Looking Ahead

"Never make predictions, especially about the future." - Casey Stengel

As this is the last blog of 2015 it is traditional to look ahead to 2015 and see what the tea leaves hold.  As projections are notoriously haphazard and more often than not incorrect, take this blog as nothing more than tongue in cheek as if we seriously believe that we can forecast the future then we should probably be admitted to the hospital with the padded cells.  With that said here goes!

Oil prices to remain low.  My first prediction is that oil will continue to remain below the expected threshold of $85 a barrel in 2015.  This will be great for the consumer and will continue to provide the US economy with a much needed boost.  By the way this boost will be far more effective than the $4 trillion blown on asinine Federal Reserve money printing solutions and could make a real impact on the economy.

Interest rates will remain below 3% on the 10-year note.  Interest rates will continue to confound the experts who continually say that there is a bubble and that these have to go higher.  For all I know we could could easily see ourselves with a 10-year Note below 2% come year end 2016.

Deflation will continue to plague the rest of the world and will be of concern to the Federal Reserve.  I would not be surprised to see another round of quantitative easing in a vain attempt to reignite inflation but as the majority of the deflationary inputs will be from oil and technological advances, such an attempt will once again fail so it would be best if they kept their backsides firmly on their money printing fingers!

GDP growth will confound the experts and remain lackluster at less than 3%.  Even with the tailwinds of low oil prices and interest rates the consumer will continue to pay down debt rather than go out on a limb for the simple reason that the job market and opportunities will remain in the hands of large business and government which will continue to cripple the middle class thereby reducing spending and continuing the trend of slow growth.

Stock markets will continue their slow grind higher with more and more frequent knee jerk draw downs.  While it pains me to say it I cannot see (unless there is severe deflation which I doubt, or a black swan event which is far more probably and unknown) what will stop the spiral higher.  The only reason I am pained to say it is that I still believe that the higher it goes the more pain will be felt when things are revealed showing the economy to be less rosy than the current market multiples suggest, but for now it appears that the bull market will rage on.

Gold and silver need fear, greed or inflation to propel them higher and until one of those show up it may be a continued struggle for the metals.  That said I still believe in the long term outlook for them but until we get one of those three horsemen it may be one step forward and a knee jerk reaction back down throughout the year.  The gold price breaking below $1,100 an ounce is not off the table but improbable in my view.

So there you have it, my attempt at stabbing at an unknown enemy in a dark room the size of the titanic.  I hope that all of you have an excellent holiday period and I wish you all a very prosperous New Year, I am sure we can all use one!

Escape Velocity

"The U.S. can continue to improve, but can we lift off, can we attain escape velocity when the rest of the world is challenged?" - Mohamed El-Erian

With only 6 trading days left in the year it seems pretty safe to say that we will end the year in positive territory.  With interest rates at just above 2% on the 10-Year Note providing a good support for the market it appears that there is little reason to expect a 12% drop during some of the slowest trading days of the year, so I should be relatively safe in this prediction.  Looking to 2015 the question is can the United States economy blast out of the range of slow growth that it has been stuck in for the past five years?  Can it achieve "escape velocity"?

The term "escape velocity" is a reference to a rocket that is trying to shake the shackles of the earth's gravitational force.  If it has enough fuel and power to boost itself free then traveling through space, or in this case expanding the economy is far easier.  Since 2009 the economy has been sputtering along at sub 2% growth, however with unemployment dipping below 6%, interest rates at historic lows, oil prices 50% off their 2014 highs and with the hoards of cash sitting on company balance sheets it seems as if the rocket is finally primed for lift off.

The main issue is the drag that is the rest of the globe but there are others.  First off is the unemployment numbers which hide the inequality of income and the bulges of unemployment at the youth levels.  Furthermore the anemic growth in hours worked and payroll increases is exacerbating the problem and keeping consumer spending low. These numbers therefore do not accurately reflect the actual conditions of the labor market and explain why Janet Yellen is continuing to keep interest rates low even after the Federal Reserve's target unemployment rate of 6% was exceeded.

This inequality of income is exacerbated by the massive shift in wealth from the middle and lower classes to the top 3% of the country.  This inequality is solidifying the divide between small business and large companies.  The latter has access to capital and opportunities that small businesses are barred from and this is the reason for the slow growth in wages and the stubborn unemployment numbers.  Growth, as I have repeatedly mentioned in this blog, comes from entrepreneurs that create small businesses which in turn hire people creating a burgeoning middle class that buoys the economy.  Recent legislation and Federal Reserve policies have created this lopsided business environment and until the policies change this will result in continued weak growth.

That said the lower price of oil is definitely having a positive impact on the consumer so there is still a hope that growth can exceed 2.50% next year but with the slowing of Europe, Japan and China I would be highly surprised to see United States growth in excess of 2.00%.  While this may not be exactly what the doctor ordered at least there are continued signs of life and from where I sit when you consider the problems around the globe it is nice to be located in an economy that may once again lead the charge.

I wish all of you a very happy, safe and festive holiday season.

A Balanced Diet?

As the oil price continues to crater it is starting to have an impact on the market.  Oil stocks are dropping fast and countries that rely predominantly on oil exports are starting to feel the pain.  As an example Exxon Mobil is down 15% since August, the Indexes of Oil Refining and Oil Pipelines are also down 15% over the same period while the Oil and Gas Equipment and Services Index is down almost 50%.  This is having an impact on the overall market and when one considers that most analysts have factored in an average price for oil of $85 a barrel in 2015, the price of crude oil will have to make a dramatic recovery from its current price of $58 to set that bar in 2015.  If oil continues to spiral lower that number will have to be taken lower meaning that there is a lot more pain to be felt not only in the oil stocks but the oil producers.

Saudi Arabia has always been the most prolific oil producer in the globe, able to manipulate prices to suit itself and its OPEC friends.  The last time oil fell this far the Saudis cut supply and watched as their neighbors continued pumping oil and stealing market share from their generosity.  They have learned their lesson and this time around they have not taken the gloves off but have continued full ahead with pumping.  They can afford to as they have almost $1 trillion stashed away in foreign reserves.  The laggards of Russia, Iran and Venezuela are really feeling the pinch as none of them have this luxury.  Their currencies are now in free fall causing widespread inflation in their countries.  It is only a matter of time before there is widespread civil unrest in these areas and this will have global impacts but that is for another blog.

So it is interesting then that my trading has formed what I term a "balanced diet".  I have four long positions and four short positions.  The longs (investment that expect the price to rise) are Gold, Silver, 10-year Treasuries and Corn.  The first three are a direct result of the weakness being seen in the market and the rush for people to seek protection.  Gold and Silver in particular look like their day in the sun may return soon after a three year hiatus while Corn is benefiting from global demand and a perceived lack of the ability to supply.  Whether this works out that way we will see as with reduced crude prices comes the ability to plant more crops so this may not work out but only time will tell.

On the short side (investments that are expected to fall in price) are Crude Oil (still), Natural Gas, the S&P 500 and Copper.  All of these are pointing to a weakening global economy which is interesting as the fall in the price of Crude Oil should benefit global output.  Today the consumer sentiment numbers were published and they were the highest since 2002.  A large part to this is the benefit that the consumer is seeing in the reduced price at the pump and this is having a direct impact on their spending ability.  So with the double benefit of global growth and consumer sentiment you would expect the market to benefit but the current fear is that  the lower crude prices will pull the globe into a period of deflation.

Already Europe and Japan are struggling with deflation and even China and the United States are seeing inflation well below their respective targets.  Could the decades of fighting the inflation beast finally be the death of it resulting in the emergence of something far more sinister?  This is what concerns the market at present and this is why it looks like it will test its October lows in the not too distant future.  Maybe having a balanced diet is the answer - as long as it includes a few pieces of Hawaiian Fudge!

Year End Yawn

"Success breeds complacency.  Complacency breeds failure.  Only the paranoid survive." - Andy Grove

"There is no place for arrogance or complacency in racing because you are up there one minute and on your backside the next." - Tony McCoy

Year end is rapidly approaching and with the holidays it seems that there is a lot of complacency in the market.  This is understandable given the wild ride it has been in 2014 but as the first statement above shows complacency is often followed by failure.

Looking at the market the VIX (an index that tracks market volatility) is close to an all time low, gold stocks have continued their downward spiral and the stock market ticks higher daily.  It appears as if all market participants have finished their turkey, yawned and are nodding off.  January seems like a decade away but for those of you still awake you should remember this past January when the market was roiled almost 10% and it appeared that there was no end to the downward spiral.  Fast forward to today and outside of October the market has been pretty much a straight line up putting investors into a daze akin to autopilot with the subliminal message repeating in their ears from the Federal Reserve; "just buy the dips, just buy the dips, just buy the dips ...".

