January 4, 2010

2010 Asset Allocation Review
January 4, 2010

The Thumbnail Portfolio

Equities-up, then down
Bonds-Corporates up, then down. Treasuries down, down, down
Currencies-dollar up, then down
Commodities-up, up, and way
Precious Metals-sideways, then up
Real estate-down to sideways

1) The Economy I am not of the 'V' or 'W' persuasion, but see a 'square root' shaped economic recovery, a 'V' followed by a long, modest rise. After a gut churning plunge in 2008 and early 2009, we are now seeing a bungee cord bounce back. GDP growth could see rollicking great 3%-4% annualized growth rates through Q1 2010. After that, you're going to need a triple shot espresso to stay awake, because growth will settle down to a more somnolencent 2% annualized rate. You can't have robust growth without credit or consumers, both of which are still missing in action in our last conflagration. It's anyone's guess how much toxic waste lies buried in bank balance sheets, so it's going to be a long time before the return to bidding for market share with free credit cards, low teaser rates, and liar loans, or their next generation iterations. The 'shadow banking system' proved to be just that, a shadow. There are still great swathes of the credit markets that have yet to make any recovery at all, like securitized home loans, auto loans, and credit card debt. Anything real estate related, commercial or residential, once a big part of GDP, will be dead weight. Another albatross around the economy's neck are thousands of states and municipalities that are sucking money out of the economy faster than the federal government can pump it in. Since we are not creating the new industries essential for real job growth, I believe the unemployment rate will stay stubbornly high  at around 10%, much like Germany has seen for decades. The jobs that decamped for China or vaporized on the Internet are never coming back. With tens of millions wiped out, and most of the rest recovering from a halving of their net worth, don't hold your breath for a consumer spending boom. Sure, there were a few more in the stores this Christmas, but most of those were probably shoplifters. Frugality is here to stay. The economy is also going to have to kick its addiction to government stimulus spending, which has accounted for the bulk of the actual growth we have seen this year. If all of that were not bad enough, headwinds in the form of rising interest rates are certain to hit sometime in 2010, either to rescue a collapsing dollar, or because of a sheer volume of government borrowing, or both. What growth we will see in the global economy will be 80% an emerging markets story. As much as I'd like to shout from the roof tops that happy days are here again, I see nothing but storm clouds on my Doppler radar.

squareroot-4.jpg picture by madhedge

2) Equities (SPX), (EEM),(EWZ), (RSX), (PIN), (FXI), (EWY), (EWT), (IDX)

I'd rather get a poke in the eye with a sharp stick than buy equities right here. At a PE multiple of 20 times earnings, US equities (SPX) are at the top of a seven year valuation range. Emerging markets are even worse, with China sporting  positively bubblicious multiples. There is no doubt that corporate managements panicked at the beginning of 2009 and chopped overheads at an unprecedented rate, leading to the eye popping 700,000 monthly nonfarm payroll losses we witnessed. With the economy snapping back faster than any of them expected, they accidently created the widest profit margins in history. Don't expect lightening to strike twice in the same place. Those margins can only shrink from here, either through the long delayed rehiring of workers that bumps up costs, or because of a double dip recession that slashes revenues. Equities are a lose-lose trade here, threatening more downside than upside. Barton Biggs taught me to always leave the last ten percent of a move for the next guy. Unfortunately, with interest rates at zero, some models value equities at infinity, and many traders seem hell bent on taking stocks there. So as expensive as equities are here, they may be about to surf a New Year tidal wave of liquidity to even greater heights, punishing those who short too soon severely.  During their eighties stock market bubble, the Japanese loved to quote a favorite local expression: 'When the fools are dancing, the greater fools are watching.' The same may apply now to American equity investors. But this next boost could well be setting up one of the great shorting opportunities of the decade, which could start tomorrow, next week, next month, or by summer at the latest. If some bully is holding you by your ankles outside a high floor window, threatening to let go if you don't buy equities, only pick the emerging market variety (EEM). Think the BRIC's, Brazil (EWZ), Russia (RSX), India (PIN), and China (FXI), with South Korea (EWY), Taiwan (EWT), and Indonesia (IDX) thrown in for a more sophisticated flavor. But keep an itchy trigger finger on your mouse, because when the turn comes, there will be no place to hide. And beat the rush by booking that house in the Hamptons, the lakefront property at Tahoe, or the mega yacht in the Mediterranean, early.

