Michael Belkin : "Play safe"

» Normxxx - "Play safe"

As faithful readers of this publication have no doubt realized by now, Michael Belkin, the keen-eyed and sharp-witted market strategist and publisher of The Belkin Report, is on the whole a most sober fellow, solid citizen and all that. Even if he did forsake the joys of Manhattan for the questionable charms of an even smaller island, off the left coast. So It was only natural to do a double-take and pick up the phone when this headline cropped up in his latest missive: “Do Drugs And Have A Beer. Not to worry”, I found him perfectly coherent. Then again, maybe that’s why we should worry!
KMW

It’s been too long since we talked, Michael, but I see that your antennae are quivering again. You’re calling another significant change in market direction?
A lot has changed since you wrote about me turning bullish at the end of ’02 and in the spring of ’03 [w@w 1/10/03 and 5/16/03]. Back then, gloom was thick in the air, but my forecasting model, which helps me determine whether we are at the beginning, middle or end of a move, and gives me the next direction, was in almost exactly the opposite position it is in today. Then, everything was pointing up. It was the beginning of something. Now, it is down—for the intermediate term and for the long-term, meaning for the next three months and 12 months.

Gee, not three days?
I still hear people claiming to “invest for 10 or 15 or 20 years.” But the reality is that most portfolio managers had better get it right in the next quarter, or their investors are going to want their money back. Which is why they focus so intently on the current quarter. And for the current quarter, my model points down.

And you’re predicting another insipid quarter for stocks?
Or worse. Not just for the equity market For everything that everyone has flooded into—every risky asset everywhere on the globe. It is hard to find exceptions.

So it would seem, glancing at your long list of shorts and short list of longs. Is there an emerging market you don’t see submerging?
The outlook is not good. Investors have been squeezed out the risk spectrum. They’ve been embarked on an increasingly risky quest for returns. Given little choice, really, for about a year now, given the negative real interest rates that Greenspan & Co. have been creating by setting official interest rates below the inflation rate. That is a surefire recipe for creating a boom that leads to a bust.

The boom part was intentional, clearly. But a bust…?
Well, that’s right. But you do get blowbacks from a policy like that, much the way that the CIA gets blowbacks from its policy errors. It sets up Osama Bid Laden to fight the Russians and, boom, we get airliners attacking our skyscrapers 10 or 15 years later. In this case, investors went looking for return in fixed incomes, junk bonds, emerging market debt, emerging market equities, shorts, puts, the volatility indexes (VIX, VXN), credit derivatives, European stock indexes. What’s different, as I see the market heading into this next bear leg, is the technology sector.

Are you implying that you’re now turning bullish on tech?
Don’t misunderstand, tech still is definitely on my underperform list. I see it going down in absolute terms, and also in relative terms. But I am really much more worried about financial sector.

The financials? Despite all the depth charges that have hit the group—there are headlines about new investigations or writeoffs daily, it seems—that’s a decidedly minority view—
That’s true. But in part that is because the financials have been such a good place for portfolio managers to hide for the last couple of years. If you look at the chart of the S&P 500 financial sector divided by the S&P, it is plain to see that the financials were starting their own relative bull market just when the bear market in the major averages began in 2000. But that relative bull market in financials has been kind of stuck on a plateau over the last year, essentially going sideways, relative to the index. And I think what is going to change the most in this forthcoming decline is that the financials will no longer be a safe place to hide.

Why is that?
Fundamentally, because my model points down for the financials, and the S&P financial group has just recently broken its 200-week moving average, relative to the S&P 500. But if you want reasons of the sort most investors call “fundamentals,” there are any number of things out there that we could point to. Just think about what has been happening. The financials are where the problems are. One headline blow-up after the other: Enron, WorldCom, Fannie Mae and Freddie Mac, AIG, now GM’s bonds, etc. In all those cases, you could tell that most professional investors knew ahead of time that something was wrong. It was clear, for instance, that Fannie Mae was piling a mountain of leverage on top of virtually no capital to keep inflating the housing bubble. That was just so obvious. Same thing with GM. “Buy one, get one free” is a bad business model. You can’t make money.

It doesn’t seem to work for Detroit, that’s for sure.
Sooner or later it has to catch up with you. If you are making money only in your mortgage finance subsidiary while losing money on health care benefits and on building cars, it just doesn’t work. But like in all of those cases, it didn’t matter, it didn’t matter—until, suddenly, it mattered. Boom. Some event triggered the depth charge. I think there a lot more situations like that in the financial sector that could go off. Probably—although this isn’t going to win me any more hedge fund clients—among the hedge funds. There’s been a huge proliferation of them, and my sense from a recent trip to New York, my first since the summer of 2001, is that they are all crowded into the same consensus trades, almost all of which are based on negative real interest rates. So they’ve all been pushed out the risk spectrum into all sorts of carry trades in Latin American debt and whatever. I fully expect that most of the hedge funds that are nothing more than disguised bets on negative real interest rates won’t survive global de-leveraging. And with widening spreads squeezing the hedge funds, I am worried about all the, shall we say, “prime brokers” financing the hedge funds. The providers of leverage will surely get whacked by global de-leveraging. There is probably going to be a bit of a shakeup of the investment banks and securities brokers.

