This week we’ll touch a little bit on financial regulation and then take a look at the bigger picture of the economy right now. Both elements impact the marketplace of investments and we’ll take a look at exactly how.
One of our favorite articles — The Inflation Chupacabra – was picked up for publication over at Global Economic Intersection. I’ve been spending some time over there in the last few weeks and it’s a pretty good site for relevant news and insightful opinion. It’s run by John Lounsbury and if you frequent SeekingAlpha, you’re probably familiar his name. He’s one of the site’s top contributors. He also contributes content to Jim Cramer’s TheStreet.com.
Earlier this week John published what I thought was some very good commentary on the Dodd-Frank financial regulation bill.
President Obama also mentioned this in his State of the Union address — which, despite the lackluster critical response, I thought was excellent, optimistic, and relatively free from dysfunctional partisanship. But two things about it stuck in my craw, the first was a claim that the healthcare bill would bring long-term costs in line. This is madness; I haven’t seen any serious analysis that shows that healthcare act will meaningfully address the unsustainable cost increases up ahead.
My other gripe was when he said that passing Dodd-Frank last summer would prevent another financial crisis. This, too, is madness.
Dodd-Frank won’t prevent another crisis
There are a couple of key things to know about this regulation that we’ve touched on here and there. The Dodd-Frank Bill does have a few good provisions, but ultimately these reforms are weak sauce. There is very little doubt right now that Obama and the congress blew a historic, once-in-a-generation chance to enact some massive reform. They missed their shot to do something really meaningful and a lot less has changed about how Wall Street does business than most people are aware of. They did get something passed, though, and one of John’s key points is that there’s also a lot of “wait and see” in these new rules.
This bill was basically designed by lobbyists. According to OpenSecrets.org the financial sector leads the way, spending nearly $4.3 billion on lobbying efforts in the last 13 years. The securities & investment industry alone (aka Wall Street) spent $190 million in 2008 and 2009 to get their way with Congress and it worked. I know I get only one vote, but I can only dream of what sort of personal interests I could coerce Congress to satisfy with $200 million. If you think that your elected representatives are sitting around like thoughtful academics, designing laws and regulation that make the most practical sense for our great society you have something to learn about how Washington D.C. works.
I watched Mr. Smith Goes to Washington a couple of months ago. It’s a great movie, but it’s a Frank Capra movie which means that cynical Gen X film elitists like myself look down our noses and give it a categorical sneer. ”Capraesque” is a dirty word in certain circles nowadays. But people forget that this was a movie that really pissed off Washington D.C. at the time and that gets a gold star in my book. Capra claimed that he actually received a letter from Joe Kennedy expressing his deep concern that the film should be withdrawn from international distribution because it would damage “America’s prestige in Europe”. That gets an LOL for a wholly different set of reasons, but still, don’t let the warm & fuzzy fool you. It was a very important cultural milepost.
Frank Capra was the guy we all needed in the 30′s and 40′s but lost all affection for by the 90′s and 00′s. By that point we were no longer shocked by something such as a corrupt Senate; instead we find the idea that an honest man could go to Washington and fight for his ideals cheesy and naive.
Anyway, the last really important point about the installation of Dodd-Frank is that the SEC and other regulators are totally overworked right now. Even if this financial regulation legislation contained a bunch of awesome reforms, the agencies in charge of enforcing it simply don’t have the manpower. The budget isn’t there to provide these guys with all of what they need to effectively watch over the industry. They’re just trying to do the best that they can with what they have.
Why do I mention this? I mention this because if you think that there’s a magical new framework that will prevent the financial industry from causing another epic mess you are fooling yourself. If they’d addressed the number one public complaint, the moral hazard of “too big to fail”, I’d be a little more optimistic. But now I see it as only a matter of time.
While we all sit around and wait for them to get stuck in the next brier patch, Wall Street will continue to be a very profitable place to work and be invested.
Investment implications of Dodd-Frank
The good news is that this has investment implications. You can use this to exploit some opportunities and take some risk. Or you can use the knowledge to protect yourself from other kinds of risk.
“Too Big to Fail” still exists. If JP Morgan or Wells Fargo ran into emergency trouble tonight, do you doubt for a moment that the Fed and Congress wouldn’t hold their collective noses and work out some kind of aid package? Whether these firms actually are systemically important isn’t the question. The question is if there’s enough fear that they might be. Fear that their failure might blow up the entire world.
So there’s a net under these guys and it’s important to know that. This is also a super profitable environment for these companies; the yield curve is almost historically steep right now and a steep yield curve correlates very highly with a robust economy and profitable banking sector. (Though it is, as we know, artificially steep.) Who cares what’s lurking on their balance sheets! We don’t use mark-to-market accounting anymore and so the banks have a lot of flexibility at how they value this stuff. They won’t mark themselves insolvent. Don’t worry.
I’m avoiding the big banks because the spooky stuff on their books scares me and that’s a risk I’d rather not deal with. But if that sort of thing doesn’t bother you, have at it. Bank of America was up like 30% in December. That’s a heck of a trade, but is Bank of America a good investment?
When it comes to financials, I prefer names like Visa & Mastercard, neither of which have really gone anywhere and are now trending towards sensible valuations. There was some worry that they and American Express would get pinched by Dodd Frank, but I think they’ll be OK. Their lobbyists won. And these guys don’t carry the stinky-asset and unknowable-balance-sheet risk that banks like Bank of America and Citigroup do. I think the next tier down, the “super regional banks,” carry the same risks but have better upside and more sensible valuations. They are priced for this risk while the big banks are not.
PNC Financial is a good example. In fact, last night on my Bloomberg podcasts I heard Paul Miller, analyst at FBR Capital Markets, sing their praises. They’re still small enough to be nimble and grow but too big to get gobbled up. They could even do some gobbling of their own this year and merge with a few other regionals. If you want the best bang for your buck, don’t look to get the growth from the banks in the biggest tier, get it from the banks that are threatening to move up into that biggest tier.
Market Recap
One interesting thing that has started to happen in the last month as the market screams ever higher is a divergence between large and small cap stocks. This is a chart of the Dow Jones Industrial Average (large cap stocks) with the Russell 2000 (small cap stocks) overlaid as the red line.
