This week will be a bit of a grab bag.  We’re going to quickly run through the major markets, offer up a movie recommendation, and then get a fresh take on what’s happening on the city level right now in the economy.

Also, we’ll let you know what might be lurking ahead for the economy.

Market Recap

As quickly as it freaked out, the stock market has fallen back asleep again.  The Dow has been up 9 days out of the last 11.  Here’s the S&P:

This has all happened on super low volume.  In the days of yore that would indicate a lack of conviction in the marketplace.  Nowadays with all this high-frequency trading sloshing around various dark pools, Volume doesn’t mean as much as it did.  I’m old school, though, so I still pay a bit of attention to it.  I don’t read the hard numbers or use any serious indicators; I just work it into my analysis via intuition.

What about bond yields?  It’s been a while since we’ve talked about bonds around here…

Well, bonds have been pretty boring.  Nothing much to report.  They sold off a bit and then rallied as people were getting nervous about Japan and now they’ve sold back off again, pushing yields back into that 3.5% range.  Keep an eye on this one, though.

I like the bond market because it’s smarter, bigger, and faster than the stock market.  It’s like the older brother who graduated top of his class at Yale and was captain of the crew team and now leads the M&A department at a major bank.  He’s little unapproachable to the average investor.  He’s austere, academic, and aloof.  But he knows his stuff and is usually the first one to do anything about anything.  The investor at home prefers to watch the stock market.  That’s the colorful younger brother who dropped out of school to join the Poker tour and sells car insurance at the local strip mall.  He’s charismatic — if a little manic depressive — and easier for the average investor to share a beer with.  He’s what people talk about on TV.

Don’t sleep on the bond market.  You may have forgotten that we still have a zero interest rate policy going in this country.  I’ve started to hear a lot of scuttle (in advance of the QE2 phaseout) about what the Fed will do about short term rates and when they’ll do it.  So far, the consensus is that we’ll be sitting at 0% on the front end of the yield curve for a long time.  Like maybe through 2012.

This matters because a steep yield curve is the most awesome thing in the world for bank profits.  And right now we still have a yield curve that is historically steep.  I’m not afraid of a bank crisis right now, at least not so long as banks can mark assets on their books at values that they themselves calculate.  And these guys are going to continue to make boatloads of money.  That’s not necessarily an endorsement of bank stocks, but more of an FYI.  Do with that information what you will.  As you all know, my policy is to categorically avoid the banks for the next decade or so, at least until the next crisis or we get some regulatory reform that isn’t weak sauce, lobbyist-authored garbage like Dodd-Frank.

At this point I feel like have a pretty comprehensive understanding of the financial crisis.  But if you’re still uncertain about a few things or don’t really feel like you can speak confidently about how it all went down, check out Charles Ferguson’s Inside Job.  It won the Oscar for best documentary this year.  Queue it up on Netflix.

Only one single thing irked me about it and it’s that the director tried to throw Martin Feldstein under the bus.  Nobody in this business thinks that Dr. Feldstein, one of the most respected economists around, thinks that he was one of the “bad guys.”  Same thing with Rick Mishkin.  But directors have stories to tell, and every good story needs villains.  The real villains are those at the tippy top of the banking industry, and as you can imagine, none of these guys had much interest in talking with a controversial director making a movie about the financial crisis.

Aside from that, I can attest that the movie is 100% true.  And the thesis of the movie is 100% true, too.  It’s really well done.

Crude Oil

And last but not least, crude oil remains elevated.

One of my favorite energy analysts is Stephen Schork.  I like him because he usually has much more to say about the energy markets than, “the long term supply is constrained and long term demand will continue to go up.”  I listened to an interview with him the other day and he said that right now people need to basically just ignore the WTI crude oil price.  They need to focus on Brent.

We started talking about this several months ago on here, this widening difference between WTI crude and Brent crude.  Brent crude comes from the North Sea.  WTI crude comes from Cushing, Oklahoma and right now funny things are afoot there.  It’s basically a roach motel.  Crude oil can get in but it can’t get out.  There is a massive oversupply in Cushing right now, all this new oil that has been piped down from Canada.  And the problem is that the infrastructure isn’t in place to get it shipped out quickly enough to the refiners.  So there’s too much supply, not enough demand, and an artificially low price.

The difference is not insignificant.  Brent crude is trading at $117/barrel.  WTI is now $106/barrel.  In a normal market the prices should be the same.   A while back I was talking with Kyle and Trini about this short-term oversupply condition with WTI Crude.  Why not go long WTI and short Brent?  How is that trade not free money?

Well, apparently we aren’t the only ones with that idea.  Mr. Schork said that the net long speculator position in WTI Crude is about 270 million barrels.  That’s almost the size of the entire strategic petroleum reserve.  There is a gargantuan speculative position that is expecting WTI crude prices to go up.

And finally, Mr. Schork said that gasoline will absolutely be over $4.00 in the major metropolitan areas by the summer.  Summer blend gasoline –which is more expensive to refine because it needs to burn cleaner — is currently being priced wholesale at $3.75 per gallon.  These are some things to think about as you map out your summer vacation plans.

What’s up, Mayors?

Now that the market has recovered from its Japan freakout and doesn’t seem to care anymore about what’s happening in the Middle East, let’s turn our attention back to this issue that is quietly working away in the background.  It’s the debate about the states.  It’s an epic Battle Royale with Meredith Whitney and her followers in one corner against basically every state treasurer and muni bond manager on the planet.  It’s a thrilla!

Our goal is to offer a sensible perspective.  We need to do this because this is an issue that touches everyone.  Or at least everyone who pays taxes or consumes public services.  If you’re not paying taxes and not consuming public services then you’re probably also not reading this newsletter.  Your backyard bunker doesn’t have the internet.

For the next installment in this ongoing drama, I urge you to check out this fascinating Charlie Rose interview.  In it he has a really neat discussion with six mayors from some of the largest cities in the country.  Michael Bloomberg gets special billing because when you are a billionaire and the god-king of New York City you get special billing everywhere.   The interview runs about 45 minutes.

Part of the reason why I get so excited about stuff like this is because it’s downright refreshing to see political figures sit down and discuss an issue with zero political BS.  I didn’t catch a single talking point in the whole thing!  At times it almost feels like a group therapy session.  Clearly, Charlie Rose became Charlie Rose by being adept at wielding this sort of arcane journalistic magic.

You guys all know that I’m as big a political cynic as there is.  But one of my dirty little secrets is that I actually have a big interest in public policy.  In fact, this is part of the reason why I’m such a cynic, because I want to talk turkey and most of the people in this space just stick to scripts and abstract blathering.  Apparently, mayors are my kind of politicians.  These guys are quite a bit different than senators and congressmen and every other elected or appointed figure in Washington D.C. for one giant reason: they actually have to balance a budget.  Cities get to borrow money for capital expenditures, but at the end of the day they have to match their revenues with expenses.  They don’t get to spend money they don’t have or won’t have very soon.

Mayoral elections are also usually non-partisan, and I guess that’s another reason why there isn’t much political BS with this crew.  Not only do they not have time for slogans, partisan bickering, and senseless debates, those sorts of things wouldn’t do them any good anyway.  As Michael Nutter, major of Philadelphia, repeated a couple of times in the interview, “you either filled the pothole or you didn’t.”

At the Federal level, the discussion about whether the “pothole” got fixed is subject to debate.  And the findings of an exploratory committee.  And a 2/3′s majority in Congress.

These majors made a lot of neat points.  The first was rather intriguing.  Each one of them agreed that the Federal Government really needs to work out the issues with our immigration policy.  Not only do we need more people in this country, we need better people.  What’s bad is sending all these Chinese and Indian and other immigrants back home after they get their U.S. college degree.  That’s bad.

(A brief aside — I don’t know if you’ve heard Gary Shilling’s crazy idea for solving the housing oversupply but it’s worth repeating.  His plan, which he first wrote about in 2009, was to guarantee residence status to any foreign immigrant who buys a house.  I’ve heard variants of this plan that also include making the residence guarantee to those foreigners who start a business here in the U.S. and create domestic jobs.  It’s not as crazy an idea as you’d think — these people are generally intelligent, hard-working, and productive.  They would be assets to our country both now and in the future.  I think it’s an intriguing idea, but nobody in Washington D.C. seemed to agree.)