While I am certainly not predicting that 2015 will be the year of the bear, at this time in the year there is still the opportunity to exit positions using losses to offset profits.  Furthermore it could be a good time to readjust your investments to ensure that you either take advantage of the coming volatility or that your portfolio is protected.  For short term trades there are the volatility indices TVIX or on the gold side JNUG or NUGT while for longer term protection you can always look to long term put options on key positions if you do not want to exit the position itself.

From a technical standpoint it certainly appears as if gold and silver have one last hurdle to clear before breaking out to the upside and with all the short term negativity against the metals it appears that 2015 may be their day in the sun.  If that is the case I would expect a massive upside gain as they have been beaten down for the past 3 years to the tune of more than 70%.

The reason I bring this up is that with the end of year coming it may be time to look outside of technology and at industries that have been beaten down as these will be the ones that will produce the largest returns in 2015 plus they will provide downside protection.  Furthermore with quantitative easing over and the weakness that is being shown by the international community it seems likely that 2015 will be filled with volatility and all of the above positions will take advantage of this.  Just a thought before you let the sandman take control of your senses as waking up with a jolt in 2015 would be no fun at all.

Under Attack

"Invincibility lies in the defense; the possibility of victory in attack." - Sun Tzu

Today is a short day for the markets due to the extended holiday that is Thanksgiving and as I am taking the day off this will also be a very short blog.  But while it may be a short day for the markets and volumes are typically light it is very interesting to see the commodities markets under complete attack.  Oil is down almost $8 a barrel or more than 10%, Natural Gas is down more than 6%, Copper is down more than 3%, Gold is down $29 or 2.50% and Silver is down $1.20 or more than 7%; and this is all today!

This is an all out route and while Gold and Silver have not broken down completely yet, Copper has now confirmed a downside bias and Crude oil has now fallen more than 40% in less than 6 months.  The raw materials of Copper and Crude will feed into inflation numbers and start to exacerbate the issue of deflation.  Furthermore their continued weakness points to a global economy that may be completely out of gas regardless of what the central bankers of the world do, but their response will no doubt be to throw more money at the issue.  Interest rates will remain benign for a lot longer than anyone can imagine so finding places to invest your cash will be difficult.  Make sure that you do not chase yield as the risks inherent in a low interest rate environment are still the same (if not higher) but the yield is reduced.

Looking ahead it seems clear that the near term concern of deflation is very real and this environment is treacherous for stocks particularly for companies saddled with debt (IBM springs to the top of the list).  Be very cautious and try to bring your debt levels down to a minimum, build up cash and wait for the inevitable.

Happy Thanksgiving to all.

Mismanagement

"It's not the lack of money that kills our economy, it's the mismanagement of it." - TJ Anderson

In a follow on to the previous two blogs I had a very interesting infusion of thought from some of my readers and one in particular caught my attention.  The discussion was in terms of the size of companies and governments and how this impacts not only returns and ultimately causes the failure of the institution.  The question was is it really the size or is it mismanagement of the assets and in all honesty I believe that one is a factor of the other.  The larger the business or government becomes the larger the influence of political posturing and by default the larger the mismanagement of the assets.  There is less concern over shareholders or tax payers and more and more concern over personal payments and power, which ultimately leads to the company's or government's demise.

As an example investment and large banking institutions are so big that they are perceived as too big to fail.  This brings into account morale hazard - the hazard associated with the management's lack of accountability.  Should the bank fail then there is no impact to the management team other than a loss of their reputation and potentially their jobs (although in modern times it seems that losing the job is the best financial decision as there is usually a multi-million dollar payout to fire the person), but until then taking inordinate risks in order to maximize profits and their pay checks is the norm.  This bubble is protected by the central bankers of the world as they step in to sort out the problem should they cause an economic shock wave.  They are essentially playing with tax payer money so their personal risk is limited to the job loss while their upside is almost unlimited.  In this kind of environment the main focus is on developing new products that will maximize returns without a concern for the risks imposed.

The authorities are expected to monitor these risks and impose laws to regulate these enterprises but they are always behind the market for the simple reason that they cannot keep up with the new financial developments and derivatives that are dreamed up daily by the wizards of the financial markets.  While in the Bible the 12 apostles may have been enough to spread the word, there is no way that the 12 Federal Reserve Districts can keep ahead of the army of international bankers that test the limits and find holes in the system daily.  Furthermore, regulations take time to be implemented and by the time these are in place the market normally has moved on having anticipated the crack down.

The side effect is small business.  These companies have to operate under intense scrutiny, they do not have the resources to comply with all the new regulations that are supposed to keep large institutions under control but cripple their ability to operate, have limited access to investment dollars and are required to repay every dollar borrowed (unlike governments and large banks who just print more).  For this reason they are masters at working on a shoe string budget and remain lean and efficient.  Money lent to these companies is relatively risk free for the simple reason that the loan requirement is so small that if one business is lost the impact on the bank is small.  As Donald Trump explained once that if you borrow $1 million then the bank owns you, but if you borrow $1 billion then you own the bank.  Much the same with small business, while it is perceived that the risk to investing in them is high (and it is as many do not make it to year two, largely due to a lack of funding) the overall risk to the economy is low due to their small size.

The current system is therefore flawed in that not only is size the problem but there is no accountability for the actions of the large institutions.  One way to solve this problem would be to adjust the method of pay.  Instead of receiving a massive payment at the end of a good year it could be withheld for 5 or 10 years.  If during this time period the bank ran into financial problems caused by the risk taking at the time of the bonus award the deferred payment would be used to offset the losses.  In this way management might think twice about a risky bet to make a quick buck and may rather look out for the longstanding of the bank and its shareholders, not to mention the lowly tax payer!

The Problem with Size

"Likewise, government deficits are particularly concave to changes in economic conditions.  Every additional deviation in, say, the unemployment rate - particularly when the government has debt - makes deficits incrementally worse.  And financial leverage for a company has the same effect; you need to borrow more and more to get the same effect.  Just as a Ponzi scheme." - Nassim Taleb "Antifragile"

As a follow on to last week's blog on Keynes, this blog will look at the other side to the argument which is normally based on the theories of the Austrian economist Ludwig von Mises.  Mises concluded that printing money would never work for the simple reason that not only does more debt not solve the problem but unless you have the ability to clean the balance sheet up at a later date that every incremental increase in the level of debt from printing money out of thin air has a smaller and smaller impact on outcome.  At some point in the future the amount of money required to have any impact is so large that the system collapses.

The issue is that the initial benefits are perceived to be linear rather than concave.  On the surface if some money issued into the economy produces a decent effect then more must produce a larger effect in a linear fashion or a straight line - the more you add the more you receive in economic growth.  This is a common fallacy and one that is truly debunked in the book Antifragile by Nassim Taleb.  (Once again if you have not read this book then you really need to - or keep reading this blog as I will continue to beat the drum for him).

Size is the issue.  As an example if everything was linear in the risk world then taking 50 jumps off stairs each one foot high would be the same as jumping off a 50 foot building.  Obviously the impact on landing from the 50 foot jump would be far more severe (if not fatal) to the jumper than jumping one foot 50 times.  The same can be seen in a mound of sand.  You can keep adding bucket after bucket of sand but at some point the whole pile will collapse.  That last grain of sand is all that is needed to dismantle the entire work of all the previous buckets that were piled on top of each other.

This philosophy can be used to show how size can destroy governments and businesses alike.  Looking at the market the large banks are a big issue as if one goes they all go and the economy is gone.  Lose a small regional bank and no-one is the worse off other than the few people that worked there.  The FDIC can easily handle paying out depositors their funds and all goes back to normal quickly.  If Bank of America goes under the problems are huge and the impact on the economy enormous.  The theory goes that the government can and will step in to repair the damage but they are already leveraged to the maximum and are possibly the most inefficient group available to manage the problem.

Think about small business.  Things get resolved quickly, there are no political debates or posturing (not always but mostly and if it is rife the business will fail) and new products and services are added quickly to take advantage of an opportunity.  On the other side of the scale is large business which while able to take on global issues always sees the profit margin fall and the efficiency drop until there is a tipping point where the company size is ultimately its undoing.

