12/21                                                                                    

Postcards From The Edge

The Recycling Plant...On Tuesday we took a quick peek at the asset allocation characteristics of the American public as well as the institutional investor crowd in this fair land.  Time to shove off for foreign shores.  All aboard.  After all, since the US has the world export market on the dollar simply cornered at the moment, just what is happening to that exported contraband?  Well it just so happens that a heaping portion of our generous dollar exports, vis-à-vis our burgeoning trade deficit, have been "recycled" in financial assets in the U.S. over the past few years.  Let's look at some numbers, shall we?

Clearly since 1995, foreign purchases of U.S. financial assets have more than doubled on an absolute dollar basis.  On the bond side of the equation, foreigners have most certainly been interested in "spread product".  Purchases of safe haven Treasuries during the scare periods of 1997 and 1998 have tapered off in favor of Agency and Corporate paper.  And why not?  That's where the absolute yield is the greatest.  Combine relative high yield with a rising dollar and you have many a foreigner only too happy to participate in US debt markets.  Albeit starting from a small base, foreign purchases of equities has simply exploded in the last half decade.  As you would only expect, the bulk of the money (on a rate of change basis) has come in this year.  Unlike a lot of the American public and institutional clan, foreign holdings of U.S. equities as a percentage of total foreign holdings of U.S. financial assets isn't off the charts from a historical standpoint:

It is quite interesting to note that the longer term experience of the foreign community is quite similar to the American public in terms of the ebbs and flows of equity ownership.  After the 1973/74 debacle in the U.S., the American public sold their mutual funds for eight straight years.  Likewise, the foreign community largely abandoned U.S. equity ownership from an overall portfolio standpoint.  As in the case of the American public broadly, foreigners again "found" U.S. equities during the 1990's and once again began committing serious money to an asset that had already experienced substantial appreciation.  Human nature is a riot, isn't it?  How come you holders of the QQQ's aren't laughing?

Scaredy Cats?...As foreigners have so kindly been recycling our seemingly never ending supply of exported dollars back into our own financial markets, what about quid pro quo?  What have we done for them lately?  Well, ever since the global economic scare during 1997, we have stuck to our own knitting, thank you.  We've been practicing the new era exercise of importing cheap (currency deflated) goods and exporting expensive paper.  Have a look at what U.S. investors and institutions have done:

Admittedly, while the bonfire of the global currencies has been raging well outside of the U.S. dollar containment zone, U.S. investors have been correct to avoid loading up on foreign denominated financial assets.  The question going forward is whether the contrary will be the appropriate action.  Clearly, that question hinges on the fate of the almighty dollar.

Our complete love and fascination with the financial markets is borne in the fact that change is the hallmark of the financial animal.  Although human nature and decision making characteristics rhyme over time, they never repeat in exact detail.  Having said that, we see a certain irony in the global rise of the dollar over the past few years.  Yes, the globe did need the U.S. consumer to become the global consumer of last resort to pick up the slack for a faltering global economy some years back.  And yes, the U.S. needed the dollar recycling operation to run full speed ahead to keep the financial markets and the U.S. consumer pulling the global economic load.  But, the Achilles heel in the circular interaction is that a rising dollar ultimately fosters a relative decline in U.S. dollar based corporate earnings momentum.  It takes some time to be realized, but isn't it an inevitability?  You bet it is.  In the recent trade deficit numbers reported a few days ago, import growth did slacken off a bit, but so did export growth.  Just ask the tech companies how foreign sales growth, or lack thereof, is progressing?  Plain and simple, a rising dollar sows the seeds of a domestic economic slowdown or contraction at some point.  The Fed and the Treasury aren't stupid.  They had to know this would happen eventually.  So here we are.  For what it's worth, it appears as though the dollar may be currently in the process of "getting it" in terms of the ramifications of the (temporary) financial new era:

The rising dollar has forestalled a more serious onset of inflation in the US over the past three or four years.  We have imported foreign deflation.  Now Greenspan faces a reversal of that process in his deliberations over easing monetary policy.  What's it going to be?  The stock market and the economy, or the dollar and inflation?  We're waiting.  In anticipating ease in monetary policy, bond market participants have bid up everything Treasury.  Now to the point where foreigners have some yield choices offset against currency choices.  Earlier this year, the spread between 10 Year Treasuries and similar government vehicles in many of the European currencies was quite large in favor of the Treasuries.  Not so as of today.  Just have a look at what a difference eleven months makes:

