Tuesday, May 26, 2009

The Second Crash

The Second Crash: On The Way And Unstoppable

By Doug Hornig | 1 June 2009

Tuesday, October 9, 2007 started as a nice day in New York City. A lovely early fall day, with the temperature still a balmy 80° at 2:00 in the morning. By evening, though, the temperature had dropped twenty degrees, the clouds had rolled in, there was thunder and rain. As with the weather, there were some hints of trouble here and there on Wall Street. But all in all, things could not have seemed better. Little did we know, the stormy end of 10/9/07 signaled a very large bubble that had just popped.

That was the day when the Dow Jones Industrial Average hit its historic peak. From there, it was all downhill— slowly but steadily at first, and then violently after last August— until the Dow bottomed (for now) on March 9 of this year. Over that span, the index lost 54% of its value.

It's been a crushing blow to just about everyone. But it's already being referred to as the crash. As if the unpleasantness were now all behind us. More likely, in the future it will be seen as, simply, the first crash. Don't believe it? In a moment you will, when you see the scariest graph of the year.

But let's quickly recall what's already happened. During the late, great housing boom, interest rates were at microscopic levels, while bankers were encouraged to grant home loans on little more than a wink and a nudge. In order to inflate their balance sheets, those bankers resorted to all sorts of gimmicky, adjustable rate mortgages (ARMs), whose common feature was an interest rate that would eventually reset. That is, it would balloon somewhere down the road. And those most likely to come quickly to grief were the riskiest borrowers, who held loans known as "subprime".

"But not to worry," borrowers were told. "Betting on ever-rising home prices is the safest wager in the whole wide world. If you have problems with cash flow when the ARM resets, your house will be worth a lot more, so you can simply sell it and walk away with a nice chunk of change in your pocket." Uh-huh.

The bankers themselves were a little more concerned about the deterioration of their portfolios. They took out insurance in the form of credit default swaps (CDSs). These were a brand-new invention in world financial history, allowing mortgages to be sold and resold until they were leveraged 20 times over. They became the shakiest part of a huge global derivatives market, with a nominal value in the tens of trillions of dollars.

For a while, this Ponzi scheme even worked. But then, as they had to, the ARMs began resetting, and there were defaults. Then more of them. Because at the same time, the housing market was cooling off and the economy was stalling out. More and more people were trapped in a situation where they owed more on their home than they could sell it for. Many simply mailed their keys to the bank and moved on.

All of this wreaked havoc in the derivatives market. Sellers of these exotic packages could no longer establish what they were worth. Buyers couldn't determine a fair price and so stopped buying. As the ripples spread through the world financial system, trust disappeared and liquidity dried up.

Now consider that the base cause for all that dislocation was the subprime sector. And how big is that? Not very. Subprime mortgages account for only about 15% of all home loans. Their influence has been way out of proportion to their numbers, because of derivatives. Here's the good news: the subprime meltdown has about run its course. These loans were resetting en masse in 2007 and the first eight months of '08. Now they're pretty much done.

And the bad news? No one in the mainstream media seems to be asking what should be a pretty obvious question: What about loans other than subprime? Truth is, the banks didn't just trick up their subprime loans. ARMs were the order of the day— across the board.

Now, here's that frightening graph we referred to earlier.

Click Here, or on the image, to see a larger, undistorted image.

Take a good, long look. You can see that from the beginning of 2007 through September of 2008, subprime loans (the gray bars above) were resetting like crazy. Those are the ones people were walking away from, sending a shockwave from defaults and foreclosures smack into the middle of the economy. Now they're gone.

The ARM market got very quiet between December 2008 and March 2009, hitting a low that won't be seen again until November of 2011. Small wonder a few "green shoots" have poked their heads above ground. But in April, resets began to increase and will reach an intermediate peak in June. After that, they tail off a little, going basically flat for the next ten months.

It's not until May of 2010 that the next wave really hits. From there to October of 2011, the resets will be coming fast and furious. That's 18 months of further turmoil in the housing market, and the beginning is still nearly a year away! (Although the months in between are likely to be no picnic, either.)

While it isn't subprime ARMs that are resetting this time, neither are they prime loans. Those eligible for prime loans wisely tended to stay away from ARMs in the first place, as indicated by the relatively small space they take up on each bar. No, the next to go are Alt-As (the white bars), Option ARMs (green) and Unsecuritized ARMs (blue). Alt-As are loans to the folks who are a small step up from subprime. Unsecuritized loans are a 50-50 proposition; either the borrowers were good enough that they weren't thrown into the CDS pool, or they were so risky no one would insure them.

Those two are bad enough. But Option ARMs are the real black sheep, loans with choices on how large a payment the borrower will make. The options include interest-only or, worse, a minimum payment that is less than interest-only, leading to "negative amortization"— a loan balance that continually gets bigger, not smaller. Imagine what happens with those when the piper calls.

Once the carnage begins, will it be as bad as the subprime crisis? That's the $64K question. Perhaps not. For one thing, subprime loans were a much larger chunk of the market when they started going south. For another, there's been a lot of refinancing as interest rates dropped; that should help ease the default rate. And the government has massively intervened, with measures designed to prop up those who would otherwise lose their homes.

On the other hand, we're in a severe recession, which wasn't the case when the subprime crisis started. More people will be unable to meet payments. And the housing market has continued to decline, pressuring both marginal homeowners and banks that can't sell foreclosed properties. Is the stock market's next 10/9/07 on the way? Yes. Which day will it be? That's unknowable. It could be in a week, or not for another year.

But make no mistake about it, the second crash is coming. It can't be prevented, no matter what desperate measures Obama and his hapless financial advisors come up with. All we can hope for is that, with a little luck, it won't be as severe as the first one. But it will last longer. We aren't even in the middle of the woods yet, much less on the way out. The order of the day is to be very defensive. There will be few safe havens, but they do exist.

Tuesday, May 19, 2009

Me, Lord Marlboro And The Dow!?

Me, Lord Marlboro And The Dow!?

By Jeffrey Saut | 18 May 2009

Reminding us of the current equity market is an anecdote about the Sport of Kings that took place in London:

An American race horse owner, while parading his entry in the paddock just before the event, fed the horse what appeared to be a white tablet. Noticed and challenged by an English track official, Lord Marlboro, the American was informed that his horse would have to be disqualified. Protesting vehemently that he only gave the horse a sugar cube, the owner popped one into his mouth and offered Lord Marlboro a cube as proof. The English official tasted and swallowed the cube. He agreed with the owner that it was a harmless sugar cube and waived the disqualification. Just before the race horse was to enter the gate, the American signaled his jockey, instructing him to keep his horse clear of trouble near the start and try for the lead early since his horse was sure to win. "In fact," he told the jockey, "Only two have a chance to beat our horse." "What two?" asked the jockey? The American owner replied… "Me and Lord Marlboro!" …Anonymous

We recalled the "Me and Lord Marlboro" quip as we watched the running of the Preakness over the weekend. Evidently, someone fed Rachel Alexandra the proverbial "sugar cube" as she won the Preakness by beating "Mine That Bird" to become the first filly to win said event since 1924. Likewise, someone must have fed the D-J Industrial Average (DJIA/8268.64) a similar "sugar cube" 10 weeks ago, as the major averages have "galloped" from a generational oversold reading into the longest "buying stampede" of my lifetime.

