Back in the USSR

Been away so long I hardly knew the place
Gee, it's good to be back home
Leave it till tomorrow to unpack my case
Honey disconnect the phone
I'm back in the USSR
You don't know how lucky you are, boy
Back in the US
Back in the US
Back in the USSR 

"Back in the USSR" by The Beatles

Bloomberg just ran the following article on an excerpt from former Treasury Secretary Hank Paulson's new book. This is the way the new cold war post-Lehman looks...scary. When the world owns your bonds strange games will be played for non-financial reasons. Fortunately the Chinese decided not to go along...this time!

Jan. 29 (Bloomberg) -- Russia urged China to dump its Fannie Mae and Freddie Mac bonds in 2008 in a bid to force a bailout of the largest U.S. mortgage-finance companies, former Treasury SecretaryHenry Paulson said.

Paulson learned of the “disruptive scheme” while attending the Beijing Summer Olympics, according to his memoir, “On The Brink.”

The Russians made a “top-level approach” to the Chinese “that together they might sell big chunks of their GSE holdings to force the U.S. to use its emergency authorities to prop up these companies,” Paulson said, referring to the acronym for government sponsored entities. The Chinese declined, he said.

Russia’s five-day war with U.S. ally Georgia started on Aug. 8, the same day as the opening ceremonies of the Beijing Games. Prime Minister Vladimir Putin told U.S. President George W. Bush during those ceremonies that “war has started,” according to Dmitry Peskov, Putin’s spokesman.

“The report was deeply troubling -- heavy selling could create a sudden loss of confidence in the GSEs and shake the capital markets,” Paulson wrote. “I waited till I was back home and in a secure environment to inform the president.”

Russia never approached China about dumping U.S. bonds, Peskov said today. “This is not the case,” he said by phone.

Russia sold all of its Fannie and Freddie debt in 2008, after holding $65.6 billion of the notes at the start of that year, according to central bank data. Fannie and Freddie were seized by regulators on Sept. 6, 2008, amid the worst U.S. housing slump since the Great Depression.

Chris Wiles

www.rockhavencapital.com

This article contains the current opinions of the author but not necessarily those of the Rockhaven Capital Management.  The author’s opinions are subject to change without notice. This article is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Domino

Don't wannna discuss it
Think it's time for a change
You may get disgusted
Start thinkin' that I'm strange

In that case I'll go underground
Get some heavy rest
Never have to worry
About what is worst or what is best
(Get it)

Oh oh Domino (it's all right)
Roll me over, Romeo, there you go
Lord, have mercy
I said oh-oh, Domino

"Domino" by Van Morrison

I'm usually not this prolific, but there's just so much going on that I can't help myself. The biggest story of the day was not the reconfirmation of Ben Bernanke as head of the Federal Reserve, it was not the President's State of the Union Address, it was not the bipartisan public torturing of Treasury Secretary Tim Geithner, it wasn't the President's embarrassing attack of the Supreme Court Justices, and it wasn't even Steve Jobs introduction of the next great thing -- the iPad. No the biggest story was the sound of dominos falling. Greece, Portugal, Spain, Ireland, and even the United Kingdom, all lined up like dominos. This news isn't making the front pages of the papers yet, but it is the most important thing happening in the markets today. We all remember how painful 2008 was, and how our global central banks decided to fix the situation we were in. That's right, print money to bail out the banks. Well when you print money your debt tends to go up. Greece now has debt levels at 120% of GDP well above the Euro target. Their 10-year sovereign bonds were yielding 6% last week and are now over 7%. It will be interesting to see if their stronger Euro partners allow them to default or bail them out, especially with Portugal, and Spain right behind them. Also, today Standard & Poors said that the UK banking system (mostly owned by the government) is no longer among stable low-risk banking systems worldwide. These are all canaries in the coal mine (rather large canaries, like that bird in "Up"), and the investing world is watching intently. We may not be able to connect-the-dots on exactly how this will impact U.S. markets, but I can distinctly remember 13 years ago how the Thai devaluation ignited the Asian contagion. I also lived and invested through the Mexican debt defaults of 1994 - 95, and the Latin American crisis of the 1980's. The scary thing about this potential crisis is that our markets and economies are much more intertwined today than any other time in history. "Lord have mercy, I said oh-oh Domino".

Investment Considerations 

Obviously we should all have itchy trigger fingers on our bond holdings, especially sovereign bonds of countries with Debt-to-GDP ratios at or over 100%. The U.S. is currently around 84%.

