We spent the morning musing on the Maginot Line. The French built this elaborate line of fortifications along its border with Germany in the 1930s to thwart an invasion by its Great War enemy. When Germany invaded France in May 1940, Adolf Hitler’s armies simply bypassed the line and invaded France through neighbouring Belgium. The Maginot Line proved to be an elaborate dud.

As Nassim Taleb points out in his book The Black Swan: The Impact of the Highly Improbable:

The story of the Maginot Line shows how we are conditioned to be specific. The French, after the Great War, build a wall along the previous German invasion route to prevent reinvasion – Hitler just (almost) effortlessly went around it. The French had been excellent students of history; they just learned with too much precision. They were too practical and exceedingly focused for their own safety.

What does this have to do with investing? It’s a fair question. To our humble minds, the story of the Maginot Line illustrates that we humans tend to base our vision of the future on past events and have trouble imagining a future radically different from what has happened before. We are, if you like, sitting ducks: we build our defensive walls and then guard them jealously only to be blindsided at the crucial moment.

One of our central aims in Notes is to imagine futures unpalatable to the mainstream – futures that often seem impossible because of their lack of precedent in the past. It’s niche work. Most people don’t have the time or the inclination to wonder about what will come next. But to be a successful investor, you must first peer into distance and imagine the world that’s coming.

Today, we offer up a vision of a diminished America – an America weakened by decades of living beyond its means and almost entirely reliant on its foreign creditors. Some might say this future has already arrived. But here at Notes, we believe the country has further to fall. We’re short, if you like, on US hegemony.

Bond king Bill Gross is also concerned. He calls this diminished America “the new normal.”

Gross is better qualified than most to prognosticate on America’s fate. He runs the world’s biggest bond fund. So it’s his job to know where the US economy is heading. He’s also an honorary underground investor: he puts his money where his mouth is and he doesn’t pander to mainstream opinion.

In his latest monthly missive, Gross argues that the tipping point for the end of US economic dominance is easy to spot and is a matter of simple mathematics.

Private sector deleveraging, reregulation and reduced consumption all argue for a real growth rate in the US that requires a government checkbook for years to come just to keep its head above the 1% required to stabilize unemployment. Five more years of those 10% of GDP deficits will quickly raise America’s debt to GDP level to over 100%, a level that the rating services – and more importantly the markets – recognize as a point of no return. At 100% debt to GDP, the interest on the debt might amount to 5% or 6% of annual output alone, and it quickly compounds as the interest upon interest becomes as heavy as those “sixteen tons” in Tennessee Ernie Ford’s famous song of a West Virginia coal miner. “You load sixteen tons and whattaya get? Another day older and deeper in debt.” Pretty soon you need 17, 18, 19 tons just to stay even and that describes the potential fate of the United States as the deficits string out into the Obama and other future Administrations.

It’s a slow motion car crash, dear reader, and all we can do is sit and gawp. As Gross also points out, the US is already producing less wealth in proportion to the rest of the world. And less of its citizens are getting into the Forbes rich list as a result.

This does not come at a good time. America’s ability to borrow cheaply is dependent on its debt-to-GDP ratio, which at 13% is already at highs not seen since World War II. One way of improving this ratio is to grow GDP. But as Gross points out, this is becoming more and more difficult thanks to “private sector deleveraging, reregulation and reduced consumption.”  And all of this does not begin to take into account what Gross describes as the “pig in the python” demographic squeeze on resources on the way.

Private think tanks such as The Blackstone Group and even studies by government agencies, such as the Congressional Budget Office, promise that Federal spending for Social Security, Medicare, and Medicaid will collectively increase by 6% of GDP over the next 20 years, leading to even larger deficits unless taxes are increased proportionately. Collectively these three programs represent an approximate $40 trillion liability that will have to be paid. If not, you can add that present value figure to the current $10 trillion deficit and reach a 300% of GDP figure – a number that resembles Latin American economies such as Argentina and Brazil over the past century.

What Gross understands better than most is that we do not live in a world without consequences. This is the beauty of the bond markets: they provide (welcome) limits to the “something for nothing” culture that has gripped the US for far too long.

The big question, of course, and the one Team Obama would like to dodge for as long as humanly possible, is who is going to buy America’s tsunami of debt?

Broadly speaking, the problem is twofold. On the supply side, the US Treasury is set to issue roughly four times last year’s amount of bonds – an estimated gross issuance of $3 trillion. On the demand side, America can no longer rely on the current account/trade deficit to fund borrowings. As Gross points out, with this figure down to about $500 billion this year, China and other surplus nations simply won’t have the spare cash to fund Washington’s spending requirements.

There are only two possible outcomes to this supply-demand dislocation. The first is that the yield curve steepens. As we argued in yesterday’s Notes, there is enormous pressure right now on long-dated US Treasury yields. Yields are rising fast. And if this trend continues unabated, any “green shoots” will be choked off by the weeds of rising mortgage rates and corporate rates.

