Putting the pieces together...

Back To 2003?

In February and March 2003 public and market fear was as palpable as it is today. The "Tech Wreck", the World Trade Center collapse, and the specter of the Iraq war loomed and weighed down sentiment. Stock market indexes were once again nearing the crash lows of 2002, gold had risen 50% since the 2001 lows, the US dollar index had fallen 18% since 2000, and interest rates were falling. Deflation was expected to return momentarily, and many feared that terrorist attacks would increase when the war began.

 

A very simple market measure of sentiment I have used since 1996  began to show reduced bearishness after the December 2002 reaction high. That sentiment gage I call the 2CS Sentimeter of Bearish Sentiment, 2CS for short. It is the five day cumulative total of daily CBOE P/C times the daily CBOE VXO. (VXO is used since the data base is longer than with new VIX.) Five days seemed long enough to smooth out single outlier days but short enough to be timely. The red numerals on the first chart are the extreme 2CS readings near the extreme lows and high swings of SPX weekly price bars.

 

 

Needless to say, current anecdotal sentiment and the news is ghastly. The price pattern of SPX in 2008 and in 2009 to date resembles the 2002-2003 price pattern with two sharp crashes followed by a multi-month rally and then another fall toward the previous crash lows. 2CS market sentiment and internet market chat site comments are even more bearishly positioned now than in early March 2003 as shown in the second chart for 2CS. Once again gold is rising, interest rates are very low, and deflation and depression are two words heard everywhere.

 

Chart patterns are, of course, only one small part of technical analysis of prices, but the similarities are striking and should cause us to be on the outlook for other signs of a market bottom in the near future.

 

 

 

 

 

 

 

Short Term Income Funds Update

Investment portfolio outcome successes depend primarily upon the age of the beneficiary or account owner and the long term probabilities of inflation, growth, and politics. The age of the beneficiary is well known while the other parameters are guesswork.  Short term politics won't matter for a 20-30 year old, but matter a lot for a 60-70 year old. Thus for practical purposes we can ignore the long term and focus on life expectancy of the beneficiary and short term politics. In this sense the outlooks of both younger and older investors are closer than most advisors would have us believe. Many advisors want all of us to stick our money into formula index plans based upon age and never move our money elsewhere. Nearly all of those plans did very poorly last year. They are based on the  expectation that stock indexes will do well sometimes and bond indexes at other times, so that a mixture of the two will win out over time.

 

For someone living off their money, retired or leisured, as well as for very conservative investors of any age, the goal is adequate income and not losing capital. In normal times one can earn 4-6% per year on money market funds or TBills with little or no risk of capital loss. This was the case as recently as two years ago, but governments have lowered short term interest rates to encourage people to take on more debt and have therefore declared war on savings and on people who do save. We hear a lot of criticism of Americans for not saving, but all the advantages are given to borrowers, not to savers.

 

Most money market funds in the US have depended upon very short term commercial (corporate) paper bills to finance seasonal inventory plus some Treasury Bills and about-to-mature mortgage bonds. Commercial paper and mortgage bills both crashed last year and Treasury bills spiked to the sky. We are very fortunate that some of the brightest people in investment run the money market funds since they saved the system from total meltdown last year.

 

But money market funds now have some major enemies. Mostly they are financial firms which are in danger of bankruptcy and collapse. But it's rather scary that Lawrence Summers, Timothy Geithner and Paul Volcker are also part of the group who came out with these preposterous claims against money market funds. They are blaming  money market funds for the collapse of Bear Stearns and Lehman Brothers last year! Most money market funds caught on to the dangers in those firms and refused to re-invest or roll over their very short term holdings in those firms' commercial bills. The money market funds protected their shareholders.

 

We have to be very careful of money market funds now. Mainly because they pay so little, but also because their enemies want to have the government repeal the $1 per share sacred trust that money market funds have made with their investors. What are they thinking?

 

What are the alternatives? My favorites are and have been up to two year maturity or duration funds holding US Federal or municipal bills and notes. (You could also ladder one to two year notes if you have enough to do that with every month, and some one to do it.) When interest rates are very low you only want funds with extremely low annual costs, so I have primarily used Vanguard funds.

 

I have three favorites. Vanguard's short term Federal Fund (VSGBX/VSGDX) is good for non-taxable (IRA or 401k) accounts. The Vanguard Federal money market fund is paying 1.39% distribution annually, while the Vanguard Federal short term funds (2.3 years) pays 3.45%. Both consist of treasury bills and notes plus Ginnie Mae's, Fannie Mae's and Freddie Mac's. All are now guaranteed government securities.

 

Vanguard also has a pure Ginnie Mae fund (VFIIX/VFIJX) with a duration of 1.8 years which distributes at a current annual rate of 4.6%. Ginnie Mae's can go down more than the others if interest rates rise, but are giving more than 3% greater payout for that risk than with the Federal money market fund. All of them are government guaranteed as to repayment of face value and coupon.

