Archive for August, 2010

Updates: Bonds and Ag

Wednesday, August 18th, 2010

The past few posts have been about bonds and agriculture, both of which had major events the past two days, so I thought an update would be appropriate.


We have had a seminal event in the bond market: for the first time EVER (ok, not ever, just 1962, but that is 48/49’s of my life which seems like ever), the dividend yield on the Dow Jones Industrial Average has surpassed the yield on the 10-year treasury bond.

Courtesy of Doug Kass' Blog

Courtesy of Doug Kass' Blog

You can see that the yields have crossed on the chart above. In my mind, that means that bonds have moved up in price (and consequently down in yields) more than they should have. The people buying them will very likely see a capital loss in their holdings when yields move to a more normalized level. As an example, if the yield on the 10-year treasury moved back to the 4% level that it was at last Spring, people who are buying the 10-year treasury bond today will see a capital loss three times greater than the income they would derive from the bond. Not an inconsequential event.

As I’ve mentioned previously, we are reducing duration in bond fund portfolios and reducing credit risk as both the treasury and the high yield sectors of the market have seen way too much money flow into them.


The other evening I wrote a blog entry on how we had increased our Agriculture holdings and would be continuing to do so based upon our anticipation for commodity inflation and supply/demand imbalances. The next morning, a huge merger announcement was made public: BHP Biliton had made a hostile takeover offer for Potash Corp from Saskatchewan, Canada.


Yesterday, Potash jumped 25% on the news – and the Potash board rejected the offer as being too low. As demand for grains increase with the increase in population and the increase in the size of the middle class in the developing world, farmers will be required to increase their yields from the same acreage. Potash is a key component of that as it replenishes the nutrients in the soil that the crops drain out.

This is the beginning of the trend, not the end.


Agriculture Comes On Strong

Monday, August 16th, 2010


In early July, we made the determination that Agriculture investments were due to rally big: drought in Canada, China and elsewhere, plus rising demand from the growing third world middle class, meant that the cloud Agriculture was under was due to end. Timing is everything as you can see from the chart of Monsanto above.

I thought maybe you’d like to check out a couple of articles recently that support our view that the Ag area is almost a no-lose proposition for the intermediate if not long term.

Here they are (followed by today’s video – I always thought the woman that Simon sings about was one of the most beautiful I’d ever seen, and viewing this video for the first time in several years, I can’t say that I’ve changed my mind much):

Food inflation dips to 9.6% on cheaper cereals & veggies

From the Economic Times – India’s version of the Wall Street Journal

NEW DELHI: Food price inflation dropped to single digit 9.67% for the first time this year, even as the government continues to face a concerted Opposition attack on rising food and fuel prices.

The data is, however, unlikely to alter RBI’s hawkish stance, which has firmly shifted its policy focus to containing double-digit inflation and cooling inflationary expectations.

The deadlock in Parliament over the rising prices of essential commodities continued with a determined Opposition stalling both Houses for the third working day of the monsoon session.

Led by cheaper cereals, rice and vegetables, the annual rate of inflation in the food price index fell to 9.67% in the week ended July 17, as compared to 12.47% in the previous week, official data released on Thursday showed.

The Reserve Bank of India in its policy review on Tuesday hiked key interest rates for the fourth time this year. Worried that the higher food prices have transferred into core inflation, it also upwardly revised its projection for headline inflation to 6% by March end.

Bond yields moved up on expectations of another rate hike by September. The yield on the 10-year bond ended at 7.78%, 3 basis points above Wednesday’s closing.

While the finance ministry welcomed the news and said headline inflation will now move ‘choppily downwards’, an RBI official reiterated the need for further rate hikes.

“Food inflation has moved pretty much on cues I had expected. But it should not be over interpreted. The RBI has taken very sophisticated steps. Given that the inflation is high, you gently push up the interest rates without putting brakes on the growth. Abrupt measures could have had impact on employment for which weekly data is not available,” finance ministry’s chief economic advisor Kaushik Basu said on Thursday.

“You are injecting liquidity at 5% and inflation is at 10%. They will never be able to control inflation, everything else remaining the same. Monetary tightening has to be more aggressive,” an RBI official said on conditions of anonymity.

