"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.
Friday, December 27, 2013
Friday, December 20, 2013
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.
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.
Friday, December 13, 2013
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.
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.
Friday, December 6, 2013
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.
"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.
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