Indeed, the stampede is now legend at 48 sessions without anything more than a one— to three-session pause/correction. Surprisingly, however, despite all the snorting, cheerleading, and animal spirits, the last tranche of index positions we sold in mid-April are virtually no higher now than they were back then. And, ladies and gentlemen, that is as it should be, for history shows that if a stampede is able to extend for more than the typical 17 - 25 sessions, the "momentum peak" tends to come between the 25th and 30th session; it is extremely rare for a stampede to extend for more than 30 sessions. In this case it appears the momentum peak came on April 17th with the S&P 500 at 876. Currently, the S&P 500 (SPX/882.88) resides only 6 points above that level.

Accordingly, we have counseled for caution over the past four weeks; and despite our renewed "hate mail" (for being too cautious), we don’t think a whole lot of money has been made since the April 17th momentum peak, which just so happened to be session 29 in the stampede. That said, as often repeated in these missives, we can find NO instance where the equity markets spring from such a generational oversold reading into a straight-up six-week buying stampede and then come right back down and test, or break, the previous reaction price low, in anything less than 12 weeks (three months). It is just the nature of the beast in that most participants "missed" the lows, have been sitting with too much cash, and are 'forced' by the performance derby to commit that cash, which is why the "dips" are being bought.

Indeed, ISI’s survey of hedge funds shows that their net exposure to equities is still well below benchmarks. And that is why the pauses/corrections have been shallow and fleeting. Three months [along] into the skein, however, the environment could change, setting up the potential for a "June Swoon". That would also be in keeping with the astute Dines Letter that observes, "April has been a month with a pivotal reversal of the March trend 67% of the time since 1963; and, at least a semi-important TOP has been reached in virtually every April or May since then". And don’t look now, but the early May "highs" felt pretty toppy to us.

So far any downside correction, since the early March lows, has been contained to between 5% and 6.4%. That suggests any correction of more than 6.4% could imply more of a correction than any we have seen since the demonic S&P 500 low of 666. Measuring from the May 8th closing high of 929.23, a greater than 6.4% price decline yields a "failsafe point" of slightly below 870 on the SPX. If that level is violated, it would suggest a decline to at least 830 (the 50-DMA is near 832) and maybe more. Moreover, last Wednesday’s "wilt" (-184 DJIA) was a 90% Downside Day, meaning that more than 90% of Downside vs. Upside Volume, as well as Downside vs. Upside total points lost, were both skewed more than 90% to the downside.

So what does all of this mean on a short/intermediate term basis? Well, after nine weeks of straight-up rally for the NASDAQ, the tech heavy NASDAQ (1680.64) took a breather last week. This is noteworthy because other than the Financials, the Techs have been the market leaders. Further, as the good folks at Bespoke Investment Group write, "The most noticeable difference about (last) week’s sell-off is that it is the first decline in years that wasn’t due to ‘troubles’ in the financials."

They go on to observe, "In fact, even though the S&P Financial sector has declined by 13% since May 8th, default risk has also had its biggest decline in months. During prior market selloffs, our CDS Index (Credit Default Swaps) has spiked sharply (higher) on fears of systemic problems. Now, that’s not the case, as our CDS index is near its lows of the year."

Inferentially, at least to us, last week’s action set up the potential for a more enduring decline than that which we seen since the March lows. Accordingly, we think participants should reduce/hedge their exposure to early-cyclicals, which have outperformed since our "buy ‘em" call of March 2nd. We also think those freed up funds should be shifted to agricultural investments.

In past missives we have mentioned numerous investment vehicles, which have rallied nicely, such as 9%-yielding Archer Daniels Midland convertible preferred "A" shares (ADM, A/$33.54), and 6%-yielding Bunge’s convertible preferred (BGEPF/$78.00) both of which are followed on a research basis by our affiliates. We continue to embrace the agricultural theme and have added the exchange-traded fund (ETF) iPath AIG Live Stock Total Return Index (COW/$30.02), as well as 3%-yielding Claymore Clear Global Timber Index (CUT/$13.06), to stocks for your consideration.

Congressman Waxman appears willing to give away credits to industries in support of the "climate change" bill. This should be a positive for electric utilities. While we don’t like the utilities right here for numerous reasons, their dividend yields and geographic positioning make some of them worthy of consideration.

Our caution on the utilities stems from the interest rate complex, where the 30-year Treasury bond has broken down in the charts (read: higher interest rates), leaving the yield above 4% for the first time since November 2008. Indeed, on April 29th the long bond broke below its 200-day moving average (DMA), thus completing what looks to be a massive top formation. Surprisingly, because higher interest rates should be supportive of a firmer U.S. dollar, the Dollar Index has also broken down and continues to reside below its respective 200-DMA.

Meanwhile, gold has traced out what appears to be a giant reverse head-and-shoulders bottom in the charts; and, we remain bullish. To be sure, bonds, the dollar, copper, and crude oil remain supportive of the "reflation trade". We have been bullish on crude oil since its mid-January "price lows," believing crude oil was making a bottom. We are still bullish, but would note that after its rally from those mid-$30s "price lows" in January, to its recent high of around $60, crude is now extremely overbought in the near-term. Consequently, we would be more cautious on crude oil stock positions; and, would actually consider hedging some of those positions to protect their gains.

The call for this week: I am leaving for Europe this coming Friday to see institutional accounts and do some seminars. Consequently, while I will continue to do verbal comments for the balance of this week, there will be no Monday letter for the next two weeks. Hopefully, I will have some insights from my travels upon returning. Nevertheless, last week felt like a trend change to me with the S&P 500 (equal weighted) losing more than 8%, the Russell 2000 surrendering some 7%, and the D-J Transports shedding nearly 9%.

Moreover, Thursday was a 90% Downside Day. As the Lowry’s service notes, "A likely key factor in determining the extent of a market pullback in the weeks ahead would be the occurrence of additional 90% Down Days. Thus far, in the rally since mid March, 90% Down Days have been isolated events, quickly followed by a renewed uptrend. However, a series of 90% Down Days could indicate the sort of sustained, heavy selling consistent with a deeper and more sustained market set back". And, as the always insightful Helene Meisler writes, "Keep your eyes on the Russell 2000 since it is the only index that has rallied back to the underside (or just about) of its broken channel line. A failure here would confirm my view that we’re in the midst of a correction."

Monday, May 18, 2009

Great Depressions Are So Methodical

Institutional Advisors: Great Depressions Are So Methodical
Click here for a link to ORIGINAL article:

By Bob Hoye | 16 May 2009

My Recent Presentation To The CMRE

Clearly, the title of this address puts me firmly in the bear camp. Just as clearly, the possibility of another great depression is highly controversial, particularly when such magnificent efforts are being made to restore the prosperity of a financial mania, which have always been ephemeral. Perhaps my credentials should be reviewed. Everything I needed to know about the markets I learned on the old and notorious Vancouver Stock Exchange. For example, in a world of extravagant claims from big government, big academe and big Wall Street the old definition of a promotion is useful: "In the beginning the promoter has the vision and the public has the money. At the end of the promotion the public has the vision and the promoter has the money."

