Change Is by Jeffrey Dow Jones Thursday August 26th 2010, 7:14 am | Printer Friendly

Lots to cover this week.

We’re going to take a look at where the markets are at and where they might be heading as summer edges towards a close.  And we’re also going to talk about another top-level investment strategy that I think works really well in this kind of environment.  Warning: it’s a tough one to practice and implement.  We’ll see if you’re up for it.

But first, a brief visit to Jeffrey’s Movie Corner.

“Change isn’t good or bad, it just is.”
- Don Draper

Floored

The other night I watched James Allen Smith’s Floored, a documentary about the floor traders at the various Chicago exchanges.

It was fantastic.  If you work in the industry or have an interest in trading, I will guarantee your satisfaction.

Perhaps it was merely chance, but I found it rather fitting that I had finished up season three of Mad Men a couple nights before.  ”Change”, of course, is one of the major themes that runs implicitly throughout that show and that theme becomes rather explicit as the third season draws to a close.  The novelty of the whole Mad Men era is a really neat hook, but what really grabbed my attention and kept me watching was the subtle dramatic irony.  It’s ridiculous fun getting to know these ad men, their secretaries, clients, and wives.  All the while the 1960′s loom on the horizon and none of them can see the tempest that’s coming.

Watching Floored was a similar experience.  It was shot during the middle of this last decade on a shoestring budget of only a few hundred grand.  These are the final days of the floor traders, the descent of whom dovetails the rise of the machines.  I’d say that here too is another situation rich with enough dramatic irony to satisfy the ancient Greeks, but Floored‘s characters are in on the joke.  These guys are aware that they are dinosaurs, nobly plodding along toward their ultimate, collective demise.  Their world is burning down around them but they carry their heads up high.  There’s something to be said for that, I suppose.

Different traders respond to this in different ways: a few embrace the computers, others deny their significance.  Some leave the industry altogether while a tortured handful rage, rage against the dying of the light.  Gentleness is not part of a floor trader’s DNA.

I think the movie speaks more broadly to everyone in the industry.  Those of you that work in finance don’t need to be told how dynamic a world it is.  I came of age during a technological tsunami; my first job was at a traditional retail brokerage while stocks like E*Trade and Ameritrade IPO’d and shot to the moon.  Talk about irony!

All my generation has known is change, especially those of us that work in finance.  Trying to keep up is impossible at best and anxiety-inducing at worst.

Some of these traders in the film are a little rough-and-tumble, a necessary characteristic for survival on the floor.  But they share that same struggle as the rest of us, the endless battle to keep up.  You may just sympathize with them.  Beyond that, I think there’s a deeper theme that speaks to all men specifically.  On a fundamental level it’s about the challenges of providing for one’s family and those who trust you to succeed.  Each day these men venture into the jungle; to eat, they must kill.  One of the traders that Smith chooses to follow is also big game hunter.  That wasn’t an accidental decision on the director’s part.  The metaphor is clear.

Mark my words now:  this movie is destined to become a cult classic within the industry, much the way Wall Street and Boiler Room and Glengarry Glen Ross have.  Those are all excellent films.  But the difference with Floored is that it is true story.  These traders and this industry are not romanticized.  This isn’t a glorification of the capitalistic dream.  There is a brutal honesty here that you will respond to in one way or another.

Be careful, however.  If you let yourself in, if you allow yourself to empathize, you risk overwhelming sadness.  You will see parts of yourselves in these traders, ugly parts.  These guys are a dying breed, and so, you will discover, are you.  There is a river of melancholy that flows beneath the film.  Jump on in if you know how to swim in those waters but keep it at arm’s length if you don’t.

Anyway, Floored is still very much under the radar right now.  It’s not for sale on Amazon yet and you can’t just walk in and buy it at Best Buy.  I notice that you can save it in your Netflix queue but the availability date is still unknown.

If you want to pick up a copy, you can order the DVD straight through their website at FlooredTheMovie.com.

I’m a believer in supporting smaller, independent works of quality.  We should reward those that produce this kind of art and encourage them to make more of it.

