Thursday, June 28, 2007

6/28 Global Financial Markets' Bipolar Disorder Even Greater than Usual

June 28 (Econotech FHPN)--Is it just me, or do global financial markets currently seem to have even greater bipolar disorder than usual?

The past few months I have been increasingly highlighting global financial markets' risks, while also noting more recently that momentum investors have been shifting into U.S. large cap and tech stocks, which in general have been laggards in the 2002-07 cycle.

Exhibits A and B just from today, compare these two stories below. First the lead story on Yahoo!Finance this afternoon; before the price rise, RIMM's trailing p/e was already 50, according to Yahoo!Finance:

"Research in Motion's 1Q Earnings Jump
Thursday June 28, 5:06 pm ET
By Rob Gillies, Associated Press Writer
Research in Motion Says 1Q Earnings Grew 73 Percent on Increased Sales; Shares Soar 14 Percent

NEW YORK (AP) -- Shares of Research In Motion surged more than 14 percent in after-hours trading Thursday after the BlackBerry maker said its first-quarter earnings grew 73 percent on increased sales and subscriber additions."

Now second, the lead front page story in this morning's "Financial Times," one of the world's most authoritative financial news sources:

"Axed deals reflect concerns over credit
By Lina Saigol and Joanna Chung in London and Richard Beales in New York
Published: June 28 2007 03:00

Companies are pulling financing deals across the globe, in one of the clearest signs yet that investors' worries about rising interest rates and US subprime mortgages could be infecting other areas of the credit world and driving up the cost of corporate borrowing ... The bonds and loan deals were pulled after investors refused to buy them under the proposed terms, demanding higher premiums and more protection. Stephen Green, chairman of HSBC, yesterday ... In an interview with the Financial Times, he said he was "worried by the degree of leverage in some big ticket transactions nowadays" and felt that "something is going to end in tears". He also warned that losses could be higher because the parcelling out of risk to so many parties across the financial system could make it more difficult to arrange a rescue - a comment that highlighted widespread and growing unease among senior banking executives ... Many investors are now reassessing risk, which could force up the cost of doing deals and cause a sharp slowdown in private equity activity. Investors appear to be rejecting deals involving the riskiest structures ... Amitabh Arora, New York-based head of interest rate strategies at Lehman Brothers, said: "The bigger risk now is that it calls into question CDOs as a financing vehicle in the corporate credit market.""

Tuesday, June 26, 2007

6/26 Emerging Markets Volatility, Regional Banks Negative Alpha Just Two More Warning Signs

June 26 (Econotech FHPN)--Due to my ongoing concerns about the global financial markets at the current time, I've been posting more frequently the past month than I feel comfortable doing. I hope that I am not becoming too short-term oriented as a result.

Emerging markets have been a clear focus of public equity market speculation in the 2002-07 cycle (there's much larger speculation in private equity, structured finance and derivative markets). In this respect, EEM, MSCI emerging market etf, is the QQQQ, Nasdaq 100, of this cycle.

Perhaps with the critical difference that EEM's p/e is now actually over an order of magnitude lower than Nasdaq's in March 2000 (I know that seems difficult to believe in retrospect, especially given how "efficient" developed financial markets' are claimed to be).

I showed in my last June 21 article (“”Goldilocks” 65 Basis Pts Higher," link) that EEM is now 2 standard deviations over its 4-year linear regression trend. Much shorter-term, over the past month since May 23, EEM has started to exhibit greater volatility.

You can see that on the attached 60-day, 60 min chart, courtesy of (left click once to enlarge).

Before May 23, EEM prices hugged the center green regression line. After May 23, these prices have been yo-yo-ing up and down. You also can see the same thing in the "true strength index" panel, with the greater oscillations around the 0 line.

To me, this chart is an early warning sign, for the following reason. Over this short-term period, reward, in this case the rate of price change, essentially the slope of the regression line, hasn't changed. Yet risk, indicated by the greater volatility (larger standard deviation of prices), is increasing.

So, EEM most recently is generating the same return, but now at higher risk. I.e., risk-adjusted return is going down, especially when you add in the additional factor of the higher hurdle of rising l-t interest rates.

Perhaps this declining risk-adjusted return may seem a somewhat subtle change if one is mainly focused on return. But I believe that when a market starts giving the same return for higher risk, it's time to start taking notice.

To be crystal clear, I am NOT predicting here imminent meaningful declines in the emerging markets, though I think the risks of that have been increasing. E.g, perhaps July might have its typical seasonal bounce, with declines to then follow.

But to continue the analogy from my June 7 article (“Equity Markets Flying Without Instruments Into a Non-Linear Storm”, link), I do think there are subsurface cracks in the ice.

In that article, I showed a chart of XBD, the broker-dealer index, with a negative alpha (risk-adjusted return) since July 2006, saying that didn't seem like a good sign for a global financial economy seemingly run for and by the Goldman Sachs’ and Blackstones’ of the world.

I-bank stocks have been weaker since I posted that due to concerns about the Bear Stearns hedge fund situation (see my June 21 ""Goldilocks"" article link).

Here is a 4-year weekly chart of another financial sector, RKH, regional bank etf, courtesy of (left click one to enlarge).

Similar to XBD, RKH’s alpha is negative, in the latter case at the lowest level of the past four years.

