TACTICAL VIEW:
Midnight Madness
by Justice Litle
Editor, Consilient Investor
August 8, 2007

I've always been mad, I know I've been mad, like the most of us...
- Pink Floyd, Dark Side of the Moon

IN BRIEF:

- Two years ago we wrote of Financial MADness: the doctrine of Mutually Assured Destruction in regard to international credit flows. Now the day of MADness -- via China's open threat of the ‘nuclear' option -- has finally arrived.

- The Japanese Yen, now rising, is another area Tactical View has focused on. The nature of the carry trade is such that the Yen was bound to go up in a credit crunch; if things get really bad, it could skyrocket.

- Regarding madness of a different stripe, it is always a spectacle when a crazy man goes insane. That is essentially what happened to Jim 'Mad Money' Cramer last week. Cramer urged Ben Bernanke to panic along with him; the Fed Chairman chose to play it cool instead.

- The action in Treasury Inflation Protected Securities (TIPS) is worth noting here; regardless of how well Bernanke has played his hand, we feel the Austrian endgame is one he cannot win in the long run. TIPs could be setting up for a trade.

- Small cap stocks are not in a happy place, as evidenced by the performance of the Russell 2000 index. Nonetheless, there will still be excellent buys in small-cap land as we move toward a "market of stocks" rather than a uniformly bullish "stock market."

- If Jerry Seinfeld were a trader, he might be asking "What's the Deal?" in regard to gold stocks. We suspect "the deal" is related to the short-sighted, "wham-bam" nature of many hedge funds.

- Crude oil is taking a hit, unsurprisingly, as a buildup of record net long positions is followed by the inevitable shakeout. If the decline continues, there could be tantalizing bargains in the energy patch.

- The ghost of Thomas Malthus, as channeled through Harvard historian Niall Ferguson, is looking vindicated (for now) as wheat futures climb to new heights.

ROUGHLY TWO YEARS AGO, your humble editor wrote of "Financial MADness," i.e. the doctrine of Mutually Assured Destruction as applied to international credit flows.

In the spring of 2005, this is what we said:

As of year-end 2004, China had more than $600 billion in U.S. dollar reserves. That is a sum that could effectively tear the financial plumbing system apart, if it were unceremoniously dumped on the markets with such massive pressure in a compressed period of time the pipes would surely burst. Of course, this would be fiscal suicide for the dumpers as well, which is precisely why such a move is not feared. China's own economy would be sucked into the vortex too, so why would the Chinese put a gun to their own heads?

The theme that applies here is the doctrine of mutually assured destruction, or MAD -- but of the financial sort, rather than the nuclear.

A product of the 1950s, the doctrine of MAD essentially states that two parties with the capacity to destroy each other will recognize the folly of hostilities. We liquidate the Soviet Union, they liquidate us and nobody wins. So peace is assured, right? Wrong. The flaw in the theory comes in the form of a question: What happens if one side or the other is thrown into political turmoil, or if the reins are taken over by madmen with nothing to lose?

We said more, of course, but hopefully you get the idea. So why dredge that up now?

Because here and now, in 2007, MADness has struck. With a bit of delay, the scenario has come to pass. Dateline August 8^th, the UK Telegraph writes:

The Chinese government has begun a concerted campaign of economic threats against the United States, hinting that it may liquidate its vast holding of US treasuries if Washington imposes trade sanctions to force a yuan revaluation.

Two officials at leading Communist Party bodies have given interviews in recent days warning - for the first time - that Beijing may use its $1.33 trillion (£658bn) of foreign reserves as a political weapon to counter pressure from the US Congress. Shifts in Chinese policy are often announced through key think tanks and academies.

Described as China's "nuclear option" in the state media, such action could trigger a dollar crash at a time when the US currency is already breaking down through historic support levels.

Bottom line: you can look to periodicals like the Wall Street Journal, the Economist, and the Financial Times for in-depth analysis of what's happened after the fact. 

It was not two years ago, but rather just a few months ago, that we covered the ins and outs of the Yen carry trade and the spectacular unwinding of 1998 (see Macro Musings: Carry On). More recently -- and before the present turmoil -- we nominated the Yen as the "mystery currency" Warren Buffett has hinted at having a big position in. (The Canuck Buck would be our second guess.)

Thanks to Jim Cramer, now we know. Last week the man went mad... if only for a few minutes. (If you haven't seen it, this is a can't-miss spectacle to behold. Click here for the YouTube clip.)

Offhand synopsis: He has no idea! No idea! NO IDEA! I tell you I have not seen this since nineteen-ninety blah blah when I went five bid for blah blah in blah blah! ASLEEP! Bill Poole SHAME! NUTS! SHAMEFUL! Yeeearrrggh!

Watching that clip, I kept thinking of Private Hudson (Bill Paxton) from Aliens:

Private Hudson: That's it man, game over man, game over! What the [bleep] are we gonna do now? What are we gonna do?

Carter Burke: Maybe we could build a fire, sing a couple of songs, huh? Why don't we try that?

Amusingly, Ben Bernanke -- the ‘academic' with No idea! No idea! NONE! -- elected to play the calm, unflappable Burke to Cramer's manic Hudson.

