Slope Of Hope with Tim Knight

Deflation or Just a Point on the Continuum?

Excerpted from the January 15 edition of Notes From the Rabbit Hole, NFTRH170

From Bloomberg on Friday [13th]: “Stocks fell, trimming a weekly gain, while the euro and commodities slid after reports that several European nations will have credit ratings cut by Standard & Poor’s. U.S. Treasuries rose…”

This is the news of one failing major currency benefiting the exchange rate of another, along with the Treasury bonds it denominates. Deflation is not global hot money hysterically running from one intrinsically worthless currency to another any more than the 2005-2008 “death of the US dollar cult” represented hyperinflation.

Gold-Silver Ratio and Its Implications (by Tanashian)

The GSR is an 'early warning' indicator on liquidity.  Its uptrend was a negative divergence to the stock market heading into the recent bear fesitivities and as long as it remains in the noted uptrend, it will negatively diverge the bull, global inflationist policy making or not.

Flipping the Silver-Gold ratio on its head, we find the GSR in a nice uptrend after it was clobbered down and out of its bottoming pattern last year by the Vampire's QE2 policy announcement.  Once the bottoming pattern broke in the GSR, NFTRH abandoned the intense risk management and rode to a nice solid +42% return in the speculative portfolio.  Thank you Ben.

Drip Drip Drip

First, I want to say a big Thank You to Slopers for supporting the blog's advertisers. I appreciate it.

I've never had the misfortune of enduring Chinese water torture, but I'm vaguely acquainted with the concept: a person is immobilized underneath a source of water which drips at random intervals. The uncertainty of knowing when the next drop is going to fall is supposed to be maddening.

Well, I think I can vouche for the mental effect. The "headline risk" from the Euro-clowns has been persisting for months now. I believe I read this is the seventeenth - SEVENTEENTH! - meeting of the big-wigs to "cure" the Euro-mess. Rest assured, there will be an eighteenth.

Gold (by Gary Tanashian)

The public now hates the fact that it bought into this gold scam.  "Damn, if only I could have held out and not gotten so emotional, I would have remained calm and let our dear leaders find a solution instead of buying into this bubble" says the public.

Real gold players know that the above is a necessary ingredient to preparing the ancient relic for the next leg in its bull market.  But a key question remains as to gold's technical status.  As we have noted all along (since the upside panic last summer) in NFTRH and on occasion here on the blog, gold has needed continued correction as measured in Euros, Loonies and to a lesser degree, Aussie Dollars.

More Thoughts on OWS (by Gary Tanashian)

Chris Hedges has stirred up a mini epiphany in the blogosphere, especially considering the endless war-making that is employed in the name of corporate gain.  I am always against war, whether it is apparently 'justified' or not.  I hate war.  I supposed that sometimes it is necessary, but only to a tiny fraction of the scale to which it is systematically carried out.

A couple more articles for your consideration can be found here http://www.biiwii.com/analysis.htm.  The first, 'Going Apeshit' by James Howard Kunstler, shows the situation in cartoon-like fashion (a huge compliment, btw) as only Kunstler can.  He also shines a light on President Obama's superficial attempt to align himself with OWS for political gain.

Inflation on Demand & Along the 'Continuum'

Global markets are in the midst of a predictable relief rally to the technical bear market that recently became actualized off of various topping patterns that were in force for most of 2011.  It is important to note that this is coming off of a similarly predictable whiff of a deflation scare, as US and European debt 'imbalances' (a polite way to put it) spooked the public out of asset markets and into US Treasury bonds, among other 'safe' havens.

Ben Bernanke, the current US Fed Chief, is a deflation scholar after all.  He is the man for the job and if he was hesitant to do his job, as was the case last spring amid the 'austerity movement' and a red-lined long term T bond yield, he can be less so now.  The 'bad cops' (Fisher, Plosser, Bullard, etc.) at the Fed have been marginalized for the time being with people like Robert Reich and Paul Krugman, along with their decidedly less financially austere views, are back in the public consciousness.

Inviting the Vampire

Nosferatu's Shadow

Dear SOH, I love October and Halloween, don't you?  ;-)

This article in no way pretends to be real, actionable analysis like that which appears in Notes From the Rabbit Hole (NFTRH) each week.  Rather, it is just a metaphorical riff on a big picture macro economic theme that is currently in play.

