Volatility Continues

Just a quick follow-up to yesterday’s analysis. Written on the weekend, we posted “Volatility Reigns” yesterday. The equity market volatility and indecisiveness profiled in that analysis was dramatically in evidence again yesterday and today.

Before the market opened yesterday, traders celebrated the news that Warren Buffett was making a major purchase of Precision Castparts. The economic news out of China was depressing with both July import and export figures down over 8%. In the perverse world of “bad news is good news,” that increased the likelihood that Chinese authorities would soon introduce even more stimulus. There were also reports that Greece and its creditors were close to agreement on another bailout for that beleaguered country. Oversold from more than a week of declines, stocks powered ahead, the Dow Industrials up by 254 points at the day’s high, closing up 241 points. Internals were likewise strong with advancing stocks outpacing declines by nearly three-to-one on the N.Y. Stock Exchange and by over two-to-one on NASDAQ. The only cautionary note was that volume was light and below the levels of recent weeks.

Overnight, China implicitly acknowledged its weakening economic performance by devaluing its currency by almost 2%. That precipitated selling of stocks throughout Asia and Europe despite rumors being confirmed that Greece and its creditors reached agreement on a massive bailout that may exceed 90 billion euros. Stocks reversed course in this country this morning with the Dow dropping 263 points to its low, then rising a bit to close down 212 points. Volume intensified on the decline.

Volatility continues, not just week-to-week but day-to-day. And governments and central bankers remain the major players.


Volatility Reigns

Through more than 46 years in the investment business, I have never before seen such extraordinary price volatility as has characterized the U.S. stock markets over this past year. In that time, the Dow Jones Industrial Average has alternated directions 33 times by amounts ranging from 300 to 2000 points.

INDU 1 year with annotations

Twenty-nine of those moves have occurred in the most recent eight months, an average of an almost 600 point change of direction roughly every six market days. Last week, one of TV’s talking heads stated that we haven’t experienced such volatility since 1904. At the very least, this is far from a normal investment environment.

The Dow closed Friday almost 600 points below the beginning level of the eight months of wild vacillation, and about 1000 points below its May high. The indecisive fluctuations have brought prices back to the level of late-October 2014. Clearly, neither bulls nor bears have been able to gain control. Such indecision is similarly characteristic of stock markets around the world. About half of those markets are up for the year-to-date, half down. About half are trading above their 200-day moving averages, half below.

While many markets are only a few percentage points below their all-time highs, there are clear signs of fatigue showing. The current U.S. stock market rally is already longer than most. With each new index high, fewer and fewer stocks are reaching individual highs. In fact, in recent weeks, more stocks are hitting new 52-week lows than highs. More than two-thirds of stocks in the broad Russell 3000 are trading 10% or more below their recent highs. A growing number are more than 20% below such highs.

While these market conditions typically precede important stock market declines, they are not precise timing tools. Major market indexes can continue to reach new highs even with fewer and fewer individual stocks participating.

The current market advance has seen greater government intervention worldwide than ever before. At virtually all the lows in the past year’s trading range, central bank or other government officials have stepped forward with actual monetary stimulus or at least promises of probable support. Such support has successfully prevented significant price declines even as major international forecasting organizations continue to reduce their estimates of U.S. and global economic growth. On the other hand, such intervention has been unable to stimulate prices to break above the top of the multi-month trading range.

We are increasingly learning that governmental intervention has taken the form of actual stock purchases. Most notable has been the commitment during the past month of nearly $500 billion by China’s government to prevent a potential stock market collapse. Japan continues to boost its market and others with massive stock purchases, both domestic and international. Switzerland, long considered a bastion of financial sobriety, recently reported that it purchased international stocks totaling 17% of its current Gross Domestic Product. The widely respected Zero Hedge website speculates that the U.S. has similarly stockpiled a huge portfolio in its effort to support stock prices. I have long believed that the Fed or Treasury has been strategically buying stocks, either directly or, more likely, through a surrogate. Such purchasing can continue to support markets indefinitely as long as governments believe they can print money or dedicate reserves to growing a national equity portfolio. Governments, however, have a less than positive track record with asset purchases over past decades. They have, for example, been widely ridiculed for stockpiling gold near all-time highs and selling gold reserves near major lows. There is little reason to expect their investment expertise to have improved.

According to Bloomberg, a few months ago, Matt King, global head of credit strategy at Citigroup, made the point that stock markets have become reliant on monetary support. He estimated that central banks need to pump about $200 billion into the global economy every quarter to keep stocks from falling. Without such stimulus, King estimated that stocks could drop by 10% quarterly, at least initially.

