THE COMING CRISIS AND THE FINANCIAL INSTITUTIONS

The minutes of the Fed has been issued. How should we look at them? When we go back to the 90s, we can see that the minutes of the Fed are not issued quite often. So, what happened and why are these minutes issued following the global financial crisis? As the transparency decreases and the problems get worse, some persons have started to issue different minutes. What is the purpose of it? The situation is critical; the interventions need to be diversified, the verbal intervention alternatives need to be enriched, one must also see it in this context. Something is happening and the markets are going to exaggerate them. Consequently, the expectations are being managed. But what are the most worthwhile things present in the minutes?

There is no mention of a modification in the calendar of the monetary expansion reduction. Instead, they are complaining about the market’s optimism and are very disturbed. They are trying to say that we did not learn our lesson. Obviously they imply that the message has not been delivered clearly, that the expected behaviors did not materialize, there’s an abnormal effort to deliver optimism due to the low volatility and this makes it difficult for the monetary authority to perform its duties. In the resulting summary, the central banks are as optimistic as the markets are. We should determine what is optimistic; you could say that we are pessimistic if we are outside the normal. If you draw an optimistic picture which is outside the normal, it is called optimistic. And this has its categories. But what you call the reality, must be accepted as the normal. Currently, the world has lost so much its direction that they the normal as pessimistic, they accept as normal a certain dose of optimism; what they call currently the optimism is to live in a world of dreams. One should define the Fed’s minutes in this context.

The markets are so plunged to live in a dream that they are unable to escape from it. Some institutions are trying to wake them up but they insist in not waking up. Normally there various activities in the economy and one can also have casinos in the economy. But not a single state would not want its citizens to gamble carelessly because it will reduce its future income and thus create social problems. But today, due to the needs, the world has become the greatest casino in history and the central banks are at the point of being a part of it. The central banks are trying to escape from it and issuing some messages but the markets are not listening to them. As fa as the expectations are concerned, the verbal intervention is important but they cannot collide nor can they find the right solution. Those who are in the top decision-making status are aware of everything but are very helpless in the events before them. Other speakers in the lower echelon are not in the position of making a decision; their mission is to believe in what is said and to market it. And there is a question mark on how much they are aware of this despair. And they insist in continuing to gamble…

The one subject that has been persisted upon very often is the wish for the data to come out very poor from the West. That is, in order to have the interest rates to remain low for a long time and to have high liquidity, one has hoped that the figures coming from the developed countries would always be poor. This way, the money would continue to come and thus permitting this Ponzi scheme to continue. Despite the occasional poor data coming in, the attitude of the United States is clear: she doesn't to see the bubble to get bigger and, consequently, doesn't want the damage to be greater in the future. Currently they are not at the point of thinking about the functionality of the global functioning of the world. They are obliged to think for themselves first in which case, the emerging countries come after. The emerging countries are forced to fend for themselves. But to lure them into this position will leave helpless the foreign funds that are coming into these countries, their governments and their banking systems. But this is not just a problem of the emerging countries; this is a global problem. A loss of performance in the emerging countries can shake the world financial system, and this in turn will affect adversely everyone, developed countries included. The preservation of today’s standards in the emerging countries may not be possible in the developed countries too. 

The emerging countries were expecting that the monetary expansion would not be curtailed, the balance sheet downsizing would be constantly postponed, and the period of the rise in the interest rates would be set further in time and would not function as an impairing factor upon the short-term expectations. The only thing that they wanted to see here was that the economic data of the United States would not show any sign of recovery or would remain well below the expectations and thus the Fed would not undertake the aforementioned things and thus the money would continue to flow into their economy and the corruption and saving the day would carry on for some time. This wish stems from the fear of going under in case the developed countries were to stop the monetary expansion. Of course, there is a group that has taken excessive risks; the rulers of the country, large groups, in short the system who have constituted this economic equilibrium based upon excessive risk-taking is very desperate.

