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Brazil’s Bond Yields Scream ‘Default!’

Summary Brazil’s government bond yields are at 14.8% – one of the highest among emerging markets. The Brazilian real has depreciated over 38% against the dollar due to capital flight. High interest rates may deter future capital flight. Brazil’s economy is contracting while its dollar-denominated debt is appreciating vis-a-vis its local currency. Brazil’s interest rates are higher than Venezuela (10.5%), though Venezuela’s debt is at junk levels. Brazil’s bond yields scream “default” and I believe them. Emerging markets are in the doldrums. Their currencies are falling, capital flight has taken hold and commodities — the main source of revenue for many — are in free fall. China’s recent currency devaluation amplified the situation. China is one of the biggest importers of everything from copper to steel to oil to iron ore; those products are now more expensive in China. Secondly, the devaluation was a de facto admission that the country’s economic growth is slowing — a bad omen for its trading partners. Selected Bond Yields In attempting to find the emerging country with the most risk, I looked at bond yields of selected countries – China, India, South Africa, Venezuela, Russia and Brazil. Brazil has the highest interest rates at 14.8% followed by Russia (11.9%) and Venezuela (10.5%). China has the lowest yields at 3.3%. Brazil is heavily dependent upon iron ore and oil in order to generate revenues. Oil is off 60% from its Q2 2014 peak and iron ore prices are 70% off their 2013 peak. Brazil’s economy contracted 1.9% in Q2 and the government is forecasting a budget deficit for the year. The country’s debt-to-GDP is about 65%, but could rise rapidly given its penchant for issuing debt in dollar-denominated currencies. According to the Wall Street Journal , Brazil has borrowed about $188 billion in dollar-denominated debt since 2008; it is second only to China’s $214 billion. Since Brazil’s currency is depreciating against the dollar, its debt-to-GDP could become untenable. Moody’s recently downgraded Brazil’s debt to Baa3 from Baa2 — one level above junk status. Another downgrade could be coming if its debt-to-GDP ratio amps up. Given 14.8% bond yields, that downgrade may already be priced in. Russia is heavily dependent upon oil and has been hard hit by economic sanctions from the U.S. and the EC. It has also engaged in conflicts to re-unify parts of the old Soviet Union, which has been costly. Like Brazil, Venezuela is heavily-dependent upon iron ore and oil to generate revenue. Declining commodity prices caused Venezuela to record a current account deficit in 2015 — the first time in nearly two decades. Currency Depreciation Currency depreciation against the U.S. dollar could be one measure of the amount of capital flight a country is experiencing. Russia’s currency depreciated 45% over the past year. Brazil’s is next at 39%. Given economic sanctions against Russia, the fact that it is at war Ukraine and is expected to make further incursions into Europe, it is almost foolhardy to maintain capital there. The depreciation of the real has been caused by capital flight to more stable currencies. At 3.76 against the U.S. dollar, the real is now at its lowest level since September 2002: (click to enlarge) I believe Brazil’s bond yields and currency depreciation are linked for the following reasons: Brazil Is In A Recession Brazil’s economy is contracting which may hurt its ability to repay its debt. Bond investors demand a higher premium for the risk of default — thus the high bond yields. Investors are also becoming more risk averse, thus capital is leaving Brazil and other emerging markets for the U.S. Higher Interest Rates Needed To Deter More Capital Flight 10 Year treasuries in the U.S. yield 2.14%. The Brazilian government may need to pay the 1,261 basis point differential between Brazilian bonds and U.S. treasuries in order to deter more capital flight. Brazil’s foreign currency reserves declined from $337 billion in August 2014 to $368 billion in July 2015. This will be a much-watched figure going forward. For instance, Venezuela only has about $17 billion in foreign exchange reserves so it is considered to have a higher default risk than Brazil. Dollar-Denominated Debt Payments Could Drain FX Reserves The more the real declines against the U.S. dollar, the more currency Brazil will need in order to pay interest and principal on its dollar-denominated debt. Those payments could be further strain on Brazil’s economy and budget deficit. If the U.S. raises interest rates, it will [i] drive more capital flight from