Commentary by Eoin Treacy

Important macro commentary - Thanks to a subscriber for this well reasoned report by David Rosenberg for Merrill Lynch covering the implications of the TARP ("Troubled Asset Relief Program) for inflation, Treasuries and gold. Here is a section:

We know, we know. Why do we remain bullish on bonds with the crop about to yield a major harvest (see more below on our reasoning)? Because, to come up with the price of anything, you cannot simply look at supply. You also have to look at demand, and we believe that retail and institutional investors alike will be seeking safe income-generating securities in a fragile financial and deflationary macroeconomic environment. If you only focused on pending bond supply in the aftermath of RTC back in 1989, you would have missed one of the great rallies in Treasuries in the subsequent three years.

Yes, the budget deficit in that period of RTC jumped 2 percentage points to 4.7% and yes, the fiscal pressures boosted the federal government debt by $1.6 trillion or more than 50% over that time frame. But in an environment where excess capacity was building in the real economy and banks were recapitalizing with a steep coupon curve in the financial economy, the demand for fixed-income securities overwhelmed the new supply issuance. Demand came from all fronts - the commercial banks about doubled their government bond portfolio to $700 billion; mutual funds raised their exposure by more than $50 billion; and the household sector directly added $220 billion of Treasuries to its balance sheet (expanding its exposure to govies by 70%).

One additional note: In the last credit crunch in the late 1980s, early 1990s, the household sector owned well more than $600 billion of Treasury securities. They now own half of that and the share of these bonds in the financial assets of the household sector is less than 0.7% - a historic low. We think this must have to do with concerns over the low level of the yield, but when investors more fully realize the return potential of the bond market - after all, a 4.8% yield on a 30-year Treasury bond twelve months ago managed to generate a total positive return for investors of 16% (compared, by the way, to a -20% total return in the S&P 500).

And take the commercial banks. When they were able to re-liquefy during the credit crunch of the early 1990s, courtesy of the steep yield curve induced by aggressive Fed rate cuts, the share of government securities in their balance sheet expanded from a 12% share to a 20% share, over a four-year period (1989-93). The current government bond share in the banking sector balance sheet is closer to 10% today - the lowest in three decades. So it stands to reason based on all this available data that despite the impressive bond rally of the past year, government bonds are still grossly underweighted in most private sector portfolios (including pension funds).

My view - As the supply of asset-backed securities dries up, fixed income investors have less variety to choose from so demand for Treasuries may increase. As long as volatility remains elevated, investors may also seek a safe haven in the Treasury markets. However, supply of bonds remains at historically high levels and the additional borrowing needed to fund the TARP will further add to inventories.

Deflation is currently the main concern for investors and it will take time for the system to absorb the full effects of the credit crisis. However, flooding the markets with liquidity, while necessary as a solution to today's credit problems, is helping to sow the seeds of the next inflationary cycle. No one in government is thinking about ever paying down the national debt with Dollars worth what they are today. Governments will always veer on the side of inflation to fix their problems and this occasion will be no different.

10yr Treasury yields topped out in 1981 near 16% and the succession of lower rally highs remains in place. The downtrend lost momentum considerably over the last 5-years and has not made a new low since 2003. Is their a possibility that yields could extend their downtrend with a sustained move below the 2003 lows near 3.1%? The quick answer is yes, but there are a number of technical milestones which would have to be overcome before that occurs. Yields fell abruptly to their January low and rallied well to a high near 4.25% in June. The most recent episode of climactic activity saw yields find support above the January lows near 3.4%. A sustained move below that level would be needed to reaffirm any bearish case for yields in the medium-term. From a long-term bullish perspective, a sustained move above 5% would be needed to complete the base.

The US Dollar Index (p&f, monthly, weekly, daily) has been in a downtrend since topping out near 120 between 2001 and 2002. Over the course of the last 30 years, the Index found support near 80 on 6 separate occasions. It fell below that level a year ago and has so far failed to sustain a break back above it. The most recent Dollar rally was the largest in years and encountered resistance near the old support level. It needs to sustain a move back above that area to question scope for further downside.

