Seek Value As Sovereigns Dump T-Bills On Overbought Markets

by: Emmet Kodesh

The end game for the unprecedented fiscal policy of debt creation and yield suppression seems very close. In April, net selling of U.S. Treasury Notes was $54 billion. Private investors sold nearly $31 billion in T-bills while "official entities" (banks) sold $23.7 billion. The corner into which the Fed is painting the economy now is very small. As foreign and domestic divestment of Treasuries increases, the net asset value bubble is leaking while rising yields, still too small to be worth holding or to sustain life in retirement nevertheless threaten world housing markets as seen in the decline in American and foreign REITs the past month.

Emerging Markets have been wobbling for six weeks as the sell-off and yield creep began. Higher borrowing costs have hit first and hardest in young economies. Foreign equities generally look frail and are falling as recession in Europe and slowdown in China was underscored by IMF comments Friday, which also cut estimates of U.S. growth. The news, though no surprise hurt markets in a sign of things to come. Playing games with interest rates disorders bond markets and disequilibrium becomes unsustainable as China sells down its T-bill holdings from nearly $3 trillion to $1.26 trillion and Japan to $1.1 trillion. This brings the euphoric end-game into sight.

Exits from the fiat system and increasing ex-USD bilateral trade agreements have been little heeded because the dominant narrative is that the U.S. is in recovery. This chatter overrode growing awareness that China's growth was slumping (though the HSBC May preliminary PMI for Chinese economic contraction caught a few eyes) and the many signs that our own economy is structurally weak: steadily declining retail sales growth with lower lows and lower highs (despite a rise from March 31, lows they sill are down 17.3% year over year and about 60% in 2 years), mediocre to terrible regional ISM-PMI data especially on the core areas of manufacturing and working hours (for those with jobs), a student debt-default crisis and rapacious tax policies that hamstring growth (and thus jobs and purchasing). As Dr. Philippa Malmgren recently warned, government hunger for citizen wealth is redefining the relationship between the governed and a ruling class that is headed toward confiscatory practices on a grand scale. That is the end and goal of Sovereign debt policies.

As more nations and individuals ditch Treasury bonds to save their principal and even slight rises in yield cripple a housing recovery heavily dependent on investment in rental properties, which already show high vacancy rates, QE will have to increase to forestall a depression. This will keep the Titanic afloat by creating further asset bubbles that will burst as China continues to trade its T-bills for gold, property and foreign companies.

The major banks, indeed any banks with leveraged derivatives far beyond their holdings will totter and, heaven forbid we might see enactment of the plan for "resolving globally active systemically important institutions," that is, major U.S. banks may begin the play for which Cyprus was a prologue, re-classifying depositors as investors or creditors and taking some of their savings to fix their funky balance sheets.

Even if this last part of a scenario does not occur, volatility and sell-offs in bonds likely would trigger equity swings and drops like those in the last months of 2008. Perhaps the helmsmen on the Fed Board will right the ship before a major wealth consolidation event. However, it is very clear to this observer, from many cultural dynamics, trends and dogmas that such an event is a policy cynosure. Robert Fitzwilson writes that "generations of norms and expectations and savings will be destroyed" in the attempt to unwind QE. The Nikkei index "has been trading like a era IPO" he adds as global bond markets begin to whipsaw while Japan's market has dropped 20% in 20 days as its fiscal hypertrophy metastasizes.

So what to do?

Well, everything may work out okay. Trembling in global markets and radical currency swings may prompt the Fed to ditch tapering QE this year. "Free money" will continue to jazz the markets and make haggard banks look rosy. Naked short selling, which recently led the SEC to slap the CBOE with a $6 million fine will be forgotten, maybe. But if these trends are not allayed, what should most investors do?

Foreign markets are not convinced that the Fed will continue QE. They noted the recent USD rise and fall, market volatility and disordered action in their own currencies. The only reason foreign investors haven't dumped the USD is lack of credible alternatives, says an analyst at Société Générale. This helps create an official rationale to continue easing, which in fact cannot end without depression and can end only in depression as von Mises explained concisely in discussing "credit expansion."