For several quarters, we have characterized the investor’s dilemma to be whether to bet on the continued success of central bankers supporting markets or to trust that deteriorating economic and stock market fundamentals will ultimately prevail. While history argues convincingly that fundamentals will dominate, governments remain on a multi-year winning streak. As prices and the soundness of fundamentals experience a growing divergence, however, the potential for a major market collapse increases. Such is the probable unintended consequence of years of unprecedented governmental interference with free markets.



The second quarter saw a continuation of the frenetic volatility that has characterized the stock market environment since September of last year. The range in the second quarter was tighter, however, than in preceding months (back and forth from roughly 17,600 to 18,350 on the Dow) with essentially no net change over the three-month period. The S&P 500 returned a small fraction of 1% for the quarter, with most other equity indexes in the minus column. Stocks closed the quarter near the bottom of their recent range, bringing prices back to November levels.

With interest rates still not far above historic lows, most bonds lost money in the second quarter. Risk-free cash equivalents continued to provide virtually no return, thanks to central bank policy.

Vacillating headlines about the potential insolvency of Greece or of another bailout had a huge influence on markets, as stock, bond and currency levels moved in step with rumors and announcements. As I write, European countries are working to see whose money they will use to enable Greece once more to stave off a formal default. Realistically, there is no way Greece will ever repay all the money it owes; but the collective judgement of its creditors is that the consequences of a formal default would be worse than another episode of “extend and pretend.” The markets seem comfortable ignoring reality and settling for the pretense that Greece or somebody will someday make good on the growing pile of debt.

Greece, however, is far from the only debt pretender. A recently published report from the highly respected McKinsey Global Institute highlighted the bloated, unsustainable levels of debt that have been amassed globally, and the huge risks they present when interest rates eventually begin to rise. The report made the point that rather than deleveraging since the 2007-08 financial crisis, the world has added about 40% to the debt levels that precipitated that crisis. The current amount is a staggering $200 trillion, a level that, according to McKinsey, “poses new risks to financial stability and may undermine global economic growth.” The report contends that “government debt is unsustainably high in some countries.” Pointing to China specifically, McKinsey voices concern that “half of all loans are linked, directly or indirectly, to China’s overheated real-estate market; unregulated shadow banking accounts for nearly half of new lending; and the debt of many local governments is probably unsustainable.”

While all U.S. Government promises will certainly never be fulfilled in dollars at today’s value, most of those commitments lie well into the future, and the federal government has the privilege of printing more of its own currency. Minus those two advantages, Puerto Rico has recently had to admit that it is close to default on some of its $72 billion of debt. “The debt is not payable,” according to Puerto Rico’s governor. Many U.S. investors hold Puerto Rico bonds–directly or indirectly–because of the island’s special tax exemption. According to Morningstar, 80% of Puerto Rican debt is in muni-bond funds, despite five years of recession and the island’s low junk bond ratings. This is yet another example of the danger of ignoring risk and reaching for yield. We’ll soon see who gets paid and how much.

Similarly, holders of Illinois and New Jersey debt may have reason to fear being less than fully repaid. Will the U.S. Government cover unpaid liabilities of its states, as Europe has been doing for Greece? Probably, but it’s a gamble risk-averse investors should be unwilling to take.

With debt levels growing around the world and governments almost universally responding by expanding the money supply, we continue to build a small gold hedge. While deflation appears to be a more immediate concern in most countries than inflation, the dramatic increase in money supply lays the foundation for a potential inflationary spiral. So long as major central bankers continue to “print money”, we will gradually expand that hedge if we can do it at progressively lower gold prices.

Abandoning all caution has been the path to maximum investment success for more than the past six years. By driving interest rates to the zero bound, the Federal Reserve and other major central banks have done their utmost to eliminate risk-free return and to push investors to take risk. Until recently, accepting such risk has been amply rewarded. Stocks and bonds have risen, and various currency plays have worked as central banks have anticipated.

Suddenly, earlier this year, the Swiss National Bank reneged on its stated policy, in place for 3 ½ years, to hold a 1.2 peg between the franc and the euro. Market pressures overcame the central bank’s policy pledge. The value of the currencies diverged by 38% in just a few minutes. There was no opportunity to escape. Because of heavy leverage, some investors and a few firms were wiped out. Now comes China.

