Video Commentary for Wednesday, August 20th, 2008

Risk in Russia’s Realm: Omnipresent Geopolitical Danger

With much fanfare, investment in emerging markets has become increasingly popular in recent years. While there have long been specialized firms targeting specific countries and regions for investment, in recent years a remarkable level of access to emerging markets has been granted to retail investors through an explosion of index funds, active ETF’s, and other investment vehicles. Backed by powerful media hype, Brazil, Russia, India, and China have been particularly thrust into the investing public’s eyes.

The World’s Emerging Markets are painted widely as ripe for nearly limitless growth, and many investors have cheerfully embraced their potential. However, as the current conflict in South Ossetia vividly illustrates, emerging markets around the world, including the BRICs, are frighteningly vulnerable to geopolitical volatility. Following the violation of Georgian sovereignty by 12,000+ Russian troops, Georgia’s stock exchange (www.gse.gov) suspended trading on Monday, and a call to their offices revealed they have no plans to re-open them as long as the conflict continues.  Meanwhile, Russia’s MICEX index gave up over six percent shortly after open only to finish up nearly four percent.  But while Russia’s markets managed to tack on some dollars on Thursday, it is difficult to imagine a situation where any positive value could be added to their economy as a result of their conflict with Georgia.

Despite fiery rhetoric from both sides, the end economic result of the conflict will almost undoubtedly be a net loss for both Russia and Georgia.  In Georgia, investors not only had a rapidly developing free-market eager for capital, they had a brilliant president fiercely pursuing membership in NATO and the European Union. They had a nation in line for large sums of aid from an increasingly friendly U.S. And according to the C.I.A. World Factbook, they had the most literate nation in the world. In short, just a week ago, Georgia had enormous economic potential, and was on track to becoming one of the Emerging World’s most eligible economies.  Now, Georgia’s people are scattered, its industries are shut down, and its leaders are in hiding. Unspecified amounts of damage have been inflicted by Russian air strikes and artillery throughout the country. Russia will likely increase the already considerable economic sanctions levied towards its southern neighbor.  Most importantly, the psychological damage done to Georgia’s economy in the eyes of foreign investors is unquantifiable.

While it is not difficult for many investors to see how investments in a developing country roughly the size of West Virginia can quickly implode in the face of sudden geopolitical pressure, it is important to note that Russia presents high levels of continuing geopolitical-related risk as well.  As the European Union reaches further towards its giant neighbor in the east, additional rows have the potential to erupt into economic and military conflicts.  Trouble with Poland or the Czech Republic would have exponentially more serious consequences than the current war in South Ossetia. As the two countries creep closer to installing components for a U.S. Ground-Based Midcourse Missile Defense System, tension will continue to rise in Moscow. Beyond those current sources of potential trouble, former Soviet Republics will continue to reach out to the west, to the dangerous chagrin on the Russian government. Russian Prime Minister Vladamir Putin, who seems to have a solid grip on power in the Kremlin for the considerable future, remarked in 2005 that the breakup of the U.S.S.R. was “the biggest geopolitical disaster of the 20th century”. One would guess he won’t be pleased by its continued fragmentation. The current conflict proves he is not afraid to deploy the country’s military to keep Russia’s sphere of influence intact. Next time, the consequences for Russia, and its economy, could be much higher.

Russia isn’t the only BRIC member potentially subject to deadly geopolitical pressure. China’s relationship with Taiwan could still lead to serious economic isolation or worse for the PRC, should an overly aggressive government play rough on either side. India faces declining, but still serious hostility over Kashmir, in one of the few world hotspots primed for nuclear showdown.  Brazil seems comparatively safe, but could be affected by conflict amongst its northwestern neighbors.

In short, Russia’s aggressive actions over the past several days should serve to remind investors that when stockpicking in the developing world, sudden turmoil can move markets. Retail investors in particular should carefully fit such investments into their acceptable risk profiles. Because, in today’s emerging marketplaces, you never know where you might stumble into the next Georgia. 

-Sean

Update: Cross-Posted/Featured on Seeking Alpha

Resisting False Hope: A Playbook for the Global Bear Market

If there was any doubt remaining about the continued ill-health of financials, Thursday’s session certainly ended the debate. The bad news from American International Group (AIG), Bank of America (BAC), and Citigroup (C), which chilled the market Thursday will go nicely with the bad news from Fannie Mae (FNM), due just in time for Friday’s session. Clearly, the financial sector has additional write-downs on the way, but deeper problems for the wider economy linger beneath the surface of the media’s current focus. Reporters, executives, and investors alike are grossly underestimating the effect the current economic slowdown will have on consumer spending. As middle class families deal with the increasing reality of a tightening economy, the market as a whole will feel the pain.

 

Instead of retreating to the relative safety of capital preservation strategies, intelligent traders can achieve significant gains by aggressively targeting the market on its way down. While ProShares UltraShort Financials (SKF) took a huge leap forward in Thursday’s session, there is still plenty of room left on the bandwagon. Get on. As write-downs continue and banks struggle to achieve satisfactory levels of capitalization, The SKF could pop an additional twenty to thirty percent. Traders should also look abroad, as problems in the U.S. bleed into the global economy.

