"The market did peak in mid July as anticipated or "hoped" and made significant corrections into lows in August and October........Perhaps I'd be wiser to rest on my laurels and not push my luck. But November and December are the most reliable times of the year to be long."
That's what I said here on November 4th, and I would indeed have been wiser not to push my luck in commenting. Instead we've had a contra-seasonal drop of 6.2% in the SP500, maximally, from that date to the recent low. The news remains all on panic in the mortgage-backed securities sector, but the markets are focusing on the prospects for a recession in the US if not elsewhere.
Twenty years in a disinflationary period from 1980 to 1998-2002 led many of us to expect that inflation would subside if the economy wavered or slowed down, as inflation did so dependably in the 1980's and 90's. But that was a different era. The Long Wave perspective says that it's "different this time". It's doubtful that a "soft landing" will provoke disinflation during an inflationary era. A deep recession like those of the late 1950's and 1960's, in similarly inflationary times, would be needed to slow down inflation at this time. Such a deep recession could happen, now that we are past the first inflationary wave since 1999, but the markets are telling us, to date, that it will not.
Markets are reflecting this change. To see crude oil, gold, and Treasury bonds all rising in price is counter-intuitive to many investors and traders, but all these are consistent with an economic slowdown or frank recession during an inflationary era as opposed to what happens in a disinflationary era. And so is US dollar decline. They are linked together.
The Reuters-Jeffries CRB commodities futures index (CRB) documents the progression. Since 1999-2001 long term low in commodity prices, and in inflation generally, there was a fairly steady overall increase in prices until May 2006. The FED noted this peak by late June 2006, in my view, and stopped tightening. It is the FED's charge to respond to events, not to antitipate them, as if they could. And they responded to the market peak in commodity prices. The impression, and hope, was that there would be a normal "interlude" in an inflationary era. That was certainly my view, and until August this year it was the view of the markets.
The initial sell off from the "mortgage mess" in July was from fear of a credit crisis leading to disinflation, and this seemed to be the FED's worry as well. The FED was simply responding to a central banker's need to provide liquidity so that individual banks wouldn't go under because of a temporary liquidity squeeze. This is why we have a FED. I am well aware that many people feel that this is "artificial" or counter-productive in the long run, or that it constitutes a guarantee or "put" for whatever a bank may wish to do. But that is an appraisal which doesn't accept the function that banks perform and what the failure of very large banks, due to temporary conditions, would mean. It does not mean that banks can't or won't fail, and many have, including the once great Continental Illinois Bank, Franklin Bank, Republic National and others. It only means that they won't fail because they couldn't find credit overnight to meet reserve requirements or other margin calls.
In August 2007 the markets quickly and correctly perceived that deflation was not the issue, but rather that inflation was coming back strong after a "vacation" for 15 months. I'm not pretending that I understood this immediately, because I was flummoxed by the upward reversal in bonds (rates going down) while oil and gold also made bottoms. Again this did not happen because of what the FED did in cutting the discount rate and then the FED funds rate. The FED and the markets saw the same things fairly closely together in time and both reacted.
Nor did I personally "make a fortune", or lose one, by missing the significance of the change in the market perception at that juncture. I was already lighter in US stocks gradually this year, and I had kept my gold and inflation hedges AND bonds, adding to the latter as a part of my portfolio positioning for retirement. Even with the decline in the US Dollar Index since Dec 31, 2006, my fairly conservatively postured portfolio, adjusted for withdrawals, is about even on the year in purchasing power. Of course this is before taxes, but I have given taxes on investments a wide berth as I have discussed before and will again at another time.
If you are a younger successful trader, as I have also been in the past, it will look laughable to you to "break even" this year on a purchasing power basis. And at your younger age you "should" laugh, and you should do much better than that so that you will have enough assets to "maintain" in your own later years as I am trying to do. Mind you, I did catch the China A Shares for a while this summer in CAF, do own Vanguard's splendid Energy and Mining Funds, and I had bonds which have outperformed nearly everything since mid August. But I have purposely had only small pieces of these and other hedges and entirely as inflation insurance.
All that portfolio talk aside, the action of the markets since mid August reinforces my need and yours, dear reader, to have some inflation insurance in place. I have discussed some of the simple ways to do this while earning interest: US gas royalty trusts (6-9%); PIMCO's commodity real return fund (PCRIX or PCRDX, 4.2%); gold in various forms; foreign sovereign bond funds; and other energy vehicles such as VGENX. We don't wan't to "bet the farm" on these items, but they can earn interest for us as well as being insurance. US Treasury TIPS bonds have also outperformed since August. They are adjusted daily (market) and annually for inflation and can be bought as managed funds from Vanguard, Fidelity, or Pimco. (Use Google or Vivisimo to get a list of information sources on TIPS.) Overall I have approximately 10% in "insurance" vehicles, 20% in US and foreign stocks, 50% in a variety of US and foreign bond funds of different durations and styles, and 20% in cash.