 

My third favorite for taxable accounts is the Vanguard short term municipal bond fund (VWSTX/VWSUX) which pays 2.70-2.78% annually and which is exempt from US federal taxes. This fund gives a higher rate than the short term federal fund, when adjusted for the 25% tax bracket, and not quite as high as the Ginnie Mae fund, but it has only one-half the risk of capital loss in case of rising interest rates.

 

A potential problem with short term, or long term, municipal funds at this time is the possibility of defaults by financially-stressed cities, counties, and state governments. Read the newspapers or the local TV news where you live. Municipal bonds have been quite safe since the Great Depression, with very few defaults, but if this is Great Depression Two or "only" a severe recession, defaults are doubtless coming. The congressional bailout bill of this week and last had an opportunity to deal with this issue but chose not to. Instead, new classes of taxable municipal bonds are authorized with hopes that banks will buy them. As I mentioned in my comment under my previous post, private investors are the key to ending the recession, but have been cut out of the loop by artificially low interest rates and by not doing away with AMT (Alternative Minimum Tax) on municipal local private construction for hospitals, sports facilities, and tax-generating commercial real estate (read "infra-structure".

 

There is now a way around the possible worsening credit of municipals as the recession deepens. Pre-refunded municipals are not new, but a fund based on them is new. Pre-refunded municipals come about when interest rates are dropping. If a city issued 20 year 5% bonds and the current rate for new bonds is 4%, they can issue new bonds for the same amount at 4%, take the money they get and buy 5% treasuries to put into escrow to pay off their 5% bond's interest and principal at maturity. The original bond owners get their 5% tax-free, but it is backed by US Treasury bonds which are safer. It is thus essentially tax-free treasury note rates. Obviously this only works when Treasury rates are higher than municipal rates which they normally are. Right now they are not, so this may be a short window of time for this idea of previously pre-refunded escrowed municipals. But for the next year or two they could work quite well and lower the municipal risk but provide a higher rate of return than the very short term municipal money market fund or short term fund with greater safety. The new fund is Van Eck's pre-refunded municipal fund PRB  which is said to have a duration of about two years and is supposed to pay about 2%. The vagaries of new funds are enormous as they have to be careful what they say to the public but perhaps not to the institutions. Right now it is early to buy and PRB must only be bought on a limit order. The market makers are holding it to a narrow a range and as close to the issue price of $25 as they can. But keep it in mind in a month or two, and check Yahoo or http:etfconnect.com for actual dividend payouts which will be monthly.

 

My plan is gradually to phase out of or substantially reduce longer term single state (my state) municipal closed end fund and move into this pre-refunded municipal ETF. I have about 5% of assets in a single state municipal closed end fund at this time. I have started building a position in PRB and will watch it closely for a while before adding.

 

These very low rate funds may seem to be "much ado about nothing", but for the very safe part of your money it's either these funds or small denomination CD's at your bank(s) which are not as liquid as these funds which can be sold any day. At this time with the US dollar being relatively strong versus the other major currencies, this is the place to be for US investors, in my personal opinion. If the dollar begins to sink again, conditions will be quite different.

 

In my case these funds are currently about 40% of my invested money is, so it's a big deal for me. This is supplemented with 20% of investment assets in an immediate cash annuity bought from Vanguard in 2007  when a 6% rate was still possible. An annuity is a "deflation hedge" as the interest rate can never go down in your lifetime. (You could do nearly the same with individual very long term Treasury bonds with a fixed coupon.) With current interest rates so low, an annuity is probably not now as serious contender for money as it was in 2007 unless the investor is over 70 years old and needs guaranteed lifetime income.

 

With deflation staring us in the face, it's hard to think about investing for inflation. However, inflation in the US has averaged 3% per year over the past century. Holding gold is one way to hedge some of our cash. Actually gold hedges more against local currency debasement than inflation per se, but the two often go together. Think of gold as a part of your money market or bank cash that you want to hold onto for a long time. I have approximately 10% of total investment assets in gold at this time.

 

Another inflation hedge is to invest in US inflation-protected Treasuries or TIPS. Many national governments issue this type of bond. At this time the yield difference or spread between the regular ten year US Treasury note and the ten year TIPS note is only about 1.3%. In other words, the market is guessing that inflation will only average 1.3% per year over the next ten years. In normal times the yield spread would average 3% or more. The TIPS note makes up the inflationary difference by making an additional payment equal to the trailing increase in the CPI (Consumer Price Index) every six months. Jonathan Burton at MarketWatch just published this good background article on TIPS: http://tinyurl.com/atbuvt

 

An alternative way to approach the TIPS and inflation-adjusted income question is with John Hussman's Strategic Income fund HSTRX. This fund has an interesting mix  of shorter term TIPS, gold stocks (5-17%), foreign currency funds (0-10%), and a small number of utilities. While most of the TIPS funds and ETF's are indexed or hold every US TIPS issue, Hussman manages his fund depending upon current valuations of the TIPS, gold, and forex. I own about 5% of assets in this fund, and hold it in tax-deferred accounts. I take the dividends but re-invest capital gains for the long run. The management cost for this fund is 0.80% which is quite a bit higher than with passive TIPS index funds, but it has been worth it as the chart shows since the starting date of TIP.

