Boris and Kathy's FX Blog www.bktraderfx.com

Top 10 Investment Stories The Week

1. Unemployment Rises

2. Was Back to School Strength Just a Mirage?

3. Is this the end of the Correction? The state of the Dow now drives all other financial markets which in turn may determine the difference between an economic slowdown or a full blow recession. WSJ has an interesting article about the volatility that precedes prior market bottoms.

4. Borrowing short and lending long is the sure fire formula for banker's bankruptcy. Unfortunately that's what many of the money center banks have been doing through their off balance sheet Special Investment Vehicles. Mish explores the issue in detail

5. Meanwhile Housing continues to be a slow motion car wreck. After CFC announced that is was firing 12,000 employees last week Wamu just chimed in that it will take more than $2 Billion write down on sub-rime loans.

6. The next shoe to drop? LBO financing. Remember investment banks hold more than $400 Billion worth of loans that they guaranteed to private equity shops. The stuff is not moving and today comes news that KKR which has been playing hardball with Wall Street up to now, finally blinked.

7. Despite the woes, someone smells a bargain. UK billionaire Joseph Lewis just took a very significant chunk of Bear Stearns - the epicenter of the sub-prime mess on Wall Street.

8. Who is going to buy our debt? Bloomberg worries that China is paring down its position in Treasuries.

9. But Brad Setser thinks that is much ado about nothing, arguing that China basically shifted from Treasuries to Agencies.

10. Finally best trade in Great Depression? Gold. Check out the rise of Homestake Mining while everything else was liquidated for pennies.


1. Unemployment Rises

Nouriel Roubini argues that hard landing is inevitable after the worst numbers in 4 years.

http://www.rgemonitor.com/blog/roubini/

There is now a vicious circle where a weakening US economy is making the financial markets’ crunch more severe and where the worsening financial markets and tightening of credit conditions will further weaken the economy via further falls of residential investment and further slowdowns of private consumption and of capital spending by the corporate sector.

A housing recession alone cannot lead to an economy-wide recession as housing is only 5% of GDP. But now the housing slump is spreading to other parts of the economy: the auto sector is in a recession; the manufacturing sector is sharply slowing down; demand for housing related durable goods (furniture, home appliances) is falling. Moreover, US private consumption – that represents over 70% of aggregate demand – is now under pressure. The US consumer is now saving-less, debt-burdened and buffeted by many negative forces. As long as home prices were rising it made sense for US households to use their homes as their ATM machines, borrow against their rising home equity and spend more than their income (negative savings). But now that home prices are falling there is the beginning of a retrenchment of consumption whose growth rate slowed down from a 4% average until the first quarter of 2007 to a weak 1.3% in the second quarter, even before the summer financial market turmoil.

There are now many negative factors squeezing US consumers and forcing them to retrench spending: falling home values leading to a negative wealth effect; sharply falling home equity withdrawal preventing households from overspending; a credit crunch in mortgages and consumer debt markets rising debt servicing costs for consumers; still high oil and gasoline prices; the beginning of a serious weakening of the labor market – as signaled by today’s employment report and other data - that will significantly reduce income generation in the months ahead. As long as income generation and job generation was robust, one could dismiss the risks of a hard landing; but the signal from today’s employment report is that the only force that was preventing a hard landing (jobs and income generation) is now starting to falter.

Thus, in the next few months you can expect a further slowdown of consumption growth from its already mediocre growth rate of 1.3% in the second quarter. Indeed, after an ok July, retail sales were weak in August: based on the Redbook Johnson and the UBS Securities/ICSC data same store retail sales in August actually fell relative to July; and in real terms such retail sales in August were lower than in August 2006. Thus, the deceleration in consumption in Q3 is already clear in the data.

The August Retail Sales data was actually not so bad as both Walmart and Target beat estimates but Barry Ritholtz casts a skeptical eye on the numbers

2. Was Back to School Strength Just a Mirage?

http://bigpicture.typepad.com/comments/2007/09/back-to-school-.html

It turns out that a the retail data came with a big fat *asterisk, which (as happens all too often) presented a very misleading view of the data.

Why? Well, we track these numbers so as to have a good read on the strength of the consumer, and how sustainable their present spending pattens are. Given that the US consumer is 70% of the economy, their actions are quite significant.