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3) Bonds (TBT), (JNK), (PHB), (HYG)

Shorting the world's most overvalued asset has got to be the big trade for 2010. I'm talking about 30 year US Treasury bonds. The relentless whirring of the printing presses is so loud that they keep me awake at night, even though, according to Mapquest, I live 2,804.08 miles away. What will be unique with this meltdown is that it will be the first collapse of a bond market in history in a deflationary environment. It is not inflationary fears that will execute the coup de grace for the long bond, it will be the sheer volume of issuance. The Feds have to sell nearly $2 trillion of debt to cover a massive budget deficit and to refund maturing paper, easily the largest amount in history. Pile on top of that billions more in offerings from states and municipalities bleeding white. By end 2010 total government debt will rocket to a staggering 350% of GDP. At some point, the world runs out of buyers, and the long bond yields will begin their inexorable climb from the current 4.6% to 5.5%, 6%, or higher.  Even Moody's is talking about a ratings downgrade for the US debt, not that we should give that disgraced institution any credibility whatsoever. It's just a question of how many sticks it takes to break a camel's back. I am a worshipper of the TBT, a 200% leveraged bet that long bonds are going down. It has clawed its way back up from $43 to $51, and $60 looks like a chip shot for the first half. Longer term this ETF could hit $200. If interest rates double from the current levels, a virtual certainty, so does America's debt service, from the current 11% to 22% of the budget. That's when the sushi really hits the fan.

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Corporate debt, which see interest rates moved more by credit quality considerations than the yield curve, will continue to trade like high yielding equities, as they did for most of 2009. After last year's cornucopia of bankruptcies, investors are also showing a preference for paying up for securities more senior in the capital structure. That means you're going to have to employ an equity type strategy for this corner of the fixed income market. The global liquidity surge that free money is spawning will boost corporate bonds as much as equities, knocking yields down further. And with the world still in risk accumulation mode, that augers well for the riskiest corner of asset class – junk bonds, whose default rates are not coming in anywhere near where they were predicted just a few months ago. Buy the junk ETF's like JNK, PHB, and the HYG here for a trade. Just don't forget to unload at the first sign of an equity market collapse.

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4) Currencies (FXC), (FXA), (BNZ), (CYB)

Any trader will tell you to never bet against the trend, and the overwhelming direction for the US dollar for the last 230 years has been down. The only question is how far, how fast. Going short the currency of the world's largest borrower, running the greatest trade and current account deficits in history, with a diminishing long term growth rate is a no brainer. But once it became every hedge fund trader's free lunch, and positions became so lopsided against the buck, a reversal was inevitable. We seem to be solidly in one of those periodic corrections, which began a month ago, and could continue for several more months. The euro has its own particular problems, with the cost of a generous social safety net sending EC budget deficits careening. Just look at Greece, with a budget deficit of 12.7% of GDP against the 3% it promised on admission to the once exclusive club. Unwinding of 'hot' longs could easily take us into the $1.30's against the euro, and new momentum driven longs could take us to the $1.20's. Use this strength in the greenback to scale into core long positions in the currencies of countries that are major commodity exporters, boast rising trade and current account surpluses, and possess small consuming populations. I'm talking about the Canadian dollar (FXC), the Australian dollar (FXA), and the News Zealand dollar (BNZ), all of which will eventually hit parity with the dollar. Think of these as emerging markets where they speak English, best played through the local currencies. If you're looking for a risk controlled pairs trade, I vote for going long the Canadian dollar and short the Euro at €1.40. For a sleeper, buy the Chinese Yuan ETF (CYB) for your back book.

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5) Commodities (FCX), (VALE), (RIG), (JOY), (CCJ), (FSLR), (UNG), (USO), (MOO), (DBA), (MOS), (MON), (AGU), (POT), (PHO), (FIW)

