Tuesday, May 31, 2011

Merrily Rolling Down the Yield Curve

Your humble and chronically bemused blogger drank the Kool-Aid today and added a substantial amount of a specific type of bond to his IRA holdings, transforming zero-yielding cash into a zero-coupon Treasury bond of 8 years duration. This was done while continuing to hold a substantial percentage of our family savings in gold and while being aware that the MIT Billion Prices Project is showing a price inflation rate that makes my 2.64% implied annual yield a loser in real terms.

(Do I contradict myself? Very well, then I contradict myself.)

Here is the thinking behind my latest speculative foray into bonds.

Basically this is a play for modest capital gains.

First, one must understand that when one buys a bond, one's broker will quote you a yield. But the reality is that the transaction is one in which price is the reality. The yield you are quoted is, forsooth, a derived value. It is not a toxic derivative as in CDO-squared sorts of derivatives, but it is a derivative value. In the case of most bonds, which pay coupon interest periodically before the borrower is supposed to return the invested principal, computation of effective yield is more complex than most people realize. One has to make assumptions about such matters as reinvestment returns on the interest payments, for example. Furthermore, standard bond tables assume that the interest is reinvested at the coupon rate of the bond. In a world where short-term money yields nothing, however, that calculation ends up overestimating the real return that a lender receives.

If one's goal in purchasing a bond is to attain a capital gain, the purest bond is one that pays no interest and thus does away with the reinvestment problem. This bond, commonly called a zero-coupon bond, trades at a price with a yield that can be computed with a compound interest calculator. Here is how to make lemonade with zero coupon bonds. First, one should have a non-callable bond. You have to be confident of the maturity date.

This is where Treasuries are almost unique in bond land.

Next, you want a positive yield curve, which is one in which the annual yield is higher as the duration of the bond increases.

So when I called up the broker today, I asked for the prices and yields on 7 and 8 year Treasury bonds. They were about 84 and about 81 respectively, correlating with yields of 2.44% and 2.64%. I purchased some 8 year (2019 maturity) bonds at around 81. What this means is that assuming los Federales are still in business in 8 years, they promise to pay me $100 for each $81 worth of bonds today, but they will pay me nothing till then. Annualized that's about 2.6% yearly. However, if I want to make a similar investment but want $100 back in 7 years rather than 8, I will have to fork over $84 today.

Let's now look forward one year. Let us say that for whatever reasons, the yield curve is unchanged. In that case, I will then be the owner not of an 8 year bond, but rather I will own a 7 year bond. All things being equal, the value of my bond will have risen from 81 to 84. Taking the fractions into account, my 2.6% bond today will rise 4.0% in value (from 81.18 to 84.47). It's a form of financial alchemy, in a sense. All I need to get a 1-year return almost equal to the return from lending money to the government for 30 full years is for the interest rate structure to simply not change.

This sort of activity is called rolling down the yield curve. It is one of the SOPs among bond portfolio managers.

In making this bet, I am taking the point of view that the Economic Cycle Research Institute is correct in its call for Treasuries rather than stocks or industrial commodities as preferred investments in the months ahead. In this scenario, we should remember that as recently as November last year, the 5-year Treasury traded with a yield below 1.1%. And that was merely in the setting of a growth slowdown, at a time when gold and silver prices had already been surging for months. What if there is a full-blown global industrial downturn, with oil in the $60-80/barrel range and copper at $3/pound or less? And perhaps silver at $25/ounce again, or lower? Who knows where the herd will take Treasury prices in the seemingly unending cascade of financial asset inflation that has been occurring for decades?

In that (quasi-)recessionary scenario, there is the potential for this boring debt instrument to return 5-10%, possibly in as little as 6 months.

Of course, there are numerous risks to this approach, most obviously the one that price inflation makes this 2.6% yield look trivial. My answer to that is ownership of gold so long as interest rates are at or below the general price inflation rate, no matter what the economic cycle is doing. I would then supplement that by adding economically sensitive, "weak dollar" assets when economic activity appears to be troughing or accelerating. But in a world where there are central authorities who are determined to make savers pay to recapitalize financially weak financial institutions by forcing them to receive rates on money in the bank that are below the rate of price inflation, one thing is mathematically certain.

Pitiful as a yield of 2.6% may be, it is greater than zero.

In a world where little except the air we breathe is cheap, beating zero with the chance for capital gain due to a possible major deceleration of economic activity seems reasonable to me.

Copyright (C) Long Lake LLC 2011

Sunday, May 29, 2011

Gold and Bonds

It's hard to see the fundamental case for gold vs. the U. S. dollar (USD) as other than strong when a flawed currency, the New Zealand dollar (NZD), has just now broken to an all-time high against the USD. Why is the NZD a flawed currency?