It’s a little difficult to see, but RKH is now below its 40-week moving average (purple line) and right near the bottom (2 std deviations) of its linear regression channel. Both served as support in Oct 2005, failure to do so again would be significant this time.

So the signs, “Warning Thin Ice,” continue to add up. Perhaps the darkest hour is just before dawn. Wall Street is probably hoping for the usual first month of the quarter bounce in July during earnings reporting season.

But perhaps these increasing warning signs mean there may be more darkness to come. That’s why I’ve recently suggested considering hedging one’s bets in the most appropriate manner for each investor.

I think most people naturally would prefer not to hear such warnings and suggestions, and I'd prefer not to give them. But no one likes losing money either, so perhaps, at selected times, it may be worth running the risk to one's credibility by making them.

Thursday, June 21, 2007

6/21 "Goldilocks" 65 Basis Pts Higher; Public Equity Mkts Lopsided Info Disadvantage; Emerging Mkts 2 Std Dev Above Trend; Laggard Large Cap/Tech Rise

June 21—(Econotech FHPN)

"Last month, Enhanced Leverage reported that its value fell 6.75% in April after the [hedge] fund's bets on the mortgage market went wrong. Two weeks later, it put the loss at 18%, spooking already-nervous investors and creditors and sending many of them running for the exits. The huge revision at least in part reflected conversations Bear Stearns hedge-fund managers had with bond dealers, three of which told them in late April that some of the funds' assets were worth less than the values stated on the funds' books ... "No one in the subprime business wants to ask the question of whether they need to re-mark all the assets. That would open the floodgates," said Janet Tavakoli, president of Tavakoli Structured Finance, a consulting firm in Chicago. "Everyone is trying to stop the problem, but they should face up to it. The assets may all be mispriced."" “Two Big Funds At Bear Stearns Face Shutdown,” WSJ, June 20, front page

"The giant market for securities backed by US subprime mortgages was thrown into turmoil on Wednesday as lenders struggled to sell more than $1bn of assets seized from two Bear Stearns hedge funds that suffered heavy losses on subprime bets. The complex securities being auctioned are rarely traded and early attempts to sell the collateral met with mixed results. The prospect of the “fire sale” knocked down prices for similar mortgage-backed assets and sent a key derivative index for the market to record lows. The rout highlights the risks investors take when they buy illiquid and hard-to-value securities. Fire sales in times of stress can trigger dramatic changes in pricing in such markets, perhaps leading other holders of assets to mark their values down and triggering demands for additional collateral from lenders." FT, June 21, front-page

"``It's a blood bath,'' said Mark Kiesel, [EVP of Pimco], the manager of $668 billion in bond funds. ``We're talking about a two- to three-year downturn that will take a whole host of characters with it, from job creation to consumer confidence. Eventually it will take the stock market and corporate profit.'' … ``When all these people see their mortgage payment and it's up 40 or 50 percent, they're going to say, `We can't stay in this house,''' Pimco's Kiesel said. ``And there are millions of people in this situation.'' … The recent increase in mortgage rates is the biggest spike since 2004. The change means buyers can afford 8 percent less house than they could five weeks ago, Kiesel said. ``Prices are going lower,'' he said." Bloomberg, June 20

Mario Gabelli: "My major concern about deals is no different than my major concern about the stock market: There is so much leverage, and the use of derivatives has built in so much leverage below the surface." Barron's "2007 Midyear Roundtable," June 18 [the key phrase here for what follows is "below the surface"]

Can Public Fund Managers Accurately Assess Private Fund Risks?

The first two quotes above are from WSJ and FT front-page articles on problems at two Bear Stearns' private hedge funds, High Grade Structured Credit Strategies Enhanced Leverage Fund and High Grade Structured Credit Strategies Fund.

The problems at these two private hedge funds is indicative of some of the financial impact of the ongoing fiasco in the subprime mortgage market, which I won't go into in this article, as it has been extensively covered everywhere else.

My focus here is on how this hedge funds' story also highlights the difficulty that public market equity investors in this 2002-07 cycle will continue to have in accurately gauging key risks in several critical areas dominated by private funds, leveraged debt and structured finance deals and derivatives.

(Btw, sorry for my article's long title, I wanted to convey all the ground covered in it. This article intersperses more pragmatic investing-oriented sections, often with charts, with ones on more "big picture" issues, as does my web site in general, so if a particular section doesn't interest you, please skip further down, thanks.)

Given that these two private hedge funds' managers themselves did not accurately know the prices (let alone values) of these structured finance assets (and Bear Stearns is considered to be one of the most knowledgeable i-banks in the mortgage markets), as indicated in the two quotes above, honestly highlighted by Tavakoli, a well-regarded expert, then what fair, honest chance does any outsider public equity investor, no matter how diligent and well-informed, have of knowing about the risks of what may happen to these two structured finance funds, and what may be their likely impact on global financial markets?

Probably virtually zero chance of accurately knowing, and that's exactly my point. And that point is not limited to whether these two particular funds may or may not work out, and what impact that may or may not have, as important as that might become.

I want to emphasize the more general point that most public equity market investors, including mutual and pension fund professionals, have no real idea what may happen not only in the case of these two particular Bear Stearns' funds, but also much more broadly no real way of accurately assessing the riskiness of potential, yet still unknown, situations in the leveraged debt, structured finance and derivatives markets, now and into the future.

