Been There, Done That

Yes, I recognize the deja vu. About one year ago I began reallocating assets to reflect a more inflationary posture. That posture lasted only a few months. Last summer's debt ceiling debate coupled with the EU debacle squelched my incremental inflationary expectations, and I peeled off risk positions in favor of a more balanced posture.

Fast forward to now. Once again I find myself adding long exposure in lieu of a tape that seems to be taking the Fed's "0% till 2014" promise to heart.

Will this action once again prove temporary in a world that's drowning in a debt bubble that wants to deflate? Not sure, but currently my actions need to express a perceived uptick in the odds of Big Inflation on the horizon.

position in SPX

Low Fed Rates till 2014 Sparks Gold

In today's FOMC announcement, the Fed signaled that they will be keeping rates ultra low thru most of 2014. That even raised my eyebrow...

This news put some giddy-up into gold, which vaulted about $50 this afternoon on the FOMC news.

I used this leap to sell my GLD position. It's up about 10% from its lows, price is now filling the gap, and stochastics are getting twisty in the overbought zone.

Am also concerned about the re-hypothecation issues surrounding these metal ETFs on the back of the MF Global situation last fall.

Selling this position puts me just about 0% net long (long metal and ag commodities against short equity index). Feels about right given the current field position of various asset classes.

position in commodities, SPX

Why Wealthy People Own Gold

Straightforward explanation of why wealthy people own gold. The key point here is that the primary reason to own gold (in its physical form) is not to speculate in near term price moves.

Instead, wealthy people own gold to preserve their wealth against problems like inflation, bank collapses, and aggression.

Viewed thru this lens, owning gold is less of a 'buy-and-hold' investment strategy and more of a buy-and-will-to-the-next-generation family wealth preservation strategy.

The Infuence of Today's Events on Inflation

As noted in this morning's post, central banks got out the bazookas today in an attempt to blow away systemic deflationary forces that are driving Euro and US banks toward insolvency.

On the surface, the concerted central bank actions are clearly inflationary.

This post on zerohedge w/ Peter Schiff comments captures it well. The snippet at the end of the post REALLY captures it well:

"...this is merely the beginning as more and more inflationary actions have to be undertaken by central banks to save banks from being crushed by untenable debt loads. Whether they succeed in overturning the deflationary tsunami is unknown. What is certain is that they will bring fiat currencies to the [brink] of viability (and beyond) in trying."

As the snippet notes, the big question is whether this collective action will work. In late 2008, the Fed got out the fire hose of liquidity to stem the Lehman blowup. After a sharp relief rally on the news, however, markets resumed their downward path as the deflationary forces were not to be denied.

Hard not to wonder whether the same set up might not be in play here. Yes, the collective bazooka exceeds the power of the Fed's firehose. But the deflationary forces are more global in nature this time around.

Peter Schiff suggests that this is the time to load up on gold. That may turn out to be the case. Heck, gold popped 40 handles today.

But the other side of the trade is that the market forces pressing against the intervention are deflationary in nature.

And it's generally not nice to fool Mother Nature.

position in SPX, gold

Ags Look Interesting

Have been adding to my agricultural commodity position (RJA) over the past few days. From a technical standpoint, looks like a multi-month reverse head-and-shoulders to me w/ a gap directly above (gaps tend to be magnets for price).

From a fundamental/macro standpoint, we've waxed about the bullish set-up in commodities before (dollar heading to dust, capacity not keeping up w/ demand, gov't policies that favor famine).

As such, I'm digging this for the long side of my hedge book.

position in RJA

The Influence of Dividends

Borrowed the chart below from this article. The graph suggests the dominant influence of dividends on stock performance over time.

Since 1871, dividends account for more than half the nominal gains in the S&P 500 Index. Today many folks shun dividends in search of capital gains. Over time, however, capital gains have accounted for less than 2% of the 8.8% annual return.

Parenthetically, note that there was no inflation prior to the mid 1910's. The Federal Reserve Act was passed in 1913.

Before running out and loading up on dividend paying stocks right here, keep in mind that average dividend yields rest at the low end of historical benchmarks. Current yield on the SPX is about 2%. Historical buying opportunities in stocks have typically corresponded to aggregate yields in the 5-6% range or higher.

While there may be special situations here or there that are paying outsized dividends, I'm trying to remain patient for much higher dividend yields in aggregate before 'buying the list.'

position in SPX

How Weak Currency Initiatives Could Hammer Gold

Fil Zucchi shares an interesting thesis that actions by central banks to weaken currencies could put downward pressure on the price of gold. This is counterintuitive because interventions to weaken a currency are typically viewed as bullish for gold.

Because there is building political pressure against weakening a currency via money printing, Fil posits that central banks might sell some of their gold reserves, and use the proceeds to buy foreign currencies (forex). Price of forex would rise, and domestic currency would weaken as per the objective.