 

One particular area of interest is China, which stands to realize considerable losses in the coming days, weeks, and months. While China has had plenty of trouble already (the iShares FTSE/Xinhua China 25 Index (FXI) has given up roughly 25 percent of it’s value already this year), sharply decreased demand from abroad for Chinese products and a weak dollar will push the market further down. The move here is to take a long position on FXP, the Chinese ultrashort fund from ProShares. One should note, positive publicity from a successful Olympics could give the Chinese market a temporary boost. However, the fundamentals here are bad, and as the U.S. economy stalls, China WILL move downward. In the tragic event of a successful terrorist operation in Beijing, investors will immediately crush the Chinese markets.

 

Commodities are another strong component of the bear market playbook. IPath’s Total Return Index Commodities ETN (GSP) is heavily weighted towards energy, allowing you to capture oil’s rebound a strong commodities in general.

 

Shorts on global financials (short IXG) and U.S. retailers, (short XRT) and a solid gold position (IAU) round out the playbook.

 

Sean

Weakness and Refuge: Broad Market Turmoil

Continued poor performance by the very sector that acts as the glue for capital markets has a nasty habit of unhinging the markets all together, creating wide instability across a menu of sectors, asset classes, and the market in general. It’s unfortunate then for bulls that financials will continue to serve as the market’s 800 pound anchor, dragging stocks down at worst, and keeping them from moving forward at best.  Many traders are now cautiously calling a bottom on financials, but they will have to keep searching, because the end ain’t here yet. While valuations on financials have come down quite a bit, and large sums of money have been written off, there is still plenty of turmoil to come. Ordinary people are struggling with rising commodities prices, increasing monthly mortgage payments and an upward trend in inflation. They are struggling to make credit card payments and cover their mortgage payments in full every month. Plenty of people are walking away from homes they have sunk tens of thousands of dollars into. Of course, none of this is good for financials, and as their liquidity begins to tighten as a result, fresh rounds of capital raising will be on the way.  While U.S. financials certainly still stand to suffer, we’re not going to see the same level of selling the market experienced in the past six months. In the U.S., many financials have gotten through the worst of the storm, though they’re not entirely safe yet. The real trouble ahead lies in the European financial markets, where like in the U.S., rising housing costs have become very problematic. Commodities are rising steadily in Europe as well. These fundamental pressures on the ordinary man are quickly rising toward the European banks, who are now maintaining nearly three times the leverage of their U.S. counterparts. We’ve seen the deadly combination of poor performance and high leverage in the U.S., and it’s very clear: when the bullet hits European financials, it will hit hard. There is no great way to trade a negative outlook on European financials in one fell swoop, but shorting IXG, the Ishares global financials ETF provides better exposure than say, the XLF.

With that said, the imminent earnings report from Fannie Mae (FNM) could send the financials, and the market in general for an interesting jolt in the very near term. I suspect we’ll get good news from Fannie, and subsequently see it recover from the punishment it took on the Freddie Mac (FRE) earnings, but I really don’t know. It’s tough to have confidence one way or the other in the current environment.

The recent rally in financials has been due largely to falling oil prices, which have propped up the market as a whole over recent days. While oil stood to take a wild downward slide after encountering the intimidating psychological mark of $150/barrel, it has now clearly gone too far. There has been solid support for oil in the upper 120′s, and we should see a climb back to those levels soon. Oil has had a nice bit of help on the way down: positive developments in Iran, solid rhetoric from the Obama camp, and generally favorable geopolitical developments. The good news has run out. $130/barrel, look out. 

As a result of continued trouble in the financial sector, I feel as if commodities are a good place to take refuge. Yes, they have risen quite a bit of late, but the market conditions driving their upward movement are still very much alive. I particularly like coal at the moment. It has taken quite a beating this week, only to recover somewhat on Wednesday. In general, it is highly undervalued in the current market, but that error will quickly be corrected. KOL is a good ETF play, and Arch Coal Inc. (ACI) is a standout individual pick. ACI has huge reserves, and is well positioned to benefit from clean coal initiatives both now and in the future. 

In the end, we are still in a bear market cycle, and traders should be mindful of this fact as they begin to call bottoms across the market. Things are still quite hot, and it’s not hard to get burned. With the Olympics kicking off, I’ll talk China tomorrow, and give my continuing vision for the market. Thanks for taking the time to read my thoughts. Best,

Sean

Update:Cross-Posted and featured on SeekingAlpha.com: http://seekingalpha.com/article/89705-commodities-provide-refuge-in-broad-market-turmoil

Vlepo

Over recent months, weeks, and days, increasing numbers of market-watchers have asked me to share my day-to-day outlook for the worldwide capital markets, and the global economy in general. I am always eager to provide my thoughts, and share ideas, news, and debate. Many of the recent conversations I’ve had with fellow investors have led to interesting revelations, detailed analysis, and specific investment & trading ideas. However, as the number of individual conversations I carry on increases, I am finding I simply don’t have the time to share my unabridged thoughts with everyone who asks for them. Vlepo-the Greek word for “vision” is my answer to this problem. On this blog, you’ll find my personal thoughts, reflections and analysis on the markets & my vision for where they are headed in the future. I’m not a licensed financial professional, and my comments should be taken as comments alone, and not as financial advice. Trading & investing involves significant financial risk, which every investor should consider on an individual basis before making any financial decisions. I welcome comments at all times, and look forward to an interactive experience as this blog moves towards its future. I hope you can benefit from my “Vlepo”. Best of luck as always.

Sean