Over the past year, the Chinese equity market has been the quintessential example of a government-influenced market. To offset the negative psychological effect of an economy growing at its slowest annual rate in a quarter of a century, the government did its best to stimulate the equity market. It cut interest rates several times, injected funds into the banking system and cheered investors. The process worked as market prices soared. Even after prices had almost doubled in less than a year, the People’s Daily, the Communist Party’s mouthpiece, declared that “4,000 (points on the Shanghai Composite index) was just the beginning.” As the belief grew that the government had investors’ backs (shades of the Greenspan, Bernanke and Yellen put?), new investors flocked to open brokerage accounts. Over 40 million new accounts were opened in the year ending in May. At the peak, accounts were being added at a rate of over 3 million per week. Deutsche Bank marveled at the stunning lack of sophistication of these new investors. Two-thirds had left school before they turned 15, with a third leaving at age 12 or younger, and 6% illiterate. Because the market looked to be a guaranteed moneymaker, the idea of borrowing to make even larger investments seemed to be a no-brainer. And borrow they did, committing about one-third of a trillion dollars to the major equity markets. Such margin lending rose to as high as 20% of the total market capitalization. By comparison, it is about 2 ½% in the U.S. That lack of sophistication didn’t prevent Chinese speculators from making money, however. Prices ultimately rose about 150% to the June peak, at which point the average price/earnings ratio was about 57. Everybody was making money until it suddenly stopped.

In about three and a half weeks, one-third of the value of Chinese stocks disappeared, as prices plummeted day after day. Margin calls led to more selling. Many investors were in disbelief. Where was government support?

Destroying any pretense of a reformed Chinese free market, the government stepped in with both feet. Once again, authorities have cut interest rates and reserve requirements. They suspended initial public offerings, which could divert potential investments. Directors, senior management or any owner of more than 5% of a company’s stock are not allowed to sell for the next six months. Institutional holders are to refrain from selling until the Shanghai Composite rises above 4500. Companies have been ordered to submit plans to stabilize their stock prices with such measures as share repurchases or employee shareholder plans. Authorities are planning to take action against “hostile short-sellers.” Chinese police and stock regulators are also announcing crackdowns on illegal stock and futures trading, spreading rumors, insider trading and stock manipulation. In case those measures should prove insufficient, over $200 billion is being made available to state-owned brokerages to buy shares directly. Bloomberg just reported that China Securities Finance has an additional $483 billion available to support the stock market. Sounds like a free market to me. Imagine how eager investors will be to put new money into a market in which they might be forbidden to sell. Wow!

This direct monetary intervention is reminiscent of U.S. bankers banding together to buy stocks to stem the 1929 market crash. In our county that worked briefly, but market forces ultimately overwhelmed artificial intervention, and prices continued their decline in the biggest stock market collapse in U.S. history. In the current environment of immense government central control–even in ostensibly free markets–it will be fascinating to see how long such intervention will outweigh fundamental market forces.

Despite seven years of historic government stimulus, fundamental conditions continue to deteriorate around most of the world. The International Monetary Fund has recently lowered its global growth estimate for 2015 to the weakest rate since the financial crisis. The White House budget office dropped its U.S. outlook to 2% from 3%. And the Fed’s Federal Open Market Committee began dropping its 2015 GDP projection in early-2013 to 3.3%. In subsequent meetings, it progressively dropped its estimate to 3.2%, 3.1%, 2.8%, 2.5% and a month ago to 1.9%. Along with declining GDP projections, earnings growth estimates continue to slow, yet equity prices and price/earnings ratios have expanded, fueled by newly printed money. Expectations of improving economic conditions have been wrong for the past several years, yet faith in ongoing central bank support has held stock prices near all-time highs.

Warnings have begun to surface from respected sources. The Bank for International Settlements, the central bank for the world’s central banks, expressed concern that “an unprecedented period of ultra-low interest rates masks deep weaknesses in the global economy.” Former Fed governor Larry Lindsey warned that U.S. debt and capital market distortions keep building. “Eventually, the Fed will find itself way behind the curve. And that is going to be a very disturbing event for the markets and the economy.”

Government support has so far overcome deteriorating fundamentals, and a great many investors have come to view those issuing warnings as “the boy who cried wolf.” No matter how long prices defy weaker fundamentals, however, history argues convincingly that fundamentals will ultimately prevail. One of the unfortunate lessons of history is that the longer distortions last, the greater the number of investors who come to believe this time is different and who lose patience with time-tested valuation principles. Having had a largely negative view of debt and valuation levels since the end of the 1990s, we have great sympathy for those who have been unwilling to ignore the risks present throughout the first decade and a half of this century. Notwithstanding the past six years having marked the longest period of dissonance between price and fundamentals, we have been greatly rewarded throughout our history for remaining patient and correctly anticipating a reversion to long-term means. Our client portfolios came through the most recent two bear markets with flying colors. In the 2000 to 2002 50% stock market decline, our clients saw their portfolios grow. During the horrendous 37% S&P 500 decline in 2008, we couldn’t quite put up positive numbers, but our average portfolio declined a mere fraction of one percent.

