This week I’ve got something that I hope will be fun for everybody.  Our friends in Washington DC have set a new economic tone, one that revolves around freebies and incentives to stimulate people into action.

Taking a cue from them, I give you…

The Draconian’s Dinner Date Promotion!

The prize is a $50 gift card for PF Chang’s.  I bought three of these things to award to our readers.  Read on to learn how you can win one.

We had a pretty good quarter in our trading business and also had a great quarter in terms of growing web traffic – for those keeping score at home, we are now the 1,378,422nd most visited site in the world!  After such an exciting quarter I had a few extra bucks in my “fun money” account, and this is one of the nice things about having total control over a website like this.  I don’t have to answer to the department supervisor to get approval from the branch manager (or my lovely wife) if I want to run a crazy promotion that throws money out the window with effectively zero return on equity.

Pay attention for a moment.  There are three ways to win:

1. Everybody that’s already subscribed via email is automatically entered in the drawing and anyone new that subscribes before the deadline will get a chance at a $50 gift card.  If more than 50 people sign up, I’ll throw in another $50 gift card to keep your odds of winning pretty good.  If 100 people sign up, I’ll go buy two more $50 gift cards.  Here’s a chance for you to send me to the poor house and make me feel good about it.
2. Everybody that refers at least one person will be entered in separate drawing.  There will be fewer people in this pool, so referring someone is your best chance to win!
3. Whoever refers the most new subscribers is guaranteed to get the final $50 gift card.

We use iContact to manage the mailout, so it’s easy for me to track who’s on the list.  So long as you follow steps one and two below you’ll get credit for your referrals.

If you consider yourself a true gamesman (as I’m wont to fancy myself), you’ll notice that it’s possible to win in more than one category.  I rigged it that way for a reason.  Go crazy.  If you win two or more of these things, take the whole family out.  Also, I’ve thought this all the way through and I know it’s possible to cheat.  You can sign up or spam your address book, win the promotion, and then unsubscribe from the newsletter.  I’ve made my peace with that and you will have to make yours.

Why P.F. Changs?  I like the lettuce wraps and honey chicken, and there are locations all over the country.  They actually beat me to it and are running their own crazy promotion with their whole “four-course meal for two for $39.95.”  Go right ahead and order one of those with your $50 gift card and leave a nice tip for your hard-working server.  They probably need a few extra bucks more than either of us.

There is zero downside here, people!

The Draconian is 100% ad and spam free and we don’t sell your email address to anybody.  Maybe that’s not such a big deal to you, but being able to run this website in accordance with my ideals is very important to me.

Here’s how to do it:

Step 1: Click here to subscribe.

Step 2: After subscribing, you’ll immediately get a welcome message and later in the day you will get a second message that has a special link you can click on to forward The Draconian to your friends and get credit for your referral.

Following those two steps will automatically give you two chances to win two $50 gift cards.

I’ll announce and contact the winners two weeks from now on February 11th.

This reminds me of a funny story from my youth.  My first real job in the industry was at UBS (back then it was PaineWebber).  I worked for a couple of brokers – super nice guys and old pros in the muni-bond market – in Los Angeles, and fell in love with the markets on day one.  I’ll tell you the story of how I got a corner office on the 30th floor another time.

Anyway, one day our branch set up a booth at a major tennis tournament held in posh West L.A. to recruit some new customers.  People could fill out a little survey card and drop it into a raffle for a chance to win a new tennis racket.

After the tournament, we took the big bucket of names back to the office and went through them one by one.  We’d set all the complete entries aside to cold call them later and then we’d look for “good names” in “good zip codes” e.g. Dr. Whoever or maybe somebody in a 90210 or 90067 zip code.  Then we called them up and told them they’d won a prize.  And tried to sell a new brokerage relationship along with it.

This sort of popped my cherry in the world of marketing and I learned something of an ugly lesson about what the financial industry was all about.  Naive little me always assumed those “Win this fabulous prize!” surveys were random and harmless.  Since then I haven’t filled out a single one.

Well, this isn’t going to be one of those promotions.

Here’s what I’m going to do.  I’m going to put everybody’s name on a big spreadsheet, roll some 10-sided dice, and pick a row.  If your name comes up I’m going to send you an email, ask you for a physical address, and drop the gift card in the mail with a Post-it note that says “Thanks!”  No funny business, no sleazy marketing.  My goal here is simply to get a few more people on the email subscription list but more importantly, to let you all know how much I appreciate and am humbled by your weekly attention.

Again, thanks for being such great readers.

I know all this economic stuff can get a little technical at times, but every single one of you should pat yourself on the back for keeping up because we have covered a tremendous range of material over the last six months.  I’ve broken down gold, housing, and inflation.  Kelsey aka “The Draconienne” offered up a very intimate, personal perspective on the jobs market.  And Kyle has covered some very technical territory with his Draco Trade School.

A lot of investment websites out there give you pretty much the same garbage week after week, and I understand that a newsletter like ours can be a little more demanding.  So far, you guys have proven to me that you’re up to it, and I hope you all don’t mind if we keep pushing you toward being even more sophisticated investors in 2010.

OK, back to business.

Market Recap

This has been the worst week in the markets we’ve had in quite some time, including a few single days that were as bad as any we’ve seen in the last year.  Market action has been lousy day after day, featuring big drops on heavy volume or morning rallies followed by afternoon declines.  The feel is one of significant selling pressure.

It’s a lot more difficult to link cause and effect in the markets than you might expect.  You probably go home every night and turn on the news and hear Brian Williams say something like “stocks were down today after weak home sales data for December.”  True, those events may both have occurred on the same day, but in reality, there are many things that move the markets.

Most of what happens within the course of a day is noise.  There are so many factors – infinite factors, really – that creating a cause/effect relationship between one news item and market action is a tenuous proposition at best.  But doing so makes for a more interesting story and besides, we all like having clear reasons for the phenomena we witness.  It’s a lot easier to digest than the truth, which consists of millions of complex, unfathomably-subtle and impossible-to-understand relationships that move markets one way or another.  That’s an existential rabbit hole that few of us ever want to go down, much less five days a week.

That being said the market has sold off, and one of the bigger reasons I’d submit is that there has recently been an increase in general uncertainty about the future.  If there’s one thing the market really hates, it’s uncertainty.  Stocks are nothing more than a claim on a stream of future earnings, and when that future stream of earnings gets murky, it sends volatility through the roof.