Because the policy interest rate is 2.5% while the latest inflation rate is 4.5%. The Prime Minister of NZ is a former Merrill Lynch banker. These guys do like printing money, that's clear. So if a country that is rebuilding after the Christchurch earthquake is doing it with cheap money, then gold should be appreciating against the NZD, all things being equal. (Please note that the NZD was one of the three currencies I highlighted last summer when I made the case for the following weak dollar plays: gold, silver, and foreign currencies. The other two courrencies I listed were those of Brazil and Norway.)

Except for countries near default, such as Greece, and with some exceptions such as Brazil and Chile, most of the world continues to operate with negative real interest rates. Sweden, for example, has a 3.3% inflation rate but only a 1.75% policy rate. All this is gold-bullish. Just last week, gold hit all-time highs in euro and British pound terms.

Is gold "too high"? Maybe, but given how depressed gold miners are, my sense is that a bull market as long and strong as gold's has been will generally end with public participation in the usual manner, namely in stocks. Instead of gold, the public has been indulging its dreams of easy money via momentum stocks of various flavors. I continue to look for $2000/ounce gold next year based on the "Elfenbein correlation" between percentage appreciation of gold and the positivity or negativity of "real" short term interest rates.

Understanding that there is a significant potential for summer weakness in all resource stocks, I also think that on a 6-12 month horizon, certain gold stock vehicles look better than bullion to me.

The big fly in the ointment, however, is the Economic Cycle Research Institute's adamant call for an important top in the global industrial economy soon. Primarily because of this, I am avoiding resource stocks except those related to gold (which has few industrial uses) and resource currencies.

As a consequence of a global industrial recession, at some point I would see capital being diverted to bonds. In that vein, I would note that the long-term downtrend line in U. S. interest rates survived the inflation scare of this winter. The chart of the same bond in New Zealand is similar at least for the past decade. (Click on chart to enlarge.)

On a trading basis, I am therefore long various U. S. Treasury debt instruments. I thus have a barbell strategy: gold as my core holding to hedge against more money-printing to make the impaired balance sheets of the TBTFs whole, and Treasuries as speculative vehicles expecting that potentially sharp downtrends in the prices of industrial commodities in association with a global industrial recession (or fears thereof) will leave capital searching for the least bad alternatives.

I also own some defensive stocks and certain specialty financials.

I intend to discuss some ins and outs of Treasury investing (speculating, really, given that I don't expect the debts to ever be repaid in other than greatly devalued dollars) in the future. In the meantime, you may wish to review a November 2010 post on the topic in which I suggested that we could then have been within months of a major top in long term rates if we were not there already (which we most assuredly were not, as it turned out).

I read lots of gold-oriented blog sites, articles on gold, etc. I don't know if I am unique, but I think it's rare to be a bull on gold and a tactical bull on intermediate to long-term Treasuries at the same time. Let's see how the months ahead go. It looks interesting, to say the least.

Copyright (C) Long Lake LLC 2011

Wednesday, May 25, 2011

A Case of Scurvy and Financial Vitamin C

One of the benefits of being a certain age is having had several different experiences while still being young enough to remember them. With that intro, I'd like to recount a diagnostic coup I observed and relate it to the financial matters mentioned in the title.

When I was an intern rotating through the Bronx Veterans Administration Hospital, I performed a history and physical exam on a newly admitted patient. He was clearly unwell, but the nature of his diagnosis was obscure in the extreme. I discussed the case with my senior resident, still a doctor in training but a year or two above me. I was puzzled; he was quite interested.

The next morning, the resident had quite the self-satisfied look. He announced that the patient had scurvy (a disease due to severe deficiency of vitamin C). Had the resident ever seen anyone with scurvy before? No. How did he know? He had correlated the symptoms with the patient's dietary habits. The patient basically lived on sardines. There was no vitamin C in sardines.
The patient was discharged on vitamin C and we all learned that there is no substitute for careful, case-by-case evaluations along with encyclopedic knowledge and an open mind.

That said, I wanted to correlated the above example with a post from Mish today titled Hyperinflation Nonsense in Multiple Places. This lengthy post is of special interest because not only is Mish one of my very favorite bloggers, but he approvingly quotes Jeff Harding of The Daily Capitalist from last fall on the prospects for hyperinflation in the U. S. As regular readers may know, I have agreed with Jeff about stagflation being the likely outcome for the foreseeable future.

I also agree with Mish that hyperinflation is not imminent, but I am mindful of the case of scurvy. Does the U. S. have the financial habits that can lead to hyperinflation, just as my patient had the dietary habits that led to the rare case of scurvy in New York City?

