The Cycle of Deflation: Impediments to Debt Relief

Friday, February 26th, 2010

The post below is a guest contribution by Marty Weiner of Comstock Partners, the highly regarded investment manager run by Charles Minter.

We have been strong believers in the deflation theme since we have been writing these reports beginning in early 2000 (and even before).  We are attaching a chart depicting the “Cycle of Deflation” which you should print out and refer to as you read this comment.

As you can see by the chart, the typical deflation starts with savings and investment which produces strong sustainable growth in the economy.  However, when “greed” gets added into the equation, things sometimes change into non-sustainable growth.  This is what happened in the late 1900’s when the dot com bubble mania convinced every man woman and adult child to believe that they were all supposed to be multi millionaires.  They became so jealous of their neighbors who boasted about all the money they made in the market, that they also jumped into the market by buying such things as Internet Capital Group, CMGI, Iomega, JDS Uniphase, and many others of the same ilk which are now worthless.

The unraveling started taking place in 2000 and it looked to us like the American public came to their senses.  We expected to have a significant recession where Americans could rebuild their balance sheets as the cycle of deflation took hold.  But,  instead the Fed lowered interest rates to 1% and kept them there for a year causing the public to again become jealous of their neighbors making thousands and millions of dollars on their homes. And also, believe it or not, the housing bubble brought about another bubble in the stock market. We couldn’t believe our eyes!!!

After the housing bubble burst, the stock market also collapsed causing a financial crisis “heard ’round the world”.  Then, we were sure the markets and economy would fall to levels that would repair balance sheets of the household sector and allow the economy to get back to the tried and true savings and productive investment that built this great country.  We still need to repair the household balance sheets that were, and still are, in the worst shape since than the Great Depression.  What will it take to get to the debt repayments and debt defaults (see the last stage of The Cycle of Deflation) that has to take place before a sustained recovery can be accomplished?

We understood that the stock market was extremely oversold in March of 2009 and that there had to be a rally.  But we found the 70% to 80% rally which occurred to be incredulous.  The market is up so far from the lows in March now that they have discounted a V shaped recovery.  We have to wonder if the public and financial institutions will ever learn.

We are now in the “competitive devaluation” part of the cycle of deflation and we should be getting close to repairing the balance sheets that are so out of line with history.  But, there is a stumbling block to the normal competitive devaluations that typically take place. In the past, a country that incurred too much debt just did what they could to devalue their currency in order to export their way out of the dilemma by exporting their goods and services to their trading partners.

Now, however, it is not so simple.  The Chinese have linked their currency to ours, so as we debase our currency, one of our major trading partner’s currency is also declining and China becomes the major beneficiary of the debasement of our dollar. Because of this peg (and the Euro tied to 22 countries) the typical method of debasing the currency of debt laden countries (or countries that just want to get even) have swung down in “The Cycle of Deflation” past competitive devaluations to “beggar thy neighbor” policies.  We explained many times that “beggar-thy-neighbor” policies essentially go much further than just currency debasement, but actually do whatever a country has to do to protect its jobs and its economy.  This means “dumping” goods and services on their trading partners (selling  goods and services below cost and subsidized by the government), increasing tariffs, and anything else in its power to help the economy at their trading partners’ expense.

A perfect example of this lies in the recent accusations from China that the U.S. has been “dumping” chicken products into the Chinese market.  It at first threatened imposing heavy trade duties on U.S. chicken companies, and just recently China did impose the heavy duties.  They imposed duties of 64.5% on Sanderson Farms, 80.5% on Pilgrim’s Pride, and 43% on Tyson Foods which just happens to be an active investor in China.   These types of “beggar-thy-neighbor” policies are an extension of the past policies they have used to support exports. But now they feel that they have to go further since China now accounts for 9% of global exports.  Earlier this month China filed a compliant to the World Trade Organization against the European Union tariffs on imports of Chinese shoes.  “The dollar peg of the rinminbi has put additional pressure on lower end Asian exporters.  This has led to charges of unfair trade from across Asia,” said Jamie Mezl, executive vice president of the Asia Society.  Even nations in Africa and the Middle East are complaining.  “When we look at the reality on the ground we find that there is something akin to a Chinese invasion of the African continent,” Libyan Foreign Minister Musa Kusa said in November.

China’s exports were helped enormously by repegging their renminbi to the dollar in mid 2008.  Their exports got a further boost once the dollar started falling from March of 2009 by about 10%.  Now that the dollar has started up they could be close to reversing that decision.  Despite all the hoopla of China trying to slow down their growth, the above policies don’t support that at all.  The Chinese total debt to GDP is very difficult to quantify, but with the enormous stimulus undertaken last year ($550 billion) and government supported bank lending ($1.3 trillion), we know they are not in great shape.

America has retaliated by imposing punitive tariffs (as much as 99%) on Chinese tires and tubular steel (used in oil and gas wells).  The Chinese government weighed in by condemning the U.S. tariffs as an “abuse of protectionism”.

These examples of Chinese actions illustrate how difficult it is now for debt ridden countries to simply devalue their currency in order to export their way out of the dilemma. And just think about the situation in Europe, where this problem is exacerbated by 22 fold, since they now have 22 countries tied to one currency.

The problem is not confined to America, Asia, and Africa-Look at what is taking place in Greece presently.  In the past, a country like Greece that over indulged and got caught with their “hands in the cookie jar,” would just debase their currency in order to export their way out of the problem.  But, now that their currency is tied to the Euro like 22 other of its trading partners, they don’t have the same option as they did in the past to bail themselves out.

In summary, due to the debt related problems many countries worldwide are struggling to help their own economies at the expense of their trading partners.  In the past this has been accomplished by debasing their currencies in order to export their goods and services.  Because of currency pegs and one currency used by 22 countries (Euro Zone), this means of debt relief is not as easily accomplished.  The next stage of the Cycle of Deflation is the much more onerous “beggar-thy-neighbor” policies in order to support the economies of debt burdened countries.  This is not good news and could have the same effect for the global economies as Smoot Hawley did (a bill in 1929 that became law in 1930 which raised the tariffs on the U.S’s. major trading partners).   Therefore, the main problem of reducing the debt of major economies throughout the world is even more complicated and makes us even more convinced that the secular bear market that started in 2000 is still intact.