We all have seen what the ECB has done; it undertook repo auctions and monetary expansion, and provided huge liquidity in order to avoid the further deterioration of the banking system. Compared to the previous year, we can see that the government bonds of Italy and Spain that fell to the status of junk bond have seen a process of appreciation unseen in history; even Portugal and Greece have profited from this. If these banks (Spain and Portugal) are unable to pay the bonds despite this favorable environment, then the situation is very critical. And if these bonds were in the valuation of the previous year, what would have happened? In this case, the EU joint banking regulations would have created a bid, serious and very costly distrust. For instance, if the banks in Spain and Portugal were to face such a situation, then larger sums of money would be lost in Eastern Europe, mainly in Hungary. This would put the Western banking system into a more difficult position due to the chain reaction. The situation is much worse the current one and its costs is substantial. Would Germany want to assume this cost? Would it be possible to preserve the EU? When wants to scratch the surface of the affair, the story starts to take different directions.

How will this affect the emerging countries? If there is a tendency of a reduction in the risk-taking towards the emerging countries, the possible consequences of such an action would be the rise in the exchange rate and the interest rates, the depreciation of the assets and the beginning of the wearing of the balance sheets. This is a state of uncertainty and it feeds automatically the risk aversion. In this case, everyone will exhibit conditioned reflexes and the price volatility in the market will increase. Since the beginning of this year, there is a decrease in the capital inflow to emerging countries and this feeds the risk aversion. We shall start to see this in the coming fall…

THE BOND COMPONENT IN A PORTFOLIO: THE IMPORTANCE TO HAVE A RESERVE AND HOW TO USE IT

THE BOND COMPONENT IN A PORTFOLIO: THE IMPORTANCE TO HAVE A RESERVE AND HOW TO USE IT

Every portfolio has a bond component which permits to balance the risk involved in any investment. Depending on the size of the portfolio and the risk level of the investor, the bond component may vary from 0% for very aggressive investors to 50% for very conservative investors. This may also vary according to the market expectations where one will be hold less bonds when the market level is low and more bonds when it is high.

But what is of interest is how to use this bond component effectively if we want to boost our portfolio's return. The starting point of this is to see the bond component of the portfolio as a reserve which could be committed at any time to buy stocks when the conditions are favorable or are dictating such a move.

A reserve in a portfolio is the bond component which is not initially committed to the investment in a stock or a group of stocks by the portfolio manager. Thus it is available to address unexpected situations or exploit the investment opportunities that develop suddenly. The portfolio manager can hold it back in order to deal with an adverse situation or to commit it in an investment operation when such an opportunity arises.

It is often better to have some uncommitted liquid money or almost liquid asset (bond) to deal with adverse situations or favorable opportunities. It is sometimes very difficult to liquidate a position in order to meet an unexpected situation whether favorable or unfavorable. This can cause a disrupt in the portfolio's structure which in turn may affect adversely its return. By using this uncommitted reserve, the portfolio manager could preserve the current investment positions and quickly move to stabilize a weak exposure or to exploit a favorable investment opportunity.

The portfolio manager's decision as to when, where and how to employ the reserve is extremely important. Usually the portfolio manager should use a portion of the reserve at the given moment and time since it will be sufficient to fulfill the objective. But committing the reserve in its entirety at once can only be considered in extreme cases. In the event that the portfolio manager wants to exploit an investment opportunity by committing the reserve, a portion of it should be held back in order to exploit unforeseen events. In case that the reserve is substantial, it can be used all together to deal with new strategic situations or investing in a suddenly depressed blue chip.

Here is an example:

In the first quarter of 2009, the ISE had dropped to 20000 from its peak of 60000 (November 2007) and the consulting company I was working for saw the stock component of its investment portfolio drop more than the market itself. But the bond portfolio was unharmed and represented, at the time, 75% of the portfolio. As the market had hit rock bottom, I proposed to the management the following investment plan:

In the first phase, the stock component would be restructured by selling all the stocks except two of them. Then the proceed would be kept in the repo until an opportunity arises.