This should further underscore the fact that this is a totally momentum-driven market right now. Keep your eye on the Russell right now to see if it can make a new high. If it can’t, I’d look to slowly pull out of my larger cap stocks as the selling pressure could spread upwards. Don’t worry, you’ll get a chance to buy all that stuff again at cheaper prices.
But if you want to play the momentum market, that’s cool. Here are a few things that will help you play it better.
Never forget that, by definition, momentum environments cannot last forever. The movement to the upside is not unlimited. So be watchful and ready to deal with surprises.
If volatility is low, hedge out some of your risk with some out of the money put options. It’s like buying insurance for your stocks. But you gotta know two things about insurance: 1) insurance costs money and 2) insurance costs less money before the earthquake than during or immediately after. Waiting until the sell-off to protect your portfolio is pointless.
The Economy
I’m getting increasingly optimistic about the economy. A year ago I was concerned about a double dip recession, but last summer we started writing about how that possibility should be taken off the table, to be revisited again in 2012 or 2013. And since then, things have continued to improve.
I know that a large chunk of it is powered by artificial stimulus. But who cares. We’re going to get some growth and growth is what we really need right now.
Some day down the road we’re all going to be asking whether or not it was worth it. I think there’s a pretty good chance the answer will be “no.” But we may as well try and enjoy it right now. Otherwise, what’s the point? You and I don’t make policy. We just have to do our best to respond to it, both today and in the future.
I was talking with Mrs. Draconian the other day and she was concerned about the world our daughter was going to have to deal with and whether she’d be successful in life. I told her to relax. The unemployment rate for people with a college degree is around 4%. The unemployment rate for people with an engineering degree is basically 0%. The jobs may not be as awesome as they were in the heyday of the late 90′s, but there are jobs out there for those with right skills.
This recession has been brutal for the uneducated and the unskilled. That’s not to say it’s been a walk in the park for the middle class who are punished for behaving responsibly and are struggling with wage stagnation. Nor has it been easy for the wealthy, who had a disproportionate share of their net worth wiped out in the crash. They’re a clever and resilient bunch so I feel less sympathy for them and trust they’ll figure it out on their own. That’s part of how they got to be wealthy in the first place, by being smart and not worrying so much about what others think.
But it’s a new paradigm for those workers on the fringe without degrees or a unique skill set. The unemployment rate is over 15% for those who didn’t finish high school and that’s on a labor force participation rate of only 46%! It gets a little better for those with a diploma, but still, shockingly few of these people have jobs right now much less good ones. In better times, these may have been workers who could get a somewhat decent job in a factory or in construction. Now they’re finding it difficult to compete in a service sector populated with higher caliber workers that have trickled down from elsewhere in the economy.
I wish I knew when it’ll get better for this group. Those of us in the middle class complain about 5% salary cuts or scaled-back entitlements. But really, we have it pretty good. Certainly better than the poor in this country or anyone in any emerging economy. For about a decade now we’ve had legitimate China angst. But median incomes in this country are ten times what they are over there. We’ve even got it better than a lot of those folks in Europe, too. Why are Americans so confident about some things and yet so insecure about others?
It’s an era of sacrifice, yes. But chin up. The good news is that you have a lot more room than you think when it comes to making sacrifices.
Perhaps this is a good time to separate the economy from the stock market. The economy may be all right and may sputter along with slow, but acceptable, growth. However, stocks are ultimately nothing more than a claim on a very long-term stream of future cash flows. And this is where the disconnect lies. Somewhere out there is a reckoning day. We all know this. We all feel this. What we are getting right now is on the surface a free lunch. We know deep down that there isn’t such a thing.
The reality is that for you, the middle class salary man or small businessman trying to make it work, there will be some sacrifices. You’ll have to deal with a little less pay, a little higher taxes, and maybe your healthcare benefits won’t be so awesome. It’ll suck but it won’t break you.
But what this reckoning day means for the market is something different altogether. It won’t be pretty. If you’re heavily invested in the stock market, you’ll lose a lot of money. If you hold a boatload of bonds and interest rates shoot up, you’ll lose a lot of money.
I’m trying to plan a few moves ahead. I see that next market reckoning as a time for opportunity. I want to be in a position to act on that and so my strategy for the short-term is to protect and prepare myself for that day. There are plenty of ways to do this and we’ve talked a lot about them over the last year or so. Right now, with elevated valuations and a future of structural headwinds, it means primarily stuff that’s lower risk.
As I said, this is the long, long view.
I’m trying to maximize what I can give my daughter when she comes of age.
I know she’ll be OK. But still.
- Obama & the Congress missed a once-in-a-generation shot to enact some meaningful financial reforms. What we got instead was weak sauce reform diluted from the efforts of a financial lobby that spends a lot of money to get its way.
- Pay attention to Hollywood and the rest of the arts. It tells us a lot about the state of our culture, where we’re going and where we’ve been. Open-minded investors can learn a thing or two about how to construct an appropriate macro framework.
- The big four banks have a net underneath them and are in a super-profitable environment right now. If the risk of what’s lurking on their balance sheet doesn’t scare you, have at it. Otherwise avoid the group as a whole.
- The economy is getting better! Relax and enjoy it! There will no doubt be a day of reckoning in the future, but don’t let that get you down. In the meantime just try and prepare your investment portfolio for all the opportunity and don’t worry about what the market is doing right now.
See you all next Thursday!
In the last few weeks we’ve spent a lot of time looking towards the future. This is a forward-looking industry, after all. But this week we take a glance at the present and get a read on the major markets.
I have a couple of really interesting — and different — newsletters planned for the next few weeks. I think you’ll enjoy them. Make sure you sign up by e-mail so they go straight to your inbox.
Today we’re going launch another new little “mini-feature” that I know that some of you are going to love. It’s called Long Story Short. One of the biggest complaints (and also one of the most frequent compliments) I get about this newsletter is that it’s a lot to read and digest and think about. I know that many of you really dig that, but I understand that plenty more are only interested in the nitty gritty.
So what we’ll do with “Long Story Short” each week is boil the entire newsletter down to the few most important concepts. It’ll be the 30 second recap, a Cliff’s Notes of each week’s newsletter. I have a structural goal for every issue: at the open I’ll provide a one or two sentence summary let’s you know what we’ll be talking about and then at the end I’ll sum it up for those that don’t have the time to hack through all my verbosity. You can just scroll straight to the bottom. This idea — along with many others we’ve implemented — came from our readers. So thanks to DF for this one!