There’s a reason why we want to retain talent in this country and not ship it back to where it came from.  Mayor Rybak of Minneapolis made that clear with a really great story:  It used to be that a kid would come from China and go to school at the University of Minnesota (which he claimed had the highest Chinese population of any public university).  The kid graduates, gets his greencard and goes to work for Mortenson Construction.  He works there for a long time and eventually goes back to China to head their Chinese office.  In return he brings a ton of foreign business back to Mortenson Minnesota.  That’s good Minnesota and good for the U.S. economy.

Sergey Brin was born in Russia.  How glad are we that he decided to stay in this country after attending Stanford?

The take home point

Anyway, I came away with one clear conclusion from this interview.  The budget for the states and cities comes down to Pension Benefits or Public Spending.  And Pension Benefits are going to get the axe.  Every mayor at the table agreed that the public has been clear and direct that what they want is for benefits to hit the chopping block before spending on parks, schools, and crime prevention.  My guess is that every mayor in America also agrees.

So what does this mean?

This goes back to what we were talking about two years ago when everybody was still trying to make sense of how this whole economic mess was going to play out.  One of the things that I suggested at the time was that the State was going to be reneging its social contract with the Public.  Quite simply, the State cannot afford to deliver all of which it has promised.  And unlike Ireland, our State will actually break these promises rather than doing insane and destructive things to try and make these promises whole.  In the long run, this is a good thing.  Just ask the people of Reykjavik.

But there will be short- and medium-term costs to bear.  Maybe you deny someone the annual cost of living adjustment to someone collecting a pension.  Maybe you scale someone else’s back outright.  Maybe you don’t give one to a new worker and force him to save for retirement on his own.  In each of those instances what you have are people that are spending less money than they were before.  And when people spend less money in an economy that is 70% consumption what you get is slower growth.

And don’t get me wrong, it won’t just be about pensions.  Public spending will make sacrifices too.  Michael Bloomberg didn’t shy away from saying that a lot of New York City schoolteachers are going to get fired and they’re going to fire the ones that are least effective.

That too is a good thing for the long run — it forces unproductive labor to somewhere else where it might be more productive.  But it’s not good for the short run.  When someone loses their job it generally means they have a whole lot less money to spend.

So what about the market?

How do I reconcile this with the market action of the last year?  It’s a good question.

On the one hand it’s a technical reversion from a pole of fear and panic to a more normal equilibrium.  We totally missed the earliest days of the rally but by Summer of 2009 we had grown bullish on the market, strongly advocating a policy of buying on dips.  That worked out pretty well until the Flash Crash and parallel EU debt crisis.  Then our policy changed basically overnight.  We believed that there was clearly a new round of troublesome economic fundamentals and on top of that, signs that the fabric of the markets was again in trouble.  Our policy of extreme caution looked pretty smart until last August when the Fed announced another go at quantitative easing.  The market went straight up and since then the policy of caution has looked pretty silly.

I have no trouble admitting that I got QE2 one million percent wrong.  The first go-around inflated asset prices, as per the Fed’s obvious though unstated objective.  And I should have foreseen that another go would have the same effect.  It did.

It’s too late to do anything about it now, though.  QE2 is scheduled to wind down over the next few months and so that tailwind will soon be gone.  The market is above its 200-day moving average and so technically this is a bull market, a market that should be bought on dips.  If you want to do that I have no problem with it.  But buying an asset after it’s rallied 100% in less than two years is the wrong time to be buying that asset.  Everything in my gut tells me that now, despite the enthusiasm and economic positivity and seemingly “all clear” vibe, it’s a time for caution more than ever.

Late at night if I turn off the lights and lie really still I can hear the ghost of Ben Graham whispering that economic fundamentals are the only the thing that matter over the long run.  And the market trajectory dictated by these fundamentals is disappointing at best and heartburn-inducing at worst.

John Hussman’s fancy economic models calculate 10-yr total returns to average about 3.5% per year.  That sounds about right to me.  He has a Ph.D. and manages a few billion more than I do so I’ll defer to his expertise about the precision of that figure.  But what that simple number does not communicate is the volatility that we’re going to see in the next decade.  Yes, it’s about beating that 3.5% per year that the market is likely to give you, but it’s also about finding investments that won’t lose half their value if the world suddenly panics.

For those that want to buy stocks, this is why I’ve been so vocal about advocating stable, predictable companies that pay good dividends.  Especially companies that will grow at a rate greater than the U.S. economy over the next decade.  These are companies that will exceed the 3.5% of the broad market but they’ll also do it with less volatility.

Anyway, if you can find some companies like that — in the past I’ve used Intel as an example (I don’t actually own it) — then you’re on the right track towards building a robust equity portfolio.  Add in some bonds, some Treasuries, a dash of commodities, some real estate, and alternative strategies if your net worth qualifies.

The goal of every portfolio manager in the world is (or should be) to beat the market with less volatility.  Not every PM does it and the amateur investor at home rarely does it.  But it’s so much easier than you’d think!  Avoid shiny, expensive things that may be dangerous.  Always think of return in the context of risk.  Read The Draconian every week.

Then you’ll be set to weather any storm.

• Ignore the WTI crude oil price, which is artificially low for infrastructure reasons.  Focus on Brent crude instead.  Brent is trading around $117/barrel.
• Buckle up for $4+ gasoline this summer.  Unless this situation in the Middle East is magically resolved overnight.
• In the battle of Public Spending vs. Pension Benefits, the latter is going to get the axe.  This will have an effect on the economy.  When you pay people less money they spend less money and the U.S. economy is 70% driven by consumption.
• Despite the quick recovery from the Japanese freakout and all the positivity in the market, I think that this is a time to start getting a little more cautious.  Remember: buy when others are afraid and sell when they’ve all turned greedy.  And the mood is not just greedy right now, it’s desperate.

This week we’re going to take a look at your single biggest investment.  You  might be wondering whoah, how does he know what’s in my investment portfolio? The all-seeing eye of The Draconian never reveals his tricks!  The real answer is not what you think and you will either roll your eyes or have a legitimate Eureka moment.

And no, contrary to a decade of misguided personal finance literature, it is NOT your house.

Before we get rolling, a quick thanks for all the feedback on last week’s letter about Japan.  This one got picked up again for publication over at John Lounsbury’s Global Economic Intersection blog.  Apparently there are some of you out there that are interested in investments that the rest of the world hates.  I thought of a couple more of these and I’ll do sequel to that article next month.

Did you happen to see this week’s cover of Barron’s?

I guess we weren’t the only ones with that idea.

Market Recap

The panic about Japan seems to have abated.  U.S. stocks found a bottom and staged a rally.

But it failed to get back through the 50-day moving average.  That’s bad.

Market action aside, there are a couple of really important lessons to learn from the Japan experience.

The first is that you should always have your risk controls implemented before the disaster strikes.  Events like this have a malicious tendency to swirl up out of nowhere and catch everybody unprepared.  I can’t emphasize it enough: have a plan in place before the market sells down.  There are a bunch of ways to manage risk — use options as insurance, keep your portfolio appropriately diversified, have hard limits on the size of loss that you’re willing to tolerate, get access to strategies that benefit in times of chaos, understand what a 10-20% correction in the market will do to your investment portfolio — any plan is better than none.  As for me, I like to model worst-case scenarios and then strategize backwards to mitigate their net effect.

Figure out where the emergency exits are before the theater catches fire not after you smell the smoke.  If you do happen to find yourself in a crowded theater and you don’t know where the exits are and you do smell smoke, there’s really only one strategy I can recommend: prayer.

The second lesson to learn from all of this is that during times of crisis it pays to keep a cool head.  One of the important ideas of last week’s newsletter is that oftentimes the events that shake up the U.S. markets have very little to do with the long-term fundamentals of U.S. stocks.  The Japanese disaster was a classic example of that.  The S&P fell [X%].  Why?  For what reason?  People were just scared and realized that they had too much risk on.  That won’t be the last time that happens this year either.

Last Wednesday (the really bad day) I tweeted:

Market now below the lows of yesterday and isn’t showing the intra-day buying of previous losing sessions.  Possible capitulation underway.

That, my friends, is called “Getting Lucky on Twitter”.  It turns out that was the exact capitulation day and understanding how to read the market action can help you spot events like that.  Let me tell you something: there is no day on which it is more frightening to be a buyer than on a capitulation day.  I’m not sure there’s anything more difficult for an investor to do than step in and buy on a day when it feels like the world is falling apart.

