Consideration Of Greater Equity Exposure

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A few weeks ago I met with the investment committee of a not-for-profit client for which I do consulting work.  Membership on the committee has changed over the years, but the organization characterizes itself as unable to sustain any appreciable level of loss, regardless of market behavior.  As a result, committee members have chosen to hold a relatively small permanent allocation to equities.  Most notably when there is committee turnover, there has been a tendency to revisit the question of equity exposure.  In 2007, after four years of stock market rally, the committee was eager to increase the permanent equity exposure.  By the second half of 2008, they wanted to explore reducing it.  After the current rally that began in 2009, the committee is once again evaluating possible increased exposure.  The following material is a portion of the report I prepared for their review before our most recent meeting.  The contents are worthy of consideration by both individual and institutional investors, many of whom may feel tempted to ramp up their equity risk exposure.

Positive Factors

Momentum:  Stock prices have been rising in the U.S. and in most of the world for more than four years.

Central Bank Support:  Our Federal Reserve and about 40 central banks around the world have been providing unprecedented stimulus. Several have acknowledged that, among other objectives, they are aggressively attempting to boost stock prices.  A number of central banks have admitted to purchasing stocks directly.  I suspect that many more central banks are also buying, either directly or through surrogates.

Corporate Earnings:  Although growing slowly, earnings are at all-time highs.

Interest Rates:  While rates have risen from their lows set a year ago, they still remain near historic lows.


At the end of the 1990s we counseled clients about the imminent inception of a long weak stock market cycle, similar to those that had unfolded with regularity over the past two centuries.  Such cycles have served the purpose of expunging excesses of the prior long strong cycle.  While differing in length, long weak cycles have averaged about a decade and a half and have ended only with stock valuations at rock bottom levels, with investors having a substantial and durable distaste for equity ownership.  The proximate causes for the inception of this weak cycle were stock valuations far above any past levels, and debt relative to Gross Domestic Product exceeded only in periods of war.

The most recent long weak cycle began in 2000, with stock prices declining by about 50% through March 2003, despite aggressive Fed monetary stimulus.  Fed rescue efforts ultimately led to a major stock market and housing rally, which culminated in the mid-decade housing bubble.  Both stock and housing prices collapsed in the ensuing crisis.  Debt excesses were so severe that the world financial system nearly froze in 2008 until central bankers agreed to support the obligations of most major financial firms.  That rescue effort continues through today with whole countries now needing central bank support to avoid debt defaults and bankruptcy.  So far, at least in the United States , investors have trusted that central banks will continue to ward off significant stock market declines.

Negative Factors

Debt Levels:  Unprecedented rescue efforts have led to historic debt throughout most of the world’s developed economies.  An increasing number of countries are reaching levels of debt relative to GDP that have precipitated financial crises and defaults over past decades and centuries.  The United States cannot possibly meet all of its financial obligations, including social security and Medicare promises.  How it will eliminate some of those burdens is unknown.  Below the federal level, the recent city of Detroit bankruptcy announcement is likely the first of many city failures.  How unpayable state obligations will ultimately be resolved is similarly unknown.

Valuations:  While far below the bubble level valuations that prevailed in the late-1990s and well into the following decade, today’s stock valuations are still extremely high.  Price-to-earnings ratios are above the long-term average, but are not extreme.  Price-to-dividends, book value, sales and cash flow, however, are at or near all-time highs except for the recent bubble period.

Unemployment:  Despite nearly five years of unprecedented stimulus, unemployment remains far above average, and many have left the workforce after lengthy, unsuccessful job searches.

Growth Slowing:  After a severe recession, Europe has just barely produced one quarter of mild growth; the U.S. is growing below what has in the past been considered “stall speed”; emerging nations–especially China–are experiencing much slower growth than forecast; the International Monetary Fund has repeatedly dropped its forecast for world growth.