If you have any other ideas, Feedback@TheDraconian.com goes straight to my inbox. I’m pretty good about e-mail and if you take the time to write anything to me I’ll take the time to send you a response.
Five Little Monkeys
Lately I’ve been learning a lot about children’s books — one of the tangential effects of having kids, I guess. Most of them are just cute and rhythmic but some of these little books have actual lessons, which I promise we’ll get to in just a minute. This is all well and good, but right now my daughter is only interested in trying to eat the pages. I see now why the publishers print these things on high-density laminated cardboard.
Anyway, if you’re unfamiliar with the story or the nursery rhyme, it’s pretty simple. It starts with “five little monkeys jumped on the bed, one fell off and bumped his head.” In the book the poor little monkey is crying in obvious pain and so the mother monkey calls the doctor. Then: “the doctor said, no more monkeys jumping on the bed!”
What happens next? The remaining four monkeys, only slightly chastened, head back to bed where immediately it becomes “four little monkeys jumping on the bed. One fell off and bumped his head.”
(c) Eileen Christelow
This is my favorite part. What cracks me up is the three monkeys still on the bed are all scratching their heads, totally baffled that identical tragedy could strike AGAIN. You can see them thinking, “oh no! How in the world did this happen again?!”
They get another stern warning from the doctor and then the three healthy monkeys head back to bed. No surprise, it’s “three little monkeys jumping on the bed. One fell off and…” well, you get the idea.
Lately I’ve been wondering if we, the investing public, have more in common with the monkeys than the doctor. I mean, we say we understand the risks of jumping on the bed and know that bumping our head is a distinct possibility. We preach to other monkeys to be careful and not jump on the bed. But we just can’t help ourselves. We will jump on that bed! And the fact that four monkeys before us all bumped their head is no deterrent.
We stare at the stock market and call it a momentum-driven fool’s rally. But we can’t help ourselves. Jumping on the bed and chasing the hot run-up is just too much fun. Again and again we bump our heads. It’s happened far too many times in my short life. It started with with gold in 1979, then it was junky Latin American debt and the savings & loans, then it was Japan, then it was tech stocks, then it was real estate, and then it was financial stocks and credit markets. Now it’s emerging markets and gold once again.
Bump… bump… bump. Owch!
Each time chasing bouncy markets with identical characteristics. Sexy yields, unjustifiable valuations, and crazy momentum. Surely there’s more to investing than this? Haven’t we learned our lessons from the monkeys?
It’s entirely possible I’m reading too far into it. I am the guy that enjoyed the heck out of Ethan Frome after all. Maybe the real lesson here is not to take anything too seriously if it’s printed on chew-proof high-density laminated cardboard.
Stocks
In case you bumped your head and are stuck in “time out,” stocks have been on quite a run lately.
One of the things we’ve been talking about for the last couple months is the disconnect between fundamental reality and market action.
I think this quote cuts straight to the heart of it, but full disclosure: David Rosenberg is a perma-bear.
The economy remains on government-assisted life support, and the government has been very successful in creating the illusion of economic prosperity. It is doing this to buy time and help preserve social stability as the adjustment towards housing deflation, consumer deleveraging, and chronic unemployment takes its toll on the growth rate in organic final demand.
-David Rosenberg
I caught that at Barry Ritholtz’s must-read Big Picture blog and this is one of the things he’s been talking a lot about lately as well. The fundamentals, particularly the longer term fundamentals, are not very good. And we know they’re not very good because The Powers That Be are terrified to let this economy and market stand on its own. None of us need any convincing about the truth of Rosenberg’s comments above. But the Fed basically gave everybody an “all clear” back in August with their renewed, aggressified efforts to prop up the markets. And so everything rallied.
Why is the Fed trying to prop up the stock market? That’s not as stupid a question as it sounds. They’re doing it because if the market goes up, rich people who own stocks feel more wealthy and so they spend more money. And spending money is good for the economy.
Wait — you’re not rich and you don’t own stocks and you don’t like what the Fed is doing with your kids’ future tax dollars? Too bad. File a grievance with your congressman. At least they keep extending your unemployment benefts! Wait — you’re not poor either? You’re a responsible member of the middle class who pays your bills on time and likes to save money? Yeah, y’all are kinda getting screwed. Those are Doug Kass’ words, not mine.
If you’re a trader, enjoy the ride and jump on the bed. I hope you’re rockin’ the rally cap right now. Our oldest, simplest trading policy for markets that show technical strength is to buy them on dips, lighten up on new highs, and make sure you’re long gone if it dips under its 20- or 50-day moving average depending on how sensitive you are. It sounds easy, but it’s harder to do than you’d think. We always recommend a well-tested systematic approach.
But what if you’re a long-term investor? Your mantra right now is patience. Say it with me now… “patience“. Don’t worry, another big washout is coming and everyone currently jumping will bump their heads. I have no idea when that’ll happen, but it’s coming. When it does, go shopping. I know that sounds really easy in theory but this is an incredibly difficult strategy to execute in practice. As an investor, the hardest thing to do is to sit around do nothing when everything is going up, up, up. The second most difficult thing to do is to buy during a washout. So you’ve got a lot going against you. Investing is a long-term proposition that centers on one concept: buying good businesses at discounted prices. Values are never very attractive in the middle of speculative rallies.
If you find yourself getting antsy, go to the gym or something. Go outside and enjoy the snow. Read a book with your kids. Do something — anything — that keeps you from chasing these high-yielding risk assets ever higher. We all know how that story ends.
If you’re really bored and feel like you have a lot of energy, take a look at your local real estate market. I wrote about this a couple months ago, but if you know what you’re doing it’s time to start thinking about real estate as an investment again. It takes work, but be aggressive and don’t pay market price. I think there is value to be had right now.
Bonds
Don’t look now, but bonds have been kinda rallying a little bit since mid-December. I find this interesting because the S&P continued to rocket higher even after bond yields started going back down again.
Here, look at this chart. The blue line is the 10year yield and the red line is the S&P 500. Ignore the axes, just pay attention to the general correlation and the recent break from it.
What’s going on? What is the bond market telling us here?