The markets have been telling us recently that even an economic slowdown, or worse, will not necessarily be good for US dollar assets as a whole. Obviously US stocks will not do well in a recession **if we have one**. US bonds will "do well" but we can't count on the dollar to do well in a recession as we could from 1980 to 2000. We're all mainly interested in this for pressing personal reasons, not as an intellectual game. We may need to re-arrange our investments a bit, not necessarily a lot, depending upon our age. There is no need to panic. We can make these changes much more easily today than at any time in the past with mutual finds and ETF's no matter how much or how little we have in assets. This was not true in the 1970's or 1980's unless one was a commodity trader then, as I was.
I am not predicting a recession, but the markets are doing so since August, and they are telling us the kind of recession anticipated: an inflationary recession, also often called "stagflation". Markets can be wrong too, but they are normally a better judge than governments or professional pundits. We shouldn't panic and totally throw everything out, but we can make incremental changes over time that will make a difference.
You can get a good explanation of some of the concepts I've raised here in an article John Hussman wrote in 1999 about gold. I like this article because we are now totally outside the realities of that time of eight years ago, thereby removing any short term bias you or I or Hussman may have. But the principles of asset values during inflation and recession are unchanging. I sometimes disagree with Hussman's opinions on US stocks, but his "science" is good. Read it.
Personally I still expect a good rally in US stocks until the New Year. If you are a portfolio tinkerer, as I am, this could be an opportunity to make some reasonable changes.
Also if you have an interest in good professional thinking on many of these subjects, presented in a low key style, and quite unlike the newspapers or market news letters, read the research reports going back several years at: http://www.smithcapital.com/
Unless you've just returned from an isolated tropical island, you've already been told that gold is approaching the high of the last Kondratieff commodity bull market in 1980 which was $850. The chart doesn't show that whole history. There were three phases starting with the crash from the 1980 commodity tops--some commodities topped in 1973/74 along with some economies, but most in 1980. Then the "flatline" of the 1990's at the new lower levels below 1980 prices until 1996/97 when the bottom fell out in a deflationary scare exacerbated by the Asian collapse and the Russian bankruptcy debacles. After the double bottoms of 1999 and 2001, commodities were off to the races with shortages of supply in everything.
Gold and natural gas (and others like copper and other metals) accelerated their climbs in 2005 before collapsing last year. The CRB Index, which represents all commodities futures trade in the US, shows the general pattern of the past two years: a three phase correction which ended recently in August. Crude oil and gold have led the charge thereafter, but the CRB inset shows that all commodities have joined the parade with their own patterns. (Click for a larger chart.)
NYMEX natural gas resembles gold in its long term chart shapes although with leads and lags and exaggerations. NG is lagging now but beginning to make its move which happened to start at its normal seasonal low of late summer and early fall. Gas is the "clean fuel" and gives the US nearly 25% of its energy needs right now, but gas is subject to distribution and storage constraints and has had its wings clipped a bit as well by the short-sighted rush into the grain alcohol "gasoline" which requires as much energy to produce as we get from it.
We have heard the reports of two new liquified natural gas ports to be built on the Sonoran coast of Mexico "not in California's back yard" but close enough for short pipelines to Arizona, California, and possibly El Paso, Texas. Gas is still being flared off from oil wells in many areas of the world, but that is going to stop in a big way as liquified natural gas finally comes to North America and Europe. The 21st century is the gas century. Russia is the gas colossus, so get used to Mr. Putin's swagger and finger-pointing.
US-sourced natural gas is widely assumed to be on its last legs, but an elegant study of the giant Hugoton Basin by the Kansas Geological Survey and University of Kansas concludes that the Hugoton Basin of Kansas and Oklahoma will remain a major producer at until at least 2050. My guess is that the import of liquified natural gas (LNG) through the new mega-ports like those in Sonora will finally put a world price floor under US gas which was a political victim of price controls for so long that exploration and distribution infra-structure has lagged.
At first glance the specter of massive LNG imports coming in a few years would seem to be bearish for US natural gas. But I suspect it will be bullish, especially given the long term Kondratieff bull cycle we are in. World gas will be priced on the same energy output terms (BTU) as is crude oil.
A wise acquaintance of mine looks for inevitable cases of supply shortages which will cause price gains and tries to buy it in some sort of vehicle that "pays you to wait" until the inevitable comes to pass. As part of my retirement income research it seemed advisable to look for one income vehicles in addition to bonds. I believe Loomis & Sayles Bond Fund (LSBRX or LSBDX) is the finest fund in the land available to me. It can go anywhere with any kind of bond or any duration, and it has done so for over 16 years. It is beating accelerating inflation for the past few years. However it seemed prudent to look at income vehicles which are directly involved in commodity areas. One simple way is to buy Pimco's Commodity Real Return Fund (PCRDX or PCRIX)and I have it. I discovered that PCRIX normally requires a $5,000,000 committment to buy, but at Vanguard Brokerage Service one can get in for a $25,000 minimum presumably because a lot of Vanguard investors buy Pimco. The difference in trailing twelve month dividend yields is 5.43% for PCRIX ($25,000 minimum) and 5.02% for PCRDX ($5,000 minimum). Both pay their dividends from their underlying TIPS bonds, which I have recently discussed, and structured commodity notes. I hadn't written about these funds for several years during the "rest period" we saw in the chart, but now is a good time to look.