Setting the clock back to January of 2011, we find long term Treasury bond yields hitting a critical high along the 'continuum' and finally beginning to signal an end to the inflation hysteria - born of the previous Fed sponsored QE campaign - as illustrated on the blog in May.  At that time, it was noted that the Wizard (metaphor temporarily switched to 'Vampire' for today's article) was powerless to work his magic against an oncoming economic contraction in the face of inflamed inflation expectations (long term yields at a 'do or die' breakout point parameter) and a then rising 'austerity' movement in the US.

Well, you see in the picture above (source info) that times are much different, a mere 6 months later.  Indeed, austerity has been cast to the scrap heap as the usual macro-managers come out of the woodwork, one after another, and invite the Vampire back into our homes.  You know the legend is that the Vampire must be invited in, don't you?  There is nothing like decelerating global macro-economic fundamentals and caving asset markets when it comes to inviting the Vampire to do his work.

Why are we using the Vampire as the metaphor for the US Fed (and I might add, its counterparts the developed world over)?  Because they are now being called upon... invited to provide more policy - in the name of asset price inflation - that is ultimately destructive to would-be normal, healthy economies that thrive on productivity and investment of capital toward these things of productivity and value.

In short, more inflationary policy creates more macro debt burden, provides potential asset price inflation and a growing overhang from which many economies will fail to recover (insert here the macro subplot in Greece and the PIIGS in general, which are just a tip of an awfully big iceberg) as inflationary policy sucks the life out of a real economy over time and cycles.

So we have come full cycle.  The updated chart of the 'continuum' is in a picture, an invitation.  The most recent red arrow indicated a time when the Vampire was reviled and politically scorned.

The 'continuum' AKA secular trend in 30 yr yields

Now we have a different atmosphere - expected by this writer and indicated by the chart above so many months ago - with deflation and systemic collapse at the forefront of the collective financial and economic mindset.  Austerity?  Please, give me a break.  The Vampire has already received his invitation, but having been scorned so soundly earlier this year, he sits back and lets the call become louder by the week.

The balance of current NFTRH analysis holds that he may await a final capitulation to be sure that the invitation is near unanimous.  

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http://www.biiwii.com

Gold is Getting 'Fixed'

Dear SOH, hi, it has been a while.  It was no use writing on the blog of a 'gold hater' like Tim ;-) and puffing up my plumage as the barbarous relic soared toward $1900/oz.  It is much better to do so during some serious carnage and questioning of the 'play'.  A deflationary event that I expected in the summer of 2010 (until the primary indicator, a gently bottoming gold-silver ratio {GSR}, was blown up by QE2), is finally upon us, complete with an impulsively rising GSR, which has broken out of a strong resistance zone we had been watching.

Hedging Against a Dollar Drop

Chafing at the world's reserve currency

After the excitement of the U.S. debt ceiling negotiations going down to the wire, Russian Prime Minister Vladimir Putin offered these comments about the U.S. and its dollar:

They are living like parasites off the global economy and their monopoly of the dollar.

[...]

If over there (in America) there is a systemic malfunction, this will affect everyone," Putin told the young Russians. "Countries like Russia and China hold a significant part of their reserves in American securities ... There should be other reserve currencies.

With Putin's sentiments in mind, let's look at a way to hedge against a further drop in the dollar

Hedging the dollar

The steps below show how to hedge the dollar by buying optimal puts on the PowerShares DB USD Index (UUP) as a proxy for it. First a quick reminder about what optimal puts mean in this context.

About optimal puts

Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. As University of Maine finance professor Dr. Robert Strong, CFA has noted, picking the most economical puts can be a complicated task. With Portfolio Armor (available on the web and as an Apple iOS app), you just enter the symbol of the stock or ETF you're looking to hedge, the number of shares you own, and the maximum decline you're willing to risk (your threshold). Then the app uses an algorithm developed by a finance Ph.D to sort through and analyze all of the available puts for your position, scanning for the optimal ones.

A step by step example

Step 1: Enter a ticker symbol

In this case, we're using UUP as a proxy for the dollar we've entered UUP in the Ticker Symbol field below.