The stock market is certifiably insane, but the bond market is a bit more sensible. Personally, I think it’s telling us that the smart money stopped chasing risk assets back in December and has now started to rebalance a little bit in favor of bonds. That and the Fed’s bond purchases may be having a bit of an effect.
Anyway, If I’ve said it once I’ve said it a million times. When it comes to bonds, don’t chase yield. Just… don’t do it.
The biggest mistake amateur bond investors make is that they go after the stuff with the highest yield. 5% is better than 3%, right? And 10% is more awesome than 5%, right? WRONG! Draconian lesson number one when it comes to bonds is that bonds have high yields for a reason. Nine times out of ten, that reason is because there’s a lower chance of getting paid back everything you loaned, getting restructured, or getting stiffed on your coupon payment.
If you’re a pro, obviously, feel free to discard my pithy advice. Go ahead and pounce on that latest offering from Portugal. Is 7% enough compensation for nightmares about Euroland chaos? Maybe it is. Or gobble up California munis. 30yr California state bonds are yielding like 9% on a pre-tax basis. That’s Greece territory, people. I’m not recommending you avoid that categorically, just understand the risk that comes with bonds with those kinds of yields.
Crude Oil
Pay very close attention to crude oil as we move towards the summer. There’s an interesting research paper making the rounds right now about oil shocks. I know this won’t come as too much of a surprise, but there exists a high correlation between oil shocks and recessions. In fact, every single post-WWII recession except one was preceded by an increase in oil prices. Having lived through a few oil shocks yourself you already understand the reason why: when energy prices go up everybody cuts back on their spending in other areas and that aggregate reduction in spending causes the economy to slow down.
This is really worth watching because the economy is on shaky footing right now. Don’t get me wrong — we’re growing rather nicely from all the stimulus — but the underlying fundamentals are very weak. There’s a reason for all this stimulus, you know.
Since summer of 2009 crude oil has been trading in a range between about $70 and $90/barrel. We’ve written several times about that big range and pointed out that the low end of that range should be bought and the upper end of that range should be sold. So far that strategy has worked out very well. Now, crude has now broken through $90. The only other time we’ve seen that was during the super-spike in 2008. But it’s not the first time we’ve seen an oil shock.
Here’s an inflation-adjusted chart of crude oil:
This probably warrants its own a series of newsletters — there’s just so much history in that chart.
But the most important thing is the uptrend that began in 1999. This is when we entered the age of “Peak EasyOil”. As demand for oil grew and oil became more difficult to extract from the ground, the price has risen in response. It’s hard to argue that this basic trend won’t continue for the rest of our lives.
If you like to trade crude oil I think it’s a great buy on any pullbacks. At least with crude you can make some sort of fundamental argument for higher prices and for the time being, this is a market that seems to want to keep going higher. I doubt the $70 level gets violated ever again barring another deflationary apocalypse — so there’s your risk with the oil trade. Hedge it out with stuff that will do well in a recession or deflationary shock. I listen to Stephen Schork (one of the leading oil analysts) all the time on my Bloomberg podcasts and he’s always quick to point out that it’s difficult for a lot of these big energy names to make money with crude oil at $70/barrel.
Long Story Short
- Stocks continue to push higher into the realm of unjustified valuations and the disconnect between the fundamental reality of the economy and the speculative fervor will continue until a new macroeconomic event spooks the market. Traders, knock yourselves out. Investors, take caution.
- Fund flows are starting to shift away from bonds back toward equities. The high-yielding stuff in the bond space carries very high risks. California munis are yielding close to Greek bonds. There’s a reason for that.
- Crude oil has been rallying since August and has now busted through the $90 level. The short- and medium-term trends are up and it’s likely going higher. The higher it goes, the bigger risk it presents for the economy.
See you all next week!
Today we finish off our predictions for the coming year. Click here to read the first part.
Inflation fails to show up. Again.
To put a finer point on it, I think the CPI in 2011 grows below trend. To put an even finer point on it, the Fed has made very explicit their target of a 2% inflation rate and I think they miss it, though probably not by much.
This might sound crazy, with me already predicting higher commodity prices and all. But there’s a lot more to calculating the national price inflation rate than looking at what the price of wheat is doing on the Chicago Board of Trade.
Whenever gas and food prices start going up I start to hear the same chorus of complaint about inflation statistics. ”The CPI is bogus! Gas prices are over $3/gallon again and I’m paying 20% more for Captain Crunch! Real people know that inflation is secretly rampant!” Apparently, these folks haven’t shopped for a big screen TV in recent years. Or a computer. Or any other piece of consumer electronics which every year get better and cheaper. Apparently none of these people are in the market for a new house or apartment. You’d think they’d at least be sensitive to the cost of labor, which is doing anything but inflate.
Figuring out a national price level and thus the true rate of inflation is both difficult and complex. There are a lot of interlocking parts as well as a pinch or two of economic sorcery, stuff like “hedonic pricing” and “owner’s equivalent rent.” Some day I will take you on an adventure through that twisted kingdom. It is not for faint of heart.
But today, check out this killer graphic from the New York Times. In case you need further convincing that we are in many ways becoming Japan:
Everybody here is panicked right now about inflation and the dollar and the money printing. Especially all these Tea Party People.
What everyone is missing is the bigger picture. The U.S. is locked in a Japanese-style battle against deflationary forces from the slow, disastrous unwind of the American Housing Web. The gigantic backdrop is a new secular cycle of credit contraction and deleveraging. That’s deflationary. Big time. So is below trend economic growth and a psychology of retrenchment (if you’re not a Milton “inflation is everywhere and always a monetary phenomenon” Friedman devotee).
Could inflation be a problem someday? Possibly. If our economy wasn’t so large and our currency not so important to the rest of the world, I’d say that inflation would definitely be a problem. But our economy is playing by Japan’s rulebook, not Iceland’s. If the U.S. has another scare with inflation it will be against the effort of the entire planet. Well, the middle-east probably won’t care. But the other dominant economies — Europe, Japan, and China — don’t want to see us running 7%+ inflation.
You might be hearing some analysts or talking heads squawk about inflation right now, but the markets simply aren’t confirming that chatter. The bond market is telling you that inflation for the next five years will average 2.09% per year. It’s telling you inflation will run at 2.39% for the next ten years and 2.55% for the next thirty.