OK, my two-cents worth on the other notable topics:

The President totally lost me when he said his goal was to double exports in five years! Wow, the last time we doubled exports it took twelve years, and that was before we exported all of our manufacturing capacity. The only way we'll come close to this is if the President counts government bonds and financial service jobs as exports!

The embarrassing public smack-down of the Supreme Court Justices was sooo un-presidential.

The proposed budget freeze was an ever so small step in the right direction.

The following is a pictorial view of 2009's Federal Budget.

The budget for 2010 is projected to be $3.5 trillion. President Obama is proposing to freeze $450 billion of this (the small slivers of the pie).

He is not proposing to reduce the spending, just not to grow it. If this happens the projected deficit of $1.35 trillion will be about $15 billion smaller,

or about 1% smaller. I guess it's a start!

I can't agree more with the following quote. The only reason I would have voted to reappoint Bernanke would be because I'm fearful of who Obama might appoint to replace him.

“You don’t give an arsonist a medal for putting out the fire,” said a commentator today about the battle over the renomination of Ben Bernanke. 

The iPad will be huge, much quicker than anyone believes. The real genius is opening up the architecture to all those crazy app creators. You will want one.

This is looking like a good weekend to spend with some Van Morrison and a good bottle of wine.

Be careful out there,

Chris Wiles

www.rockhavencapital.com

This article contains the current opinions of the author but not necessarily those of the Rockhaven Capital Management.  The author’s opinions are subject to change without notice. This article is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Suppose You Were an Idiot

"Suppose you were an idiot. And suppose you were a member of Congress...But then I repeat myself."

- Mark Twain

"Liberty has never come from the government. Liberty has always come from the subjects of government. The history of liberty is the history of resistance. The history of liberty is a history of the limitation of government power, not the increase of it."

- Woodrow Wilson

"How did you go bankrupt?" Bill asked.

"Two ways," Mike said.

"Gradually and then suddenly."

- Ernest Hemingway, "The Sun Also Rises"

As a professional worrier I've been asked, "what is your biggest worry?"

My answer is easy, the potential bankruptcy of the U.S. Government. If progress is not made to significantly narrow the budget deficit, than the credibility of the U.S. dollar could be called into question, which would usher in an era of hyper-inflation and declining living standards. In a recent analysis, Alan Auerbach and William Gale did an excellent job laying out the facts. In 2009, tax revenues came to about 15.5% of GDP, the lowest level since 1950, while expenditures were 27.5% of GDP, the highest level since WWII. Our country ran a deficit of around $1.7 trillion or 12% of GDP, of which the structural component (the part that is fairly entrenched, interest payments, entitlement programs, etc) was $800 billion or almost 6% of GDP. To put those numbers in context, in 2008 personal income tax receipts were just about $1.2 trillion. To eliminate the structural deficit in one fell swoop, they'd have to go up by 66%!

Another study done by professors Carmen Reinhart and Kenneth Rogoff, has found that a 90% ratio of government-debt-to-GDP is a tipping point to economic growth. Beyond that point developed countries have growth rates two percentage points below their normal levels. The U.S. government-debt-to-GDP ratio is currently 84%. (See Forbes February 8, 2010 "The Global Debt Bomb". http://www.forbes.com/forbes/2010/0208/debt-recession-worldwide-finances-global-debt-bomb.html ) 

There really are only two ways to make significant cuts in the deficit, 1) massive reductions in entitlement programs, and 2) very large increases in taxes. Unfortunately it is highly unlikely that we will see anything that even resembles a cut in entitlements come out of Washington, so that leaves higher taxes. The question pertaining to higher taxes is not if but when? Taxes were boosted after the Great Depression in 1937 and again in Japan in 1997, both with disastrous consequences. Washington is populated with depression experts (led by Ben Bernanke), and they are in no hurry to kill a barely recovering economy with new taxes. But new taxes are coming, probably a national sales tax or Value-added-tax (VAT). This is a very tricky problem and both the timing and political will to act have to be nearly perfect. 

Fortunately by having the dollar as the worlds reserve currency and having China, our largest creditor, engaged in its own program of buying their way out of poverty, we have some time. But make no mistake, U.S. fiscal policy is hurtling toward a currency crisis, and at some point in the next few years the brakes must be applied. Somewhere in the near future we will have to start showing the world that we are reversing the upward trajectory in our deficits, gradually but persistently. We've been going bankrupt gradually, hopefully we can avoid the final sudden drop...This is my biggest worry.  

