Plenty of people believe the US government and the Federal Reserve when they say that inflation is benign. However if you review their policies you will know that inflation is inevitable and that this scam has been played out decade after decade. In order to address this I have provided you a brief study on inflation and its causes.
How is inflation created? Well it is a policy not a requirement. The policy is determined at the government and the Federal Reserve levels. In our case Bernanke has as his mantra that there will be no deflation and so he is doing everything in his power to re-inflate while still preaching no inflation!
How is he doing this? Well there is really only one way to create inflation and that is to create a larger pool of money. In the good old days of the gold standard there was no inflation as you had to add to your gold reserves in order to create an increase in the money supply. With the move to the current fiat money system it is easy to increase the money supply; just start your printers. In fact in the US it is even easier than anywhere else as all the money is the same size so just change the number on the bill and there you are.
Creating money supply means that there is more money chasing the same basket of goods. More demand leads to higher prices. Now the argument against this theory is that the velocity of money is stagnant so there is no inflation. Velocity of money is the term used to define how many times a dollar moves through the system. Money times velocity equals a country's GDP so a low velocity of money can offset massive money printing. Well to some degree this is correct. The cogs of the wheels of commerce have ground to a halt as banks try to recapitalize their balance sheets and so the bulk of the money being printed is locked up in bank vaults. This is a temporary state of affairs as regardless of where the money goes it will ultimately create inflation.
How is this possible? At present if you are a banker and you are with one of the fortunate banks that was rescued by the Federal Reserve you are enjoying unprecedented profits. You are sending out massive bonuses to your staff and life is good. The rest of the country and most citizens do not feel this joy initially until this money starts to roll into other areas of the economy. So let's follow the thread a bit more closely.
After watching the bankers get their bonuses commodities started to move. Oil moved up from $30 a barrel to over $90, gold moved from $800 an ounce to over $1,400, wheat moved from $5 a bushel to $8 a bushel, and on and on it went in the commodity world. So now you have the farmers and the miners suddenly quiet as they are now enjoying the benefits of inflation.
What about the masses? At what point do they share in this joy? Well that is the problem with inflation. Certain groups enjoy the riches and the rest are left to pay the price and that is precisely what is happening. Furthermore as the money printing was not working that effectively the policy has been accelerated through a weak dollar.
A weak dollar increases the price of all imported goods and commodities thereby accelerating the inflation rate. This is "stealth" inflation as most citizens do not tie the impact of a weak currency on the inflation rate. To this end the government is playing a very dangerous hand. In thinking that they can continue to print money to the order of $3T over the next three years on top of the already $14T of debt and keep inflation under control is sheer lunacy. It is clear that the dollar will continue to slide and at some point this may turn into a complete collapse when the world finally loses faith in the US and its policies.
Apparently (according to our leadership) this is not a problem as long as we study the core rate of inflation rather than general price moves and as long as the stock market keeps going up. Once again the bankers are enjoying that ride as the bulk of the citizens have limited exposure to the stock market. Furthermore I believe that the market itself is being manipulated by the key players at the expense of the common man. Be very careful of this market, do not chase it higher, look to short long term treasuries and watch the dollar closely for signs that the orderly demise has turned into a rout.
Tuesday, January 25, 2011
Thursday, January 20, 2011
The Statistics of Forecasting - Part III
The final part of the three part series deals with forecasting bias. How are forecasts derived? Well as we discovered in the second part of the series it is impossible to guess as to what new technologies or natural disasters will happen. Therefore in order to provide an educated guess we need a point of reference. That point of reference is where we are today. So the first problem is that all "guessers" are at different starting points so their points of reference and hence their predictions will be biased towards their personal situations.
Consider a "guesser" living in London versus a "guesser" living in India or China. Certainly very different circumstances and hence very different points of reference from which to begin to make a forecast. The Londoner would look at the dismal economic growth of Europe and the housing market in and around the United Kingdom plus the massive deficit that his government is running. The Chinese "guesser" thinks to herself that while the rest of the world is having its problems things are good in China and we have a massive surplus. Housing prices may be high but we all believe in our government to support us and with this support we will become the next super power. Certainly very different outlooks and this will bias the forecast considerably.
The next issue is that the forecast must be based on something and humans base their forecasts on the past. Our past should point to our future right? Not in the least and this is the main reason why forecasts are notoriously incorrect. While the past can repeat itself, there is no reason to believe that the timing or the magnitude of the future move will be anything like the past. Furthermore, while history is thought to repeat itself it is impossible to have a true comparison as the circumstances at the time of the "similar" event were more than likely very different to the conditions faced today. Different leaders, different geographical regions and different ideologies just to name a few.
