The Death of the Mutual Fund

ETF's are much more attractive than mutual fund competitors, with their notoriously bloated expenses and spendthrift marketing costs. You can't miss those glitzy, overproduced, big budget ads on TV for a multitude of mutual fund families. You know, the ones with the senior couple holding hands walking down the beach into the sunset, the raging bulls, etc? You are the sucker who is paying for these. Sometimes I confuse them for Viagra commercials.

I once did a comprehensive audit on a mutual fund, and a blacker hole you never saw. There were so many conflicts of interest it would have done Bernie Madoff proud. Any trainee assistant trader can tell you that more than 90% of all mutual fund managers reliably underperform the indexes, some grotesquely so. Published performance is bogus, they show a huge survivor bias, not including the hundreds of mutual funds that close each year. And there's always that surprise tax bill at the end of the year.

If there was ever an industry crying out for a fundamental restructuring, consolidation, price competition, and ultimately a whopping great downsizing, it is the US mutual fund industry. ETF's may be the accelerant that ignited this epochal sea change, with the number of mutual funds recently having shrunk from 10,000 to 8,000. It's still early days, with ETF's only accounting for 5-6% of trading volume, even though they have been around for a decade.

 

The Mutual Fund's Days Are Numbered

Coal?s Hatchet Job on Natural Gas

After my year in the White House Press Corps, I vowed never to return, and took a really long shower, hoping to scrub every last spec of prejudice, self-interest, and institutionalized dishonesty off of my battered carcass. But sometimes I see some maneuvering that is so unprincipled, crooked, and against the national interest that I am unable to restrain my fingers from the keyboard.

I?m talking about the absolutely merciless hatchet job the coal producers are inflicting on the natural gas industry. Coal today accounts for 50% of America?s 3.7 trillion kilowatts in annual power production. Chesapeake Energy?s (CHK) Aubrey McClendon says correctly that if we just shut down aging conventional power plants over 35 years old, and replace them with modern gas fired plants, the US would achieve one third of its ambitious 2020 carbon reduction goals.

The share of relatively clean burning natural gas of the national power load would pop up from the current 23% to 50%. Even the Sierra Club says this is the fastest and cheapest way to make a serious dent in greenhouse gas emissions. So what do we get?

The press has recently been flooded with reports of widespread well poisonings and forest destruction caused by the fracking processes that recently discovered a new 100 year supply of ultra-cheap CH4. The YouTube images of flames shooting out of a kitchen faucet are well known. But MIT did a study investigating over 50 of these claims and every one was found to be due to inexperienced subcontractor incompetence, not the technology itself. The demand for these wells is so great that it is sucking in neophytes into bidding for contracts, whether they know how to do it or not.

While the coal industry has had 200 years to build a formidable lobby in Washington, the gas industry is just a beginner, their only public champions being McClendon and T. Boone Pickens. Every attempt they have made to get a bill through congress to speed up natural gas conversion has been blocked not by environmentalists, but other conflicted energy interests.

Memories in Washington are long, and Obama & Co. recall all too clearly that this was the pair that financed the Swift Boat Veterans for Truth that torpedoed Democrat John Kerry?s 2004 presidential campaign. What goes around comes around.

This will be unhappy news for the 23,000 the American Lung Association expects coal emissions to kill this year. Can?t the coal industry be happy selling everything they rip out of the ground to China?

There! I?ve had my say. Now I?m going to go have another long shower.

 

 

Time to Take That Shower

The Final Word on the Volatility Index

The inside story on the collapse of volatility is now out, and as a result, managers are reviewing the harsh lessons learned and tweaking their strategies. It highlights the dangers of buying securities without reading the prospectus and understanding what is under the hood.

As investors piled into stocks in February, they also bought downside protection in the form of the Velocity Shares Daily 2X VIX Short Term ETN (TVIX). For reasons that are yet to be explained, the issuer, Credit Suisse, arbitrarily decided to quit issuing new shares, effectively turning this vehicle into a closed end fund. Money poured in anyway, driving the price up to a 100% premium over the intrinsic value of the fund.