That's what makes today's asterisks so significant: Much of the volume gains came via one offs, unusual factors, and huge discounting, with retailers sacrificing margin in exchange for volume:

What other asterisks are out there for retailers?

* Florida and Texas pushed back the start of their school openings by several weeks this year, inflating the August sales of teenage-oriented retailers (Abercrombie & Fitch, Aeropostale)

* Tax-free shopping days — formerly a single day or week, have been extended through much of August. Abercrombie (ANF) admitted that without the delay of tax-free shopping days in Florida and Texas, its sales would have risen just 1% rather than 5%.

* The International Council of Shopping Centers (ICSC) noted that August 2007 saw a 2.9% increase -- relatively weak compared with August 2006's 3.8% sales gains.

* Marketwatch reported that "the hottest August weather in 113 years also sent shoppers buying air conditioners and other hot-weather items as retailers cleared out their summer merchandise in a transition to fall goods, said weather consulting firm Weather Trends International

* Retail slumming is in full effect: Discounters, rather than full-price chains, reported the strongest performance in August '07. At stores open at least one year, sales rose 6.1% at Target (TGT) and 3.1% at Wal-Mart (WMT).

* Gasoline prices below $3 a gallon made consumers feel more comfortable about shopping. However, since then, Oil has ticked back up towards its highs, with gasoline prices sure to follow

* The NYT reported that Wal-Mart said "Consumers flocked to its stores for bedding, apparel and towels, categories that the chain had struggled with for much of the year." Why the sudden reversal of fortune? Big discounts.

* Who else was the big winner? Luxury chains. Sales rose 6.6% at Nordstrom and 18.2% at Saks.

* Whose struggling? Full priced department stores. Sales fell 4% at J. C. Penney, 5% at Dillard’s and 0.6% at Kohl’s.

3. Is this the end of the Correction? The state of the Dow now drives all other financial markets which in turn may determine the difference between an economic slowdown or a full blow recession. WSJ has an interesting article about the volatility that precedes prior market bottoms.

http://online.wsj.com/article/SB118937309413321829.html?mod=todays_us_nonsub_money_and_investing

The question on everyone's mind is, when will the market hit bottom? Analysts who dissect market movements have many theories about how to pick the bottom. One that has been effective is to look for days of exceptionally heavy selling, followed by days of exceptionally heavy buying. The logic: When stocks are approaching the end of a decline, investors tend to be in a panic, and their sell orders dominate trading. Then, once the selling runs its course, bullish investors step in with heavy buy orders that dominate trading and, in turn, signal the beginning of a rally.

Lately, that combination of heavy selling followed by heavy buying is exactly what the market has seen -- on steroids.

"We have been getting these days at the rate of one every 3½ days, and that's just crazy," says Paul Desmond, president of research service Lowry's Reports in North Palm Beach, Fla., who has done extensive research on the subject. "We don't have anything like that anywhere in our history" of data, going back to 1933, he says.

Heavy volatility can excite investors when markets are rising, but it is scary when markets are disturbed, as they have been lately. The trick is to figure out when the down volatility is running its course, and that is what seems to be getting harder to do.

To identify one-way days, Mr. Desmond looks at total trading volume for all stocks that finished up and for all stocks that finished down. He also looks at the total price moves, in dollars, for those two groups. The days to watch are those on which 90% of volume was in the same direction, and 90% of price moves were as well.

On the Friday before the 1987 crash, 90% of volume and 90% of price movement were accounted for by declining stocks, according to Mr. Desmond's data. On Monday, Oct. 19, 1987, the crash day, trading was even more heavily centered on decliners. But that was the low point of the selling. On Oct. 21, 90% of stock volume and price movement was up, indicating the worst was over.

Similar days occurred at the bottom of the 1990 bear market. There was only one such day at the 2002 bottom, but several such days hit a few months later, in 2003, when the U.S. invaded Iraq and stocks fell almost to the 2002 low. After that 2003 decline, stocks entered the bull market that has continued until now.

The article has a great chart showing the phenomena

4. Borrowing short and lending long is the sure fire formula for banker's bankruptcy. Unfortunately that's what many of the money center banks have been doing through their off balance sheet Special Investment Vehicles. Mish explores the issue in detail

http://globaleconomicanalysis.blogspot.com/2007/09/duration-mismatch-causing-severe-stress.html

Leverage is a wonderful thing when spreads are moving in your direction. It's now payback time for those who borrowed short and lent long. Short term borrowing costs are rising while the value of long term assets, especially mortgage debt is sinking.