Source: Comstock Partners, February 25, 2010.

Tags: Adult Child, Balance Sheets, Bubble Mania, Cmgi, Debt Relief, Financial Crisis, Household Sector, Housing Bubble, Ilk, Impediments, Internet Capital Group, Investment Manager, Iomega, Jds Uniphase, Man Woman, Millionaires, Minter, Stock Market, Sustainable Growth, Weiner
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Michael Belkin’s Model Points Up for Stocks

Tuesday, February 2nd, 2010

Kate Welling of welling@weedon has just conducted another of her top-class interviews with Michael Belkin. Belkin is the author of The Belkin Report that I used to read regularly, but have had difficulty in obtaining over the past two years or so. He has a huge reputation among institutional investors and got his calls right more often than not when I still had access to his material.

Friend Barry Ritholtz (The Big Picture) provides some insight into Belkin’s latest thinking with the following excerpts from Welling’s report:

“Where my views are probably different to what some of the higher profile names are currently saying is that I’m not pointing to the equity market now as the source of a bubble or of malinvestment, in Austrian terms.

“If not the stock market, where are you pointing?

“At the bond market. Specifically, since the March 20, 2009 turning point in the equities market, if you look at the AMG weekly data on inflows into ETFs and mutual funds, bond fund flows have been positive every week and have averaged $4 billion a week. There hasn’t been a single down-week. But meanwhile, for equity funds, there’s been a completely different pattern. They’ve been down two weeks, up one week, then down, up four weeks, down five weeks - and the average inflow is only $500 million a week.

“Just barely positive?

“Yes, at last count only $24 billion had gone into all kinds of equity funds over this entire recovery rally, versus $178 billion into bond funds. I’ve been looking at this for quite a while and sort of scratching my head and wondering what was going on. But finally it just occurred to me. They’re buying bonds. It’s rather obvious. I think what has happened is that the public in previous cycles bought emerging-market funds or internet stocks or whatever, when the Fed would lower interest rates to an artificially low level, thereby penalizing people on their savings. So right now, for instance, I have friends who inherited a lot of money and I’m an informal advisor to them, not a paid advisor. They keep asking me, what do I do now? They were investing in CDs, which were parceled out to a lot of different banks on which they were making 2, 3, 4%. But now they’re maturing and the banks are offering, like, nothing. So they are asking, what do we do, what do we do? They need the yield; they need income; they don’t want to lose the nominal principal. What to do? What to do?”

“Belkin’s time series regression analysis is not only data driven, but he is also aware of historical predecessors. I find his argument that bonds are at greater risk than stocks to be very counter-intuitive, contrary - and compelling,” added Ritholtz.

Source: Barry Ritholz, The Big Picture, February 1, 2010.

Tags: Barry Ritholtz The Big Picture, Bond Fund, Bond Funds, Bond Market, Class Interviews, Emerging Market Funds, Equity Funds, ETF, Friend Barry, Fund Flows, Funds Bond, Inflow, Institutional Investors, Internet Stocks, Michael Belkin, Model Points, Mutual Funds, Profile Names, Stock Market, Turning Point, Weedon
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Year-End/New-Year Indicators: Progress Report

Saturday, January 30th, 2010

An old stock market saw tells us if the month of January is higher, there is a good chance the year will end higher, i.e. the so-called “January Barometer”. On the other hand, every down-January since 1950 has been followed by a new or continuing bear market or a flat year. “As January goes, so goes the year,” said Jeffrey Hirsch (Stock Trader’s Almanac).

The result for January is in, and it is not a good one: The Dow Jones Industrial Index closed 3.5% down on the month and the S&P 500 Index 3.7% lower.

Also, according to Hirsch, the “December Low Indicator” says that should the Dow Jones Industrial Index close below its December low anytime during the first quarter, it is frequently an excellent warning sign. The key number to watch was the low of 10,286 (December - now history with the Dow down to 10,067.

Although this is not particularly scientific research, it is clear we are not seeing a good start to 2010 and should at least be mindful of these indicators.

Considering the short-term technical picture of the Nasdaq Composite Index, Adam Hewison (INO.com) provides a short analysis showing a rather negative downside break. Click here to access the presentation. (He also recently analyzed the Dow Jones Industrial Index and the S&P 500 Index. Click here and here.)

Tags: Almanac, Amp, Barometer, Bear Market, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Index, Downside, First Quarter, Good Chance, Jeffrey Hirsch, Key Number, Month Of January, Nasdaq Composite Index, New Year, Progress Report, Stock Market, Stock Trader, Warning Sign, Year End
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Doug Casey: “Stock market set to crash”

Friday, January 15th, 2010

Doug Casey is an American free-market market economist, financial author and entrepreneur. He has been writing a monthly investment newsletter, the International Speculator since 1979 and I always find his ideas quite refreshing.

In the paragraphs below, he is interviewed by Louis James, editor of the International Speculator.

L: So, what’s on your mind this week, Doug? I understand you’ve had a “guru moment”…

Doug: Well, it’s nothing but a gut feeling, but I think the stock market is riding for a big fall this year.

Everyone was afraid the world was going to come to an end a year ago, and it almost did. But governments all around the world stepped in and printed up trillions of their various currency units - it’s not just the United States. And still, retail price inflation hasn’t blossomed. It seems that governments are bent on keeping asset prices up to avert panic. They focus on controlling perception instead of fixing the problem. It stems from an economic version of the theory that all we need to fear is fear itself. As long as we have the right psychology, everything is going to be okay - total nonsense.

L: That old saw: as long as there’s confidence, all is well.

Doug: Yes. It’s the Wile E. Coyote theory of economics. As long as you never look down after running off a cliff chasing the roadrunner, you can keep treading air. Unfortunately, although the power of positive thinking may help in many ways, it’s of zero use if you continue living above your means and making stupid decisions.

L: Insolvency doesn’t seem to matter; as long as everyone has confidence that things will keep going, the experts believe they will. But in the real world, you can’t remain insolvent for long, even if “you” are the United States as a whole society.

Doug: Exactly. My thinking about the stock market is this: corporations have done as “well” as they have mainly by cutting expenses. Laying people off, that sort of thing. So the bottom lines have not fallen as far as we might expect - but the top line has been hit. Revenues are falling for corporations across the board.

