Is is Time To Finally Short JGBs and Buy Equities?

JGBs or Japanese government bonds, have been in a bull market for years. Near zero percent interest rates leave bonds with no more room to advance and is in large part, blamed for much of the financial malaise that has gripped Japan for the past generation.

In response to the devastating earthquake, tsunami, and multiple nuclear fallouts, the Japanese government has unleashed a massive spending program on an order that would make Ben Bernanke proud. Trillions of yen are being printed to address the short term liquidity crunch, pay for much needed repairs, and to support equity markets. (Note - While I do not intend to downplay the human toll of recent events, this is a blog dedicated to financial speculation and its ripple effects. It is possible to be both humane while still sticking to the original mission statement).

But even before the recent catastrophe Japanese public finances were in a dismal state. With public debt to gdp approaching 230% the JGB bond market had attracted the attention of bond vigilantes eager to short. In comparison, the US debt level is closer to 95%-100% (depending on which source you rely on).

While these bond bears had initially arrived in the early to mid 1990s following the dramatic Japanese market corrections and property bubble, most had moved on to greener pastures, unwilling and/or unable to fight the firepower of the Japanese central bank. Other bears switched to the increasingly lucrative forex trade where they sold the low yielding yen to buy higher interest bearing currencies like the Aussie, Real, and Kiwi.

In the intervening years, Japan continued to wallow through deflation. Its ranks of elderly grew while the number of young people shrank. These members of the "lost generation" became disaffected by societal changes beyond their control. Many became "otakus" or socially ignorant shut-ins whose only refuge was the Internet. The complete lack of job security for young workers who can only find temporary employment has made life difficult for new families and caused the birth rate to be cut in half (job openings are restricted to care for the ranks of middle aged and elderly that were promised a cradle to grave existence by prior managements). Society became more insular and engrossed in domestic affairs.

Nowhere was this demonstrated more dramatically than last year when China overtook Japan as the world's 2nd biggest economy. But even this event was noted with weary resignation by a population already accustomed to a diminished role on the global stage.

So, will the recent turn of events cause them to return? The short answer is possibly. But not right away.

Rising bond yields are correlated with rising equity markets. Or are they? In the months following the Kobe earthquake of 1995 the Nikkei continued to slide. The Topix bottomed out in June 1995 (Japan's largest index after the Nikkei, similar to the rivalry between the DJIA and the S&P 500). Even the Nikkei failed to regain its pre-2008 highs. Japan's government has traditionally been able to rely on domestic consumption to finance most of its needs. This is a generalization but foreigners find it difficult to engage the non-Japanese investor. Companies and families are now faced w/the prospect of liquidating their assets (including JGBs) to pay for much needed supplies like food, water, and housing - not to mention the enormous debris clearance and reconstruction efforts. Some bears are beginning to awaken from their hibernation, entranced by the prospects of JGBs achieving junk status in the near future.

But the BOJ has never intervened on a scale like this before. Additionally, the worst effects of persistent deflation seem to have been priced out. Indeed, the effects of deflation are so strong that JGB yields are STILL implying zero inflation despite oil >$120/barrel and staple food prices advancing over 150-200% in a year!

Risky Business in Asset(less) Lending

Retail investors have been on a hunt for debt based yield ever since Bernanke announced QE 2.0 last year. However, most bargains had already been snapped up earlier in 2009 by savvy fund managers. Most of the best issues have already been priced out of the market as reflected in lower interest rates. This was a win win situation for both debtors and lenders as the former were able to refinance at a critical time while the latter was able to achieve impressive gains.

But as the year progressed, less financially sound companies began to seek similar sources of funding among investors. Those who missed the initial rally in high yield issues have piled onto riskier and riskier issues. The principal cases in point are the recent surge in covenant line loans, pik toggles (payment in kind), and other mezzanine based debt structurings.

These types of deals were blamed by some critics for being a harbinger of the financial crisis in 2006-2008. The higher returns being offered to investors are a reflection of the greater risk involved to junior creditors. The most worrying parts are loan provisions that allow a borrower company to default in the event of deteriorating finances or even natural disasters such as acts of god. Unlike senior note holders, junior creditors are usually left holding the proverbial bag in case of a default. They are usually unsecured, or lack collateral, in their underlying loans.

So, what are some warning signs of a potential default? Here is a short list - large borrowings to pay special dividends, large bonuses paid to management, poor cash flow, goodwill comprising an unexpectedly large part of the balance sheet, and potential legal suits.

http://www.ft.com/cms/s/0/9f7c528c-4da3-11e0-85e4-00144feab49a.html

The German Success Story

Great article from Time Magazine about how Germany is becoming the success story of the EU. Exports have driven much of the country's growth since the doldrums of post-reunification.

http://www.time.com/time/magazine/article/0,9171,2053595,00.html

Chinese Farmland Continues to Experience Dry Conditions

Some interesting news coming out of China. Of particular concern is the wheat crop. 2011's wheat harvest is dependent to a great degree on Chinese output. The problem is compounded by some local governments' insistence on re-routing water tables for industrial use. Winter wheat in particular is very water intensive.