The good news is that on a technical basis, the market is as oversold as it’s been since the crisis.  The trend has been decidedly up, and those of you chart technicians know that when the trend is up and the market gets oversold, it’s often a good time to buy.  On the below chart, I’ve indicated the levels at which the market was trading below 40 on the RSI.

Be careful, though.  Two weeks ago we warned about a few red flags that were popping up in places like Greece, Dubai, and China.  And last week we mentioned the three most important events that are set to directly affect the U.S. this year.  Give those a read if you haven’t yet.  (Thanks for all the positive feedback on those two articles, too!)

You guys all know our outlook for 2010 and beyond.  I think the theme of the year will be a reminder that things are really difficult out there and the market will respond accordingly.  It will be an environment that can be tactically traded by those that know how, but those with a little longer horizons need to make sure they’re properly diversified and not weighted too heavily in equities.

Banks leading the way

Financial stocks have led the way lower and seem to be rolling over on concern that the administration is going to crack down on them via higher taxation and more regulation.  Despite talking tough, Obama & Co. have been extremely friendly to the banks post-crisis.  But now in 2010 they seem to be taking a different tack and may actually be bowing to some political pressure from their Main Street constituents who haven’t faired nearly so well as Wall Street in the last year.  In this environment of uncertainty, it’s suddenly a lot more difficult to evaluate the earnings power of these financials (not that it was easy to begin with).

The topic du jour is this new Volcker Rule, which will supposedly prohibit traditional banks from running prop trading desks, hedge funds, private equity funds, and other higher-risk/higher-reward activity.  Personally, I like the rule and its spirit, but having something like that installed wouldn’t have prevented the crisis.  Controlling leverage is the theme to focus on if averting another 2008-style disaster is what we’re really interested in.

Those of you who recall our 10 Predictions for 2010, will remember that #9 was “big financial institutions get smaller.”  I feel kind of guilty about that one being such a no-brainer, and I didn’t think we’d see real action on this come to fruition so quickly.  It’s unclear when this Volcker Rule – which nobody saw coming, by the way – will go into effect.  The details are still unknown, but if this or something like this passes it will force a lot of these banks to divest themselves of certain lines of business.

Assuming that does happen, you can bet your bottom dollar that Goldman Sachs and Morgan Stanley will be converting from commercial banks back into investment banks before too long.  This means they’ll be subject to more relaxed capital requirements and less regulation, but it also means they won’t have access to all the wonderful bailout facilities the traditional banks do.  No big deal though, right?  If the going ever gets tough for those guys they can always convert back into commercial banks and get awesome loans at the Fed discount window.

All snarkiness aside, I think Goldman may actually be a good bet to go private in 2010-2011.  Seriously, they are one of the biggest targets of the government right now and in this era of populist backlash they are one of the most unpopular companies around.  If you were Goldman Sachs, wouldn’t you want to just buy the public out and go about your business with a little more privacy?  Wouldn’t it be nice to pay your employees whatever you wanted to pay them without any kind of politics weighing in?  This is a company with a market cap of about $75 billion that’s set to generate about $45 billion in revenue this year.  After setting aside about $20 billion in employee bonuses, they’re connected to plenty of capital to make it happen.  Plus, Warren Buffett still has his warrants entitling him to purchase up to $5 billion of Goldman at $115/share, a truly smokin’ deal.

Beware the Ring of Fire

You may have already read the most recent Bill Gross piece, but here’s all you need to know.  This chart relates a country’s current budget deficit to it’s total public debt.  Countries in the top left have budget surpluses and don’t owe a lot of money.  Countries in the lower right are running big deficits and owe tons of money.

We’ve talked about several of these countries in the weeks prior.  You probably weren’t aware of the illustrious company that the U.S. now keeps.

If you’re one of those folks that are a little concerned about the Dollar over the next decade, foreign currencies are an interesting way to diversify, especially if you want to avoid riskier assets.  You can go to Everbank.com and buy CDs denominated in currencies like the Canadian dollar, Danish krone, or Brazillian real.  Some of these like Australia and New Zealand will pay you higher rates than Treasuries or money market accounts and also give you some diversification outside the U.S. dollar.

Just stay away from Japan, the UK, and the Mediterranean.

On a final, positive note, we’re set to get the report on 4th quarter GDP tomorrow and it looks likely to be a real barn burner.  I think that this will probably be the last bit of data the NBER needs before officially calling the end of the recession in Q3 or Q4 of last year.  You’ll remember way back last summer we wrote that this would be a recovery in name only, one only a statistician could love.  The recession may be over, but my guess is that today, when you look around, you probably don’t feel that way.  Hopefully the last year’s market action has been signaling that sometime soon, you will.

See you all next Thursday!

I feel that this week’s letter is incredibly important as we take a look at three major events all set to converge in mid-2010.

The market has sold off a bit in this holiday-shortened week, but there hasn’t been any new major market-moving events that we haven’t already discussed.  The trend is still up and we like doing our buying on dips.  Traders, here is your dip. 

Now that that’s out of the way, let’s jump straight to it.

The Analogy of Winter

Regular readers are probably groaning “here we go again with the weather!”  But hey, people like talking about the weather, and more importantly, they understand it.  Even someone such as myself, with basically zero aptitude for small talk, can appreciate the fact that this is one of the great common denominators in our culture.  It’s a language that every single one of us speaks, so indulge me for a moment as I use this language to tell you a story about investing.

I wrote last week and also month or so ago that winter is a season that consists of a series of storms, each of which look a little different from the last. 

Up here in the Sierras, the first storm we got this winter was nasty.  Vengeful, even.  Mother Nature blanketed the valley with over a foot of snow and then, from her lofty throne, threw down about two straight weeks of sub-freezing temperatures.  So that snow and ice didn’t melt for a while.

We did have some fairly nice weather in the first part of January, but as old school Nevadans, we were not fooled and kept the Bermuda shorts and sundresses tucked away in the back of the closet.  Good thing we did, because this week has been windy, wet, and cool, not exactly what we saw in December, but still, everybody knows what season it is.  After so many winters in the mountains, we know that the storms won’t stop until winter finally recedes. 