In 2006 to 2007 the public had the vision that policymakers could depreciate the dollar forever and were positioned accordingly. And for a moment the promoters looked brilliant as everyone thought they were wealthy. Moreover, as with any promotion the bigger it is— the bigger the crash.

There are two failures going on. The most obvious is in the financial markets and the other is in interventionist economics. The latter failure is in theory as well as in practice, and can be described as the greatest intellectual failure since the Vatican insisted that the solar system revolved around the earth, more particularly, Rome. Until recently, too many believed that the financial world revolved around the Federal Open Market Committee.

Last year's disaster fit the pattern of the 1929 fall crash with remarkable fidelity. Such a crash was obvious and as the train wreck in the credit markets continued through the summer of 2008 the Fed continued its recklessness. But with some marketing skills, the objective of "stimulus" changed from keeping the boom going to the absurd notion that bailing out one insolvency, Bear Stearns, would revive the boom. As usual with a bubble, it was not just one bank that had been imprudent— most had been.

The establishment missing this recurring event was bad enough but there is another clanger and that is the hopeless notion of a 'national' economy. Even in ancient times, Cicero knew that the prosperity of Rome was vulnerable to the credit conditions in the Middle East. In this regard, Mother Nature has again been providing some harsh lessons, and history suggests that she and Mister Margin will ultimately be successful in teaching markets 101 to many policymakers.

In the meantime, coming out of the classic fall crash, orthodox investments such as commodities, stocks and bonds were expected to rebound out until April-May. Until this hooked up, the typical GDP forecast was tentative in looking for the recovery to begin "by mid-2010", but our "model" needed forecasts of the recovery starting much sooner. Then, thanks to the "Green Shoots" that began to appear with the rebound in March, confidence was gradually restored in high places such that the miracle of recovery [was anticipated to] happen sooner. The higher the stock market gets, the more popular this idea becomes.

And this gets us to another lesson from the old Vancouver Stock Exchange. "So long as the price is going up— the public can believe the most absurd story." This has been the best explanation of why Wall Street, the supposed bastion of capitalism, focused on every utterance from central planners in a central bank. Then when the price breaks, the vision disappears along with liquidity.

The Next Phase Of [Violent] Contraction Has Been Expected To Start After Mid-Year.

For participants, post-bubble bear markets have been sudden and severe. The 1929 example ran for three years and the post 1873 example lasted for five years. The latter has been the best guide for our recent mania and its bust, but this will be expanded [on shortly] as it is worth reviewing the excuses offered by many in not anticipating that short-dated interest rates as well as gold would plunge in a classic fall crash. This was the pattern with the 1929 and 1873 crashes and knowledge of such a plunge in short rates should have ended conventional wisdom that a Fed rate cut would have prevented crashes from 1929 to 2008. [[As, it didn't prevent them happening then.: normxxx]]

The quickest sign of a gold bug forecast going wrong are exaggerated claims of "Conspiracy!". On the other hand, Wall Street strategists described their latest disappointment as a "Black Swan" event, and therefore 'unpredictable'. That has been a 'cheap out' as each transition from boom to bust has been quite methodical [as will be outlined shortly]. Others called it a "Minsky Moment". Minsky accurately described the mechanism of a crash but, being a Keynesian, he also wrote that "apt intervention" could keep the economy on a successful path.

Actually, financial conditions had already reached the 'perfect' "Keynesian Moment". As we all know, Keynes said "If you save five shillings you put a man out of work for a day." As part of the greatest mania in history, the savings rate plunged to zero— Keynesian perfection had finally been accomplished. Many in the Street, but only a few economists, knew this was dangerous.

Econometric modelers, who still believe in the powers of regression equations, have long had their out, which has been "Exogeneinous", and in one memorable paper of 1983 there was "Super-Exogeneity". This arrived in May 2007 when the yield curve reversed from inverted to steepening. Our research expected it to occur around June. By July of that fateful year, there was enough deterioration to conclude that "This is the biggest train wreck in financial history". It is not over.

Although crashes are grisly events, they share a common response from the establishment. No matter how shocking, bloody, expensive, ruinous or just plain shattering a crash is— within a week, there is no one in the Street who didn't see it coming. As ironical as this is, there is a critical link from the stock market to the economy.

In the usual business cycle, the peak in stock speculation typically leads the peak in the economy by about a year. On the previous example [of a typical recession], stocks set their high in March 2000, and the NBER set the start of that recession in March 2001. Using their determination this has been the case for most cycles back to 1854. But, at the conclusion of each Great bubble in financial and tangible assets, things become abnormal. The failure in the financial markets and the economy beginning in 2007 have been virtually simultaneous.

As we all know, in 1929 the recession started in August, but the Dow made its high in September. In 1873 the bear started in September, and the recession in October. This time around, the stock market high was in October 2007 and this recession started in December of 2007. Close enough to fit the post-bubble model, with implications that financial history is now in the early stages of another Great Depression.

This painful event is being confirmed by the behaviour of politicians and policymakers. After traveling around claiming credit for the boom, politicians panic [when the bust arrives] and then find ready scapegoats. Remember the "Goldilocks" celebration of 'perfect management' of interest rates, money supply and the economy?

Well, all five great bubbles from the first in 1720 to the infamous 1929 have been accompanied by such boasting. Then, it is followed by what can best be described as frenzies of recriminatory regulation. If the political path continues— protectionism— will follow. One of the worst such examples was called, in its time, the 'Tariff of Abominations'.

But, this is enough of such dismal events— it is time to mine the irony for further amusement and enlightenment. The clash between the establishment and financial history is rich with irony. Beyond that, financial history itself [[of which everyone in the financial community is conveniently ignorant: normxxx]] should be considered as an impartial "due diligence" on every 'grand scheme' promoted during a financial mania by the private sector as well as by policymakers. Let's use a good old fashioned term— our policymakers have been 'financial adventurers'.

One of the richest ironies occurred with the 1873 mania and its collapse. With the typical strains developing in the credit markets during a speculative summer, the leading New York newspaper editorialized:

"…but while the Secretary of the Treasury plays the role of banker for the entire United States it is difficult to conceive of any condition of circumstances which he cannot control. Power has been centralized in him to an extent not enjoyed by the Governor of the Bank of England. He can issue the paper representatives of gold, and count it as much as the yellow metal itself. [He has] a greater influence than is possessed by all the banking institutions of New York."

In so many words, because the treasury secretary was outstanding and had the benefit of 'unlimited issue' of a fiat currency— nothing could go wrong. Which it did: the initial bear market lasted for five years and the initial recession ran a year longer. The pattern of severe recessions and poor recoveries continued such that in 1884 leading economists began to call it "The Great Depression," that endured from the 1873 bubble until 1895. [[So, our Great Depression of 1929-39 was merely a feebler second!: normxxx]]

An index of farm land value in England fell almost every year from 1873 to 1895. Of course, academic economists were fascinated and for a couple of decades wondered how such a dislocation could have happened, or even worse, discussed how it could have been prevented. Ironically, this debate continued until as late as 1939 when another Great Depression had been belatedly discovered.

