Potential Risks in 2016

I just thought I'd post a few things I have been contemplating about the current year:

1. I truly think that China's problems will become the world's problems. The world has been increasingly reliant on Chinese growth over the last 25 years, but debt has grown exponentially in China, and China is now drawing on currency reserves to prop up its economy, stock market and growth rates. It will be harder to profit from this thesis, as increasingly this thesis is becoming consensus in the marketplace.

2. I believe that the Federal Reserve will reverse course on interest rates later this year, and this eventually (but likely not this year) will result in negative federal funds rate. I simply don't believe that the U.S. can increase rates and experience a stronger currency, and still expect to experience any form of inflation. Currently, by raising rates, I feel the Federal Reserve has created an environment of exporting inflation to economies with weakening currencies, while deflating commodities, imports and prices of consumer goods in US dollar terms. I don't feel this process ends quickly, and the ECB's current calls for further quantitative easing in the Euro region will only exasperate the situation.

3. I feel that the U.S. may experience its first brokered convention in many decades, and, should Bloomberg attempt a presidential run, they may even see a situation where Congress and the Senate determine the next president and vice president of the United States (12th Amendment). This could be a black swan event, and I'm unsure what impact this has on the markets, or world order for that matter. This is simply something I am contemplating (thanks to cherzeca CoBF for bringing the potential general election issue to my attention).

4. I have believed that deflation will become a global phenomenon, and I still see no reason to back away from that thesis.

There are hundreds of thousands of other risks that could arise, but I can only prepare my portfolio to handle such issues, rather than attempt to directly profit from those risks.

Market Musings - January 17, 2016

Currently, the market participants are embroiled in discussions about whether the market is simply undergoing a simple but violent correction, or if something more sinister is in the cards. To me, it appears to be a little bit of both. While the U.S. appears to be seeing improved economic metrics, much of the rest of the world is not. Europe, China, South America and much of the rest of the advanced economies of the world are experiencing slowing growth or outright recessionary pressures. China is sporting a 282% overall debtload to GDP, and is desperately trying to prop up its market via the currency market. Europe continues in the doldrums they have been stuck in over the last 7-8 years, and their demographics continue to work against them. Finally, South America, Canada, Australia and the like are all experiencing deep and painful declines in much of their economies, due to the dramatic declines in commodities and the strengthening US dollar. The issues in China appear to be problematic, similar in nature to what occurred in Japan in the 1980's and Southeast Asia in the 1990's. The economy reached an inflection point in 2008, when it appears much of the demand-driven growth slowed. Since then, Chinese consumers, corporations and governments appear to have fueled further growth using debt and building inventories. The debt load to GDP appears to be very high, but, as has occurred in numerous occasions in the past, and it likely could grow further now, unless the market reaction confirms debt deflation is in the cards. European trade appears to have ground to a halt, although the lifting of Iran sanctions will help Airbus immensely. Nothing really has been resolved to repair the treasury/fiscal issues that a complex arrangement as the Euro economies present (multiple budgets and economies versus one currency). Deflation could very well be imported from China and the US over time as currencies continue to be manipulated via quantitative easing and interest rate policies. In the next few months, I will be watching for WTI/Brent oil to fall to the low $20's per barrel, gold to rise to $1,200/oz, the S&P 500 to fall to 1,700 or slightly below, and the CAD/USD to fall to the $0.67 mark. I feel that oil will bottom when the market has a washout fall, while the oil futures do not fall in sympathy (building a more thorough contango). In the meantime, I had established a short position in the S&P 500 ETF (SPY) to hedge my long positions in equities. My major positions are in tobacco, consumer packaging (CCL Industries) and Novo Nordisk, a diabetes drug company. I also hold a fairly large position in Fairfax Financial, a Canadian based, global insurance company that is fully hedged against the market, and is holding deflation hedges (CPI puts) against major global economies.

