Reality Sets In

"Life is a series of natural and spontaneous changes.  Don't resist them - that only creates sorrow.  Let reality be reality.  Let things flow naturally forward in whatever way they like." - Lao Tzu

The euphoria that the market experienced after the Federal Reserve announced an increase in rates seems to have evaporated as the market has woken up to reality that the Federal Reserve is no longer providing the support it requires to maintain its unsustainable upward trajectory.  I would therefore not be surprised to see the market take it on the chin to such an extent that the Federal Reserve's idea of gradually raising rates in 2016 is put on ice.  In fact they may even be forced into a retraction of the first increase in rates since the iPhone was introduced!

For long time readers of this blog you will know not to get sucked into thinking that this current drawdown is a buying opportunity.  Keep your powder dry as there will be plenty of opportunity to buy stocks at far cheaper prices than those on offer today.

Beware of the FANGs

The quote today is from the famous cartoon scene in The Jungle Book where Baloo the bear in an effort to save his friend, a human boy named Mowgli, has grabbed Shear Khan the tiger's tail as Shear Khan is running to catch and kill Mowgli.

Buzzie (the vulture): [Flaps and Dizzy (also vultures) have just saved Mowgli] "He's safe now. You can let go, Baloo."

Baloo: "Are you kidding? There's teeth in the other end!"

To me this sums up the current state of the stock market.  While the quote above refers to teeth there is a well known acronym FANG's that is used to describe the four must own stocks that are currently driving the stock market indices higher.  Each letter refer to a stock and for those of you who have missed this the stocks are Facebook, Amazon, Netflix and Google (now know as Alphabet).  These four stocks are masking the poor returns of the majority of the stocks that make up the S&P 500 to such an extent that if you removed their stock returns this year the market would be down considerably. All four of these stocks support P/E ratios well into the hundreds and have an average P/E of over 400 however they are still must have stocks!

At market tops there is a tendency for a very small number of stocks to control the market and unfortunately this is the exact same case today.  For those of you with short memories we have had the Nifty Fifty, the SOX (just 17 stocks) and the Four Horsemen among others.  Each time the market is beholden to a small group of stocks to drive the index higher things become lopsided and tend to topple over.  When you add to this fact the length of the current market run, the fact that the Federal reserve in all likelihood will raise rates in a couple of weeks and global economic weakness it seems to me that 2016 will be the year of the tipping point (if we can make it through December without a massive draw down).

Looking at these four stocks one can see that they are all technology companies.  Three of them produce nothing and one is completely reliant on people to remain social.  Yes they are making a ton of money but so too was IBM in its heyday when Big Blue was the only stock to hold.  Remember 2000 and the must have stocks of Ariba, InfoSpace, Inktomi, Verisign and Veritas Software or one of my favorites PMC Sierra?  Where are these stocks and companies today?  Not that I expect the current FANG stocks to disappear (IBM is still limping along a mere shell of its former self) but when you have an average P/E of over 400 and these are the only stocks holding the market up, something has to give.

In the quote above Baloo gets hit by a branch and the tiger Shear Khan, free from his grips ravages his opponent and while Baloo does not die (it is Disney after all) I expect a similar fate for this market in the not too distant future as there are FANGs on the other end!

Thanks for Nothing

"I made something out of nothing, thanks for nothing." - Lil Wayne

I have to say that one of my favorite holidays in the United States is Thanksgiving.  Not only is the food delicious but it essentially marks the end of the year as the mood generally changes in preparations for the coming holidays.  In the small business community in which I operate it seems that there is a general sense of relief that we made it through another year.  The giving of thanks is more about another year of survival than a celebration of massive profits.  Obviously this is painted with a very broad brush as some businesses had a breakout year but overall small business has still not felt the full impact of the "recovery".

While big business has had a banner fiver year stretch small businesses have continued to struggle.  In another article highlighting the woes of small business it was revealed that banks have reduced their lending to small businesses this year from 58% of originated loans in 2009 to 43% this year.  The majority of small businesses therefore have to look beyond the normal avenues for sources of capital and while the capital is available it comes at a price.  Typically there is a spread of at least 5% over a bank loan and a private loan and often it is far higher than this.  For companies that are not showing profits or assets to use to secure the loans rates can rival those of credit card debt.

This drag is having a massive impact not only on their earnings but on growth prospects.  Consider a company requiring $1M that has to borrow at 12% instead of 3%.  The increase in the cost of interest equals two full time employee's salaries.  Assuming that the business requires the money for growth prospects there is a high probability that the goals will not be achieved as they will either have to be met in a far shorter time frame than originally intended or they will have to try to make the target with fewer employees.  Neither of these prospects are encouraging and reduces significantly the chances of success.  In contrast the large business with access to limitless capital in the form of loans and stock issues can not only take advantage of opportunities but also has the luxury of time to let the idea develop and flourish.

As I have mentioned repeatedly in previous blogs, until this landscape changes from completely skewed in favor of large business, GDP growth will not only stagnate but be highly prone to economic shocks from outside the United States.  So while large business deals with the prospects of slowing revenue and lower profits they can at least be thankful of those whereas the small business owner sees more heavy sledding ahead with no end in sight.  Little incentive to start a small business and often times too little incentive to carry on plodding.  For those of you in small businesses or just starting a small business I applaud you and give thanks for your perseverance and wish you much success for 2016!

The Credit Cycle

In a very interesting article in the Economist Magazine the flow of debt was followed from banks to consumers to businesses and countries.  Studies were highlighted showing that debt burdens on consumers has a far larger impact on growth than debt held at businesses.  Furthermore it was shown that emerging economies are more prone to economic shocks due to swift changes in debt levels however these countries can be split further into those with current account deficits and low levels of foreign capital versus those with current account surpluses and large foreign reserves.  The former is subject to large swings in its economic fortunes and the value of its currency versus the latter who can weather the storm.  This subset can be further divided into open economies and controlled economies with the former more readily able to shed the dead wood versus controlled economies that can drag bad debt along like an anchor for years.

As an example China, a controlled economy, keeps lumping more and more debt onto poorly run and money losing state enterprises creating a drag on economic growth.  The money spent could easily be used to create jobs and economic benefit elsewhere.  In contrast countries such as the United States are relatively good at letting bad investments die however this will be sorely tested during the next  recession as the problem of too big to fail will once put into question political stomach versus the economic merit of holding onto poorly run enterprises.

As the United States' thinks about raising interest rates this is sending shock waves through the emerging markets particularly those economies like Brazil which are prone to runs on its capital reserves.  An interest rate rise should propel the dollar higher resulting in a larger burden on Brazil to pay its dollar denominated debt and making the Real fall in value.  This will be exacerbated by a flow of capital out of Brazil dragging the economy into a recession.

Now back in the good old days that would not have mattered much to the first world economies but in 2015 emerging markets make up the lions share of global GDP.  In fact they are approaching 60% of the world's GDP.  In addition they are the engine of global growth able to produce sustained periods of growth well above 5%.  This type of GDP growth has not been seen in developed economies in decades and more than likely will never be witnessed again.  So if the world is to exit from the cycle of growing debt levels the only way out that I can see is for global GDP to grow at a rapid pace and the only place that this will come from is the emerging markets.

As I have mentioned before while the United States believes that it is in good enough shape to raise rates it cannot withstand a sharp slowdown in emerging economies growth rates.  For this reason while the Federal Reserve may be stupid enough to raise rates next month they will not have the latitude to continue to move them higher as the repercussions of a strengthening dollar will undermine any form of global recovery forcing them to end the interest rate increases.  Worse still as the debt funnels back from emerging economies to the United States the result might be that the world's debt crisis may end up right back where it all started, in the hands of the Federal Reserve and that would be worrisome!