The same for governments.  The bigger they become the harder it is for them to shrink to a more manageable and efficient size.  Feuds are rife and bureaucracy fosters inefficiency as the more inefficient you are the larger your budget and the more power you control.  Become efficient and your budget and your power is cut.  So the thought of a smaller efficient government that balances a budget is akin to asking a child if they would like another candy.  Of course they would and of course the government size will continue to grow.  The only time governments are reigned in is during times of crisis when they are forced to do their job and many lose theirs in a change of the political system.

Now last week I said that Keynes' theories of printing money and providing fiscal stimulus would work and it appears that I am now saying that they will not so let me clear that up.  I believe that Keynes' theories would work if they were all done at once (money printing, shovel ready projects and tax reductions) and that once they were seen to stimulate the economy that the government would efficiently clean up their balance sheet and trim its size.  In business language, push the product with marketing and then cut back to make sure that the profits flow and the debt level is paid down or off.  The problem is, as I have detailed above, that the government will not balance its budget, nor will it cut its size and it is not using all three of the legs of the stool but only one or maybe two.  Under this scenario the results are concave (see image below) in that the benefits are felt early but ultimately they are doomed to failure, it is just a matter of time.

 

Keynes Rules!

"The importance of money flows from it being a link between the present and the future>" - John Maynard Keynes

In an article in Business Week Keynes was listed as "The Man of the Moment".  Keynes died in 1946 but his economic theories live on.  He was the first to promote the idea of fiscal and monetary policy as a solution to economic turmoil.  To summarize his ideas he said that during good economic times governments run surpluses and these surpluses should be spent during times of economic weakness to take up the slack from a weakened business environment.  Using both fiscal (tax cuts and spending on shovel ready projects) and monetary (printing money and lowering interest rates) an economy can be stimulated.  Once business picks back up the government can exit the market and recoup their investment through increased tax revenues.

It appears that the world's central bankers (German's aside) are bent on giving Keynes's theories one massive try.  The interesting thing to me is that his theories encompass ALL of the aspects of stimulus not "some" of the inputs.  Looking around the world then it is clear that while on the surface his principles are being used to "stimulate" the global economy when you dig deeper there are a number of things amiss and these missing pieces are undermining the efforts.

First let's take a look at Japan.  While the world applauded their most recent money stimulus and government spending packages they failed to mention that Japan has already raised the consumption tax and is planning to raise it again.  According to Keynes tax reductions are needed in addition to these other stimulus's and so while Japan is using two of the inputs the third is offsetting any perceived benefit.

Europe, the laggard of the group is barely using any stimulus other than monetary.  The Germans are even against that but the problem is that fiscal policies remain under the tight constraint of the Eurozone parameters.  This makes it near impossible for any of the countries that fall under the EU umbrella to stimulate beyond some monetary stimulus that they receive from the central bank and even this stimulus is becoming increasingly difficult to achieve.

The United States has definitely been the shinning star in terms of monetary policy having printed more than $4 trillion.  However on the fiscal side there has been little in the way of shovel ready projects and the tax burden being felt by individuals and businesses is massive.  Not only are the tax rates higher but with Obamacare in full force the cost of keeping full time employees is growing and is akin to an additional tax.

The final problem is that virtually none of the countries have had a budget surplus in decades (other than Germany).  They were all in a hole before they began printing money and are now in an even bigger one.  Furthermore the thought of them ever being able to balance their budgets seems impossible.  The United States as an example has not only a huge deficit to fill but with Social Security and Medicare kicking in the chances of a balanced budget are slim to none.

So while it appears that Keynes rules the day, unfortunately his ideas are really nor being followed as if they were I have to believe we would be out of this mess instead of digging a deeper hole each and every day.

Dead Man's Party

"It's a dead man's party, who could ask for more, everybody's coming leave your body at the door, leave your body and soul at the door." - some of the lyrics to Oingo Boingo's song Dead Man's Party

Its Halloween today, one of my son's favorite days (he is Sherlock Holmes today), so I had to look up the origin of the day and it turns out as usual there is much debate on this topic.  What is agreed upon is that it initiates the triduum of Allhallowtide which is the time in the liturgical year dedicated to remembering the dead.  As spooky and scary is the theme of most Halloween parties I find it amusing that the scariest game in town right now are the global markets and by markets I am not just referring to the stock market I am including the commodity markets as well.

As of this moment the S&P 500 is breaking to new all-time highs, gold and silver are down 5.7% and 8.0% respectively in three days, oil has fallen more than 20% this year (a bear market) as have corn and soybeans, housing after an initial rally has seen its luster fade; all this while interest rates hover at multi-year lows.  Fortunately I am completely agnostic to market movements so while I continue to prosper I can feel the workings of something larger than what appears on the surface lurking around.

Certainly with the price of oil and the grains falling it should relieve some of the stress on the consumer.  I have to say that I am rather enjoying gasoline at $3.40 a gallon down from almost $5.00 a gallon a year or so ago.  Business also seems to be picking up in most of the sectors that I am invested and overall 2014 is turning out to be a fairly good year for me so I am not complaining in the least.  The Federal Reserve ended its quantitative easing this month and the stock market, rather than implode, is making new highs.  Conventional wisdom it seems is out of the window as $4 trillion of stimulus has not produced inflation (in fact there is even talk of global deflation), the dollar continues to strengthen daily and interest rates are still exceedingly low.  How is this even possible or are we at a dead man's party?

Never in the history of the globe has such a large amount of financial stimulus been tried and I am certain that the Federal Reserve officials are patting themselves on their backs right now.  History seems to have been defeated and a new era of economic prosperity is upon us, or so they would have us all believe.  What I will say is that for now it does seem to be working but while they have said that quantitative easing is over they are still stimulating the economy to the tune of $40 billion a month (roughly) in that they are not letting their balance sheet shrink.  As they have a $4 trillion investment portfolio of debt roughly $40 billion is maturing each and every month and for now this is being reinvested.

With Europe still extremely weak, Japan in trouble and China slowing down it is no wonder that the dollar is charging.  This is more a factor of external global weakness than a celebration of the economic policies of the Federal Reserve.  It once again appears that there is time to reduce their $4 trillion portfolio and to me they should take this opportunity.  The reason that they will not is that the labor market is still weak and there are fears that the rest of the world will export deflation.  While I can understand these concerns I believe that it is more important to take the opportunity to put some powder back in the barrel for another time as it will come and then it would be nice to have something to fall back on.  For now though let the dead man's party roll on, what do you say my dear Watson?

Paradise

"He that does good for good's sake seeks neither paradise not reward, but he is sure of both in the end." - William Penn

It is another perfect day in paradise here in San Diego.  We have not had a day with temperature below 70F since May 27 and today is no exception.  It will be total shock to the system when we have a day that breaks this streak and last night I had to actually pull a very light blanket on the bed around 3 am as it was a touch chilly!  While this is all happening there is a growing problem - lack of water.  Starting in November water restrictions will be in full force and this will impact many everyone from farmers to people watering their yards.  As I look outside my window I can see massive digging equipment and trucks that are laying the pipeline for San Diego's desalinization plant water pipe so something is being done to alleviate the stress of the low water table but there are plenty opposed to the idea.

As these thoughts wander through my brain I am drawn to conclude that the stock market is much the same.  On the surface everything seems absolutely perfect.  The pesky volatility of last week has been replaced with "business as usual" as the market recovered most of the losses this week.  In a meeting I had last night I was informed by the lieutenants leading the investment sales charge for some large institutions that all was good and that 18,000 on the Dow Jones Industrial Average was only a matter of time and could even happen by year end!  That would be roughly 1,300 points higher from here or roughly 8% rally in two months.  Reasons given for the rally to continue were that the economy is out of the woods, unemployment is falling, businesses are making a lot of money AND don't forget that it is the only game in town!  With most individuals ignorant to the risks and believing this pitch is in no wonder so many lose their shirts in the market.

Taking a look at a chart of the market and it certainly looks like it could move that high in that short amount of time, so who am I to argue?  The reason that I am not in the stock market is because I have always felt and do so now even more strongly that the current policies that have ignited the massive run in the market are the same policies that will be the undoing of the market.  While I agree that some headway has been made, the amount of headway (or lack there of) is minimal for the amount of money that was thrown at the problem.  The reason for the lack of headway is the same reason that is undermining the market's future and that is every dollar used to support the market is a wasted dollar and the impact of that dollar on driving the market higher becomes less and less with every new dollar printed.  At some point the market will wake up to the fact that the whole thing is a fictitious game and will implode.  Does this happen tomorrow or in a decade, I cannot tell you but what I do know is that there are alternatives in which to invest (which is what I have done) that are outside of the risk of the stock market and that should benefit from a market correction while continuing to produce great returns in the interim.  Unfortunately the arm of sales people continue to promote only stocks and bonds and so most will be impacted by the unwinding of the great Federal Reserve experiment.