And now making this public equity market information disadvantage considerably worse, the risks of playing that lopsided information game have been significantly increasing with rising 10-year rates the past few months, which is making it more difficult to even price some of the more esoteric private securities, as mentioned in the quotes above, let alone assess their real future economic value.

To re-iterate the analogy about unseen sub-surface cracks in the ice of bullish investor psychology from my June 7 article, "Equity Markets Fliying Without Instruments Into a Non-Linear Storm," link, public equity market investors and fund managers simply have no way of being intimately familiar with the working details and hence actual risks of various critical markets, most of which are dominated by private players, especially leveraged debt and structured finance deals and derivatives, in the 2002-07 cycle. (Another key sector in this cycle, emerging markets, is also very difficult for U.S.-based equity investors to adequately assess.)

It's not that well-informed public equity market managers are not very aware of these opaque private markets and issues, many have diligently, professionally stayed on top of them, in general outline.

And these issues are well covered in the mainstream media, as indicated by the front-page quotes leading off this article, and on many informative web sites, including those I’ve provided links to on my web site (right below the long list of my own articles in the “Links” section on my web site link , with special thanks to those that post and link to my articles and site).

Nevertheless, whatever public knowledge is available is almost always from an outsider perspective into mostly private, and often deliberately opaque, markets. (Global central bankers and financial regulators are often in a similar informationally disadvantaged situation, and along with multinational economic organizations, have been saying so for years now.)

Unfortunately for public market equity investors, these more opaque private markets are where the main financial action is in the 2002-07 global boom, one key way in which this cycle is significantly different than the tech bubble of the late 1990s.

Back in that earlier bubble, when private hedge fund LTCM ran into huge trouble in Sep-Oct 1998, briefly freezing up global financial markets, the Fed stepped in with interest rate cuts and organized a Wall Street bail-out of LTCM, then the main action quickly shifted back to the enormous speculation in the public equity markets in 1999, with Nasdaq up over 80% in a huge torrent of legal but nevertheless essentially negligently, if not even fraudulently, mispriced IPO's, with the role of private hedge funds far smaller in aggregate than today.

In that bubble, which of course ultimately worked out extremely poorly for most public equity market investors in the deep bear market of 2000-02, public equity fund managers knew all the critical working details of the IPO deals they were involved in, even though they tended to get caught up in the hype and lunacy, for obvious self-gain and/or self-delusion.

But public fund managers were at a huge information disadvantage to the private venture capitalists and i-banks feeding the IPO's into the public markets, an inherent information disadvantage that private equity firms once again fully intend to take huge advantage of in this cycle when they go to sell back their LBO's into the public markets, more on this in a section below.

So, to sum up, a not insignificant risk for public market equity investors right now that I continue to believe is underappreciated is that most of them, including professional mangers of mutual and pension funds, less so in private hedge funds that are involved in many private equity and structured finance deals, are assuming a level of safety for which their daily working knowledge simply is not adequate to assume, and thus are probably overly complacent.

As I've said, public equity market investors are not unaware of the risks in their lack of working knowledge of these leveraged debt and structured finance deals, but because they do not know the deal details, most, including public market mutual and pension fund managers, seem to assume that these deals must be okay, simply because nothing has happened so far, until proven otherwise, in which case it might be too late.

For a structured finance professional's assessment of the Bear Stearns' hedge fund situation, see this June 20 video interview of Andrew Brenner on Bloomberg link.

U.S. Equity Market Valuation Now 20% Less Attractive than Three Months Ago

By my back-of-the-envelope calculation, just plugging a few numbers into the ultra-simple “Fed” valuation model, the S&P 500 is about 20% less attractive today than it was just three months ago in early March (as of June 20, the 10-year bond yield was about 12% lower back in early March, and the S&P 500 price, hence p/e, was about 10% lower back then, assuming consensus 2007 estimates haven’t moved up too significantly since then, though first quarter earnings were signficantly better than previously drastically reduced expectations).

Yet so far, global financial markets don’t seem to care very much. If one wanted to explain or rationalize this, then perhaps you could say markets may just be about 20% less undervalued now than they were then, though based on both cyclically and secularly extremely high earnings and profit margins, and still historically low long-term interest rates, with it still being too early to tell if that critical secular disinflationary downtrend line since the 1980s has been decisively broken.

(The recent move up in long-term rates was due mainly to an increase in the extremely low term premium, since estimtates of both long-term real growth and long-term inflation have barely moved, though many have questioned the accuracy, even legitimacy, of the still relatively low inflation data from the government.)

The still consensus belief is that the combination of strong global economic growth and high liquidity continues to create a best possible “Goldilocks” investment environment, especially for record-setting m&a and lbo deals and emerging markets. "Goldilocks" is perhaps a little less attractive with 10-year bond yields 65 basis point higher than three months ago.

To be sure, there is no shortage of hand-wringing over this Goldilocks view. One can constantly read of all the various concerns of mainstream investors, economists, regulators, journalists, etc. consistently in Bloomberg and FT articles, let alone the more dire ones of the Net denizens.

Needless to say, one of the key sectors on everyone's radar screen remains the residential real estate market, which has just had yet another leg down of bad news, mainstream views of this recent news are discussed in these two video interviews on Bloomberg on June 18, link and link.