In a word, yes. Central bank monetization of large amounts of Federal spending is the key.
The politics of the day are in favor of this policy. The Democrats refused to raise taxes when, for two years, they controlled both Congress and the White House. Then they were all too happy to keep taxes as they were after the midterms, at least till the next election. Now they are happy to complain about the Republicans' position on Medicare while not saying how they will fund it. Presumably money will arrive from the tooth fairy AKA the Federal Reserve or a coalition of the unwilling and coerced. Net-net, my take is that the irresponsible fiscal and monetary policies that were followed when Bush the second was president have simply gotten worse in the Age of Obama.

So if the prediction of a significant global industrial downturn starting no later than summer is correct, there will be a cyclical factor working to restrain prices. But the trend in consumer prices is up, and with returns on bank deposits yielding much less than the rate of consumer price inflation, the hoarding mentality that can quickly lead to high and accelerating rates of inflation may take hold rapidly. Most Americans have never experienced anything approaching hyperinflation and are not as savvy as the brilliant doctor who sniffed out scurvy. In practice, all this continues to argue for possession of a significant and permanent holding of gold. Had the patient simply eaten some fruit or taken a vitamin pill, he would have had better health status. Similarly, gold and only gold is the classic way to hold long-term purchasing power when a government goes out of fiscal control, as the government of the United States may do sooner rather than later. There is no financial VA Hospital you can go to should the rate of loss of purchasing power vs. money rates paid by banks get worse. There may only be the Internet, depending on the point of view of any financial advisor(s) you may have.

I don't know anything about future choices that the authorities will make. Whether the U. S. goes in and out of deflation, as Mish predicts, is above my pay grade. All I can do is ask whether the U. S. is as deficient in financial prudence as my scurrilous patient was before he got sick enough to come to medical attention. Thus, my equivalent of financial vitamin C is gold.

BTW, in follow-up of my recent posts, I reversed trading course this AM and covered most of my shorts and also added more longs. The reason was that too many headlines were gloomy, and bearishness does not love company.

Copyright (C) Long Lake LLC 2011

Tuesday, May 24, 2011

Another Non-Barking Dog

A dog that did not bark today was the stock market. After Monday's drubbing, bulls wanted to stage a "Turnaround Tuesday". Instead, with less than an hour to go in the regular stock trading session, stocks are flat with the VIX down (a lower VIX indicating less fear in the marketplace as judged by certain options activity). However, Treasuries reversed from down in price to up in price, joining gold in the plus column.

Meanwhile, my favored proxy group for the fundamentals of the economy, namely large financials, are depressing. JPM, generally considered the best of the TBTFs, is weak again today. BofA stock looks horrible, as do C and AIG. A high-quality not-quite TBTF, the President's banker (Northern Trust) also has a failing chart. DE and CAT don't have hot charts, either.

I recently read an erudite piece out of Cumberland Associates that "sell in May and go away" historically has not applied when some circumstance or another that in my approaching dotage I cannot remember is present, as it was when the writer wrote that. But at least for industrially sensitive stocks and commodities, today's action is more consistent than not with the thesis that for the next few months, investors' trading accounts are better off on defense than offense.

Disclosure: I am short BAC and NTRS, though I am long a much greater quantity of offsetting longs in a similar investment niche. I am also long gold in various forms and have certain other longs and shorts. My major recent asset allocation change has been to sell out of almost all foreign currency positions and energy stocks as soon after the reported "hit" on Mr. bin Laden occurred and silver and oil began crashing, and replace much of those positions with long Treasury bonds and most of the rest with cash.

Copyright (C) Long Lake LLC 2011

Sunday, May 22, 2011

Exited, Pursued by a Bear

We may be on the verge of learning more about how much capital has been wasted by the malinvestments of the past decade. I believe that the single most important stock group is the financial group. It is the financials that reflect whether the "marks" that are assigned to assets are accurate, and if they are inaccurate, in which direction the inaccuracy is. As Shakespeare might have said, leverage is all (unfortunately), and the financial stocks reflect this modern reality.

When economic activity is increasing and especially when it is accelerating, financial institutions have strong capital bases and compete with each other to lend funds. When there is a sound base for economic expansion, as in the 1980s and 1990s, the lenders have lots of good credits to consider, and in return, the good credits are able to provide substantial collateral and/or down payments to the lender. So the loans tend to be net profitable to the lender.

Internet 2.0 and weak dollar matters aside, and government spending (i.e. Fed "money") notwithstanding, there are no signs of that happier situation in the country as a whole as we approach two full years since the trough of economic activity. The top tier "Too Big to Fails", namely JPM and WFC, have uninspiring stock charts and have continued to underperform a rising stock market. This is just what happened in 2006 and 2007. On the other end of the quality scale among the TBTFs, here is a 5-year stock chart of BofA. A renewed bear market in the stock is threatened. (Please be aware there is no prediction here of what the stock price will do, especially in the short term.) But I will disclose that I have sold the stock short, creating my own micro-mini hedge fund considering I own a considerable amount of offsetting but not very liquid long positions in a similar place but with, I feel, better value for the price.