For the record, I did not do any actual buying that day.  I just like to tweet some of my more time-sensitive thoughts that I don’t discuss here in this newsletter.  Sometimes I get lucky and I get it right as often I get stuff wrong.  I also (personally) am not a very active trader.  I can count the number of buys and sells in my personal accounts in a given year on one hand.  I think in the past I’ve actually told you the exact investments that I own.  Most of my money is invested in our firm’s hedge funds and those funds are actively traded.  Obviously, I can’t talk about the details, but some of our systems have been very active lately.

I only mention this because one of the things that can help you be a buyer on days of opportunity is to employ trading systems that are quantitative in nature.  This kind of trading doesn’t work for everybody, but we’ve had pretty good results with it over the last 25 years and it suits our personalities.  Computers help us separate fact from emotion.  We spend a lot of time on research and we try and design systems that are extremely robust.  Then we just let ‘em go and focus on optimization while continuously improving risk control in the background.

In the meantime, follow me on Twitter and watch me look super-smart or make a fool of myself in real time!  I only tweet about once per weekday and I try to either offer a relevant thought about the daily market or share a piece of content that I find particularly fascinating.

Your Biggest Asset

Most of you aren’t aware that your single biggest investment is right under your nose.

It’s your job!

Calm down.  I can hear you saying, yeah, yeah yeah, whatever.  But stay with me.  We’re going to talk serious dollars today.

The way it works in finance is that we evaluate investments by the rate of return they generate relative to the amount of capital that they require.  If I make an investment that requires $100,000 of capital where I believe I’ll get a 7% rate of return, it should generate $7,000 of gains per year.  I know that’s, like, Investing 101.  But we’re going to take this basic concept and turn it on its head to prove a point.

Let’s work through a little exercise.  There will be math but you can use a calculator.

QUESTION: How much do you make?  That is to say, how much gross cash flow does your job generate per year?  It’s OK.  You don’t have to tell me.  Just plug it into your calculator.

Is it $30,000 per year?  $100,000?  If you are Barack Obama and you are reading this — and I have no reason to suspect that you are not — then use $400,000.

Take your income, whatever it is, and rewrite the equation as follows:

[My Annual Income] / [Discount Rate or "Yield"] = [The Value of Your Job]

Are you a government worker with basically zero chance at losing your job?  Go ahead use something close to a risk free rate.  The 10-year Treasury note is yielding 3.3% right now.

Are you in sales or do you work at a startup firm where there is no guarantee you’ll even be employed by this time next year?  Use a higher discount rate, maybe 10%.  The stock market is a pretty risky investment and over the looong run it returns in the neighborhood of 7% (GDP + Inflation + Dividends).  Everybody else in the world uses that as a benchmark so use that if you feel your job has significant uncertainty.

Divide your annual income by this discount rate.  The answer is how much your job is worth.  It’s the monetary investment value of your career.  You shouldn’t “sell” your job by quitting or trade it for a new one unless you’re improving that value.

Hold on — you think looking at your boring old job this way is crazy?  Why?  This is exactly how every business is valued.  If I want to buy the bagel shop down the street I take a look at how much annual income it generates, assign a multiple to that income which is a function of the growth rate and rate of return that reflects the risk inherent in the business.  Then I come up with a valuation.  If the owner is trying to sell it for more than that valuation, I pass.  If he’s selling it for a discount to that valuation, I buy.

It works the same way with stocks.  This is the basic principle of their valuation.  Warren Buffet looks at Burlington Northern’s income and relates it to the earnings yield and derives a valuation.  In this case his valuation was at least $34 billion.  This happens every day in the market, too.  AT&T generates about $2.30 of earnings per share.  The market is willing to pay a multiple of about 12x those earnings and comes up with a value of $28 per share.

As you run through this little exercise with various jobs you’ll notice something.  The most valuable jobs are the ones that carry the lowest risk and highest pay.  Well, duh! Investing works the same way.  Now you know why spend just as much time talking about risk around here as we do return.  Value is a function of both.  We really, really like investments that offer the best returns per unit of risk.

If your job gives you good income and carries low risk, pat yourself on the back.  You’re sitting on a very valuable asset.

A Young Draconian

My first stable job after graduating college was doing audits for Ford Motor Company.  I got paid $31,048.  It was pretty much all the money in the world for a kid like me.  I got to drive all over Southern California in the company Windstar and put the smack down on dealerships when they did naughty things with our cars like when the general manager would give his 16 year old daughter a demo loaner.  The weekends were great.  On Saturdays Ms. Draconian and I would drive down through Topanga Canyon and unwind at the beach.  She would fall asleep in the sun and I would read Bret Easton Ellis or Don Delillo or something else sufficiently postmodern.  She still lived with her mom.  In the evenings we would go out for sushi and then sit under the stars in the hot tub at my apartment complex.

By my math, that job was worth somewhere around $850,000.  But I can already hear Mrs. Draconian saying, “wasn’t it worth more than that?”  And she’s correct.  We had some good times.  How much value does one assign to memories like that?

I have no idea!  So let’s do what economic theory suggests and just ignore it.  We’ll assume those details net out over time.

Today I co-manage a family of hedge funds and write an investment newsletter.  My current job is worth substantially more than my job back then.  I use a different discount rate because there’s more risk when you’re running your own business than working for a big conglomerate.  I’d say my quality of life has improved over the years.  But part of being sentimental is that it’s natural to question how much my quality of life has changed, really.

If you conduct this type of analysis for the various jobs you’ve held in your life, my guess is that your results are the same.  Your first few jobs probably weren’t worth much.  But you made investments in yourself and you traded up for more valuable jobs.  Your quality of life probably increased but my guess is that every once in a while you wax sentimental about the simple pleasure of a warm beach and a good book.

Sentimentality aside, the goal is to always keep improving the value your career.  Redeploy the gains and increase your annual returns.

It is no different than investing.

It’s hard work

My job and the job of investing happen to be one and the same.  But for most of you it is not this way.

Personally, I take offense at this crazy idea that came about in the last few decades and peaked alongside the housing bubble.  It was this ridiculous (and dangerous) notion that you could sit around and get paid for doing nothing.  You invested your money and your money “worked” for you.

How ridiculous is that?!  The idea that you can get paid for doing nothing?  The idea that you can get paid simply because you are special enough to have some money in the bank?  It’s really silly when you think about it and the markets have a cruel knack for teaching people this lesson decade after decade.

Look, investing is work.  If you don’t work it, you shouldn’t expect results.  If you don’t show up to the office and work hard alongside your employees why should you expect to have a successful business?  If you get lazy about it, should you be surprised if all the profits vanish?

This is our full time job.  There are six of us here and every single day we go to work and try and figure out how to make money in the marketplace for ourselves and our clients.  It isn’t easy.  Our company spends 48 man hours per day trying to solve the problem of how to productively and protectively allocate capital.  And still, we get things wrong all the time.  We blow calls and make bad investments.  We make mistakes every day.  Despite all that, I’d like to think that our long-term track record suggests that on balance, what we’re doing is worthwhile.  I think that our work has paid off and that it will keep paying off so long as we don’t get complacent, stay focused, and work hard.  That’s the key element, the common denominator of hanging around for 27 years.

I am confident that your own experience is exactly the same, whatever field your job happens to be in.

Take your job seriously.  Invest in it.  Work it hard.  Grow it.

If you hate your job, if you feel like none of it is worthwhile, then do what we do when we make a bad investment: sell it and move on!

If your business sucks, start a new one, a better one.   If your job is at a dead end and you want more money or more fulfillment, do the same thing you’d do after getting stuck in that dud stock you bought.  Ditch it and invest in a better one.  Your time is valuable — make sure you are allocating that precious resource as productively as possible.  Make sure you have an eye out to increase the value of your career.

Your job is an asset.  Probably your biggest one.  Show it the same care that you do your brokerage account.

The Time Machine

I’m not sure why people don’t think of their jobs this way.

I think part of it is due to the mindset in the United States is that everyone is entitled to a job.  Consider one of the two mandates we gave the Federal Reserve: full employment.  What does our central bank have to do with making sure that everyone in our country has a job?  Think about that for a minute.  I bring it up to illustrate the psychology that this nation has about employment.  Americans feel entitled to lots of things, but first and foremost is a job.

I think the other part of it may have something to do with the “worky” nature of work.  The stuff we joke about in The Office or Dilbert.   Work sucks, right?

WRONG!

