Wednesday, March 2, 2011

Canary In A Coal Mine


First to fall over when the atmosphere
is less than perfect
Your sensibilities are shaken by the slightest defect
You live your life like a canary in a coalmine
You get so dizzy even walking in a straight line


I just had a canary drop off of my charts; emerging market equities. While not dead yet, the sudden drop in performance has caused me to move to a neutral weight in emerging market equities. This is notable because it is the first time, since August of last year, that we haven't been at maximum weight in equities (US, EAFE, or Emerging Market). We've also gone to a minimum weight in emerging market bonds for the first time this year. What has caused this avian swoon is simply inflation. Not the fear of inflation, but actual honest to goodness rising prices. Rising prices on food and energy impact the poorer countries and their citizens before they reach us in the more developed world. Chairman Bernanke still insists that the Fed's flood of money is not the cause of this bout of inflation, we could argue that contention till there are no more canaries, but the simple fact is that inflation is rising rapidly in emerging markets. This causes their economies to slow, and their equity and bond markets to sell-off. Could this be the first sign of what's to come here in the US or Europe? 

Our goal of being in harmony with the markets has caused us to increase our cash holdings to 17.5%. This is being split between US dollars, Chinese Yuan, Brazilian Real, and Australian dollars. The US dollar is not the safe haven that it has always been perceived to be.

Now if I tell you that you suffer from delusions
You pay your analyst to reach the same conclusions
You live your life like a canary in a coalmine
You get so dizzy even walking in a straight line

Are we delusional if we believe that you can cure a debt crisis with more debt? Does Quantitative Easing and Government Stimulus/Spending/Investing actually heal the economy, or is it simply covering up symptoms of an unhealthy economy? In other words, is the canary being suspended by a string? I tend to believe that it is. As the excellent charts from PIMCO show, foreigners own about 50% of all Treasury securities, the Fed owns 10%, and the rest of us (mainly banks, pension plans, and insurance companies) own 40%. But since the Fed started QE2 last fall, foreigners have bought 30% of new issues, the Fed has bought the remaining 70%, and the rest of us have run to corporate debt, equities, and commodities. This $800 billion in purchases equates to about $1.5 trillion on an annualized basis. The key question is, Who will buy the Treasuries when the Fed stops in June? 
I'm not sure who that buyer will be, but there will be a buyer. I guess the key question is at what price? Many experts believe that the Fed's buying of Treasuries has depressed the yield on Treasuries by about 1.5%. It's interesting that the yield on Treasuries has actually gone up from about 2.5% to 3.5% on 10 year bonds since the Fed started buying them. Come June, will rates have to rise from 3.5% to 5% in order to attract buyers? Will that be enough? What will happen to the attractiveness of corporate bonds, equities, and commodities? 
Lot's of great questions, fortunately I don't have to try and predict the answers, I'll just follow my models and stay in harmony with what is working and steer clear of what is not.




The Fed's Ponzi: 

While we're on the subject of Quantitative Easing I thought I would attach this very brief educational video on how QE2 is supposed to stimulate the economy. Remember that what the Fed is doing is no different then what Ponzi or Madoff did. The Treasury issues bonds, and the Fed prints money and buys them. Then the Treasury issues more bonds, and the Fed prints more money and buys them. This works beautifully, until it doesn't.


The Oracle Of Omaha Speaks:
 
Today on CNBC Warren Buffett was on the air for about three hours, in case you missed it I recommend that you go to www.CNBC.com and check out some of the replays. I found his discussion of gold versus productive assets to be pretty useful.  Buffett Prefers Stocks - Not Bonds  3 hrs ago
In a nutshell he hates all bonds (even though he owns a lot of short-term debt), because they are unproductive assets and the returns are miniscule. He likes stocks and other income producing assets like rental real estate and farm land. As for Gold he says, "Gold is a way of going long on fear, you own it with the hope that people become more fearful in the next several years." This is exactly the reason we maintain an allocation to gold, we don't know if the world becomes more fearful in the future, but we want a bit of protection just in case.
He did have some fun stats:
If you take all of the gold that has ever been dug up it would create a cube 67 ft. by 67 ft. At today's prices it would be worth about $7 trillion, thats equal to about 1/3 of all the stocks in the US. In fact you could buy all of the farmland in the US (about half the land mass) for $2.5 trillion, seven ExxonMobiles, and have 41 trillion in walking around money left over. On the other hand you can just fondle your 67 ft. cube and ask it to do something, but it just sits there looking pretty.
Great nuggets of wisdom from a master. 

Be careful out there, and keep the light's on,

Chris Wiles, CFA
412-260-7917


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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.

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