In the second phase, with the upcoming of the opportunity, the money stationed in the repo and the bond component would be merged to form a general reserve which would be used to invest in stocks.

In the third phase,  the general reserve would be invested in 10 stocks in total but TL equal weighted once the risk level of the market becomes meaningless.

The opportunity came on 23032009 and the portfolio was invested altogether into 10 stocks and the former 2 stocks that were present in the portfolio were first sold and the proceed was passed to the general reserve. The overall performance of the portfolio until November 2010 was 280% whereas the stock market's return was 200% (when the investment had been undertaken, the market stood at 23000 and when the portfolio was sold, it stood at 70000)...

THE NEXT STOCK MARKET CRASH

THE NEXT STOCK MARKET CRASH

The U.S. had printed too much money during the 2008-2009 financial crisis and while the property market was going through a major crisis due to the sub-prime mortgage scheme, the financial institutions' crisis forced the Fed to bail out a number of them. Then, the Fed has tried to encourage investment and spending by lowering the interest rates by force (historically low short-term policy rates, repeated reassurances that interest rates are going to stay low for some time and quantitative easing). The bubble that emerged ever since in the stock market has been characterized by the investment into the blue chip stocks that could be bought and held forever with confidence. The mutual funds have been presented as the safest and the fastest way to get rich for the common man. As the bubble expands, investment managers use aggressive investment techniques in order to generate huge increases in the value of their mutual funds shares. As mutual-fund asset values goes up, new money pours in. Thus, we have a self-reinforcing process which gives the false illusion of a money-making machine for everyone. But as the value of the assets has reached its intrinsic value, the thin spread between price and value forces the investment managers to take on more and more risks in order to generate adequate returns.

We can say that the next financial crisis will be due to the mutual funds as the decline in prices will inevitably be followed by a drop in the value of their assets. This will be triggered by the expectation that the Fed is about to end its quantitative easing program later this year (expected in October) which in turn should result in a rise in bond yields. Institutional investors  are in search of avoiding risk and will start soon to switch from the overvalued equities to the bonds which seem to be overvalued. The current bet in the market is on the extended period of low yields and are willing to invest for longer terms i.e. 30 years but these long term bonds do not offer adequate protection against any future rise in the interest rates.

Consequently, as the investors will get worried by this decline, they will start to cash in their mutual fund shares which in turn will force the investment managers to sell more assets thus starting a downward spiral. This may result in a severe drop in the stock market (say between 30% - 50% range) within a period of two years. But the blow will hit harder the stock markets of the emerging countries where drops in the 70% - 80% area would not be uncommon.

When the market will hit the bottom, a new area will open and we will see the rebirth of the value investment. Following the bottom out of all the main stock indexes, in all cases the recovery may be a slow process. Although some of these markets will recover faster than the others by returning to the original level within a couple of years, in real terms, this will take longer than expected with the inevitable surge in the inflation coupled with the rise of the interest rates. 

THE COMPLACENCY SYNDROME IN THE CAPITAL MARKETS

The brokerage firms such as Merrill Lynch have conducted a survey among the global fund managers and all have reached a common conclusion: the investors are afraid the most about "Geo-political" crises. The Geo-political crises are namely the shooting down of the Malaysian passenger aircraft over the Ukraine, Israel's actions in Gaza which could create reactions in the Muslim world. While all these have been realized, the spot market has reacted weakly to them. In the derivative markets which provide an insurance against such risks, a complete insensitivity is raging. This insensitivity is called complacency syndrome and the actual mental state  has become the threat number one to the capital markets. Complacency is a windfall for the states such as Turkey which are following nonsense economic policies. Bubbles will soon begin to take shape in the world capital markets. Then what could end this complacency and when will it occur?


 The world is crawling. ISID's victories in Iraq and Syria are causing thousands of mujaheddin to come to the region and the actions of Israel in Gaza is causing a reaction in the Muslim world with an increasing pace. In such an environment, if a 9/11 type terrorist attacks repeat, one should not be surprised. Also, the ISID which has repulsed the Iraqi army should be expected to undertake an offensive towards Baghdad and Kirkuk in which case, it will create a panic in the Brent oil market.