Oh yeah, here’s a trailer.  It contains some bad words, but that’s how these guys talk.

On with the recap…

Market Recap

It’s been an exceptionally bumpy couple of weeks in the stock market.  Did you know the market is currently in a 13% drawdown?  Do you still have profits from the stocks you bought this year or last year?  Maybe you thought I was crazy to call for a 20% correction at some point this.  In July the market was down -17% from its highs, and it appears that it right now is attempting to make another run a testing those lows.  That’s a big dip!  Mr. Market is a mean ol’ S.O.B.

All you regular readers know that I like to look at broad trend lines and the S&P’s movement around the 200-day moving average has been downright fascinating.

Look at how many times it’s bumped it’s head on that 200-day moving average.

It just can’t establish itself above that level!

Since the financial crisis I’ve noticed that the fundamental picture has become a little… murky.  Forecasting earnings and determining the true health of a company was always a tough thing to do, but in this environment it’s more difficult than ever.  In the case of the bank stocks, I’m of the belief that assessing what they’re truly worth and breaking down their balance sheets is actually impossible.  If Chuck Prince couldn’t understand all the stuff that Citigroup was doing while they were in the middle of doing it, how on earth can a guy like me or any other analyst on Wall Street truly understand what’s going on inside these firms with trillions of dollars of assets and liabilities.

With fundamental analysis so difficult to perform now, I’ve seen a lot of investors turn to technical analysis.  Every so often on CNBC when they’re at a loss to come up with an explanation for the day’s market movement I’ll hear them say something like, “the market is being driven entirely by technicals right now.”

I’m not sure I’d agree — a million different things drive the market every day.  Plus, technicals don’t drive the markets; they are a way of interpreting the market’s movement.  So I think they’re right to point out that technical analysis is one of the few ways to make any kind of sense out of all this movement.  Moving averages may seem kind of simple but they’re a solid place to start.  Don’t discount them.

In the meantime, be skeptical of any rally until the market can establish strong footing above that long-term 200-day trend.  I’m slowly getting a little bit more bullish on quality stocks.  Now is a good time to assemble a shopping list for the next deflationary washout.

Bonds

Bonds have rallied ferociously in the last couple of months.  Those of you who have been following along in the last year know that we have been pushing bonds of many different flavors — high-quality corporates, intermediate term Treasuries, and TIPS — pretty hard.  Quite simply, that trade has been a winner.  The healing of the credit markets combined with increasing deflationary expectations has made for a record-breaking environment in fixed income.  But I had no idea it would work out that well.  I just liked them because they provided modest upside with minimal risk.  Turns out that type of investment suddenly got very trendy in 2010.

But every trade must come to a close and I think the meaningful gains have already been had.  Yes, bonds could rally a little further if the world panics or falls into another deflationary booby trap.  In our very Japan-like future, that’s a legitimate probability.  But I don’t think those possible gains are worth the risk the come along with it.  One of the biggest characteristics that separate the elite investors from the amateurs is the ability to frame return in terms of risk.

For the record, I still like TIPS has a long-term play — not a bet per se on inflation, but a nice thing to have in your portfolio if that someday that becomes a problem.  I’m nowhere near convinced that will happen any time soon.  But if it does I can see myself saying, “sure glad I bought all those TIPS way back when.”  You know, just in case.  I like ‘em better than straight Treasuries because what’s the difference, really, between 1% and 2.5%?  I’ll pay the extra basis points to get the special inflation features and lower risk.

The back end of the Treasury curve now terrifies me.  In February I was listening to analysts call for 5% on the 10-year!  Now that’s a really appealing yield.  But things have changed since then.  We’re at 2.47% today and I don’t think that is nearly enough compensation for all the baggage that comes along with owning a government bond over the course of a decade.  Better to hide out in the 2-year and wait around for another shot at better long-term yields.

The 30-year long bond is yielding 3.5% and that’s borderline insanity.  It may take a while to materialize and it’s not without certain risks, but shorting the 30-year may wind up being one of the greatest shorts in the history of shorts.