Work is awesome.  Work is what allows you to experience wonderful things in life.  It’s what allows you to take your kids to Disneyland, to enjoy a fancy date with your wife, and to give back to society in meaningful ways.  It’s what provides the balance that helps you more greatly appreciate all the other dimensions of your life — it’s like sprinkling salt on a strawberry.  And when you are doing work that you believe in it fills you with joy and a sense of satisfaction every bit as powerful as other things in life.

If you want a free ride, if you want to play all day in the sun then you need to do one of two things.  You can ditch your entitlement and make peace with a style of “play” that corresponds with the reality of your finances.  Or you can hop in your time machine and travel to the year 802,701 to chill with the Eloi.

H.G. Wells’ landmark science fiction novel is every bit as powerful a meditation on work and society as the writings of Marx or Ayn Rand.  And Wells raises a relevant philosophical question: are the Eloi just stupid cattle for the Morlocks to eat or is there legitimate joy in a simple life of ignorance?  I don’t have the answer.  We each have to figure that one out for ourselves.

And while you’re in your time machine you may as well hit up Greece circa 2005.  What would H.G. Wells have to say about those guys?

There is no free lunch in this world.  Just ask the Germans.

The Retirement Caveat & the Law of .05

Obviously none of this applies if you’re retired.

But my guess is that if you’re in retirement you probably spend some extra effort on the work of investing or at least have a trusted relationship with your financial professionals.  My other guess is that if you’re one of those lucky ones who have enough principal and income to live off of in retirement, you spent most of your working life taking the things we talked about above to heart.  You took your career seriously, invested hard work in advancing it, and saved responsibly.  If you apply that same hard working approach to your investments in retirement you’ll be fine.

If you do happen to be retired or think that someday, maybe, you’d like to, then The Law of .05 may be helpful.  It’s one final way we can use this analysis.

How much does your life cost?  How much does the life that you want to live cost per year?

As you ponder that, here’s a great chart of how the typical American spends their money:

The average household spends about $49,000 per year.

Now ask yourself, can you make 5% after tax?  That’s probably as high a rate of return as I’d feel comfortable really counting on.  If you’re retiring you certainly don’t want to take too much risk with the principal.

Take that annual life cost and divide it by 0.05.  That’s how big your investment portfolio needs to be.  For the average household it is $992,760.  It’s how much you need to save.  Think about that number long and hard before you decide to leave your job for good.

What’s that?  You think you can reliably make 8% per year?  Give it a go.  Use 0.08 as your denominator.  But understand that 8% is much harder work than you might think.  This is a higher rate of return than the stock market and most professional fund managers don’t beat the market.

And you can see now why all these Boomers who had a 10% number in their head are not leaving the workforce.  They’ve saved based on that fantasy number and now they realize that they saved nowhere near enough.  In a roundabout way, each one of these folks who have postponed their retirement have a new appreciation for their job.  A visceral appreciation.

It doesn’t matter how you wind up at that conclusion, only that you do.

We’re going to get to Japan in just a minute.  As usual, our perspective may sound a little different.

First I want to welcome all the new subscribers that have come through in the last few months.  Thank you for stopping by!  In case you new guys are curious about who we really are, last year I posted some photos of us and our office on our Facebook page.  Check it out! You may or may not know that our real business is running a bunch of hedge funds.  In the pictures I tried to show what it’s like to spend a day working at a hedge fund.  It’s less glamorous than you might think but still very serious work.

Make sure you click the “like” button while you’re at it.  Unlike a lot of friends and businesses that you follow on Facebook – ahem! – we only send out one status update per week.  It happens immediately after the newsletter gets posted.  We provide a quick summary of what’s going on and every once in a while someone will start a little discussion.  One time we gave away 400 TRILLION DOLLARS.  The Draconian loves you but respects your privacy.

Market Recap

A couple weeks ago when all the economic data was rosy and before things got unsettled in far flung places, I wrote the following:

Separate the economy from the stock market.  The economy may be all right and may sputter along with slow, but acceptable, growth.  However, stocks are ultimately nothing more than a claim on a very long-term stream of future cash flows.  And this is where the disconnect lies.  Somewhere out there is a reckoning day.  We all know this.  We all feel this.  What we are getting right now is on the surface a free lunch.  We know deep down that there isn’t such a thing.

Reckoning days rarely work themselves out directly.  That is to say: people don’t wake up one day, realize that there’s a problem and then immediately pay a price.  It’s typically something else that indirectly triggers a correction of the original problem.

The series of disasters in Japan are a good example of that, as was the spike in crude oil on the Middle East revolutions before it.  In the grand scheme of things these events have very, very little to do with the long-term performance of U.S. stocks.  But what happens is these events trigger caution and fear amongst investors which then acts as a catalyst to send the markets towards where they need to go.

As of yesterday, stocks were down for the year and after this morning’s relief rally, they’re pretty much flat:

Things change quick in the market, huh?  As usual, the 50-day moving average offered a nice helping hand if you were late in getting out.  If you’re still heavily long, I’m not sure what sort of advice I can give you.

Sometimes we take a little flack for being so generally cautious and for spending so much time on risk management strategies.  Weeks like this are why.  One of the most important principles of portfolio management is to get your risk policy implemented before the disaster strikes.  The time to find the emergency exits is before the movie starts not after the theater has caught fire.

If you’ve constructed the right kind of portfolio with the right kind of risk controls then it frees you up to be able to take advantage of opportunities in the marketplace.

And that’s what we’re going to talk about now.

Drafting for value

Earlier this week we had our fantasy baseball draft (click here if you want to spy on my team).  I play in a few leagues but this is my favorite.  My fellow Draconian co-workers are in it, and so are a couple buddies and my roommate from college.  True to my word from a couple weeks ago I wound up drafting a lot of the players that everybody seems to hate this year.  I didn’t just grab every ugly duckling that was out of favor; I did my research.  Remember: some guys are out of favor for a reason.

I tried to sort out the guys that were ranked too low for no legitimate reason.  Luck plays a big role in baseball and most of these out-of-favor guys had an unlucky season last year.  It pays to understand this because fantasy baseball people suffer from the same recency bias that investors do.  They overweight the importance of recent data and ignore much of the data that came before it.

When it comes to fantasy baseball, the guys that get drafted higher are usually the ones who had really good seasons the year immediately prior.  Investors do the same thing and sit down every January to re-balance their mutual fund portfolio, flocking to the funds that performed best in the previous year.  Performance chasing is one of the worst sins you can commit as an investor.  The way you win your fantasy baseball league is by being good at identifying the guys that will do well this year, not last.

I grabbed the following screenshot from my bank the other day.  These brokerage aren’t morons and they know how the investing public shops for funds:

Anyway, our baseball draft inspired me to take a look around the world and find some investments that are really out of favor right now.  I’ll offer three of them and deal with them in order of increasing risk.

Real Estate

Real Estate is the obvious one.  I’ve written about that enough in the last couple of months.  You all know where we stand on that.  It’ll be a slow grind for a year or two as we sort out the massive oversupply but at some point the market will normalize.  There’s still plenty of distressed listings out there.  For the first time in a long time investment properties finally pencil.  If you need a place to live —  finally! — it’s cheaper to own.

Just like fantasy baseball, everybody is down on real estate right now because it had a disastrous couple of seasons.  One of the players I drafted this year cost $20 at last year’s draft.  He had spent six years as one of the top guys at his position.  He was money in the bank!  But last year he had some ridiculously bad luck and then got a fluke concussion and sat out the rest of the year.  It was a disaster for everybody who owned him.  He may not be the top outfielder once was, but this year I paid $5 for him.  He should return at least double that.  Placing too much emphasis on how he did last year is wrong.

Look, the real estate bubble wasn’t a fluke.  I knew something was up when I got my first mortgage back in 2004.  We knew that something was going to happen because we knew there was a bubble and that’s just the way that things go in the wake of a “POP”.

But the point is that’s over now.  And everybody has forgotten about all the history that came before the housing bubble.  There was a time — say, the mid 90′s — where people bought a house and didn’t worry about whether the price was going to go up or down.  That’s the historical norm for the housing market.  For all intents and purposes, we are at or are close enough to that point where most people can sleep OK at night if they choose to enter the market.

It should go without saying but I’ll say it anyway: don’t be stupid about it.  I watch the local listings.  A lot of properties around town are priced correctly.  But many are not and you can tell because they’re the ones that have been sitting on the MLS for 347 days.  Don’t buy these.  These people are still living fantasy land.  Don’t get all emotional about buying a house and don’t indulge these yo-yos.  Prices are still falling, but a lot of it is just non-distressed properties catching up with the rest of the market.