Every one is waiting on the upcoming prophecy from the FOMC June 18-19, and the blessings or maledictions of the Fed Chair. The markets depend on continued debt creation to buy some time and increase the impact of the inevitable crash. Lipper reports that in June Americans have withdrawn $17 billion from funds and ETFs, $7.1 billion from varied fixed income investments.

Jeffrey Saut, chief investment strategist for Raymond James believes that the markets will remain difficult in the short term but after some consensus emerges about QE the YTD uptrend will continue through 4Q. Saut notes that hedge funds have been playing currency and bond markets by borrowing in Japan at super low interest rates, then converting to high dividend stocks. These buyers he states have been selling the past three weeks. He is not sanguine, at least not yet about 2014 but it is hard to see this year playing out without a moment of truth resulting from the past five years of extreme debt creation and inflated asset prices. He compares current predictions of a continuing equities surge to 2007 hype about a continuing rise in the S&P then.

Another salient point is that the condition of the equity indices is the reverse of commodities generally and the PM sector particularly: the markets have soared despite troubling economic fundamentals (contracting American industrial PMI) while commodities and PM prices have tanked despite strong and strengthening fundamentals based on greatly increasing demand. Traders like Gary Savage have noted the growing divergence of the S&P (NYSEARCA:SPY) 50-day and 200-day moving average. With the S&P about 1640, this divergence resembles the 7%-8% disparity seen at the beginning of the May 2012 and summer 2011 corrections. Added to the imbalances in the bond markets globally this gap increases the likelihood of a significant market correction in 2-3 Q 2013: indeed one may have begun that only can be averted by more debt creation. This supports the views of experienced fund managers and strategists like Saut, above. Here are two additional views based on historical cycles and current fundamentals that the secular bear is ongoing and will consume the debt-dependent, highly leveraged cyclical bull. At the first of these links Sy Harding notes that in 1999 Warren Buffett effectively predicted there soon would be a 17-year correction of the bull that began in 1982.

So here's what to do: increase cash positions and look for value. Top fund managers like George Soros, Steve Cohen of SAC Capital and John Paulson of Paulson & Co have found value in the PM and mining sector.

For those already allocated 10%-20% in this area (the range for most people of moderate means) hold tight: the drop since October 2012 should begin reverting to the mean as equities are primed to do. John Hathaway, Senior Managing Director of the Tocqueville fund Group urges patience for those invested to their personal maximum in the PM and mining sector and sees a large rise as general equities correct (in fact he sees "a severe meltdown" on tap). Disorder and increasing volatility in bond markets, the last thing most bond investors want is hurting and will hurt equity indices, too.

Seek mega-cap companies in undervalued commodity and mining sectors and major players like United Technologies (NYSE:UTX) and Boeing (NYSE:BA) that should rise with the chaos in these times of global turmoil and interventions. Both companies are rated Strong Buys at Union Pacific (NYSE:UNP) has performed strongly and even in a downturn will be carrying freight for global trade. It too is rated Strong Buy. Corrections toward the 200-day MA may be harsh so it is prudent to take profit in consumer discretionary companies like Comcast (NASDAQ:CMCSA), Starbucks (NASDAQ:SBUX), TJX or Loews (NYSE:L) or in ETFs that give low-cost exposure to them like Vanguard's (NYSEARCA:VCR). If there is assurance of continuing QE expect this sector to leap but remember: consumer debt/ GDP is 80% and rising and the market is filled with margin debt. It is best to seek companies that can weather a storm.

The beginning of copper exports from Rio Tinto's (NYSE:RIO) Oyu Tolgoi site in Mongolia helps diversify their enormous commodity holdings (iron ore, aluminum, copper, coal and diamonds). Depending on developments in the Mongolian elections and the need of that nation for the income RIO and its holdings Turquoise Hill (NYSE:TRQ) and South Gobi Resources (OTC:SGQRF) will generate, RIO is another major that should ride out storms. The political-financial strength embodied in its board (profiled here) that helped secure $4-5 billion loan guarantees from the EBRD and U.S. Export-Import bank for potential Phase 2 development at OT as well as its holdings make RIO a strong long-term position. The 12-month consensus target for RIO is $72.27, nearly 40% above its June 14 close at $43.31. It has a preponderance of "Strong Buy" ratings and earnings growth within its sector will improve if the Mongolian sites proceed.

