If you've been watching the markets on a daily basis you probably need a dose of Maalox. Each day and week the markets have something new to worry about. One day it's Greece, the next day it's Italy. The following week it could be a recession in the U.S. or it could be the growing risk to the European banking system. What is clear is that systemic risks are building again; this time the epicenter is Europe.
Like the U.S. in 2008, European governments can't reach a consensus on what needs to be done. The Fed and our government acted in a similar manner in the fall of 2008. It wasn't until they let Lehman Brothers fail, which triggered a domino effect in bankruptcies—AIG, Merrill Lynch, Wachovia—that the Fed acted decisively with an alphabet soup of financial programs to backstop the U.S.'s financial system. In the end Europe will need to do the same. It is our estimate, and the opinion of other experts I have interviewed, that it is going to take a bailout of somewhere between $1.5–$2.0 trillion Euros to fix the European financial system. Until now only half-measures have been taken.
In the meantime the lack of a clear "Plan B" for the European debt crisis is putting strains on European bank funding, creating a self-reinforcing debt spiral between banks and sovereign nations. Money is being withdrawn from the banking system over fears of bankruptcy or debt defaults. The European crisis is one reason why our firm uses only U.S. Treasury-backed money market funds for our clients' accounts. Regular money market funds pose too great a risk due to bank safety and bank liquidity concerns.
The other major concern for the markets is over a growing slowdown in the U.S. economy, and other major economies around the globe. As shown in the list below of the world's major economies, most are either contracting or close to contraction, which includes the U.S., China, Japan, and Germany—the four largest economies in the world.
Click here for full size image of contracting Global economies
The numerous lists of worries are centered on two major issues; sovereign debt and an economic slowdown. There is also the growing concern that government remedies are proving ineffective in resolving these issues. U.S. debt has increased by .5 trillion. The Fed's balance sheet has expanded by over trillion, and things aren't getting better. The unemployment rate rose after the stimulus instead of declining. Then there is the economy, which many experts feel never actually recovered from the 2007–2009 recession. It may have recovered in terms of nominal dollars, but with unemployment hovering over 9%, jobs simply aren't being created in the private sector at a fast enough pace to bring down the unemployment rate. Now, the fear is if the economy lapses back into recession, more jobs will be lost. (Bank of America intends to lay off 30,000 workers in the years ahead in order to shave billions in costs.) The financial sector within the economy is knee-deep in recession and likely will remain there for years to come.
So what do we have to show for the trillions of new debt and the trillions of newly created money on the Fed's balance sheet? Not much! However, on Main Street we're left with the aftereffects which are higher levels of inflation. The annual inflation rate as reflected in the CPI (consumer price index) has risen by 3.8% y-o-y. At the same time that inflation is rising, the Fed has informed markets that it intends to keep short-term rates at near-zero until at least mid-2013. This week the Fed made the decision that it intends to drive long-term rates even lower in an effort to stimulate more borrowing.
Click here for full size image of T-Bill Rates
Source: Bloomberg
They don't understand that we are facing a balance-sheet-led recession. What got us into this mess in the first place was too much debt. What our experts are proposing is to fix our debt problem by going deeper into debt. They are doing this by expanding the size of government which now makes up 25% of GDP vs 18% of GDP less than four years ago. The government doesn't create wealth nor do they create real jobs that expand our economy. But they aren't asking me for advice. All that we can do is deal with the consequences of their actions now and what they will do in the future.
As I wrote in Part I of this piece almost a month ago, I expect a massive stimulus program to be enacted that will be followed by another dose of QE (quantitative easing). Former Fed governor Vince Reinhart suggested that whatever the Fed does next it needs to be big. Otherwise, we'll be facing the same issues of another slowdown a year from now. I take what Mr. Reinhart says seriously. He has co-authored papers with his friend and colleague Ben Bernanke on what to do to combat deflation or a financial system with zero interest rates. Mr. Reinhardt's wife, Carmen Reinhart, is the author of a study on using inflation as a tool to reduce the government's debt problem. The suggestion is that running an annual inflation rate over several years (think a decade or more) could bring our debt imbalances into line.