Consider the housing crisis of the 1980s compared to today's housing crisis. While we could (and many analysts do) use the 1980's crisis as a barometer to gauge how the recovery process will unfold, to use it in a vacuum would result in a severely flawed forecast. While the 1980's crisis caused some problems and dragged down some savings and loan institutions it did not wreak havoc with the global economy and the United State was not $14 trillion in a hole. These are very different animals and should therefore not be compared too closely.
Now please do not think that the past cannot be used as a point of reference. I certainly believe that a study of the past is critical to prepare for the future, but always be prepared to remain flexible as the current situation will not completely replicate the past.
Tuesday, January 18, 2011
The Statistics of Forecasting - Part II
This is the second in a mini-series regarding statistics and forecasting. Not the most exciting series ever but certainly something that all investors should understand if they want to prosper in the market today.
The second thing that I want to delve into is the reason we even follow forecasting. We as humans think that we have the ability to forecast the future. Every now and then someone guesses something completely out of the ordinary and it actually happens and they are immediately in the press, on the news and on every magazine cover. The "guesser" expounds on how he or she has found some unique model that can accurately forecast the future and that we should listen to everything he or she has to say and pay them handsomely for their advice. This happens for a time until a year or two later when their forecasts fall flat everyone smells a rat and they turn their attention to the next "guesser" of the moment.
Why would we do this? The answer is that we all crave to know what will happen next. If we knew with 100 percent accuracy what would happen then we could plan for this and change outcomes that we did not like. Well that is precisely why forecasting is impossible. Everyone has a different opinion and those that "have" try to keep the status quo while those that do "not have" try to change it. These forces are constantly at work and are constantly changing the future right before our eyes.
Think of all of the disruptive technologies that have happened just in the last decade. Then try to guess as to what new disruptive technologies will replace those that have just arrived. While fun to do it is completely futile. Even if you are correct, you have no idea that your guess will be the accepted technology or just made redundant instantly by someone else's idea in a far off land that is working just as feverishly to develop the next great widget. In addition the invention of a product can create a whole new industry as new ideas spring off the original invention and most of the time the originator of the idea never even thought of the common use for the idea at the time of the invention!
Furthermore we as humans have no control over nature. We think we do in that we are convinced that we can stop global warming by creating new cars and having a cap and trade system for emissions. Now don't get me wrong, I am all for cleaning up our air quality and keeping the environment clean, but I cannot believe that we can have any impact on something as grand as the temperature of the globe.
Beyond that who is to say that there will not be some massive earthquake or some comet from outer space or some tsunami wave. All of these are beyond our control and can affect everything that happens in the future. Can you predict that? Nostradamus tried centuries ago and we are still waiting for his premonitions to come true. Don't hold your breath and do not get overly concerned for other's forecasts as all they are at best are educated guesses.
Wednesday, January 12, 2011
The Statistics of Forecasting - Part I
Now I am not sure I should have bitten off this topic, but it is very interesting to me and certainly something that the average investor does not understand - forecasting is really a guess and not something on which to weld your portfolio investment methodology.
The first topic that I want to dive into is correlation. Correlation is used extensively in creating portfolios. The idea is to try to reduce the volatility (risk) of a portfolio by investing in an array of differing investments. If each investment is not identical to the other then they will not produce the same returns as each other in the same market place. It is said that they are not correlated to one another. If we take this a step further and find assets that move in the opposite direction to one another then we have a negative correlation.
As an example a bear fund should go up when the market goes down and this should offset losses associated with the remainder of your stock investments. This negative correlation can be a great protector of value during market corrections and can smooth returns during a volatile market. However there are a lot of misconceptions on this score and it can water down your returns during a roaring bull market.
The first misconception is that the negative correlation holds in all market conditions. People that diversify their portfolio into stocks, bonds, commodities, real estate and other exotic investments discovered, to their dismay, that when the market tanks that these relationships erode and all positions deteriorate at the same time removing the net just at the time it is most needed.
Second is that while the most sophisticated financial models can find correlations to anything these models end up "mining" data. That is to say that they get so sophisticated that they end up finding correlations that are fictitious. Back in the early 1900s Pearson described this as a "lurking variable". There is a false variable that for a moment shows that the two positions are negatively correlated so it is added to the portfolio under the guise that it will reduce the overall portfolio volatility. In fact this lurking variable can disappear at a moments notice and remove that supposed "positive" influence.
The thing to remember is that while we all strive to reduce the volatility of our portfolios it should not come at the expense of losing a rational investment methodology. If things get bad, get out! Do not rely on your supposed diversification or your correlation studies. These will fall apart at the seams right when you need them most. Invest wisely and take risk off the table by selling rather than hoping.
