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Recently Barrons asked the question: “Do you believe in technicals or fundamentals?” The article pointed out that while the technical picture looks bullish, the fundamentals remain weak and caution is warranted.

I agree that the technical picture looks quite positive as the bulls seem to have regained their footing. On the other hand, respected investors and analysts such as John Hussman to David Rosenberg have been warning about the deteriorating economic backdrop.

The price of economically sensitive Dr. Copper tells the story of improving technical picture. As the accompanying chart shows, trend following models experienced a “dark cross” (circled), which point to a downtrend when the shorter 50-day moving average crossed below the longer 200-day moving average. However, copper prices have rallied significantly since that event, which points to further short-term price improvement.

On the other hand, Gluskin Sheff chief economist David Rosenberg wrote on July 27, 2010 (free registration required) that “the technical picture has improved. The data have really been unimpressive even if not horrendous. And I think we have the potential for a lot of disappointments in earnings to come as the plays on ‘domestic demand’ are in the offing.”

SocGen strategist Albert Edwards likens the current situation to Japan’s Lost Decade(s):

We are at the most dangerous stage in the Ice Age – the ‘post-bubble cycle’. For although it is clear that leading indicators have turned downwards, the choir of sell-side sirens is singing its song of reassurance. The lesson from Japan was that once the cyclical rally is over, any downturn in the leading indicators should find you stuffing beeswax in your ears to block out that lilting melody so as to avoid the jagged rocks of recession.

In the end, it depends on one’s time horizon and risk tolerance. My inner investor remains extremely cautious and looks for market strength to lighten up positions. My inner trader, on the other hand, tells me to go with the flow and stay on the bullish momentum train.

A couple of weeks ago I wrote that war might be the surprise way for the US to dig itself out of a debt hole. After all, investors tend to care less about mundane things like debt service ratios when the shooting starts – and who knows what kinds of assets the winner may gain in a war?

The hawks circle
Avner Mandelman, who has been warning about the possibility of war, wrote on the weekend about the beat of war drums:

[L]ast month the U.S., British and French navies held an unprecedented joint exercise in the Mediterranean, and right after, the U.S. aircraft carrier Truman and its 10 accompanying battleships crossed the Suez Canal to join the two other U.S. carrier groups already in the Gulf. Even more interesting, two weeks later an air caravan of American and Israeli cargo planes landed in Azerbaijan, downloading "equipment," which caused the Iranians to protest loudly and go on war alert.

Such force concentration near the oil fields doesn't mean a conflagration is imminent, but it does mean the risk of one has gone up, with possible investment implications.

Michael Hayden, former director of the CIA, believes that the march to war with Iran is “inexorable”. Consider these two interpretations on his interview with CNN’s State of the Union. The first is from the viewpoint of the hawks from DEBKA and the second from the doves at the Fabius Maximus blog.

A bullish fat-tailed event
For investors, war would be the ultimate reflation trade that would make the bears really run for the hills. This is a possible fat-tailed event that we need to keep an eye on. While coverage is not easily found in the mainstream press, it is possible to find sources such as DEBKA, which is good source of information (or disinformation, depending on how you view things).

Don't just react to newsflow, analyze
Readers should be warned that DEBKA has a Likud Israel-is-under-continual-siege mentality and is prone to exaggeration as it has falsely pounded the war drums before. For example, this recent story about the deployment of a third US carrier opposite Iran sounds alarming. Upon closer examination, the third carrier turns out to be the USS Nassau, which is an amphibious assault ship carrying marines rather than a large Nimitz class carrier such as the USS Dwight D. Eisenhower or USS Harry S. Truman, which are reportedly deployed in the theatre.

Please be reminded that the United States has heavy troop presence in Iraq and Afghanistan and it would not be overly unusual to have one or two large Nimitz class carriers in the region.

Investors should be prepared for the possibility of war, but analyze the situation carefully before jumping to conclusions.

The task of managing portfolios isn't as easy as it seems. Not only do you have to think about issue selection, you also need skills like portfolio construction and trading. Over the years, I have seen very smart and experienced sell-side analysts who have had great difficulty making the transition to the buy-side and portfolio management.

David Merkel at Aleph Blog wrote a terrific series called The Education of a Corporate Bond Manager (see Part 1, part 2 and part 3) that addresses many of these problems. For example, Merkel discusses the problems of putting together a portfolio when time is limited and there is no time for analysis:

But when the market was hot, and deals would close within an hour, I would work differently. When the deal would come, I would put in for bonds, so that I would get some allocation. I would ask for the high end of what I would normally ask for, knowing that I would get scaled back considerably. Then I would send the details to my credit analyst, telling them that if they did not like the company, I would sell the bonds.

Eventually, most of my analysts during the times when the market was hot would come to me and say, “How can you put in for bonds without an opinion from us?” First I would reassure them, and tell them that I valued their opinions, and that I would not hold onto a bond permanently unless they liked it. I would sell all bonds they did not like, but when the technicals favored it, within a few months.

And the problems with trading:

But I started selling away, and began to learn the art of price discovery. When you want to sell a bond, you first have to look at what investment banks ran the books of the deal. There is an unwritten rule that if they play that large role in origination, they have to make a market in the bonds thereafter.

I also wrote a series called What do you do after you've made your picks that looks at the problems from the viewpoint of an equity manager (see Part 1, part 2 and part 3).

Go and read them and you'll get some perspective.

I would like to address the issues raised by my last post about buy-and-hold vs. dynamic asset allocation about the diversifying properties of other asset classes, specifically commodities.

Are commodities diversifying?
AllAboutAlpha recently wrote about the death of commodities as an asset class. One of the studies cited was from RS Investments, where they show commodity prices are increasingly correlated to equity returns.

AllAboutAlpha concluded that commodities remain a good source of diversification since they are highly correlated to inflation.

One giant risk trade
Izabella Kaminska at FT Alphaville addressed the commodity diversification issue slightly differently by observing that commodities are increasingly correlated to stock market returns because of the stampede of institutional funds going into the asset class. She went on to discuss the lengths that some dealers and institutions have gone to in order to minimize the loss of returns from rolling the contango.

The rising correlation to equities and correlation to inflation both point to the same thing. The commodity trade has become just a risk trade.

When I view commodity prices through the inflation-deflation macroeconomic lens in the Inflation-Deflation Timer model and put it on the risk-safety axis, commodities have become the risk, or inflation/reflation trade. The other end of the deflation, or safety axis is occupied by the US Treasury long bond. By the way, equities are correlated with commodity prices because they, too, represent the risk trade, or reflation trade, albeit in a less volatile fashion.

Are commodities a good diversification building block? I am afraid not. They are just an extension of the reflation or risk trade represented by equities.

MarketWatch published an article last week discussing the rise of trend based market timing strategies, compared to the more traditional buy-and-hold approach to investing. I also covered the same issue when I posted that we may have to wait eight years for a new equity bull to begin.

To recap, we may very well be in a secular bear market, where returns are roughly flat as illustrated by the chart of the DJIA below.

Zero return with portfolio volatility?
Let’s do a back of the envelope calculation. The stock market’s dividend yield is around 2% and the 10-year Treasuries yield around 3%. Assume that stocks have no capital appreciation over the next 5-10 years, the expectation of return of a buy-and-hold balanced fund is going to be around 2.5%, regardless how you play around with the asset mix decision.

Don't forget layer on the transaction costs and fees. After factoring in trading costs, which can easily be 1% or more for individuals, and investment management fees (conservatively estimated at 1-2% for an active solution, under 1% for passive solutions), the investor is left with little or nothing to show for his efforts, except for the volatility in his portfolio.

Why not just sock the money into a savings account?

Yield at a reasonable safety margin
To cope with a low return environment, the first-order solution for the buy-and-hold crowd has been to seek out yield. But there is no free lunch here either. Higher yield comes at the price of credit risk and credit risk could blow up in our faces in the current fragile economic environment. Some investment managers have sought to mitigate that with the concept of yield at a reasonable safety margin, which is not a bad solution under the circumstances and the constraints of a fixed asset allocation.

Dynamic asset allocation using trend following principles
My solution, along with some others cited in the MarketWatch article, is to trade the swings. The swings can be considerable – witness the trough-to-peak behavior of stocks since the March 2009 bottom.

I am not alone in my choice of modeling platform. My Inflation-Deflation Timer model is based on trend following principles, as applied to various commodity prices. The MarketWatch article cites others who use similar techniques. Mebane Faber uses similar kinds of principles to limit losses in asset allocation.

Coping with a low return environment is hard. Preserving financial staying power is of paramount importance under these circumstances. For those who believe in the static buy-and-hold asset allocation approach to investing, reaching for yield as a source of stability can be a reasonable approach if credit analysis is done properly. I happen to be in the dynamic asset allocation camp, where I believe the returns can be considerably higher given the likely volatility of the financial markets.

The news flash came across my desk: China's leading credit agency downgrades the US, Britain and France from AAA. This news is undoubtedly a sign of things to come. The question is, can America retain its status as a leading economic power?