Implications for Investors

Committee members should evaluate current world economic and market conditions carefully before making any change in risk assumption.  Dramatic negative surprises could occur very quickly in the current environment.  When a country default might realistically be announced overnight with potential bank failure fall-out, permanent equity positions could be hit very hard.  Should Germany ultimately decide not to underwrite much of Southern Europe, market reactions could be violent.  These are not traditional concerns like those preceeding possible recessions.  The potential is very real that a country might be allowed to default, and world confidence in the stability of affected central banks would be tested.  Permanent equity positions would, of course, be exposed.  The committee must decide whether the assumption of that type of non-traditional risk is appropriate.

Given the very clear worldwide correlation between recent stock market progress and prospects for continued central bank stimulus, adding permanent equity exposure constitutes a bet that experimental monetary policies will ultimately succeed in overcoming problems brought on by excessive debt.  While that outcome is possible, many centuries of history argue against it.  Hundreds of worldwide debt-related financial crises over the past eight centuries demonstrate many similarities, although the specifics of each may differ.  Almost all of them led to prolonged economic disruptions (one to two decades), notwithstanding aggressive government rescue efforts.  While deflation certainly occurred as part of many of the episodes, profligate money printing (as characterizes the current debt crisis), more often than not ultimately resulted in substantial inflation.  It is unknowable how the current episode will end or when.  We remain in a high-risk environment.


Will Debt Ever Matter?

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Today is another landmark day in the ever-lengthening parade of government irresponsibility.  This morning’s news brought the message that Japan’s national debt has risen beyond one quadrillion yen.  That staggering figure is more than double the size of that nation’s GDP and exceeds the combined GDP of Germany, France and the United Kingdom.

Not many years ago, few had ever used “trillion” in financial reporting.  Now we’re talking about 1,000 trillion.  As is the case in a growing list of countries, Japan will never be able to pay all its obligations with money worth anything like today’s currency.  The United States is on that list.

In recent years, the U.S. Federal Reserve has led the way among major developed countries in “betting the ranch” to rescue financial institutions and to lift its economy out of a debilitating recession.  The Fed’s balance sheet was about $800 billion when it began to gun the monetary engines in 2008.  Today it reads about $3.5 trillion and climbing.  While the Fed’s largess has barely boosted the lethargic economy above recessionary levels, it has done marvelous things for the U.S. stock market.  Despite the obvious increase in future borrowing needs, the Fed’s direct intervention in the bond market has kept interest rates near historic lows until very recently.

The apparent success-to-date of the Bernanke model has emboldened monetary authorities throughout the world to abandon traditional propriety and similarly explode their balance sheets.  So far there has been no serious investor resistance.  Quite the contrary, until recently most world stock markets have soared, and interest rates–most notably in weak Southern European countries–have plummeted.  Perhaps the monetary alchemists have learned how to turn base metals into gold.

But what if these monetary wizards turn out to be no more legitimate than their medieval forebears?  Remember that the economic collapses of this century have all stemmed from excessive debt.  How likely is it that the solution to those problems will be a multiplication of the levels of debt?

That the Fed and other major central bankers have been able to bury the debt worry is compelling testimony to the power of unrelenting monetary steroid injections.  Investors have been mesmerized by soaring stock prices as though they constituted proof that debt can indeed be overcome by more debt.  Students of history, however, know that debt resolution is not that simple.  As laid out in copious detail in Reinhart and Rogoff’s, “This Time Is Different,” financial crises don’t die quickly and rarely without extended episodes of economic disruption.

The current recovery is fully dependent upon the retention of investor confidence.  Any number of things could disturb that confidence, not least among them a continuation of recent failures like Cyprus and Detroit.  At a point, investors will almost inevitably begin to wonder what lies beneath central bankers’ promises of endless support.  The day that investors come to see Bernanke’s successor, Draghi and Abe as wizards without portfolio, trillions in stock market gains could be immediately at risk.


2nd Quarter 2013 Market Commentary

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Clients who have chosen to have us implement our 2-Mode or 3-Mode equity allocation processes have seen a nice boost to the equity portion of portfolios during the first half of the year.  Those who elected to employ one of the processes through that entire period realized the full benefit.  Those who added one of the processes as the first half progressed earned a portion of the profit.  In a dangerous domestic and international environment, we encourage all clients to evaluate the processes as a reduced risk approach to equity participation.