The Pulse of the Global Market

"We have to choose between a global market driven by calculations of short term profit, and one which has a human face." - Kofi Annan

"No society can surely be flourishing and happy, of which the far greater part of the members are poor and miserable." - Adam Smith

With the world seemingly getting smaller by the day and global trade having an ever larger impact on local markets and economies I thought that this week I would revisit the pulse of the global market; that is to take a look at indicators that print the health of the global economy.  The three main indicators that I look at are the price of oil, the price of copper and the daily price of dry bulk shippers.  All three of these indicators are global in nature; oil is obvious, copper as I have mentioned in previous blogs represents industrial growth and dry bulk shipping rates show the level of international trade.  While all three prices are driven by demand and supply inputs they are more prone to demand side shocks than changes in supply making them as close to a perfect pulse on the global market as is available.

To rephrase the above comment while the number of say dry bulk ships can be reduced or not replaced, it takes years for this slow drip method to take effect.  Furthermore it takes at least a year or two to build a ship so some are still coming onto the market that were ordered years ago adding to supply even as demand falls.  The result is that the market slowly reduces the number of ships while demand quickly adjusts to changes in global growth or contraction.  This same equation holds true of copper and oil which is why these indicators contain within their prices the pulse of the global economy.

The first chart is the daily price change in Crude Oil.  As you can see crude hit a low around $39 a barrel in late August.  This was touted as the bottom of the market and a recovery was imminent.  Subsequently there was a trading rally but this was met with resistance around $51 a barrel and now it looks like lows are about to be broken.  Certainly not an indication of global demand and resilience.

The next chart is the copper price.  As you can see the price of copper, like crude tried to rally late August but not only has it rolled over it has broken below its August lows and appears to be heading lower.  This is a reflection in large part of the weakness in China but it is a clear indication of global economic weakness.

The final chart is the Baltic Dry Shipping Index.  This is the daily rate that dry bulk shippers can demand from their clients.  As you can see there is limited demand for dry bulk shippers and this index has not come close to recovering from its 2009 highs and is once again in a clear downward trend.

Based on the above snap shot of global trade it is clear that global economic growth is anemic and should make you wonder why the market will jump from here to new highs.  To me it seems obvious that earnings will remain lackluster for the foreseeable future keeping the Federal Reserve at bay in regards to interest rate hikes and could result in a significant contraction in the value of equities which have become increasingly expensive as earnings contract.  Until these indicators start to show signs of life my advice would be to remain on the sidelines.  As the old trading adage says, "Do not try to catch a falling knife!"

Heterogeneity Stumps the Fed

Heterogeneity - the state of being heterogeneous; composition from dissimilar parts; disparetness.

Ceteris paribus (Latin for "with other things remaining the same") was one of the favorite terms used when I was studying economics and it appears that not only is the Federal Reserve reliant on this phrase but they are also using the other economic theory of all people acting rationally.  Neither of these ever works in the real world but economists love to try theories based not on real world examples but based on ceteris paribus in an effort to prove the impact of a change in one economic variable.  This is akin to data mining, digging for data that proves your point even though the two variables are often not even vaguely related, but it is becoming more and more apparent that something as simple as Heterogeneity is stumping the Federal Reserve for the simple reason that they seem to rely on ceteris paribus and rationalism.

Heterogeneity essentially says that people will act differently from one another given a set of economic variables.  The Federal Reserve does not seem to consider this when making their policy decisions as if they did then I would expect their decisions to be very different.  Without digging too deep into the subject let's take a look at their current policies of low interest rate and money stimulus.  The idea was that if you hold interest rates low and pump trillions into the economy through the reserve banking system that individuals would not hold onto cash but would load up on debt and invest the proceeds creating businesses and jobs.  All you had to do was dump enough money into the top of the funnel and it would eventually trickle down to the man on the street.  Voila, simple as that and hey presto all is well.  (Sorry I could not resist the kitsch phrases as to me they highlight the lunacy of the decision making process.  Who knows maybe they use these words behind closed doors as how else can they hatch such a poor plan?)

Years later and trillions of dollars they are still scratching their heads as to why this ridiculous plan has not worked but it is as simple as heterogeneity.  People do not act in one massive unified body and, changing one variable, interest rates, does not make another variable, high debt levels, magically vanish. The results of this massive stimulus project has been to create what is turning into another stock market bubble and one of the largest wealth divides in history with such feeble economic footing that the economy cannot even handle 1/4 of 1 percent increase in rates..  

As I pointed out a few weeks ago the velocity of money is at an all time low for the simple reason that people are not spending money.  As the vast majority of individuals are earning less today (in inflation adjusted numbers) than they were a decade ago and as the labor participation rate is at a 38 year low, it is no wonder that there is little to no economic benefits coming from more Fed stimulus.  People act within their own personal constraints and the lower end of the labor market has not seen any economic recovery and is still struggling to recover from the last economic meltdown.  Until they feel the benefit of an economic recovery throwing more stimulus at an overvalued stock market will not get the job done and raising rates will kill the supposed golden goose.

Had the Federal Reserve and the government spent their time and money looking at how to get the labor participation rate up rather than making fat Wall Street bankers fatter I would argue that the economy would be on solid footing.  Simple examples to get money into the hands of the low earners would be to stimulate small business growth with tax incentives and lower reporting requirements, provide students with no interest on their student loans while sending a rebate check to those that just fell outside of this benefit and spend money on roads and infrastructure projects to name a few.  Doing this would mean more jobs, resulting in more money in the hands of those that would spend the extra income, improving consumer confidence and an economy not reliant on zero interest rates.  For now though their focus is on more stimulus and while their numbers seem to show success the global economy and company earnings are pointing in the opposite direction which is why my money stands on the sideline watching and waiting.

Earnings Dictate the Market

"I'm living so far beyond my income that we may almost be said to be living apart." - E.E. Cummings

It is common knowledge that stock prices are based on company earnings and earnings potential.  The metric often used is the P/E ratio or the Price to Earnings ratio where a stocks price is divided by the company earnings.  The higher the future earnings potential the higher the stock price as investor bid up the price of shares in expectation of future earnings streams.  For this reason you often witness high flying stocks with P/E ratios at 200 plus and growth rates to match while low growth stocks often only command P/E ratios in the low double digits.  Mature companies that make up the S&P 500 usually hover around 15 which is considered a normal price level.  Anything higher than this number shows a market that is overvalued and lower than that shows a market that might be a buying opportunity.  This is all very basic and cut and dry but the market is anything but that as people's expectations of economic growth and their confidence dictate how high or low the market can go.  One thing that shines through is that the earnings of companies dictate the price of the stock and this determines the direction of the market.

Looking at the earnings coming out of the S&P 500 during the past few weeks and it is clear that company earnings are slowing.  With it the market is gasping for air and the oxygen is being provided by repeated Federal Reserve stimulus packages and low interest rates.  It is hoped that this stimulus will keep a bull market that by any metrics is very long in the tooth afloat, but as the graph below shows this is a long shot. (The chart is provided by href
='http://www.macrotrends.net/1324/s-p-500-earnings-history'>Source: MacroTrends)

The dark line is the S&P 500 index while the light line is the S&P 500 earnings.  As you can see the market moves in tandem with earnings.  You may also notice that the company earnings have faltered in recent quarters and that this is the first time that this has happened since the beginning of the recovery.  Admittedly earnings were incredibly low at the trough in 2009 but still to recover to new highs in such a quick time was incredible and could not be sustained.

