Submitted by Matthew Lowenstein va The Diplomat,

China’s economy is straining to keep up a semblance of its former growth rate. The surest sign is the way a shadow market in bank paper has evolved to substitute the commodity that China is increasingly running short of: cash.

Bankers are passing around their own ersatz currency, stimulating trade with what, in effect, are off-the-books loans. As in the wildcat currency era of the United States, the antebellum period before America had a national currency, this paper trades at a discount from province to province. It is increasingly used for speculative purposes, is potentially inflationary, and is hard to regulate. The People’s Bank of China (PBOC) has been unable or unwilling to crack down, lest it provoke a serious slowdown. But when the world’s second largest economy must resort to passing around IOUs, the financial community should take note.

Bankers acceptance notes (BANs) are nothing more than a post-dated check with a bank guarantee. For example, a buyer in Chongqing might have a hard time passing checks to vendors in Shanghai. But if the purchaser gets his paper signed by, say, Bank of China, his check now has the guarantee of a major financial institution: it is money good. BANs facilitate trade by obviating the need for vendors to assess the creditworthiness of purchasers. But in China, this prosaic instrument of commerce has become a kind of shadow currency that allows under-reserved banks to purchase deposits, fuels speculation, and undermines the central bank’s control over the money supply.

“From the bank’s point of view, Banker’s Acceptance Notes are all about getting deposits,” explains a banker in Zhengzhou. In a typical transaction, a customer with cash in his pocket can put down 100 RMB as a security deposit and walk away with double that amount in BANs. The bank is pleased because it receives hard currency in return for its own funny money. The customer is delighted: he has turned 100 RMB in cash into 200 RMB in something almost as good. In effect, the bank has given the customer a 200 RMB loan without using a cent of cash.

The transaction harkens back to U.S. banking in the era before fiat currency, when banks used their own banknotes to purchase reserves of everything from gold bullion to national bank notes, British pounds, and bushels of wheat. Chinese banks print their own scrip to purchase “reserves” of cash, i.e., deposits. If the bank paper is accepted, it functions as currency and banks get to hold onto their reserves. But if people worry about the bank’s credit, or need cash (perhaps during a crisis) the bank will be forced to redeem its paper, possibly in a hurry.

In theory, all BANs are issued to support trade. When a customer is issued BANs, he must show proof of an underlying transaction. And to the extent the notes truly are backed by trade – by televisions shipments to Chongqing, say, or refrigerator exports to Seattle – there is very little risk. The notes get paid down as transactions are settled, and the bank need not worry about them. But to the extent BANs are not used for trade – to the extent they are merely rolled over and circulate as a secondary currency – they represent a constant, outstanding bank liability to high-risk industries.

“The truth is, most BANs are not used to support real transactions,” says a grinning shadow banker in Shenzhen. His company is one of many Chinese conglomerates whose business tentacles seem to span every industry from mining to tourism. But nearly half of its transactions are unprofitable: they are formalities, conducted solely for the purpose of acquiring BANs. “BANs are supposed to be issued only to support trade. But the rules are very flexible, and there are ways around them,” he continues. For example, trading partners can coordinate so that transactions net out. Party A sells Party B 100 RMB of widgets and Party B sells Party A 100 RMB of widgets. They both walk away with the same widgets they started with, and an extra 100 RMB of BANs each. As if by magic, the transaction has generated 200 RMB of highly liquid, bank-guaranteed financial assets.

BANs without underlying trade are used to finance speculation. Shadow bankers sell the BANs at a discount of about 5 percent – a process known as “discounting” – in return for cash. The seller of the note needs walking-around cash and is willing to dump his paper at a loss. After all, the seller is likely a speculator. He only loses 5 percent on the sale of the BAN, but his cash is invested in trust products or lent into the grey market at yields well in excess of 10 percent. The buyer of the note is likely to be a grey market BAN broker. As far as he’s concerned, he’s earning a risk free 5 percent by purchasing bank-guaranteed paper at a discount. In other words, a piece of paper – an IOU – is being passed around on which first a speculator and then a bank gives a guarantee. In this way, credit flows from the banks through shadow bankers and into property and other high-yield, high-risk industries such as mining or infrastructure. What looks to a banker like a purchase of televisions or washing machines in Shanghai could easily end up financing condominiums in Jiangsu or rolling over coal debt in Inner Mongolia. Most worrisome is that banks account for BANs as guarantees; guarantees are obligations that, a la Fannie-Mae, do not appear on a balance sheet.

The banks find the off-balance sheet accounting treatment of BANs particularly useful. Onerous statutory requirements force Chinese banks to keep a loan to deposit ratio (LDR) of 75 percent or less. BAN issuance simultaneously decreases loan balances while increasing deposits; it relieves LDR pressure on both sides of the vinculum. Of course, the change in LDR is a purely cosmetic change: the risk – and leverage – in the bank is just as high as if it had extended a plain vanilla loan, but the leverage is moved off balance sheet. Hence, to the extent BANs are used for speculation, they represent bank exposure to high-risk activities that is invisible to regulators, investors and even bankers themselves.

Not surprisingly, China’s local governments, themselves heavily involved in project and commercial finance, have become a huge market for BANs. Since 2008, local governments across China have been diligently at work on grand infrastructure and “urbanization” projects, of which ensuring an adequate supply of ghost cities seems to rank highest in priority. In the process, local government financing vehicles (LGFVs), the corporate subsidiaries that local governments use to fund infrastructure projects, have racked up an estimated 19 trillion RMB in debt according to the National Audit Office. Because LGFV investment has been so unremunerative – ghost inhabitants don’t pay taxes – the fiscal burden on local governments is crushing. For cities and counties that are short of cash, there is scarcely a more appealing solution to printing their own.