At least in the United States and Japan, stocks are up so far in 2013.  Bonds are down around the world.  Gold and commodities are down.  Risk-free return is non-existent.  This is a critically important time for investors to evaluate their asset allocation policies.

Economic growth rates are declining in the United States and China, the world’s two largest economies.  Europe is still in recession.  Emerging market economies are slowing.  To counteract the danger of the world economy falling back into recession, central bankers have resorted to unprecedented levels of financial stimulus.  In a strikingly non-traditional economic and market environment, investors are faced with the quandary of whether to bet on the success of central bank rescue efforts or to defend against deteriorating fundamental conditions.  The stakes are extremely high.

Until very recently, central bankers have succeeded in boosting investor confidence with an aggressive combination of direct bailouts, quantitative easing and copious amounts of verbal cheerleading.  Central banks have always intervened in fixed income markets through direct purchases of securities.  As financial conditions deteriorated in recent years, however, central banks began to pollute their balance sheets with lower and lower quality securities in categories–like mortgages–never before included.

Most notably in Japan, but certainly in our country as well, central bankers are effectively printing money at unprecedented rates.  It is interesting that Japan and the United States are the only two major countries with stock markets appreciably in the profit column so far in 2013.  Central bank efforts are being applauded.  So far, other countries like Korea, whose foreign trade figures are being damaged by Japan’s plummeting yen, are complaining but not taking retaliatory monetary measures.  The potential for destabilizing currency wars, however, is perilously close.  Should they arise, their negative effects would be felt worldwide.

Since the financial crisis in 2008, central bankers have bent massive efforts toward supporting bond markets by directly purchasing fixed income securities at a great variety of maturities and by forcing short rates toward the zero bound.  Until recently, that intervention has rewarded bond market investors, especially those willing to accept the greatest risks in duration and credit quality.  The world has changed, however, this year.  Despite ongoing central bank efforts to keep interest rates near the floor, investor fears of upcoming higher rates have led to extensive bond market losses.  Whereas the allure of consistent bond profits drew billions per month from risk-averse investors, the sudden realization that bonds can lose money has produced a torrent of withdrawals from fixed income mutual funds and ETFs.  Many of those with no stomach for investment losses rue the day they let the Fed’s zero interest rate policy force them to accept investment risk to earn a prospective return.  Even for those who have not experienced losses, investment returns from fixed income securities have been meager, with the yields on 10- and 30-year Treasury debt higher today than at the height of the crisis in late 2008, despite massive central bank intervention since then.  Over that period of time, we have maintained that the level of risk is disproportionate to the potential for return.

So far in this country the Fed has successfully promoted profits in stocks, despite the slowest economic recovery from recession in modern U.S. history. Many speculate that stock prices will continue to climb so long as the Fed keeps expanding its balance sheet with more debt.  Two weeks ago the growth of first quarter GDP was revised down to a barely rising 1.8%.  And last week’s far worse-than-expected trade deficit report leads to expectations of a mere 1% GDP figure for quarter two.  Perhaps it doesn’t matter, however.  Some leading research firms now believe we’re in a win/win situation.  Good economic news is good; less than good economic news is also good, because it diminishes potential that the Fed will take its foot off the stimulus gas pedal.  Nobody seems to be asking: What horror does the Fed fear that it would continue to pile more debt on an already bloated balance sheet more than four years into an economic recovery?  It must be tremendously scary.