The issue as I mentioned above is that when things are good and expected to continue, investors pay up for the promise of future growth.  This translates into a P/E in excess of 15.  At present and based on the current market price the S&P 500 P/E stands at roughly 22 well above its normal price.  This must mean that the market expects earnings growth to continue to accelerate to new highs.  Should this perception be met with continued poor earnings then the reverse will occur and the P/E will drop to below 15 plus earnings contraction will take the index even lower, the so called double whammy.  Assuming that earnings contract to $90 (from $94) and the P/E ratio falls to 15 (I do not want to get overly aggressive) then the S&P 500 index would fall to 1,350 from 2,200 or 40%.

As I cannot see why earnings will resume any time soon I have to conclude that this is more than probable and that the market is being held together with Federal Reserve loose money policies and at some point these too must end!

Adrift - Part III

"What Wall Street is, their market makers.  Wall Street's business model is making money on the velocity of money.  They're a click industry.  That's what Wall Street is.  They make a lot of money when there's a lot of turnover.  And they make a lot of money when that velocity is fast." - Laurence D. Fink

As we have seen in the previous two blogs the world is awash with debt and dollars and the problems associated with these are rapidly coming to the fore.  So why do the central bankers of the world think that continuing down the same asinine path will actually work?  I believe that it all comes down to the expectation that the velocity of money will turn its head up at some point creating the windfall everyone expects.  As you can see from the chart below the velocity of money has been in a tailspin for the past 15 years.  Dissecting this further you can see that entering the 1990's velocity of money was relatively stable.  The years prior were relatively quiet on the debt front with central bankers tinkering with free exchange rates and leaving the gold standard.  Once all of this was done they were free to explode onto the scene armed with the modern tools of economic warfare; control over interest rates and the money supply.  

Now no man is ever going to let his toys lie idle so they put them to work and under Greenspan the games began.  At first the velocity of money went into orbit as fresh dollars came into the market providing the stimulus that was expected.  In fact the stimulus worked so well that money velocity exploded higher through 2000 creating the NASDAQ bubble.  Once this burst the theory was that a little more debt ("stimulus") would fix the problem (it had before right?) and so more money was added.  This time however the amount of money required far exceeded the paltry $40 billion of the first test but velocity bounced creating the second bubble, the housing bubble (see the bounce in the velocity of money around the time of the housing bubble).  After this bubble burst the theory has been that more money should be added (as it worked the first and second time right?).  The thought is that once the velocity of money increases it will return us all to prosperity (read another bubble).

The problem with this theory is that the utility function of new money has not only lost its ability to provide stimulus but the amount of money has crowded out the private market, both of which have resulted in a velocity of money that continues to historic lows.  Adding more money to this pot of debt will not make it taste better; as any chef knows, adding more salt into a stew does not make it less salty!  As an aside the utility function refers to the perceived value of adding one more dollar to a person’s net worth.  So for example giving a dollar to a beggar will be meaningful but giving the same amount to a billionaire will be meaningless. 

Now should this velocity of money return to normal levels, based on the amount of “stimulus” ($30 trillion and counting) there would be massive bubbles across the globe.  It would be the boom of all times and it would all end in one massive global depression.  This however is what the central bankers of the world are hoping for, a return to "normal" velocity levels, but they they believe (unlike me) that that they can somehow control everything with their useless tools and provide us with a soft landing.  Furthermore the prosperity will result in such a tax and economic windfall that all debts can be brought down to normal levels avoiding any calamities.  Their argument is to print more money – just give it more time and it will work.  

As we have seen in the past two blogs the pot is boiling over with little effect and so until they get their hands out of the pot there will be little in the way of growth and more than likely a debt laden slowdown and possible deflation.  In the meantime should a recession appear on the horizon they have no new tools with which to assist so this time around the markets will be left to sort themselves out and that will cause a lot of pain.

Adrift - Part II

"Let every man, every corporation, and especially let every village, town and city, every county and State, get out of debt and keep out of debt.  It is the debtor that is ruined by hard times." - Rutherford B. Hayes 

In order to stimulate the global economy it has been decided by the Federal Reserve and other central bankers that the only way is to print and monetize debt.  Back in 2005 the global public total debt was $27 trillion.  Ten years later this amount has more than doubled to $57 trillion.  As I mentioned in last week’s blog a lot of this debt is dollar denominated and while the “external” dollars are loosely controlled by the Federal Reserve there is still a level of control far in excess of the US's global economic clout.  This massive debt experiment was supposed to have achieved full employment and global prosperity but it seems to have done anything but that.

Taking a look at the incredibly weak employment numbers coming out of the US and one can see that things are anything but rosy.  Furthermore more than 94 million Americans or 38% of the total workforce are not even looking for work.  This is the lowest labor participation rate 38 years!  Inflation (according to the Federal Reserve) is close to a deflationary number and in many parts of the globe deflation has already taken hold.  In many countries interest rates are negative and still there is no end in sight to the low interest rate environment or even how low these rates can go.  I continue to believe that rates will go even lower for the simple reason that the global economy cannot be repaired with more debt.

As I have mentioned before adding more debt has the effect of crowding out market participants, clogging up the wheels of free enterprise and creating a drag on global growth.  In a chilling statistic the large cap stocks of the S&P 500 as a group paid out through stock buy backs and dividends all of their operating earnings last quarter.  No money was therefore spent on capital from which to grow.  Capital spending includes research and development, capital projects, factory expansions and heavy equipment and machinery purchases.  Money for operations was found in the debt market and used to buy stocks and pay dividends.  No wonder there is an ever increasing social divide!

This party is a massive problem for many reasons however it can last for years as long as low interest rates remain the norm.  Furthermore if those low interest rates are locked in for 20 or 30 years then there is also a benefit however this is not the case.  In fact there is almost $2 trillion of corporate debt coming due between now and the end of next year.  Now it appears that interest rates will remain low through that time however the spread between investment grade credit and junk is starting to widen to levels that are going to cause problems for a number of the companies planning to refinance.  This increasing spread is an indication that not all is well in the credit world and that there may be problems looming.  Should the Federal Reserve raise rates not only will this lead to a large increase in company defaults but the government itself would see a large increase in the deficit as the interest paid on its massive $18 trillion debt would rise pretty quickly. 

The main issue though is that at some point debt becomes deflationary and I think that we may have already reached that level.  Think about it in terms of your personal finances; if you are burdened with debt you cannot spend money on goods and services but are forced to pay down the debt.  The same occurs with businesses and, at some stage, government.  Companies already seem to have lost the incentive to grow their businesses mainly because there is no perceived or anticipated global GDP growth.  Instead they are juicing their numbers and their upper management with dividends and stock buy backs.  The has or will lead to a situation where companies are so burdened with debt that instead of using profits to fund growth it is used to pay down debt.  

The same happens with governments; they have issued so much debt that they are crowding the corporate world out and are getting to a tipping point where they will need to start to repay their debt.  With all eyes focused on paying the debt back not only is this not inflationary it in fact leads to deflation and slow growth both of which are being witnessed before our eyes.  Until there is some expectation of global growth large businesses will continue their financial trickery widening the social divide and removing any chance of a return to normalcy.

Adrift in Debt - Part I

"So you think that money is the root of all evil? Have you ever asked who is the root of all money?" - Ayn Rand

As the world is awash with debt and dollars I decided to take a look at the impact that all of this is having on global growth.  If one considers that the financial crisis occurred in 2008 / 2009 you would expect that by now with more than USD 27 trillion of new capital issued by the central bankers of the world that the global economy would be booming.  Furthermore you would also expect that by now central bankers of the world would be fighting the inflationary pressures of low unemployment and capacity constraints by raising interest rates and tightening the money supply however, as we all know, this is not the case.  In fact the global market is so weak that the Federal Reserve decided that it could not handle even a ¼% increase!