Headline inflation touched 10.55% in June and the government is worried that it will be even higher in July when the full impact of the fuel price hike is absorbed in the economy. The fuel price index rose 14.29% in the period, as against a 14.27% in the previous week.

Most economists are also of the view that while food prices are cooling, core inflation is now a bigger problem.
“We must wait for more data before reaching any conclusion. But if this trend continues, inflation could come down much sooner than expected and touch 6.5% by March. But I expect the RBI to remain vigilant as it is worried by non food inflation,” said DK Joshi, principal economist at rating agency Crisil.

NR Bhanumurthy, an economist at NIPFP, who agreed and said, “Moderation in food prices is part of a continuing trend. But the RBI is more concerned by the food and fuel price inflation pushing up headline inflation. So I expect another round of rate hikes.”

U.S. Food Inflation Spiraling Out of Control

From PRnewswire

FORT LEE, N.J., April 22 /PRNewswire/ — The National Inflation Association today issued the following food inflation alert to its members:

The Bureau of Labor Statistics (BLS) today released their Producer Price Index (PPI) report for March 2010 and the latest numbers are shocking. Food prices for the month rose by 2.4%, its sixth consecutive monthly increase and the largest jump in over 26 years. NIA believes that a major breakout in food inflation could be imminent, similar to what is currently being experienced in India.

Some of the startling food price increases on a year-over-year basis include, fresh and dry vegetables up 56.1%, fresh fruits and melons up 28.8%, eggs for fresh use up 33.6%, pork up 19.1%, beef and veal up 10.7% and dairy products up 9.7%. On October 30th, 2009, NIA predicted that inflation would appear next in food and agriculture, but we never anticipated that it would spiral so far out of control this quickly.

The PPI foreshadows price increases that will later occur in the retail sector. With U-6 unemployment rising last month to 16.9%, many retailers are currently reluctant to pass along rising prices to consumers, but they will soon be forced to do so if they want to avoid reporting huge losses to shareholders.

Food stamp usage in the U.S. has now increased for 14 consecutive months. There are now 39.4 million Americans on food stamps, up 22.4% from one year ago. The U.S. government is now paying out more to Americans in benefits than it collects in taxes. As food inflation continues to surge, our country will soon have no choice but to cut back on food stamps and other entitlement programs.

Most financial experts in the mainstream media are proclaiming that the recession is over and inflation is not a problem in the U.S. Unfortunately, they fail to realize that rising food and gasoline prices accounted for 58% of February’s year-over-year 3.85% rise in retail sales. NIA believes price inflation is beginning to accelerate in many areas of the economy besides food and energy, and all increases in U.S. retail sales this year will be entirely due to inflation.

Saturday, August 14, 2010
The Future of Overall Food-Price Inflation is Inevitable

From Trends & Forecasts

The future of overall food-price inflation is inevitable, as Wal-Mart reportedly has already hiked prices amid a recent jump in wheat prices and the failure of the Russian harvest.

A JPMorgan survey of supermarket pricing in Virginia showed a 5.8 percent increase in average prices at Wal-Mart, The survey compared a 31 item like-kind basket at a Wal-Mart Supercenter, Kroger, Safeway, Harris Teeter, and Whole Foods, the Business Insider reported.

Global fundamentals are supportive of a long-term rise in the price of food,

The UN’s Food and Agriculture Organization forecasts that total world demand for agricultural products will jump 60 percent between now and 2030, rising much more rapidly than the population

Richer people eat more meat. This increases demand for grain feeds for livestock over and above that used for human consumption

Ironically, a wheat stockpile in India that could feed 210 million people for a year is starting to spoil because the government lacks enough warehouses to store it.

According to The Associated Press, 17.8 million metric tons of wheat are exposed to the elements — stored outdoors, under tarps in India’s pounding monsoon rains.


The Mad Rush Into Bonds

Tuesday, August 10th, 2010
Courtesy of J P Morgan

Courtesy of J P Morgan

Have you ever seen a boat lean dangerously to one side after everyone rushed to that side to see something?

That is the feeling I have right now relative to bonds. Everyone is moving into higher yielding bonds and bond funds from the safety of lower yielding bank deposits. This scares me – whenever some asset class has everyone moving into it, that is generally the time that it is set to fall.