Japan

This is what I’ve got my eye on right now.  Obviously our thoughts and prayers are with the millions affected over there.  It’s a sensitive issue right now but this is something that investors really need to start looking at.  Don’t jump in head first, but start looking.

In the aftermath of the global financial meltdown we have become a society that benchmarks things as “the worst X since Y.”  In Japan they’re calling this the worst crisis since WWII.  (It’s true, unfortunately, but if you want to argue that their “lost decade” was a crisis I’ll listen.)  But their markets are going to be a little chaotic for a while and the news flow will be negative.

There are still millions without power.  Shibuya has been totally dark to conserve energy.  The big story is the, uh, “difficulty” they are having with some of their nuclear reactors.  20% of their electricity comes from nuclear and believe it or not it’s about more than just the risk of meltdown.

I saw one of my friends on Facebook got the whole week off of work and immediately after that they said on Bloomberg that lots of people wouldn’t be going to work for a while.  Make no mistake; all that is going to have a major economic impact.  This is undoubtedly going to slow down their economy for the short term.

But we’re trying to bring the big picture into focus and the history you need to understand is that investors have hated Japan for decades.

In a sense, Japan is a lot like a slow-motion version of the U.S. housing bubble.  There was unprecedented historical excess and then a long sluggish period that followed as the problems were getting fixed.  I was at a hedge fund symposium a couple years back and somebody asked one of the panelists about Japan.  The guy laughed and said, “the funny thing about Japan is that people keep trying to make it interesting, and fundamentally, it’s just not.”  For years investors have been wondering where the bottom is in Japan.  I wish I knew the answer to that question.

But I do know this.  This is a country that recovered from the almost-unimaginable catastrophe of the war to become the second largest economy in the world.  It is a tremendous society and they deal with pain better than perhaps any culture in the world.  The Japanese have always been known for great inner strength and calm, rational wisdom.  Those characteristics will be their greatest asset as they recover from this disaster.  They will reinvent themselves and rebuild.

Will this be final straw?  If this is indeed the worst crisis since WWII one needs to ask if this is the final catalyst that their economy has needed to get it back on something resembling a growth track.  Obviously, the details are still a ways from being known, but a whole lot of rebuilding is going to need to happen in Japan in the coming years.

The problem, of course, is the one that existed prior to the earthquake.  It’s their nightmarish demographics.  Japan has an old and rapidly aging population.  They have one of the lowest fertility rates in the world.  The other side of the resilient Japanese culture is that their island-society is rather xenophobic.  There is virtually no immigration into the country.

You might not pay much attention to demographics when constructing your top-down investment view, but you should.  Over the long-run, demographics and geopolitics are two of the most powerful — and easy to predict – variables in a country’s growth equation.  Japan’s demographic problems basically put a cap on how much the country can grow its GDP.  It places a lot of pressure on young kids coming into the labor market because they have to support the top-heavy population.  Fewer workers and fewer citizens means fewer people contributing to the economic growth pie.  The good news is that nobody should have trouble getting a job in Japan for at least an entire generation.  Especially after this earthquake.

The other bit of good news is that their economy is export dependent.  They run trade surpluses with pretty much every country in the world, even China!  Japan makes stuff that the rest of the world wants.  And the rest of the world is doing OK right now.

Don’t just go all in and buy Japan.  As with real estate and fantasy baseball, be selective and do your research.  When shopping for companies to buy, buy the ones that derive most of their growth from abroad.  The Japanese economy may have something of a growth cap on it but that’s not to say that every company in Japan will have limited growth.  It will be asynchronus.

Avoid the companies that are focused on internal demand and internal consumption.  Why buy a Japanese utility company when you can buy an American utility?  Or even better, a Chinese utility?  Stay away from their zombie banks too.  This earthquake is going to eviscerate small business over there and that’s bad news for the banks that have loaned these businesses money.

The other catch is their currency.  Japan is saddled with almost unimaginable levels of debt.  Think that our debt load is bad?  Try doubling that.  And this earthquake won’t help the situation either.

While this crisis could be a catalyst to get Japan’s long-term economy back on track, this could also be the end of the line for the strong Yen.  I know that a lot of people out there have been trying to short the Yen for years.  That road is littered with the bodies of blowed-up hedge fund managers, forex desk chiefs, and amateur currency mavens.  Is it finally time to short the Yen?  Yes, here at the highest levels since WWII, it might finally be time to strap in short the Yen.

If you’re going to get serious about investing Japan, think long and hard about some sort of currency hedge.

And if you’re not an investor, maybe book a vacation to Japan instead!  I’m sure there will be some good deals on travel once some of the cleanup gets underway and I’m sure the economy will appreciate your business.  Mrs. Draconian and I went to Mexico after the Peso crashed and it was awesome.  We had pretty much the whole five-star resort to ourselves.  The rates were insanely cheap and every night we got 2-for-1 drinks!

Me & Mrs. Draconian trying hard to look suave for the camera in the empty Los Cabos bar

I’ve always wanted to go to Japan but now that I have a 1-year old daughter, the thought of 10 hours on a plane fills me with a little too much anxiety to make it worthwhile.  I feel my days of being an “opportunistic traveler” coming to an end.

Nuclear power

Nuclear power was hot stuff before the earthquake.  I even wrote a fairly detailed piece on some investing strategies for it.  Up until a week ago that had been a pretty tremendous investment.  Obviously, what’s happening at the Fukushima-Daiichi site has changed the game.

There’s a lot of concern right now that this may change the policy direction for nuclear energy.  So far the global reaction has been mixed.  Germany has put up some new roadblocks but they were a country that didn’t like nuclear power to begin with.  France, which gets 90% of its electricity from nuclear sources has been very vocal about helping Japan get this reactor issue cleaned up, like, rapide.  Obama made nuclear energy a big part of his campaign and so far the administration’s line has been that they still endorse it.  I heard the other day he called for $36 billion of loan guarantees to help fund the construction of new reactors.  China, as you probably could have guessed, said, “whatever” and is going full steam ahead to roll out all their new nuclear plants.

This is a fairly critical juncture for the future of nuclear energy.  If this winds up more like Three Mile Island where nobody gets hurt and no serious environmental damage persists, then there’s a future.  It won’t be the future that would have been, but at least there will be some future for nuclear power.  If this winds up like Chernobyl (or worse) there may not be a future.

As we all sit around and ponder this and hope that they can get this fuel core cooled down without much additional radiation leakage, keep a few other things in mind.  Last year we had the worst coal disaster in this country in 40 years — far more people have been killed in coal mines than nuclear plants.  Last year we also one of the worst oil spills in history.  Remember how pissed everybody was at BP?  The endless stream of photos of pelicans soaked in oil and black beaches?  Remember the offshore drilling moratorium?!  There was even some honest debate about whether this was a policy our nation wanted to continue.  Kevin Costner got involved!  But eventually everybody just said “meh” and went back to filling up their gas tanks.  We’re all watching what’s happening in the Middle East right now and glad we didn’t shut down a bunch of our own wells.

And, BP came back:

None of this is to imply that this industry is going bounce right back.  Policy makers are super slow to react.  They’ll chew on this and debate this for a while and so it will remain uncertain while we weight pros and cons.  And maybe that’s OK as public backlash slowly recedes.  It’s not a bad strategy.  I give these politicians a hard time, but they’re clever folk and when it comes down to it they’re basically just survivalists.

And as a final thing to consider in a fact-based debate about whether or not the world should consider continuing to pursue nuclear power:

The reactor at the Fukushima-Daiichi site is one of the oldest reactors in the world.  This 40-year old plant has, for the most part, survived one of the worst earthquakes in history followed up by a gigantic tsunami.  If this creaky old reactor can endure a natural disaster of this magnitude, what about the ones that are being designed and built nowadays?  What about the ones that are being built in places that don’t have earthquakes and tsunamis?

The strategy for global energy production is one that will play out over the next century and not the next few weeks.  All of this may be moot for a few years because coal and natural gas power plants are still cheaper than nuclear to build and operate.  But a lot of people are writing this sector off completely and that might be a little hasty, especially when most of the equity damage has already been done.  There is still tremendous risk present here and there is no guarantee the debate about this will remain rational.

As always, practice caution and keep a long term perspective.

