Investing

I believe that we are nearing the end of this bull market that started a few years ago. There are many reasons I think that this is the case:

• Presidential cycles: Usually the first and second year of a new president are down market years
  
• Liquidity: Growth in the money supply has slowed to nearly zero.
  
• Yield Curve: The difference between short term debt and long term debt has narrowed to almost nothing, this has been the most accurate predictor of a recession according to Federal Reserve research, and this is tied to liquidity declines.
  
• US Dollar: The precipitous drop in the dollar that was fuelling earnings has slowed
  
• Time: Cyclical bull markets in secular bear markets are typically shorter. Based on all historic bull markets we are passed the 50% mark.
  
• Earnings: Growth is slowing
  
• LEI (Leading Economic Indicators): Have been trending down for months
  

This has me worried primarily due to liquidity. Not the type of liquidity I mentioned above but the likelihood that investors will have to liquidate holdings of stocks that I’m invested in to meet margin calls on tech stocks. What really worries me is that the fall of the NASDAQ that I think is coming (and based on historical data will likely be lower than the 2001 bear market lows) is going to suck down the price of sound, undervalued companies. I hope that very few investors are both in Technology and Uranium (for example) but a sinking market is going to lower all boats!

Again I am hoping that resource stocks will fall with the market, but less so and then rise again as money will flow into the only asset class not doing quite so badly. I’ve invested in QQQQ puts and if the NASDAQ goes down and resource stocks up I’ll make money on both sides (long resource stocks, short NASDAQ). However, if NASDAQ stocks go down and drag down resource stocks with them, I have a chance of making enough money on the NASDAQ puts to offset the losses. Ideally I would like a stash of cash on the sidelines to buy more if this happens, but with fundamentally significantly undervalued companies, I am choosing to stay fully invested and ride the tide.

These are my estimations 1-2 years out:

• Case 1 (10%): NASDAQ Up, resource stocks down: I have no reason to believe this will happen but I lose on both sides of the trade
  
• Case 2 (15%): NASDAQ Up, resource stocks up: Well I loose my QQQQ puts but I’ll do well on my resource stocks, this is a good outcome
  
• Case 3 (35%): NASDAQ down: resource stocks down: There is a reasonable chance that the QQQQ options will balance out the drop in my long portfolio or at least cushion the blow and avoid margin calls.
  
• Case 4 (40%): NASDAQ down: resource stocks up: Best possible scenario and not entirely unlikely. There are completely different factors driving natural resources to those driving tech valuations.

I expect to end up somewhere around cases 3-4 and as time passes I think case 4 becomes more likely than case 3 as the lowering of interest rates as a result of the NASDAQ fall will probably cause liquidity to flood somewhere and natural resources are a good bet given the other fundamentally positive forces.

Anyone with exposure to the US market should well consider putting a little (10% or so) money into QQQQ LEAPS over the next 6 months. If the NASDAQ doesn’t fall you had insurance (no one ever complained about paying car insurance premiums and never having a claim!) but the risk today in the NASDAQ is to the downside.

I wrote this the day after the Yuan revaluation but didn't get around to posting it. Many of the ideas are still not mainstream.

What you're not being told about the Chinese Yuan (RMB) revaluation:

There was a lot of chatter before China's recent announcement that a revaluation of the Yuan would benefit the US by making Chinese imports more expensive. This in turn would help to support domestic US manufacturing and US exports would become cheaper and more competitive in China. All in all congress had become pretty sure that a revaluation of the Yuan was going to cure all that ails the US economy.

Here are some of the truths

• A revaluation of the currency only affects the labor component of product price. Most exported Chinese products have significant inputs of metals, fabrics or other components that are imported. As the RMB becomes cheaper so do these imports. Apparently less than 10% of a product's cost is in labor so even a 10% revaluation is going to have no more than a 1% effect on the price the item can be imported into the US at.
  
• Chinese revaluation is going to have two effects on interest rates, it is going to drive them up and down. In the short term, a lot of speculative capital is going to head to China. That capital will be converted into Yuan and the PBOC will use the dollars to buy more treasuries therefore driving down interest rates. Over the medium to long term, China will be less of a buyer of US treasuries as exports to the US decrease which will happen as price goes up. China mainly buys treasuries today (or in effect US dollars) to keep the RMB's price down. As the RMB starts to float the PBOC will stop buying as many US dollars and eventually they will stop entirely this will drive interest rates up significantly in the US. This effect on interest rates will far outweigh the small benefits to domestic US producers.
  
• There are a few reasons why reported inflation has been low while apparently the price of everything around us has gone up by double digits. One of the reasons is a deflation in a range of products imported from China. The price of these good are effectively subsidized by the Chinese government. As the RMB's price rises, the goods deflation will turn into inflation and yet another class of products will start rising in price to join fuel and food! Maybe we will start to calculate the CPI excluding Food, Energy and Chinese Imports!
  
• As the RMB rises against the US dollar, imports of commodities become cheaper. For the same cost China can import 2% more of the world's commodities. As many commodities are already in deficit, this will accelerate and commodity prices like fuel and metals (which are inputs into most things) will rise even more and not linearly.
  

The net effect of these forces is the opposite of the effect congress is looking for.

• Interest rates will increase significantly,
  
• Inflation will rise (which will further increase interest rates),
  
• Goods prices will go up for those who can least afford them,
  
• Commodity prices will rise as demand increases while supply remains constant
  

I doubt this was anyone's objective but Chinese tourism to the US will probably increase as a US holidays become much cheaper.

All these factors are more or less bullish for commodities.

I have just updated my valuation for Canadian Oil Sands (COS-un.to COS_un.to COSWF.PK). I still think the stock has about 2x upside with current oil prices. Quite amazingly that means that the stock price has not increased to reflect the business or the upcoming expansion. All the increase has been a reflection of the price of oil. Back when I first recommended Canadian Oil Sands I thought it was trading at 33% of intrinsic value and I still do.

COS is still valued above today's price of 113.75 CAD if oil were only trading at $35USD. This makes the case for investing, even if you think oil prices might moderate, very strong. COS is basically trading as if oil were at $35USD and oil is in fact nearly double that. Though you could have made over 400% on COS if you had bought when I first started to recommend it. I still think there is 2x left in it and I would not be a seller at this point because with the exception of Strathmore Minerals and Silver Standard it's still my 3rd best idea. Once the current expansion is paid off and the distributions start to rise (I think distributions could hit $25 within 5 years) the value could start to be unlocked.

Finally, Matthew Simmons was interviewed on financialsense.com and said the supply and demand imbalances could easily drive oil up 5-10 times. Though that sounds amazing, prices are not linearly derived from supply and demand and he predicts there could be a 5M bbl per day deficit soon. $66 oil has not really affected people's decision to drive and Holland gets by with gas prices 3 times higher than the U.S so don't think $200 oil is going to crater the economy or even significantly lower US demand. $400 oil probably would change driving habits and would start to bring supply and demand back into balance. I smile every time I fill up my car and it costs another 10% because I know my oil could have come from Syncrude!