Above you can see that I have a graphic (courtesy of J P Morgan) that compares the amount of money that has moved into bond mutual funds to the amount of money that moved into technology mutual funds immediately prior to the NASDAQ Crash in 2000. You can see that more money has now moved into bonds than moved into technology funds.

Just like in 2000, my gut feeling says that there are a number of people that have moved money into high yield bonds in recent weeks so that they get an 8% yield but that they do not understand the risks associated with bonds, and junk bonds in particular. I am also betting they do not have anyone like BankChampaign that is looking out for them and trying to proactively manage the investment process on their behalf.

In recent days, we have been lowering our exposure to longer duration bond positions, corporate bond positions, and high yield bond positions. This is just a precautionary move that we feel is prudent given the big move by the unsuspecting populous into an asset class they do not understand. When investing in bonds, your risks are primarily Interest Rate Risk and Credit Risk. If you are invested in government bonds, theoretically, you have no credit risk, just interest rate risk. In corporate bonds, you have both interest rate risk and credit risk. In high yield bonds, you also have both interest rate risk and credit risk (including a higher risk of default), but you also add in the fact that high yield bonds react to the movements of the stock market in addition to the movements of the bond market. This makes it a much more complex investment.

As you review your statements for this reporting period and over coming reporting periods, you are likely to see that we will continue to make incremental moves into shorter duration fixed income positions and treasury inflation protection bond positions in order to protect the principal of our clients’ investment portfolios.

Bonds are not CD’s, and I think there are lots of people out there about to find this out.


Summertime, And the Livin’ is (not quite so) Easy

Tuesday, August 3rd, 2010


The chart at the top shows the performance of the bond market over the past 30 years. This thousand foot view over a long period of time shows that you could have quintupled your money in long-term treasury bonds over the past 30 years with no exposure to the stock market. Its pretty amazing when you think about it.

But the question anyone that is loaning our government money should be asking is: how much higher can the bond market go AND how much lower can yields go? Prices and yields are inversely correlated for fixed income investors – as yields go down, prices go up, and as yields go up, prices go down.

If yields can’t really go down much more, you have to ask yourself whether the risk is to the downside on the value of the fixed income investments that you own. And, if the risk is to the downside, then what might be out there that could cause yields to rise and prices to go down.

Enter stage-left: St. Louis Federal Reserve Bank President James Bullard. Here is a link to a white paper he released on Friday (you’ll need to copy/paste it into your browser):

In the paper, he advocates that the US faces Japanese style deflation (falling prices for assets) that could last decades unless the Fed takes some action (this is paraphrased from the long paper). The action being implied is another round of Quantitative Easing (aka, QE) – remember the $1 trillion in mortgages that the Fed bought from Wall Street banks during the crash – it basically printed dollars and exchanged them for the mortgage loans. The concept is that the Fed prints dollars and gets them into the banking system – banks exchange them for treasury bonds to earn a positive return on this free money – and eventually, lending will increase as the recession wanes, pushing economic activity and GDP higher. Good theory.

Unfortunately, the first trillion dollars didn’t do much to stimulate economic growth as the treasuries never got converted into loans – it however did allow many homeowners to refinance their mortgages and positively impact their personal balance sheets, so that was a positive.

Bullard’s plan for the next trillion (or whatever the number ends up being – bigger or smaller) is for the Fed to print dollars and buy treasuries directly from the US Treasury who would spend it on “stuff” in the real economy, thus putting money into circulation that otherwise would not be there. This assumes that the US Treasury would spend it on stuff that impacts the economy in the way Bullard envisions, I suppose.

There are lots of conflicting debates going on about whether the Fed will actually take this step. They clearly do not want to be viewed as allowing the economy to falter along for a generation like Japan’s has, nor do they want to see it fall into that elusive double dip recession, especially in an election year. So there needs to be a catalyst that convinces them that the economy is softening to the point where such drastic measures are needed.

Enter stage-right: Ugly Economic Reports
1. Pending home sales came in at -2.6% in stead of the consensus forecast of 3.9% following up last month’s -29.9%.
2. Factory orders also dropped to -1.2%, versus expectation of -0.5%, after the prior -1.4% reading.
3. June durable goods number was revised from -1.0% to -1.2%.