Here is a chart of XHB, the homebuilder etf, courtesy of (left click once to enlarge).

XHB tracks the changing sentiment regarding the outlook for the U.S. housing market. The small upturn in sentiment in the second-half of 2006 topped out in early Feb with renewed concerns about sub-prime lending woes. XHB is now at its previous April 2007 low, breaking that and going toward the lows of last summer 2006 would be a poor indicator not only for this critical sector, but obviously also for the overall U.S. economy.

And of course, the converse would be that if XHB were to hold here at the April lows, that might become a double bottom and a higher low from 2006, thus indicating that perhaps the worst, in terms of expectations, is over for the homebuilding sector.

But so far none of these highly articulated concerns have dented global markets very much, other than throwing small periodic scares that the global hyper-speculators still quickly shrug off.

Despite far lower equity valuations, this is now getting to feel just a little similar to 1999-early 2000, perhaps not accidentally, though once again, the main excesses this time around are in the global credit, not equity, markets, valuations in the latter are far below the earlier bubble, while credit spreads remain at or near historically record low levels, even after the recent rise in long-term rates.

I recall reading around five years ago about a study, by Ned Davis research I believe, that said that since 1950, the S&P 500 has averaged a 50% increase from its low in the second-year of the 4-year political cycle to its high in the third year.

At that time, Nasdaq had gone up up over 80% in 1999, it later went up 50% in 2003. So far this time around, as if on schedule, the S&P 500 is up 25% from its closing low of 1224 in June 2006.

Unfortunate Evolution of Global Financial Markets: Transfer of Risk to the Public for Private Gain

"Blackstone IPO seven times subscribed amid overseas demand," FT, June 21, lead headline

Today's FT lead headline on the Blackstone IPO runs opposite one that says, "Subprime sector hit by $1 bn assets sale," so while the latter sector remains in the outhouse, the private equity sector is clearly enjoying penthouse status.

Perhaps one of the key features in many aspects of the current global economic and financial landscape is the transfer of risks to the public for private gain. One sees that in the corporate sector, with "at will" employment contracts, outsourcing, pension and healthcare looting, etc., and may soon see it politically with respect to Social Security, Medicare, Medicaid, etc.

One can view much of what is going in the financial markets in a similar way of public risk transfer for private gain, most especially with rampant, record-setting private equity deals. As I say, they call it "private" equity for a very good reason.

Of course there is absolutely nothing wrong with private capital, per se. In fact, one can make a very plausible argument that private capital may be inherently far less manic and irrational than public markets (can you picture Jim Cramer at Blackstone?)

That is perhaps because, with private capital, crucial confidential corporate business information can be readily shared between the financial sector and corporate officers, which simply can't be efficiently done in U.S. public markets, and is now completely illegal with the so-called level playing field.

(This more efficient transfer of confidential corporate information also characterizes Asian and European bank-based financial systems and their more industrial customer base, systems which have had other drawbacks--alas, there is no perfect system.)

But there are at least two glaring issues with the current private equity boom/bubble.

First, and more relevant here, currently private equity has increasingly become essentially a legalized con game (hence my term ROLLL, return on leverage legal looting), in which the inevitable sucker to be played almost always is fully expected and projected to be the public investor and public corporations, which have incredibly far less inside information and financial incentives than the private equity side when the expected transfer of assets, at wildly overly inflated prices, is made back to the public.

I'm ignoring the inherent enormous information disadvantage, huge financial incentives, and obvious legal conflicts of interest in any LBO with senior corporate management participation, in which management essentially forsakes its legal fiduciary responsibility, in order to trade against public equity and bond holders.

(Private equity supporters attempt to cover up these various inherently unfair con games by claiming that pension funds are increasingly beneficiaries of the con. That's like saying private equity robs Peter, the public, to pay Paul, themselves, then gives a little back to Peter. Same, btw, with private equity philanthropic giving.)

A second glaring problem with the current version of private equity, as I've said several times before, especially in my long Dec 19 article on "World Needs Better "Face of American Capitalism" than Private Equity" link, is that it focuses mainly on sheer financial leverage and hence excessive short-term corporate cost cutting, at the expense of longer-term investments in innovation.

That cost-cutting focus may have made some sense in the 1980s LBOs, but at this point it is the exact opposite of what is necessary for corporate incentives, since corporate America have been cutting to the bone under various guises and banners--total quality management, restructuring, reinventing, lean production, outsourcing, offshoring, six sigma, i.e. repackaged tqm, lean six sigma, etc.--for well over twenty years now.

Not that there's anything wrong with these efforts, per se, especially in terms of improving quality of products and services, and hopefully customer focus, though that they tend to more internally oriented. Rather it's simply that the emphasis needs to be on innovation and growth, and especially with products and services that address the still glaring unmet needs of the vast majority of the global population.

To put the private equity legalized con game in human nature terms, the basic thing wrong with current private equity excesses ironically may not be that much different than the very same thing that inevitably undermined what private equity would claim to be its polar opposite, socialism and all other utopian schemes, namely rampant human greed and excessive power that is unchecked by any publicly accountable strong enough countervailing power.

