Investment Philosophy, The Mystery Buyer, Trouble Brewing for Munis, NYS Going Broke, SAC Capital Under the Gun

Every morning my father and I begin the trading session with a review of our investment strategy. We point out pros and cons and attempt to poke holes in theory. We perform this ritual every day, without fail, for the simple reason that when investing in the stock market those who stand still get steam rolled.

Success can have the nasty side effect of creating arrogance and arrogance has no place in the realm of portfolio management. Our hardest (but perhaps most important) job is to spot flaws in our own thinking and react without passion or prejudice.

At the same time, having the courage of one's convictions is the yin to the yang of this self flagellation. You must build an investment strategy over time and have the patience to wait and not be tired of waiting. If you can keep your head when all about you are losing theirs...then "Yours is the Earth and everything that's in it,/And - which is more - you'll be" a successful portfolio manager, my son! Little did Kipling know he was describing auspicious stock market investing.

"IF" you have had enough of philosophy let's get down to business. I have been writing about the rather disturbing trend of low volume rallies and high volume sell-offs in the equity markets. On Oct. 28th I highlighted this negative trend. In this morning's meeting Gary directed my attention to the following story that offers amazing insight into this volume conundrum. As you will see, market manipulation is clearly present. Don't be alarmed by that weird sensation you will feel when you finish reading; it's just your skin crawling, the sensation fades...

WHO IS THE MYSTERY BUYER? By The Pragmatic Capitalist

I don’t know if any characteristic of this massive 6 month rally has been more apparent than the huge futures run-ups we’ve seen at random points during the trading day. Without news, the S&P 500 futures get gunned on huge volume and surge higher. I’ve seen it at least every other day for 6 months. It tends to occur on low volume days such as the one we’re currently experiencing. As you can see in the chart below, the futures are getting gunned on massive volume without any coinciding volume in SPY. This means an institution is jamming the futures higher knowing that they can drive the market higher on no volume. Effectively, they can take out every asking price with a large enough order and immediately create a 0.25% bump in the market in no time. If you’ve been wondering why we’ve seen huge surges on low volume days and conviction high volume selling on down days this explains much of it.

To View Charts discussed above CLICK HERE

So, who is the mystery buyer? We think the answer lies on the 9th floor at 33 Liberty Street.

...The key takeaway from the knowledge revealed above is not to become angry. Fighting against the machine is futile. Instead, the key is to understand the house of cards we are living in and react appropriately when the wind begins to blow.

So far, the weather seems fair with only a slight breeze. However, we hear thunder rumbling in the distance and the winds can pickup quickly. The following are a few stories that show up on our radar and give us pause...

Famed short seller says dump munis - Barron's
James Chanos, the famed short seller who was among the first to foresee the collapse of Enron, recently sounded the alarm on the municipal-bond market -- in the hallowed halls of the New York Historical Society, no less. The "cracking of state and local municipalities is coming," he predicted at a recent meeting attended by Barron's staffer Susan Witty, adding that he wouldn't touch munis. In a subsequent telephone interview with this columnist, Chanos said, "State and local municipal finance are a mess and going to get worse." It's not just the recession, which has reduced tax receipts. Rather, he says the poor economy "is masking real problems in municipal cost structures." The big problem, he says, is "the platinum-plated health-care and retirement benefits" given to state and local workers. "It's all coming home to roost" as boomers start to retire. California faces a $60 billion deficit, and the politicians there believe that in "a worst-case scenario, the federal government will bail them out," says Chanos. "If the feds do bail them out, as I believe they will," the state's bonds will likely lose their federal tax exemption, he adds.

Paterson: NYS Will Be Broke Before Christmas Delivers Scary News To Legislature, Says Only Way To Fix Problem Is To Have Immediate Cuts To Education, Hospitals

...He said if the Legislature doesn't cut the budget now the state could run out of money by next month. "We're going to run out of cash in four and a half weeks. We are going to run out of money. Unless we do something about it, (it will) threaten generations," Paterson said.

...On Oct. 26th I mentioned three developments that could become a problem for the equity markets. Development Three was about hedge fund unwinds that could possibly add instability to the markets as they did in Q4 2008. At the moment, this development is just a rumble, but as the probe widens and further mistrust of the hedge fund industry mounts trouble could ensue...

Hedge-fund giant surfaces in trading probe - WSJ
WSJ reports the widening investigation of insider trading on Wall Street is expected to examine transactions at Steven A. Cohen's SAC Capital Advisors, one of America's largest and most successful hedge funds, according to people familiar with the matter....

