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A U.S. Liquidity Update

(January 3, 2010)

Dear Subscribers and Readers,

I hope all of you had a wonderful Christmas and a great start to 2010!  Pleasantries aside, it is now time to get back to business as we navigate through what should be one of the most interesting periods in U.S. financial and societal history.  That said, I have been under the weather over the last few days and thus haven't had time to review and polish my thesis for the Chinese economy (and its impacts on the rest of the world, including commodities).  Instead of providing you a half-hearted analysis, I will instead save it for next week.  In the meantime, I would like to provide you a quick update on U.S. liquidity.  I have also just written a book review on WSJ Senior Writer Gregory Zuckerman's book The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street And Made Financial History.  Many of you will find it a page-turner.  We have reproduced our book review in its entirety at the end of this commentary.

Throughout the last seven weeks, we have repeatedly asserted that the U.S. stock market was stuck in a short-term consolidation phase as it works off its overbought conditions.  Since then, the Dow Industrials has traded in a tight range of 10,230 to 10,600.  In our last commentary, we reiterated that this continues to be our stance for the foreseeable future.  This view is supported by the U.S. liquidity picture, namely the following chart showing the amount of "investable cash on the sidelines" versus the S&P 500 market cap:

Total Money Market Fund & Checkable Deposits / S&P 500 Market Cap (January 1981 to December 2009) - At its peak at the end of February 2009, this ratio spiked to a 27-year high 65.89%. There is no doubt that the March 9th low represented a major bottom for the US stock market. Since then, it has declined to 38.58%, and is now at its lowest level since the end of August 2008. This ratio has come down too far, too fast. This author is thus looking for the market to consolidate further, although the longer-term uptrend remains intact.

As can be seen in the above chart, the ratio of investable cash (retail money market funds + institutional money market funds + total checkable deposits outstanding) to the S&P 500 market capitalization has continued to make new rally lows.  In fact, this ratio - currently at 38.58% - is now at its lowest level since the end of August 2008!  While this ratio is still high from an absolute standpoint (especially compared to its historical record from January 1995 to December 2007), it has definitely come down too far, too fast.  Probability supports a continuation of the current consolidation phase in the market, unless: 1) A major central bank announces a new liquidity facility (the prime candidate would be the Bank of Japan), or 2) a major technology (one that could speed up U.S. productivity growth) is commercialized over the next several months (which is not likely).

In the meantime, the Fed's liquidity creation efforts (its “credit easing” policy) has been mediocre to average.  For the two weeks ending December 23, 2009, the Fed purchased a net $55 billion in agency securities (it is no longer purchasing Treasuries).  However, for the three weeks revolving around the Thanksgiving Holiday, its purchases were effectively halted::

Weekly Net Purchases of Treasuries and Agency Securities by the Fed (US$ billion) - After slowing down its purchases during the three weeks revolving around Thanksgiving, the Fed stepped up its purchases again, purchasing $21 and $34 billion in Agency securities over the two weeks ending December 23, 2009 (the Fed has halted its Treasury purchases). This was sufficient to support the financial markets till the end of the year. I expect the Fed 's purchases to be about average for January, given potential investors' fears about 2010. Unless the Fed further steps up its purchases, I expect the market to be range bound for a little more while.

As we head navigate the first month of the New Year, it doesn't seem like the liquidity situation will improve anytime soon (unless the stock market takes a dive).  In addition, investors may start getting more jittery as the Fed's credit easing program will be coming to a close at the end of the first quarter of 2010.  The wildcard remains the Bank of Japan - which may come to the assistance (by monetizing its debt or by buying US Dollars by printing money) should the Yen strengthens or should the Japanese government bond market get weaker.  At this point, the Bank of Japan is the only other central bank that is capable of influencing global liquidity, along with the European Central Bank and the People's Bank of China (which incidentally has tightened liquidity over the last few months).  Subscribers please stay tuned.

Following is our latest book review of Gregory Zuckerman's book “The Greatest Trade Ever.”

Book Review: The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street And Made Financial History

We know that in one of the most successful trades in financial history, John Paulson's hedge fund firm Paulson & Co., made $15 billion for itself and its investors in 2007, with the firm's two credit funds chalking up a whopping 440% return.  We also know that Paulson & Co. followed up with another impressive performance in 2008 by taking short positions in various financial stocks, with its flagship fund, Paulson Advantage Plus (with $7 billion in AUM), racking up a 37.6% return net-of-fees in 2008.

What we do not know about one of the most successful trades in financial history are the behind-the-scenes actors – actors at Paulson & Co., and others who betted against the U.S. subprime housing market – as well as the pains and humiliation that most of these actors suffered at the hands of their peers and investors when the housing market went against them in 2005 and through the end of 2006.

Written by famed WSJ writer Gregory Zuckerman and published in November 2009, “The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street And Made Financial History” is a Tour de Force  chronicling the rise of John Paulson from a mediocre merger arbitrage investment manager into a financial titan – one that Congress and even George Soros seeks for advice.  Paulson is intelligent and has always had a knack for making money – but an early career detour into consulting quashed his early chances at making it big in Wall Street.  Moreover – while it was not explicitly mentioned in the book – Paulson's financial background was all in merger arbitrage.  As any investor should know, merger arbitrage is a strategy that typically promises slow and steady returns.  Any extreme move in a merger arbitrage strategy is usually to the downside.  Paulson & Co. simply cannot “make it big” without venturing away from its core strategy (e.g. shifting from merger arbitrage into global macro) – and in the institutional investment world – any “style drift” usually lends to investor redemptions.  Paulson & Co. simply cannot take such a risk unless it was very sure that it would work (and only lead to minimal losses in the event that it does not).  To that end, the bet against the U.S. subprime housing market was the perfect bet – as one can glean from reading Zuckerman's book.

At its core, this book is about biases in investor psychology, human relationships when significant money is at stake, and a history about how the financial world and the U.S. housing market have progressed in the last 30 years.  It has something for everyone that is interested in financial history.  It provides the backdrop behind the financial crisis, the financial instruments but it does not detail the mathematics or the models behind the trades.  It discusses Paulson's relationships and conflicts with his friend Jeffrey Greene and his right-hand-man Paolo Pellegrini – both of whom had a falling out with Paulson despite (or in spite) of their collective successes.  Perhaps the best discussions about human relationships – especially in this context – were the ones Paulson (and other managers involved in the same trades) had with his investors.  As John Maynard Keynes would say: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”  The road to successfully constructing and implementing one of the greatest trades in financial history is a very long, treacherous, and difficult road, indeed.

Whether this book will end up being a must-read for global macro investors – such as Edwin Lefevre's “Reminiscences of a Stock Operator” or Jack Schwager's “Market Wizards” series will depend on Paulson's future success, but the elements are mostly in place.  Should Paulson continue with his streak of successes in the global macro world, a revised and updated edition of the book – a book that will be much more timeless – will be sorely needed.

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