This is my favorite asset class for the next decade, as investors increasingly catch on to the secular move out of paper assets into hard ones. Don't buy anything that can be manufactured with a printing press. Focus instead on assets that are in short supply, are enjoying an exponential growth in demand, and take five years to bring new supply online. The Malthusian argument on population growth also applies to commodities; hyperbolic demand inevitably overwhelms linear supply growth. Of course, we're already eight years into what is probably a 20 year secular bull market for commodities and these things are no longer as cheap as they once were. So you are going to have to allow these things to breathe. Ultimately this is a demographic play that cashes in on rising standards of living in the biggest and highest growth emerging markets. You can start with the traditional base commodities of copper and iron ore. The derivative equity plays here are Freeport McMoRan (FCX) and Companhia Vale do Rio Doce (VALE). Add the energies of oil, coal, uranium, and the equities Transocean (RIG), Joy Global (JOY), and Cameco (CCJ). Crude (USO) has in fact become the new global de facto currency (along with gold), and probably $30 of the current $78 price reflects monetary demand, on top of $48 worth of actual demand from consumers. That will help it spike over $100 sometime in 2010. Don't forget alternative energy, which will see stocks dragged up by the impending spike in energy prices. My favorite here is First Solar (FSLR). Skip natural gas (UNG), because the discovery of a new 100 year supply from fracting and horizontal drilling in shale formations is going to overhang this subsector for a long time. The food commodities are probably among the cheapest resources around, with corn, wheat, and soybeans coming off the back of bumper crops in 2009, and can be played through the futures or the ETF's (MOO) and (DBA), and the stocks Mosaic (MOS), Monsanto (MON), Potash (POT), and Agrium (AGU). Through an unconventional commodity play, the impending shortage of water will make the energy crisis look like a cake walk. You can participate in this most liquid of asset with the ETF's (PHO) and (FIW).

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6) Precious Metals (GLD), (SLV), (PTM)

With gold's  whopping great $150, 12% pull back from the all time high in the past month, I have been deluged by readers asking if this was the peak, if it was the final blow off top, and if gold is finished as an asset class. My answers are no, never, and not on your life. Obama has not suddenly become a paragon of fiscal restraint. Bernanke has not morphed into a tightwad overnight. When I pull a dollar bill out of my wallet, it's as limp as ever. If you forgot to buy gold at $35, $300, or $800, another entry point is setting up for those who, so far, have missed the gravy train. We could be seeing a replay of 2008-2009, where the yellow metal traded in a sideways range for many months before blasting through to a new all time high and quickly tacking on 25%. Start scaling in around $1,040. That's where the Reserve Bank of India started the recent love fest for the barbaric relic with its 200 ton purchase in November. If the institutional world devotes just 5% of their asset to a weighting in the yellow metal, and an emerging market central bank bidding war for gold reserves continues, it has to fly to at least $2,300, the inflation adjusted all time high, or higher. ETF players can look at the 1X (GLD) or the 2X leveraged gold (DGP). I would also be using the current bout of weakness to pick up the high beta, more volatile precious metal silver (SLV) and platinum (PTM), which have their own long term fundamentals working in their favor.

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7) Real Estate (ESS)

The agony is going to continue in this world of hurt, and any allocation to either residential or commercial real estate is going to be dead money for the next decade. If you strip away the industry fig leaves, and ignore the paid apologists, the excesses in this sector are truly of Biblical proportions. 'Official,' shadow, and bank inventories, and another 1.5 million imminent option arm induced foreclosures, probably mean there is five years worth of supply out there. Fannie Mae is taking down 75% of the new mortgage in the secondary market, and the FHA is taking almost all of the rest, and there is no way the socialization of the mortgage market can continue indefinitely. The jumbo market has ceased to exist, and it is raining McMansions in tony neighborhoods everywhere. The demographic pressure of 80 million retiring and downsizing baby boomers easily add another five years. The commercial sector is even worse, with valuations off 50%, some 5% of the industry's $1.8 trillion loan book in default, and cap rates soaring from 5% to 8-9%. The refinancing needs of this industry are gargantuan, and except for some triple 'A' paper taken down by the TALF, there is no bid other than from the vultures inhabiting the distressed world. And no one seems to be taking into consideration the fact that huge chunks of the office market are being permanently emptied out by the Internet, which is sending people home to work, transferring their jobs overseas, or vaporizing them altogether. If the liquidity induced surge in stock prices continues, I might even be enticed into shorting some of the big listed REITS, like Essex Properties (EES), which has nearly doubled from its lows, and is choking on its high prices California exposure. Only buy a home if your wife is nagging you about living in that cardboard box under the freeway overpass. But expect to put up your first born child as collateral, and bring in your entire extended family in as cosigners, if you want to get a bank loan.

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