According to the Western states,  the Malaysian passenger aircraft was shot down by the East Ukrainian separatists with the missiles and tactics provided by Russia. Accordingly, we may see the announcements of new sanctions against Russia which will target the energy and financial sectors. Putin will not stand empty-handed; the world is drifting towards a new Cold War.

But the reaction given by the financial markets to the shocks that could potentially change the history of the world is very weak and transient. When the crises abrupt, the markets sell a day or two, and then continue their journey to the peaks of 2014. This apathy is understandable in the spot market. Even if the large funds understand the medium-term risks, they cannot explain them to the customers to whom they are making sales without the reflection upon the economic parameters. Because the "Geo-political" issues are raising uncertainty about the future, one would expect the investors to purchase insurance  in the futures and options markets.  Perhaps what is happening in the Middle East and Ukraine did not change my expectations of a positive return on shares  but I can say that the uncertainty as to my expected return has increased. I would protect my portfolio by buying puts and by shorting the index futures. Furthermore, the premium to be paid for such insurances is historically low. But the investment funds are not tempted by these insurances, and if they did, we would have seen jumps in the volatility indices, mainly in VIX.

That's what we call behaving as if there were no imminent and obvious risks. There are several reasons for such complacency. First, there is the common perception that the Fed and ECB will preserve the the financial system in case of an occurrence of adverse shocks. Second, financial asset prices other than "junk bonds" are not very expensive.Third, the world economy has an accelerating momentum and the investors think that the Geo-political crises will not suffice to curb this momentum.

It is very easy to predict the consequences of complacency. For a few weeks, the S&P 500 and other global stock exchanges will test new highs with the coming of strong sales and profit figures compared to the past. Then re-acceleration of the world economy will be priced in the marketplace. When October is reached, this complacency will turn into a bubble i.e. speculative pricing in the critical financial markets. In October, with the official start of the Fed's exit from QE and/or the heavily indebted Euro-zone states are such a bad shape that not even ECB will be able to save them is understood, a disturbance will begin. As the prices are too high, panic sales will follow in case of a bad news or a slight shock. 

Of course, the markets will anticipate this, thus the panic sales may start in September but may be delayed until the end of the year. But one thing is for sure: the result of any complacency has always been a bubble and a financial crisis and in the process, we are now very close to point of no return.

ARGENTINA'S FOREIGN DEBT: THE TANGO WITH DEATH

ARGENTINA'S FOREIGN DEBT: THE TANGO WITH DEATH.

We see statement ads appearing in the American newspapers. One days the Argentine Government publishes a statement with the following heading: "A handful of vultures is rendering Argentina insolvent and thus threatens the world economy." The following day, you can see a statement coming from the investors who are accused of being vultures as follows: "We are not vultures. This is our investment and there is a court resolution regarding it. We want to have our rights on it; because the Argentina's Government does not accept us as interlocutors, they are risking the world system."

Then what is the problem? Argentina could not pay the bonds maturing in 2001 and became somehow insolvent. Then in 2005, a debt restructuring agreement was made with the bond holders​​. A further restructuring of the debt had been made in 2010. It was a bond stock worth about 100 billion dollars. And the interest rate was too high. With the first restructuring, an agreement had been reached with 76% of the bond holders in 2005. They took their new bonds and retreated. Then in 2010, the number of investors with whom an agreement had been reached attained 93%. But the remaining investors refused to enter into agreement. These bonds had been accumulated by some vulture funds. Recently, the U.S. Supreme Court announced that the Argentina's Government had to reach an agreement by paying an interest for the period without agreement too as well as for these bond holders. When Argentina saw the bill put before her by the court, she said "that's too much!". And that is precisely when the war of ads begun.

Why did it happen? For a very simple reason. The payments to the bond holders were being done through Mellon Bank of New York in New York. Because the transaction was taking place in the United States, the American courts could come into play quite easily. Because the U.S. dollar was a reserve currency, the American law was valid everywhere.