Is it a bubble?  You tell me:

Bonds have gone in one direction for thirty years.  They probably are in a bubble.  I think the best argument to made for the bubble case is not the price, but the eerie psychology in the bond space right now.  Everybody seems to know that bonds are too expensive and yields are too low.  Everybody agrees that ultimately, some day, at some point bonds will be a lot lower.  But in the meantime we all keep buying them because, darnit, it’s just the thing to do!  This was the same psychology during the dot-com boom and the housing bubble.

Anyway, I think it’s time to listen to what the bond market is telling us.

If you’ve owned bonds, enjoy the gains.  Think about realizing those gains and moving in on the yield curve.  If your portfolio is still underweight bonds, be careful when and how you scale in.  If you need more yield and are aware of how the risks work, take a look at the corporate bond space instead of going too far out the Treasury yield curve.  Pimco’s $28 billion Total Return Fund will get that job done in a balanced way, but if a super-gigantic fund isn’t your style there are other options.  I’ve long been a fan of and currently own Vanguard’s Short-Term Investment-Grade Bond Fund (VFSTX).  It yields about 2% and is very low risk.  VFICX is the intermediate-term variant and that one yields about 3.5%.

The Strategy of the Moment

Assuming the bond market is to be believed — and let’s face it, it’s smarter and more powerful than either of us — then the right strategy is a cautious one with an overweighting of cash.

I’d modify that strategy a bit, and restate it as follows.  If all that previous talk about interest rates and yield curves put you to sleep, now is the time to wake up.  Wake up!!!

The Strategy of the Moment is to hold a bunch of cash and wait for the market to give you opportunities.

The bad news is that this is quite possibly the most difficult investment strategy in the world.  It’s difficult for the amateur investor at home and it’s damn near impossible for professionals.

It’s such a difficult strategy because it requires the two rarest of disciplines, disciplines which are almost never found together.

1. Patience
2. The ability to identify great opportunities

I know people that are patient and I know people that can spot great opportunities, but I can probably count the number of people I know who can truly do both one one hand.  Take a glance at the cream of the crop of investment industry and you’ll notice that a disproportionate number of these guys — particularly those that call themselves long-term investors — are both patient and have that knack for finding the right opportunities.

Your humble narrator will cop to his own deficiencies.  I am plenty patient but have much to learn when it comes to assessing opportunity.  My other problem is that of inaction, of being perhaps too patient.  ”Analysis paralysis” if you will.  I’ll see the opportunity in front of me, recognize it, but fail to act or find some silly reason to talk myself out of following through.  I know I’m not the only one that suffers those very human flaws.  I’m actively aware of these faults and it’s part of the reason why I enjoy working with people who are so different from me; their skill set balances the flaws in my own.

I mentioned that it’s damn near impossible for professionals to follow this kind of strategy because it’s damn near impossible for investment professionals to sit still.  One of the big problems this industry has is that it’s overpopulated by people who feel they need to constantly be doing something to justify their job.  Financial advisors encourage their clients to rebalance their portfolios just to remind their clients (or themselves) that the advisory service they provide is defensible.  Perhaps we all have this latent fear, this innate knowledge that we are a value-obsessed culture that feels entitled to receiving something for nothing.  Financial professionals are deeply aware of this and I think it makes them nervous.

So just hang out for a while.

There isn’t much upside in fixed income anymore, certainly not the way there was a year ago.  The low-hanging bond fruit is long gone.  Yields are depressing to say the least.

Stocks right now are a decidedly mixed bag.  I wouldn’t touch most of the S&P right now, especially the banks and consumer discretionary stuff.  But I think there are some gems to be found in the high quality space.  In prior weeks I’ve talked about Uranium / nuclear power, timber, and value plays like Intel.  Johnson & Johnson is yielding 3.7%.  Do you have more faith in a company like that than the Federal government?  I kinda do.