Investment Strategy Turns More Cautious, Existing Home Sales, Record Auctions This Week, Galleon Grief

Stock Market Investing: The Equity markets were down across the board Friday as the week ended. Last week was a week of churning and distribution, two actions I hate to see during a market advance as they often mark the end of a rally. To make matters worse the churning occurred at key areas of resistance on all three major averages: 10,000 on the DOW, 2,200 on NASD and 1,100 on the S&P 500. Investment Strategy: Turning more cautious.

With this negative week still fresh on the mind it seems appropriate to evoke the immortal words of Andy Grove, "Only the paranoid survive." and discuss three possible developments that could derail the bull.

Development One: Economic numbers that suggest recovery begin to outpace negative economic news. This leads to the perception -- or possibly, the reality -- that the Fed will reverse its stance on easy credit.

If you are a new reader I strongly advise the perusal of past posts before you begin your protest. Those of you who are familiar with my work will know the well documented relationship between bad economic numbers, easy credit, weak US$ and strong equity markets. As long as the Fed remains committed to easy credit in all its forms the bull market can continue.

However, I have witnessed a disturbing trend over the last few weeks. Good news on the economy leads to selling. This suggests to me a real fear pervades the markets with regard to the continuation of easy credit. The equity markets are trading at these lofty levels because of liquidity not reality and if the Fed-controlled gravy train of easy credit stops, then trouble will ensue. When the gravy stops dog will eat dog. What the distribution of the last few weeks may be telling us is that the big dogs are smelling trouble and are preparing.

Today's trading offers a perfect illustration of Development One. First, good earnings numbers out of Microsoft & Amazon were not able to move the markets higher. Instead, the excitement was used by the big players to distribute their holdings. Second, the following "good" economic report hit the news wires this morning, but the equity markets sold off almost immediately after the release:

Existing Home Sales Exceed Expectations
Existing home sales jumped 9.2% to 5.57 million units in September. The increase followed an unexpected decline (-2.9%) of sales in August. The consensus was expecting sales to rise by a much more modest 5.1% to 5.35 million units.

Beyond the headline sales numbers, there was another good piece of news from the data release. Distressed properties, which accounted for almost 50% of sales throughout the spring and summer, have declined significantly to only 29%. Sales of non-distressed homes make it more likely that consumers will start looking at more expensive properties as homeowners move up the pricing ladder. The increase in sales helped push the total available supply down to 7.8 months.

Development Two: A funding crisis unfolds.

Will the US$ decline in value to a point where long rates must increase aggressively for our government to continue funding its debt? How long will China and others tolerate the ruse of quantitative easing before demanding higher rates?

We obviously don't have the answer to these questions. However, this very real possibility must be respected. There has always been a high correlation between long rates and the equity markets. I can think of no better example than the crash of 1987. For four months the bond market was collapsing (rates rising) before the equity markets infamously followed.

Of course, in '87 bonds sold off because the Fed was tightening. If, however, bonds sell off even in the face of Fed easy credit policies then I hate to see the ensuing equity market response.

Record Auctions Announced...euro 1.5001...yen 91.5060 (3.411% -07/32)
Treasury will sell a record batch of bonds next week with $44B 2-yrs Tuesday, $41B 5-yrs Wednesday and $31B 7-yrs Thursday. The record levels show an increase of $1B on the 2-and-5s, and $2B on the 7-yrs. There will also be $7B reopened 5-yr TIPS going off Monday along with $29B 3-mos and $30B 6-mos. The market may get some relief as the news is over, but the high end of expectations had been for closer to $115B versus the $116B announced, so any relief may be brief.

Development Three: The high profile SEC take down of Galleon may cause a ripple effect leading to hedge fund unwinds.

Galleon had over $3 billion and now according to DJ: "Galleon is winding down all hedge funds."

Last year we all witnessed what happens when hedge funds are forced to unwind. Many of the big funds are often involved in the same trades and one unwind leads to another. There will be many denials along the way but the equity markets will speak the truth.

I will also respectfully submit to you, the readers, that the derivatives crisis is far from over. The individuals who created the credit crisis are still running the show. If you believe this statement is incorrect or feel President Obama promised you change so his cabinet must be full of new thinkers, I suggest you view the PBS Frontline documentary entitled The Warning.

The Warning brings to mind two obvious questions:

1- What will cause the next derivatives crisis? Could it be the take down of a major hedge fund that ignites the next collapse?

2- Why isn't Brooksley Born a major member of the Obama administration? If Obama was truly an agent for change wouldn't she be a must in the cabinet?