“There is a risk of banks and LGFVs colluding to fake security deposits and print BANs with no underlying trade,” warns a Ministry of Finance discussion document. Local governments up to their eyeballs in debt have the advantage of control – often of ownership – of banks within their territories, and can order up BANS at will. LGF
Vs turn to sister banks as a makeshift printing press, printing pseudo-currency virtually on demand. LGFVs use BANs to pay suppliers and obscure the truth about their overburdened balance sheets. A jaded banker in Tianjin complains, “When a borrower uses a BAN, they are supposed to record it on their balance sheet as a liability. But it’s kind of an unspoken rule that they don’t. To be honest, a lot of people see this is a major advantage of using BANs; they can pretend they have lower debt than they really do.” And the LGFVs never have to worry about principal repayments because banks are happy to roll over BANs as they come due. In short, LGFVs have nearly unrestricted access to notes that allow them to make payments, do not get recorded as debt, and never have to be paid down – i.e., their very own money.

Local governments printing their own money has led to a partial fracturing of the monetary system. A BAN issued by a local bank is likely to be accepted within its province, but its credit might not be honored – or honored only at a punitive discount – across provincial borders. An employee at an LGFV in Jiangsu engaged in contract work for infrastructure projects said his company routinely accepts BANs from Jiangsu banks. However, it refuses scrip from neighboring Anhui; out-of-province banks must pay in cash.

“A lot of smaller, local banks print more BANs than their balance sheet can support; in fact the reason they print BANs in the first place is because they don’t have the cash to make loans,” explains a banker at the Zhuhai branch of a major commercial bank, “Their BANs won’t be accepted outside of that province. It’s kind of like in international currency markets. The U.S. dollar is accepted in every country as the reserve currency.  Similarly, RMB are accepted anywhere in China. But provincial BANs can only be used within their native province.” It’s almost as if the non-consumer part of the Chinese economy had reverted to the 1930s, when each province issued its own legal tender.

It is impossible to estimate how much of China’s outstanding BANs were issued to LGFVs, but it is meaningful enough for the Guangdong Audit Bureau to list BANs as a new financing channel available to local governments. If China is to maintain a coherent fiscal and monetary regime, sooner or later its LGFV debt will have to be digested, either by paying it or writing it down. When regulators attempt to do so, they will find the National Audit Office’s estimate of 19 trillion RMB in LGFV debt understated, in part owing to BANs issued to LGFVs.

According to the People’s Bank of China, almost nine trillion RMB of BANs are circulating in an economy with a monetary base of 107 trillion RMB.  This huge economic underground is a measure of the extent to which highly speculative investment is outpacing the ability of Chinese banks to finance through deposits. If LGFVs and property developers had sufficient cash flows they would not need to resort to BAN funding. If returns on invested capital were sufficient, banks would see their deposits grow organically and not be reduced to purchasing RMB with this strange breed of banknote. These notes may behave like money, but their use is constricted; they cannot be used to purchase groceries or pay wages and will never be acceptable internationally. The BAN economy is thus separate, unable to be integrated with the rest of China’s economy. How long can it be sustained?

 

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/4cNPzThFgkw/story01.htm Tyler Durden

Submitted by Matthew Lowenstein va The Diplomat,

China’s economy is straining to keep up a semblance of its former growth rate. The surest sign is the way a shadow market in bank paper has evolved to substitute the commodity that China is increasingly running short of: cash.

Bankers are passing around their own ersatz currency, stimulating trade with what, in effect, are off-the-books loans. As in the wildcat currency era of the United States, the antebellum period before America had a national currency, this paper trades at a discount from province to province. It is increasingly used for speculative purposes, is potentially inflationary, and is hard to regulate. The People’s Bank of China (PBOC) has been unable or unwilling to crack down, lest it provoke a serious slowdown. But when the world’s second largest economy must resort to passing around IOUs, the financial community should take note.

Bankers acceptance notes (BANs) are nothing more than a post-dated check with a bank guarantee. For example, a buyer in Chongqing might have a hard time passing checks to vendors in Shanghai. But if the purchaser gets his paper signed by, say, Bank of China, his check now has the guarantee of a major financial institution: it is money good. BANs facilitate trade by obviating the need for vendors to assess the creditworthiness of purchasers. But in China, this prosaic instrument of commerce has become a kind of shadow currency that allows under-reserved banks to purchase deposits, fuels speculation, and undermines the central bank’s control over the money supply.

“From the bank’s point of view, Banker’s Acceptance Notes are all about getting deposits,” explains a banker in Zhengzhou. In a typical transaction, a customer with cash in his pocket can put down 100 RMB as a security deposit and walk away with double that amount in BANs. The bank is pleased because it receives hard currency in return for its own funny money. The customer is delighted: he has turned 100 RMB in cash into 200 RMB in something almost as good. In effect, the bank has given the customer a 200 RMB loan without using a cent of cash.

The transaction harkens back to U.S. banking in the era before fiat currency, when banks used their own banknotes to purchase reserves of everything from gold bullion to national bank notes, British pounds, and bushels of wheat. Chinese banks print their own scrip to purchase “reserves” of cash, i.e., deposits. If the bank paper is accepted, it functions as currency and banks get to hold onto their reserves. But if people worry about the bank’s credit, or need cash (perhaps during a crisis) the bank will be forced to redeem its paper, possibly in a hurry.