Should investors disregard weak and deteriorating domestic and world economic growth and simply put their faith in a market under the Fed’s protective guidance?  That trust has worked up to now.  On the other hand, that blind faith worked in the bond market as well – until it didn’t.  And that faith was similarly rewarded throughout much of the world in stocks until this year.  Despite still aggressive central bank support, most world stock markets are down so far in 2013.  In fact, of the 16 major countries regularly profiled in Investor’s Business Daily, only the U.S. and Japan are up appreciably so far this year, with three European markets essentially flat and the remaining 11 country markets down.  Declines exceed 20% in Brazil, South Africa and China.  Correlations are far from perfect from one country to the next, but it’s rare for one or two major markets to climb significantly when the vast majority are in decline.  Especially in a weak economic environment, international market weakness introduces much greater risk to our domestic market.  It is important not to lose sight of the fact that the Fed doesn’t always win.  Notwithstanding recent years’ stock market progress, the lesson of history is not encouraging. In the past, when nations have built debt edifices similar to today’s in the U.S., Japan, the Euro nations and many more, resolutions have extended for a decade or more, with serious economic dislocations and, most typically, significant inflation erasing much of the debt.  That scenario may or may not provide an accurate roadmap for our current situation.  At very least, however, it should highlight the extreme level of risk that attends today’s investment scene.

In a highly risky environment, in which the Fed has dramatically altered traditional fundamental considerations, we have been encouraging clients to adopt our formularized 2-Mode or 3-Mode equity allocation processes for the equity segments of their portfolios.  These processes have outperformed the S&P 500 over the past 32 years.  Most important to us, however, is that they have been able to do that with fewer and smaller losses than the index.  Those who have been in the processes since the beginning of the year have realized an 8.85% return on the money so deployed with an exposure to equity risk just 52% of the time.  While no process eliminates all risk, we strongly believe that these processes remove major portions of that risk.

Because the Fed and other major central banks around the world remain deeply committed to ongoing money creation, we have begun to build a small hedge in gold.  When we initiated the position, we made clear that it was not based on a belief that gold would necessarily continue its multi-year rise immediately.  We firmly believe that gold rises and falls with investor sentiment, with fear and greed the prime movers.  We said at the time that if gold prices continued to surge, we would earn a nice profit on a small position.  Greater profit in the long run, however, would come only if we could build a larger position at lower prices.  With the sharp decline in June, we brought the gold position to a still small 4% of portfolio value.  Should prices decline further from here, we will be able to build a more significant position at lower levels.  If central banks continue to inflate away current massive debts and ongoing annual deficits, this position should ultimately prove to be a profitable hedge.

With portfolio assets not immediately needed for longer-term positions, we have negotiated multi-year certificates of deposit at far better than current rates to provide a safe income base to the portfolio.  Having negotiated minimal prepayment penalties, we retain the option of holding the CDs so long as they remain more attractive than current alternatives.  Should short rates rise or more attractive long-term alternatives appear, we can exit the CDs on our chosen timetable.


U.S. and Japanese stock markets continue to respond favorably to massive central bank stimulus.  Most major world stock markets have declined so far in 2013.  Most world markets also remain below their 2000 and 2007 highs.  Virtually all bond markets around the world have produced losses this year, despite aggressive central bank efforts to support those markets.  It is an open question whether or not central bank efforts will be successful in rekindling economic growth and preventing substantial stock market declines. Over several centuries, history demonstrates that the ultimate resolution of problems brought on by excessive debt has typically taken a decade or more in length and involved significant economic disruption.  Substantial inflation has often been the ultimate result.  In such an environment, a permanent position in bonds is dangerous.  Warren Buffett recently categorized such a fixed position under current conditions as “silly.”

Equities offer additional gains so long as investors remain confident about the success of central bank rescue efforts.  Should that confidence wane, the consequences of excessive debt will likely do similar damage to equity prices as in 2000-03 and 2007-09.  We began to warn of a pending long weak cycle in stocks at the end of the 1990s because of excessive debt and historically high valuations.  Valuations are less extreme today, but still very high.  Overall debt conditions are even worse than they were at the turn of the century.  We caution against large permanent equity positions in the current high-risk environment.  We believe that our formularized equity allocation processes are safer alternatives to permanent equity allocations.


What If It Doesn’t Work?