See Duration Mismatch to Bankruptcy (in one week flat) for the saga that caused Sentinel to go bankrupt in short order once their mismatch mattered.

The issue is not whether it's absurd for Lehman or Bear Stearns debt to be trading at a discount to Columbia, the issue is how much leverage Lehman (LEH), Bear Stearns (BSC), Merril Lynch (MER), Goldman Sach (GS), Citigroup (C), Morgan Stanley (MS) are using as well as the timing and size of needed debt rollovers.

It was a huge mistake for corporations to assume they could perpetually roll over short term debt at good prices. If you stop and think about it, many homeowners over leveraged in homes have a similar mismatch problem. Incomes have not risen as expected but short term financing costs have gone through the roof with no way to roll over the debt.

5. Meanwhile Housing continues to be a slow motion car wreck. After CFC announced that is was firing 12,000 employees last week Wamu just chimed in that it will take more than $2 Billion write down on sub-rime loans.

http://www.reuters.com/article/bankingfinancial-SP/idUSN1030940720070910

Washington Mutual Inc said on Monday that most U.S. housing markets are weakening, creating a "near perfect storm" that may force the largest U.S. savings and loan to set aside more money for bad loans.

Chief Executive Kerry Killinger said the thrift may set aside $500 million more for loan losses than the $1.5 billion to $1.7 billion it had forecast in July. Any increase would be Washington Mutual's fourth this year.

Speaking at a Lehman Brothers Inc financial services conference, Killinger said the housing market faces rising delinquencies and foreclosures, higher borrowing costs, tighter underwriting standards and tough capital markets, "creating what we call a near-perfect storm for housing.

"Most housing markets appear to be weakening, to us," Killinger said. "We would not be surprised to see declines in housing prices in many regions of the country ... for the next few quarters." He said corrections in the housing and credit markets will last longer than the thrift expected.

6. The next shoe to drop? LBO financing. Remember investment banks hold more than $400 Billion worth of loans that they guaranteed to private equity shops. The stuff is not moving and today comes news that KKR which has been playing hardball with Wall Street up to now, finally blinked.

http://online.wsj.com/article/SB118946745104023162.html?mod=googlenews_wsj

The truce private-equity giant Kolhberg Kravis Roberts & Co. has reached with its bankers on the financing of First Data Corp. could provide the model for other deals coming to market over the next few weeks.

KKR, known for vowing to hold the line against banks seeking better terms, agreed to make several concessions to bankers, according to people familiar with the matter. But the firm changed the terms largely at the margins. That assured that market attention will remain focused on the $26.4 billion First Data leveraged buyout as the first and most important in a string of coming deals valued at about $400 billion.

First Data "is the canary in the coal mine. If it gets done, then another $350 billion is doable," says the co-head of private equity at one major Wall Street firm. "But if not, then the whole market may plunge, and the rest of the capital markets will react badly."

Sunday night, KKR reached an agreement with its bankers to introduce one covenant, or performance standard, on First Data debt, said the people familiar with the matter. Under the covenant, First Data, a processor of electronic payments, must maintain a certain ratio of earnings before interest payments, depreciation, tax and amortization to its amount of senior debt, these people said. The covenant somewhat reduces risk for investors who buy the debt, though people familiar with the matter say the ratio is modest.

Still, KKR declined to agree to increase fees to the banks to enable them to cut their losses on financing the $24 billion in debt. And more importantly for investors, KKR declined to agree to an increased interest rate on the loans. The concessions were sufficiently toothless, said one banker, to describe them as offering the banks "sleeves on the vest."

7. Despite the woes, someone smells a bargain. UK billionaire Joseph Lewis just took a very significant chunk of Bear Stearns - the epicenter of the sub-prime mess on Wall Street.

http://investing.reuters.co.uk/news/articleinvesting.aspx?type=tnBusinessNews&storyID=2007-09-10T151443Z_01_WNAS3723_RTRIDST_0_BUSINESS-BEARSTEARNS-INVESTOR-DC.XML

Reclusive billionaire Joseph C. Lewis, who made his fortune trading currencies, has taken a 7 percent stake in Bear Stearns Cos Inc (BSC.N: Quote, Profile , Research), snapping up the investment bank's sagging stock to become one of its largest shareholders in less than a month.

