada and Australia.

But if you have to invest in bonds, the most effective ways to access bonds are through active or passively managed ETFs (lowest transaction costs plus good diversification). I prefer to take some credit risk to seek yield but I generally want shorter maturities and duration with high cash flow yields. Hence high yield corporate bonds issues, through an ETF, is our preferred space. To the extent that spreads compress further and yields stay low, I would prefer cash or other liquid measures over any fixed income.

10-Year Bond Yields are at Multi-Decade Lows and Are Close to 1940s and 1950s Lows

2. SOVEREIGN AND MORTGAGE BONDS

I am underweight fixed income relative to previous allocations because I am concerned about its near-term performance outlook. A further fall in 1-year UST yields seem extremely improbable, while a rise over 12-24 months seems likely. Our rationale for this concern is (i) fixed income is currently trading at a premium on a historical basis and appears overvalued; (ii) benchmark UST yields are near 50-year lows in the US and gilt yields are near 300-year lows in the UK; and (iii) there is limited upside potential for principal appreciation.

I expect that over 10-years the purchasing power of the USD and fixed income securities will be significantly lowered due to:
i) high and volatile inflation as economic growth picks up and the velocity of money increases (I think inflation will be 100-300bps higher than the current ~2.5% breakeven level implies);
ii) continued financial repression (negative real yields in many core instruments), as detailed in the Reinhart paper “The Liquidation of Government Debt”;
iii) Further quantitative and qualitative easing asset purchases, after which the Fed won't be able to contract its balance sheet, leading to classic monetary inflation in 2-4 years.

Breakeven Inflation Rates are Too Low Due to Fed Purchases and an Exploding Fed Balance Sheet

Finally, mortgage bonds also seem unattractive due to extreme Fed intervention through Fannie and Freddie to support mortgage bond markets. I would like to note that the 30-year conventional mortgage rate is significantly below its 40 year low. Hence any upside in mortgage bonds is superseded by the downside risks.

Mortgage Yields are at Multi-Decade Lows - The Biggest Owner of Agencies is the Fed

3. INVESTMENT GRADE CORPORATES, HIGH YIELD CORPORATES, AND STRUCTURED BONDS
Most investment-grade bonds look unattractive due to 50-year low yields last seen in the 1960s. Yet investment grade spreads and high yield spreads over USTs look decent compared to last ten years. I think this is deceptive due to the artificially low UST yields due to monetary and quantitative easing.

Investment Grade Bond Yields are at Multi-Decade Absolute Lows, Though Spreads seem OK

If forced to invest in bonds, high-yield bonds are the best of a bad lot because they have low duration (due to a higher coupon) and decent cash flow yields. Yet high yield bond spreads are not necessarily cheap/low either. Spreads at 750bps above USTs are interesting and 900bps above are attractive. Current spreads in the 600bps range are merely acceptable, given our low allocation. Our preferred vehicles for high-yield bonds are ETFs like JNK, HYG, and PHB. Our strategy here is to hold a shorter duration index and clip the coupons – the risk behind this is if rates rise quickly, an investor can get hurt fast. Finally, structured finance vehicles like CMBS are too new and have high product risk – it’s hard to get exposure there and so for now I would like no allocation to them.

High Yield Bonds with Low Duration are the Best Offering of a Bad Lot

Economic Commentary: Long Natural Gas Equities - Ari

There's "blood in the streets" as one Natural Gas investor recently told me. Nat Gas is trading below production costs for most drillers and has been so cheap for the last couple of years that many companies in the natural gas industry are near bankruptcy. I smell opportunity.

First, let's look at why Nat Gas prices have fallen so much and why I expect them to be significantly higher in 5 and 10 years. Prices have fallen precipitously because of a dramatic increase in production from new technology. A decade ago, the bulk of US production came from the gulf region and was prone to disruption from summer hurricanes. In the last few years, tremendous amounts of new production have come online in places like Pennsylvania and New York via shale extraction. This is a true game changer and means we're unlikely to see the spikes of $15 natural gas during hurricane season again anytime soon However, the current price of $2.60 is unsustainable. These low prices are persisting because at many sites, drilling produces profitable crude oil and throws off natural gas as a byproduct. No matter how low natural gas prices go, it will still be produced at these sites.

