As we are in interesting times, I am spending more time than usual on current events and less on portfolio analysis. For in fact only by understanding what is going on will I know what to own. I think my current portfolio is "OK", but it may need some changes going forward,
Anatole Kaletsky and the father and son Gave's have emerged in recent years as among the very best market economists and investment analysts. Google them or their firm GaveKal for a list of publications.
Kaletsky has been writing a stream of articles recently for the Times of London on the monetary crisis there and in the US. John Maudlin has made available an update of GaveKal thinking today.
This is an excerpt, but I urge you to read the whole argument:
"In 1933, Mellon famously advised Roosevelt to "liquidate labour, liquidate capital, liquidate the financial markets. It will lead to a much more moral society." This, better than any other statement, encompasses the "perma-bear" philosophy: sinners have to pay for their sins; and when the central banks step in to give sinners a helping hand, this can only ensure eternal damnation for the rest of us (either in the fires of an inflationary bust, or those of a deflationary bust, depending on the perma-bear to whom you speak)."
"Needless to say, with the Fed having just cut 50bp, the prophets of inflationary doom are having a field day. Everywhere we care to turn, we are told to sell the US$ and buy gold. Once again, paper currencies are going to be shown to be worthless."
"But is the Fed's track record really that horrendous? As Milton Friedman himself wrote in the WSJ "on August 19th, 2003: "Fifteen years ago... I wrote 'no major institution in the US has so poor a record of performance over so long a period as the Federal Reserve, yet so high a public recognition'. As I believe I demonstrated at the time, that judgement is amply justified for the first seven decades or so of the Fed's existence. I am glad to report that it is not valid for the period since".
"Indeed, for all of the perma-bears' laments that the Fed keeps on pushing inflation in the system, we are not sure that this assertion is backed up by the data. Indeed, let us ask a very simple question: were recent interest rate cuts by the (according to Milton Friedman) competent Fed followed by a rise in the CPI shortly afterwards? Let us have a look:
"Since 1970, most cuts by the Fed (1970, 1974, 1985, 1989, 2001) were followed for at least two years by massive declines in the inflation rate. There were, however, exceptions: 1980 (which was quickly taken back by Mr Volcker) and 1998 (which was also quickly taken back)."
"Which leaves us with the following question: Will the recent Fed cut prove to be right? Or will it be, like 1980 and 1998, a mistake quickly taken back? We tend to believe that the Fed was right to cut and that, given the massive collapse in velocity, commercial banks will need a steep yield curve in order to recapitalize their fragile balance sheets and avoid a Japanese-style deflationary bust."
"However one puts it, we can't escape the conclusion that Milton Friedman was (once again) right: In recent years, the Fed has been more broadly right than wrong (five out of seven). Better yet, when it has been wrong, it was quick to change its course and adjust to the underlying realities. Can the perma-bears claim the same batting ratio and the same intellectual flexibility?"
The first paragraph is by a poster at WW, the rest mine with some help from Richard Russell's great Dow Jones book:
Tuesday was reportedly only the 7th day since 1950 with more than 25 stocks up in volume versus every 1 down. The average market gain 3 months later was 9.4%. Each signal day was followed by quite a rally. In the case of 1982's signal, well it ran all the way up into year 2000. The dates are 12/27/50, 1/11/51, 10/23/57, 11/1/78, 8/17/82, 8/20/82, and 9/18/2007.
The 1950 example was the example of 25/1 up/down volume most like now. It came about 18 months after the great stock crash low and commodity low (Kondratieff Wave low) of June 1949, Dow 161. There had been a good rally for a year, but then the market sputtered with the terrible geo-political gloom and doom (USSR, China, Korea) and made a higher low at 228 right after Christmas.
The 1957 example was out of the October crash low of 425. Severe recession. Political gloom and doom. Communists pressing their luck in the US and throughout the world.
The 1978 example was out of October crash low of 790. President Carter abandons the Shah of Iran and gives away the Panama Canal; FED Chairman Miller newly installed (worst ever); dollar and bonds collapsing; gold breaks above 240 not long after.
1982's example was out of the bitter August crash lows of 772. Auto production was the lowest in 35 years, factory capacity utilization 69%, 10.1% unemployment.
In every case of a 25/1 up/down volume day the possibility of a big rally was totally dismissed since the economy, and the world could obviously only get much worse.
This chart visualizes the price plateau of the 19th century, post Napoleon, until the completion of European and finally the US dollar devaluation in 1934.