Most Of China's Cultivated Farmland Lacks Irrigation -Official
More than half of China's cultivated farmlands are dependent solely on weather conditions for water, with only 49% served by effective irrigation, a senior Ministry of Agriculture official said in an essay on an academic website.

The government targets spending of CNY4 trillion ($608 billion) over the next decade on water conservation infrastructure projects. It is redirecting $12 billion this year from property tax revenues to irrigation projects and making water conservation the centerpiece of its 2011 agriculture policy.

Zhang Hongyu, the ministry's supervisor of agricultural policy, said on the Chinese Academy of Social Sciences Rural Development Institute website Tuesday that "irrigation is the weakest link in China's agricultural production infrastructure."

Two-thirds of China's farmlands are affected by drought, steep slopes, poor soil, salinity and other factors, he said.

In China, efficient water use through irrigation is just 60% that of developed economies, Zhang said in the essay, without elaborating.

In his essay, which was first published in the Communist Party's People's Daily newspaper, Zhang also called for the government to redirect industrial investments to the agriculture sector to "release the potential of rural consumption."

"The need to expand domestic demand is a basic necessity of improving agricultural infrastructure," he wrote.

Even as rural incomes have risen on the tide of surging agriculture commodity prices, China last year recorded its widest rural-urban income gap since 1978.

Source - CME News for Tomorrow

Argentinian Land Bubble?

Longtime readers will know that I have long favored South America as an investment destination for agricultural products. Interest in all things agricultural has only grown with the advent of high food prices.

Type in buy farmland in Argentina on Google and you will face tens of thousands of hits. Most of the results are of dubious value and years old. However, I received a story today from a credible source that is pertinent.


Argentina Should Limit Foreigners' Farmland Purchases - Minister

Pressure is building in Argentina to limit the amount of land that foreigners can buy as record prices for grain and derivative products fuel concerns that deep-pocketed overseas investors might end up controlling a significant percentage of the country's farmland.

Last year, congressmen from a across Argentina's political spectrum sponsored about 12 different bills that would have put limits on foreign land ownership. While those bills are stalled in the agriculture commission of Argentina's lower house, the administration of President Cristina Fernandez looks set to weigh in on the issue.

"[Fernandez] believes that the legislature needs to debate the protection of the country's primary non-renewable strategic resource--the land," Agriculture Minister Julian Dominguez said in a speech on Sunday.

The land "has to stay in Argentine hands," Dominguez said.

Agriculture exports were largely responsible for Argentina's whopping $12.06 billion trade surplus last year, while taxes on farm exports accounted for a significant percentage of the federal government's tax revenue. Argentina is the world leader in soymeal and soyoil exports, ranks No. 2 in corn exports, and third in soybeans.

As global commodity prices soar, investors have increasingly looked to the fertile farmlands of Argentina and Brazil for investment opportunities.

That has helped fuel surging land prices in recent years. At the end of 2010, prime farmland in Argentina's Buenos Aires Province was selling for $15,000 a hectare (2.47 acres), according to local daily La Nacion. That is about double the price in 2007 and over five times prices in 2002 when the country was in the midst of an economic crisis (emphasis my own).

Argentina's northern neighbor, Brazil, has already taken steps to protect its national sovereignty over farmland. Last year, Brazil's former President Luiz Inacio Lula da Silva slapped limits on foreign ownership.

Land purchases involving a foreign investor or a local company that is majority owned by foreigners are now reviewed on a case by case basis. Certain limits will apply depending on the geographic area of the purchase.

A similar law is needed in Argentina, where about 7%, or 20 million hectares, of the country's productive farmland is in the hands of foreigners already, said Omar Principe, who heads the land commission at the Argentine Agrarian Federation. The association, know as the FAA, is one of the country's leading farm groups and represents small-scale farmers.

Source: CME News for Tomorrow

Equity Markets Tends To Rise in March

I suppose I would be remiss if I did not take on the bulls' case. Well, here is an interesting note. The S&P 500 as represented by the SPY etf tends to rise in March. See attached chart. I am unsure for the reasons behind the rise and welcome thoughts.

A closer look at the shorter term charts and other market indicators is warranted before making a decision.

Update - Volatility Where Art Thou?