Delving into the facts and figures brought me to the conclusion that it would be impossible to take all of this on in one blog (well actually I could have but I doubt anyone would read all the way to the end) so I have broken my findings into three.  The first blog published below will deal with the currency market, the second blog will deal with the global debt and the third blog will pull all the findings together in a conclusion that will provide some insight into what I believe the future holds.

In today’s world there is one currency that transcends all others and it is the United States Dollar.  Trillions of dollars of transactions occur around the clock and around the globe all denominated in dollars.  In fact in a recent report the Economist Magazine estimated that more than 60% of all global trade is conducted in dollars.  If one looks at the dollar market it can be broken into two pieces; those that are issued by the US Treasury and those created with a stroke of the pen in banks outside the United States.  These so called Euro or Asian dollars are backed by the bank issuing the dollars rather than by the US Treasury but they are still dollars and can be exchanged as real currency.  This second set of dollars used to be quite small in value but now estimates place the size of these “external” dollars at roughly 60% the size of those issued by the US.

The reason countries hold these dollars is for ease of trade but also to hedge against movements in the value of the dollar itself.  Back in 1997 when the contagion of the emerging market currencies was in full force countries decided that the best way to protect their currency was to hold a lot of dollar reserves.  These can be used to mitigate massive currency swings and also can be used to acquire strategic resources if the local currency devalues sharply.  The idea is that if you can control your currency swings you can control the level of economic growth.  This theory was put into practice and worked well for a while however recent events have shown that there is a problem with this theory; you are now open to the vagaries of the Federal Reserve.

As we have seen, with the US economy being the supposed shining beacon in a world of poor economic results, dollars can move easily back to the mother-ship stranding the emerging economies and destroying their currencies.  Furthermore as the dollar gains strength the commodities and inputs so desperately needed become more and more expensive crippling the local economy further.  At the very moment that the local country is hurting most the Federal Reserve raises rates creating further havoc in the local economy.  With the economy in tatters dollars pour out of the weak economy to the strength and higher returns of the USA and so the spiral continues.

We have already witnessed this to some degree as the currencies of many emerging economies have seen both their currency and their economies crater as the world waits to see if the Federal Reserve will raise rates.  For this reason the Federal Reserve has more control over the global markets than most people seem to realize which is why I have repeatedly mentioned that they need to look more globally when raising rates.  So while the US economy is losing ground as a percent of global GDP the Federal Reserve is still in control of a large portion of the globe's destiny due to the massive amount of trade handled in dollars and their veto power at the World Bank and the IMF (both of which are in a serious state of neglect and under funding).  Interestingly then at the time when the US so desperately needs to show global leadership they are more intent on political infighting and this will have a massively negative impact on global growth for years to come.

Amazing

"Sometimes it takes the worst pain to bring about the best change." - Anonymous

Today the US economy sputtered out truly weak employment numbers.  This was followed up with a 1.7% factory order contraction.  Neither should have come as much of a surprise but what is amazing is the recovery in the stock market.  Initially the market sold off almost 1.5% before staging a massive recovery and accelerating into the black on the basis of a rally in the NASDAQ.

What is amazing to me is that anyone is buying stocks at these levels and particularly in the face of weak economic numbers and a future that is looking increasingly weak.  I understand that the stock market is forward looking so it must be seeing a new round of quantitative easing coming as there is nothing that I can see that should spark a rally outside of the Ponzi scheme that is Federal Reserve money laundering.

Let's take a look at what the market faces from here; the weak oil prices will continue to put a lid on any growth out of that sector while providing some relief for the consumers, however with the weakness in the economy coming from the strength in the dollar layoffs should continue undermining the resilience of the consumer.  Furthermore China, Europe and Japan are slowing so limited growth can be expected from those regions.  Weakness will continue in emerging markets as the strong dollar is creating havoc with those financial markets and their access to capital; money is repatriated to the safe haven of the US hurting access to capital forcing governments to raise rates to protect their currencies.  Corporate earnings season is also about to start and we should start to see the impact of a slowdown overseas plus a strong dollar so I expect those to be weak. Finally margin cash is at an all time high so the ability to continue to buy stocks is limited.

With all of this bad news it certainly is a wonder that the market participants see a reason to buy but that is exactly what they are doing this afternoon.  Who cares about all of the above when you are convinced that the Federal Reserve will once again step in to rescue the poor and needy investment bankers.  The fact that after more than $4 trillion dollars of stimulus we are still grinding forward is of no concern to anyone it seems.  In fact the Federal Reserve is still talking up the coming interest rate hike and this is right after they voted 9 to 1 against raising rates at the last meeting!  Market strength is coming from the massively over valued bio tech sector so I guess market participants are finding a last banner of hope on which to fly their flags.  It is certainly working for now but don't get fooled.

Another interesting fact is that the government will spend nearly $4 trillion this year while collecting roughly $3.5 trillion.  These are records by the way.  Tax revenues are up 25% since the market crisis but our leaders have managed to increase their spending by 33%, way to go!  By now we should be firmly into budget surplus particularly when you are borrowing money at close to zero.  If interest rates were to rise we would quickly see this deficit balloon back into the trillions as the cost to the government of a 1% increase in borrowing costs is $200 billion.  Were we in a budget surplus position right now I would have to say stocks would be the way to go but with all of the above it is truly a marvel to me to see the market rally.

I guess I should not be surprised but even after all of these years it can still amaze me to see resilience fly in the face of reason but, more often than not, reason wins out.  So for now I will remain firmly on the sidelines and watch with amazement as the global experiment that is money printing plays its manipulative tune on the markets.

Picture This

"Every picture tells a story." - Proverb

Looking at tea leaves you can apparently predict the future.  I am not sure that I will ever believe that but the charts below seem to indicate that the future for the market is tough sledding ahead.

The first chart shows the S&P 500 chart for the past twelve months.  As you can see the index was stuck in a trading range for most of the year before falling to the support line around 185.  It bounced there but could not break above the resistance at 900 and appears to be under duress at present. 

Before drawing conclusions it is always good to take a look at what some consider to be the market's leading indicator and that is the Russell 2000.  This index is made up of 2000 smaller companies that make up a broader market and also tend to lead the charge on both the up and downside.  The reason being that smaller companies benefit from and feel the pain of positive and negative market impacts far earlier than the larger companies.  Taking a look at this index and one can see that the lows of 2014 have still not been reached.  In fact this index is holding up better than the S&P 500 at present but that said it also looks weak and if the lows of 1050 are broken it could signal a very poor market ahead.

The final index that I want to look at today is the Dow Transportation Index.  There has never been a period of new market highs without the transports recovering and settling into a long run bull market.  The reason for this is that transports are the pipes of the economy that funnel growth.  If these pipes are crammed full then things should be going well and if not watch out below.  It is clear, looking at this chart that the transports are signalling more weakness.  Not only are they in a prolonged downward trend but they have clearly breached the 2014 lows and are not showing any clear signs of a recovery.

So while the Federal Reserve once again begins its jawboning about raising interest rates it is clear that the market is uneasy and while we may have just entered a correction it is certainly looking like some more pain lies ahead and I would not view this as a buying opportunity.

Boxed In!

What a surprise, the Federal Reserve this week left interest rates alone.  Readers of this blog would have expected nothing else but what is now interesting is that this move shows how the Federal Reserve is completely boxed in.

The market got what it desperately needed, low interest rates to prop up ever higher values and free money to go deeper into margin debt, but after the S&P 500 jumped to 2018 minutes after the announcement was released it dropped 60 points or almost 3% a day and a half later!  Had the Federal Reserve raised interest rates it may have cratered even more so it is clear that regardless of which direction they head the one banner of hope, the US Stock market, has decided that enough is enough.

