How Much is Too Much?

"Perhaps too much of everything is as bad as too little." - Edna Ferber

"I think we consider too much the good luck of the early bird and not enough the bad luck of the early worm." - Franklin D. Roosevelt

When it comes to debt in an economy the question of "too much" is one that is really hard to answer.  According to the Economist global debt has grown steadily since the Second World War.  It was thought that debt on a national level was fine as it netted out to zero (the debtors would receive the collateral from the creditors making it a zero number) but 2007/8 dispelled that theory.  From 2004 to today total global debt has risen from $24.5 trillion to $55.1 trillion, an increase of more than 100% in 10 years.  More interesting is that since 2007 global debt has skyrocketed from $28.1 trillion or almost 100% in just seven years and this includes the massive write-down taken after the financial shock in 2008.  As a percent of global GDP the world debt level now stands at more than 200% of global GDP so it is time to dig into how much is too much as this will have implications for all investments.  It is the largest macroeconomic influence on all of your investments so it needs to be understood.

The initial premise that should the world have to pay off all the debt that it would amount to zero is a fallacy.  This assumption assumes that the collateral will be there with value to support the loan.  As 2008 showed, the world's collateral pool can lose significant value quickly, particularly when there is a loss of faith which is the exact time that the collateral is needed to pay the debt back.  Taking this a step further, if all of the debt outstanding was called in today, there is no way that every asset could be liquidated in such short order so prices would capitulate and the sum total would be zero, that is the debt holders would receive assets worth zero or a total write-off.  Now as we know this is never going to happen but I used it just to illustrate the point that debt at these levels is not a zero sum game.

Debt is manageable as long as there is economic growth or inflation.  These two factors go pretty much hand in hand as one cannot really exist for an extended period without the other showing up.  Growth at some level will result in inflation and inflation is normally driven by growth although it can also come from poor monetary policies and over extension of monetary stimulus (think of Zimbabwe or the Weimar Republic). For this blog and as we are talking global debt I will leave inflation tied to growth.  If you have GDP growth or inflationary growth the percent of debt to the underlying value of the assets falls thereby giving the illusion that the debt level is manageable.  It is an illusion as it only holds as long as asset prices do not fall.  Inflation too makes the debt more palatable as higher wages and tax revenues means that it is easier to service the debt and therefore more controllable.  The worst possible situation for debt is deflation which as I have mentioned in previous blogs makes asset values shrink while the debt remains fixed thereby making the debt level unmanageable and in some cases unserviceable.  With the world edging very close to the deflationary cliff this is a worry as if the world slips into this spiral investment dollars would be non-existent as debtors would be using every available dollar to repay debt rather than investing in business ventures, ideas or infrastructure.

The only way that the debt can remain manageable under this scenario is to keep interest rates low.  Even a small spike in the interest rates would send the world into a debt spiral as once again interest payments would eat up all excess cash crippling investment and cutting government spending.  As an example if interest rates were to rise 2% the annual amount spent on interest payments alone would increase by over $1 trillion a year!  It is not inconceivable that interest rates could jump by 5% knocking $2.5 trillion out of the debtors pockets stunting growth rather severely.  As it is in no-one's interest to let interest rates rise any time soon (at least until global growth shows signs of accelerating in which case as mentioned above debt payments become more manageable) I fully expect interest rates to remain low for a very long period.  Obviously this assumes that governments can keep interest rates down which is also a leap of faith.

As long as consumers, businesses and foreign governments believe that the debt level is manageable then everything is good to go.  If at some point in the future this thought changes, countries and businesses will suddenly see interest rates rise as really it is all based on a simple demand and supply curve.  Right now there is enough demand (faith in repayment is still high) for the debt at low yields but if the demand for the debt falls (lose of confidence in repayment) the only way to encourage buyers to step up is to raise the returns and suddenly you have a situation where the market controls prices rather than the central bankers.  Yields spiral higher and problems expand.  There is an argument that a spike in interest rates would not have an impact as yields are based on long term notes but with $55 trillion of debt with an average maturity of 10 years there is more than $5 trillion maturing each year ($14 billion every day of the year) and that debt would be subject to the higher rates so it would not take long for the increase in rates to be felt.

So while this rising debt level is still not a problem it is important to keep your eyes on it and understand the implications associated with any changes in interest rates and deflation.  Maybe earning 0.0002% interest on your savings forever is better than the alternative!

The Dirty Harry Market

"I know what you're thinking, "Did he fire six shots or only five?"  Well to tell you the truth in all this excitement, I've kinda lost track of it myself.  But being this is a 44 Magnum, the most powerful handgun in the world and would blow your head clean off, you've gotta ask yourself one question, "Do I feel lucky?" Well, do you - punk? - Clint Eastwood as Dirty Harry

I just love this quote. talk about the ultimate tough guy.  The story as some of you may remember continues where he picks up the bad guy's shotgun and walks off.  The robber asks, "Hey, I gotta know", at which point Harry turns around, points the Magnum at the guy's head, pulls the trigger and there is just a click, no bullet remains.  Then with a smile he walks off.  I won't repeat what the bad guy says.