Investment Considerations

All things considered, the immediate risks of an inflationary spiral aren't high enough yet to make dramatic changes to our portfolios. Inflation expectations will probably continue to creep up, and we will need to be very diligent with our fixed income holdings. Fortunately, corporate America has very strong balance sheets, cash flows, and earnings, so equities may continue to do well. But a currency devaluation would destroy profit margins. Obviously international exposure will continue to be a core element of our portfolios. The following graph shows that Developed Country Debt is a much higher percentage of GDP than Emerging Market Debt. In our Global Tactical Asset Allocation portfolios we have equal target weights in both international developed market debt and emerging market debt. While the developed countries have riskier balance sheets, the emerging market countries have riskier political environments, therefore we believe that equal target weights are warranted at present.

Be careful out there,

Chris Wiles

www.rockhavencapital.com

This article contains the current opinions of the author but not necessarily those of the Rockhaven Capital Management.  The author’s opinions are subject to change without notice. This article is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Tell Me Where is Sanity

Everywhere is freaks and hairies

Dykes and fairies, tell me where is sanity

Tax the rich, feed the poor

Till there are no rich no more

I'd love to change the world

But I don't know what to do

So I'll leave it up to you

"I'd Love to Change the World" by Ten Years After

Where's the outrage, where's the congressional hearing, where's the Presidential teleprompter anger?

How can we, as a nation, sit idly by and let a corporate titan, who just a short year ago was on its knees begging the American taxpayer for a bailout loan, pay one if it's employees $45 million of our hard-earned tax dollars to go away? Sure this guy had a contract, but since when do we let silly little things like contract law get in the way of anger?

Of course I'm not talking about fat cat Wall Streeters, I'm talking about one of Hollywoods fat cat funny-men...Conan O'Brien.

Yes Conan O'Brien, former host of NBC's Tonight Show, owned by the "Hedge-Fund-Lightbulb" firm known as General Electric, is the recipient of the publics largess. 

If we remember way back in the dark days of 2008, General Electric did not initially qualify for government backed loans under the Troubled Asset Relief Program (TARP). But because of behind-the-scenes appeals from GE, regulators soon loosened the eligibility requirements to allow GE to participate in a new program known as Temporary Liquidity Guarantee Program or TLGP, and participate they did.  TLGP allows companies to issue debt at much lower interest rates because it is backed by the U.S. government (you & me), and GE Capital has issued nearly a quarter of the $340 billion in debt backed by the program. As GE's chief executive Jeffrey Immelt acknowledged, "the governments actions have been powerful and helpful". Gee, thanks.

Now I have absolutely nothing against Mr. O'Brien, I personally think he is funnier than Jay Leno, and he and his team are worth every penny of the $45 million that their contract says they should receive. What I am against is the double standard. Why were GE's executives excluded from over-sight by the pay-czar? Why is Mr. O'Brien's contract more sacrosanct than the investment banker that helped Goldman Sachs earn enough money to pay back TARP early and with interest? These double standards are common in fascist states, where private companies that cooperate with the government and do its bidding are allowed to remain under private control, are given unfair advantages over their competition (Fannie Mae & Freddie Mac), and avoid late-night visits from the KGB. I'd like to think that the United States is better than that, but I know that's not true.

Investment Considerations

When you go to the Mafia or the KGB for a loan or some special favor, you have to realize that even though you think you paid them back, you are free only when they say you are free...and they reserve the right to change their minds at any time. We started down this road over a year ago, when the head of the Federal Reserve and the Treasury Secretary, started telling companies who they would merge with and at what price. When the government refused to let companies fail and instead played grand puppet-master we allowed ourselves to slip towards the dark side. 

From an investors perspective you have to realize that the playing field has changed, no longer can you count on buying stocks or bonds of firms based on their operating fundamentals alone. Now you have to look at their relationship with the government, and their competitors relationship with the government. It's not the end of investing, its just another variable to factor in. Take Russia as an example. You can still invest in companies, make or lose money, you just have to realize that you do so only with Putin's blessing.

Tell me where is sanity...

Chris Wiles

This article contains the current opinions of the author but not necessarily those of the Rockhaven Capital Management.  The author’s opinions are subject to change without notice. This article is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Going Down

Well I'm going down
Down, down, down, down, down
I'm going down
Down, down, down, down, down
I've got my head out the window
And my big feet on the ground

"Going Down" by Jeff Beck

It's a good thing the markets were closed Monday and we only had four days of trading. Tuesday the markets were up nicely as it appeared obvious that Scott Brown was going to become the new Senator of Massachusetts. But the next three days saw stocks fall more than 5% for the first time since the rally began from last March's depths. Yes, Mr. Brown woke up a lot of people in Washington to the fact that none of their jobs are secure, anybody who had a hand in this economic malaise is at risk. Being the astute politician that he is, President Obama quickly jumped onto the peoples side by announcing all out war on Wall Street and those fat cat bankers. He brushed aside Treasury Secretary Tim Geithner, and trusted advisor Larry Summers, to embrace the respected former Fed chief Paul Volcker and his plan to break up the big banks. 

