Eric Roseman's Eruptions: Stocks, Global Markets and Commodities BLOG

Sub-Prime and Private Equity Sabotage Bull Market

Although global stocks are recovering from last week’s plunge, signs still point to more distress for the troubled U.S. sub-prime mortgage market and funding problems now engulfing private equity. It’s also highly unlikely that following the deepest weekly plunge in stock values since late 2002 that the bull market can quickly recover and resume its primary trend. That’s because credit spreads, or the yield differential between risk-free Treasury bonds and lower credit bonds is rapidly widening from all-time lows (see below).

A liquidity crisis has emerged globally and markets are screaming for more credit as the distressed debt market continues to hemorrhage. The problem is most central banks are still raising interest rates while the Federal Reserve remains vigilant, instead targeting rising inflation. If central banks won’t cut lending rates, then global market participants will have to soak-up the excesses in credit derivatives, leveraged loans and mortgage-backed securities. That task is far more difficult when the Fed isn’t creating liquidity to offset credit distress.

Since mid-July, investors have started to shun bonds and loans needed to fund leveraged buyouts where approximately $690 billion dollars of debt-fuelled takeovers have supported this year’s stock-market rally. With high-yield bonds plunging in value since last week, over 40 deals have been shelved as a buyers’ strike has emerged. And previous credit crises have accurately foreshadowed additional stress for stocks, too.

According to Morgan Stanley, turmoil in credit markets this year is likely to continue to spillover into stocks. Over the last 20 years, corporate bond spreads widened on average six months before European stocks reached highs in 1987, 1991, 1998 and 2000. Subsequent declines of at least 10% followed for European shares. The same phenomenon occurred in the United States in all four cases as equities suffered declines following a liquidity crisis in the credit markets.

The distressed debt sector, marked by junk bonds and syndicated loans is suffering from the inability to secure crucial financing amid soaring yields. While Treasury bonds drew the bulk of safe-haven flows last week from nervous investors as equities tanked, weaker credits saw their yields hit fresh 52-week highs, including emerging market bonds. Also, several more mortgage-backed hedge funds in Australia, the United Kingdom and the United States have collapsed or closed as a result of huge losses.

And the sub-prime crisis in the United States has now spread overseas, although on a much smaller scale.

In Germany, two banks, including the country’s second largest, Commerzbank AG, reported losses exceeding $100 million dollars this year. Britain’s HSBC Holdings, the biggest bank in the world, aggressively purchased U.S. sub-prime subsidiaries earlier this decade and has been saddled with huge losses far in excess of Commerzbank’s.

Fallout from the sub-prime mess is also affecting REITs.

After a stunning six-year rally, U.S. real estate investment trusts or REITs, have crashed 15% this year taking the majority of REITs elsewhere in the world, including Europe, to the basement.

Eventually, the best bargains in the market will surface in U.S. and European financial services stocks, including REITs. Many of these issues have either corrected sharply or crashed. But until the Fed relents and starts cutting interest rates or the last shoe finally drops, stay away from the financial services sector. Lower lows are coming our way.

Shipping Costs Hit New Highs, Defy Liquidity Scare

The ongoing global liquidity squeeze this month precipitated by the sub-prime mortgage
bear market and subsequently punctured by the private equity funding crisis, has yet to hit
one of the leading cyclical growth barometers.

The Baltic Dry Index, one of the leading gauges measuring dry bulk shipping conditions, climbed another 4.4% last week to a record, despite the big plunge in stock-market values worldwide. In a classic monetary squeeze whereby global central banks are tightening interest rates, economically-sensitive indices like the Baltic Dry Index would normally tank; but that’s not happening this month as countries and companies continue to move record amounts of commodities like grains, iron ore and coal. Global growth remains brisk and countries like China continue to devour almost every conceivable raw material to fund her booming economy.

In addition to freight rates hitting new highs this month amid one of the worst global market declines since late 2002, most commodity indices were moderately lower last week as crude oil prices hit their highest levels in almost a year. Crude oil is the single largest commodity weighting in all resource benchmarks, including the S&P/Goldman Sachs (GS) Commodity Index. Though many commodities declined last week, oil prices continue to surge, also defying the notion of an impending growth-scare affecting global growth.

