Trade Idea: Treasuries vs Copper ($TLT $JJC $DBB)

Noted deflationist Gary Schilling via Zero Hedge:

"I'm agnostic on the precious metals. We have in our portfolios been short copper. Copper peaked out in February and it's down about 25% from its peak. I think it will go a lot lower. As you pointed out, copper goes into almost anything manufactured. It's a great indicator of global industrial production. What I think will really knock the pinnings out from under all commodities is a hard landing in China, which is what we're forecasting."

Copper is the best deflationary bet. In fact, you could short the 30 year Treasury and short copper and probably do well either way. To put it another way, last time long-term interest rates were this low, the price of copper was closer to $1/lb instead of the current $3.20/lb.

One of my favorite types of trade is to look at two different markets that should be keying off of the same fundamental variable, but aren't, implying an inconsistency. [That way, you are agnostic about what exactly the future will look like, just betting that an empirically and logically justifiable relationship should continue to hold.] So the long-term U.S. interest rates are screaming deflationary depression but copper prices aren't.

Why might this be? A regulatory arbitrage scheme in China seems to have artificially boosted the demand for copper over the past several years. Apparently, importing copper is or was a way for Chinese businesses to circumvent their government’s restrictions on lending.

My understanding is that the long-run marginal cost of copper is in the mid $2s/lb, i.e. 25% lower than the current spot price. However, if there was going to be a depression of the type that the Treasury market is implying, the price of copper should be closer to the 2008 low. That would happen instantly if the Chinese copper stockpiles were put on the market, perhaps due to forced liquidations.

How Cheap is Cheap?

This is an excellent point from the gurufocus interview with Prem Watsa of Fairfax Financial:

Ben Graham was reflecting in the ‘30s and he writes, if you were not bearish, if you're not concerned about the economy in 1925, not in 1927, 28, 29, but in 1925, there was only a 1/100 chance that you survived the depression, because what'd you have looked at was if you were not bearish in 1925, you'd have seen the crash in 1929, drop 50%, and you'd have come right in and thought of it as an opportunity, because the Dow Jones dropped from 400 to 200, went back up to 300, and the second leg after that was a killer, dropping about 90%!! That was a worry, a lot of problems at the time, and I keep thinking of that because the second leg, I have seen in many industries, oil drilling and farm equipment, that second leg can be vicious, and we might well be entering that second stage.

Tuesday Links

Artificially Constrained Volatility

• "[T]he history of macroeconomic interventions post-WW2 has been the history of prevention of even the smallest snap-backs that are inherent to the process of creative destruction. The result is our current financial system which is as taut as it can be, in a state of fragility where any snap-back will be catastrophic."
• Taleb on complex systems that have artificially suppressed volatility: they "tend to become extremely fragile, while at the same time exhibiting no visible risks. In fact, they tend to be too calm and exhibit minimal variability as silent risks accumulate beneath the surface."

Misc

• Ray Dalio: "I think the distinction between creditor and debtor nations is interesting. Western economists have for a long time believed that economic growth is driven by consumer spending. I think economists are confusing cause and effect. On the contrary, I think economic growth is driven by savings and capital investment—consumer spending is just the effect of the economic growth, not the cause of it."
• Rent seeking: huge price increase in NYC taxi medallions since 1980. A parabolic looking "five wave up" pattern. I'll bet Prechter would tell anyone in the NYC taxicab business to reduce their exposure to medallion prices to zero. You could actually do that and stay in the business, by selling your medallions and leasing them back. And I suspect that the price/rent ratio for a medallion is really high since everyone assumes continued capital gains are guaranteed. 
• Latest Hugh Hendry interviews.

"Before David Einhorn was David Einhorn"

"David Einhorn currently manages over $10b, however he started with only $900,000 in 1997. Due to fantastic returns (not good marketing) of 22% per annum, he is now one of the largest hedge fund managers in the country. [...] Einhorn thought he could initially raise assets of $10m; however the process was much more difficult. Einhorn started with $900,000, half of it coming from his parents."

