Speculate Like Its 1999

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

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

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

 

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

 

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

 

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

 

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

The Rise of the Temporary Worker

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

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

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

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

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

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

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

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

Death of the Hedge Fund

"When markets are trending up strongly, and there is bad news, the bad news counts for nothing. But if there is a break that reminds people what it is like to lose money in equities, then suddenly the buying is not mindless anymore. People start looking at the fundamentals, and in this case I knew the fundamentals were very ugly indeed." - A quote from Jack Schwager's book 'Hedge Fund Market Wizards'

There was recently an article publish in Bloomberg Magazine that pointed to the poor performance of hedge funds over the last few years.  The article went on to say that hedge funds are a thing of the past and that paying their exorbitant fees was ludicrous particularly when you look at their under performance compared to their mutual fund brethren.  The cover of the magazine was a man (I presume a hedge fund manager) with a graph pointing down that seemed to find its source at his crotch.  I am sure that this was not done by accident!

For decades the world has had a love hate affair with hedge funds and the managers that run them.  The fact that a number of high profile managers have made billions of dollars and spent these lavishly has not helped the hedge fund cause or image which has been portrayed as a bunch of wild men taking massive bets on market swings.  While to some extent this may be true, hedge fund managers are, as a group, considered to be some of the top investment talent in the globe.  Most of them have stellar pedigrees of trading success and have shunned the norm to create value through Alpha.

Alpha is the holy grail of investing in that it is a measure of excess return for a given level of risk.  Say for example an investment that should, based on the risk of the investment, return 6% produces 8% then the additional 2% is said to be the Alpha.  It is this Alpha that hedge funds tout as a reason for paying their high fees and these fees limit their investor base to high net worth investors.  Not only are these investors considered sophisticated, they can wait for a strategy to play out and over the years these individuals have been rewarded with massive wealth at the expense of the average investor.

The reason for their success is that hedge funds do not run with the market.  You do not make billions of dollars by betting that the market will continue in its current direction forever (which is what the majority of mutual funds do).  How the money is made is by taking bets that the cycle will end, seeing the end coming and then leveraging up to make a killing.  Now this strategy is one of many, but it is the most publicized as this is where the pain (losses) is felt and the quick money is made.  This also explains why hedge funds are under performing the markets right now - they do not expect the current market to continue and they are getting ready for the fallout.

These funds will perform magnificently well if and when the market crashes and that is why an allocation to hedge funds should be added to your portfolio.  Not keeping up with the market during good times is less of a worry and should not be a concern if the investment continues to make money when the market capitulates and this is what hedge funds offer.  Blindly throwing money into a market that is not based on solid economic fundamentals is not an investment policy followed by hedge funds.  Making and protecting their investors money during bad times is what they have been created to do and this is why an allocation to them is critical particularly when they are under performing the market as you can bet your bottom dollar that in the near future they and their investors will be laugh all the way to the bank.

The Tortoise and the Hare

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

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

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

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

The End Of HFT?

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

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

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

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

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

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

TIPS From Gold

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

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

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

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

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

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

Independence

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

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

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

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

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

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