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Wednesday demonstrated once again that the world’s equity markets are responding first and foremost to central bank intervention, not traditional investment fundamentals.  The Chinese market has been battered this year, trading nearly down to its 2008 crisis lows, despite continuing reports of still vigorous GDP growth.  Upon the announcement of truly dreadful import and export data, stock prices soared by 3%.  Investors reportedly anticipated that such bad economic news would force Chinese monetary authorities to resume stimulus.

Wednesday also marked the release of the Fed’s June meeting minutes.  U.S. stocks bounced up and down after the announcement but closed little changed.  When Chairman Bernanke responded to questions after the market close, however, overnight prices soared.  Foreign markets jumped, and the U.S. opened Thursday with the Dow up about 150 points with some major indexes closing at all-time highs.  What produced such enthusiasm?  Bernanke didn’t change his message from earlier written and oral reports, but he certainly emphasized the more accommodative portion of those reports.  While tapering of the Fed’s bond buying program will still remain “data dependent,” the Chairman made it clear that today’s economic conditions remain so weak that the Fed will likely remain highly accommodative for a considerable period of time.  Investors apparently didn’t worry about the weak economic conditions.  They celebrated the prospect of continuing availability of essentially free money.

When the Fed and its European counterpart say that they’ll just keep expanding their balance sheets until they achieve their desired results, it begs the question: What if such stimulus just doesn’t work?  It clearly hasn’t worked so far, despite four years of unprecedented monetary expansion and rock-bottom rates.  Europe remains in recession, while the U.S. still suffers its worst unemployment in three decades and can’t even elevate its GDP to the somnolent 2% level.  Even a minority on the Fed argue that this process doesn’t work.  Meanwhile the debt burden grows and grows.  Sorry, future generations.


Responses to “Why Gold?”

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We never know how many clients read the blog that I post most weeks.  Since last week’s entry “Why Gold?” was relevant to all clients who hold a position in the metal, we sent it to all who hold gold. The widely read Seeking Alpha site also picked up the article, and forwarded it to more than 300,000 of their subscribers.

From that list of recipients we received a number of responses, almost all favorable.  For most clients, the message was not new.  I had disclosed the rationale for our gold position from the day we acquired our first holdings.  I did receive one skeptical response, essentially stating that the article would have been far more helpful had it been written in 2003 instead of a decade later.  Given gold’s huge price rise over that period of time, it was an understandable response and one that might logically be shared by others who did not respond.  Let me provide a little history.

While we have not dedicated any of our conferences or seminars specifically to the subject of gold, we have addressed it in perhaps half of those gatherings either in the prepared presentation or in the question period.  Beginning at the end of the 1990s, when debt levels had risen to extremely dangerous levels, we began to outline probable outcomes to that perilous condition.  Most importantly, we anticipated the beginning of a long weak stock market cycle that would serve to correct the excesses of the then ending long strong cycle.  While not knowing how long such a cycle would take, we offered the historical perspective that such a corrective cycle had averaged about a decade and a half in length over the past two centuries.  We speculated that the upcoming one might be longer and/or more severe because it was correcting the most substantial long strong cycle ever, which had produced historic excesses.  Thirteen years later, stock market price levels are barely above those of 1999, and most of the excesses remain uncorrected.

Throughout history, because the normal governmental response to extreme debt levels has been to minimize them by depreciating the currency, we suggested that action to be a probable response by our Federal Reserve in the early twenty-first century.  I made the point any number of times that my wife and I had acquired physical gold in the mid-1980s at an average price around $350 per ounce.  I also indicated that we did not consider it to be a part of our investment portfolio.  It was, instead, a form of insurance against inflation or other financial disruptions.  I urged all listeners to own some gold for similar reasons, notwithstanding gold’s weight and the inconvenience of safe storage.  I have repeated that message every year since.

As I explained when we acquired our initial portfolio gold position in 2011, I first decided to include gold in client portfolios when it became clear that multiple major central banks were committing to overt currency depreciation policies to extricate themselves from extreme debt burdens.  I won’t repeat last week’s points about our expectations.  For reasons stated in that earlier article, we anticipate that gold prices will ultimately be higher–possibly soon, possibly not for years.  If prices rise from current levels, we will soon have a nice profit on a still small position.  If prices decline further, we will acquire larger positions at increasingly lower average prices leading ultimately, I suspect, to much larger long-term profits.