• Investing in the things that everybody else hates can be a great strategy if you’ve got the stomach for it and know how to separate fact from fiction and emotion from logic.
• Real Estate, Japan, and now nuclear energy are three places that the world hates very much right now as an investment.  Risks abound, but there are opportunities in each for those that know how to do quality due diligence.
• The market is now basically flat for 2011.  Weeks like this are why we’ve been so cautious lately and are keeping so much dry powder on hand.  Stay tuned and we’ll let you know when there are short-term opportunities to deploy some of that.  In the coming weeks we’ll outline strategies for scaling back into the market.

This will be a quick week.

You’ll have to excuse me if any of this is a little more incoherent than usual.  I slipped down to San Jose last week to see a Sharks game and brought back a nasty flu.  My general policy is to avoid public places and large crowds but sometimes that policy conflicts with the rest of my life goals.  Serves me right!  It might be all the drugs talking, but I have to admit I’m impressed with the quality of virus that you guys down in California are cultivating.  Any calls from Qaddafi about weaponizing this stuff?  I hear he’s got a population he needs to subdue.

Market Recap

Check out the movement in the Dow since March began:

-168
+9
+191
-88
-79
+124
-1
-211 (so  far)

It’s like – whoah – volatility!

Here’s a lesson from Technical Analysis 101.  That’s called a “range”.  It should be very clear.  The stock market does this when it’s trying to figure things out.  If the market closes above those little peaks around 12,200 or 12,400, that’s a good sign and means that the market could resume it’s trend higher.  If the market closes below that 12,000ish range, that’s a bad sign and it means that the market could sell off for a little while.  Today we’re holding right in there at the lower end of the range so watch today’s action.

When things like this happen and it’s unclear which way the market wants to go, I find it helpful to take a look at some major, economically- and systemically-important stocks.  Let’s see if we can find confirmation elsewhere.

An ETF of consumer discretionary stocks, the XLY, which contains companies like Disney, Amazon, Ford, Target, and McDonald’s tells pretty much the same story:

So it’s possible that some of this uncertainty has to do with the consumer and how they’re going to feel in the months ahead.

And when we look at the energy ETF, we see the other side of that story:

Energy stocks have been going straight up alongside crude oil and while that’s good for their businesses, it’s bad for consumers.  Remember that as you come out of a deflationary pit of the economic cycle, crude oil (and energy stocks) tend to correlate with the rest of the market.  But once they pass a certain point, they take on an inverse relationship.  Higher oil and gas prices (and higher profits for the energy companies) translates to consumer pain which means a slower economy.

This is why energy companies can be a nice, natural hedge for your portfolio.  Ideally they go up and you make money as you spend more to fill your car up with gas and heat your home.  If there’s one sector that every investor should be exposed to both over the short run and over the next decade or so, it’s the energy sector.

We’ve been getting some good news lately on the employment front — the weekly unemployment claims finally dipped under 400,000.  This is basically a measure of how many people file for unemployment insurance per week and it’s a leading indicator on jobs.  For a while now I’ve been listening to more and more voices in the industry say that this is a crucial indicator to be watching right now.  The 400,000 level is an important threshold and we finally appear to have dipped under it.

The labor market is improving.  It’s going to take some time — but we all knew that anyway.

Checking in with the states

One of the big themes I’ve been focusing on and a fundamental element in all of our forecasts for 2011 was this issue of the states under duress.  By now, we all know that The Problem started in the private markets in the banking sector.  Then Uncle Sam got involved with epic bailouts and stimulative budgets and The Problem took on a sovereign dimension.  At some point all of this was bound to infect the vast, troublesome world of municipalities.

This week I’d like to turn your attention to a fantastic article in the New York Times Magazine from Roger Lowenstein called “Broke Town, USA“.  Roger Lowenstein wrote When Genius Failed, which is the definitive history of the Long Term Capital Management blowup, but also was a prophecy of sorts.  That book was written in 2001 and it shined the spotlight on some of the same basic demons that would raise their heads later in the decade — things like excessive leverage and moral hazard.  Anyway, he’s one of my favorite financial journalists and unlike a lot of these guys running around nowadays, he tends to offer up perspectives that are sensible and free from melodrama and populist finger-pointing (hey, I enjoy Matt Taibbi too).

In a sense, Lowenstein is the perfect guy to weigh in on this issue, to balance out the various extreme perspectives that currently make up the discussion.

Thus far, the debate about the states has centered on their debt – municipal bonds.  Meredith Whitney fired the big shot by dropping a massive study suggesting that there would be a staggering number of defaults at the city & county level.  It took them a little while, but eventually a pack of state treasurers and major bond investors banded together and launched a counter-attack, denouncing Whitney’s analysis as crazy.  For the record, I do think Whitney’s totally wrong about the size of the defaults.  But the spirit of her call is correct.  These municipalities are in serious trouble.  There’s nothing crazy about that.

Lowenstein joins the discussion and makes a really critical point: we aren’t going to see a massive number of defaults because it’s a budget problem, not a debt problem. In other words, the states still have plenty of revenue to service their debt — payments which are usually required to be made first under most state constitutions – and not enough to pay for everything else.  So what will happen is a slow bleed of public services.  Public workers will take pay cuts, their benefits will get worse, parks will get less maintenance, class sizes will get bigger, sales taxes will rise, police forces will shrink, and maybe the trash will get picked up every other week.

This is how it’ll go for the municipalities, not an epidemic of default.

And seriously, haven’t you been paying attention for the last few years?  The moral of the story is that the bondholders make out OK while the taxpayers get the shaft.  Why are we so fixated on defending bondholders?  I have no idea.  Why do people who loan money to companies like AIG and cities like Vallejo absolutely have to get paid back regardless of the cost to the rest of society?

In any case, trying to gauge the size of these defaults completely misses the point.  It’s a MacGuffin.

You guys all saw The Maltese Falcon, right?

It was Hitchcock who coined and popularized the term MacGuffin, which is basically just a device to distract the viewers’ attention while the rest of the plot drives on.

There is perhaps no more famous MacGuffin in history than the namesake statue in The Maltese Falcon.  At first, the plot seems to revolve around the search for the legendary gold & jewel-encrusted statue, but as the movie progresses, the statue matters less and less.  The movie isn’t about the falcon, it’s about the characters — real stories are being told about romance, the limits to which people go to gain what they desire, and it’s a deep study of one of the most famous and fascinating characters in film history, Sam Spade.  I’ll admit that even I was fooled the first time that I saw it, expecting a tidy mystery where somebody would eventually go home with the falcon.  It’s no surprise I completely failed to notice the movie’s true brilliance; I was so distracted by the stuff that didn’t matter that I missed everything that did.

And that’s what’s going on with the states right now.  Everybody is so hung up on defaults and defaults have nothing to do with it.  It’s not about Meredith Whitney trying to win more acclaim or Bill Lockyear’s biased defense of the sector.  Those are all MacGuffins.

The real issue is the effect that all these budget cuts will have on the economy.

It’s going to slow consumption.  How could it not?  Raising taxes means people have less money to spend.  Pay cuts mean people have less money to spend.  Reduced pension benefits mean people have less money to spend.

And this is all on top of the psychological effects of watching your city, county, and state cut back on all the public goods you’ve come to know and enjoy.  Is that going to fill consumers with confidence?

Right now everyone in the world is focused on crude oil (and rightly so), trying to get a sense for how bad the economic impact of $4.00 gas is going to be.  But this thing with the states is a sneaky issue that’s still lurking in the shadows.  It won’t catch anybody by surprise.  We know that bogeyman is out there.  We’re just kind of willing ourselves into a state of happy ignorance.

And maybe that’s OK for the guy on the street.  But I’m a financial professional and I get paid real money to worry about stuff like this.  My job is to ignore the MacGuffins and keep my eye on the ball.

Did I get it wrong?

So far it remains to be seen whether this will all become as big a story as I thought.

I guessed that this was going to be the dominant issue of 2011 because the magnitude of the problem is gigantic and also because it’s a visceral issue.  Raising taxes, slashing pensions, and laying off teachers are the kinds of things that our country normally gets kind of riled up about.  And for those of whom it has affected so far, I’d say they’re pretty riled up.  For Scott Walker and those union folk protesting in the halls, this will be their big story of the year.  Madison has received a little bit of national press so far, but the rest of the country just kind of shrugged its shoulders.