 

I have positions in VMMXX, VSGDX, VFIJX, VIPSX, VMSXX, VWSUX, HSTRX, and PRB. In addition to these income vehicles I continue to hold shares in seven oil & gas trusts not discussed today.

 

 

 

Holding Pattern

There is not a lot that's new to say. S&P earnings forecasts and even dilatory reported trailing earnings are plunging faster than stock prices, so the value buy spot , bruited by many  long term bearish value guys as "OK to buy over time", is fading into the mist.  Some say the P/E  ratio is as high as it was at the top of 2007. It looks worse than awful. That's when we are urged to buy in all the books. But is blood really running in the streets yet? I suspect this concept was originally meant truly as in revolutions and riots. So in that sense, "no", we aren't there.

 

The politicians are lost in FDR-land without a compass or understanding. They are long since brain-washed on the FED accelerator and brake concept which is supposed to control everything. They can't deal with the wings icing up on the economy as happened to that extremely sad flight into Buffalo NY today. When the wings ice up, you don't slow things down, as the FED did in 2006-2007. If you do you drop under stall speed instantly and crash. Diagnosing weather conditions and aeronautical lift  parameters is key to survival, and Bernanke didn't. He was captive to the monetary delusion, as were and still are most academic economists. Push on the gas and it will go. But not if you've already stalled out. Honestly, I did not predict a crash.  But I sensed that  the engines were not revv'ing  correctly. The engine was overheating, but we weren't going anywhere in late 2006 and early 2007.

 

The stimulus, or "porkulus", program is a very generous, un-focused, political jesture to prove to history that "we did something". It consists of throwing good money after bad, as the saying goes. I repeat: how can pouring more debt onto a problem caused by too much debt help things? It can't, as any weekend economist can readily understand. It can only add to the evidence of the national decline. Once that is clear, investment reality shifts gears into survival mode. I don't want to go into that here full tilt at this time. First of all I am not a financial advisor. I'm a private investor/citizen thinking for myself and my family. Secondly, it has not sunk in yet for most people what is going to play out, so we still have some time to think hard and plan.

 

For now I'm still in very short term (approximately one year) Federal and municipal notes with much higher than TBill rates. But I am long gold and royalty stocks in metals and energy. I have small "black swan" positions in non-US and non-Euro currencies. I am nervous and thinking constantly,awaiting the next non-surprise. The stimulus passage today,the short term tidal cycle,and seasonal considerations could lift stock markets out of this gloom for a while. Whether one trades it or not is a personal matter, but if it happens it's an opportunity to  reallocate.

Money Supply Follows the Banks

As followup to yesterday's  post on the failure of the 1930's FED stimulation to speed recovery, I ran across some more claims that expanding the money supply is what drives the economy and inflation. This is, of course, common belief even at the highest levels of economics and politics.

 

There is a government conspiracy devotee who runs ShadowStats, and who reconstructed M3 which the FED dropped as a money supply  data series several years ago. the theory is that M3 money supply does lead changes in inflation, but the only chart I had previously seen of this alleged phenomenon was a ten year moving average of both M3 and CPI year over year changes.  The need for a ten year moving average  sounded suspect to me, so I went back to the ShadowStats.com site to see if I could find a better chart, and I did. ShadowStats makes the point that it is money supply, specifically "sacred" M3, that drives both GDP changes and inflation. This chart shows official and ShadowStats CPI and the Shadow Stats M3 since 1990. John Williams of ShadowStats--alas not the composer nor the great classical guitarist of the same name--claims a high "correlation" of CPI and M3, but the vertical black lines I put on the chart at cyclical tops and bottoms of CPI demostrate clearly that M3 lags CPI by well over a year in every instance since 1990!

 

http://screencast.com/t/UZH9QLw68

 

Since inflation and GDP growth rates are closely correlated, we see the same lead of both GDP and CPI over money supply.

 

http://screencast.com/t/OE2t4WEfQsx (Note that GDP is a quarterly number whereas CPI is monthly, so the CPI chart is a bit choppier.)

 

In short, the FED accomodates to the lead that the banks have already taken in expanding or contracting credit. The lead is a year or more.