Btw, the same has probably been true in the political arena. Due to the current lack of effective, sufficient countervailing power, both market and political, neither private equity excesses and more generally global hyper-speculation, nor current political policies seem to have much chance of changing in the near future, but that's a whole other story (for those interested, see my 17,000 word Oct 27 article, "Global Strategic Bargin: Positive Reality Therapy for America's Critical "States of Denial," link).

Global Emerging Markets Currently 2 Standard Deviations Above 4-Year Trend

As I've said in my most recent articles (e.g. on May 31 link), to me most key charts still look very over-extended, even though they haven't wanted to go down, as of yet. This view obviously presents a dilemma, the specific nature of which and how to address it (try to hedge risks perhaps trying to time entry and exit points to keep hedging costs reasonable, ignore rising risks, lighten up, lower beta, etc) depends on one’s own particular investment positions and outlook, financial situation, risk aversion, etc. (hence I don’t give investment advice on my web site link).

Anyway, I’ll discuss once again EEM, the MSCI emerging market etf, since emerging markets have clearly been the market leader in the 2002-07 cycle. With EEM outperforming the S&P 500 and Nasdaq 100 by 4 to 1 over the past four years, it’s difficult for me to see how this cycle can end without this chart eventually rolling over. This is a four-year weekly chart of EEM, as of June 20 close, courtesy of, except without my usual log scale (as I will explain shortly), left click to enlarge.

The key message on the chart is that EEM still seems to be very over-extended, using simple linear regression analysis. The center green parallel line is a linear regression line generated statistically.

(I use regressions because, if you get the endpoints right, which is the key to accurately depicting a trend using this approach, then simple regression trendlines are fairly “objective” (ignoring the issue of which regression technique to choose) and thus helps to minimize the all too human condition to see and draw trendlines that one wants to see, per my comments on investors bull/bear “cognitive dissonance," in "A Tale of Two Cognitions, Bull and Bear" on June 4 link).

The parallel red lines on this chart are 2 standard deviations away from the center trend line, the parallel green ones 1 sd, and the blue ones 1.5 sd. (These parallel lines excessively curve on a log scale chart due to EEM's very large percent price change, about 240%, over the past four years.)

Two sd’s indicates that 95% of the observations fall between the red lines (assuming a bell-shaped normal probability distribution).

EEM is now at the red line, 2 sd's above trend. I chose that color to indicate a clear warning, i.e. that if this trendline is correct, and that is the key if, then there would seem to be a rather low probability of strong gains from this level, prior to, at minimum, a sideways consolidation, or maybe worse a sharp pullback, as occurred in May-June 2006, or perhaps then becoming the beginning of something worse over time.

Is such a pullback statistically pre-ordained? Of course not.

E.g., we could easily imagine or draw other plausible steeper trendlines, such as one connecting the previous major high in April 2004 and April 2006, which would make EEM seem less overbought (I haven’t done so to avoid overly cluttering this chart for presentation purposes). Or if EEM were to continue strongly up, it would have the effect, over time, of simply steepening the slope of the regression channels, making the up move look more reasonable, in retrospect.

Nevertheless, to me, at this moment, this regression line is the best fit look I have, coming off the March-April 2003 (Iraq invasion) lows, and so the odds seeme to be stacked against a strong up EEM move from here. The same picture emerges using different timeframes, and also using other leading indexes, etfs, etc., though U.S. major indexes are generally less overextended, as I discuss regarding QQQQ, the Nasdaq 100, below. The U.S. market hasn't wanted to go down in seasonally weak May-June, and it's soon to enter seasonally better July and August.

Going back to the 4-year cycle numbers I mentioned earlier, could global equity markets go much higher? Perhaps could global markets be in an era not only of serial multiple asset bubbles, which many observers now readily concede, but bubbles of such magnitude that the 1998-2000 equity market "innovation/productivity" tech bubble was not just a once in a lifetime experience, but rather one of a series of seemingly once-in-a-lifetime bubbles (as already was the case with the follow-on global real estate "re-rating" bubble)? E.g., could the emerging markets boom just continue right off the charts, so to speak?

Of course, China's white-hot equity markets are on everyone's radar screen nowadays, so here is a chart of the Shanghai composite, courtesy of (left click to enlarge). Obviously this index is once again at an important point, namely whether, after its recent sharp pullback to once again its 50-day moving average, it can take out its previous high, as it quickly did after the smaller pullbacks in Feb and April of this year.

It is extremely difficult, perhaps impossible, to guess the top in any parabolic market like this. Do you think it is likely for most American equity investors, including professionals, to do so for a huge country across a huge ocean that they have very little understanding of?

Too harsh? How many American investors even know the names of the leaders of China and India, let alone how much steel China is currently producing--the overwhelming majority would be shocked by the answer in comparison to the U.S. In fact, I use these questions as everyday litmus tests, and no one gets them right, just like no one came even remotely close to guessing Nasdaq's p/e at its all-time peak, for many more years to come, in March 2000.

Btw, to shift gears, there are several good independent analysts who have done excellent work for a long time, often combining fundamental and technical data from a huge number of data series into their numerous models, among them the above-mentioned Ned Davis, Steve Leuthold, John Hussman, Jim Stack, etc. E.g., here’s a June 18 Bloomberg interview link with Leuthold that is representative of the views of those who do so much hard work, in his case he's recently reduced his equity asset allocation.