So to me the market is akin to San Diego's weather, on the surface it seems perfect (a direct line to infinity) but rain (volatility and a decent correction) is needed badly to right the situation.  The problem is that investors are being sold on the idea that it will never rain and if it does that they will not get wet (they will either get out in time or the Federal Reserve will save them).  Unless you are 8 years old and still believe that you can dodge rain I am here to say that if you are exposed to the stock market your chances of not getting wet are slim to none and once again you are being sold down the river as there is no magic here and the reality will hurt.  Take the time to turn to alternatives, you will be glad that you did.

Volatility - Good or Bad?

"Well you see Norm, it's like this. A herd of buffalo can only move as fast as the slowest buffalo.  And when the herd is hunted, it's the slowest and eakest ones at te back that are killed first.  This natural selection is good for the herd as a whole, because the general speed and health of the whole group keeps improving by the regular killing of the weakest members.  In much the same way, the human brain can only operate as fast as the slowest brain cells.  Now, as we know, excessive intake of alcohol kills brain cells.  But naturally, it attacks the slowest and weakest brain cells first.  In this way, regular consumption of beer eliminates the weaker brain cells, making the brain a faster and more efficient machine.  And that, Norm is why you always feel smarter after a few beers." - Buffalo Theory as explain by Cliff Clavin of the television show Cheers.

As we have all noticed the volatility in the stock market has increased dramatically in October.  At one point the market had fallen more than 8% in less than a month and yet today it appears that the rally is still intact.  With one day down the next up and most days with moves of more than 1% it is enough to scare anyone, the question then is what is this volatility telling us and is it good or bad?

Life is full of volatility; the daily ups and downs not to mention illnesses from which you recover or challenges that cause stress all normally result in a stronger individual both physically and mentally.  Some time the volatility is so intense that the person never recovers but these cases are relatively rare.  In general the human race has evolved by taking on the challenges of volatility, learning from these challenges and becoming stronger.  As 21st century humans our bodies are immune to many diseases that killed many people in the early 1900's simply because nature passes along the antibodies from previous generations.  Furthermore the volatility caused by new diseases has resulted in many medical breakthroughs along with significant improvements in cleanliness and treatment processes so for all intents and purposes volatility in nature is a good thing.

Turning to the economy it is human nature to try to smooth out volatility.  The Federal Reserve is hell bent on giving businesses a smooth ride and making sure that everyone has jobs all the time.  This goal unfortunately has the side effect of increasing the volatility.  Certainly there are periods when volatility remains under control but this provides a false sense of security.  During these periods businesses and individuals assume that the smooth ride will continue forever and invest accordingly.  Risk is perceived to be insignificant so ever larger bets are made based on the false perception.  For this reason when the dam wall breaks there is an increased level of volatility for which hardly anyone seems to be prepared.  The lack of preparation creates significantly more volatility as companies and individuals are forced to exit investments en mass creating a route that is far larger than it would have been had the market been left to its own devices in the first place.

By removing the normal levels of market volatility there is increased stress on the system and hence there are major market collapses.  Given the mantra of central bankers across the globe to erase volatility and given the large amounts of money being pumped daily into the globe by central bankers in an effort to calm volatility it is clear from the recent market gyrations that not all is healthy and that we may be in for a long period of turmoil.  One thing that you can bet on is that the authorities are not going to stand aside and let volatility rear its ugly head without trying another futile round of quantitative easing.  They will return with a "new" quick fix program, one that will create a bigger explosion at the end of the line.

For now however enjoy the fact that the United States markets are (at least for the moment) being left to their own devices and as you can see lower may be the order of the day.  That said I would not be surprised to see the Federal Reserve step in once more if we enter a proper correction which is a mere 5% lower from here.  The problem is that this support is futile and does not provide jobs but will create an even larger problem in the years ahead.

Yeee Ha!

"If you think bull riding isn't intense, come sit on his back and try on my saddle.  This ain't for tenderfoots." - Clancy Jean Driscoll

With volatility picking up this week it is like riding a bull in the rodeo.  With 3 days of the past four (today has yet to really begin) and 6 of the past 8 having more than a 1% up or down day things are really rocking.  Volatility of this sort has not been seen in a while and shows a struggle between the bulls and the bears to establish domination.  The bulls are not going to give up without a fight and the bears expect a correction as the Federal Reserve's safety net has been removed.

Who will win is anyone's guess but if the past is any indication each time the Federal Reserve has removed the safety net the market has corrected at least 10%.  Each time this has happened they have stepped back into the arena to print more money and support the market.  The question is will they do it again and I have to believe that if there is a correction of that magnitude that they will.  Housing is still in the doldrums and although unemployment has fallen below 6% (according to the Federal Reserve) most Americans still feel like they are in a recession.  So the only metric that is working in the Feds favor is the meteoric rise of the stock market and I believe that barring any unforeseen circumstances that they will try to prop that up one more time.

The question is then how do they ever exit the quantitative easing strategy without there being any pain?  The answer of course is that there is no way out without causing some if not a large amount of pain.  The problem is that the American people vote with their wallets and so any pain will result in a change at the top and with an election year coming right up it will be interesting to see just how independent the Federal Reserve is.  Once again, if the past is any indication they will bend to the politicians but at some point this lunacy of printing money has to stop and as in all cases the sooner the better.

Its All About the Jobs

"Its a recession when your neighbor losses his job; its a depression when you lose your own."- Harry S. Truman

Today the market is recovering some of its previous week's losses on the back of some heady employment numbers.  The headline unemployment number fell to 5.9% finally breaking the 6% barrier and the underemployed number fell to just below 12%.  Both of these numbers are encouraging as more people employed means more wages and therefore more spending power for the demographic that makes up roughly 70% of United States GDP.

Increased employment numbers however do not necessarily lead to more consumer spending.  If the hours worked per employee fall or if wage rates fall then this can offset the growth in labor but fortunately both of these metrics improved.  Average number of hours worked per week increased to 34.6 from 34.5 and aggregate earnings increased 0.5%.  These are hardly numbers to get too excited about but at least it does point to increased consumer spending in the coming months.

The only fly in the ointment (and it is quite a big one) was that of the 236,000 jobs gained in the private sector 97,000 came from a decline in the labor force.  What this means is that more people gave up looking for work and non of the discouraged workers (those who have given up looking) came back into the labor force.  Had this number remained the same the unemployment number would not have moved.

So once again while the market celebrates the gains in unemployment the underlying current is continued slow growth.  Fortunately the United States is growing (unlike Europe) but I doubt that these numbers will affect the Federal Reserve's policies and I would be surprised to see any movement in interest rates in the near term, something that the stock market may continue to celebrate for the rest of the year.

Japan in Jeopardy

"Ingwa wa, kuruma no wa." (Cause and effect is like a wheel) - Japanese Buddhist Proverb

Japan was once the marvel of the globe.  Their efficiency and manufacturing prowess was revered and Japanese companies morphed from obscurity into global power houses.  Japanese executives were seen trolling the globe armed with fists full of Yen and the desire to snap up buildings and companies around the globe.  The Japanese stock exchange reached an all time high of 38,915 in December of 1989 and it seemed as if the Japanese were invincible.

Fast forward to today and Japan is in a world of hurt.  The current administration under Shinzo Abe is fighting deflation and slow growth with.Mr. Abe's economic stimulus plan, Abenomics consisting of three measures: monetary easing, fiscal stimulus and structural reforms.  These measures were expected to repair Japan's economy through quantitative easing strategies similar to the United States, spending to stimulate private investment and structural reforms to make the market more open to new businesses and improve labor policies to reduce the reliance on welfare and make the labor market more flexible.

After a year of actively pursuing the first two strategies the results are anything but stellar.  The effect of quantitative easing has been to devalue the Yen by more than 25%.  While this was the intended effect the results were not as expected as exports have not flourished as they have in the past.  Normally when a currency devalues it promotes exports of local products as they become cheaper on the international markets.  As Japan relies heavily on exports, devaluing the currency has been a quick fix to stimulate the economy however this time around the effect was muted by the fact that a large majority of exporters are building their products off shore.  The result is that Japan government debt has rocketed to more than 220% of GDP and this is creating a new set of problems.