This sort of sums up the opening of the year which I am terming The Dirty Harry Market.  Oil prices continue to crater, stock markets vacillate violently and the mood is generally one of concern and uncertainty (what else is new).  In the first five trading days of the year the market moved more than 1% in four of them and twice more than 1.7%.  Volume on the up days is lower than that of the down days (not a good sign) and this rally is look long in the tooth.  Furthermore there is finally some realization that high yields do equal risk as the spread between investment grade bonds and high yield (or junk) bonds has started to widen considerably in the past few months (see chart below).

As a large amount of money invested in the high yield market was allocated to oil and gas ventures it is clear that the drop in oil prices is having a dramatic effect on the cost of capital.  Undoubtedly a large portion of this debt will become worthless as borrowers will not have the capacity to repay these loans with oil down around $46 a barrel.

So the question that we have to ask ourselves as investors is "Do we feel lucky?"  "Well do you?"  While the United States economy seems to be in relatively good shape (particularly when compared to the rest of the world) there are still major concerns regarding the rest of the world.  Can the United States pull the rest of the world out of their problems or will the rest of the world's problems drag the United States' tepid recovery down with them.  In my blog last week I mentioned that the United States is in a liquidity trap but as a good friend of mine commented it may be more about a leadership trap than a liquidity trap and I have to say that I agree.  Without any clear leadership in the White House and with elections coming up next year it seems that the United States economy is drifting rudderless and the seas are becoming rough.  Pity we don't have Mr. Harry to clean up the rot here but unfortunately life is not at all like the movies.

With this as a backdrop there has to be a proper draw down it is just a matter of when.  Not that I am hoping for one it is just that history always repeats itself and with three years of one way tickets to heaven it just seems like an investment in the stock market is akin to taking a chance that Dirty Harry's gun is out of bullets.  Furthermore make sure that any investment offering a high yield is covered with sufficient collateral as otherwise I would expect that only five bullets were used!

The Liquidity Trap

"A liquidity trap is a situation described in Keynesian economics, in which injections of cash into the private banking system by a central bank fail to decrease interest rates and hence make monetary policy ineffective." - Wikipedia

While central bankers of the world struggle to prevent a deflationary spiral the solution has been to print more money.  In the past money printing worked by forcing interest rates down, attracting consumers and businesses to borrow money thereby stimulating investment, consumption and the economy.  The theory behind why this works is the IS-LM model developed by Sir John Hicks.  The IS-LM model is like a simple demand / supply chart where more demand requires more supply short of which prices rise until the supply catches up.  Too much supply swamps demand pushing prices down driving companies out of business, thereby limiting supply and the equilibrium price returns.

The first line of the IS-LM graph is the downward sloping line IS which stands for investment and savings.  On the vertical axis is the interest rate.  Therefore the independent variable is the interest rate and the dependent variable is income.  As interest rates drop income falls, investment increases and savings fall moving the line to the right and increasing GDP (which is on the horizontal axis).  The upward sloping line is the LM line or liquidity-money line.  The dependent variable is the interest rate while the variable input is income.  This says that the more money that is placed into circulation the lower the interest rate.  Lower interest rates should therefore stimulate the economy as the IS line should move towards more investment.

Based on this theory the Federal Reserve can control the economy and GDP growth by increasing or reducing the supply of money into the economy.  The point at where the two lines intersect should show the level of GDP growth associated with the input of additional funds and the corresponding interest rate.  There is a problem to this theory though.  When there is general pessimism about the economic outlook the IS line shifts to the left and no matter how low interest rates fall or how much money is input there is no growth as the two lines are disconnected - the so called Liquidity Trap.

At this point conventional monetary policy is worthless.  As far as I can see and as I have explained in previous blogs, the  reason that economies get to this level is that governments do not want to do the full Keynesian Monty - that is they are too scared to take all of their clothes off for fear that everyone else leaves their on and they are left to explain why they are naked.  To put it another way if they use all the various aspects of Keynesian stimulus, fiscal and monetary policies (low interest rates, print money, lower tax rates and throw money at shovel ready projects), and they do not work (for whatever reason) they would have no tools with which to try to repair the mess and the mess would be far greater.  Talk about egg on your face!  Additionally, if they use all of these stimulants and they work better than expected then inflation could potentially run out of control once again creating a problem that might be too difficult to control.  More egg, same face!

For these reasons the central bankers of the world seem to feel that it is better to leave a few stimulants on the table for use at a later date.  Make sure the broth is not too hot, cold or worse still too salty before taking a big swallow.  If it is too hot cool it off by removing more stimulants and if too cold add a few more stimulants continually testing it to ensure it is going according to plan.  If you get it too salty then watch out as there is nothing to do but let market forces work it out and that is their worst nightmare.

Now this may seem sensible but economies do not heat up in a few minutes, they can take months if not years to show a sign that the additive is working.  Also once the heat is turned off, the economy can continue to accelerate reaching levels of inflation that become very uncomfortable very quickly.  So in essence it is impossible for a central banker to truly tinker with these levers without creating economic shocks which is what continues to plague all economic theory and which is why barring another global catastrophe my hope for 2015 is that they leave their hands off the switches.

Looking Ahead

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

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

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

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

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

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

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

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

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

Escape Velocity

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

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

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

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

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

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

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

A Balanced Diet?

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

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

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

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

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

Year End Yawn

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

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

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

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

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

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

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