Motorhome Shipments Down 17 Percent Year over Year in August

Wholesale shipments of motorhomes were down 17% in August 2011 vs the prior year, and total RV shipments (which includes motorhomes + towables) were down 2%. Obviously, the motorhomes are a much bigger revenue/profit item for the manufacturers. It looks like we have seen a substitution effect into the inferior/cheaper RV good, due to consumer weakness.

Great Comment On EMU

“What if the Euro experiment, instead of introducing the new currency, had simply been the proposition that all EU countries issue their sovereign bonds denominated in Deutsch Marks? Wouldn't it have been clear immediately that certain problems with such a scheme were unavoidable? And isn't that essentially where we are now?”

Does Trading Create Any Value?

Markets are the only successful means human beings have developed to define their state of knowledge about the fundamental fact of existence for all life on the planet - scarcity. Medical research, engineering and dramatic production (my favorite "art") are all wonderful gifts; but none of them can exist without the seemingly useless activity of the people who define prices.

Silver Market Open

Silver down 7%! Just dropped 40% like a rock in three days, amazing.

Bearish China Bets: Base Metals, Mining Companies, and Casinos

The slow motion collapse of the Economic and Monetary Union of the EU (and possibly - hopefully - collapse of the EU itself) is monopolizing investor and media attention, with the result that nobody is talking about the situation in China.

A friend of the blog calls our attention to the deterioration in the Chinese stock market, with the FTSE China 25 index dropping to the lowest level since May 2009! Even worse, some of the financial company stocks in the China 25 have dropped below their 2008-2009 lows, for example the China Life Insurance Company (which is 4% of the index) and also Huaneng Power. The other China alarm bell that is going off is the price of copper, which has absolutely cratered over the past two weeks.

As I have written before, I am in the bearish on China, Jim Chanos camp. A few key facts about the fixed asset investment bubble in China:

• 25 of the top 50 skyscrapers in China (not including Hong Kong and Macau) were built with investments from the property sector, unlike most of the top 50 US skyscrapers, which are used as company headquarters.
• China had over 200 skyscrapers under construction in 2011, a number equal to the total number of U.S. skyscrapers.
• Dubai, at the peak of its building boom, had 240 square meters of property under development for every $1 million in national GDP. In urban China today that ratio is four times as high.

Related to the malinvestment in China is the broken Chinese economic and political system that I wrote about in my review of The Party: The Secret World of China's Communist Rulers. Their entire system is at cross purposes with the carefully considered positive ROI projects that are needed to actually create wealth.

There are three good ways to bet on a collapsing China bubble: short commodities and particularly base metals, short base metal miners, and short the U.S. companies that have made huge bets that Chinese consumers are as stupid as U.S. consumers (think casino stocks).

The reason to be short base metals is that they are not only used in fixed asset construction, but also because the Chinese have built up enormous stockpiles of them.This recent WSJ article shows the number of weeks of inventory for Al, Zn, and Pb, and the first two look very high going into another worldwide recession. Don't forget that Chinese economic data like metals inventories is unreliable and probably biased downwards. One good base metal short play would be the PowerShares DB Base Metals Fund, which has listed options. Another choice would be the Dow Jones-UBS Industrial Metals Subindex which has copper.

With miners, there would be a number of choices: Global X Copper Miners ETF, the Dow Jones Emerging Markets Metals & Mining Titans, and the SPDR S&P Metals and Mining ETF.

I like betting against China and commodities because there are actually U.S. energy related values that I want to own, but which need to be hedged. There are the resource company converts that I have written about, and this weekend I am finding exploration and production straight debt yielding 10%+ with debt/proved resources less than $1/mcf!

Silver Bubble Finally Pops

I have been pounding the table about the dangerous silver bubble for a long time. With the 25% decline back below $30 last week, I think we can say now that the silver bubble has popped.

My first post about silver was in January, when the price was crossing $30 for the first time. My two most conceptually important posts about silver, both in late February with silver at about $33 were the one about the precious metals boiler room and also the thought experiment about why nickels would outperform silver in every conceivable scenario.

The silver bugs would get hopping mad about these posts, which was all you needed to know about who owned the metal and how weak their hands were. I probably got more comments on my silver posts than everything else I have written in five years combined.

