What’s an investor to do in markets like these?

By Frank Holmes

Legendary businessman Steve Forbes once said, “Everyone is a disciplined, long-term investor until the market goes down.” It’s challenging to have the fortitude to hold on to investments during a one-day carnage event like last Thursday. Everywhere you looked there was red on the screen, as U.S. stocks lost 2.5%, commodity equities lost 3% and gold declined 5%. Gold stocks took one of the biggest blows, falling about 7.5%.

So what should an investor do after a day like Thursday? Stay calm and invest on, as I believe there is opportunity in picking up what the bears left behind. Here are a few ideas to ponder.

Gold

Gold fell below $1,300 on Thursday, and based on our oscillator data, the yellow metal is now in extremely oversold territory. On an annual basis, bullion is down 2.6 standard deviations, which is the worst reading over the past 10 years.

This is the opposite reading that gold buyers had in the summer of 2011, when it was up two standard deviations, or at the $1,900 level.

Last week, before this market event occurred, I said that gold could fall another 10%, but that there could be a 30% upside over the next 18 months. You can see the upside potential in the chart, as gold appears due for a reversal toward the mean.

However, short-term financial gold traders may be discouraged from acting on this bullish sign, as the yellow metal is now even more expensive to trade. After last Thursday’s huge sell-off, the CME Group, the largest operator of futures exchanges in the U.S., decided to raise margin requirements on gold. As of the close of trading on June 21, the minimum cash deposit for gold futures will increase 25% to $8,800 per 100-ounce contract.

This is the second increase in only three months. In April, the CME raised the initial gold margin requirement, which is what triggered the short-term liquidation out of financial gold ETFs and futures.

This isn’t a typical move for the CME. Usually, the firm raises margins when prices are rising rapidly to cool down speculation or lowers margin requirements in an attempt to boost liquidity.

In contrast, cash buying of gold is increasing, and this is good news for two reasons: 1) Retail gold investors are not leveraged like futures gold trader, and 2) their buying tends to be stickier.

As we have always suggested, it is prudent to have a 5% to 10% exposure and to view gold as a long-term investment. It’s important to rebalance annually or when the oscillator shows that gold has moved two standard deviations.

Weakness in ETFs Highlights Strength in Mutual Funds

Buyers of ETFs beware, as last Thursday’s selling exposed a fundamental weakness in the structure of the exchange traded fund. Unlike a mutual fund, which allows the investor to buy or sell at the daily net asset value, ETFs can trade at a premium or discount to their net asset value (NAV). At any point in time, an investor can overpay for an asset (i.e. premium) or receive less than the asset is worth (i.e. discount).

These premiums and discounts can be tremendous on days with big NAV changes, as investors realized Thursday. The chart below shows the NAV trading premiums and discounts for the MSCI Emerging Markets Index ETF (EEM) over the past year. As you can see, the ETF often experienced significant premiums and discounts in this time frame; however, the discount was never as severe as it was last Thursday. As panic selling set in last week, the discount grew to be as much as 2.56%. Simply stated, “at the very moment of maximum selling, the ETF exacts the maximum trading cost from the seller (and rewards the buyer similarly, with a discount),” says Brendan Conway from Barron’s.

He explained the difference in the pricing of the MSCI Emerging Markets Index compared to the underlying ETF. Using data from Morningstar, he writes:

“iShares fund enters Friday’s trading session with a closing Thursday market price of $36.88. But the NAV is $37.85. It’s about a full dollar higher. View it in total-return percentage terms: EEM’s market price was down by 16.4% as of Thursday’s close. But the NAV had only lost 13.2%.”

Conway’s contrarian lesson for ETF investors: “Don’t sell into a panic. ETFs are built to penalize lemmings and reward contrarians.”

When it comes to investing, I believe there is no such thing as a free lunch. ETFs have relatively low expense ratios compared with actively managed funds in the same sectors, but that doesn’t mean that in the end an ETF costs less to own or that an ETF generates better returns. On volatile days such as last week on Thursday, ETFs can be expensive to trade.

Case Study on a Chemicals Company

Instead of seeking the short-term trade, we prefer to actively look for solid companies that we believe will outperform over a longer period of time. One such promising opportunity currently held in the All American Equity (GBTFX) and Global Resources Funds (PSPFX) is materials company, LyondellBasell (LYB).

