Archive - Oct 2012 - Story

Modern Portfolio Theory (MPT) is broken. That is how we interpret Niels Jensen's (Absolute Return Partners) latest missive as he draws a concerning line between the number of managers who rely sheep-like on the diversifying 'artifacts' of MPT in a new normal world of undiversifiable systemic risks. The shifts in intra- and inter-asset class correlations (both long- and short-term) have been incredible both in terms of direction change and magnitude - for example (as Nielsen notes) - In the 2000-03 bear market commodities were an excellent diversifier against equity market risk with the two asset classes being virtually uncorrelated (+0.05). Nowadays, the two are highly correlated (+0.69). This shift to a risk-on / risk-off world, fed by central bankers, makes the empirical Sharpe ratios of olde and track records of your favorite balanced-fund manager entirely useless for any investor seeking protection from not just volatility risk but ultimate risk - the permanent loss of capital.

If there is any demarcation with profound implications going forward, it isn't the line between the 1% and the 99% or the line dividing the Status Quo into two safely complicit ideological camps: it is the divide between those who squarely face the burden of knowing the present is unsustainable and those who flee into the comforts of denial. Those who accept the burden of knowing are part of the solution, those who cling to denial are part of the problem. Those who accept the burden of knowing do not necessarily have answers, but they are alert to alternatives and potential solutions. Those in denial can only hope that reality can be buried for a while longer.

In the weeks leading into QE3 we repeatedly stated that virtually the entire impact of the latest Fed market boosting quantiative easing program has already been priced in. Below, we present this visually, while also comparing the impact of all the other (four of them) easing programs launched previously by the Federal Reserve.

European sovereign bond spreads weakened notably today - extending losses from yesterday - ending the day unchanged to slightly wider on the week. There has been a rather notable pattern though emerging in the last week as from the US Open to EU Close, we see bonds consistently sold off. EURUSD pushed up above 1.30 on a decent stop-run amid Draghi's words. It seemed Draghi was a little less dovish than in recent days - no rate cuts, more pain for Portugal, no concessions on Spain. European equities underperformed European credit for the second day in a row - playing catch down as financials underperformed.

If you are the person who sold 1,300 tons of Swiss gold in the pre-"New Normal" era, you probably would like to keep that fact to yourself. But not Michael Paprotta, or the guy who did sell 1,300 tons of gold for the Swiss National Bank from 2000 to 2005. As a reminder, the price of gold in the period was between $250 and $450, making Gordon Brown's own dump of a meager 400 tons of UK gold between 1999 and 2002 seem like amateur hour by comparison. Assuming a current price of gold of $1800 and a blended disposition price of $350/oz, this means that Switzerland effectively gave up on just under $60 billion in upside. That's ok though, the SNB's balance sheet is now full to the gills with money-good EURs. Who needs gold in a fiat regime anyway? Certainly not Michael Paprotta who gives up on tens (soon hundreds) of billions in gold upside fiat equivalents in the morning, then goes skiing in the afternoon.

If the US Government were applying for a loan, what would its credit score be? ConvergEx's Nick Colas estimates it at 655 (based on www.myfico.com) - which is higher than we suspected - but consistent with the structural belief in both sovereign and personal debt rating systems that historical payment patterns matter more than ability to pay, leverage, or loan amounts.

Alan Wheatley, Global Economics Correspondent for Reuters has written a very interesting article, 'Analysis: China's currency foray augurs geopolitical strains’ where he emphasizes China’s desire to wean out the US dollar’s currency reserve status. China is actively taking steps to phase out the US dollar which will decrease volatility in oil and commodity prices and deride the ‘exorbitant privilege' the USA commands as the issuer of the reserve currency at the centre of a post-war international financial architecture which is now failing.   In 1971, U.S. Treasury Secretary John Connally said, "It's our currency and your problem". China is frustrated with what it sees as the US government’s mismanagement of the dollar, and is now actively promoting the cross-border use of its own currency, the yuan, or also called the renminbi, in trade and investment. China’s goal is to decrease transactions costs for Chinese importers and exporters. Zha Xiaogang, a researcher at the Shanghai Institutes for International Studies, said Beijing wants to see a better-balanced international monetary system consisting of at least the dollar, euro and yuan and perhaps other currencies such as the yen and the Indian rupee. "The shortcomings of the current international monetary system pose a big threat to China's economy," he said. "With more alternatives, the margin for the U.S. would be greatly narrowed, which will certainly weaken the power basis of the U.S."

It would seem the austerity-to-social-unrest 'correlation' is proving out as 250 furious shipyard workers stormed the Greek Defense Ministry in Athens demanding to be paid their wages (which they have not seen for six months)...

