AAGANAN: BUDGET ANALYSIS 2010 - KEYNOTE ADDRESS

at Reva Institute of Technology and Management on 13th March, 2010

AAGANAN Budget Analysis 2010

The recent budget was well received in many quarters as it assuaged the concerns of deficit hawks, helped the rural masses as social sector schemes continued and satisfied urbanites as tax slabs were revamped and there was renewed focus on infrastructure development. Although no speech, presentation or document can fully capture the essence of a budget, I recently spoke to 250 MBA students from different colleges about various aspects of the budget. The presentation I shared with students is given here for viewing and downloading. Comments, suggestions and criticisms/appreciation are always welcome!!

A few notes for the students.

1. You may visit the Ministry of Finance website by clicking here.

2. If you want to read the first chapter (and other chapters) of the Economic Survey, it is accessible here.

3. The Union Budget 2010 website with many resourceful links is given here.

4. A brief document that summarizes important Budget initiatives is given here.

NEW RULES OF THE GLOBAL MARKETPLACE

By Adhvith Dhuddu

(Op-ed as appeared in the Hindu Business Line on January 13th, 2010)

A decade of boom and bust has culminated in a new set of global standards even as India's image has soared as a credible survivor of the financial crisis.

The first decade of the 21st century has been unprecedented in many ways with the tech bust in the early 2000s, the rise of the BRICs and other emerging economies, the commodity boom and of course, the global financial mess in the recent years. As we enter the last lap of this decade, there are many “new normals” that have been scripted in the Indian and global context.

There is a new normal in the global economic playing field: Regulatory shackles have resurfaced prominently in the western world and government is back amidst “free markets.”

Developed economies, led by the US, rewrote the rules of global finance during the crisis, which will have ramifications in the American, European and Asian continents. As countries, companies and individuals emerge out of this crisis, everyone can be sure that it's not going to be business as usual at least in the near future.

NEW FINANCIAL STANDARDS

In a recent article in The Wall Street Journal, JP Morgan CEO Jamie Dimon captured the new normal succinctly, when he welcomed the Obama Administration's proposals that “focus on strong capital and liquidity requirements — not just for traditional banks but for a broad range of financial institutions”. This quote is sufficient for an economist to conclude that the new normal (in the US) will mean: increased government intervention and oversight in the financial sector, significantly lower capital being available for new investments globally, diminished appetite for risky leveraging and sparse availability of cheap credit.

In addition to this, specific regulations requiring further transparency in key markets like derivatives, introduction of stronger oversight in hedge funds, checks and balances in the shadow banking system and stringent regulations for over-the-counter financial products are all consequences of the tectonic shift aimed at expanding governmental role in the US' economic landscape.

Understanding the new normals in the world's largest economy is crucial as many of their economic and financial legislations often have worldwide effects, thanks to the influence of global finance.

New global regulations, historic bailout packages, co-ordinated responses by numerous central banks and other sweeping actions taken during the financial crisis are guaranteed to have widespread affects. Despite the resilience and growing strength of the Indian economy, these drastic changes globally will significantly affect Indian business, trade and commerce.

CAPITAL CRUNCH

In the last few years, the ability to leverage gave institutions on Wall Street access to ample capital and simultaneously increased their risk appetite. The momentum built up in leveraging was felt across the globe as capital was pumped continuously into emerging markets and unconventional assets like commodities, complex derivatives, art, etc. But this financial fallout and massive government intervention has forced many firms to deleverage and use cash conservatively.

It is important to recognise that the accelerated growth our economy experienced from the early 2000s was driven to some extent by foreign investments, which are sure to dry up in the short to medium term. This is not because India is a less attractive investment destination, but because of insufficient capital and the inability to leverage available capital.

When investment banks, hedge funds and PE firms could access $1 billion with only $50 million in collateral (1:20 leverage), the $1 billion was distributed to India, China, Brazil and Middle East into equity, real estate, commodities and fixed income assets.

But in the post-crisis era, when the amount available is only $50 million (no leverage) or $250 million (1:5 leverage), any amount of distribution to emerging markets and asset classes translates to less capital inflows into India or other emerging markets. This credit crunch, or more appropriately, “capital crunch,” forces us to realise that there is less capital available.