To a somewhat lessened degree, Goldman Sachs and Morgan Stanley have stock charts that look like BofA's.

There has also been no sustained sign of life in the truly moribund giant financials, Citigroup/AIG/Fannie/Freddie, all of whom were saved from some form of bankruptcy by direct support from the central authorities.

I take this as a bad fundamental sign. If matters go well in the economy, one will look for sustained outperformance in these companies. Right now, I prefer not to fight the tape. And since the Fed is scheduled to end QE 2.0 imminently, a cautious or bearish stance toward stocks is no longer fighting the Fed. If the Economic Cycle Research Institute (ECRI) is correct in their prediction of a significant global industrial downturn beginning this summer, these global financial companies should see their own business both diminish overall and switch more toward less profitable segments, such as fixed-income trading rather than M&A and stock trading.

There are also valuation metrics which resemble those extant at the 2007 peak. To wit, here is a chart from the Andrew Smithers website. Please note that the S&P 500 is up from where it was when this chart was created. Click HERE for an explanation of both independent valuation measures this graph utilizes.

The averages are at similar degrees of overvaluation as have rarely been seen in the past 11 decades.

People protest that current values are "OK", because interest rates are so low. My response is a "Yes, but" type of response. Interest rates are low because organic credit demand is lacking. This is the problem of our current biflation.

The nominal price of homes is flat to down. Housing grew to be such an important source of non-revolving credit that it became the animal that could sit wherever it wants. When housing went down and continues to stay down, significant percentage upticks in credit demand in much smaller sectors (smaller from a credit standpoint) fail to replace housing's importance. Thus, capital was credited to savers such as myself, but there is a surfeit of capital relative to users of capital. So, the weak credit environment explains the low interest scenario (without justifying the extremism of the zero interest rate policy of the Fed), and that goes hand in hand with weak economic growth prospects. These weak prospects are, in my view, enough to be consistent with much lower stock prices.

It is my view that all the money-printing, bailouts, happy talk from the media, and the like, have lulled investors to sleep. However, how many investors realize that from their respective bottoms in fall 2008 and winter 2009, gold has has a somewhat greater appreciation than the Dow Jones Industrial Average, dividends included? In other words, since the stock market bottomed in nominal terms in March 2009, it has actually declined further in terms that I prefer, namely gold.

Meanwhile, not only is housing double dipping, but autos are dipping as well, and at a much lower annual rate than was the case at the peak in the aughties. From J. D. Power and Associates:

High Gas Prices and Lower Incentive Levels Contributing to Dismal Start for May New-Vehicle Retail Sales

" . . .Retail sales in May are being hit by several negative variables—specifically, high gas prices, lower incentive levels and some inventory shortages," said Jeff Schuster, executive director of global forecasting at J.D. Power and Associates. "As a result, the industry will likely be dealing with a lower sales pace at least through the summer selling season, putting pressure on the 2011 outlook.'"

It is clear from the title, the above excerpt, and the whole text of the press release (which makes clear that most U. S. and global auto manufacturers have no exposure to Japanese parts and thus can make all the cars the market can afford), that the automakers' main problem is that when they tried to raise prices (by removing or decreasing incentives), buyers could no longer afford their merchandise, in view of the economy in general and gas prices in specific.

Because homebuilding and the industries that feed off of new home sales and home resales are so depressed, the ongoing depression in those industries will not be enough to cause a new recession. It will however be enough to eventually cause the accountants to lose patience with unrealistic valuations of real estate owned by banks (REO) and the value of mortgages, especially second liens. This is why I highlighted BofA above.

Finally, real people are feeling just like the stock market when the stock averages are adjusted for gold's price. They are seeing and feeling no improvement in their lives. Here are two examples. Gallup.com runs a daily crawl on its website that tracks a measure of employment levels and discretionary spending. Currently, the average respondent is spending $62/day. My recollection is that 3 years ago, when I started following the same website, spending was about double that. And this is not adjusted for the general increase in prices. Thus, people are truly squeezed. On the same site, the hiring/not hiring differential is only +12 today. It was +25-30 3+ years ago, when unemployment was rising, so this level is at best consistent with employment growing in line with population growth (in my very humble opinion).