In this industry and in so many aspects of our lives we simply talk, talk, talk. Let’s give listening a try.
Let’s listen to the data instead of the dogma.
The Ascension of Paul Ryan
I first heard about this guy in an article in Fortune magazine back in March. Even as a stone-cold political cynic, I was intrigued. Just who was this free-market guy from Wisconsin who sleeps on a cot in his office on Capitol Hill and leads a bunch of other congressmen in weekly P90X workouts?
My interest in him grew when I came across his Roadmap for America. I’ve linked that on here before and it’s a lot to sift through, but check it out if you get a chance. And if you’re really feeling geeky or just need convincing that this is more than political rhetoric, check out the Congressional Budget Office’s response to Ryan’s roadmap. Doug Elmendorf — who is an intelligent, sensible Democrat and was one of Obama’s first appointees — basically said, “Yeah, this’ll work.”
I’ve also been impressed by his work with Alice Rivlin, another lifelong Democrat who served as budget director under Clinton and director of the CBO under Jimmy Carter. She and Ryan came up with a similar plan to that groundbreaking Bowles/Simpson proposal to rein in the deficit. There’s some pretty radical stuff in there too and even Ryan readily admits that there’s little chance that much of it gets enacted. But he’s done all this to start the (adult) conversation about what to do with things like the debt overhang and the unsustainable future of Medicare and Social Security. I’m of the belief that more and more people are wanting to have this conversation – deep down we all understand the challenges of the future and I think more and more of us simply want some real expectations about what we’re in for, even if it means sacrifice.
Right now it’s only the political and policy wonks that are talking about this guy. But by the end of the year I believe that his name is on all the lists for Republican presidential candidates in 2012. Over at Intrade today it’s showing about a half percent chance that he’s the nominee. I don’t ever play around on Intrade, but it’s a good bet that that number is way higher by the end of the year.
I know the right wing is all a-flutter with Sarah Palin right now. But if you consider yourself a rational conservative instead of an emotional conservative, Ryan is the horse you may want to think about backing. I haven’t been this blinded by the brightness of an individual’s political future since I heard Barack Obama give that speech at the 2004 DNC. Seriously.
Emotional liberals hate this this guy, and understandably so. He wants to slash a lot of entitlements and redesign the tax code. But I think this is a guy that rational liberals can work with. They actually already are.
Anyway, today’s hyper-hostile politics are preventing us from reaching our country’s social and economic potential. Cynical as I am, I don’t think that’s a condition that lasts forever. At some point reality hits us in the face and our elected representatives stop behaving like gladiators in a spectator sport and start acting like the adults we secretly want them to be.
Mystery Country
Here’s a fun one. Let’s play a game. The game is called “Mystery Country”.
What if I told you about a country…
- …that is still at the peak of a housing bubble, perhaps the last housing bubble on earth? It’s a country where the median home price in its major metropolitan areas is about eight times the median income.
- …that has an economy heavily leveraged to the commodity boom, with upwards of 30% of GDP driven by commodity exports to growing, resource-hungry nations like China and thus highly susceptible to deflationary shocks or slowdowns.
- …with a private sector debt-to-GDP among the highest of all nations?
- …that is currently rocking a planet-leading 160% household debt-to-income ratio from people using their homes as ATMs exactly the way that we did in the United States.
- …where many of the largest banks are once again trading near all-time highs? Where these banks have been actively pushing for higher leverage ratios and looser mortgage standards?
In the words of Bob Ryan:
Yes Bob, that does sound like something I would be interested in. Interested in shorting!
The answer to Mystery Country is “Australia.”
If you’re looking for a prediction that is waaay outside consensus then I think that Australia is a disaster waiting to happen. It is a bubble in search of a pin, in modern parlance.
And nobody — I mean nobody — is talking about this right now. The reason, of course, is that Australia is booming. They are digging very valuable stuff up out of the ground as fast as they can and selling it for ever-higher prices. Unemployment is low and their currency is strong.
When you’re looking for assets to short, you don’t go looking for the ones that have already fallen like a rock. You find the ones that have legitimate fundamental concerns and are trading well above where they should be. Shorting the U.S. housing and stock markets in 2006 or 2007 seemed totally nuts; but that was the time to gear up for that trade. There were major problems afoot but everyone thought the strength would continue forever.
Have a look at this chart in case you object to the claim they’re in a housing bubble:
That’s a bubble.
And if we’ve learned one thing from housing bubbles in the last couple decades it’s that they are nasty. I mean, nasty!
Japan is still mopping up the bloodshed from its epic real estate collapse twenty years ago. In the U.S. the housing bubble catalyzed a little financial crisis. Several years after the fact, we’re still coming to terms with the knowledge that we’ll be struggling with the fallout from our real estate bubble for some time to come. Spain had an even bigger housing bubble than we did and they’re paying the price with 20% unemployment right now. The United Kingdom is still on the way down and everybody knows it will be ugly over there for a while. Iceland, of course, blew up in spectacular fashion, erasing generations of wealth in the blink of an eye. The housing bubble and bad banking standards were the primary reasons why.
So to find a country that’s still locked in the irrational throes of real estate ecstasy is something of a treat. It’s a movie we’ve seen many times before. We know the ending.
The Chinese real estate bubble gets all the publicity now, but theirs is concentrated in a handful of major cities. Australia’s housing bubble is centered in the major metropolitan areas too, but the problem is that this represents most of the population. The five largest cities (Sydney, Melbourne, Brisbane, Perth, and Adelaide) account for 61% of the entire country’s population! When you add Canberra, Hobart, and the Gold Coast, which have also seen stratospheric increases in home prices as well, that number gets closer to 70%. Basically, this is a bubble that affects the entire nation.
Today the story with Australia is that it’s a roundabout way to play China. I think that playing China directly is a better way to play China. But if you’re one of those China nonbelievers, then I think that shorting Australia might be a better way to short China than shorting China directly.
There’s a good chance that paragraph may have totally confused you, so let’s try this: in absolute terms, the probability of Australia wiping out because of their housing bubble is high. I think it’s much higher than China cooling off for any significant length of time. So Australia has a long-term, near-inevitable risk going against it (housing bubble) plus a variety of short-term cyclical risks (China slowdown or other economic hiccup).