INDIA'S PROSPECTS

Asset managers, financial experts and economists have realised that India was better insulated than many other emerging economies during this crisis. Not only has this cast away many apprehensions about our economy, but it has considerably altered how India is perceived at the global level.

This is definitely another “new normal” for India; our voice is perceived differently, it's respected in the global arena and India's say is not only a credible one but an influential one. The importance of this development is noteworthy, because something like this would have been impossible 10 or 20 years ago.

Finally, another significant “new normal” is the pressure on the local urban and rural markets to perform. It's important to recognise that the Indian consumer differs significantly from the US consumer; unlike the archetypal westerner, the Indian consumer is more of a saver than a spender and our economy is not credit-driven or consumer-driven, like in the US.

If India wants to continue growing at 8-9 per cent in the post-crisis era, where capital is scarce and expensive and leveraging is a thing of the past, our local markets, both rural and urban, must perform better than expected. If this doesn't happen and local demand doesn't gain momentum, moderate growth of 6-7 per cent can be expected in the next few years. The need for local demand to improve is crucial because, for the last decade, the true strength of the local market was overshadowed by rising overseas capital finding its way into India.

(The author is an asset manager based in India and the US)

ONLINE LINK TO THIS ARTICLE: CLICK HERE

THE SUNNY SIDE OF CLIMATE CHANGE

By Adhvith Dhuddu

(Op-ed as appeared in the Hindu Business Line on December 8th, 2009)

In the US, discussions about climate change are often partisan and impassioned. While the Democrats, who control Congress and the White House, largely accept the potentially insidious consequences of climate change, Republicans continue to deny the climate change phenomena. I mention this political bickering about climate change in the US because, as they struggle to reach a consensus on this volatile issue, we in India have largely accepted that climate change is something to confront, but have perceived it as a threat to our economy rather than an opportunity.

How reforms paid-off

When I think of climate change, I often remember a quote that Dr Manmohan Singh, as Finance Minister, referred to during the 1991 reforms, “An idea whose time has come.” That was just two decades ago, and we all remember how these reforms were pronounced by many “experts” as harmful and a threat to the Indian economy and local businesspersons. Their gloomy forecasts have only been debunked.

Likewise, climate change according to me is, “A phenomena whose time is coming whether you like it or not.” A rendezvous with destiny is eminent; to accost climate change in India as a threat to our economy rather than an opportunity will be damaging to our society, the Government and the economy in the long run. The reforms in the early 1990s have been a win-win-win for the people, businesses and the Government.

Climate change presents a similar opportunity. If India is bold and seizes the moment, a similar win-win-win can be created with a thriving new industry in India. Like how the IT revolution spurred exports, created employment and helped the exchequer, an ET (Energy Technology) revolution can do the same. No one exemplifies the threat and the opportunity better than renowned author and columnist, Thomas Friedman, in his book, Hot, Flat and Crowded.

In two decades, by 2030, the International Energy Agency forecasts that global oil demand will rise to 116 million barrels/day from 87 mbpd. But the startling fact is that two-fifths of this increase will come from India and China.

Clean energy

Clearly, energy consumption is set to rise considerably. But what matters is how the rise in demand is met: by embracing climate change and favouring an ET revolution and clean energy initiatives, or “protect” our economy under the veil of “let's become serious about climate change later, after we've had our share of polluting,” only to buy modern and advanced energy technologies from China and the West at a future date.

On this particular issue, the Chinese deserve credit as they've shown leadership and recognised climate change as a significant opportunity. Some of the leading solar, clean energy and green tech companies are now based out of China. Both the government and industries are investing millions in research and development of clean energy technologies and very soon the Chinese will be exporting affordable and quality energy technology solutions to many countries.

Enthusiastic youngsters

But in India one heartening observation is that Gen Y has identified this as an opportunity. Students and young entrepreneurs are churning out business plans and setting up small businesses in the clean energy sector.

A few months ago I was privileged to be on the jury of Manthan 2009, a paper presentation competition arranged by the Federation of Karnataka Chamber of Commerce and Industry (FKCCI).