Inflation, Hyperinflation, Stagflation and the Investment Strategy to Benefit, Richard Russell, Fed's Lacker, Credit Tightens, Banks Sift Reserves

Welcome back, today we will continue our discussion about the inflation/hyperinflation/ stagflation trade. In my last post I illustrated how the important news stories of last week clearly unveiled the footprint of the inflation trade. You may recall that I ended with the familiar refrain: "Inflation (particularly hyperinflation) is a currency event, not an economic event."

Therefore, the investment strategy required to profit in this environment is one that begins with the close monitoring of the U.S.$ and ends with the investment in assets that appreciate in value when the U.S.$ suffers.

What is the number one asset we expect to benefit from this developing trend? I will pause here and allow long time readers, clients of RCM, and partners of the Fortune's Favor Family of Funds the chance to shout in unison...GOLD! And as Ed McMahon used to say, "Yes, you are correct!"

With the above investment strategy in mind, I would like to continue our journey following the footprints with a recent word from a respected investment professional. One who has vast experience and in a succinct manner uses his success through the years to impart some valuable wisdom...

The Sage, Richard Russell: "...What happens next is that the cheap dollar is dumped on the market in huge quantities. When any currency or any item is created in massive quantities, that item must fall in value. And the dollar is falling. Ah, Professor Bernanke, what do you do now? To make a currency more attractive, you raise the rates that it pays. But raise the Fed Funds and you squeeze that already gasping US economy. Also, when you raise rates you raise the cost of carrying the gigantic US debt. Total public and private debt in the US is around $57 trillion. A one percent rise in interest rates would drain $500 billion each year out of the US economy...."

Well said! So what are the Fed members saying this week? Is there a will to raise rates...?

Fed's Lacker says he doesn't: "think we should tighten policy today"; willing to go along with purchasing full amount of long-term securities purchases for now...Seeing rise in losses from commercial real estate lending, likely to continue for a while...

No, there is no will to raise rates and to make matters worse the bulk of the commercial real estate tragedy has yet to unfold. In fact, the tentacles of the commercial real estate problem are winding around the neck of small businesses. Without small and midsize businesses recovering, unemployment will continue to get worse further impeding the Fed's ability to raise rates...

Credit tightens for small businesses - NY Times reports many small and midsize American businesses are still struggling to secure bank loans, impeding their expansion plans and constraining overall economic growth, even as the country tentatively rises from its recessionary depths.

Most banks expect their lending standards to remain tighter than the levels of the last decade until at least the middle of 2010, according to a survey of senior loan officers conducted by the Federal Reserve Board. The enduring credit squeeze appears to reflect an aversion to risk among lenders confronting great uncertainty about the economy rather than any lingering effects of the panic that gripped financial markets last fall, after the collapse of the investment banking giant Lehman Brothers. Bankers worry about the extent of losses on credit card businesses as high unemployment sends cardholders into trouble.

They are also reckoning with anticipated failures in commercial real estate. Until the scope of these losses is known, many lenders are inclined to hang on to their dollars rather than risk them on loans to businesses in a weak economy, say economists and financial industry executives.

These developments are all U.S.$ bearish. Central bankers around the world see the writing on the wall and are moving towards the exits...

Dollar reaches breaking point as banks shift reserves - Bloomberg.com Bloomberg.com reports central banks flush with record reserves are increasingly snubbing dollars in favor of euros and yen, further pressuring the greenback after its biggest two- quarter rout in almost two decades.

Policy makers boosted foreign currency holdings by $413 billion last quarter, the most since at least 2003, to $7.3 trillion, according to data compiled by Bloomberg. Nations reporting currency breakdowns put 63% of the new cash into euros and yen in April, May and June, the latest Barclays Capital data show. That's the highest percentage in any quarter with more than an $80 billion increase... The diversification signals that the currency won't rebound anytime soon after losing 10.3% on a trade-weighted basis the past six months, the biggest drop since 1991.

Meanwhile, the price of Gold has advanced roughly 22% since the beginning of the year. Our hedge fund, Fortune's Favor Precious Metals, has exceeded the performance of gold year to date. You can review our investment philosophy as well as the quarterly and annual returns on our website: http://www.rosenthalcapital.com/.

I have received many questions recently about the sustainability of the precious metals move higher. As Gold took out the $1,000 level a menagerie of analysts and letter writers wrote of the impending doom of the Gold rally. As Gold moves above $1,050, I hear countless tales of certain failure, of commercial shorts winning the day. I LOVE THIS TALK! This type of bearishness is typical of continued momentum higher.