The Fed has a couple hundred billion dollars of mortgages maturing soon, and if they simply allow them to mature and take the proceeds, that ends up being a de facto monetary tightening, which I can’t see them allowing based upon the above economic reports. These reports may not be a sufficient catalyst to cause them to go for the full enchilada of another trillion in QE, but my best assessment is that they will certainly buy a couple hundred billion in new mortgages or treasury bonds in order to avoid the de facto tightening.

Is this the right solution? No, but the right solution is too politically unacceptable – less debt (government and private), lower asset prices, and better industrial/economic policy, a freeze and means testing on entitlements, lower government spending (transfer payments and the military), establish a value-added tax and increase income taxes across the board (you can’t ever fix the economy if 53% of Americans pay no federal income tax – they just don’t have the skin in the game to buy into the draconian fixes that are needed). I just see no other way to pay off the $20 trillion in debt we will have by 2015, nor the $30 trillion we will have based upon estimates from Jack Welch, the former CEO of General Electric, that he anticipates will happen if we stay on the current trajectory.

But, these changes will never be implemented until they are forced on us by our creditors (smile and say xie xie) – maybe that happens at Jack’s $30 trillion national debt level or maybe before. Until then, we will simply have a long slow debasement of the dollar by printing more and more of them to keep our economy afloat as we kick the can down the road. That debasement leads to inflation, but you hope inflation of the manageable variety given that the dollar – for now – is the world’s reserve currency.

Sorry for the depressing commentary today, but I have to look at all sides of things to make sure we are managing money for clients correctly. Looking at the action in the Inflation Protected Bonds market (see chart below) there seem to be others that are concerned about what appears to be on the horizon – currency debasement and inflation:


We have added this TIP ETF to client accounts as well as the open ended TIP mutual fund from Goldman Sachs. We haven’t made a wholesale shift yet, but incrementally we are preparing for what could be our future.

Sometimes I get comments from readers that I only talk about the near-term movements of the stock market and not the long-term horizon for the broader investment markets, and I have to agree that I tend to focus on that in these blog posts. But, I do watch the long-term and wanted to give you something that you can keep an eye on that has generational impacts: next week the Fed meets and an almost certain topic on the agenda will be Bullard’s QE discussion.

Watch for the Fed statements that come from that and the speeches made in the days following – if you hear something about the Fed rolling over their mortgage holdings into new mortgages or treasuries, or if you hear about additional purchases of treasuries beyond the couple hundred billion in maturities, then you’ll know Bullard won the debate and we are likely kicking the can down the road by moving along some form of the path outlined above.

Oh for the good old days where Summer allowed for livin’ easy.


Big Rally Nears Target Zone

Monday, August 2nd, 2010


Looking at the chart above, we can see that today was pretty impressive. We moved above the 200-day moving average and approached the bottom of our price target zone (the pink box) for the S&P 500.

The MACD indicator is above the zero line and widening plus the Relative Strength Index is above 50 but not overbought.

The only negative about this rally is the rather light volume – but that is to be expected given that its August and most of Wall Street is in the Hamptons or on The Vineyard. Those that are paying attention to the market are focused on Friday’s employment report – which is anticipated to be better by 100,000 jobs.

Today’s rally was kicked off by better than anticipated PMI manufacturing numbers out of China. Our own PMI came in slightly better than expected, but still less than the previous month.

I’m looking for a move into the 1130 to 1150 area as detailed by the pink box we’ve been watching for several weeks now. Several good technical things happen if we move into that area – we will have broken the series of lower highs and lower lows that the market has been printing since the April high. That will be key for many under-invested money managers to move money into the market or fear that they will be left behind.

Remember, the technicals of the market are simply ways to understand the psychology of its investors. They also give you clues to know what money mangers tend to do based upon various patterns. If the typical reaction of a money manager that sees a break in a patter of lower highs and lower lows is to commit money to the market, then when we see the pattern we try to factor that into our investment work.

So we are watching for a move into the new target zone. That will give us a break of the pattern of lower highs and lower lows. If we get bad news on Friday’s jobs report, the break of the pattern can act as a cushion for any bad news as money mangers view it as a buying opportunity. If that’s the case, we’ll be watching for a potential move to the 1175 area, or the market peak in mid-May.

So, lots of variables out there. No need to be a hero and make a rash move – just watch what the market tells you in conjunction with the fundamental data – and you’ll make the right decision.