Amazingly, the first and second place winners presented intriguing and innovative solutions in the green energy and alternative energy sector. Fuel from coconut fibre and the business of carbon credits won top accolades.

Ministry initiative

It's unfortunate to see the media and the Environment Ministry preoccupied with the wrong issue, i.e., whether we agree to legally binding emission cuts or not. What matters is if the Environment Minister, Mr Jairam Ramesh, can envision a clean and green India, whether he can inspire a generation to embark on an entrepreneurial journey in the clean energy and ET sector, whether his ministry can facilitate and stimulate this, and whether he can present an energy vision for India.

We don't need to bind ourselves with emission cuts, what we do need to bind ourselves with, is the fact that the climate change phenomena is a tremendous and unprecedented opportunity for an emerging, developing and vibrant economy like ours. If one recognises this and takes the required steps, we can automatically alleviate the emission problem.

Incentivise business

When it comes to actual policy-making, the Environment Ministry needs to realise that incentivising business' to adapt a clean and green approach will yield better results than mandating them to do so. To create a win-win-win for the Government, business and the people, it's imperative that the Environment Ministry assume a proactive and forward-looking stance as opposed to a protective and defensive stance.

Climate change will not wait for any country to fulfil its fair share of pollution, or any technology to be developed to combat emissions. One thing is certain: how climate change will unfold is highly unpredictable, but countries that are well prepared will be at a significant advantage during the crunch times. Opportunities like these don't present themselves often, and India is poised to seize this chance. We must not let it go by.

ONLINE LINK TO THIS ARTICLE: CLICK HERE

WHAT'S NEXT FOR GOLD?

By Adhvith Dhuddu

(Op-ed as appeared in the Business Line Hindu on Oct 21st)

Gold recently broke through the $1,000/ounce psychological barrier, generating interest among investors, traders and even the common man. Currently there are many factors abetting the price rise in gold. Although no concrete prediction can be made about the price, the outlook appears bullish. There are nine crucial factors that affect the price in the short and long term.

LONG-TERM DRIVERS

Forex reserve allocations: The Asian Financial Crisis in 1997-98 resulted in an accumulation of forex reserves over the last decade. After amassing forex reserves in US treasuries, many Asian economies and export-oriented countries have exhausted their appetite for US debt.

The slow divestment from US treasuries to gold and other precious metals will impact the price of gold. An increasing proportion of forex reserves is being held in gold as countries realise that this could also be a sensible hedge against a slumping US dollar.

Dollar-denominated asset: Gold, like most other commodities, is a dollar-denominated asset. The implication of this is simple: Any significant movement in the US dollar directly impacts the price of gold. Broadly speaking, the price of any dollar-denominated asset (oil, gold, silver, etc) will increase as the US dollar declines and vice-versa (this is because as the US dollar erodes in value, it can buy less of the same commodity).

Over the long term, this will drive the price of gold as many economists and investors continue to express their bearish outlook on the dollar.

Commodity bull market cycle: The commodity bull market cycle will considerably impact the long-term price of gold. Commodity cycles usually last 15-20 years and this one, which started in early 2000s, will peak between 2017 and 2020. Prices of steel, copper, sugar and oil have risen significantly from the early 2000 and will continue to do so steadily for another decade or so.

Inflation fears: If the purchasing power of a currency erodes slowly, it is only because of the inflationary forces present in the system.

Similarly, the purchasing power of the dollar is a direct function of the supply and demand. For several decades, the supply of dollars has been increasing constantly but, concurrently, there has been a steady rise in the demand for dollars. Now, supply of dollars is rising at a higher than average rate, and there is no guarantee that demand will persist.This is why many pundits fear an inflationary spiral in the US that could send gold prices soaring.

Dow-gold ratio: Many analysts use this ratio to gauge the long-term trend of gold and the Dow Jones. The Dow-gold ratio is nothing but the Dow Jones Index divided by the price of one ounce of gold. Currently, it takes approximately 9.9 ounces of gold to “buy” the Dow. This number has ranged from two to 44 in the last 80 years but 9.9 is slightly below the long-term average of 12-13.

