Christopher Pavese's  Instablog

We thank the good folks at Credit Write downs for providing the soundtrack for this quarter’s Broyhill Letter which is posted below.

Quantitative Easin'

In addition to unconventional monetary policy, our beloved Fed Chairman has now resorted to unconventional media policy (immediately following the FOMC meeting) to further flame investors’ animal spirits.  In a recent Washington Post Op Ed, Bernanke explains that Quantitative Easing “eased financial conditions in the past and, so far, looks to be effective again.  Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action.  Easier financial conditions will promote economic growth.”

In other words, if I can blow another bubble in asset prices, I believe all our troubles will wash away in liquidity.  Good grief.  Anyone seeking a dose of reality should read QE2 blunderbuss likely to backfire in the FT before placing blind faith in the Fed.

“Maybe Ben Bernanke will make the VIX go to zero and we’ll all win every day. Maybe not. We do not think this will end well. If anything, the next market crash could be perpetuated by the Fed itself.”

Keith R. McCullough, HedgEye Chief Executive Officer

Markets have drifted higher aboard The Great World Cruise of QE2 as market participants debate the classic question – what’s priced in?  Readers know where we stand on this one so we’ll resist the urge to add our two cents.  But perhaps the better question to ask, is how are speculators positioned?  With most of the market leaning over one side of the boat, we feel safer Uncomfortably Alone on the opposite side.  See Dave Rosenberg’s comments below:

The Fed’s jawboning has already triggered substantial speculative pressure across most asset classes. The net speculative long position in crude oil has surged to 209,535 contracts (contracts of 1,000 barrels). To put that in perspective, the largest net long position by non-commercial accounts on the Mercantile Exchange in 2008, when crude touched $145/bbl, was 152,282 contracts. Talk about danger levels of speculative activity — it is 40% higher today with oil at $80/bbl than it was back then at the price peaks.

The net speculative longs in copper are now 24,017 contacts. Platinum and palladium are off the charts (25,639 and 15,379 contracts, respectively). Corn is at 449,834 net longs. Gold is at a record 282,254 net longs. The net speculative long position in the Aussie dollar looks nuttier than it is in the case of the loonie — 67,788 net speculative long contracts. The net speculative long position in the yen (45,927 contracts) is in the upper end of the historical range even though the Bank of Japan is doing everything but wield a machete at the currency to weaken the thing.

Meanwhile, what are speculators short? The bond (8,261 contracts) and the VIX (17,176 contracts — the sixth largest ever; talk about complacency).

Anecdotal evidence appears to be largely consistent with the data above.  At a recent Investment Roundtable we attended, full of nearly 70 institutional investment managers in the region, nearly every hand in the room went up when asked about those increasing their allocation to international and emerging markets.  We were one of two or three Uncomfortably Alone in the room and willing to admit that we were cutting back.  This is not to say that we are not believers in the long term secular growth dynamics of emerging economies.  We all know that the world can’t depend on the G7 to pull us out of this funk.  But this does not mean we can ignore price or sentiment.  We were constructive on emerging equity markets early in 2009, as we discussed in the First Quarter 2009 Broyhill Letter.  We still believe that Blowing Bubbles in emerging markets may well develop into the next Financial Mania.  But after a QE-induced Melt Up in the Reflation Trade, investor fear has been quickly replaced with greed.  And greed has an unfortunate habit of making investors blind to risks.  We encourage folks to open their eyes and look at the one-way bets illustrated below.  There is still a good chance that the Presidential Cycle sets us up for a powerful run over the next twelve months, but it’s difficult to imagine that run starting from today’s overbought extremes with wildly optimistic sentiment.  An abrupt decline that cleared overbought levels and injected renewed fear into the psyche of speculators, might provide a better base for the typical Third Year Boom.

Source: Business Insider

Disclosure: At the time of publication, the author was long Bonds, Gold and VIX and short Australian Dollar, Copper and Japanese Yen , although positions may change at any time.