Here’s another awesome Trade-of-the-Decade: short Australia and get long China. You can implement that with each countries’ assets and companies — You can also try specifically shorting the banks. We all know that banks feel it most in the aftermath of a housing bubble and it’s possible that Australia may not have the political will or economic capacity to bail them out and zombify them the way that Japan did and we have done in the U.S. There’s a good chance that many of their banks just fail.
Seriously, go look at their bank’s webpages and compare them with the ones in this country. There’s an “investment property” section featured prominently on every Australian bank’s website. Investment properties! Remember those? In Australia you can get special “introductory rates” and “lines of credit” as well as the “60 minute home loan” and “customized mortgages to meet the needs of the self employed.” It’s madness!! I haven’t seen anything like that from Bank of America or Wells Fargo since 2005.
Look, I’m not a bank analyst. I’m just a guy with a barely-above-average knack for identifying large scale patterns and cycles and who has probably spent more time than any sensible person he should have at the Australian Bureau of Statistics. I have no idea if these Australian banks are technically insolvent or not. All I know is that they’re doing exactly what U.S. banks were during the peak of our own real estate boom (and Japan’s, and Europe’s, for that matter). I’ll let someone else get hung up on the details.
So do with this suggestion what you will. Personally, I have nothing against Australia.
Incidentally, this long China / short Australia trade also works for the currencies. The Aussie Dollar is way strong right now with high interest rates demand for their exports as robust as ever, and everybody knows the Chinese RMB is artificially undervalued.
There’s an added bonus with this trade too. Since these two markets are somewhat tightly linked, this trade probably won’t have the volatility that other global relative value trades will. Shorting Australia is a semi-hedge for getting long China. The correlation between FXI and EWA is at around 0.8 right now. At some point that linkage will erode. Long-term, China has a lot more going for it than Australia and there are countless scenarios where China does well and Australia doesn’t. I have a much harder time coming up with scenarios in which Australia wins and China doesn’t.
This isn’t necessarily something that plays out in 2011. But it’s time to start talking about it. If I’m wrong on this one this year, count on it being a prediction for 2012. I’m a terrible market timer. The Australia real estate bubble won’t officially end until greater fools stop paying ever-higher prices and who knows when that happens.
Humans are funny creatures. Why we ignore bubbles while they’re being inflated will always remain a mystery.
The VIX spikes above 30
The one trend that I do believe will continue is that there will be some more volatility this year. It might seem almost unfathomable for the VIX — currently around 16 — to get above 30. But I think there are enough risk factors and enough people not showing them proper respect for there to be a serious volatility spike sometime in the coming year.
My guess is that it coincides with the Spain- or Italy-phase of the still-unfolding EU debt drama. Or maybe when tremors start rippling through the U.S. municipal bond market. There are plenty of bogeymen out there that could give the market a scare. The problem with a whopping 56% bullish sentiment in the market is that everybody stops thinking about all the ways the fun days might end, instead focused entirely on why the fun days will continue indefinitely.
Bullish or bearish, this is a prediction that you can put to good use. With the VIX at these low levels it means that the price of put options (basically an insurance policy for your stocks) is super cheap. If you’re concerned about surprises that may stun the markets in 2011, take advantage of the current level of complacency in the markets and shop for some options. Don’t do it during the shakeup! That’s when the price of these options skyrocket.
ETFs are affecting the markets in ways that people don’t fully understand
This isn’t really a prediction, but it’s something I wanted to get on the record about.
Financial innovation is usually a good thing. Not always. But usually the innovations that make it to the market improve one thing or another. The problem is that many of these innovations have other consequences that are neither intended nor expected.
Generally speaking, exchange traded funds (ETFs) are a good thing. I can’t see how the 3x levered ETFs are anything other than one more product for an investment house to sell and day traders to mindlessly swap back and forth in minute-by-minute intervals. But something that gives an investor easy, quick, and inexpensive access to a diversified portfolio of, say, energy companies or retail stocks is a step in the right direction.
The problem is that as more and more money flows into these things they are beginning to affect the market in unintended ways.
The obvious one is correlation. In this sense, ETFs have permanently altered the marketplace. As money flows into the market and these funds, all the stocks in these funds rise together. As money flows out, they fall together. And when they do drop it’s the type of drop we’ve grown accustomed to in recent years; everything moves jointly and sharply. I think that we’ll continue to see high correlation between stocks, especially between stocks in the same sector.
Another is how GLD has affected the price of gold. There’s no doubt that a vehicle like that is helping to push the price higher. With gold it doesn’t matter so much, but billions and billions of new dollars sloshing around other commodity markets can have a real effect on real people in the real economy. We all need to take another look George Soros’ theory of reflexivity.
I’m going to give this item a lot of thought and study in 2011. Right now, the best that I can come up with is that ETF-driven high-correlation phenomenon will manufacture specific types of opportunity. When the market (everything) sells off dramatically, it will give adept investors a chance to pick up good companies at artificially depressed values. There will be some companies who get dragged down further than they deserve because the ETFs have chained the whole market into one squirmy beast.
So keep that in mind as we head through 2011. It could be a bit of knowledge that helps you spot some opportunity.
One of my favorite things about writing an investment newsletter is that I get to do stuff like this. I love playing around with ideas and trying to figure out how trends and surprises may impact the world.
If you’re new here, a brief disclaimer: you shouldn’t take these predictions too seriously. I hope you’re not relying on anybody’s forecasts to come true. Everybody knows that predicting the future is impossible, but what’s more is that it’s really a game for fools. So let’s have a little fun with this and try to put it to good use. Borrow some of these ideas as a starting point for conversation around your dinner table tonight. Or use them as a litmus test for your portfolio — how will your portfolio respond if these predictions come true? What if they are spectacularly wrong?
Consensus predictions are boring, so last year I tried to come up with some that pushed a bit against the mainstream. I missed a bunch, but I nailed a few that seemed crazy at the time. Never underestimate how wrong conventional wisdom can be. These are interesting times we’re living in and “black swan” events seem to happen with disturbing regularity. Rather than passively assuming that the current trends will continue indefinitely, we should be mindful of how rapidly things can change.
With that, let’s put on our Zoltar hats and get started!
