Research Watch

PORTFOLIO POINT: This is a sampling of the week's best research notes. In a world of too much information, we hope our selection helps you spot the market's key signals.

If Europe only has a matter of days to fix its crisis, decision makers should take a good look at this week's lead chart: Morgan Stanley illustrates exactly what it means to have a lender of last resort. Otherwise, a respected banker models a sturdy fiscal union, while Citigroup instructs how to trade sovereign trauma as you wait for things to collapse into place. Also this week, take a peek inside Goldman Sachs' 2012 portfolio, and use the price-to-net-value indicator to look to 2022. Ponder the ridiculousness of the BRICs, break free from correlation in Israel, or start fresh in Iraq – it’s the place to be for investment bankers. On video, the agonising last gasps of Occupy Wall Street.

This is what a lender of last resort looks like'¦

“What you’re looking at here are three lines. The black line is Morgan Stanley’s market capitalisation, which tends to hover in the $US40 billion range but which fell as low as $US9.8 billion in November 2008. The orange line is the amount that Morgan Stanley owed to the Federal Reserve on any given day – an amount which peaked at $US107 billion on September 29, 2008. And the red line is the ratio between the two: Morgan Stanley’s debt to the Federal Reserve, expressed as a percentage of its market value. That ratio, it turns out, peaked at some point in October, at somewhere north of 750% '¦ If the ECB wants to avert a liquidity crisis, charts like this give a sobering indication of just how far it might have to go, and how quickly it might have to act.” (Felix Salmon, November 27)

And this is what a European fiscal union should look like'¦ “1. The ECB would [be the first pillar], with independent responsibility for safeguarding monetary, financial and price stability within the eurozone. As such it would act as the lender of last resort only to the eurozone banking system, not to sovereigns. 2. A newly created European monetary fund would form the second pillar. It would be responsible for safeguarding medium term debt sustainability and would oversee the fiscal union, by assessing member states’ economic and fiscal performance; providing support programmes; and policing reform and adjustment programmes. 3. The third pillar would be a European debt agency, which would be the sole issuer of eurozone sovereign debt, with responsibility for financing all the eurozone’s member states. The credit standing of the EDA would reflect the eurozone’s overall strength, through joint and several guarantees provided by all its members. This would naturally be reliant on the stronger AAA-rated countries, but in practice would merely formalise the responsibility these have already assumed. The quid pro quo would be that debt could only be mutualised up to a level consistent with medium term debt sustainability, and that reform and adjustment would be overseen by the EMF. This should not be formulaic, but depend on a member state’s future debt profile.” (Manfred Schepers, vice president and chief financial officer of the European Bank for Reconstruction and Development, November 28)

Learn to trade sovereign trauma'¦ “[Citigroup's] crucial insight is to tie the evolving crisis to the Kubler-Ross stages-of-grief and recognise that expecting a decoupling (or lower correlations between and within asset classes) is only for those in denial. Trade the phases instead in 2012, following the path of this year. As we re-enter the 'Bargaining' phase, correlations will remain high (as will stress).”

(Citigroup via Zero Hedge, November 29)

Welcome to the best month of the year '¦ “December has been the best month of the year [for equities] since 1950. Given the oversold conditions, prospects for a eurozone solution and generally high levels of fear, seasonal patterns could ring true into the holidays.”

• #1 month for S&P ( 1.6%) and #2 month for Dow ( 1.7%) since 1950, #2 month for NASDAQ (2.0%) since 1971.
• Small caps start to outperform larger caps near middle of month.
• 2002 was the worst December since 1931, Dow and S&P down over 6%, –9.7% on NASDAQ.
• 1998 was part of best fourth quarter since 1928.
• Fourth quarter expiration week most bullish triple witching week, Dow up 15 of last 19.
• In pre-presidential election years December’s rankings slip: #3 month for S&P and Dow, still #2 month for NASDAQ.

(The Stock Traders Almanac via Pragmatic Capitalism, November 29)

China's counter-offer to Europe'¦ “China is looking to buy EU factories and railways instead of wobbly government bonds as prices fall amid the eurozone crisis. Minister of commerce Chen Deming articulated the strategy at a business congress in China [this week]: 'Next year, we will send a delegation for promoting trade and investment to the European countries ... Some European countries are facing a debt crisis and hope to convert their assets to cash and would like foreign capital to acquire their enterprises. We will be closely watching and pushing forward the process,' he said. Chen's remarks come after the chief of the $US410 billion Chinese Investment Corporation, Lou Jiwei, wrote in an op-ed in the Financial Times on Sunday that EU infrastructure needs outside help. 'Traditionally, Chinese involvement in overseas infrastructure projects has been as a contractor only. Now, Chinese investors also see a need to invest in, develop and operate projects,' he explained.” (EU Observer, November 28)