Longer term, I am really glad that silver is going to get cheap again. The ideal opportunity would be if sometime next year you could short a 30-year Treasury bond yielding 3% and use the proceeds to buy silver at or below the marginal cash cost of mining. Although, it's possible you will want to buy the mines themselves since the mood of miners will be pessimistic, as they will regret topticking the metal price by starting so many projects.

By the way, there is going to be an pretty astonishing amount of silver coming out of the ground. When I did my survey in April of silver miner investor presentations, it was all photos of projects under construction and bar charts of growing silver production.

Solar Scandal Means DOE Loans Will Be Much Harder to Come By

From the NY Times:

“It was alarming,” said Frank Rusco, a program director at the Government Accountability Office, which found that Energy Department preliminary loan approvals — including the one for Solyndra — were granted at times before officials had completed mandatory evaluations of the financial and engineering viability of the projects. “They can’t really evaluate the risks without following the rules.”

The best thing for a bureaucrat to do with one of these loan applications from now on is... wait. If they wait long enough the company will either go under, or survive and be a good credit or maybe not even need a loan. Either way, no decision needs to be made, and the best decision for a bureaucrat is always no decision. Decisions have no upside for a bureaucrat because they can only lead to blame.

Saturday Links

"We’re witnessing the most difficult market for the most amount of participants in years. Spread traders, credit traders, macro guys, long-only funds, commodity traders: everyone is getting caught in the crosscurrents."

The price of gold in the year 2160: "So how did these money systems fail? Did their cultures implode? Did their governments fail? Quite the contrary, all commodity based money systems were destroyed by one simple factor—technology. At some point, technology enabled low cost production of the commodity, and the currency collapsed."

The second decline of violence was a civilizing process that is best documented in Europe. Historical records show that between the late Middle Ages and the 20th century, European countries saw a 10- to 50-fold decline in their rates of homicide.

Photovoltaic Solar

It works like this: a photon of light comes in from the sky, penetrating some depth into the silicon. If it has enough energy (imagine a sign out front: “you must be this tall to go on this ride”), it can pop an electron out of the lattice, leaving a “hole” behind.

"We Can End the Fed"

Ever seen the Fed's marble palace in Washington, DC, on Constitution Avenue (of all streets!)? That bunch sure knows how to live. I've long had a dream of being the auctioneer when the Fed is sold off for private offices, or maybe a Museum of Sound Money! Help me dull its scissors and then break them, so the Fed can't cut down our dollar's value. Indeed, I believe that people ought to be ashamed to work at such a place; an institution that has done so much damage to American prosperity and freedom, as well as to the freedom and prosperity of the whole world. For example, I want no more bowing and scraping to the Fed chairman when he goes to Capitol Hill to peddle his nonsense. He is just a bureaucrat, albeit a disastrous one.

- We Can End the Fed by Ron Paul.

Another Obvious Market Inefficiency: Stock Returns by Debt Rating

From Falkenblog.

Letters from A Self-Made Merchant To His Son - Being the Letters written by John Graham, Head of the House of Graham & Company, Pork-Packers in Chicago

"Because there ain’t any rotten apples in the top layer, it ain’t always safe to bet that the whole barrel is sound.

A man doesn’t snap up a horse just because he looks all right. As a usual thing that only makes him wonder what really is the matter that the other fellow wants to sell.

So he leads the nag out into the middle of a ten-acre lot, where the light will strike him good and strong, and examines every hair of his hide, as if he expected to find it near-seal, or some other base imitation; and he squints under each hoof for the grand hailing sign of distress; and he peeks down his throat for dark secrets.

If the horse passes this degree the buyer drives him twenty or thirty miles, expecting him to turn out a roarer, or to find that he balks, or shies, or goes lame, or develops some other horse nonsense.

If after all that there are no bad symptoms, he offers fifty less than the price asked, on general principles, and for fear he has missed something."

Another Way of Looking at Corporate Profit Margins

Corporate after-tax profits as a percentage of national income are more than two standard deviations above the historical mean.

There are two things that could cause this series to mean revert: either falling pretax profit margins, or rising corporate taxes.