The second example is Bloomberg's Consumer Comfort Index. This has sunk to 9-month lows:

So when I think of the intersection of markets and the economy, I think that the American people have it right. They know what's happening in their jobs, communities and bank accounts. For the first time in memory, a technical recovery in the economy and a surge in the stock market has left almost all people behind. There is no magic to this. It simply reflects an amazing amount of money printing. It is my supposition that all this new base money has been created by the Fed because the amount of capital that was destroyed (misallocated/malinvested) was massive. The weakness in the dollar, which commentators usually wrongly describe as strength in gold, simply reflects that the country was never really as rich as it was measured as being in the late 1990s till the Great Recession finally brought the reality home. One of these days, the stock market will resume being a weighing machine rather than a voting machine. What the nominal pricing will be is unpredictable, but one of these days, a look at the 110 years of the Smithers chart suggests that the stock market will be depressed as far below its average as it is now above.

That's why, for what may be a summer of negative economic news, I have fled growth-oriented investing and weak-dollar investing and have circled the wagons around the basic investments of gold, cash, and Treasuries. Barring general systemic collapse, the worst that can happen to me in this posture is that I do not participate in some up-moves. But I can sleep a lot better that way than if capital is destroyed by what I view as the stock market reverting to normal pricing of pre-owned securities.

Copyright (C) Long Lake LLC 2011

Thursday, May 19, 2011

Evidence of How Difficult It Is to Garner Excess Returns in the Stock Market

In January 1995, the Republicans took over Congress for the first time in, almost, forever. Quickly a form of gridlock took place that helped the stock market levitate. The R's wouldn't let President Clinton spend, and he wouldn't let them cut taxes. So the cash budget balanced soon enough, capital gains taxes were cut, and the prior record of three consecutive years of 20%+ stock market gains gave way to five years- 1995-99 inclusive. And then the S&P 500 hit a new record late in 2000. It was an amazing run. Since January 1995, the U. S. economy has only been in recession for about 8 quarters out of the 65 completed quarters since then. This is a historically better than average performance. So one would think that stocks have been fine performers overall.

Here are the stats. The S&P 500 has risen from 470 to 1340 (approximate numbers). This is a compound annual return of 6.60%. Adding in dividends brings the annual return to about 9%.
If one invested in a low cost index fund to mirror the index, fund expenses would bring the total return lower. And of course, assuming the fund is not held in a tax-exempt vehicle, taxes on dividends and capital gains would have been taken.

Also at the beginning of 1995, 10-year Treasuries yielded 7.2%, and 30-year T-bonds yielded 7.7%. Given a typical discount, that suggests that high-grade muni bonds would have yielded about 7% for long-term bonds. So, munis would have been as good as stocks for taxable accounts from then till now.

For retirement accounts, where tax rules for the unrealized appreciation inherent in zero coupon bonds are not relevant, the total return from a zero coupon 30-year Treasury bond (non-callable) can be calculated as follows.

At an annual yield of 7.7%, the price for a $1000 face value bond would have been $108. In other words, $108 in 1995 would be promised to turn into $1000 in 2025, with no interest payments for all that time. Today, 16.4 years later, this bond would now be a 13.6 year zero coupon bond, which I am estimating would be trading around $620 to give a yield to maturity of something over 3.4%. Thus the bond would have risen from $108 to $620 in 16.4 years, which my interest rate calculator says is about an 11.2% per year annualized return. This return is from the starting interest rate of 7.7% enhanced by a decline in market interest rates, further enhanced by the upward slope of the yield curve.

In other words, a time period that began with the greatest 5-year surge in stock prices in the history of the United States (at least since the dawn of the 20th Century) has led to equal stock market performance to that of plain vanilla municipal bonds for taxable accounts and to significant underperformance to that of a plain vanilla zero coupon Treasury bond for tax-deferred accounts.

In my view, this example should "put paid" to the idea that most people should put most of their investment funds in the stock market all of the time.

Copyright (C) Long Lake LLC 2011

Wednesday, May 18, 2011

More a Stock Market than a Market of Stocks: Playing Defense or not Playing at All

Why begin a post on stocks by mentioning that I purchased a 5 year 'A' quality muni bond today yielding 4%?

Perhaps because I feel the risk-reward is better for this than for the stuff I've been buying lately in my stock accounts. And I hasten to add that in my retirement I am far from earning enough to even come close to the high tax brackets, so that I don't really need the tax-free nature of muni interest payments very much.

Nonetheless, having closed out almost all my weak dollar, growth-y financial assets except gold-related matters shortly after the hit on bin Laden, I have reviewed the 2007-8 investment scene as well as the 2000-3 post-bubble period and have found some asset classes that by those precedents look better than cash heading into what appears to be a cyclical industrial slowdown.