In a true global economic liquidity squeeze, interest rates would be rising in the United States and most commodities, including crude oil and the Baltic Dry Index, would be crashing. But that’s not happening this month because the ongoing “scare” is just that – a global funding crisis or hiccup whereby private equity has flooded the market with too many debt-financed deals. In my eyes, the markets are saturated with private equity deals and a correction in the primary trend was inevitable and ultimately, healthy for the market as risk is reassessed for some of the more speculative deals. Plus, the Federal Reserve is not tightening monetary policy and in fact will likely cut lending rates before the end of the third quarter.

Commodities remain in a long-term secular bull market driven by robust demand and declining supplies for many raw materials, namely several base metals, the grains, vegetable oils, dairy products and some precious metals, namely gold and silver.

Inflation is definitely climbing as most commodities rally, including oil and soft commodities. The Fed, however, has no choice but to cut interest rates this fall despite rising inflation because housing is still in the midst of a major blow-out, threatening the American consumer and inflicting major pain on domestic consumption.

Save the American consumer from a housing crash or raise interest rates to choke incipient inflation? The Fed will choose the former and do what it has always done best: Print credit.

Fed Should Cut Rates Now

Though I wasn’t a fan of former Federal Reserve chairman, Alan Greenspan, he did know when to open the monetary spigots amid a liquidity crisis.

Under Greenspan’s tenure from 1987 to 2005, the Fed reacted immediately when liquidity starved the credit market and threatened the financial system.

Greenspan’s biggest test was right after he became Fed boss in 1987 when stocks crashed 22% on October 19, 1987. The Fed immediately cut rates by 2 full points. And again, when the collapse of hedge fund Long Term Capital Management threatened global credit markets in the summer of 1998, Greenspan reacted swiftly, providing immediate credit to the financial system.

But Ben Bernanke is a different sort of Fed boss.

In 2007, the Federal Reserve is more concerned with inflation, a misplaced concern considering U.S. home prices are still crashing, suggesting incipient deflation is a concern. With the ongoing turmoil affecting the credit markets, Bernanke should cut short-term interest rates now or at the Fed’s next FOMC meeting. All high-risk segments of the corporate and mortgage-backed market are hemorrhaging, a clear warning that there’s a credit bubble currently unwinding, threatening the financial system unless immediate liquidity is created to assist all parties and counter-parties affected. Also, the country’s banks are coming undone, sliding to new 52-week lows this week as concerns mount that loan-losses will increase as sub-prime defaults spread to the next tier of borrowers.  See Bank Regional Holders (RKH) chart below.

Once again, hedge funds around the world have begun to fail with several high-risk mortgage-backed hedge funds in Australia, England and the United States either near-collapse or teetering on the brink of failure this summer. The spreads between safe Treasury bonds and other high-risk credits have now hit 52-week highs, a warning that there is a credit crisis underway. As spreads continue to widen, the scope of this liquidity crisis will spread, slowing economic growth and halting the boom in private equity financing, which depends on stable interest rates to finance debt-backed deals.

Inflation has never been a real concern for the Fed, despite its official utterances to the contrary. Since it’s creation in 1913, the Federal Reserve has consistently de-based the dollar’s purchasing power; but it does score high points for printing money, especially amid liquidity crises. And now is the time for the Fed to abandon its inflation rhetoric and create immediate liquidity to boost credit and mortgage markets. C’mon, Ben, do what you do best…

Have a nice weekend.

Liquidity Crisis Underway in Distressed Debt Markets

Credit spreads continue to widen and that’s bad news for the economy.

Since hitting multi-year lows versus Treasury bonds on the yield scale, credit spreads of high-yield debt have widened a considerable 361 basis points, or 3.61% from a record low of just 2.41% on June 5, prior to the latest distressed debt debacle. Many new deals have been shelved recently as companies balk at much higher financing costs and Wall Street scrambles to find financing for several other key deals, namely the massive Cerberus Chrysler buy-out. The bear market in distressed debt has arrived (HYG)

A value investor would have avoided high-yield and other high-risk bonds over the last several months and beyond. That’s because credit spreads between the riskiest bonds and risk-free Treasury’s were progressively narrowing over the last 12 months; tight credit spreads never last, and are a symptom of easy bank credit, rampant investor speculation and private equity’s relentless bid to finance corporate takeovers with cheap debt. The party had to end and starting on June 5, it did.