At the present level (and growing) debt service payments are more than 25% of the government's annual budget and this is with interest rates at essentially zero.  Even a small rise in interest rates to say 2% would effectively make the government insolvent as the tax receipts would not cover the debt payments.  In an effort to stem this tide Japan raised its consumption tax from 5% to 8% in April.  The result of this move is that the country's economy declined at an annual rate of 7.1%.  While many believe that this trend will reverse in the current quarter there is another round of consumption tax increases expected in October 2015 so it would not surprise me to see consumption stay down for an extended period.

Another side effect of the weakening Yen has been to hike the cost of base goods like electricity.  With the loss of a large portion of the country's nuclear power and the aftermath of concern following the Tsunami and the radiation leaks Japan has come to rely more and more on natural gas powered plants.  As Japan is not a gas producer this gas is imported but with the price of natural gas tied to the USD the Yen weakness has resulted in a spike in the cost of producing electricity.  These price increases are being pushed on to the Japanese consumer who is now paying 28% more for their electricity than they were four years ago.  Between this squeeze, consumption tax increases and lackluster pay increases it is no wonder that the consumer is closing their wallets.

So the only arrow left in Abe's quiver is to change the country structurally.  The problem with structural reforms is that they do not happen overnight and Japan needs something to happen quickly as time is running out.  Amazingly through all of this the Nikkei is leaping to 6 year highs on the back of some stellar company earnings courtesy of the weak Yen but if the structural problems facing Japan are not sorted out these highs may soon be distant memories much like the high last printed 25 years ago.  While all of this seems to be unrelated to the United States consumer, one need only look at the issues that arose out of Europe's mess to see that any significant problems in the world's third largest economy would be felt around the globe.

China's Ascendancy

"Open sesame!" - Alibaba and the Forty Thieves

Today marked an historic occasion as Alibaba's stock was listed on the New York stock exchange.  It marked the largest IPO ever raising the company more than $21 billion and valuing it at more than $220 billion.  The shares opened up more than 40% making Ma, the founder, China's wealthiest man.  Talk about "Open Sesame"!  To think that he started the company in 1999 in his house while teaching English as a school teacher makes the story even more remarkable and even more like the original story (he was a poor woodcutter who found an entrance to a secret cave where thieves hid their loot; the words Open Sesame unlocked the cave entrance and access to a fortune).

What also interests me is that this Chinese company not only eclipsed the likes of Facebook and Amazon but it shows China;s ascendancy into a technology superpower that more than rivals the United States.  Furthermore it shows just how important a large population and rapidly expanding middle class can be to local companies.  The company boasts more than 220 million active buyers using its platform and it now has plans to expand its services and platform throughout the rest of the world.

He will now use American money to expand internationally taking on Amazon, EBay, Google and others while these companies face massive government intervention in their efforts to expand throughout China.  So the protectionism that China has for its companies has worked in that they are now becoming global players but at what point in the future will the walls blocking free entrance to China be removed so that there can be a level playing?

With the Chinese flag flying in front of the NYSE today it appears that greed trumps everything but to me it also shows that business and economic freedom can supersede political squabbling.  It is now time for the Chinese to allow foreign businesses to operate freely throughout China but in order to achieve this we have to turn to the politicians to hash out an agreement.  While this will take time and will come with a large amount of baggage and distrust, until things can be ironed out I will continue to marvel at the greed that is American investment banking but hopefully Alibaba can use the magic words to open the gates to free competition.

And We All Go Down Together

"Money cannot buy you happiness, but it does bring you a more pleasant form of misery." - Spike Milligan

"The only people who buy at the lows and sell at the highs are .... liars." - Baruch

"The investor's chief problem, and even his worst enemy, is likely to be himself." - Benjamin Graham

Part of what I do on a daily basis is trade the futures and commodities markets.  While I do not trade in all of them I do trade a wide variety namely crude oil, natural gas, S&P 500 Index, Gold, Silver, Copper, Corn and Soybeans.  I do not trade currencies as the government manipulation (and I am not just talking about the US government but all of them) makes it too difficult to predict a trend and for the time being I have stayed out of the financials market.  My trading style is agnostic as to the price direction.  I am just as willing to short a market as I am to buy it which serves me in good stead regardless of market directions.

The trading philosophy is based on my proprietary algorithm which spits out signals which I use to enter or exit trades.  These signals are not influenced by CNBC or any of the other squawk boxes and therefore provides signals that can sometimes seem counter intuitive.  Needless to say the system works incredibly well and has provided an excellent rate of return for me over the years. Now the reason I bring all of this up is not to pat myself on the back but to alert you to something very interesting.

Starting at the end of July the price of crude oil began to fall.  At the time going short crude oil with all of the world's crises (particularly in Russia and the Middle East) seemed completely the wrong direction but as it was a signal and rule one is to obey all signals, I sold short a position in crude.  Right behind that came a short sale in Soybeans followed by Silver and then Gold and then Copper.  Furthermore the long position that I had in the S&P 500 was stopped out (meaning that the price fell sufficiently to trigger my sell signal) and since then the market has continued to slid lower along with all of the above commodities.

It is not since 2008 that I have received so many sell signals all at once and while the market is still a while away from another sell signal it certainly seems to be heading lower.  One thing to remember is that these trades are normally pretty short term and they can turn in an instant which is why I do not normally post anything about trading but when everything starts to go down together it is a real eye opener and so for this blog I thought I would alert you as to my current findings.  Whether this is the beginning of a decent market correction or just another short term trend is unknown but one thing I do know is that until these markets can turn around it is not looking to good for the stock market.

It is also interesting to note that the bond market has also been falling all month.  Normally in these types of markets you would see bonds rallying but with the Federal Reserve starting to talk about inflation and possibly raising interest rates even this safe haven is leaking.  This rise in interest rates is starting to have a negative impact on the housing market but it is too soon to gauge whether this is a secular move or just a slow down before winter.  Only time will tell.

As I mentioned in last week's blog a lot of these moves are being caused by the meteoric rise in the dollar index and while that has taken a breather this week it appears that it has done a lot of damage in a very short time.  The export of weakness from Europe, Japan and China is being felt in the United States and we will see if it feeds into the results of the S&P companies but I would imagine that it will in the quarters ahead unless there is a sudden reversal of dollar strength.  So at present, unless you are short pretty much everything it certainly appears a time to keep your head down and your eyes on the dollar.

Deflation Rears Its Head

"The catastrophic destruction of wealth that began in January 1990 has left assets, equities and real estate mainly deflated against a mass of liabilities that are mainly bank loans." - Carl B. Weinberg

This week the European Central Bank (ECB) announced that it would aggressively tackle the deflationary problem that is plaguing Europe.  As can be seen by the chart below Spain and Greece are already in a deflationary spiral with Italy barely positive.  Europe as a whole saw inflation at the lowest level in 5 years with a reading of 0.3% so the ECB cut its Refinancing Rate to 0.05% and its Deposit Rate to -0.2% (that is not a misprint it is a negative interest rate - essentially you are charged for a deposit).  They will also begin to purchase Asset Backed Securities at a rate of $14 billion a month in an effort to stave off continued deflation.

So what impact will this have on the rest of the globe and particularly the United States.  First off I would be highly surprised to see US interest rates move higher.  With the dearth of European capital looking for a home and the United States 10-year Treasury at 2.40% it is the best buy in town.  In contrast the yield on the German Bund is 0.96%, Switzerland is 0.48%, France is 1.29%, Spain is 2.13% and Italy is 2.32%.  Would you really want to take on the risk of Spanish or Italian debt over the United States?  This demand for yield has driven the dollar to 52 week highs.  While this strength is inevitable it will cause some issues for US exporters and this should result in a slow down in United States GDP.

Furthermore the rise in the dollar and the deflationary spiral of Europe are weighing on commodities.  As most commodities are priced in USD an increase in the value of the dollar means that the price increases in Europe and other countries.  Increased prices means less demand and less demand is showing up in the price of Gold, Silver and Oil, all of whom have fallen more than 10% in the last few months.  While this will keep the lid on inflationary pressure in the United States there will be some worry that Europe will export deflation and for this reason I find it highly unlikely that the Federal Reserve will raise interest rates any time soon and they may even consider another round of quantitative easing.

The reason for the massive fight against deflation is that economies run on the premise of economic growth and asset appreciation.  As the economy grows so the demand for goods and services increases and this results in price inflation and asset appreciation.  It also results in greater profits and higher wages and with this comes wealth creation and once again more expansion and inflation and so it goes.  Now if you have price contraction or deflation then consumers are not interested in buying goods and services as the price is lower tomorrow.  With the reluctance of consumers to buy comes a contraction of GDP and a fall in asset values as the demand wanes.  With the value of debt set and the underlying asset value declining the result is another wave of defaults, layoffs and so it goes.  Under this deflationary scenario it is extremely difficult to stimulate even using negative interest rates for the simple reason that prices may be falling faster then the negative interest rate plus you can keep you money in cash removing the impact of the negative rate.  With asset prices falling investment is shunned so stocks, properties and other hard assets take a beating.