Everywhere that you look people are losing their jobs.  HP, Qualcomm and the LA Times being the most recent companies to announce mass layoffs but I am sure there are more to come.  The slow down in China and the rest of the world is having a marked impact on large US business and this is feeding into an accelerating slowdown in the global economy.  Whether the market bounces around here for a while before cratering or whether it keeps accelerating to the downside it is clear to me that the world's economy is in bad shape and this will feed into market returns.

It is also clear that printing money and giving it to banks to exploit does not work.  It never has, it never will and it certainly is not working now but I am sure that if the market continues its downward spiral that they will fire up the printing presses in one more effort to prove that they can fix the problem with even more debt.  Moreover I expect that they will be joined by the rest of the world's central bankers in one last almighty money printing effort.  This is the fuel needed to explode gold and precious metal prices higher and with the mining stocks at decade lows it is, to me, the only place in the market to allocate investment dollars.

I have said it over and over in the last few months but I see no reason to invest in the stock market other than in precious metals and mining stocks but as those normally make up a very small portion of an investment portfolio I would advise cutting your exposure to a 10th of what it normally would be and wait it out or, as I am doing, find alternative investments that will take advantage of the situation and alleviate the daily stress of an overly hyped market.

The world engulfs the USA

"You know, I think of the global economy as an inverted triangle, resting on the shoulders of the American consumer.  and if the American consumer cannot have enough disposable income in order to maintain a standard of living that creates more opportunities generation after generation, that's bad for everyone." - Hilary Clinton

In decades past the world was firmly in the palm of the United States' hand.  Whatever happened economically in the United States was immediately exported to the rest of the world but as recent troubles in China have shown, those days are over.  While this was always inevitable the speed at which it has happened is truly amazing and the impact on ones portfolio need to be addressed in far more of a global light than ever before.  It appears that the world has now finally engulfed the United States and the scary part of it is that as the quote above shows our political leaders have their heads deeply buried in the sand (or somewhere else far from reality).

One of the biggest issues with the current economic arena in the United States, and one that I have discussed at length in previous blogs, is the tilting of the playing field firmly in the direction of big business at the expense of small business.  For the past 50 years or more big business has employed legions of lawyers and lobbyists to drag government policy toward their side of the ring.  In addition to this politicians are no longer ordinary people bent on improving the lives of their citizens but are career political clowns.  The mix of the two has created a huge divide between the upper and lower classes and this can be seen in the frequent social unrest across the country (mostly related to police brutality and race discrimination but the aftermath gives a sense that their is more to the frustration).

As large business is now clearly in the pound seat when it comes to business laws, political control and access to capital, the effects of global problems are felt very quickly.  Back in the 90's when there was a problem outside of the United States' borders the impact was minimal for the simple reason that small business was in its prime and large swaths of the economy relied exclusively on their output.  These businesses were more immune to a slowdown or problems abroad as their market was local not global.  According to the SBA the percent of GDP related to small business in the United States has fallen from 51% to 45% since 1998 and the downward trend shows no sign of turning the corner.

Furthermore back then large business had more of its products consumed within the country's borders than outside but today with small business reeling and large business exposed across every border in the globe, crises from abroad impact the United States almost instantly.  So while the current slowdown in China may not necessarily mean a recession there it could easily export a recession to the United States for the simple reason that a large portion of United States company revenue and earnings growth has come from China's previously strong economic growth.  Add to this continued slow growth in Europe and Japan and external forces are now having a larger than normal impact on the United States economy.  As a larger than normal percent of US GDP growth is reliant on large business (55% and climbing) and the companies that make up the S&P 500 are feeling the pinch in both their revenue and earnings growth, the impact of a global slowdown is being felt very rapidly in the United States.

If the playing field was more balanced and small business was booming, the issues abroad may be contained slightly more but the greed of both policy makers and large business is now coming back to haunt the United States who will continue to struggle with economic growth and wage distortions until the structural issues that have been created over the last 50 years are unwound.  The problem is that outside of Donald Trump every candidate is a career politician with no incentive to change the rules as doing that would hurt the people changing the law - themselves!  Now while I am not a fan of Donald at least he is a breath of fresh air and while he more than likely will not win the presidency he has certainly gained the ear of the American people for the simple reason that they are fed up with more of the same.  It is a pity then that the politicians cannot see the error of their ways and start to make amends but until then expect the market to become more prone to huge swings associated more with the outside world's issues than with problems in the United States.  Time to brush up on your macro-economics as this will have more impact on the market direction than a set of good financial results.

The Palm Tree Index

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

In our efforts to extrapolate an edge over the market we investors and analysts are constantly searching for a predictive index or data points that give us proper insight into the future of the economy.  In the good old days Warren Buffet used to go to Disney movies repeatedly just to see how full the cinema was so that he could estimate whether Disney stock price was undervalued and worth owning.  Nowadays hedge funds often acquire the rights to satellite images of shopping malls during the holiday season to see how full they are and then use this data to try to predict how strong the holiday shopping season will be.

While these efforts may have some validity there are numerous indices that are completely useless such as the football index that has predicted the year's market direction about 80% of the time based on whether an NFC or an AFC team wins.  There is obviously no correlation between the index and the market so the index is a mere coincidence.  With the current market volatility and the questionable reasons being given for the negative sentiment (such as a quarter percent rate hike), it seems to me that it may be time to look at two indices that have some presidence regarding the future.

Before I look at these one needs to understand that assuming the Federal Reserve makes an adjustment to the interest rates the immediate impact on the economy is purely psychological.  There will be minimal difference in the rate charged to home buyers, there will be limited impact on companies borrowing money and you will not see a sudden spike in the interest rate on your credit card.  The initial move is more of a signal to the market that the economy is overheating and requires some cooling down.  This is the first step in a long road to supposedly finding that happy medium between growth and overheated.  An increase in rates takes time to achieve its goal of slowing an overheated economy and as the economy is far from overheated I would expect at most a very gradual controlled rate increase rather than the accelerated pace that we witnessed under Greenspan back in the late 90s when he was fighting a true bubble (by the way one that he created with his loose policies).

The first index that I want to discuss is the price of copper.  As I have mentioned previously, copper is a global product that is driven by the forces of demand and supply.  A rise in the price shows growing global GDP while a sharp drop in the price of copper shows a world where GDP is slowing quickly.  While the price of this commodity is fairly volatile the price has been in a tail spin since May falling from around $3.00 to $2.25, a drop of 25% in 4 months.  This indicator is clearly signalling a sharp global contraction.

The second index that may seem a little on the wild side but is what I am referring to as the Palm Tree Index.  A friend of mine has a palm tree business and each time the economy slows his business feels the heat almost instantly.  The underlying reason is put down to discretionary spending and people and companies will cut out the palm tree for a much cheaper tree when times start to become difficult.  In his words; "When the market tanked last time (2008) I saw the slow down coming in palm trees well before the #@!# hit the fan --the phone stopped ringing -- ironically my business has been crazy busy this year until about two weeks ago -- the phone has stopped ringing -- somewhat similar to back in 2005 without the weird mortgages."

So while the Federal Reserve toys with the idea of slowing the economic growth engine with its first rate hike in years I believe that the rest of the world's woes are doing this job nicely and it may be that we are very close to a global recession.  Certainly not the time to be putting on the brakes and it may be that with hindsight the historians will come to the conclusion that as in the 1930s so again in 2015, the brakes were put on at the exact wrong time.  This certainly would not surprise me in the least but one thing is for sure it is a critical decision for the globe economy.  Palm trees anyone?

Dead Cat Bounce?