It’s entirely possible I underestimated the American People’s willingness to accept sacrifice.  Or it’s entirely possible that the fragmented, regional nature of this problem will keep it from becoming a national issue.  Unless any dramatic human story lines start playing out on the nightly news.  Human stories are fueled by emotion and those tend to get people more involved than abstract questions such as the necessity of reducing a city budget by 18.5% and complicated philosophical debates like the cost/benefit analysis of organizing a union.

Or maybe it’s just this flu virus going around and everybody just kinda feels blargh or anesthetized from massive amounts of TheraFlu.

I guess we’ll know for sure by the end of the year.

Don’t forget about the Greeks.  Opa!

The yield on 2yr Greek bonds is now above 15%.   That’s a record.  The spread over German bonds, currently at about 9.5%, is the highest level in two months.  The cost to insure against a default in Greek government bonds is also at an all time high.  It costs over a thousand basis points for Greek credit default swaps!  That’s more than the spread over German bonds.  The market is pretty much guaranteeing a default of some sort.

And it’s not just Greece, yields have been rising in Ireland and Portugal as well.

What I still can’t reconcile is that the market was really worried about this last year.  The S&P almost had a 20% drawdown last spring.  Since then the problem has gotten worse yet the market has rallied to new highs.

Why?

Well, QE2 had a lot to do with it, a forceful remind that central policy is still committed to re-inflating popped assets whatever the long-term cost.  But I prefer taking a step back and looking at the bigger picture.  The bigger picture right now is an environment of incredibly low yields.  Short term real interest rates are negative.  Let me tell you something about negative real interest rates: negative real interest rates are a major incentive to take risk.  With this kind of policy, The Fed is basically holding a gun to head of every investor and saying, “if you don’t buy stocks or real estate or bonds and leave the money in the bank then we will guarantee that you will lose money.”

Risk premiums are way too low.

Over the last six months as the rest of world has forgotten all about the European Debt Crisis I have noticed a subtle, sinister change in language.  Last summer, the question was about whether or not these peripheral European countries would default.  Now the language seems to revolve around how big the haircut is going to be.  From what I hear, the haircut needs to be about 40-60%.

Let this be a reminder that the next time you see a 2yr yield anywhere at 15%, the yield is that high for a reason.  In the case of Greece, is 15% enough compensation for a high probability of a 50% haircut?  You’ll have to answer that question yourself.

How about California munis?

Today I saw some Oakland bonds yielding 9.5%.  On a pre-tax basis that’s nearly 14%.  Almost Greece territory.

Why are people buying this stuff?  I’m sure it’s probably just greed and desperation for yield, but maybe that California flu has scrambled everybody’s brains.

• Watch the market here at 12,000 to see if it closes below this support.  If it does, that’s a bad sign.  In the meantime, the economy and labor markets are slowly improving.  Cross under the 400,000 level for weekly unemployment claims is a really big deal.
• Go read Roger Lowenstein’s article in the NY Times Magazine called ”Broke Town, USA“.  It’ll bring you up to speed on what’s happening at the state and city level.  Remember that we thought this would be the dominant issue of 2011 (along with higher energy prices) and so far it remains to be seen whether or not this’ll be correct.  Lowenstein’s perspective is a nice balance between the extremes of Meredith Whitney’s apocalyptic forecasts and somebody like Bill Lockyear’s biased defense.
• When it comes to bond markets, don’t chase yield.  Don’t do it.  Greek 2yr bonds are yielding 15% but the behind-the-scenes scuttle is that those bonds are going to need about at 40-60% haircut.  Is the risk of that worth the 15%?  There are some California municipal bonds that are almost in the same territory.

Today we’re going to take a quick look into what has become an increasingly hot debate: inflation.

It’s getting a lot of press lately with all this action in the Middle East, protests which were catalyzed in large part by recent increases in food prices.  Just this morning the United Nations said that world food prices have risen to a record.

We’ll get to that in a minute, but first let’s run through the markets.

Market recap

It’s been an uncharacteristically bumpy week.

After reaching a short term high about two weeks ago, the markets have sold off and chopped around.  I included a volume overlay on this first chart and you can see that the volume has been noticeably higher on the down days.  Because of the explosion in high frequency trading, I’ll admit that volume isn’t the interesting indicator that it once was.  Still, it always warrants caution when you get the point in a rally where the down days are the most severe and carry the highest volume.  This is a very complacent market that every once in a while wakes up terrified.

We’re up again this morning and it appears that support around the 1300 level has held.  Next we will turn our eyes to see if the market can break through resistance at about 1335 and 1345.  It’ll be a good sign if it does.

Our prediction at the beginning of the year was that we’d see some strength from the market for a couple of months until one of two things were likely to send it into a rocky patch, either a geopolitical/economic catalyst or brewing uncertainty about what happens when the Fed starts to unwind QE2 in June.  We figured that March would be about when that would start.

It remains to be seen whether or not that forecast will be correct.  It’s a guess about the future and, well, you know those things go.

We’ll now be paying more attention than we were in January and early February.

CrudeWatch 2011

I think this is the number one issue right now and for the short term.  Another one of our forecasts for this year was for oil prices to break through $100/barrel.  I had no idea that these revolutions in the Middle East would spook the energy markets the way they have, so I can’t take too much credit for getting this one right.  I thought it would just slowly trend through $100 as we moved into the summer.

This is the big issue because this is the newest, most tangible threat to the economy.  A couple of months ago I wrote about all the research that shows that recessions tend to be preceded by spikes in energy prices.  This warrants mentioning because the relationship is not just correlative, it’s causative.  When energy prices go up, consumer spending goes down which means that an economy that’s about 70% driven by consumer spending tends to suffer.

Here’s a helpful rule of thumb to gauge the impact of all this.  A $10 increase in the price of oil translates to about a 25 cent increase in the price you pay for gas at the pump.  Every one cent increase in the price of gas means an addition $1 billion in aggregate energy consumption.  Assuming that consumers don’t borrow to maintain consumption, a $10 increase in the price of oil nicks the economy for about $25 billion.  That’s about 0.2% of real GDP growth.

That’s significant.  And as quickly as oil prices jumped from the high $80′s to around $100, we saw economists slash their forecast on 2011 GDP growth by as much as a half a percent.  If we get gas prices up around $3.50-3.75 per gallon again then that will knock out just about all the effect of the payroll tax stimulus.

The other day I heard John Herrmann of State Street Global Advisors say that if we were to see sustained prices at around $120/barrel that’s when we would really start running into trouble.  I agree with that.  That’d take gas to towards $4 per gallon at which point you would have a change in economic behavior as well as a change in psychology.  $4 gas is where the complaining gets shrill and people stop feeling so great about the recovery.

Anyway, all this underscores the point of this massive, heroic stimulus: the purpose is to keep us bouncing along the bottom and not falling through the floor.  I’m not convinced that this economy is strong enough to stand on its own two feet without slipping dangerously close to recession.  That’s not to say that we should be engaging in all this stimulus or even that we should fight tooth and nail to avoid recession (this is not a free lunch, you know; this stimulus carries long-term costs).  I’m just saying that the economy faces a lot of structural challenges, that we should expect more oscillation between excitement and despair, and that no one should get too optimistic about the long term or pessimistic about the short term.

Basically: the stimulus is defensible but that doesn’t necessarily mean it was the right course of action.

Also: the road will be bumpy.  Ups and downs.

Which reminds me…

What about Inflation?

You guys know we have been voices of reason when it comes to the — what shall we call it… the “inflation debate”.

For pretty much two years now a gaggle of people out there have been crying about the inflation!  the inflation!  Ben Bernanke is printing money and he’s going to destroy the dollar!

And despite all this we haven’t seen a meaningful whiff of broad based price inflation.  Now make no mistake, I agree that it’s really hard to see a scenario whereby the U.S. escapes from this gigantic debt burden without some kind of bond haircut or currency depreciation.  I read the Reinhart & Rogoff book.  These movies all end the same way.

Some day it’ll be time to panic.  Don’t worry.  We’ll let you know when.  I will post a special newsletter called IT’S TIME TO PANIC ABOUT THE INFLATION!

But for the time being this just isn’t a scenario that the average person needs to be concerned about.  There are far too many deflationary forces to worry about.  I know that gas is starting to get painful again and that your bill at the grocery store is getting a little bigger.  But there are unbelievably gigantic structural headwinds in front of the U.S. economy that will act as a deflationary buffer.