The news is grim. I have written before about the analytical framework of deficit reduction. That kind of macroeconomic adjustment is only effective if Americans retain their underlying competitive advantage. John Hussman wrote this week that the basis of American competitive advantage rests on superior physical capital and human capital [emphasis added]:

The main source of this difference in productivity is that U.S. workers have a substantially larger stock of productive capital per worker, as well as generally higher levels of educational attainment, which is a form of human capital. This relative abundance of physical and educational capital has been a driver of U.S. prosperity for generations. Neither advantage in capital, however, is intrinsic to American workers, and it will be impossible to prevent a long-term convergence of U.S. wages toward those of developing countries unless the U.S. efficiently allocates its resources to productive investment and educational quality. This is where our policy makers are failing us.

The US is squandering its lead on both fronts. Instead of investing on productive physical capital, we have seen excessive malinvestment leading to bubbles in technology, real estate and finance over the past couple of decades. The internet and real estate bubbles were plain to see.

As for finance, what does all of the malinvestment of human talent into Wall Street say to the world? Despite the ineffectual efforts at financial regulation, American remain in denial about the role of finance in society. The news of the Alan Greenspan chair at NYU is just another sign of denial.

‘Nuff said.

Trouble in higher education
In addition, there seems to be signs of trouble in higher education, which is a key driver of the productiveness of human capital.

Firstly, the lead in education isn't what it used to be. A recent study concluded that elite universities are eroding their competitive edge. I had blogged about a Tiananmen Square protester returning to China for the sake of his children because of the lower quality the Canadian education system, which from first hand-experience equivalent or slightly higher quality than the American system.

As well, the cost of a university education is spiraling out of control. Consider Rolfe Winkler’s comments:

The market for college education looks a lot like the market for houses circa 2006 – very bubbly. And the reason is similar: There is too much credit.

Colleges can keep raising prices, despite the recession, because the government keeps lending students more money to pay them.

Rising prices and ample credit to finance purchase – does that sound like anything we saw before, such as the housing market? Carpe Diem shows this chart to illustrate how fast prices have been rising and went on to warn of a bubble in higher education:

Malinvestment in physical capital and failing human capital...there will a time to pay the piper and that day may be coming sooner than anyone expects.

Since the G20 meeting there has been a lot of hand wringing over the level of sovereign debt. Calculated Risk posted alarmingly about the frequency of sovereign debt in the past.

Defaults tend to come in clusters, and the behavior of lenders often changes substantially after defaults. In the Volatility Machine, Michael Pettis asserts that sovereign default contagion follows predictable patterns, and that contagion is primarily due to investors in the first defaulting country also having investments in other countries which are vulnerable. This is especially the case with leveraged investors.

So far, investors have firewalled many of these debt default concerns in the US. In fact, every time something blows up somewhere, Treasuries have rallied. Can this state of affair continue indefinitely?

The answer is no. The United States has to find a long term solution to its problem of growing debt. But how serious is this problem? Deus Ex Macchiato posted a chart of the British debt-to-GDP ratio for a very long term perspective:

The first peak in debt to GDP occurred just after the Battle of Waterloo in 1815 and the second just after the end of World War II in 1945. Some market observers have pointed out that the US debt to GDP ratio has been higher than they are today. It is also instructive to go back to an earlier era to learn about how Britain dug itself out of her debt hole after the Napoleonic Wars.

The answer is India. It began with the British East India Company rule of India and progressed to the British Raj. Simply put, the British went to India and took things as part of their colonial adventures.

Could the US go down the same path? Tim Knight at the Slope of Hope posted that financial crises and crashes have led to wars. While the causation and historical links between financial stress and war look a little tenuous, there is a kernel of truth to the story.

War is a possibility, but not a highly probable one. Avner Mandelman has written about this very issue (see Watch out if a cash-poor U.S. seeks new spoils and Austerity in the West? Not if the generals can be useful).

During the 1990s, I said privately that the solution to Japan’s Lost Decade was to land 100 of the Japanese Self Defense Forces on the disputed Kuril Islands. The effects would be highly reflationary for Japan's economy. I also blogged on April Fool’s Day about A modest proposal to restore America.

Ironically, war would likely be bullish for the markets, though it is not a possibility that most of us would like to contemplate. It is nevertheless a path that we have to allow for in our investment planning scenarios.

Since the G20 meeting there has been a lot of hand wringing over the level of sovereign debt. Calculated Risk posted alarmingly about the frequency of sovereign debt in the past.

Defaults tend to come in clusters, and the behavior of lenders often changes substantially after defaults. In the Volatility Machine, Michael Pettis asserts that sovereign default contagion follows predictable patterns, and that contagion is primarily due to investors in the first defaulting country also having investments in other countries which are vulnerable. This is especially the case with leveraged investors.

War is a possibility, but not a highly probable one. Avner Mandelman has written about this very issue (see Watch out if a cash-poor U.S. seeks new spoils and Austerity in the West? Not if the generals can be useful).

During the 1990s, I said privately that the solution to Japan’s Lost Decade was to land 100 of the Japanese Self Defense Forces on the disputed Kuril Islands. The effects would be highly reflationary for Japan's economy. I also blogged on April Fool’s Day about A modest proposal to restore America.

Ironically, war would likely be bullish for the markets, though it is a possibility that most of us would like to contemplate. It is nevertheless a path that we have to allow for in our investment planning scenarios.

USA Today recently asked How will Baby Boomers' retirement affect stocks?

I may have an answer from academia. Further to my post about anxious and volatile markets, John Geanakoplos, co-author of the paper entitled Leverage cycles and the anxious economy, also wrote another intriguing paper called Demography and the Long-Run Predictability of the Stock Market, with Michael Magill of the University of Southern California and Martine Quinzii of the University of California at Davis.

In this study, Geanakoplos et al related demography to long-term stock returns. They found that P/E ratios were correlated to the ratio of middle-aged people to young adults, otherwise known as the MY ratio. When MY rises, the market P/E will tend to rise and when it falls, P/Es tend to fall.

If the conclusions of the study are correct, then we should see a continued fall in P/E ratios with a long-term bottom in stock prices forming about 2018, or eight years from now.

Back to the '70s
Recall that the previous anxious markets paper that I cited indicated that current macroeconomic conditions called for volatile markets in the aftermath of the economic crisis. This latest paper suggests that we are gripped by a secular bear market until 2018. Putting it all together, the current environment is reminiscent of the 1970s, which was gripped by inflationary fears, slow growth, volatile markets and flattish equity returns.

The chart below of the Dow Jones Industrials Average shows that, since the Second World War, the market has been gripped by two episodes of secular bull markets to be followed by secular bears. The secular bulls were characterized by a substantial advance lasting over a decade while secular bears were marked by sideways markets lasting over a decade.

These studies are also consistent with the big bear charts at dshort.com, where Short shows the progress of the stock markets following the Great Depression and Japan’s Lost Decades.

Flat markets mean flat returns
Investors who accept such a scenario need to change their approach to investment policy. The buy-and-hold approach, long espoused by investment advisors during bull markets, will result in subpar returns in range-bound periods. Flat markets mean flat returns.

During secular bear markets characterized by flat returns, investors need to use dynamic asset allocation techniques such as the Inflation-Deflation Timer model to capture the swings of a flat market.

The market action last week was dominated by concerns of a double-dip. Indeed, the week began with John Hussman warning of a double-dip recession and ended with John Mauldin's hand wringing over the NFP release.

Dr. Copper, one of the most economically sensitive of commodities, is curiously showing weakness but hasn’t fallen apart. This is an indication to me that it may be a little early to over-react to recessionary fears.

By contrast, the SPX has shown a greater degree of weakness than copper. While the red metal is in a downtrend, it hasn’t even tested major support levels. By comparison, equities sliced through support like a hot knife through butter.

In fact, the entire commodity complex is showing the same pattern as copper – weakness but no freefall.

Apocalypse not yet
Does that mean all is well?

Not quite. Take a look at the copper to SPX ratio. While the ratio is indicating a near-term positive relative performance by copper, the ratio is displaying a rounding inverted saucer top pattern which is indicative of a long term decline.

These conditions are consistent with the readings of my Inflation-Deflation Timer model, which remains in neutral but perched at the edge of a deflation reading, which would be indicative of a 2008-style panic. The Inflation-Deflation Timer model is a trend following model, which can be late in calling economic trends.

These conditions are also consistent with John Hussman’s earlier essay outlining the tripwires of a double-dip recession. The only sign that remained to call for a full blown double-dip recession was the ISM Index at or below 54. The latest release of the index came in at 56.2, declining fast but not quite at 54 yet. Hussman did note, however, that the ECRI Weekly Leading Indicator, which has been in freefall, is highly correlated with ISM with a lead time of 13 weeks - and that's why he made the double-dip recession call.

Overall, I am tilting towards the views of Barry Ritholz, who wrote that "We do not rule out a double dip or a recession in 2012 — we simply do not have sufficient evidence to draw that conclusion."

Right now, my inner investor is extremely cautious and defensive in light of the risks of a hard landing. On the other hand, my inner trader tells me that a waterfall decline is not an immediate threat, but to be prepared for a short and sharp relief rally to lighten long positions and/or to initiate short positions.