Then, out of the blue, Credit Suisse reversed its decision and decided to issue new shares after all last week. This could mean only one thing to the professional volatility trading community, which jumped on the (TVIX) with both feet. They took the ETF down a stunning 65% in a week, all the way down to a 20% discount to intrinsic value. During the same time, the (VXX) fell by 25%, while the (VIX) was up 10%. Now that?s a tracking error with a turbocharger!

It now appears that there was some advanced knowledge about the reissuance of shares, and the SEC is almost certain to make inquiries. Those who had hoped for downside protection in the stock market got a slap in the face instead. To say the least, confidence in the financial system has not been advanced.

To make matters worse, a major hedge fund based in Chicago has a gigantic position in the (TVIX) with a ?put tree?. This involved buying one $21 put and selling short one $18 put and three $17 puts. Below $17 they were 300% long the (TVIX). When the ETF broke that level, the sushi hit the fan, triggering panic selling of all (VIX) products at any price, including the unrelated (VXX). I can?t tell you who it is without risking litigation. But with the quarter end upon us, their investors will find out soon enough. Watch the newspapers to find out whom.

The debacle has sent analysts scurrying to find other ETF?s that may be trading at premiums to their underlying. Here are the top three:

Platinum (PGM) 27%
Municipal bonds (GMMG) 14%
China small cap (PEK) 6%

The premium in the (UNG) frequently goes as high as 50% and results from the contango in the futures market, where far month contracts are trading at big premiums to the front month. That makes it a great shorting vehicle in falling markets, because the ETF always falls faster than the underlying. I have drunk at this well many times.

What happens from here? My guess is now that managers see that their downside protection is a sham, they won?t want to play. That could translate into stock selling, now that holders understand that these positions involved more risk than they realized.

In the meantime, if you plan on dabbling in the $1.4 trillion 1,400 issue ETF market, it may prove wise to check out the intrinsic value of any ETF before you buy it. You can do this easily by going to Yahoo Finance and adding .iv to any ticker symbol. So while the (TVIX) intrinsic value this second is at $7.51, the current market is at $7.96, a 6% premium. If you value your wealth, you might well get familiar with this exercise.

 

 

 

 

Trading Volatility Isn?t Always So Fun

Buy Toyota Motors as a Cheap Yen Play

Looking for beneficiaries of the coming collapse of the Japanese yen (FXY), (YCS), Toyota Motors (TM) has to be at the very top of your list. A cheaper domestic currency brings a lower cost of production, high foreign sales proceeds, and wider profit margins all the way around.

I am probably the only person in the country who once worked for Toyota, speaks Japanese, and worked in the White House Press Corps, so I feel uniquely qualified to comment on the current state of play with Toyota.

When Akio Toyoda, president of the Toyota parent and grandson of the founder, and English speaking Yoshimi Inaba, president of Toyota Motor North America, Inc. appeared in front of congress, it was the usual kabuki theatre.

The member from Kentucky, where nonunion Toyota plants are located, listed off the firm's charitable donations to the community, while the one from Michigan launched a vicious, no-holds-barred attack.

The language spoken by the two Japanese couldn't have been more different. Toyoda spoke the words of inherited wealth, of a ruling shogun, of privilege, and of condescension. Inaba talked like the hardscrabble warrior that he was, who spent 40 years clawing his way up the Toyota organization ladder.

I think the entire crisis happened because Toyota management believed in their products to such incredible extremes that any criticism was viewed merely as the unhappy grumblings of competitors. That?s how the whole brake pedal fiasco ran away from them, leading to the largest vehicle recalls in history. Similarly, the quality of Japanese products became so ingrained in the minds of American regulators that they too fell asleep at the switch, giving the company a free pass on the rising tide of consumer complaints.

On top of this, you can pile the Japanese cultural aversion to sending bad news up the command chain. This was a major reason why Japan lost WWII, and explains how the suicide rate in the country is so appallingly high. When the bill finally came due, the price tag was 37 dead in acceleration accidents, and a witch hunt on national TV. Toyota's management will make sure, literally on pain of death, that every product rolling off the assembly line, from here on, will be models of engineering perfection.

