SP500 vs Tips and Inflation

The Chart shows S&P versis 10y Tips zero rate and the breakeven inflation implied. The risk premium according to TIPS decline with S&P in 2001-2003. Since 2003, S&P rally, breakeven inflation jumped from average 1.5-2.5% to 2.5-3% while the risk premium staying low. Even though the nominal rates has increased with this rally in Equities, the risk premium has only just picked up. This might hurt the stock market.

Trends are developing

Which is more important? The level of the dollar or the level of rates? This is the question the markets are currently trying to figure out. With global reserves loaded in USD is it possible that higher US rates would be a better solution toward continued globalization? a weaker USD? Or both? Clearly, it is a tricky question that is being venting thru GOLD, OIL, and other financial markets.

I have been of the opinion that the USD and bonds would suffer material weakness against our major trading partners. Reserve diversification and the level of global rates are currently shaping the investment landscape. With the most recent bout of USD weakness there was an explosion to the upside in various Asian equity markets, precious metals, commodities, and a material back up in global yields. In time, I expect the continued compression of global yield spreads leading to inversion. (US yielding more)

The end game doesn’t look very pretty regardless of what the optimists say. When the day of reckoning arrives we will have a lower dollar, higher rates, and lower asset values within the US. Cash continues to make up a large position of my holdings. The yields being given on the 2yr is very close to 5%. In this environment that is getting close to value. GOLD for preservation – CASH for deflation - FOREX for appreciation.

It is possible that the upcoming venting that has taken place in GOLD will continue. OIL will make its way considerably higher as geopolitical issues take hold. Corrections to be expected. Foreign currencies might be considered “cheap” against GOLD. This is NOT a pairs trade but a diversifier. US Equities should continue to underperform their Asian counterpart.

Globalization has caused a huge build up of paper currencies. The continued pricing of commodities and global trade in dollars will keep it the reserve currency so say the bulls. This makes sense in the short term. At some point, the imbalances will force the USD lower with tradable goods and services trending higher. This is inflation. The bond markets are beginning to recognize this endgame. Keep durations short.

If the markets vented all the imbalances on a weaker USD that would be fine. FOR THE US! This would allow the US to devalue their currency and repay their debts. A gradual rise in rates would be of benefit to all. The FED is worried about housing and consumption. Rates will not cure the price of commodities. That is a true demand/globalization theme. Higher rates to compensate for a falling USD will raise the savings rate and help restore global balance. This will not be easy and will definetily have winners and losers. Currencies of surplus nations will be the main beneficiaries.

I continue to invest accordingly. I have traded some gold shares for physical gold. I continue to buy into the H2o theme on a very select basis. The AG complex continues to defy gravity which imo gives credence to the rise in OIL. Diversifying away from the USD continues to make sense. I have also begun to build a PUT position dated into Jan 07 in Finance, Retail, and select Technology.

NEW HIGHS?

The USD is beginning to correct against the Asian currencies. These are the most important currencies of the world. The Asian Central Banks hold over 2 Trillion of USD in reserve. What they decide will dictate the path of adjustment. The FED can control either the level of interest rates or the level of the USD. NOT BOTH. This is causing an endgame for many profitable trades which were launched by the worlds monetary authorities.
I continue to focus on the beneficiaries of these adjustments. A weaker USD against most Asian currencies seems very plausible. The EUR will gain against the USD as most financial players are not yet comfortable with the Asian transition from exporter to self reliant. More balanced CB reserves will continue. The Asian CBs have the comfort of huge surplus alongside other advantages once afforded to the West. GOLD will also be a beneficiary of these trends.

The recent monetizing of financial gains is evident across many asset classes. The Saudi Prince is floating 30% of his kingdom on the Saudi Stock Exchange. The recent listing of the NYSE alongside already public CME BOT and ISE. The continued bid in commodities and renewed USD weakness. These are all "shots across the bow" as to the imbalances that have taken place. It is not necessarily a bad thing. It is the effects of globalization. It is no longer prudent to keep all reserves in one currency. This is true for individuals and institutions.

I continue to believe thru the rise of living standards, pollution, globalization, and population expansion that agriculture will become even more important in international trade. This is the main pillar to the H2o play. With all of the above taking place more uses of H2o will tax the limited supply. As land is used for more financially beneficial means agriculture is being pushed to the side. The rise of Asia, Latin America, and the fall of communism has unleashed the demand for a higher quality of life. Food prices will no doubt rise just as real estate, stocks, bonds, or Knicks tix during a good season. Higher demand will cause prices to rise. If one cannot (as Sinclair says) invest in agriculture, one can buy the "miners of agriculture". It is still early in the premise. I have small positions in DE MON AGU POT CPO CRESY BG ADM SYT to further this thought. They have recently caught a bid on the ethanol story.

Is there a broad reason to own the "miners of agriculture"? Yes. just be aware these stocks have had strong runs. I would not rule out a correction of magnitude in the next several quarters.

The main H2o stocks continue to attract ALOT of attention. This is causing some concern in the short term but more positive on a LT basis. General Electric recently bought Zenon Environmental for a +45% premium. The theme is real and will only get bigger going forward. I would continue to focus on ITT PNR WTS CWCO CLC LAYN NWPX HWKN PLL on the infrastructure side. These are long term plays. The utilities are have been even more impressive. Several are making new highs as traditional utilities are making new lows. This is most likely liquidity and changing fundamentals within this space. I am currently long AWR CWT SWWC SJW WTR MSEX YORW.