The headline on Marketwatch blared that the BP spill may lead to higher oil prices. Indeed, Jeff Rubin has expressed similar sentiments about how the Deepwater Horizon disaster is likely to affect the supply situation for oil (see examples here and here).

I agree wholeheartedly. My latest monthly comment for Qwest Investment Management details these same supply concerns. I would also add the possibility of higher heating demand from a global cooling cycle.

There is a controversial view that solar cycles are responsible for the warming and cooling cycles on earth. The English astronomer William Herschel noted a relationship between sunspot cycles and wheat prices and that link has been confirmed by other researchers.

Right now, the sun is undergoing an extraordinarily quiet period and tracking previous periods of global cooling. If the climate were to cool, which would raise heating demand, and oil supplies fall because of higher operating and environmental standards – look out!

Come and read it all here.

There has been a lot of discussion over financial regulation lately. My view has always been that trying to regulate financial entities is like herding cats. Just when you think you’ve got them rounded up, one or two get away and trouble starts all over again.
Consider this exchange with a hedge fund manager about how clueless people participated in bubble creation [emphasis added]:

HFM: Look, bubbles create other bubbles, they’re like derivative bubbles, so to the extent that there was a bubble in credit or a bubble in the mortgage market, that created a bubble for people who could trade those products. There was a misallocation of resources not only into mortgages, let’s say, but also into the trading of mortgages, and it sucked talent into those areas that probably should be deployed other places. And the way talent gets sucked into those places is by a price signal, the compensation going out. So what was happening was that the pay scale for finance was just—incredibly out of whack. You had guys who were literally just a couple of years out of college, maybe they’d done a year or two at an investment bank, making several hundred thousand dollars a year doing pretty low-value-added Excel-modeling tasks…

It was kind of crazy what people were being paid. And for the more senior people, the kind of deals they were getting—because their pay tends to be not just a number range but a percentage of the profits they generate—they were getting very high percentages of the profits, and very high guaranteed income. The decision to pay those kinds of numbers was motivated by the fact that other places were paying those kinds of numbers, and their ability to pay those kinds of numbers was motivated by the fact that there were huge amounts of assets coming into hedge funds, and hedge funds are able to charge a management fee for the assets under management. So if you had tons of assets coming in, you needed people to manage those assets, you had to get quality people, you had a ton of money to spend, and everybody was looking for people who had a resume that singled them out, or that identified them as qualified to work at a hedge fund—there was just tremendous competition for those people, and it drove prices to ridiculous levels. It changed people’s attitudes—there was a palpable cockiness that one sensed from employees. And there was a lack of distinction I think between people who were really good, who you would want in any environment, and people who you could just fill a seat with because they had a resume that stamped them as minimally qualified.

There are a lot of very creative people working on Wall Street and they will engage in regulatory arbitrage. If you try to regulate one activity, e.g. how hot IPOs are distributed, that particular problem will go away but that creative talent will go elsewhere to do something else that creates the next regulatory problem.

It’s not that I am ideologically opposed to regulation, but in this case a heavy-handed regulatory approach just doesn’t work. The correct solution is to create the right operating structure for the financial marketplace:

Complete and timely disclosure; and
Symmetric incentives.

The disclosure part is easy to understand. Complete and timely disclosure doesn’t allow one side to stack the deck.

The second part is a little bit more subtle. The current structure at investment banks aren’t incentivizing people to get rich slowly by building long-term relationships, but to get rich quickly by doing the trade while ignoring the long-tailed risks that may come with the trade. That’s an asymmetric incentive structure. One very simple solution is to bring back the partnership investment bank. Barry Ritholz and I are on the same page on this issue and he correctly points out that none of the Wall Street partnerships got into trouble in the last financial crisis.

In praise of good government
While I am disinclined to regulate, it doesn’t mean that government is inherently bad. In fact, good government can be a positive force in creating the structure for economic growth.

For the Tea Partiers and Libertarians out there, consider this. Consider this modern account (from the same aforementioned hedge fund manager) of what happens when you don’t have good government:

[T]here’s something very attractive from an investment standpoint of going to a place like Lagos... You’d go to an office building or a hotel and in the course of the day the power goes out six times and the generator kicks on to power the building, and that generator is powered by diesel, and you see all these fuel trucks all over the place that have to bring diesel to fuel the generator, and the generators are noisy and loud. You’re like, “Wow, there’s an obvious opportunity here. Somebody should build a reliable power plant! It would just be tremendous, a tremendous economic efficiency, because you wouldn’t need all these diesel trucks zooming around, you wouldn’t need all these generators…”

Then you realize that the place sounds like a scene from The Sopranos:

But then you realize that it’s not like they can’t figure this out. It’s not like they don’t get the fact that it’s pretty annoying that the power goes out six times a day and it’s pretty annoying to have six fuel generators humming all the time. The reason investment doesn’t happen is because it’s in some powerful person’s interest that it not happen. There’s some guy who controls the diesel trucks who makes tons of money from being a diesel distributor, and there’s a guy with all these generators who would be out of business if power plants were built, and he stands in the way.

In fact, the structure of the fictional Soprano mobster family sounds an awful lot like the feudal states of a bygone era, where the baron (don) lorded over his estate surrounded by his knights (his "crew" of “made men”). But wait, are feudal states really from a bygone era? Wasn’t Ferdinand Marcos just a king by another name? What about Dear Leader Kim of North Korea? Consider this account from Foreign Policy about what is clouding our perception of Afghanistan:

Western observers attempting to come to grips with Afghanistan's fragmented state authority also find themselves drawn to other aspects of the medieval era, a period in which leadership in Europe was personal rather than bureaucratic and the state's power to impose its will quite limited.

The difficulty for a monarch was that the resources remained in the hands of his vassals, who then acted in their own interests. The rise of centralized states in Europe in the 16th through 18th centuries finished a process by which monarchs gradually centralized power and dispossessed their feudal nobilities. Then, in the beginning of the 19th century, the rise of the European nation-state took this process a step further and dispossessed the monarchs while keeping intact the centralized administrations they had built.

Foreigners encountering Afghanistan in the post-2001 era saw this devolution of power as an example of state failure. Many of the multiple competitors for legitimate authority at the local level had no desire to participate in politics in a state-centered system. Autonomous tribes and ethnic groups, local militia commanders, criminal syndicates, and even blood-feuding families sought to resist state power, but they did not seek to overturn or replace it. This arrangement is analogous to medieval Europe, where kings were frequently also unable to maintain a monopoly on the legitimate use of violence, but were still able to retain their thrones.

Is that what we really want? Be careful about what you wish for when you want the government off your back.

There has been much angst in the aftermath of the Chinese announcement of further currency flexibility. Despite the hoopla, the RMB barely budged against the USD in the wake of the news.

The source of friction in Sino-American relations is the US-China trade gap. There are some other adjustments in evidence that could close the gap, notwithstanding any change in exchange rate. Firstly, on the China side, the Chinese minimum wage went up by 20% in early June. In addition, an article in Bloomberg/Business Week states that American companies are getting better quality local workers at a cheaper price as the discouraged unemployed take a job...any job:

The 6.8 million Americans out of work for 27 weeks or longer -- a record 46 percent of all the unemployed -- are providing U.S. companies with an eager, skilled and cheap labor pool. This is allowing businesses to retool their workforces, boosting efficiency and profits following the deepest recession since the 1930s.

Rising wages in China and falling wages in the US makes the Chinese labor arbitrage less compelling. These factors are more powerful than the exchange rate adjustment the American politicians want to beat the Chinese over head about and should serve, in the long run, to alleviate some of the trade tensions.

…until multi-nationals migrate to even lower wage countries like Vietnam.

As the G20 meeting get under way in Toronto, it is evident that not all is well and the posturing began long before the summit.

Despite the soothing offical pronouncements, it is evident that the US position is a source of division at the G20 meetings. In Europe, the cult of austerity has caught fire. The UK has passed a high profile austerity budget (see analysis here) and so has Germany. Nevertheless, the G20 remains divided. On this side of the Atlantic, US officials are urging G20 to avoid growth dampening budget cuts.

What gives?

The risks of fiscal austerity
Unfortunately, the answer to the fiscal austerity question isn't black and white. There is no question that countries cannot run these kinds of enormous deficits without getting into trouble. Deficit hawks point to the Britain under Margaret Thatcher and the benefits of that painful restructuring.

While the Thatcher experience is instructive, there is a differences between then and now. Thatcher’s Britain was the only country in the region to take the deficit reduction path at the time. It worked because of my favorite economist phrase "everything else being equal". What happens everything else wasn't equal and if everyone tries austerity at the same time? Martin Wolf of the FT explains [emphasis added]:

[S]uch thrift entails either current account surpluses or fiscal deficits. Of these countries, only Germany and Japan have current account surpluses. The rest are capital importers. These countries will duly run fiscal deficits that are bigger than their private surpluses. We have, as the hysterics note, a tide of fiscal red ink. Which came first – private retrenchment or fiscal deficits? The answer is: the former. In the case of the US, the huge shift in the private balance between the fourth quarter of 2007 and the second quarter of 2009, from a deficit of 2.2 per cent of GDP to a surplus of 6.6 per cent, coincided with the financial crisis. The fact that aggregate demand and long-term interest rates tumbled at the same time shows that the collapse in private spending “crowded in” the fiscal deficits. Wild private behaviour drove the wild public behaviour.