The stock has held up amazingly well so far, probably because it is mostly owned by strong hands, with few traders involved. Not only should you buy the stock when global markets return to a sustained risk accumulation mode, you should buy a Toyota car as well. It will be the only time in your life that you can find them at a discount. All of this explains why the 37% pop in the stock this year outperformed the main indexes in the US, but also those in Japan as well.

 

 

Is This a Buy Signal?

Momentum is Building for the Yen Shorts.

I?m hearing from my buddies in Japan that while things are already quite bad in that enchanting country, they are about to get a whole lot worse, and that it is time to start scaling into a major short in the yen. Australia and China have already raised interest rates, to be followed by the US, and eventually Europe.

With its economy enfeebled, the prospects of Japan raising rates substantially are close to nil, meaning the yield spread between the yen and other currencies is about to widen big time. In the case of the Australian dollar, that works out to 4% per annum. Leverage up ten to one, and pile on anticipated capital gains brought in by a weakening yen, and you have a real carry trade on your hands. This will generate hundreds of billions of dollars? worth of cascading yen selling as hedge funds dog pile in. It?s macro investing at its finest.

Until now, the government has been able to finance ballooning budget deficits caused by two lost decades, but those days are coming to an end. Japan is quite literally running out of savers. The savings rate has dropped from 20% during my time there, to a spendthrift 3%, because real falling standards of living leave a lot less money for the piggy bank.
The national debt has rocketed to over 200% of GDP, and 100% when you net out government agencies buying each other?s securities. Japan has the world?s worst demographic outlook. Unfunded pension liabilities are exploding. Other than once great cars and video games, what does Japan really have to offer the world these days, but a carry currency?

Until now, the government has been able to cover up these problems with tatami mats, because almost all of the debt it issued has been sold to domestic institutions. Now that this pool is drying up, there is nowhere else to go but foreign investors. With Greece and the rest of the PIIGS at the forefront, and awareness of sovereign risks heightening, this is going to be a much more discerning lot to deal with.

That great bell weather of global risk taking, the Euro/Yen cross is telling us that the mother of all carry trades has already started. You also see this in the Ausie/Yen cross, and outright yen markets. I have scored one round trip in the yen this year and hope to do several more.

You could dip your toe in the water here around ?82.40. In a perfect world you could sell it at the next stop at the ?85 level. My initial downside target is ?90, and after that ?100. If you?re not set up to trade in the futures or the interbank market like the big hedge funds, then take a look at the leveraged short yen ETF, the (YCS) or buying puts on the (FXY). This is a home run if you can get in at the right price.

 

 

 

 

An Evening With ?Government Motors?

Long term readers of this letter are well aware of my antipathy towards General Motors (GM). For decades, the company turned a blind ear to customer complaints about shoddy, uncompetitive products, arcane management practices, entitled dealers, and a totally inward looking view of the world that was rapidly globalizing. It was like watching a close friend kill himself through chronic alcoholism.

During this time, Japan?s share of the US car market rose from 1% to 42%. The only surprise when the inevitable bankruptcy came was that it took so long. This was traumatic for me personally, since for the first 30 years of my life General Motors was the largest company in the world. Their elegant headquarters building in Detroit was widely viewed as the high temple of Capitalism. I was raised to believe that what was good for GM was good for the country.

I opposed the bailout because it interfered with creative destruction, something America does better than anyone else. Without GM a large part of the US car industry would have moved to California and gone hybrid or electric.

When an opportunity arose to spend a few hours with the new CEO, Dan Akerson, I graciously accepted. After all, he wasn?t responsible for past sins and I thought I might gain some insights into the new GM. Besides, he was a native of the Golden State and a graduate in nuclear engineering from the Naval Academy at Annapolis and the London School of Economics. How bad could he be?

When I shook hands, I remarked that his lapel pin looked like the hood ornament on my dad?s old car, a Buick Oldsmobile. He noticeably winced. So to give the guy a break, I asked him about the company?s results last year.

It was the best in the 103 year history of the company, with revenues up by an eye popping $15 billion. It was now the world?s largest car company with the biggest market share. The 40 mpg Chevy Cruze was the number one selling sub compact in the US. GM competed in no less than 117 countries, and was a leader in the fastest growing emerging market, China.