Gold has me terrified right now; I’m at that weird phase of the investment where I’m definitely not buying any more but haven’t quite begun to reduce my allocation weighting.  I’m sorry if you guys missed out on the meat of the gold trade.  I wish I’d started this newsletter in 2004!  Gold could still go to $2,000/oz and everybody needs to own at least a little bit in their portfolios.  But risks are now abound, especially over the medium term as long as these deflationary worries are present.

I see a lot of people getting involved in gold who don’t understand how violently this market can correct and the extent to which it can piss you off.  I wrote about this in our epic gold newsletter.  No other market in the world baffles traders the way gold does.  It rarely does what you want it to and it never does what you think it will.  Next week I’ll tell you a funny story about how much things have changed in the gold market.

I’m of the opinion that real estate has further to fall, especially non-distressed properties.  I subscribe to the Northern Nevada MLS and watch all the new listings and sales come up every day.  This is entirely anecdotal, but the properties that are selling are the cheap ones.  It’s like there are two totally different tiers of houses: those that are priced right and those that are priced wrong.  And it’s really obvious which is which.  Eventually this bifurcated market will normalize.  All the distressed sales will finally run through and prices on the non-distressed sales will come down as people slowly come to terms with the true value of their house.  That’s a process that is going to take some time.  Like equities, I think there are nuggets to be found.  If you know how to navigate the distressed market there are opportunities where the risks have a solid floor and the upside is compelling.

I know.  This isn’t what you want to hear.  You don’t want to be told that it’s a historically tough environment in which to make money.  You don’t need to be told that — you live it every day.  And what’s more, you certainly don’t want to be told that the best way to cope with generally crappy yields and generally crappy opportunities is to learn to live off of less.  It’s difficult to hear because it goes completely against our American DNA and everything that we all learned in the 80′s and 90′s.  But be careful and lower your expectations.

I think at some point towards the middle or back end of this decade there will be great opportunities all over the place.  In the meantime, work on keeping your powder dry.

Look: the markets have undergone tremendous change.  In a “Don Draper style,” existential sense this change is neither good nor bad.  It simply… is.

Your job is to adjust to it and it is your reactions that will be judged.

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The Theory of Market Neutrality by Kyle Ferguson Thursday August 19th 2010, 8:58 am | Printer Friendly

“We hold balanced portfolios in each country, i.e., portfolios very close to being equally long and short.  Our trading models tend to buy stocks that are recently out of favor and sell those recently in favor.”

James Simons on Pairs Trading
Founder and Chief of Renaissance Technologies, Medallion Fund
November 2009, testifying before congress

Why Market Neutral

Last week we dove head first into the strategy of buy-and-hold and tried to determine if buying stocks and holding onto them for long periods of time is the best way to invest in the stock market.  We found that although it is possible to profit off of the buy-and-hold strategy during certain periods, too many factors, such as timing and stock selection, have to be perfect in order to consistently profit off of the buy-and-hold strategy.

We also determined that when it comes to the stock market an investor must decide if they are going to be an active or a passive investor.  Our research shows (as does the great Jack Bogle’s) that if you choose to be a passive investor you are better off picking a few indexes such as the S&P 500 or the Russell 2000 to invest in rather than half heartedly picking stocks you think will go up over the long term.

However, if you choose to be an active investor like us then you need to arm yourself with a strategy that has the ability to profit in both up and down markets as well as markets with extreme volatility.  The fact the market has gone absolutely nowhere over the last 12 years has caused a lot of passive investors to start thinking about active strategies.  We also believe you can get better risk-adjusted returns, more diversification, and protect yourself from large market swings by employing the right active equity strategy. 

After 25 years of researching and implementing trading strategies in the marketplace, we’ve found that one of the most effective market neutral strategies is one called “Pairs Trading.”

Let’s clear up some definitions

Through The Draconian and our monthly investor newsletters you have probably heard us use the terms Statistical Arbitrage, Pairs Trading, and Market Neutral.  Although these sound like three totally different strategies, they’re basically the same thing.