According to the mean reversion theory, one of two things should happen: The price of gold should fall from its current levels or the Dow has to rise considerably. It is really anyone’s guess what could happen.

As a safe haven: The supply-demand equation of an asset is what determines its price in the marketplace. Like many other commodities, the supply of gold will always be constant and increase slowly as mines become operational and new technologies to unearth gold are invented.

But the demand for gold can surge if there is a sudden perception of weakness in a currency, the economy or the stock market. New highs in gold prices clearly reflect that demand for gold is rising and will continue to. Gold has always been a safe haven investment in times of economic and financial crisis, and it could happen again if the current recovery shows cracks.

SHORT-TERM DRIVERS

Surpassing resistance: When gold surpassed $1,000/ounce, a crucial resistance level was broken. In the last four-five years, gold had difficulty breaching the $1,000 level and backed off three times after hovering around the high $900 levels.

This time, after breaching $1,000/ounce, it has shown considerable strength and could reach $1,250-1,300/ounce in a few months.

Technical chart: In addition to breaching resistance, two other important technical indications point to higher prices. The price of gold is comfortably above the two critical moving averages, the 50-day and 200-day moving averages. If a six-seven-year gold chart is examined, gold prices form higher tops and bottoms consistently.

This bullish chart formation only strengthens the case for higher gold prices. Worth mentioning in this context is that the dollar index chart forms the exact opposite structure with lower tops and lower bottoms, confirming that the dollar might continue to weaken in the short term.

Indian festival season: According to analysts, the Indian festival season could give a temporary impetus to gold prices and help sustain the bullish run.

Although not a driving factor in the long-term price of gold, the appetite of the common man for gold in countries such as India and China does impact the price. It is true that the long-term average return on gold is a measly 3-4 per cent; but the next few years could see greater yields on investments in the yellow metal.

(The author is an asset manager based in India and the US.)

ONLINE LINK TO THIS ARTICLE: CLICK HERE

Make use of forex reserves

RBI’s primary use of forex reserves is twofold: As an emergency fund in case of a fiscal crisis or food crisis, and to help mitigate any significant volatility in the rupee

By, Adhvith Dhuddu

As appeared in Mint-WSJ on Sept 14th, 2009

Recently, surpassing $2 trillion, China’s foreign exchange (forex) reserves make up close to one quarter of the total reserves in the global economy. Though a pittance compared with China’s reserves, India’s forex reserves have grown healthily over the last decade and a half and are in many ways a reflection of our success as an economy. With close to $260 billion—approximately 25% of our gross domestic product (GDP)—in forex reserves, our coffers are extremely well padded to tackle a crisis. But what’s disappointing is the Reserve Bank of India’s (RBI) reluctance to deploy these funds in creative and resourceful ways.

In his book, Making Globalization Work (2007), Nobel Prize winning economist Joseph Stiglitz dedicates a whole chapter to explaining how the global reserve system should be reformed for the greater good of the world economy. After analysing how Asian countries have accumulated significant reserves following the Asian financial crisis, Stiglitz says: “The money put into reserves is money that could be contributing to global aggregate demand; it could be used to stimulate the global economy. Instead of spending the money on consumption or investing the money, governments simply lock it up.”

Not surprisingly, India is a victim of this flawed strategy. RBI’s primary use of forex reserves is twofold: As an emergency fund in case of a fiscal crisis or food crisis, and to help mitigate any significant volatility in the rupee. In its half-yearly Report on Foreign Exchange Reserves, RBI states that, “safety and liquidity constitute the twin objectives of reserve management in India and return optimization becomes an embedded strategy within this framework.” Despite its stated intention, RBI conveniently chooses to ignore how return optimization will be achieved.

There are several ways to measure return optimization of forex reserves. One standard reliable way is to see if forex reserves meet, exceed or lag reserve adequacy ratios.