First, let's review what two conservative strategists think of the stock market as a whole. The Ph.D. economist and fund manager John Hussman has updated his views this week. He sees an average return for stocks over the rest of this decade as little better than 3% annually. So in his view one could just buy a 10-year Treasury for the same yield and wake up a decade later (the Rip van Winkle approach). He also refers to the more senior strategist Jeremy Grantham, who is famous for making uncannily accurate 7-year projections, and who is even more bearish about U. S. stocks than is Hussman.

Finally, there is the less well-known Andrew Smithers, who bravely published a book in 2000 calling out the stock market as a huge bubble. He soldiers on, every 3 months updating a chart valuing the stock averages both by his estimate of fair value based both on earnings (10-year average earnings) and asset value ("q"). According to his estimates, stocks are at least 75% over fair value, and are similar to their valuations at their mid-1960s and 2007 peaks.

But all these considerations are in the face of the seemingly permanent zero interest rate policy (ZIRP). So if cash is trash, and the powers that be have a somewhat illogical commitment to price inflation of pre-owned equities that is in aggregate called the stock market, then most portfolio theorists recommend some exposure to stocks, and I agree. And in truth, much as have been a proponent of gold investing since 2009 and was in and out of gold beginning in 2002, so long as I live in a "fiat" world where gold is not money in the transactional sense, and I have bills to pay, I need to think of fiat dollars and think that I can do a bit better than Hussman's 3+% with stocks for the short run.

Therefore, taking the Economic Cycle Institute's (ECRI) warnings about a major global industrial business cycle to heart, I have invested funds in the following stock groups: electric utility, health insurance, and defense. Admittedly I have primarily negative feelings toward the latter two groups of companies, but the only stocks that I have always refused to buy are cigarette stocks. (In fact, 30 years ago I refused to buy Bic stock because they made lighters in addition to pens; it soared without me on board.) I have also been buying into closed end muni bond funds, as these funds are able to use leverage to enhance yield with reasonable safety, and an individual cannot accomplish this.

On the other hand, interim kickback rallies notwithstanding, I look askance at the charts of energy, materials and even most tech stocks. Japan's history with ZIRP is that major bear markets can indeed occur without the central bank lifting interest rates. Cyclical industrial downturn such as that which may be approaching soon can teach a severe lesson to both veterans and noobs alike who trust in the central bank to prevent asset prices from falling in nominal terms.

If ECRI is correct, there will be continued important shifts in the pricing of different sectors of the stock market with more movement within the market than the averages will reflect, unless and until another systemic crisis a la late 2008 comes upon us and babies get tossed out with bathwater. One may need Biblical fortitude to resist the blandishment of tantalizing rallies in risk assets, however, to follow this cautious strategy through to its conclusion, which could very easily end (or not yet be ready to end) with the CNBC crew putting their Dow 10000 hats on backward.

Copyright (C) Long Lake LLC 2011

Sunday, May 15, 2011

Whither the Markets?

Yours truly has been following the news and much Internet/blog commentary lately with interest and calmness. On The Daily Capitalist website, we have seen Econophile opine about a stagflationary outcome, and Keith Weiner provide a futuristic view of some sort of hyperinflationary "crack-up boom", a term used by von Mises.

My view is more toward Econophile's but with some differences in the short term. Here's why. Mr. Weiner suggests that we watch, some years from now, for gold to trade at a higher price in the near-term months on the futures market than in the more distant months (i.e. "backwardation"), and that this will be a warning sign of what he calls a coming financial Armageddon. Without beating a theoretical horse that may or may not occur, I can think of a number of reasons why gold could go into sustained backwardation without leading to a breakdown of trust in the financial system. Reasons could include demonetization of gold, manipulation, mania, off-market contracts for gold delivery, and a general deflationary trend in prices of tangible goods, as well as the possibility of centrally-dictated negative interest rates.

In any case, perhaps a hyperinflationary depression is in our future, as Mr. Weiner posits. Shorter-term, I think we truly need to worry about a global industrial recession. My read of the commodity markets is consistent with that.

There is one very interesting topic in Econophile's linked post that I will address. That point relates to his statement that not all capital was consumed by the crash. I wonder. Certainly the physical structures of the United States were not damaged. There were no enemy bombs bursting in air, no giant toxic radioactive leaks, etc. But what if all banks, more or less, were bankrupt? Then, all the fiat claims and counterclaims tied into worthless bank deposits.

The way I am putting the Armageddon-lite events of the 2008 era together is as follows. The U. S. and Britain suffered a collective financial major myocardial infarction following Fannie and Freddie going into receivership in late summer 2008. This was followed by Lehman's collapse, Sunday evening panicky special broadcasts starring Hank Paulson and the like, President Bush admitting he was violating capitalist principles to save capitalism, and crony capitalism the likes of which America had not seen for many decades. The serial bailouts and intense subsequent money-printing just might be because the authorities took a look at the 40:1 leverage of the investment banks, the (perhaps) 100:1 leverage of the GSEs, and the unknown but high leverage of the other large financial institutions and realized that there was no equity left.