Here’s why:

Our trading philosophy is very simple.  We believe in the world of statistical arbitrage, which consists of finding small inefficiencies in two similar securities and profiting off these inefficiencies.  It’s called Statistical Arbitrage because the price discrepancies are statistical in nature.  It can take hours, days, or months for these inefficiencies to correct themselves; to us it does not matter.  Our goal is to establish a consistent set of rules that finds and exploits these inefficiencies on a daily basis.

The method we choose to expose these inefficiencies is through pairs trading.  We find two securities that are in the same sector and highly correlated to each other and we buy the security that is undervalued and short the security that is overvalued.  When the two securities have converged, we look at other pairs to repeat the process.  Pairs Trading is a flavor of Statistical Arbitrage.

Finally, by exploiting these inefficiencies in the equities, futures, and currency markets this makes our portfolios market neutral.  Which is a simple way of saying we don’t care what the overall market is doing, it can go up like the 1990’s tech boom, or it can crash like 2008.  We only care about our “Pairs” and the fact that our long position makes more than our short position, or vice versa.

So from here on out we will talk about “Pairs Trading” as our choice for establishing a market neutral portfolio.

The goal of Pairs Trading is to produce positive returns in any market environment, while reducing the volatility of the overall portfolio dramatically.  Using the Pairs Trading approach is focused around the belief that, at any given time, multiple stocks are priced incorrectly.  It is a little-known strategy with investors at home.  The success of it depends completely on the ability to correctly identify these stocks that are undervalued and overvalued.

Fundamental vs Quantitative Analysis

There are numerous strategies, time periods, and variables that you can use to make your portfolio market neutral through pairs trading.  You can use fundamental analysis on individual stocks or industries, sort of like what Jeffrey did in The Trade of the Decade.  In order to determine what the market thinks about a company you must establish some common measures of value to compare companies against each other.  The most popular fundamental measure for doing this includes the price-to-earnings ratio, price-to-sales ratio, price-to-book ratio, and forward price-to-earnings ratio.  If you pair some technical analysis with that fundamental research you can get an even better edge at determining the best pairs for your portfolio.

Because of the high correlation that all asset classes have shown over the past few years and all the government intervention in the private sector, we believe a more efficient and effective way for finding pairs trades is through the use of quantitative analysis.   Quantitative Analysis utilizes computers, mathematics, and statistics to sort through thousands of possible trades per day.  Based on different technical indicators like standard deviations, correlation coefficients, and profit factors, specially designed computer programs can find inefficiencies in the market place and exploit them throughout the trading day or trading year.

A simple example

I think it’s easiest to understand all these concepts with an example.

Here is a sample pairs trade featuring two stocks, Alpha Airlines and Jumbo Jets.  They both are in the same sector and since they are each subject to the same set of economic inputs, their stock tends to trade in very similar fashion.  They tend to go up and down at the same times.

Here’s what’s happening in that chart:

A.  In the early periods and through prior history, the correlation between AA and JJ is very high.  They each move up and down together.

B.  Something strange happens in Period 5 and they start moving in different directions.  AA goes up and JJ goes down.  Alpha Airlines is getting a little overvalued and Jumbo Jets is getting more undervalued.

C.  The relationship continues to stretch through Period 6 and a trade signal is generated.  We buy the undervalued company, Jumbo Jets, and we sell short the overvalued company, Alpha Airlines.

D.  As the historical relationship normalizes in Periods 7-9, the system produces a profit and the trade is closed.  During the green period when we have the trade on, Jumbo Jets has outperformed Alpha Airlines.

The neat thing about this example is that this hypothetical mini-portfolio is 50% long and 50% short.  If the market crashes tomorrow, we’ll lose money on our long position but we’ll make a similar amount of money on our short position.  If the government comes out and promises to subsidize every passenger’s airfare and the entire airline industry rallies, our portfolio will again be protected from that volatile spike.

What makes this system profitable is ability to identify the right trades.  It’s an entirely skill based trading strategy.

What are the advantages?

