Freedom from Stagflation
I would just like to wish everybody a happy and safe Independence Day before I jump into this month's letter. Regardless of how bad some things sound, I remember that the people of the United States have created one of the world's great civilizations in a very short time. No ten to twenty year period should destroy the gifts of our geography, the cumulative depth of our visions and the consistent hard work of a nation. America can overcome any theft or any bastardization of American ideals if we just use common sense to trump ideological dogma.
The End of QE2
"QE2" the nickname given to the Federal Reserve's second batch of monetary stimulus was a quantitative easing program whereby the Fed bought $600 billion of U.S. Government Debt from the bond market. The result was that money was pumped into the capital markets via the twenty primary dealers of Wall Street. That program ended last week.
Prior to the most recent Quantitative Easing (QE2)- the Fed did what could go by QE1 in 2009 which pumped about $2 trillion into the capital markets, much flowing to the stock market. On top of that, several trillion dollars, it is tough to know exactly how much really since about a trillion dollars appears to have been spent but not accounted for, was directed to domestic and foreign financial institutions via various bail outs and supports.
A recent study by Trim Tabs, an elite research firm hired by many hedge funds, believes that most of the gains in the U.S. stock market can be linked directly to the Fed's quantitative programs and various government supports of the financial system. Trim Tabs found that the roughly $9 trillion gain in the U.S. stock market since 2009 did not come from the traditional sources.
"If the money to boost stock prices by almost $9 trillion from the March 2009 lows did not come from the traditional players, it had to have come from somewhere else. We believe that place is the Fed. By funneling trillions of dollars in cash to the primary dealers in exchange for debt, the Fed has given Wall Street lots of firepower to ramp up the prices of risk assets, including equities."
This supports what I have suggested for a year, which is that much of the stock market gains are illusionary. Hence, why I have stayed away from broad market risk. This situation is very similar to what real estate experienced from 2003-2006. So while I discussed that the government spending made sense to stave off a spiraling collapse of the American economy, it is time to back off and grind out improvement over a number of years. We have properly put money back into the economy, now it is time to let it slowly start to work. Unfortunately, the short term result could be another significant stock market drop.
Trim Tabs goes on to say, "...economic growth will not be sustainable without massive government support. Then even more QE will be needed, and stock prices could keep rising for a while. In our opinion, however, no amount of QE will be able to keep the current stock market bubble from bursting eventually."
With earnings estimates at all time highs and cash in mutual funds at all time lows, the stock market is nearly priced for perfection. Earnings estimates for the S&P 500 are about $100. The historic mean is in the upper $60s. If we have a reversion to the mean, which we generally will unless things really are different this time, the stock market could have a very rough ride. That mutual funds are sitting on record low cash would complicate things as when investors head for the doors and ask for their money, the mutual funds will have to sell stock to raise cash, exacerbating any decline.
A Strange Stagflation?
Fed Chairman Ben Bernanke recently described the U.S. economy as growing a little less than anticipated than the already low expectations and with a little more inflation- which is vastly understated in the first place. The combination of slower growth and higher inflation or stagflation would put enormous pressure on corporate earnings.
He also stated that the U.S. dollar would get stronger after the QE2 was ended on June 30. What the Fed is trying to do, according to the Fed, which might not be accurate, is balance a slow motion rebound in economic growth without igniting high inflation. It is a delicate balancing act.
The Financial Times recently discussed that global slack in production is closing, putting pressure on prices. As employment continues to pick up in the United States, and it is, albeit slowly, avoiding inflation will be very important. A slightly stronger dollar will be instrumental in that looming fight.
In my opinion, stopping the decline in the dollar is one key to preserving the standard of living in the nation. Some argue that a weaker dollar is good for America. They would say that a weaker dollar leads to more exports (due to our products being cheaper abroad) and more employment. The empirical evidence does not come close to supporting that notion. What a weaker dollar really does is increase earnings for a handful of large multi-national companies with the residual effect being lower paying jobs, while the cost of living increases.
A further weakened dollar- which causes prices to rise as our money becomes worth less- in an economy with high unemployment and under-employment is a recipe for social unrest. How many of us want $5 gasoline and milk, while real incomes are flat or even falling? Already, there are 40 million Americans receiving food stamps, which is feeding about 100 million people when the children of recipients are included. That is a record. Does it concern folks that so many are still near the brink, three years after the financial collapse? It should.
Unfortunately, many in government support a weaker dollar policy, implicitly at least, because of the temptation to inflate our way out of debt, that is pay our debt with less valuable dollars because the nominal debts do not change. If we go down that path, our creditors might decide that it is in their interest to take actions that are not in our interest. China owns over a quarter of our debt. That could be dangerous for us if we take actions that slow down their economy which increases their social pressures.
Of note, a stronger dollar would necessarily mean higher interest rates, which would hurt the bond market while rates rose. However, ultimately that could help secure the baby boomer retirement a bit as they would have a chance to lock into some higher interest rates without the uncertainty of being heavily exposed to the stock market. Bill Gross the world's largest bond fund manager is betting on that rise in rates and bonds doing poorly short and intermediate term.