Naturally the long depression was blamed upon the old and unstable Treasury System, and at the height of the "Roaring Twenties" John Moody summed it up with:

"The Federal Reserve Law has demonstrated its thorough practicality, and thus secured the general confidence of business interests. The old breeder of financial panics, the National Banking Law, which had been a menace to American progress for two decades, has now been replaced by a modern scientific system which embodies an elastic currency and an orderly control of the money markets."

The probability of a depression has been discussed in the media. It seems that both sides have yet to provide adequate research, with the establishment's response limited to a classic non sequitur. "This is nothing like the Great Depression, where we had 25% unemployment". …being just the most recent example. A sounder research would compare unemployment numbers from the first year after the crash. In 1930 the number was around 8%, and whuile noting that there could be some difference in methodology, today's number is an 8 percenter. [[Actually, using similar methodology as then, the present number is easily over 16%.: normxxx]]

Will it get to 25 percent? This remains to be seen, but unemployment in the private sector will be the worst since the last great depression. By way of a wrap we will take it from the top.

In late 2007, Gregory Mankiw, boasted that the US had a "dream team" of economists as advisors and, as with all claims at the top of the five previous bubbles, "Nothing could go wrong". And even if things went only a little wrong there were the "safety nets" that Krugman claimed would prevent serious deterioration. Our view on Keynesian safety nets has always been that in a bust they would be about as useless as a hardhat in a crowbar storm.

In the post-1929 bust policymakers were realistic enough to know that the boom caused the bust. The SEC was established to prevent another hazardous 1929 mania. One of the promoters of the SEC boasted that the SEC would put a "Cop at the corner of Wall and Broad Streets". Without much doubt the SEC has failed to live up to its billing. The discovery of malfeasance always accompanies the discovery of malinvestment.

Of course, the other Act passed to prevent another 1929 mania was Glass-Steagal, which separated commercial banking from the evils of Wall Street. This was taken off the books in 1999 as too many banks were ignoring it to participate in the high-tech frenzy. Has this happened before? I'm glad I asked the question.

With the financial violence of the South Sea Company in 1720, the House of Commons passed the "Anti-Bubble" Act, which was taken off the books in 1771— just in time for the full expression of the 1772 bubble. As with the climax of the 1720 bubble the Great Depression ran for some twenty years. This was also the case for the bubbles that blew out in 1825, 1873, and 1929. [[On that last, I suppose, if you discount the war years in the US.: normxxx]]

This ominous sequence of financial excess and consequent disaster brings us to 2007, which will soon have the connotation of "1929", as the world experiences the sixth Great Depression. Quite likely, the only offsetting event could be the collapse of interventionist policymaking, that would eventually be seen as a blessing.

The title of this address, "Great Depressions Are So Methodical" is intended to be ironical, but some may be startled by the audacity of the statement. Actually it is the only conclusion that one could make after a thorough review of economic history. The real audacity is in the claims of charismatic economists that their personal revelations can provide one continuous throb of happy motoring. As Hayek said— Keynes, as a young scholar, was absolutely ignorant of financial or economic history. Only someone who was ineffably ignorant of financial history would claim that it can be altered arbitrarily.

The next Oscar in audacity goes to Paul Samuelson, who, in the 1960s, boasted that the business recession had been eliminated. Right! And yet another such example was recently provided by Gregory Mankiw when he condemned the "old" Fed with "When you look at the mistakes of the 1920s and 1930s, they were clearly amateurish".

Any impartial review of market history would conclude that the "Roaring Twenties" and the [subsequent] contraction was the way financial history works— after all it was the fifth such example. It is worth recalling that at the height of the 1929 mania John Moody had condemned the "old" Treasury System while reciting that the "new" Fed was the perfect instrument of policy.

Mankiw then bragged "It is hard to imagine that happening again— we understand the business cycle better". The Harvard professor topped this late in 2007 with: "The truth is that Fed governors, together with their crack staff of Ph.D economists, are as close to an economic dream team as we are ever likely to see."

Now it is time to get into the [Methodical] way Great Depressions have [always] worked. All six have started with soaring prices for tangible and financial assets that, typically, run against an inverted yield curve for some 12 to 16 months. Then, when the curve reverses [again] to steepening, it is the most critical indicator that the credit contraction [has begun]. This time around, the sixteen-month count ran to June 2007 and the curve reversed by the end of May. Our presentations in that fateful month stated that "the greatest train wreck in the history of credit" had begun. Deterioration through July prompted the advice that most bank stocks were a nice "widows and orphans" short.

Beyond the raw power of speculation, one of the key features is that each mania has been accompanied by a remarkable decline in real long interest rates, sometimes to zero, and sometimes to minus. In our case the decline was to around minus 1.5% in January and the [subsequent] increase so far has been 5 percentage points. In the five previous examples, the typical increase has been 12 percentage points, which has been Mother Nature's way of correcting untempered expansion of credit. And— in our times— untempered policymaking.

Lower-grade corporate bonds have already suffered an increase of some 25 percentage points, which suggests that the 12 point potential for treasuries is [still] possible. There is another important distinction. At the peak of a Great bubble, the stock market peaks virtually at the same time as the business cycle.

In 1873, the stock market blew out in September and the recession started in that October. As noted above, a fiat currency with the potential of 'unlimited issue' was not proof against yet another Great Depression. In 1929 stocks peaked in September and the economy peaked in August. This time around stocks set their high in October, 2007 and according to the NBER, the recession started in that December.

Since 1937 the average length of [a typical] recession has been ten months, with six in the order of 8 months. This one has run for 17 months, which breaks a long-standing pattern. Following 1873, the initial recession lasted 65 months, and following 1929, it ran for 43 months. NBER data starts in 1854 and these were the longest recessions, with no others in this league. This one has the potential of being a long one.

That is a lot of history; but what is happening in the markets right now? Well, perhaps the Green Shoots have finally encompassed chairman Bernanke. On May 5, Bernanke observed that the "broad rally in equity prices" is indicating that "economic activity will pick up later in the year".

At the height of the similar rebound to April-May of 1930, Barron's wrote that the "will to speculate was just as speculative as ever" and that it would be "difficult to quench the fires of enthusiasm". Prompted by the animated stock rally, the Harvard Economic Society, with more gravitas, concluded that it "augured" a recovery by late in the year. As we all know this did not last. What we should understand is that it is the dynamics of a crash that sets up the exciting rebound. Not policymakers. [[Indeed, what Bob Hoye is saying is that all of the international efforts, by CBs, banks, and governments, have so far been utterly futile and the "crash" is playing out exactly as it has on the previous five occasions. : normxxx]]

Let's look at a classic fall crash, which we expected. The pattern is interesting. The 1929 crash amounted to 48%. The decline to the low in November 2008 was 47%, and within this the hit to October 27 amounted to 42%. In 1929 the initial plunge amounted to 40% to October 29. The rebound was to November 4, in both examples, with 2008 gaining 17% and 1929 gaining 12%. The final slump into each November was 22% and 23%. Is it important to identify it as 1929 or 2008?

