Trends I'm Watching

Is the Current Stock Market Rally Sustainable?

Trend: The current stock market rally is not sustainable in the view of many of the observers who predicted the financial crisis.

It's no fun communicating dismal predictions about the future. Killing the messenger is a common tendency. However, facing reality prepares us for the surviving the hard times so we can enjoy the good times. Denial is not a viable strategy, as history so often confirms.

John Hussman explains why he believes a second market plunge and economic downturn will occur in 2010. Excerpts below.

Link: Reckless Myopia - John Mauldin's Outside the Box - InvestorsInsight.com.

...I was wrong about the extent to which Wall Street would respond to the ebb-and-flow in the economic data – particularly the obvious and temporary lull in the mortgage reset schedule between March and November 2009 – and drive stocks to the point where they are not only overvalued again, but strikingly dependent on a sustained economic recovery and the achievement and maintenance of record profit margins in the years ahead.

I should have assumed that Wall Street's tendency toward reckless myopia – ingrained over the past decade – would return at the first sign of even temporary stability. The eagerness of investors to chase prevailing trends, and their unwillingness to concern themselves with predictable longer-term risks, drove a successive series of speculative advances and crashes during the past decade – the dot-com bubble, the tech bubble, the mortgage bubble, the private-equity bubble, and the commodities bubble. And here we are again.

We face two possible states of the world. One is a world in which our economic problems are largely solved, profits are on the mend, and things will soon be back to normal, except for a lot of unemployed people whose fate is, let's face it, of no concern to Wall Street. The other is a world that has enjoyed a brief intermission prior to a terrific second act in which an even larger share of credit losses will be taken, and in which the range of policy choices will be more restricted because we've already issued more government liabilities than a banana republic, and will steeply debase our currency if we do it again. It is not at all clear that the recent data have removed any uncertainty as to which world we are in.

Peak Gold May Boost Gold Prices as Mainstream Media Creates Awareness of Inflation

Trend: Gold prices may be moving towards a bubble as the mainstream media writes about gold, the average Joe considers buying some gold, and gold miners see a decline in production.

Barrick Gold, a major miner of gold, says that global gold production is in terminal decline despite record prices and Herculean efforts by mining companies to discover fresh sources of ore in remote spots.

George Will at The Washington Post writes that interest in gold rises as worry about the growing debt in the US and subsequent inflation increases.

Jim Willie describes why holding gold and silver is so compelling to many people in the US.

Note: While many observers say that the price of gold has reached an all-time high, the inflation adjusted price of the recent "high" is less than half of the 1981 high.

The Federal Reserve Buying U.S. Debt: How Long Can It Continue?

Trend: The Federal Reserve has been buying U.S. long-term U.S. debt to support lower interest rates and the economic recovery.

The authors of this commentary suggest that Fed's debt buying actions appear to be unsustainable. Excerpts below.

Link: Who is really lending the US all this money? |AR Absolute Return - Alpha

...foreigners are selling longer dated US Agency/MBS debt and moving the money they raise into shorter term US Treasury debt. And who is buying this debt? The Federal Reserve.

Out of nearly $2.1 Trillion of net issuance across the Treasury, Agencies and MBS markets from June 2008-9, the Federal Reserve has accounted for nearly 40% of the total demand, buying more than every foreign government combined. It is also not a stretch to say the Fed has become the entire mortgage market; it has purchased nearly $500B of MBS securities during a period where there was only $350B issued. Looking at the first seven calendar months of 2009 yields similarly startling results: of the total $1.1 Trillion of net issuance across these markets, the Fed has purchased $861B or almost 80%.

The question we must all grapple with is what will happen when the Fed has completed its purchases. According to the US Treasury’s Department of Debt Management, the US is expected to issue $1-1.6 T of Treasury debt in the 2010 fiscal year. This implies that total US government market issuance next year could once again run in the $2T range. To make up for the Fed’s nearly $900B worth of purchasing would require the recently elevated household savings rate to double from 6% to 12%. Commercial banks, which have purchased nearly $200B of US debt in the same time period, would also need to double that amount again from this past year.

If the Fed simply walks away or even gradually moves away from the market, we will see bond market prices drop and mortgage and all other rates go higher, potentially crushing the nascent recovery. The CEO of Wells Fargo recently told a group of investors that if the Fed stopped buying MBS, mortgage rates could spike 100-150 basis points in a week.