Good but below-consensus economic growth, rising interest rates, and a schizophrenic stock market
Here’s the broad story for 2011: we get legitimate economic growth. It won’t be as much as most are expecting — the current consensus is now up to around 3.5% real — but it’ll be growth that we can actually feel good about. It will be enough to justify slowly rising/normalizing interest rates, especially as the Fed finds out it’s only so influential in the bond market, a bond market that at some point will start to get a little jittery. The growth won’t kill the political will to keep stimulating the economy, but it’ll be enough to keep any additional intervention we do see from being massive enough to really matter. At some point a new round of uncertainty will creep back in and disrupt the stock market, making for a much more volatile year than basically everybody is predicting.
What we’re seeing now — strengthening economic data, an increased willingness for consumers to spend, and a rising stock market — should continue for a little while. But I think that the second half of the year is a different story. It’s where we are reminded that the economy won’t be as consistent as we all came to appreciate in the last few decades. Economic growth will be lumpy with GDP moving in fits and starts. Don’t be so down on environments like that; they create opportunity.
We’re going get a pretty big shot of stimulus from this temporary payroll tax reduction. It will put about $120 billion directly into people’s pockets. A payroll tax reduction is one of the more efficient forms of stimulus and with its multiplier effect, this could represent upwards of one full point of nominal GDP growth. This alone probably saved the economy from any risk whatsoever of a double dip recession in 2011.
Aside from boosting short-term consumption it won’t change behavior. The political spin on this payroll tax holiday is that it will inspire confidence in small businesses and give them an incentive to hire new workers! That’s ridiculous. Go read up on Milton Friedman and his permanent income hypothesis. People consume based not on their situation in the present but on their expectations of the future. You don’t spend based on what last month’s paycheck was; you spend based on what the next few months’ paychecks will be or what your salary will be next year. Businesses do the same thing.
The economy isn’t going to show significant, stimulus-free growth until more jobs are created. The majority of that comes from small business and if you want to know what small businesses are thinking and doing, listen to Bill Dunkelberg of the NFIB. This won’t come as a shock to any of you who owns a small business, but businesses aren’t hiring new workers because demand from their customers sucks. That’s what it’ll take to get the job creation engine moving again and you can see the chicken/egg nature of this problem. It has nothing to do with payroll taxes and don’t buy into the “small businesses aren’t growing because the banks won’t extend them credit” meme. The data simply don’t confirm that, which makes you wonder how exactly a credit-easing program QE2 is supposed to stimulate the economy.
Anyway, everything in this economy is still on steroids. We’re being propped up with a million different forms of stimulus right now, and what’s more is that those who have injected all the stimulants are afraid to see what happens when they start withdrawing their doses. The economy will indeed grow but many years down the road we’re going to be asking whether it was all worth it.
It’s fun in Hollywood to leave endings open, to wonder about what happens to the aging hero after the screen fades to black. Was the price his body paid worth it? Does he regain his former glory? It’s one thing to discuss that sort of stuff over coffee, but what we’re doing in the economy is serious business. What sort of claims are all these policies placing on future growth?
At some point the stock market wakes up to that realization. All of this revised 2011 growth has been priced in to current levels. Tactically, I’m also concerned about what happens when the QE2 program ends in June.
To throw some numbers and dates out there, I think the market makes its high in the first part of the year and I think it closes the year at least 10% below peak. It might even have a flat or down year, a prediction which flies so far in the face of consensus estimates — somewhere around 1400 on the S&P — that you might be wondering just what, exactly, I am smoking. The answer is nothing and perhaps that’s the problem! Maybe if I burned one down I could just embrace the awesomeness of the here and now, man, and ditch all these uncool worries about the future.
Want an old school investment strategy that hasn’t really worked in recent years that everyone has sort of forgotten about? One that I think returns to glory in 2011?
Sell in May and go away.
Municipalities under duress is the dominant issue of 2011
I think this is a good prediction for two reasons.
The first is that the bond market is always the first thing in the world to react to anything. It leads the rest of the markets, it leads the news media, it leads the water cooler conversations on Monday morning.
The bond market has already started reacting to this:
That’s not the only municipal bond fund to struggle lately. November was the worst month for muni bonds since the crisis and it triggered a whopping $3 billion of outflows from those types of funds.
While the cracks are starting to appear in the bond market, the stock market hasn’t really reacted to this yet. And the story certainly hasn’t caught on yet in the mainstream news.
Anyway, 2011 is when that happens. I think it’s the cause of a little market correction or two and it’s when we start getting concerned about things like our state pension, our state income tax or sales tax rates, or the local civil services we’ve all come to love and appreciate.
I think this is a dominant story because of its size — there’s talk of hundreds of billions of possible muni-bond defaults — but also because of the visceral nature of the problem. Unlike the EU sovereign debt crisis, this will be an issue that really hits home with Americans. Schoolteachers getting fired and state workers losing their pensions has a very tangible aspect to it. It’s the kind of thing that people get emotional about. This will be a lot more like the housing and banking crises rather than the EU sovereign debt crisis.
And yes, it will move the markets. If you’re looking for the market to make a big move lower, this could be your catalyst.
For the record, I think that Meredith Whitney’s forecast that there will be $100-$200 billion of municipal defaults is a… “bold” prediction. What she’s doing is essentially calling for another financial crisis. I don’t agree with our new American dogma of backstops and bailouts, but I think Whitney is underestimating the government’s willingness to pony up ridiculous sums of money in order to defend bondholders from losses. We’re not going to see hundreds of billions in defaults, but we will see a record number because the thrust of her research is on target: the states are in big trouble and it’s hard to see how this doesn’t end in tears.
This also has a vaguely European political dimension to it in that relatively responsible states like Texas or Montana might have a little something to say about their federal tax dollars being used to bail out the looming economic disasters of California and Illinois. It was one thing to bail out a financial sector with a deeply entrenched national footprint, but I think this issue with the states is where some people draw the line and say, “nuh uh, I’m not paying to bail out those yahoos on the other side of the country. Their problem doesn’t affect me and it’s up to them to solve.”
Either way, bailout or not, it’s the kind of the thing that people everywhere will be talking about and it’s why I think this is the one issue that frames all the economic discussion in the coming year.
Higher commodity prices are the other major story in 2011. Crude Oil shoots through $100/barrel & commodity prices keep going up. People start to feel it.