The Fed's decision to leave interest rates unchanged on Tuesday -- and not immediately ride to Wall Street's rescue as Easy Al would have done -- was perhaps Bernanke's way of saying Gentlemen, gentlemen... Relax. Toast some marshmallows, hum a little Kumbayah. You leveraged your way into this, now deal with it. No cavalry coming just yet.

Based on the post-Fed bounce (as of this writing), Bernanke's cool response seems justified... and Cramer's "Armageddon" call a tad overdone for now. "Helicopter Ben" has enhanced his credibility by refusing to open the emergency spigot at the drop of a hat (or rather, the drop of an index).

Those who think Bernanke is wrong to be calm, don't forget: the Fed can always act on the spur of the moment if need be. If things deteriorate much further, Bernanke can respond with a surprise inter-meeting cut. (Greenspan was no stranger to this move; as a commodity broker back in 2000, I recall an inter-meeting ‘surprise' that made a client $30,000 in 30 seconds via S&P futures. Not bad for a quick trade.)

While we grudgingly respect Chairman Bernanke's savvy thus far, we feel there is no way he can win a rigged game... the Austrian End Game, that is, in which the ultimate decision is to "destroy the economy or destroy the currency" as Von Mises put it.

For Fed Chairmen and heads of state, the Hobson's choice outlined by Von Mises is really no choice at all. It's a no-brainer for governments to gradually debase their currencies in service to false stability, as they have been doing consistently since Roman times.

Thus we watch the uptrend in TIPS with interest. Upside follow-through on this recent correction could make for a swing trade entry. As shown in the chart above, the TIPS ETF has registered a clear change in trend and broken solidly above its 200 day exponential moving average (green line), where it now seeks support.

We don't rejoice in the fall of the Russell 2K, though Tactical View has recommended buying long-dated puts on it more than once these past few months. Instead it is noted that what we have, now that the bloom is off the rose, is more a diverse "market of stocks," as opposed to a bullish one-size-fits-all "stock market."

Though the days may be over when any old thing gets bought -- no more windstorm for the turkeys to fly in -- there are still a lot of excellent small cap stocks out there worth scooping up.

If Seinfeld took up a new career as a trader, he might now be asking, "What's the Deal with Gold Stocks?"

Gold is supposed to the be anti-dollar and, by extension, the obvious port in a storm when credit markets go kablooey. Why, then, is gold merely doing "okay" even as Lloyd Blankfein's nightmares come true... and why have gold stocks fared so poorly?

We suggest it has something to do with the short-term, "wham-bam" nature of many hedge funds (as described in Coyote Dawn).

These "wham-bammers" do not discriminate on the long side; they know the inflation story and they are willing to buy anything that's going up, including gold and gold stocks. The problem comes when hot money hedge fund portfolios get hit hard by general market adversity. If a fund is bleeding badly in one area of the portfolio, other areas of the portfolio are affected too; the risk manager screaming at the top of his lungs doesn't care about the internal logic of this position vs. that position. In a time of crisis, everything gets trimmed.

Perversely, this can lead to gold stocks getting dumped along with the rest of the market, as retreating wham-bammers throw out the good with the bad. The action in turn leads to short-term technical decay, which feeds on itself in a self-fulfilling prophecy.

Ah well; their short term loss can be our long term gain. Patience and foresight often pay dividends; panic and short-sightedness almost never do. There are some gold stocks that represent excellent value at current levels, given that further dollar debasement is a dead lock and inflation will no more be ‘contained' than subprime was. (Trillion dollar Iraq war anyone?)

The CFTC Commitment of Traders report shows large speculators (hedge funds, institutionals and commodity trading advisors) net long a record number of crude oil futures contracts, roughly 110,000 to the bullish side. Such a heavy weighting increases the odds of profit taking, as gasoline prices soften a bit and OPEC hints at a willingness to increase production. The market's nonresponse to new oil-related violence in Nigeria suggests temporary saturation on the long side.

Whether the selloff picks up steam or not, we aren't deeply interested in shorting crude (except, perhaps, as a potential portfolio hedge for concentrated energy stock positions). Instead, we'd rather watch for confirmation that the coast is clear to pick up energy-related bargains on the long side. (And what bargains there could be...)

Some people worry about peak oil. I worry more about peak grain.

The fact is that world per capita cereal production has already passed its peak, which was back in the mid-Eighties, not least because of collapsing production in the former Soviet Union and sub-Saharan Africa. Simultaneously, however, rising incomes in Asia are causing a surge in worldwide food demand.

Neo-Malthusians are a small but vocal lot; we'd rather not rile them up by expressing too much distaste. Especially considering that, in the short run, the grain markets are backing Ferguson's Neo-Malthusian view. Whether Malthus' ghost is ultimately vindicated or laid back to rest by technology, the threat of food shortages -- and consistently higher grain prices -- is a fixture of the times.

We can see this in the weekly CBOT wheat futures chart, which has taken on a vertical disposition as of late. This presents another reason to take the stock market meltdown in stride; there are a lot of agriculture-related plays out there that could soon be very good buys, if they haven't been discounted to favorable levels already.

And that's all this week from Northern Nevada, where the weather is cool and crisp even as a heat wave blankets the country. May you prosper in this mad, mad, mad, mad world.

Profitably Yours,

Justice

© 2007 Justice Litle
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