Some rule-of-thumb reserve adequacy ratios are: sufficient reserves to cover three-four months of imports; reserves that amount to 20% of M2, a broad classification of money supply; a reserves-to-GDP ratio of 10%; and reserves-to-total external liabilities ratio of 100%. Measured against all these global reserve adequacy standards, India’s forex reserves exceed the requirements. Our forex reserves can cover seven-nine months of import; they are at 85-100% of M2; at 25-27% of GDP; and cover our short-term liabilities five-six times over. By this count, the optimal level of forex reserves for India would be somewhere in the $170-190 billion range.

As a start, 10-15% of reserves can be invested in India for various purposes: infrastructure, agricultural loans, educational loans, and so on. Lawmakers and regulators should understand that deploying just $25-30 billion will in no way increase our external vulnerabilities and a sudden outflow of capital would still be manageable.

In fact, the Asian Development Bank endorsed this strategy in early 2008 and encouraged India to use forex reserves to augment infrastructure development. Recently, the India Infrastructure Finance Co. Ltd successfully tapped our forex reserves through its UK subsidiary to fund capital goods purchases for infrastructure projects. So, whether it’s creating special purpose vehicles for investment in India, forming a sovereign wealth fund (SWF) or allocating $100 million each to the best 100 investment ideas in India, the options available to RBI are abundant.

Creative deployment of forex reserves will have political hindrances —SWF investments, for instance, can be badly politicized. But as Stiglitz points out, the current alternative is “governments just (locking) up” these reserves without putting them to work. Old habits, such as investing heavily in government securities and staying satisfied with substandard returns for forex reserve funds, are hard to break.

Adhvith Dhuddu is an asset manager based in India and the US. Your comments are welcome at otherviews@livemint.com

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WEEKLY ECONOMIC ANALYSIS: December 4th, 2009

Provided by TEAM Financial Services

"I will do everything I can to stop your nomination and drag out this process as long as I can. We must put an end to your and the Fed's failure and there is no better time than now. Your Fed has become the creature from Jeckyll Island."
- Senator Jim Bunning, December 2009

Items for discussion

For those readers who don't live all things financial markets/economy, you may have missed Senator Bunning's "questioning" at Fed Chairman Bernanke's confirmation hearing this week. It is the first time we've seen a government official address Mr. Bernanke, or Mr. Greenspan, in a way we can relate to. The 13 minute video can be seen on Youtube here. Personally, I probably haven't cheered on someone so gleefully since John Elway during the last touchdown drive of the 1998 Super Bowl versus the Packers.

The rolling waves of internal market correction finally reached our shores in a violent fashion Friday, as many commodities and related stocks suffered a substantial selloff. As we have long warned our clients, positions in the precious metals industry are infamous for incredible volatility, and the past few weeks have certainly not disappointed in this regard. From the beginning of November, the HUI precious metals stock index was up over 36% into its peak reached this week. Friday ushered in a vicious one day decline of over 7% at one point on Friday. December gold futures declined over 6% from the Thursday peak of about $1,226 per ounce at their low on Friday.

The US dollar enjoyed a violent rally versus every major currency, as the US dollar index was up over 1.5% - a huge move for the index. It appears that the one sided anti-dollar trade finally attracted one too many adherents, at least in the near term, and the vicious process of the pendulum reverting in the opposite direction may have commenced.

It is always difficult to experience these types of violent moves regardless of how many times one has experienced them in the past. The better than expected November US employment report released Friday morning appears to be the major catalyst for this latest shift in markets. TEAM is busy trying to ascertain whether a fundamental and intermediate term inflection point may be developing or whether this is simply a nasty shakeout/correction that will serve to scare the you-know-what out of those who own these positions. At present, it is too early for us to offer a definitive “forecast”, but we can offer our initial take.

Markets appeared to have priced in the base case assumption that the Federal Reserve would keep interest rates near zero through 2010 and even into 2011. Friday’s employment report appears to have re-introduced some anxiety over the wisdom of that assumption. We certainly understand the rationale behind this anxiety and respect the fact that markets often move violently once too many people have moved to one side of the boat – just a small number of people shuffling back to the other side can cause a rapid period of the boat tossing back and forth.