Our historical model expected the crash and the rebound, as well as the nature of the establishment's utterances. Another usual event is a frenzy of recriminatory regulation— all supposedly new, but delivered without knowing that their counterparts over the centuries have made the same futile gestures. More irony, today's excitement in the markets and the conviction of "success" in policymaking circles are simply key further steps on the path to a Great Depression.

As disconcerting as this may be, it is worth reviewing another cliché of policymaking, which is the notion that lowering administered rates will restore the momentum of a boom. Massive declines in short rates, such as Treasury Bills, have occurred in [each] post-bubble crash. In 1873 the senior bank rate plunged from 9% to 2.5%, as the stock market crashed. In the 1929 example the fed discount rate plunged from 6% to 1.5%, as the stock market crashed.

This is getting a little heavy. Not so long ago, but in another world, financially speaking, when an economist would change a forecast on GDP from 3% to 3.25% it was only done to display a sense of humor. Now policy wonks seriously debate whether the Fed target rate should be zero or ¼ percent. It is patently absurd to debate [how small] the rate should be or whether ¼ percent, more or less, would have any effect on financial markets, based on past history.

It won't, because we are in a world of financial violence that is not random [or singular], and [certainly] not due to the Fed making the 'perfect' rate cut [or taking other extraordinary, heretofore unthinkable actions]. Instead it is a natural [building up and bursting forth] of private speculation, as well as a chronic experiment in policy by 'financial adventurers'— to accurately use a Victorian term.

Another term goes back to the 1600s, when what is now called Holland was the commercial and financial center of the world. The Dutch described the good times as associated with "easy" credit and the consequence as "diseased" credit. I'm sure that all in this room would agree with the accuracy of the latter description. Diseased credit.

What can be done about it? Nothing— since the 1500s the literature is complete with many comments that someone, or some agency can "set" interest rates— either high or low depending upon the personal concerns of the writer. Misselden in the 1618 to 1622 crash earnestly believed that throwing credit at a credit contraction would make it go away. (Despite all of this history, Keynes and his disciples cannot be accused of plagiarism.)

What's next?

Virtually, all of the "good stuff" likely to be 'revived' into May has been accomplished. This includes investments such as commodities, junk-bonds and stocks, as well as positive statements from the establishment. Both technical and sentiment measures on the stock market are at "tilt" levels.

Because it is up at the right time, the conclusion is that the down will come in on time as well. This would be the next step on the path towards another Great Depression. Of course, there is no guarantee that events will continue on the path. But, then there is no guarantee that it won't. Best to consider the odds.

  M O R E. . .


The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Saturday, May 16, 2009

The $33,000,000,000,000 Question

The $33,000,000,000,000 Question

It has long been my contention that we are entering an extraordinary period of time in which using historical analogies to plot market behavior is going to become increasingly problematical. In short, the analogies, the past performance if you will, all break down because the underlying economic backdrop is unlike anything we have ever seen. It makes managing money and portfolio planning particularly challenging. Traditional asset management techniques just simply may not work. Buy and hope strategies may be particularly difficult to navigate.
[[In physics, this is known as a 'singularity', aka, a 'Black Hole'. : normxxx]]

Part of the reason we are so challenged in our outlook is that we are experiencing a deleveraging on a scale in the world that is absolutely breath-taking in its scope. And to balance that, governments are going to have to issue massive amounts of sovereign debt to deal with their deficits. But who will buy it, and at what price? And in which currency? This week's Outside the Box gives us some very basic data points that illustrate the challenge very well. But the problem is that even though we can see the challenge, it is not clear what the final outcome will be, other than stressful volatility as the markets react.

This week's OTB is by my good friends and business partners in London,
Niels Jensen and his team at Absolute Return Partners. I have worked closely with Niels for years and have found him to be one of the more savvy observers of the markets I know. You can see more of his work at www.arpllp.com and contact them at info@arpllp.com.

John Mauldin, Editor
Outside the Box

The $33,000,000,000,000 Question

by Niels C. Jensen, The Absolute Return Letter | May, 2009

"Never in the history of the world has there been a situation so bad that the government can't make it worse." — Unknown

Is The Crisis Really Over?

Commercial paper spreads have come down dramatically. Libor rates are (hmm— almost) back to normal. Even high yield spreads are narrowing. It certainly appears as if the credit crisis is well and truly over or, at the very least, the light which most of us think we can see at the end of the tunnel is no longer that of an oncoming freight train.

No wonder equities are currently enjoying one of their best spells ever. And while equities continue to go up and up, most of us are left scratching our heads. Is this the real thing or will it go down in history as 'just' another bear market rally? Not so long ago, the entire financial system stared Armageddon in the face. Now, only a few months later, equity markets behave as if all the worries of yesterday have been washed away. How is that possible?

The Great Bank Illusion

The current bull market began in earnest in the second week of March, but what really got everyone going were the surprisingly good Q1 US bank earnings which were reported during the first half of April. Most commentators interpreted the numbers as the clearest piece of evidence yet that we are now firmly on the road to recovery.

Of course US banks made good money in Q1. The environment created for them is the equivalent of the US government reducing the cost of goods to zero for its embattled car manufacturers and then going on to buy— courtesy of the US tax payer— a couple of million cars that nobody really needs. Even Detroit would make money given those conditions!

Liquidity Is Trapped

The problem for the rest of us is that the banks are not sharing the candy they have been handed. Much of the liquidity created by the central banks remains trapped in the financial sector (see chart 1). Quite simply, the 'multiplier' is not doing its job, as many [[insolvent?: normxxx]] banks prefer to hoard cash rather than increase lending at this juncture.

This is both good and bad news at the same time. Good because it implies that we probably do not have to worry too much about the inflationary effect of the aggressive monetary easing currently taking place; bad because it means that the economy is not going to kick back to life as quickly as everyone would like— and expect.

Meanwhile investors are growing cautiously optimistic about the GDP outlook for the second half of the year with many now forecasting modest growth— at least in the United States. Only a fool would suggest that GDP would shrink by 5-10% per quarter in perpetuity, as has been the case over the past two quarters. The economic slowdown is now decelerating and, as I pointed out last month, there are good reasons why we may see a temporary lift in economic activity later this year, but it will almost certainly prove transitory.

We Are Still In A Bear Market

The dangerous conclusion to draw from the experience of the past few weeks is that all is now well and dandy and it is time to load up on stocks again. I cannot emphasize it strongly enough: The bull market of March-May 2009 is almost certainly a bear market rally— as one of my partners pointed out the other day, NYSE saw four 20%+ rallies between 1929 and 1932 (see chart 2). Bear market rallies can be extremely powerful and hence deceiving.

The problems are not over yet. Not by a long stretch. It will take longer than 18 months [[and a lot more grief: normxxx]] to unwind the excesses of the past 25 years. Analysts at Morgan Stanley reckon that the 15 largest banks— which among them have shrunk their balance sheets by about $3,600 billion so far in this crisis— will shed another $2,000 billion in 20091. If you do not share my pessimism, please take a quick look at chart 3 below. The US financial sector debt load (as a % of GDP) is now 117%. In the early days of the great bull market in 1982, the same number was 22%. Households are not much better off with total household debt now at 96% of GDP vs. 47% in 1982.