Why I am convinced of a United States Recovery

In my opinion, the apparent complete lack of economic coordination in Europe, and the lack of currency adjustment in China, has led many great investors (Warren Buffett and Seth Klarman to name a couple) to become bullish on the United States. When you look at world GDP, it was approximately $63.04T USD. Of this, the Eurozone represents $12.17T (both figures according to the World Bank). China is currently at $5.88T, and facing a hard landing on its economy, and Japan has a GDP of $5.50T, and embarking on its rebuilding efforts following the earthquake and tsunami this year. Finally, there is the United States ($14.58T), with a long history of capitalism, ebbs and flows, recessions, reactions and recoveries, watching everything unfold with no issues of lack of economic coordination, a three year head start on recovering from its own housing downturn, no major natural disasters from which to recover, and a fairly free moving currency that makes the country look more and more attractive everyday versus China.

While I have not seen consensus, the last forcast I have is for a 3.2% increase in global GDP (World Bank website). that would mean that we should expect a growth of $2.02B in GDP globally. Excluding Japan, Eurozone, and the United States, the rest of the world has a combined GDP of $30.79T. Assuming a very aggressive 5% growth rate for these areas (note that I have not excluded Canada, U.K. from the list, which are among the top ten largest economies in the world), the emerging markets should provide $1.54T of the growth. From the remaining three economic zones, we should therefore presume that we will see $0.5T of growth. If the Eurozone continues to falter, investment will be pushed to one of China, Japan or the United States, I would anticipate. Let's look at a scenario where the Eurozone simply stagnates and produces a GDP growth rate of 0% (I believe they will be in recession next year).

In China, we are in a scenario, where the country is importing inflation as a result of pegging its currency. Therefore, labour and commodity prices are rising for the same finished products. This is then sold out to Europe and the United States (predominantly), where in many cases the prices remain fairly stagnant (due to the economic situation of high unemployment). The scenario lowers margins for many companies, so it would be safe to say that China may not experience supernormalized returns from its current 9-11% GDP growth rates. So this really leaves the future investment to the US and Japan. With Japan facing a rebuilding and an already aging population, it would be safe to also suggest Japan will not experience more than a couple of tenths of a percent of growth in the coming years. This leaves us with the United States. I would presume that much of the European slack would come from the United States, due to its similarity in industrial output, primary economic drivers, and labour force. This projection, even with many of its flaws, would mean the US would grow 3.2%, far higher than the new OECD expectation of 2%. With government cutting back on investments, this would mean more than 100% of the growth would come from the United States. This would bolster growth, and improve financial metrics of US public companies.

Just my thoughts. I may be wrong, but I'll still bet on the U.S. over Europe.

Radiation Leak adds further pressure to Nikkei: Nikkei 225 Futures down 14.5% at Midday Break

Before I begin this post, I would like to convey my feelings on the recent destructive earthquake and tsunami in Japan. The tragedy in Japan has been heartbreaking, and my thoughts and prayers go out to the Japanese people. I hope that all nations and capable people will do whatever they can do to help the people that have been affected.

Please donate to a charity that can help the recovery efforts, like the Red Cross (I have linked to the Canadian and American sites), Doctors Without Borders (U.S.) or Medicins Sans Frontieres (Canada), or UNICEF.

After such a devastating few days in Japan, the news continues to shock the world. While I may sound presumptive, it does appear that the latest explosion in reactor #2 and the fire in reactor #4 of the Fukushima Daiichi Nuclear Power Station have allowed large amounts of radioactive material to be released into the air, and the containment structure may now be breached. The government is now speaking of radiation that is harmful to humans, and that anyone within a 30km radius from the power station should stay indoors. Unfortunately, the odds appear to be very slim that disaster can be fully averted. The futures worldwide have reacted as a result.

The issues in Japan are unprecendented, in terms of the natural disaster and the chaos that may ensue. At this time, the best position of any investor is to look for Mr. Market's most irrational moves, and build positions in strong companies.

And please donate!

Unrest in Saudi Arabia sparking Oil rally, further Volatility

According to the Associated Press, Saudi police have fired on protestors in the Eastern part of the country. If this is true, and becomes escalated, this could spark a huge rally in oil and petro-currencies, and further declines in the world markets. Any disruption of oil supplies from Saudi Arabia would result in a complete imbalance in demand vs. supply of the commodity, and could push oil significantly higher than any disruption caused by Libya, Algeria or any of the other Arab country, where unrest persists.

