Weekly Strategic Plan 10082012

Liquidity Cycle
The stock market came into the week having corrected the overbought condition created by the surge higher immediately following the QEfinity announcement in mid -September. The prices advanced all week fueled by optimism that OMT in Europe might be coming soon and by Draghis remarks that the ECB was prepared to buy bonds and support any country that requested conditional aid. The implication being that there is agreement in place by all necessary parties even if unofficial. Friday The unemployment rate fell sharply in the US fueling a sharp rally in the morning. The latter part of Friday markets gave back the early gains, falling enough to make trade at the start of this new week worth watching. The upside trend must still be given the benefit of the doubt given the central banks stated intention of providing ample liquidity almost for free for the forseeable future. Dont fight the Fed is an old aphorism on Wall Street. But longer term remember the Fed is not looking out for you. The Fed is owned and works for the banking system. Easy money is always eventually paid for by the middle class until the middle class fails and the financial system collapses.

The Liquidity Cycle Indicator pull back was more definitive during the consolidation of the Index but it began to regain momentum this week too. Allocators are adding risk on assets but seem quick to back away on poor news. Conviction is low. Actual OMT spending in Europe, more aggressive ease in China and further BOJ action are needed to keep money flowing on hopes for better global growth. The US economy has been performing better than Europe or China none are strong. If growth prospects do look to be improving values in Europe and some of the Asian markets are more attractive and should begin to catch up to the US. All three major US indices sold off Friday afternoon.
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icmWEEKLY STRATEGIC PLAN
Sentiment at least by this measure is rather neutral as the consolidation since FOMC has worked off the overbought conditions. Small investors represented by the AAII bullish sentiment have been reluctant to follow the equity index higher so far. Should the public become more optimistic, there is buying power available to power further gains.
The Bespoke Economic Diffusion Indicator has been performing better since late 2011 and is now climbing to the top of its historical ranges. After an extended upside run optimistic expectations raise analyst estimates and the diffusion indicator begins to disappoint and lose momentum which in turn weakens enthusiasm among the bulls. The interactive chart from FinViz.com is linked to its source but even a glance at the 5 day performance clearly shows mostly green as equities advanced for the week. The late Friday move down did leave some red and those are found mostly in the technology and energy sectors, which have been leaders on important rallies.
This next chart compares the yield curves of Spain, Italy, France and Germany and the spreads between Germany and the others in the bottom half.
Fixed Income: Fixed Income prices are still near al time highs as a result of central bank reaffirmation that ZIRP will be maintained till early 2015
and direct purchases in markets will continue for an open ended period conditional upon evidence of more robust and sustained economic strength and much lower unemployment. The longer term instruments are trying to price in the likelihood and level of higher inflation if central bank policies work.
Italy and Spain must pay increasingly heavier penalties in yield at the short end until reaching premiums of 300 and 400 basis points over Germany around 5 years leveling off after that. France on the other hand has little extra premium to Germany at present. The prospects for downgrade of French credit and deterioration of French finances make it worth considering a long German short French credit spread in the 3-year duration. I so not have this trade on but I am going to look for a way to take advantage of the setup.
Volatility Environment
Equity Index Volatility

Index implied levels are all in the low end of range which historically has been a marker of complacency about risk. Central bank assurances of easy money indefinitely have apparently reduced the demand for put protection. I personally am somewhat less confident of central banker abilities or intentions.
The following has the implied/realized table and the skew table for the indices. The implied to realized vols are pretty similar and skews are generally in the low end of their ranges sending much the same message of complacency as the implied vols.
Implied/Realized and Skew table
Commodity and Energy Vols
Currency 3 month implied vols
Foreign Exchange
5 day returns versus the dollar last week
Implied to Realized and Skew tables on next page.
Commitments of Traders Charts from 4 Cast show the big decline in the number of Euro short positions. Longs in Aussie and Canadian Dollar are still strong. USD
EURO
Aussie
Canada
Articles and Commentary

