A Look Back to Look Forward

"You can't help but with 20/20 hindsight go back and say, 'Look had we done something different, we probably wouldn't be facing what we are facing today." - Norman Schwarzkopf

In hindsight it may even seem inevitable that a socialist society will starve when it runs out of capitalists." - Larry Niven

The problem with looking back is that your mind is warped with a different sense of what happened at the time.  While historians can try to relive famous battles or dissect military maneuvers pointing out the flaws and speculating at the revised outcome, they are not dealing with the stress and the inputs of the situation as it happened so it is impossible to say that the choice made would have been different.  Furthermore speculating at the changed outcome is also rather pointless as changing history results in a completely different world from that which we live in today.  For every action there is a reaction and speculating at what that reaction would be to something that did not happen is relatively pointless.  With that said it is always good to look back on the year to try to relive some of the decision points in an effort to learn from them in an effort to limit the errors going forward.

The stock market had a banner year and will end up around 30%.  While I did not participate in this rally I feel comfortable with my results for the simple reason that pretty much everything that I worked on is panning out as expected.  What I did not expect was a massive rally on the back of weak economic fundamentals but in hindsight the Federal Reserve's easy money policy set the stage for the rally.  Based on this it certainly looks like more to come in 2014.  Janet Yellen, the incoming Federal Chair, will continue to print money and the market should continue to fly however once again I do not intend to participate for the simple reason that the market is running too far too fast and without the support of economic fundamentals the result is going to be as disastrous or maybe worse than 2000 and 2007.  Now whether this crash happens in 2014 is any one's guess but I would not be surprised to see the market continue to rally at least through the first half of the year.

One potential problem for the market is the yield on the 10 year note.  This is a barometer for interest rates in the United States and with the yield approaching 3% this could start to have a negative impact on growth.  Already the housing market is feeling the pain of higher rates and if rates creep much higher money is going to start to return to bonds at the expense of the stock market.  Just looking at large company retirement funding obligations, once the rate reaches around 3.5% a lot of corporate treasurers will be plowing billions into the bond market, locking in the yields and protecting their companies from another round of underfunding.  There will be other buyers along with the Federal Reserve but this is a number worth following closely.

Housing had another excellent year but as hard as it is to believe with rates as low as 4% on a mortgage it appears that the easy money has been made in this market and that without a healthy uptick in the employment numbers this market will probably not see much in the way of return in 2014.  Obviously there will always be pockets of the country that will produce a good rate of return but as rates tick higher the impact on this market will be large.  This will affect unemployment as a weak housing market will place more people back on the unemployment line once again.

On the unemployment front 2013 was a struggle.  Sure the unemployment number did fall but the results of the continued stimulus were not at all successful.  Unemployment has remained stubbornly above 7% and it looks like it will take a herculean effort to get it below 6.5% which is the Federal Reserve's target.  Until we get to that number the Federal Reserve expects to keep stimulating but the problem is once again the interest rate increases.  If these start to spiral higher at some point they will have to turn their attention to driving the yield down as otherwise all their efforts to stimulate will be for nothing.  For these reasons I do not see unemployment falling below 6.5% in 2014.

Precious metals were the worst performer of 2013.  Those of us that invested into gold and other precious metals we felt the pain of another bear market.  Stock prices fell around 40% and the commodity price fell over 20%.  It was carnage in this market which makes it even more interesting given that the fundamental reason for holding gold is firmly in place.  So you had a year where stocks rocketed on weak fundamentals while gold was decimated on strong fundamentals.  Furthermore you had more a market that brought more money losing companies to market than in any year barring 2000 and you can see why I am still not interested in participating in the stock market in 2014 other than a small trade here and there.

Not that I am not participating at all as the majority of my assets are tied up in privately held businesses that are starting to perform admirably.  It is clear to me having been involved in numerous start up companies over the past few years that the playing field has been tilted firmly in the direction of large business.  Small businesses continue to struggle and until this playing field is leveled the outlook for economic growth and lower unemployment in the United States is bleak.  The problem is that it took over 50 years for congress to get us to this point and there are no laws on the horizon to change this.  In fact things are getting even more arduous with the Health Care Reform and higher tax rates destroying the middle class and forcing many small businesses to shut down.  Without this engine of growth the United States will continue to see slow or negative growth for the foreseeable future.

I wish all of you  a wonderful holiday season and all the very best for 2014.  I look forward to an excellent year and I hope that you all manage to listen to my radio show on ESPN 1700AM radio or download the podcasts at www.theportfoliodoctors.com.

Tally Ho!

Lieutenant George: "Tally ho, pip pip and Bernard's your uncle."
Captain Blackadder: "In English we say good morning." 

General Melchett: "Ah, tally-ho, yippety-dip and zing zang spillip.  Looking forward to bullying off for the final chucka?"
Captain Blackadder: "Answer the General, Baldrick!"
Private Baldrick (whispering): "I can't answer him sir, I don't know what he is talking about."

Scenes from the wonderful English comedy Blackadder

The stock market rocketed forward once more this week on the back of the Federal Reserve decision to put tapering off for the foreseeable future.  Yes they did say that they would cut back on the purchase of mortgages and treasuries by $5B a month each but this is ultimately a drop in the bucket when you consider that they will still continue to purchase these at a rate of $75B a month and that their balance sheet has already ballooned to over $3 Trillion in the past few years.  Cutting the continued buying by $10B is really just a rounding error and nothing significant at all.

To make sure that this was not perceived as "bad" news Bernanke said that the Federal Reserve would continue to hold the federal funds rate at the historic lows for a significant period of time, beyond even the initial target of a United States unemployment rate of 6.5%.  Considering that the unemployment rate is currently 7.0% (according to the Fed) and it has taken them from October 2009 to get there from 10.0%, it can be seen that to reach the initial target of 6.5% is going to take most if not all of 2014.  Once that target is reached (assuming it ever is) if the inflation rate is still below 2.0% they will hold these rates down ad infinitum.

No wonder the market rallied.  The fuel that has been pumped continually onto the fire in a massive spigot will remain open for at least the next 12 months and more than likely well beyond that.  Furthermore Bernanke affirmed that the new Fed chair would continue to keep these policies in place after his tenure expires.  So as expected Janet Yellen will keep dumping money into the hands of the banks thinking that this is creating jobs.  As we all know, giving free money to banks who then turn around and give it straight back and earn a return does not produce jobs. 

Another weapon that the Federal reserve has is to reduce the Federal Funds rate to zero.  Doing this would eject more than $2 Trillion out of bank reserves into the loan market.  While this would certainly help jettison spending (think back to 2006) the problem is that sub prime lending would jump straight back into the fray as in all reality those that should qualify for a loan can and have; adding more debt onto a consumer that is not adequately equipped to assume it would result in a situation that would be worse than 2006 for the simple reason that the numbers are far larger this time around.  Last time the Federal Reserve was in for a few hundred billion and this time around it is 100 times larger.

Another problem that the Federal Reserve has with this weapon is that a lot of the bank reserves are being left at the Fed not only to earn interest but to form a type of margin account for the massive risks that they are taking in the derivative markets.  As I mentioned a few blogs ago this market has burgeoned to more than a quadrillion dollars (better become familiar with this number as I am sure at this speed that trillions will be child's play in a few years) and so a few trillion is little more than a deposit on this potentially explosive problem.  Should this market ever implode there is no central bank in the world that could shoulder this level of debt and this would truly be the end, but the game is being played with a small nominal value of a few trillion deposited with the Federal Reserve.  So it is interesting to think that if this margin balance is ever needed (to pay losses in the derivative market) rather than investing the money in places that would actually help the economy grow (as the Fed believes it is) it would just go to pay off gambling debts!

So it is no wonder that the market rallied as the juice to fuel the massively dangerous derivative and equity markets is being left in place and the game can continue.  The problem is that when this bubble finally bursts the only remaining solution will be to let everything find a proper base and that my friends is a long way down.

Another Case for Gold

"All that is gold does not glitter, Not all those who wander are lost;
The old that is strong does not wither, Deep roots are not reached by the frost.
From the ashes a fire shall be woken, A light from the shadows shall spring;
Renewed shall be a blade that was broken, The crownless again shall be king." - J.R.R. Tolkien, The Fellowship of the Rings

I know, I know everyone hates gold as an investment or at least they do in the United States.  You cannot use it, you cannot eat it, it does not produce a stream of cash flow, it is essentially a worthless glittering piece of jewelry or, worse still, a glittering piece of metal that takes up a lot of space in the family vault.  There is absolutely no economic benefit from owning gold so dump it like a hot coal!  This is certainly the consensus in the United States where gold stocks and gold ETFs have been bludgeoned for the past two years.  Year to date the price of gold is down 25% and the price of the mining stocks is down almost 50%.  This is a massive sell off and is very interesting given the fact that the stock market is up over 25% during the same time.  Gold haters rule the roost in the United States and so far, based on the performance of the stocks, it appears that their arguments listed above are correct.  So is there a reason to snoop around the gold market or should you shun it forever?