Further Write-Offs To Come

The IMF reckons that both European and US banks— but in particular the European ones— are well behind the curve in terms of recognizing their credit crunch related losses. According to the IMF, there is at least another $1,500 billion to come. So when the US banks reported 'surprisingly good' numbers for Q1 it was certainly not because the economy had suddenly and miraculously revived itself, but because some of the oldest tricks in the book were used to gloss over much bigger problems2.

As the recession bites into the lives of ordinary people, banks will face losses not only on sub-prime mortgages but on all loan products. As you can see from chart 4, sub-prime is indeed a small fraction of the total loan book for the US banking sector.

Delinquencies Are On The Rise

And that is precisely what is beginning to happen as illustrated in chart 5. Delinquencies are now on the rise on all mortgage products; however, whereas sub-prime started to deteriorate as early as 2007, it is only recently that delinquencies related to Alt-A and adjustable rate mortgages have taken off, and prime and jumbo loans are only just now starting to suffer.

These are all temporary problems, though, however bad they may appear. By far my biggest concern at the moment is the enormity of the debt problem facing most OECD countries. In the March issue of the Absolute Return Letter I referred to an important study conducted by Carmen Reinhart and Kenneth Rogoff back in December of last year3 which I would like to re-visit (see chart 6).

Banking Crises Run And Run

Reinhart and Rogoff studied every banking crisis of the past generation and made some startling observations. One in particular caught my attention. It has to do with the subsequent rise in government debt which, according to Reinhart and Rogoff, has been "…a defining characteristic of the aftermath of banking crises for over a century". According to the authors, governments inevitably underestimate the ultimate cost of a banking crisis, because the indirect costs (such as falling tax revenue in subsequent years) end up much higher than predicted.

The IMF estimates that the cost of the current crisis to the United States will eventually reach 34% of GDP or close to $5 trillion. However, the Obama administration, through its various implicit and explicit guarantees, is already using a number closer to $9 trillion4. And Reinhart and Rogoff's historical average of 86% of GDP implies an ultimate cost of over $12 trillion!

The IMF Is Too Optimistic

I have a lot of respect for all the good work being produced by the people at the IMF; however, they are sometimes too politically correct for my taste; maybe too afraid of stepping on someone's toes. So when they go public, as they did recently, with an estimate of how much the current crisis would ultimately cost, their projection will more than likely prove hopelessly inadequate.

The true cost is important, because [[(eventually): normxxx]]it has to be financed through new bond issuance, and it is my thesis that the sheer size of this tsunami will eventually overwhelm the world's bond markets. As you can see from chart 7, using the official IMF estimates, the twelve most industrialised of the world's G20 countries (in my book known as the Dirty Dozen) will have to issue about $10 trillion worth of new bonds to cover the cost of the current crisis.

The Final Cost Will Be Enormous

However, if you (like me) believe that IMF underestimates the true cost of this crisis, Reinhart and Rogoff offer a more realistic approach (see chart 8). Using their least costly case study (Malaysia 1997) as our best case scenario, the true cost comes to $15 trillion. If one uses the average of 86% instead, the cost jumps to a whopping $33 trillion. I didn't even bother to produce a worst case scenario— it all got too depressing!

I need to put the $33 trillion into perspective, because it is so big that it is almost incomprehensible. According to Wikipedia (see chart 9), total private wealth across the world today is about $37 trillion less the losses incurred in 2007-09, so the real number is probably closer to $30 trillion now. Total global savings (loosely adjusted for the big losses in 2008) are probably somewhere in the region of $100 trillion. In other words, financing this crisis could absorb one-third of total global savings. No wonder Gordon Brown looks tired!

Where do we find the money?

Obviously, governments may buy a portion of these bonds themselves, but they cannot afford more than a fraction of the total unless they want to challenge Mugabe (of Zimbabwe) as the ultimate master of illusion. Neither should investors hold out for sovereign wealth funds to do the dirty work. As is clear from chart 9, the total amount of wealth accumulated in these funds is pocket money when compared to the projected bond issuance over the next few years.

Hence it comes down to the price at which governments can attract sufficient demand from people like you and me. One of two things may happen. Either this crisis will ignite such a bout of deflation that investors will happily own government bonds yielding 2-3% or the deflation scare goes away ultimately, the global economy recovers, and bond investors demand much higher yields for taking sovereign risk. I am not yet sure which scenario will prevail, but I do know that both are quite bad for equities longer term. Take your profits!

Niels C. Jensen

1 "Doomsday is on hold but banks will still feel further pain", The Financial Times, 30th April, 2009.

2 In particular one US accounting rule change (FASB rule 160) explains a large part of Q1 profits.

"The Aftermath of Financial Crisis", Carmen Reinhart & Kenneth Rogoff, December 2009.
[[Or, see "This Time is Different: Eight Centuries of Financial Folly" : normxxx]]

4 http://zerohedge.blogspot.com/2009/04/bail-out-for-dummies-part-1.html

Thursday, May 14, 2009

How You'll Know The Market Has Bottomed

Here's How You'll Know The Stock Market Has Bottomed
Lumber Has Given Back Its Gains… Will The Stock Market Follow?

By Tom Dyson | 24 December 2008

Don carries a tape measure on his belt. A yellow pencil lives behind his ear. And to get from one end of his yard to the other, he drives a forklift truck… Don entered the lumber business in 1979. In his 30-year career in the lumber-distribution business, he has worked for both the huge national lumber distributors and the small regional suppliers. He's also worked through two major construction busts… in 1979-81 and 1990-91. Today, Don is general manager of a $100 million lumberyard based near Orlando, Florida.

I figure, if we're going to see evidence of inflation, it's going to show up first in building products. This was the first industry to crater back in 2005. It should be the first industry to complete the cycle.

The government thinks the falling real estate market is driving the recession and the credit crunch. If it can get the real estate market rising again, it thinks it'll be able to beat deflation and solve all our problems. Any signs of life in the real estate market will "validate" the Fed's strategy and generate a burst of optimism in the stock market.

So, the people in charge have decided that if they can "fix" the real estate market, then everything else will "fix itself". The Fed has aimed its printing press directly at the real estate market. It will buy $500 billion of mortgages using freshly created dollars. The government has focused many of its other plans on the real estate market, too… like its demand for the banks to have a temporary moratorium on foreclosures (now lapsed) and Obama's $50 billion mortgage and foreclosure rescue plan.

In other words, the U.S. real estate market is seen as the pivot in the whole economic mess we're in right now. So, if you can figure out what's happening in real estate, you can figure out everything else. And, the best leading indicator of real estate is lumber. About two thirds of American demand for lumber comes from the homebuilding and remodeling industries… so its price is highly sensitive to strength and weakness in construction.