Restricting a banks ability to grow, increasing regulation, forcing them out of profitable lines of business, and capping the amounts of money they are allowed to pay employees will not foster growth in the economy, it will stifle it! 

If Volcker's in, that means free money for everyone, Ben Bernanke is out. Not that Bernanke doesn't deserve to get canned, since he was at the helm as the financial system he watches over nearly collapsed, its just that Wall Street hates uncertainty. 

On top of all of our political issues, we have the Chinese government tapping heavily on the liquidity brakes (China's stocks down 14%) and all commodities tied to China's growth down strongly. Then we have Greece's continued default dance. And lastly, late on Friday the UK government increased their terror alert to Severe meaning a terror attack is highly likely. 

Now some contrarians like to buy dips, but this one feels a bit heavier, there is just too much uncertainty. Too much hostility towards Wall Street. Too much going down. Down, down, down, down.

My indicators still have us fully invested in equities and commodities, but we are moving closer to neutral in several categories. 

Be careful out there,

Chris Wiles

This article contains the current opinions of the author but not necessarily those of the Rockhaven Capital Management.  The author’s opinions are subject to change without notice. This article is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Dream On

Every time I look in the mirror
All these lines on my face getting clearer
The past is gone
It goes by, like dusk to dawn
Isn't that the way
Everybody's got their dues in life to pay

"Dream On" by Aerosmith

Well I guess it's time for the mega banks to pay their dues. Silly them for dreaming that borrowing money from the government would be just like borrowing from one of their peers...you know, you borrow money, you pay it back with interest, and the transaction is over. So they borrowed (via TARP), payed it back and let the government report a nice gain, and thought that would be the end of it. Nope! The dream bailout has turned into a nightmare. First it was controls on compensation, then an added fee/tax (even though there was nothing in the fine print), and now this. Today, reeling from the knock-out punch thrown by Massachusetts voters, President Obama announced new limits on the size and trading practices of big banks. "Never again will the American taxpayer be held hostage by a bank that is too big to fail," Obama said. Clearly trying to tap into the publics anger over bailouts, Obama proposed new rules that will prohibit a bank from investing in or sponsoring a hedge fund or private equity fund, as well as barring the institutions from proprietary trading (trading for their own accounts). Guess what happens to bank stocks when you take away one of their most profitable lines of business??? Thats right, Citi -6%, JPM -5%, BAC -6%, and GS -6%. He went on, "In recent years, too many financial firms have put taxpayer money at risk by operating hedge funds and private equity funds and making riskier investments to reap a quick reward." Now I may be wrong but I'm pretty sure that only the Federal Government can put taxpayer money at risk! It was the government that agreed to bail these institutions out, not the taxpayers. In fact, almost every taxpayer I know believes that individuals and companies that over-lever themselves, to live beyond their means or stretch for outsized profits, should be allowed to fail when those dreams vaporize. Yes, the fear of failure is a powerful deterrent, not this constant manipulation of the rules. Even though the banks are earning record profits by borrowing at zero, the stocks are falling because of the constantly changing rules coming out of Washington. Markets hate uncertainty and that is exactly what they are getting from D.C.. A year ago, January 30, 2009, Obama criticized Wall Street saying, "there would be a time for them to make profits, and there will be a time for them to get bonuses. Now's not that time." A year later and it clearly is still not the time... everybody's got their dues in life to pay.

Why does this matter? Because, not only are the big banks and Wall Street the lubricant that keeps all things financial flowing in this country, but they are also one of the largest sectors in the stock market. If the financials struggle the entire market will most likely struggle too. Our equity market indicators are still all in the bullish range, but we are seeing weakness develop in some sectors (i.e. Financials).

While we're still on the subject of dreaming, I am always amazed when I read surveys of what investors return expectations are, and not just individuals but financial planners and institutional investors as well. A nationwide survey last year found that investors expect the U.S. stock market to return an annual average of 13.7% over the next 10 years. Another survey of leading financial planners were asked what they thought returns would be after inflation, fees and taxes (net-net-net returns) and their average was 6%, with some as high as 9%. These return expectations are dreams, historically net-net-net returns of 3-4% were great, and returns of 1-2% are pretty normal. Now, in a country where tax increases are going to be the norm, and higher inflation is a distinct possibility, we should probably dream of meager returns. This is also why we strive to find the lowest cost ETF's, that give us are desired exposures. Several investing experts were asked what guaranteed net-net-net return they would take to sell all their current assets. William Bernstein of Efficient Frontier Advisors would take 4%. Laurence Siegel, former head of investment research at the Ford Foundation would take 3%. John C. Bogel, founder of the Vanguard Group would take 2.5%. Elroy Dimson of the London Business School, an expert on the history of market returns would take 0.5%. Ask your financial advisor what net-net-net return you should expect. If he says anything north of 2% see if you can lock it in. If its anything north of 4%...Dream on, dream on, dream until your dreams come true.

