More Questions Than Answers As We Enter 2012

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The S&P 500, the investment community’s most widely-watched index, fell in the last few minutes of today’s trading session to close the year at 1257.60.  It closed 2010 at 1257.64.  We finished a year marked by surging corporate profits, mega-doses of government stimulus, plummeting treasury bond yields, headline-grabbing bankruptcies of American Airlines and MF Global, ongoing armed conflicts, overthrows of Middle Eastern governments, violent protests in Europe, “Occupy” protests here at home, unresolved housing and unemployment problems, our AAA credit rating diminished, politicians who can’t craft a compromise, and European banks and countries on the edge of bankruptcy.  All that action notwithstanding, the S&P 500 closed the year virtually unchanged.  Beyond the S&P, the Dow Jones Industrials and Utilities tacked on gains, while the Dow Transports, Nasdaq Composite, New York Stock Exchange Composite, Mid-caps, Small-caps and the most inclusive Dow Jones Total U.S. Stock Market Index all showed losses.  Overseas the carnage was more significant, with both emerging and developed markets falling.  All but a very few countries experienced declines ranging from about 15% to 40%.  Not a happy year for equity holders.

We enter 2012 with hope but with far more questions than answers.  Let me list a few:

  • Will recently improving employment, manufacturing and consumer confidence statistics continue into the new year as government stimulus and tax incentives wind down?
  • Will housing prices halt their declines in 2012?
  • Can we make a meaningful dent in the overhang of homes for sale?
  • With Real Disposable Personal Income now declining, will the U.S. consumer continue to cut his/her savings rate in order to maintain spending?
  • Can U.S. corporations continue to grow earnings in an environment of weak housing and massive unemployment?
  • Will our major political parties reverse the trend of moving farther away from common ground?
  • Will Occupy Wall Street simply mark the beginning of growing social unrest?

Europe and the Euro were the dominant financial stories in 2011.  With their multiple problems still unsolved, these are likely to remain the primary themes at least through much of 2012.  That probability raises additional questions.

  • Can the Eurozone escape a serious recession despite rapidly declining economic indicators?
  • Can several European countries roll over massive amounts of debt coming due in 2012 at rates that will not worsen already serious debt conditions?
  • Can the Eurozone hold together?
  • Will more European countries introduce austerity programs sufficient to meet Eurozone standards without sinking their economies?
  • Will the European Central Bank need to obtain a changed mandate to print its way out of the worsening debt crisis?

The United States is faced with an equally problematic debt dilemma, although less imminent.  We have so far been spared European-type pain, because the world remains willing–even eager–to fund our massive deficits.  Whether or not we begin to experience Europe’s problems depends upon the sustainability of investor confidence.  The reality is that we can never pay for all our past promises with a dollar possessing anything like its current value.

  • Will our politicians cobble together a debt reduction plan to sufficiently placate rating agencies in order to keep the U.S debt rating from being lowered further?
  • Will the Federal Reserve resort to some form of QE3?
  • Will we begin to renege on some past promises, either domestic or international, to keep budgets from exploding?
  • Will we ultimately resort to dramatically rapid money printing?
  • Will foreign sources continue to buy U.S. debt at historically low interest rates despite our huge deficits?
  • Will gold prices rise for the twelfth consecutive year if investors fear the inevitability of massive money printing?

Many bullish investors argue that, despite growing debt problems in the developed world, the emerging economies will provide the engine of growth that will keep the world financially steady.  That prospect raises some difficult-to-answer questions.

  • Why did the world’s emerging country stock markets significantly underperform those of the developed world in 2011?
  • Why did the stock market of China, the economic giant of the emerging countries, fall precipitously in 2011?  Why is it down by almost two-thirds over the past four years?
  • The most powerful influences on markets often flow from events that are totally unanticipated. What currently unforeseeable events, good or bad, will unfold in 2012?

With so many open questions facing investors in the coming year, we will remain extremely flexible and ready to adapt to the unfolding story.

As we close 2011, we wish you and your families a new year filled with good health, happiness, peace and prosperity.


More About Our Gold Position

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Last week’s blog post about Mission adding gold to client portfolios elicited a few questions and comments. Among others, there were questions about the relative attractiveness of bullion, exchange-traded funds or gold mining stocks.