Update on Nascent Shift into U.S. Large Cap and Tech Stocks

For both momentum investors and die-hard U.S. large cap and tech stock ones, the latter haven't had too much to cheer about in the 2002-07 cycle, there is some ongoing rotation into these stocks, as I noted in my May 31 "Brief Update on U.S. Materials, Retail, Large Cap/Tech ETF Trends link. Another indicator of the same nascent speculative sentiment shift is that the long-term alphas, risk-adjusted excess return, of the semiconductor index and etf (SOX, SMH) are just now turning back to positive.

QQQQ, the Nasdaq 100 etf, is only 1 sd above its lackluster 4-year trendline, as shown in the 4-year weekly chart below, courtesy of (left click to enlarge), encouraging the current buy-the-laggard mentality for tech sector stocks. Also note in the bottom panel that QQQQ alpha has just turned positive.

Cyclical GARP-type tech bulls have lately started bidding up such stocks as Micron (MU), a commodity play hence usually a good indicator of increasing tech sector speculative sentiment (some also like it as a longer term play on video bandwidth secular growth), while growth bulls continue to love such much more highly valued tech stocks as AAPL, GOOG, RIMM, AMZN, and smaller ones like RVBD (an emerging leader in WAN optimization).

Here is a 60-day, 60-minute chart, as of the June 20 close, of QQQQ, the Nasdaq 100 etf, courtesy of, left click once to enlarge. Due to the length of this article, I'll keep my description of this chart briefer than usual.

QQQQ has been in modest uptrend the past two months, consolidating the sharper gains off its March lows. After breaking down to the bottom red line, it had its almost requisite short-covering bounce last week, but so far only back to the center green trendline, which is also near the purple trendline connecting recent tops, both now around 48, before turning down June 20 afternoon, again about on schedule. For the uptrend to continue, 48 eventually needs to be taken out.

If and When to Hedge?

As I've tried to imply earlier in this article and in recent previous ones, while I have consistently presented "the long-term uptrend is your friend" view on my web site since the middle of the sharp global sell-off May-June 2006 (starting with my June 2, 2006 article link), now might be one of those times to consider incurring the costs of hedging your bets, in some way to some extent, depending on your preferences. Again, in terms of timing a hedge strategy, July, like most first months of each quarter, tends to seasonally stronger, after negative earnings news comes out in the previous month.

Why consider hedging at all at this time? Perhaps one reason is the one I led off with in my June 7 article link and this one, i.e. one of the key differences in this 2002-07 cycle is the opacity, often deliberate, of critical markets to public market equity investors, including professionals, and that rising long-term rates have now made these information gaps considerably more risky to continue to ignore.

To finish up, here are a few quotes, in alphabetical order, without my editorial comment from this week’s mid-year Barron’s roundtable update (I may add a few more quotes from the second part of this roundtable later today):

Scott Black: "the index, at current levels, sells for 17.6 times earnings. The market is about 10% overvalued. That doesn't mean it can't go up ... Another problem is the casino mentality of many market players. Between the hedge funds trading in and out and the private-equity people chasing stocks at very inflated multiples of price to enterprise value ... And there seems to be no fear ... [what could break this cycle?] You almost need to have a hedge fund blow up, or a couple of private-equity deals go south. The private-equity business is more of a fee-gathering business now than an investment-performance business."

Marc Faber: "A lot of money flows into the pockets of affluent people ... The economy of the middle class and the workers is not doing particularly well. The U.S. stock market, like all other asset markets, is in cuckoo land. We have bubbles everywhere, which hasn't happened before ... those markets have become correlated with the U.S., so if the S&P goes down 5%-10%, nothing much will go up. If the S&P drops 10%, emerging markets easily could drop 20% or more ... The S&P either will really begin to correct, or continue to move up, perhaps until August, and, like in 1987, have a very sharp setback in the second half ... And it's not just hedge funds. The whole system is geared to taking a lot of money out of the pockets of clients. Where are the customers' planes?"

Mario Gabelli: "We are no longer at the dawn of the fourth major takeover boom since the 1950s. But we are certainly not at the sunset. We are probably just starting the mid-afternoon. When does the stress-testing come? In 2009 or '10. Deals with covenant-lite provisions can cover two years of economic challenges. At the end someone will overpay, there will be an episode of insider trading, or something. A lot of garbage will surface."

Bill Gross: "Corporate bonds for the most part, and high-yields, and certainly subprime debt are moving into a vulnerable period, unless the economy really snaps back to its good old healthy self. We don't see that happening."

Art Samberg: "The S&P 500 is up about 7%, or 15% on an annualized basis. That's too much, so I'm sure we'll get hit over the head soon. Adjustable-rate mortgages really started resetting in May and the resets peak around January, so housing-market troubles could impact the stock market in the second half. There will be another consumer scare between here and the end of the year. We'll get some kind of a correction. But the big drivers are corporate profitability and all the money sloshing around. Not much has changed since January."

Felix Zulauf: "We had a mild and short correction in late spring, and likely will get a sharper one in the third quarter. But this is not going to be the end of the bull market. It will shake out a lot of investors, and then the market will go up again. Eventually, the difference between a 7% earnings yield and a 5% bond yield will be arbitraged away through all sorts of merger and acquisition activity, corporate buybacks, private-equity deals and such."