While the current reshuffling of the boat deck could certainly take a couple/few weeks to unfold, we do not yet see signs that the cyclical recovery in commodities is over. There has been a Pavlovian reaction from traders to sell commodities with any whiff of US dollar strength, which is something that historically is not a given. There have been many periods historically in which commodities rallied with the US dollar in relation to foreign currencies, and TEAM believes that a similar scenario is possible. In addition, this latest spike in the US dollar could end up being very temporary, though significant in percentage terms, before it resumes its downtrend.

We continue to retain our significant allocation to commodities and related stocks, as painful as doing so was on Friday, as we believe they continue to present a compelling risk/reward opportunity over the intermediate term. We were encouraged to see that precious metals stocks were down about in line with the metal itself. Often times during these types of violent moves the stocks will be down a multiple of the metal. This suggests to TEAM that the stocks may be poised to finally lead the metal once the current decline exhausts itself, whenever that may be.

Market/Economic Climate

The strength in Friday’s employment report corroborates the forecast we made a couple of months ago that job growth could actually resume by the end of 2009. As completely unlikely as it seemed at the time we expressed that forecast, it now appears within reach – such is the “magic” of well constructed leading indicators! TEAM continues to forecast that government reported GDP growth in the 1st and 2nd quarters of 2010 will surprise many with the extent of the strength. Our research suggests that there is widespread aggressive inventory management across many industries. Whether it is retailers petrified of a weak holiday shopping season or an industrial firm worried the demand for their widgets will not resume.

We already know that firms have cut payrolls aggressively over the past two years, so if/when demand does pick up, even if it is modestly and regardless of whether it is being created by government stimulus, a cyclical “perfect storm” could unfold. With inventories extremely low and labor cut to the bone, production and labor pressures could emerge quickly. There is no question that the US has lost a huge amount of its manufacturing base to other countries, so employment trends in the US could continue to lag. However, whether a widget is manufactured in Malaysia or Michigan, the demand for raw materials is the same.

We believe this combination of low inventories, dramatically reduced work forces and incredibly loose monetary policies globally is likely to keep a significant wind in the sails of commodity prices. As we stated several months ago, leading indicators suggest the US service sector is poised to lead the US recovery, so service jobs and end demand may revive faster than most expect.

Humor for the Weekend

Weekly Economic Analysis newsletters are provided by TEAM Financial, and are written by TEAM's Chief Investment Officer, James L. Dailey. Visit TEAM's website if you want to receive weekly economic updates right in your inbox - Click here.

WEEKLY ECONOMIC ANALYSIS: October 30th, 2009

Provided by TEAM Financial Services

"All objects, all phases of culture are alive. They have voices. They speak of their history and interrelatedness. And they are all talking at once!"

- Camille Paglia

Items for discussion

There have been two important developments in the past two weeks that most readers are probably not aware of. The central banks of Australia and Norway both raised their interest rates. This has coincided with the market carnage of the past two weeks. TEAM believes these developments are important over the intermediate to long term, as it is indicative of an end to the global synchronized monetary regime that has existed over the past twelve months.

Since the financial crisis took full force last fall, central banks around the world have followed fiscal stimulus with monetary stimulus. Spending has increased by governments around the world while interest rates have been slashed. Fiscal deficits have exploded and rates have remained at record lows. The fact that two central banks have moved to begin removing some monetary stimulus is indicative of something we expected to be inevitable. Countries were never likely to maintain a uniform perception of reality or their self interests.

If we are correct, then we are likely early in the transition towards the third of the three crises. The financial crisis morphed into an economic crisis, and now we believe that government responses and policies around the globe are likely to usher in a global currency/funding crisis. While we may be in the beginning stages of this transition, it could take quite a period of time until the crisis becomes main stream and dramatically impact the broader economy and financial markets.

Market/Economic Climate

Something we learned long ago is that if one makes an economic or market forecast long enough, then one is likely to be correct….eventually. After fighting our shadow for a few months and preparing for the correction of substance that was seemingly never to arrive, it appears to have finally arrived. We had communicated a basic scenario for the fall which we expected to play out and it now appears possible. It appears that renewed concerns about the durability of the economic recovery have many investors running for shelter.