In theory, all BANs are issued to support trade. When a customer is issued BANs, he must show proof of an underlying transaction. And to the extent the notes truly are backed by trade – by televisions shipments to Chongqing, say, or refrigerator exports to Seattle – there is very little risk. The notes get paid down as transactions are settled, and the bank need not worry about them. But to the extent BANs are not used for trade – to the extent they are merely rolled over and circulate as a secondary currency – they represent a constant, outstanding bank liability to high-risk industries.

“The truth is, most BANs are not used to support real transactions,” says a grinning shadow banker in Shenzhen. His company is one of many Chinese conglomerates whose business tentacles seem to span every industry from mining to tourism. But nearly half of its transactions are unprofitable: they are formalities, conducted solely for the purpose of acquiring BANs. “BANs are supposed to be issued only to support trade. But the rules are very flexible, and there are ways around them,” he continues. For example, trading partners can coordinate so that transactions net out. Party A sells Party B 100 RMB of widgets and Party B sells Party A 100 RMB of widgets. They both walk away with the same widgets they started with, and an extra 100 RMB of BANs each. As if by magic, the transaction has generated 200 RMB of highly liquid, bank-guaranteed financial assets.

BANs without underlying trade are used to finance speculation. Shadow bankers sell the BANs at a discount of about 5 percent – a process known as “discounting” – in return for cash. The seller of the note needs walking-around cash and is willing to dump his paper at a loss. After all, the seller is likely a speculator. He only loses 5 percent on the sale of the BAN, but his cash is invested in trust products or lent into the grey market at yields well in excess of 10 percent. The buyer of the note is likely to be a grey market BAN broker. As far as he’s concerned, he’s earning a risk free 5 percent by purchasing bank-guaranteed paper at a discount. In other words, a piece of paper – an IOU – is being passed around on which first a speculator and then a bank gives a guarantee. In this way, credit flows from the banks through shadow bankers and into property and other high-yield, high-risk industries such as mining or infrastructure. What looks to a banker like a purchase of televisions or washing machines in Shanghai could easily end up financing condominiums in Jiangsu or rolling over coal debt in Inner Mongolia. Most worrisome is that banks account for BANs as guarantees; guarantees are obligations that, a la Fannie-Mae, do not appear on a balance sheet.

The banks find the off-balance sheet accounting treatment of BANs particularly useful. Onerous statutory requirements force Chinese banks to keep a loan to deposit ratio (LDR) of 75 percent or less. BAN issuance simultaneously decreases loan balances while increasing deposits; it relieves LDR pressure on both sides of the vinculum. Of course, the change in LDR is a purely cosmetic change: the risk – and leverage – in the bank is just as high as if it had extended a plain vanilla loan, but the leverage is moved off balance sheet. Hence, to the extent BANs are used for speculation, they represent bank exposure to high-risk activities that is invisible to regulators, investors and even bankers themselves.

Not surprisingly, China’s local governments, themselves heavily involved in project and commercial finance, have become a huge market for BANs. Since 2008, local governments across China have been diligently at work on grand infrastructure and “urbanization” projects, of which ensuring an adequate supply of ghost cities seems to rank highest in priority. In the process, local government financing vehicles (LGFVs), the corporate subsidiaries that local governments use to fund infrastructure projects, have racked up an estimated 19 trillion RMB in debt according to the National Audit Office. Because LGFV investment has been so unremunerative – ghost inhabitants don’t pay taxes – the fiscal burden on local governments is crushing. For cities and counties that are short of cash, there is scarcely a more appealing solution to printing their own.

“There is a risk of banks and LGFVs colluding to fake security deposits and print BANs with no underlying trade,” warns a Ministry of Finance discussion document. Local governments up to their eyeballs in debt have the advantage of control – often of ownership – of banks within their territories, and can order up BANS at will. LGFVs turn to sister banks as a makeshift printing press, printing pseudo-currency virtually on demand. LGFVs use BANs to pay suppliers and obscure the truth about their overburdened balance sheets. A jaded banker in Tianjin complains, “When a borrower uses a BAN, they are supposed to record it on their balance sheet as a liability. But it’s kind of an unspoken rule that they don’t. To be honest, a lot of people see this is a major advantage of using BANs; they can pretend they have lower debt than they really do.” And the LGFVs never have to worry about principal repayments because banks are happy to roll over BANs as they come due. In short, LGFVs have nearly unrestricted access to notes that allow them to make payments, do not get recorded as debt, and never have to be paid down – i.e., their very own money.

Local governments printing their own money has led to a partial fracturing of the monetary system. A BAN issued by a local bank is likely to be accepted within its province, but its credit might not be honored – or honored only at a punitive discount – across provincial borders. An employee at an LGFV in Jiangsu engaged in contract work for infrastructure projects said his company routinely accepts BANs from Jiangsu banks. However, it refuses scrip from neighboring Anhui; out-of-province banks must pay in cash.

“A lot of smaller, local banks print more BANs than their balance sheet can support; in fact the reason they print BANs in the first place is because they don’t have the cash to make loans,” explains a banker at the Zhuhai branch of a major commercial bank, “Their BANs won’t be accepted outside of that province. It’s kind of like in international currency markets. The U.S. dollar is accepted in every country as the reserve currency.  Similarly, RMB are accepted anywhere in China. But provincial BANs can only be used within their native province.” It’s almost as if the non-consumer part of the Chinese economy had reverted to the 1930s, when each province issued its own legal tender.

It is impossible to estimate how much of China’s outstanding BANs were issued to LGFVs, but it is meaningful enough for the Guangdong Audit Bureau to list BANs as a new financing channel available to local governments. If China is to maintain a coherent fiscal and monetary regime, sooner or later its LGFV debt will have to be digested, either by paying it or writing it down. When regulators attempt to do so, they will find the National Audit Office’s estimate of 19 trillion RMB in LGFV debt understated, in part owing to BANs issued to LGFVs.