"Even a dead cat will bounce if dropped from high enough." - An old trading saying

The dead cat bounce is a term used to describe a rally in a bear market.  After the market craters there is often a short term rally that can suck people into buying stocks thinking that the worst is over and that the market has finally reached the bottom.  Backing this up will be the talking heads on Wall Street and television to talk their book, encouraging people to buy stocks "on the cheap".  The focus of their discussion is normally on where the stocks were a few days or weeks ago and how a recovery is imminent.  (I can see them hanging their "buy now while cheap" signs out their windows now.)  There is never any discussion on where the stock could go if the bludgeoning continues and more often than not it is a lot lower than people can even imagine.  So let's take a look at the dead cat bounce and see if this is one of those events or not.

First off the market has not entered a formal bear market or even a correction yet.  A correction being a fall of 10% or more which while briefly touched during the trading session of the 25th did not stick as the market rallied sharply from that level and closed well off the lows.  As we are not formally in a correction there is a chance that the bounce is sustainable as the sell off could be just that, a sell off caused by the China rout and we are back to business as normal.

The next two thing to look at are the magnitude and age of the sell off.  While relatively deep the sell off still did not enter a correction so by this metric it may be more than a bounce. Considering the short period of a week it is very young and therefore has not established itself as a longer term bear market.  As the "correction" (assuming that is what we are witnessing) is an infant there is a good chance that the market has legs and can do more than just bounce from here but can somehow spring back to life.

A fourth thing to consider is which stocks were responsible for the recovery rally.  Looking across the board it appears that it was a short covering rally as stocks like Arch Coal gained 33% while Google only gained 3%.  The former has a very concentrated short interest (sellers that have no stock in the company and are betting that the price will fall) while the latter has very little short interest.  Short covering is considered a key ingredient to dead cat bounces as they are not true buyers of the stocks but are just covering their trades to lock in profits.  Once their covering ends the market resumes its previous trend so this metric checks the box of a dead cat bounce.

The final thing to consider is the underlying fundamentals of the market.  With the long unchecked upward trend well overdue for a correction, stock price valuations way above normal, China's economy cratering before our eyes, Europe and Japan weak and the Federal Reserve up against the wall it looks very much to me like the dead cat bounce wins the day.

Regardless of whether I am right or wrong on my prediction you should ask yourself, based on the week's massive volatility is this a market that I really want to play in and if you do is it a speculative investment or something that you truly believe in?  My guess is that anyone that is willing to buy stocks here is gambling with their investment dollars and that is a sure way to the poor farm unless you are a seasoned professional in which case you would be short the market.

The Market Sobers Up

"Statistics are used much like a drunk uses a lamppost, for support, not illumination." - Vin Scully

After a party that has lasted almost seven years it is looking more and more like the market is waking up to reality.  After the binge on easy money and low interest rates of the past few years it looks like there is a realization that the economy is too weak to handle an interest rate hike and that if the Federal Reserve does not hike rates soon things will get out of control on the inflation front.  In other words market participants are finally realizing that the Federal Reserve is boxed in and this is making market participants nervous to say the least.

Now while I could go on about how an interest rate hike will have negative impacts on earnings, housing and the market I do not plan to use the lamppost for support as I have done that at length in previous blogs.  What I can say is that the market appears to be hanging on to a very weak thread and that the correction so long overdue is looking more and more probable by the day.  On a trading basis the level of support for the S&P 500 is 2046.50.  This level was briefly tagged and broken on Thursday and should a sustained rally not ensue on Friday things could get ugly for the simple reason that margin debt is at the highest level ever recorded and the vast majority of that money will exit the market en masse at any further sign of weakness.

For those of you still interested in staying in the market (for reasons that I cannot understand other than you once again wish to be beaten up by another vicious market draw down) I would hope that you will move a large portion of your investments to gold miners and possibly their silver brethren.  These are stocks that are down 80-90% from their highs and should the market implode they will benefit from a rise in the value of gold.  Furthermore the ratio between the gold price and the price of silver is wide and should mean that silver will appreciate faster than gold.  Still silver is a squirmy beast not easily tamed so expect an adventure in that market but that to me is the only place to turn right now.

Outside of that ensure that you do not get sucked in by the lamppost leaning drunks who throw any kind of statistic at you to make you believe things are going well.  They are not, not in the United States, not in China, not in Europe and not in Japan.  Furthermore the market is due a correction so ensure you do your homework and sidestep the impending mess.

A Gun Fight

I couldn't resist inserting this link to the You Tube clip of Indiana Jones taking on the sword wielding bad guy.  The rule of course is never bring a knife to a gun fight!

https://www.youtube.com/watch?v=7YyBtMxZgQs

So while the market tries to blow off the Chinese devaluation of the yuan (twice in two days) it is clear that the Federal Reserve is bringing its sword to the gun fight that is currency devaluation.  Already this year the dollar has surged against a basket of currencies (see graph below) but apparently the Chinese economy, the second largest in the world, needs more help to try to resume its growth.  (This is a five year graph with 2015 in the last block of the graph.)

This dollar surge is hurting the large companies that represent the S&P 500 for the simple reason that the price of US goods and services when priced in dollars is becoming more expensive throughout the globe.  Already we are seeing companies from Apple to Tesla complain of the negative effects of the dollar rise and all are ratcheting their growth projections down.  Behind this slowdown are the announcements of large scale layoffs but according to the Wall Street Journal this morning more than 80% of economists expect the Federal Reserve to raise interest rates in September.

Now while I do not expect them to raise rates they might just to show the world how tough they are but that would be akin to the sword wielder in the clip above.  Raising rates would fuel a further expansion in the value of the dollar and would hurt an already slowing economy even further.  Not only would it hurt what is left of economic sales growth outside of the US but it would hurt internal growth as well as a rate increase would feed negatively into housing and investment.

It is interesting then that in light of this and the impending interest rate raise that the bond market is gaining momentum to the upside lowering the yield on the ten year note to levels not seen in months.

So it appears that the bond market is signalling no interest rate hike is coming which to me makes the most sense.  The market itself has struggled to break the trading range since February and briefly broke below support on Thursday before showing a strong recovery but I would not want to be the canary in the stock market's coal mine or the sword carrying Federal Reserve as once they raise rates the rest of the world will relish the chance to devalue further killing off the only economy in the world showing any form of strength.

The Resurrection of Houdini

"My professional life has been a constant record of disillusion, and many things that seem wonderful to most men are the every day commonplaces of my business." - Harry Houdini

Harry Houdini as most of you I am sure are aware, was one of the greatest magicians ever to live.  His feats astonished many but as the quote above shows, he used commonplace ideas and props to achieve the marvelous.  As a great magician one of his greatest mysteries is how he died but it appears that he has managed to resurrect himself in the form of a central banker or an analyst or someone with great power in the financial sector as apparently there will be a miraculous global economic recovery later this year.  Not only this but the Federal Reserve will be so amazed by this recovery that they will press the raise interest rate button and we will gracefully grow into the future with not so much as a ripple to disturb the peace.

This is certainly what the market is pricing but I have to say that there is a mild form of despair lingering in the air particularly after this week once again saw the markets falling back into the trading range that has been intact since the beginning of February.  Since May the market has tried three times to break to new highs but each time it has been beaten back and this week's attempt was feeble to say the least.  It may be that the market is waiting for the Federal Reserve to raise interest rates or for some signs of economic strength however the numbers and data points are showing anything but strength.

While the payroll report today showed continued strength I expect this number to be revised lower and certainly to weaken later in the year particularly when you factor in all layoffs announced during the recent earnings season.  Outside of this small show of strength the economy is slowing down rapidly.  The main reason that analysts point to an interest rate hike in September is due to the supposed labor market strength and a recovery in the second half of the year.  To me neither is happening but everyone else seems to believe that it is mainly due to the smoke and mirror dance being talked up by the central bankers of the world.