Gold continues to exhibit considerably less volatility than the other precious metals and has the most consistent chart in the group. Although this is a larger reaction than any to date, it remains in an overall uptrend with a series of steps one above another. It found support two weeks ago near $750 which was above the last consolidation and would need to sustain a move below that level to question scope for further higher to lateral ranging.

Platinum and silver have both experienced considerably more technical damage than gold. However, if gold continues to attract investor interest, it is only a matter of time before these metals regain their position of relative outperformance.

The Dow Jones Industrials Average almost doubled between 2002 and late 2007. It found support last week having retraced approximately 50% of its advance but remains in a consistent downtrend. The rally resulting from the Fed and Treasury's intervention has been impressive, and puts at least a near-term floor under the market. A sustained move below 10,500 remains necessary to question potential for some further higher to lateral ranging.

Astaire Research: The India Report - Thanks to Deepak Lalwani for his most recent update which concentrates on the impact of the credit crisis on India. Here is a section:

So, how does all this affect India? Perversely, the very bureaucratic and regulatory controls that have frustrated many international investors now actually proved to be a good firewall against the current virus from the West. India was already facing problems of its own . a clearly slowing economy, inflation near a 13-year high, interest rates at a seven-year high, a depreciating currency and record selling by FIIs ($8.8bn YTD reversing record purchases of $17 bn last year). So, what is/will be the short (up to six months) effect on India of the US-led credit crunch? (a) A leap in risk aversion making FIIs sell and reduce India exposure in light of the slowing economy; (b) Credit/liquidity becoming scarce for foreign firms. This will affect foreign funds led investment in Indian projects; (c) Sentiment for emerging markets being severely dented as there is a flight to quality. Despite these factors, it should be remembered that the Indian economy is expected to grow around 7.5% in this fiscal year, lower than the 9.1% last year, but much higher than most developed economies. However, the SENSEX valuation at 14x, while more realistic than earlier this year, is not yet compelling in the current climate. Expect high volatility to continue.

My view - This is the largest and most lengthy correction for the Indian stock market in quite some time. However, while the Nifty remains in a, so far, consistent downtrend, it is performing better than its peers on a relative basis. The Nifty found support in July near 4000 and would need to sustain a move below that level to question potential for some further higher to lateral ranging.

Morgan Stanley, Goldman Search for Deposits; Banks Are `Lunch' - This article by Ambereen Choudhury for Bloomberg covers the impact on regional banks of Goldman Sachs and Morgan Stanley changing their classification. Here is a section:

Morgan Stanley and Goldman Sachs Group Inc., the two largest remaining independent U.S. securities firms, may add to the $81 billion of financial services deals unveiled during the past week as they morph into banks.

Morgan Stanley plans to sell as much as a 20 percent stake for $8.4 billion to Mitsubishi UFJ Financial Group Inc., Japan's largest bank, to shore up capital. Goldman Sachs said that its new status as a bank will help it purchase assets.

Stock market declines of the past 10 days helped push Lehman Brothers Holdings Inc. into bankruptcy and Merrill Lynch & Co. into a takeover by Bank of America Corp. That's helped financial services leapfrog the mining sector to become the most active for mergers and acquisitions this year, data compiled by Bloomberg show. Regional banks probably will become ``lunch'' for larger institutions, JPMorgan Chase & Co. analyst Steven Alexopoulos told clients yesterday.

``We are seeing deals that are highly opportunistic and speedily arranged, where targets are distressed,'' said Marco Boschetti, co-head of global mergers and acquisitions at the Towers Perrin consulting firm in London.

Goldman Sachs, granted permission Sept. 21 to transform into a bank holding company, may raise capital to buy assets assuming it finds the right opportunities, said company spokesman Lucas van Praag in New York.

``If we see assets that are attractive, we might raise capital in order to be able to acquire them,'' he said yesterday, adding that Goldman has ``no immediate plans to raise capital.''

Circling Seattle
Washington Mutual Inc., the Seattle savings and loan that put itself up for sale this month, has at least five companies mulling takeover bids, said a person familiar with the matter yesterday. They include Toronto-Dominion Bank, JPMorgan in New York, Wells Fargo & Co. of San Francisco and New York-based Citigroup Inc., the second-, third- and fourth-biggest banks.