While supply will gradually fall at current prices, the bigger change will come from demand. Historically, a barrel of crude oil has traded at between 6x and 10x the price of an mmbtu of natural gas. The low end, 6x, represents thermal parity, and the high end reflects the logistical advantages of crude over natural gas. This suggests a "fair" price of natural gas between $10 and $16. A tremendous price disparity can and probably will be maintained as long as our energy infrastructure continues to strongly favor crude. Currently, it would be much cheaper to run a car off of natural gas, but we don't have many cars capable of burning nat gas, nor do we have the fill station infrastructure ready. Alternatively, we may move to electric cars that run off the energy grid, necessitating far more nat gas burning power plants. Additionally, its clearly in our national interest to shift demand to natural gas; if we could replace 50% of our crude oil imports with natural gas that we produce domestically, this would dramatically reduce our dependence on "problematic" countries in the Middle East and South America as well as reducing our trade deficit by more than a quarter.

The bigger short-term catalyst for price appreciation will likely be the export of liquified natural gas (LNG). Currently, natural gas is basically a continental market. It's very expensive and logistically difficult to transport natural gas from the US to Europe or from the Middle East to Asia. A lot of money has been flowing into creating the necessary infrastructure recently and the Japanese nuclear disaster was the necessary catalyst for demand. Japan's imports of liquified natural gas have been surging, and the global demand for natural gas has followed suit as countries like Germany reduce their reliance on nuclear energy.

So why not just buy natural gas futures? Why bother with equities? Because I view this is a 5-20+ year secular trend, equities will likely produce a significantly higher return. For example, if you buy nat gas futures and they triple in value over 10 years, you've earned about 11.5% a year, not bad, but we can probably find companies that will produce returns on capital of greater than 30% a year in the same scenario. We're likely to benefit from both the accrued corporate profits as well as a higher valuation multiple. In other words, profitable companies churn out profits every year and they benefit from the higher earnings multiple that comes with higher natural gas prices. For bets of under 2 years, I generally prefer to stick with commodity futures, but for 5+ years, equities are usually preferable. Additionally, investing in equities lets us earn additional returns from our skill in individual stock picking.

While I have growing confidence in my ability as a stock picker, small natural gas companies are tough to value without industry expertise. So, I turned to my friend Josh Young, portfolio manager of Young Capital Management, and asked for his advice. Josh recommended 2 specific energy producers that he believes are very cheap relative to their peers: Gastar Exploration (GST) and Sonde Resources (SOQ) and I have a small amount of money in each. Josh thinks these are good buys even if nat gas prices remain weak and suggested that these are not the ideal picks if we specifically want to bet on nat gas prices rising dramatically. I like these stocks as a happy middle ground to profit even if nat gas doesn't strongly rebound while giving us significant upside if it does. I expect to periodically look for additional stock picks in the energy sector over the next five years with a particular focus on companies that provide upside to natural gas prices as well as companies that will profit from investment in natural gas infrastructure.

As an aside, I recently had the pleasure of moderating a panel at the University of Chicago. Jeff Yass, the founder and managing director of Susquehanna International Group (SIG), explained how he thinks about markets and was then joined by prominent finance professors George Constantinides and Ralph Koijen. One of Yass' interesting points was that in a high volatility environment, the median of a stock's distribution will be quite a bit below the mean; since stock's have unlimited upside, the most likely future value must be below the current price since the likely loss must be balanced against the small chance of unlimited upside gain. As a result, a 50% or even 80% fall in prices is not evidence of market inefficiency.



Cheers,
Ari

Economic Commentary: Shorting Japan - Ari

Investors,

First I'll offer a quick update on the global markets and economy and then zero in on my next big bet: shorting Japanese Yen and government bonds.