Yet it would now be particularly damaging for fiscal austerity to overcome the European economy and so force beggar-my-neighbour outcomes on the hapless US. As Fred Bergsten of the Peterson Institute for International Economics in Washington noted in the FT last week, such policies could be very dangerous. Thus, far from being stabilising, premature fiscal retrenchment threatens destabilisation of the world economy. In this case, a decision to turn the eurozone into a huge Germany would – and should – be seen as an act of mercantilist warfare upon the US. How long would the latter put up with the hypocrisy of surplus countries that blame borrowers for the deficits their own surpluses make inevitable? Not much longer, would be my guess, at least now that the US government has become the world’s borrower of last resort.to be a balance.

New Keynesians like Paul Krugman believe that it’s far too early for austerity and such policies would be disastrous for the world economy. Indeed, it may be somewhat early to implement austerity programs. In their book This Time is Different, economists Reinhart and Rogoff studied a range of financial crises throughout history and observed that government debt rises an average of 86% after a banking crisis.

The US states as fiscal laboratories
Consider what would happen if that kind of budget cutting were to occur in the US. We have a laboratory in America: the states, which are required to be balance their budgets. The New York Times reports that individual states are starting to look like Greece. Time has written on the dire state of the states. California is on the verge of system failure and that experience is not isolated. Barry Ritholz pointed out that much of the state budget woes stem from unemployment. State budget austerity is therefore pro-cyclical, which would exacerbate the problem.

What about the muni market?
This is a recipe for disaster in the financial markets. The muni market seems to be oblivious to the coming storm. Minyanville recently reported that investors are flying to municipal bonds like moths to a flame. I agree with Rick Bookstaber that the municipal bond market is an accident waiting to happen.

What happens then? TARP for state and local governments? What happens to sovereign debt risk then?

Remember the adage that all politics are local and populist sentiment is sure to rise under such circumstances. The Globe and Mail quoted Warren Buffett as believing that bailouts are inevitable:

Billionaire Warren Buffett, who advised U.S. President Barack Obama during his White House run, suggested recently that a Washington bailout of California and other troubled states is inevitable. How, he wondered, can Washington deny California after saying yes to General Motors, AIG and dozens of banks.

Do we want to really want to see the US government pile on with fiscal austerity at the federal level?

No easy choices - Hurt now or hurt later?
I wrote before about an analytical framework for the deficit hawks. Economists at the BIS recently wrote a report the likely trajectory of government spending and the kind of reductions and actions that are required to bring deficits under control.

The Centre for Economic Policy Research recently released a discussion piece on the deficit reduction question and put the dilemma into perspective. The Economist recently had an article that explained the deficit conundrum more simply:

Debt is as powerful a drug as alcohol and nicotine. In boom times Western consumers used it to enhance their lifestyles, companies borrowed to expand their businesses and investors employed debt to enhance their returns. For as long as the boom lasted, Mr Micawber’s famous injunction appeared to be wrong: when annual expenditure exceeded income, the result was happiness, not misery.

Now comes the hangover. It’s a question of whether we want to hurt now or hurt later. There are no good choices. This is only a slight exaggeration but politicians who choose an effective “hurt now” option, as per the BIS analysis, could go down in history as the economic equivalent of the Pol Pot regime. The “hurt later” school, by contrast, are choosing the financial equivalent of releasing a latent Ebola virus into their population, to be manifested at some time in the future.

Recently the IMF warned of the risks of hot money flows to emerging markets, otherwise known as "emerging asset" markets with limited liquidity. "Emerging asset markets" is a term coined by Ana Fostel and John GeanakoplosI in a paper entitled Leverage cycles and the anxious economy. In that paper, the authors detail “anxious economies” and how Minsky Moments (my term, not theirs) occur in them:

We distinguish three different conditions of financial markets: the normal economy, when the liquidity wedge is small and leverage is high; the anxious economy, when the liquidity wedge is big and leverage is curtailed, and the general public is anxiously selling risky assets to more confident natural buyers; and, finally, the crisis or panicked economy, when many formerly leveraged natural buyers are forced to liquidate or sell off their positions to a reluctant public, often going bankrupt in the process. A recent but growing literature on leverage and financial markets has concentrated on crises or panicked economies. We concentrate on the anxious economy (a much more frequent phenomenon) and provide an explanation with testable implications for (1) contagion, (2) flight to collateral, and (3) issuance rationing. Our theory provides a rationale for three stylized facts in emerging markets that we describe below, and perhaps also explains some price behavior of other “emerging asset” classes like the US subprime mortgage market.

The authors studied “emerging asset” economies, i.e. emerging markets, but they note that their analysis is applicable to some of the smaller liquidity constrained markets such as “the US subprime mortgage market”. In the paper, they introduce the concept of the “anxious economy”:

This is the state when bad news lowers expected payoffs somewhere in the global economy (say in high yield), increases the expected volatility of ultimate high yield payoffs, and creates more disagreement about high yield, but gives no information about emerging market payoffs. A critical element of our story is that bad news increases not only uncertainty, but also heterogeneity. When the probability of default is low, there cannot be much difference in opinion. Bad news raises the probability of default and also the scope for disagreement. Investors who were relatively more pessimistic before become much more pessimistic afterward. One might think of the anxious economy as a stage that is frequently attained after bad news, and that occasionally devolves into a sell-off if the news grows much worse, but which often (indeed usually) reverts to normal times. After a wave of bad news that lowers prices, investors must decide whether to cut their losses and sell, or to invest more at bargain prices. This choice is sometimes described on Wall Street as whether to catch a falling knife.

They go on to model how financial leverage exacerbate the booms and busts to create Minsky Moments in an anxious economy:

Agents are allowed to borrow money only if they can put up enough collateral to guarantee delivery. Assets in our model play a dual role: they are investment opportunities, but they can also be used as collateral to gain access to cash. The collateral capacity of an asset is the level of promises that can be made using the asset as collateral. This is an endogenous variable that depends on expectations about the distribution of future asset prices. Together with the interest rate, the collateral capacity determines an asset’s borrowing capacity, which is the amount of money that can be borrowed using the asset as collateral. The loan to value (LTV) of an asset is the ratio of the asset’s borrowing capacity to its price. The haircut or margin of an asset is the shortfall of its LTV from 100 percent—in other words, the fraction of the price that must be paid in cash. The maximal leverage of an asset is the inverse if its margin. The leverage in the system, like the other ratios just mentioned, is determined by supply and demand; it is not fixed exogenously…

The underlying dynamic of the anxious economy—fluctuating uncertainty and disagreement— simultaneously creates the leverage cycle and the liquidity wedge cycle; that is why they run in parallel. Since leverage affects the liquidity wedge, the leverage cycle amplifies the liquidity wedge cycle. So what does collateral, and the possibility of leverage, add to the liquidity wedge cycle already discussed? It generates a bigger price crash, not due to asset undervaluation during anxious times, but due to asset overvaluation during normal times. This may lead the press to talk about asset price bubbles.

While the dynamic described by Fostel and Geanakoplos was intended to describe smaller emerging market economies, their description appears to sound an awful lot like the American and European economies in the current environment of rising concerns about sovereign debt.

Higher volatility ahead
One of the conclusions of the paper is that during and in the aftermath the downleg of the crisis, volatility is high because of a heightened liquidity wedge:

We define the liquidity wedge as the spread between the interest rate optimists would be willing to pay and the rate pessimists would be willing to take. As we shall see, the liquidity wedge is a useful way of understanding asset prices. When the liquidity wedge increases, the optimists discount the future by a bigger number, and all asset prices for which they are the marginal buyers fall. The liquidity wedge increases because the disagreement between optimists and pessimists about high yield grows, increasing the desire of optimists to get their hands on more money to take advantage of the high yield buying opportunity. The portfolio and consumption effects create a liquidity wedge cycle: as the real economy moves back and forth between the normal and the anxious stage, the liquidity wedge ebbs and flows.

The observation about higher volatility is consistent with my comments about rising volatility and the implications for investment policy. The chart below from Macquarie Research illustrates the environment of rising macroeconomic volatility.

Wayne Whaley of Witter & Lester has observed the same effect.

Jonathan Tepper of Variant Perception has commented on the same thing.

Examine investment policy assumptions
In the current environment of heightened macroeconomic volatility, which imply higher investment risk and uncertainty, investors need to re-think their approaches to investing and asset allocation. Buy-and-hold allocations may be suboptimal under such circumstances.

I have written extensively before about the inflation vs. deflation dilemma. There are huge stakes and risks involved for investors. Get the call right and you’ll be a hero; get it wrong and you’ll be the goat.

Why are gold and US Treasuries rallying?
Now more and more people have weighed in on the debate. The Economist/Buttonwood blog recently asked the question "why are both gold and US Treasuries performing so well?" One would suppose that their returns should be polar opposites of each other. The answer is that the inflation and deflation views are increasingly becoming bifurcated among investors [emphasis mine]:

Martin Barnes of Bank Credit Analyst, a research firm, points out that the direction of official policy (low rates, quantitative easing, big deficits) looks inflationary but the economic fundamentals (a big output gap, sluggish credit growth) look deflationary. Faced with this dichotomy, investors who buy both Treasury bonds and gold are not displaying cognitive dissonance. They are just hedging their bets.