Many years earlier, we had serious concerns about the Japanese stock market that had been screaming upward for years, far outdistancing any relationship with underlying fundamentals. While we professed no significant expertise regarding the Japanese market, a profound appreciation for the dangers of severe overvaluation led us in 1987 to caution investors to avoid exposure to Japanese stocks. Stock prices continued to rise. We repeated our caution at our 1988 client conference with the market continuing its persistent ascent. In 1989 we urged readers and listeners to trust history, rather than embrace “It’s different this time” thinking. While prices continued up through the remainder of the year, the bubble burst on New Year’s Eve. The market closed 1989 at roughly 39,000. From there prices plummeted, hitting 14,000 in 1992 and ultimately bottoming at about 7,000 in 2009, taking prices back to the levels of the early 1980s. There’s an old saying, “You can’t fool Mother Nature.” Similarly, you can’t indefinitely defy fundamental norms that have prevailed for a century or longer, no matter how long excesses prevail.

Today’s debt excesses around the world are the most severe in history. In this country, valuations exceed those throughout history but for the dot.com bubble at the turn of the century, from which point stock prices were more than 50% lower nine years later. Over the decades, there has been a very clear negative relationship between valuations at the time stocks are purchased and subsequent returns. With valuations currently stretched near all-time highs, stocks are swimming against the historic tides in the years ahead. And the experiences this year with the Swiss National Bank and the Chinese stock market demonstrate how quickly such losses can unfold.

Aldous Huxley famously observed: “Facts do not cease to exist because they are ignored.” The facts are that debt and equity valuations remain at dangerous extremes, having been ignored for years. Instead, trust has been placed in government’s willingness and ability to keep stock prices elevated. So far over this market cycle, that trust has been well placed. Investors are still faced, however, with the dilemma of whether to bet on a continuing divergence between equity prices and underlying fundamentals or to expect market prices to revert toward historic fundamental norms. For all but relatively short-term traders, we strongly suggest the latter alternative. It is important to recognize that, for virtually all investors, they don’t get to keep what they have at market highs but rather what still remains at market lows. And given how overextended this market is after seven years of powerful government support, we fully expect there will be opportunities to get more aggressive in equities in the quarters and years ahead at lower prices–possibly substantially lower.


Fear At The Fed

I strongly suspect that Janet Yellen is afraid to pull the trigger on the first rate hike.  Having passed on earlier opportunities to dismantle her debtor-friendly Zero Interest Rate Policy (ZIRP), she has painted herself deeper and deeper into a corner.  Raising short rates will likely lead to rate rises all along the yield curve, adding increasingly to debt service burdens for government, business and households.  And declining bond prices may do serious damage to the Fed’s bloated balance sheet.

IMF Managing Director Christine Lagarde upped the ante recently when she counseled the Fed to defer a first rate increase until at least 2016.  Yellen and her cohorts on the Fed have already demonstrated serious timidity in the face of any negative stock market reactions. Should stock prices fall precipitously after a Fed tightening action, Yellen would rightly be blamed for having facilitated the trauma with a multi-year destructive monetary experiment.  Additionally, her professional credentials would be seriously stained because the IMF would likely be perceived as more foresighted than the Fed.

The Fed’s ZIRP has been misguided from the beginning, bailing out seriously overextended debtors on the backs of savers and taxpayers in general.  Moral hazard runs rampant, and lightweight reforms leave few barriers to a repetition of the past decade’s debt-fueled problems.

It would be no surprise if the Fed were planning to implement a stock market support plan in conjunction with an initial rate rise, whenever that might occur, to erase evidence of a cause and effect relationship.  In fact, I believe the Fed has been actively supporting stock prices at strategic times over the past several years, either directly or–more likely–through surrogates, in pursuit of its goal of increasing the wealth effect.

When the history is ultimately written about the Fed’s misguided effort at economic central planning, there will be plenty of blame to go around.  One unfortunate consequence will be the distortion for years–even decades–of the performance of formerly free stock and bond markets.  I doubt that Janet Yellen fully appreciates the magnitude of the consequences of her past and pending actions; but I believe she hesitates to take the next necessary step because she fears the potentially significant unknown.  Unfortunately, the longer she waits, the more dangerous the ultimate consequences become.


Is “Extend and Pretend” the Only Answer?