 

Currently the FED is attempting to lead the banks, as they attempted in the 1930's. But the banks are not finding enough good business plans and enough corporate or household credit-worthies to lend to, so excess bank reserves are piling up back at the FED as they also did in the 1930's.

 

This a perfect case of "pushing on a string" and it appears on both logical and historical grounds doomed to failure or at least to a prolonged delay which is really the same thing. If it takes ten years as it did in the 1940's, that's not a delay. It just didn't work until deleveraging and liquidation had run its normal course.

 

Tom

Post NeoClassical Deflation Economics

 

 

Last week I outlined  two reasonably clear explanations of possible outcomes for the current credit crisis recession: one inflationary and one deflationary. My tentative conclusion was that we'll experience deflation overall but with some commodity inflation as in the 1930's. I was convinced when I saw Mike Shedlock's  chart of the St. Louis FED's Base Money Suppply (M0) from 1918 to present. This measure of money supply rose about 33% from December 2007 to 2008; however, the same money measure rose from about a -5% year over year rate in 1931 to as high as +26% in 1940. So despite all the past and current matter-of-fact statements that the depression of the 1930's was caused by or worsened by and/or prolonged by inadequate FED money supply growth, the money supply did indeed grow as much as it has this past year, but that increased money supply for ten years did not pull the US out of depression in the 1930's! Note that this metric is on a percentage basis, so the two periods are comparable. Also note that different writers use different sources and data bases for measuring money supply. They are all valid data bases but vary a bit in their short term end points.

 

Despite the fact of persistent hugely increased money supply growth for ten years from 1931 to 1941, the depression continued. So why do so many think it will work this time? Economics professor Steve Keen presents convincing evidence (and he does so in layman's language and with great clarity) that the standard economic models and beliefs about money supply and its creation are completely wrong. Keen shows that Bernanke, in his writings and speeches, is a loyal follower of Milton Friedman's conviction that the FED controls the money supply and therefore the economy. If the economy slows down, all the FED has to do is increase the money supply, and by the magic of fractional reserve banking, the banks will amplify that amount by a factor of tenfold by the time it works its way into the system through loans and bank deposits. Keen: "If neoclassical theory (Friedman-Bernanke mainstream theory) was correct, this (current large) increase in the money supply would cause a bout of inflation, which would end bringing the current deflationary period to a halt, and we could all go back to “business as usual”. That is clearly what Bernanke is banking on......."

 

Unfortunately, Keen sees that as completely backwards to what actually happens. He demonstrates conclusively that the banks create credit lines and loans first, and the FED catches up about a year later with the increased reserves. And as Shedlock also  showed, the greatest amount of the current St Louis FED money supply consists of required bank reserves on deposit back into the FED! That's what happened in the 1930's and what is heppening now.

 

Says Keen: "...from the point of view of the empirical record, and the rival theory of endogenous money, this will fail on at least four fronts:

 

1.    Banks won’t create more credit money as a result of the injections of Base Money. Instead, inactive reserves will rise;

 

2.    Creating more credit money requires a matching increase in debt—even if the money multiplier model were correct, what would the odds be of the private sector taking on an additional US$7 trillion in debt in addition to the current US$42 trillion it already owes?;

 

3.    Deflation will continue because the motive force behind it will still be there—distress selling by retailers and wholesalers who are desperately trying to avoid going bankrupt; and

 

4.    The macroeconomic process of deleveraging will reduce real demand no matter what is done, as Microsoft CEO Steve Ballmer recently noted:  “We’re certainly in the midst of a once-in-a-lifetime set of economic conditions. The perspective I would bring is not one of recession. Rather, the economy is resetting to lower level of business and consumer spending based largely on the reduced leverage in economy”."
 
Since existing debt is 3600% (!) greater than the money supply, and the recent increase in money supply is only 36% by some measures (or 100% by others) the money supply argument is an exercise in futility, to put it quite mildly. The "Stimulus Package" is not going to turn the economy around! Banks are **not** going to loan money to corporate or household deadbeats who are going bankrupt. The economy will turn around when enough bankruptcies have put the incompetent or unlucky out of business, when prices of all items get low enough, and when bankers see some new business plans from people which make enough good sense to qualify them for loans. The rest of the political BS from Congress and the President is just that: an effort to convince people they are really doing something meaningful when they are not. They are doomed to failure in reviving the economy and will have to wait for the economy to heal itself, as it has always done in due time.

 

Economic recovery and political posturing are two different systems with their own different methods and procedures. The political BS we hear is simply a cover for the program of welfare, or in modern terms an "improved social safety net", during the depression: increased unemployment benefits, public works projects of all sorts, housing assistance, and a lot of hot air, "hope", and jawboning. The nation via its taxpayers and bond buyers **will** naturally extend a hand to those who suffer the most. That's what the Stimulus Package is all about. It's what America does when necessary.