The high-yield or junk bond market, however, is not the only sector coming undone since early June.
The mortgage-backed market and every segment of this huge financing component of the economy are now in a freefall. Specifically, the sub-prime market, where over 20% of all outstanding mortgages reside in the United States, has crashed. Now, fears are spreading that the sub-prime fallout is hitting the Alt-market, or the next tier of borrowers with a higher credit quality.

The bond market has always been where the “smart money” lies on Wall Street. Bond investors are far more in-tune with the economy’s performance and future direction, unlike stocks. And right now, the distressed debt markets are crying for liquidity as the punchbowl has left the party.

Even if rising oil and gas prices persist this summer threatening higher inflation, the Federal Reserve will cut short-term lending rates. The real estate bear market is getting worse and continues to starve for easier credit. Bernanke talks a tough game, but in the face of a mortgage-backed disaster now unfolding, the Fed should get its act together and cut rates soon.

The 21st Century Belongs to Asia and Her Investors

This century belongs to Asia. If the United States dominated the last century and Britain spearheaded the 19th century’s economic progress, then China and many of her regional trading partners will set the standard for wealth accumulation and host the greatest economic boom the world has ever witnessed over the next 100 years.

No other economic region has amassed more foreign-exchange reserves, sports the largest combined trade surpluses with the rest of the world and holds title to the most undervalued currencies. At some point, Asia will create a common Pan-Pacific currency unit, rivaling the mighty euro and possibly challenging the latter as the leading contender to become the world’s de facto reserve currency later this century as the U.S. dollar continues to decline.

Although the majority of Asia markets have already hit all-time highs, several countries, currencies and local real estate markets remain excellent value and should compliment every long-term growth portfolio.

China the New Japan in the 21st Century

Compared to ten years ago, Asia has completely resurrected its balance-sheet following an economic depression in most countries that almost completely destroyed regional capital markets. And while Asia continues to boom this decade, led by China and other Asian markets, the industrialized economies of Western Europe and the United States continue to accumulate record deficits ahead of huge entitlement spending burdens as their populations continue to age.

Prior to the bull market boom of the 1980s and 1990s in Asia, Japan was one of the fastest-growing economies in the region. Like China today, Japan in the 1960s grew very rapidly and consumed swaths of raw materials as her mighty economy grew rapidly. But with accelerated industrialization and a massive bubble in her capital markets in the late 1980s, Japan became the first Asian domino to fall starting in 1990; seven years later, Thailand unleashed another wave of financial panic, spreading across the region and resulting in the Asian economic crisis of 1997-1998.

Asia, including Japan, has learned a great lesson from the economic crisis a decade ago.

Compared to 1997, the region currently holds almost $2 trillion dollars in foreign-exchange reserves, bulging trade surpluses with the rest of the world and extremely undervalued currencies, especially versus the euro. And unlike ten years ago, many regional markets have introduced bold new measures to curb speculation and leverage; to be sure, there’s still plenty of risk investing in these markets. But a value investor in Asia will find several countries paying big dividends in cheap currencies supported by healthy balance-sheets – extremely compelling factors to remain a long-term investor in any country.

Here Come the Pension Funds!

Supply and demand dictates price trends for every asset class. And across Asia, more state-sponsored pension funds are directing capital to stocks as they seek to boost U.S. dollar-based inflation-adjusted returns. A few hundred billion dollars will find its way to regional and global equity markets over the next decade, and that alone will reduce the net supply of stock. Provided global inflation remains historically low and interest rates are stable, pension funds will increasingly apportion more capital to equities.

For example, in Japan, the government’s state-controlled pension fund recently announced it will invest $900 million dollars in Japanese smaller companies. Other countries, including China and South Korea have announced equity investments to augment their fat reserves, mostly invested in Treasury bonds.

Asian Real Estate a Big Draw

At the upcoming Asian Advantage Tour in October, I’ll be introducing several high-value Asian investments with superb profit potential. Each of these securities are coined “contrarian” investments, meaning they trade at or near their lows, sport big dividends in local currencies and in some cases, have declined more than 40% from their highs. In particular, I’m looking at Singapore REITs (real estate investment trusts), Hong Kong REITs, Thai blue-chips and distressed Japanese smaller companies – all incredibly undervalued.

Asia’s real estate market is especially exciting because compared to most major cities in the world places like Singapore and Bangkok remain undervalued. And in Hong Kong, home to tax-free REIT dividend income to foreign investors, local real estate funds have declined over the last 12 months amid a speculative stock-market frenzy in nearby Shanghai, detracting fund-flows. But overall, Asian REITs continue to rise in value this year while real estate investment trusts in the United States, Canada and Western Europe are suffering steep losses following years of outsized gains.