I asked how a private equity guy from the Carlyle Group was fitting in on the GM board. He responded that all of the Big Three Detroit automakers were being run by ?non-car guys? now and they generated profits for the first time in 20 years. However, it was not without its culture clashes. When he publicly admitted that he believed in global warming, he was severely chastised by other board members. He wasn?t following the playbook.

When I started carping about the bailout, he cut me right off at the knees. Liquidation would have been a death blow for the Midwestern economy, killing 1 million jobs, and saddling the government with $23 billion in pension fund obligations. It also would have deprived the Treasury Department of $135 billion in annual tax revenues. It was inevitable that in this election year the company became a political punching bag. Akerson said that he was still a Republican, but just.

GM was now selling 1,000 Chevy Volts a month. The cars are so efficient, running off a 16kWh lithium ion battery charge for the first 25-50 miles that many are still driving around with the original tank of gas they were delivered with a year ago. Extreme crash testing by the government and the bad press that followed forced a relaunch of the brand.

The recent production halt says more about GM?s more efficient inventory management than it does about the hybrid car. GM?s recent investment in California based Envia Systems should succeed in increasing battery energy densities threefold (click here for the link).

However the Volt was just a bridge technology to the Holy Grail, hydrogen fuel cell powered cars, which will start to go mainstream in five years. These cars burn hydrogen, emit water, and cost about $300,000 a unit to produce now. By 2017, GM hopes to make it available as a $30,000 option for the Chevy Aveo.

Another bridge technology will be natural gas powered conventional piston engines. These take advantage of the new glut of this simple molecule and its 85% price discount per BTU compared to gasoline. The company just announced a dual gas tank pickup truck that can use either gasoline or compressed gas. Cheap compressors that enable home gas refueling are also on the horizon. Fleet sales will be the initial target.

Massive overcapacity in Europe will continue to be a huge headache for the global industry. There are just too many car makers there, with Germany, England, Italy, France, and Sweden each carrying multiple manufacturers. Governments would rather bail them out to save jobs and protect entrenched unions than allow market forces to work their magic. GM lost $700 million on its European operations last year, and Akerson doesn?t see that improving now that the continent is clearly moving into recession.

I asked if GM stock was cheap, given the dismal performance since the IPO last year. It is still 36% down from the launch price. He said that the government holding had been cut back to 27% after figuring in dilution. Until the public learns of its liquidation plans, investors were staying away from ?Government Motors? in droves. Also, the old bond holders still owned substantial numbers of shares and were selling into every rally. That is hardly a ringing endorsement.

Akerson said that a cultural change had been crucial in the revival of the new GM. Last month, the Feds announced an increase in mileage standards from 25 to 55 mpg by 2025. Instead of lawyering up for a prolonged fight to dilute or eliminate the new rules, as it might have done in the past, it is working with the appropriate agencies to meet these targets.

Finally, I asked Akerson what went through his head when the top job at GM was offered him at the height of the crisis. Were they crazy, insane, delusional, or all the above? He confessed that it offered him the management challenge of a generation and that he had to rise to it. Spoken like a true Annapolis man.

 

 

Shifting GM from This?.

To This?.

And This

Volatility Melt Down Continues

The market was buzzing today about the continued collapse of volatility and the significance thereof today. Today the chief whipping boy was the double leveraged Velocity Shares 2X Vix ETF (TVIX), which cratered 33% on the day, and down 90% from its October high.

This was on a day when the ETF should have gone through the roof, with the Dow down 100 points and a rapidly deteriorating Chinese Purchasing Managers Index threatening of worse to come. Even the (VIX) and the (VXX) only brought in modest gains at best. Against this backdrop they should have been up much more.

Conspiracy theories abounded. Some speculated about margin calls on a major hedge fund triggering a forced liquidation. Other?s thought that complacency was peaking, creating spike bottoms in volatility products that could signify a final move. Certainly a buying opportunity is setting up here, but how do you determine where when the ETF is doing the exact opposite of what it is supposed to do.

Whatever the reason, investors? trust in these instrument has been permanently dented. A 33% one day drop certainly was not in the prospectus.

 

 

 

 

What?s Going on With the VXX?