Now as most of you probably know I am bullish on gold and with this current sell off (or should I say massacre) I am even more convinced that the market has once again overdone the selling and that the opportunity to make a roaring profit in gold related stocks is enormous.  The first reason is obvious, when everyone hates an industry or an investment it is normally the exact time when you should be loading up.  Now that is not a very scientific reason so let's take a look at some more fundamentally sound investment metrics.

The price of gold is determined exclusively by supply and demand.  Over the years the supply of gold being mined has been dropping while the demand for gold has shifted to India and China.  China is expected this year to overtake India as the world's largest consumer of gold.  It is expected that China will purchase over 1,500 metric tons of gold while India will purchase around 1,000 metric tons.  The combined total of more than 2,500 metric tons is more than the amount of gold mined this year which is expected to be around 2,400 tons.  So demand for gold outside of the United States is huge and growing and this demand is being met by selling in the United States.  In fact the gold ETFs have sold almost 800 metric tons of gold this year alone.  Now investors are notoriously fickle and if their desire for gold returns they will soon find that there is no supply, skewing the supply demand equation to the demand side and forcing the price to sky rocket.

So what will change their minds?  Gold is reliant on the two investor hot buttons of greed and fear.  Although gold is also thought to be a hedge against inflation there are numerous studies that have shown otherwise so for now I will take that argument off the table and focus on the raw human emotions.  Right now fear has left the building and when that happens greed runs rampant.  In this type of a market environment stodgy old mining stocks and gold are shunned in favor of new technologies and high flying momentum stocks.  This is being played out in the market today.  At some point in time, as I have been saying for too long now, fear will re-emerge and with the fear will be a return to gold and gold stocks.  When this will happen is anyone's guess but it is my opinion that now is the time to add a decent allocation to your gold holdings and if you have none to look at dipping your toes in the water.  Not only will this investment serve you well when the market craters it should provide a good diversification option that will protect you when fear returns.

Hidden Profits

"It is well enough that the people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning." - Henry Ford

"I believe that banking institutions are more dangerous to our liberties than standing armies." - Thomas Jefferson

It is common knowledge that the banking institutions in America are riding a wave of profitability.  It is also interesting to note that a number of economic recoveries are due to the profits of the banking industry pointing to economic growth.  They are a major cog in the economic wheel as they grease the economic engine with financial liquidity.  So the fact that they are and have been making massive amounts of profit is very interesting in that the economy has not picked up and loan originations are not providing the necessary boost to their earnings.  So it begs the questions where are these profits coming from and is this a forebearer of good economic news?

In answer to the second question first, unfortunately these profits are definitely not pointing to a stronger economy.  All the market metrics from unemployment to GDP growth are all pointing in the wrong direction or are sluggishly creeping forward.  Nothing is pointing toward economic growth in the magnitude of the growth of banking profits over the last few years.  So with all this poor economic news it was interesting to read a number of articles this week uncovering not only where these profits are coming from but also the risks to the economy that these profits are posing. 

Profits in the banking industry are largely coming from two areas.  The first is from the Federal Reserve itself and the second is from the every burgeoning derivative market.  Looking at the Federal Reserve, back in 2008 new legislation was put in place giving the Federal Reserve the right to pay interest on banking reserves.  With this legislation the reserve ratio, the amount of reserves that a bank needed to hold at the Federal Reserve as a safety net, was removed.  In the past banks only held the Federal Reserve's mandated minimum as it was money that earned no interest but now that they receive interest banks are piling cash into reserves.  The reason for this is that the interest that they pay out on money market funds is essentially zero while the interest that they receive from the Federal Reserve, even though it is only 0.25%, is essentially risk free profits.  Now there is nothing more that a bank enjoys than risk free profits so bank reserves have morphed from next to nothing to over $1.5 trillion.  Considering that the Federal Reserves balance sheet has increased by just over $2.5 trillion and you can see why the economy continues to struggle.

But that is not risky money so why is there a danger?  Well the first thing to understand is that a spread of 0.25% even if it is risk free is not enough to generate the kinds of profits that we are witnessing at the banks.  It is a fantastic start but as always bankers are looking for more.  So in order to generate large profits with minimal loan portfolios you require leverage and this leverage is coming from the derivative markets.  The derivative market has spiraled to over $1 quadrillion that is a thousand trillion or $1,000,000,000,000,000 of nominal value!!!  To understand this better when you invest in a derivative you place a small amount of money upfront called margin and this leverages a large nominal value.  If you bet correctly you reap a massive return on your investment but if you bet incorrectly you are left to pay out on the larger amount.  Margins therefore can quickly be extinguished and large losses can explode in an instant.  So while things are going in the right direction (read the stock market and other bubbly investments) the banks are making billions of dollars.  The day that this house of cards comes toppling down the losses are going to be enormous and there is no way that the Federal Reserve can cover these debts.

For these reasons it is important that you realize and understand the risks to the current market and, when the next market upheaval arrives, that we do not once again as tax payers step in and shoulder the burden of banking excesses.

The Generation Impact

"The aging process has you firmly in its grip if you never get the urge to throw a snowball." - Doug Larson

"You are as young as your faith, as old as your doubt; as young as your self -confidence, as old as your fear; as young as your hope, as old as your despair." - Douglas MacArthur

"Growing old is mandatory, growing up is optional." - Chili Davis

"Wrinkles should merely indicate where smiles have been." - Mark Twain

OK so this Thanksgiving happens to be just past my 50th birthday so that may be why the topic of aging is at the forefront of my mind this week but then again, as I enter the downhill slide, I join a growing army of veterans and so add to the burgeoning population of older citizens.  Now those of you that know me know that I am firmly a part of the third quote above and my son is doing an excellent job of keeping me young at heart but the sad fact is the developed world is aging at a pace not before seen and this is having dire consequences on economic growth.

Japan, Europe and America are all barely growing in terms of population in fact a number of countries have population growth rates below two, the number required to replace the outgoing population.  The impact on expected economic growth that this is having is huge as the older generation is not in the habit of large consumption and is in the habit of protecting what they have for retirement.  So let's look at each one of these metrics in a little more detail.

Large consumption is typically taken on when a young or middle age couple expand their family, buy houses and cars and invest in businesses.  During these years the consumption of everything from automobiles to houses has a massively positive impact on economic growth as demand for goods and services is high.  In economies where the bulk of the population is young to middle aged (as was the case in the United States during the baby boom era) annual GDP growth is strong.  Companies benefit from a strong consumer and as this makes up over 70% of GDP recessions are short and growth cycles are extensive.  As we approach 2014 more and more of these baby boomers are aging thereby slowing the consumption of goods and services while increasing savings in preparation for retirement.

This drag on GDP growth has significant impacts for investments in both bonds and stocks.  In a recent study it was found that as populations age the returns to the stock market and the bond market are negatively impacted.  This is relatively intuitive as without solid GDP growth and outlook it is hard for stocks and bonds to produce abnormal returns.  So it is interesting that the stock market has run so far in the United States when there is the potential long run economic drag of an older population. 

On the bond side, as I have argued in my book How to Thrive in the Obama Economy due to this demographic shift there is a high probability that interest rates remain subdued for years to come.  Consider that if there were a spike in the 10-year Treasury to say 5%, the demand that would result to lock in that yield after years of sub 3% returns could drive the bond price back up holding interest rates low.  It appears to me that the consensus that bond rates will automatically rise does not take into account this growing demographic and their shift in desire from speculation and risk to protection and yield.

With the head winds of the aging population in most advanced countries the obvious solution is to look beyond these for stock investment to the BRIC countries of Brazil, Russia, India and China.  Obviously these investments come with a large dose of volatility and risk but certainly the demographic trends are in your favor and if history is once again on your side you would do well to take advantage of the opportunity presented in these markets.

The Stealth Tax

"Inflation is when you pay fifteen dollars for a ten dollar haircut that you used to get for five dollars when you had hair." - San Ewing

"Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man." - Ronald Reagan

"Inflation is taxation without legislation." - Milton Friedman

From the quotes above I am sure that you get the picture, inflation is the stealth tax that decimates retirement planning and steals money right out of your wallet while you stand and watch it happen.  There is nothing you can do to stop it but you can prepare for it and if you do this will go a long way to fulfilling your retirement and investment goals.