emerging markets to the U.S. and [ii] force Brazil to pay more interest on its government bonds to keep capital at home. At some point it may become pure folly for Brazil to pay back dollar-denominated debt which is growing at double digits simply due to a depreciating real. It may behoove Brazil to default , thus its interest rates are so high. Brazil pays higher interest rates than Venezuela (10.5%), despite the fact that Venezuela’s bonds are rated at junk levels (Caa3) by Moody’s. Conclusion Brazil’s bond yields are screaming “default!” I believe them. I am short the ETF (NYSEARCA: EWZ ). I am also short Brazilian oil giant Petrobras (NYSE: PBR ) which has been hurt by a corruption scandal and lower oil prices, and is also exposed to dollar-denominated debt. This article may also impact the following securities: (NYSEARCA: BRZU ), (NYSEARCA: BZF ), (NYSEARCA: BZQ ), (NYSEARCA: BRAQ ), (NASDAQ: FBZ ) and (NYSEARCA: UBR ). Disclosure: I am/we are short EWZ, PBR. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Ignore Buffett: Refiners Are A Low-Quality Industry About To Plunge

Refining companies have been all the rage in 2015. After a brief lull, Buffett reignited passion for the sector buying a stake in Phillips 66. Ignore the hype, refiners are at the top of a cyclical boom. Aggressive investors should consider shorting the sector during this period of high volatility. So refiners are back in the news. They’ve been the toast of the town for much of 2015 as strong margins have driven rocketing share prices. Refining margins started plunging recently, and the stock market dumped; the one-two punch knocked the refining space down pretty hard. Predictably, lots of folks are running around calling it a big buy the dip opportunity. These calls are getting louder now that Warren Buffett has announced owning a large stake in Phillips 66 (NYSE: PSX ). He bought a stake worth roughly $4.5 billion, not chump change, even to a company as large as Berkshire Hathaway (NYSE: BRK.A ) (NYSE: BRK.B ). Buffett’s track record with energy is mixed. PetroChina (NYSE: PTR ) was a huge win for him, Chevron (NYSE: CVX ) and his dive into Energy Futures bonds were large mistakes that caused big losses for his company. His recent buy on Exxon (NYSE: XOM ) was extremely poorly timed, but he had the good sense to sell before it turned into another large loss. While I think buying refiners now is a terrible idea, I’ll give Buffett and his Phillips 66 a pass. Phillips is rapidly moving into other segments that are less vulnerable to the feast and famine dynamics of the refining industry. This is good because the refining industry stands like a shaky rig staring down a class four hurricane just miles away. Refiners have had a big boom since 2010, largely driven by expanding margins. Alas, these refining booms never last, this industry is a cyclical money pit that ends up having the same sort of returns that only fare well compared to, say, airlines or asteroid mining schemes. Just to be clear, this industry is about as far as you can get from anything suitable for buy and hold investors. It’s very much a trader’s paradise, buy when these companies are on the brink of bankruptcy, sell when people get euphoric again. Take the long-term 35-year chart for Tesoro (NYSE: TSO ), one of the more competent and (occasionally) beloved pure-play refiners. (click to enlarge) In 1980, yes, back when disco was still a respectable trend, Tesoro shares traded as high as $16. They then did nothing for the next 12 years, falling as low as $1.37 in 1992. Refining entered one of its periodic booms, sending shares up 8x to $10 in 1998 – still well short of where it was back in 1980. Then disaster hit on the next cyclical collapse, sending shares as low as 62 cents in 2002. That’s a miserable return on investment since 1980, a 96% capital loss over 22 years! And to be clear refining is a capital intensive industry, these guys only pay acceptable dividends (for short periods of time) during sector peaks, followed by long periods of abolishing the dividend all together while they’re in “avoid bankruptcy” mode. You’re not getting paid to wait owning these guys while their stocks go sideways decades at a time. After 2002, fortunes turned brighter with a big increase in gasoline demand as the SUV craze hit. As gasoline usage surged, refiners suddenly (finally) found themselves with excess demand for their industry, and margins soared. Tesoro shares would go on a monster run, clocking out a 100x return for anyone that bought near the low. Shares peaked in the 60s in 2007 and then started to dive. In 2008, as the economy started to sink and rising oil prices killed