For now this is predominantly a European problem but as you can see it can easily be exported and some of the effects are already showing up in the United States.  These initial benefits (lower prices at the gas station and minimal inflation) create a small windfall but if this windfall does not translate into job and economic growth wallets are soon shut.  So for now the United States is enjoying the reprieve of price pressure which is allowing the Federal Reserve to stay its course of cutting stimulus without the worry of interest rates rising but unless the ECB can reign in their problems we may soon be receiving another unwanted import.

Wealth Creation without Student Debt

"The higher the amount you put into higher education, at the Federal level particularly, the more the price of higher education rises.  It's the dog that never catches its tail.  You increase student loans, you increase grants, you increase Pell grants, Stafford loans, and what happens?  They raise the price." - Bill Bennett

"I would get my student loans, get my money, register and never really go.  It was a system I thought would somehow pan out." - Ray Romano

"By making college unaffordable and student loans unbearable, we risk deterring our best and brightest from pursuing higher education and securing a good paying job." - Mark Pocan

There is a lot of debate going on over the massive $1 trillion student debt that hangs over the heads of all demographics in the United States.  This is not a unique situation as global student debts are rising rapidly.  There is a concern that this debt level is stunting economic growth as these people struggle to afford to purchase houses, cars and other items that are required to stimulate the economy.  Removing this debt, it is thought, would have a massive economic benefit because unlike other forms of debt, student loan debt is unable to be written off through bankruptcy (there are some cases where some of it can be eliminated but for all intents and purposes it is there until paid back).

The issue is that with the government providing loans to almost anyone, more and more people can pay (not necessarily afford) to be educated so the schools are able to continue to raise the cost of education without impacting enrollment.  Think about it, if you own a school and you have 100 seats available but 5,000 applicants one way to reduce the number of applicants is to raise the fees until you are left with with only 1,000.  From this group you can pick the top students keeping your standards high while increasing your profits significantly.

If governments stop intervening in the school process then school fees suddenly are left to the free markets.  Loans would be far harder to come by, student enrollment would drop and schools would be forced to reduce fees.  This is a very simple but effective method of taking care of the price of education but what about the students that now do not have access to higher education?

In a very interesting spin on this studies have revealed that higher education does not create wealth but rather hinders wealth creation.  Now this flies in the face of consensus which says that the way to prosperity is to get educated.  Furthermore this is also the drum that is beat by universities around the world but considering the source of the drum beat questioning it is probably valid as academics are experts at creating formula and science to fit previously created conclusions and calling it their own.  In the business world there are too many examples to name but a few that spring to mind are Bill Gates of Microsoft, Steve Jobs of Apple and Mark Zuckerberg of Facebook, none of whom finished their formal education, all of whom have created significant wealth.  In an aside Bill Gates received an Honorary Degree from Harvard once again showing how the academic world loves to take credit where none is due.

Now while schooling is required to become a professor, lawyer, engineer or a doctor the question that needs to be asked is does this create wealth and is there another way outside of a formal schooling to get you where you want to be financially?  It turns out that most of the really successful people in the world relied far more on a mentorship or apprenticeship program than on any formal education.  Thinking back to my formal education I have to say that there were plenty of classes that were of absolutely no value to my education, in fact I could point to a few classes that were beneficial but those could all have been taught in a few months rather than three years.  The expertise and skill I have derived have all been post college and I would expect that for most of us it is similar.  Take accounting for example, do you really need a degree in accounting to learn your way around a spreadsheet or a financial statement?  Business is the same, do you really think that you will learn more or even anything about how to run a business effectively at Harvard versus a three year apprenticeship under the personal tutelage of a successful local entrepreneur?   What you will get are a lot of very powerful contacts which you can use to your advantage but education about business will come from trial and error in the real world.

Now while you may not get paid much during your apprenticeship you will be far better qualified to maximize your wealth outlook through this program and you will not be saddled with mountains of student debt.  The problem is that society has bought hook line and sinker into the formal education sector rather than embracing the model of apprenticeship.  It is almost impossible to get a well paying job unless you have a degree but the question to ask yourself is do you want a well paid job and massive debt or the opportunity to create a massive amount of wealth by learning and using that money spent on education to jettison you into orbit?  If you want the latter then you might want to follow the steps of those before you and certainly turning our government support off may not be such a bad idea after all.

Is Goldilocks in the House?

"An economy that is not so hot that it causes inflation, and not so cold that it causes a recession. There are no exact markers of a Goldilocks economy, but it is characterized by a low unemployment rate, increasing asset prices (stocks, real estate, etc.), low interest rates, brisk but steady GDP growth and low inflation." - Definition of a Goldilocks Economy taken from Investopedia

I have surveyed all of my charts, data and other tea leaves to get a feel for the current rally that we are experiencing and all indicators point to higher.  Now as you know this flies in the face of plenty of my other blogs that I have posted but I have to take the data at face value and while I still do not trust the rally, outside of some economic calamity it seems to point to higher.  The question then is are we now in a Goldilocks economy and looking at the definition above, other than a stubbornly high unemployment rate it appears so.

Certainly we have low interest rates and rising asset prices.  GDP growth seems moderate and companies have just reported the highest profit levels ever.  Inflation seems tame by modern standards, crude oil prices are falling and with excess capacity from labor and factory output it appears that it will remain low.  The global economy seems moderately robust, particularly if you take the recent rallies in international stock markets as an indicator, copper is rallying signifying global economic growth and with gold and silver and the VIX down substantially the fear trade seems to be off.

On the surface all is well so it is no wonder that the Federal Reserve is exiting their quantitative easing stimulus and I would be highly surprised if they are not completely done with their stimulus by the end of October.  When you look at the dollar index it is breaking out to the upside and while this may hurt exports it does show support for the United States economy and allows the Federal Reserve to continue to issue bonds at low interest rates.  

Now while all of the above sounds rosy I have to expect that there will be some repercussions from the Federal Reserve exit.  The rally, now more than 1,000 trading days without a correction (10% price reversal) is very long in the tooth.  Also looking at the hard numbers from Europe, Japan, China and the United States while the ship is sailing it is dragging the anchors of debt, high levels of government intervention and high unemployment. Also geopolitical problems are currently at extreme levels and any flare up in the Middle East or Europe could spark a correction.  Until these anchors are raised I remain on the sidelines and watch things spiral higher.  Jumping in head first at these levels is like jumping off a bridge without the bungee cord attached.  So while the porridge might seem just right, it is cooling quickly and we know that too cold is just as bad as too hot.

Laws Can't Be Broken

"This is one of man's oldest riddles.  How can the independence of human volition be harmonized with the fact that we are integral parts of a universe which is subject to the rigid order of nature's laws." - Max Planck 

Almost everyone breaks the law every day.  Just get into your car and I am sure that pretty much everyone does not come to a complete stop at every stop street or light, neither do you indicate for a full three seconds before changing lanes, not to mention following more than 4 car lengths behind the car in.front of you and don't even get me started on the speed limits!  So imposed laws are often broken but the Laws of Nature can never be.  These laws are set in stone.  The universe follows these laws to the letter, that is just the way it is in nature.

Looking at the the fundamental law of investing that more risk should receive more reward and we find a blend of the human style imposed laws and the laws of nature in that this law is often bent but is never broken.  In times of extreme fear or greed the boundaries of this equation or law are stretched to a breaking point and it is at these times when a reversion to the norm is in order.  The problem with finance is that no-one knows exactly when this reversion will happen we just know that the boundaries are being stretched and the more that they are stretched the more likely it is that the reversion will occur sooner rather than later.

Looking around the world at the markets it is very apparent that the risk to reward investment is skewed toward high risk and low reward or extreme complacency.  Take the stock market as an example, when you buy a stock you are expecting that future company cash flows will provide a base for continued company success and therefore a return on your investment.  The higher the price that you pay the more risk you are taking as the risk premium, or the return, is compressed.  The reason is that if the company growth is linear the returns should be linear therefore paying a higher price today should result in slower future stock appreciation to offset the premium paid.  At present with the stock markets around the world all near or at all time highs with no real improvement in the global economic outlook it is clear that unless the outlook improves significantly that returns on new stock purchases will be far lower than during the past three years and have a high probability of being negative.

