Enzio's Clock

Background

1. 2011 guesses

Having been so dreadfully wrong on stock markets this year, please read the following cum grano salis.

Here are some "pattern predictions":

a) Worse  Economic Time®.  Currently there is a very clear excess supply of money and an excess supply of goods.  But with Central Banks starting to move to "exit mode", expect that excess supply of money to wilt just a little.  And with banks starting to lend again - albeit gingerly - money demand will rise.  So we will be confronting the first shoots of an excess demand for money.  Meanwhile, on the goods side of the equation, unemployment will remain high. This implies that the excess supply of goods will remain for a long time. So, looking ahead, the Economic Clock® is going to move to the excess demand for money/excess supply of goods quadrant. 

b) Worse profits outlook.  One consequence of a worsening Economic Time has to be that this year's rosy run in stock markets will come to a screeching halt. That is because the worsening Economic Time has to bode terribly for profits.  Indeed, in yesterday's Financial Times (FT) we learn that "...the proportion of holiday sales made over the Thanksgiving week end, when discounts are prevalent, has been rising, suggesting (rising) price sensitivity."  And with aggregate unemployment stuck at 17% (yes: once you include those who have given up looking for a job, the headline 10% is jettisoned to 17%), people are not exactly in a shopping mood. In terms of the profits equation, then, revenues have to decline. And revenues, along with technology (e.g. price comparisons via the internet and IPhones) will thwart growth in margins.  So, looking ahead, expect markets to have to accept the "reality of reality" namely that those rosy profits forecast this year will turn out to be malarkey.

c) Rising volatility. This acceptance of the "reality of reality" suggests that markets will be in for a rough ride. This year has been all about rising profit expectations. The result is that the market became more of a smooth, one-way bet. Thus, volatility shrank: a popular measure, the VIX index, stood at 81 on 20th November 2008 and closed on 24th December at 21 - a fall of roughly 75%!  But if our view of a souring of profits prevails, then watch VIX climb back up the hill.  So, looking ahead, expect greater volatility and thus the unwinding of carry trades. 

d) Props desks' short positions. We all know of the moral turpitude of a Government Sachs & Co.: I would not put anything past them in their avaricious quest for profits and boni.  So, one thought of mine is that if just one major proprietary trading desk (props desk) decides that the market has stopped rising, its traders will begin a huge shorting programme.  They probably will tell their most public analysts (in  their "huddles", for instance) to keep talking the market up - so that the props boys can put short positions on, on the cheap. Once they have their short positions in place, watch these very same, public analysts now begin to decry profits outlooks; instead, they will tell all of us that the markets are about to tank. And  who, pray, makes tonnes of money on the way down....? So, looking ahead, talk with you trader friends at the big and small banks; try to get an inside view as to what their props desks are up to. Remember that like most of us, props desks are a herd of sheep, where "follow the leader" is the currency of the day...

2. Why bonds are safer than deposits

Deposits at the bank have become a very risky asset. This is because when you deposit money at your purportedly "safe" bank, you actually are lending the bank your money: you are a banker to the bank!  So if the bank tumbles, your deposits tumble with it.

Given the plethora of news about banks' problems, we hardly need remind you of the danger that these institutions pose to your money.  On top of which Moody's reckons that they have to refinance ten trillion dollars worth of debts by 2015; by way of comparison, the size of the world's most powerful economy is fourteen trillion dollars.  And, according to Aline van Duyn in the FT of 22nd December, "...there are potential further losses on assets accumulated. The Institute of International Finance (IIF) says that the assets owned by the five largest US banks have grown to $8,300 bn this year, up from $2,600 bn in 1999. These now represent 60 per cent of US gross domestic product. In the UK, the biggest five banks own assets worth four times as much as GDP, and in the eurozone, the big five banks' assets represent 88 per cent of GDP... 'The impact of asset growth and potential losses, especially in commercial real estate exposures, continue to pressure bank capital ratios,' the IIF said in a report."

Do you want to entrust your money to a bank whose assets are of dubious quality? Next to sub-prime problems that continue lingering, what about problems besetting commercial real estate? If our view of a huge profits disappointment comes true in 2010, then watch banks' problems multiply. Problem is, this time the government won't have as much dosh to bail them out with...

Bonds are safer than deposits because with individual companies, you should have a better handle on what they do.  Ratings agencies, as corrupt as they probably are, do at least give you a compass as to which bonds are safer than others. Crucially, when you buy bonds, the banks do not get your money; instead, they act as custodian of your money. So they don't own your bonds at all; in fact, when the bank tumbles, it still owes you your bonds back.

3. Why bonds are richer than deposits

Bonds yield more than deposits because bonds have longer maturities.  Going back to what we suggested about the yield curve: the longer the maturity, the higher the interest rate, meaning that in normal circumstances, the yield curve has a positive slope.

Meanwhile, back at the bank, your deposits are normally of short-term nature, so you get less interest income because these maturities are at the short end of the curve.

Finally, bonds yield more because if you buy investment grade paper, you can be pretty assured that you will get the coupons and your principal back once the bond matures.  Given the size and turpitude of banks' assets, these two elements are not "givens" any more.

4. How to Make Money Off This Idea

1. Always consult your financial adviser first.
2. Replace the deposits which you have at the bank with bonds. Or buy a good bond fund.
   
3. Buy bond maturities of up to about two years: once rates rise, the capital values of longer-dated paper will slide.
4. Buy the dollar: rising volatility means that carry trades will be unwound...