L: And the market has to notice this reality sooner or later.

Doug: Yes. The world’s financial system has to adjust to a new reality, one with lower levels of consumption and differing types of production. The legions of unemployed are not going to go back to work anytime soon, at least not doing anything like what they were doing before the bubble burst. The economy is going to continue deleveraging. There’s going to be less debt to allow the purchase of all this stuff people have been buying, resulting in lower corporate earnings. So it’s hard to see revenues doing anything but continue to spiral downwards for years to come.

And then there are financial “accidents” waiting to happen.

L: Like the bank failures the government has admitted it expects this year? The FDIC says there will be more bank failures in 2010 than in 2009, with the spin being that 2010 will be the peak of the crisis.

Doug: Sure. But I also expect corporate bond failures. And there are other things out there. As Porter Stansberry (whose style as an analyst I really like) has pointed out, General Electric - which is really just a hedge fund disguised as an industrial concern at this point - is leveraged thirty to one. It’s a dead man walking. It’s the next AIG. When something like that happens, it really shakes Wall Street to its foundations.

So, I’ve been bearish on general equities for years, based on fundamentals. Whether they go up is no longer a reflection of prosperity - it’s a reflection of how much money the government creates and where it goes. But I am feeling particularly strongly bearish on Wall Street right now. That’s my gut. The social mood of the country is going to turn ugly and gloomy; people won’t want to call their brokers and “get into the market.”

The Greater Depression is going to be really serious. I can’t see buying stocks until dividend yields are in the 6-12% range. And people have forgotten the market even exists. Anyway, Baby Boomers, who own most stocks directly and indirectly, are going to be selling them to support themselves in retirement.

L: Would you recommend shorting GE?

Doug: It should be an easy bet, but the government is certain to try to prop it up, as it has other dinosaurs pursuing business models that no longer work, like General Motors - although it didn’t help their shareholders. “Too big to fail.” That makes shorting riskier. But GE still has a $179 billion market cap, so it should fall quite a bit from here, if not all the way to zero.

L: No way out for the stock market?

Doug: Well, the government has been suppressing interest rates for a long time now, which is exactly the opposite of what they should be doing. These artificially low interest rates discourage people from saving and encourage them to gamble, hoping to outrun inflation. But eventually the market will force interest rates to go higher, and that will kill the stock market, because the stock market does tend to fluctuate inversely with interest rates. High interest rates almost always mean a low stock market, and low interest rates tend to mean a high stock market. So it seems to me that there simply is no good news on the economic front. Interest rates are headed way up, both out of a need for capital and as a reflection of the high price inflation ahead.

L: This doesn’t sound like a guru moment - a flash of the famous Casey inspiration. This sounds more like a well-reasoned argument to me.

Doug: Well, when you get a really strong gut feeling, it’s usually because you intuit many things that are out there, subconsciously if not analytically. Look, dividends are dropping across the board. Top line earnings are dropping. Where net earnings have been maintained, it’s been by expense cutting.

L: Even if margins are maintained, the companies are getting smaller, and people are making less money, on the whole.

Doug: Right. And interest rates are at all-time lows. That’s the short sale of the decade, if you want to short something. Bet against bonds.

And there’s more. As the government takes over more and more of the economy, they’ll mismanage that activity, as they always - necessarily - do. Why do I say necessarily? Because they do things that are politically productive for them, not economically productive for society. That’s going to hurt productivity and profitability, misallocating and even destroying capital wherever they stick their noses. And, today, that’s absolutely everywhere.

Taxes, of course, will go way up. That’s going to give individuals less money to buy stocks. Corporations will have less money left over to reinvest or pay dividends with. All the draconian new rules they’re enacting in response to the crisis will only serve to inhibit entrepreneurial activity and investment. It will encourage speculation.

The real estate market has not, by any means, bottomed yet. What’s going to happen in the commercial and office real estate markets is just starting, and the housing market is still going to get worse.

All of this is very bearish for the stock market.

L: Not a single ray of light? No way you can be wrong?

Doug: The only bullish factor I can think of is that people might panic out of dollars and will buy anything that’s real - or at least represents actual wealth, as stocks are supposed to do. That’s the only reason I can think of for buying Wall Street, and it’s too early for that to happen. Retail inflation hasn’t reared its ugly head in a big way yet, and we’ll have to have big inflation numbers before Americans start really panicking out of the dollar.

L: That seems to still be a bit down the road.

Doug: Yes, and I hate making predictions about the direction of the stock market. It’s like that joke I like to tell about Einstein.

L: The one you used when we talked about interest rates.

Doug: Right. It makes no sense to be in the stock market at this point. Real estate is a terrible place to be. Bonds are a terrible place to be. Even cash, especially if you’re holding euros or dollars, is surprisingly risky, for all kinds of reasons (as we just spoke of regarding currencies). That makes this a truly unique time, in which there’s almost nothing that’s a good place to be.

L: Nothing? What about gold?

Doug: Gold had a good day today, and it’s back near its new record high again. I’m very bullish on gold, but I’m reluctant to tell people to go out and buy gold when its trading near a peak price - a price that’s quadruple the price when I was telling people to buy gold a few years ago. I still think gold is going over $2,500 or even $3,000, in today’s dollars, but it’s risen enough that it’s not going to be a one-way street straight up from here. It’s not being artificially suppressed to $35 anymore…

This is a very strange time - I’ve never seen anything quite like it - with no good places to be, at least as far as Americans in America are concerned. Maybe Canadians are next - their real estate market hasn’t really collapsed yet. If I still owned property in Canada - I used to live in Vancouver - I’d hit the bid tomorrow morning. The same in Australia, China, and the UK.

L: Okay, but back to gold - even if it is four times what it was a few years ago, with all the money creation that has gone on full throttle around the world since the crisis hit, that’s really not a concern. If gold corrects in a big way, back to three digits, maybe back below $900, or even below $800, given where gold has to go once price inflation follows monetary inflation, that correction just becomes a great buying opportunity for those who didn’t get in early.