“China orders banks to keep lending to insolvent provincial projects.” That front page headline in the May 16-17 weekend edition of The Financial Times shines a spotlight on one of history’s most perilous financial conditions. Since the end of the 1990’s, we have been warning of the extreme danger posed by excessive debt. In this century’s first decade, the world suffered two painful recessions, and domestic stock markets twice declined by 50% or more.

According to former Fed Chairman Ben Bernanke and former Treasury Secretary Hank Paulson, the United States was headed into a depression following the Lehman Brothers bankruptcy, necessitating what has become the most massive financial rescue in history. In this country alone, the Federal Reserve has created about $3.5 trillion since 2008, in the absurd, but ironic, attempt to solve a problem precipitated by excessive debt by creating even more egregious levels of new debt. That effort has succeeded in levitating stock, bond and home prices, although the broader economy has made only meager progress. With no dire consequences so far attending the “money for nothing” approach, the central banks of Japan, Europe and China have decided to follow the U.S.’s lead in supplying unprecedented levels of monetary stimulus.

One need only reread the headline at the top of the page to view the logical extension of this misguided policy. The U.S. banking system has become expert at the “extend and pretend” approach to excessively indebted borrowers. The European Central Bank continues its ongoing charade with Greece over debts that will never ultimately be repaid. Now China has reached the point at which numerous local government projects can’t meet principal or interest deadlines. Again, the solution around the world is not to stop borrowing but rather to borrow more, ultimately creating a bigger problem but deferring the day of reckoning.

In February, the McKinsey Global Institute highlighted the dangers of the expanding world debt burden. Their report warns that the $200 trillion global debt, much of it recently accumulated, “poses new risks to financial stability and may undermine global economic growth.” Former Fed governor and close personal friend Martha Seger stopped by our offices recently, where she was once Mission’s first Vice Chairman. Martha confessed her concern that someday she’ll awake in the middle of the night, turn on financial TV and learn that the over-indebted world financial system has unraveled.

None of that seems to bother equity investors, who have bid prices in most of the world close to all-time highs. There is a remarkable complacency that central bankers have the situation under control. History disagrees. As Carmen Reinhart and Kenneth Rogoff point out in copious detail in This Time Is Different, debt levels even less onerous than today’s have been severely punished with regularity over many centuries. With central bankers building the debt edifice ever taller, investors are betting either that they’ll be able to time a prudent exit or that this time is truly different.


Do Regulators Even Care About Honest Markets?

Since July of last year, the Dow Jones Industrial Average has experienced 16 price moves ranging from 600 to 2000 points, eight up and eight down. Twelve of those moves have taken place in the last five months, each lasting an average of just two weeks. This is highly abnormal market action, clearly demonstrating a lack of investor conviction. In fact, volatility has become even more intense since mid-April. The Dow has experienced six moves ranging from 350 to 450 points in just 17 market days, each move completed on average in less than three market days. Some rallies and declines have lasted as little as a day or two.

In recent months, volatile market moves have typically come in response to domestic or international news, especially related to our Federal Reserve or other central banks. Now, apparently, markets have decided to move many hundreds of Dow points in a day or two without the stimulus of news stories. This, too, shall pass, but not without leaving a trail of serious investors longing for regulators to crack down on high frequency traders and others gaming the system for ill-gotten short-term trading profits. Reform on Wall Street is desperately needed.



March marked the sixth anniversary of the Fed–sponsored stock market rally that, along with the housing recovery, has resuscitated the balance sheets of the wealthiest segment of the American population. Having benefited from mountains of essentially free money and generous accounting forbearance, the nation’s major banks were rescued from insolvency. The Fed’s intended “wealth effect” has served the wealthy well. Unfortunately, it has done relatively little for the vast majority of Americans, who continue to struggle in the slowest economic recovery in three-quarters of a century. As the latest iteration of money printing winds down, the dominant question is whether or not stock and bond markets can continue to progress without the benefit of unprecedented Fed stimulus.

Both domestically and internationally, central bank largesse has overcome a litany of geopolitical and economic concerns including: Greek solvency and Eurozone membership, Russia/Ukraine and sanctions, Israel/Gaza, ISIL, Ebola, the end of Quantitative Easing and the prospect of rising rates, IMF warnings of another Eurozone recession, Japan slowing, dramatically slowing growth in China, growing evidence of global deflation and the emergence of currency wars. Clearly, the world’s investors retain confidence that central bankers remain willing and able to keep stock and bond prices elevated despite this lengthy list of concerns.