According to the People’s Bank of China, almost nine trillion RMB of BANs are circulating in an economy with a monetary base of 107 trillion RMB.  This huge economic underground is a measure of the extent to which highly speculative investment is outpacing the ability of Chinese banks to finance through deposits. If LGFVs and property developers had sufficient cash flows they would not need to resort to BAN funding. If returns on invested capital were sufficient, banks would see their deposits grow organically and not be reduced to purchasing RMB with this strange breed of banknote. These notes may behave like money, but their use is constricted; they cannot be used to purchase groceries or pay wages and will never be acceptable internationally. The BAN economy is thus separate, unable to be integrated with the rest of China’s economy. How long can it be sustained?

 

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/4cNPzThFgkw/story01.htm Tyler Durden

Two phrases sum up the 'new normal' farce that is the world's equity markets in 2013… "Don't fight the Fed (or BoJ, or PBoC, or BoE)" and "Climbing the wall of worry"… one wonders, of course, what happens to 'climber' once the central bank's 'belay' is taken away (but that's just silly talk because it's all priced in, right?)…

 

Via Strategas' Jason Trennert (WSJ blog),

“YOU’RE NOT JUST FIGHTING THE FED”

The Federal Reserve’s $85 billion-a-month bond-buying program has been a major driver of the stock market rally. But as the chart below shows, it’s not just the Fed that has been attempting to stimulate the economy. Central banks around the globe, from the Bank of England to the European Central Bank to the Bank of Japan, have launched policies designed to kickstart economic growth. Even as the Fed may start trimming its bond purchases later this month or early next year, global monetary policy remains very easy. The old Wall Street adage is “don’t fight the Fed.” But as Mr. Trennert points out, it’s now more like don’t fight the world’s central banks.

 

 

 

which means "The Wall Of Worry" has been handily ascended…

 

 

So what next?

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/U6Ykm_nRt28/story01.htm Tyler Durden

Healthcare.gov may or may not be fixed, depending on who one listens to (and if one reads the WSJ’s, “Errors Continue to Plague Government Health Site” this morning, there is much more fixing left despite the administration’s most sincere promises), but a greater issue is already looming: payment. “We have a bigger number of applicants than people who have paid,” Aetna Chief Financial Officer Shawn Guertin said in an interview today in New York. “That’s a situation that I am a little bit worried about, that people will think they have completed the process but haven’t paid the premium yet.” Whether Americans didn’t realize there would be an actual payment involved in America’s socialized healthcare system, or simply there is too much confusion over how the process is run, is irrelevant – the bottom line is that for whatever reason people are simply not paying their premiums.

As Bloomberg reports, the disjointed process of having customers shop through the government-run marketplace and then pay insurers separately has created a risk that people who have chosen a plan won’t actually be covered Jan. 1. And if people don’t pay by Dec. 31, insurers may end up stuck with a disproportionate number of sicker and costlier customers.

“You have to remember that many times we are dealing with low-income people,” Robert Laszewski, an Alexandria, Virginia-based consultant to carriers, said in a telephone interview last week. “They signed up and they certainly want the insurance, but do they have the money or have they changed their mind by Dec. 31? Nobody’s done this before.”

And while the government has been touting the surge in sign up numbers, with the CMMS announcing yesterday that some 365,000 people have signed up for a private plan through November, what the government has not said is how many of these people have already paid their premium. Judging by the Aetna CFO remarks there is a major, gaping discrepancy between the two. And even if people do expect to get completely free healthcare, that is not what Obamacare is about, at least not yet. So suddenly Obama may have a situation where he has millions signed up for the ACA, and only a fraction has actually paid. Recall that Obama has a goal of 7 million sign ups by the March 31 end of open enrollment.

In the meantime, while it remains to be seen if the new plans will be feasible, the old healthcare plans have already been largely scrapped.

Aetna, based in Hartford, Connecticut, also said it faces too many administrative hurdles to reinstate policies that it’s terminating next year because they don’t meet the new standards set by the health law. Hundreds of thousands of people around the country have gotten cancellation notices from insurers this year, prompting a political firestorm for President Barack Obama.

 

Obama responded last month by giving insurers and state regulators the option of extending the policies by an extra year. Aetna decided it would be too difficult to do in time for Jan. 1, Guertin said. Some customers were able to renew their policies early before the termination notices arrived. Guertin declined to say how many.

 

“It gets them a plan frankly that we’re ready to service,” he said. “It would just be too administratively burdensome to try to get everything ready to restore all the old plans.”

Well, nobody said central planning works everywhere. The good news that for now, at least, the fourth – monetary – branch of government is offsetting any and all other disappointments created by the legislative and executive. Because no matter how vast the shock, or how acute the disappointment, one can always point to an S&P that is just shy of all time highs. And all is well if the “markets” say it is…

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/-s3w92mNsTs/story01.htm Tyler Durden

Healthcare.gov may or may not be fixed, depending on who one listens to (and if one reads the WSJ’s, “Errors Continue to Plague Government Health Site” this morning, there is much more fixing left despite the administration’s most sincere promises), but a greater issue is already looming: payment. “We have a bigger number of applicants than people who have paid,” Aetna Chief Financial Officer Shawn Guertin said in an interview today in New York. “That’s a situation that I am a little bit worried about, that people will think they have completed the process but haven’t paid the premium yet.” Whether Americans didn’t realize there would be an actual payment involved in America’s socialized healthcare system, or simply there is too much confusion over how the process is run, is irrelevant – the bottom line is that for whatever reason people are simply not paying their premiums.