Doug: I’m confident that within a couple years, gold is going to be trading at $3,000 or more per ounce. I really think that’s going to happen. I’d rather buy more at cheaper prices, of course, but the simple fact that it has quadrupled doesn’t prevent it from quadrupling again. And there is no gold bubble. The average guy hasn’t even thought about gold, much less bought any.

L: That makes sense. But about interest rates; the government has been keeping them artificially low for years - why can’t they just keep on doing that through the rest of this year and beyond?

Doug: They might be able to. After all, interest rates are like any other market; they are prices set by buyers and sellers. More buyers of bonds (bills, whatever) drive down interest rates. So, if the Federal Reserve comes in and buys bunches more of this stuff, yes, the immediate and direct consequence will be lower interest rates. But the indirect and delayed consequence will be vast quantities of new dollars, which is the actual cause and definition of inflation, and as a result, the market is going to demand higher interest rates in the U.S., just as it did in Zimbabwe.

Don’t forget that the U.S. government is going to run another trillion-dollar-plus deficit this year, plus they have to roll over another trillion of maturing paper. Who’s going to buy all that? Nobody - unless rates go much higher. Or the Fed buys it with newly created dollars.

L: No way out?

Doug: I hate to sound so definitive - it makes it easier to be wrong. I realize that in the art of predicting, you’re supposed to use lots of hedge clauses and never give both a price and a date in the same sentence. You’re supposed to be cryptic, like an oracle, or speak in meaningless generalities like a Fed chairman. I certainly don’t want to sound dogmatic, because almost anything is theoretically possible, but at this point, if the U.S. and the world avoid a financial catastrophe, it’s really, really going to surprise me.

I just don’t see any way around it, and most people simply do not think in these terms, so they are going to be blindsided. They listen to what they hear in the news, read in the papers, get from government pronouncements… Green shoots, things are getting better… To me it’s so wrong-headed what the governments are doing, it’s not just ignorance, it’s deliberate…

L: Malice?

Doug: Malice. That gets back to the confidence con. A lot of these morons think that’s really what it’s all about. Confidence and consumption - just the opposite of what’s needed right now.

L: When what’s needed is caution and saving. And at some level they must know that discouraging people from doing these things is wrong.

Doug: It depends on the degree to which you think these people are knaves or fools. I think they are both, but some are just stupid. Some are actually stupid in the sense of “unintelligent.” But more are stupid in the sense of evidencing an unwitting tendency to self-destruction.

L: Both evil and stupid? Great!

Doug: Yes, it’s a very dangerous combination for the world at large. But it characterizes exactly the type of person that gravitates into government.

L: So, it goes into a death spiral. They have to sweeten the pot more and more, or foreigners won’t accept increasingly worthless paper. Result: even a guy as smart as Bernanke is supposed to be could take the U.S. down the path of Mugabe.

Doug: No question. He’s warming up those helicopters as we speak. And unfortunately, it’s not just the U.S. at this point. China, which everyone seems to be thinking will save the world’s bacon, is in an unbelievable real estate bubble now. Prices have doubled and doubled again in the last five years. As you know from our conversation on real estate, I’ve had dealings in the Hong Kong market for a while now, and prices that apartments are going for in Hong Kong now are literally off the scale. Totally over the top. When that Chinese bubble bursts, you’re going to have scores of millions of Chinese - and the banks that lent them money - lose everything, just like Americans. It’s going to burst, and it’s going to be a disaster.

L: So, it’s truly a worldwide problem - no surprise there.

Doug: Yes. The bottom line is that all of this is bad for the stock market. The only good news is that those of us who are long gold are going to continue to do well. There’s also an excellent possibility that a bubble will be ignited in gold stocks.

L: But won’t gold stocks get whacked in a major market meltdown, if only temporarily, as they did in the crash of 2008?

Doug: That’s very possible, which is why you only want to own the best of the best gold stocks, with great people, projects of real merit, and enough cash to advance them for two years or more - the kind that you focus on in the International Speculator and the kind of profitable producers Jeff Clark focuses on in the Gold and Resource Report. Such companies can weather the storm - just as they did the crash of 2008.

Also remember that gold and gold stocks are different, almost opposite things; gold you own for security, gold stocks are for high-stakes speculation.

L: Got it. And now, so do our readers: hot off the presses, Doug Casey’s guru-sense is tingling, and it’s telling us another major stock market crash is likely this year. Hopefully, they will listen to you and be prepared.

Doug: Most won’t, but I’ll be glad for the ones who do.

L: A sobering conversation, but an important one. Thanks, Doug.

Doug: My pleasure.

Source: Conversations with Casey, January 13, 2010.

Tags: Asset Prices, Canada, China, Coyote, Currency Units, Doug Casey, Emerging Markets, Financial Author, Gold, Gut Feeling, Insolvency, International Speculator, Investment Newsletter, Market Economist, Paragraphs, Power Of Positive Thinking, Price Inflation, Roadrunner, Stock Market, Stupid Decisions, Theory Of Economics, Treading Air, Trillions, Wile E Coyote
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Earnings into Focus

Friday, January 15th, 2010

As the US Q4 earnings reporting season kicks off, not only growth will be closely monitored but also the quality of earnings. These aspects will be very strongly on my radar screen over the next few weeks as I believe the intermediate trend of the stock market could take its cue from the state of corporate America.

This brings me to the topic of valuations (at 06:00 in the morning in the transit area of Munich airport!). Based on operating earnings (i.e. stripping out everything that is bad), the historical price/earnings (PE) multiple of the S&P 500 is 21.10; using “as reported” (GAAP) earnings the figure is a higher 25.7, but down from the 80+ valuations that characterized the previous few quarters. Getting past the loss-making fourth quarter of 2008 and calculating prospective multiples through December 31, 2010 reduce the valuations to 15.3 and 25.2 respectively - still hardly the type of valuations that will inspire one to be a buyer across the board. (The earnings estimates are courtesy of Standard & Poor’s.)

Another way of looking at valuation levels, and cutting through the uncertainty of having to forecast earnings, is by means of Robert Shiller’s cyclically adjusted price-earnings ratio (CAPE), effectively muting the impact of the business cycle by averaging ten years of earnings. Using rolling ten-year reported earnings, my research (based on Shiller’s methodology, but including some refinements) shows the “normalized” price-earnings ratio of the S&P 500 Index is currently 21.2. This compares with a long-term average of 16.4 and implies an overvaluation of 29.3%. The graph below show data since 1950, but the actual calculations date back to 1871.