Take retail sales growth for example, these are nearing contraction levels and have been falling since mid-2011.  Automobile sales, one of the bright points in the economy, has been growing due to low interest loans and discounts.  This is normally a sign of future weakness as stuffing the channel today results in weak sales later.  In fact if you strip out automobile growth United States GDP year over year growth is zero.  China is slowing at an alarming rate dragging down all the commodity rich countries with it and Europe along with Japan are still a basket cases; BUT, magically in the second half of this year the US will lurch forth with a spate of growth and rescue the world once again.  Not only that but it will shoulder an interest rate hike to boot!

Yes, Houdini has definitely returned but this time when the slight of hand is revealed it may be too late to stop the Federal Reserve pressing the interest rate button and the world economy will already be in a state of shambles.

The Great Unknown

"We are now ready to start on our way down the great unknown. Our boats...are chaffing each other, as they are tossed by the fretful river.  We have but a month's rations remaining.  We are three quarters of a mile in the depths of the earth, and the great river shrinks into insignificance, as it dashes its angry waves against the walls and cliffs that rise to the world above; they are but puny ripples, and we but pygmies, running up and down the sands, or lost among the boulders. We have an unknown distance yet to run; an unknown river yet to explore.  What falls there are, we know not; what rocks beset the channel, we know not; what walls rise over the river,we know not." -   John Wesley Powell explorer 1834 - 1902

As humans we are constantly striving to uncover the hidden secrets of the universe.  Centuries have been dedicated just to answer questions such as what is the purpose of life, are there other civilizations out there and who am I?  There may never be an answer to any of these but it does not stop the human mind from questioning and probing.  So too in the world of finance people have for centuries tried to develop systems that take advantage of perceived market anomalies or try to remove the risk from investments through diversification.  Medicine too is constantly trying to extend our lifespan with new wonder drugs and treatments but in all of these one thing is very seldom considered - the great unknown.

Let's start with medicine.  Clinical studies are a very poor way to determine whether a drug is right for the final patient.  No two people are the same and no two people have the same diet or drug intake, all of which will have unintended effects for the taker of the drug.  Furthermore the methodology used drives the cost of the drugs to such heights that often the people most needing the drug are not able to afford them.  Finally, the testing process is short (and often riddled with one sided data) while sometimes the prescription period can be decades leading the patients into the great unknown as far as side effects and impacts on their health is concerned.

In finance it is the same.  Legions of "trained" financial experts continue to develop the next new product that will satisfy the masses required rates of return while limiting risk, providing a one stop shop where the lemmings can deposit their money and walk into the sunset and off the side of a cliff.  "Fortunately" the investment bankers are protected by the laws set up to protect the innocent and as long as they disclose properly (normally in such small font that the majority of people cannot read it and certainly way to complex to understand) and charge low fees they can advertise that they have the solution to everyone's investment problems!  Once again the problem is that these tools are not tested on real data but on past data (data mining or back testing it is called) that is easily manipulated and does not reflect reality or the great unknown.

In either of these examples the first thing to understand is that the great unknown will always be unknown.  There is no way to uncover its secrets.  Furthermore secrets that are uncovered reveal that there are more unknowns.  So worrying about the unknown is a waste of time, what your focus needs to be on is how to benefit from the unknown.  This is not an easy question to answer as how can you benefit from something that is unknown?

As this is a financial blog I will respond to this question by remaining in the world of finance but the answers can be transposed into any area that you like.  In finance the thing to realize is that there is no such thing as normal.  A "normal" return is absurd as the market is constantly changing.  Take for example interest rates.  Right now the "normal" risk free rate might be considered 2% but in the context of 100 years 4% might be a better proxy for normal but then again what do the first 50 years of the century have to do with me and was that period, which included world war one and two "normal"?  Looking back just 20 years and the Internet was in its infancy so why was that "normal"?  So if a normal rate of return is ludicrous then what you have to determine is your required rate of return and forget about everything else as it is just noise.

The next thing to understand is that the unknown will, at some stage, create havoc in the markets.  This is not an "if" but a "when".  Consider all the financial tinkering done by the world's central bankers and it quickly is clear that there will be a problem sooner or later it is just a matter of time.  Also believing that the central bankers of the world have the ability to avert the problem is naive at best.  In reality they are the biggest part of the problem as the more that they try to "protect" the more harm is done in the unintended side effect of the unknown.  In other words, the more they try to smooth out volatility the greater the volatility will be once it reappears.

So the key is to invest in a way that not only produces your required rate of return but benefits from the fragility of the financial situation.  As Taleb coined "Antifragile".  There are simple ways to start the process for example try to be debt free or even better keep some cash aside to buy when the markets crater again.  More creative is to purchase put options on positions with perceived large downside in weak markets or distressed debt on properties in solid economic hubs at pennies on the dollar to mention a few.  There are many more ways to benefit from the unknown but the investment style, risk and expected return need to be a good fit for the investor.  One thing is for sure; to ignore the great unknown is akin to financial suicide so make sure you review your investments in light of this outlier and rework it so that you benefit as that will be an abnormal return!

An Island

"No man is an island, entire of itself; every man is a piece of the continent, a part of the main. If a clod be washed away by the sea, Europe is the less, as well as if a promontory were, as well as if a manor of thy friend's or of thine own were: any man's death diminishes me, because I am involved in mankind, and therefore never send to know for whom the bells tolls; it tolls for thee." - John Donne poem For Whom the Bells Toll

As the poem above illustrates, no man is an island.  I would also go on to say that no portfolio is an island and no country is an island.  For as much as we believe that we are insulated from global affairs and that we can hid from economic disasters unfortunately the reality is that we are very closely linked to events and affairs in remote parts of the world.  So when planning an investment strategy you need to take into account not only the investment's return and risk but also how it fits into the overall portfolio and then how that portfolio will withstand shocks from the outside world.  Talk about difficult!

Let's start with what I will term the "direct" influences on the portfolio; for example a company in which you have an investment has good earnings and the stock rises.  The impact on the investment is directly related to that investment.  These impacts give the investor the sense that their portfolio is an island that is only affected by direct influences.  Under these pretenses an investor would be forgiven for thinking that a portfolio where the investments show a certain lack of correlation is well diversified and therefore protected.  However looking at "indirect" influences might shed an entirely new light on the picture.

"Indirect" influences are varied and can be as remote as an earthquake in China to close to home such as losing your job.  When putting an investment portfolio together these "indirect" influences can actually be far more important than the "direct" influences in that they make up a larger portion of the portfolio and can have a magnified impact on the overall return.

Taking the close to home influences first a lot of investors make allocations based on what is perceived as a "normal" investment strategy and use a mix of stocks and bonds with little consideration even for these "indirect" influences.  The allocations are normally based on age and do not incorporate other "indirect" influences which is a mistake as leaving these off the table can destroy a portfolio quickly.  Some of the main "indirect" influences not considered are human capital, riskier employment and riskier home ownership.  Unfortunately this blog does not have the time to delve into each of these now (but I may in subsequent blog posts) but these "indirect" inputs often make up the bulk of the investment portfolio and are not considered.  Allocations into areas related to these inputs magnifies the impact of these thereby undermining the overall portfolio's resilience.  Furthermore allocations into higher risk areas when the "indirect" influences are already high in risk adds significantly to the overall risk of the portfolio and should be shunned for a more conservative approach.

Looking further afield complicates the investment process further.  In reality the idea that these influences can be predicted is asinine but with the global economy so highly integrated a general understanding and consideration of these "indirect" influences needs to be assessed during regular financial check ups.  While no-one has knowledge of what the next Black Swan will entail performing some kind of stress test on the portfolio would be helpful but unfortunately most stress tests do a poor job and often are not even considered let alone performed.  To me this is a big mistake and can expose a portfolio to unnecessary risks as, when the expected protection from diversification is most needed, it tends to evaporate.