The next several weeks present a ``window'' for financial firms to issue new capital or merge, said Michael Mayo, a New York-based analyst at Deutsche Bank AG. The U.S. Treasury's plan to buy troubled assets, disclosed Sept. 18, and a temporary ban on short-selling make it easier to shore up capital, he said.

Morgan Stanley and Goldman probably will increase deposits by going after retail and corporate banking customers by selling products such as certificates of deposits, said Richard Bove, an analyst at Ladenberg Thalmann & Co. in Lutz, Florida.

``There's a whole bunch of small banks in the United States that might be willing to sell out to them, but not big banks,'' Bove said. ``Why would they want to link up with a company which is struggling to stay alive?''

My view - Regional Banks may be interesting targets for larger financials seeking to grow their deposit bases and have been outperforming both the S&P500 Banks and Diversified Financials over the last few weeks. The S&P 500 Regional Banks more than doubled from the July lows and is looking somewhat overextended. However, it would need to sustain a move below 70 to question scope for some further higher to lateral ranging.

Eoin's personal portfolio: FTSE-100 long stopped out at a profit - I was stopped out of my FTSE-100 long last night at 5190 against my purchase on Thursday at 5109, regrettably allowing most of my profit to slip away. Volatility remains high and this is an environment where trading profits need to be seized when available. I'm promising myself that I will follow my own advice during my next foray.

Email of the day (1) - on Blackrock Gold & General Fund:

"I am looking to make an investment in one of the Funds on David's investment list, (in addition to doing my own due diligence), and would like to ask to get the Fund name/label correct.

"The fund is the Blackrock AM UK Gold & General Fund (MRCGLDA).( - at least this is the one I have been tracking in my favourites folder on the fullermoney site).

"I am unable to find this exact equity fund on the BlackRock site. I found a World Gold Fund (equities (MIGGMFI LX)), and my money manager (Citi Quitler) are following Blackrock Gold & General Fund Inc (0173258). This is a unit trust.
(Same managers at least; G Birch/E Hambro).

"Any help would be appreciated.

"It's a great service, & I have learned so much in the last year."

My comment - Thank you for your inspirational comment and interesting question. Here is a link to where you can find the fund on Blackrock's website. They have both accumulation and income versions. Both can be found in the Chart Library.

Which countries have introduced limitations on shorting? - The USA, UK, Canada, France and Ireland have all put restrictions on short selling over the last few days. Australia, Taiwan and Russia have banned shorting altogether for varying periods of time. This type of activity is a powerful signal that governments are willing to change the rules to support their stock markets and are capable of further action if it is deemed necessary.

Email of the day (2) - on the possibility of an immediate spike in inflation:

"After listening to your audio today (22 Sept) I am stuck that with all the money the US Fed and Treasury intend to throw at the financial sector, the commodity sector is rising. Could it be that the investing public contemplates the inflationary potential of this massive bailout, and that instead of stabilizing the financial industry and markets by attracting investing capital to them, this bailout will instead directly fuel runaway inflation, not in a year or two, but right now?"

My comment - Thank you for this interesting question. The deflationary threat to the economy is probably more powerful right now than the effect of adding so much liquidity to the markets. But inflationary pressures will be building over time. Commodities also remain in varying degrees of a medium-term correction and their chart patterns do not currently appear capable of supporting anything more than a technical rally.

A lot of shorts in oil got squeezed yesterday as the October contract expired and the activity lifted the entire commodity complex. However, I would not expect action like that every day (oil 2nd month continuation) . In the last two-weeks most commodities found support and would need to sustain moves to new lows to question scope for at least further higher to lateral ranging.

The situation remains highly volatile and the outcome of the TARP uncertain. I would rate a spike in commodity prices as a serious headwind to stock markets, but also do not think we are not going to get one right now. Central banks are doing everything in their power to contain this crisis and if commodities were to surge again, I would not be surprised to see the CFTC introducing rules to combat speculation.

Please note - David will be away until Monday 29th September.

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