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Kotok: Overweight US Energy, China ETFs

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David Kotok, co-founder and chairman of Cumberland Advisors, thinks something important happened last week:Central banks collectively told the financial markets that another Lehman Brothers-type failure isn’t going to happen. It’s a reassurance that a nervous market badly needed.

Kotok is quick to admit his euro-optimism of a few years ago was way off the mark, and he’s underweight Europe now. But things got interesting when he told IndexUniverse.com Managing Editor Olivier Ludwig that he’s overweight U.S. equities now, in part because he sees a boom in oil and gas shale as inevitable. He’s also overweighting China, because part of last week’s splashy central banking news told Kotok that the “Middle Kingdom’s” credit-tightening cycle is over for now.

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Ludwig: What happened last week in the market was certainly head-turning. But the world hasn’t changed, has it?

Kotok: Yes, the world has changed.

Ludwig: But the next steps are all about going back to the sclerotic, Brussels-based process. As I recall, the late French President Francois Mitterrand and the former German Chancellor Helmut Kohl look positively cozy compared with Nicolas Sarkozy and Angela Merkel now.

Kotok: Well, coziness is everybody’s view. I don’t know what’s cozy and what isn't cozy. Sar-kozy may be cozy!

But if you look at what happened last week, you saw a coordinated central bank action. And it included China … notice the timing. It’s more than coincidence, in my opinion. No one from the Bank of China called me and told me that. But the action China took with a 50-basis-point cut (in bank reserve requirements) is absolutely consistent with a 50-basis-point cut in a swap line in U.S. dollar interest rates. So it’s very, very similar.

And what it says is that the central banks of the world, which represent nearly all of the weight of the capital markets of the world, have acted and announced there will not be a liquidity event.

Ludwig: Averting a Lehman-esque collapse, essentially?

Kotok: That’s right. It won't happen. Lehman and AIG were liquidity events at the end of a period where liquidity events were successive, and the central banks were being reactive. Now, arguably, the central banks are proactive.

Now, what triggered that? Was it a meeting at the Fed with some “hedgies” a few days before? Maybe. Was it the risk of a failure of a large financial institution in Europe? Maybe. Maybe both.

And some of the institutions that have funding needs in the short-term markets are the ones that are the most exposed to liquidity constraints. And, in fact, we saw that with Lehman and AIG. We saw that with MF Global. And we saw that with the run on Jefferies right behind MF Global.

If you fund in the short-term markets, which a lot of organizations do, and then the short-term markets get stressed—which they do very quickly these days on the heels of the Lehman-AIG experience—then the central bank has to do some kind “proactive function.”

Ludwig: You don’t see the Peter Schiff world view of a debasing of the currency, or the possibility that developed economies are reaching the Keynesian endpoint?

Kotok: Well, maybe. But the point is that I don’t think the central banks organized themselves and said, “Let’s have the end of the world happen here,” or “Let’s have a coordinated prolonged reflation policy.” I think what they did is they said:“There’s a liquidity issue. And we have to make sure that market functionality is undisturbed. We cannot solve solvency issues. We can solve liquidity issues.”

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Ludwig: Right. But to return to my initial question, “Has the world changed?”, a concerted central bank action of this magnitude is certainly, as you frame it, noteworthy and significant. But how do you begin to parse the prevention of a liquidity event and the overall health and trajectory of the global economy?

Kotok: Well, the Merkel-Sarkozy “confab” triggered a rise in interest rates. They came out with a proposal, and it was a nonstarter. And it said to the markets:“The politicians can't find a way to agree and accomplish.”

And what did we see? We saw spikes in interest rates in the peripheral weak countries. We saw spikes in interest rates in the stronger ones. We even saw the bund pick up. So there was a message there. And you can look at it and say, “Well, Merkel and Sarkozy, in one of their dances, triggered this bond market sell-off.” Now, what’s the next step? Well, we saw the spike in the interest rates. It terrified everybody in Europe. It brought borrowing costs to levels that are clearly not sustainable and would blow apart budgetary fixes. And it triggered a follow-on action.

Ludwig: You're referring to the 7 percent threshold on the 10-year notes that people point to as a breaking point?

Kotok: That’s right. But is 7 percent or 6 percent the threshold for Belgium or Italy or Spain? I don’t know. What we do know is that when spreads are 400 or 500 basis points over the bund, that’s a lot. We don’t have to quibble over a few basis points.

So having had that happen now, you see those spreads coming back in. You see those interest rates having peaked a week or four or five days before the central bank announcement, which leads to a whole lot of speculation as to who in a hedge fund might have staked out a position that altered market pricing in anticipation of an action. But that’s something we can only speculate about.

So, we had a surprise announcement. It shocked the market. Markets are repricing based on this information.

And the markets now, I believe, have more predictable monetary policy than they have had in a very long time. They know what the interest rates are going to be for at least a year or two. They know the policy is to provide liquidity and not have liquidity shock. Those are two very big things.

Ludwig: Yes they are.

Kotok: How many times, in the last 40 years, could you sit on a given day, and say, “I have a pretty good bet as to what the interest rates are going to be for the next year, year-and-a-half, or two. And I have a pretty good bet on what the policy stance of the central banks of the world is for the next year or two.”

Ludwig: I take your point. Now reading back on some of the things you’ve said in the past, when the euro crisis first began to take real shape—I guess it would be early 2010— you were on record as a euro optimist; you thought this too was going to pass.

Kotok: I wrote a book on it.

Ludwig: There you have it.

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Kotok: If you ever want to say, “Kotok, don’t become a market timer,” look at my book.