Bear Stearns' shares were up 1.5 percent at $107 in early trading on the New York Stock Exchange. Lewis was not available for comment.

Lewis disclosed the stake on Monday in a filing with the U.S. Securities and Exchange Commission. His stock purchases - between August 6 and September 4 -- make him one of Bear Stearns' biggest shareholders, if not the largest.

Lewis owns 8.1 million shares of Bear Stearns, according to the SEC filing. That's more than what any other shareholder reported at the end of June. At that time, Putnam Investment Management was Bear's largest institutional shareholder with 7.03 million, or 6 percent, of Bear's outstanding shares.

Bear Stearns Chairman and Chief Executive Jimmy Cayne owns about 5.8 percent of the company's stock, including restricted stock and incentive-related shares, according to the company's latest proxy statement.

The company was not available for comment.

Bear Stearns' shares are down about 35 percent this year, hammered by the collapse of two hedge funds and its heavy reliance on mortgage-related revenue amid a meltdown in the subprime lending industry.

Born in London, Lewis operates from the Bahamas and Florida. His investments include English Premier League soccer club Tottenham Hotspur, golf course developments in Florida, Alcatraz Brewing Co. and life sciences companies. His investment vehicle, Tavistock Group, holds interests in more than 170 companies in 15 countries.

A New York Times profile of Lewis in 1998 said he was born in 1937 in London's rough-and-tumble East End, the son of a pub owner. The newspaper said he dropped out of school when he was 15, but built his fortune on theme restaurants, currency trading and real estate speculation.

Lewis-controlled entities named Aquarian, Cambria, Darcin, Mandarin and Nivon bought large blocks of Bear Stearns shares in August and September, the SEC filing shows. The last reported purchase was a block of 400,000 shares on September 4.

8. Who is going to buy our debt? Bloomberg worries that China is paring down its position in Treasuries.

http://www.bloomberg.com/apps/news?pid=20602007&sid=a6zQi5wESdK0&refer=rates

Treasury investors basking in the biggest rally in four years have reason to fear for their profits: The largest owners of U.S. government debt are heading for the exit.

Two-year Treasuries returned 1.09 percent in August, the best monthly performance since 2003, according to indexes compiled by Merrill Lynch & Co. At the same time, holdings of U.S. bonds by governments and central banks at the Federal Reserve fell 3.8 percent, the steepest decline since 1992.

The dollar's slump to a 15-year low against six of its most actively traded peers is turning the gains into losses for international bondholders, prompting China, Japan and Taiwan to sell. Overseas investors own more than half of the $4.4 trillion in marketable U.S. government debt outstanding, up from a third in 2001, according to data compiled by the Treasury Department.

``The support that Asia has shown in buying U.S. Treasuries has been a major supporter of keeping long-term interest rates lower than where they probably would be,'' said Gary Pollack, who oversees $12 billion as head of fixed-income trading in New York at the private wealth management unit of Deutsche Bank AG, Germany's biggest bank. ``This could put some upward pressure on yields in the United States.''

U.S. long-term interest rates would be about 90 basis points, or 0.90 percentage point, higher without foreign government and central bank buyers, according to a 2006 study for the Fed by Professors Francis and Veronica Warnock at the University of Virginia in Charlottesville.

9. But Brad Setser thinks that is much ado about nothing, arguing that China basically shifted from Treasuries to Agencies.

http://www.rgemonitor.com/blog/setser/213948/

Over the course of 2007, three things have been happening.

First, some central banks with large existing holdings of Treasuries have been slowly reducing their Treasury holdings – whether by selling into the market or by not rolling over maturing bonds – and adding to their Agency holdings (and perhaps otherwise diversifying as well). Korea and Japan are the obvious examples. If nothing else was going on, that would tend to lower Treasury holdings.

Second, those central banks that are adding to their reserves rapidly have been buying more Agencies and fewer Treasuries – China is the most obvious example (Russia is, strangely enough, buying more Treasuries than in the past … but that isn’t saying much, since it previously held an “all Agency” portfolio)

And third, the overall pace of global reserve growth picked up sharply. In the first two quarters of the year, I suspect it will be about $300b a quarter – a $1.2 trillion pace – though that estimate hinges on the q2 IMF data and some expected revisions to the q1 data.