Inflation risks from the US printing presses
James Hamilton at Econbrowser believes that the current environment is deflationary, but he is worried about the seemingly inevitability of inflationary policies down the road:

The source of my concern about long-run inflation comes not from the expansion of the Fed's balance sheet, but instead from worries about the ability of the U.S. government to fund its fiscal expenditures and debt-servicing obligations as we get another 5 or 10 years down the current path. Just as many analysts have had trouble seeing how Greece can reasonably be expected over the near term to move to primary surpluses sufficient to meet its growing debt servicing costs, I have similar problems squaring the numbers for the U.S. looking a little farther ahead.

The way that I would envision these pressures translating into inflation would be a flight from the dollar by international lenders, leading to depreciation of the exchange rate, increase in the dollar price of traded goods, and possible sharp challenges for rolling over U.S. Treasury debt. We've of course been seeing the exact opposite of this over the last few months, as worries in Europe and elsewhere have resulted in a flight to the dollar and the perceived safety of U.S. Treasuries. That appreciation of the dollar has been one factor keeping U.S. inflation down. So any inflation scare is clearly not an incipient development, but instead something we'd possibly face farther down the road.

Developments are policy dependent
David Merkel at Aleph Blog wrote about the Social Security time bomb [emphasis added]:

There are no good solutions now. Budgetary cuts and tax increases reduce the possibility of government default. They also will tend to slow the economy, unless the tax increases stem from cutting cheating, and the budget cuts affect only things that are a fraudulent waste.

Once you reach the point of no return, it doesn’t matter what prescriptions one follows — failure is coming. One can shape the type of failure, but not that there will be failure.

All that said, there are still options, though none of them are good. Will the currency be inflated? Will the government default? Will taxes be raised dramatically? I don’t know. Be alert; be ready. The endgame is here; we will see what moves the government makes.

I agree with Merkel. The government seems unwilling to make the hard choices so the collapse is coming. The kind of collapse is entirely dependent on policy…and we have no idea which path the authorities will choose (or humorously, what the consequences are, hat tip to Crossing Wall Street).

Buy-and-hold asset allocation = riding a salt-n-pepper ride at the carny
For investors, Cassandra does Tokyo draws the parallel of the current inflation/deflation situation to being on a "salt-n-peper" ride at the carnival, a musical metronome, the Newtonian pendulum, or the sand-weighted Punching Dummy:

Humanity, in general, their households, and their sovereign and corporate institutions alike will undoubtedly take hits - many hits, and from all sides - but life will go on, and as in post-war Europe, Lebanon, Argentina, Turkey, Serbia, and other seemingly unimaginable examples to our unpracticed imaginations, it will rebound and rise again, in fits, starts, almost randomly lurching to' and fro', before balancing upright again - if only to have the collective shit kicked out of it yet another time...

Under such a volatile environment, preserving financial staying power will be of utmost importance. Fixed buy-and-hold asset allocation solutions will doom an investor to mediocre returns in such conditions. Investors need to go back to basics and rethink their asset allocation assumptions. It's time to stay flexible with the use of dynamic asset allocation techniques such as the Inflation-Deflation Timer model to survive the coming crisis.

Last week I wrote about the possibility of another financial Armegeddon:

I have become increasingly concerned about the markets and the economy, largely because of the poor behavior of economically sensitive commodity prices. If the current commodity weakness were to persist, then conditions may be setting up for a repeat of the Great Bear of 2008.

In a subsequent post, I set out some goals for the bulls to achieve in order to stave off a “deflation” signal on my Inflation-Deflation Timer model which would signal the kind of waterfall decline that the markets saw in 2008. I pointed to copper prices and the relative price behavior of the Morgan Stanley Cyclical Index (CYC) against the market.

In the last week, the bulls did manage to rally the markets and achieve a stalemate with the bears, which is a victory of sorts. Take a look at the price of Dr. Copper, which rallied up through the downtrend line but ended the week lower. This may be a signal of underlying strength and a sideways pattern rather than a continuation of the downtrend. Nevertheless, a “dark cross” is imminent in copper prices indicating the development of an intermediate term downtrend.

A similar picture was seen in the relative chart of CYC vs. SPX. CYC rallied through the downtrend line but weakened again which points to a possible sideways consolidation pattern.

The good news
There are signs of good news. David Leonhart at Economix reports that private hours worked are rising in the US, which indicates that the economy is rebounding:

Jeff Matthews wrote that corporate management is reporting signs of nascent economic strength, both in the US and Europe. Such bottom-up reports from the ground are always useful antidotes to the top-down analysis from 50,000 feet.

There is good news in China. China’s economy is slowing but may be headed for a soft landing. Jeremy Grantham was quoted as China may avoid a housing bubble. The vestiges of a command economy still remain in China and her policies seem to veer between flooring the accelerator and stomping on the brakes. It appears that the authorities have decided that they have stomped on the brakes too much and it’s time to step on the gas pedal again. The Shanghai Composite appears to be finding a floor at current levels and there are signs that China’s plunge protection team is going into action ahead of the Agricultural Bank's ginormous new stock issuance.

In addition, the People’s Bank of China announced on the weekend that they are preparing for “currency flexibility”, which is code for an easing or elimination of the RMB to USD peg. Such a move would serve to ease trade tensions ahead of the G20 meeting.

Eye of the storm
Where are we now? Todd Harrison believes that we are currently in the eye of the storm and I agree with that assessment:

We've been pushing risk further out on the time continuum for such a long time that it's become an accepted -- dare I say normalized -- pattern that interconnects the world through a tangled web of derivatives.

While the recent price action has been docile, I believe we're in the eye of the storm, a relative calm between the first phase of the financial crisis and the cumulative comeuppance that'll flush -- and perhaps reset -- the system.

Harrison went on to view any downturn with a sense of optimism, because of the possibility of renewal:

I view the Great Depression as the framework for optimism. Most of society worked, great discoveries were made and formidable franchises were established.

Indeed, if the greatest opportunities are bred from the most formidable obstacles, we're about to enter a most auspicious era.

Unfortunately, I don’t share his optimistic view as I believe that the extrapolation of the American experience in the Great Depression to today has survivorship bias problems (see my comment here about what happens in the really long run). What if America today is not the America of the 1920s or 1930s, but the Britain, France or Germany of the same period? Those were the great developed market economies of the time too.

I do agree, though, with Harrison’s assessment that we are in the “eye of the storm”. We could very well be moving into Act II of the financial crisis, as postulate by George Soros as we move through the eye of the hurricane to the other side.

A time for caution
Despite the rally in risky assets last week, it's a stalemate and it would be premature to conclude that the bulls have the upper hand. The markets remain on a knife edge as the technical picture remains mixed. The above charts of copper and CYC to SPX show rallies through the downtrend but weakness back below the trend line. Could this be a headfake? Indeed, some Dow Theorists believe that the bull may be near death. The copper/gold ratio is also pointing to further stock market weakness.

Mish wrote that the Philly Fed survey, which came out last week, shows signs of weakness and the growth risks remain tilted to the downside. The ECRI Leading Indicator released on Friday continued to weaken from its negative reading the previous week. As well, the Baltic Dry Index is turning down again, indicating slowing global trade.

Despite my reservations about the downside risks, I am not panicking and I continue to maintain the discipline of adherence to the asset allocation based on the results of the Inflation-Deflation Timer model. Trader's Narrative's weekly summary sentiment surveys show that readings are not at extreme levels and give little insight to near-term market direction.

Regardless of the current model reading, the global economy and markets remain in a fragile state. The Inflation-Deflation Timer model is a trend following model and is not designed to spot tops or bottoms, but trends. Should the economy and markets turn south, there will plenty of time to capitalize on the trend.

I can only trade what I see and the current picture is neutral.

My very first post on this blog was to question what exactly are hedge funds hedging? My principal objection was that hedge funds were one giant risk trade and aggregate hedge fund returns were correlated with stock returns. Now nearly three years later, nothing has changed. The latest figures from HFRX show their global hedge fund index to be slightly down for the year after suffering a horrible May, just like equities:

What's more, Byron Wien recently spoke out to say that he believes that the hedge fund industry may have to engage in more risk control, which will serve to depress returns (and volatility). This is a clear indication of over-capacity in the hedge fund industry, of too many players chasing too little alpha.

Remind me again, why are investors paying the big 2 and 20 fees for these equity-like returns?

Rick Bookstaber has a great post up about the weaknesses of any potential financial regulation. You can escape it by regulatory arbitrage by picking and choosing your regulator.

Macro Man, on the other hand, has a better idea in this environment of higher taxes and goveernment regulation:

I have had in the back of my mind for many years that a large consortium of the mega-rich, private and corporate, should buy Eritrea from its owners and build a low tax, regulation free Utopia. The Country motto being Caveat Emptor and the only rule being, in Mad Max style

But serious, folks...