As per many sources, tomorrow is expected to be a "Day of Rage" in Saudi Arabia, with protests expected in the Eastern region.

Overnight Developments - March 10, 2011

Some information that may affect the market:

1. Japan GDP shrinks a greater than expected 1.3% last quarter.

2. China reports a $7.3b trade deficit, its highest in 7 years.

3. Spain downgraded by Moody's, outlook negative.

Of course, everyone is awaiting today's jobless report, at 8:30 am ET.

Forbes list of World's Billionaires released, shows that it pays to be Slim.

2010 appears to have been a banner year for Carlos Slim. The world's richest man increased his net worth $20b to a cool $74b, $18b more than Bill Gates, the world's number two. Overall, there are now 1,210 billionaires worth over $4.5 trillion.

Other interesting tidbits:

Mark Zuckerberg is no longer the World's youngest billionaire. His Harvard roommate, Dustin Moskowitz, 9 days his junior and the third employee to Facebook, is now a billionaire, thanks to Facebook's valuation increasing 238% in 2010 (to $50b). The valuation has subsequently increased another 30% since, to $65b. On another note, Eduardo Saverin, former best friend of Mark Zuckerberg, is now worth $1.6b, based on his 5% stake in Facebook (reportedly brought down to 2% through share sales), and Sean Parker is also now worth $1.6b.

The list includes 30 hedge fund managers, 54 investment managers, and 1 drug trafficker, Joaquin Guzman Loera ("El Chapo"), of Mexico.

Moscow, with 79 billionaires, is home to the most billionaires, followed by New York City at 58.

108 of the 214 new billionaires came from the BRIC countries (Brazil, Russia, India and China).

According to Forbes, there are 24 Canadian billionaires, including newcomers Frank Stronach (Magna) and Chip Wilson (lululemon).

Why I am Short Netflix, Inc. (Nasdaq:NFLX)

Background

Netflix, Inc. is a subscription based service, providing access to thousands of movies and television shows on demand to over 20 million subscribers. Recently, the most vocal short-seller, Whitney Tilson of T2 Partners closed his short position. I believe that Tilson was right in shorting Netflix, and when Tilson closed his short position, it actually sparked the recent peak for Netflix (as all major analysts and investors in NFLX were then buyers of the stock).

Why is NFLX so successful?

Netflix was first successful in filling the vacuum left by Blockbuster’s bankruptcy. Blockbuster’s bankruptcy fragmented the movie rental business, allowing another company to step in, and take further market share. While Netflix was the market disrupter that proved to be the catalyst for Blockbuster’s demise, it was also the temporary beneficiary of Blockbuster’s losses. Innovativeness allowed NFLX to move with consumer demands, especially when it moved to the streaming subscription service from its mail-order DVD rental service. I believe that both the market gains from Blockbuster’s bankruptcy and Netflix’s innovativeness will only be temporary gains for the company. Eventually content-owners will try to capture much of the supernormal returns (charging more for content, or in the form of competition, as the Warner Brothers/Facebook deal shows), and further third party competition (like Amazon and GoogleTV) will reduce earnings to more normal levels. Competition is only starting to heat up, and access to the lucrative European markets is already threatened by other early entrants, which could restrict profitability in the region.

Aggressive Valuations

Regardless of all my theses above, let’s consider what could happen if NFLX were to achieve 50% market share in the United States, based on current market conditions. Currently, there are 83.3m broadband subscriptions in the United States (Source: OECD, http://www.oecd.org/document/54/0,3343,en_2649_34225_38690102_1_1_1_1,00.html), with intentions to increase this to 100m households with broadband access by 2020. If we assume an aggressive 50% subscription rate, at the current $7.99/month subscription rate, we arrive at $4b in annual revenue. The historical expected gross margin rate appears to be around 35%, resulting in $1.4b in annual gross margins.

I have assumed that the OPEX run rate would have to stay at the current 25% rate, as Netflix would have to continue to be aggressive in its marketing of the service in the face of higher competition, as well as in continuously trying to be the first-entrant to new technologies. At 25%, OPEX is expected to be $1b/annually, which results in an annual net operating income of $400m.