Much of Wall Street was scratching their heads yesterday as the iPath S&P 500 Vix Short Term Futures ETN (VXX) plunged to new lifetime lows despite a 69 point decline in the Dow index. It wasn?t supposed to work that way. Falling markets should send investors scrambling to buy downside protection in the form of put options which would automatically send the volatility index skyward. Except when they don?t.

I spoke to over 30 market participants yesterday attempting to root out the cause of this seeming anomaly. All I got was shrugs or idle speculation. A (VXX) at this level assumes that the complacency now endemic in the market will continue for several more months. It is betting that the S&P 500 will continue moving sideways or up with no pull backs greater that 2%. Oh, really?

It is also discounting a rise in the (SPX) to 1,500, based on a multiple expansion from 14 to 15, while corporate earnings are falling. This will see confirmation when Q1, 2012 earnings start to hit in April. Oh, really again? It will do this in the face of economies that are dramatically slowing in both Europe and china while oil prices are spiking. Oh, really, a third time?

I finally got through to some friends in the Chicago pits who explained what was going on. A sizeable portion of the trading community believes that we will see a rise in volatility someday, but not in the near future. So they have been buying June and September call option in the volatility index (VIX). To pay for these they have been selling short calls in the front month April and May calls.

Since the (VXX) focuses on only the front two months of the options calendar, it has taken an inordinate brunt of the selling. This is why the (VXX) has continued a rapid decent even on days when the (VIX) was stable and the Dow was down. The first hint we got of this was on Monday, March 12 when traders started to roll in earnest from the March to the April (VIX) contract.

When they started executing this trade in December, both the short term and long term volatility were trading around 28. Holding a June or September call while selling calls for each expiring month against it has kept long dated volatility high at 28, but driven short term volatility down to an eye popping 14. Needless to say, it has been a huge money maker for the early participants.

How does this end? At some point we do get a serious sell off in the stock market, and the (VIX) rockets back up to 28 or higher. That means that anyone who initiates this position now will get slaughtered. But the long term players will simply write those losses off against the substantial short dated premium they have taken in in the meantime.

As long as this dynamic is in place, there really is no limit to how far the (VXX) can fall. As traders roll from one expiring month to the next, they will continue to hammer volatility. So when the (VXX) hit my stop loss at $20, the previous lifetime low for this contract, I let it stand and followed up with a trade alert reminder investors to bail.

Any loss that you don?t learn from is a wasted lesson that is bound to be repeated. The key in this situation is to make sure the hits don?t become life threatening by limiting them to small single digits. The combined loss of my two errant (VXX) trades came to -3.46% for my notional $100,000 portfolio. That is not the end of the world. It simply cancels out the profits I made earlier on my short positions in the Japanese yen and natural gas, as well as my long call spreads in Apple and Microsoft. Coming out here also lets me shrink and neutralize my book, a good think in these uncertain times.

I?m sure we?ll see the (VXX) above $30 sometime this year. I just don?t want to bleed to death before it happens.

 

 

 

Markets Can Remain Irrational Longer Than you Can Remain Solvent

The Structural Bear Case for Treasury Bonds

If you want to delve into the case against the long term future of US Treasury bonds in all their darkness, take a look at Foreign Affairs, the establishment bimonthly journal read by academics, intelligence agencies, and politicians alike, which I am sure you all have sitting on your nightstands. In a well-researched and thought out article penned by Roger C. Altman and Richard N. Haas, the road to ruin ahead of us is clearly laid out.

The US has no history of excessive debt, except during WWII, when it briefly exceeded 100% of GDP. That abruptly changed in 2001, when George W. Bush took office. In short order, the new president implemented massive tax cuts, provided expanded Medicare benefits for seniors, and launched two wars, causing budgets deficits to explode at the fastest rate in history. To accomplish this, strict ?pay as you go? rules enforced by the previous Clinton administration were scrapped. The net net was to double the national debt to $10.5 trillion in a mere eight years.