Already, our TSI Investment Portfolio has earned big profits in several Asian open positions, including Singapore REITs (+95%), Taiwan stocks (+25%) and Thai equities (+15%).

As the year progresses, I’ll be introducing more Asian securities in our TSI Investment Portfolio. And if you come to Asia I’ll give you a first-hand tour of local markets and how to tap into some of these fabulous investments….hope to see you there!

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The Last Bear Market: Busted Home-Builders

In a world marked by generally expensive stocks following a torrid four-year bull market, one last bastion of value exists: home-builders, lenders and other financial services companies tied to the distressed real estate sector. But it’s still too early to bargain-hunt as more bad news emanates from the worst housing market decline since the late 1980s.

Since peaking more than 12 months ago, U.S. residential home prices have plunged to their lowest levels in more than a decade. With long-term interest rising and adjustable rate mortgages up sharply over the last three years, it’s no wonder homeowners are struggling to meet mortgage payments. And the spillover has been significant, affecting the entire housing-related industry from the home-builders, mortgage companies and home-improvement firms. Many of these stocks have been decimated, down more than 50% while others in the mortgage lending business have seen their share values crumble over 75%. Most of the plunge has occurred recently following a series of credit problems (see chart below):

Credit Problems and the Bear Market Plague Homebuilders

To be sure, at some point a major recovery lies ahead for the home-builders, including REITs and other financial services companies tied to the mortgage-backed market. For contrarian value investors, some mouth-watering values can now be had for several high quality companies trading below their book-value and trading at low price-to-earnings multiples.

But before getting too bullish, the Federal Reserve will have to finally acknowledge the crisis in U.S. housing by reducing the Fed Funds rate. Markets don’t expect the Bernanke Fed to cut rates this year because of incipient inflation fears and high energy prices. However, the Fed will be forced to cut lending rates before December as more distressed mortgage companies continue to falter, spreading their woes across other areas of the economy. I think it’s fair to assume that in a U.S. presidential election year in 2008, the Fed will pander to the White House and Congress by cutting interest rates, alleviating growing real estate stress on the economy.

As markets begin to finally discount an imminent interest rate cut, the best buying opportunity since the Savings & Loans crisis in 1990-1991 will surface as the home-builders and other mortgage-related securities are aggressively purchased by value investors. It’s too early to go shopping now; but I’ll let you know when to get your shopping cart.

Following the Tax-Cut Trail to Big Profits

One of the biggest catalysts for impressive stock-market gains and the birth of a bull market are tax cuts. And across many markets in Europe and Asia, governments are slicing corporate and individual income tax rates in a concerted effort to boost global competitiveness.

As tax cuts accelerate in many OECD countries, investors should take notice and ride those markets where tax cuts are deepest – namely in France, one of the harshest tax regimes in Western Europe.

The French, interestingly, are exactly where the Germans were several years ago as economic malaise, faltering exports and rising unemployment resulted in two economic recessions from 2000 to 2004. Then the tax cuts arrived – under a socialist named Gerhard Schroder.

Good Things Happen Following Tax Cuts: The German Model

In early July, the Germans, in a series of proposed cuts dating back to 2000, reduced the corporate income tax rate by 8.9%. Since 2000, the Germans have cut corporate tax rates on several occasions from 52% seven years ago to 29.8% by 2008; over the last three years, German blue-chip stocks have more than doubled and continue to rally as corporate earnings have literally skyrocketed following tax cuts, labor reform and low interest rates. Even more amazing is the fact that German exports are booming in the face of a mighty euro, now trading at an all-time versus the beleaguered American dollar and up over 65% over the last five years.

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What’s really incredible is the widespread acceleration of broad-based tax cuts now enveloping countries like Vietnam, Northern Ireland, and even France, where recently elected French president, Nicolas Sarkozy, has proposed cutting corporate tax rates from 34.4% to 25%. If this proposal passes through French legislators, French stocks will rank as the best potential investment since the German DAX five years ago.

Unfortunately, the United States is heading in the opposite direction on the tax-cut trail as Congress threatens to raise the tax rates on corporate dividends.