First of all let's look at the most widely used measure of inflation the Core Inflation rate.  Core inflation refers to the long run trend in the price level.  What it tries to do is strip out any "noise" or wild swings in prices caused by one off exogenous shocks, say for example a temporary spike in the price of gasoline due to a strike at the refinery.  The problem is that doing this strips out the most volatile items namely energy and food and these two items account for a large portion of most individuals monthly budget.  Now the question is how is the Core Inflation calculated?

Well there are numerous ways to calculate this number.  The most widely used methodology is the Consumer Price Index or CPI.  This measure was used by the Federal Reserve for years but has recently been dropped for Personal Consumption Expenditures Price Index or PCE.  Many people still rely on the CPI as a gauge for inflation, for example social security payments are index to the CPI so let's look at how the CPI is calculated.   Essentially CPI is a basket of consumer goods excluding food and gasoline.  The idea is that as this basket of goods changes prices a relative measure of inflation is calculated.  The problem with this concept is that while consumers change their buying habits fairly regularly the basket of goods was set for an extended period.

For this reason the Federal Reserve recently changed over to use the PCE.  This takes into account the ever changing consumer preference for different items and has resulted in a lower number being calculated for the United States inflation rate by about 30%.  This is significant in that the Federal Reserve has as its mantra to keep a lid on inflation and by changing the way that they calculate inflation they have magically lowered inflation.

Another problem with calculating inflation is that it is extremely difficult to adjust prices for the improvement or benefit from using say an iPhone 5 versus an iPhone 4.  The 5 may cost more but if there is a benefit from an improvement in living standards then just looking at the price increase is not capturing the improvement and so the Federal reserve makes an adjustment for this lowering once again the inflation rate.  In addition to this adjustment they also make seasonal adjustments to strip out seasonal influences on prices thereby tinkering again with the published rate.

So what is the real rate of inflation?  Well as we have seen the number published is anything but accurate.  It serves a purpose for the Federal Reserve but really has no bearing on the rate of inflation that you personally bear.  You buy gasoline and food and I am sure that your basket of goods is vastly different from the Federal Reserve's published basket.  In fact not only is your basket different from the Feds but it is more than likely different from mine.  This means that your inflation rate is different from mine and, if you want to get nit picky, different from everyone else's.  To dig even deeper, even if you buy exactly the same things as your next door neighbor if the timing of the purchases is different there is a high probability that you will pay different prices.

So while we all have a different inflation rate it is this inflation rate that you need to consider when you look to a real rate of return on your investments.  The real rate refers to the rate of return in excess of the inflation rate.  This is the rate at which your portfolio is actually growing as inflation is eating away at the rest of the returns.  This is why it is important to not only review your spending habits to determine a personal rate of inflation but it is critically important to factor in the rate of inflation and the impact it is having on your portfolio returns.  Turning a blind eye to the rate of inflation will severely impact your ability to retire happily as the stealth tax will destroy your portfolio much like termites destroy a wooden house.

The Portfolio Doctors

"It is not true that I had nothing on, I had the radio on." - Marilyn Monroe

"It's so sweet, I feel like my teeth are rotting when I listen to the radio." - Bono

Today is a very special day in the life of Steve Bick in that today is the day that my radio show, The Portfolio Doctors, airs for the very first time.  Together with a good friend and trusted advisor, Dan Osgood, our show will air weekly on Friday on ESPN 1700 radio at 2pm.  Now the reason I am telling you this is not only to broadcast the new show but because I could not help myself, I had to tell the world to wake up!

In my wanderings and dealings with people across the globe there is a common complacency regarding retirement and investments.  In general investing is seen as a gamble, a crap shoot or a number of other derogatory words, so you may as well just lump your hard earned money in with everyone else and earn what everyone else is earning.  This is short sighted and irresponsible for the simple reason that protecting and ensuring your financial future is your responsibility and ignoring this fact is to jeopardize your well being in your retirement years.

If you truly think that anyone will take the care required to nurture your retirement portfolio as well as you think again.  Your inflation rate is different from everyone else, your goals are different from everyone else, your risk tolerance is different from everyone else, yet in the main you invest in the same portfolios as everyone else.  Why?  For the simple reason that it is easy and convenient and you do not have to take responsibility for any losses.  If it goes down, well so did everyone else.  This is a cop out and will not serve you well going forward because the markets are setting you up for failure.  Interest rates are at historic lows and the market is at historic highs all on the back of a weak economy.  Blindly allocating money to a basket of stocks and bonds will not provide you the retirement that you need.

It is time to take the bull by the horns and face the reality that you need to become highly skilled and educated in managing your investment portfolio.  Now I am not saying that you need to become a skilled trader, but you do need to start studying your options outside of the norm and understand how the macro economic environment will affect your portfolio.  Beyond that, you need to know where to look to find safety and how to protect your fragile basket of investments and turn them into an anti-fragile basket of investments.  This is the aim of the show, to educate you and to show you a path to success or at worst to help your sidestep some common mistakes enabling you to proper and retire not only in comfort but in the knowledge that you have the understanding and ability to weather the storms ahead.

I encourage you not only to listen to the show but to let your friends and family know about the show as it may benefit them as well.  For those of your that work during those hours we will be posting a podcast on our website at www.theportfoliodoctors.com weekly.  Finally if any of you would like to advertise or be on the show to share your experiences and wisdom let me know and we can discuss how you can get involved.  Let's spread the word and make sure that our future is prosperous.

Back to the Future!

Here is an excerpt from the movie Back to the Future in which Dr. Emmett Brown who is now in 1955 is doubting Marty McFly's story that he is from the future:
Brown: Then tell me, future boy, who's President of the United States in 1985?
Marty: Ronald Reagan
Brown: Ronald Reagan?  The actor? [Chuckles in disbelief] Then who's vice president? Jerry Lewis?  I suppose Jane Wyman is the First Lady?
Marty: Whoa, wait, Doc!
Brown: And Jack Benny is secretary of the treasury?
Marty standing outside the lab: Doc, you gotta listen to me.
Brown opening the door: I've had enough practical jokes for one evening.  Good night future boy!
Slams the door leaving Marty outside.

Back to the Future is one of my favorite movies.  Dr. Emmett Brown has invented a time machine and the two have some fantastic adventures rushing back and forth through time trying desperately to adjust things so that what happened in the future is "fixed" before it happens.  The reason Marty is back in 1955 is to warn "Doc" that he will be shot by some Arabs who are annoyed that he stole their plutonium to run the time machine.  After much trying "Doc" reads the note and saves himself thereby altering future events.

The same thing is happening the world over in the halls of the central bankers.  They are desperately trying to make it "different this time".  The funny thing is that they are using the same old tools, printing money and lowering interest rates to unsustainable levels.  This methodology has never worked in the past and therefore should not work in the future.  The sad part about it is that they are convinced that this time it will work and that the last time we just did not print enough.  Their theory is that maybe plutonium is not strong enough so let's use something stronger!  The problem is that more force with the wrong tools will provide the same result.

One area where the results are the same is the stock market.  This week Twitter became a public company.  The fact that they have never turned a profit did not keep the speculators from pouring in to grab a slice of the action driving Twitter's stock up 95% above the IPO price on day one.  The current market capitalization of a money losing company is now $31 billion but that is fine because apparently the company growth will dig them right out of this hole!  This speculative frenzy smacks of 1999.  Back then I was a pretty green investor as all I had ever really known was a bull market so I would have jumped all over this issue and pocketed a fairly large amount of money.  The problem is that when 2000 hit I was hit upside down very quickly and as easily as the money had arrived it left.

Fast forward to 2013 and things are once again out of control.  There are tons of companies that are way overvalued and continue higher.  Tesla, Amazon and Twitter are just the tip of the iceberg.  Behind this come the denizens of momentum stocks that continue to soar with every billion dollars printed at the Federal Reserve.  The problem is that this time the economy is still weak with millions on food stamps and massive budget deficits.  Furthermore the currency continues to strengthen as countries around the world try to debase their currency in order to stimulate exports.  Nothing is working other than the stock market spiraling out of control higher and the mountain of debt climbing at an astonishing rate.

Looking forward to 2014 could also be like going Back to the Future in that it could be the next seven year itch.  Think about it 2000 and 2007 were disastrous years for the markets.  Furthermore 2007 was far worse than 2000 for the simple reason that the amount of stimulus was far greater in 2003 and 2004 than it had been in 1998 and 1999.  This time around the stimulus is higher by multiples of 100.  So if you thought 2007 was painful do not expect next time to be better.  Ensure that that you learn from the past because believe me the current tinkering will not change the outcome.  The only thing I do know is that if plutonium created the 2007 explosion then I am not looking forward to the result when this new super fuels ignites.