If I apply P/E of 20 to the net operating income (I applied an aggressive P/E to match with the typical technology stock, as well as allow for errors in other assumptions), I arrive at a market capitalization of about $8.0b. The current market capitalization is over 20% higher than this aggressive figure! I realize that expansion internationally is possible, but this would not necessarily lead to $8 monthly subscription costs in other countries, and content costs would increase as foreign language films and institutions would need to be added to the company’s library.

Conclusion

Based on the above findings, and the recent parabolic move in Netflix (from $180 to $245 in about 15 trading days), I believe that short sellers can still be rewarded in shorting NFLX here, even after its move below $200 today.

I am currently short NFLX. These statements are for entertainment purposes only, and should not be construed as investment advice. Please contact your investment advisor before acting on any information.

Stock Picks - 2011

Details to follow:

1. BP plc (NYSE: BP)

2. Johnson & Johnson (NYSE: JNJ)

3. Citigroup (NYSE: C)

4. Oshkosh Corp (NYSE: OSK)

5. M-Split Shares (TSX: XMF.A)

Approaching Flash Crash Bottom

I spoke to a couple of friends during the Flash Crash, indicating that the market would have to fall at least to those levels before we could see the correction dissipate, or at least calm down. We are now within a couple of percentage points of this reversal mark. While still bearish about the European prospects, and worried about the credit drought building there, I am now of the opinion that it is time to wade into higher quality stocks that have at least 65% of their revenues residing in North America, and are in less volatile sectors. National Presto, Laboratory Corporation of America, and Quest Diagnostics are some companies that appear qualify for purchasing at this time. I don't know where this market is headed, but companies with these characteristics should still profit during these times of economic uncertainty.

Full disclosure: I am long both NPK and LH at this time.

A $1T waste of money???

The $1 trillion dollar measure to support the Euro, and Euro-zone countries did not address the fundamental and structural issues surrounding the countries that it intended to save, and, to me, this is the one reason I think it will not resolve anything. The political maneuvering of Angela Merkel (German Chancellor) did not save her from losing control of Germany’s upper house, nor will it have saved the slide of the Euro and the remaining Club Med countries’ debt problems. The ECB will have to devalue its currency intentionally to really show that it is taking action. Throwing money at this problem is only showing to the world that the southern European nations have influenced the north, and now the whole Euro-zone is willing to destroy their fiscal responsibility.

The Euro must establish and enforce new austerity measures on EVERY country within the Euro-zone, including the usually responsible countries of Germany, France and the Benelux region. It is time the Euro-zone take responsibility, and promote productivity, deleveraging and individual responsibility.

Germany's vote: The key to the next two weeks.

The unprecendented (we have never seen such a drop and immediate turnaround) action in the markets have led to many theories. Trader error, computerized trades, plunge protection team, etc. are all theories brought forward to explain what is a fat-tail event. At one point trading institutions were compounding the situation, and the Nasdaq and NYSE ended with their highest and second-highest volume totals respectively. The similarities to 2008 has been uncanny:

1. Iceland could be considered the Bear Stearns of sovereign economies. It fell first, and provided us with a sign of things to come.

2. The Club Med countries (Spain, Portugal, Italy, Greece, etc.) are all behaving similarly to the remaining financial companies in 2008. Their markets are all clearly falling, and they are bringing the Euro down with them.

3. Germany, one of the largest investing countries in Club Med, has hesitated in addressing the bailout. Like the US Senate, who hesitated on the economic bailout, members of Germany's controlling coalition are hesitant on accepting the bailout.

4. The feeling on the marketplace now appears in complete meltdown mode, and is now in a death spiral, with lack of confidence in counterparties and in the economies around the world.

With everything in turmoil, the biggest saving grace will be Germany's vote on the Greek bailout. If Germany votes unanimously to bail out Greece, it will provide some footing to the markets, and confidence that Germany will continue to support the Euro. If, however, German opposition and members of the key coalition decide to vote against the measure, either making the vote extremely close or even allowing the bailout to fail, the markets could go into freefall. With Germany investing in a substantial amount of the Club Med debt, I expect the vote to pass quite comfortably. But, I expect the markets to remain very skeptical of Spain, bringing them to the limelight in the next few weeks.