The second possible outcome is that the Fed steps into the breach and continues to buy back US Treasurys. This is horribly inflationary, as the money the Fed uses to pay for US debt is of the freshly printed variety. The Chinese are already getting nervous at the swelling of the Fed’s balance sheet. Should this trend continue private and sovereign holders of dollar-denominated debt will increasingly look to diversify out of their dollar assets, selling US Treasurys in the process.

The picture is a grim one. But the illusion of something for nothing is strong, and Team Obama shows no signs of quailing in front of this precipitous debt pile.

We read with horror in USA Today that one in six dollars of Americans’ income comes in the form of a federal or state check or voucher. This is the highest level of state-funded personal income since records began in 1929.

“In all,” reports the paper, “government spending on benefits will top $2 trillion in 2009 — an average of $17,000 provided to each US household, federal data show. Benefits rose at a 19% annual rate in the first quarter compared to the last three months of 2008.”

We don’t expect a return to balanced budgets anytime soon.

What other ways are there to hold on to your wealth in this “new normal”? It’s another fair question, and one that has been preoccupying us here at Notes for some time.

According to Gross, “staying rich in this future world will require strategies that reflect this altered vision of global economic growth and delevered financial markets.” Here’s what he advises:

Bond investors should therefore confine maturities to the front end of yield curves where continuing low yields and downside price protection is more probable. Holders of dollars should diversify their own baskets before central banks and sovereign wealth funds ultimately do the same. All investors should expect considerably lower rates of return than what they grew accustomed to only a few years ago. ]]> http://www.contrarianprofits.com/articles/bong-king-gross-says-ditch-the-dollar-before-its-too-late/17569/feed 0 http://www.contrarianprofits.com/articles/its-all-about-the-stress-tests/16356 http://www.contrarianprofits.com/articles/its-all-about-the-stress-tests/16356#comments Thu, 07 May 2009 14:54:39 +0000 Chuck Butler http://www.contrarianprofits.com/?p=16356 Tired of reacting to rumors!  Aussie dollar continues to rally…  More on China…  Bank of England keeps rates unchanged… And Now… Today’s Pfennig!
Well… The Stress Tests get their public showing today… The rumors continue to be something strange… Strange in that, one it’s Bank of America (BOA) needing to raise $10 Billion, the next day it’s $35 Billion, and then later in the same day, BOA doesn’t need to raise any capital! Talk about wild swings of emotion! WOW!

The rumor going around this morning, is that the banks are all right on the night, and not in major deep dookie any longer. Hmmmm… Didn’t I tell you over a week ago that this was going to be the case? I…

To refresh your memory, the rumor dated back nearly a year.  During a secret session of Congress, members were supposedly briefed on plans for “the imminent collapse of the U.S. economy to occur by September 2008”… followed by “the imminent collapse of US federal government finances by February 2009″… followed by the introduction of the Amero and roundups of dissidents to be hauled off to camps built by the former Halliburton subsidiary KBR.

What made the rumor so spooky, of course, were the events of September last year — Fannie and Freddie nationalized (although its debts weren’t taken onto government books, go figure), Lehman collapsing, Merrill Lynch’s shotgun marriage, WaMu seized, Wachovia, AIG… as I said last month, maybe not outright collapse, but close enough.

But it’s hard to say “U.S. government finances” collapsed last month.  Yes, we now have a record-high proposed federal budget with a record-high deficit to match.  But none of the possible catalysts I wrote about took place: Commercial real estate is in horrible shape, but nothing that’s triggered a big crisis.  The Treasury auctions went about as well as could be reasonably expected.  U.S. Treasury debt is still rated AAA.

That’s the good news.  The bad news is that all the Black Swans that could have shown up in February and didn’t could well show up during March.  Because the driving forces behind fading market and consumer confidence are all still there — starting with indecision and repeated acts of insanity from the White House and Treasury stunningly similar to that of the previous administration.

I mean, how many more bailouts is AIG going to need?  “Had the government not taken such action, AIG would have had its credit ratings cut by major agencies,” reports Marketwatch, “and that would have triggered the need for the firm to post collateral it did not have.”

Collateral it doesn’t have — isn’t that sort of the whole problem everybody’s got?  So there are the Fed and Treasury essentially telling us, “Yes, we know the last bailout didn’t really do the trick, but take our word for it, this one will.”  It’s like Bullwinkle forever trying to pull the rabbit out of his hat — “This time for sure!”

At some point, he’ll pull out a Black Swan.  Then it’ll get really interesting.

Source:You Survived Black Swan Month

This from Andrew:

Two weeks ago I sold the Virginia-based utility company Dominion Resources (D).  I got out at a double-digit profit.

Of all the utilities in the S&P 500, Dominion had the best earnings growth (38.5%) last quarter. So why did I get rid of the stock?

When I recommended it in mid-2005, electricity consumption was still rising and regulated rates were providing cover for rising energy costs. Dominion also had productive gas fields in Texas and expanding Liquified Natural Gas (LNG) ports.

But now the sector is heading in the wrong direction.

In the last week alone the utility sector lost 8.2 percent. Only the financial, conglomerates and industrial goods sectors have done worse – recording bigger losses over the past week and last three months.