A year ago in the markets we were in the midst of one hell of a blizzard.  It was driven by panic and fear, fear that the economy would fall apart, fear that banks were insolvent, fear that borrowers couldn’t pay back their loans.  Uncle Sam stepped in, the blizzard passed, and for the rest of 2009 the market weather was rather balmy.

Do not be fooled.

Winter is not over.

Your weather forecast for 2010

Last week we discussed a few little storms that are currently raging, just not raging here in the U.S.  It’s important stuff, especially as Greece has continued to deteriorate and China has continued to shake up the markets and both stories get more and more attention.  You can get caught up on that right here in case you missed it or want to learn a little bit about Greek mythology.

Allow me now to put on my meteorologist hat for a minute and take a look at the next series of major storms that are brewing off the coast.  What do you guys call them on the Atlantic side?  Nor’easters?  Right now, there are three big systems gathering strength and they are all set to converge on us at about the same time.  I’ll address them in order of importance.

1. The cessation of the Fed purchase program

I’ve written about this before, as I think this is the single biggest thing to watch in 2010.  For new readers, I’ll quickly recap:

• The housing bubble popped and the value of mortgage-backed debt collapsed, eviscerating the balance sheets of large financial entities and causing the credit markets to freak out.
• The Fed shot nearly $1.5 trillion of liquidity into the markets to calm everybody down.
• As these liquidity measures have unwound, the Fed has moved towards a strategy of buying up the stinky mortgage-backed debt that originally caused the balance sheet crisis.

Here’s a chart of the Fed’s assets courtesy of the Federal Reserve Bank of Cleveland:

As you can see, this chart tells a fascinating story, a bold new experiment in U.S. monetary policy.  When everything hit the fan in late 2008, loans to Financial Institutions – you know them as Citigroup, Bank of America, AIG, Goldman Sachs, etc. – exploded.  In the past, that had always been a relatively small portion of the Fed’s balance sheet, which normally consists primarily of pretty liquid stuff like cash reserves, gold, and short-term treasuries.

Through 2009, the banks that borrowed money from the Fed started paying it back, and as they did, you can see that the Fed started buying mortgage-backed securities with the proceeds.  The gray chunk and the brown chunk correlate (inversely) almost perfectly.  And what’s more, the increasing size of that brown chunk, the MBS purchases, correlates almost perfectly with the enormous market rallies that we saw in 2009.  It turns out that wasn’t just correlative, it was actually causational. 

Remember this helpful graphic?

The Fed bought about $919 billion of mortgage backed securities in 2009, and the key question is what will happen when the Fed starts getting rid of them.  Actually, getting rid of them isn’t so much an a issue as what the heck is going to happen when they just stop buying these things? 

Brrr.  That could be a very chilly headwind for markets in 2009 as they fight to justify artificially high valuations.

Watch this, people.  This is literally history in the making and while nobody’s really talking about it in the mainstream, it is going to have epic repercussions in the markets.  Right now, the cessation of this program is scheduled for March.

2. Obama makes some difficult policy decisions

Sometime later this year, probably once healthcare gets sorted out, the administration will need to start some real dialogue on what kind of policy it wishes to chart.  There are two major challenges worthy of his attention and unfortunately they involve mutually exclusive solutions.

On the one hand, Obama can choose to focus on the jobs market and try and mitigate the effects of a workforce where 10% of the workforce is unemployed and over 17% aren’t as “employed” as they’d like to be.  Almost two years after unemployment started rising, these numbers are still going up though they do seem to be approaching a peak.  But the reality is that any major improvement in the labor market will be a long, slow haul.

Obviously, a depressed labor market makes it really hard for the economy to grow, and if Obama chooses to tackle this issue we’ll probably see a whole lot more stimulus.  More stimulus and more money printing mean that the risk of abnormal inflation goes up substantially, which would reduce everybody’s longer-term quality of life via higher commodity prices and also threaten demand for the U.S. Dollar and Treasury Bonds.

On the other hand, Obama can choose to address the deficits which every day come under greater scrutiny by both Americans and the rest of the world.  Fixing the deficits is pretty easy, it just means less government spending and higher taxes.  Clinton did it, and Obama could do it too, though times are a little different today.  In my view this course all but guarantees a double-dip recession, an event which would certainly send the markets way lower. 

If I had to guess, I’d say the administration trains its focus on jobs.  Ultimately, these politicians are self-serving and their number one goal is to keep themselves in power.  Doing so will require pandering to their constituents and lobbyists who will both likely be demanding more government cheese!

Either way, it’s an incredibly difficult decision.  He can’t and shouldn’t try to accomplish both because fixing one problem necessarily exacerbates the other.  Neither carry a lot of positive consequences, but we ignore them at our peril.

Buckle up for some heavy duty drama, both in terms of its effect on the markets and also in terms of political theater.

3. Bernanke sets a course for interest rates

In the mainstream, this has received and will probably continue to receive most of the attention because it’s the easiest for investors to understand.  It will be a significant event, one that will effect the markets one way or another, but I don’t think it will be as significant and certainly won’t carry the same long-term ramifications as the aforementioned events.

In the post-Greenspan era, pretty much everybody now recognizes the danger of leaving rates too low for too long.  Don’t get me wrong – the low rate punch bowl is darn tasty to drink from, but the more one drinks the nastier the hangover.  That’s the last thing our economy wants to look forward to.

So at some point this effectively-zero interest rate policy is going to have to be reversed.  We all know it, but we might not all be aware of the timing issues involved.  You see, Bernanke has spent the last few months basically running for reelection.  True, Obama has already nominated him for a second term, but his reappointment needs to be officially confirmed by the Senate, and the deadline for that is January 31st. 

Lately, he and the other members on the board have been giving speeches and saying all the things that politicians want to hear, like a super-accommodative Fed and low interest rate policy.  Once Bernanke doesn’t have to worry about his job security anymore, he can finally start having a real conversation about interest rates and where they need to go.  It will probably take a month or two after his confirmation before this conversation begins, but it will be one that really moves the market.

Here’s a weather map for the next few quarters:

Winter is here

Listen, winter is the tough season but it serves an important purpose.  It’s a time when weak things die.  It’s a time when problems get solved.  It’s a time when we all huddle up together and figure out what’s worth saving as we long for spring.