Volatility - Life's Strengthener

"It's a lot of random situations that combine in a certain volatile form and create a bigger-than-the-whole situation that nobody could have predicted." - Paul Kantner

As investors we love to try to predict future events.  Predicting them correctly gives you an edge and will make you a lot of money so people spend countless hours creating models that they think will capture the majority of future events.  Using these models they construct portfolios that will benefit from these predictions but more often than not the predictions turn out to be hopelessly poor and future events are not even remotely close to the predictions.  When an analyst guesses correctly (and I use the word guess rather than predict) he or she is an instant media sensation and all future predictions are taken very seriously.  Take Meredith Whitney or Noriel Roubini as two examples.  Both predicted massive economic collapses and both are now hero worshiped but since that one time prediction they have had limited success but for some reason people continue to take note whenever they speak.

Volatility is seen as investment risk.  The more volatile the markets (volatility refers to the movements up and down in the market, the more the market gyrates the higher the volatility) the higher the risk for the simple reason that trying to predict future market moves when it is gyrating around furiously is almost impossible.  For this reason investors tend to buy and hold rather than trade the market.  Buying the market locks in market rates of return and for most that is a simple way of investing.  Do not worry about daily market movements and rely on history to repeat itself with a continued long term rate of return in excess of 8 percent.  The problem with this strategy is that you never can predict when you will require the money.  What if you fall ill or lose your job?  Typically both or one of these events occurs right at market lows as the economy is weak causing layoffs and illness due to stress and anxiety.  So right when you need the money the value of your portfolio is at its lowest.  Withdrawing funds at this point is not optimal which is one of a litany of reasons why the majority of investors receive sub par returns.

Volatility in nature however has been used to strengthen the whole.  Nature has had to deal with unknown events for billions of years and the results are humans.  Every time something spectacular occurs nature's resilience allows it to use the catastrophe to become stronger allowing future generations to benefit from the event by being immune to future events similar to the last one.  What nature realizes though is that while you can try to prepare for the unknown it is just that, unknown so the best thing that you can do is to latch on to the strongest cells, the ones that survive the catastrophe, allowing the weak ones to die and so evolve into a stronger organism.  That said there are events that could wipe humanity off the earth but nature will once again evolve into something stronger and revive itself at the expense of the weaker race of humans.

So one thing we know is that volatility is here to stay.  As much as the Federal Reserve and an army of Wall Street investment bankers try to hammer it into line the more it wiggles.  In trying to box volatility in it creates a wild untamed beast that eventually finds an exit and once it does it creates havoc with portfolios around the globe.  Furthermore as the globe becomes more and more joined at the hip economically speaking the greater the volatility and the less control one Federal Reserve has against the growing multitude of global problems. 

Now what if instead of fearing volatility and the effects that it has on your portfolio you embrace it by creating a portfolio that benefits from increased volatility?  In his book Antifragile Nassim Taleb suggests that this is the best way to invest and I have to say that I agree.  In fact this is one of the main themes to my recent book How to thrive in the Obama economy and I am proud to say that I had not read Taleb's book prior to writing mine.  Creating this type of portfolio is possible but it will take some effort and education on your part but I advise you that it will be well worth your time and effort as not implementing these strategies will play havoc with your portfolio and your retirement options.  For this reason I am launching a radio show on November 15 on ESPN 1700 AM radio that will attempt to educate people of the pitfalls of investing your hard earned money in a "normal" portfolio and will give ideas as to where to look to create a portfolio that becomes stronger the worse things get and believe me they are not going to get any smoother.  I invite you to read my book and tune in on Friday afternoons between 2 and 3pm as we launch the show and try to help you achieve your investment goals but outside of this it is extremely important that you ensure that your portfolio benefits from these major market gyrations rather than implodes.

Old versus Young

"The greatest glory in living lies not in never falling, but in rising every time we fall." - Nelson Mandela

"Age is getting to know all the ways the world turns, so that if you cannot turn the world the way you want,  you can at least get out of the way so that you won't get run over." - Miriam Makeba

I am currently visiting family in South Africa and aside from the great time it has been seeing family and friends it is also very interesting from an economic perspective.  While it is never easy to make comparisons between the United States and an emerging economy the size of South Africa there are some very interesting metrics to look at.

The first is the level of debt.  At 41% of GDP South Africa's debt level is relatively low in comparison to the United States whose debt level is at roughly 100% of GDP.  Still the International Monetary Fund is applying pressure to South Africa to take measures to reign in the debt level   The IMF said that, "in many sub-Saharan African economies, inflation control is vulnerable to food price shocks, given the importance of food in consumption baskets".  This apparently is less of a problem in the United States as food is stripped out of the inflation number but the reality is very different and makes one wonder about the double standards of the IMF; one that applies to a large established economy and one that targets a small emerging economy.  Certainly just as with business there is more risk lending money to a small economy but should the disparity be as large as this?  When you look at Japan with a debt level of more than 200% you begin to wonder where the ceiling is for a large economy but as I have repeatedly written it can only be sustained as long as there is the perception the developed nation will be able to handle the debt.

Interest rates are also at all time lows in South Africa but at 5% they are more than five times higher than in the United States.  A one year Fixed Rate Deposit in South Africa earns 5.75% while a one year CD in the United States earns 0.50%, so the rate here is over 100 times higher.  If interest rates in the United States were to move anywhere close to these rates the entire economy would collapse and a very deep recession would ensue. 

Demographics are also completely different with over 50% of the population in South Africa below the age of 25.  In the United States 28% of the population is over 65 and the median age is 38.  Furthermore the fertility rate has fallen to 1.88 in the United States which means that the population is actually shrinking.  This aging population is placing enormous stress on the United States government retirement programs and in order to fund these the United States will be forced to increase the debt level.  Now while South Africa has a massive advantage of a young workforce the main issue is that a huge number of these people are unskilled and unemployed.  This drain on the South African GDP is being felt and is one of the reasons that the IMF is placing South Africa on a warning regarding its debt levels.

Politics is yet another area of worry for South Africa.  Certainly the United States has political issues and it appears that the policies of the current government are not in line with the desired economic outcome, but at least it has political stability.  South Africa, while political stability appears to be in place on the surface, there is still the threat that one of these days the ANC will scrap the constitution and rule with an iron fist and for this reason investors will always require additional return on their investment.  With a lower level of political uncertainty the United States is perceived as a safer bet hence anther reason it can continue to issue billions of dollars of debt for next to no interest.

So while these are just a few data comparisons it is clear that until the global economy finds its footing the United States will be able to continue to issue debt.  The question still remains as to how much they can issue before it becomes a problem.  If rates were to rise to South African levels the United States debt service would balloon the budget deficit exponentially and that would make the world raise an eyebrow and demand a risk premium from the United States.  While the loss of credibility seems a way off it will behoove you to pay close attention to the inflation rate as once it starts to rise watch out below.

A Study in Retirement

"Retired is being twice tired, I've thought.  First tired of working, then tired of not." - Richard Armour

"Retirement can be a great joy if you can work out how to spend time without spending money." - Author Unknown

We all want to be able to retire.  The problem is that there are so many forms of retirement that it means a totally different thing to different people.  To some the idea of retiring is akin to dying while to others retirement is the holy grail and should be grasped as soon as possible.  One thing that we can all agree on though is regardless of whether you actually retire in the true sense of the word or not, we all want to have the financial strength so that the freedom to be able to retire is available to us.  So the big question is how to get that financial strength and once you have it how do you protect it?

Well a lot of this is answered in my book How to Thrive in the Obama Economy (available on Amazon) and I do not plan to repeat it here but there are many schools of thought about how to protect your retirement and I will focus today on four strategies popular with the financial planners of the world. 

The first is the Floor Leverage Rule.  This strategy invests the vast majority of your investment portfolio into low risk investments and the remainder, roughly 15%, into very high risk investments such as a 3x fund.  A 3x fund leverages the investment to such a degree that the returns and losses are magnified three times the underlying portfolio.  So for example if you invested in a 3x S&P500 fund your returns would be three times greater than the current market returns.  So in effect you would be up over 50% year to date on 15% of your portfolio.  The key now comes through rebalancing as you would now allocate a large portion of the gains to the low risk portfolio bringing the whole position back into the 85:15 ratio again.