The result – central banks were buying a lot more of everything, including Treasuries. So their Treasury holdings were going up, just not as fast as their holdings of other assets. In some parts of the Treasury market, there actually aren’t many outstanding bonds left for the central banks to buy.

August though was a bit different. Global reserve growth slowed, particularly in places where global reserve growth reflected large capital inflows. International investors took profits and took money off the table. Money even flowed out of a few markets – Russia most notably.

Absent those inflows, the trend move out of Treasuries and into Agencies looked a bit more prominent. And I suspect that central banks needing liquidity sold their most liquid asset – Treasuries. That is a good thing. Right now the private market wants Treasuries.

But the fall in the Fed’s custodial holdings exceeds Russia’s need for liquidity – and even if you add in a few other countries, my guess is that the fall is a bit bigger than can easily be explained by a slowdown in global reserve growth.

So a few central banks that previously held long-term Treasuries sold – and either bought Agencies or moved into bank deposits.

That could include Japan and Korea. This would be a great time for both to accelerate their long-standing plan to diversify away from Treasuries.

And it also might include various European central banks. Remember, a lot of European banks right now have an enormous need for dollar liquidity (all their conduits) ….

I hadn’t thought of the European angle, but Tony Crescenzi, chief bond market strategist at Miller, Tabak & Co in New York, did. Reuters:

"half of the decrease (in Treasury holdings) relates to the purchases of agency securities. The rest of it may be that central banks are looking to hold dollars, rather than investments because there has been a shortage of dollars in the European banking system."

It makes sense to me.

This is a case where the easy conclusion (central bank Treasury holdings are falling, China must be selling) is not likely to be the right conclusion.

I have long argued that there is a risk that central banks are a potential source of financial instability should they stop adding to their dollar holdings at points in time when the market doesn’t want dollars. That still strikes me as a risk – though not a high probability one. There are a set of countries that hold far more dollars than makes economic or financial sense, and at some point they might decide that they don't want to continue to buy even more.

But all indications suggest that emerging market central bank have been a stabilizing, not a destabilizing, force in the markets over the past month.

10. Finally best trade in Great Depression? Gold. Check out the rise of Homestake Mining while everything else was liquidated for pennies.

http://www.gold-eagle.com/editorials/great_crash.html

Financial assets as reflected by the Dow Jones Industrial Average (DJIA) reached its peak value of 385 in October 1929, marking the beginning of our country's worst bear market. And although the DJIA finally bottomed at 41 in June 1932, the vast majority of stock investors continued to suffer the effects of the languishing bear market during the next three years. By December 1935 the stock market (DJIA) had only recovered to 140 from its 1932 bottom -- still down a whopping 64% from its October 1929 peak.

As might be expected, interest rate sensitive equities were also decimated during the Great Crash of 1929. In September 1929 the Dow Jones Utility Average (DJUA) hit its peak at 145. From late 1929 the DJUA tumbled to its abysmal l o w of only 15 in March 1932 and again in March 1935. The interest rate sensitive utilities had plunged a cardiac arresting 90% from their unrealistic and lofty 1929 highs.

Three years after hitting its nadir, the DJUA was still severely depressed. Imagine: A $10,000 investment in the relatively "safe" utilities in late 1929 was only worth a mere $2,100 on New Year's Eve 1936! This is heart-wrenching financial history...
What Did Smart Money Do In the 1929 Crash and Aftermath?

During the same bear market period smart-money moved from the plunging equity markets (i.e. financial assets) to hard asset investments, like Homestake Mining - which is used heretofore as a surrogate for all gold stocks.

The stock price of this gold mining company soared relentlessly upward during the entire bear market. Homestake Mining stock rose continuously from $80 in October 1929 to $495 per share in December 1935 - which represents a total return of 519% (excluding cash dividends) during the devastating bear market period.

Contemplate and appreciate the monumental difference in investment returns during a serious bear market. Smart-money invested $10,000 in Homestake Mining (hard assets) in late 1929 - which increased in value to almost $62,000 by December 1935. This represents a compound rate of return of 35% per year in appreciation alone!

It is meaningful to note that in late 1929 the value of Homestake Mining was about $80 per share. Moreover, during the next six years Homestake Mining paid out a total of $128 in cash dividends. In fact the 1935 dividend alone reached $56 per share. That's almost a 70% dividend yield payout (basis 1929) in only one year! Indeed, hard asset investments (gold mining shares) were islands of economic refuge during the grueling years of the Great Depression.