Why Gold?

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Two years ago, common wisdom declared you an idiot if you didn’t own gold.  Today you’re seen as an idiot if you do. In late 2011, when we first bought small positions in gold following an almost 20% price pullback, we made it very clear that our action was not because we believed prices were destined immediately to follow their decade-long march to higher levels.  When prices resumed their rise into late 2012, we were chided for having established such a small position.

When we first acquired the metal, we did so to hedge against the depreciation of the dollar by a Federal Reserve seemingly intent on inflating away debts that could never otherwise be repaid.  We said that the gold holding might or might not be rewarded in the near term.  We argued that there is no legitimate measure of the “appropriate” price for gold.  It moves higher or lower on waves of investor emotion, characterized at extremes by fear and greed.  At the time of our initial purchases, we indicated that if prices rose from there, we would end up with nice profits on a small portion of the portfolio.  On the other hand, we would continue to build the gold position only if prices declined–perhaps even precipitously.

When the price rise in 2012 stalled short of the 2011 high, we took profits on a portion of the initial position.  We rebuilt our position to the 3% level at successively lower prices in early 2013.  We increased the position to 4% when prices plummeted last week, bringing the average purchase price down significantly.

I am not a believer that one should average down on price unless the reason for holding an asset remains strong.  That reason certainly remains true for gold.  Over many millennia, gold has been universally recognized as a valuable commodity.  It will still be so thousands of years from now, unlike many corporations or currencies that live and die over time.  While the specific price level of gold will inevitably fluctuate, the lesson of history is clear.  If countries devalue their currencies by printing more of them, the price of gold rises in terms of those currencies.

Notwithstanding talk of tapering or the eventual end of quantitative easing, US budget deficits will remain huge for years to come, providing compelling incentive for the Fed to continue its efforts to inflate that debt away.  The story is similar throughout virtually the entire developed world.

We suggested when we began the gold purchase program that portfolios would ultimately benefit most if prices declined over time and allowed us to build a bigger position at successively lower prices.  That still remains true.  We simultaneously warned that, should that happen, clients would be uncomfortable in the short run, but would almost certainly reap greater rewards in the long run.  Wherever gold’s ultimate low price proves to be, whether this year or in the years ahead, it will take only a relatively small rally to render the full position profitable if the average purchase price is carefully crafted.  The potential upside is unlimited and largely dependent on the extent of central bank money creation.


More Questions Than Answers

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Virtually all asset classes were beaten up this week.  Stocks and gold garnered most of the headlines, but potentially the most meaningful decline was in bond prices, as interest rates soared for fixed income securities of all types and across all but the shortest maturities.  The phenomenon was certainly not restricted to U.S. markets but was observable, rather, throughout the world.  Most striking was the upward explosion of Chinese short rates, with their seven-day repo rate rising into double digits.

Rates have been rising aggressively since the end of April, but went into overdrive late Wednesday after Ben Bernanke’s question and answer session with the press.  Quite predictably, the press and other financial commentators attributed the new high yield levels to the Fed Chairman’s reinforcement of previously announced plans to gradually reduce the Fed’s massive stimulus program as long as the economy continues to expand.  Realistically, he announced nothing new; yet markets reacted violently.  With financial commentary now a 24-hour phenomenon, it’s highly unlikely that investors simply misinterpreted Bernanke’s message. Since Wednesday any number of apologists have emphasized that he broke no new ground.  Almost certainly, Bernanke’s message had no influence at all, for example, on China’s surging short rates.

I expect that we will have a fuller understanding of these volatile market moves in the months ahead.  With absolutely no proof in hand and hardly any tangible evidence, I can only suspect that the markets are anticipating defaults of some consequence somewhere around the globe.  Leverage has been increasing, dangerously in many areas, as governments have encouraged the expansion of credit to stimulate moribund economies.  Beyond recession-bound Europe, rumors have been rife for some time that Chinese banks and regional governments are perilously overleveraged.

