10 Things I Think I Think

1. The government’s decision to stop publishing the M3 data serves to hide the overall market truth - this market is flooded with liquidity, inflating asset prices across the board. A website, www.shadowstats.com, has reconstructed the original M3 to a five-nines (.99999) correlation. That current construction shows the M3 running at annualized rate of 12.8%. More money equals inflation. This excessive printing by the government to fund the war and keep the housing market from crashing, is exacerbated further by the other liquidity issues in the market (high leverage, consumer credit, etc). All this money serves to drive asset prices higher, but at an increasingly growing risk.
2. Which leads to the next point…The governments production (and I use that term due to the theatrical sense of today's market) of its inflationary data is a joke. The release keys of "core" inflation which is essentially inflation without the inflationary inputs. They remove the items they consider are non-"core" which are food and energy, which are part of the core expenses everyone needs to live. That makes no sense, hence the use of the word production. A recent WSJ article surmised that U.S Prices have been growing between 8 and 11% annually since 1996, dramatically higher than the reported core rates between 1.5 and 4.5%. The M3 reconstruction, and the uselessness of reporting that "core" inflation remains tame supports my overall liquidity theory.
3. The spread between gas and oil is very interesting. Oil supplies are high, and gas production is lower due to seasonal refining capacity issues, which are very high and likely to continue to be high (i.e. lower capacity) for the summer season. Historically, according to the WSJ, these refineries run at 92-96% capacity during mid-summer, this year's projections are for the refineries to run around (or just below) 90%. Continued refining capacity issues will keep this spread high and drive stock prices of these companies higher. A recent Barron‘s article pointed out that supply last month of gasoline was at a 50-year low of just 21 days. That is extremely low and any issues slowing supply could spark not just a rise but a spike in gasoline prices. The Middle East and Nigeria issues will be the drivers in the price action most likely throughout the summer and the hurricane season (which is predicted to be highly active according to the government) will drive prices for both crude oil and gas towards summer's end. Oil should remain strong as the U.S. supply serves to barely meet demand. According to the WSJ’s recent interview with T. Boone Pickens, worldwide oil production supplies 85 million barrels a day, and demand is right at that number. Any disruptions will drive oil prices higher and as long as refining capacity remains historically weak, gas prices will go higher as well.
4. The China talk is absolutely dominating the media and rightfully so if some of the speculation ends up true. The Blackstone deal could be indicative of China's desire to employ their reserves more actively. Sovereign investment companies are growing in number. The Blackstone deal could amount to a toe-dipping prior to a cannonball for China. A recent WSJ article discussed that China's recently formed State Investment Company (acquirer of the Blackstone interest) could invest between $200 to $400 billion in the market. Considering that China's reserves are increasing annually at $200 billion per year indicates the funds could grow quickly. This is extremely bullish long-term for stocks.
5. Warren Buffett has been rather outspoken in his criticism of the U.S. Government's handling of the trade deficit (especially with regards to China). Recently he commented that, "Running a $700 billion annual trade deficit is effectively selling the U.S. to its trading partners” (China). The Blackstone deal reiterates that fact. Now China own tons of their reserves in U.S. Treasuries (U.S. Debt) and now they are indicating their intent to own U.S. Companies. Buffett is right; the government is selling the farm.
6. This LBO stuff is unbelievable. Though I'm young I can't recall a time there was literally billion dollar buyouts being announced on a daily basis. This is a consequence of the two double-edged swords: the seemingly endless liquidity and Sarbanes Oxley. Liquidity helps strengthen economies, but excess liquidity creates bubbles. SOX was designed to give investors comfort over management’s controls over their financial reporting, but it has done so at a monstrous cost to the companies and therefore to shareholders. The beneficiaries of SOX, the big four accounting firms are wondering what all of this means to them. A recent poll by PricewaterhouseCoopers noted that 2/3 of senior financial executives polled thought their organizations will undergo significant M&A activity in the coming five years. Supply and demand 101 teaches you, when there is fewer shares available due to buyouts (without corresponding new supply - i.e. IPO's) and more dollars (see money supply discussion above) prices have to go up. It's not rocket science, it's supply and demand. If private equity shops can get cheap loans and buy quality companies, they will continue until they determine the prices aren't reasonable.