If the economy turns down, sparking a flight to safety in Treasuries, the Fed will once again have to worry about deflationary expectations and respond by printing money.

Unfortunately, printing more money, expanding its balance sheet further, and hoping to “kick the can down the road” may not be a viable strategy for the Fed much longer either as nearly two-thirds of the US government debt comes due in the next 36 months.

The Federal Reserve, through a confluence of past mistakes, effective crisis response, and circumstance has found itself trapped with only painful options from which to choose.

Investing in the Shortsightness of Government Officials

Trend: Governments that have focused only on short-term problems are facing some grim realities as neglected long-term problems expand exponentially.

Below are some excerpts from a speech by David Einhorn, President of Greenlight Capital. He describes some of the trends that worry him and the events that got us into this situation. For the first time, he suggests holding gold to protect capital. He is renowned for shorting Lehman Brothers before the financial crisis after uncovering the problems that the ratings agencies ignored.

Link: John Mauldin's Outside the Box - InvestorsInsight.com

Presently, Ben Bernanke and Tim Geithner have become the quintessential short-term decision makers. They explicitly "do whatever it takes" to "solve one problem at a time" and deal with the unintended consequences later. It is too soon for history to evaluate their work, because there hasn't been time for the unintended consequences of the "do whatever it takes" decision-making to materialize.

In the context of the recent economic crisis, a highly motivated and organized banking lobby has demonstrated enormous influence. Bankers advance ideas like, "without banks, we would have no economy." Of course, there was a public interest in protecting the guts of the system, but the ATMs could have continued working, even with forced debt-to-equity conversions that would not have required any public funds. Instead, our leaders responded by handing over hundreds of billions of taxpayer dollars to protect the speculative investments of bank shareholders and creditors. This has been particularly remarkable, considering that most agree that these same banks had an enormous role in creating this mess which has thrown millions out of their homes and jobs.

...Americans understand that the Washington-Wall Street relationship has rewarded the least deserving people and institutions at the expense of the prudent. They don't know the particulars or how to argue against the "without banks, we have no economy" demagogues. So, they fight healthcare reform, where they have enough personal experience to equip them to argue with Congressmen at town hall meetings. As I see it, the revolt over healthcare isn't really about healthcare, but represents a broader upset at Washington. The lack of trust over the inability to deal seriously with the party goers feeds the lack of trust over healthcare.

The Budget Deficit Tipping Point

Trend: According to the Congressional Budget Office, in FY 2009 40% of federal government spending was funded by debt, compared to 15% in 2008 and 6% in 2007.

Michael Panzner calls our attention to a disturbing benchmark. Let's hope that the US government can lower the budget deficit before the consequences undermine the financial system in this country. Excerpts below.

Link: Financial Armageddon: The Real Threat to Future Economic Stability.

According to research highlighted by Hayman Advisors in their October Letter, the fact that such a sizeable share of government spending is being financed with borrowed money has, historically at least, been a harbinger of trouble ahead:

There have been 28 episodes of hyperinflation of national economies in the 20th century, with 20 occurring after 1980. Peter Bernholz (Professor Emeritus of Economics in the Center for Economics and Business (WWZ) at the University of Basel, Switzerland) has spent his career examining the intertwined worlds of politics and economics with special attention given to money. In his most recent book, Monetary Regimes and Inflation: History, Economic and Political Relationships, Bernholz analyzes the 12 largest episodes of hyperinflations - all of which were caused by financing huge public budget deficits through money creation. His conclusion: the tipping point for hyperinflation occurs when the government's deficit exceed 40% of its expenditures.

Currency Devaluation and Gold

Trend: Currency devaluation – the falling dollar – is a primary reason that gold is attracting smart money.

Alice Schroeder at Bloomberg.com describes why gold is a good investment before financial crises. Excerpts below.

Link: Gold Tells You U.S. Bubble Hasn’t Popped Yet: Alice Schroeder - Bloomberg.com

...the relationship between gold and financial crises goes back centuries. In the aftermath of the credit-bubble bust, we confront a Moby Dick-size pile of leverage and the question of whether this is inflationary or deflationary. So it’s worth considering what the price of gold may be telling us.

Leverage is a broad term that covers the complete history of finance, which all boils down essentially to the same structure: debt secured by assets. You give me a cow, I give you a piece of paper. Later innovations are simply variations of obligations secured by assets.

