There is no free lunch

So finally, the US govt has done what it should have done a year ago, but which is politically not feasible till a few companies blow up. The way brokerages and AIG fell last week resembled a bank run by depositors - only that the run was by shareholders, which made capital raising prohibitively expensive.

There are a few things that one can bet on right now:

a) Tax rates are going up in US. Somebody needs to finance the bailouts, and it is the tax-payers. So buy muni-bonds. This ain't a free lunch.

b) Earnings estimates are high now simply because corporate tax rates next year are going to be higher than this year. So forget $90 S&P EPS estimate. Be happy if we see $75.

c) Debt issued by financial sector companies is now a great place to invest, particulary with the US govt stepping in as a buyer in the credit market. If this enables the financial companies to clear their balance sheets and raise equity from marketplace, debt holders can really benefit.

d) The impact on dollar is unclear. Any other country, and I would have said short the currency. But because this is the US, and dollar has the safe haven status, I dont know what happens here. If there is a run on the dollar, it will become a bad nightmare.

e) Because the direction of dollar is unclear, the direction of commodities is unclear. Buying gold might not be a bad option after all right now. If the world loses faith in the dollar, gold can go up 2x-3x easily. All the Indian grandmothers will have a smirk on their face at that time - for they would think thet figured this out sitting in the homes while the high flying financiers on Wall Street got bankrupt.

A Global Sell Off

For probably the first time in this bear market, the prices of stocks across sectors has started falling simultaneously. Financials, retailers etc were falling in 1H. Now they have been joined by commodity and tech - which were rallying in 1H. This is the first true global sell off. The crisis has moved from Wall Street to Main Street.

An industrial capex slowdown?

One of the most resilient sectors of the last year has been industrials. It has been industrial exports that have kept US afloat over the last year. Now it is not financials, FMCG, tech, restaurants, retailers etc that industrials sell the majority of their goods to. Industrial capex thrives due to capacity expansion by commodity producers (steel, oil and gas etc), refining/chemical buildout, infra buildout, new power plants, auto plant expansion etc etc.

Have commodities fallen so much in the last month that commodity producers start thinking about scaling back their capex plans? Who is going to provide them funding for their capex plans if they havent yet tied up the funding? These are all long gestation projects - so if debt investors start demanding a higher interest rate for the risk, a project IRR's will decline sharply.

The slow beginning of deflation - the case for bonds

Commodity prices are cracking up left, right and centre. Ospraie - one of the stars of the commodity hedge funds - has blown up. The speed at which things unravel is sometimes startling.

Slowly but surely, the global real estate asset price deflation is moving to other asset classes. Is there any link between asset price inflation/deflation and consumer price inflation/deflation? Considering that we had a period of 2002-2007 (and many more periods before that), when asset prices (esp real estate) moved up sharply while CPI remained contained, one would argue that these are two different categories of inflation. So one should be careful in extrapolating asset price deflation to CPI deflation.

At the same time, I would be really surprised if we continue to have asset price deflation and CPI inflation. I haven't read any paper which has looked at the historic correlation between these two, so this is more of a hunch than anything else.

If this assumption indeed is true, it has profound implications. The wrong thing to do in a CPI deflationary environment is to buy equities. When prices that companies charge for their goods fall, they might pull down absolute profits left for shareholders, because it is not necessary that price declines lead to volumes picking up in a depressingly deflationary environment. The best time to buy stocks are when interest rates are rising from low levels to moderate levels (in response to accelerating growth), than when they are being cut from high levels to moderate levels (in response to decelerating growth).

So one needs to be higher up in the capital structure. Considering that spreads on bonds are also quite high these days when everyone is still worried about inflation, one can end up making a killing in bonds on a risk-adjusted basis. Over the next 5 years, inflation might come down and spreads might compress, so there is money to be made.

My biggest bet of the last year - being long on USD and short on Rupee - has wiped out all losses from 1H08. But, if things in US are as bad as I think they still are, Fed will cut more. The recent commodity price deflation and the USD strength has given them enormous wiggle room. So we might see another period of USD weakness in the next 9 months. But that again is bullish for bonds. The interesting thing to watch would be whether it leads to another commodity spike.

There was one more trade I had tried to do earlier this year - shorting the pound when it was at 1pound = $2USD. I couldnt figure out how to execute it economically. Now it is $1.80. It is amazing to see how currencies move around to transmit the positives/negatives across countries and continents.

Verizon will make a bid for Vodafone in 2012 - the depreciation of the pound has not ended by any stretch of imagination.