As Bloomberg reports, the disjointed process of having customers shop through the government-run marketplace and then pay insurers separately has created a risk that people who have chosen a plan won’t actually be covered Jan. 1. And if people don’t pay by Dec. 31, insurers may end up stuck with a disproportionate number of sicker and costlier customers.

“You have to remember that many times we are dealing with low-income people,” Robert Laszewski, an Alexandria, Virginia-based consultant to carriers, said in a telephone interview last week. “They signed up and they certainly want the insurance, but do they have the money or have they changed their mind by Dec. 31? Nobody’s done this before.”

And while the government has been touting the surge in sign up numbers, with the CMMS announcing yesterday that some 365,000 people have signed up for a private plan through November, what the government has not said is how many of these people have already paid their premium. Judging by the Aetna CFO remarks there is a major, gaping discrepancy between the two. And even if people do expect to get completely free healthcare, that is not what Obamacare is about, at least not yet. So suddenly Obama may have a situation where he has millions signed up for the ACA, and only a fraction has actually paid. Recall that Obama has a goal of 7 million sign ups by the March 31 end of open enrollment.

In the meantime, while it remains to be seen if the new plans will be feasible, the old healthcare plans have already been largely scrapped.

Aetna, based in Hartford, Connecticut, also said it faces too many administrative hurdles to reinstate policies that it’s terminating next year because they don’t meet the new standards set by the health law. Hundreds of thousands of people around the country have gotten cancellation notices from insurers this year, prompting a political firestorm for President Barack Obama.

 

Obama responded last month by giving insurers and state regulators the option of extending the policies by an extra year. Aetna decided it would be too difficult to do in time for Jan. 1, Guertin said. Some customers were able to renew their policies early before the termination notices arrived. Guertin declined to say how many.

 

“It gets them a plan frankly that we’re ready to service,” he said. “It would just be too administratively burdensome to try to get everything ready to restore all the old plans.”

Well, nobody said central planning works everywhere. The good news that for now, at least, the fourth – monetary – branch of government is offsetting any and all other disappointments created by the legislative and executive. Because no matter how vast the shock, or how acute the disappointment, one can always point to an S&P that is just shy of all time highs. And all is well if the “markets” say it is…

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/-s3w92mNsTs/story01.htm Tyler Durden

For weeks now, I have contended that the $VIX would need to break the 12 level as confirmation that US equities are going meaningfully and sustainably higher. The $VIX has not broken through this “wall of support” despite tagging the 12 to 13 level numerous times since that original video in early September. In fact, as we can see from this weekly chart the $VIX is actually threatening to break through resistance at the 14.64 level. See figure 1.

WEEKLY

Figure 1. $VIX/ weekly

 

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The black dots on the price bars are key pivot points, which are the best areas of support and resistance. Breaks above resistance are suggestive of falling equity prices. Conversely, breaks below support in the $VIX are typically associated with higher equity prices. As stated, the key level on the $VIX to watch is at 14.64. A weekly close above this level and equity prices are headed lower. Past and recent breaks above resistance are shown on the chart.

Figure 2 is a weekly chart of the SP500 with an indicator that attempts to measure the current level of the $VIX relative to past key pivot points in the $VIX and trend lines formed by those pivot points. The indicator is rolling over. Past and recent crosses in the indicator are noted with the failure that occurred in quarter 1, 2013.

Figure 2. $VIX/ weekly

DAILY

Figure 3 is a daily chart of the SPY with the $VIX data hidden. The red and gold pivot points are formed when the price of the SPY pivots during extremes in the $VIX. As an example, see the pivot inside the blue box. At this time, the $VIX was extreme relative to the past 40 days (our look back period); during the extremes in the $VIX buyers surfaced (as expected), and price of the SPY pivoted higher. Thus forming the pivot. This becomes support. Currently price is below this pivot, which means that support becomes resistance. In essence with price below old support, the trend has likely turned lower.

Figure 3. $VIX/ daily

 

In summary, the rally is running out of steam. The $VIX should have broken below a level of 12 to confirm a sustainable price move. Instead, the $VIX is looking to close above resistance levels, which in all likelihood would be the end of this rally.

 

See more investor sentiment and strategies for bonds and precious metals.  Visit Tactical-Beta.  It’s 100% FREE!!

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/awRFP4apeR8/story01.htm thetechnicaltake

In the past we have explained how QE continues to “fail upward” because instead of injecting credit that makes its way into the economy, what Bernanke is doing, is sequestering money-equivalent, high-quality collateral (not to mention market liquidity) – at last check the Fed owned 33% of all 10 Year equivalents – and by injecting reserves that end up on bank balance sheets, allows banks to chase risk higher in lieu of expanding loan creation. Alas it took a few thousands words, and tens of charts, to show this. Since we always enjoy simplification of complex concepts, we were happy to read the following 104-word blurb from Bridgewater’s Co-CEO and Co-CIO Greg Jensen, on how QE should work… and why it doesn’t.

The effectiveness of quantitative easing is a function of the dollars spent and what those people do with that money. If the dollars get spent on an asset that is very interchangeable with cash, then you don’t get much of an impact. You don’t get a multiplier from that. If the dollar is spent on an asset that’s risky and very different from cash, then that money goes into other assets and into the real economy. That’s really how you see the impact of quantitative easing. What do they buy? Who do they buy it from? What do those people do with that money?

Of course, this is why sooner or later the Fed will proceed to “monetize” increasingly more risky, and more non-cash equivalents assets, until “this time becomes different.” Which it never is, but the Fed will still try, and try and try.