Energy Conversion Devices ($ENER) Files Form 8-K: Notice of Delisting or Failure to Satisfy a Continued Listing Rule or Standard; Transfer of Listing

Today was an odd day in Energy Conversion Devices (ENER) common stock. It rallied out of the gate and then there was a huge superspike up at 2pm, of the type that you often find in worthless stocks. The superspike deflated and then after hours the company put out a Form 8-K regarding its failure to satisfy NASDAQ continued listing requirements:

"On September 15, 2011, Energy Conversion Devices, Inc. received a deficiency letter from The NASDAQ Stock Market notifying the Company that it no longer meets NASDAQ’s requirements for continued listing on the NASDAQ Global Select Market... because the minimum bid price of the Company’s common stock has not equaled or exceeded $1.00 at least once over a period of 30 consecutive trading days. [...] The Company intends to actively monitor the bid price of our common stock and will consider available options to resolve the deficiency and regain compliance with the NASDAQ requirements. Such actions could include implementation of a reverse split of the Company’s common stock, which would need to be authorized by the Company’s stockholders, or other possible actions."

Not accusing anyone of anything, but I remember trading another now-bankrupt solar stock that it was uncanny how often there would be a huuuge rally followed by a bad news release. It got to the point where you could be highly confident that rallies meant bad news.

There is a capital structure arbitrage opportunity in ENER, because the company's 3% convertible notes due 2013 trade at ~47 to yield over 50% to maturity! Also, the company has a cash balance that is greater than the current market value of the convertible notes, meaning that the note price implies a negative enterprise valuation.

In contrast, the eight-figure market capitalization implies a much higher enterprise valuation. The prices of these two parts of the capital structure certainly seem to be inconsistent, which would indicate an arbitrage opportunity.

Also worth noting is that the convertible notes traded higher volume today but didn't so much as break the 50 price level where they were only about a month ago. I imagine that arbs were buying the notes and shorting the stock today.

Netflix Crushed After Cutting Subscriber Guidance (NFLX)

ZH:"Netflix Plunges After Subscriber Guidance Cut".

Barron's:"...the world is moving to streaming and dumping discs, as evidenced from the big cut in Netflix’s DVD subscriber forecast. That makes outfits like Starz, which control distribution, more powerful..."

Yes! Here's the fundamental problem with Netflix: they were able to use the first sale doctrine to snooker Hollywood and build an impressive DVD rental business. Everyone assumed that this would translate into a profitable streaming business, as though a streaming business was just a question of "brand" or "mindshare". In my review of Hollywood Economics, I diagnosed the problem with Netflix:

[E]pstein has also written about the problems with the Netflix (NFLX) business model,

"Netflix can buy 10,000 copies of a major title for $150,000 to mail out, [but] it will need to spend about $16 million to license it for streaming. Such a 100 fold increase in price can obviously be deleterious to profits especially since Netflix still has to maintain its mailing centers, and buy DVDs, for the subscribers who elect to continuing using the mail-in service..."

He hit the nail on the head. The problem with Netflix is a problem of competitive position. There are several streaming movie competitors, and they all need to offer their customers the back catalog of streaming movies that people want to see. That means that they bid against each other; the content owners can play them off each other.

The rents from the streaming entertainment business are going to go to the content owners. And it is clear that Netflix does not understand this. Earlier this year, when the stock was at $300 (it's down 40%!), the company had a market capitalization of over $15 billion. The smart play would have been to sell stock and acquire content, either by buying libraries or by generating new content. 

Georgia Gulf Announces Notice of Redemption for 2016 Senior Subordinated Notes

"Georgia Gulf Corporation today announced that it has distributed a Notice of Redemption to the holders of the Company’s 2016 senior subordinated notes. The Notes will be redeemed on October 20, 2011, for $105.375 per $100 of face value. Based on amounts outstanding as of September 15, 2011, the Company will redeem an aggregate principal amount of $41.9 million of Notes."