As I have stated before, I question the Euro's ability to survive the market action of the last 2 years (refer to my posts in October 2008 and January 2009). I personally feel that in order to survive, either all Euro countries need to accept devaluing the currency, or expelling the countries that cannot meet strict monetary disciplinary practices.

I am currently holding put options on NYSE:EWP (Spain) and NYSE:FXI (China), and intend on going short NYSE:EWG (Germany).

The Jobs Report - Good Friday Edition

For the third month in the last five, the U.S. job market has started to show signs of a pulse. Nonfarm payroll increased by 162,000, while the unemployment rate held steady at 9.7%. Overall, the Civilian Labour Participation Rate (the proportion of individuals employed versus the total population of individuals of employable age) is at 64.9%. Temporary workers, both for the Census and the private sector, continued to dominate the growth side of the ledger, as did healthcare (more on that later).

Whereas the unemployment rate is reported as 9.71%, the true U.S. unemployment rate is far higher than this, when we consider the fact that the Civilian Labour Participation Rate has declined from 67.3% in March 2000 (when the secular bear market began) and 66.4% in January 2007 (when the housing market collapse was confirmed), it is apparent that many individuals have simply left the job market. If we were to simply look at the unemployment rate using the past participation rates, unemployment rates are closer to 12.93% and 11.35%.

What does this all mean? Simply put, we are not nearly close to peak employment, and thus many inflationary pressures internal to the U.S. should remain low (such as housing and consumer capital goods). We should also hope that the U.S. Federal Reserve takes this into account when considering interest rate hikes in the future (after all, you don't want to alienate further parts of the population permanently out of the market).

The interesting labour trend of the last 3 years has been the increase in temporary and healthcare workers. Increases in temporary workers makes sense in the worst recession since the 1930's - companies are unwilling to risk their futures on a "shaky" economic outlook. However, the trend of increasing health care workers may be a sign of where the next economic bubble may occur. In the past, we have seen the first economic gains during recessionary times in areas where the bubbles form, like in the finance and construction sectors in the early 2000's and the technology sector in the early 1990's. I know it's early on, but the opportunities to make supernormal returns may present themselves in this field for the next 3-4 years, as investors identify the trend, and returns continue to grow. Compound this with the new healthcare bill, and we may have a winner (temporarily, of course!).

Five Stocks for 2010

Just for fun, here are my 5 stocks/ETF's for 2010:

1. National Presto Industries (NYSE: NPK): Who doesn't like some Presto cookware with some ammunition?

December 31, 2009 Price: $109.23 USD

2. Manulife Financial (TSX: MFC): Cheap, cheap, cheap. Beaten down because of shoring up capital. We'll see the upswing as people realize it is undervalued.

December 31, 2009 Price: $19.33 CAD

3. Progressive Insurance (NYSE: PGR): Huge cash flows, lots of premiums (unrealized claims) that generate large investment gains for the company. Just like Geico, this stock is ripe for growth.

December 31, 2009 Price: $17.99 USD.

4. Fastenal Corporation (Nasdaq: FAST): Simply put, this company sells small tools at construction sites and in industrial zones. If the stimulus package States-side is for "shovel ready" programs, than Fastenal should reap the benefits.

December 31, 2009 Price: $41.70 USD.

5. Barclay's India ETF: My opinion is that India will show accelerating growth and future prospects due to infrastructure, and attention to the largest democracy's growth prospects. After all, most Americans will be looking for safer alternatives to the US market and exposure to the USD.

December 31, 2009 Price: $64.11 USD.

Guessing the S&P 500 December 31, 2010 value: 1,231.49.

These picks are for fun, and should not be construed as investment advice. Contact your professional advisor for any investment advice.

Abu Dhabi bails out Dubai

In a sign that the risk trade has been restarted, Abu Dhabi announced that it will provide $10b to Dubai World, the sovereign wealth fund that was over-leveraged on risky assets. With this move, we should see stock markets power past their recent resistance points. In this market full of government cash and support, and little recourse for poor decision making, we should be mindful of investing in good balance sheets, and building our personal balance sheets for the next crisis to come. It will only be a matter of months before we start seeing an inflation crisis that will pull the weakest personal balance sheets to insolvency.