1. Low Correlation to the Market

Since 2008 there has been an increasing correlation in most asset classes and trading strategies compared to their historic norm.  Historically, market neutral strategies such as pairs trading have had one of the lowest correlations to the overall stock market.  This means that market neutral strategies are not dependent on what the market is doing to make money.  Those of you that have actually been invested with our firm since the 80’s and 90’s know that our #1 goal is to try and make money whether the markets go up or down.  Pairs trading is one more tool that gives us this ability.

2. Higher Risk-Adjusted Returns

Pairs trading allows you to get a high rate of return relative to the amount of risk that you take.  Being long $100 of a stock and short $100 of a stock in the same sector creates a reasonable hedge.  If the market falls 10% in one day your long stock will lose a lot of money but your short stock will make as much money, perhaps even more than the amount you lost.

Pairs trading strategies provide great protection against broad market swings.  When the market is moving down a well-constructed market neutral portfolio will not show as much of a loss as the market indexes and could even show a gain if the portfolio manager is skillful.  Conversely, when the market is moving up a good market neutral portfolio should show a gain but most likely it won’t be as much as the market index.

3. Lower Volatility

The current volatility in the markets over the last few years has been at an all time high.  Since the Pairs Trading strategy is designed to have close to zero correlation to the overall market, Pairs Trading strategies can provide relatively low volatility during periods like the bear markets of 1997 and 2002, or sharp rallies to the upside like 2009.  Not only is Pairs Trading a natural hedge your portfolio, but it has the ability to consistently outperform the market without the use of leverage.

Here’s a chart of the HFRI Equity Market Neutral Index vs. the S&P 500.  The HFRI Equity Market Neutral Index contains a lot of different market neutral strategies, and since it’s a benchmark, it contains a lot of strategies that aren’t very good.   But it’s still good enough to use as an example.

This chart measures rolling 12-month rate of return for each index.

As you can see, the market neutral line is a lot smoother than the S&P 500.  Market neutral actually made money as the dot-com bubble was deflating and it was still modestly profitable when the stock market came rallying back.  This market neutral index lost a little bit of money during the financial crisis but it wasn’t anywhere close to what the stock market lost.  It wasn’t even a 10% loss!  These strategies have also been profitable over the last year.

If you add up the total amount of money made and lost over the last decade, market neutral did pretty well.  From 1997 until now the HFRI Market Neutral Index rose a total of +97%.  The stock market, as we all know, is right back around where it was twelve years ago.

Now you can see why we get so pumped up about market neutral strategies!

Let’s recap

Market neutral strategies are a really great idea in theory.  In practice, pairs trading is a very effective and simple way to implement it.  There are lots of ways to do it but we prefer statistically-based systems in our own trading.

For professionals, this sort of strategy is easier to implement.  We actually use it in one of our funds.  The drawback for the individual is that it to do it effectively it requires a fairly robust trading infrastructure.  We have a computer programmer devoted full-time to research and system development.  And at any given point in time we may have several hundred different positions on.  For a firm like us that isn’t so bad, but for the average investor at home it can be a little difficult to manage a portfolio of that size.

Just because it can get a little complicated, we don’t think that individuals should avoid it altogether.  As I said there are a million different ways you can do it.  You can trade one pair at a time or you can trade several hundred pairs at a time.  It doesn’t need to be anything more complicated than saying “I think Ford is a better company than GM.”  Jeffrey has talked about this in the past — the way a lot of the big boys trade is with relative value strategies.  A lot of the investors at home don’t understand the concept of relative value.

Finally, this does involve shorting stocks, which carries a set of risks that you’ll want to talk to your financial advisor about.  But on balance, a market neutral strategy like this can be a great way to reduce volatility in your investment portfolio.  It’s worth discussing it with your financial advisor and if he’s a good one he’ll listen to you about it with an open mind.