And spring will come.  Spring is the time for planting, for sowing the investment seeds that we will reap in the fall.  Eventually winter will pass, but it won’t pass until all of these fiscal and monetary challenges get resolved.

If we look back over the last three decades, there’s a pretty clear pattern.  Does anybody remember 1982, as the last big winter of the 70’s was finally moving through?  People were tired, the future was bleak, and stocks and other assets were trading at valuations unseen in a generation.  But spring was on the doorstep, and those that invested through the 80’s made hay in the balmy summer of the 90’s.  The last decade has been decidedly autumnal, as the leaves started to turn brown (but not fall off) and a few last-minute bubbles were inflated as we hoped that this would be the cycle when winter wouldn’t come.  But as of 2008, winter is here, and now is the time to atone for the mistakes we made in the prior seasons.

I don’t have the answer for when exactly spring gets here, but it will.

It will probably happen when this wintry cycle of de-leveraging and balance sheet cleanup is finished.  It will be happening at the personal level as individuals save more, spend less, and deal with their various debts and shaky employment situations.  It will be happening at the municipal level as cities and states respond to lower tax revenues, restructure some of their debt obligations, and cleanup their workforce.  It will be happening at the corporate level, as businesses large and small get their credit back in line, write off their stinky assets, and become more efficient with their operations and staffing.  And it will be happening at the sovereign level as countries (not just the U.S.) cautiously relax stimulative Keynesian policy and address the risks they’ve created with their budgets, currencies, and debt.

All of those gears fit together and turn one another, powering feedback loops within feedback loops.  I’m of the belief that this is a process that will take the next decade or so to resolve.  This is an investment newsletter after all, so what might things look like at the end of this decade?

• I have a hard time seeing a Dollar that isn’t quite a bit weaker.  This is tricky, because we might actually see some strengthening against the Euro or Yen or Pound.  But relative to things like gold and other fixed assets and less troublesome currencies like the Looney, Kiwi, Aussie Dollar, or RMB, the dollar could be a lot cheaper.
• I see the stock market about where it is, or at least where it is after being adjusted for inflation.  I don’t think this is a decade where stocks average 10%/year and investors who need return streams like that will have to look to the world of alternative investments.
• Real estate will be back to normal, but a normal real estate market is one that requires rather strict borrower qualifications and higher rates than we’ve grown accustomed to in recent years.  It’s a market that doesn’t really appreciate much beyond inflation.  It’s a place to live, a place where only true professionals know how to make an investment out of it.

Here’s your road map: get as diversified as you can.  Pay down your debt.  Own inflation sensitive assets like Gold and TIPS.  Build a cash hoard to capitalize on opportunities and protect against deflationary panics.  Own some stocks, but not too many, favoring solid companies that pay good dividends.  Stay out of risky debt and stick to investment grade.  Own assets and currencies of other countries, countries that don’t seem to be as screwed as we are.  Get access to alternative strategies if your net worth qualifies.  Find a house that doesn’t weigh down your cash flow, a place to live not a place to flip.

I know that’s a very long-range strategy, but don’t worry, Kyle’s started working on another Draco Trade School piece set to run sometime next month and that should give you a few more tactics for managing the short run.

Spring, Summer, Fall, Winter…and Spring

There’s probably like 4 of you out there who caught the reference in the title.  For everyone else, it comes from the brilliant 2003 Korean drama from Ki-duk Kim, Bom yeoreum gaeul gyeoul geurigo bom.

It’s a film that is about many things, not least of which is the grand cyclicality suggested by its title.  It follows the life of a monk and a young boy on a tiny mountain lake.  The beautiful cinematography might take your breath away, but it was the movie’s profound subtlety that left me speechless.  Even with an almost complete lack of dialog, it is a film that contains answers, answers which will undoubtedly lead you to asking many more deep questions, as previously invisible dimensions of life unfold before your eyes.  Its message is unequivocally Buddhist, but Buddhism is a rich vein of wisdom which too few people in this country mine for its multidisciplinary merits.  Anyway, this is Jeff’s Movie Recommendation of the Month.

If you don’t want to add it to your Netflix queue, just know that the economy, as does life, moves in long cycles.  We are powerless to rage against these cycles, and there is a peace that comes with understanding and accepting them.

It has always been this way, and this is the way it will always be.

In Greek mythology, Cassandra was the daughter of King Priam and Queen Hecuba of Troy.  She was renowned not only for her status as a young princess, but also her great beauty – the most beautiful of all of Priam’s daughters.  Lusty combinations like that seldom went unnoticed up on Mount Olympus, and before long Apollo found himself smitten by the young Cassandra.  In an attempt to win her heart, Apollo granted her the gift of prophecy.  But Apollo’s godly love went unrequited, and, unable to rescind the powers he had already bestowed, he cursed her instead so that no one would ever believe her predictions.

It was a shame, because she accurately predicted the Trojan War and Troy’s defeat and warned her countrymen not to accept that sketchy-looking horse.  As the Greeks were divvying up the spoils, King Agamemnon took her as a prize.  But he got what he had coming as well.  He didn’t listen to Cassandra’s predictions that they would both be murdered by his crazy wife back in Mycenae, and lo, when they returned to Mycenae, they both got murdered by his crazy wife.

Greek mythology isn’t the only place that one can go to satisfy one’s hunger for drippy irony.  There is also the markets.

Today we’re going to look at a few interesting events that could be precursors to another round of difficulty in the markets.  I promised back in this piece, where we talked about the abatement of the crisis, that I would let you know when I started to see some cracks in the system, some possible canaries in the coal mine.

Well…

Red flags are starting to appear

First of all, I am no Cassandra.  I am neither beautiful nor of high status, and most importantly, I can’t predict the future.  So I hope I don’t come across as a prophet of doom, though the gods know there’s certainly a market for that kind of commentary!   (Alas, Nouriel Roubini’s got that niche pretty much cornered.)

Here at The Draconian, we just try to call them as we see them.  If anything, we are prophets of caution, as the one thing history tells us is that the world of investing is a lot more risky than the average person on the street gives it credit for.  Our commentary isn’t designed for a specific type of reader, nor is it exclusively geared for financial experts of varying stripes.  The Draconian is simply aimed at intelligent readers, and our general message is “be careful.”