Albert Andrews, strategist of Société Générale, provides an interesting graph showing the run-up in the US forward PE has not been accompanied by higher expectations of long-term earnings growth. “This means the equity market is far more reliant on the expectations for strong 2010 growth being fulfilled, said Andrews.

Source: Société Générale - Global Strategy Weekly, January 11, 2010.

I repeat my conclusion of Sunday’s “Words” from the Wise” review: “It goes without saying that the strong rally since March is bound to be followed by a correction at some stage. But rather than pre-empting (and more often than not getting it wrong as a result of short-term noise), I will be guided by the longer-term charts and the yield curve to identify a major top. Meanwhile, I am watching valuations carefully, and specifically how the Q4 earnings reports stack up. Although I am treading with caution after the 75% rally in the mature markets and 109% in emerging markets, I am not ignoring good old stock picking, and specifically those companies with strong balance sheets that will be growing their dividends over time with a reasonable degree of certainty.”

Tags: Business Cycle, Corporate America, Earnings Estimates, Earnings Growth, Emerging Markets, Fourth Quarter, Gaap, Intermediate Trend, Munich Airport, Price Earnings Ratio, Quality Of Earnings, Radar Screen, Reporting Season, Robert Shiller, Societe Generale, Stock Market, Strategist, Term Earnings, Transit Area, Valuation Levels, Valuations
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What Type of Bear Are You?

Tuesday, January 12th, 2010

The diagram below comes courtesy of FallStreet (hat tip: The Big Picture). I suppose until such time as a “Bull Index” sees the light of day, one could argue that the “wall of worry” phase of the stock market is still in place and therefore give the bull the benefit of the doubt.

Source: Fallstreet.com, January 8, 2010 (hat tip: The Big Picture).

Tags: Advertisement, Benefit Of The Doubt, Big Picture, Hat Tip, Stock Market, Worry
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Be mindful of Santa Claus Rally and other year-end/new-year indicators

Friday, December 25th, 2009

If Santa has not yet made his way to your investment portfolio, don’t despair. According to Jeffrey Hirsch (Stock Trader’s Almanac), the “Santa Claus Rally” normally occurs during the last five trading days of a year and the ensuing first two trading sessions of the new year. During this seven-day period stocks historically tend to advance (by 1.5% on average since 1950), but when recording a loss, they frequently trade much lower in the new year. Well, yesterday marked the official beginning of the Santa Claus Rally period, with the Dow Jones Industrial Index off to a 0.5% start.

Another old stock market saw tells us the first five trading days of January sets the course for January (known as the “First Five Days Early Warning System”), and if the month of January is higher, there is a good chance the year will end higher, i.e. the so-called “January Barometer”. Every down January since 1950 has been followed by a new or continuing bear market or a flat year. “As January goes, so goes the year,” said Hirsch.

Lastly, according to Hirsch, the “December Low Indicator“ says that should the Dow Jones Industrial Index close below its December low anytime during the first quarter, it is frequently an excellent warning sign of lower levels ahead. The number to watch is the low of 10,286 recorded by the Dow on December 8.

Time will tell whether the year-end/new-year indicators play out according to the historical pattern. Meanwhile, we’ll have some fun tracking how it pans out.

Tags: Barometer, Bear Market, December 8, Despair, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Index, Early Warning System, First Quarter, Good Chance, Investment Portfolio, Jeffrey Hirsch, Month Of January, New Year, Santa Claus, Stock Market, Stock Trader, Trading Sessions, Warning Sign, Year End
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Investing in Range-bound Markets

Tuesday, December 15th, 2009

This article is a guest contribution by Vitaliy Katsenelson*, Portfolio Manager and Director at Investment Management Associates in Denver, CO.

December 15, 2009

In the bull market that preceded the collapse of Lehman Brothers and the financial crisis, equity valuations reached some very frothy levels.

The correction that followed lasted only until March, and since then the S&P 500 index and the FTSE Eurofirst 3000 have risen more than 60%. Even in spite of the post-Lehman correction, equity markets have been in a secular range-bound phase since 2000.

Investors must understand the dynamics of range-bound markets and the best ways of investing in such an environment.

Secular market cycles

Let me lay out my thesis for secular (long-term, longer than five years) market cycles.

Ask an investor what the stock market will do over the next decade, and he’ll tell you his expectations for the economy and earnings growth, and that will turn into his projection for the market. However, this kind of thinking looks at the half of the equation that explains stock market (and individual stock) returns, while completely ignoring a very important variable that is responsible for a significant part of stock returns: valuation.

Mathematically, stock prices in the long run (not minutes or days, but years) are driven by two factors: earnings growth and (it’s a very important and) changes in valuation (P/E ratios). Once you add a return from dividends, you’ve captured all the variables responsible for total return from stocks.

During the last two centuries, every time we had a long-lasting bull market the market what followed was not a bear but a range-bound, sideways market. (The only notable exception was the decline during the Great Depression.) This happened not because of some hidden, embedded magical pattern. No, there is no practical joke being played on gullible humans; it happens because our emotions get the best of us. Yes, emotions! Secular bull markets start at low, below-average P/Es. A combination of earnings growth and P/E expansion (which is a simple reversion towards the mean) bring spectacular returns to now jubilant investors.

Then the investors get overexcited about stocks and drive valuations (P/Es) to above- average levels.

P/E expansion is a powerful tailwind and a significant source of the returns during secular bull markets, but high P/Es can create a headwinds. When they start to fall, they curtail returns during secular range-bound markets. As P/Es stop expanding at the very late stages of a secular bull market, investors who were accustomed to above- average returns grow less than thrilled with lower rates of return. The higher the P/Es, the more difficult it is for stocks to continue to climb, as earnings growth alone cannot keep the secular bull market going. Returns from stocks decelerate to below the levels investors have learned to expect, and investors gradually migrate from stocks to other asset classes.

Welcome to a range-bound market!

