The Tortoise and the Hare

The age old tale of the Tortoise and the Hare can be used as a metaphor for the dueling economic factions of Austerity and Monetization.  The Tortoise represents Austerity and the Hare represents Monetization.  As we all know the race is won by the Tortoise as the Hare, knowing that he is faster spends time bragging about his ability to win and even more time sleeping.  All this time the Tortoise slowly plods towards the finish line and even with a mad dash at the end it is too late and the Tortoise wins.  The picture above is even a better representation of the outcome of the economic factions not that I remember the Hare crashing over a cliff in the original story!

It appears that the austerity measures being taken across the pond in England are starting to reap some rewards.  GDP growth has returned and other metrics such as average housing prices, which reached a record high in June, seem to point to continued growth ahead.  At the same time government spending has been sharply curtailed which should result in a balanced budget and possibly a surplus in the not too distant future.  Of course all of this is based on continued buoyancy in exports and as those are tied mainly to the Euro zone this growth could be curtailed, but at least it appears that the pain taken early was relatively short and the result should be a healthy economy for an extended period regardless of exogenous shocks.

Europe, while still a basket case (particularly Spain, Greece and the other usual suspects), has continued down a path of relative austerity.  The pain felt there however was far more severe than in Britain but even so it does appear that barring some major financial crisis (read another mess exported from the United States, which is not a low probability event) that they will resolve their issues slowly and painfully but successfully.  Once again this all comes under the huge umbrella that they can somehow become a more cohesive economic union (which is seriously doubtful) but it does once again appear that recovery will be achieved and in a far more controlled way than that being conspired in Japan and America.

These two nations have tried time and again to take the "easy" route, bragging along the way that the tough decisions made in Europe and Britain are recipes for disaster and that the only way out is to print.  Similar to the Hare whose constant bragging about his speed led to the challenge and ultimately eating humble pie.  I have said all along that the methodology followed in the United States is a short term finger in the dyke solution based on the massive ego of the Federal Reserve and their ability to "mop up" excess liquidity when inflation rears its head.  They have never managed this in the past and have never printed so much money in the past.  Their track record does not speak to confidence in winning the race so hopefully they will take note of the green shoots in England and will reign in their speed before they reach the point of no return as the Hare has in the picture above. 

The End Of HFT?

"High-frequency trading, long an obscure corner of the market, has leapt into the spotlight this year. Wildly successful in 2008, high-frequency traders are the talk of Wall Street, attracting big bucks and some unwanted attention. Concerns that some traders are taking advantage of less fleet-footed investors has drawn the attention of regulators and members of Congress." - Scott Patterson of the Wall Street Journal

This quote, taken from the Wall Street Journal, was written only four years ago.  At the time HFT was the talk of the town and was attracting billions of dollars.  At its peak in 2010 HFT accounted for more than 60 percent of all the volume on US stock exchanges.  It appeared that it was just a matter of time before they took over the remaining 40 percent.  The worry was that these traders were going to make the flash crash look like a minnow in a shark's presence as when they market crashed (and it was sure to at some point), all of these traders would head for the exit at the same time potentially driving values to next to nothing.  So how is it that they are now in retreat?

First off let's get clear on what HFT is and how they make money.  HFT traders make money by arbitraging positions.  For example one of the first HFT traders used their ability to amass data from the market makers themselves prior to market opening.  Using this data they were able to determine the most likely direction of a stock's move at open before the market maker themselves could work it out.  In the few seconds after the open their computers would trade any shares where the opening quote was perceived to be marginally incorrect.  Once the correction was made they would then offload the position pocketing a small fortune off the small move.

Well back then this was revolutionary.  Within a few seconds and trading a spread of a few pennies billions were made.  This attracted a lot of attention and by 2009 HFTs traded roughly 3.3 billion shares a day and made $5 billion in profit but the spread was now down to a tenth of a penny a trade.  Once again the success of the strategy was their undoing.  By 2012 HFT trading was down to 1.6 billion shares a day and the spread had dropped to a twentieth of a penny.  Profits had dropped to $1 billion and the risk of the trade was increasing.  Furthermore in order to stay ahead of the competition HFT firms required faster and faster data feeds and this required being closer and closer to the exchange.  The exchanges themselves woke up to this and started to charge a massive premium for close access putting many a fund out of business.

The interesting point to me is that here is a classic example of the market at work.  Initially there was an opening and it was exploited for a massive profit.  This profit was produced as long as the spread existed but with competition the spread has been all but eliminated making it a better market.  With the lack of profit potential the funds are moving away and the threat has been reduced.  Fortunately there funds did not cause a massive sell off (although there were a few stocks that were hit temporarily) and the threat has improved oversight as authorities managed to keep abreast of the situation so it appears that the initial fear is gone and the market has sorted itself out without the usual government intervention.

Pity that this example is not used at the Federal Reserve who is bent on making sure that no pain is felt by creating a fictitious economic environment.  It would have been far better to have exited their assistance after the financial crises was averted and let the markets work themselves out but their continued interference has now created a massive problem and I am afraid that their lack of conviction and overly optimistic outlook will be their downfall.