And from Greenspan from the previous week on Bloomberg, again without editorial comment:

"Referring to historically low premiums on emerging-market debt, Greenspan said ``it ain't going to continue that way. And indeed, all the spreads you are looking at, including your spreads relative to the 10-year, are going to start to open up and the 10-year is going to be moving as well.'' ``So I'd suggest someone out there is not going to be as happy as we are today,'' Greenspan said" Bloomberg, June 12

Thursday, June 07, 2007

6/7 Equity Markets Flying Without Instruments Into a Non-Linear Storm?

June 7 (Econotech FHPN)--At the risk of writing too frequently, I think the current investment environment merits more rapid updates than I usually do.

Two Potentially Critical Blind Spots For Global Equity Investors--They Call It "Private" Equity for a Reason

I would like to make two key points that I think are not as widely understood as need to be right now.

First, at certain critical inflection points, there is not a linear, one-to-one relationship between rising interest rates and rising market risk. Rather at some point, rising interest rates might more rapidly move global markets downward, I used the analogy of cracked ice (investor psychology) giving way in my June 4 article link.

I.e., if interest rates continue to rise, especially with the 10-year bond yield now over 5%, things may get rather more risky rather more quickly than overly complacent global financial markets still currently expect, again especially due to the fact that global markets are so highly dependent in the 2002-07 cycle on very leveraged m&a and lbo deals and emerging market debt, and because of the weak state of the mortgage market, especially with upcoming ARMs upward resets.

(See section on "volatility shock" in my April 13 "When Leading Fund Mgr Talks, Do People Listen," link, one of three "heads-up" articles with similar titles that started with my April 4, "When Citibank Chief Exec Talks, Do People Listen," link.)

Second, another critical point that I would like to re-emphasize is the lack of transparency for American equity investors, including professional, of both the leveraged debt markets and debt and equity emerging markets.

Again using the analogy of subsurface cracks in the ice, almost all equity investors, professionals and gurus included, simply are not well-equipped to see leveraged debt and emerging market cracks in the ice of global investor and business psychology, that’s one of the key things that makes the 2002-07 investment cycle so different.

To put it as bluntly as possible, most professional equity investors, even very incredibly successful ones, have very little actual, real-time working knowledge of what is really happening in these two critical markets, leveraged debt and emerging markets, and may be very surprised by events in them.

Despite Market Uptrend, Alpha Weakening for Key Sectors

I’ve previously noted that alpha, risk-adjusted excess return, of EEM, the MSCI emerging markets etf, has been coming down to near zero, and how this might trigger a flight of momentum money should the bullish psychology on/off switch suddenly flip. (See my May 24 "When Greenspan Talks, Do People Still Listen?" link)

Similarly, here is 4-year weekly chart of another critical sector, $XBD, U.S. broker-dealer stocks, courtesy of (left click once to enlarge for better viewing).

Note that its alpha, bottom panel, is negative. Since the global economy now often seems to be run by and for the benefit of the Goldman Sachs’ of the world, this negative alpha wouldn't seem to bode too well, and rising interest rates usually doesn't help the record-setting deal flow that drives this sector.

If Current Uptrend Might Be in Jeopardy, Which Timeframe Are We Talking About?

Whenever Wall Street, the mainsream media, experts, etc talk about uptrends, they almost always fail to make clear which timeframe they are talking about.

Right now there are at least three, nested "current uptrends," from most to least important: the long-term, from the Oct 2002/Mar 2003 lows; the intermediate-term, from the Jun-Jul 2006 lows; and the short-term, from the Feb 27 2007 lows.

The practical investment/trading problem is that no one knows, of course, if the short-term uptrend ends, whether it will stop there, and that the intermediate and longer-term ones will not in turn subsequently end.

For the past month or so, key markets have been at the top or even above their regression channels in several different timeframes on my charts, e.g., as I've previously shown with XLB, the materials sector etf, a key beneficiary of the huge growth in emerging markets. (See my May 31 "Brief Update," link)

That overextended, increasingly risky situation needs to be taken into account right now, though I consistently have given the benefit of the doubt to the current uptrends staying intact until clearly broken, and even though global liquidity and a record-setting global m&a deal binge have been propping up global markets.

Monday, June 04, 2007

6/4 A Tale of Two Cognitions, Bull and Bear

June 4 (Econotech FHPN)--I added the last phrase to the quote below from my May 31 article link to help make the point in today's first section.

“Financial Leverage May Boost Global Economic Growth,” Bloomberg headline, June 4, 2007

“The global economy, led by China, India and other emerging markets, is in arguably its strongest five-year boom in history, in terms of sheer scale, scope and speed, and unfortunately also of financial leveraged speculation.” Econotech, May 31, 2007

“It was the best of times, it was the worst of times.” “Tale of Two Cities,” Charles Dickens, 1859

Unprecedented Both Global Growth and Speculation May Cause Cognitive Dissonance for Market Analysts

“Basically, cognitive dissonance is a state of tension that occurs whenever an individual simultaneously holds two cognitions (ideas, attitudes, beliefs, opinions) that are psychologically inconsistent. Stated differently, two cognitions are dissonant if, when considered alone, the opposite of one follows from the other. Because the occurrence of cognitive dissonance is unpleasant, people are motivated to reduce it;” “The Social Animal, 8th ed,” pg 182, Elliot Aronson, 1999 [bold emphasis in original]

In the 2002-07 global market cycle, both the global real economy and global leveraged speculation are very strong, in fact both are at record levels.