But another news came forward. The French Finance Minister Michel Sapin gave a statement where he stated in a romantic fashion that the reserve currency characteristic of the U.S. dollar should be brought to an end. The French Minister was quite unhappy about the 9 billion dollar fine given by the American courts towards BNP Parisbas. BNP Parisbas had performed transactions with Soudan and Cuba without respecting the sanction decisions taken by the American Congress. Transactions effectuated against the sanction decisions brought 9 billion dollars fine. BNP Paribas accepted this fine. There was nothing left to Michel Sapin other then complaining. The big French bank blatantly did not respect the American sanction. That was the first mistake. More importantly, the French Government did not determine even on its own the transactions that were contrary to the sanction. And that was the second mistake and it was a severe embarrassment.

The sanction comes out from the American Congress. The American Courts rule for fines to the ones who do not comply to it. And the French bank said "yes" to it. And the only thing that the French Minister can do is to complain about it. As a matter of fact, there is nothing that he can do. Why not? Because the world keeps on working with the U.S. dollar. The world has about 10 trillion U.S. dollar of reserve currency. 60% of it is constituted of U.S. dollars. The remaining is acting like a dwarf: their trading volume do not beyond billions of dollars. China's money is kept in the depositories of the United States. Why is everybody investing in China where there no law? Because its money is kept in the United States. If a problem arises, you open a lawsuit, obtain a freezing of the assets and then make the necessary collection. BNP Paribas is paying its fine. Argentina will try to reach a compromise with the bond holders with whom she did not reach to an agreement. The resolutions of the American courts are going to be applied and Argentina will be forced to comply to them one way or the other...

If successful, all these things could make us think that one should expect a similar development regarding the other populist Latin American countries such as Chile, Venezuela etc. The aim would be nothing more than the destitution of the populist governments and their replacement with liberal governments. Let's see what's going to happen...

ECONOMIC PREDICITIONS UNTIL THE END OF 2014

ECONOMIC PREDICITIONS UNTIL THE END OF 2014

Following the declaration of Bernanke in previous May stating "I think we may exit QE", the emerging markets faced two small crises. Since the middle of March, the risky assets, i.e. stocks, emerging markets' F/X, and the bonds across the world have witnessed a strong rally. What will happen for the remaining of this year? Will the emerging markets face a major crisis or will they continue to see a rally?

The rally may continue until the end of September in the risky markets. In order to have a change in the guidance of the Fed which fuels the risk appetite in the markets, one needs a rise of 3% in the wages which in turn cannot materialize in the short term. The ECB may perform an additional QE during the period of September-October. Thus, we have a substantial liquidity present in the markets.  The world economy has left behind the state of hibernation and the overall recovery has spread. 3Q profits from companies are expected to exhibit good performance. Valuations are expensive, but the "fury" or "bubble" stage is not present for the time being. There is still a large amount of cash present in the global funds. Volatility indices are in the bottom of the latest 5- to 7 years and with the exception of geo-political crises, there are no reasons for its rise for the time being. The momentum is very important in the financial markets: the momentum of the rally of 2Q is expected to continue in 3Q.

What is going to happen in the last quarter of the year?

Risks will increase geometrically as the end of the year nears. In October,  asset purchases of QE of the Fed will stop. Markets will inevitably ask the questions as to the increase in interest rates once again as well as the time of the dose and how long it will last. While market players will be searching for the answers for a while, a profit taking is quite possible. How much inflation will cause the global growth? With  the looming rise in food and oil prices while the output gap is closing around the world, central banks constituting the reserve currencies may be forced to withdraw the previous optimistic discourses. At the end of Q3, the financial assets will see a bubble in their prices and even in a small shock wave will set the stage for a hard sell.

The most fortunate of financial assets:

The Japanese and the emerging markets' shares are among those highly recommended. Both have historically low P / E averages.

What are the most hated assets?