For the purpose of our purchase, which is to hedge against the probability of money printing, bullion is the best pure play. Gold is heavy, however, and presents the problem of storage and possibly also of transport. For our purposes, investing in physical gold for large numbers of individual clients would be impractical.

While investing in the common stocks of mining companies would be an easy alternative, mining stocks do not always move in concert with the price of gold. Often, the direction of the overall stock market has a greater influence on gold stocks than does the direction of gold’s price. While mining stocks pay a dividend, unlike the metal itself, that dividend yield is typically below the already low average yield of most common stocks. Despite the fact that gold’s price has risen for a decade, the stocks have been far less consistent. Most major gold stocks are trading below their levels of four to six or more years ago. In fact, giant Newmont is trading barely above its price in early 1994. Periodically gold stocks do very well, but they are not as consistent a hedge against the perils of the printing press as is gold itself.

The exchange-traded fund GLD presents the best combination of direct correlation to the price of gold and ease of ongoing ownership for large numbers of investors. It’s not perfect. In an extreme market disruption, access to the value of the asset could be temporarily compromised, as would be the case with any tradable security. It does not, however, suffer the inconveniences of storage and transportability, which burden physical gold.

A separate question was why we bought now and not years ago. As longstanding readers of our commentaries and attendees at our seminars know, I have long been an advocate of individuals owning some gold. I have characterized such ownership in those communications as more an insurance policy than an investment. Its purpose has been to protect against unpredictable and dangerous economic, political or monetary events.

What has changed our thinking about adding gold positions to client portfolios is the growing belief that we are now faced with predictable and dangerous events. Over the past six months there has been clear evidence in this country and Europe that governmental and monetary authorities are unwilling to take meaningful actions to deal with our respective debt crises. Europe’s unwillingness has precipitated the dramatic rise in sovereign bond yields in recent months. While we still maintain that the timing of the ultimate resolution of these crises is highly uncertain, it looks increasingly likely that the resolution will have to involve large quantities of newly printed money. Because such heavy printing could be ramped up at any time, we decided that it would be worth initiating gold exposure now in case such printing should begin very soon. As indicated in last week’s post, we plan to build our position if gold prices correct further in the weeks, months or quarters ahead.

In the meantime, we wish our readers a merry Christmas and happy Hanukkah and a peaceful, relaxing holiday season.


Gold: The Antidote To The Printing Press

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An aphorism passed down over centuries says that you should always have enough gold to bribe the border guards. In modern industrial societies, that concern has rarely been the motivation for gold ownership. In most time periods, only those labeled “gold bugs” pay any attention to the investment merits of the precious metal. Periodically, however, some political, economic or monetary condition gets gold’s price rising. If it climbs far enough, publicity pushes gold into the consciousness of those whose otherwise closest connection is their jewelry box.

While I have never been counted in the “gold bug” camp, I have counseled for several decades that holding some gold is a prudent insurance policy against any number of potential political, economic or monetary disruptions. Prior to this week, however, we have not established long-term positions for clients in gold or gold stocks. This week we changed that practice.

With a nod to Reinhart and Rogoff’s comprehensive history of 800 years of financial crises, This Time Is Different, governments and central banks have for centuries resorted to money creation to cover up prior eras of overspending and overleveraging. As our country faces its mother of all long-term debt crises, it appears virtually certain that our politicians and monetary gurus will eventually choose the easy way out– by way of the printing press. The unconscionable inaction by the Congressional supercommittee charged with carving out a mere $1.2 trillion from the next decade’s projected deficits announces clearly that there is no real commitment to getting our budget under control. Fiscal discipline won’t happen–if at all–until we demand term limits that would eliminate legislators’ need to bribe the electorate with near-term goodies in a seemingly perpetual bid for reelection. Similarly, our august central bankers have demonstrated their utter disregard for the elderly retired and generations unborn. Their expansionary bailout attempts benefit primarily the current working generation, whose budgetary imprudence has constructed the bulk of our precariously tottering debt edifice. Almost certainly the Fed will ultimately choose more money creation rather than accept the consequences of a decade and a half of dangerous central bank decisions.