The Long Wave peaks of 1812, 1866, and 1920 and the lows of 1844 and 1896 are quite clear. Even the 1980 US price peak shows up, but since the entire economic and political environment had changed to social democracy and easy credit in the 1930's, and remains such today, we only get decreases in the rates of inflation after price peaks instead of outright deflation as from Napoleon to Roosevelt.
We now have financial derivatives to the nth degree which require atomic analysis to fathom, and few could or did fathom mortgage-backed securities, as we are seeing lately. It's hard to believe that until about 100 years ago, the only financial derivatives were trade bills, sovereigns, and joint stock company certificates, known today, respectively, as commercial paper, treasuries, and stocks. We do not think of stocks and bills as derivatives, but they are.
Until well into the 19th century one either owned land or bonds. Hereditary land in England and in much of Europe had become marketable and could be collateral for loans, which had not been the case in the middle ages but which gradually became feasible after 1500. Those who had no land but who had made money in trade, profession or business would invest in sovereign bonds.
From the final defeat of Napoleon (and from the Council of Vienna in 1815) to the first World War there was a hundred year period when the yield on the perpetual British sovereign bond known as the Consol (http://en.wikipedia.org/wiki/Consols) fluctuated to a minor degree around its 3% coupon as shown on the chart of Joseph Kitchin (1861-1932) the British economist and expert on gold and the gold standard.
Britain and most of Europe were on the gold standard, so there was virtually no inflation for that 100 years, thus 3% was a decent return on an investment. You'll note on Kitchin's chart that short term LIBOR (London Inter Bank Offered Rate) was far more volatile than the Consol yield since even under the gold standard there were numerous financial panics in the 19th century when banks had lent out more than their deposits would warrant and loans went bad. This is what we are seeing currently with the blowup of junk CMO's and the blow off in LIBOR as banks scramble to borrow reserves.
Despite the chorus of today's gold bugs that all is well under gold, financial panics were a regular event, and bank interest rates varied widely. Even the Consol rate settled down from 6% during the French revolution and Napoleon's wars to 3%. LIBOR bottomed at 2% several times in the depression of the 1840's and 50's and then had three spikes to 6%, the last in 1866. Then came the long disinflationary depression/recession into 1896 when LIBOR fell under 1% and UK commodity prices fell to their lows.
The next peak in LIBOR, the Consol rate, and commodities came in 1920. Now we clearly note the association of peaks with wars when borrowing and commodity demand rises. The 1812 and 1920 peaks are quite evident, but the late 1860's peak, which was so dominant in the US with the dollar ("Greenback") crisis of the later civil war, was somewhat muted in London. From the inflationary peak of 1920 a long disinflationary and deflationary period recurred, like the two similar depressions of the 19th century, into the LIBOR low of one half percent in 1946-49.
The 50-60 years peaks between successive interest rate highs and commodity boom highs are what led Kondratieff, a Russian economics statistician, to the Economic Long Wave which bears his name. Kondratieff's data ran only to the later 1920's. Kitchin's chart runs to 1971, and shows LIBOR was over 10% then, on its way to 20% in 1974, and commodity prices were rising into the mid 1970's peak in Britain and the secondary high of 1980 in the US. From 1980 commodity prices fell and began making lows in the late 1990's early early in this century, with the secondary low in gold in 2001 at $256. USD LIBOR bottomed at about 1% in 2003, EUR LIBOR at about 2% and GBP LIBOR at about 3%.
What's different about the current crisis from others of the 19th and 20th centuries? Essentially nothing. Banks over-loaned on dubious projects and called in the loans (or quit rolling them over) when the loans began to go bad and tightened up on new loans. Neither gold nor an enlightened central bank made a difference in the genesis of crises of the last two centuries nor now. A strong central bank alone or in concert with others can prevent a crisis from becoming total stoppage, at least in theory. Chairman Bernanke's remarks about dropping money from helicopters to beleaguered bankers was made before he became chairman. There is, to be sure, the lesson of Japan which says that a "liquidity gap" can occur during which unlimited money is available at a zero interest rate, but no one lends or borrows or spends enough to recharge the economy.
In fact it has become evident that Japan's BOJ liquidity binge has financed much of the world's borrowing of the past five years. A realization of the risks of that so-called "yen carry" arose in August when the New Zealand dollar fell nearly 10% in a few days as the yen strengthened. An enormous borrowing in yen at 1% is invested at much higher rates in New Zealand (and Australian and British) bank deposits and bonds.