Emotions now shift into reverse. P/E compression is like gravity pulling stocks down, where earnings growth is the force that counteracts its effects. All the benefits from earnings growth are gradually offset by constant P/E compression (the staple of range- bound markets). P/Es mean-revert from above to average to below-average levels. Stocks go nowhere for a long, long time in the process.

I discuss this topic in great detail with plenty of charts and tables on my Contrarian Edge website.

US equity markets remain locked in a range-bound state

In the US, economic performance has not been significantly different during range- bound and bull markets. That is, as long economic performance was not far from its average state we had either range-bound or bull markets. However, when you coupled high (above-average) valuations with long-term economic contraction, you had a secular bear market. This is exactly what took place during the Great Depression (and has taken place in Japan from the late 1980s until today).

In secular bear markets, economic growth does not offset a price/earnings (P/E) mean reversion; declining earnings add fuel to the fire and supersize the decline in P/E, thus causing stock prices to decline over a protracted period of time.

In the last (1982-2000) secular bull market P/Es reached their highest level ever. Today, nine years into a range-bound market, US stocks are still at above-average valuations. If over the next few years the US economy doesn’t achieve positive nominal earnings growth, we may slide into a secular bear market.\

The Fed is throwing an enormous amount of liquidity into the economy, yet it has very few tools to deal with deflation (you can make borrowing virtually costless, but borrowers may still choose not to borrow or to spend). The Fed is much better equipped to fight inflation: it can make money very expensive, and expensive money curbs spending. Thus, historically the Fed was willing to err on the side on inflation - be it in consumer prices, housing, commodities, or the stock market (”Bubbles-R-Us”). (In part we are paying today for the Fed’s handling of the 2001 recession: Alan Greenspan took interest rates to a very low level and kept them there for too long, starting a bubble in real estate.)

Current Fed actions may have the unintended consequence of promoting another bubble in stocks. I believe it will be harder to achieve a broad market bubble, since the more you stimulate the less effective stimulus becomes, over time; but I can see how a few sectors may (and already have) bubbled up.

The Fed and politicians will likely err on the side of overstimulating the economy, as the career risk for taking the economy back into recession through constrictive monetary policy is too great.

The exit strategy from a range-bound market

Will my observations continue to play out in the future?

In my book Active Value Investing: Making Money in Range-Bound Markets (Wiley, 2007), I inadvertently created a framework that explains the mechanism behind stock market cycles. As things change over time one thing remains the same: our emotions will make us overexcited about stocks, and this will drive stocks to above-average levels, giving us cause to be underexcited (I think I just made up a new word), which will result in treacherous periods of range-bound markets.

If it were not for our emotions, stocks would always hew very close to their value levels (a normalized P/E of 15) and secular market cycles would not occur. I am oversimplifying; but if it were not for emotions, returns from stocks during short, intermediate, and long-term periods would be identical to their earnings growth.

Human emotions don’t let valuations (P/Es) remain in their average state of 15, and so they are driven to extremes, on both sides of the mean. Returns from stocks over short (one year) and intermediate terms (5, 10, or 15 years) may have a significant disconnect from their earnings growth. And the disconnect between earnings growth and stock market returns may persist for decades, or even longer.

Over, say, thirty years in the US (it takes that long for bull and range-bound markets to cancel out each other), returns from stocks will be in line with economic growth.

The role of technical analysis and market timing

About a month after my book came out I regretted its subtitle, “Making money in range- bound markets.”. People assumed that I knew what the range was, and the name also implied that I use technical analysis. “Sideways markets” would have been a more accurate description, but what’s done is done.

Secular market cycles are full of many cyclical bull and bear markets; the last range- bound market, which started in 1966 and ended 1982, had five cyclical bull and five cyclical bear markets. It is impossible to succeed at short-term market timing, as you have to get two things right: the short-term economic numbers and the market’s response to them, which in many cases may be irrational.

What I propose in the book (and practice at my firm) is active value investing. Instead of being a market timer, I’m a buy-and-sell investor, with a focus on valuing individual stocks.

Positioning against a decline in the dollar

Though problems in the US are well-known, I am not a long-term dollar bear (though, as a hedge, we own some stocks that would benefit if the dollar continued to decline).

If the dollar is to fall, one must ask what against currency will it fall?:

The Japanese yen? Japan has its own, more immediate crisis: its economy has been in recession since the late 1980s, it has one of the oldest populations in the developed world, and its savings rate has declined greatly and is still falling. Japan has been trapped in a zero-interest policy that it may not be able to sustain for much longer. Its debt-to-gross domestic product is second only to Zimbabwe’s, and even a small increase in interest rates will put a significant pressure on its budget. So the yen is not it.

As I have written previously, Japan was on the stimulus bandwagon for more than a decade; and with the exception of government debt-to-GDP tripling, Japan has nothing to show for it . Its economy is mired in the same rut it was in when the stimulus marathon started. It had a hard time giving up stimulus because the short-term consequences were too painful. Also, Japan is proof that a low (zero) interest-rate policy loses its stimulating ability over time and turns into a death trap for the economy as leverage ratios are geared to low interest rates. Now, even a small increase in interest rates (say, from 1% to 2%) would be devastating for Japan’s economy.”

The US is not Japan: our housing and stock market overvaluations were not as extreme; our corporations are in much better shape (though consumers are in worse shape); we are not xenophobic, thus our population is growing through immigration; we don’t have a significant cultural issue of “saving face” to overcome. Thus, although we sometimes don’t let bankrupt companies go bankrupt to the degree we should - at least not since Lehman - creative destruction is allowed to exist to a far greater degree here than it was in Japan.

The euro? The euro blankets a collection of 20+ countries with very different interests. As John Mauldin put it, and I agree, the euro was created for prosperity, not adversity. Europe has its own demographic issues, such as high unemployment. So I am not betting on the euro against the dollar, either.

The Chinese renminbi? The People’s Republic of China is neither the people’s nor is it a republic. Despite its economic progress, China is still a communist country with a totalitarian regime and limited human and property rights. The Chinese government made the choice of growth at any cost even if projects don’t (or barely) cover the return on capital. It has done so at the cost of undermining the purchasing power of its people by manipulating its currency, keeping it significantly undervalued. I’ve written a lot about significant Chinese economic problems will likely surface down the road.

