Friday, October 5, 2012

Whatever it takes


   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.  

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