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/ZGLApkdZhDM/story01.htm Tyler Durden

In the past we have explained how QE continues to “fail upward” because instead of injecting credit that makes its way into the economy, what Bernanke is doing, is sequestering money-equivalent, high-quality collateral (not to mention market liquidity) – at last check the Fed owned 33% of all 10 Year equivalents – and by injecting reserves that end up on bank balance sheets, allows banks to chase risk higher in lieu of expanding loan creation. Alas it took a few thousands words, and tens of charts, to show this. Since we always enjoy simplification of complex concepts, we were happy to read the following 104-word blurb from Bridgewater’s Co-CEO and Co-CIO Greg Jensen, on how QE should work… and why it doesn’t.

The effectiveness of quantitative easing is a function of the dollars spent and what those people do with that money. If the dollars get spent on an asset that is very interchangeable with cash, then you don’t get much of an impact. You don’t get a multiplier from that. If the dollar is spent on an asset that’s risky and very different from cash, then that money goes into other assets and into the real economy. That’s really how you see the impact of quantitative easing. What do they buy? Who do they buy it from? What do those people do with that money?

Of course, this is why sooner or later the Fed will proceed to “monetize” increasingly more risky, and more non-cash equivalents assets, until “this time becomes different.” Which it never is, but the Fed will still try, and try and try.

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Today we note that:

 

1)   The US economy is tipping back into recession again

2)   Corporate profits are at record highs and set to fall

3)   Stocks are extremely overvalued

 

All of these add up to a real problem for long-term stock investors today. The classic method of valuing stocks, the P/E ratio is comprised of market cap relative to earnings.

 

If earnings are at record highs today and stocks are already overvalued, how high will P/Es be when earnings begin to contract with stocks at these levels?

 

Speaking of earnings, let us now move to #2 on the list of items I listed at the opening of this issue: the recent collapse in revenues and earnings at economically sensitive firms.

 

We’ve seen a recent spate of terrible results from corporate America.

 

In the last few months alone we’ve seen disappointing earnings at:

 

1)   Caterpillar (global machinery)

2)   Microsoft (software)

3)   Google (search engine ad revenue)

4)   Chevron and Exxon Mobil (oil)

5)   Discovery (credit cards)

6)   Amazon (online retail)

7)   Charles Schwab (brokers)

8)   Wynn Resorts (casino)

 

There are dozens and I literally mean dozens of ways to craft earnings to be better than reality. You can writedown assets, alter depreciation methods, manipulate bad debt expenses in accounts receivables, game the closure of deals, take one time charges, utilize derivatives and mark to model valuation of assets, etc.

 

Indeed, a study performed by Duke University found that roughly 20% of publicly traded firms manipulate their earnings to make them appear better than they really are. The folks who were surveyed for this study about this practice were the actual CFOs at the firms themselves.

 

In this sense, it is safe to that 2013 earnings, as poor, are they are, have been “massaged” to look better than reality.

 

Indeed, we get confirmation of this from revenues misses. As I mentioned a moment ago, earnings can manipulated any number of ways, but revenues cannot; either money came in or not.

 

With that in mind, we’ve in the last few quarters we’ve seen revenues misses at:

 

1)   Merck (big pharma)

2)   Molson Coors (alcohol)

3)   Clorox (cleaning materials)

4)   US Steel (steel)

5)   McDonald’s (fast food)

6)   3M (conglomerate)

7)   GE (conglomerate)

 

This brings me back to an earlier point, that profits and earnings are likely peaking. Net profit margins today are at all-time highs. There is virtually nowhere to go but down here.

 

Finally, I want to draw your attention to the massive cash hoards value investors and wealthy individuals are sitting on.

 

Warren Buffett, arguably the greatest value investor of the last 100 years, is currently sitting on a cash hoard of $49 billion. This is an all-time record for Buffett. And it’s a strong indication that there are few great deals in the market today.

 

Few investors understand inflation as well as Buffett (though his views on Gold are confusing for many). But Buffett is a master of beating inflation. He’s well aware that by sitting on cash today with interest rates at zero he’s “losing money.” The fact he’s willing to do this rather than invest in stocks should be a major warning to investors that there is a dearth of great value opportunities in the markets today.

 

Buffett is not the only one.

 

Mega-private equity firms, Fortress and Blackstone have been urging their clients to get out of the market.

 

Moreover, a recent study by American Express and Harrison Group has found that the wealthiest 1% of clients has been shifting rapidly to cash with their savings rates soaring from 34% to 37% last quarter.

 

Bank of America had similar findings of its millionaire clients with 56% of them stating they have a “substantial” amount of their assets currently in cash.

 

This just confirms my concerns that the market is currently offering few opportunities for long-term deep value investors.

 

For a FREE Special Report on how to beat the market both during bull market and bear market runs, visit us at:

 

http://phoenixcapitalmarketing.com/special-reports.html

 

Best Regards

 

Phoenix Capital Research

 

 

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/1wh48bXAeb4/story01.htm Phoenix Capital Research

From Archaea Capital Research (pdf)

ANNUAL REPORT – COMMENTARY

2013 & 2014: Closing, Reflection, and Five Bad Trades To Avoid Next Year

December 12, 2013

To our Clients and Investors,

Our investment process continues to focus on filtering highly favorable reward-to-risk opportunities. Yet the last 12 months have presented an interesting anomaly. Looking back and reflecting on 2013, we find a year inordinately cluttered with apparent opportunities that turned out to be bad trades. More so, in fact, than any other year we can remember. In 2013, avoiding bad trades contributed more alpha to an investment portfolio than identifying great opportunities. Not losing was the new winning.