I am going to make this short today (as well as late) because I am out of town and so I will use links rather than more complete text.
These three highly compelling studies are: Debt Overhangs: Past and Present, by Carmen M. Reinhart, Vincent R. Reinhart, and Kenneth S. Rogoff, National Bureau of Economic Research, Working Paper 18015, April 2012; Government Size and Growth: A Survey and Interpretation of the Evidence, by Andreas Bergh and Magnus Henrekson, IFN Working Paper No. 858, April 2011; Page 2 Quarterly Review and Outlook Second Quarter 2012 The Impact of High and Growing Government Debt on Economic Growth An Empirical Investigation for the Euro Area, by Cristina Checherita and Philipp Rother, European Central Bank, Working Paper Series 1237, August 2010. These papers reflect serious research by worldclass economists from the US, Europe, and Sweden and they all confirm the detrimental consequences of extreme governmental indebtedness. Misery on the Rise Again In the past year, Okuns impartial arbiter averaged 10.5%, the highest on record for the third year of an officially recognized economic recovery and almost double the average of the 1950s. The latest readings have occurred despite US gross public debt in excess of 103% of GDP and with the Federal Reserves unprecedentedly large balance sheet that approaches nearly $3 trillion. Other measures of well-being confirm the Misery Index. The Poverty Index in 2011 appears to have reached 15.7%, the highest reading in five decades. Not surprisingly, two unenviable records have been set: 46 million, or 14.6% of the population, are now in the food stamp program, up from 7.9% in 1970 and a record-high 41% pay zero national income tax. In the eleven quarters of this expansion, the growth of real per-capita GDP was the lowest for all of the comparable post-WWII business cycle expansions. Real percapita disposable personal income has risen by a scant 0.1% annual rate, remarkably weak when compared with the 2.9% post-war average. It is often said that economic conditions would have been much worse if the government had not run massive budget deficits and the Fed had not implemented extraordinary policies. This whole premise is wrong.
Unintended Consequences of Well-Intended Policies In the early 1960s, when JFK was in the White House and William McChesney Martin was Fed chairman, Keynesian economics was in full bloom. One of its major tenets is the Phillips Curve, which posits a stable inverse relationship between the rate of inflation and the unemployment rate. Yale professor James Tobin and others argued that the social outcome could be improved by a more activist monetary and fiscal policy. Specifically, they contended that the unemployment rate could be lowered while only resulting in slightly higher inflation. The argument posited the notion that economic policymakers had sufficient knowledge to intervene or fine-tune the economy with tools like those of a surgeon. Presidents Johnson, Nixon, and Carter (two Democrats and one Republican) followed this policy. At one point, President Nixon made the famous statement that We are all Keynesians now. Moreover, as the White House led, the Fed chairmen of the era Martin, Burns, and Miller generally acquiesced. To judge the effectiveness of this policy, an objective standard is needed. Arthur M. Okun, Yale colleague of Tobin, developed such a standard, which he called the Misery Index the sum of the inflation and unemployment rates. Under the activist, Phillips Curve-based policy, some reduction in unemployment was temporarily achieved. However, inflation accelerated much more than was anticipated, and the net result was higher unemployment and faster inflation, an outcome not at all contemplated by the Phillips Curve. The Misery Index surged from an average of 6.7% in the 1950s, to 7.3% in the 1960s, to 13.6% in the 1970s, with peak rates above 20% in the early 1980s. Many US households suffered. Wages of lowerpaying positions failed to keep up with inflation, and when higher unemployment resulted, many of those people lost their jobs. Those on the high end had far more resources that enabled them to protect their investments and earned income, so the income/wealth divide worsened. A half-century later, the United States has never regained the prosperity of the 1950s. Working independently in the late 1960s, economists Milton Friedman and Edmund Phelps, who would both eventually be awarded the Nobel Prize in economics, had determined that while the Phillips Curve was observable over the short run, this was not the case over the long run. While the economics profession debated the Friedman/Phelps research, the US had to learn its findings the hard way. Growing Evidence of the Long-term Depressants from Activist Policies In addition to the compelling evidence that more active monetary and fiscal policy involvement did not produce beneficial results over the short run, three recent academic studies, though they differ in purpose and scope, all reach the conclusion that extremely high levels of governmental indebtedness diminish economic growth. In other words, deficit spending should not be called stimulus as is the overwhelming tendency by the media and many economic writers. Whereas government spending may have been linked to the concept of economic stimulus in distant periods, these studies demonstrate that such an assertion is unwarranted, and blatantly wrong in present circumstances. While officials argue that governmental action is required for political reasons and