consumer demand for gasoline and other refined products, the refineries started another classic bust. Shares, which started the year at $45 in 2008 fell as low as $6 by that winter, a stunning 85% one-year collapse – a dive so steep, it put most of the banks to shame. Remember, if you paid $16 a share in 1980, at this point, you’re still sitting on a 60% loss, 28 years later – and Tesoro is a refining industry leader. Just think of how the lower-quality refiners did over that three decade span! In 2010, refiners started to recover, aided at first by some timely hurricane activity and then by the rise of US oil production. The glut of US oil produced by the domestic energy boom caused a massive oversupply of oil locally compared to the world market. This resulted in boom times for the US refineries, which suddenly got to enjoy cheap input fuels while the value of their refined products including gasoline, heating oil, and jet fuel remained robust. The recovering economy also helped on this count. Alas, the refining boom of 2010-2015 has died. They’re engraving its tombstone as we speak: “He had a great run, but in the end the oil bust and Chinese commodity collapse was too much for his aging heart to bear.” The refining boom was fueled up primarily by three factors. The glut of US oil, the improving US economy, and the lack of new refineries. All three of those factors are played out. As you know, oil prices have collapsed this past year. This is placing intense strain on US-based marginal oil producers. There’s a ton of data that disputes exactly where the break-even for a US shale project is, but it’s clearly north of $45 where we are today. There’s talk that US production isn’t falling yet, contrary to expectations, since capital-constrained players have to keep producing. Yeah, I acknowledge we may not see US domestic production fall straight off a cliff, but let’s be straight here, there’s no reason to expect US oil production to remain at these elevated levels. Capitalism stops unprofitable activity from continuing sooner than later. Lower prices will cause lower levels of production sooner or later, basic economics assures us of that. And US suppliers, as some of the higher marginal cost producers, will be among the first to shut up shop. When they do, the disparity of prices in between WTI and Brent crude, and particularly in discounted Midwestern crude that companies like Western Refining (NYSE: WNR ) have used to great advantage will fade. The refining boom was largely built on getting access to below normal market priced crude and letting all that extra margin soak through to the bottom line rather than going to consumers. That’s why you’ll not be seeing gas nearly as cheap as you expected at the pump with oil plunging. Another cause of higher margins has been that the US refining industry was capacity restrained. No new refineries had been built in 30 years, and many of the country’s refineries were shut in the 1980s when there was excessive capacity. The sudden appearance of the shale boom suddenly caused the nation’s refining stock to be insufficient to process all the country’s oil output. However, for the first time in ages, new refineries are being built in the US, which will add supply to the industry, putting pressure on margins. Additionally, there were an unusual number of strikes and explosions in refineries in early 2015 that put transitory upward pressure on margins. This boost is now dissipating. And finally, the economy had been improving in the US and neighboring regions that also consume US-refined petroleum products, namely Mexico and Canada. Canada now appears to be heading into a serious recession, and Mexico, while still growing economically, is sputtering. And the US economy is definitely decelerating, with the Fed threatening to tighten monetary policy as the domestic economy struggles and emerging markets are crashing. Sure enough, the crack spread has absolutely collapsed, falling from near 30 just a couple of weeks ago to the 15s today. It plunged during the market dive, and has continued diving this week, down 15% Monday, and another 5% Tuesday. To be clear, the crack spread is what butters the bread for refineries. The crack spread is the difference between their input crude and the output products such as gasoline, and fuel oil. Sure refiners can hedge, some have more exposure to other products like asphalt or specialty products, and whatnot. But that spread in general drives the industry. Notice how quickly refining stocks surged this spring when the spread shot upward. Now with it plunging again, refining stocks are likely to resemble falling anvils in coming