Therefore they just decided to create enough new dollars ("fiatscos") as were needed to begin the cycle anew. Of course, under a debt-based system of money creation, this could only be accomplished with ultra-low interest rates. Thus, "ZIRP". Thus, the Bank of England and "the Bernank" were charged with inventing any excuse to not see price inflation that the whole world sees, or to call it transitory. Thus, periodic endings of money printing, QE 1, QE1.5, QE 2.0, etc., in order to see if the economy was self-sustaining yet. Sort of like a cook taking a dish out of the oven to see if it needed more cooking. If no self-sustaining recovery, well, OK, let's cook it some more (i.e. print more money).

Thus, biflation, as the massive and leveraged capital that went into building too many homes, and too expensive homes, had perhaps destroyed all financial capital in the country, after accounting for debts to foreigners, and without selling the physical country and its mineral rights etc. to the foreigners.

Of course, this is just a theory, and I'm interested in comments. To me, it fits the facts as I see them, and it explains why hyperinflation has not happened and why we may be entering into a period of general disinflation and commodity price deflation as an industrial recession looms. The human, physical and intellectual capital exists, but when the accounting is/was done properly, perhaps the value of all those assets expressed in terms of the money stock that existed as of the summer of 2008 was zero.

If I am correct that the cyclical economy is on the rocks, stocks that will rise or at least hold steady will be few and far between over the next months. These may include utilities, McDonald's and retail discounters. Personally I have taken several short positions to offset my few longs, but mostly I am in cash with a reserve of gold. If I am correct, oil could easily hit $80/bbl on the downside this summer/fall and perhaps could go much lower. $60 has very strong support if $80 decisively fails. If we see $60/bbl, watch for gold to test $1000/ounce before, perhaps, doubling in short order to $2000+. If oil hits $80 and holds, then rebounds on an economic rebound plus QE 3.0 or its equivalent, then gold might hold above $1400 at its worst and then head to new highs by year-end.

Thus I am presenting a somewhat different potential scenario for the months ahead. Let's see what happens. As always, I am data-driven. Anybody who has a high degree of confidence in any sort of prediction and who lacks inside information is in my view overconfident.

Copyright (C) Long Lake LLC 2011

Sunday, May 8, 2011

Changing on a Paradigm

Last summer, I embarked upon a series of three posts explaining why I was committing our funds substantially into a weak dollar set of investments; click for links to the first, second and third of the series, which delineated three ways to invest on that theme: gold, silver, and foreign currencies. I also wrote favorably of stocks, with emphasis on those with substantial international exposure.

All these investment classes have done quite well.

I believe that for a multi-month horizon, it's time for a new paradigm.

As might have been expected given an economy that merely had a growth slowdown last summer and fall and then rebounded on its own in association with a simultaneous huge injection of government spending "paid for" by newly-created Fed "money", there has been a massive speculative top in silver a week (plus) ago, wild speculation in certain "Internet 2.0" stocks, such factors as the one-sided coverage of this past Friday's employment reports (with the media mostly ignoring the negative household survey in favor of the positive establishment report), the increase in new unemployment claims, the return of the Consumer Comfort survey (now a Bloomberg report, formerly ABC News) to near-2009 lows, and (last-not-least), the reported double dip in housing. The stage is set for another growth slowdown at best, eerily similar to that of last year, but perhaps ending worse.

The major reason I am reversing the summer 2010 decision I made to go heavily into the "risk on" assets is, however, seen in the video linked to HERE. This should be seen in conjunction with the charts on the left side of the current home page of the Economic Research Institute (which may change).

ECRI raises the possibility of a global industrial recession, and the likelihood of a significant deceleration of industrial activity. It is the second derivative of growth that traditionally most affects markets, meaning unexpected acceleration or deceleration away from the prior trend.

Given where market prices are today compared to where they were when I wrote the above articles, it's risk off in the DoctoRx investing world. Anybody who monitors bloggers and other commentators who complain about Comex "hits" on virtuous silver buyers may wish to consider that silver was roughly $20/ounce when I wrote my linked piece.

For those familiar with investment lingo, last week I sold in May and went away. The only significant non-bond, non-cash assets that remain in our portfolios are gold and some public but illiquid undervalued equities, which I have hedged with short positions in more liquid investments which may be fundamentally worse values. If ECRI is correct, the only weak dollar hedge one needs is gold.