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The Trade of the Decade by Jeffrey Dow Jones Thursday August 05th 2010, 7:10 am | Printer Friendly

Here are some of the industry bigwigs that I follow and their single best trades for the coming decade.  This comes from the latest Agora symposium in Vancouver, and keep in mind that most of these guys are contrarians.  I didn’t put Mr. Navellier on this list but I can guarantee you that his trade of the decade would be, “buy growth stocks with both hands and don’t bother shorting anything!”

• John Mauldin – Buy emerging markets, sell sovereign debt…but not now.  Treasuries are going to go lower in the short term.
• Andrew Lowenthal – John is 100% right: Rolling over US debt is going to be so much easier than what people think…it’s too early to short Treasuries.
• Eric Kraus – Buy resource producers in places where people are afraid to invest.  Short finance sectors of developed countries.
• Barry Ritholtz – Short the euro, long stocks in 2016, when the next bull market begins.
• Byron King – Sell the euro: It’s doomed, just a question of time.  Buy crude oil.  There’s just not enough of it.  I’m long the Tea Party, too.
• Doug Casey – I’m inclined to own a lot of gold, cattle and agricultural land…keep it simple.  I would short the euro, yen and US stock market.
• Gary Gibson – I own nothing.  If I had anything, I would have dollars now, uranium later.  Buy energy.
• Eric Fry – Short euro, long uranium.
• Porter Stansberry – There are just too many good shorts.  Short Treasuries, especially in US and Italy.  Buy gold, silver, timber and super-high-quality blue chips when they yield 10% or more.
• Chris Mayer – Short the state of California and Illinois. Long uranium and high-quality farmland.

I was surprised to discover so many of these guys ready to bet the farm on Uranium.  We wrote about that last week.  I’m a believer.

For the record, I like a lot of these trades.  I think the Euro swings below parity at some point in this cycle.  That’s a good candidate to short.

A lot of these guys sounded pretty bearish on U.S. Treasuries specifically, and all sovereign debt more generally.  At some point, that seems like a no-brainer trade, right?  It’s almost impossible for interest rates to get much lower.  Impossible because the Fed Funds rate is currently 0.0/0.25%.

I suppose the 10-year could go from 3% to 1%.  Initially I thought that was unfathomable but then I got out the binoculars and looked across the Pacific to our friends in Japan.  The 10-year JGB yields 1.00%.  It’s a seven year low.  People have been trying to short Japanese government bonds for twenty years and that dark road is littered with the corpses of once-confident, now-bankrupt bond traders.

So I’m not on board with the “get short U.S. Treasuries” trade.  I don’t think it’s a no-brainer.  I’m not sure if I’d go so far as to endorse David Rosenberg’s bearish call that the 10-year will get to 2% next year.  But I do think the U.S. is becoming a lot more like Japan than people give it credit for and I do think that Japan offers a better template for the U.S. than anything else I can find in the history books.  The analogy isn’t perfect.  The demographic and cultural differences between our two countries are almost opposites.  But we’re both operating from nearly identical economic playbooks as we each try and sort out the mess of subsequent speculative bubbles in our equity and housing markets.  The only difference is that we are about 5 years into that process while Japan is about 20 years in.

Against the Backdrop of De-leveraging

One of the major themes I see in the next decade is de-leveraging.  We’re going to see it everywhere.  In essence, the next decade (or two) will be something of a reversal of the credit-boom.  The U.S. has grown a lot since the 1980s and has grown because of a lot of different reasons.  But I think a lot of that growth is due to credit expansion at every level.

At the very least, I think the credit expansion ceases — which we have clearly seen in the data — and that simple cessation will be a major problem for future growth.  That’s a U.S. economic airplane flying with one engine instead of two.  And should that credit contract further as it has since 2008, should the de-leveraging of American society continue, it’ll be like switching one engine to reverse instead of simply shutting it off.  I’m not a pilot but that’s probably a bad thing.

Think about it for a minute.  If the financial sector is willing to make a lot of loans and do it with looser policies, more people will borrow and more people will spend.  All that spending grows the economy.  When the financial sector pulls back that credit, people stop spending and the economy slows down.

Sounds pretty intuitive, right?

But is it actually correct?  Does that intuitive principle translate into actual reality?