Lately I’ve been hearing chatter of “nominating” the Chinese currency to reserve currency status. This is unlikely to happen for the reasons I’ve just mentioned, and also it goes against the Chinese business model. As long as the Chinese model is to be a low-cost producer and exporter to the world, reserve currency status is off the table. If the rest of the world decides to park their money in the Chinese currency, it will drive the renminbi up and decapitate China’s export industry.

Maybe the Russian ruble? Unfortunately, Russia is a a one-trick petrochemical pony. The natural resources of Russia are more a curse than a blessing, as they detract capital from and hinder development in non-commodity industries.

What’s happening in the US isn’t good for the dollar, but I’m not sure the rest of the world is in a much better position.

Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo. He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).

Tags: Bull Markets, China, Collapse, Commodities, Denver Co, Dividends, Earnings Growth, Emerging Markets, Financial Crisis, FTSE, Great Depression, Investment Management, Lehman Brothers, Management Associates, Market Cycles, Portfolio Manager, Practical Joke, Ratios, Secular Market, Stock Market, Stock Prices, Stock Returns, Valuations
Posted in Markets | 1 Comment »

Richard Russell: 6 Reasons to Invest in Gold

Friday, November 13th, 2009

The paragraphs below are excerpts from Richard Russell’s latest Dow Theory Letters, arguing the case for gold bullion.

“Today I ask myself, where would I rather have my subscribers be - loaded up in the Dow Jones Industrial Average or loaded up with gold?. And in all honesty, I believe they are better off in gold than in the stock market with DIA.

“There are a number of items favoring higher gold now.

(1) Interest rates are at zero, which means the ‘opportunity cost’ of owning gold now is highly favorable. You sacrifice no yield in owning gold vs. Treasury bills. T-bills pay you nothing, so you might as well have your money in gold.

(2) The Bernanke Fed will evidently stop at nothing in its all-out attempt to ‘jump start’ the wobbly US economy. This means spending and building debt at a never-seen-before rate. This will result in inflation. The Fed can create fiat money - any quantity at will, but it cannot direct where that money will go. So far, the money is not going into the economy, banks remain reluctant to lend and consumers are reluctant to spend. The newly-created money has been going into bank reserves and into the stock market. Stocks have been rising on an ocean of liquidity. The sinking dollar has been a huge help to the big Dow-type stocks which benefit from their ability to export. This is resulting in world-wide central bank inflation as the banks seek to devalue their money in an effort to keep the dollar strong.

(3) The world’s central banks are now seeking to protect themselves from a falling dollar by buying gold. After years of selling gold, ironically, the central banks are now buying gold. In today’s Wall Street Journal we see the headline, ‘Central Banks Join A New Gold Rush’. This is indeed ironic. In swapping their own paper for gold, many central banks are admitting that gold is superior to the very paper they are creating out of thin air.

(4) Many nations are now seeking to boost the ratio of gold to paper in their reserves. The US has the largest ratio of gold to junk fiat paper, 77.4%. But the US stupidly only places the value of our gold at $42.22 an ounce. If the US marked our gold to market, it would be a tremendous help to our government’s balance sheet. But the US prefers to live in a fantasy world where gold is worth less than $50 an ounce!

Germany has 69.2% of its reserves in gold.
Italy has 66.6%.
France has 70.6%.
UK has 17.6% (after idiotically selling most of its gold near the low below $300 an ounce).

Japan has 2.3% of its reserves in gold.
India has 4.0%.
Russia has 4.3%.
China has 1.9%.

It’s easy to see that Russia, India and China are low on gold. All three would like to at least double the percentage of gold in their reserves. The race is on for these central banks to accumulate gold without running the price of gold sky-high.

(5) In the US, literally no one owns gold. Rather, US citizens are selling their gold (jewelry) to companies who are advertising that they’ll buy ‘your overpriced’ gold for cash.

(6) A few nations are actively promoting the ownership of gold. China, the world’s biggest miner of gold, has been encouraging its people to buy gold. In London, Harrod’s department store is now selling gold coins and bars to anyone who has the paper to buy gold. Within a year or so, I expect public buying of gold to reach a crescendo. Interestingly, most Americans have never seen a gold coin.”

Although gold certainly looks bullish on a medium- to longer-term horizon, one must be cognizant of the precious metal perhaps having risen too much too soon for the moment. David Fuller (Fullermoney) said: “On a very short-term technical basis, gold is temporarily overbought following its steady march higher ever since the market was surprised by India’s purchase. Today’s small key day reversal suggests that a pause and consolidation may now occur, possibly similar to the small reactions and trading ranges seen in September and October. However, we may also see a briefer and shallower consolidation, as is often the case when a trend becomes more widely recognised and therefore attracts participation.”

Sources: Richard Russell, Dow Theory Letters and David Fuller, Fullermoney, November 12, 2009.

Tags: Bank Reserves, Bernanke, Central Banks, China, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Average, Dow Stocks, Dow Theory Letters, Emerging Markets, Fiat Money, Gold, Gold Bullion, Gold Rush, India, liquidity, New Gold, Opportunity Cost, Richard Russell, S Central, Stock Market, T Bills, Thin Air, Treasury Bills, Wall Street Journal
Posted in Gold, Markets | 1 Comment »

Jim Rogers: Gold, Market Bubbles, Equities, and Dr. Doom

Tuesday, November 10th, 2009

This article is a guest contribution from Damien Hoffman, of Wall Street Cheat Sheet.

Jim Rogers is one of the most respected investors in the world. I had a chance to chat with him the other morning to get more details about some of his recent comments in the media …

Damien Hoffman: Jim, you were in the media a few times last week and I want to follow up on a few points you made. You said on Bloomberg that Nouriel Roubini did not do his homework regarding the asset bubbles about which he is now warning. Can you explain what homework he did not do?

Jim: All of it. How can you talk about a bubble when assets such as silver are 70% below their all-time high? Same for coffee, sugar, cotton, natural gas, and many more. I have a problem talking about a bubble when assets are this depressed from their all-time highs.

A bubble is when assets are screaming to new highs everyday, everyone is talking about them, and everyone owns them. Right now, virtually no one owns commodities. So for Mr. Roubini to talk about a bubble in commodities defies comprehension. It proves he does not understand markets.