The logical result of excessive money creation is the depreciation of the currency, which has led many analysts to forecast the decline of the U.S. dollar. In fact, the U.S. dollar’s purchasing power has been systematically reduced throughout the nearly one-century life of the Federal Reserve. Relative to a basket of foreign currencies, the dollar is worth far less than it was a decade or a quarter of a century ago, although it is above its 2008 low and about 10% above its May low in this most recent cycle. The recent rise comes not from any dollar strengthening moves from our central bank, but from persistent weakening conditions in other major currencies. And in the short run, that could continue.

Several asset categories demonstrate a negative correlation to the worth of the dollar. Gold, especially with the wide acceptance of the GLD exchange-traded fund, is an extremely liquid and easily accessible investment choice. Following the significant decline from GLD’s September price high, we began to build what could become a meaningful portfolio position in gold.

Above price levels that would be largely determined by jewelry demand, there is no sound way to value gold, notwithstanding the many authoritative-sounding analysts who grace the airwaves. Most are short-term traders. Rather, gold’s price is largely a reflection of investor fears and emotions.

The timing of factors that will stimulate investor fears and emotions is highly uncertain. Europe appears to be on the brink of a regional recession with the possibility of a banking collapse. Should Europe weaken markedly, it is likely that the rest of the world will follow in varying degrees. Such a condition would be disinflationary–even deflationary–which would logically be negative for the price of gold. On the other hand, such a condition would also logically prod central banks into action. As the aforementioned Reinhart and Rogoff have pointed out in great detail, inflation is typically the method of choice to rescue economies from debt crises. There is little reason to expect this episode to vary from the historical norm.

Given the uncertainty of the coming sequence of events and their timing, we began to construct our position in GLD this week at two potential levels of support: the trendline in effect since January, then GLD’s 200-day moving average. Given the current poor technical condition of gold, it was not surprising that prices broke through both levels. Because most gold surprises for the past decade have been positive, we wanted to begin our holding with a small portion of a desired full position at these levels, in case central banks got itchy trigger fingers and began to print earlier than we have reason to expect. Should such printing occur soon, we will likely see nice profits but on a relatively small position. On the other hand, should gold experience a larger correction of its earlier substantial price advance, we plan to add to the position over the weeks, months or quarters ahead at price levels where gold has found support in the past. Should the price decline last for a while, we will experience some loss of value on the small early positions, but we will build the potential for much larger gains from larger positions purchased at lower prices.

Whatever the near-term course of events, we anticipate that governments and central bankers will honor their genetic predisposition to avoid current pain without regard to longer-term economic dislocations. In fact, I suspect they are actively oiling their printing presses today.


What Does A 490 Point Advance Foretell?

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After Wednesday, November 30th’s massive 490-point rally in the Dow Jones Industrial Average, USA Today ran a lead story highlighting the ten biggest point gains ever. The most recent advance was the seventh largest. All ten have occurred in the last ten years. While the USA Today story did not pretend to draw conclusions about future price movements, it clearly implied that such an advance was an indication of overdone fear in a context of many positive, underappreciated factors.

A quick look at the dates of the other nine biggest gains clarifies that most took place in major bear markets. Eight of the prior nine took place after major market declines yet well above ultimate bear market bottoms. Only the 497-point surge on March 23, 2009 occurred near the beginning of a new bull market. In that instance, stock prices had bottomed just two weeks earlier, and the advance proved to be part of the initial surge in a market rally that carried for 26 months. From the history of this century-to-date, therefore, the recent rise looks unlikely to mark the kickoff of an extended rally.

Leaning in a more bullish direction, however, is a study by Ned Davis Research, Inc., a highly reputable source of historical data. Their December 6 report revealed that since 1950, there have been 37 instances of a 4% or better one-day advance in the Dow Jones Industrial Average. In 33 of those instances, the market was higher 12 months later. Those advances included most of the big gains that took place during the two giant bear markets that opened the twenty-first century.

The Ned Davis data showed that over the six-decade period of their study, such 4% one-day surges have typically initiated advances that grew roughly another 20% — more or less steadily over the subsequent 12 months. That behavior clearly differs from eight of the most recent nine advances in the last decade, which saw major declines to ultimate bear market bottoms before beginning lasting recoveries. Another important observation in the Ned Davis study was that preceding the 4% one-day surges, stock prices had on average been declining aggressively, by about 22% in the prior seven months and an even more aggressive 18% in the immediately prior three months. In other words, stocks typically surged out of a significantly oversold condition.