The U.S. used this policy to bring our World War II debts back into balance. Many of the same tools proposed this week, like "Operation Twist" (bringing down long-term rates), were first used in 1951. Nearly sixty years later that very same policy was announced by the Fed this week. What is needed is debt forbearance and the best way to do that is through higher rates of inflation. What is being advocated by these Fed governors is an annual inflation rate of between 4–6% per year. Of course they won't say that in the minutes of an FOMC (Federal Open Market Committee) meeting. They will call it something else: "Operation Twist", monetary stimulus, or something else more esoteric like QE. As shown in the graph below from my friend John Williams at Shadowstats.com, the real inflation rate is already at this level. According to John the real inflation rate is running around 7.5%.
Source: www.ShadowStats.com, 23 September 2011
So what I'm expecting to see come into fruition by year-end or early next year is another stimulus package that will be preceded or followed by another round of quantitative easing, otherwise known as money printing. We simply are going to inflate. There is no other way out of this mess. So get used to seeing higher prices for the daily necessities you use each day from food and gasoline to toothpaste and toilet paper.
However, before the Fed can launch its next round of QE they need to see commodity prices come down. As shown in the graph below there is a direct correlation between rising inflation and the LEIs. In a consumption-oriented economy, as prices rise on basic necessities, consumers have less money to spend on discretionary items. Hence, consumption begins to contract, and GDP along with it.
Click here for full size image of CPI/LEIs
Source: Bloomberg
As shown in the graph above it is clear there is a strong relationship between CPI and the LEIs. AS CPI rises the LEIs begin to roll over. The Fed is very aware of this and that's why I believe they will either wait or intervene in the commodity markets. Unlike last year when CPI was falling when they launched QE2, this time it is the opposite: CPI is rising. The Fed needs inflation levels to come down before they launch the next round of money printing, which is going to be massive. The alternative is another major recession which would balloon the government's budget and cause the unemployment rate to rise dramatically. I don't believe politicians want to be facing voters with the economy in another deep recession and the unemployment rate at depression levels. So in the short term, expect lower commodity prices.
Now, let me bring you back to the stock market. Despite the worries, and they are numerous, I would like to direct your eyes to the charts below of the Dow and the S&P 500.
Click here for full size image of SPX
As you can see here, the markets have gone nowhere since August 5th. Up, down, up, and down again ending exactly where we were at the beginning of August. We've essentially traveled sideways for almost seven weeks now.
To demonstrate this fact I would like to quote Lowry's, a well-respected technical service that has been around over 70 years. They have made a lot of great market calls over that period and they are one service we pay special attention to.
Since the August 8th/9th bottom, market gyrations have produced: two intermediate trend Buying Controls, one intermediate trend Selling Control, one conventional short-term sell signal, two trader's sell signals, one conventional short-term sell signal, two trader's sell signals and three trader's buy signals. For all these signals, the S&P 500, as of September 15th, is just 9 points above its August 5th level, the day before all these market swings began.
(On Demand, 16 September 2011)
Last Thursday was a good example of this. In the profession they call it the Thursday/Monday Syndrome. This is what we saw occur on the 22nd. The markets open under pressure and selling accelerates in swelling volume. By afternoon the selling turns into a virtual selling stampede. On Thursday all asset classes saw sudden and sharp moves far in excess of normal volatility. There was widespread liquidation across asset classes: currencies, bonds, commodities, and stocks all moved swiftly and sharply and screamed "Sell, sell, sell!" Investors were in full panic mode. The mantra of the day was "get me out," "I want safety," "put me in cash," "get me liquid." This kind of market behavior is very indicative of panic selling that gets you closer to market bottoms. On Friday (the 23rd), the same kind of selling was taking place in the precious metals markets with gold and silver down 6–15%.
As Art Cashin, a grand old veteran of the markets, said in his morning notes on Friday, "Some may even get out a special shopping list. They will set their basket right, put in silly bids and hope some panicky souls throw a bargain in."
One of the hardest tasks we have as money managers on days or weeks like this is not to get caught up in the high level motions of the day. That is why we have models and remain true to our discipline. Unlike other firms we have plans: a plan if things go south, and a plan if things go north. In contrast, most mutual funds have only 3–4% cash. In fact mutual fund cash levels are at record lows. Our cash levels are much higher in most client accounts, and we fully intend to take advantage of cheaper prices on specific stocks when our models give us an "all clear" signal.