Failure to accept major risks has seriously reduced portfolio performance for the past six years. On the other hand, properly identifying major risks preserved portfolio values over the nine immediately prior years. Over that nine-year period following the dot.com peak in 2000, Mission’s risk-adverse approach produced a 5% per year return for clients with the S&P 500 declining by 6% per year. That 11% average annual advantage saved clients from one of the most dangerous periods in U.S. market history. Evidence strongly indicates that at least one more major stock decline is probable before the long cycle that began in 2000 ends. We expect that Mission’s appreciation of today’s unique risks will serve clients well as this decade further unfolds.

Central bank policies have driven risk-free rates to zero, which has eliminated return for those unable or unwilling to accept investment risk. The Fed has held short rates at the zero bound for more than six years, penalizing savers to rescue overextended debtors.

Those willing to invest in the normally low-risk Treasury bond market may, in fact, be assuming far more risk than they perceive. Longer fixed income yields in the U.S. and around the world are at or near historic lows. At current yield levels, an increase in rates of less than one-half of one percent would turn the total return on a 10-year U.S. Treasury negative for a year. A significant jump in rates would decimate a fixed income portfolio. At these yield levels, the penalty for being wrong in fixed income securities is far greater than the reward for being right.

Fearful of danger to the world’s financial system, investors have committed $4.2 trillion to securities providing no yield or a negative yield. In a quest for safety, many are paying for the privilege of loaning money to several seemingly safe countries for periods even up to ten years. This is the quintessential example of investors concentrating on the return of their money rather than the return on their money. There is no comparable example in world history, and it highlights how far from normal are today’s financial conditions.

To implement their stimulus programs, our Federal Reserve and other major central banks have effectively “printed money.” So far, those programs have successfully supported both stock and bond markets, but at the expense of creating historic, formerly inconceivable debt burdens. By horrific example, in its first 95 years the Fed built a balance sheet of just over $800 billion. In just over six years since, it has multiplied that balance sheet by more than 400% to about $4.5 trillion. Over centuries, countries that have created debt burdens even less onerous than today’s relative to the size of their economies have suffered economically and in their securities markets for a decade or more.

Compounding the problem, stocks today are more overvalued than at any point in U.S. history but for the dot.com mania at the turn of the century, from which point stock portfolios were more than 50% lower nine years later.

For the third time in the last 20 years, stocks have risen steadily to levels of overvaluation unprecedented before this period. In all three instances, investors willing to ignore fundamental risks, ride the momentum train and believe in central bank guidance substantially outperformed investors who relied on fundamentals and historical precedent. After each of the first two instances, however, despite aggressive Fed support, stock prices plummeted by more than 50%. In fact, the stock market decline from 2007 to 2009 took prices back their 1996 levels, eliminating 13 years of price progress. In the current instance, the Fed has played an even more aggressive role, and the price advance could continue if investors retain their faith in central bank support and control. Confidence in central bankers may waver, however, as investors reflect further on central bank activities in the early months of 2015.

In January, the highly regarded Swiss National Bank, with no warning, abandoned its peg between the franc and the euro, which it had held for 3 ½ years. This so shocked the foreign exchange market that the relative value of the two currencies diverged by 38% in minutes, a move that would normally take years. Soon after, the Austrian central bank indicated that it would not make good on the debts of the “bad bank” set up to house the weak loans of a leading Austrian bank rescued in the financial crisis. And most recently, the Brazilian central bank abandoned its expressed intent to support the Brazilian real. Within three months, three central banks were forced by overwhelming market action to abandon clear commitments, with disastrous consequences to investors who counted on those central bank promises. If investors begin to doubt more broadly the ability of central bankers to support markets, there may prove to be an air pocket beneath prices. As seen in the case of the Swiss National Bank, such consequences can unfold with lightning speed.

As we head into the year’s second quarter, investors are faced with the dilemma of whether to align assets with historic probabilities or to cast their lot with central bankers. Central bankers have been winning for the past six years, but with experimental policies that have been penalized throughout history. As has been the case twice so far in the 21st century, capital preservation may soon again prove critical in the period ahead. Mission’s great success through the last two major market declines was the reward for our accurate anticipation of the pending problems.

The final page of this analysis summarizes our concerns about threats to the world economy and markets. The cartoon originally appeared in The Financial Times and we have provided annotation and statistics.



Free Markets: May They Rest In Peace

For more than two centuries, Americans have pointed with great pride to this country as a bastion of democratic free markets. Many have looked with antipathy at European economies tinged with socialism and with disdain at the centrally planned economies of communist countries. Whether out of convenience or desperation, we have recently come to welcome central planning.