So a simple explanation of bubbles is that they form whenever someone creates a rationale to increase obligations too far beyond the level justified by the assets, regardless of the form of the asset or obligation.

The Erosion of Trust – CPI and GDP Distorted for Political Purposes

Trend: Official statistics continue to be distorted to hide real economic performance.

Trust in investing with Wall Street has sufferred a huge setback on Main Street recently as stories of greed and fraud dominate the media. The lack of oversight by government agencies like the SEC has contributed to the environment of distrust. But out of the headlines, key statistics like the GDP and CPI are used for important decisions when they are not reliable measures anymore.

Demand for gold reflects mistrust in governance and leadership. Gold prices rise during crises and when the currency is being debased by money creation.

In this context, precious metals like gold and silver are not investments but insurance for hyperinflation or financial collapse.

It is common knowledge that the CPI does not reflect the real rate of inflation. In the two videos about Fuzzy Numbers that follow, Chris Martenson's Crash Course describes how and why the government distorts the numbers.

After the Financial Crisis: Recovery, Mediocrity, or Instability?

Trend: The Economist Intelligence Unit predicts a 10% probability of Instability, the worst case scenario for the aftermath of the financial crisis.

In a post earlier this month (Our Next Five Years: Recovery, Mediocrity, or Instability?), we discussed three scenarios for the financial crisis in 2010 - 2015.

London's Economist Interlligence Unit says there's a 90% probability of Recovery/Mediocrity and a 10% probabilty of Instability.

The Economist Interlligence Unit has identified three macroeconomic scenarios for the evolution of the crisis that began in the US sub-prime mortgage market and is now reverberating throughout the world economy.

Scenario 1: Our central forecast (60% probability)

Government stimulus stabilises the global financial system and restores economic growth in leading developed markets during 2010, albeit at lower levels than in recent years. 

Scenario 2: The main risk scenario (30% probability)

Stimulus fails, leading to continued asset price deflation and sustained contraction in the leading economiesóa depression persisting for some years. The stubborn decline in global economic activity is punctuated by occasional rallies that are taken as signs of recovery, but these quickly fade as the
underlying downward trend reasserts itself. The prominent role of governments in propping up banks and reviving domestic demand leads to strong political pressure for protectionism, effectively putting the process of globalisation into reverse. 

Scenario 3: The alternative risk scenario (10% probability)

Failing confidence in the dollar leads to its collapse, and the search for alternative safe-havens proves fruitless. Economic upheaval sharply raises the risk of social unrest and violent protest. A Political Instability Index covering 165 countries, developed for this report, highlights the countries particularly vulnerable to political instability as a result of economic distress. The results of the index are displayed in map form and in a ranking table in the centre pages, along with a brief methodology. 

Our Next Five Years: Recovery, Mediocrity, or Instability?

Trend: We do not know how this financial crisis will end, but the aftermath will determine which investments win.

When I analyze the predictions by intelligent observers about the future of the United States in 2010 through 2015, I can group the forecasts into three distinct camps: Recovery, Mediocrity, and Instability.

I'll describe the best case scenario first.

Recovery

A quick rebound after the financial remedies have the fixed the banking system, with life back to "normal". Jobs are plentiful, consumers are spending, builders are building, real estate prices are up, and the stock market is gaining.

Larry Kudlow at CNBC is a prominent advocate a quick recovery. Here's a sample from his blog at the Kudlow report:

Doom-and-gloom crowd take notice: Today’s retail-sales report showed far more strength than Wall Street economists dreamed possible.

Overall, February was down slightly, but January was revised up to a 1.8 percent gain. Excluding autos, February was up 0.7 percent and January was up 1.6 percent. In terms of core retail sales (ex autos, gas, and building materials), which feed into the GDP reports, February was up 0.5 percent and January was up 1.7 percent.

In fact, consumer spending in first-quarter GDP could turn positive. Overall, GDP will be down because of a massive inventory liquidation, but the sooner that draw-down is complete the faster we’ll get positive GDP growth — maybe even in Q2.

Meanwhile, the retail-sales upturn is hugely important.

In other words, even before one dime of the Obama spending package goes into play, the economy is beginning to show the first signs of recovery.

Stocks, by the way, are up 240 points at this writing — their third-straight daily rise on the shoulders of new banking profit reports and today’s positive retail-sales numbers.

The middle course, Mediocrity, is not that inviting, but much better than the worst case.