Another $4.5 trillion in Keynesian reflationary deficit spending by president Obama since then has taken matters from bad to worse. The Congressional Budget Office is now forecasting that, with the current spending trajectory and THE 2010 tax compromise, total debt will reach $23 trillion by 2020, or some 160% of today?s GDP, 1.6 times the WWII peak.
By then, the Treasury will have to pay a staggering $5 trillion a year just to roll over maturing debt. What?s more, these figures greatly understate the severity of the problem. They do not include another $9 trillion in debts guaranteed by the federal government, such as bonds issued by home mortgage providers, Fannie Mae and Freddie Mac. State and local governments owe another $3 trillion. Double interest rates, a certainty if commodity price inflation continues unabated, and our debt service burden doubles as well.

It is unlikely that the warring parties in Congress will kiss and make up anytime soon, especially if we get another split congress after the November election. It is therefore likely that the capital markets will emerge as the sole source of any fiscal discipline, with the return of the ?bond vigilantes? to US shores after their prolonged sojourn in Europe. They have already made their predatory presence known in the profligate nations of Europe, and they are expected to arrive here eventually.

Such forces have not been at play in Washington since the early 1980?s, when bond yields reached 13%, and homeowners paid 18% for mortgages. Since foreign investors hold 50% of our debt, policy responses will not be dictated by the US, but by the Mandarins in Beijing and Tokyo. They could enforce a cut back in defense spending from the current annual $700 billion. They might even demand a retreat from our $150 billion a year commitments in Iraq and Afghanistan.

Personally, I think the US will never recover from the debt explosions engineered by Bush and by ?deficits don?t count? vice president Chaney. The outcome has permanently lowered standards of living for middle class Americans and reduced influence on the global stage.

But don?t get mad about our national debt debacle, get even. Make a killing profiting from the coming collapse of the US Treasury market through buying the leveraged short Treasury bond ETF, the (TBT). Just pick your entry point carefully so you don?t get shaken out in a correction.

 

Looks Like I Can?t Afford the Next War

US Headed Towards Energy Independence

My inbox was clogged with responses to my ?Golden Age? for the 2020?s piece yesterday, particularly my forecast that the US was moving towards complete energy independence. This will be the most important change to the global economy for the next 20 years. So I shall go into more depth.

The energy research house, Raymond James, put out an estimate this morning that domestic American oil production (USO) would rise from 5.6 million barrels a day to 9.1 million by 2015. That means its share of total consumption will leap from 28% to 46% of our total 20 million barrels a day habit. These are game changing numbers.

Names like the Eagle Ford, Haynesville, and the Bakken Shale, once obscure references on geological maps, are now a major force in the country?s energy picture. Ten years ago North Dakota was suffering from depopulation. Now, itinerate oil workers must brave -40 degree winter temperatures in their recreational vehicles pursuing their $150,000 a year jobs.

The value of this extra 3.5 million barrels/day works out to $134 billion a year at current prices (3.5 million X 365 X $105). That will drop America?s trade deficit by nearly 25% over the next three years, and almost wipe out our current account surplus. Needless to say, this is a hugely dollar positive development.

This 3.5 million barrels will also offset much of the growth in China?s oil demand for the next three years. Fewer oil exports to the US also vastly expand the standby production capacity of Saudi Arabia.

If you want proof of the impact this will have on the economy, look no further that the coal (KOL) and rail stocks (UNP) which have been falling in a rising market. Power plant conversion from coal to natural gas (UNG) is accelerating at a dramatic pace. That leaves China as the remaining buyer, and their economy is slowing.

It all makes the current price of oil at $105 look a little rich. As with the last oil spike three years ago, this one is occurring in the face of a supply glut. Cushing, Oklahoma is awash in Texas tea, and the Strategic Petroleum Reserve stashed away in salt domes in Texas and Louisiana is at its maximum capacity of 727 barrels. It is concerns about war with Iran, fanned by elections in both countries that have taken prices up from $75 in the fall.

My oil industry friends tell me this fear premium has added $30-$40 to the price of crude. This is why I have been advising readers to sell short oil price spikes to $110. The current run up isn?t going to take us to the $150 high that we saw in the last cycle. It is also why I am keeping oil companies with major onshore domestic assets, like Exxon Mobile (XOM) and Occidental Petroleum (OXY), in my long term model portfolio.