New Zealand steps out from the Recession

New Zealand became the latest country to statistically step out of the shadow of the recession, sparking an increased appetite for the carry trade, and thereby bringing the USD under pressure again overnight. Ironically, the country's growth was partially a result of dairy sales, which have caused such grief in Europe.

What's the Fed to do?

Tomorrow will be a significant day for the markets. It may mark the first day we hear the Fed's plans to exit the quantitative easing program initiated during the midst of the crisis. This could cause significant pain to the market short-term, but may provide a catalyst for the markets to move higher. As the Fed moves out of the mortgage business (effectively ending its purchases of 10 and 30-year treasuries), the market will need to soak up all the Treasury's liquidity without the U.S. government's assistance. I'm not sure where the heavy lifting will come from, and this may prompt higher yields in longer term treasuries. While this will reduce confidence in the U.S. dollar, it will do wonders for the competitiveness for U.S. exports, and bringing some inflation into the market. Depending on the velocity of the Fed's tightening of the money supply (through reduced treasury purchases), we will see this inflation bring higher commodity and equity prices, as future earnings prospects will accelerate.

On another note, it will be some time before we see the Fed increase the fed funds increase, as the Fed will need to first remove the layers of support that have been thrown over the faltering economy, including the quantitative easing, TARP and TALF programs. Thus, I see a steeper yield curve, a lower U.S. currency (vs. commodities at the very least), and better future prospects for the equities market. Only time will tell - the initial reaction is not necessarily the right one in the market.

Permabears turning bullish...Many bulls remain frozen in the headlights...

James Grant, a famous bear who had been harping about the housing and credit bubble for years, has turned remarkably bullish, in spite of his fears about the long-term implications of shoveling money into the economy. Grant evidences that in each major recession in the past, the economy has rebounded very quickly, and the harder we fall, the faster we rise.

With the economic meltdown as severe as it was in 2007-2009, it is clear that the next bull market will be much steeper than many predict, and it's great to have a permabear trade in his claws for some horns and hooves.

While Grant has become bullish, many economists and institutional managers alike remain bearish. This in itself is a bullish sign, and I am in the camp that we have entered a secular bull market, that many will only conclude is such a market when we make new highs on the S&P and Dow, which may still be years away. While we may have corrections (even at the current levels), my personal opinion (to be taken with a grain of salt) is that any correction will be fast and furious, to flush out the weakest of hands and the gambling speculators.

Thesis on the Market Recovery

It's been a few weeks since Warren Buffett's op-ed piece, "The Greenback Effect". Obviously the concerns being portrayed are one of a depreciating US currency. I personally see this as being only half the story.



I personally believe that most of the developed world is building a Ponzi scheme of debt, financing each others' ambitious infrastructure plans that will save capitalism from collapse. I don't doubt that this will have been the best approach given the circumstances in the marketplace at the time (frozen credit markets and a catatonic consumer base).



I theorize that the US currency may not fall versus most currencies worldwide, but most currencies will depreciate against hard assets and useable commodities, like oil, copper, etc. With the flood of cash, and some evidence that the credit markets are thawing (see the 750,000 cash for clunker deals that have taken place - at least some of those had to be financed), I expect that the velocity of cash will accelerate quickly through the economy, increasing demands for credit, in order to "get ahead of the curve". As companies will start showing increasing profits and revenues through this "cheap cash", the cash will continue to produce increasing cash through the marketplace (courtesy of the economic multiplier). This cash won't generate jobs as quickly as people anticipate - the market is not quick to bring jobs back into the forray, but productivity gains will continue to increase. The middle class is squeezed by the fact that jobs don't return as quickly as the economy does, and the price of goods increases by worldwide demands. Therefore, middle class individuals lose on two counts: less job stability and inability to increase compensation at the rate of inflation. Until we reach full employment, middle class employees are squeezed, and their wealth is reduced in real rather than nominal terms.

Buffett's latest take - an Op-Ed in the New York Times

This is an important report about the implications of opening the coffers of debt to save the U.S. economic system from collapse. More to follow.

http://www.nytimes.com/2009/08/19/opinion/19buffett.html