I got out just in time. Since I exited my position in Dominion, it has lost 9.1 percent. But as you can see, Dominion has lots of company…

As recently as last quarter, utilities were holding up fine. Their profits had risen an average of 5.3 percent (unweighted) and 0.9 percent (weighted). Along with health care and consumer staples, utilities formed a strong line of defense against the encroaching recession.

So what the heck happened?

Listen, utilities have certain advantages, like fixed prices, monopoly-like markets, and a consistent revenue stream.

But that revenue stream has sprung a few leaks. Listen to CEO Lewis Hay of Florida Power & Light (FPL)…

“A lot of people think demand for electricity is inelastic. It’s not. Our customers are cutting back, and they’re not paying their bills, either.”

I wrote to my readers last week that “I’m not quite ready to put utilities in the same category as banks…”

But utilities are sounding more and more like banks. Here’s another utility CEO, Michael Morris of American Electric Power (AEP), sounding off…

“Clearly, industrial sales will be off,” he said, “we’re selling less electricity to neighboring utilities as their needs drop.”

The recession has finally caught up to the utilities. As a result, utilities are husbanding their cash along with all the other companies…

APE is cutting back spending from $2.5 billion to $1.25 billion. FPL is and Georgia Power is also cutting back.

And in the strongest sign yet that the utility sector is no refuge for investors, two utilities cut their dividend last week: Ameren (AEE) and Constellation Energy (CEG).

Investors made a lot of money shorting banks. I’m not ready to put utilities in the same camp as the banking sector, but the weaker companies in the utility sector definitely represent shorting opportunities. My Red Flag portfolio used to be full of banks and financials. My bets that their shares would sink made mostly triple-digit gains.

Last week I added a couple of utilities to the portfolio. The utility sector is catching up to the rest of the economy – and not in a good way.

Source: Why Utilities Are No Longer a Refuge for Safe Investors

It’s not where they make the big decisions, and as such the gathering is little more than an excuse for sandalistas to show up and protest.

But it was hard to avoid the media coverage this year, given the hoopla over how “the world had changed” since the last gathering.  Still, there was absolutely nothing interesting or revealing about this year’s model, save perhaps for the fact that fewer bankers showed up.

Except… an enterprising reporter for Italy’s Corriere della Sera newspaper made the most of his assignment at Davos.  Federico Fubini surveyed “60 top central bankers, financial market regulators, fund managers, and industry opinion-makers.”

He first asked whether they themselves “might have contributed, even in a minor way, to the financial crisis.”  The result:

• No — 63.5%
• Yes — 31.5%
• Not sure — 5%

“How strange,” quipped Carlyle Group chief David Rubinstein to Fubini. “I thought 100 percent of them would say they had nothing to do with it.”

Fubini then asked those who said “yes” what lay behind their hare-brained decisions.  It broke down as follows.

• “Too much optimism” — 68.7%
• “I felt I had to keep dancing while the music was playing” — 31.3%
• Greed — 0%

So let’s sum up:  Less than a third of the central bankers and other assembled world-improvers (as Bill Bonner calls them) felt they were culpable, and among them, less than a third had a grip on reality.

That’s less than 10% of the total.

I guess I shouldn’t be surprised.  World improvers fall along a bell curve just like everyone else.

Fubini wraps up his dispatch with an account of a talk given by The Black Swan author Nassim Nicholas Taleb.

The participants enjoyed his talk, which was brilliant and provocative as usual, but as he spoke, one couldn’t help wondering if what they were actually enjoying was the simplistic comfort that Taleb’s message could provide.

The audience seemed to enjoy the idea that the current crisis is a “Black Swan,” a very unlikely, though possible, event. The alternative view is that of a train driven full speed into a wall. Thinking that way requires one to ask who was in the driver’s seat, and just maybe recognizing one’s own fingerprints on the wheel.

In other words, they think they got a bad break: Their mathematical constructs told them that something like the September meltdown could happen only once every 500 years, and they just had the misfortune of it happening on their watch.  The models in their minds are still valid.

But as we saw last week, Black Swan potential still abounds, even if the record-setting Treasury auction this week has so far passed uneventfully.

Source: Clueless in Davos

“Today might be the day that marks the beginning of a legitimate U.S. dollar correction,” wrote Jack Crooks, president of Black Swan Capital.

“We’ve been open to this potential for the last several weeks, as we think a lasting correction is due before the U.S. dollar can start on its next powerful leg of what we are expecting could be a multi-year bull market,” Crooks said.

With the election finally over, many analysts are saying the result isn’t likely to be a major driver for currency markets.

“Implied volatility has continued to fall, suggesting the euro could move higher in coming days with market participants likely to look past today’s U.S. presidential elections toward what could be horrendous jobs numbers on Friday,” wrote currency strategists at Brown Brothers Harriman.

The euro surged despite near-universal expectations that the European Central Bank will cut interest rates on Thursday. Also predicted for Thursday is a cut in British rates, but the pound rallied anyway, as well.

Source: Dollar is Hammered