For an alternate view on RIO relative to BHP Billiton (NYSE:BHP) see the fine piece by Bob Johnson on BHP here.

Another reason for liking RIO is its gold properties at Oyu Tolgoi and via a 40-60% partnership with Freeport McMoRan (NYSE:FCX) on the gold output at Grasberg mines in Indonesia. Mining operations there will resume: government officials have signaled clearly and repeatedly that they want production to proceed and generate revenues they need. The unions have threatened a walkout unless five managerial personnel are fired but mine operations will be upgraded in any case and work will proceed. I believe that Mongolia and Indonesia are learning from Ecuador's painful experience of driving out miners with extreme taxes and a consequent reliance on China (see below).

There are two very different short-term scenarios: in one, at the FOMC meetings this week the Fed announces it will continue QE. In this case the indices will surge. On the other hand, if there again is ambiguity about QE, particularly in the eddy of bad news on global slowdown, the markets will stumble, perhaps sinking toward the 200-day MA, which would be a more than 8% correction. Hints of slowing Fed purchase of MBS and T-bills spiked long-term yields 37% in the past six weeks. The volatility and increasing red days in global markets and heightened currency instability (in part from the yen carry trade) are a warning of turmoil to come as management by fiat exhausts its ability to balance support for banks with economic growth.

The overbought indices, shaky economic fundamentals and extremely depressed values in the commodity and PM sector suggest increasing cash positions and that those looking for value plays should note the example of Messrs. Soros, Cohen and Paulson to be in place for some reversion up toward the mean in that depressed sector. High premiums to purchase bullion indicate that its true price is higher than spot. Strong Sovereign and retail buying will support a rise even against selling in the futures markets. SEC action regarding "naked shorting" on the CBOE, like the sell-off in the main ETFs (NYSEARCA:GLD) suggest that this form of price distortion may diminish.

Fiscal policies have pushed people out of bonds and into equities. "Globally active, systemically important" banks within the matrix of fiat fiscal policies drive people from precious metals into equities. The main indices are primed to revert down to the mean. As this happens, despite the "common wisdom" about crushed and volatile PM prices, very low valuations invite investment in some major producers like Goldcorp (NYSE:GG). Its current assets, cash and cash equivalents are 2.5 x its liabilities as Vinayak Maheswaran reported and its target analyst ratings are very positive at $38.25, almost 40% above its June 14 close at $27.74 which is the bottom of its estimated 12-month trading range of $27-47. It now yields 2.16% which is distributed monthly: June 18 is the next ex-date. Like RIO it has a preponderance of Strong Buy - Buy ratings. Marketwatch has a $38.71 target and "overweight" guidance from 26 analysts on GG with the majority rating it a "Buy."

The mining sector has geographic risk but resource nationalism cuts two ways. The socialist government of Rafael Correa has painted itself into a penurious corner with its 70% windfall profits tax on miners which last week prompted Kinross Gold (NYSE:KGC) to walk away from its site at Fruta del Norte, the famous discovery of geologist - analyst Keith Barron. Now KGC is leaner and more profitable and Ecuador is impoverished and more reliant on China whose open-pit copper mining and opaque governance will not long delight Latin Americans.

Many value buys are in the mining sector, both precious and base metals and other basic materials. With global growth slowing it is possible that PM miners pegged to a new monetary system and steady physical buying will outperform even the mixed commodity giants. This also is the view of Michael Pento and John Hathaway who expect the delicate fiscal situation to result in an extension of gold's secular bull. For those fully invested in the sector, patience will be rewarded. For those underweighted, it presents one of the best though still volatile value areas in a sea of inflated prices.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in GG, KGC over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I own shares of PM companies in two mutual funds.

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