I hadn't given this scenario much thought but I do think Fil has an interesting angle. Domestically, the Tea Party movement and other social awakenings seem to be sensitizing the public about the dangers of money printing by the Fed and other central banks. By selling gold to weaken the currency, central banks can achieve their goal in a politically expedient manner--i.e., they cannot be accused of pure money printing to manipulate currency cross rates.

Should such actions occur, it would almost certainly drive the price of gold lower. How much lower and for how long would be anybody's guess. What we do know is that central banks could not engage in this operation indefinitely as they would run out of gold to sell at some point.

Fil notes that, while the selling of gold by central banks would be bearish for gold price in the near term, it would likely set up a very bullish scenario for gold at some point. Once central banks deplete their gold, then the only way to continue currency debasement (which is the heart and soul of central banking) would be to crank up the printing presses full force. At that point, 'big inflation' would be en force; gold would be situated for a moonshot increase.

It would also constitute a sort of poetic justice, since gold will have left government hands and landed in the hands of the people--where it naturally belongs.

Like Fil, I'm currently out of 'paper' gold and silver, having sold the last of my trading position in SLV last week before ensuing price weakness (better lucky than smart). I do maintain exposure via my physical metals position--a position that I do not plan to sell.

Meanwhile, I'm going to watch gold price from the sidelines for a while, and look for evidence that Fil's thesis may be playing out.

position in gold, silver, USD

Fudging the CPI Numbers

As part of the federal budget talks, there is a proposal on the table to alter the way that the consumer price index (CPI) is calculated. Essentially, the proposed method would try to take into account the fact that consumers often trade down (e.g., go from steak to hamburger) when prices rise.

If passed, the alteration would make the 'headline' inflation number smaller.

Why is this on the table as part of the budget debate? Because a smaller inflation number would lower federal payouts (such as social security) that include cost of living adjustments. Viola! An instant $200 billion in budget savings.

This would not be the first time that the CPI has been dumbed down. There have been multiple changes to the methodology over the past couple of decades. The weird (criminal?) thing is that when the goverment changes the method, they do not go back and alter the historical series. Those looking at historical CPI data are not comparing apples to apples (the same is true for unemployment, GDP, and other measures). If we were measuring the CPI the same way as in 1980, the headline inflation number would be nearly triple the currently reported level.

How such a practice is viewed as legitimate and is tolerated is beyond me. If I had tried to manage measurement systems like this during my industry days, then I would surely have been fired.

Make sure you understand the dynamic here. The federal government is printing money, which undermines the value of the dollar. Government officials are then supressing the metric that is supposed to reflect the dollar's value, effectively under-reporting reporting the inflationary consequences of their activities.

Weak Jobs Number

Big miss in the jobs number this am. And it should be noted that the 54,000 number includes 206,000 estimated jobs created using the 'birth/death' model of the BLS.

Over the past 3 years, government has borrowed and spent $trillions, and printed and spent $trillions more largely in the name of 'creating jobs.' Yet, anemic employment persists despite the federal government's best efforts to paint the data pretty.

Will markets view this job report thru a glass half full or glass half empty lens? The bullish argument is that weak jobs data will require more government intervention (can you say 'QE3'?).

The bearish argument is that a weak employment situation persists in the face of $trillions of government intervention, suggesting that perhaps prolonged economic weakness is unavoidable.

Cash and Opportunity Cost

Jim Grant sees some value in large cap stocks like Cisco (CSCO) and Johnson & Johnson (JNJ). Generally, however, he sees most asset classes as richly priced.

He suggests that one investment strategy in the current environment is to simply hold cash, because the opportunity cost associated with not being in T-bills and other short term instruments is 'not much.' Although you make next to nothing on the cash, it is available when other asset classes become more attractively valued. Overvaluation, he observes, often 'passes in a thunderclap' and those who are liquid can 'get fully invested in a comfortable way.'

This strategy has made sense to me for some time. I find it interesting coming out of Jim Grant's mouth because of his inclination toward inflationary macro scenarios. What he is describing his more consistent with what happens in a deflationary situation. After all, why hold cash if you think its value will be inflated away.

Currently my cash level is just over 50%. I wouldn't mind bumping this to the 60-70% range, and will be looking to sell strength to do so.

positions in CSCO, JNJ

Low Bond Yields in an Inflationary World?

One phenomenon that is perplexing many who believe in the Big Inflation thesis is the behavior of bond markets--particularly government bond markets. Theory says that yields should go up with inflationary expectations. People should be selling bonds today out of worries that the real value of their bonds will go down as their coupons get paid back in dollars that are lower in value.

That theory has not been working out well in practice. Despite the $trillions created by the Federal Reserve over the past couple of years, and commodity prices screaming higher, long bond yields have not gone to the moon as many inflationistas have forecast.