In the meantime I expect markets to remain in a trading range until policy experts can reach a consensus as to what they should do. The problem is the Europeans. They are slow to move because of their unique political arrangement: a monetary union without a political union. Eventually that will happen as we now have the Swiss—who have abandoned centuries-old traditions of bank secrecy, sound banking methods (a rogue trader at UBS just lost the bank .3 billion in bad trades) and sound money practices—on board.
Our U.S. Treasury secretary Tim Geithner has been making frequent trips to Europe to advise them what to do, or what I suspect, to coordinate an eventual massive monetary response. Believe me, there is going to be some form of stimulus both monetary and fiscal. The alternative is riots in the streets. Even worse, political leaders become unemployed. We've seen riots not just in Athens but in London. We've seen them in Illinois, Wisconsin, and maybe coming soon to a neighborhood near you.
Until this thing sorts itself out we will remain on the defensive (i.e. in higher levels of cash).
Which brings up the question: If we're worried about massive stimulus and dollar printing, why not put everything in gold? For one reason it is volatile. Witness the selloff in precious metals these last few days. As I write this, gold is down 9 on the day and silver is down over . It would appear that the government is intervening in the metals markets again in order to drive prices down ahead of the next round of money printing. Yesterday the Chicago Mercantile Exchange (CME) announced an increase in margin requirements on gold by 21%, on silver by 16%, and on copper by 18%, effective Monday. I believe they are trying their best to drive down the price of metals so as to drive money out of precious metals, and to discredit gold and silver. They want money to flow into paper assets, not metals or commodities. Unfortunately, this just makes the price cheaper, which stimulates more buying. This too shall pass. The government is losing control over the price and this latest attempt at manipulation smacks of desperation.
The media is talking with glee as to why gold has been in a bubble and how the latest selloff proves the point. As shown in the chart of gold below, every year since 2002 to 2010 gold has corrected to its 40-week moving average and been down, peak to trough, an average 15.6%. In fact every year since 2002, gold has gone up, and after its sharp moves up (like what we saw happen this year), it has corrected, consolidated and then relaunched to even higher levels. I expect the same may happen over the next several months. However, these corrections can be painful, like the one we're seeing today, which is one reason why we don't put everything into gold.
Click here for full size image of Gold Prices
There are other reasons we don't go "all in" when it comes to gold. The main reason is taxation and the government. Suffice it to say, I eventually expect the government will enact a windfall profits tax on gold, that and gold eventually will be remonetized. Keep in mind that the current tax on bullion is nearly twice the tax on financial assets: 28% vs 15%. I also expect, and have been discussing this issue with knowledgeable international tax experts, to see the U.S. government impose a foreign holding tax on assets held outside the country. President John F. Kennedy did this in the early 1960s. I expect the next American president, whoever that turns out to be, to do the same. Some of you may not be aware that as part of the Hire Act passed last December by President Obama, U.S. citizens are now required to report all overseas assets held each year on their annual tax return or face stiff penalties. The reason is simple: the government wants to know how much you have overseas and, I believe, will eventually level a holding tax on it similar to one enacted by President Kennedy.
Secondly, with gold selling at close to $1,700 and silver at over $30 (as I write this on September 23rd), the mining companies are minting profits. Over the next 12 months I expect the stocks to outperform bullion as they did last fall. The news in the metals mining sector keeps getting better. Producing mining companies are flush with profits and cash. It is much easier to buy reserves already in the ground than it is to go out and explore, drill, and bring a new mine into production. From time of discovery to time the first ounce is mined can take up to 10 years. Buying an existing-development junior can cut that time by almost two-thirds.
I've been investing in this sector for nearly 17 years—more heavily since 2001. I've been through numerous gold corrections, as have many of you. There have been four periods over this timeframe when bullion has outperformed precious metal equities. This year has been of those periods. What I can tell you looking back at history is that every one of those periods has been followed by a sharp outperformance by the stocks. I can't promise you that history will repeat itself. What I can say is the stocks are grossly undervalued in comparison to bullion. I don't just believe this; I'm investing my own money in this way.
To sum up, we're still playing defense, because that is what our investment and economic models tell us to do, until the government changes the investment game. At which point our models will tell us it's time to move from defense to offense. We're not there yet, but we're getting closer.