Too many investors, prodded by the unrelenting monetary zeitgeist or their own emotions (or both), voluntarily entered these traps, at one time or another, throughout the year. Identifying the bad calls in advance, and implementing a basic filter, saved a great deal of financial and mental capital—and kept us in the race. Looking through our global macro lens, we list some of these potholes in chronological order:

First among them was the universal belief starting around 4Q12, and lasting well into 1Q13, that Emerging Markets were going to be the star performers this year. Then by March, the latest fashion was to sell the British Pound on coming devaluation. Moving into April, Copper and Materials became a favorite short to ‘play’ the Chinese downtrend. Several faulty assumptions behind that logic chain, to be sure. By late June, the rage was to short Bonds on ‘taper talk’. Emerging Markets were declared dead. As July came, the Dollar was ‘breaking out’, and was a ‘must-own’. As September approached, economists had reached near-universal agreement on an imminent Fed taper. Few bothered to listen to what the Fed was actually saying, for the better part of three months (then proceeded to blame the Fed for poor communication). Fortunately, we had the courage to avoid (and even fade) these ‘top trades’.

Other pockets of frenzied consensus, to our surprise, managed to hold up—and in some cases, became even more misaligned. The ‘Great Rotation’ actually came to pass, as retail investors managed to dump their Bonds at the lows only to pile into Stocks at the high. Never mind who lifted those Bonds from them, and sold Stocks to them. Precious metals and the miners broke after everyone said they would, then promptly disappeared from the investment menu. Selling Yen after May, Selling Bonds and Gold in late June, all struck us as really bad trades. Most haven’t gone anywhere, yet their proponents are even more convinced the gains are coming. This bizarre contrarian “Moebius strip” has disguised several bad trades as good, for now. Even for the mighty S&P, 70% of the year’s gains were clocked in by late May. Chalk it up to Mr. Market’s convincing tricks, and investment mandates where patience has been cut to zero. Having long believed patience to be correlated with alpha, as we transition into 2014, we cannot envision a better time to keep a cool head.

In hindsight, perhaps one of the greatest lessons of 2013 was the importance of Japan to the macro discussion. To any market practitioner (economists not included) who has glanced at a 50-year chart of Japanese Equities, the Yen, and U.S. 10-Year Treasury Yields, we believe these trends happened together for very important, fundamentally separate but systemically inter-related reasons—all of which are too important to fit in a brief reflection note. Suffice to say, if an investor thinks that one of these two trends (Japan/U.S. Rates) has turned for a period relevant to their time horizon, they should take the time to study what the fundamental and systemic implications are for the other. Apparently, most investors have not.

Without further delay, let us return to the discussion on deceptive opportunities that become bad trades, as we ponder the coming year.

Five Bad Trades To Avoid Next Year

BAD TRADE #1 For 2014: Ignoring Mean Reversion

The stock market had a great year. Supposedly, history favors a good follow-through. We disagree. The chart below shows the S&P’s annual returns for the 20 years that followed two consecutive double-digit annual gains in the stock market. Over nearly a century, the third year posted a significantly smaller return than the historical median/average (84% less than the median return, and 65% less than the average return):

Here are the 20 thumbnail charts of those years for quick perusal, in order from the performance bars above:

Nearly every chart, with the exception of perhaps 1945 and 1997, favored mean reversion. In short, buying on January 2 and holding just may not cut it in 2014. Those levering for a repeat of 2013 in U.S. Equities are likely walking in to a meat grinder. As for the lessons of 2013 on currencies, commodities, and even Emerging Markets, please read the first page of this note. Trends were fickle, and we expect plenty of encores in the coming year. As a side note, the most bearish outcome for 2014 would be a gravity-defying big return (net of the mean-reverting swings we expect). From the eight best years above, three came in 1997-1999—and we know what followed. Worse, without these three bubble years, the median return falls to 0%, and the average to -1.45%.

 

BAD TRADE #2 For 2014: Which-flation?

This debate is also related to mean reversion. Below is a 15-year chart of U.S. CPI with relevant Economist magazine covers marked in vertical lines (to the nearest month). The covers read:
     May 24, 1999: Economy Wars – Starring Alan Greenspan, Inflation Fighter
     June 19, 2004: Back to the 1970s? Inflation returns, worldwide
     May 24, 2008: Inflation’s back… but not where you think
     Nov 9, 2013: The perils of falling inflation

As per above, there are only wrong answers in this eternal debate. If we were to guess, the Fed may finally get their inflation ‘on target’ next year—as inflation tends to considerably lag economic activity anyway (roughly 2-4 quarters) and 2013 was on balance an expansion year. Inherent lags could easily drift CPI (and Core) back to 2% or higher, throwing a wrench in all the central planning models.

Speaking of which, below is the “last gasp” (white arrow) in Core CPI during the previous cycle, with a 50-month moving average for guidance. Is a repeat coming?

If the question seems outlandish, the below chart shows the last seven U.S. Recessions, and Core CPI (white) relative to the same 50-month moving average (blue). The S&P is in yellow. Periods of Core CPI trending above its long-term average all led to poor economic and investment outcomes:

Looking to yet another time for guidance, in late 1989 stocks (yellow) made new all-time highs just as Core CPI inflation (white) stabilized around its long-term average (blue)—identical initial conditions observed today.

Inflation then rose for a year, while stocks were put through the meat grinder from September 1989 to September 1990. Ultimately stocks fell 20% as recession hit.