In addition to the Morgan Stanley soap opera, you mean?
Exactly. Proprietary trading desk losses likely will become an issue. Everyone is not going to get it wrong. But I am sensing, after a first quarter in which performance numbers weren’t good, but in which the hedge funds saw enormous inflows, that the flood of money into the hedge funds just might start to reverse.

All that liquidity has to go somewhere—and why should hedge fund investors be any more inherently sensitive to bum performance than mutual fund holders have shown themselves to be?
Well, it takes 60-90 days for hedge fund redemption notices to kick in, but that might actually start happening in the second quarter. The people—and even the institutions—that invest in hedge funds are not paying premium fees for performance that’s mediocre or worse. That implies that the hedge funds will be de-leveraging. Which is not good. Leveraging has been the essential force buoying the world markets. If we now go into liquidation and de-leveraging, it will be like pulling the layers off the onion. That makes markets go down. It is like a gigantic global margin call. One that should puncture the bubbles in stocks, bonds, emerging markets, credit spreads and derivatives.

But why should even a gigantic margin call create such problems in a world awash in liquidity? All the mega-merger deals being announced speak volumes about very easy money—no matter how many times the Fed has hiked rates.
Correct. I am not much of an expert on private equity and M&A, but at the moment there does seem to be a surplus of willing buyers wanting to pay top tick. And plenty of lenders willing to find the wherewithal for them to do so. But that sort of liquidity can disappear in a flash. I concede that I am mostly outside the consensus in this forecast. But where I have been in the consensus recently—basically on the S&P materials sector and energy—those trades haven’t been working well in the last few weeks. They are fairly old signals and the trades have gotten crowded.

Everybody “knows” that energy prices are going up and materials getting scarce because the Chinese need it all.
Which is why I am getting more agnostic on those two sectors. There are fresher signals. Specifically, I see a turn decidedly toward the defensive side in sector and industry group rotation. With, as I said, the financials no longer playing defense.

What hiding places are left?
Some of the utilities, which are quasi-financials, I guess, though I wouldn’t rank them as my No. 1 outperform idea. The more traditional defensive outperform stuff, like consumer staples and maybe health care should do better this time.

Maybe healthcare?
I am no fan of the big drug companies, knowing that their real business model was to basically have their sales reps bribe doctors to prescribe their medicines. They still spend more money on marketing than they do on creating drugs. But that is for a whole other story. Besides, I don’t let my views on the ethics of various businesses influence my interpretation of my models. If my model says the pharma sector is going to outperform, then I go with it. And that is what it is saying. Then too, health care and pharma could bounce in relative terms, without necessarily going up in absolute terms.

Drug companies have been garnering lots of negative headlines lately, too.
That’s why I’d suggest a basket approach. There is loads of individual company risk in the sector, with the FDA waking up to all the drugs that are proving dangerous after they’ve been approved, on top of the uncertainty that has always dogged drug stocks with “promising” new products in clinical testing. But another way you could approach this sector is by putting on spread trades, shorting some of the over-owned health care equipment companies that have been outperforming the drug stocks for years, while going long some of the beat-up pharmas.

You didn’t sound terribly excited about consumer staples, either.
Remember, these are relative calls, not absolute. Consumer staples could be a place for long-only portfolio managers to hide—ones whose freedom to go to cash is curtailed by their mandates. For long-only institutions, I am recommending maximum defensive positions here. This won’t be like 2000, when you could short tech and buy value. Granted, Tiger got blown out of those positions right at the top, but all the trades they had on were the right idea, if they could have held on. They worked for several more years. That is what is so different today. Back then, the market wasn’t so thoroughly picked-over. There were groups that had not gone up in the bubble, that could go up in absolute and relative terms. Now, what hasn’t been picked-over? Small caps? Forget about it. Mid caps? Forget about it. Cyclicals? Nope. Gold stocks? Be serious. This stale rotation has cycled through virtually everything. I can find very few stocks that are negatively correlated in this market, so it is just a question of what is going to fall more and what is going to fall less over the next 3-12 months. The U.S. market now reminds me very much of the Japanese market, which has been in a bear market for 15 years now—

Which is why I have heard some people suggesting that the Japanese market might be a pretty good place to hide.
I just closed out my long position in Japanese stocks. I did have a buy signal there, but it’s not there anymore. Maybe, I’ll get another buy signal there, but I am following my model. The other place that could be an exception to the global bear trend is China. I am no big China bull now, but China hasn’t really gone through a big bubble yet. As you know, I don’t mind investing in bubbles, I just want to get into them cheaply, on the ground floor. The thing is, there are few prospects for that in China now, even though, given the population’s propensity for speculation, you have to assume it has bubble potential.