What do these seemingly conflicting data suggest for the aftermath of our most recent stock market surge? It is important to note that the November 30th rally did not flow from a seriously oversold condition. In fact, it began at a price level roughly 10% above where the index had traded about two and four months earlier. This is markedly different from the typical advance profiled in the Ned Davis study and all nine of the biggest point-gaining days of this century.

If I had to choose between the precedents offered by price patterns in this century and those from the last half of the prior century, I would lean toward the most recent experience. These observations took place in the era of egregiously overextended debt, which continues to provide the backdrop for today’s market. That, I suggest, is the single most critical variable weighing on economic progress and equity prices. If prices follow the recent precedent, they are likely to move significantly lower before beginning the next sustainable market advance.

While we are now in the seasonally strong month of December, interpretation of news from Europe will probably be the single biggest determinant of stock prices’ immediate path.


Central Banks Provide Liquidity

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The drama continues to play out.

Tuesday afternoon Standard & Poors downgraded 37 global banking giants–hardly a surprise. But when someone points out that the emperor is wearing no clothes, our markets reflexively decline, as they did in Tuesday night’s futures session. Just hours later the U.S. Federal Reserve, the European Central Bank and the central banks of England, Canada, Japan and Switzerland jointly agreed to cut the cost of borrowing U.S. dollars from 1% to just half that. Whether part of a coordinated move or not, the People’s Bank of China simultaneously announced a 50 basis point cut in that country’s Required Reserve Ratio for banks. The appearance of central bank solidarity quickly turned overnight futures from negative to strongly positive. That strength continued throughout Wednesday’s session with the Dow closing up a spectacular 490 points.

The financial press speculated that what prodded the central banks into their stimulative move was the prospect of an imminent collapse of a major bank, most likely French. Interviewed on TV Thursday, former Fed Governor Larry Lindsey admitted the likelihood of a major bank failure this month, but suggested the most probable stimulus to the central bank action to be S&P’s bank downgrades.

At least for one day the stock market celebrated this action as a big deal. One TV talking head characterized it as the banking authorities firing both barrels. On the other hand, it is not an immediate infusion of new money that can be put toward asset purchases. It is rather the expansion of a safety net should banks otherwise be unable to acquire U.S. dollars. One analyst aptly analogized it as putting foam on the runway to limit the damage of a crash.

At the very least, the move is encouraging because it provides clear evidence that cooperation is possible among the world’s largest central banks. At the same time, however, it underlines how severe the current crisis has become. The central banks acted because funding between banks has been freezing up, as it did in 2008, necessitating the greatest bailout in history. The S&P downgrades simply increased the distrust that banks have of their peers’ abilities to repay loans.

Whether or not this central bank action will provide meaningful assistance in calming the European storm is open to question. During the 2007-2009 banking crisis, similar swap line actions were taken four times, typically leading to dramatic stock market rallies. They ultimately failed, however, to promote the desired interbank confidence, which was only reestablished when the Fed provided broad guarantees. Such pledges would be politically improbable a second time around. Notwithstanding the stock market rallies precipitated by these liquidity-providing policy actions, all such gains were ultimately forfeited as the markets continued their plunge of more than 50% to their 2009 bottom.

Even if successful, these rescue actions are designed solely to solve emergency liquidity problems, not underlying solvency problems. And solvency is at the heart of the banking crisis. Bank of England Governor Mervyn King stated this week that the downward spiral facing banks looks like a systemic crisis. And the always insightful Martin Wolf, writing in Wednesday’s Financial Times, warns: “…that the eurozone has a choice between bad and calamitous alternatives. The bad alternative is radical policies to promote adjustment, while warding off a wave of sovereign debt restructurings (defaults), financial crises and a true depression. The calamitous alternative is that depression, along with a breakup of the (euro) project.”

As we have stated repeatedly, the ultimate resolution of this crisis is unknowable. A systemic collapse is possible with terribly severe potential consequences to worldwide asset prices. More hopefully, politicians and central bankers will craft a series of plans that will sufficiently boost investor confidence to keep asset prices afloat while the underlying debt problems are resolved, or where that is impossible, restructured. The latter alternative could lead to intermittent powerful rallies. Because the former alternative remains very possible, investors should weigh carefully how much exposure to risk they wish to assume. As recent market volatility demonstrates clearly, good or bad announcements can lead to precipitous moves in both stock and bond markets. In a truly dramatic resolution to the crisis, either positively or negatively, market prices could gap in either direction allowing no opportunity to get trade executions over a very broad price span.