public anxiety, governments would be better off to admit that traditional tools only serve to compound existing problems. In all likelihood the governmental measures made conditions worse, and the poor results reflect the counterproductive nature of fiscal and monetary policies. None of these numerous actions produced anything more than transitory improvement in economic conditions, followed by a quick retreat to a faltering pattern while leaving the economy saddled with even greater indebtedness. The diminutive gain in this expansion is clearly consistent with the view that government actions have hurt, rather than helped, economic performance. Sadly, many of those whom the government programs were supposedly designed to help the most have suffered the worst. The Way Out The original theoretical argument in favor of deficit spending originated in J.M. Keynes The General Theory of Employment, Interest and Money. A search of Keynes work reveals no recognition of the bang point, or the condition where a government engages in deficit spending for such a prolonged period of time that a massive buildup of debt leads to denial of additional credit to the government because of fear that the existing debt will not be repaid. Nor did Keynes address the situation where a large number of countries are all simultaneously getting deeper and deeper in debt and there are gradations of debt among these countries serious shortfalls in the basic Keynesian theory. Keynes, as opposed to some of his interpreters and predecessors, may have implicitly recognized that a bang point could occur, because he did not recommend constant budget deficits. Instead, he advocated cyclical deficits, counterbalanced by cyclical budget surpluses. Under such a system, government debt in bad times would be retired in good times. However, Keynes original proposition was bastardized in support of perpetual deficits, something Keynes himself never advocated. Milton Friedman, whom many consider to have been the polar opposite of Keynes, also never addressed the concept of a bang point, but he may also have understood implicitly that such a situation could occur. The reason is that Friedman advocated balanced budgets, which if followed or required constitutionally as Friedman argued, would prevent a buildup of debt. This view was largely rejected as being inhumane since in a recession, government policy would not be responsive to unemployment and other miseries of such a condition. What should have been discussed is whether some short-term misery is a better option than putting the entire country and economic system in jeopardy, as numerous examples in Europe currently illustrate. The most sensible recognition of budget policy came not from Keynes nor Friedman, but from David Hume, one of the greatest minds of mankind, whom Adam Smith called the greatest intellect that he ever met. In his 1752 paper Of Public Finance, Hume advocated running budget surpluses in good times so that they could be used in time of war or other emergencies. Such a recommendation would, of course, prevent policies that would send countries barreling toward the bang point. Countries would have to live inside their means most of the time, but in emergency situations would have the resources to respond. In the context of todays world, this approach would be viewed as unacceptable because it would limit the ability of politicians to continue their excessive spending, thereby saddling future generations with obligations and promises that cannot be honored. But isnt Humes recommendation exactly what we teach our children in preparing them to manage their own personal finances? --Lacy Hunt PHD
Jim Grant video
Chinas naked truths reveal emperors garb The Chinese Communist party would like the world to believe that the forthcoming trial of Bo Xilai will be a triumph of authoritarian self-policing and evidence of its ability to root out a few bad apples. In fact, the downfall of one of the countrys most senior politicians and the lurid details of murder, sex, money and power that accompanied it have had almost entirely the opposite effect. From revelations of massive corruption to the murder of British businessman Neil Heywood by Mr Bos wife Gu Kailai, the sordid affair has shown the Chinese people and the world that the rot goes right to the top. For the last three decades, the party has carefully cultivated the perception that, while there may be corruption and wrongdoing at lower levels, the system is governed by clean and selfless elites who live only to serve the masses.
Fukishima repair beyond current technology
Instead of my usual comment I am turning over the podium to my nominee for the new US Ambassador to the United Nations. Here is the link to his video commentary. Have a good week Bruce Lawrence Oct 8, 2012
Kyle Bass Interview

Weekly Strategic Plan 10082012

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Liquidity Cycle

icmWEEKLY STRATEGIC PLAN

icmWEEKLY STRATEGIC PLAN

icmWEEKLY STRATEGIC PLAN

Equity Index Volatility

icmWEEKLY STRATEGIC PLAN

Implied/Realized and Skew table

Commodity and Energy Vols

icmWEEKLY STRATEGIC PLAN

icmWEEKLY STRATEGIC PLAN

Currency 3 month implied vols

Implied to Realized and Skew tables on next page.

icmWEEKLY STRATEGIC PLAN

icmWEEKLY STRATEGIC PLAN

icmWEEKLY STRATEGIC PLAN

Articles and Commentary

icmWEEKLY STRATEGIC PLAN

Jim Grant video

Fukishima repair beyond current technology

Kyle Bass Interview

icmWEEKLY STRATEGIC PLAN

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