In pursuit of its dual mandate of a stable currency and maximum employment, the Fed has apparently decided that it simply cannot allow even a garden-variety recession–possibly ever. With the Fed balance sheet and total domestic debt at levels inconceivable just a few years ago, it is hard to imagine a scenario in which a recession would not lead to dangerous debt defaults.

This week’s Federal Open Market Committee meeting produced a statement designed to be all things to all people. Language from earlier statements was eliminated, and Fed Chair Janet Yellen stressed that future action on interest rates would be “data dependent.” Those words, however, have now become meaningless, because prior data hurdles that were to be triggers for interest rate rises have all been abandoned when reached. This Fed has clearly painted itself into a corner. They hate to leave interest rates at the zero bound, because they have no ammunition left to counter future problems. At the same time, they are deathly afraid to raise rates because the economy remains in its weakest recovery since World War II. Celebrating the continuing medicine of easy money rather than fearing the underlying disease necessitating it, Wall Street partied on, the Dow Jones Industrial Average rising 400 points intraday from just before the FOMC announcement to just after.

Because the Fed continues to accede to Wall Street’s wishes, there are few complaints from the financial community about the erosion of free market principles and the progressive evolution toward central planning. Should the Fed’s experimental monetary policies fail to keep stock prices buoyant, however, stones will inevitably be cast. There will logically be questions asked about how the country could have allowed its economy to be controlled by a group of academics and regulators, virtually unsullied by any real world business experience.

This week’s violent anti-European Central Bank protests in Frankfurt, Germany bring to mind other potential problems. Our central bank has been an integral force in creating an environment in which the economically privileged have prospered mightily from Fed-sponsored stock and bond market progress, while little benefit has filtered down to the broader economy. Should that disparity continue or worsen, it’s not unrealistic to imagine large protests born out of economic frustration in this country as well.

I have long opposed the Fed’s zero interest rate policy and the massive expansion of its balance sheet. With an admitted objective of pushing stock prices higher for a positive wealth effect, the Fed, I suspect, has also succumbed to the temptation to support stock prices with strategic buying, almost certainly through surrogates. Since the market bottom in 2009, buying has mysteriously appeared at points from which price breakdowns would normally have proceeded in decades past. Should the Fed eventually be found to have surreptitiously supported stocks as part of their central planning and control, I hope they will be properly punished. And if Main Street protestors become sufficiently incensed, they may seek to identify those who unjustly rewarded Wall Street insiders.

As one firmly committed to non-violence, I regret seeing public protest turn violent. However, I would welcome comprehensive investigations and appropriate prosecutions of anyone who distorted free and honest securities markets–up to and including Fed officials. If individuals can be prosecuted for distorting market prices, so should those wielding far greater power. And if regulators really wanted to reestablish free markets, they could and should go after large trading desks that paint the tape in one direction to create an environment in which they can establish their intended larger position for a move in the opposite direction. Distorted markets will continue until the clamor is loud enough to make them free and honest. A welcome first step would be for the Fed to abandon its direct interference and to back away from its artificial experimental monetary policy.



The theme for investors in 2014, at least in the United States, was “Don’t worry; be happy.” Anyone who let worries about slowing global growth, unprecedented debt levels, Ebola, terrorism or Russia’s theft of Crimea from Ukraine keep them from fully invested positions sacrificed performance.

While worries about deflation put downward pressure on bond yields, aggressive central bank buying was an even bigger factor in pushing prices up and yields down. In our country, the Fed kept short-term rates essentially at zero, penalizing retirees and all others desirous of low-risk returns. In Europe, fears of potential sovereign defaults or of a Eurozone breakup have pushed safe haven fixed income yields to 300 to 500 year lows. Some giant investors, more concerned about the return of their money than the return on their money, have been willing to pay for the privilege of loaning money to governments considered “safe”. In a half dozen northern European countries, investors are willing to settle for negative returns for periods ranging from a few months to a few years. In Germany, the perceived safest of the safe havens, interest rates are negative out to five years.

The willingness to settle for a small negative return is more understandable in Europe than here in the United States. The major stock markets in Europe and around most of the world were down in 2014. Similarly, the US markets were down for the year when the markets tumbled in September and October. The coordinated verbal rescue efforts, however, by the Fed, European Central Bank, Bank of England, Bank of Japan and People’s Bank of China stopped the decline and turned prices back up. While US prices moved from negative into the plus column, they stayed negative for the year throughout most of the rest of the world. Clearly, investors are still responding enthusiastically to central bank promises of further stimulus and support.