So, intelligent readers, know that this Dubai World shakeup is disturbing for a lot of reasons.  For those who haven’t been following this story, you can catch up on it here.  Dubai, which was basically Las Vegas on steroids, is now dealing with some problems of its own.  Their flashy tourist-centric economy has collapsed and now they are having difficult with their debt payments.

The bonds of a lot of these Dubai companies, some state-controlled and some not, are now trading at less than 50 cents on the dollar.  The credit default swaps for some of Dubai World’s bonds show a 1/3 chance of default (and rising).

This is not an isolated event by any means.  Many claim it is, of course, reminding me of the old saying about there being “just one cockroach.”  Those of you who have unfortunate experience with these pests know that there’s never just one cockroach, there’s always a horde lurking behind the wall.

Dubai received financing from many banks around the world, though most of them were European.  RBS was one of the biggest lenders to Dubai, and as you can see, it’s had some trouble lately:

This should serve as a reminder that our global troubles are not behind us.  This is $60 billion of dodgy debt held by who-knows-whom.  Dubai has also just had its first major foreclosure, and it’s expected many more will follow.  Canaries are dropping dead around us and we should be mindful of what that might signify.

Is China a bubble?

Another red flag that warrants mention is billionaire hedge fund manager Jim Chanos’ recent declaration that China is a gigantic bubble.  Actually, I believe the words he used were:

“China is Dubai times 1,000 – or worse.”

Full disclosure: Chanos is famous for being a short-seller, so the fact that he has called something overinflated shouldn’t surprise you.  But he did pick out Enron, Tyco, Boston Chicken, as well as the US subprime bubble.  Everybody gives short sellers a hard time because they’re always so negative, but these guys are always the first to sniff out frauds and bubbles.

This story scared the bejesus out of me, and unless you’ve been totally out of it for the last five years, it should probably give you pause as well.  If it doesn’t, then you need to read Reinhart & Rogoff’s This Time is Different right now.  It is a heady read, so at the very least know that their take-home point is that financial crises are caused by a systemic overextension of credit and have been for 800 years.  More interestingly, they  compiled a mountain of compelling data that shows an eerie pattern of pretty much all major financial crises being preceded by a bubble in real house prices.

When I read stories about how high-end real estate prices in Shanghai were up 54% on the year or hear about Beijing developers celebrating record years with extravagant parties, I stop for a moment to contemplate.  Didn’t that happen somewhere else?  Oh yeah, here.

There is also this story floating around, about China surprising the markets and increasing the reserve requirements for its banks.  I actually don’t think this is truly indicative of Chinese worries that their economy is growing too fast (seriously, who worries about that?) or that they need to put the reins on inflation.  I think this real estate bubble and over-extension of credit has them secretly fearing a potential banking crisis a few years down the road.  If that’s the case, kudos to them.  They obviously learned a lesson from the U.S. in 2008.  Higher reserve requirements for banks would have gone a long way towards mitigating or even preventing some of the effects of the financial crisis we had here.  Bear & Lehman might still be standing.

I like China because its changing demographics are staggering in scope and could have dramatic global repercussions.  Plus they have a gargantuan amount of reserves.  But I don’t like China because I don’t trust any data that comes out of it and I have no way to assess it from a fundamental perspective.  Seriously, do you trust what the Chinese government tells you about its economy?  This is the same government that launches cyber attacks against human rights activists and restricts the search results Google can display.  It’s probably best to stay away unless you really know something about China or know how to trade markets using technical analysis.

For a spicy relative value trade, try shorting FXI (the Xinua 25 Index ETF) under SPY (the S&P 500).  The “11th prediction” that I wanted to make for 2010 and probably should have included was that the U.S. outperforms emerging markets in 2010.

More cockroaches

Greece recently had their debt downgraded by Fitch from A- to BBB+, amidst doubt that the country can avoid a default on some of its debt.

Their prime minister is on record as saying that “there is no risk of default,” but I’ve found the markets always tell a more interesting story, and with much more honesty, than politicians.  Here’s a chart of National Bank of Greece, down 35% in the last three months:

I’ve been to Greece twice, and let me tell you, I’m not hopeful for the Greeks.  Don’t get me wrong – Greece is one of the most beautiful countries in the world, and is home to an equally beautiful body of people.  The culture there is intoxicating and the food is divine.  It’s impossible to spend time on the islands and not be profoundly moved in some deep, metaphysical way.  (On my first visit I was actually changed in a physical way, but that’s a story for another time, the moral of which is “wear a helmet if you get on anything with two wheels that goes faster than 35mph.”  Also: Europe’s healthcare system is not better than the United States’.)

Right now Greece is suffering from a major hangover from the 2004 Olympics as well as the same credit trouble plaguing many other countries today.  I was there in 2001 as they were designing all these infrastructure projects, and things seemed so optimistic amidst hope for joining the European Union and hosting the games.  But when I returned in 2007, Athens was a mess.  Thanks to 9/11, they didn’t get the economic boost they were banking on from the Olympics, and all these massive projects are now sitting idle, gathering dust, a complete waste of resources.  Our bus driver summed it up best in his accented English, “Greeks, we are, ehh, not an organized people.”

The years of excessive deficit spending are now catching up to Greece, and soon their Debt-to-GDP ratio will be the highest in the EU.  Unfortunately, their national psychology is not one equipped to deal with environments like this.  Last week I mentioned the data that Reinhart & Rogoff dug up on financial crises and Greece’s history might surprise you.  After joining the EU they’ve been OK, but since 1800, they have spent a little over 50% of the time in one state of default on their debt or another.

Standard & Poor’s also just revised its outlook for Spain from stable to negative, following an earlier warning about Portugal.  Few are talking about it, but Spain is a complete disaster right now.  They had an even bigger housing bubble (in percentage terms) than we did and their skyrocketing unemployment rate is about ready to move above 20%.

None of this makes me very optimistic about the Euro, and makes me excited to own something like Gold or investment-grade corporate bonds in Euro-terms.

Cassandra’s warning

China’s odd maneuvers, Dubai’s problems, and the brewing credit trouble in Greece seem relatively small in the grand scheme of things.  I suppose I can’t argue with that.  But this is how these things go.  In 2007, a few hedge funds blew up and the world said it was an isolated event.  Then Bear Stearns collapsed and was quickly gobbled up by JPMorgan; this too was “isolated”, and the world rejoiced at Jamie Dimon’s smarts.  But then came the Lehman fiasco and the financial world fell apart.