Unlike the Reagan Revolution in 1980 when broad tax cuts boosted a lethargic economy amid soaring interest rates and surging inflation, spawning the greatest bull market in U.S. history, the United States is headed backwards while the rest of the world cuts tax rates. That means investors should follow the tax-cut trail in other countries, namely in Asia and parts of Europe that have lagged during this bull market – particularly France. And for the record, Eastern European and Baltic countries have already sliced tax rates in a big way since 2000 spurring a massive bull market in equities until recently.

Tax cuts are a good thing. When corporations, investors and individuals keep more of what they earn, productivity and wages are increased and capital spending increases markedly. In next month’s Sovereign Individual, I make the compelling case for investing in one of France’s top-performing equity funds ahead of what hopefully will be the next Reagan-like economic revolution under Mr. Sarkozy.

The Most Undervalued Currencies in the World

Over the last 12 months, my colleague and I, Jack Crooks (Crooks on Currencies), have staunchly agreed that Asia’s currencies are hugely undervalued and at some point, will muster some big gains versus the U.S. dollar and even the euro. The latest foreign-exchange reserves statistics in Asia once again confirm this forecast.

Asia’s reserves reached a staggering $3.52 trillion dollars in June, an increase of $57.7 billion dollars compared to May and up from $2.92 trillion dollars 12 months ago, according to Dow Jones Newswires. Any way you measure these numbers, they’re simply awesome and point to a major revaluation in the future versus most world currencies.

What’s even more compelling is how cheap these currencies have become over the last five years versus the almighty and overvalued euro, British pound and even the Brazilian real, one of the top-performing global currencies since 2003. In stark contrast, Asia’s currencies have declined vis-à-vis all three currencies over the last several years and are absolutely cheap when measured against not just against the U.S. dollar, but versus most currencies in Europe and parts of Latin America.

The cheapest of these regional units remains the Japanese yen, a principle funding currency for the carry-trade since this global economic expansion began in late 2002. The yen is still trading at an all-time low versus the euro – massively oversold versus the European single currency and trading at a 20-year versus a basket of major currencies. At some point, the yen will commence a historical rally that will simultaneously flush-out the carry-trade. In my book, investors looking to hedge their portfolios from market chaos might want to buy yen versus the euro as portfolio insurance; when this trend reverses, it will yield enormous profits as most other financial assets decline at the same time.

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Through Everbank in the United States, investors can now access the Sovereign All-Weather Currency Fund, including the Japanese yen and the Chinese yuan, to name just a few Pacific currencies. I think this is a great way to own these unbelievably cheap regional currencies for one small investment and backed by FDIC deposit protection.

I’m heading on holiday next week, so my next post will be on Monday, July 23. Have a great weekend.

Time to Buy Depressed Ethanol Stocks

Although I don't like ethanol stocks longer term, the recent crash in this sector has afforded the best buying opportunity for value investors since the boom in initial public offerings two years ago.

Ethanol, a biofuel, is a corn-based distillate in the United States and while it's still sparsely used in gasoline blends across the country, the wave of the future implies far more consumption. The Brazilians are world leaders blending sugarcane ethanol, now represented in over 60% of all Brazilian vehicles. Ethanol currently comprises just 4% of U.S. gasoline supplies.

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In the United States, ethanol is a major political football. And that alone means ethanol is here to stay.

Ethanol is extremely well supported in Washington and the powerful farmers' lobby. The Bush administration continues to push heavily for ethanol development and Washington offers a hefty subsidy to producers. But until recently, the majority of ethanol companies were losing money because of high input costs, namely soaring corn prices.

From their ten-year highs in February, spot corn prices have tanked by almost a third. After watching a crash unfold for ethanol stocks over the last year, I'm now short-term bullish on the complex. From a universe of almost a dozen producers, I recommended the most profitable pure ethanol play this week in my Commodity Trend Alert. This company, down by over 30% over the last 12 months, actually makes money and has virtually no long-term debt and more net cash than its entire debt load. Basically, this ethanol stock is not only a pure value play, it also offers some big upside over the next several months because ethanol prices are now lower than gasoline price for the first time since 2005. A gallon of ethanol sells at $1.97 versus $3.03 per gallon for unleaded gasoline.

A secular long-term bull market in corn prices does not bode well for ethanol producers or investors in these companies. But with the current U.S. corn crop the largest since WW II, supplies are abundant as farmers scramble to grow politically viable corn. And a lower corn price, at least short-term, is bullish for ethanol producers. I'm buying ethanol.