Perhaps the theory doesn not account well for the dynamics of transitionary periods.

For more than two decades, central  banks have been suppressing interest rates and offering credit on the cheap. This credit has gone into all kinds of risky assets--stocks, commodities, real estate, plants and equipment. Bonds are also a risky asset class although they are often perceived as less risky than other categories. This is particularly true of bonds issued by the US government.

The easy credit spawned a secular boom in leveraged risk taking. Individuals, organizations, and governments have all borrowed at low interest rates and invested in assets deemed to return something more than the cost of carrying the loan. This behavior is also known as the carry trade.

Leverage magnifies returns when prices are going in your direction. A few years back people could buy a $500,000 house with little money down and low interest rate, and flip that house a year or two later for $750,000, generating an enormous return over the cost of carry.

As many have discovered over the past couple of years, leverage magnifies losses as well. When firms like Bears Stearns and Fannie Mae (FNMA) were levered 30:1 or higher in mortgage related derivatives, it did not take much decline in home prices before their assets were less than liabilities, creating conditions of insolvency.

In leveraged systems, falling prices motivate many to close out their carry trades. Risky assets are sold, dollars are bought back, and loans are paid off. We saw, and continue to see, a lot of this since 2007-2008.

But not all carry trades are taken off. Some leveraged investors, rather than totally getting out of risk, merely substitute less risky assets. Thus, rather than using credit to buy stocks, carry traders buy bonds instead. Leverage is still in the system, but it is located in assets classes deemes 'less risky.'

One explanation as to why bond yields have not yet backed up is that much leverage remains in the system. Carry traders are content to earn the spread between nearly 0% borrowing cost from the Fed and ten year T-notes paying 3.1%.

But this is a transitory situation. Huge amounts of leverage cannot last forever. Central banks can seek to force spreads open but over time they must collapse as resources borrowed from the future are paid back (or defaulted upon). Short rates will rise and/or returns on risky assets will fall and the carry trade spread will be crushed--regardless of government intervention to the contrary.

At some point, then, we may witness another counterintuitive situation as markets rebalance. It does not seem out of the realm of possibility that bonds could sell off big-time as more and more leverage leaves the system.

position in SH

Real Household Income

Interesting chart showing the disposable income. Over the past decade, real income has basically gone nowhere for the median household.

'Real' income means that it has been corrected for changes in the CPI. For example, if your salary increases by 5% but the prices of goods and services also increase 5%, then your 'real' income in terms of purchasing power has not changed.

There is a fair amount of evidence that the goverment is under reporting the CPI and has been for many years. Some estimates suggest that if we compared apples to apples with older methodology, the CPI is increasing at triple the currently reported rates.

If that it true, then what is the real trend in real disposable income over the past decade?

What Could Stop the Presses?

After last week's dovish guidance from the Fed in the face of rising commodity prices, it is now very hard to imagine what would drive policy makers to stop the monetary printing presses, or even to slow them down. Of course, it is precisely these types of situations that require investors to make sure they see the other side of the trade.

Markets are seemingly looking thru every crisis (e.g., EU) and discounting the government bailouts that would likely follow.

Still, I can conjure a couple of situations, in my view not well discounted by markets, that might give policymakers cause for pause. Both of them are scenarios in which commodity prices experience a dramatic increase in prices--perhaps extreme enough that policymakers are forced to rethink their approach.

One scenario is a significant upward revaluation of the yuan. US bureaucrats have been hounding Chinese officials to quit 'manipulating' their currency (obviously US officials are not against the pot calling the kettle black). There was some chatter on trading desks last Friday that China may in fact be preparing for a yuan revaluation.

Washington should be careful for what it wishes. Revaluation would mean that the yuan would strengthen against the dollar, which would of course would hammer USD purchasing power. The Dollar Index is already approaching all time lows. Lower dollar means higher commodity prices.

The other scenario relates specifically to oil. This weekend, prices at the pump here in Ohio are said to average $4.11/gallon--an all time high that surpasses the summer oil 2008 spike.

It's hard not to look at the above chart of oil and think 'bullish.'

Should oil prices continue their upward march, and particularly if prices head into a parabolic frolic like gold/silver, there is likely some level where the economy cries uncle.

Higher oil prices is the situation I currently find most likely to force the Fed's hand.

position oil, gold, silver

Fed Accomodation and its Consequences

The Fed continued to coo like a dove today. On the back of the accomodative FOMC statement, the dollar tanked. The Dollar Index (USD) appears destined to test its all time low of 72ish. A break below that, and it's a brave new world.

Gold, on the other hand, exploded higher on the news--and marked another all time high. (Silver, btw, rallied 5%).

Can't help but think that today marked a watershed event: the day the Fed sped past the "Stop--Cliff Dead Ahead" sign.