Chris Wiles

This article contains the current opinions of the author but not necessarily those of the Rockhaven Capital Management.  The author’s opinions are subject to change without notice. This article is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

"Mother, should I trust the Government?"

Mother, do you think they'll drop the bomb?
Mother, do you think they'll like this song?
Mother, do you think they'll try to break my balls?
Mother, should I build the wall?
Mother, should I run for President?
Mother, should I trust the government?
Mother, will they put me in the firing line?
Is it just a waste of time? 

"Mother" by Pink Floyd

Due to my career (investing) and my wife's career (accounting) we tend to hang out with a lot of number crunchers (CFA's & CPA's), and no matter what you've heard, I can personally attest to the fact that they are not all boring. People who make a living with numbers tend to love the exactness of math, I'm sure the same is true for engineers and most scientist's. Math has a purity to it, in a rather impure world. On todays editorial page in the WSJ Michael J. Boskin writes an excellent piece on how there recently seems to have been an attack on numbers at an unprecedented scale. "Politicians and some scientists, when confronted with data they do not like, have taken to simply changing the numbers. They believe that their end -- socialism, global climate regulation, health-care legislation, repudiating debt commitments -- justifies throwing out even minimum standards of accuracy. It appears that no numbers are immune: not GDP, not inflation, not budget, not job or cost estimates, and certainly not temperature. A CEO or CFO issuing such massaged numbers would land in jail." I, like most citizens of the world have always distrusted the government, or more specifically, politicians, but I always held out hope for scientists. But it even seems that some scientists aren't above trying to push forward their agenda when the numbers don't support it. The most recent blatant example was the efforts by some climate researchers at the University of East Anglia, attempting to hide or delete temperature data when the data didn't show global temperatures rising, in order to halt the publication of studies that differed from their conclusions. Of course Al Gore will run with the numbers that support his case even if they are phony, but to see scientists doing it is just an affront to all lovers of numbers.

OK, if you're still with me you are probably wondering what this has to do with investing? Well so much of what we do as investors is based on data that we receive from the government, and we constantly have to ask ourselves, "Mother should I trust the government?" A timely example is the Consumer Price Index (CPI). CPI is calculated by the governments Bureau of Labor Statistics and is widely used as the nations inflation gauge. Now it has been obvious for some time that it is in the governments best interest to keep reported CPI low, it keeps borrowing costs low, it keeps payments low on inflation adjusted cost-of-living entitlement increases, and it helps stimulate growth through borrowing. Where this becomes an issue for investors is when it comes to buying the right kinds of inflation protection. One very popular inflation hedge has been Treasury Inflation Protected Securities (TIPs). TIPs are issued by the treasury and are designed to pay a fixed return above the rate of inflation, so if inflation goes up the value of your TIPs will go up. The problem is that the creditor issuing the TIPs is the same entity calculating the CPI. So TIPs have flaws when it comes to protecting your portfolio from true inflation, they probably understate the return on true inflation, and in periods of high inflation they will probably lag even more. But, what are the alternatives? As with so much in the investment world, it is all relative. TIPs will clearly outperform bonds in an inflationary environment, and the default risk is minimal. Will they perform as well as gold or REITs, probably not. 

Part of our global tactical asset allocation model is allocated to TIPs (currently 8%), but we also own an International Government Inflation-Protected Bond ETF (WIP at 3%) that invests in 18 countries (diversifying our sovereign risk and our lying risk). Last year WIP outperformed, TIP 17.14% to 8.89%, due mostly to the decline in the value of the dollar. We also have exposure to both gold and REITs. TIPs are not perfect inflation hedges, but they are a valid diversifying tool, as long as the numbers can be at least partially trusted. As with all of our ETFs, if they don't track the underlying benchmark closely enough, or they don't give us the return and risk characteristics we expected them to, then we'll just have to find a better alternative. "Mother should I build the wall?"

Chris Wiles

This article contains the current opinions of the author but not necessarily those of the Rockhaven Capital Management.  The author’s opinions are subject to change without notice. This article is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.