And now for something completely uncorrelated'¦ “Alfredo Viegas, an emerging-markets strategist for boutique brokerage Knight Capital Group, is encouraging clients to bet against Israeli bonds. His theory: Investors are so focused on Europe that they are misjudging risks in the Middle East, such as a flare-up in relations between Israel and Iran, or greater conflict in Egypt and Syria. Once they wake up to those risks, Israeli bonds are likely to tumble, Viegas reasons. In the meantime, the investment isn't likely to be pushed one way or another by the European crisis, he says. While European government-bond yields spiked '¦. Israel's $70 billion of dollar-denominated bonds remained relatively steady, yielding 1.4 percentage points more than US Treasury bonds. That made them cheap to bet against, or short. A $100 million bet against the bonds for three months, combined with a hedging position in US Treasuries would cost about $750,000, Viegas says. He says the trade would stand to make at least $5 million, and potentially much more, if a crisis erupts in the Middle East. Uncorrelated investments like a bet on Israeli bonds are designed to move less with markets than most bets because they depend on specific events, like war, legal decisions or the result of liquidation auctions.” (Wall Street Journal, November 28)

Bloody Ridiculous Investment Concept '¦ “The term 'BRIC' – coined by Goldman's Jim O'Neill 10 years ago to denote Brazil, Russia, India, and China – should really denote 'Bloody ridiculous investment concept,' writes Societe Generale strategist Albert Edwards in a note '¦ That's because the BRICs'”as well as emerging markets in general'”are actually doing terrible right now; even worse than the struggling eurozone.”

(Societe Generale via Money Game, November 30)

The secret figures behind the bailout '¦ “The Federal Reserve and the big banks fought for more than two years to keep details of the largest bailout in US history a secret. Now, the rest of the world can see what it was missing. The Fed didn’t tell anyone which banks were in trouble so deep they required a combined $US1.2 trillion on December 5, 2008, their single neediest day. Bankers didn’t mention that they took tens of billions of dollars in emergency loans at the same time they were assuring investors their firms were healthy. And no one calculated until now that banks reaped an estimated $US13 billion of income by taking advantage of the Fed’s below-market rates '¦ Saved by the bailout, bankers lobbied against government regulations, a job made easier by the Fed, which never disclosed the details of the rescue to lawmakers even as Congress doled out more money and debated new rules aimed at preventing the next collapse. A fresh narrative of the financial crisis of 2007 to 2009 emerges from 29,000 pages of Fed documents obtained under the Freedom of Information Act and central bank records of more than 21,000 transactions '¦ Add up guarantees and lending limits, and the Fed had committed $US7.77 trillion as of March 2009 to rescuing the financial system, more than half the value of everything produced in the US that year.” (Bloomberg, November 27)

Goldman's favourite trades for 2012'¦

1. Short European High Yield credit (Buying protection on the iTraxx Crossover index), for a target of 950bp (opened at 770bp) and a potential return of 4.5%, stop at 680bp
2. Short 10-year German Bunds for a target of 2.8% (open at 2.3%) and a potential return of 4.5%, stop 2.0%
3. Go long EUR/CHF for a target of 1.35 (opened at roughly 1.2260) and a potential return of 11% including carry, stop at 1.20
4. Long Canadian equities (S&P TSX) vs Japanese equities (Nikkei), FX unhedged for a target of 120 (opened at 100) and a potential return of 20%, stop at 90
5. Long a Global Rebalancing Basket (CNY, MYR versus GBP, USD) for a target of 107 (opened at 100) and a potential return of 7%, stop at 98
6. Long July 2012 ICE Brent Crude Oil futures for a target of $120/bbl (opened at $107/bbl) and a potential return of 12%, stop at $100/bbl

(Goldman Sachs, November 30)

Fancy a finance job in Iraq? '¦ “Even as the US prepares to pull out its last troops from Iraq, well-heeled investment bankers are starting to descend on Baghdad, hoping to capitalise on the strife-torn country’s tentative efforts to rebuild its physical and financial infrastructure. Safety remains a big concern. Visiting bankers must travel with contingents of security personnel. When in Baghdad, they reside in the heavily guarded “Green Zone”, or in containerised housing units – rudimentary, converted shipping containers – on the outskirts of the city. Undeterred, investment bankers from institutions including Morgan Stanley, Goldman Sachs, HSBC, Citigroup and BNP Paribas are still flocking to Iraq. Mandates on offer include advisory work on a sovereign credit rating, stock flotations, billions of dollars worth of infrastructure and project finance, and in the longer term, potentially Iraq’s first publicly sold sovereign bond. The first significant deals are likely to be the initial public offerings of Iraq’s three phone operators. Zain Iraq, Asiacell and Korek are required by the authorities to offer a quarter of their shares on the Iraq stock exchange by the end of August, and could raise more than $3 billion if the flotations go smoothly.” (Financial Times, November 27)

Video of the week: The end of Occupy Wall Street'¦ As one commentator tweeted, "A movement is dead when Miley Cyrus writes disco music for it."

(LA Times, November 28)