The first topic that I want to dive into is correlation. Correlation is used extensively in creating portfolios. The idea is to try to reduce the volatility (risk) of a portfolio by investing in an array of differing investments. If each investment is not identical to the other then they will not produce the same returns as each other in the same market place. It is said that they are not correlated to one another. If we take this a step further and find assets that move in the opposite direction to one another then we have a negative correlation.
As an example a bear fund should go up when the market goes down and this should offset losses associated with the remainder of your stock investments. This negative correlation can be a great protector of value during market corrections and can smooth returns during a volatile market. However there are a lot of misconceptions on this score and it can water down your returns during a roaring bull market.
The first misconception is that the negative correlation holds in all market conditions. People that diversify their portfolio into stocks, bonds, commodities, real estate and other exotic investments discovered, to their dismay, that when the market tanks that these relationships erode and all positions deteriorate at the same time removing the net just at the time it is most needed.
Second is that while the most sophisticated financial models can find correlations to anything these models end up "mining" data. That is to say that they get so sophisticated that they end up finding correlations that are fictitious. Back in the early 1900s Pearson described this as a "lurking variable". There is a false variable that for a moment shows that the two positions are negatively correlated so it is added to the portfolio under the guise that it will reduce the overall portfolio volatility. In fact this lurking variable can disappear at a moments notice and remove that supposed "positive" influence.
The thing to remember is that while we all strive to reduce the volatility of our portfolios it should not come at the expense of losing a rational investment methodology. If things get bad, get out! Do not rely on your supposed diversification or your correlation studies. These will fall apart at the seams right when you need them most. Invest wisely and take risk off the table by selling rather than hoping.
Thursday, January 6, 2011
Inflation is Here
It is official (other than in the US), inflation is here. World food prices hit a record high this week and look to accelerate higher unless the world can magically grow another 2% of supply. With the growth in the wealth of the emerging nations there is a huge demand for "new" staple foods such as corn and wheat over the "old" staple food of rice. This is driving demand for the "new" staples plus pushing demand for cattle and poultry higher. In addition oil broke through $90 a barrel this week and looks like it will take a run at $100.
Now why does the Federal Reserve think that inflation is under control? Well they use the CPI as an indication of inflation. Essentially this is a basket of goods and services that represents (in their eyes) a good proxy for price increases. Digging into this number and how it is derived reveals some very obvious mistakes, the most obvious of which is that it does not weight food or energy correctly. In fact energy is a sub-category of transportation and housing (apparently it will feed into the numbers if it gets high enough - and no I did not make that up)! Maybe everyone in Washington DC and New York does not cook food or drive to work, but the rest of the world does. In fact there are billions of people who do not own a house but need to eat.
Currently the top 6 US CPI weightings are:
Now why does the Federal Reserve think that inflation is under control? Well they use the CPI as an indication of inflation. Essentially this is a basket of goods and services that represents (in their eyes) a good proxy for price increases. Digging into this number and how it is derived reveals some very obvious mistakes, the most obvious of which is that it does not weight food or energy correctly. In fact energy is a sub-category of transportation and housing (apparently it will feed into the numbers if it gets high enough - and no I did not make that up)! Maybe everyone in Washington DC and New York does not cook food or drive to work, but the rest of the world does. In fact there are billions of people who do not own a house but need to eat.
Currently the top 6 US CPI weightings are:
- Housing at 42%
- Transportation at 17%
- Food and Beverage at 16%
- Recreation at 6%
- Medical Care at 6%
- Education and Communication at 6%
With the cratering of the US housing market it is easy to see why the Federal Reserve thinks that inflation is benign. In fact if (or should I say when) the number does grow out of control then they change how it is calculated. Since 1996 they have changed the methodology 9 times. I wonder why?
In an inflationary environment bonds will perform poorly so look to exit or short those. Furthermore this could be the year of the farmer so agriculture, live stock, feedstock and oil products should provide you an excellent return.
Tuesday, January 4, 2011
USA as a Creditor Nation
I have been asked by some as to why my outlook for the US is still so negative? Granted there are a number of positive signs and it certainly looks like the first half of this year will be fine, but my negative sentiment is based on a long term view and on economic fundamentals. These long term trends will eventually overwhelm the short term stimuli implemented today.
Imagine, if you will, that the US is running a $200 billion surplus and has $2 trillion in reserves. What would you think about this country? For one the currency would be strong and foreign investment capital would be flying in. How could you get a more safe investment than investing in such a well run country? Demand for our products would far exceed that being purchased by us, our citizens would enjoy a high level of employment and there is a huge safety net for welfare, medical support and retirement. In short, things are good. The only thing to worry about would be inflation running above an "acceptable" level, but even a spike in inflation would mean that asset values are increasing to the benefit of many.