I am flabbergasted at Mr. Roubini’s comment about bubbles because there is not a single market in the world making all-time highs except Gold, US Government Bonds, Cocoa, and the Sri Lankan stock market. That’s hardly reason to call for a bubble. So, I am most perplexed about this alleged bubble which is out there.

If an asset rises 100% in one year, that’s a great year, but not necessarily a bubble. Look at oil. It’s up huge off the bottom but nowhere near it’s old highs. Look at Citigroup. The stock is up 3 or so times off the bottom …

Damien: … and I doubt long term shareholders feel like they are in a bubble.

Jim: Exactly. And since Mr. Roubini thought oil would stay below $40 a barrel for all of 2009, I would love for him to tell me and the rest of the world exactly where are all the oil supplies because the International Energy Agency (IEA) — which has the best global data set on energy supplies — has no idea where is the oil. Mr. Roubini should tell us where this price suppressing oil supply is hidden. All the oil possessing countries in the world have declining reserves. All the oil companies have declining reserves. So Mr. Roubini must know something the rest of us don’t.

Damien: On another note, Gold has been reaching new all-time highs, although not inflation adjusted. You said Gold may reach $2,000 an ounce over the next decade. Can you explain what variables will push Gold to $2,000?

Jim: First, I hope you will keep Mr. Roubini’s statement where he said Gold going to $2,000 an ounce by 2019 is “utter nonsense.” I think you’re going to get a chance to call him before 2019 to ask him what he thinks of Gold at $2,000 and why he thought it was “utter nonsense.”

Regarding variables, it’s very clear there is huge suspicion about paper money around the world. This suspicion is gathering steam. Governments are printing huge amounts of money. This has always led to higher prices. Maybe I am wrong and it’s different this time. But I doubt it.

Additionally, no new large gold mines have been opened in decades. Some of those mines are over 100-years old. They are all depleting. On the other hand, central banks have huge Gold reserves above ground — and they are less interested in selling than in the past.

If you adjust Gold for inflation and go back to it’s former all-time high in 1980, Gold should be over $2,000 an ounce right now if you want to say it’s reaching new inflation adjusted all-time highs. That does not mean Gold has to get back to a true all-time high. Nothing has to. However, I suspect that given all the money printing in the world, we will see much higher prices for hard assets.

Despite Gold’s potential, I think I will make more money in other commodities such as silver, cotton, or coffee — all of which are terribly depressed.

Damien: Speaking of other assets, as an outsider living abroad, what is your opinion on US Equities?

Jim: This is one of the few times in my life I have not had shorts anywhere in the world. I have also not had a lot of longs in the stock market because I’ve chosen longs in commodities and currencies. I have kept away from shorts because there is a gigantic amount of money being printed and it has to go somewhere. I thought some of it would end up in the stock market, and it has.

How much higher can the equity markets go? I don’t know. There are a lot of problems in the economy, but I don’t know when those problems will cause a downdraft in the stock market. All we’ve done is paper over the problem, so I expect we’ll have to deal with those issues in the future. Printing and spending money we don’t have simply prolongs the problems and makes them worse in the long run.

If the world economy improves, commodities will lead the way due to demand and shortages. If the world economy does not get better, commodities are still a great place to be because governments are printing so much money. And, if the world economy doesn’t get better, they will print even more money!

Damien: Jim, thank you for taking the time to share your outlook and opinions. I greatly appreciate it.

Jim: You are very welcome. Your site is very impressive. I look forward to staying in touch.

Tags: All Time Highs, Bloomberg, Bubbles, Cheat Sheet, Citigroup, Cocoa, Coffee Sugar, Commodities, Comprehension, Dr Doom, Ener, Gold, Gold Market, Government Bonds, Hoffman, Jim Rogers, New Highs, oil, Oil Supplies, Roubini, Single Market, Sri Lankan, Stock Market
Posted in Commodities, DXD, Emerging Markets, Gold, HFD, MYY, Markets | No Comments »

Eric Sprott: Investment Outlook (November 2009)

Thursday, November 5th, 2009

Eric Sprott’s just released his latest investment outlook, Surreality Check Part Two: Dead Government Walking. Its a follow up to Surreality Check Part One: Dead Men Walking, originally published in November 2007 where Sprott described the ‘bizarro’ market preceding last year’s credit and financial market meltdown. As usual, its excellent reading, as Sprott does his best to make sense of the senseless:

The equity market performance in November 2007 masked the underlying problems plaguing the financial system at the time, and it’s blindingly apparent that it is doing the same again today. The government has assumed most of the financial system’s liabilities in a giant game of ‘kick the can’. The calls for a new bull market are coming fast and furious. Market participants are bidding up the stocks of companies that are demonstrably bankrupt, and government balance sheets have ballooned to unforeseen levels. As respected market commentator David Rosenberg recently wrote, “the stock market is divorced from economic reality”.1 It’s time for another surreality check, but this time it isn’t the publicly traded companies that deserve attention, it’s the governments that have saved them. Make no mistake - the dead men are still walking - they’re just a lot bigger now than they were two years ago, and they don’t generate earnings - they print money and tax their citizens.

Download the whole report here.

Tags: Advertisement, Balance Sheets, Bizarro, Citizens, David Rosenberg, Dead Men, Dead Men Walking, Earnings, Economic Reality, Eric Sprott, Financial Market Meltdown, Game, Governments, Investment Outlook, Liabilities, Market Commentator, Market Participants, Market Performance, Mistake, Money, Stock Market, Stocks
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David Rosenberg: Stocks Overvalued by at Least 20%

Thursday, October 29th, 2009

The stock market has become overheated since exploding off its March lows and could be in for a strong correction, economist David Rosenberg told CNBC.

“It is overvalued by at least 20%,” Rosenberg, formerly chief economist at Merrill Lynch and now with Gluskin Sheff & Associates, said in an interview. “But it comes down to what your view in corporate earnings (is) going to be. By the time you’re up 60% from any egregiously oversold low, you’ve already got the earnings recovery.”

Source: CNBC, October 27, 2009.

Tags: Amp, Chief Economist, Cnbc, Corporate Earnings, David Rosenberg, Gluskin Sheff, Lows, Merrill Lynch, October 27, Stock Market, Stocks
Posted in Markets | No Comments »