None of the above represents a short term timing call in any way, shape or form. After last week's carnage, my trading sense would suggest that silver and oil, for example, are due for a bounce higher in the upcoming week. It's also not a bear call on stocks per se, given that many stocks are "defensive" and given that capital rightly continues to seek alternatives to cash.

Much more to follow as the Obama deficits continue to meet Helicopter Ben.

Copyright (C) Long Lake LLC 2011

Tuesday, May 3, 2011

Stock Vs. Precious Metals Rates of Return

Since 1985, gold has returned 5.5% annually, silver 7.5%, and stocks 9% plus dividends. The relative trends suggest that there is at least as much chance that stocks are overvalued than are the metals.

Copyright (C) Long Lake LLC 2011

Reflections on a Less-than Golden Dollar

The image nearby reflects the St. Louis Fed's very long term chart of the US dollar vs. major currencies. It shows a downtrend which I am confident is statistically significantly different from stable. In that time frame, the price of gold and oil are each up 30-40 times. The Dow Jones Industrial Average is up about 13 times, but in those about 38 years from the beginning of the chart, dividends are significant. Perhaps the total return of the DJIA is very similar to that of gold.

What does the future hold? Who knows, but it appears to me that in a period of large governmental debts and negative demographics, one can simply hold gold for an extended period of time in one form or another rather than bothering with stocks, unless one is very "good" at choosing stocks. And if one likes stocks, precious metals stocks look OK to this observer.

I'd also like to get just a bit snarky, because some of the most prominent bloggers do what the MSM does, and pretend to give you the big picture while often merely providing concealed propaganda. I'm all for proselytizing, but I'm against presenting selective data. To that end, please consider a dollar chart presented by Barry Ritholtz recently. For some reason, perhaps the annotation on the chart, I am unable to upload that graph to this post, but rather than showing the Carter-era bear market in the USD and then the incredible surge in the first years of the Volcker-Reagan era, including the post-1982 period when interest rates plunged (but price inflation fell faster than rates), he chooses to begin in 1983 or so, after the broad dollar index had already risen by about 33%. Huh?

This by itself is unobjectionable, but consider the point of his post, which states that it is to provide a longer-term view of the dollar than a prior 15 year chart he had presented in a previous blog post. So anyone looking at this more comprehensive 38 year chart he presents gets to see two epic collapses, one under Ronald Reagan, the other under "W". Anyone who recalls Mr. Ritholtz's ardent embrace of candidate Barack Obama in fall 2008 and his attacks on those who disagree with him on the Fannie-Freddie-Community Reinvestment Act issue may wonder as I do if it is unlikely that the brilliant and well-informed Mr. Ritholtz simply inadvertently left out the evidence that the USD had two sustained periods of outperformance in the last 38 years, and both had much to do with Republicans. One period was in Reagan's early years (when the R's also held the Senate), so that the average of the dollar in his 8 years was much higher than when he took office. The other began on or about January 1995. That date is significant. It is when the candidates from the "change" election of November 1994 took office. You will note that despite a very large increase in interest rates in 1994 (not shown), the dollar was weak that year. It was only when the Republicans took office with a mandate from the people to shrink the size of government and balance the budget and actually began to act serious about that mandate that the dollar rose. It then kept rising throughout the rest of the Clinton (gridlock period) years and continued for the beginning of the GW Bush presidency. Then came 9/11/01 and a guns and butter policy, and the rest is history.

My take is that the politicians hire central bankers to take the fall for inflationary policies when the inflation becomes a sore spot with the public, and then the pols can take the credit for the natural vigor of the economy when an up-cycle occurs. That the long-term trend of the dollar has been down against the other major currencies has some significance, but I think the major point is that all currencies are politically managed in this era of fiat money. Please do not fall prey to price illusion, which is a mainstay of "Keynesian" economics. Please also be aware that adjusted for the price of gold, and even including dividends, the stock averages have not moved at all from their 2009 lows. I take that as a worrisome sign. Just as was the case in the summer of 2007, when the public felt that the country was already in a recession, the public has never after felt the love that the stock market appears to feel lately. They don't care if, their cost of living is rising 4% while their pay package is unchanged, rather than their living costs rise 10% while their pay goes up 6%. In other words, the money illusion doesn't really work anymore. Been there, done that. People "get it" after all these years of price inflation.

Terms of trade have moved against the US lately, as other nations ("emerging" and otherwise) have mostly not suffered from the massive malinvestment the US made in housing and related "stuff" to fill up the more numerous and unaffordably large homes that were created using Ponzi finance. The piper is now getting paid via a relatively lower standard of living, just as Austrian economists predicted. This will likely pass, but right now I see no reason for the 38-year trend toward relative dollar weakness against other fiat currencies to reverse, short-term fluctuations notwithstanding.

Copyright (C) Long Lake LLC 2011