Voices are now being heard again from those deflationists who never recognized that there was a decline in interest rates and commodity prices and economic growth rates from the 1970's to 2000's. They further failed to realize that it ended by 2003 and that inflation, caused by supply/demand imbalances, will be around for another two decades as from the mid 1840's to late 1860's, and from the mid 1890's to 1920, and from 1949 to 1974/80. There has been a contra-trend pullback in inflationary pressure which began over a year ago as shown by the ratio of the Commodity Research Bureau Index (Reuters-Jeffries CRB Futures Index) to US Treasury long bond that I showed last time. This current crisis will likely extend the "rest stop" somewhat longer in time. But inflation is here to stay and will be back after that rest.
Everyone is aware that there are some shifts going on this year in asset allocation. One way I get a better grasp of potential shifts is to look at simple relative value ratios over a long a period of time.
Recently I wrote here http://twocents.blogs.com/weblog/2007/08/2cs-sentimeter-html about "range shifting" in stock market sentiment this year. The 2CS Sentimeter (5 day running total of the daily product of CBOE VXO and CBOE Put/Call ratio) not only made a higher 2CS low (less exuberance) than it has done at an interim high the past few years; but 2CS also made a much higher high (more bearish exuberance) than at any time since the 2002 lows at the July/August lows. The is a dramatic change in sentiment. We could normally look at this and say that the bears are just being even "dumber than normal". But sentiment is sentiment, and when the indicator ranges shift, as they did in March 2000 and in March 2003, they may be heralding a longer term reaction or direction change. So 2CS is a hint. But I am looking further.
An even earlier clue of change this year was in real estate. We all know about the residential realty debacle, but commercial realty had seemed immune. REITs had been zooming up for years, outperforming nearly all domestic stock sectors, even energy. But REITs hit the wall in February, well before other sectors. The Vanguard REIT Index fund (VGSIX) is down 20% from its February high and down 10% year to date. The Dow Jones Wilshire Index of real estate operating REITs and operating non-REITs has dropped 25% from its high and on a monthly a basis has fallen below several simple trend measurements for the first time since 2003.
The SP500 Stock Index, using the same trend measurements as with realty companies, hasn't quite broken down, but the "early warning" MACD could do so this month unless it rallies and closes higher than where we are today. Even more likely to break down is the ratio of the SP500 (SPX) to the ten year US Treasury note (UST). SPX has done better than UST since April 2003, but the ratio's MACD is signalling a reversal of that trend unless either UST drops quite a bit and/or SPX rallies quite a bit by the end of the month.
The same thing is being hinted about the rest of the world's stocks. The FTSE All World ex-USA Index is begining to slip the same way, and the Dow STOX50 Euopean Index (not shown) looks virtually identical to the SPX when compared to the US ten year Treasury.
More surprising is the ratio of the traditional CRB futures index to the ten year US Treasury note. The traditional CRB Index is not weighted as heavily to crude oil as most other indexes are, and it has been around far longer than the rest. It includes all US-traded physical commodities plus three metals traded in London. So it is a good index of true overall commodity futures prices. Spot or current prices may be higher but futures say that prices will be lower "in the future". The chart with the same parameters as the charts above shows that the ratio of the CRB to UST broke down last year and is still falling.
Even more surprising is that the US Dollar Index has outperformed the CRB for the past year. Only modestly so to be sure, but its trend strength, measured by the MACD, has been improving for several years.
And even the US Dollar Index is stabilizing versus the ten year Treasury on a trend strength basis! This brings up the crucial issue for all of these investment asset allocation comparisons: is the US dollar making a bottom after a nearly seven year slide? I won't get into that question in any depth except to say that the trade-weighted US Dollar Index is near 80 which has been support for thirty years. Nor do I wish to discuss Elliott Wave which is out of favor currently, and probably rightly so. But take a look at the cash EUR/USD daily chart for the past seven years. There are credible ways to label that chart suggesting that a reversal of fortunes is in the making for the Euro and the Dollar.
If the reversals mentioned here, in real estate, stocks, bonds, commodities and the the dollar, come to fruition, what are the implications? For investment it would mean lower interest rates and a higher dollar which says one should emphasize US Treasury notes and bonds above other classes. Implications for the economy would be that the economy slows meaningfully which probably means a recession. We shall see.