When In Doubt, Reduce Risk Exposure

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The equity markets had little to be thankful for during the U.S.’s holiday-shortened week. The S&P 500 dropped by 4.7% through the normally bullish Thanksgiving week. Other commonly watched indexes fell even more. Not affected by our holiday, world markets likewise fell precipitously.

Expectations that Europe would cobble together a plan to prevent imminent economic collapse led to a spectacular October rally in stock markets around the world. However, as persistent bickering among heads of state decreased confidence in that outcome, markets sagged throughout most of November. Markets still go hour by hour waiting for a positive rumor from Europe. A plausible plan to “kick the can down the road” will likely lead to a substantial rally, especially with markets as oversold as they are today.

Nonetheless, the longer-term picture is getting darker by the day. Rating agencies downgraded sovereign bond ratings en masse last week. Moody’s cut Hungary to junk levels and Fitch did the same for Portugal. Belgium was downgraded. S&P warned that it may cut Japan’s rating. Fitch said that France’s triple-A was at risk. Investors also downgraded bonds on their own, independent of the rating agencies. The Italian ten-year bond reached 7.3%, and the two-year climbed over 8%. There is no realistic prospect that Italy will be able to grow its way out of this debt morass with debt service burdens at such levels. Even Germany, the financial engine of the Eurozone, saw its bond rates surge last week. In just over two weeks, German ten-year rates climbed from 1.72% to 2.25%. By way of comparison, the U.S. ten-year stayed at 1.96% over the same period. Fear is creeping in with respect to all of Europe. And Europe is a giant piece of the world’s economic and market composite.

As I write this on Sunday evening, a report is circulating that the International Monetary Fund is preparing a $794 billion rescue package for Italy. The rumor has overnight futures markets in rally mode. With markets as oversold as they have become over the past few weeks, snap-back rallies could be powerful if it looks likely that some sort of rescue package will defer a near-term debt collapse. On the other hand, long-term investors must remain conscious of the rapidly spreading deterioration of underlying fundamentals. Massive debt problems don’t cure themselves. Left to their natural outcomes, they unwind in a deflationary spiral. Rarely through history, however, do governments and central banks allow natural outcomes. More often than not, money printing becomes the defense of choice, resulting in a debt burden reduction through inflation. In extreme situations, runaway inflation eliminates all debt but introduces economic chaos. The last example of such an outcome for a major industrial country was in Germany in the 1920s. In any inflationary environment, varying only by degrees, lenders (bondholders) are penalized and borrowers are rewarded.

Today’s investors are by rights in a serious quandary. The financial system, at least in Europe, is in danger of collapse. Perhaps investors will believe in a rescue plan that will defer the pain for a few years, and equity prices may rise in celebration. Holders of sovereign bonds in perceived safe-haven countries (the U.S., Germany and Canada, for example) may profit if a disinflationary or deflationary recession unfolds. On the other hand, such bondholders may be beaten up badly if central banks resort to the printing press to alleviate the debt pressures.

Eventual outcomes will be politically determined. Successful investors may succeed more by their ability to anticipate political outcomes than by a deep understanding of investment fundamentals. In such an environment we rely on our underlying philosophical guideposts, which have stood us in good stead in this extremely dangerous century-to-date. In a high-risk environment, reduce risk exposure. Buy risk-bearing assets only when you can acquire them at extremely attractive valuation levels. Never lose sight of the fact that there will always be another opportunity to make significant gains. You will not be able to take advantage of that opportunity, however, if you lose a substantial amount of your assets when markets decline.


Volatility and Uncertainty Continue

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This has been mostly a business travel week, capped by a New York visit in time to witness the University of Arizona’s thrilling basketball win last night over St. John’s at Madison Square Garden. Tonight I’ll be able to see the tournament championship game against Mississippi State before heading back to Tucson. Go Cats!