Another example is the high yield bond market.  As investors have tried to find yield they have turned to increasingly risky investments.  Yields of bonds in Greece, Portugal, Spain and Italy are at levels not seen since before the Great Recession began while their ability to service these debts has barely improved since 2008.  Money from the housing bubble has flown into these high yield markets for the simple reason that the "carry" (the spread between the interest rate received on the investment less the cost to borrow the money to buy the investment) is so low that the investors are drawn in to invest in these assets believing that the spread will last for the life of the loan.  Furthermore with money as cheap as it is right now investors believe that the problems will alleviate themselves by a magical wave of the wand as somehow more debt at lower interest rates will be the solution!

I could go on but it is clear that until investors realize that the investments that they are making are high risk with low levels of expected return and that the law requires a reversion, the markets will continue to compress the risk premiums.  In such an environment it is not a case of if there will be another financial crisis it is just a matter of when do investors wake up to the lack of return and all run for the exits.  Remember that you may get away with a few misdemeanors for a while but at some stage the law will enforce itself.

I'm Just Saying....

"The world is in greater turmoil than at any time in my lifetime." - Senator John McCain

While the Federal Reserve and out leaders continue to reassure us that everything is going according to plan, today's blog takes a look at the real world.  You can draw your own conclusions (as I hope you always do) as I'm Just Saying...

First off the US GDP has not managed to post anything near a 3% annual growth number (the number required at a minimum to create jobs) since the end of the Great Recession even though we have thrown almost $4 Trillion at the problem.  As this experiment in "stimulus" has provided no results the Federal Reserve is now reducing the purchases on a monthly basis.  They have cut their "stimulus" from $85 billion a month to $25 billion and will cut another $10 billion in September and the remaining $15 billion in October.  The reason for the slow withdrawal is that in the past when they stopped cold turkey the markets went into a tailspin and the one thing that they managed to manipulate higher was undone in a matter of weeks.  So with much fanfare they have managed to sell Wall Street on the idea of a slow tapering and through the end July it was working as the markets continued their heavenly spiral unabated.  Recently it appears that the markets are finally waking up to the reality that their stimulus is almost gone (I say "their" as this was the only place where it was actually producing results) and that the economy is not in any shape to take up the slack.

The high flier stocks have already been killed and although they have recovered some of their losses many are still down more than 30% from their highs. The market has now rotated from these stocks into the larger capitalized stocks but these too are starting to show signs of trouble ahead.  Recently it took just a week for the market to essentially lose all of its upward momentum and a large portion of its returns for the year and based on the lack of bounce and follow through there is little reason to see any recovery bounce from here.  The small cap index, the IWM, is down more than 3% for the year and this does not bode well for the market as a whole as this is the growth engine of the market.

On the global front there is more strife now than in many years.  Just yesterday bombs were dropped in Iraq, Russia is still "negotiating" its way back into the Ukraine, Malaysia airlines have now lost two passenger planes and Afghanistan is as unstable as before the United States and the coalition forces arrived.  Last week Portugal's second largest bank needed to be bailed out and the German economy stalled in the second quarter.  Any thoughts that Europe's troubles were behind them can clearly be seen as smoke and mirrors.

Through all of this the Federal Reserve is trying to reassure the market that their policies are going to provide the economic growth that will provide jobs and stability, but the more that they try to manipulate the numbers the worse things are and the more unstable everything is becoming.  What the Federal Reserve policies (and I am going back in time and not blaming all of this problem just on Janet Yellen, although she has left no doubt that she is on the same page as the rest of the chairs) have done is to create moral hazard, encourage the formation of asset bubbles, widen the wealth inequality gap, discourage and penalize savings and investment and monetize the government deficit spending.  These policies have not created jobs or stimulated the economy but have left us with a huge debt to service and ultimately repay.

Now that they are trying to unwind their "stimulus" the market is awakening to the actual problems in the world.  It appears that the party is over and will be until the Federal Reserve decides to try a "new" (read same old experiment again) which will produce worse results than the previous four or more (if you include Greenspan) erroneous policies but you can make up your own mind as to how to proceed, I'm Just Saying....

The Beginning of the End?

"Now this is not the end.  It is not even the beginning of the end.  But it is, perhaps, the end of the beginning." - Winston Churchill

I have to say that Churchill is one of my all time favorite people to quote.  He certainly had a way with words that inspired a generation.  The words come from a speech at the Lord Mayor's Day luncheon in November 1942 when Britain was in the grips of the struggle to keep Germany off its shores and, at the time, it was looking pretty bleak for the British.  In contrast to what was going on in 1942 the week in review is not even remotely as dismal although the market's were certainly roiled by the Argentina default and the weak outlook for United States economy in general.  Not that this news (other than maybe Argentina) should be surprising to those of you who read this blog, but the question remains whether this down week marks a top in the market and a return to a bear market or just a blimp on the radar screen.

I have reviewed all of my economic data points and reviewed all of my charts and I have to say that the markets are looking particularly weak.  The S&P 500, the Dow Jones and the NASDAQ all broke down through their 40 day moving averages and seem destined to test their 200 day moving averages about 10% below where they closed today.  Fundamentally the US Dollar gained more strength as investors flocked to the safe haven (after being rattled by the Argentina mess) and this will weaken exports which has largely fueled U.S. economic growth. 

On the debt side there was a sharp correction in the high yield bond world.  This market was already at historic highs as investors desperate for yield pushed the yield on risky investments to historic lows.  This bet was bound to result in pain and the high yield ETF plunged 5%.  The recipient of this selling fueled buying in United States treasuries which saw the yield on the 10-Year Note fall to 2.52%. A continued sell off in this market is likely although until the market is completely spooked and investors lose confidence in the economy as a whole I doubt that we will see a panicked sell off just yet.

So while the numbers across the board were weak I am not sure that this weakness will spread into universal panic.  A lot of my indicators are showing a high over sold level so I would expect some form of a bounce next week.  Furthermore the selling was not panicked and in fact the markets staged a minor recovery in the middle of the day.  This type of recovery buying is indicative of buyers not leaving the market so I would not be surprised to see a bounce early next week.

On the flip I would not say that this is a buying opportunity as the market is finally showing its true colors.  The Federal Reserve support is weakening with every $10 billion reduction in the level of quantitative easing and volumes in the market (which show buyer conviction) were low (until the past two days).  This is not a metric that you want to see - high volume on down days and low volume on up days as the tendency is for the dramatic market moves to be in the direction of the higher volume or in this case, down.

With weakening global fundamentals, the default out of Argentina and the loss of economic stimulus from the Federal Reserve the market is due for a correction.  Furthermore the market rally is extremely long in the tooth and we are in the part of the year where volumes are low leading to volatility and weakness.  For these reasons I would not try to time an entry to the market (in fact I would be a seller on any bounce) and would wait until the dust settles later in the year to pick a market direction, although as long time blog followers will know I would not be surprised to see a healthy correction sooner rather than later.

Yellen's Dashboard

"The only function of economic forecasting is to make astrology look respectable." - John Kenneth Galbraith

I do not envy Janet Yellen, but I have to say that I am warming to her as the Federal Reserve Chair.  Last week the FOMC had its meeting and the results are a slight testimony to the Federal Reserve in that she pretty much admitted that the data presented was too unclear to formulate a decisive direction for the main Federal Reserve's policies.  Finally someone has come forward and admitted that they really have no clue where the economy is going and that they will have to wait to see what happens next before proposing a solution.  This is refreshing in that she is owning up to what we already knew, the Federal Reserve is reactionary rather than being preemptive.  For all of those who believed that the Federal Reserve had a "special" set of metrics that it could use to steer the economy on an even keel, this bubble has finally been burst.  There never has been a magic number and there is no magic formula, they are just as constrained and confused as everyone else, the only difference is that they have massive sway over the markets and have used it to manipulate it for the supposed benefit of all.

Looking at their forecasts shows this first hand.  While unemployment is expected to fall to 5.3% over the long run, inflation is expected to continue below the Federal Reserve target of 2%  and GDP is expected to remain around 2.5%.  I find these numbers very interesting as with anemic economic growth it will be increasingly hard to reduce unemployment much further than the current level so either the unemployment number is overly aggressive or GDP and inflation are too low.  In response to this line of questioning Yellen responded that incoming data could prove stronger than expected and potentially invite rate hikes that occur sooner and more rapidly than now envisioned but she also added that incoming data could go the other way too, and lead to rates staying lower for longer than now envisioned.  So in other words she is on the fence and other than continuing to reduce the monthly buy of Treasuries to zero by October the Federal Reserve is in a wait and see mode.