Every month, Don tells me what he thinks is going on in the industry and updates me on the prices of lumber, sheet wall, concrete sidings, and other building products. These prices come straight from the manufacturers. Prices peaked in October 2005. Since then, many materials have fallen in price over 50%. I just got Don's latest e-mail last week. It's shocking how prices have jumped…
  • Plywood rose 9.9%.

  • Pine lumber was up 5.8% to 15.7%.

  • Most metal connectors were up 5% to 20%.

  • Truss prices fell only 2.9%, but the strength in pine will push those prices upward in January.

  • Molding prices were up 12.5% to 13.6%. Door prices were mixed.

  • Concrete siding was up 9.4%, and vinyl trims were up 4.8%.

  • Vinyl siding trim was up 14.5% with a reduction of manufacturers.

(Some prices declined, too. Roll foundation plastic fell 6.7%, rebar dropped 3.4%, spruce lumber gave up 15%, studs fell 10%, and drywall products all fell between 6.7% and 9%.

Don creates a Whole House Commodity Price Index with this information. It's the price of materials to build a 2,250 square-foot wood-frame house. It doesn't include labor, decor, plumbing, electrical, or mechanical materials. In November, Don's Whole House Commodity Index was up 1% percent, to $23,773. "Every major supplier in drywall, roofing, insulation, insulation board, steel studs, cement board, and most of the miscellaneous building material categories have announced increases in cost from 7%-10%," says Don.

It's still too early to make conclusions from Don's pricing data (which should be used to confirm the earlier trend in lumber prices). I suspect many companies realize they'll go out of business if they keep selling their products at a loss. So they've raised their prices out of desperation. In other words, these price increases aren't necessarily a reflection of increased demand— they're a sign of capitulation in the building materials industry… and we're about to see some major bankruptcies.

Let's give Don's building prices three more months. If they stick, it's a sign the Fed's strategy just might be starting to work. And that should mark a bottom for stocks. [[Note: That would have been March, 2009! : normxxx]] But, if building prices don't continue rising, we'll be in for more deflation.

Good investing,



The World's Most Important Commodity

By Tom Dyson | 18 February 2009

By watching the price of Don's Whole House Commodity Price Index for home building materials, you'll know when the recession is ending… before anyone else. You'll know if Obama's stimulus plan is having any effect. You'll know when the construction industry is about to start hiring again or when the banks are about to start lending again. And you'll be able to tell your neighbors when house prices are going to rise again.

Around the office, we say copper has a PhD in economics because it predicts recessions and booms. We call it "Dr. Copper." But Don's Index is a much more valuable indicator for right now, and no one's paying attention to it. Let me explain.

Take the timeline of the current crisis as an example. The lumber price reacted before any other market: Lumber prices peaked in May 2004. The Bloomberg Homebuilders Index didn't peak until July 2005. Don's Index peaked in October 2005. The Case-Shiller U.S. home price index peaked in July 2006. The credit crunch started in February 2007, when New Century Financial collapsed. The S&P 500 peaked in October 2007. [[And, finally, the complete collapse of the credit market occured when Lehman Bros. filed for bankruptcy on 15 September 2008. : normxxx]]

When the recovery comes, I expect it'll show up first in the lumber price, too… Right now, lumber is down 66% from its 2004 all-time high. A standard railcar load of lumber sells for $17,050— the same price it was selling for in 1973. Looking at the monthly chart, there's still no sign of an uptrend… but I can report the lumber price has risen 12% in the last three weeks, up from 1969 prices.

The lumber price holds the key for investors right now. Make sure you keep an eye on it.

Good investing,


P.S. You can get this chart of lumber prices on StockCharts. Just type in the symbol $LUMBER.


This Indicator Says Home Prices Are Nearing A Bottom

By Tom Dyson | 6 April 2009

I ride my bike to work, always taking the same route. I pass the same 100 or so houses every day. This week, I noticed two new properties have come on the market. One of these houses is on the beach. The owner has posted a large billboard on the curb. "Foreclosure Sale," it announces. "Online Auction."

Every week I see new for-sale signs along my route. This is the first auction notice I've seen. And although it's an ugly, worn-out old house, it's on prime beachfront property. Most Americans gauge real estate using the same process I use on my bike. They talk to their neighbors, they notice for-sale postings along their street, and they watch local news reports.

From this "bicycle-seat view," it appears to the average American that the bear market in real estate in still in full swing and getting worse by the week. Here's the thing: Trying to predict trends in the real estate market by watching house prices is like trying to predict the stock market by watching CNBC. It doesn't work.

Houses are illiquid assets. It can take months for homeowners to accept their houses have fallen in value and lower their prices appropriately. Many potential sellers have mortgages larger than the value of their homes. They can't sell. Banks have it even worse. It takes an average 15 months for a bank to sell a property after the first missed mortgage payment. Many foreclosures haven't hit the market yet.

House prices are what economists would call a "lagging indicator". [[Actually, changes in local housing inventory are a good inverse precursor of changes in housing prices.: normxxx]] They are slow to react to new trends in the market. For forecasting purposes, they are useless.

To judge what's really going on in real estate, you need a leading indicator, such as the price of lumber. The lumber market is a small, illiquid market, so it's sensitive to any changes in supply and demand. In the last cycle, for example, lumber prices peaked in May 2004… two years ahead of house prices. If house prices are going to turn up, you'll see it first in the lumber price… and that's what's happening right now.

In the last three weeks, the lumber price has soared 29%… after making a "quadruple bottom" at $140 a contract. Last week, it broke out to a new high for the year. This is incredible strength in a market you'd think would be dying. But, if this trend withers, expect lower house prices ahead… On the other hand, if it continues, expect a bottom in home prices within the next 18 months.


This Indicator Holds the Key for Investors

By Tom Dyson | 15 May 2009

To predict the stock market, I watch lumber. To store lumber, you need a large climate-controlled warehouse with a railroad spur. Even then, it could still spoil within six months, destroying your entire investment. Because lumber loses its value quickly and it's expensive to store, the investment public at large does not participate in the lumber market. The costs are too high.

The mills use "just-in-time" manufacturing principles to keep inventories to the bare minimum. By producing only what they can sell immediately, they avoid wastage. Lumber customers do the same thing. They only buy what they need that week.

There is a lumber exchange in Chicago where you can trade lumber futures. It's a "professionals only" industrial matchmaking service. If you're a homebuilder and you need lumber for a current construction project, the lumber exchange works fine for you. But if you're an investor looking to hold lumber for a year or more, you'll get ripped off.

First, you'll pay huge storage costs. The market builds these costs into the futures price. Second, there's almost zero trading volume once you get beyond the next three months, so you'll pay a massive premium for illiquidity. For example, right now, if you want to buy lumber into the future— say a contract that expires one year from now— you'll have to pay a 38% premium over the price of lumber delivered next week.

These costs keep the riff-raff out of the market. This is why I love to watch lumber. The price of lumber is set entirely by commercial money responding to real business conditions. There's no public speculation to muddy the water and generate confusing signals.

Take the 2008 credit crisis as an example. The lumber price was the first to signal a bear market was coming, in May 2004. Here's a chart of lumber going back three years. As you can see, lumber bounced like everything else earlier this year, but has not been able to hold its gains.