There is no current public deathwatch with respect to any specific institution or entity.  It would not be surprising, however, to learn soon that one or more new but important cogs in the world economy can’t pay its bills.



Equity Declines No Longer Permitted in the U.S.

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Of the 18 major world equity markets that I follow on a daily basis, ten are down for the year, three are virtually unchanged and five are up.  Of the five that have provided a positive return, four have fallen sharply from their May highs.  Only the U.S. remains largely unscathed, not far below its all-time high.

Broad price declines have been experienced throughout the world despite a growing number of central banks adding equities to their balance sheets.  So far our Federal Reserve has not volunteered that it has actively intervened in the equity market, although it has acknowledged pushing prices up to be an integral part of its wealth creation program.

What is apparent is that some force has played an important role in manipulating the U.S. market.  Whether it’s the Plunge Protection Team, other central banks operating at the behest of the Fed, major investment banks or high frequency traders, the effects are clear.  Prices have bounced repeatedly from levels that over the long history of markets have signaled breakdowns from which further price declines typically flowed.  Not so any more.  Over the past six months the S&P 500 has suffered not even a single 5% decline.  Until this week, the Dow had not experienced three consecutive down days since last fall.  All this with the majority of world markets in decline.  Remarkable!

Even the popular press has noted unusual trading patterns.  Thursday’s USA Today highlighted the phenomenon of the Dow experiencing intraday price swings of 100 points or more in 15 of the past 16 trading sessions.  Thursday’s 249 point swing from low to high made it 16 out of 17.  Regardless of who is providing support against breakdowns, the Fed has promoted a highly non-traditional market environment.

Investors have historically been advised to be long-term in their thinking and investment practices.  In an environment no longer governed by traditional valuations or market practices, long-term investing runs the risk of suffering severe consequences should central bankers’ dangerous, unorthodox approaches ultimately prove flawed.  In an abnormal environment, we continue to advise a strategic, flexible approach to equity ownership rather than the more traditional buy and hold.


Frontrunning Undermines Confidence

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For the past few years, long-term market professionals have been puzzled by the failure of volume to return to the U.S. stock market.  The mystery is especially noteworthy because the current cyclical bull market in stocks has now extended beyond the four-year mark.  Historically, the normal pattern calls for greater investor participation the longer a bullish trend remains in place.  Because old-timers have observed the “volume confirms price” lesson for decades, many of the most experienced professionals have looked skeptically at this rally in which prices have moved persistently higher without volume confirmation.

Numerous explanations have been offered, not least among them the unprecedented intervention of the Federal Reserve in this country and other major central banks elsewhere around the world.  Fearing the artificiality of market rallies in an era of monumental money printing is certainly understandable.  Market action this week may further explain lack of participation by large numbers of investors.

On Monday morning, many millions of dollars of exchange traded funds were traded 15 milliseconds before the scheduled 10AM release of the potentially important ISM manufacturing report.  We later learned that Reuters “inadvertently” released the report a fraction of a second early to certain high frequency trading clients, who obviously were prepared to act on it.  On Friday morning we saw a similar situation play out in a different venue.  Just 62 milliseconds prior to the scheduled release of the widely watched non-farm payroll report, gold prices plummeted, preceding an even more significant sell-off as the day wore on.  No explanation has been confirmed.

With memories of 2010’s “flash crash” still vivid in investors’ minds, apparent market disruptions at the hands of high frequency traders have to drain confidence from investors who suffered through massive market declines from 2000-03 and 2007-09.  That confidence is further undermined by the clear appearance of favoritism when select investors receive data before others and frontrun other traders and investors.

There are a great many reasons why individual investors have retreated from stocks.  Until, however, regulators see fit to level the playing field for all investors, a large segment of those investors are likely to remain permanently absent.