In order to track movements in the economy she has opened up that her dashboard of indicators is far larger than her predecessors.  In other words the more data the better.  The problem with all that data is that there is also a lot of noise infiltrating the decision making process but at least she is not confining herself to a short list of metrics that really have no baring on the economy.  Using the underemployment rate, changes in consumer spending and the job quits rate are all better metrics than the unemployment rate.  So while these are giving her a better indication of the labor market it could mean that the Federal Reserve remains in limbo for an extended period while they wait for an uptick across the dashboard during which time inflation could be rearing its head in metrics other than the Core PCE, her preferred metric. 

The result could be that the Federal Reserve keeps interest rates low for an extended period (through 2016) only to be forced into trying to extinguish an accelerating inflationary fire after it has already burned half of the country.  Once again acting in a reactionary way to data that the rest of us are witnessing first hand right now.  At least she is more honest than her predecessors in saying that she has no ability to guess the future but outside of that know that you need to protect yourself rather than rely on the Federal Reserve.

Rule of 20

"A measure of stock valuations called the Rule of 20 states that the stock market is fairly valued when the sum of the average price earnings ratio and the rate of inflation is equal to 20."

The Rule of 20 is interesting in that should the total of these two numbers be less than 20 then the rule states that stocks are cheap and should be purchased and if they exceed this number then they are expensive and should be sold.  Based on today's S&P500 index reading of 1965 and dividing this number by the expected total earnings per share of the S&P500 of $109, the price to earnings ratio of the S&P500 is just above 18.  Add to this number the Federal Reserve's expectation of inflation of 1.5% and you can see that at this level in theory the S&P500 is slightly undervalued as the total is 19.5.

Looking at the ratio in a little more detail shows just how quickly this indicator can swing.  If you take for example a more realistic inflation number of 4% (I am not sure that even this number is that realistic but it is closer to reality than the Federal Reserve's cooked number) suddenly the total is 22 and the indicator shows that stocks are overvalued.  Furthermore if stocks cannot earn $109 this year and earn say $100 the index is suddenly flashing sell as it is now 23.65 a number not seen since before the 2008 crash.

The problem with looking at one indicator in isolation is thus highlighted.  The numbers are based on expectations and once these change and the real numbers come in the indicator can swing pointing clearly to a buy or sell signal that was not present in the moment.  This dilemma is normally present when an indicator of this nature reaches an inflection point.  Were it to print a number of say 10 (which it did near the bottom in 2009) it is a clear buy indication, as was the sell signal it printed in 2007.  At inflection points it is important that investors look at additional indicators to get a better understanding of the risks before deciding on a direction for the market.

Looking at a second indicator, the Price to Sales ratio, things look a lot different.  The P/S ratio takes the value of the S&P500 and divides it by the total revenue of those companies.  Sales is used for the simple reason that the sales number is the hardest number in the profit and loss statement to manipulate (readers of this blog can refer to the article on IBM and see just how badly earnings can be manipulated) so using this number gives a better idea of the market health.  If sales are growing profits should follow but at present sales are actually contracting so this indicator is now at an all time high.

Another indicator is the price to GDP level.  GDP is the total output of the nation and so a high price in relation to GDP shows over priced stocks.  At present this indicator is back to its 2007 levels.  I could go on but you get the picture that adding these indicators together shows a market that is in dire need of continued Federal Reserve stimulation and that is being tapered at a rate of $10 billion a month.  Continuing on this path and it could spell trouble for the market right around October which has historically been one of the worst performing months in the history of the market - it gave us Black Monday and the Flash Crash among other fun meltdowns.

So while the indicators are signaling trouble there is still time to pull in your horns.  Do not get caught holding the proverbial hot coal that the professional money managers are desperately trying to palm off onto any new comers to the market, or if you really need to be in the market make sure you have adequate protection or have the investment on a very short leash.

The Unskilled Issue

I recently read an article that made a case for the next recession in the United States coming from the large drop in the wages of the lowest portion of the population.  According to the study when there is a negative real rate of growth of the lower income this normally results in the onset of a recession for the simple reason that the in the economy most of the population falls below the median income due to the skewness of the income curve.  Losing their spending power results in cutting back on goods and services and this leads to a recession as companies are unable to sell their wares into the market.

This article interested me as Africa is a continent with massive unskilled worker problems.  More than 40% of unskilled workers in South Africa are unemployed which is why crime levels are so high.  So if the United States is having a problem that may drag it into recession, what of Africa and how does one manage to get these masses employed and their real rates of income higher?

This is a global problem and one that is rapidly being exacerbated by the continued influence of technology on society.  More and more there is a requirement for the unskilled to become skilled and so access to training and education is the obvious solution.  Now while this may seem obvious the next issue facing the United States is one of massive student debt.  I believe that it is imperative that the government provide assistance to students, the problem is that there are plenty of schools that are not providing the level of education required to ensure gainful employment once they depart the school.  Furthermore while shortages are still prevalent in technology and other skilled sectors of all economies the problem is that the high school proficiency in science and mathematics are lacking so there is not a large enough pool of college entrants to fill these spots.

Taking this one step further spending money on higher education is wasted until you get your primary education house in order and in this respect the United States and South Africa are both lacking.  In comparison the eastern economies place high regard on academic studies at the high school level there is a total disdain for this in these two countries.  Now as always this is a very broad brush I am painting with as there are institutions in both countries that prize their level of education but overall the masses are pushed through the system with little regard for the follow on options required to stimulate the economies.

The obvious solution would be to target this as a place for large scale investment and new government policy to align the desired level of education with the expected challenges and opportunities of life beyond high school.  No child left behind was flawed in that the result was that schools were rewarded for making sure that the bottom tier passed forgoing the rest of the kids in the grade.  The thing to remember is that not everyone will be a science and mathematical whizz but with all the new technological developments being created unless this tertiary education can be improved these problems will remain.

Risk or Opportunity?

"The man who knows it can't be done counts the risk and not the reward." - Elbert Hubbard

Currently I am in South Africa visiting friends and family and I have spent a lot of time trying to bring myself up to speed with the business and economic environment.  After asking numerous questions and digesting the information it is clear that where some investors see only risk while others see opportunity.  Like most investments the difference between determining whether the opportunity presents itself as an investment or something to be shunned comes down to your assessment of the risk of the investment and the expected reward, however there is more to the equation than first meets the eye.

When you look at investing in Africa as a foreigner the idea is daunting.  The capital risk is enormous as not only can the investment be lost to government nationalization but strikes, bribes, extortion, corruption, blackouts and worker and social unrest are the norm, spending on protection is common place and governments can change overnight.  In addition trying to find and retain skilled workers is becoming increasingly difficult and you start to wonder why anyone in their right mind would bother to invest at all.  It is also no wonder that most African currencies are taking a beating against the dollar and the Euro.

As an example when the South African mobile phone operator MTN expanded into Nigeria they had factored in the cost to build the cell phone towers only to discover that the power grid was so poor that each tower required its own generator to provide power.  Once these were installed they soon found that a new expense was required in that the generators were soon being stolen so now they had to hire security guards to protect the generators.  Fortunately for them the opportunity was so vast that they were able to manage these expenses while continuing to profit which brings me to the first addition to the equation, recurring revenue.  MTN can make a go of this because of the recurring revenue model that is the cell phone industry.  Were this a one off project I doubt these expenses could possibly be borne.

The next thing to look at for MTN was that they had essentially maximized their opportunity in South Africa and so to expand they needed to look elsewhere.  This is similar to a Apple or Microsoft in the United States who seek to grow their markets by expanding into new regions.  For a South African country moving into Africa is the obvious choice as the expertise is there and they are already familiar with the lay of the land.  This expertise is critical and has led to some other South African companies expanding based on first exploiting their local knowledge before taking on the rest of the world.

South African Breweries springs to mind.  They started as a local brewer and soon managed to become the preeminent brewer in South Africa.  They then tried to expand into Africa with minimal success until they realized that their lack of success was due to the lack of refrigeration.  So they began delivering refrigerators to their distributors around the continent and sales started to boom - who doesn't want a cold beer on a steaming African safari?  They are now one of the largest brewers in the world having acquired numerous other breweries including Miller.

The opportunity therefore presented itself to these businesses because of their proximity to the opportunity, their expertise and the recurring revenue that was present (once the refrigerator was installed the only cold beer in town was SAB's or the refrigerator was removed).  So the next time that you determine an opportunity is worth an investment do not limit yourself to the risk and the reward equation but expand it to include expertise and recurring revenue!