As you can see, absolute yield spreads have almost disappeared between European denominated bonds and similar maturity Treasuries with the recent rally in UST's.  Question: Why would a European investor want to hold US Treasuries as opposed to home country government debt?  Although we can think of a few political reasons, the overriding rationale is relative currency strength.  At least a year ago, European bond buyers had spread plus dollar strength.  Now it's down to currency alone, and that is coming into question as the dollar approaches its 200 day moving average.  Clearly, a weakening US dollar from here would ring the selling alarm bells for the foreign holder of US Treasuries.  Foreigners have to be questioning the logic in holding US stocks now that the domestic equity markets have become a tiny bit uncooperative.  From here on out, isn't it just as clear as a bell that the dollar is the key to the cross border asset holding shooting match?

As we showed you on Tuesday, US investors (institutional and public/retail) have allocations to equities as a percentage of total financial assets at near record levels.  Well, over the last two years, foreign investors have gone on a veritable spending spree in accumulating U.S. equities.  They have also not done too badly in the credit markets either as foreign holdings now account for 10.6% of total domestic credit market instruments outstanding.  Suffice it to say that the foreign investment community has become a very significant player in the arena of US financial assets.  A player that could have a severe impact on domestic financial markets with actions taken simply "at the margin".  God forbid foreigners decide to dump U.S. financial assets in wholesale fashion.  Forget the worst case.  They just have to stop buying to create a huge impact.  It's actions at the margin that can change the direction of financial markets.  We'll keep you posted.

Operator, Can You Help Me Make This Call?...You know the old traders saying by now.  "Never meet a margin call."  Crazily enough, we are seeing a good number of margin calls be met these days.  Even more astounding is the fact that many calls are being met with debt.  The CEO of Safeguard Scientific.  Big Bernie and WCOM.  And what about the less well publicized players?  (You know who you are.)  Maybe this is what we should expect as initial reactions in a bear market.  Denial.  Disbelief.  Financial bravado.  It amazes us that these types of decisions are playing out when all the players have to do is simply have a good look at the following chart:

From the peak, the NASDAQ may be down 50%, but margin debt has only fallen about 20%.  As you would imagine, we firmly believe margin "reconciliation" has just a bit further to go.  Just a bit.  Don't you think?

Cash Is Trash, Except In A Cra....(Well, You Know The Rest)...As we showed you on Tuesday, the public is as fully invested in equities as at any time in the last 50 years.  Foreigners have been on a big buying spree.  In like manner, it sure appears that the professionals at the equity mutual funds have little fear at this point:

As of September quarter end, cash in equity oriented mutual funds stood at 5.1%.  Buy, with what?  It's quite a statement on professional confidence.  As you know, equity mutual fund managers have been taught to remain fully invested or risk missing the stock slingshot train as it leaves the station during the past half decade.  How else would you expect them to act in a world where the NASDAQ can move 10.5% in one day?  Miss it and you're dead.  New era "investing", we still don't "get it".

At The Wire...AMG reported the single greatest one week outflow from equity mutual funds in the history of the U.S. today.  $19.2 billion.  Wow!  Before getting too worked up about this, remember that it is capital gains distribution time and these distributions can be counted as outflows.  As you know, we have discussed many a time how cap gains distributions this year would most likely be a sight to behold.  Well behold you have.  You've lost money in your fund this year and now here is your tax bill for that wonderful experience.  Given that these "tax bills" were determined at October month end for the mutual fund industry, we have the sneaking feeling that pro forma taxable distributions for 2001 have already started growing significantly over the November-December period this year.  Unrealized gains...the dirty little secret of the mutual fund industry.  We have the feeling the secret is getting out.  Coming to a 1040 near you real soon.

The Long Ball...Tim has prepared another bird's eye view of the S&P for us.

As you can see, the last time we had this kind of elongated "red candle" on the S&P weekly, Junior Fire Marshal Greenspan doused the offending candle fire with liquidity (1998).  Rumors circulated in the pits today that an interest rate cut was imminent.  Sorry to be redundant, but critical to judging the future health of the financial markets will be investors reaction to the first interest rate cut.  Rate cuts do not change corporate earnings overnight.  Rate cuts do not immediately reconcile corporate or personal balance sheets.  Rate cuts do not change overweighted portfolio asset allocations to equities.  Rate cuts do not immediately change the direction of global economic growth.  Rate cuts, though, may change the relative value of the dollar and global capital flows.  Let's just hope the postcards we receive from abroad post that rate cut aren't sell tickets.