Lyondell is one of the world’s largest plastics, chemicals and fuels companies, pays a dividend and just announced that it intends to repurchase up to 10% of its outstanding shares over a 12-month period. A “combination of organic cash generation and financial flexibility” could be potentially profitable for its shareholders, as over the next two years, returning “cash to holders of more than 30% of Lyondell’s equity market capitalization,” says Bank of America Merrill Lynch (BofA-ML).

The company is poised to benefit from a recent trend that’s been developing in the chemicals sector. In a recent report, BofA-ML reported that ethane will likely be oversupplied for the next three years. This is causing ethane to “trade near ‘floor’ prices as determined by the value of natural gas over this period.” With natural gas currently sitting below $4 per million British Thermal unit (MMBtu), ethane will likely average less than $0.30 per gallon.

Ethane is the raw material that’s used in the petrochemical industry, and cheap ethane translates to significantly increased profit margins for U.S. chemical companies, including LyondellBasell.

You can see in the chart below that U.S. chemical companies have much higher profit margins compared to their global peers, with profit margins around $0.50 per pound. This compares favorably to the chemical companies in Europe and Northeast Asia, which have current margins at $0.20 and $0.05 per pound, respectively. These companies use what’s called polyethylene naphtha, which is polyethylene made from the raw material, naphtha. Naphtha is oil-based, and because oil is much more expensive to natural gas, ethane is a cheaper feedstock.

This is just one example of opportunities you can find in today’s market if you keep calm and carry on.

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Revisiting the Muni Market

by Greg Harmon

Back in late March I thought the Muni market was setting up for a pullback in Muni’s Have Had It….This Time For Real. It took its time to correct but did touch the 104.30 target, on the way to Monday’s low at 100.28. Quite a bit further than the expectation. With a more than parabolic fall, a Baumgartner fall, it is looking like the time to buy the bloody crash. Here are 6 reasons why in the daily chart. The Relative Strength Index (RSI) is under 13. It has been this low only 1 time before, just before the start of the run higher in December 2010. The Moving Average Convergence Divergence indicator (MACD) is at

historic lows. Both of these may go lower but I have an idea for that. Next The price is more than 10% from its 50 day Simple Moving Average (SMA). It is also far outside of the lower Bollinger band. The volume is also spiking. Finally the Spinning Top candle shows indecision, often a reversal signal. If you need more convincing the RSI on the weekly chart is also in the teens and at all time lows as the price sits on the 200 week SMA with the MACD at extremes as well. You may notice that the previous low in the RSI did not mark the bottom but was very close. If this is a concern then you can start your position by selling the July 99 Puts for the first 1/3 of your position. These were offered at about $2.05 when I traded them at 2:00pm Monday.

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Shape of the yield curve adjustment impacted by bond buying pattern

by SoberLook

Here is how the treasury curve shifted over the past two months (through today).

The obvious question is why has the sell-off been most acute in the 7-10yr range (the 7-year yield has increased by 90bp)? And why have the bonds in the 20-year range been a bit more stable. The answer has to do with the Fed's buying patterns.

Source: NY Fed

Maturities where the Fed has been most active are the ones which are more vulnerable to this correction. Those are the bonds whose prices the Fed has been supporting (aside from treasury bills that are now used as safe-haven). As the support diminishes, the bond pricing adjusts to post-QE levels. (Note that the bucketing used by the Fed doesn't match the bond maturities in the first chart precisely and the pattern is obviously not exact - yet the relationship is still visible). This tells us that a great deal of the fixed income pricing to date has been determined by the monetary expansion rather than the fundamentals of the markets.

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Financialization = Inequality

by Charles Hugh Smith

Financialization is the disease eating away the heart of the economy and what's left of democracy.

There are a number of factors behind the widening canyon of economic inequality, but the primary driver is financialization. Financialization has given those with capital and access to financier expertise ways to skim great wealth from the system without creating any value whatsoever.

Those with a home that is owned free and clear and $500,000+ in a 401K or retirement account have more capital than the vast majority of Americans, but members of the upper-middle class have no access to the leverage and tools of financialization.

In other words, financialization isn't a consequence of having capital: it's the consequence of having access to unlimited credit, leverage and low-risk, low-tax skimming operations (for example, tax codes enable hedge funds to declare income as low-tax long-term capital gains).

From the financier point of view, the upper-middle class tax donkeys who keep all their investment capital in mutual funds are the marks who supply liquidity to the system. The wealthy who park money in hedge funds are marks of a higher order, as their cash enables fund managers to gamble with other people's money and then return a thin slice of the gains (if any, after fees) back to the investors.