All of those “isolated” events were linked to the same basic problem, the overextension of credit.  And what disturbs me today, is that Dubai and Greece and Spain and China can also be traced back to that same basic problem.

I’ll take a moment and quote myself from a few weeks ago, which seems a little more relevant today now that we’ve had our first round of snowstorms up here in the mountains:

Winter consists of many storms.  The first might drop several feet of snow.  That snow will melt and the next storm might bring icy rain or possibly a dry week of sub-zero temperatures and high wind.  No two storms are exactly the same.  If we can be sure of one thing it’s that the next crisis will look a little different than the last.

All these storms have the same cause, though.  Winter. Sorry to be such a Debbie Downer about all this.

Here, this will make you feel better about Greece:

On my list of things to do before I die is to return to Santorini, rent a villa, and just forget about the world and its troubles for a month or two.  Ahh…

OK, back to reality.

Job losses: they won’t stop!

There was a little bit of optimism after November’s jobs report which showed a modest gain in nonfarm payrolls.  But December showed another 85,000 jobs lost, most coming from the construction and manufacturing industry.  After an improvement in the unemployment rate in November from 10.2% to 10%, it held steady again at 10% for December.

The calculation of the headline unemployment rate is a very misunderstood process.  Contrary to popular belief, the Labor Department doesn’t just call up a bunch of people every month and ask them if they’re unemployed.  But the concept of unemployment is fairly easy to understand:

Unemployment Rate = Unemployed Workers / Labor Force

Those numbers aren’t what you think.  The calculation begins with the labor force, which is basically everybody aged 16+ that wants to work.  If you’re retired or are going to school or simply want to hang out on your buddy’s couch for a while, you aren’t included in the labor force.  As you can imagine, it’s a pretty dynamic number with young people entering the labor force every day and elderly people leaving it.  This is the denominator in the calculation, so when the labor force contracts while everything else is held constant, the unemployment rate will improve.  Believe it or not, we are currently at a 25 year low in the labor force participation rate and it contracted by a record amount (-1%) in December.  You are correct to notice that this contraction in the labor force improves the unemployment rate.

The top half of that equation is the number of unemployed workers, and these probably aren’t what you think either.  These are people that are not working but are ready and wanting to work and have also actively searched for work in the last 4 weeks.  What’s interesting is what this number does not include.

If:

• You have temporarily given up on searching for a job because the economy stinks, or
• You would really like to work but just haven’t looked for it in the last month, or
• You have any kind of part-time job but want full-time work and can’t get it because the economy stinks,

Then you are NOT included in the unemployment calculation.

You might be curious to wonder what the unemployment rate would look like if The Bureau of Labor Statistics included all those people, and lo and behold, they do have a separate term for that, wonkishly called “U-6”.  The colloquial term is “underemployment” and it’s a much more sensitive measure of the health of labor market.

This number rose in December to 17.3%. It was bouncing around 8% just a few years ago.

The good news is that it seems like the unemployment rate is peaking or close to peaking, if only for technical reasons.  The bad news is that as the labor force starts to come back online and previously-discouraged workers start to look for work again, it will have the technical effect of slowing down statistical improvement.  The economy has officially shed about 9 million jobs since the start of the recession, but a net 5.6 million people – who would probably take a job if you gave it to them – have quietly slipped out of the labor force.  What happens when they try to come back?

People coming back into the labor force might be a positive economic indicator – that people are again hopeful about finding work – but politicians aren’t going to like it because they tend to hang their hats on the raw number.  They could have difficulty putting a positive spin on an increasing unemployment rate, but they’re resourceful folk and I’m sure they’ll figure something out.

In the meantime, check out this excellent chart from Calculated Risk, one of my favorite sites to help stay on top of economic data flow:

Note first of all that the red line, the current employment recession, is still going lower.  Also note how much longer it took employment to recover after recent recessions.  There’s a good reason for that.  In the old days, the U.S. economy was primarily manufacturing-based; when the recession started people got laid off, and when demand started firming back up they were quickly rehired.  With a much more technologically advanced manufacturing economy and a more services-centric national economy, the rate of job creation is much slower nowadays.

Assuming the economy starts actually creating jobs sometime this year and the subsequent rate of job growth is somewhat consistent with what we saw in 2001 and 1990, you can see from the above chart that we are a long, loooong way away from pre-recession levels of employment.  Like, second half of this decade away.  This is consistent with what we’ve written before on this topic.

Anyway, as we move closer to legitimate economic recovery, it will become increasingly important to look at both the headline unemployment rate and beyond to get a sense of what’s really going on.

See you all back here next Thursday for what will hopefully be a more enjoyable time!  I’ve got a fun, different newsletter to run for next week assuming the markets stay fairly quiet and there isn’t something tremendously important to discuss.

This week we’re back with five more predictions for 2010.

Click here to read the first five in case you missed them.  Those were rather macro in nature.  Today’s will be a little more specific and don’t carry quite the same broad implications:

6) Gold bubbles.

It seems like everybody and their brother is getting long gold right now.  The really savvy gold investors were all buying gold much earlier in the decade and they continue to hold on to their gold as part of their long-term investment strategy.  A lot of the hedge funds that I know began getting long gold in 2009 – these are funds that are angling for short and medium term profits.  And now the public is starting to wake up to the notion of gold as an investment.

Everybody seems to be very optimistic about gold’s prospects, but what scares me is that hardly anybody out there seems to have any legitimate reason for how it could go down.  Seriously: what is the bear case for gold right now?  The only one of I can come up with that has any degree of merit involves another round of crisis a la 2008, where everybody panics, sells whatever assets they can, and buys dollars.

This is all fairly unnerving when you think about it.  This is the mindset that the world typically has about assets that enter the final “bubble phase,” a mindset where nobody can see any possible reason why the asset could go down.  Remember when nobody thought home prices went down, or when the technology explosion was permanently changing the world (and valuations)?

So I think you’ll see a double-digit year in gold.  What’s more, I think it could go completely crazy.  Like, $2000/oz crazy.  Gold’s had a heck of a run since 2003, but until this past year, the only ones talking about it were those that actively followed it.  But now it’s hitting the mainstream, and as is the case with most bubbles, most people don’t get on board until it’s too late.