In conclusion then your investment portfolio is anything but an island so ensure that you review carefully the impact of the "indirect" influences on your portfolio as these will have the largest influence on the overall returns of the portfolio.  Shunning an analysis of there will expose you to risks that will undo even the most carefully diversified portfolio.

Risk Free?

"The biggest risk is not taking any risk.  In a world that is changing really quickly, the only strategy that is guaranteed to fail is not taking any risks." - Mark Zuckerberg

If you had taken a wander into the deepest darkest jungles of Brazil for the past seven months and had suddenly emerged it would appear on the surface that nothing had changed in the world of finance.  The rate on the 10-year Treasury was roughly the same as it was at the beginning of the year, the stock market has essentially not budged and looking abroad it is much the same picture on the international scene (other than the Chinese stock market).  You would be forgiven for thinking that everything was moving along in a slow and steady march to prosperity but what the surface reflects is not the case behind the scenes.

Take the German and the US 10 year bonds.  These assets are considered by the financial world to be the two investments considered to be as safe and as risk free as is possible.  The perception is that there is limited to no chance that an investment into either of these assets will ever result in a loss of principle.  The investment therefore is considered risk free.  Tied to this investment is a rate of return or yield and this yield is considered to be the risk free rate.  Any investment made outside of these investments other that shorter or longer termed investments into these government bonds is expected to return something in addition to the risk free rate.  The term for the return in excess of the risk free rate is the risk premium and the risk premium should coincide with the risk of the investment.

As an example if you invest in a high quality corporate bond the risk of default may be low but it will still be more than the government debt so it should yield slightly more.  As you move out on the risk scale to say private equity, the risk of loss increases considerably but so too should the expected payout therefore, the expected return on the investment should be substantially above that of the government bond.  All other investments fall somewhere along the spectrum of risk and return and all are measured against the baseline of the risk free investment.

So one would then consider that the risk free investment, being risk free, should remain relatively stable.  Considering that the central bankers of the world do not adjust the interest rate on the underlying bonds often, the only thing that adjusts the yield on these bonds is the secondary market which trades these bonds after they have been issued.  It is the forces of supply and demand in the secondary market that determine the current yield on the investment and these forces are influenced by the expectations of the market itself.  Even so the market should be relatively comfortable with the security of the investments so they should remain relatively stable with some minor movement here and there.

Looking at the yields on these two assets year to date shows huge fluctuations in the yield of these assets.  The German Bund has gone from a yield of 0.80% at the beginning of the year to a yield of zero before rocketing back to 1.00% and then falling back to its current position of 0.80%.  The 10-year Treasury cratered from 2.20% at the beginning of the year to 1.63% before bouncing around and then jumping up to 2.45% and then gradually coming back to around the 2.20% mark again.  While to the outsider these moves may seem small but percent wise these are enormous moves and throw into question just how safe are these investments?

Now I am not considering for a moment that these investments will not be repaid, they will and so they are safe but what I am pointing out is that the world of investments at present is anything but safe.  There are considerable undercurrents that are bubbling below the surface, the majority of which are being created by the massive "stimulus" policies of the central bankers and this is what is causing the massive swings in a normally complacent market.  Think of it in terms of global warming, as the world heats up there are more and larger environmental consequences beyond the control of humans, the same is happening in the world of investments; as the pot of money sloshing around the financial markets increases daily by billions of dollars in the biggest monetary expansion experiment known to man, so the risks to the financial systems around the world increase exponentially.

In this ever changing world make sure that you keep a close eye on the gyrations in yields in these markets as until they settle down it is clear that there is a lot of risk that is being hidden below the surface.

A Bubble Bursts - Oh Well

"If you must play, decide on three things at the start; the rules of the game, the stakes and the quitting time." - Chinese proverb

"Please God, just one more bubble." - Bumper sticker in Silicon Valley 2003

Since the June 13, 2015 peak of 5,166 the Chinese stock market plunged to 3,507 on July 7 before staging a moderate recovery.  The loss of 1,659 points or more than 30% has all the signs of a bubble bursting.  Certainly at their peak Chinese stocks were far too richly valued with the average price to earnings ratio at 64.  To give you a metric for comparison, U.S. stocks normally trade with a P/E of 15 and are thought to be extremely overvalued when they reach 25.  So there was no doubt that the Chinese market was in bubble territory and I would expect that it has far further to fall as even today the average P/E for Chinese stocks is above 40 and their stock market is still up over 20% year to date and up almost 100% over the last twelve months.

This sudden plunge spooked international markets and combined with the Greek issues and the possibility of an interest rate rise it appears that the market in the United States is ready to follow suite, but while the two external shocks are bad for the locals I have little reason to believe that these events will undermine the US economic recovery.  First the fallout in Chinese stocks seems to be a local affair with the small investor taking the brunt of the fall.  Second the Greek issues are largely contained as most of the debt, assuming it is written off, sits in the central bankers coffers rather than individual banks.  Third the chances of contagion occurring throughout the Euro zone are limited as the poorer performing nations are expected to remain in the Euro and may even get their houses in order quicker once they witness the fall out effects of a Greek exit.

So while the markets here are gyrating wildly these events are not the black swan that people are waiting for (remember that a black swan event is something completely unknown so by its very nature these events cannot be black swans).  The short term results are more than likely a longer period of low interest rates and potentially a resumption of the secular gold bull market.  The Federal Reserve is under no pretenses that the global economy is weak and has been further weakened with these events.  Furthermore raising the interest rates now, as I have repeatedly blogged, would strengthen the dollar and weaken the tepid recovery in the United States right when it appears that there is finally some decent economic traction.

Whether the market recovers and shoots to new highs is any ones guess but to me a decent bet would be to buy into some of the gold mining stocks.  They have really been battered over the past few years and if the Chinese move their money from the stock market into the gold market, as is being promoted in China, it would not take a lot to tip the scales back into the gold bull camp and this would be magnified in the down trodden gold stocks.

Good Greekf!

"Good grief." - Charlie Brown

No the heading is not a typo but a poor play on words as it seems to me that there is a very lackadaisical attitude towards the Greek debt issue.  Not only does it seem that the world's leaders and markets have assumed that Greece will remain in the Euro they have also assumed that the debt will be repaid!  Less than a year ago Greek debt was yielding less than 6% and today with default imminent it is only at 14%, hardly a big number considering the risks of default.

If I look at the situation from a turnaround and restructuring perspective it appears to me that the Greeks have nowhere to turn other than to leave the Euro and default on all of their debt.  Sure they have the ability to recover but they need the ability to let their currency devalue steeply to achieve the necessary stimulus that lower prices will have on tourism and exports.

While some may argue with me that leaving the Euro would be suicide I would point out that adding new debt to an already over burdensome debt level definitely will not sort out the problem.  Reducing the debt to a manageable amount would raise the heckles of Portugal, Spain and Italy so this is virtually off the table; so all that remains if they stay in the Euro is to lend them more money essentially kicking the can once again down the road.  This is exactly what happened last time this crisis was here and all it did was delay the inevitable for two years.

Even a moratorium on all debt and interest payments for say 5 years would still not provide enough runway to repair all of the structural problems that Greece faces and I question whether their current leader is mature enough to handle such changes.  In fact until these structural changes are implemented even leaving the Euro would not solve their problems in the long run but it seems to me to be a far higher probability than the markets are expecting.

So if the markets are not pricing a Greek exit from the Euro and it happens then there will be bloodshed in the markets next week for the simple reason that it would be an unexpected outcome.  To me it should not come as a surprise however the depth of the market correction will be unknown.

I would like to wish all of my America colleagues, friends and readers a very happy 4th July.