A carry trade is a classic skimming operation. The term is based on the difference between the costs of holding (carrying) one position and the gains earned by investing the proceeds elsewhere.

A typical example has been borrowing money for near-zero interest in Japan (yen) and using the proceeds to buy higher yielding Treasury bonds in the U.S. Here is Dan Norcini's description:

To define this term, "carry trade", for those who are a bit newer to the markets, it consists of borrowing large amounts of Yen for extremely low costs due to the miniscule short term interest rate in that nation, and taking those proceeds, exchanging it into different currencies and then using that money to make investments elsewhere where higher yields may be obtained. If that is not risky enough, most of these hedge funds then leverage their speculative bets in the hopes of compounding their gains.

There is a risk to currency carry trades: if the currency you borrow appreciates, then the trade blows up as the exchange rate loss exceeds your interest rate gain. The yen carry trade expanded to an estimated $1 trillion because the dollar/yen exchange rates were relatively stable.

The sweetest carry trades occur when two currencies are officially pegged but there is a big difference in interest rates between the two currencies. The lack of volatility in the exchange rate lowers the risk of this trade to near-zero--until the peg blows up.

You Don’t Really Understand the Carry Trade, Do You? (Yahoo Finance)

Would you like to leverage a carry trade 10 to 1? Hmm, who will loan you $1,000,000 based on $100,000 collateral? That's a key feature of financialization: the real power--leverage and access to global markets--is not available to you. The skimming operations are only open to the financier class.

Leveraging phantom collateral is another feature of financialization. Commoners were allowed a taste of this when subprime lenders were offering no-document, no-down payment mortgages back in 2004-2007. Phantom income was posted as collateral for the nothing-but-leverage loan.

The same sort of trade appears to be occurring in China, where a warehouse of copper is pledged as collateral for a legitimate bank loan at a rate of 4.5%. The proceeds are then loaned out at 10% (or higher) in the shadow banking sector of informal, unregulated credit.

What's to keep several people from pledging the same warehouse of copper? Nothing.

The carry trade blows up when the shadow-banking borrower defaults. Globally, the shadow banking system has ballooned to almost unimaginable proportions as financiers have sought out skimming operations:

Leverage and high-finance skim operations do not require much capital. It takes essentially no capital to originate a derivative; just craft the thing to protect your interests and sell it to some money manager as a valuable hedge.

If you have the right position and tools, it doesn't even require collateral to access gargantuan trading lines of credit.

The point is financialization is about leverage and skimming the existing system for immense profits. It's not about hedging legitimate industries' risks or investing in productive enterprises; it's all about skimming wealth while providing no value to the real economy or society.

The hidden toxin in financialization is the resulting concentration of wealth can buy concentrations of political power. Financialization is thus self-perpetuating: once the skimming operations generate billions of dollars in profit, it only takes a relatively small piece of these profits to buy/influence the political class. Once the politicos are in your pocket, the regulators and judiciary fall into line or are marginalized by new statutes or gutted budgets.

When Congress dared to question hedge funds' primary tax break (declaring income as long-term capital gains), the industry went apoplectic and declared capitalism, Mom and apple pie were all at grave risk if their skimming operations were taxed at the same rate you and I pay on our income.

Financialization is the disease eating away the heart of the economy and what's left of democracy.

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Good explanation for tight interbank liquidity conditions in China - finally

by SoberLook

Someone sent us a quote from JPMorgan that finally explains the origins of the tight interbank liquidity conditions in China. It's roughly what analysts have been suggesting.

JPMorgan: - ... there is an additional reason for the tight liquidity, in the form of a crackdown on illegal bond trading by regulators. In recent years, wealth management products (WMP) have become an important channel for Chinese banks to attract deposits. Most wealth management products are short-maturity (65% are below 3 months, and 20% range from 3-6 months). The maturity dates of such products are usually at the quarter-end, to meet regulatory requirements on loan-to-deposit ratios. Due to competition in providing high returns for WMP, banks were forced to buy high-yielding bonds with 1-5-year maturities to serve as underlying of the WMP. Examples of such bonds are lowly rated credit papers with poor liquidity, or non-standard securities such as discounted bills and bank loans. This resulted in a term mismatch between the maturity of WMP and their underlying asset. To avoid any squeeze from this mismatch upon maturity of the WMP, small banks started to engage in a kind of sale-and-buyback operation of the underlying bonds, consisting of two steps. In step 1, bonds were sold before quarter-end in a “fake” sale to a friendly counterparty, with the aim to obtain cash to pay back the maturing WMP. In a second phase of the trade, the bond was then bought back using cash from new WMP issues. But in May the regulator banned this practice, as part of a general clampdown of the abuses in the WPM market. Part of the interest rate squeeze we are observing today is due to the difficulty in liquidating the (illiquid) underlying bonds before the maturity date of WMP at June-end. The demand for cash has therefore risen significantly, at least from the small banks. Note that China’s larger banks do not have problems accessing liquidity, but that primarily the small banks are suffering.