7. Also on my gripe list of government statistics is…drum roll please…employment data. The monthly BLS data is, well, worthless in every sense of the word. How useful can data be if it has to be revised (drastically) two, sometimes three times, often several months later. On top of that, the BLS appears to greatly understate unemployment. And this is evidenced by? Another BLS report of course! The Business Employment Dynamics (BED) report. This, according to the WSJ, shows dramatically different data and substantially higher unemployment. Well, I wish I knew which data set was more accurate to use? Let's see, the BLS uses some curious "birth/death" model to guess job gains and losses while the BED report uses, "nearly complete coverage 'of the employment universe provided by the unemployment insurance system." I think I'll go with the latter, more realistic, more accurate report not the government's "Let's paint a pretty picture" report.
8. Goldman Sachs and the Fed are doing a rather nice job turning a cold shoulder to the housing market’s slow down…and its potential effects. Let’s take a look at the facts: A high number of Adjustable rate mortgages are adjusting out in the next 12-16 months (see exhibit below). The current housing inventory of 4.2 million units is running at 8.4 month supply at current sales rates. The Case-Shiller Home Price Indices show negative annual returns in the U.S. for Q1 2007. Returns were down 1.4% since Q1 2006, which is in sharp contrast to the Q1 2006 returns which were 11.5% above Q1 2005. Perhaps the most interesting statistic is that sales of existing home units have been decreasing for 3 consecutive years. The simple fact is, if foreclosures continue to grow, due to ARM’s and other exotic mortgages adjusting to today’s higher interest rates, some small regional bank or even worse a larger, national bank will falter or fail (think New Century Part 2). Funny how we find out later that the big bully on the block, Goldman Sachs, was the largest creditor to New Century. Housing isn’t stabilizing like the NAR would like you to believe. The facts scream otherwise…

9. The market fundamentals for gold remain very strong. Even the fed acknowledges that inflation is an issue (and they like to paint that rosy picture!). The market supply of dollars due to excessive printing of money, leaves us with more dollars to buy the same amount of gold. World currency markets are reflecting this supply/demand relationship. The Euro, in the midst of a short-term pullback, is near a historical all-time high vs. the dollar. On top of that demand for gold remains very strong. Industrial demand in China and commercial and personal demand in India are both strong. Additionally, supply of gold is weak around the globe. Gold serves as a strong inflationary hedge and therefore the Fed’s very public stance that inflation remains their chief concern, will continue to drive investors towards the inflationary safe-haven. Also, gold serves as a safe-haven for investors who are weary about the continued instability of the Middle East. The only thing keeping a cap on gold prices has been the increased level of selling by central government bankers. The question is, how much gold is in the coffers, and are they actually delivering on it or is it just a paper deal to keep gold in check?
10. Bringing it all together: The main issue in the market is liquidity, and an excess of it. This market has all the signs of retreat but that is in the face of a strong rally. So…what gives? I think the answer is that today is a different day in age in the markets. The government is able to sway popular opinion with voodoo reports and strong language in all forms of media (tv, newspapers, blogs etc). There are some simple facts laid out in the above 9 points: liquidity is high due to excessive printing of money, inflation does exist, oil and gas (energy in general) remain fundamentally strong, sovereign funds and private equity buyouts could continue to drive these markets forward regardless of fundamentals, the government is selling itself to its trade partners especially China, debt and fast money continue to fuel the LBO craze which is driving the markets share supply/demand relationship, unemployment is understated, housing is weak and getting weaker and gold remains fundamentally strong. And this week we find out that GDP came in at a meagre 0.6% for Q1. Production is slowing, although the business writers opine that growth will pick up in Q2. So what can we gather? The markets should be reaching a tipping point but that tipping point is continuously being pushed to a later, albeit messier, date by money printing, some fancy work with the government data, the rise of the sovereign wealth funds, and the LBO craze. The delay of a much needed correction only increases the risk associated with being involved in this rally. So when will this market reach its spill-over point? That’s anyone’s guess, but I’m not wasting time trying. I have, in the words of a recent commentary in Barron’s, “a wary acceptance of the market’s recent gains.” Currently I’m patiently waiting for gold and oil stocks to trade into an accumulation zone so that I can load up on these fundamentally strong industries.