Perhaps to unconsciously minimize cognitive dissonance, permabulls (Wall Street) constantly emphasize the former, the unprecedented growth of the global economy, while permabears (common on the Internet) continually analyze the latter, the unsustainability of huge global speculation using debt.

However, both are different views or frames of the same seamless overall reality, and thus need to be simultaneously kept in mind in order to optimize investment results.

Two Monday Morning "Heads-Up" Charts, China's Shanghai Composite and U.S. 10-year Treasury Bond Prices

In the attached chart (left click once for better viewing), courtesy of, since China's stock market peaked on May 29, the more well-known Shanghai Composite is now down -15.3%, the newer CSI 300 -15.7% The index closed on its 50-day moving average for the first time since the beginning of Sep 2006.

So far global markets have shrugged off this equity market correction in China, the strongest global equity market this year. Global equity markets are making new highs, as if money is flowing out of China into the U.S., Germany (the strongest developed equity market this year), Japan (the latter two showing somewhat less anemic economic growth than has been the norm until recently), and elsewhere.

Wall Street has offered up the usual rationalizations for this lack of concern, such as China's stock market is small, its correction is overdue and won't impact China’s economy, the U.S. economy is re-accelerating after a weak first quarter, corporate profit growth remains strong, etc.

These are all plausible sounding, except if/when a correction in China or elsewhere were to become more serious. Then you may hear a different set of stories. For now, it's too early to dismiss China’s ongoing correction as something not to be concerned about more globally.

Second, the rise in U.S. 10-year bond yield to approaching 5% is starting to get a little worrisome for stocks, see attached Treasury bond price chart, courtesy of, left click once to expand for better viewing.

To use an out-of-season metaphor, this rise in yields, decline in Treasury bond prices, can create small subsurface cracks in the global markets’ ice (i.e. support levels of bullish psychology) that can widen and give way, with a loud bang, more suddenly than may seem obvious right now on the surface, especially given the huge amount of leveraged deals which are driving global markets, and the fragility of the real estate mortgage market, especially with ARMs resets.

Challenge to Private Equity: Innovation, Not Cost-Cutting, Drives Economic Growth, Living Standards, Asset Values

“"We're in two different industries," says Ted Schlein, a venture capitalist at the Silicon Valley firm Kleiner Perkins. "We recruit. We help companies sell product. We do business development. [Private equity] is not an industry that can talk about creating ten million jobs."” “Raising taxes on VCs,” Adam Lashinsky, Fortune magazine, May 16

I have my own long-standing criticisms of overly opportunistic venture capital as the major focus in the U.S. of a business model for innovation, but I agree with the above vc quote with respect to private equity.

Huge confusion is caused by the fact that Wall Street and the mainstream media, in their self-interest, would have you believe that immense leveraged financial speculation, especially by private equity, is helping to drive the global economy, e.g. the Bloomberg headline at the beginning of this article which makes very explicit the implicit assumption of much mainstrean financial coverage.

One "enlightened" form of this argument, sometimes favored by economists and vc/technology types, is that financial speculative excesses, bubbles, are a necessary evil, so to speak, a small price to pay in order to incentivize and drive innovation and strong economic growth.

Rather, I believe that the exact opposite is the more accurate view, that not only are huge financial speculative excesses unnecessary and harmful, but also that the immense growth in the global real economy, led by China and India, is what is allowing huge global speculation, what I consistently call return on leveraged legal looting (ROLLL), to essentially skim off record unearned speculative income. (For elaboration, see my long Dec 19 article, "World Needs Better "Face of American Capitalism" than Private Equity," link.)

The paper “wealth effect” on economic growth of rampant asset/debt bubbles, concentrated at the very top of the income/wealth pyramid, can only support cancerous or parasitic speculation to some limit, though no one seems to have any idea how long that may be.

In the economists' infamous "long run," ROLLL can not support global valuations that are currently based on an extended future period of strong, low-inflation growth. E.g., there is a very large but still only finite number of m&a restructurings that can be done that emphasize cost-cutting, outsourcing, layoffs, speed-up, health care and pension looting, etc., let alone that make business and economic, or even financial and political, sense.

A couple of decades ago, economists finally figured out what entrepreneurs have always instinctively known, i.e. that innovation and real productivity (not working more hours for less money, since 1972 real median weekly earnings are down -15% in an unprecedented shift in American history) is what drives long-term growth in the real economy, living standards and asset valuations. (Hence my web site's tag line, "Finance Innovators, Not Speculators" link.)

Unless and until private equity, which is on pace to smash last year's record, makes the case that it is driving innovation and real productivity, it is an exercise in unjustly enriching a very few, including the corporate CEO’s who have unavoidable legal conflicts of interest in making buy-out deals on their own behalf, and even worse, tremendously distorting incentives for the allocation of scarce corporate resources, especially human talent, and developing markets capital (which is funding unprecedented U.S. current account deficits driven by paper "wealth effects").

In other words, concretely, what innovative, useful products, services, processes, etc., is private equity creating better than had been done before? I've never read or heard of one, so far.