I present to you the other major story for 2011.
This will be a big deal because this is another visceral issue, one that hits home with Americans. There weren’t any stories like this last year. The big one in 2010 was Europe, a situation that is truly frightening — it’s a legitimate crisis over there! But it was over there and everybody here said “meh, whatever” and bought the stock market and spent money because they were tired of being frugal.
This year, higher commodity prices will hit home and you’ll start to hear a lot more bitching and moaning about food cost, gas prices, and utility bills.
We’ve written in the past how the $85-90 range tends to be a level at which crude oil stops correlating with the market. Above that is where the knock-on effect happens, where it starts impacting the economic decisions that consumers make. $100 is an important psychological level too. I can almost guarantee you that if it makes a whole-hearted run toward$100, it will go through $100. Whether that happens because of legitimate fundamental reasons or simply a positive feedback loop, this is a mechanical phenomena that is impossible to deny.
I also think there will be some decoupling. Stocks and commodity prices may keep correlating for a little while but at some point the relationship breaks and the economy starts to feel the effect of these higher commodity prices. Commodity prices can keep going higher, too, as speculators chase assets that are going up in value instead of down.
Keep your eyes on the food and restaurant stocks. These guys will be super-sensitive to this as higher food prices squeeze their profit margins in two ways: 1. their input costs go up and 2. their demand from consumers go down as people struggle with higher prices and cut back on spending. The same thing happens with other kinds of retailers, like clothing stores. Cotton prices are up over 80% in the last six months.
Buckle up for higher gas prices too. I think the national average gets above $3.50/gallon. We’ve had quite a run recently and that’s another 15% rise from here.
If you absolutely have to invest in stocks in 2011, do it in sectors and with companies that will benefit from higher commodity prices and won’t be so sensitive to a consumer who may embark on a second round of retrenchment later in the year. That trade wins in a lot of different scenarios but it gets killed if we have another deflationary panic. So hedge it out with some bonds, which are highly likely to benefit in such a scenario.
We could be entering a phase a lot like the end of 2006. Remember 2006 when we thought the carnage of the tech bubble was finally behind us? Any real risk of recession is at least a year or more away. Commodity prices have been rising alongside the stock market. Maybe that relationship breaks as the market gets whiff of a possible slowdown a year or so down the road. Maybe stocks begin to sell off while speculators continue to drive commodity prices higher. Maybe there’s another crisis 2-3 years out where everything comes crashing back down together.
I know that history never plays out exactly the same way twice and the details will always differ, but this is an interesting pattern that could be setting up here. After all, nothing has changed with our fundamental policy dynamic of creating conditions whereby bubbles are easy to inflate and worrying about the mop-up if and after they burst.
Real estate makes a new low, a final low
In some sense this is a bold prediction — there’s no doubt that the consensus view on housing is very negative. Everybody hates real estate right now and the mindset in most areas around the country is deflationary i.e. prices will stay low or get lower. But I think we’re a lot closer to a final bottom and a normal market than the consensus seems to think. I think the major home price indices make new lows in 2011 with the Case/Shiller dipping into the 130′s. That would represent a 5-10% pullback from the recent bounce.
But I think that’s it. And 2011 is the year where certain conditions start to work towards clearing the markets, stuff like increases in residential investment and new home starts.
If you still think that it’s all gloom and doom in real estate, check out this chart:
I know that inventories are still grossly inflated and demand is pinched in a number of ways, but this relationship underscores the point that the market has in some ways normalized.
When people can buy houses cheaper than they can rent them, people buy houses and rent them out. This is what the smart money will be doing in real estate. The masses were playing Real Estate Tycoon in 2004-2007, which as you can see, was the worst time in history to be doing such a thing. The average investor — the “dumb public” to use a derogatory term — is always doing the wrong thing at the wrong time.
What, you may ask, is this guy doing right now?
You know what he’s doing: he’s buying gold!
Gold Bubbles On!
I’m feeling increasingly confident that we’re in a gold bubble right now. I have no idea how far into this bubble we are and I have no idea how far this bubble will go. I am neither smart enough nor stupid enough to predict when or why it’ll end. Sadly, I’ve lived through enough bubbles in my young life to have a pretty good sense at how these things play out and how complicated they are to navigate.
We are past the point of investing in gold “as a hedge against inflation” or “because you’re worried about the Dollar”. The fundamentals have stopped mattering and the price is driven entirely by people expecting that prices will keep going up. That’s the academic definition of a bubble.
Check it out:
You’re seriously going to sit there and tell me that there’s absolutely no chance that gold is in a bubble right now? Only once in the last 140 years have we entered this territory before, a time that we all recognize and agree was one of the most dramatic bubbles in modern history.
I appreciate the fundamental argument that a lot of people are concerned about paper currencies right now, specifically the U.S. Dollar. But this isn’t the first time in history people have freaked out about the Dollar. Plus, nothing in any other market is confirming that worry — long-term interest rates are low and other dollar-denominated assets like real estate, commodities, or even stable foreign currencies are nowhere near 3.5 standard deviations away from their 130-year trendline.
Gold is 100% speculation right now. By buying gold, you are speculating that:
- the bubble will continue
- or heavy duty inflation will materialize before too much longer
I know that a lot of you that read this newsletter really like gold. Every single one of you are either rolling your eyes right now or getting ready to shoot off an angry e-mail. I’m not saying that the party is over. I’m saying pat yourselves on the back for keeping the faith and make sure that what you’ve still got on the table won’t kill you if it goes *poof*. I’m saying that as we move further away from $1,000/oz and closer to $2,000/oz, it’s time to start asking questions about why you really own gold or are buying more of it.
If Gold does get to $2,000/oz — and I think it’s even-odds that happens in the next year or three — you need to understand that you are playing with fire.
Anyway, I’ll make two predictions for gold.
- It ends the year above $1500/oz and makes an honest run toward $1600 at some point.
- We get a major fakeout along the way (a >20% correction)
I see this being a more volatile year for gold. There are a lot of gold rookies in the market right now and a lot more will enter in the coming year. A lot of these guys don’t have a full appreciation for how violently the gold market can move. I think that we’re due for a reality check, and then another round of enthusiasm to push the market even further into bubble territory.
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