Madness over. However, there is one country that is quietly shaping up to be a pretty good contender for the role of off-shore Europe..... The new Carthage. Have you seen what Libya are up to these days?

The ultimate escapes, but be careful about what you wish for.

Further to my last post entitled Are the markets setting up for a repeat of 2008, I received a couple of emails from readers asking exact how much commodity prices need to rally to negate the potential “deflation” reading on the Inflation-Deflation Timer model.

The exact details of the Inflation-Deflation Timer model are proprietary, but I can answer that question in a number of indirect ways that address the big picture.

In general, I would characterize current market conditions as being akin to being in the bottom of the ninth inning, with the bulls trailing by two runs, with two outs and one man on base. The bulls still have a chance to tie the game but they face an uphill battle.

I see downtrends…
Putting my technician's hat on, I noted in my last post that Dr. Copper was in a downtrend. I would like to see a cyclically sensitive metal such as copper rally to break the upper band of the downtrend line before I feel comfortable that the threat of a deflationary panic has subsided.

The relative chart of the Morgan Stanley Cyclical Index (CYC) compared to the market tells the same story. CYC broke down out of a relative uptrend in mid-May and is now testing the upper band of a relative downtrend line. I would like to see CYC/SPX line to decisively break out of its relative downtrend line as a signal that the US economy is not moving into double-dip territory.

Over the weekend, I read other technicians coming to the same conclusion (a typical example here). The market is in a downtrend, but there has been support evident at the 1044 level on the SPX. While the existence of the downtrend suggests that the bears have the slight upper hand, technicians cannot discern a direction until the pattern is resolved (either by upside breakout or by support violation).

Macro forecasters: High risk zone
From a macro-economic perspective, respected forecasters are confirming my ninth inning assessment that the US economy is at serious risk of a double-dip recession. David Rosenberg (free registration required) wrote on Monday that the latest reading in the ECRI Weekly Leading Indicator shows an 80% probability of a double-dip recession:

[W]e can safely say that this barometer is now signalling an 80% chance of a double-dip recession. It is one thing to slip to or fractionally below the zero line, but a -3.5% reading has only sent off two head-fakes in the past, while accurately foreshadowing seven recessions — with a three month lag. Keep your eye on the -10 threshold, for at that level, the economy has gone into recession … only 100% of the time (42 years of data).

John Hussman of Hussman Funds came to a similar conclusion as Rosenberg and me. In his latest weekly comment, Hussman notes that the conditions for forecasting a double-dip recession are almost all fulfilled. It is possible, however, that his indicators could strengthen and a double-dip is avoided.

In short, both the technical and top-down macro picture are telling the same story. The bears are leading in the bottom of the 9th inning. Can the bulls rally and tie the game?

I have become increasingly concerned about the markets and the economy, largely because of the poor behavior of economically sensitive commodity prices. If the current commodity weakness were to persist, then conditions may be setting up for a repeat of the Great Bear of 2008.

Commodities are signaling trouble
As an example, the price of Dr. Copper, which earned its nickname of having a Ph.D. because of its ability to forecast downturns, is in a downtrend and on the verge of a dark cross.

The Reuter/Jeffries CRB Index has already exhibited a dark cross.

Ominous readings from the Inflation-Deflation Timer model
My Inflation-Deflation Timer model, which is a trend following model based on the price movement of commodity prices, is on course to flash a “deflation” signal the week of June 21 unless commodity prices stage a strong and broad based rally from current levels.

My concern stems from the quick transition from an “inflation” signal to a potential “deflation” signal. The model only moved from an “inflation” reading to “neutral” in early May. For the model to go from an “inflation” to “deflation” reading in six weeks is highly reminiscent of the Lehman crisis experience of 2008.

The chart below shows the model signals for the critical period from December 2007 to December 2009. The black line shows the cumulative simulated returns of the Inflation-Deflation Timer model, where the red line shows the cumulative returns of equities, the purple line commodities and the green line the US long Treasury Bond. The pink shaded area indicate periods when the Inflation-Deflation Timer showed an “inflation” signal, the white areas a “neutral” signal and the light blue areas a “deflation” signal.

Anatomy of a Financial Crisis

In 2008, the model moved turned “neutral” from an “inflation” reading in late June and went to a “deflation” reading in early August, in the space of about five weeks. Financial markets were already tanking during the July transition period when the model reading was “neutral”. As the model went to “deflation” signal, the markets panicked and went into freefall because of the Lehman crisis and virtual all asset classes got clobbered.

While in 2008 the Inflation-Deflation Timer correctly moved to the safety of US Treasuries during the Lehman crisis and then rotated back into risky asset classes as the crisis ebbed, I remain concerned about the current backdrop of market psychology and macro-economic landscape. Today, we have a similar situation where model readings are potentially transitioning quickly from an “inflation” to “deflation” reading, which is highly unusual, and financial markets are jittery and under stress.

Is this just a correction or something worse?
To be sure, we may not see a 2008-like waterfall decline because markets are oversold and may have begun a reflex rally. Investor sentiment remains bearish, which is contrarian bullish. The blog post at Trader’s Narrative put the sentiment picture into context. Current readings are consistent with a market bottom if this is a run of the mill correction, but not extreme enough for a bottom if the recent action represents the re-emergence of a bear run.

What if this is the re-emergence of a bear market? There is good support for such a thesis. George Soros recently warned that we are now in Act II of the global economic crisis. John Hussman also warned about “Aunt Minnie” type conditions in his market comment dated May 24, 2010 [emphasis added]:

Such indicator subsets, or Aunt Minnies, are essentially "signatures" that often have very specific implications. In medicine, an Aunt Minnie is a particular set of symptoms that is “pathognomonic” (distinctly characteristic) of a specific disease, even if each of the individual symptoms might be fairly common. Last week, we observed an Aunt Minnie featuring a collapse in market internals that has historically been associated with sharply negative market implications…

Historically, we can identify 19 instances in the past 50 years where the weekly data featured broadly negative internals, coupled with at least 3-to-1 negative breadth, and a leadership reversal. On average, the S&P 500 lost another 7% within the next 12 weeks (based on weekly closing data), widening to an average loss of nearly 20% within the next 12 months - often substantially more when the Aunt Minnie occurred with rich valuations and elevated bullish sentiment.

Even Paul Volcker, the former central banker who is so circumspect that he once quipped that when he went out for dinner, he would say that “I’ll have the steak, but that doesn’t mean I don’t like the lobster”, has become vocal about his own pessimism: “I don’t remember any time, maybe even in the Great Depression, when things went down quite so fast, quite so uniformly around the world.”

In addition, ECRI confirmed Volcker's view of economic weakness as its weekly leading indicator (WLI) turned negative last Friday. However, Lakshman Achuthan of ECRI qualified the negative reading and indicated that the negative reading is not a forecast of recession but a forecast of slower growth.

Don't panic yet
What should investors do in the face of this negative and high risk backdrop?

From my own viewpoint, I am maintaining the discipline of adherence to the Inflation-Deflation Timer model and I am not in the business of anticipating signals. At this point, I would not batten down the hatches or run for the hills - yet. However, these conditions are creating a high degree of concern about the near-term downside potential of returns for many asset classes.

However, the possibility of such a negative signal makes me ever cautious. Commodity markets need to stage a significant rally this week to negate the potential negative signal next week.

It’s not time to run into the bomb shelter, but it wouldn’t hurt to crack open its door.

There has been some buzz as David Cameron gave a hint of the budget cuts to come in the UK as its credit rating is at risk of a downgrade. While it is unclear how much austerity is possible under a coalition government, the market appears to be anticipating some fairly tough measures.

While we are on the topic of cutting government budgets, Angela Merkel has also announced some draconian measures in Germany. Observers are now asking about the Canadian fiscal “miracle” (see discussions here and here). To me, it doesn’t feel like a “miracle”, but happenstance that was the result the combination of austerity, a bull market and the decision not to go overboard on military expenditures. Recall that at the end of the Clinton era, both the American and Canadian fiscal budgets were in surplus, artificially buoyed by capital gains from the Tech Bubble market. In the wake of 9/11, the US embarked on a series of military adventures and keeled over into deficit, while Canada only made a limited commitment and remained in surplus for a few more years.

Putting any cuts into perspective
It is beyond the scope of this post to comment on the pros and cons of fiscal tightening at this stage of the economic cycle. That dilemma is not insignificant but further discussion of those issues will have to be delayed to another day. Nevertheless, to the deficit hawks who are reading this, I would caution that you should put any budget cuts from any government into the following perspective.

I had discussed the BIS report entitled The future of debt prospects and implications before. The chart below is from the report and shows the projected debt to GDP ratios of Europe, Japan and the United States for the next 30 years. The red dotted line depicts the baseline scenario, which assumes that assume that government total revenue and non-age-related primary spending remain a constant percentage of GDP at the 2011 OECD projected levels. The green line assumes budget cuts of 1% of GDP for five years starting in 2012. The blue line assumes deeper cuts to entitlement programs, e.g. pension benefits, etc.

The UK chart on the bottom row shows budget balances spiraling out of control in all three scenarios. By contrast, the announced German cuts amount to about 0.7% of GDP per year for the next four years, which falls short of the BIS projection of 1% of GDP.