Why not now?
Their boom is fading and there are enough things wrong over there, with the stocks that are listed, in terms of state ownership and such, that I just don’t see it. Clearly, though, all those well-recognized problems mean that China’s rulers have a lot of room to make policy changes that would pleasantly surprise investors and get the juices flowing. So China is on my radar screen as something negatively correlated to every other investment theme in the world, but the timing is not now.

Isn’t there a silver lining somewhere in all this?
Getting back to Japan, if you look at a 20-year chart of the Nikkei, you see that it topped out on the last day of 1989 and it has since traced out 5-10 enormous declines within that long-term downtrend. If you were a buy and holder in Japan, you’ve been just constantly eroded. But along the way there have been enormous rallies. These were great trading opportunities, lasting 6-18 months, that would take the Nikkei up 4800%, before it got knocked back down to the bottom again.

So we’re on the Japanese plan?
Nothing is ever exactly like anything else. I have given up the habit of overlaying charts and predicting that this time is going to be exactly like that one. That always seems to work, until some point—when the trends completely diverge. Still, there are general patterns that long-term bull markets, as well as bear markets, follow. You get sharp and vicious rallies in bear markets, but when they top out, the market sinks back almost to its lows. The current positions of the U.S. equity market and the primary European markets (the DAX, FTSE, CAC,) remind me very much of the tops in many of Japan’s extended rallies over the last 15 years. They are rolling over and preparing to scrape bottom again.

How so?
While some stocks went to enormous new highs on this move, most didn’t. Most indexes are below their early-2000 peaks. In emerging markets, there has been a convergence play: Hungary and the Czech Republic and Poland are going to join the EU, so buy them. If you look at their charts, you see parabolic blow-offs and then some. To my eyes, that makes these emerging markets the Yahoos and Amazons of this cycle. Those three emerging markets have been rockets. But they are rolling over. I have been involved in emerging markets for 20 years now, ever since I started at Salomon, and my model has proven pretty good at spotting vulnerabilities before the crises hit, whether in Russia, Asia, Mexico, Argentina, etc. And I have to say that it is currently signaling, boy, just a really a powerful down move in emerging market currencies, debt and equities. As you know, capital has flooded into these often illiquid markets. Somebody has been just blindly allocating in and buying, buying. When things reverse, when a crisis or scandal surfaces, these markets have a tendency to go no bid in no time. My model’s signal for the IFC Composite Emerging Market Equity Index, (which is equities, denominated in U.S. dollars), is particularly powerful. So are my bearish signals for Latin America and Eastern Europe—not so much Russia, but Hungary, Poland and the Czech Republic. Meanwhile, my model sees the dollar strengthening, especially versus those currencies and the Mexican peso. As for the EMBI/JPM Emerging Market Debt Index, that is an accident waiting to happen. It represents a collection of emerging market high-yield bonds, another risky area that has been flooded with capital. But the index has broken down significantly in the last several weeks and it has a long ways to go, down. It’s not an asset class you want to be long in here.

Michael, has the sun shone at all in the Pacific Northwest in the last month or so?
That’s not it. This is not seasonal affective disease or something like that talking. I try to be impartial and objective about this. My forecasts are based on this probability model, I just follow where the statistics lead. If that were up, like in early 2003, I’d be bullish. But it’s not. Really, I try not to let my personal view of the fundamentals interfere with the model’s signals, because I have learned that it is better at timing market moves than my internal hunches are. Still, there’s a fundamental case to be made right now, alongside my probability model, that also says there’s a lot of downside risk in the markets because of this latest bubble Alan has created.

And very few places to hide.
Right. Now, I am no guru and institutions don’t index their portfolios to the Belkin model, but my recommendation is go to your maximum defensive position, whatever that is. For hedge funds, that means to go net short, sell the rallies. For long-only institutions, that means raise cash, shift into defensive sectors. And that very definitely doesn’t include bonds here. The long bull cycle in bonds is ending very typically, really, with rising inflation and higher interest rates—not just on the short rates that the Fed controls, but on the 10-year, the 30-year. Which is a big change. I have a preliminary forecast that the curve will steepen, which would be another de-stabilizing force in the financial markets, since everyone seems to have curve-flattening trades on. In fact, if long rates rise more than short rates, that could squeeze a lot of leverage out of the fixed-income markets and there’d likely be casualties. Anyway, what we are seeing is that setting interest rates too low lit a fire under inflation, so prices are rising, interest rates going up, the equity markets going down. Credit spreads are expanding. This is a classic end-of-cycle scenario.