But getting back to natural gas, there are at least four US gas royalty trusts which trade as stocks and pay rather nice dividends. I started accumulating them on price declines. They do not trade in huge volumes so you have to use limit orders and be patient. Owning them is also all about patience as you are collecting 6-9% annually in monthly payouts while waiting for the great gas bull market. No taxes are paid by the trusts, only by you. San Juan Royalty (SJT) gets its income from the New Mexico San Juan field and Hugoton Royalty (HGT) from the Kansas field. These two are nearly 100% natural gas with just a bit of petroleum distillate. Mesa Royalty (MTR)--the grandaddy of US trusts founded by T. Boone Pickens--and Cross Timbers Royalty (CRT) started by the same parent as Hugoton Royalty--give us approximately a 70% natural gas exposure. SJT and HGT pay between 6% and 7% due to trailing lower gas prices and MTR and CRT pay over 8% due to ~30% crude oil/distillate components.
These are "wasting asset" holdings in the sense that they are not renewing their assets except by modest in-filing between wells, whee permitted, and reworking of current wells, both by their underlying operators. They have conservative reserves equal to at least ten years each, but if one looks back at these reserve life numbers four or five years ago, they were similar then. The Kansas University Hugoton study lends weight to the idea that there will be additional extensions to current estimates.
Younger investors and/or those not looking for yield may want to consider Russia's Gazprom (OGZPY) and US-based XTO Energy as a long term gas holdings. An independent and free, but delayed release, website for continued updates on many energy companies is Kurt Wulff's McDep Oil and Gas Investment Research.
The markets have obliged me by roughly following the schematic I outlined in July in "Heading for the Hills"and in "Second Half". My thinking was based upon the annual cycle or "seasonal" pattern of US stock market prices as well as the "decennial cycle" in which the year ending in "7" in each decade is typically more muted in price amplitude. The market did peak in mid July as anticipated or "hoped" and made significant corrections into lows in August and October.
Perhaps I'd be wiser to rest on my laurels and not push my luck. But November and December are the most reliable times of the year to be long. The Dow Jones seasonal runs from 1928 to present and the SPX seasonal from 1950 to present (see below).
I have to confess--since you've already read it--that part of my willingness to accept a falling market for this past summer, and early this fall, was due to "concerns" about the economy in the US. However, recent data suggest that the economy is continuing to run fairly well. I am not an economist, but the few economists that I follow regularly seem to be agreed that things are not that bad. It's hard not to hear news wherever you go, and as usual it's all bad. But that's normal for, as Barabara Tuchman the British narrative historian said,
"A ...hazard, built into the very nature of recorded history, is overload of the negative: the disproportionate survival of the bad side--of evil, misery, contention, and harm. In history this is exactly the same as in the daily newspaper. The normal does not make news. History is made by the documents that survive, and these lean leavily on crisis, calamity, crime, and misbehavior, because such things are the subject matter of the documentary process--of lawsuits, treaties, moralists' denunciations, literary satire, papal Bulls......."
Normal or happy events are rarely heard from, but most of the unhappy events are heard and recorded. This is what Nassim Taleb, author of my current favorite, "The Black Swan", calls the "fallacy of silent evidence". Namely, we humans tend to make value judgments and form beliefs based on what is presented to us as definitive ancient and current outcomes to events. But in fact far more outcomes are lost to the news and to history than are saved to it, and so we often base many of our opinions upon what I would call the Darwinian "survival of the foulest" outcomes.
When we hear this concept we almost all will think, "of course", but we don't change our methods of establishing opinions. However, one surprisingly good outcome of this defect of human nature is that it gives rise to the profitable technique of sentiment analysis. In speculation and investing we don't need to collect millions of personal anecdotes or news items to find out how gloomy market participants currently are. We can measure the degree of ambient gloom and doom by seeing what the two major classes of market participants--the "retail" investors and the knowledgeable professional insiders-- are actually doing with their money. And we can do this each day and to a limited extent within each day.
All that said, my lean or bias toward accepting the historical record of the annual cycle or seasonal pattern for the Dow and SPX for the second half of 2007 was at least partly formed on the basis of economic hearsay and my own non-professional evaluation of the economy. I let the gloom and doom of late June's economic hearsay influence my investment approach, and it was wrong, as the economy did not weaken until now as hearsay predicted.
However, the seasonal pattern worked anyway! So I have learned a lesson, which I will doubtless forget and then allow myself again to become prey to news and unbalanced current opinions. As the late Peter Cook's character, Sir Arthur Streeb-Greebling, exclaimed in Good Evening: "Oh, yes, I've learned from my mistakes and I'm sure I can repeat them exactly." Read Nassim Taleb to learn more about how to improve upon one's human nature by means of sceptical empirical testing and prove Sir Arthur wrong, if you can.
The US markets, and many around the world, fell nearly back again to the October 22 lows late this past week. The historic odds favor a rise to the end of the year, and sentiment of the statistical type, based on what market players are actually doing, supports that idea despite, or, perhaps "because of", current preoccupations with gloom and doom stories based on the credit issue.