A framework for analysis
Budget cutting isn’t easy for fiscal authorities. Paul Krugman characterized the US government as a giant insurance company with a military. The key items to watch are the cuts to entitlement programs (i.e. pensions, health care benefits, especially given the higher demands of an aging population). Paul Volcker recently raised the issue of dealing with these long-tailed liabilities of government because "the time we have is growing short":

Restoring our fiscal position, dealing with Social Security and health care obligations in a responsible way, sorting out a reasonable approach toward limiting carbon omissions, and producing domestic energy without unacceptable environmental risks all take time. We’d better get started. That will require a greater sense of common purpose and political consensus than has been evident in Washington or the country at large.

For investors, evaluating the effectiveness of any fiscal austerity program isn't easy either. It can be hard to cut through the ideological noise and baggage that burden all of us. However, things become much clearer once we use the analytical framework as outlined by the BIS report.

Here are a couple of noteworthy items that have recently come across my desk:

Al Qaeda on Strike
BBC News - Muslim suicide bombers in Britain are set to begin a three-day strike on Monday in a dispute over the number of virgins they are entitled to in the afterlife. Emergency talks with Al Qaeda have so far failed to produce an agreement.

The unrest began last Tuesday when Al Qaeda announced that the number of virgins a suicide bomber would receive after his death would be cut by 25% this February from 72 to 60. A company spokesman said increases in recent years in the number of suicide bombings have resulted in a shortage of virgins in the afterlife.

The suicide bombers' union, the British Organization of Occupational Martyrs ( or B.O.O.M. ) responded with a statement saying the move was unacceptable to its members and called for strike vote. General Secretary Abdullah Amir told the press, "Our members are literally working themselves to death in the cause of Jihad. We don't ask for much in return, but to be treated like this is like a kick in the teeth".

Speaking from his shed in Tipton in the West Midlands , Al Qaeda chief executive Osama bin Laden explained, "I sympathize with our workers' concerns, but Al Qaeda is simply not in a position to meet their demands. They are simply not accepting the realities of modern-day Jihad in a competitive marketplace. Thanks to Western depravity, there is now a chronic shortage of virgins in the afterlife. It's a straight choice between reducing expenditures or laying people off. I don't like cutting benefits, but I'd hate to have to tell 3,000 of my staff that they won't be able to blow themselves up."

Spokespersons for the union in the North East of England , Ireland , Wales, and the entire Australian continent stated that the change would not hurt their membership as there are few virgins in their areas anyway.

According to some industry sources, the recent drop in the number of suicide bombings has been attributed to the emergence of Scottish singing star, Susan Boyle. Many Muslim jihadists now know what a virgin looks like and have reconsidered their benefit packages.

What sovereign risk?
The Economist/Buttonwood blog reports that the yield on Thai government debt is now about the same as US Treasuries.

Regular readers will know that while I have a bearish bias, my inner trader believed that the market is oversold and ripe for a rally, which has so far not materialized. In the last few days, there were a number of analysis showing that we are as oversold or sentiment washed out at levels last seen during the February lows. This comment from Technical Take is a typical sample:

Judging by the emails I receive, it seems to be hard for investors to grasp the idea that I view the current market environment as a "fat pitch". If we use the analogy of a card counter in black jack, I can only determine when I bet aggressively. I cannot guarantee that I will get a winning hand even though the cards should be in my favor. Nonetheless, I would always prefer to bet when the chance for strong gains is likely. This is just one aspect of the "fat pitch". The other aspect and it may be more important than all those potential gains is that a failed signal tends to portend a poor outcome for the markets. Based upon my data, I have clearly defined risk parameters, and this is what is so good about the "fat pitch" --possibility for strong gains plus the ability to define my risk.

How things might be different
It is useful from a trader’s perspective that Technical Take qualified his comments about entering a trade with “defined risk parameters” and that “a failed signal tends to portend a poor outcome for the markets.”

Having waited in vain for a market rally, my inner trader is now tilting from bullish to bearish. The primary reason is that whereas in February, when the bulls were still in control of the tape, today the bears are in control. The change in trend is evident as there are now death crosses everywhere in large cap stocks.

There are systemic risks everywhere. A contact at a major brokerage firm recently informed me that leverage is still on at hedge funds and major institutional long-only accounts are still positioned for a recovery and not a correction. As good traders know, overbought markets can get more overbought and oversold markets can get more oversold. If bearish momentum continues to carry the day, then there is still a lot of pent-up selling to be done.

What’s more, Mr. Market seems to be infected by a global contagion. Free market economists generally believe that markets are self-correcting (and therefore oversold bounces are more likely) because there are many independent market participants expressing their views. What if the views aren’t independent but self-reinforcing? Macro Man details how self-reinforcing these views might be [for the newbies, the term "spoos" refer to the S&P 500]:

"Well it’s definitely the equity markets driving this", say the FX boys, "If Spoos drop we sell Yen crosses, so they must be driving it"...

"Can't be us", reply the equity boys, "We just sell when we see the Yen rally or spreads widen"... Oooops, don't like the sound of this...

Must be those bond boys then...? "Nah not us, we buy bunds when we see Yen strengthen and equities drop and when Libor tightens".

Must be the short term cash boys then...? "Not us, we just demand more when we see Yen rally, stocks drop, bonds rally and if one of those central banks say the banks need to increase capital requirements when they can't..."

Hillary Clinton famously wrote a book called It Takes a Village detailing how interconnected people are as a celebration of community.

I am not so dogmatic as to be married to any single model of the markets. I only trade what I see. Right now, the lack of any substantial reflex rally on Monday after Friday's precipetous drop must be a concern for the bulls.

If financial markets are indeed interconnected and the whole village is arrayed against you, then it’s time to watch out for downside risks. But regardless of your bullish or bearish views, I agree with the views of Technical Take (see above). This is an extremely volatile market and it's important to define your risk parameters.

In the June 2nd edition of Breakfast with Dave (free registration required) by Dave Rosenberg of Gluskin Sheff, Rosenberg writes:

The name of the game is to focus attention on strategies that:
Delivers income (including dividend growth, hybrid funds and corporate bonds since company balance sheets are in fine shape);
Minimize volatility and emphasize on capital preservation in a secular bear market (true long-short “hedge fund” portfolios), and;
Commodities (precious metals as a “buffer” in a financially unstable world; and industrial commodities to take advantage of (i) the secular growth dynamics in Asia, and (ii) repeated rounds of currency depreciation inevitably lead to trade protectionism and “security of supply” constraints, which tend to benefit basic materials.

I have the greatest of respect for Dave Rosenberg. In the current environment of economic uncertainty and volatility, this is the most reasonable asset allocation that I can think of. However, there are a lot of macro risks out there, namely an implosion in Europe, a hard landing in China, risks to the US banking system from another round of residential mortgage resets, from commerical real estate, an imploding muni market and others. Depending on if and how things implode, a portfolio that focuses on income bearing securities may be a source of instability.

I believe that Rosenberg intuitive understands the weakness of a buy-and-hold allocation as he went on to quality his statements in the following way:

This by no means suggests that now is the time to load up on resources seeing as they are cyclical in nature and prone to sharp short-term swings — but commodities are in a secular bull market so these periodic spasms offer nice long-term buying opportunities. Defense stocks — hardly politically correct but I don’t claim to be a saint — should also be considered seeing as global military conflicts tend to follow suit, if history repeats itself, in the context of these global financial crises (Turkey is all of a sudden a big power broker, and not necessarily in a very stable fashion). Investors should focus their attention on the currencies and government bonds of countries whose public balance sheets are truly AAA rated — low debt ratios, low primary or structural deficits and with stable banking systems: these would include Canada, Australia, New Zealand, Norway, Sweden and Switzerland.

Towards a new asset allocation framework
James Montier of GMO recently wrote a research article that expresses my view in a much more articulate fashion on asset allocation.

Typically, analysts derive an efficient frontier based on the past performance, volatility and correlations of returns of different asset classes. From this efficient frontier, it is said that and investor can trade off between risk and return to build an “efficient portfolio”.

While many believe that diversification is the only free lunch to be had, many of the effects of diversification disappear when you need it the most – during panic episodes such as we saw in the Lehman crisis, the Russia crisis, etc. The basic assumption in a buy-and-hold asset allocation is that correlations and volatility estimates are stable. What happens when return correlations converge to 1 as they do during panic episodes?

Putting it in geek-speak, Tony Cooper wrote the following in his National Association of Active Investment Managers' 2010 Wagner award winning paper entitled Alpha Generation and Risk Smoothing using Volatility of Volatility [emphasis mine]:

In traditional asset allocation vovo [volatility of volatility] has a cost. As an example, consider a balanced-fund manager who uses, say, bonds to reduce the volatility of a fund which contains equities. Or a financial planner who assesses the risk tolerance of a client investor and proposes, say, a 60-40 equities-bonds mix. The traditional way of managing these investments is to look at the long term historical volatility of the component asset classes to decide the proportions to invest in. Usually no consideration is given to the vovo of the asset classes and no constant volatility target is set. So the investor or manager with a static or reasonably constant 60-40 mix has to suffer the varying volatility of the markets. sometimes sleeping well at night, occasionally not. In order to ensure that the worst volatility is minimised the asset allocation will have erred on the side of conservative. This will have cost returns.

