Wednesday, May 12, 2010

Second Thoughts About the EU's Shock and Awe/TREASURY AUCTION/GOLD At Record High/Intel/The Dollar Index & Foreign Government Bond ETFs WIP & BWX

I have found myself reviewing my portfolio repeatedly this month to determine whether I am conservatively positioned, which is where my gut tells me to be at the present time. I realized after staring at my portfolio for a long time yesterday, and doing little else, that I had been moving toward a more conservative allocation scheme for weeks. In fact, I would characterize my allocation scheme to be as cautious as the one adopted in 2007. Possibly, if treasury bills and money market funds were paying 3 or 4%, I would increase my cash allocation now. Given the Fed's two year Jihad against savers in the U.S., resulting in near zero interest rates on short term "safe" money, I see no reason yet to increase my cash levels. I am going to stay with a slow mo, go slow approach to adding any stock positions, requiring any purchases to be funded out of cash flow from dividends and interest. Caution is the operative word. The foregoing restriction does not apply now to the purchase of bonds, preferred stocks or bond funds.

1. The Day After: Questions About Europe's "Shock and Awe": On Monday, the Euro initially surged after the European leaders announced their 1 trillion dollar aid package, rising to $1.31 against the dollar. It then retreated to just under $1.28 by the end of the day on Monday. I mentioned in a prior post the disparity in the way the European markets and the EURO reacted to the news of this aid package. On closer inspection, many currency traders believe that Europe has not solved the underlying problems that created the need for urgent action on Monday. NYT The weaker economies in Southern Europe are still struggling with bloated deficits and weak economic conditions. It is not like anybody has changed over night and will now start living within their means, especially when borrowing and spending money is so easy.

And, lacking the option of currency devaluation, the weaker economies will remain non-competitive and under deflationary pressures, as noted by Randall Forsyth in his Barrons column. I would add a caveat to that contention. The common currency is effectively undergoing a devaluation now, one orchestrated by the market, which should help Europe's ability to compete.

In Forsyth's article, he notes that Germany has grown only .5% per annum over the last eight years, and Italy's GDP has actually contracted over the entire business cycle.

In addition, many skeptics have noted that the aid package is not yet funded, except for 60 billion Euros. The main part of the package involves the creation of a special purpose vehicle (SPV), if needed, to raise money, with guarantees from EU nations of up to 440 billion Euros, in order to buy government debt. This has not been done. I suspect that the Masters of Disaster will continue to attack the EURO, at least until Europe raises the 440 bilion Euros to fund the SPV.

Many question the wisdom of solving a debt crisis by borrowing even more money. If activated, the European SPV does not address the underlying causes of the sovereign debt problems, but simply transfers the debt problems from the weak governments to a more creditworthy borrower. In effect, the EU absorbs the debt of its weaker members.

The EURO traded yesterday to a lower level than prevailing immediately before the announcement of the aid package: FXE: Historical Prices for Currencyshares Euro Trust The aid package, while taking the worst case scenario off the table for now, can be viewed as both an act of desperation and a sign of weakness that will encourage the wolves and vultures to continue circling, looking for a fresh kill. Perception of weakness can be more important than the reality.

The market was certain that the EURO was worth $1.5 just a few months ago: EUR/USD Currency Conversion Chart Now, the consensus appears to be the EURO is going to fall to parity and has yet to find the floor, let alone a bottom. A lot of this is nothing more than group think and herd behavior.

Part of what I have read over the past day seems to be shorts talking their position to reporters.

For one persons technical analysis of the EURO, see Euro to fall 'Rapidly' to $1.03 After Breaching $1.19: Charts - CNBC.

2. Treasury Auction of 3 Year Notes: The treasury auctioned yesterday 38 billion in 3 year notes to yield 1.414%. .pdf The coupon was 1 3/8%. The notes were sold at $99.885991 per $100 with $.07473 in accrued interest. I am not about to feed the beast by loaning it money for 3 years at 1.414%. It would take 49.51 years to double my money at 1.41% before inflation and taxes. Maybe I am pessimistic sometimes, but I do not think that I would live to see money double at that rate.

This is a link to the recent auction results for each treasury denomination: Welcome to TreasuryDirect My only interest is in the 10 year TIP auction, which is next scheduled for early July 2010: /auctions.pdf And, I have no interest in the 10 year TIP at the current coupon, which is currently around 1.27%.

3. Gold: Gold for June delivery rose $19.5 yesterday to close at $1,220.30, near its all time record high of $1227.5. The spot price was at $1222.5 at yesterday's London fix. GLD rose yesterday $3.06 to close at $120.63. The 52 week high is $120.87. Kitco has several spot gold charts that show a multi-year bull market in gold starting in 2005. In after hours trading, the price hit an all time high. Kitco News

What does this mean? I personally do not view the move from $900 or so to be related to inflation or even fears of inflation. As a corollary, the move in my opinion is saying nothing about the prospect for deflation either. The recent spurt in gold has been accompanied by a rise in the U.S. dollar and a fall in U.S. treasury yields. Instead, I share the opinion of those who view gold now as an alternative currency that can not be debased by a government printing more of it. Thus, gold is being bid up now due to a lack of confidence in currencies and the government's responsible for them. While I am a long term holder of gold, I find the recent rise to be disconcerting.

4. Intel (owned): Paul Otellini, Intel's CEO, told investors yesterday that Intel anticipates that it will grow both earnings per share and revenue in the low double-digits, on average, over the next few years. This would be a double in the rate of growth compared to the past five years. Reuters

5. The Dollar Index: I look at the Dollar Index Chart (DXY at Marketwatch) to assist me in making decisions about purchasing or selling BWX and WIP, two ETFs which contain foreign government bonds. I have a somewhat simpleton approach. I will consider selling both BWX and WIP, which I have already done, when the dollar index nears 75. This would indicate the six foreign currencies contained in the DXY, weighted toward the EURO (U.S. Dollar Index), have gained in value against the U.S. dollar. Assuming a relatively stable interest rate environment, I would expect BWX and WIP to be gaining in value as this foreign currency basket gains against the U.S. dollar. As shown in this Chart, the DXY moved from a high of 88.5 in March 2009 to a low 74.86 on November 27, 2009. This indicates dollar weakness. The dollar then start gaining in value and closed at 84.73 yesterday, showing dollar strength.

BWX hit a low of $48.3 on March 9, 2009: BWX Fund Charts - (NASDAQ) SPDR Barclays Capital International Treasury Bond ETF Fund This coincided with low in the DXY. The high for BWX was hit on guess when? The date was 11/27/2009 at a price of $59.91. It closed yesterday at $53.91. This just demonstrates the influence of currency fluctuations on the value of BWX. There are of course other risks, including the sovereign credit risk and interest rate risk. But for the past couple of years, currency risk has been more important in my opinion than either credit or interest rate risk for the foreign government bonds contained in BWX.

To repurchase either BWX or WIP, I will have to gain more confidence in the EURO than I currently possess. When and if the dollar index starts to approach 90, however, the currency risk will be swinging in my favor. I would then have to evaluate more closely the interest rate risk of the bonds.

Some of my prior discussions of BWX and WIP, and my reasons for selling out my positions, are contained in these posts:

ITEM # 8 Bought 50 EUO at $17.17 as a Hedge (Sold remaining shares of BWX based on evaluation of risk/reward at the price sold, which was $59.38)

One factor which will minimize the amount of any purchase is the relatively insignificant dividends paid by BWX and WIP. The currency change will be far more significant than the income dividends. I currently have no positions in either WIP or BWX.

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