This is probably the wrong time to buy gold for a long-term basis, but over the short-run, you could have some very powerful winds at your back.

So I think in 2010 it starts forming a speculative bubble, or at least generates plenty of mainstream conversation about whether or not it’s in a speculative bubble.  I think that could be one of the main conversations throughout 2010 – debate over whether gold is in a bubble or not.

7) Rates rise, but the unwind of the Fed’s purchase program is what bears watching.

Everybody makes a lot of fuss about the Fed Funds rate, but the real thing to watch in 2010 will be how the Fed responds to the $1.3 trillion worth of “securities held outright” it has purchased in the last year.  Details on these “securities” are a little murky, as the Fed has resisted efforts from rogue congressmen to force an audit of its balance sheet.  But it’s pretty easy to guess.

Undoubtedly, there are plenty of Treasury bonds lurking here (buying bonds drives interest rates lower), bonds that the Treasury issued to pay for the budget deficit that were then immediately purchased by the Fed.  And there is probably plenty of stinky stuff too, piles of agency debt and Fannie/Freddie-related securities, backed by assets (houses) which aren’t really worth what they’re being carried at.

Remember, folks, that the original intent of the $700 billion TARP was to scoop up all these toxic mortgage-related securities on the taxpayer’s dime in order to restore faith in the solvency of large banks.  But it was very quickly discovered that the problem was far more immediate and needed an immediate solution.  This was Paulson’s famous reversal, of course, where TARP was changed from a relief of troubled assets to direct capital infusions in these technically-insolvent banks.

2009 was a year where the Fed got back to that longer-term strategy of vacuuming up (Roomba style!) these junky securities.  That gave investors around the world fresh capital, some of which filtered into the equity markets, fueling a violent rally.

Two major loops powered what we saw last year.  I have prepared the below picture to help you understand the subtle mechanics and nuances that powered all this epic public spending:

The second loop was how we got rid of a bunch of junky mortgage-related securities and re-inflated asset classes like the stock market:

I know all you taxpayers were really excited to own AIG at a cost of about $170 billion.  I’ll bet you are totally jazzed to discover you also now own $910 billion of mortgage-backed securities that the private sector didn’t want!  (That was sarcasm.)

What happens to these “securities held outright” in 2010 will be very interesting and will carry significant repercussions.  Somebody will have to buy all those Treasuries, and that junky debt still isn’t less junky:

Should the Fed begin dumping these on the market, it would be a chilly headwind for bonds and would drive interest rates northward.  This has been such a low interest rate environment for so long, and it seems like so many powerful rate forces have been tenuously held in check.  At some point these dams will break.  I don’t think that rates go completely nuts in 2010, but to me it seems really hard to bet against rising rates in 2010.

Right now, I think the risk/reward on the longer end of the treasury yield curve is totally out of whack and were I to acquire some treasuries, I’d stick to the shorter end of the curve.  Investors who need a longer horizon should consider TIPS, whose principal will readjust with inflation-measuring CPI.  Generally, I don’t think treasuries do much in 2010 unless there’s another panic like we saw a year ago.  And I agree with Bill Gross that corporate bonds fare relatively better this year.

The Fed got out its checkbook and spent an awful lot of money in 2009.  What happens to markets when it stops that spending, or worse, starts selling this stuff back?

8.) Here comes the VAT!

We’re not going to get one in 2010, but I think that 2010 could be the year where the debate starts to really heat up.  When politicians as different as Nancy Pelosi and Mike Huckabee, and economists as different as Alan Greenspan and Paul Volcker all start talking about the viability – and possible necessity – of a VAT, perhaps we should start listening.

For the uninitiated, a VAT (Value Added Tax) is basically a national sales tax.  Every other industrialized country has one, as do many emerging countries.  Why don’t we have one?  I have no idea.  The old saying goes:

Republicans don’t want a VAT because it’s a money machine and Democrats don’t want it because it’s regressive.  But we’ll get a VAT when Republicans figure out it’s regressive and the Democrats figure out it’s a money machine!

Personally, I love the idea of a VAT, as do I love the idea of any flat tax.  But I think in terms of abstractions, and approach problem solving from a highly-theoretical perspective.  Were one to design a tax system from scratch – perhaps on a tiny island republic – how could one resist the efficiency and elegance of such a system?  Political realities aren’t the first things I consider when assessing what’s wrong in any given system.

For as long as we’ve all been alive, politicians have used the tax code as a tool to get elected, and the problem today is that our tax structure incentivizes many bad behaviors while punishing many virtuous ones.  Don’t forget that this is an election year and politicians’ jobs are at stake.  To my knowledge, few politicians in history have kept their jobs after promising higher taxes on everybody.

But at some point, these guys will have to stop worrying about getting elected and start worrying about solving problems, right?  We’re going to all have to confront this glaring issue of too many expenses and not enough revenue, won’t we?  The U.S. can’t keep spending more than it makes indefinitely, can it?

Who knows – either way, the VAT discussion is one we should be having.  Especially in this environment when neither Republicans nor Democrats have earnestly exhibited any behavior to curb spending.

9) Big financial institutions get smaller.

This will be another major theme of 2010.  “Too big to fail” has become too-big and too-sensitive a catchphrase right now, and I think the era of actually reacting to that has begun.  Everybody from the voting public to corporate shareholders is going to rejoice when these financial firms start getting smaller and various divisions get spun off.

So expect to see one or more of these firms break itself up.  Maybe it’s Wells Fargo, maybe it’s JPMorgan Chase.  Most likely, it’ll be Citigroup.

Don’t forget that a lot of these gigantic megabanks were cobbled together during the heart of the crisis.  Remember the shotgun marriage of Bank of America and Merrill Lynch?  Or JPMorgan gobbling up what was left of Bear Stearns, with a little assistance from Uncle Sam?  I don’t think those specific deals get reversed in 2010, but I do think that a general pattern of slice-and-dice does emerge.

There’s been a lot of talk lately about reinstating the Glass-Steagall Act, which was a piece of legislation passed during the Great Depression that separated commercial banks (Main Street) and investment banks (Wall Street).  It was repealed in 1999, an act which many today blame for exacerbating the recent financial crisis.  The simple fact that your representatives in Washington D.C. are talking about reinstating Glass-Steagall should serve as proof enough of its repeal’s culpability.  Resurrecting Glass-Steagall or something similar would legally force some of these megabanks apart.