Classic, perhaps. But not widely recognized as such. Practically everyone expected higher rates last year. When they didn’t materialize—
Right. There is no strong consensus on the fixed-income markets at the moment. Being bearish on bonds last year didn’t work. Now, sentiment is mixed. But I think Treasury yields go up. I don’t expect something like 1998, where you have a crisis and the Treasury market benefits from a flight to quality. There is some potential for that on the short end—I’m not as bearish on the price of short-term securities; I don’t see much rise in short rates; that move has pretty much run its course. My model’s strong signal is that long-term rates are going up and so are all the credit spreads against long rates—mortgages, the S&P speculative grade credit index, junk bonds. The signal on Moody’s BAAs is almost there, but not quite. Corporate bond yields are very close to their lows still and the three-year is still pretty close to its low yield—and these rates should not be there. I think they are going to go up. Ultimately, widening mortgage spreads will be another signal with ominous implications for this whole housing-led, “your house is your ATM, consume and buy a lot of stuff from China” economy. That whole economic model is going to get shaken. Maybe, after it is, and after the economy slows, bonds will be a buy again. But that will probably be a slow process. When housing plateaus, people tend to go into denial and keep asking top dollar for their houses, unless they absolutely have to sell. So very few houses change hands, because no one is willing to pay top dollar and no one wants to take a loss, if he can help it. But meanwhile, houses become increasingly unaffordable as mortgage rates rise. The upshot is that the housing market tends to take a long time to adjust, in sharp contrast to the financial markets, which adjust rather quickly to the bid and asked prices. In real estate you only get price discovery when the two-income family that stretched to take out a too-big adjustable rate mortgage gets hit with a job loss. That whole thing is a house of cards, and it will come down then. Believe me, I take no glee in it, but I think that will happen down the line. Creating the real estate bubble to replace the Nasdaq bubble was another very bad policy error on the part of the Fed. And now that financial asset inflation is finally leaking into real-thing inflation.

But not into wage inflation.
Not yet. But if you look at core PPI and CPI, the forecast is up. I don’t think this is the beginning of hyper-inflation. Although, when I ask myself where I might be wrong, a hyper-inflation is essentially the only fundamental scenario that I can come up with. If the Fed were to somehow decide to just try to inflate our way out of our deficits and we crossed over into a Brazilian style hyper-inflation, my forecasts would be derailed. But I do not assign a high probability to that scenario. It’s more likely that we finally get a slowdown that allows for some re-adjustments.

Gee, Greenspan’s parting gift won’t be yet another bubble inflated to replace the loss of wealth from the bursting of the housing and equity bubbles that the Fed fostered?
I doubt it. But if they are going to create another, I wish I knew where—because I would be buying whatever it is. Seriously, I wouldn’t want to be in the Fed’s shoes. It’s a joke to me that Greenspan is still celebrated and praised; that Congress wants to hear what he has to say about Social Security. He is the perpetrator of these bubbles, and yet somehow this guy has had nine lives. He has been able to escape the blame not only for creating these successive bubbles, but for pricking the previous ones. When this game ends, Greenspan will no longer be a hero, though it clearly will take time for people to recognize how irresponsible monetary policy became under him.

Irresponsible? Don’t you remember, it wasn’t all that long ago that the big worry was deflation? So Greenspan spiked the punch, big time? That lesson wasn’t lost on Washington.
So he’s a world-class pusher of monetary Prozac. But there’s a fundamental question about Fed policy that doesn’t get asked very much. Which is, why should anyone set interest rates? Hello? Don’t we believe in free markets? But that’s a whole other tangent. And we don’t want to go there. Your readers are already suffering through this interview, considering all of our happy talk.

If they’ve gotten this far, they must think you have something to say—and be hoping for some more ideas about how to insulate their portfolios from the wrenching readjustments you’re forecasting for the economy and markets—
Well, at some point there will be a great buying opportunity for an extended rally, but first we have to get to that point. And, no small matter, if we want to participate, we will have to have some available cash. That implies investors should shepherd their resources so that they are available when that big bounce potential materializes, even if it’s only a trading rally in a long-term bear market. But for now, besides the drugs, my model has outperform forecasts only on some of the typical defensive plays like household products and beverages—where the candidates are mainly brewers. So maybe it’s time to do drugs and have a beer, while hedging, shorting, whatever you can do. It’s not too late to get defensive for a potentially very long decline.

Well, that’s half of a good idea, anyway.

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The contents of this letter/report does not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of this message is not to be construed as constituting market or investment advice. It is intended for educational purposes only. Individuals should consult with their own advisors for specific investment advice.

-- posted by Normxxx