Further complicating matters in America is that there are in fact several million jobs available to be filled, mostly in engineering related fields, higher skilled work and welding, but not enough educated and skilled people to fill those jobs. Several companies have already announced plans to relocate that work to other countries.
So, we have another problem besides a weak currency, a labor force that has fallen back in its skill set. Yet, we are cutting education rather than special interest tax breaks to fill our budget gaps. That seems backwards to me. The ultimate reckoning to an increasingly under skilled workforce will be brutal if not corrected. If we are not up to the task of doing higher end work anymore, what does that say about our future? It says we will be employed due to global expansion, but at lower wages.
So in addition to halting the decline of the dollar, we must improve education and skills training to the levels seen thirty to forty years ago. Neither is an easy task. But, both must be done, or we face a future of rising prices and falling incomes.
A Slow Grind Continues
Unfortunately many people have very unrealistic expectations. There is no quick fix to anything that has transpired financially the past decade plus.
The United States is now a mature economy, and it's largest growth engine is retiring- the baby boomers. With that retirement comes massive financial liabilities that are not fully funded. To fill that gap we need another group as large as the baby boomers to enter the work force en masse. That would be the Echo Boomers, today's teens and twenty somethings. This is a large enough group to stabilize the economy long term, if they are educated and skilled enough.
Even if the echo boomers are up to the task and the dollar gets a little stronger, we still need to get serious about domestic energy policy, flattening defense spending, creating programs that promote work versus long term entitlements, continue to tweak health care without gutting services and making the tax code more fair so that we are not in trouble for longer than we need to be. Realistically, even with how irresponsible we have been, overspending and allowing too many thieves too high up, we should be able to overcome by the end of the decade.
It is said that in America we try everything else, then we do things right. This might surprise you at this point of the letter, but I think we just might do things right and address our budget issues, support the dollar, train our labor for higher end work and innovate our way out of this economic malaise. If we do make the right decisions in the short run, the stock, bond and real estate markets will struggle as we pay for the things that will fix the nation. In the long run however, we could set up for a multi-decade improvement in our standard of living.
It is up to us to not opt for the sugar high of more easy money and the dogma of unfeasible ideologies, both of which undermine the nation long term. The ability of people to separate ideology from fact sets will be extremely important as we make decisions. Both parties need pressure on them, by the independent people of America, to stop catering to the extremist edges. Common sense compromises must be achieved or the fears of our impending collapse may in fact come true and we will be in for a situation where our standard of living stalls for two generations.
Our themes remain the same as the past several years, only more pronounced. We will continue to be involved in natural resources, alternative energy, bio-tech, China and a handful of global themes. Natural resource and alternative energy linked investments are attractive to thwart inflation, which will occur due to scarcity in the intermediate term as the world expands regardless of the value of the dollar. Bio-tech is attractive due to the advances in science and the demand by the aging baby boomers. China, despite volatility and growing pains is the biggest growth story on the planet and will be for decades.
I have described a scenario which could see stocks, bonds and real estate all do poorly again for a short run to start soon. That does not leave much for "long only" mutual fund investors to do if markets do fall other than go to cash. If that happens the downturn would be significant as investors leave the market, but frankly, probably healthy for the long run. Those who are willing and able to make investments in securities that rise when markets fall could actually do very well in a downturn. Fortunately, we can make those trades.
We continue to move towards a balance of reaction v prediction as described in the linked article and our spring investment work shops.
From a reactive perspective we will continue to trade in confirmed market trends. Our investments in several stocks with good momentum and against the broader market in June have worked out well the past month.
From a predictive perspective we continue to believe that asset prices must suffer at least one more substantially correlated (most things moving the same direction) correction in the next few years, though natural resources would likely suffer least. We are hedging our portfolios using exchange traded funds and options that can rise if certain markets drop.
Currently, most clients are near the conservative edge of their personal strategy. Some of our long positions include specific stocks (i.e. Exact Sciences, GT Solar, Citigroup, General Moly) and sectors (i.e. Uranium stocks via URA), and inverse positions against broader indexes (the S&P 500) and the retail sector- that list is not all inclusive. We will adjust as facts change.
My Calendar, a New Address and Revised Information Sharing Format
Over the summer I will be spending some extra time with my teenage children trying to get in some quality time before I am put on ignore for the balance of their adolescents. Please forgive me if I am a bit scarce. I will post some pictures in the autumn, we are hoping to make it to South Dakota, Montana, Wyoming and Iowa for a family reunion.
On September 1st my firm and the commercial insurance firm I have been housed with the past seven years will move into a new office suite a few blocks from our current digs. It is a great space and I am very excited. I will get you that information next month by email, as well as posting on this site.
Until next quarter, your forward looking and hoping for a long-term boom, even if we get a short-term thump, advisor.
This newsletter contains forward looking statements that may not come true. Past performance does not guarantee future results. This letter is intended for informational purposes only, and reflects only my thoughts and opinions in general, and do not constitute individual advice. Opinions expressed may change without prior notice.