The chart below shows the level of volatility in the OECD leading indicator, which point to an environment of rising macro volatility. How stable are asset return correlations and asset price volatility estimates under these conditions?

Volatility of OECD Leading Indicator

Montier made more points about the problem with static buy-and-hold framework to asset allocation, including:

Confusing risk with volatility
Not considering valuation risk, or the instability of the equity risk premium
How benchmarking alters manager behavior

He also points out a whole host of other important issues. Go read it all.

Back to basics
Fixed asset allocation makes good sense in secular bull markets. In a secular bear market or in a range bound market, fixed allocations will be of little use and will result in subpar returns.

I would suggest a back to basics approach to portfolio construction. The first step is to look at the problem from an analytical point of view instead of relying on estimates of volatility and correlation based on historical data. Why is X correlated or uncorrelated to Y and why? Look for causality (e.g. when interest rates rise, bond prices fall) instead of historical correlations.

Think about how different assets behave under different macro risk scenarios. Where does an investment asset lie on the risk vs. safety scale? As an example, consider the tradeoffs between equities vs. default-free government paper. For example, are emerging market equities more or less risky than developed market equities given the higher secular growth exhibited by emerging market economies? My answer: in the long run, EM is probably less risky than traditionally perceived but in a meltdown scenario, they are more volatile.

If you are reaching for yield, where do REITs sit on the risk vs. safety scale? How would they behave in a market panic?

As a second step, you can then assemble a portfolio based on sensible estimates of diversification effects.

For bonus points, you can move from a fixed allocation buy-and-hold framework to a dynamic allocation framework based on forecasts of risk, using a combination of factors such as valuation, momentum, sentiment, etc.

As Mr. Market waits for the US Non-Farm Payroll release, it is useful to reflect upon the fact that real-time market indicators seem to point to a pending double-dip recession. A recent Bloomberg report highlighted the following observations from the market:

The Journal of Commerce Industrial Price Commodity Smoothed Price Index, where half the items it tracks don’t trade on futures exchanges and therefore a better sign of actual economic activity, is plunging.
Manufacturing indices are sliding, such as China’s Purchasing Manager Index, as well as indicators in the Eurozone and the ISM survey in the US.

The Economist/Buttonwood blog concurred with the above points and added the following negative signs:

Stocks are correcting;
The 10-year U.S. Treasury yield are dropping; and
The money supply in Europe and the US is flat or falling.

...with the only positive sign as the upward sloping shape of the yield curve. FT Alphaville also highlighted this week some of the risks to the US commercial real estate market that I wrote about before are now rearing their ugly heads.

Speaking of NFP, Barry Ritholz at The Big Picture analyzed the correlation between the ISM Manufacturing Index and NFP and asks the question: “Is this as good as it gets?”

Market sentiment still upbeat
Intermediate term sentiment indicators are still worrisome as Bespoke pointed out that the Street’s investment strategists remain bullish, which is contrarian bearish.

Given the recent change in tone in the market action, I believe that investors should be adopting a more defensive posture in their asset allocation.

How a jittery market react to news is an important test of future direction.

Consider the news over the weekend of the Israeli raid on the aid flotilla that left at least 10 dead. (The fact that one of the ships was called the Rachel Corrie does not help Israel's image.)

I am not here to judge who is right or wrong, but to see how events like this affect market reaction. Turkey has called for an emergency meeting of NATO, the implication being that she could invoke Article 5 of the NATO Charter which states that an attack on any member state is an attack on NATO itself [emphasis added]:

The Parties agree that an armed attack against one or more of them in Europe or North America shall be considered an attack against them all and consequently they agree that, if such an armed attack occurs, each of them, in exercise of the right of individual or collective self-defence recognised by Article 51 of the Charter of the United Nations, will assist the Party or Parties so attacked by taking forthwith, individually and in concert with the other Parties, such action as it deems necessary, including the use of armed force, to restore and maintain the security of the North Atlantic area.

Turkey invoking Article 5 would be the nuclear diplomatic option for that country. At the time of this writing Ankara is raising the stakes by threatening to escort future aid convoys with the Turkish navy. Such actions would threaten the NATO alliance in so many ways that I couldn't even begin to name. Not only that, such a rupture may not be taken kindly by the markets.

When the bulls were in control of the tape a few months ago, the markets would have shrugged off this news. Today, with the markets jittery but deeply oversold, such an event serves as an acid test to see whether the bulls, bears or the undecideds are in control.

Last Friday, CNBC featured two guests who debated the inflation vs. deflation story. I think that the CNBC participants were missing the point. There is both inflation and deflation in the system, if you know where to look.

Certainly when you look today, you will see a strong case for deflation: a weak consumer, in both the US and Europe, rising unemployment, excess capacity and debt problems everywhere (an example of one of many arguing the deflation case can be found here).

Does that mean that inflation is dead? Not quite. Shadowstats’ CPI figures show that their alternate CPI is north of 9%:

What kind of inflation?
The question shouldn’t be one of inflation or deflation, but what kind of inflation given the deflationary landscape. Scott Grannis at Calafia Beach Pundit showed that there is inflation in services but deflation in durable goods:

To that analysis, I would add “inflation in raw materials”. As I wrote before:

A portfolio that relies on commodity and commodity-linked equities would be an effective inflation hedge under such a scenario. However, portfolios that rely on fixed income based solutions, such as inflation-indexed bonds like TIPS or even yield steepener trades, may be less effective as these kinds of inflationary signals may not show up as well in those markets.

Timing the inflation/deflation trade
I think that another reason that many market participants are confused about the inflation vs. deflation debate is the degree of macro-economic volatility that we are observing. While it is true there is a great degree of volatility in the economic outlook, investors can profit from that volatility with a timing system such as the inflation-deflation timer model, which is currently showing a neutral reading right now.

Further to my last post about buying Australia and selling Canada, an alert reader emailed me and asked me to comment about buying Singapore and selling Hong Kong as another pair trade with the Asia Ex-Japan region.

Here again, is Bill Hester's analysis of relative country valutions based on cyclically adjusted P/Es and dividend yields. Indeed, it shows that Singapore as very undervalued and Hong Kong as roughly fairly valued.

The chart below shows the relative total performance of the iShare Singapore ETF compared to the iShare Hong Kong ETF, both in USD. This chart casts more doubt on the profit potential of a Singapore/Hong Kong pair trade.

I wrote in my previous post: "Hester’s analysis, combined with the above chart, screams out for a trade of going long Australia and shorting Canada."

The Australia vs. Canada pair trade that I proposed had the benefit of a valuation spread and price mean reversion. In the Singapore vs. Hong Kong case, the pair is already moving in Singapore's favor and it does not appear to be a mean reversion trade. There appears to be less of a historical price relationship between those two markets than Australia and Canada.

Under these circumstances, I would steer clear of the trade.

Recently Bill Hester of Hussman Funds did some analysis of average country valuation based on a composite of cyclically adjusted P/E ratios and dividend yields and concluded that US equities remains overvalued compared to its own historical average.

What fascinated me about the chart was the degree of overvaluation exhibited by Canada, compared to Australia, which is trading at roughly its own historical average. The economies of Australia and Canada are similar in character. Both are resource based economies and about the same size. There is a minor difference as Australian resource industries tend to be more tilted toward the bulk commodities (i.e. coal and iron ore) whereas Canada has a higher weight in energy.

Long Australia/Short Canada
The chart below shows the relative total performance in USD, which takes out any currency effects, of the iShares Australia ETF (EWA) and the iShares Canada ETF (EWC). This chart suggests that Australian and Canadian markets have tracked each other relatively closely since late 2002 and Australia is now at the bottom of a trading range relative to Canada.

Hester’s analysis, combined with the above chart, screams out for a trade of going long Australia and shorting Canada.

The risk in the trade is seen in the recent steep selloff in the Australian market, attributable to the news of a super-tax of up to 40% being imposed on resource companies. Nevertheless, the trading range is indicative that the risk-reward ratio is positive for this pair trade and that most of the bad news is already in the Aussie market.

Here are some of the things that could go right for the trade:

Australia took the lead, but the super-tax contagion could spread. How long would it take for budget constrained countries like Canada or Brazil to consider a form of super-tax on resource extraction companies? The 40% tax rate is awfully tempting and forms a very high ceiling rate from which to impose a new tax. Sympathy for resource extraction companies is low, especially in offshore oil extraction given BP’s environmental and public relations nightmare.
The Australian government has indicated that the door is open in changes to the tax regime. While the news is bad right now, the Aussie market could rally should the government step back and ease up its tax proposal.
The Reserve Bank of Australia is ahead of the curve in its monetary policy, as it has moved into tightening mode. By contrast, the Bank of Canada remains behind the curve in its monetary policy. What would happen to the Australia/Canada spread if and when the BoC tightens?

A long Australia/short Canada trade is a highly speculative position. As such, I would be entering into such a trade with a target and pre-defined stop loss levels.

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