The last two months have been relatively quiet for the global markets despite plenty of scary headlines. Iran threatened to close the strait of Hormuz and crude oil rallied moderately. US equities started strong on the back of better than expected employment and consumption data and were then further buoyed by good news out of Europe - Spain and Italy were more successful in their debt auctions then expected and Greece may be nearing a resolution with debt-holders for an orderly restructuring. The Euro has gradually sold off and I covered almost all of my short Euro position. I'm generally too early in covering my winning bets, but with record short interest in the Euro, the downtrend may have run its course for a while. A good line about the Euro comes from Jim Rogers; Rogers has been bearish on the Eurozone for a decade but is long the Euro at the moment because he believes that while the Eurozone will eventually collapse, it won't be this year or next.

I've talked before about Japan's coming crisis, but was reluctant to pull the trigger on a major bet because I didn't feel like I understood the timing well enough. I still don't have a clear picture of how the crisis will unfold but I believe I can structure a bet with excellent reward for the risk despite the uncertainty. I'm shorting both Japanese Yen and Japanese government bonds.
Why short Japan? First the basics - Japanese debt to GDP is around 230%, far higher than any country has ever been able to sustain in the history of the world. Social security alone accounts for 52% of the government budget. Japan has gotten away with this debt load primarily because almost all their debt is owned domestically (about 95%); the Japanese people keep buying debt that yields almost 0% for cultural reasons and because the government requires them to do so (many institutions are required to have huge holdings of government bonds). The demographic situation in Japan is rapidly worsening. The percentage of elderly Japanese is rising from 17.4% in 2000 to 25% in 2014 (versus 12.8% in the USA.) Now throw in stagnant growth in tax revenues and the fact that 25%* of tax revenues go to pay interest on the debt. This is debt that yields close to 0%! It's easy to see that if Japanese debt sells off even moderately and yields climb just slightly, the country will almost immediately have to choose between defaulting and monetizing its debt.

What could trigger yields to rise? While Japan's fundamentals have been worsening for a decade, their bonds were supported by increases in savings. The rate of savings has been gradually falling but nominal savings were increasing. The savings rate has is now on track to hit 0% and turn negative in the next few years. Another specific catalyst is that the latest data from the Japanese government suggests that Japan just experienced its first trade gap since 1963! As Japan's current account surplus vanishes, that means there's less excess capital to buy Yen denominated bonds.
So how does this crisis play out? A lot of the demand for Japanese bonds exists because the Japanese have had more than a decade of deflation. A 0.5% yield is tolerable under these conditions. Once yields start ticking higher and headlines of "Monetize or default?" start flooding Japan, at least some of the bond holders will start to sell. With every tick up in yields, the situation becomes exponentially more vicious. Even a 1% increase in long-term yields would produce an immediate cash flow crisis. Most likely, the central bank will start to purchase the bonds to keep yields down. This monetization will produce the threat of inflation, causing more bond selling, forcing more central bank purchases leading to a rapid and large devaluation of the Yen. The Japanese government would likely sell holdings of US securities to partially finance these purchases so we might see brief but sharp upward pressure on the Yen for this repatriation of government assets. Any scenario I try to envision of Japanese bond yields rising seems farfetched to me because it would be suicidal for Japan, but I'll be shorting Japanese bonds in case they choose not to monetize. In case I'm completely wrong and Japan starts to finally experience growth, this may also lead to higher bond yields so the short JGB helps to reduce the risk exposure with, I believe, a positive expectancy hedge. With long-term yields near 0, I'm getting a very cheap option on higher yields.

I should also note that a crisis in Japan will surprise many investors with its contagion effect. We rarely think of Japan as a key driver of the global economy, but Japan is the third largest economy in the world (just slightly behind China) and represents almost 9% of global GDP. Japan is also the second largest holder of US treasuries and US dollars in the world. In a crisis, they will likely become aggressive sellers to raise money.