TIPS From Gold

"We are at a wonderful ball where the champagne sparkles in every glass and soft laughter falls upon the summer air.  We know, by the rules of experience, that at some moment the Four Horsemen of the Apocalypse will come shattering through the great terrace doors, wreaking vengeance and scattering the surviving guests.  Those who leave early are saved, but the ball is so splendid that no one wants to leave while there is still time.  But some pause and ask "What time is it?  What time is it?"  Alas, none of the clocks have hands." - Lucky Christov

Treasury Inflation Protected Securities (TIPS) are bonds issued by the US Treasury.  The idea behind TIPS is to protect you against inflation.  The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index.  When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater.   Interest is paid twice a year, at a fixed rate.  The rate is applied to the adjusted principal; so, like the principal, interest payments rise with inflation and fall with deflation.

Protection against inflation is also sought in the precious metal market with gold and silver.  Both of these but particularly gold rise when inflation expectations rise.  So in some respect TIPS and precious metals move in tandem to one another and in lock step with inflation expectations.  As I have recently mentioned gold and silver have taken an almighty pounding recently.  Along with this pounding, TIPS have seen their price fall precipitously, so both of these investments point toward deflation.  The question becomes what happens to stocks in a deflationary environment and is deflation even possible?

The first part to the question is relatively easy to answer as every time deflation enters the door, stock markets dive off a cliff.  Deflation is the worst possible environment for stocks for the simple reason that not only do asset prices fall during deflation but it is incredibly difficult to get an economy moving once you enter the deflationary spiral.  Consumers shut their wallets as prices will be cheaper tomorrow than they are today so large expenditures are shunned.  This feeds into company earnings which remain lackluster and with this outlook stocks plummet.  For a simple example look once again at Japan whose market index the Nikkei sits at 14,500 down from an all time high of just under 40,000 more than 20 years ago!

The second part to the question is very tough to answer as it all depends on what you use as your gauge of inflation.  As I mentioned a number of blogs ago, inflation should almost be measured by each individual as we all have different inputs and price drivers.  This measure however will never drive markets.  What drives them is general consensus and this consensus comes from evaluating the TIPS and gold markets for clues and with both of these markets in the doldrums inflation expectations are teetering at critical levels.

Fortunately since the Federal Reserve recanted their earlier statements of slowing down the level of asset purchases these two markets have made a recovery (as has the stock market which once again made new highs this week), but it is worth keeping a close eye on these two indicators as you cannot have a falling TIPS price and falling gold prices without a collapse in the stock market prices.

Independence

"There is no more independence in politics than there is in jail." - Will Rogers

July 4th, 1776 was the day that America adopted the Declaration of Independence from Great Britain.  It was the day that the shackles of another society (Great Britain) were cast off and it was allowed to create its own laws, policies and government.  It was given a clean slate on which to craft its own unique society and from this emerged the constitution that has stood America in good standing ever since (although parts may now be outdated but that is a separate topic altogether).

Jumping forward to today we are lead to believe that the Federal Reserve is independent of politics.  The Federal Reserve was created to manage the economy independent of political influences.  Their job is to keep inflation contained and employment levels robust.  Now if they were truly independent it is hard to imagine that they would continue on with their current policies.  As I explained a couple of blogs ago, when they mentioned that they were going to slow down the magnitude of their money printing the market took a massive tumble and interest rates spiked. 

This spike in interest rates has had an immediate effect on the housing market which saw mortgage applications skid to their lowest level since November 2011.  Now I will not place all the blame of the housing weakness on interest rates alone as affordability of housing is headed in the wrong direction in a hurry as the price of housing continues to spiral higher at ridiculous rates but what is clear is that the markets of housing and stocks are both inextricably tied to the Federal Reserve's quantitative easing strategy.  Stopping will have the same effect as cutting the rope when a climber is hanging from it with the line being his only hope for survival.  On the flip of this if they continue on their merry way then there is no way to contain inflation.  All that is needed to ignite the inflationary fire is for the velocity of money to raise its massive head and all bets are off.

For the velocity of money to start up though you do need lending to improve and with housing going into orbit slowing mortgage applications and with the recent announcement that the banks need to add more reserves to their balance sheets, it appears that this will be held at bay for a little longer but between then and now what is desperately needed is an independent Federal Reserve.  The problem is that with Bernanke's term coming to an end it is clear that the long arm of politics is more interested in protecting themselves than they are in protecting the economy.  On the surface therefore it seems highly likely that Janet Yellen will replace Bernanke.  Now if you thought Ben could print I think Janet will take it to a new level however this in my mind will be the hair that breaks the camel's back.

China is already becoming a global economic super power and if the Federal Reserve continues on its way it will not be long before the dollar loses its status as the world's currency of choice.  Lose this status and printing money is no longer an option.  It is time for the Federal Reserve to re assume its independence and instill a policy that creates jobs and protects the economy as that is what is required but as this is not going to happen it is clear that the only option to protect your portfolio during the coming years is to load up with gold.  Gold always has and will continue to prosper during times of economic weakness and high inflation rates and with its recent pounding you have been given a great opportunity to buy so that you prosper once mud starts to fly.