This week the stock market repeated the past few months’ pattern, characterized by tremendous daily price volatility. In fact, triple-digit daily moves in the Dow Jones Industrial Average have become the norm, not the exception. The week closed with the S&P 500 down by nearly 4%.

Both stocks and bonds bounced back and forth with each new headline about European or U.S. debt crises. As we have noted previously in these posts, current markets are responding to rumors, hopes and speculation far more than to investment-worthy data. With stock trading volume low and volatility high, it is apparent than the indexes are in the hands of hedge funds and high-frequency traders rather than true investors.

As has been the case for months, European bankers and heads of state are long on plan announcements and short on committed cash. It’s apparently far easier to pledge than to pay.

As its first deadline nears, the congressional supercommittee is increasingly in the news. The committee’s bipartisan recommendation and the subsequent congressional vote are due next week. Most political analysts believe there to be substantial risk of failure to agree on even the minimal $1.2 trillion deficit reduction over ten years. It’s impossible to know how investors will react to various degrees of success or failure to agree on the mandated reductions. Nonetheless, based on recent market performance, it is highly likely that reactions will be violent in one direction or another–or both.

Realistically, the debt problems in many European countries and the United States cannot be solved, only deferred. At present, deferral is all that investors are hoping for. It is impossible to forecast when the intractability of the debt condition will force itself upon investor consciousness. The only realistic alternatives in the long run are partial default or inflating away the problems by money creation. Which of the alternatives unfolds over time will subsequently induce bond market reactions that are polar opposites. The threat of default would penalize any suspect bonds but induce a flight to safety into perceived “safe haven” paper. The prospect of inflation could decimate bonds of all credit quality levels.

Equities could experience virtually opposite reactions. The threat of any consequential level of default would likely lead to severe economic contraction and a resultant stock market decline. Moderate inflation for an extended period of time might be beneficial for equities. On the other hand, rampant inflation would introduce huge economic uncertainty. Some companies would benefit; others would suffer. Historically, periods of powerful inflation have generally produced weak stock markets. Ironically, returns on short-term cash have outperformed stocks in periods of severe inflation.

Such uncertainty reinforces the advice we have given for well more than a decade: investors will be better served by maintaining a flexible asset allocation rather than the traditional fixed allocation with periodic rebalancing. The worst of all worlds for the fixed allocation approach would be a declining stock market induced by rampant inflation, which in turn produces negative bond returns – certainly a realistic possibility.


Too Big To Fail; Too Big To Bail

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In last week’s entry I pointed to the U.S. stock market’s daily Pavlovian responsiveness to stories and rumors coming from Europe. That action continues this week with the focus shifting from Greece to Italy. Greek Prime Minister Papandreou’s government has collapsed, and opposing parties are scrambling to find enough points of agreement to coalesce around a unity candidate. Virtually no one expects such a government to last. The desperate hope is that the politicians can simply assemble a sufficiently credible coalition in support of the promised austerity measures, so that the next tranche of bailout money will be released before Greece runs out of funds.

Despite the immediacy of that concern, the 800-pound gorilla that has taken its place in the middle of the room is Italy. Italy’s economy and debt levels are many times larger than those of Greece.

Last week I lamented that Italy’s ten-year bond yield had risen to 6.4%, a level that strongly called into question the government’s ability to service its debt and grow its way out of financial distress. Conditions have since worsened. On Wednesday, fear pushed that yield up to 7.25%. It is noteworthy that reaching the 7% threshold was a red flag warning that preceded the necessary bailouts of Greece, Portugal and Ireland. Italy’s political situation is in obvious disarray, and there appears to be no compelling voice strongly advocating the severe austerity measures needed to bring the country into compliance with Eurozone financial standards.

Italy’s growing crisis dramatically compounds the rescue problems that have so far bedeviled Eurozone finance ministers and heads of state. Italy’s failure to roll over its maturing debt at a manageable rate of interest would send shock waves through the European economy. On the other hand, in a weak economic environment, there is virtually no chance that the combined Eurozone members will provide enough rescue money to get Italy over this hurdle.

If the markets push Italy to the wall, there is no European entity (as currently funded) capable of coming to the rescue. The European Central bank could be further capitalized, but that is unlikely given the already-existing financial pressure on its members. Or the Eurozone could agree to permit the ECB to print enough money to paper over the problem. Such a solution, however, runs painfully against the grain for Germans, who retain in their DNA an abhorrence to inflation that decimated the value of their currency in the 1920s. If Germany doesn’t want it, it isn’t going to happen.

