Where the Owl is heading this Fall

Well hello, and welcome. Actually, I am not so sure about the welcome. And I guess I should instead say that perhaps you get a grudging hello.



I have only started this blog as a way of collecting my thoughts, getting them on digital paper, and preparing them for a book which I will inevitably write and then flog for millions. For those of you who have discovered it, I congratulate you on your good fortune....don't spread it about too much.


I want to begin by emphasizing that while these notes have everything to do with money and its shameless acquisition, I may not always be right. That's a tragedy. It makes no one more heartsick than me. What it will always be, however, is original thought.


You see, original thought is so essential to making money. If you are the guy who can spot what is happening before everyone else does, you are the one who benefits most. The only way that can be the case is if you are paying attention and drawing your own conclusions. I don't want to sound preachy (actually I don't care if I sound preachy, I am and I know best, so I will preach if I please) but too many people simply follow the herd. They don't think on their own, and this leads to bubbles, and if you are invested when a bubble pops, you will end up in a very bad situation.


I'll put it another way. If I am a crab on the bottom of the ocean, and I am told by all the other crabs that there are shiny metal pots with free eats in them, and I simply accept this as truth, I will likely go scurrying along thoughtlessly to my death. I should be far more concerned with where these pots came from, when they arrived, how they got here, why the food in them is free, what they are here for, and who put them there. If I am asking the right questions, I will be getting the right answers, and I will instead be watching the other crabs going off to their hideous dooms and paying pennies on the dollar for the assets they have left behind. I know this doesn't sound overly moral, and that is because it isn't. It is money and morality isn't part of the equation. If you are tedious and moral and are offended by either of those statements, you can share it about after you've made it. But first you have to make it.


So, lets get to the analysis. That is the important thing.


You'll note that in my narration, I am the crab who asks the questions. This means that I am the crab who is intensely interested in being appraised of all the facts and who, with them, can draw his own conclusions. My first suggestion to you is to find good sources of financial news and other mediums of information, and then to check them regularly. You will find lots and lots of causal relationships, and this type of knowledge is strictly essential.



The trick is not to follow the herd, but to lead it. This is not quite as difficult as it sounds. The fact of the matter is that by the time you are out at a restaraunt and hearing the smartly dressed posers in the next table over blabbing about some financial instrument, you should be moving on to the next big thing. A year or so ago, it was real estate. Every one was gonna be a real estate millionaire. Now, it is commodities. I'm not denying that there was money to be made there. I made it, but I would NOT be buying at a time when it is common knowledge.


If, for instance, I had purchased a house a year or two ago, I would likely be currently faced with negative equity (or a loss of a portion of my investment). Commodities are headed the same way. To understand why this is the case, and to then take this information further and identify the next big money makers, keep reading.


Last August, a Bear Stearns fund announced that it was worthless. A complete loss. This sparked the financial panic that led to a huge run up of the prices of commodities. But why? The reason lay in the method of operations of most large lenders. When a loan was made to any individual (regardless of how shady), it was broken up into portions called 'tranches'. These were then moved off of the banks' balance books and into structured investment vehicles and sold off. Combined with CDO's (collateralized debt obligations) the balance books of most banks were not too trustworthy. This proved a problem, as much of the business that banks do is with each other.


Banks simply were unwilling to lend to each other because they weren't sure that they could trust their books, and therefore that they would be paid back. This mistrust led to what is flippantly termed a credit crunch because banks began to hoard their money. This proved wise for some, but catastrophic for others. Because banks make their profits off of loans and money for lending was being hoarded, the financial system that underpins the American, and arguably the world, economy was threatened. Money became tight and even corporations across the nation began to delay projects due to the uncertainty surrounding their ability to obtain financing. This began to push unemployment higher.


At this point in time, fewer loans were getting done and adjustable rate mortgages continued to reset to higher rates. This meant that with banks becoming more cautious about their lending standards, fewer people could qualify for loans - and all at a time when people were beginning to lose their jobs. Rising ARM rates without accompanying increases in wages would be difficult in any situation, but when house prices had already been driven unsustainably high over the previous half decade through irresponsible lending practices which flooded the market with buyers - WELL! Foreclosures galore. Terrific and hideous swaths of destruction, depression, and despair. This was especially bad for the banks, as they had to liquidate their holdings in their SIV's, and nobody was buying. In the end, they were sold for pennies on the dollar. And why? Because there were growing numbers of houses for sale, and there were fewer buyers who could qualify. This meant that housing supply was high, demand was low and that prices were beginning to fall.


But I digress....actually, I don't. That implies that all this wonderful background information was a waste. It isn't and I don't waste my words. I'm far too clever for that.


There was no doubt, we were in a crisis. Who could come to the rescue? The Fed of course. They did two things, one of which was a trigger for a run on the commodities, and one of which kept our financial system stable so that we could work through this mess. In fact, I didn't just work through it, I porked my way through it like a glutinous piggy feeding at the trough of other people's problems. The first thing the Fed tried was rate decreases. This was important, as it acted as bait to encourage corporations across the nation to spend money on projects that they may otherwise not have tried. It is an important note here that companies will spend money on projects that yield a return greater than the cost of the money invested in the project, and will keep on undertaking projects until the return that they receive is equal to the marginal cost of money. As rates decreased, more and more corporate projects became feasible, and this stimulated the demand for lending. This helped to keep the wheels of commerce greased, and worked especially to the advantage of banks, who needed more customers at this period of time, not less.