The major stock market averages are down about 6% from the peak reached just seven trading days ago. That rate of decline would be on par with the June-July mini-correction over the summer, but we expect this correction to be deeper. Our base case scenario is a correction to evolve into 10-15% decline from the recent peak around 1,100. Market sectors hit hardest in the initial stage of this correction have been those sectors that lead the March-October move higher. Financials, energy and materials have been hit the hardest. Small companies have been hit harder than large companies, and foreign (especially emerging markets) have been hit harder than domestic.

At this point, TEAM believes the unfolding correction may end up being similar to the 4-6 week correction markets suffered in May-June of 2006. Economic fundamentals remained strong on a global basis during that correction, which was largely a purging of excess optimism on an intermediate term basis. Major market rallies/bull markets often experience three major phases. Phase one is when the rising tide lifts all boats and low quality stocks tend to outperform. Phase two is typically ushered in via a correction in which many of the low quality stocks never recover. These stocks, as a group, typically make their peak at the end of phase one. Phase two unfolds with investors upgrading their portfolios into higher quality company stocks and leadership narrows in the market. Breadth and advance/decline indicators typically begin to diverge as fewer and fewer stocks participate in the advance. Phase two can include a new market high in the broad market averages, but it does not have to. Phase three includes the final stages of the exhaustion in the market and the transition to the beginning of the bear market.

At this point, TEAM believes that phase one has ended and that the current correction should usher in phase two. Client portfolios have been structured to weather this transition for several weeks – about two weeks premature as it turned out. While shorter term market forecasts are always treacherous, our base case is for the current correction to be quite violent in both directions and last into late November. We expect to maintain significant portfolio hedges until we see signs that the correction has exhausted itself. At that time, it is very possible that we may significantly reduce or even eliminate portfolio hedges and add addition positions to portfolios.

Of course, it is possible that we’ve reached a major market peak and that the market will simply crumble into a major collapse. While this is a very low probability in our opinion, we always approach market declines with a disciplined process that waits for some signs of stability prior to increasing portfolio risks.

Humor for the Weekend

Weekly Economic Analysis newsletters are provided by TEAM Financial, and are written by TEAM's Chief Investment Officer, James L. Dailey. Visit TEAM's website if you want to receive weekly economic updates right in your inbox - Click here.

WEEKLY ECONOMIC ANALYSIS: October 10th, 2009

Provided by TEAM Financial Services

"At twenty a man is full of fight and hope. He wants to reform the world. When he is seventy he still wants to reform the world, but he know he can't."
- Rodney Dangerfield

Items for discussion

While we covered this topic recently, we believe it is important enough to highlight once again. Bond mutual funds have seen an explosion in inflows from retail investors over the past year. The inflows have dwarfed the amount of assets that have flowed into stock mutual funds, despite the 50%+ recovery in the major stock market averages since the absolute March low.

For those readers who actually have a life and don’t follow such things closely, much of the bond market trades on what is known as a “spread basis”. Essentially, the value of a bond is gauged relative to what is considered a “risk free equivalent”. For example, company XYZ may issue a new 10 year bond and its spread to the 10 year US Treasury bond may be 2%. The current yield on the 10 year US Treasury is 3.384%, so a 2% spread would result in a yield of 5.384%. Many bond investors worry mostly about this RELATIVE spread far more than they worry about the ABSOLUTE yield of bonds. TEAM hopes most of our clients know by now that our primary obsession is focusing on absolute returns in general – i.e. whether the stock market is up or down 50% in any given year, our goal is to make reasonable positive returns. We view bonds through a similar “absolute return” lens.

The Federal Reserve has purchased well over ½ of the massive amount of US Treasury bonds issues in the past 3 months. TEAM is left to wonder where Treasury yields would be if this artificial demand was not in play. As we’ve chronicled in the past, the Fed is printing money out of thin air in order to monetize/buy these Treasury bonds. Would yields be .5% higher or 1% higher if this wasn’t occurring? We have no idea, but we suspect they would be higher.

In our opinion, those bond investors relying on spread relationships in order to invest may be making a terrible mistake. We believe there is a tremendous risk that US Treasury yields will head significantly higher over the next 3-5 years. We’ve identified a US “funding crisis” as the next potential crisis to face investors, and part of such a potential crisis would likely include significantly higher Treasury yields.