The second strategy is the 4% Rule Strategy.  Using this strategy retirees set up an amount of the portfolio that they will use to fund their retirement per year.  In an effort to keep spending sustainable throughout retirement the draw can be increased each year by an amount equal to or great than inflation.  This of course brings in a myriad of issues such as what is the actual rate of inflation (refer to an earlier blog for an analysis of this) and what happens later in life when the portfolio is a lot smaller but you have the large medical bills associated with the elderly.  In order to address this some advisers suggest drawing less in the beginning and more in the end.

The third strategy is based on behavioral finance and takes mental accounting to task in that it sets up the portfolio in buckets.  Each bucket is drawn on at certain times in the retirement spectrum so for example you can start by drawing on the low risk bucket first as this allows your higher risk bucket of stocks time to mature and iron out the fluctuations.  The question here is that as you get older your risk tolerance changes so you are constantly tinkering with your buckets and this can create havoc with your overall returns.

The fourth strategy is a utility strategy which takes the utility function of an additional retirement dollar and allocates a risk strategy based on this.  In this strategy the basic economic principle that each additional dollar losses its utility is used.  The theory goes that as you earn more money each dollar earned has less utility so that by the time you are earning $1 million a year, earning one more dollar is essentially meaningless.  In this example the last dollar can be put to use in a very high risk investment as the impact of loss of this dollar is essentially nil while if it turns into another million it has a big impact.

The problem as you can tell in all of these strategies is that they are mostly based on allocations of stocks and bonds.  As my book suggests this is too short sighted as the risks associated with limiting yourself to these two broad investment allocations results in a very high opportunity cost and opens you to large volatility.  In addition using derivatives such as the 3x strategy will result in high slippage costs.  These are the costs associated with running the fund and not tracking the index closely.  In my experience the 3x funds have very high slippage and do not produce even close to the results that are expected meaning that you do not make as much as you expect when the markets run and lose more when they dive.  Mental accounting is rife with problems as I do not know one person who uses this investment that is sufficiently disciplined to stick to the buckets.  This type of person is constantly tinkering with the buckets either out of greed or fear and ends up under performing the market.

What is needed in my opinion is a strategy that combines the utility strategy with a broader array of investments such as hedge funds, commodities, real estate and other exotic style investments.  Limiting yourself to the standard investment strategy will end up with the result that most of the population obtain and that is a sub par 2% annual compound rate of return.  I am not joking the statistics show that this is the return that most retirees obtain.  Looking at it that way either you should invest in Fixed Rate Deposits and earn 4% or at worst read my book but once again make sure that you take responsibility for your investment portfolio as the onus is now firmly placed on your shoulders since defined benefit plans became defunct and given the current manipulation of the markets 2% may end up looking very good!

The Skewness of Risk Tolerance

"The length of this document defends it well against the risk of being read." - Winston Churchill

"Only those that risk going too far can possibly find out how far one can go." - T.S. Eliot

Risk tolerance is a very interesting topic as it is embedded in the psychology of trading and investing.  There are numerous studies done on the topic but what is often missed is the change in risk tolerance with the returns of the market.  Investors can be placed into buckets by risk tolerance.  In the first bucket are the conservative investors that never earn a large rate of return but are relatively well protected during years where the market performs poorly.  In the other bucket are the high risk investors that press the envelope in an effort to beat the indices and make a large profit in a short amount of time.  Now obviously each bucket has a very different risk tolerance but as a group this can swing from more risk to less.

When the market runs (as it is now) these high risk investors sway the risk tolerance of the overall group towards the high risk spectrum for the simple reason that their net worth moves up far faster than the conservative investor (not to mention that a lot of conservative investors jump across buckets as they hate to be left behind).  This group therefore commands a greater portion of the market raising the overall group's risk tolerance.  When a market correction occurs these investors lose far more than the conservative investor and so the group's risk tolerance retreats to a lower level when markets are down.  Looking at this from the theoretical window it is easy to see the fallacy of their ways as quite clearly investors should have a higher risk tolerance after a market correction whereas in fact the opposite always occurs.

As an example look no further than Brazil where Batista the Brazilian billionaire has seen $34.5 billion wiped out in a matter of months.  The reason is that in order to make $34 billion in a lifetime you have to take on enormous levels of risk.  Now while most billionaires start to pare down their risk levels once they achieve levels such as these, Mr. Batista thought of himself as a superhero and continued pushing the envelope until finally everything fell apart at the seams.  Worse still is that he had managed to suck in seasoned investment professionals such as Pimco, GE, Blackrock and Abu Dhabi's sovereign wealth fund to name just a few high profile investors.  Shows you what a fast boat, fast cars and playboy models can do!  It also shows you that often times following the supposed "smart" money is not the answer.

Looking at the market today it is clear that the risk tolerance levels are reaching very high levels.  The signals are easy to spot; margin levels are at all time highs and market volatility is high while investor perception of risk is low.  Margin refers to money borrowed by investors to finance additional stock purchases.  Essentially the broker lends you money to add to your positions meaning that you take on ever more risk as every move in your portfolio magnifies the returns or losses.  Risk perception as measured by the VIX shows a complete disdain for risk even in the face of the stalemate in congress.  The reason that this fear is low is that investors after four bouts with similar congressional stalemates and debt ceiling raises have put the whole thing down to political posturing and are ignoring the seriousness of the outcome.

This is worrying from many levels but to me the market complacency is a signal that while investors believe that the outcome is inevitable (and it certainly seems like it is) if there is a change in perception another October crash could be in the works.

Fiyon!

"Too infinity and beyond." - Buzz Lightyear a character in the Disney movie Toy Story

When my son was only 3 he loved the movie Toy Story.  One of the lead characters was a space ranger named Buzz Lightyear.  My son loved him and used to stand on the edge of the couch, hold out his arms like wings and as he would jump off the couch to fly like Buzz he would say the word Fiyon!  This was his way of saying "Too infinity and beyond".  Needless to say he never flew and neither did Buzz in fact when Buzz tried to prove he could fly he was fortunate in that he bounced on a ball and then hooked on the ceiling fan giving the impression of flying.  His friend Woodie, exasperated says, "That wasn't flying, that was falling with style!"

Recently I watched a show about the concept of infinity.  It was fascinating in that most of us while we understand that infinity is forever have no real concept of the actual term.  Think about it for a second.  Infinity - forever, hard to imagine.  How can something go on forever?  The idea is that the universe is forever but that is hard to believe, how can it go on forever?  But the problem is, if it is finite then what is outside of the universe?  Going even deeper, if you grasp the concept of infinity then there must be an infinite amount of infinities and therefore there must be an infinite amount of worlds and people and an infinite amount of you scattered around the universe.  Pretty crazy stuff but the reality is that once you believe in infinity then anything that can happen is happening somewhere in the universe.

So bringing this concept back to the markets opens a plethora of possibilities.  For this reason there is no reason to believe that the market can be supported by the Federal Reserve forever (as it appears some people believe).  On the flip of that there is no reason to believe that the market will die tomorrow.  Low interest rates could be with us for a far longer time than anyone could even imagine, driving stocks higher than anyone dares predict.

Now one thing that you can guarantee is that the market will crash.  It has on numerous occasions and it will again.  The question that traders try to predict is when?  With the markets at precarious levels and the indexes being driven higher by the speculative stocks and momentum rather than value it appears that this could happen at any minute but that is just it, it could also keep churning higher for a few more years.  It appears that the Federal Reserve will be lead by Janet Yellen next year and that means more printing not less.  So with continued stimulus the market could continue unabated for the foreseeable future.  The question is do you want to place a bet on this or not and my answer, as I detail in my book How to Thrive in the Obama Economy, is that this is not the time to try to fly as unlike Buzz you may not fall with style and that risk far outweighs the potential rewards.  Find other avenues for your investments and stay out of the madness that is the stock market.

The Next Productivity Boost

"What an economy really wants, after all, is not more investment per se but better investment.  It wants capital to flow to companies that will create value - not in the form of a rising stock price but in the form of more goods for less cost, more jobs and rising wages - by enhancing productivity." - James Surowiecki

Productivity is another interesting economic input.  To create a product you need materials, a plant and labor.  The number of products produced for a unit of labor is referred to as productivity.  Throughout history there have been major leaps in productivity from the railroad to the Ford manufacturing methodology to the Internet.  Each of these has fueled growth and created huge wealth for the innovators.  Furthermore there is a body of consensus that points to increases in productivity providing job growth and wage increases, both of which are desperately needed today.  So is there another productivity miracle in the works and will it be the golden spoon that pulls the global economy out of its quagmire?