It is tremendously frustrating to investors–like Mission–that prices respond more directly to promises by central bankers than to fundamental economic and corporate data. While market prices throughout history have always eventually reverted to valuation and other fundamental means, such factors are far from accurate timing criteria. There is, in fact, a venerable old saying that markets can remain irrational longer than you can stay solvent.

Our primary concern, as we have communicated repeatedly, is the exploding level of debt, both domestically and internationally. Virtually all major stock market declines have followed outsized debt expansions. Debt extremes throughout history have invariably led to lengthy periods of below par business conditions, and some of history’s most severe stock market declines. Central bank rescue efforts have raised debt totals to levels that would have been inconceivable just six years ago. In response to prodigious increases in money supply and debt in countries worldwide, currency wars loom as a significant risk in 2015.

When the Fed commenced its experimental monetary policy a few years ago, virtually all analysts said something to the effect of: “This will undoubtedly end badly, but it will help in the meanwhile.” Since no horror has yet unfolded, and Fed intervention has been greeted with ever-higher stock prices, we no longer hear about such intervention ending badly. Additional Fed support is seen as all good. Even though history argues convincingly that excessive debt build-ups will ultimately be punished, investors have adopted the Scarlett O’Hara approach. They’ll worry about that tomorrow. For clients who, for the most part, are not able to replace substantial lost capital, we are not inclined to assume high levels of risk in a historically dangerous debt environment. For a fuller analysis of the debt situation, refer to our Quarterly Commentary for the third quarter of 2014. You can find this on the blog page of the Mission website, under October 2014. The link is as follows: http://www.missiontrust.com/blog/2014/10/quarterly-commentary-third-quarter-2014/

In the shorter term, what horror could Fed Governor Charles Evans have been anticipating in his comment last week that it would be a “catastrophe” if the Fed raised short-term interest rates above zero any time soon? If the domestic economy would find it catastrophic if short rates were above zero in the sixth year of recovery from recession, conditions are far from sound.

Investors and investment managers alike are faced with a critical dilemma. Do you maintain your assets in concert with fundamental conditions and historical probabilities, or do you simply go with the flow, throw caution to the wind and cast your lot with central bankers? The latter approach has been winning recently, but the former wins eventually unless excessive debt becomes irrelevant.


The Herding Instinct Is Powerful

Readers of the financial press have undoubtedly seen recent articles describing investors’ retreat from actively managed portfolios and migration to passive investments that attempt merely to match market indexes. The latter have done better in recent years. Because investors are invariably trend followers, that phenomenon is very understandable. When markets go up or down for several years in a row, investors have a predictable habit of connecting the dots, creating a trend line and projecting it into the indefinite future. Collectively we expect good news to be followed by good news and bad news by more bad news. Unfortunately, those expectations lead the majority of investors to buy high and sell low.

Mutual fund purchase and sale data demonstrate the perverse buy high/sell low tendency quite clearly. Near market highs, news reports are typically positive and confidence is high. Investors who may have missed much of a rally see how others continue to profit by participating. The siren call to get invested becomes increasingly compelling the longer a rally lasts. Conversely, when markets have declined for an extended period of time, the news invariably turns gloomy and forecasts become increasingly negative. As market prices descend, growing numbers of investors reach their pain tolerance limits and lighten or eliminate their risk exposure. As a result, there are far more fund purchases at high prices and redemptions near the lows. This tendency plays itself out across all sectors of the investment spectrum. And it’s not just a recent phenomenon.

In the twentieth century, it was very common for investment managers to assume the prime responsibility for adjusting investors’ asset allocations. Many investment managers were categorized as Tactical Asset Allocators (TAA), whose approach was to move assets to those investment areas deemed safest and/or potentially most productive. For decades, many of those firms practicing the TAA approach did an excellent job of protecting and growing client assets. The decade of the 1990’s, however, produced a major shift in investors’ attitudes. There were precious few market declines of any consequence, so managers who allocated away from risk almost inevitably were penalized for their caution, not rewarded, as they had often been in the past. As the decade wore on, TAA firms became scarce. Those that survived largely migrated to a more fully invested, fixed allocation approach. The good times lasted so long that even the most patient investors opted to join the crowd and assume greater and more permanent risk exposure. Unfortunately, this shift was just before the 50% stock market decline from 2000 to 2003, when properly executed asset allocation would have been most appropriate.

The tendency for investors today to forego caution and simply go with the flow of free money and rising stock prices is remarkably similar to attitudes prevalent around the turn of the century. Tomorrow is unknowable, but there is substantial reason to expect reversion to the mean in the years ahead as the excesses of the free money era are eventually eliminated. Beware of herd mentality. Remember: what we get to keep is typically what we have at market lows, not what we have at the highs.