Now let's look at where the US is currently. We have massive levels of debt both at the individual and the government levels. Worse still is that total debt is growing rather than shrinking. Unemployment is stubbornly stuck at an elevated level. Inflation, while under control is being stoked by the massive influx of new dollars being printed and this could undermine the entire recovery. Housing remains weak despite massive efforts to stimulate buying and with interest rates at historical lows.
Now the first scenario is strikingly familiar. Of course the emerging economies and in particular China, are huge beneficiaries of the massive levels of debt incurred by the US. The main difference is that there is still an inherently large level of risk in investing into these countries. As an active investor in Chinese stocks I can assure you first hand that there is a level of lawlessness and a level of disdain for foreign investors. Companies seem to do what they want and answer questions later with little regard for the shareholders or the "rules" of the game as imposed by the West.
In addition, the Chinese government holds everything very close to their chest and there is a high level of skepticism for their numbers and their policies. What is said is often not done. Not that this is new to the world of politics, it is just that the state has such a heavy hand that investors are warranted to be skeptical and not to pile into the investment world of China. Furthermore foreign investment is limited and has so many strings attached that going all in is virtually impossible.
For these reasons the world is still prepared to put up with the excesses of the United States. The main question is how long will this last? With the European economy in a shambles time is still on our side. If the Euro house were in order then I would expect to see a significant appreciation in the Euro at the expense of the dollar, but that is not the case. China would need become a free market, implement legitimate laws and policies to support this system and allow foreigners to compete on an equal footing with the same rights as local citizens. This is decades away (if ever) from happening, so for now the US has time.
Will we use the time wisely? In order for me to change my long term outlook we would have to implement some severe levels of austerity. Budget surpluses would need to become the norm and the level of government debt would need to be reigned in. Can this be done? Well we did have a brief period during the Clinton era where there was a surplus. If you can remember back then, the dollar was strong and unemployment was low. Can we return there? Yes, but it would take a strong leader and at present I do not like our options, plus it appears that time is starting to run out.
Imagine, if you will, that the US is running a $200 billion surplus and has $2 trillion in reserves. What would you think about this country? For one the currency would be strong and foreign investment capital would be flying in. How could you get a more safe investment than investing in such a well run country? Demand for our products would far exceed that being purchased by us, our citizens would enjoy a high level of employment and there is a huge safety net for welfare, medical support and retirement. In short, things are good. The only thing to worry about would be inflation running above an "acceptable" level, but even a spike in inflation would mean that asset values are increasing to the benefit of many.
Now let's look at where the US is currently. We have massive levels of debt both at the individual and the government levels. Worse still is that total debt is growing rather than shrinking. Unemployment is stubbornly stuck at an elevated level. Inflation, while under control is being stoked by the massive influx of new dollars being printed and this could undermine the entire recovery. Housing remains weak despite massive efforts to stimulate buying and with interest rates at historical lows.
Now the first scenario is strikingly familiar. Of course the emerging economies and in particular China, are huge beneficiaries of the massive levels of debt incurred by the US. The main difference is that there is still an inherently large level of risk in investing into these countries. As an active investor in Chinese stocks I can assure you first hand that there is a level of lawlessness and a level of disdain for foreign investors. Companies seem to do what they want and answer questions later with little regard for the shareholders or the "rules" of the game as imposed by the West.
In addition, the Chinese government holds everything very close to their chest and there is a high level of skepticism for their numbers and their policies. What is said is often not done. Not that this is new to the world of politics, it is just that the state has such a heavy hand that investors are warranted to be skeptical and not to pile into the investment world of China. Furthermore foreign investment is limited and has so many strings attached that going all in is virtually impossible.
For these reasons the world is still prepared to put up with the excesses of the United States. The main question is how long will this last? With the European economy in a shambles time is still on our side. If the Euro house were in order then I would expect to see a significant appreciation in the Euro at the expense of the dollar, but that is not the case. China would need become a free market, implement legitimate laws and policies to support this system and allow foreigners to compete on an equal footing with the same rights as local citizens. This is decades away (if ever) from happening, so for now the US has time.
Will we use the time wisely? In order for me to change my long term outlook we would have to implement some severe levels of austerity. Budget surpluses would need to become the norm and the level of government debt would need to be reigned in. Can this be done? Well we did have a brief period during the Clinton era where there was a surplus. If you can remember back then, the dollar was strong and unemployment was low. Can we return there? Yes, but it would take a strong leader and at present I do not like our options, plus it appears that time is starting to run out.
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