That leaves a coordinated worldwide solution as the only realistic possibility. Getting the International Monetary Fund (17% U.S. funded) and the U.S. Federal Reserve on board with the ECB appears to be the only option for pooling enough financial firepower, should Italy need rescue. Could you imagine getting approval of such a monetary commitment if it were put before voters in the United States? Inconceivable in today’s tough times. Should Bernanke, Geithner and the boys pledge U.S. money to such an effort, it would be yet another example of “We know better than you do.”

If you oppose the parade of financial bailouts, as I do, I urge you to let your voice be heard in any way you can. Don’t allow our government officials to reward the profligate at the expense of the prudent.

And if Italy is temporarily rescued, Spain is waiting in the wings. And how are we going to solve our own debt crisis here in the United States?


Bonds Contradict Recent Stock Progress

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Another very volatile week! Friday’s mere 61-point loss on the Dow Jones Industrial Average on very light volume brought a frenetic week to a relatively calm conclusion. Reacting to a possible unwinding of the Greek rescue plan, the Dow lost 573 points on Monday and Tuesday. Fed Chairman Ben Bernanke’s reassuring words that the Fed retained numerous options to shore up a flagging economy prompted a 386-point recovery on Wednesday and Thursday. The net of all action was a 2% loss for the week.

This week demonstrated conclusively the market’s responsiveness to headlines and rumors. The Dow rose and fell 100 points or more several times during the week as rumors circulated about prospects for the Greek bailout. Clearly, traders–not investors–had control of the buy and sell levers.

Trading closed for the week with the Greek parliament debating the fate of the Papandreou government and, in turn, with the European debt rescue effort hanging in the balance. It is remarkable that while the heads of state of Eurozone member nations have been meeting repeatedly for months, they have yet to agree on a concrete plan of action. Given the dire consequences that would flow from one or more sovereign defaults and from the resulting damage to the banks holding such bonds, it is hardly a surprise that individual investors are leaving the stock market in droves. It may take years for many of them to return. However, notwithstanding this week’s market decline, traders have been pushing prices up for several weeks with apparent confidence that governments and central bankers will prevent defaults from leading to a banking system failure. Whether or not that confidence will be rewarded is an open question.

Longer-term stock market price patterns still look negative. Ned Davis Research’s study of 45 world markets shows 41 of the 45 with stock indexes trading below their respective 200-day moving averages, a line viewed by many analysts as the demarcation between bull and bear market conditions. Additionally, 40 of those 45 moving averages have turned down, serving as confirmation of a bear market in the eyes of many.

Further disagreement with traders’ recent confidence comes from the bond markets. A vast amount of money has fled to risk-free U.S. treasury bills, which yield effectively nothing. Money has likewise poured into the bonds of safe-havens like the United States and Germany, each of which can borrow for 10 years for a mere 2%. In contrast, despite substantial supportive buying by the European Central Bank and the promise of further support from the block of Eurozone nations, Italian 10-year bond yields have soared to about 6.4%. Most analysts fear that yields over 6% will preclude distressed countries like Italy from servicing their debts and growing out of their current financial distress. The bond market is casting a powerful vote of no confidence in the efforts of politicians and bankers to cobble together a viable solution to the growing European debt crisis.

If Eurozone problems cannot at least be deferred, the consequences for the world financial system could be severe. When ongoing financial success depends upon programs crafted by politicians and self-interested bankers, we are not looking at a normal investment landscape, but rather a casino in which the standard rules of investment only minimally apply.


Third Quarter 2011

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The third quarter was painful for stock market investors with the S&P 500 losing 13.9%, leaving that index down 8.7% over the first three quarters of 2011. In a very difficult environment we are pleased that where we have complete asset allocation responsibility, client portfolios are up slightly both for the quarter and the year-to-date.

Investors read the news daily to learn whether Greece will soon join the ranks of countries currently in default on their debts. The bigger story surrounds speculation about whether much larger countries like Italy and Spain will also be unable to pay their bills. Greece is almost universally acknowledged to be incapable of financial survival without further bailout assistance. Spain’s debt rating was just downgraded. The problems are growing.