Looking at the last 50 years there have been major leaps in productivity each decade other than the most recent one.  This is leading economists to predict that another one is just around the corner however the problem with leaps in productivity is that you never know when it will arrive or where it will come from.  Certainly there is more and more money being spent on research and development globally but it is hard to imagine that we will ever see something as impactful as what was witnessed with the creation of the Internet.  That said we have witnessed the birth of three dimensional printing that is allowing companies to develop products far more quickly than ever before.  On top of that as the price of the printers has dropped significantly more and more people have access to these machines and they are able to tinker away at product development in the comfort of their homes.  While this is a great new technology it is hard to imagine it having the productivity impact of the Internet but it may result in the next productivity miracle being designed.

Another recent development has been Fracking.  This new technique for extracting oil and gas out of rocks has drawn a lot of skepticism from the environmentalists but it is changing the economic landscape as America is suddenly becoming an energy super power.  Once again though this innovation will not provide much in the way of a productivity benefit although it is having a marked impact to the employment numbers in the northern part of the United States.

So we do not know where the innovation will come from but it appears that we have not witnessed the next productivity wave we are only basing the expectation on historical data.  Now while I have no doubt that productivity will continue to improve I do have a question as to whether this will have any meaningful impact on unemployment.  In the past innovation that resulted in productivity gains resulted in increased employment opportunities and higher wages.  As factories became more efficient market share was taken from others and the home country benefited at the expense of others.  As I have mentioned before with the advent of the Internet the globe shrank metaphorically speaking as things could now easily be produced in countries with a comparative advantage (see previous blog on this topic).  The result of this was an export of jobs to places like China and India.  Those that managed to keep their skill set aligned with the changes benefited with higher wages but there was a large portion of the population that has since been made obsolete.

It is this portion of the population that is creating a drag on growth for the simple reason that the balance of the workforce has to make up for the lost wages and purchasing power of these individuals.  My contention is that when the next wave of productivity gains appears (and it will) we could see another spike in unemployment.  In fact we could be at a point in time where full employment in the United States is no longer 4% but has shifted to 6% or even 7%.  Printing more and more money to try to foster employment by businesses in this scenario is pointless as no matter how much money is thrown at the problem the result is still high unemployment numbers.  The only result is an ever burgeoning level of government debt and the problems that come with that.

Not that I believe that the way to get people to work is reducing productivity.  What will happen over time as productivity continues to improve is that the employment market will shift and workers will adapt to the changes.  This takes time and could take decades but the way to lower unemployment under this scenario is for the government to spend their money assisting people on retooling their skills to match the changes in the market place.  Instead, the Federal Reserve continues to believe that throwing money at banks will result in a trickle down effect that will eventually reach the out of work sector.  This is clearly not happening as improvements in productivity are giving businesses the ability to reduce their workforce while continuing to increase volume.

If the government and the Federal Reserve would take a long hard look at all the entitlements that reduce the desire to work and the stimulus and how it is being spent maybe they would see that a far better way to reduce unemployment is to spend money on innovation and retooling rather than blindly throwing money out the window.

Econometrics: The Big Disappointment

A mathematician, an accountant and an economist apply for the same job.  The interviewer calls in the mathematician and asks "What do two plus two equal?" The mathematician replies "Four." The interviewer asks "Four, exactly?" The mathematician looks at the interviewer incredulously and says "Yes, four, exactly."  Then the interviewer calls in the accountant and asks the same question "What do two plus two equal?" The accountant says "On average, four - give or take ten percent, but on average, four."  Then the interviewer calls in the economist and poses the same question "What do two plus two equal?" The economist gets up, locks the door, closes the shade, sits down next to the interviewer and says "What do you want it to equal?" 

Three econometricians went out hunting, and came across a large deer. The first econometrician fired, but missed, by a meter to the left. The second econometrician fired, but also missed, by a meter to the right. The third econometrician didn't fire, but shouted in triumph, "We got it! We got it!" 

A mathematician, a theoretical economist and an econometrician are asked to find a black cat (who doesn't really exist) in a closed room with the lights off:   The mathematician gets crazy trying to find a black cat that doesn't exist inside the darkened room and ends up in a psychiatric hospital.  The theoretical economist is unable to catch the black cat that doesn't exist inside the darkened room, but exits the room proudly proclaiming that he can construct a model to describe all his movements with extreme accuracy.   The econometrician walks securely into the darkened room, spend one hour looking for the black cat that doesn't exist and shouts from inside the room that he has it caught by the neck." 

 

It is easy to pick on Economists as the jokes above show.  Economics, in my mind, has always been an art even though it falls under the sciences at universities.  In an effort to try to make it more precise Econometrics was devised whereby economists use mathematical modeling to determine the probability of certain outcomes.  I remember when I was studying economics back in the early 80's this was thought to be the future of the industry that would unlock the secrets of the investment universe so that investors would be able to determine with clarity the risk of an investment and the likelihood of an unwanted economic event.

Fast forward 30 years and while the models have become more and more sophisticated so has the investment marketplace.  As more and more intricate investment derivatives are created the ability of the econometric model to predict the risk of an event and more specifically the chance of a fat tail event are becoming more and more feeble.  A fat tail event is an event that is not captured under the normal bell curve and therefore has fantastic or disastrous consequences on your portfolio.  The fatter the tail the more likely an unknown event is to occur.  Finding these fat tails is the job of econometrics but the models have for all intents and purposes failed.

So let's take a look at the two sides of a fat tail.  On the one side you have the unknown event that helps you tremendously.  For example a cousin's, aunt's mother tells you to dump $100K into Facebook while Zuckerberg is still in college.  Little do you know it at the time but it is about to turn you into a billionaire.  On the other side of the tail is the catastrophe that was 9/11.  On that morning no one was to know what was about to happen and this played havoc with your investment returns, not to mention the poor people and families that were directly involved in the tragedy.  This is a fat tail event that was unpredictable and has disastrous consequences. 

So although mathematical models are used by economists to take a shot at predicting the future they are not able to capture the one event that haunts ever money manager.  In order to protect your portfolio from these fat tail events it has to be broadly diversified.  By this I do not mean just into a basket of stocks and bonds but into assets beyond those.  In my recently published book How To Thrive In The Obama Economy" (available now on Amazon see link below) I explain the reasons why it is more critical than ever today to look beyond a "normal" portfolio.  I encourage you to read the book as I am certain it will help your investment philosophy and your returns.

Looking further at fat tail events there is no need to look further than the returns on the stock market.  Since its inception there have been on average 12,000 listed companies.  Of these companies roughly 300 represent half of the total stock market capitalization.  Furthermore a lot of companies go bust year after year and are replaced by new companies.  What this means is that over time only a small fraction of companies have made investors any real money.  Miss these companies and your portfolio will really be hurt.  This is why investors buy the market using ETFs and is a reason why they are so popular however this strategy opens up the portfolio to the fat tail event.  The need to protect your portfolio outside of this one allocation is more important today than ever so take heed, open your eyes and prosper.

http://www.amazon.com/Thrive-Obama-Economy-Stephen-Bick/dp/1490975128/ref=sr_1_1?s=books&ie=UTF8&qid=1379694723&sr=1-1&keywords=stephen+bick
 

The World Is Shrinking

"Globalism began as a vision of a world with free trade, shared prosperity and open borders.  These are good, even noble things to aim for." - Deepak Chopra

While the global economy is still trying to recover from the Great Recession global trade is surging.  In 2012 world goods exports surged to just over $16 trillion from $12.5 trillion in 2009.  It is interesting that this surge in trade is coming on the back of weak global economic expansion but when you look at some of the reasons behind the growth it appears that this trend will continue unabated for the foreseeable future making the world seem to be shrinking.

Basic economic theory states that goods and services will migrate to a country that has a comparative advantage over other countries.  Comparative advantage refers to a country's ability to produce goods or services at a lower opportunity cost than another country.  This means that even if one country can produce all goods and services at a lower cost than every other country, there is still an opportunity to increase profits by focusing on the goods and services that reduce the overall opportunity cost.  So let's assume country A can produce every good and service cheaper than everyone else.  Country B however is able to produce certain goods that have a low opportunity cost in country A cheaper (in opportunity cost measures) than country A.  Therefore country A stops producing that good and imports this from country B.  There is a benefit to both countries in doing this as their overall profit increases.

So let's explore opportunity cost.  This is the cost of doing something at the expense of not doing something else.  Take for example work versus play.  At any given time in the day you could walk out of your office and go for a surf.  Now while you are surfing you are not making any money so the opportunity cost is relatively high.  That said if you value your free time more than the amount of money you would make during that hour surf session then it would be wise to go surfing.  Now to take this one step further it may be that there are no waves that day in which case you would stay at work as suddenly the opportunity cost is higher at work than surfing.  So you can see that opportunity costs can vary over time depending on circumstances.  This is why countries can have an opportunity cost in one product for a while and then lose it a few years later for the simple reason that international trade shifts all the time.