From where I sit, chances of a currency crisis have now ticked up considerably. While I have been working them lower, cash levels in my personal accounts still exceed 50% of total liquid assets.

I am growing increasingly uncomfortable w/ this position. Over the next week or so, I will be looking to swap out of a signficant fraction of my remaining dollars. 

position in gold 

The Fed's Problem

Not sure anyone has analyzed the technical problem that the Fed faces here more than John Hussman. Dr J has examined the historical relationship between T-bill rates and monetary base per nominal dollar of GDP (a.k.a. 'liquidity preference').

The results show an asymptotic relationship. When rates are high, people have less desire to carry money around because of opportunity cost. When rates approach zero, however, people are increasingly prone to hold cash because there are few competing uses for it.

I like to think about this in terms of cash that I am holding in investment accounts. I would like to put this cash to work in short term vehicles, but alternatives such as 3 month T-bills or 3 month CDs are yielding next to nothing. Thus, I'm comfortable just staying in cash because at least I am in a flexible position to deploy it should opportunities arise. To me, that is worth more than the pathetic yields I would be getting by tying up cash in short term fixed income vehicles. Just as John's analysis shows, ultra low interest rates have me holding more cash than I otherwise would.

The problem for the Fed is that in order to press interest rates closer and closer to zero, the amount of base money that the Fed has to pump into the system via its asset purchase programs such as QE2 must grow exponentially. Any exogenous forces putting upward pressure on rates (e.g., perceptions about inflation, slow down in offshore Treasury buying) must be met with ever more money printing by the Fed, otherwise all of this money that has been created would quickly seek other uses, and prices of many things would explode higher.

Since the Fed is approaching the zero bound for interest rates, it stands to reason that at some point, perhaps soon, the Fed will be physically unable to suppress rates further in an environment where exogenous forces are pressuring people to reduce their liquidity preference.

Should we reach this point, the Fed faces one of two alternatives: a) it could sit back and watch prices rip higher as people swap out of cash perceived as a rapidly depreciating asset, or b) it could rapidly withdraw the funny money that it has been pumping into the system.

Remember the nonlinear relationship between money printing and interest rates, however. The Fed would have to remove a disproportionate chunk of stimulus in an attempt to normalize rates just a fraction higher than where they currently stand. Dr J estimates that, in order to normalize short rates at 0.25 - 0.50%, the Fed would have to reverse its entire $600 billion QE2 program.

The point is that, if the Fed tries to tame inflation at this point, it will have to suck gigantic amounts of liquidity from the system. If the Fed decides not to do this, then prices of most things are certainly headed much higher.

This is the box that the Fed is in.

This situation also goes a long way toward explaining the action in precious metals. Investors have sniffed the Fed's bind out, and are bidding gold and silver up on a bet that the Fed will choose option a) above.

Before us is a game of chicken of historical proportion.

position in gold, silver

Fed Front Running

Pretty breakout above resistance from a multi-month inverse head-and-shoulders pattern in the S&P (SPX) today. New recovery highs once again.

Interestingly, this bullish action is occuring one day prior to the bimonthly FOMC policy statement. Seemingly, market participants are front-running the Fed, anticipating that the central bank will continue its money printing ways.

Should tomorrow's FOMC statement indeed be perceived as accomodative, then today's action may mark the beginning of another leg higher.

However, should Uncle Ben & Co surprise the masses with some hawkish FOMC verbage suggesting that the monetary spigots may be turned off, then today's break out might turn into tomorrow's fake out.

position in SPX

Alternative Consumer Price Index

This price index developed by MIT provides an interesting alternative to the the US government's Consumer Price Index (CPI) data. Check out the steepening slope over the last four months. Amounts to about 8% annualized.

Which is ~3x the increase suggested by official government stats.

TIPS

Many people presume that Treasury Inflation Protected Securities (TIPS) are fixed income securities with protection against inflation. This article suggests that buyers of TIPS get less insurance than they might suppose.

When it sells TIPS, the US Treasury is selling a bond plus and insurance policy (or put option). One question to ask is why would an insurer want to be short a put option unless it believes that the option was priced in its favor?

no positions

Silver Streak

Silver got going late last summer about the time of the Fed's QE2 ruminations. It has looked back since.

Current action has that gappy, parabolic look of a blowoff. Various oscillators such as the relative strength index and slow stochastics are pretty much plastered against the ceiling.

There are, of course, plenty reasons why 'White Lightning' could continue to zap higher, not the least of which is the Fed's non stop printing press.

Action like this that demonstrates why it's so difficult to stay on board during a bull market. The moves higher seem too good to be true, and the corrections that follow seem too painful.

position in silver

Gold Milestone

Gold has crossed $1500/oz. Silver now stands above $45/oz.

Another milestone met largely with...quiet.

Remember that gold can be viewed as a bet on disorder.

position in gold