More Notes About the Worthless Stock Inefficency

Some more notes about the worthless stock inefficiency:

• The SEC’s 2003 annual report [pdf] talks about their campaign against worthless stocks: “During 2003, we received numerous complaints from investors who purchased stock in bankrupt companies under the mistaken belief that the stock price would rise when the company emerged from bankruptcy. In each case, however, the company had announced in its plan of reorganization its intention to cancel its existing common stock and to issue new stock.”
• In a paper called Who Gambles in the Stock Market [pdf] by Kumar (2009) shows that "poor, young, less educated single men who live in urban areas, undertake non-professional jobs, and belong to specific minority groups (African-American and Hispanic) tend to invest more in these lottery-type stocks."
• In an article called Corporate Bankruptcy and Insider Trading [pdf] Seyhun and Bradley (1997) say that they find "significant sales by the insiders of firms filing bankruptcy petitions prior to the filing date."

Capital Structure Arbitrage Idea (HOV, HOVNP)

I can't believe that basically all the homebuilders survived the crash without having to file for bankruptcy or completely wipe out the equity. Granted, they had to restructure by raising massive amounts of equity and exchanging debt for new equity.

Anyway, realization is dawning once again that residential real estate is still troubled due to massive inventory overhang, especially all the houses that are the wrong type (too big) or built in the wrong places. The SPDR homebuilder ETF (XHB) is down 17 percent year to date.

I notice that the more troubled homebuilders are developing mispricings in their capital structures. For example, the Hovnanian preferred stock (HOVNP) trades at 12 cents on the dollar. That's a market value of 15 million for the 125 million in face value of preferred, which is a deficit of 110 million. Yet the company has a market capitalization of 140 million. That is a pretty glaring inconsistency.

Equity investors are wildly optimistic (as we saw with the worthless stock inefficiency) and therefore a company's common stock price is usually not as realistic a reflection of enterprise value as the prices of more senior securities. I think the most likely outcome with HOV is that both the common stock and the preferred go to zero. That is certainly what the preferred stock and bond prices suggest.

The one downside to a long HOVNP short HOV trade is that the preferred dividend is not only suspended, but also is not cumulative. That means that the dividends are not accruing, although the common stock cannot receive distributions until the preferred dividends are reinstated.

Hussman Makes a Great Point

"[T]he literature on 'real options' is clear that significant economic uncertainty is much like the implied volatility of an option - high uncertainty increases the benefit of waiting to 'exercise' the option. Material restructuring of mortgage debt and sovereign debt, as painful as it might be in the short run, is really the only way to remove the drag of deleveraging and the weight of credit uncertainty that have anchored the economy in unemployment."

Also:

"[F]rom a liability-management perspective, the Treasury really ought to be issuing long-dated Treasury debt to the public here with both hands, particularly if yields decline further on credit concerns. [...] On any substantial decline in yield, the best way to preserve the solvency of the U.S., particularly if we have inflation in our long-term future, is to lock in low interest costs for very long maturities."

Something I've been saying for over a year. The Treasury could be doing much more to take advantage of low interest rates.

Ray Dalio Presentation

Via Stableboy. This is an amazing indictment of typical hedge funds:



"Hedge funds on average are not doing enough independent thinking."

This is why we have a tag called groupthink.

Wow!!

"August S&P return was in the bottom 10% of monthly returns since 1928. Over that time 58% of monthly returns have been positive with an average return of 0.6% (7.4% annualized). August volatility was in the 98th percentile over that period at more than triple its 15% average since 1928. Just 25 out of 1004 months over the past 83 years have experienced higher realized volatility than August 2011."

EMU

“I am sure the Euro will oblige us to introduce a new set of economic policy instruments. It is politically impossible to propose that now. But some day there will be a crisis and new instruments will be created.”

Preordered The Quest: Energy, Security, and the Remaking of the Modern World by Daniel Yergin

I pre-ordered a copy of The Quest: Energy, Security, and the Remaking of the Modern World by Daniel Yergin, the author of The Prize: The Epic Quest for Oil, Money & Power.

Stephen Schwarzman Lecture at Yale

Short?

I look at over 1,000 charts per day. And my jaw has been dropping at the shorting opportunites. Morning pop be damned, my bottoms-up approach to investing tells me that the market is unsupportable. It is begging, pleading, and beseeching to be dropped and dropped hard.