weeks. Given the end of the conditions that caused the refining boom in the first place, there’s no reason for these stocks to have bids anywhere near these levels. Tesoro, for example, is trading at 9x cycle peak earnings levels. Analysts estimate earnings will drop by $4/share in 2016 to less than $8/share. That alone is eye-catching, you never want to see a company shed $4 in earnings power in a single year. Consider this : in 2009, Tesoro lost 87 cents a share, it lost a penny in 2010, made $4.02 in 2011, $6.20 in 2012, and then earnings plunged by more than 50% to $2.85 of EPS in 2013. Do you think that company’s current $10+ EPS earnings power is a permanent improvement, or a passing fad caused by a now-expired domestic oil boom? If EPS goes back to $2.85, like they earned in 2013, let alone making losses as they did in 2009-10, what would the stock be worth? The current $90 share price is a more than 30x multiple on earnings from just two years ago. Unless you think the domestic refining industry has entered a period of permanent bliss, despite all signs pointing to the contrary, paying 9x the unusually high current earnings is simply myopic. That refining stocks haven’t collapsed faster is a bit surprising. Perhaps they’re benefiting from the best house standing in a bad neighborhood effect. Previously, the “smart money” was flowing to the pipeline players such as Kinder Morgan (NYSE: KMI ) causing them to become substantially overvalued. I pointed this out this spring, Kinder shares are down sharply since then. Now that investors are scared out of pipelines, refiners are pretty much the last energy house that hasn’t collapsed. But their industry fundamentals have turned sharply negative, and profit margins have imploded in the past month. To sum up, here are long-term charts of two more pure-play refiners, Western and Valero (NYSE: VLO ). Western, a favorite of mine at $6 in 2008, but absurdly overvalued nowadays: (click to enlarge) And here’s Valero, the industry bellwether: (click to enlarge) Note how terrible these investments are over time – it truly is a miserable industry, like airlines for long-term holders. See where we were in 2007 when the SUV-driven refining craze ended? Yeah, that’s about where the refining industry is now. Take note of what happened next. Do your own diligence before following Buffett blindly into the refining sector. Disclosure: I am/we are short TSO, WNR. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Season Of The Glitch

When I look over my shoulder What do you think I see? Some other cat lookin’ over His shoulder at me. – Donovan, “Season of the Witch” (1966) Josh Leonard: I see why you like this video camera so much. Heather Donahue: You do? Josh Leonard: It’s not quite reality. It’s like a totally filtered reality. It’s like you can pretend everything’s not quite the way it is. – “The Blair Witch Project” (1999) Over the past two months, more than 90 Wall Street Journal articles have used the word “glitch”. A few choice selections below: Bank of New York Mellon Corp.’s chief executive warned clients that his firm wouldn’t be able to solve all pricing problems caused by a computer glitch before markets open Monday. – “BNY Mellon Races to Fix Pricing Glitches Before Markets Open Monday”, August 30, 2015 A computer glitch is preventing hundreds of mutual and exchange-traded funds from providing investors with the values of their holdings, complicating trading in some of the most widely held investments. – “A New Computer Glitch is Rocking the Mutual Fund Industry”, August 26, 2015 Bank says data loss was due to software glitch. – “Deutsche Bank Didn’t Archive Chats Used by Some Employees Tied to Libor Probe”, July 30, 2015 NYSE explanation confirms software glitch as cause, following initial fears of a cyberattack. – “NYSE Says Wednesday Outage Caused by Software Update”, July 10, 2015 Some TD Ameritrade Holding Corp. customers experienced delays in placing orders Friday morning due to a software glitch, the brokerage said.. – “TD Ameritrade Experienced Order Routing, Messaging Problems”, July 10, 2015 Thousands of investors with stop-loss orders on their ETFs saw those positions crushed in the first 30 minutes of trading last Monday, August 24th. Seeing a price blow right through your stop is perhaps the worst experience in all of investing because it seems like such a betrayal. “Hey, isn’t this what a smart investor is supposed to do? What do you mean there was no liquidity at my stop? What do you mean I got filled $5 below my stop? Wait… now the price is back above my stop! Is this for real?” Welcome to the Big Leagues of Investing Pain. What happened last Monday