It took two years to write a book that was positive about Europe. When I started the book, it was a good story. It took Wiley seven months to get the final manuscript to a hard copy publication and release. The book was hot for about four weeks, and then Greece blew up!

Ludwig: So have you changed your mind? Are you still an optimist?

Kotok: No. If I wrote the book today, I’d write it entirely differently. In the beginning of the development of the book, we were right. Three years later, when the book came out, a lot had happened. I was on Tom Keene’s show on Bloomberg TV the other day, and in the middle of the interview talking about Europe, he puts up charts and spreadsheets and says:“By the way, you wrote a book on Europe.” And I said, “Yeah, it’s a lousy book. Don’t buy it. It’s all wrong.”

Ludwig: So have you become a euro skeptic?

Kotok: Yes, I’ve been a euro skeptic for a while. Look at the weights in our portfolios. We’re very underweight Europe. We don’t own anything in the periphery, only Northern Europe. And there, we’re underweighted against benchmarks that weight Europe at 24 percent of the world benchmark. I think we’re 12 percent. That’s pretty extreme.

Ludwig: So you’d be favoring things in Europe like the iShares MSCI Germany Index Fund (NYSEArca:EWG) at this juncture?

Kotok: Yes. If you're going to take a position, you go into the country ETFs of the Netherlands and Germany and Austria. That’s the way to do it; and do it with very small weights in the context of whatever allocation.

Ludwig: Are you including the United Kingdom in what you're talking about, in terms of being at half the amount of the benchmark?

Kotok: Well, no. We look at the U.K. separately, in terms of deciding on a weight. They're still coming out of problems.

Ludwig: So what about your overweights?

Kotok: Our large overweights worldwide now are the U.S.—and we use a bunch of different ETFs to get to it—and China. And we use several there. We just took up China weights. The interest rate cut in China has prompted us to raise the weight.

Ludwig: Oh, really? You're not concerned about inflation getting stoked there again?

Kotok: Sure; inflation will get stoked down the road. But what this says is the Chinese tightening cycle is over. And that’s what’s key.

Ludwig: Understood. Now regarding your overweight in the United States, people are still looking at high unemployment, a real estate market that continues to be “sucking methane”—plenty of things to worry about, in other words..

Kotok: Well, I don’t know about that.

Ludwig: OK, then; let’s hear your case for overweighting the U.S.

Kotok: Well, the household formation numbers are improving. Houses are not being built fast enough to stay even with them. About 600,000-650,000 housing units were built last year. About 300,000 of those are needed to replace those that are destroyed through casualty, losses or obsolescence. And we had about 1.2 million to 1.3 million households formed.

Ludwig: What about the empty new houses destroyed for tax reasons by developers in the shadows of the San Gabriel Mountains in California?

Kotok: OK, I’m with you. Housing is a very interesting thing. It’s local.

If you go to North Dakota, housing prices are rising, builders are building and people are buying. And the unemployment rate is half the national average. And you’ve got a mini boom in the energy patch driving it. And if the policies of the United States would allow energy to be developed instead of impeding it, we would have 2 million more people working in the energy patch around the country.

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Ludwig: Right. But the writing’s on the wall there, isn't it? I don’t think anyone—Democrats or Republicans—are, in the end, going to stand in the way of that train, are they?

Kotok: Well, so far, they are, aren't they? The Democrats and Republicans in Washington, last time I looked, certainly are.

Ludwig: Anything else besides the energy patch that’s clearly a driver that you look at as a reason to overweight the U.S in your portfolios?

Kotok: I am overweight the energy patch. I think one needs to be in exploration/ production, because it’s going to boom—I’m thinking of shale gas and shale oil. The prospect of the United States being energy independent, not needing to import a single drop or a single element, is very real, if we release the constraints. Imagine if our trade balance has a positive instead of a negative number.

Ludwig: It’s almost unimaginable at this point.

Kotok: Well, it’s here; we have the stuff. We just have to produce it and use it. And we have to develop it. We have to remove the shackles on American entrepreneurs. And if we do, we will have changed the entire world view and the geopolitics of the world in a massive way.

Why the Obama administration stands in the way of that, I do not understand.

Ludwig: I’ve even heard that there is a prospect that gas—as in natural gas—can be reverse-refined into a liquid quite like gasoline, and without all the sulfuric baggage that you get from many types of crude oil.

Kotok: Absolutely. Turn loose American entrepreneurial and manufacturing development and research in a profit-oriented system that will exploit a domestic natural resource.

Ludwig: I understand.

Kotok: We’ll change the world.

Ludwig: I understand the primacy of the energy issue, and its potential as a game-changer. But apart from energy, do you see any real bright spots that people are just conveniently overlooking in their pessimism at the moment?

Kotok: Yeah, I think it’s time to step up and buy some of the banks and financials.

Ludwig: Really?

Kotok: I do. And I've taken the weights up several times, and I have an overweight position in regional banks using KRE [the SPDR S'P Regional Bank ETF, NYSEArca:KRE].

Ludwig: OK. The SPDR S'P Regional Bank ETF is one of those ETFs and just changed indexes, right?

Kotok: Well I use KRE because I like the composition.

Ludwig: And what about China, with the end—for now—of the tightening cycle, that’s the crucial piece there. And, in terms of accessing it with ETFs, are you thinking big, like NYSEArca:FXI? Or more like NYSEArca:GXC?

Kotok: I’m not fully positioned, so I can't tell you yet.

Ludwig: Understood. Well, thank you for your time.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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