Wow. I have not posted in a long time. I have been pursuing career development (like opening a law practice) in other areas and relegated blogging more or less to a hobby. To say the world has changed a lot since my last post is an understatement. Instead of giving a detailed chronological account of the last few months, I will jump right in and address the current event topics.

The markets have been on a bullish tear since Bernanke made his announcements of Quantitative Easing in late summer/early fall 2010. Since that time, the bulls have been seemingly undeterred by any bearish news. Even the collapse of two Middle Eastern dictators has not done much to stall their advance. However, there are multiple storm clouds on the horizon that would give even the most ardent among the herd a reason to head for shelter.

I see 2 problems looming, Stagflation and European defaults. Neither of these are new but the context in which they are being presented is changing rapidly.

Stagflation
Stagflation is defined as a combination of weak economic growth and high inflation. It is the one threat that has the potential to impede further progress in equities and other risk trades. After all, the recovery trade is more or less done at this point w/most companies having borrowed to buy back their shares (which is my own belief behind the market's advance). While inflation remains relatively low in the West, it is offset by continuing weak labor markets. Instead, inflation is strongest in emerging markets where food and fuel comprise a larger percentage of residents' budgets.

The fundamentals of higher food prices are linked to dietary progressions up the calorie chain for more expensive items. People used to eating rice and lentils have become hungry for chicken and beef. These added demand constraints on farmers and land use has been further exacerbated by volcanic activity in Kamchatka, Russia and colder weather patterns in the Pacific Ocean. Kamchatka is a remote province in the Russian Far East most famous for its large population of bears and elk. But the same geography that is responsible for its geographic isolation is also responsible for a recent spurt in eruptions that have sent hundreds of tons of soot and ash into the atmosphere. La Nina is a reference to the cooler waters in the southern Pacific Ocean that generally lead to drier weather in North and South America.

As any decent farmer knows, the world turns in cycles. (See some of my past posts on El Nino for example) Most of the seasons can be predicted with a great deal of accuracy. But these additional wild card factors are causing substantial changes in heretofore unforseen ways. The changes have resulted in supply constraints that have sent agricultural prices skyrocketing.

European Defaults

Private creditors are not exactly lining up to buy peripheral EU debt. They have their reasons. A case in point is the recent elections in Ireland that saw the outgoing party, Fiana Fail, lose the most within 3 generations. Irish voters were enraged beyond measure about the party that got them into the current mess and wanted to turn them into slaves to foreign creditors. So, why does an election in a country with a population a tiny fraction of the total EU? EU ministers have been promising that all debts will be repaid. Unfortunately Irish voters basically said NO to that idea with a resounding voice. The new govt is likely to push for
a restructuring - a default in all but name. And when that happens the other PIIGS will also want the same thing. What do you think will happen to the markets when a wave of defaults on that scale occurs?

VIX

Ok. Enough fundamentals. Let's talk technicals. After all that's the title of this post. For the purposes of measuring volatility we will look at the S&P 500 Vix (volatility options index). I like the vix because it is about as pure a mathematical indicator as you can get. It has been alternately called the fear index b/c when the vix spikes, it indicates nervousness among options buyers on the S&P 500 stock options prices.

So, how To Protect Against Volatility?

I have put up several charts of the vix which indicate a potential spike in volatility over the next few months. Note the ATR (average true range) and standard deviation indicators. Like all options, vix options pricing reflects market sentiment by the sellers for future months. Outright buying vix options (in this case calls) 3,4,5 months in the future seems feasible at first until you consider that the only way to make a profit on those is by having the rate of change accelerate dramatically (preferably in the near term). To some extent this is true of any options buyer but the vix is different b/c the underlying values change for every month. In turn this is due to reversion to the mean as measured by standard deviation - which is more volatile by far than the vast majority of stocks or commodities.

The vix also spends most of its time in contango - a term used to describe the larger premiums demanded for far off months than compared to near month contracts.(Vix futures can be priced for backwardation but this happens less often - usually when the vix is already flying next to black swans -look no further than the September 2008-March 2009). The reason for this can be readily explained by looking at the vix over a long period of time. While the vix can and does readily revert to the mean, it can spike significantly in the short term and even stay there for protracted periods of time. The higher priced premiums are the result of options sellers demanding suitable compensation for taking on that level of risk.

So, what to do as a trader or even a hedger looking to protect against a fat tail event? In (relatively) low volatility times, debit (put) spreads on index etfs or leading stocks seem to be the way to go. There is limited risk but limited upside (of course the upside can still be considerable). Premium selling strategies are not worth it with low volatility. Of course, one can always buy calls or puts (well in this case puts if you favor a sustained market correction). You still have to be right with both trades (debit spreads and straight options buying) but at least volatility is favoring the options buyers.