I think this is one of the no-brainer bets of 2010, and I’m sure you agree.  But I’m not sure about the best way for the average investor to play it.  An initial idea would be to short some of these traditional banks against their more profitable peers – remember that Glass-Steagall was torn down so all these traditional banks could get their fingers into the more profitable corners of the market.

Stay tuned throughout the year as this will be on the forefront of my mind.  I’m sure there’s a buck or two somewhere to be made off this trend.

10) There is at least one significant sovereign debt default.

I’m surprised I haven’t heard more people make this prediction.  To put a finer point on it, I think that somebody out there reaches an inflection point with their debt and it shakes up the global markets.  Back in November, we talked about possible catalysts that could destabilize the markets, and a major sovereign debt default/restructuring could be another.

There is a looong list of candidates.  Greece, Dubai, Portugal, Spain, Italy, Ireland.  Latin America has repeatedly proved itself untrustworthy with credit.  I find it hard to believe, but here’s another scary one: Japan.  Straight up defaults in industrialized nations don’t really happen, but at some point the Japanese have to hyper-inflate their way out of their debt, right?  How long will they allow it to weigh down their economic future?

We are faced with a similar dilemma and future here in the States, but Japan’s debt-to-GDP puts ours to shame.  This has been a major theme in this newsletter and our macro view of the future, but Japan today could be us ten or twenty years from now.

Over the holidays I read Carmen Reinhart & Ken Rogoff’s This Time Is Different: Eight Centuries of Financial Folly.  Personally, I think that’s one of the most awesome book titles ever and if that didn’t sell you on picking up a copy right here right now, perhaps the following quote to open the book might get you intrigued:

The essence of the this-time-is-different syndrome is simple.  It is rooted in the firmly held belief that financial crises are things that happen to other people in other countries at other times; crises do not happen to us, here and now.  We are doing things better, we are smarter, we have learned from past mistakes.  The old rules of valuation no longer apply.  Unfortunately, a highly leveraged economy can unwittingly be sitting with its back at the edge of a financial cliff for many years before chance and circumstance provoke a crisis of confidence that pushes it off.

This is not a book for those looking for a light, fun read.  It’s a book for data-heads.  I am flabbergasted by the data and research in this book – Reinhart & Rogoff somehow managed to quantify an incredible number of financial crises over the last 800 years, though the majority of the data comes from 1800 on.

Their message is pretty clear.  This time, it is not different.

Banking crises, debt crises, currency crises, and financial crises have been occurring pretty much since the dawn of the modern economy.  The lesson that any student of financial history cannot avoid is that periods of growth and asset inflation that are driven by an expansion in credit and systemic leverage invariably end in tears. The form it takes varies depending on the details.  Emerging economies, faced with few options and repercussions typically just default on their debt.  Larger economies tend to undergo prolonged periods of inflation, devaluing the currency they use to pay back that debt and bringing real GDP to halt.  Either way, the unwind is always ugly and the losers are the nation’s citizens and creditors.

We haven’t even come close to solving the problems that so many countries have created in the last decade.  I’m actually surprised there hasn’t been any major defaults/restructurings or currency crises so far.  Though, it might spook you to learn that Reinhart & Rogoff unearth an eerie pattern of sovereign crises following banking crises.  There’s good reason for that, of course.  Credit dries up during banking crises and economic growth contracts.  That produces a drop in exports in emerging economies, making it much more difficult for them to make their debt payments.

The last few years have been the nastiest banking crisis any of us have witnessed.  I hope that a round of nasty sovereign crises are not to follow, but that’s predicated on the naive belief that this time will be different.

History suggests otherwise.

A single grain of salt

If you’re someone that believes that humans can consistently predict the future with any significant degree of accuracy, I hate to break your bubble.  Take a look at others’ (or your own) predictions from the past and consider how frequently reality fails to shape up as it was forecasted.  Quite simply, we are lousy at predicting the future.  Yet we continue to do it, to go out on that limb and take the social and economic risks that carry such harsh judgments and financial costs if we are mistaken.

Making predictions in the public sphere might seem like a difficult thing to do, but all it really requires is just one quality: a complete lack of fear at being proven wrong.

Early in life I gravitated towards the sciences, a place where individuals made guesses, tested their guesses, and concluded whether their guesses were right or wrong.  I saw it as wonderfully win/win.  Right or wrong, I was guaranteed to gain something in the deal!  The best thing, too.  Knowledge!

Finance, of course, is dominated by a very different type of individual.  Those who want to understand phenomena and find the scientific method so compelling tend to wind up the world of science, while finance attracts those that want to know the future.  Deep down, everybody knows that predicting the future is impossible, which always made me wonder why so many take it so seriously.  The stakes are indeed high, as are the rewards, I suppose.  And perhaps that’s why it typically attracts those more interested in money than knowledge.  In aggregate, I guess that’s the majority of us and explains the relative dearth of scientists running around out there.

A large proportion of my friends are honest-to-God scientists, and I can attest that no, it doesn’t pay.  Certainly not the way hazarding guesses about the future can.  My science friends are incredibly high-functioning individuals and they aren’t obsessed with amassing vast quantities of wealth, and that discovery of self guided them to a field full of untold personal rewards.  They are among the happiest and most well-adjusted people I know.  Not because science contains all the magical secrets of happiness, but because it did for them.

Next January we’ll check back in and see how I did.  I’m a lot less interested in whether I wind up correct or not than in why I got it right or wrong.  This is why it took me 6,000 words to make 10 simple predictions – this piece is about the methodology, not the actual prediction.  I can guarantee you now that the “2010 prediction review” newsletter will spend much more time on where my analysis was on target or why it misfired.

And finally, before getting too excited about these predictions, go check out this post over at The Financial Philosopher.  It serves as a beautiful disclaimer-of-sorts to all that I’ve just written.  I don’t know if you’re familiar with The Financial Philosopher, but it’s a site worth your time, if for no other reason than it’s unlike any other finance blog that you’ve read.  All too often we in this industry spend our time looking for profits, but Kent’s blog will help you look for meaning.

See you all back here next Thursday!