In the past we’ve talked a lot about the bond market.  The bond market is very cool.  It is also very powerful.  Maybe the most powerful thing on the planet.  It directly and indirectly affects nearly everything in your world — from how much it costs to own your home to the size of your future social security checks to how easy it is to start and operate a business.  The stock market is fun to talk about, but if you really want to get a read on how things are moving you need to know how to read the bond market.

Government bonds come in two basic flavors.  The first is vanilla, your standard U.S. Treasury Bond.  The second flavor is exactly the same in every single way except for one little twist: its price automatically adjusts with the inflation rate.  So it’s like vanilla with chocolate syrup.  These bonds pay a lower yield but that’s OK because investors will accept a lower yield since they know the price will get readjusted if inflation rises.

In fact, if you subtract the yield of these chocolate-covered inflation bonds from the yield of the regular vanilla bonds, you get a number that tells you exactly how much bond investors think that inflation is going to be.  It’s like extracting all of the chocolate syrup and weighing it on its own.

I made a chart because charts make it easy:

This is another reason why I’m not worried about inflation.  Because the bond market isn’t worried about inflation.  And despite all the protesting Libyans you see on television, nobody in the world is more sensitive to inflation than a bond investor.  These guys have their own money on the line!

I concede that chart is pretty boring.  There is really only one little item of interest and that’s the end of 2008.  We all know what was happening then.  The powers that be all gathered in a smoky room, brushed the dust off of Ben Bernanke’s famous/infamous Helicopter Speech, and said, “No.  There will not be any deflation in this country.  Not on our watch.”

It worked.  Inflation expectations went back up to around 2% again as measured by the spread between regular Treasuries (vanilla) and TIPS (with chocolate syrup).

Many of you might remember the early days of this newsletter.  I was gaga for TIPS.  Like a manic Jim Cramer I was grabbing people on the sidewalk and urging them to buy TIPS with both hands.  ”TIPS!” I said.  ”What?” they said.  ”You need to buy TIPS!” I said.  ”Buy tips for what?” they said.

My enthusiasm for TIPS has waned a little bit in the last few months but I still like them.  They are a very useful tool when constructing an investment portfolio and not only are they risk-free but they are 100% guaranteed to protect you from inflation.  The bad news is that they are boring.  A brand new 10-year offering will pay you about 1%.  Yawn.

Wake up!

This is your chance to make a really sophisticated portfolio management decision.  Today the 10yr TIPS-Treasury spread is 2.5%.  If you think that inflation for the next 10 years is going to be higher than 2.5% then you should buy TIPS.  If you think it will be lower than 2.5% then you should buy vanilla Treasuries.

Those of us that live here in Nevada know a thing or two about how the gaming industry works.  A couple of you out there are probably grinning and recognize that that above proposition looks a whole lot like making a book.  This is how betting lines are established.  You let the market figure out a spread that gets an essentially equal number of people on either side of the bet and then you charge a little vig while you’re at it.

Nobody knows who is going to win and nobody knows what the exactly inflation rate is going to be.  But the spread is what the market thinks it’ll be.

2.5%: over or under?

Hold the phone

Personally, I think that the 10yr inflation rate will be over 2.5%.  That’s why I’ve liked TIPS for the last few years over Treasuries.

I know I just gave you this lengthy diatribe on why I’m not worried about inflation, BUT, it is time to be a little vigilant.  The TIPS/Treasuries spread has been steadily creeping higher.  It’s not at panic levels yet, but it is trending upward and anytime it’s trending upward one needs to being paying attention.

I also just discovered the Billion Prices Project at MIT.  These guys are attempting to track inflation in real time.  How’s that for audacity!  The thing is: they are seriously on to something here.  Bloomberg economics editor Mike McKee thinks it could be a “category killer”.

This has been inching higher as well:

Look at the entire data set.  Don’t just cherry pick the points that support your dogma.

I’ve got my eye on inflation again.  If these numbers taper off a bit or if the economy looks like it might slow down, then I’ll go back to ignoring it.

On Wall Street

Last week I made some mean comments about Wall Street.  To be diplomatic I will say today that it is an industry with a very, uh, “interesting” history.  Even though our business is technically based in the Sierra Nevada Mountains, we swim in the same pool and call this industry our own.  I love this industry.  Why am I so critical of it?

It’s a good question.  I guess I need to just vent my frustration about not being able to reconcile my ideals with reality.  I want it to be a better place but know that it will never happen.

I came across this quote the other day and it really touched a nerve.  It might be the best quote about Wall Street I’ve ever seen:

To the merchant and banker it is a financial center, collecting and distributing money, regulating the exchanges of a continent and striking balances of trade with London and Frankfort.

To the outside observer and novice it is a kind of work-shop thronged by cunning artisans who work in precious metals, where vessels of gold and silver are wrought or made to shine with fresh luster, and where old china is fire-gilt as good as new.

The moralist and philosopher look upon it as a gambling-den, a cage of unclean birds, an abomination where men drive a horrible trade, fattening and battening on the substance of their friends and neighbors — or perhaps a kind of modern coliseum where gladiatorial combats are joined, and bulls, bears and other ferocious beasts gore and tear each other for public amusement.

The brokers regard it as a place of business where, in mercantile parlance, they may ply a legitimate trade, buying and selling for others on commission.

To the speculators it is a caravansera where they may load or unload their camels and drive them away betimes to some pleasant oasis.

To the financial commanders it is an arsenal in which their arms and chariots are stored, the stronghold to be defended or besieged, the field for strategy, battles and plunder.

It was written in 1870 by a guy named William Worthington Fowler.  1870!  If you’d told me that it was written yesterday I wouldn’t have blinked an eye.

It has been revealed on this site that I am a certifiable Investment Geek, Movie Geek, and Fantasy Baseball Geek.  You may or may not know that I am also a certifiable Literary Geek.  As you can imagine, my company is popular with about 12 people on the entire planet and I hold each one of them dear as my close friends.  At cocktail parties, people introduce themselves, nod politely, and then make some excuse to disengage from conversation to get more shrimp.

Spreadsheets usually get my juices flowin’ but the bookworm in me cannot avoid being overcome with the frisson of hearing a phrase like “a cage of unclean birds.”  I will bang away at my silly little keyboard for the rest of my life and never write anything as beautiful, humorous, or as relevant.

Anyway, I bring all this up because it reminds me of  a question I get all the time.  People are always asking me for recommendations on what to read — books, other blogs, newsletters, whatever.  A few people have suggested a book review section where we talk about and review our favorite investment literature.  It’s a good idea.  Someday I’ll get around to that; I promise.

Today I’ll share my favorite book about investing.  It’s an obscure little book called Where Are the Customer’s Yachts? by Fred Schwed Jr.  You can buy it for about $13 over at Amazon.

I like it for three reasons:

1. It’s easy to read.  In fact, you can probably knock the whole thing out in one afternoon.  Financial concepts are difficult enough to understand as they are and these books don’t need clunky prose getting in the way.  This book is completely non-technical and literally anybody can pick it up and get a complete education about Wall Street.  I’ve been at this for over a decade now and I can personally testify that this book is all true.  You should also know that it resides in the “entertainment/humor” section at Amazon.  It’s funny because it’s all true.
2. It’s timeless.  The book was originally published in 1940 after a nasty bear market and it was given a big update in 1955 which was in the middle of a huge bull market.  It incorporates wisdom from every era and like the quote above, it’s every bit as relevant today as it was 60 years ago.  60 years from now, Mr. Schwed’s book will still be relevant.  It will still be relevant because it’s about human nature.
3. It’s useful.  Most investment books give you fad strategies that help you deal with the market movement of the times.  But this book will help you navigate the human element which is a skill that you’ll need for your entire life.  Being a successful investor is about much more than just understanding things like GDP and moving averages.

Check it out!  If that quote from Mr. Fowler made you smile, I think you’ll dig it.

• For the short term the market seems to have held at support levels.  Look for a break above 1335 and 1345 for indication that the bull market in complacency is still running.
• Continue to watch crude oil.  Energy prices are going up and we’re in the zone now where consumers are feeling it.  If it stays too high for too long, the economy could be in serious trouble.
• When it comes to inflation, don’t pick and choose your data points.  Look at broader indicators of inflation like the CPI or the TIPS/Treasury spread or something new like the Billion Prices Project at MIT.  Don’t ignore data for the sake of your dogma.
• If you want to read a book about investing, pick up Fred Schwed’s Where Are the Customer’s Yachts?.  It’s one of my favorites.