To sum up, I will simply reprint the headline from a recent Barron's story: Gold Is Still a Lousy Investment By Dave Kansas. Need I say more?

Until next time, chew on this:

"It is not because things are difficult that we do not dare; it is because we do not dare that they are difficult." Seneca, philosopher

Courtesy of Obama 'Change' is a Baffling Word, Bernanke Reappointment, "Cure Rate" on Mortgages Plunging, Central Bankers Call for Continued Stimulus

The American people are receiving a true education from our president regarding the various uses of the baffling word that is 'Change'.

First, during Obama's campaign for presidency, we were led to believe that change meant 'out with the old, in with the new'. Old representing all that was bad and new all that was good.

Then, after obtaining the presidency Obama has been kind enough to illustrate the use of the word change as in 'the more things change the more they stay the same.' This use of the word change can be evidenced by the Bernanke story below as well as countless examples of cronyism and kotowing to lobbyists by the Obama administration. Simply look up stories connecting Obama to ACORN if you desire evidence. Both of these egregious endeavors were objects of ridicule by Obama during his campaign and, might I remind you, reasons to vote for the caped crusader as he promised to eradicate the evils of Washington.

And that brings me to the next use of the word 'change'. If anyone actually believed that Obama was going to change Washington then I respectfully request you review the phrase, 'A leopard can't change its spots.''

Obama to reappoint Bernanke as Fed chief - WSJ
The Wall Street Journal reports President Obama will announce the nomination of Ben Bernanke to a second term as Federal Reserve chairman on Tuesday, opting for continuity in U.S. economic policy despite criticism in Congress of the low-key central banker's frantic efforts to rescue the financial system. Mr. Obama's decision had become a subject of growing speculation and uncertainty in financial markets and in Washington policy circles. The president called the Fed chairman to the Oval Office this past Wednesday to offer him another four-year term. Mr. Bernanke then flew off to Wyoming where he gave a defense of his controversial policies at the Fed's annual meetings in Jackson Hole.

In recent weeks I have read countless stories about the end of the recession and the beginning of monetary tightening. I have witnessed innumerable reports on TV regarding the inevitable strength coming in the US$ because of the wonderful turnaround unfolding across world economies. And yet, the US$ value sits barely above the year low. Why the disconnect you might ask? Well, read the next three stories. These stories represent the reality of the situation and illustrate the desire of central banks around the world to continue the course of currency devaluation to stimulate nascent/non-existent growth.

Fewer catching up on lapsed mortgages - WSJ
WSJ reports homeowners who fall behind on their mortgage payments have become much less likely to catch up again, a new study shows. The report from Fitch Ratings focuses on a plunge in the "cure rate" for mortgages that were packaged into securities. The study excludes loans guaranteed by government-backed agencies as well as those that weren't bundled into securities.

The cure rate is the portion of delinquent loans that return to current payment status each month. Fitch found that the cure rate for prime loans dropped to 6.6% as of July from an average of 45% for the years 2000 through 2006. For so-called Alt-A loans -- a category between prime and subprime that typically involves borrowers who don't fully document their income or assets -- the cure rate has fallen to 4.3% from 30.2%. In the subprime category, the rate has declined to 5.3% from 19.4%.

"The cure rates have really collapsed," said Roelof Slump, a managing director at Fitch. Because borrowers are less willing or able to catch up on payments, foreclosures are likely to remain a big problem. Barclays Capital projects the number of foreclosed homes for sale will peak at 1.15 million in mid-2010, up from an estimated 688,000 as of July 1.

Central bankers stress not rushing for exits - Reuters.com
Reuters.com reports if there was one message from central bankers gathered at this mountain retreat this weekend it was this: Don't expect us to raise interest rates any time soon. A series of speakers at the Kansas City Federal Reserve Bank's annual conference, which drew the monetary policy elite from around the world, heralded the global economy's apparent push out of its deep recession. But they noted that economies were recovering only with extraordinary stimulus from governments and central banks, and said it was too soon to talk of a self-sustaining recovery.

"I am a little a bit uneasy when I see that, because we have some green shoots here and there, we are already saying, 'Well, after all, we are close to back to normal,'" European Central Bank President Jean-Claude Trichet said on Friday. "We have an enormous amount of work to do." As ECB Governing Council member Ewald Nowotny told Reuters, there seems to be a consensus among central banks to make sure they do not withdraw their stimulus too soon. "What we see now is that to a large part this is still a recovery sponsored by public measures," he said. In the words of Harvard University professor Kenneth Rogoff: "They don't want to go back into what we just got out of."