Looking at how this landscape has changed over the years it is easy to see not only technology at work by also economies of scale.  Technology is making it easier and easier to transact globally.  It is relatively simple to wire money across borders, find a manufacturer in a foreign country and fly there and back for a small fee.  Furthermore shipping costs are falling and with things like three dimensional printing a product can be designed on the fly, the specifications emailed across the globe in seconds and a week later the product is being shipped back to your home port.

Economies of scale are also helping drive the costs down and this too sets the stage for growth in international trade.  Architects in London are used to design buildings in Australia and the main infrastructure of the building is made in Indonesia with parts shipped from China.  These parts are then shipped from Indonesia to Australia where they are assembled much like Lego blocks with the finishing touches done by Australian artisans.  The only way that this can be done in a cost effective manner is if each part of the equation is cheaper than doing it in the home country.  Looking more carefully at this example the cost of the building is mainly made up of parts and labor.  Parts are far cheaper in China and labor costs only $7 a day in Indonesia.  So all that is left is to make sure that the shipping costs do not blow the budget.

To this end Maersk is building 20 Triple-E container ships.  These behemoths are as long as the Empire State building and can house 18,000 containers, enough to ship 182 million i-Pads in one go.  The ship itself weighs 55,000 tons.  One link in the anchor chain weighs 500 pounds.  If you stacked the containers end to end they would stretch over 68 miles.  Fuel one way from Rotterdam to Shanghai costs around $2.5 million.  The bet of course is on the continued growth of global trade but as amazing at is first appears it also is driving down the cost shipping.  The reason of course is the economies of scale.  Back in 1956 to ship one ton of freight across the Atlantic was $5.83.  Using container ships drove this down to 15.8 cents per ton.  Using the Triple - E will drive these costs even lower and that is the benefit of economies of scale.

Interestingly the boat is being built in South Korea with parts shipped in from around the globe and assembled on the docks.  It is clear that with the continued advances in technology combined with economies of scale and comparative advantage, global trade will continue to flourish.  This should be seen as a positive as it will draw the global closer together and should foster better relations between countries.  The one fly in the ointment would be war and while one can never count this out unless Syria sparks an international divide, for the foreseeable future global trade should continue to flourish.

An Economic Recovery?

"People are realizing that they cannot make it in the current Wall Street dominated corporate capitalist economy.  It is not designed for most people to make it.  Rather it is designed for a small percentage to profit while everyone else is exploited and economically insecure." - Kevin Zeeze and Margaret Flowers

This week there were some signs of an economic recovery.  There were some impressive numbers from the service sector with the US ISM non-manufacturing index jumping in August to a seven-year high of 58.6.  This points potentially to an improvement in GDP growth in the third quarter.  Looking deeper into the number it appears that most of the demand came from internal orders and not exports so there is hope that the local economy may be on more solid ground than previously thought.  The payroll report today was not great as it appears that the level of growth in payrolls is slowing however there is still growth which is mildly encouraging.

On the European front it appears that certain of the economies are starting to recover and unemployment while still high seems to have stabilized.  So with both of these economies appearing to be in recovery mode it must now be time for the Federal Reserve to exit the market, right?  The issue is that as I have mentioned repeatedly, the recovery is very tentative and any sign that the safety net that is the Federal Reserve will be removed will have dire consequences on the stock and bond markets.  The question is will a spike in bond yields combined with a sudden drop in the stock market unnerve the Federal Reserve and send them back to the printing presses?  My guess is that it will as it has in the past and therefore there is no reason to believe that this time will be any different.

Beneath the surface of this recovery is a very tepid technology sector, weak growth in the small business market, slow growth in employment and increased expenditure coming in the form of Obamacare.  Furthermore stock prices are exceptionally elevated and have baked in a far more robust recovery.  Removing the stimulus will take away the fuel and the fire will die.  As an example of stocks at ridiculous levels take a look at the stock of the year Tesla.  Now I have seen their cars and have been told they are fantastic to drive but the stock is trading at a market capitalization of over $21 billion on earnings of negative $112 million.  Sure they did report a profit this last quarter but please, the headwinds against this company are still enormous and to command such a lofty market capitalization you need to be selling cars into the mass market and not just to the rich and famous in California.  At the current vehicle sticker price that is not an option.

So it will be very interesting to see at the FOMC meeting later this month whether the Federal Reserve will consider trying to taper again and how the market reacts this time.  Based on previous meetings it is clear that even the Federal Reserve knows that it needs to exit this printing game but the question is how as they have shown that they have no stomach for a stock market crash.  Furthermore if yields on the 10-year bond rise much higher any form of recovery in the housing market will be put to rest right as they are deciding to exit the government owned mortgage finance companies, Fannie Mae and Freddie Mac.  It seems that once again the officials have timed the exit from the housing market to perfection!

The Current Account Conundrum

"Well, the U.S. is running a current account deficit; we are creating lots of investment opportunities in the United States that exceed our own domestic savings rate, so the issue here is to encourage higher savings rates in the United States." - John Snow

As the Federal Reserve debates when to scale back on its massive quantitative easing program shudders are being felt around the world.  In an article penned by Stephen Roach, one of Yale's most prodigious economists, he states that the current account deficits being run in countries such as Brazil, South Africa, Turkey and Indonesia (to mention a few) will rear their ugly heads once the Federal Reserve cuts its massive stimulus program.  Mr. Roach has his finger pointed firmly at the central bankers of the world for overindulgence in printing money as the cause once again of these countries coming plight.

In effect he has said that central bankers around the world believe that they are able to manage their economies so well that current account deficits are nothing to worry about.  The problem with these deficits is that they have to be financed by someone.  Up to now that someone has been the Federal Reserve as yield seeking investors have taken over $4 trillion and plowed it into developing nations fueling the bonfire.  The problem is that when the fuel runs out, it is hard to keep the economy warm.  The effects of this are being felt in these nations as their currencies are taking a beating against the dollar and the economies splutter for air.

In simple terms a current account deficit comes about when a country imports more than it exports.  It is widely viewed that a developing nation running a current account deficit is headed for recession.  However, if the deficit is temporary then going into deficit can be a useful way to stimulate an economy.  If a country can import products, run a short term current account deficit while turning these imports into products that stimulate the economy reversing this trend then there is nothing to worry about.  The issue comes when these imports are not used wisely and it appears that rather than invest this stimulus it has been used to live beyond their economic means.  As the Federal Reserve switches off the stimulus hose these economies will be left to repay the investment.  This would not be a problem if they were running current account surpluses but as this is not the case it looks like they will have a hard time doing making these payments and this could be the beginning of another global mess.

So if current account deficits are bad, how can the United States continue year after year, to run a massive deficit?  The answer is that being the largest economy in the world it pays all the other players of the globe to support this deficit.  Furthermore the United States has the ability to finance this deficit and make good on their interest payments.  It is considered a safe bet and until this opinion changes it can run current account deficits. 

The question is how long can this current account deficit be run before the amount owed is so large that the rest of the world questions whether it has the ability to repay the debt?  At present this seems a long way off for the simple reason that the rest of the world is dealing with their own problems and certainly cannot afford to have a crippled US economy.  That said a spike in interest rates could unravel this happy equation and reeling in the stimulus could have this effect as there will then be no false market to keep interest rates low.  On the other side of the equation continuing to print is unsustainable as the emerging economies can attest.  The answer could be to encourage saving but with interest rates at all time lows it is hardly conducive to encouraging savings.

This means that there is no easy way out of the hole that they have dug but as Will Roger's said, "When you find yourself in a hole, the first thing to do is to stop digging."  It is time for the Federal Reserve to own up to this fact and start to look at the problem through an eyeglass that portrays realism rather than speculation.

A Perfect Signal

"Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell."

"If you want to have a better performance than the crowd, you must do things differently from the crowd."

"The four most dangerous words in investing are 'This time it's different'." - All three are quotes from one of the world's best traders Sir John Templeton

In trading there are a number of keys to making money, a few of which are presented in the quotes above.  Traders are constantly searching for a signal that will give them an edge over their fellow traders and the market.  Using this edge they can amass a small fortune by timing the market and predicting the direction of the move.  In order to keep that fortune a high level of discipline is required to exit poor positions, but that topic will be left for another day. 

When a trader finally finds a signal that works he or she will protect that signal fiercely as once the word gets out, more and more people will use the signal and its value will eventually vanish.  Interestingly that does not mean that the signal is lost forever as once the signal losses its predictive value everyone moves on and, guess what, the signal will suddenly start to work again.  So traders spend their time trying to find signals that work, move on when they don't and circle back around to check old signals to see if they are "working" again.