Uh… yes.  It does.

In fact, we can probably even say that the aggressive expansion in consumer credit played a role in all the growth we’ve seen since World War II.  Most people associate the “credit boom” with the post-1980′s, but we can trace this trend even further back.  Perhaps the 1970′s — a period where credit did not expand, the markets went nowhere, and everybody wore funny pants — erased our memories of the previous cycle.  We did a lot of drugs back then too so maybe that was the reason.

Now, how much a role all this credit has played is certainly up for debate.  We’re only talking about numbers around 10-15% of GDP.  In case you’re wondering, the “consumer credit” that we’re looking at here is credit cards and loans on stuff like cars, boats, and mobile homes.  It’s not everything.  But if you overlay other types of credit onto this chart — business loans or mortgage loans, for example — you’ll see a similar pattern and it all adds up to total credit expansion playing a significant role in long-term U.S. growth.

So let me ask you, do you think that’s going to continue?  Do you think credit will continue to expand at the rate it has since the 80′s?

It’s highly doubtful.  There is just far too much debt floating around and far too many wounded banks that are reluctant to extend more of it.  Captain America has been the only one willing to borrow ‘n spend but the political atmosphere is changing.  Even mainstream Democrats are silent about further deficit spending and voters have had enough of the waste.  I cannot for the life of me see how all that is not a major economic headwind for the decade to come.

If you take another look at that chart you’ll notice that those lines don’t actually correlate.  The red one leads the green one by varying lengths depending on the environment.  Credit expansion tends to lead growth in the stock market.  Credit contracts during recessions and the market tends to drop before recessions.  Because the correlation is loose, I wouldn’t want to trade on a chart like this over the short-run.

But over the long run, a general expansion in credit will correlate with an expanding economy.  This works just perfectly for a Trade of the Decade.

So what’s the trade?

On the buy side, I like resources, especially energy.  We’ve talked about uranium and timber already and I’d like to own both over the next decade.  Don’t forget about coal and natural gas.

Ultimately, I want to be long the things that people need and avoid the things that people don’t.

Go get:

• Commodities and natural resources.
• Companies that make the stuff that people and developing economies need.
• Unloved high-quality stocks, especially if they pay a nice dividend and have a global footprint.  Make a shopping list and buy them when the market falls into a booby trap.  (Intel fits the bill — check out the article I did the other day for SeekingAlpha)
• Emerging markets, particularly the BRICs.  I heard about the “CIVETs” the other day — Columbia, Indonesia, Vietnam, Egypt, and Turkey.  I like Turkey a lot in the next decade or two for geopolitical and demographic reasons.  I’ll do some research on how the average investor can get exposure there and report back to you.
• The Chinese RMB.  Love the RMB!
• Japanese stocks.  Yeah, you heard me.  I’ll dig into this further in subsequent newsletters but right now it’s one of the cheapest and most hated markets in the world.  Which makes me curious.  Sometimes the consensus gets it right, but being able to identify when consensus is way wrong is how you make boatloads of money in this industry.

Stay away from:

• Domestic companies that are highly dependent on consumer demand.  I wouldn’t touch a stock like Best Buy with a ten foot pole.
• For-profit education stocks.  This short may not make it through the decade but I agree with Steve Eisman (featured in Michael Lewis’ The Big Short) that these things are a subprime-style disaster waiting to happen.
• Banks, especially banks in developed economies like the U.S. and Europe.  Brazilian or Chinese banks are a different story.
• Both the Euro and the Yen.
• U.S. Treasuries won’t be great over the long-run, but sovereign debt in less systemically important countries like Spain or Greece will be messy.
• Real estate.  Still another 10-20% to go so buy your house to live in it.
• Politicians.

If I had to boil it down to a single idea, it would be to avoid or short the sovereign debt, banking systems, and currencies of over-leveraged economies and buy the equity of unloved, under-priced companies, especially if they’re involved in making stuff that people need and have a global footprint.

Check back with me in August 2020 and we’ll see how it worked out!

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