Below we overlay the U.S. 10-Year Treasury Yield (green) against the same Core CPI (white) for that period. Here, yields rose for a few months in tandem with inflation, but by year-end 1990 yields were right back to where they had started. Mean-reversion at its finest:

In a classic repeat of history, 2014 could see a late cycle (last gasp) rise in inflation of 50-100bps, and a Fed once again looking through the rearview mirror of a lagging indicator to set policy. As seen from the previous charts, this alone would present a whole new set of problems for asset prices. And of course, no one would see it coming, as the magazines already suggest.

As for interest rates, here are the same magazine covers placed over a chart of the U.S. 10-Year Treasury Yield. By the end of 2014 the current deflation scare may look a bit silly. Where Bond prices end up, and how they get there, remains to be seen. Between now and then, there will be no shortage of economists with consensus forecasts—try to ignore them.

 

BAD TRADE #3 For 2014: Forgetting Late Cycle Dynamics

Inflation isn’t the only late-cycle theme that has disappeared from the investment discussion:

Large investors turn cold on commodities—Financial Times, December 5

“After two years at the helm of the world’s worst-performing asset class, managers of commodities funds could be forgiven for feeling unloved. Wall Street analysts, big-picture strategists and powerful consultants have turned cold on oil, metals and grain futures as a decade-long rally peters out. And investors are listening, with many now reluctant to commit further funds. Some are heading for the exits. […]”

A Commodities Rally Isn’t Carved in Stone—Wall Street Journal, December 2

“If the market had its own Ten Commandments, near the top would be “thou shalt revert to the mean”—or, what goes up must come down and vice versa. Commodities bulls betting on this lifting their favorite investment out of its funk need to ask themselves where that mean is, though. […] Above all, in historical terms, prices for copper, oil and gold aren’t even that cheap—they only look so compared to recent dizzy peaks. Somewhere in those alternative commandments is another instruction for investors: Thou shalt not catch a falling knife.[…]”

Interest in the Commodities space has been plumbing the depths throughout most of the year—and the market (as measured by the S&P GSCI index) has, unsurprisingly, gone nowhere:

Copper has also returned as a favorite short to ‘play’ China. The grand thesis is that Chinese policy is shifting from industrial to consumption-driven growth. So the consensus is to short Copper into the next Plenum. We’ll pass. The idea that Commodities are ‘dead’, as we noted with deflation also dominating the economic debate, seems to offer fertile ground for a temporary surprise next year.

 

BAD TRADE #4 For 2014: Blind Faith In Policy

Markets break rules. Investment aphorisms that gain enough believers usually stop working—right when they are counted (depended) on the most. On Page 1 of the market rule book stands, alone, “Don’t fight the Fed” (with a nod to Marty Zweig—who probably would have cringed at how ubiquitous the phrase has become—and who also said “the problem with most people who play the market is that they are not flexible”).

Central bank credibility is like any other asset. It swings in and out of favor, in fairly predictable cycles. The time to go long Fed credibility was five years ago. If we could sell global central bank credibility, we would do so today:

There are no good options for late-cycle monetary policy. Central bank mandates have an inherent structural flaw. They are tasked with controlling inflation and unemployment, both of which lag the real economy. That is, when both inflation and unemployment are stable and improving, and policy is accommodative, “Don’t fight the Fed” works rather beautifully. Straight lines work wonders in economic models. Unfortunately at the turns, model-driven policy tends to fall behind the reality curve. Lest we forget, 2007-2008 was a classic example. As the below chart shows, accommodative policy didn’t arrest the crash of 2008, the tech bust in 2000, the recession and bear market of 1990-1991, the double-dip recession of 1982, or the crash of ’74. Perhaps 2014 will see the Fed digging itself into the same late cycle hole, temporarily reducing accommodation just as unemployment troughs and inflation perks up. The models won’t like that—and we worry for those following blindly at the turn.

 

BAD TRADE #5 For 2014: Reaching for Yield During Late Cycle

Moody’s maintains a handy high-yield credit spread model based on rating changes. For the first time in this 5-year credit expansion cycle, predicted high yield credit spreads have crossed rather significantly above actual. It worked quite well as a leading indicator during the crisis. Overall, the history of these gaps does not bode well for sustained spread compression:

The above also suggests that placing blind
faith in monetary policy (as we discussed previously), as the sole driver for further spread compression, may ultimately disappoint credit investors. Ignoring credit quality deterioration in late cycle is simply a bad trade.

Add Covenant Lite Issuance at 60% of loans, far surpassing the 2007 highs…

And PIK issuance off the charts (nearly a third to pay dividends)…

In both cases, we have a picture of investors who do not appear to be carefully analyzing individual credit risk. Further, companies are not levering up to invest in future growth, but to feed their shareholders. Call it the pillaging of corporate balance sheets, by the very insiders charged with steering the ship. Incidentally, just as they are (in aggregate) directing their companies to buy back shares and pay dividends (courtesy of savers, prodded by the Fed), only 17% of recent individual insider transactions have been purchases. According to Prof. Nejat Seyhun of the University of Michigan, this is the lowest level since 1990, when his database begins (the average runs at 38%). What could possibly go wrong?

As we enter a new year, we thank you for the opportunity to be a part of your investment process. May we together “figure out” the pieces of the market puzzle. May 2014 be rewarding for the patient, diligent investor.

As we like to say, “imagination, innovation, understanding, and action are pillars shared by all successful investors”. When some of the best opportunities come from doing nothing, the market’s message is one of great informational value. The value of avoiding big mistakes in 2014 may be greater than ever before. And with a long list of potentially bad trades already competing for investors’ attention at the opening gate, we will prepare for the coming year in careful study and thought.

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