U.S. and Euro-Zone (EU) "neighboring countries" (Greece, Portugal, Italy, Ireland and Spain) government securities premiums are excessive. The very low returns cannot be explained by economic or political developments. These assets are kept afloat with the generosity of the central bank and the carry-trade.

Euro, gold, and oil prices will trade how?

No one will earn any money in 3Q. It is likely that the EUR/USD will decline in the short term. But there are formidable barriers to the rise of the Euro; ECB does not want it. Thus, the EUR/USD will trade in the band of 1.35-1.40 during 3Q. This situation will provide a partial support to the gold and oil. The retreat of the gold till 1.000 USD/ounce has become a sort of a dream now. The gold is expecting the inflation to surface in the United States after which it will make its major move. The biggest support for the gold stems from the fact that the United States' real interest rates will remain very low for years to come. The reasonable goals for the gold in 3Q would be a trading zone of 1.350-1.400 and a year end target of 1.450. The decline in the oil prices is caused by the supply dynamics; for example, the United States has risen to the position of number one producer of oil after Saudi Arabia within two years. The world economy will never reach its previous power which sent the Brent barrel's price to 140 USD. The Brent oil may trade 100-110 USD but one has to consider the geo-political risks. The scary scenarios would be the failure to achieve a peace agreement between Iran and P5+1 and ISID's jihad in Iraq inspires terror and sabotage in the oil-producing centers of the Arab world.

Sales in the emerging markets will begin in October:

The Presidential election in Turkey do not cause a threat but the economic policy that Erdogan is going to apply in this position will look more like a time bomb. Professionals such as Babacan and Simsek will not be present in the new cabinet. The government will undertake a rapid economic growth campaign by forcing the Turkish Central Bank. We shall see a renewal in the rise of the current account deficit and inflation. With the Fed going out from the QE which will ignite the escape of the speculative funds, the Turkish Central Bank will be forced to raise its interest rates again. Turkey's dream will end by the end of this year and the nightmare will begin.

What are the greatest dangers facing the world?

Clear risks are no longer seen on the economic front. Dangers such as the failure to improve the economic growth and the transition to the deflation in the EU are present but they will evolve very slowly and the investors will adjust their positions by anticipation. But the political arena is a brewing pot. The war in Iraq may soon become a battle ground encompassing the whole Middle-East. Does Russia have another objective after the defeat in Ukraine? Will Argentina and Venezuela, which are the problematic countries of Latin America, have a balance of payments crisis which in turn will shake to the ground all the emerging countries? Will the dispute between China and the other regional countries over the continental shelf turn into an armed conflict? And the most important question: will the fundamentalist Islamic terror that took roots again in Afghanistan and Iraq, undertake a new tragedy of 9/11?
 

EQUITY TRADER: THE DECK OF CARDS

Any equity trader could improve its portfolio's growth by considering two decks of cards which have in total only 108 cards. The normal procedure will be to consider 52 cards to represent all the investments done in one single company at a time during the lifetime of the portfolio. For example, if the trader opened a position for a single company by betting the ranch, he will put away one card from the deck of cards. And he will repeat this process for the remaining investments. The red ones will represent the investments which resulted in a loss while the black ones will represent the investments which resulted in a gain.

Once the deck of cards is out cards, the equity trader can not make any more investments at all. Under those rules, he will be forced to think carefully about what he is going to do and thus, in the long run, he will do much better.

One will ask himself why such an approach? Quite often, the traders overemphasize the concept of portfolio diversification while their initial capital is low. Then, they have a tendency to think of placing their limited capital here and there, and then wait for the results while hoping for the best. Instead, they should concentrate upon one company at a time and set to themselves a take-profit level; once reached, they will transfer the grown capital into another company and this will continue until a satisfactory level is reached. Thus, with the use of a deck of cards, this will simplify the matters and put some discipline into the affairs.

This approach is very simple and is very efficient in changing the life of the trader. It will help him quite a lot in beating the market by a wide margin over a long period of time.