I continue to be beyond skeptical on what is taking place in financial markets. I think we are in the very early stages of the unwinding of the real estate financing bubble. Bank stocks are what tech stocks were to 99-00 and homebuilders in 00-04. The homebuilders have since corrected 50%. The banks should lag as far as forward recognition of problems go. Bad loans take time to turn ugly. If not this year....well, they will. Greed vs Fear. Its capitalism.

My point is....If my broader views of global finance come even remotely true most financial assets will compress. I continue to build up my cash position and am willing to sit thru the meltup that looks to take hold. Its hard but I think ive seen this before. If I can earn over 4.75% in cash....Ill take it. Preservation Yield and then Growth. That is still my plan.

I have also been adding to my FOREX positions rather aggressively of late. I continue to buy GOLD coins for wealth preservation and diversification.

What to do NOW

The financial markets are crowded and confusing. The only trend that seems to be on the rise is geopolitical risk. There seems to be new risks everyday. This is not being priced properly. The only "positive" is that the FED is continuing to raise rates so inflation wont be a problem?!. There will always be pockets of strength and weakness. Capital preservation, income, and then growth seem to be the order in my mind. There has been BIG moves in subsectors of the SPX with little movement from the index.

The AG stocks have been VERY well bid. They are rallying due to ethanol, globalization, and possibly H2o scarcity coming from China. Fast money will cause more volatility if they are viewed as alternative energy plays. PEIX CPO ADM DE BG MON POT AGU SYT are the companies I have focused on. PEIX is VERY volatile but "technically promising". CPO is more stable and could play catch up to ADM which has recently broken out to all time highs. DE is trading above 3yr highs and has raised its DVD 2-3x in the past 6 months. I plan on holding these stocks for a very long time. I originally bot them as a sidebar to H2o merits. The ethanol talk has only made them rally harder in the short term.

The H2o stocks continue to rally as well. PHO is the easiest purchase. I like the H2o utilities which include WTR (biggest) AWR CWT SWWC SJW. They should have pricing power due to scarcity and growing needs of the southwest (AZ CA NV NM). All are withing striking distance of all time highs with DVDs as well. The infrastructure plays make sense LT. PNR WTS BMI (thin) CCC (spec) LAYN (like it) CWCO (Desalinization) CLC (Filtration) PLL (take out?) This is going to be a huge oppurtunity over the next 10 yrs. Market caps are small problems are large. This is the one area of the financial markets that procrastination will lead to a real mess. WE NEED WATER. However this comes about.....exposure is not a bad idea.

GOLD remains VERY firm regardless of the direction of the USD. I have sold 1/3 of my equity position over the past 2 months. I am going to buy additional physical with the proceeds. I have to say that I was assuming a deeper correction in both time and price. The fact that GOLD continues to go up in relentless fashion speaks volumes. LONG TERM always a buy and probably short term as well. Richard Russell (Dow Theory Letters) said on Friday, "Because personally, I doubt very much whether the world will lust for US dollars fifty years from now." This is probably true. Regardless of GOLDs short term movements the LT is the more profitable path. Volatility is to be expected.

OIL is very volatile due to spec and global instability. I have been adding to QRAAX (GSCI index fund) on recent weakness. It is a call option on volatility. The retest of the recent lows could prove a spring board which gives way to an 80 target. Upside unlimited if its caused by a disruption or continued instabilities. I like CVX (green, big cap, yld) SU (Canada) KFX (highly spec but running), and GAGEX. If OIL spikes their could be some problems for foreign oil in the hostile parts of the world. I would rather own Canadian companies then have exposure to hostile regions. QRAAX is the easiest (non levered) way to express this view.

Banks are firm is an understatement. I DO NOT have any idea what the strength in BANKS mean. It makes no sense to me. I am LONG GOLD VS SHORT BANKS. I still think the BANKS will head lower but am shocked at their continued strength. We have an inverted curve, rising rates, global instability, and a US consumer is "fully levered". If asset prices continue to rise without wage gains....well, that could create a problem. Banks will be forced to deleverage just as in prior contractions. This is the idea behind the FEDs hiking campaign. I have a hard time understanding where future growth will come from. The BKX hitting new highs should be viewed as bullish. But, the continued rise in GOLD negates the implications to neutral at best.

Retailers seem to face the same headwinds. It is a game of the haves vs have nots. The companies focused on the have nots have suffered. The housing market has fueled more growth that is currently assumed. WMT FDO DG DLTR NDN have gone nowhere since 97ish. The stimulus is behind us. This "SHOULD" weigh on the entire sector in forward quarters. I am focusing on RTH HDI CCL BBY thru options and stock. I am also keeping an eye on HET and some other gambling/casino/hotel stocks as well.

I continue to hold Asian equities and will add on pullbacks. I do not feel any region will avoid a downdraft if/when the US slows. I am willing to sit thru a correction(s) in select markets. Asian currencies seem cheap relative to the USD. I continue to hold/buy THB SGD JPY. If US slows, Asian currencies might appreciate as repatriation begins. I would rather hold currencies/bonds of countries with surplus. Asia fits the bill. There are definitely risks/concerns but no worse (better) than US. Diversification seems the right thing to do. I am weary of US bond market.

All in all I think it pays to be a little cautious. There seems to be ALOT of easily identifiable negatives which DO NOT seem to be denting markets. Wall of worry or complacency? Not sure, but cash aint trash at 4.5%.

Something is quietly moving up!

One way street for CNY

Gold Stocks vs S&P (1995-2006)

10yr Note and Nikkei

Japanese Equity looks strong.

NKY(above) testing the resistance but TOPIX(below) has clearly broken it.

Long term 5year note maybe breaking the down trend

CRB vs 10yr Note