The Fed, determining that these decreases in interest rates did not alleviate the trouble in the interbank lending sector, then set up a direct lending window, where banks could obtain short term loans from the Fed itself. Well! What innovation! It worked, and has probably prevented a global depression by averting the failure of the worldwide banking system. Don't get me wrong, it isn't that the system is fundamentally flawed, it is just that the fear that gripped the sector prevented business as usual, and the Fed allowed banks to buy enough time to work through their troubles.


So, knowing what happened and why, the question is how did I interpret the information in such a manner as to make a profit based upon it? It is really fairly simple. As soon as the credit crunch occured last August, it was evident that the Fed had to intervene. This meant an interest rate easing cycle, and as the EU and England were fighting off inflation and the dollar was already weak, the dollar would decrease in value as a response, but it was likely not going to be proportional in nature to any increases in commodities.


What do I mean by that? I mean that if interest rates in the US are lower than those offered in the EU and UK, that more money will flow to banks in the UK and EU, with the increase in demand for those currencies driving up their value in comparison to the dollar. The dollar would weaken in the international exchange, and its purchase power would decrease. A smart investor at the time would have purchased a commodity. I bought gold at $705 an ounce. I also said that the decrease in the dollar was likely not to be proportional to the corresponding increase in commodities. This is because as more people caught on, more would pile in and the sharp increase in demand for commodities would outpace the slow decrease in demand for the dollar. This is what I meant by leading the herd.


I sold out of gold at $920 an ounce, and do not recommend buying it any time soon. I made over 30% on the investment, and the drop in the dollar's index value was 12.5%. This proves that the response was not proportionate, and points to a bubble building. Oil and other commodities had also run up substantially. I got out because the situation which had driven me to put my money there no longer existed. Recently, the dollar has strengthened. The EU and UK, while still concerned about inflationary pressures, are more concerned about the strength of their economies and their monetary policy is no longer so hawkish. But the shift in the strength of the dollar is more than that. It isn't based on announcements from Central Banks, it is more subtle.


Watch:



You see the chart above? This is the dollar index since August of last year. It was already perilously low then, but it since crashed through support at around 80, and plummeted all the way down to around 71, where it hovered for a bit before beginning a strong upward rally around mid July.

Why? No policy decision was announced which would make this change. Rates stayed still. Only a shift in the demand for the dollar could have made this sort of change. If I am a European with my currency driven up to all time highs against the US dollar, and my Dax, or FTSE aren't yielding me much in the way of returns, and the outlook for real estate is glum, I will be looking to put my money where I will yield the best return.


You must understand that there is a tremendous amount of money on the sidelines, and everyone who has it is naturally anxious that it should be working for them. And right now, truly the only deal out there is the US stock market. The Dow has fallen from 14,400 to 11,000 and the US economy is not in as dire a situation as many fear mongers had expected.

What is also interesting to note is how gold has performed since mid July.





As you'll note from the chart above, it is down nearly $100.00 per ounce, which is just over 10%. Ouch! What this suggests is that a lot of money is leaving commodities, and that is only happening because the wealthiest people in the world have decided the same thing that I have: The US economy is gonna be fine and it is currently undervalued. Oh yeah, and commodities are a bubble that aren't producing yields anymore.


But you can bet that all that money is going somewhere. It isn't just being taken and put on the sidelines. You only make a switch like this if you are pretty sure you have a better place to put your cash. Somewhere where you can build a whole new huge bubble and collect fat profits while others catch on too late and buy out your stake only days before prices crash....Where could that be? How about somewhere in the economy where the goods are marked down by about 80%?


We remember the banks mentioned at the start of this little discourse. How are they now? Their share prices have been soundly thrashed. They have announced little but losses for several quarters now, but the SIV's and CDO's have been cleared away. Those little nasties were big problems, and like the hideous carbuncles that they were, they have been removed and now the banks aren't such grotesque prom dates anymore. In fact, they're starting to look mighty fine.


And the markets are forward looking. In about three months, banks will be reporting their profits for the third quarter of 2008, and comparing those to the third quarter of 2007, when their losses began to come in in earnest. These comparisons will look a lot more favourable than big losses in the first quarter of 2008 did compared to the fat profits in the first quarter of 2007 did. But what does the smart money think?


Let's look at a chart of one ETF that focuses solely on the financial sector and of which I am a proud owner:





See that little dip just to the right of the chart here? that was mid July. From $23 all the way up to $33 a mere weeks later. And this little beauty pays a fat dividend as well. 7% at the time I bought it. That sort of run does not happen without heavy volume pushing it. The same sort of heavy volume that occurs when pounds and euros are changed to dollars, and which strengthen a currency through the exchange to the point that commodities like gold and silver and oil decrease in price as a result. I think the pattern is evident, and would recommend two courses of action in the face of this knowledge.


First: Buy financials. ETF's like RKH, RFL, KBE, IAT, IYG, KRE, XLF, PRFF, VFH, and IYF are all potential plays and many of them pay good dividends on top of the potential increase you will see when the heavy hitters get back from vacation in August, and the banks start reporting their earnings against more favourable comparison statistics. Also, you may choose something that is optionable, as writing covered calls is usually a solid short term play. AND THE FINANCIALS HAVE NOT EVEN CLOSE TO REACHED THEIR PRE-PANIC LEVELS. THERE IS STILL PLENTY OF MONEY TO BE MADE. And, again, if I am European, any profit I make in the market will be especially sweet, as the rebound in the strength of the dollar will bring me more gains! I will win through the currency exchange as well as through any increase in stocks that I hold!





Second: Short Commodities. DUG, SMN, and DZZ are all good mediums for the attainment of this goal.





So there you have it. The background, the history, the whys and whatnots. You have to admit, the decision makes a lot more sense now that you understand the salient questions and their answers.





Now, here's your chance to get in early so that you can be the poser in the restaurant instead of the eavesdropper.