We’ve been admittedly quiet on the blogging front.  While we enjoy sharing thoughts with our readers, our first priority is to our investors and unfortunately, there is only so much time in a day.  I have a tremendous amount of respect for the many great thinkers able to provide detailed analysis on a regular basis.  But I can’t help but wonder how they do it.  With so many interesting developments in the world today, our posts are put on the back burner while we dedicate our time to research and analysis.  We also try to limit our ramblings to material developments or important issues worth noting rather than a random schedule of publication or daily downloads.  As such, we think investors should think twice before extrapolating this QE-induced 12% melt-up in domestic stock prices much further into the future.  As we warned in our most recent letter to investors:

Albert Einstein’s classic definition of Insanity is doing the same thing over and over again and expecting different results.  As we see it, releveraging an already overleveraged economy is not a path to sustainable growth.  It may temporarily ignite animal spirits and lift valuations of the most liquid assets, but is unlikely to have any lasting impact on stimulating aggregate demand.  But what do we know?  Perhaps our attempt to print and borrow our way to prosperity will turn out to be successful.  Anything’s possible.  But such “success” would be the equivalent of an addict’s last high, before facing the reality of unresolved structural problems ultimately resulting in a greater crash down the road.  As stewards of your capital, we’d rather endure the temporary frustration of lost opportunity than suffer a permanent loss of capital.

John Hussman offered up similar concerns in his weekly commentary this morning:

Over the past two years, the Fed has emptied what has largely turned out to be a chamber of blanks. Its remaining credibility lies in the belief by the public that Bernanke still has a live round left to fire. Once the Fed engages in QE, a failure of appreciable improvement in U.S. employment and economic activity would result in a substantial loss of public confidence. The Fed would be wise to save whatever ammunition it has left for a crisis point when the U.S. public is in dire need of confidence . . . “The current enthusiasm about QE seems much like the enthusiasm of a ten-year-old child about to launch over a plywood ramp on a bicycle. Once the wheels are airborne, it will be a bit too late to ask “now what?”

We highly encourage friends to take a few moments to read the full piece which can be summed up in two words: Reduce Risk. Dr. Hussman has the rare ability to translate complex macroeconomic variables into simple “cause and effect” relationships, that even our current administration can understand.  This is exactly the type of thinking that policy makers so sadly lack today.  When I read the following paragraphs, I can’t help but wonder why our elected officials fail repeatedly to Get It.

Better policy options are available on the fiscal menu. Historically, international credit crises have invariably been followed by multi-year periods of deleveraging, but measures can be taken to smooth the adjustment. The key is to focus on the economic constraints that are binding. Presently, these relate to high private debt burdens, uncertainty about income, weak aggregate demand, and the reluctance by U.S. businesses to launch new projects. Appropriate fiscal responses include extending unemployment benefits, ensuring multi-year predictability of tax policy, expanding productive forms of spending such as public infrastructure, supporting public research activity through mechanisms such as the National Institute of Health, increasing administrative efforts to restructure debt through write-downs and debt-equity swaps, abandoning policies that protect reckless lenders from taking losses, and expanding incentives and tax credits for private capital investment, research and development.

Meanwhile, the best course for the Federal Reserve is to identify specific constraints within the U.S. banking system that create barriers to sound lending, and to formulate specific policies to relieve those constraints. Throwing a trillion U.S. dollars against the wall to see what sticks is not sound monetary policy. By pursuing a policy that relaxes constraints that are not even binding, depresses the U.S. dollar, threatens to destabilize international economic activity, encourages a “boom-bust” cycle, provokes commodity hoarding, and pops off the Fed’s last round of ammunition absent an immediate crisis, the Fed threatens to damage not only the U.S. economy, but its own credibility.

John – if you are listening, you have our vote for Fed Governor, Treasurer, Economic Advisor, etc.  Admittedly, your shareholders would be at a loss. But we have no doubt that your insights would provide Washington with the tools to generate a Greater Gain.  Something to think about . . .