China to keep policy loose as economy faces new woes - Reuters.com
Reuters.com reports China will maintain its stimulative policy stance because the economy, far from being on solid footing, is facing fresh difficulties, Premier Wen Jiabao said. In a downbeat statement on the government's website following a trip to the eastern province of Zhejiang, known as a hotbed of private enterprise, Wen said Beijing would ensure a sustainable flow of credit and a "reasonably sufficient" provision of liquidity to support growth.

"We must clearly see that the foundations of the recovery are not stable, not solidified and not balanced. We cannot be blindly optimistic," Wen was cited as saying. "Therefore, we must maintain continuity and consistency in macroeconomic policies, and maintaining stable and quite fast economic growth remains our top priority. This means we cannot afford the slightest relaxation or wavering." China still faced great pressure from the slowdown in demand for exports, Wen said, adding that it was difficult to boost domestic demand in the short term to fill in the gap -- despite the boost from the government's 4 trillion yuan ($585 billion) stimulus package.

This is a public service message to the Obama administration:

Please review the following story closely. You will see a pristine example of how the real world reacts to tax increases. The evidence clearly illustrates that jobs are lost in the country where taxes are increased. Please have the good sense to avoid the evil temptations of tax hikes in the midst of a jobless economic recovery effort. This has been a word from your sponsors, you know, the voters.

New UK tax sends hedge funds fleeing - WSJ
WSJ reports a stream of hedge-fund managers and other financial-services professionals are quitting the U.K., following plans to raise top personal tax rates to 51%. Lawyers estimate hedge funds managing close to $15 billion have moved to Switzerland in the past year, with more possibly to come. David Butler, founder of professional-services co Kinetic Partners, said his company had advised 23 hedge funds on leaving the U.K. in the 15 months to April. An additional 15 are close to quitting the U.K., he said.

"In the past, managers would say they'd move some operations or dip their toe in the water," Mr. Butler said. "Now that's changed." Hedge fund Amplitude Capital took its $735 million in assets under management to Switzerland at the start of this year. In May, Odey Asset Management threatened to move. All the hedge funds that have left the U.K. for Switzerland are concerned about tighter European Union regulations, as well as a new top rate of income tax announced by the U.K. government. Starting next April, individuals in the U.K. who earn more than 150,000 pounds, or about $247,000, a year will pay tax at 51%, including national insurance. They will also be taxed heavily on pension payments.

US$ Decline / Equity Market Rally Continued, Obama's Orwellian Comment

Arguments about earnings and "green shoots" are a waste of time and actually a distraction when trying to understand the current strength in the equity markets.

We are confronted with a useless barrage of conflicting opinions as the debate rages on every financial news channel. The image that comes to mind right before I turn off the TV and begin writing this missive is that of the pug, Elvis. He is on the floor beside me ferociously chasing his tail. The similarities are stunning. What's going through his mind we can only guess and when he catches the tail he looks as confused as a TV anchor reading an earnings release.

The explanation for the strength may actually be simple:

1- U.S.$ weakness is leading to the inflation trade. As I've written before, inflation is a currency event not an economic event. Please see the July 21st post for more on this topic.

2- Hedge funds are receiving 0% interest on cash balances held at GSEC and the like.

3- Money market funds pay close to 0% interest and in some documented cases have a negative return.

4- Hedge funds received inflows of $146 billion in the last two months. This new money must be put to work; cash is not an option.

To conclude, the equity markets collapsed last year as massive amounts of hedge fund redemptions forced selling. The markets have exhibited the opposite effect in the last few months as cash inflows have forced buying amid a desire to sell U.S. dollars as the dollar continues to decline.

I'm posting the following story simply because I can't believe it. Words like fatuity, absurdity, hubris and his favorite, audacity (the second usage in the dictionary) come rushing to mind. If this story doesn't disturb you then your name must be Hugo or Fidel or perhaps more appropriately, Orwell.

Obama proposes new transaction fees for financial firms' riskiest investments - WSJ
President Obama said for the first time that the government might assess new fees against financial companies engaging in what he labeled "far-out transactions," in order to protect taxpayers from future bailouts. Mr. Obama on Wednesday compared the possible fees to the assessments that more than 8,000 banks pay the FDIC to guarantee deposits. He didn't describe what sorts of transactions might trigger the fees, though the way he described it suggests the proposal could cover exotic instruments such as credit derivatives that some believe played a key role in escalating the financial crisis. He also indicated that the fees might be levied against transactions the government wants to discourage...