For anyone who has invested for more than the past 10 years, or at least is familiar with market history (yes I admit to being in my mid 30’s!), a 10 year Treasury yield of 7-8% would be considered reasonable. Many may remember when yields were in the mid double digits in the early 1980’s. My colleague, Sam Lindenberg, is fond of telling the story about his 15% mortgage when he bought his house when he moved to Central PA (much like the old “I walked to school in 3 feet of snow stories” some of our seasoned citizens share!). Money market rates have commonly been in the 4-6% range over time.

Many bond investors appear willing to lock up money for 10 years at mid single digit returns and justify it because they are getting an “adequate” risk spread over US Treasuries. TEAM has seen this game before on several occasions. Relativism can be a very dangerous practice as an investor. There were dot com stocks in 1999 that were “cheap” relative to other dot com stocks. There were Las Vegas condos that were “cheap” relative to other Vegas condos in 2006.

One of the most pernicious and morally reprehensible components of our government’s current policy is what it is doing to otherwise conservative savers who are now being “forced” to take risk. We witnessed this with horror during the 2003-2007 period as many seniors rushed into bank preferred stocks and other vehicles that subsequently "blew up". A senior living off of a 10 year CD that may have been at 6% may be finding out that a comparable CD may only yield 3% today. In a quest to preserve their income for such gratuitous items such as medications, food and shelter, is it any wonder why someone in that situation may be willing to move out the risk curve to try and preserve that level of income? Why not buy a “conservative” bond mutual fund that yields around 5%?

Despite all of the crazy market developments since 2000, investors haven’t faced a good old fashioned bond bear market in a long time. There was a relatively brief flirtation with one in 1994 before Alan Greenspan folded (as he always did) to the Wall Street bond traders screaming for mercy. Prior to that time, it has been since the late 1970’s and early 1980’s that bond traders/investors have had to deal with persistently higher interest rates. While mob rule can get one run over if one tries to stand in the way of the stampede, they almost always end badly. We don’t yet have a good feeling as to when the current stampede may end. However, just as prior stampedes have left the masses with deep regrets (rushing into tech stocks in 1999 or flipping houses in 2007), rushing into bonds at the moment is likely to be bad for one’s financial health over the long run. We suspect those rationalizing bond purchases using relative metrics will eventually learn the expensive lesson of absolute value.

Market/Economic Climate

While the stock market remained extremely, and impressively, resilient this past week, there is some movement in the quicksand that lay in the foundation. The US dollar index reached a downside target in our model and bounced significantly off the lows late in the week. It has been very unusual for stocks to ignore a rally in the US dollar, yet that is precisely what occurred on Friday. The US Treasury market also reversed sharply on Friday, as bond prices dropped and yields rose. The synchronized trend in recent weeks has been stocks/commodities/bonds rallying as the US dollar drops. Friday was the first day in which these correlations broke down. The US dollar rallied with commodities and bonds falling. As mentioned, stocks defied the dollar rally and diverged.

Of course, this is just one day, but given the proximity of the major stock market averages to one of our longer term target areas, next week is likely shaping up to be very important to TEAM as to how we adjust client portfolios. At present, client portfolios remain positively exposed to stocks and commodities, but at a dramatically lowered level due to extensive portfolio hedges. This is due to our research and model indicating that there is a high probability that the US dollar is poised to enjoy at least a multi-week rally and that stocks will eventually relent and correct in price at the same time. Our current allocation should be fairly well positioned to weather such a scenario. Importantly, should things not develop as we expect, then we may need to swiftly shift portfolio exposure and scale back some of our hedges.

We recognize this kind of account activity can be unnerving to many clients, but it is a critical part of our flexible strategy that has enabled us to provide consistent absolute returns over time. As always, we are happy to address any client questions or concerns regarding portfolio holdings or activity.

Humor for the Weekend (From last week)

Weekly Economic Analysis newsletters are provided by TEAM Financial, and are written by TEAM's Chief Investment Officer, James L. Dailey. Visit TEAM's website if you want to receive weekly economic updates right in your inbox - Click here.