As discussed earlier, it is clear that the PBoC does not have a good handle on banks' risk-based capital and the smaller banks in China have been playing the game of regulatory capital arbitrage. This is similar to US banks using off-balance-sheet vehicles funded with commercial paper to "convert" long-dated illiquid assets into short term (less than 365 days) exposure.

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Calmer Markets, but Precariously So

Marc to Market

A number of factors have helped stabilize the capital markets today. A partial recovery of US equities helped, though it took a nearly full recovery of the Shanghai Composite from an initial 5.5%+ decline to help lift the European markets. The recovery of US Treasuries yesterday and follow through today have help global bond markets recouped some of their recent losses. The US dollar for its part is steady to softer against the major currencies, while most of the free traded emerging market currencies are broadly higher.

The main impetus for the calmer markets is two-fold. First is simply technical. The sharp downside momentum in bonds and stocks seen from the second half of last week had appeared to exhaust itself. This forced short-term participants, especially momentum players, to pullback and even take some profits. Second, comments by officials, first in the US and then in China, also helped ease investor anxiety.

In the US, comments by Fed's Fisher and Kocherlakota (both non-voting members of the FOMC) reiterated that US monetary policy will remain easy even if there are long-term asset purchases. The useful reminder was not lost on the investors: the Fed is not close to tightening. What will be under consideration in a couple of months is whether the Fed should reduce the pace of easing.

Again, we are struck by the divergence of Fed and market views on the issue of the transmission mechanism of QE. Many in the market continue to see the purchases themselves as the key to the easing of monetary conditions. The Fed takes in Treasuries and MBS and credits dealers with reserves. Yet these reserves sit largely idle. The Fed has consistently argued that the real transmission lies with holding the "risk-free" assets off the market. 

There are at least nine Fed officials who are speaking between now and the end of the week.  Although the speeches do not seem particularly coordinated, we expect the underlying message to be largely the same:  the Fed may slow its easing efforts, as the downside risks have eased, but there is no intention to tighten policy any time soon.  

US economic data slated for release today will likely provide more points for the Fed's assessment that downside risks have eased..  Durable goods orders are likely to post back-to-back monthly increases for the first time since last Sept-Oct.   CaseShiller house price index is expected to have risen 1.2% in April, which is slightly above 3, 6, and 12 month pace.  Rising house prices have lifted some 1.7 mln households (according to CoreLogic) out of the negative equity position, they were in a year ago.  New home sales also are expected to have ticked up.    Meanwhile, keep in mind that core PCE deflator, due out tomorrow, is expected to show this important (for the Fed) measure of price pressures remain near record lows. 

In China, the cash crunch appeared to ease.  The overnight repo rate slipped almost 50 bp to 6% today (at the fix), which is half the rate seen at last week's peak, but it is still twice the average for the year.    The Deputy Director of the PBOC's Shanghai branch had some reassuring words for the market, suggesting that the central bank has the resources and will to keep money market rates at "reasonable" levels and suggested that the seasonal forces (apparently a reference to the quarter end settlement of various wealth management products that have been used to enhance returns available on deposits that involve in some ways a carry trade of sorts). 

In the foreign exchange market, the  euro briefly traded through yesterday's highs in late Asia, but European dealers initially sold into the up ticks that extended to $1.3150.   Short-term technical factors suggest the North American session will try it again.  Sterling has been in less than half a cent range today around yesterday's highs scored late in the day.  Support is seen near $1.5400-20 and provided it holds, a new marginal high seems likely..  Perhaps it the Scandis that best illustrate the corrective forces at work today.   They were among the hardest hit yesterday and are leading the recovery today with the Swedish krona up 1% and the Norwegian krone up 0.7% (near midday in London). 

Yesterday, we noted how the dollar was stopped against the yen at the 50% retracement of the losses it had suffered from May 22 through June 13.  The pullback began yesterday carried it to JPY97 in the European session before finding a bid.   Near-term consolidation that could extent back toward JPY97.70 today seems likely. 

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