Step 2: Enter a number of shares

For the purposes of this example, let's assume an investor has a $1 million portfolio, all in dollar-denominated assets.  So, since we're using UUP as a proxy, the number of shares we'll enter will be $1,000,000 / the most recent share price of UUP ($21.17, as of after hours Monday) = 47,236.7. We've rounded that up to 47,237 and entered that number in the "Shares Owned" field in the screen cap below.




Step 3: Enter a decline threshold

You can enter any percentage you like for a threshold when using Portfolio Armor (the higher the percentage though, the greater the chance you will find optimal puts for your position). I've entered 15% in the "Threshold" field below.



Step 4: Click the red button

A moment after clicking the red button, you'd see the screen cap below, which shows the optimal put option contracts to buy to hedge against a >15% drop in UUP between now and March 16, 2012. The cost of this protection on a $1 million position would be $6,608, or about 0.66% of the position value.<sup>1, 2



1</sup>Note that, in this case, Portfolio Armor rounded down the number of shares of UUP we entered to the nearest hundred (since one put option contract represents the right to sell one hundred shares of the underlying security), and then presented us with 472 of the put option contracts that would slightly over-hedge the 47,200 shares of UUP they cover, so that the total value of our 47,237 shares of UUP would be protected against a greater-than-15% decline.

²To be conservative, Portfolio Armor quoted that cost based on the ask price of the optimal puts. In practice, an investor can often purchase puts for a lower price, i.e., some price between the bid and the ask.

QE Correlation

Springheel Jack’s post yesterday (UUP Breaks Up) got me thinking about the correlation between the dollar (UUP) and the S&P.  Apparently, Tim was thinking along the same lines this morning with his Forex post (The Euro and the ES).  I am trying to look at the long-term picture of what/how the various Fed “efforts” have moved the market.  The story of [Ben turns on the presses = goosed market] is already known, but I’m looking to determine the extent of the correlation during the different periods.

Quick history: In late November 2008, the Fed started buying $600 billion in Mortgage-backed securities.  By March 2009, it held $1.75 trillion of bank debt, MBS, and Treasury notes, and reached a peak of $2.1 trillion in June 2010.  After a relatively short break and a coincidental 20% drop in the market as QE1 ended, the Fed decided to renew quantitative easing because “the economy wasn't growing robustly”. Its goal was to keep holdings at the $2.054 trillion level by replacing maturing debt. To maintain that level, the Fed bought $30 billion in 2-10 year Treasury notes a month. In November 2010, the Fed announced it would increase quantitative easing, buying an additional $600 billion of Treasury securities by the end of the second quarter of 2011.

 

The correlation between UUP and the SPX since March 2007 is -.35; not exactly investment-worthy in my book.  However, I broke out the correlation during the aforementioned periods:

Pre-QE                       -.27

Since QE1 started      -.83

During QE1          -.68

Between 1&2       -.94

During QE2          -.67

A couple things jumped out at me here… First, that since QEs started, the market now dances to the Fed’s tune (duh); but more importantly, the correlation data says it is by a significant- and therefore investable- amount.  Second, the -.94 is a surprisingly extreme number… it was only for a 4 month period, but I cannot say with any certainty why.  I would imagine that by not knowing if there was going to be a QE2, traders followed Forex more closely.  On the other hand, the Forex and equity markets could have been reacting to, as I recall, a tremendous amount of chatter back then speculating that QE2 was coming.

Now that QE2 has “ended,” I bring up these points because in a speech to Congress, Bernanke said the Fed is preparing for another round of Treasury bond buying (y’know- just in case this “soft patch” isn’t as temporary as Washington would like voters to believe) and the QE3 chatter seems to have increased (e.g., Why Bernanke And Pals Will Soon Need a New Pair of Pants, Stocks Rise Amid Hopes for Further Stimulus). 

I’m neither an economist nor a political commentator, but with an election next year, I think they will throw everything they have at keeping the market propped-up… including some creative way to implement QE3.  So, if recent history is any indication, we should now be in a period similar to the one between QE1 and QE2; where there is a high inverse-correlation between the dollar and the market.