morning, when Apple was down 11% and the VIX couldn’t be priced and the CNBC anchors looked like they were going to vomit, was not a glitch. Yes, a flawed SunGard pricing platform was part of the proximate cause, but the structural problem here- and the reason this sort of dislocation WILL happen again, soon and more severely- is that a vast crowd of market participants- let’s call them Investors- are making a classic mistake. It’s what a statistics professor would call a “category error”, and it’s a heartbreaker. Moreover, there’s a slightly less vast crowd of market participants- let’s call them Market Makers and The Sell Side- who are only too happy to perpetuate and encourage this category error. Not for nothing, but Virtu and Volant and other HFT “liquidity providers” had their most profitable day last Monday since… well, since the Flash Crash of 2010. So if you’re a Market Maker or you’re on The Sell Side or you’re one of their media apologists, you call last week’s price dislocations a “glitch” and misdirect everyone’s attention to total red herrings like supposed forced liquidations of risk parity strategies. Wash, rinse, repeat. The category error made by most Investors today, from your retired father-in-law to the largest sovereign wealth fund, is to confuse an allocation for an investment. If you treat an allocation like an investment… if you think about buying and selling an ETF in the same way that you think about buying and selling stock in a real-life company with real-life cash flows… you’re making the same mistake that currency traders made earlier this year with the Swiss Franc (read “ Ghost in the Machine ” for more). You’re making a category error, and one day- maybe last Monday or maybe next Monday- that mistake will come back to haunt you. The simple fact is that there’s precious little investing in markets today- understood as buying a fractional ownership position in the real-life cash flows of a real-life company- a casualty of policy-driven markets where real-life fundamentals mean next to nothing for market returns. Instead, it’s all portfolio positioning, all allocation, all the time. But most Investors still maintain the pleasant illusion that what they’re doing is some form of stock-picking, some form of their traditional understanding of what it means to be an Investor. It’s the story they tell themselves and each other to get through the day, and the people who hold the media cameras and microphones are only too happy to perpetuate this particular form of filtered reality. Now there’s absolutely nothing wrong with allocating rather than investing. In fact, as my partners Lee Partridge and Rusty Guinn never tire of saying, smart allocation is going to be responsible for the vast majority of public market portfolio returns over time for almost all investors. But that’s not the mythology that exists around markets. You don’t read Barron’s profiles about Great Allocators. No, you read about Great Investors, heroically making their stock-picking way in a sea of troubles. It’s 99% stochastics and probability distributions – really, it is – but since when did that make a myth less influential? So we gladly pay outrageous fees to the Great Investors who walk among us, even if most of us will never enjoy the outsized returns that won their reputations. So we search and search for the next Great Investor, even if the number of Great Investors in the world is exactly what enough random rolls of the dice would produce with Ordinary Investors. So we all aspire to be Great Investors, even if almost all of what we do- like buying an ETF- is allocating rather than investing. The key letter in an ETF is the F. It’s a Fund, with exactly the same meaning of the word as applied to a mutual fund. It’s an allocation to a basket of securities with some sort of common attribute or factor that you want represented in your overall portfolio, not a fractional piece of an asset that you want to directly own. Yes, unlike a mutual fund you CAN buy and sell an ETF just like a single name stock, but that doesn’t mean you SHOULD. Like so many things in our modern world, the exchange traded nature of the ETF is a benefit for the few (Market Makers and The Sell Side) that has been sold falsely as a benefit for the many (Investors). It’s not a benefit for Investors. On the contrary, it’s a detriment. Investors who would never in a million years consider trading in and out of a mutual fund do it all the time with an exchange traded fund, and as a result their thoughtful ETF allocation becomes just another chip in the stock market casino. This isn’t a feature. It’s a bug. What we saw last Monday morning was a specific