I take this as a message from the homebuilders and the giant logging companies that the real estate market is getting worse again. And if that's the case, it might be time for stocks to take a breather, too.

Good investing,


Wednesday, May 13, 2009

Pipeline MLPs; Arbitrage opportunities in the oil patch

techiedan: Ah yes, Wish. And that would be me...and I presume, you! How long can this go on? Beats me, but I'm going to enjoy it while it does!

Indefinitely; although the actual payouts are highly dependent on what oil sells for (there is likely to be little diminution of actual pipeline activity, but their take is in part determined by the price of oil or gas). Normally, these pay around 10%; the current higher return is due to everyone expecting the payout to drop and the current difficulty of rolling over loans originally slated for pipeline expansion, etc. Avoid those MLPs with big debt loads.

Arbitrage opportunities in the oil patch

by Justin Perucki, Morningstar | 18 Mar 09

We believe we've found a potentially lower-risk return booster.

A few weeks ago, Magellan Midstream Partners MMP announced they are acquiring their general partner (GP) Magellan Midstream Holdings MGG . The transaction is an all-unit offering at a 25% premium based on the previous day's close. The 25% premium coincidentally is the same premium MarkWest Energy Partners (MWE) paid to acquire its GP last year. There are a number of GPs that are publicly traded, and the Magellan transaction led us to investigate the pipeline space for investment ideas. We believe we've found a low-risk medium-reward investment opportunity.

First, some quick background: due to a 1980s-era tax law, energy-related infrastructure entities are allowed to be formed as master limited partnerships, or MLPs. An MLP is similar to a REIT or an S-Corp. MLPs pay no corporate taxes. Instead, taxes are the unitholders' responsibility. MLPs are highly cash-generative enterprises with somewhat limited reinvestment opportunities. As a result, they distribute a large percentage of their cash flows to unitholders.

An MLP usually has a general partner, or GP, that manages its operations. The GP usually takes a 2% cut of the cash flow before it is distributed to limited partner (LP) unitholders. In addition, GPs usually hold incentive distribution rights (IDRs), which entitle them to an increasing cut of the cash flow depending on the LP per-unit distributions— in other words, they are MLPs on steroids. Something to watch for as a GP owner is the sustainability of the distribution, as the IDRs work both directions (i.e., if LP per-unit distributions fall, GP distributions fall even faster).

Many GPs are publicly traded, including Buckeye GP BGH , NuStar GP Holdings NSH , Enterprise GP Holdings EPE , Energy Transfer Equity ETE , and Magellan, to name a few. Because of IDRs, GPs should trade at a premium. In other words, their yields should be lower than their corresponding LPs— as long as you believe that cash flows will rise over time. Therefore, when this relationship is violated, you may be presented with an arbitrage opportunity: buy the GP and short the LP. Theoretically, the faster the growth, the larger the yield differential should be.

However, there is not a large price discrepancy between a number of publicly traded GPs and LPs. This lack of differentiation partially drove the Magellan and MarkWest transactions we mentioned earlier.

Morningstar's head pipeline analyst Jason Stevens points out that these transactions are beneficial to the LP: they eliminate incentive distributions, which reduces the entity's cash cost of capital and increases the potential rate of distribution increases. They also slash duplicative overhead expenses from operating two different entities. Finally, they help remove any uncertainty surrounding the carried interest debate.

Our favorite name to execute a similar transaction is the NuStar complex— the GP NSH and LP NS . The key factors are as follows: The distribution coverage ratio is strong, at 1.25 times. Because the LP will likely be issuing shares to consummate such a deal, having sufficient cash flow to pay the additional distributions is critical.

There's no debt at the GP level. At first glance, Energy Transfer looks like an even more likely candidate to eradicate the discount of its GP shares— ETE— given ETE trades at a discount to the LP ETP. However, ETE has a debt load that would either have to be assumed by ETP or paid off. The debt can't be assumed because it would limit ETP's distributable cash flow, and it can't be paid off because ETP doesn't have the cash lying around. The clean balance sheet of NSH thus makes a takeout more feasible.

Chairman Bill Greehey is notorious for taking advantage of mispriced assets. For example, as CEO of Valero VLO he rolled up small independent refineries during the dog days of the 1990s. He initiated the spin-off of NuStar from its former parent Valero. We don't think this is a large driver of a takeout, but it adds to our confidence.

Another attraction we have with NuStar is its overall business model, which has historically enjoyed stable cash flows. The most attractive part is its interstate refined product pipelines. These pipelines have consistent volumes and are able to raise pricing annually based on the PPI. However, if there's a decline in PPI, NuStar would be required to reduce its fees, which may occur in 2009.

A greater concern would be a drop in volumes. We have already seen a significant drop in refined product demand last year— 4% for gasoline, 5% for diesel, and 6% for jet fuel. With the economy completely rolling over and unemployment rising, we should see further demand destruction in 2009. However, gasoline prices have fallen significantly, which should stem declines.

One aspect of this trade that we like is that the GP doesn't need to be taken out to win. If the LP can increase distributions, GP unitholders will benefit due to the IDRs. The company, however, is planning to rein in distribution increases over the near term in light of the economic weakness.

We view this trade as relatively low-risk with medium reward. As long as distributions are not cut, your cash carry is simply the yield spread between the GP and LP units— about 1% (for purposes of structuring this transaction, you'll short NS and long NSH at equal dollar amounts). However, you must also account for the opportunity cost of your capital. If you plan to park your money in a money market fund, the opportunity cost of your capital is relatively low, at maybe 1%-2%. However, if you see other attractive opportunities in the market, this cost can be very high. For simplicity's sake, let's just call it 10%— the theoretical "long-run" return profile of the stock market. Therefore, the total cost to you in this case is about 10% + 1% = 11%.

The return profile is also relatively simple. If future transactions follow the Magellan Midstream model, you stand to gain 25%. The sooner a potential transaction happens, the higher the annualized returns. If the deal happens in exactly one year, at a 25% premium, annualized cash returns are 24% (25% - 1% cash carry), and annualized excess returns would be 25% - 11% = 14%. If it happens in three months, the annualized cash returns are 96%, and the annualized excess returns are 56%. These are not hit-it-out-of-the-park numbers, but it's not bad at all for a low-risk transaction.

Alternatively, distribution growth can resume, in which case the yield differentials should return to semi-historical levels. Over the last two years, NSH's yields were on average about 2%-3% lower than NS's. If one year from now the yield spread climbs to 2.5%, this trade should return about 20% in cash and 9% in excess of total costs.

Investors considering this trade should also be mindful of the tax implications of investing in MLPs. Given the anticipated shorter holding period of this investment, we don't believe tax carrying costs will be significant.

Warren Buffett, in a shareholder letter written 20 years ago, mentioned he uses "...arbitrage as an alternative to holding short-term cash equivalents...At such times, arbitrage sometimes promises much greater returns than Treasury bills and equally important, cools any temptation we may have to relax our standards for long-term investments." Given the uncertainty in the market and near 0% short-term interest rates, we think this opportunity is not a bad place to park some cash.