So what if there is a signal that has worked remarkably well for the last 150 years?  I would think that you would take notice of that signal unless the signal has no economic merit.  I will explain this by way of an example.  The so called Super Bowl Indicator says that if the team from the AFC division wins the Super Bowl then the market will decline the following year and if the NFC team wins then the market will rally.  Now while there is a relatively high level of correlation between the team that wins and the following year of market returns, no-one takes this too seriously as there is no economic link between a football team winning a game and the stock market, it is just a happenstance!

Now what if the signal does have some economic merit?  Well obviously we would take serious notice of this.  So does the Skyscraper Index have economic merit and what is the Skyscraper index?  This index was first discovered in 1999 and has been providing a good indicator of economic recessions for over 150 years.  It turns out that every time a country decides to build a building that once completed will become the tallest in the world, it signals the beginning of a severe economic slowdown in that country.  The most recent signal was the building of Burj Khalifa in Dubai in 2008 right at the beginning of the worst financial crisis since the Great Depression.  Prior to that the Chrysler Building was built right at the start of the Great Depression and the World Trade Center was completed right on the eve of a recession.

So with this is mind it is a little eerie to see ground being broken on the Sky City building in Changsha China.  It is not hard to see that this signal may once again prove itself valid and point to an economic slow down in China.  Already their economy is stuttering and it will not take much of an exogenous shock to push it right off the rails.  So the question is should we take this signal with a pinch of salt or seriously, in other words does it have any economic merit?

While building a tall build in and of itself has no economic merit, the fact that it is the world's tallest does in fact have some merit for the simple reason that building a structure of this magnitude is normally a sign of economic ego.  The authorities are trying to show the world that they are financially strong and it is a signal that the underlying economy is burgeoning.  It is a show piece of economic strength.  The problem is that it takes years of planning to finally get a shovel in the sand and by that time economic euphoria has set in or is fading; just as is the case in China (see the quotes above as a point of reference).  This is the reason that the signal works.  These buildings are thought of at the peak of economic euphoria which is the exact time when caution should be taken.

Looking out a year or two I would not be at all surprised to see that this signal once again marked the time when the economy (in this case it will be China's economy) took a tumble.  The problem is that with China slowing down this could be a signal that marks the beginning of the next global recession.  Certainly not a time to be euphoric.

Speculate Like Its 1999

"I was dreamin' when I wrote this, Forgive me if it goes astray
But when I woke up this mornin',  Could of sworn it was judgment day

The sky was all purple, There were people runnin' everywhere
Tryin' to run from the destruction, You know I didn't even care

'Cause they say two thousand zero zero, Party over, oops out of time
So tonight I'm gonna party like it's 1999" - Lyrics to the Prince song 1999

 

For those of you who traded through the 90's it was a time when speculation was rife.  It was extremely easy to make a killing and many people did just that.  The problem was that once the party was over the market cratered.  Tech stocks were the hardest hit as their earnings were non-existent.  Stocks values were based on concepts and perception rather than solid fundamentals.  On top of this the rally was fueled by Greenspan money printing.  A lot of this money found its way into the stock market and the frenzy fed off itself until one magic day the frenzy stopped.  The party was over and the hangover set in.

 

Today is not much different.  Stock earnings ratios are nearing their highs of 2007 right before the last crash, bad news is ignored and the focus is on the 50 day moving average over fundamentals.  Will this magical line hold and if so the speculators will pile in once again blindly trading off this signal.  I would not be surprised if there is not another new all time high printed very shortly.  The problem as I have repeatedly mentioned throughout this blog is that all of this frenzy is being created by easy money printing and is not based on proper fundamental value.  As we have seen time and time again this will end poorly but this time it is different for the simple reason that never in the history of man has there been such a combined global monetary easing effort as the one currently being undertaken.  Moreover for all the effort there is no success other than a high flying market and a once burgeoning housing market.

 

I say once burgeoning housing market as the recent data points of housing starts and resale have slowed considerably for the simple reasons that house prices have rapidly become unaffordable to the masses and interest rates at 4.6% have put a lot of potential purchasers on hold.  To think that a rate rise to 4.6% can derail the housing market is a signal in and of itself as that rate is low by historical standards.  The fact that the rise to this level has caused buyers to walk from purchases points to a very weak economy and not something to be proud of if you are the Federal Reserve.

 

Furthermore the Federal Reserve as we have seen recently with the hiccup in the market at the announcement of the tapering of their purchases has painted themselves into a corner.  If they stop printing money bond yields will rise choking any growth and the stock market will dive into the abyss.  As these are the only two data points that show any kind of success losing control of these markets without a feasible plan of action in place will undermine the Feds credibility and place the economy in the hands of the open markets.  This is when the end will not be pretty as for the first time since the 90s the markets of the world will ignore the Federal Reserve and deal with the problem head on making the hangover of 1999 seem tame.  With Bernanke set on printing to the end of his term and then scampering off back to the bubble world of learning institutions the mess will have to be sorted out by someone else.  The problem is that the lineup all seem to be intent of blasting more champagne corks into the air rather than dishing out the pain relievers and hitting the gym!

The Rise of the Temporary Worker

"It is the working man who is the happy man.  It is the idle man who is the miserable man." - Benjamin Franklin

I could not agree more with this quote.  I have had a few times in my life when, for a few weeks, I was unemployed and by the end of that time I was miserable.  One time many years ago I finally found a job as a gardener in London in the middle of winter and even though it was bitterly cold and the work hard I enjoyed that far more than sitting idly in front of the fire.  This is the issue facing many Americans today, finding full time employment is difficult so more and more are turning to part-time employment and a number are giving up altogether.  This is having a huge impact on GDP growth in the United States and will continue to form a drag on the economy until there is a structural change that unlocks the unemployment conundrum.

Digging into the numbers reveals a lot of interesting data points.  The first is that the group that is worst off is the 25-54 demographic.  This age group is bearing the brunt of the problem.  In fact with over 7 million jobs being created since 2010, this demographic has barely seen an improvement in their employment level.  Interestingly, the over 54 demographic has enjoyed continued employment growth throughout and subsequent to the recession.  The problem for the economy though is that the 25-54 age group is the main consumer group.  The older generation is in saving mode as retirement looms while the younger generation is consuming as they buy houses and start families.

The jobs that have been created using a 7 year trailing average shows that the majority of the employment comes from part-time work.  In fact over 3 million permanent jobs have been lost and these have been filled by part-time workers.  This change in the status has been caused by many things but there is a study that points to this difference accelerating in lock step with the Federal Reserve's monetary policies and Obamacare.

Looking at the Federal Reserve's current monetary easing policy, they are reliant on the trickle down effect as the Federal Reserve has no control over where the money goes.  In effect they give dirt cheap money to the banks in the inner circle and relies on them to distribute these funds.  The result is there is a transfer of wealth and power to a lot of elderly bankers skewing the playing field in their favor.  The result has been a long period of prosperity for the 55 and older demographic particularly bankers and investment professionals who have a direct benefit from the asset appreciation of the stock market at the expense of the lower class and younger generations.  A burgeoning stock market it turns out does nothing to help the underemployed find work but it does allow the already entrenched manager retain their position.  What a surprise!

Worse still is that Obamacare has created turmoil in the small business world as it is far cheaper to hire a part-time worker than a full time employee for the simple reason that part-time workers do not require the company to pay for their health insurance.  This law has effectively slowed down the growth of permanent employment and once again has passed the cost of the insurance back onto the part-time employee.  A part-time employee now earns less and has the burden of health care loaded onto their already meager wages.  This is not a way to expand consumer spending.

Finally the problem is that with the increase of part-time employment comes the lowering of median household income and the loss of worker power.  Now some will argue that a loss of worker power is a good thing but as with all things there is a delicate balance between management and workers and this balance has skewed its way too far to the managers benefit and this is not a desirable outcome.  This is not a recipe for success as not only does this point to slow economic growth but the structural change will create an unstable political, financial and economic environment.  Unless this structural divide can be repaired quickly the result will be catastrophic and will affect the wealthy as much if not more than the less privileged.

With weak leadership in the White House and at the Federal Reserve there is little chance that the necessary structural changes will happen any time soon.  In fact when the Federal Reserve finally hinted at a tapering of the monetary policy the knee jerk reaction of the stock market had the Fed backtracking faster than Matter reversing in the movie Cars!  So we are stuck with a policy that is creating more and more problems with little in the way of change for at least the next three years.  Better hold on when the wolf finally comes knocking as he will not huff and puff but will send a hurricane through the living room.