manifestation of the behavioral fallacy of a category error, one that cost a lot of Investors a lot of money. Investors routinely put stop-loss orders on their ETFs. Why? Because… you know, this is what Great Investors do. They let their winners run and they limit their losses. Everyone knows this. It’s part of our accepted mythology, the Common Knowledge of investing. But here’s the truth. If you’re an Investor with a capital I (as opposed to a Trader with a capital T), there’s no good reason to put a stop-loss on an ETF or any other allocation instrument. I know. Crazy. And I’m sure I’ll get 100 irate unsubscribe notices from true-believing Investors for this heresy. So be it. Think of it this way… what is the meaning of an allocation? Answer: it’s a return stream with a certain set of qualities that for whatever reason – maybe diversification, maybe sheer greed, maybe something else – you believe that your portfolio should possess. Now ask yourself this: what does price have to do with this meaning of an allocation? Answer: very little, at least in and of itself. Are those return stream qualities that you prize in your portfolio significantly altered just because the per-share price of a representation of this return stream is now just below some arbitrary price line that you set? Of course not. More generally, those return stream qualities can only be understood… should only be understood… in the context of what else is in your portfolio. I’m not saying that the price of this desired return stream means nothing. I’m saying that it means nothing in and of itself. An allocation has contingent meaning, not absolute meaning, and it should be evaluated on its relative merits, including price. There’s nothing contingent about a stop-loss order. It’s entirely specific to that security… I want it at this price and I don’t want it at that price, and that’s not the right way to think about an allocation. One of my very first Epsilon Theory notes, “ The Tao of Portfolio Management ,” was on this distinction between investing (what I called stock-picking in that note) and allocation (what I called top-down portfolio construction), and the ecological fallacy that drives category errors and a whole host of other market mistakes. It wasn’t a particularly popular note then, and this note probably won’t be, either. But I think it’s one of the most important things I’ve got to say. Why do I think it’s important? Because this category error goes way beyond whether or not you put stop-loss orders on ETFs. It enshrines myopic price considerations as the end-all and be-all for portfolio allocation decisions, and it accelerates the casino-fication of modern capital markets, both of which I think are absolute tragedies. For Investors, anyway. It’s a wash for Traders… just gives them a bigger playground. And it’s the gift that keeps on giving for Market Makers and The Sell Side. Why do I think it’s important? Because there are so many Investors making this category error and they are going to continue to be, at best, scared out of their minds and, at worst, totally run over by the Traders who are dominating these casino games. This isn’t the time or the place to dive into gamma trading or volatility skew hedges or liquidity replenishment points. But let me say this. If you don’t already understand what, say, a gamma hedge is, then you have ZERO chance of successfully trading your portfolio in reaction to the daily “news”. You’re going to be whipsawed mercilessly by these Hollow Markets , especially now that the Fed and the PBOC are playing a giant game of Chicken and are no longer working in unison to pump up global asset prices . One of the best pieces of advice I ever got as an Investor was to take what the market gives you. Right now the market isn’t giving us much, at least not the sort of stock-picking opportunities that most Investors want. Or think they want. That’s okay. This, too, shall pass. Eventually. Maybe . But what’s not okay is to confuse what the market IS giving us, which is the opportunity to make long-term portfolio allocation decisions, for the sort of active trading opportunity that fits our market mythology. It’s easy to confuse the two, particularly when there are powerful interests that profit from the confusion and the mythology. Market Makers and The Sell Side want to speed us up, both in the pace of our decision making and in the securities we use to implement those decisions, and if anything goes awry … well, it must have been a glitch. In truth, it’s time to slow down, both in our process and in the nature of the securities we buy and sell. And you might want to turn off the TV while you’re at it.