Mediocrity

A slow decline in the quality of life in the United States prevails as the middle class slowly slides to a lower standard of living. Consumer spending is undermined by saving and frugality becomes stylish. Real estate prices stay down and jobs are scarce.

John Maudlin, who predicted the financial crisis, writes articulately about the aftermath:

We are in a synchronized global recession. Yes, we will recover, but the causes are not those of the typical business-cycle recession. We are seeing massive debt deflation, deleveraging on a scale never witnessed, a financial industry that has to be rebuilt, and a housing industry that is reeling all over the world. We created a lot of excess in a number of industries. We decimated the savings of a generation that was hoping to retire soon, and now will have to work longer and save more.

This is not a typical recession. And for any analyst, writer, or pundit to trot out past historical data to demonstrate that the stock market is going to rebound at such and such a time and at such and such a pace simply ignores the fact that the future is unlikely to look like the past for at least the next 2-3 years. We are in a brand-new world, macro-economically speaking.

And let me also suggest that when we do get the problems worked out, and we will, the recovery that ensues may be breathtaking in its scope, as the technological changes that will be coming down the pike in the next 5-10 years are simply going to dwarf what we have seen in the past 30. Ray Kurzweil predicts that we will see twice as much change in the next 20 years as we saw all of last century. Think about the implications of that.

Just as we cannot let past performance and wishful thinking blind us to the reality that we confront today, we must not let 3-4 years of a slow Muddle Through world after this recession ends blind us to future opportunity. Projecting the current trends into the long future is nearly always a mistake. And the longer the trend goes, the more complacent (or negative) we get. But trends change. Remember that. (Thoughts from the Frontline)

Instability

A precipitous decline into an era where jobs and necessities are scarce and life is tough. Owners of guns and gold are the smart investors. Gardens and local farms provide most of the food.

Michael Panzner, author of the book Financial Armageddon (published in early 2007, it predicted the financial crisis), describes the plight of the unfortunate many:

To many people, the unfolding crisis feels like a bad dream. Every day they wake up, hoping things will somehow be back to "normal" (whatever that is). But just like the last great unraveling that took place 80 years ago, a good night's rest does not change the reality of the situation. It doesn't eliminate the imbalances that have built up over the course of many decades. It doesn't alter an unhealthy dependence on debt and fast money. It doesn't take the place of a corrective economic cleansing that was way, way overdue. But what it does do is leave those who are ill prepared and scrambling to get by.... (Financial Armageddon blog)

I remember that many of the same arguments were in play about Y2K.

The Big Question

The reason it is important to identify the prevailing trend is that investment winners in 2010 through 2015 will be affected significantly by which scenario prevails. We will be exploring the differences in this blog for investing in each scenario in the future as we scan the environment for clues for how the future will unfold.

Trust in Investing

Trend: Trust is an essential element of a bull market – and distrust is the dominant emotion in the markets now.

Andrew Mickey, Chief Investment Strategist at Q1 Publishing, discussed the role of trust in investing. Excerpts below.

Link: Q1-Publishing - Home.

David Burrows is a consistently top-performing portfolio manager in Canada. He’s not one to hold onto any position for too long if it goes against him. And the strategy has served him and his investors well over the past decade, during good times and bad.

He looks at the stock market a bit differently than most people (most very successful investors do). When he talked about his philosophy, he referred to a relationship between the stock market and investors and the role of a sense of trust.

Trust is imperative to a bull market. Take a look at what got us here. For a little over 20 years (between the 1987 crash and today’s crisis) the stock market laid a strong foundation of trust with most investors. If investors were willing to regularly put more money in, then stocks would generally rise.

Sure there were ups and downs, but the big trend was up. The rising tide was so strong and everyone’s portfolio rose with it.

It was a good deal – while it lasted.

All that changed this year though. The trust has been broken. Although many people have been willing to ride out the downturn so far, any more significant downturn will send the markets much lower.

For now though, the government is pulling out all the stops when it comes to keeping the markets propped up. And they’ll surely help keep this upturn going as strongly as possible.

In the end though, the government will probably not be able to overcome Mr. Market – it never has before. So if you’re an active trader, enjoy this run to the upside. At this point, it seems like Dow 8,000 or Dow 9,000 is within reach. Beyond that though, there will be some big roadblocks and the markets will probably take a turn for the worse.

The government PR programs are working. The rule changes (nothing more than Band-Aids on a fatal wound) are working. And the markets are lapping it all up.

It’s tough to imagine it lasting much longer.