It’s Time To Stop Fed Central Planning

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This week provided strong testimony to and evidence of the Fed’s controlling influence over stock prices.  Dallas Fed President Richard Fisher, an outspoken opponent of the Fed’s expansive monetary policy, was interviewed on CNBC on Monday.  Despite his past strong critiques of the unparalleled levels of stimulus, he argued that stopping quantitative easing immediately “…would be too violent for the marketplace.”  It was a clear admission that he believes today’s equity price level to be dependent on continuing stimulus.  In a nice turn of phrase, he cautioned against going from a “Wild Turkey” monetary policy to “cold turkey” overnight.

On Wednesday, Fed Chairman Ben Bernanke read a prepared statement to the U.S. House of Representatives in which he acknowledged the Fed’s recognition that it would have to reduce its massive monthly stimulus over time.  To stifle any concern that such a reduction was imminent, he took great pains to indicate that Fed largesse would continue–in fact might even increase–if sluggish economic conditions persist.  Wall Street loved that prospect of an indefinite stream of essentially free money, and the Dow shot up by 155 points.  Following his statement, Bernanke’s responses to questions from the representatives, complemented by a release of the Fed’s meeting minutes, took the bloom off the rose.  It became apparent that a growing number of other Fed governors were in favor of tapering the amount of stimulus.  When free money appeared less certain, the Dow rapidly fell by over 275 points.

On the day before Bernanke’s session with Congress, Pimco’s Mohamed El-Erian penned an article for Financial Times about recent large fluctuations in the price of gold.  In it he included the following caution about the possibility of a failed Fed effort:

“Today’s global economy is in the midst of its own stable disequilibrium; and markets have outpaced fundamentals on the expectation that western central banks, together with a more functional political system, will deliver higher growth.  If that fails to materialize, investors will worry about a lot more than the intrinsic value of gold.”

On Wednesday, in his monthly Elliott Wave Theorist, Robert Prechter expressed a far greater level of derision toward the Fed’s ongoing actions:

“The nominal values of the world’s financial assets have been serially inflated like a school of puffer fish by record levels of unpayable debt.”

The Fed has painted itself into a very dangerous corner.  Starting with unprecedented government intervention in 2008, monetary officials have bent monumental efforts toward saving the banking system and the economy generally from a spectacular breakdown.  I suspect that their expectation at the time was that such a massive rescue and stimulus effort would certainly put the economy on the path to a glorious recovery, which would eventually take the U.S. taxpayer off the hook.  It was, after all, shock and awe.  The reality, however, is that initial and subsequent efforts have spawned a minimal recovery at best, by far the weakest in the post-WWII era.  As each new and expensive rescue effort has failed to produce an economic escape velocity, the Fed has had to up the ante and put today’s and tomorrow’s taxpayers at increased risk.  At this point, they’re unable to admit defeat and seem committed to increasing further what Prechter characterized as “record levels of unpayable debt.”

There is no attractive alternative.  As I argued at the time, the U.S. made moral hazard-laden decisions in 1998 to rescue Long-Term Capital Management, in principle not unlike earlier bank rescues in the ill-fated oil patch and lesser-developed country eras.  Horrible as outcomes might have been in those earlier instances had banks and other businesses been allowed to fail, they would have been progressively less severe had the specter of failure hung over the heads of owners and top executives.

Obviously the Fed’s fear of recession and its painful consequences is high or it would not continue to boost government debt levels.  Unfortunately, each unsuccessful rescue effort makes tomorrow’s consequences even more painful.  Those hurt the most will always be individuals on the lowest rung of the economic ladder.  It is long past time that the Fed should abandon its ill-fated rescue policy.  Allow the markets and the economy to reset.  Stop penalizing the fixed income-dependent elderly retired and future generations that will inherit monumental debt burdens.  Stop rewarding debtors at the expense of savers.  Accept whatever pain might initially flow from eliminating central bank support.  An economy free of the guiding hand of meddling central bankers will, as it has in decades past, eventually reward entrepreneurs and produce a more vital economy capable of producing many millions of jobs.