The market appears convinced that it now has nothing to worry about when it comes to the fiscal cliff. After all, if all fails, Bernanke can just step in and fix it again. Oh wait, this is fiscal policy, and the impact of QE3 according to some is 0.75% of GDP. So to offset the 4% drop in GDP as a result of the Fiscal Cliff Bernanke would have to do over 5 more QEs just to kick the can that much longer. Turns out the market has quite a bit to worry about as Goldman's Jan Hatzius explains (and as we showed most recently here). To wit: "our worry about the size of the fiscal cliff has grown, as neither Democrats nor Republicans look inclined to budge on the issue of the expiring upper-income Bush tax cuts. This has increased the risk of at least a short-term hit from a temporary expiration of all of the fiscal cliff provisions, as well as a permanent expiration of the upper-income tax cuts and/or the availability of emergency unemployment benefits." This does not even touch on the just as sensitive topic of the debt ceiling, where if history is any precedent, Boehner will be expected to fold once more, only this time this is very much unlikely to happen. In other words, we are once again on the August 2011 precipice, where everything is priced in, and where politicians will do nothing until the market wakes them from their stupor by doing the only thing it knows how to do when it has to show who is in charge: plunge.

It would appear the US consumer has become entirely bipolar. Bloomberg's US Consumer Comfort index has swung in +/- 3-sigma ranges for much of the last few months as hope turns to despair and once again rises phoenix-like to hope. The last four weeks have seen the biggest rise in 'comfort' in six years - mirroring quite closely the chaos that was occurring in the lead up to the financial crisis. What is a little perplexing - with all this exuberant optimism and confidence, that factory orders just plunged off a cliff - falling the most since Jan 2009 (though slightly better than expected). Or is it so bad that it can only get better as the imploding economy is imploding slightly slower than expected?

The ratio of negative-to-positive pre-announcements for the third quarter earnings season is running at 4.3-to-1. As Citi's Tobias Levkovivh notes, this is the highest since 4.7-to-1 in Q1 2009 and shows management's clear lack of confidence about even short-term economic performance (elections, fiscal cliff, China slowdown, Europe depression). He, like us, expected management to 'trim back' earnings expectations on their conference calls - especially as Q4 EPS growth estimates at 8% are simply 'too optimistic'. Of course, that doesn't stop the thundering herd of extrapolating analysts from imagining what the world could be like - as the following three charts of Q2 2012, Q3 2012, and Q4 2012 earnings growth estimates so clearly indicate. It would seem that with the Fed less able to 'surprise' given its QEternity bazooka has been fired, and China's PBOC stymied, it falls back to Draghi to drive us to this unreality - and after today's more disappointing call, that appears less forthcoming.

There was a time when the world had (somewhat) free markets. Then Lehman failed as the inevitable culmination of a credit bubble that was second in size and severity only to the one being blown currently, and the central planners took over, converting equity, bond and FX markets into nothing but monetary policy tools dominated by central banks. Below is a great summary of how parallel to SkyNet's HFT takeover of stock trading, the central planners conducted their own not so stealthy take over of all capital markets. The chart is open-ended. Expect much more intervention by the Big 4 in the months and years ahead as the circular nature of increased central bank intervention leading to less faith in financial markets leading to increased private sector deleveraging leading to increased-er central bank intervention and so on, accelerates.

Draghi has said lots of things in today's conference, most of them regurgitated. So far the most notable item is what ha already been implied on several occasions, namely that the ECB will not restructure its holdings of Greek bonds (something restructuring professionals call debt for equity in other circumstances) for one reason:

• DRAGHI: RESCHEDULING GREEK BONDS WOULD BE MONETARY FINANCING

And there goes any hope that the Greek bonds currently in the market will soar due to an OSI restructuring. It also means that the ECB was merely, well, lying when it said that any future bond purchases under the OMT will be Pari Passu. The won't be, as this would imply, as Draghi said, a monetary financing should a PSI/OSI  restructuring ever take place in Spain. Which it will.

The now-ubiquitous prior revision higher in jobless claims made the rise in jobless claims of 4,000 seem a lot less than otherwise as claims didn't even budge the market's needle. Coming in at 367k, slightly better than expected but within the 352k to 392k range that it has been in all year, the most interesting thing we can say about today's print is "it's off the lows". After last week's significant beat, no follow through is seen as we contonue to muddle through.

The former Goldmanite head of the ECB, and CEO of DraghiFX LLC, whose only recommendation is still to not short the EUR and thus to make sure German exports suffer, is not expected to say anything too exciting or contradictory today, although he will surely be bombarded with questions about just how and when he plans on dethroning Spain's Rajoy who still refuses to play along with the program, and enact the Spanish bond buying program. Alternatively, if Draghi makes any indication the ECB is now backtracking from the OMT expansion and instead is forced to rely on first loss guarantees and other doomed ideas that failed a year ago, watch as everything goes risk off. Watch the full thing below.