In the United States, the situation has become severe enough to warrant a third-quarter downgrade of our formerly sacrosanct AAA debt rating. Further downgrades are possible if Congress does not quickly craft a credible debt reduction program.

Fundamental conditions throughout the developed world are extremely weak. In the U.S. a few recent economic readings have improved slightly, but remain at depressed levels. Many economists, those from Goldman Sachs among them, have argued strongly that the U.S. will skirt a recession. Other economists contend that, while we may not be in recession today, the economy could easily slip into negative territory. The highly respected Economic Cycle Research Institute states boldly that its readings are at levels that have always forecast a recession. In ECRI’s view, a recession is inevitable.

Many contend that Europe is already in recession. At the very least, Europe is expected to be in recession soon. For years, emerging market economies have provided the bulk of world economic growth. These economies are slowing perceptibly and are unlikely to be able to carry the worldwide economy absent much greater support from the developed world.

A minority of analysts voice serious concerns about China, the leading engine of emerging economies. Some foresee an imminent collapse in the Chinese real estate market. Others point with alarm at dangers they perceive in the Chinese banking system. While growth figures remain substantial, something must be wrong in China. Its stock market is still more than 60% below its 2007 peak. A Chinese crisis would be disastrous for the world economy.

The global economy remains weak despite a record amount of on-going multi-country stimulus. Resulting debt levels now stand in the way of a continuation of such stimulus. Banking systems and sovereign debt structures are so precarious, however, that further government rescue money is seen as necessary to prevent imminent collapse, notwithstanding the long-term damage such additional rescues may cause. Current politicians are determined not to allow economic collapse on their watch. Defer the calamity to the future, even if it makes debt problems worse. Let our children and grandchildren deal with them.

Long-standing clients know that we began warning about an approaching long weak cycle at the end of the 1990s. We pointed to two primary reasons: 1) extremely extended stock valuations and 2) excessive debt (long before debt became a four-letter word). In the first decade of the new century, valuations have become less extreme, although in the aggregate they remain well above average. The debt issues, however, are far worse today than they were a dozen years ago, and there is no credible solution in sight. We pointed out that over the two prior centuries, long weak cycles averaged about a decade and a half in length and ended only after they had expunged the excesses of the prior long strong cycle. Unfortunately, we will not eliminate the problem of excessive debt for several more years at the very least. The persistent debt crisis doesn’t preclude intermittent rising equity markets. It does make it less likely, however, that we will have sustained rising equity markets until debt problems are solved. So far in this century we have experienced two historic market collapses and two powerful rallies. The net of all that action is that stock returns are negative for the century-to-date and prices today are where they were in the late-1990s. With banking systems and numerous countries on the edge of failure, great danger remains in the equity markets.

In the long weak cycle to-date, we have protected portfolios extremely well through the declining phases. We have attempted to find low-risk opportunities in the rising periods. We have found some opportunities, missed others. Net of it all, our client portfolios are up 65% before fees, which vary based on portfolio size. For the remainder of the long weak cycle with its huge potential for losses, our operating philosophy will be that it is far better to miss an opportunity than it is to lose any appreciable amount of money. There will always be another opportunity if capital is intact.

Through the twenty-first century so far, bonds have been the premier financial asset category. As a result, investors have recently flocked to bond ownership. At interest rates very close to all-time lows, however, bonds have become a high-risk asset class. They could do relatively well in the years ahead if the economy remains weak, especially if it falls again into recession with a deflationary bias. On the other hand, a stronger economy would almost certainly lead to higher interest rates and bond price losses. Should the monetary authorities attempt to solve the country’s overwhelming debt problems by printing large volumes of money, interest rates could skyrocket. One can make a plausible case for either rising or falling interest rates over the next few years. At today’s extremely low rates, however, the potential gains from steady or declining rates are far smaller than the potential losses from rising rates. It is instructive to remember that when interest rates last began a long rising cycle, bond returns trailed risk-free cash for four decades from the early-1940s to the early-1980s. At these interest rate levels, even top quality bonds can be a very high-risk investment.

We are pleased to have been able to avoid the equity market’s losses in 2011. We will continue to look for low-risk profit opportunities as the ongoing long weak cycle continues.