Putting the pieces together...

PIIGS R US?

The seven year US Treasury auction did not go well today. It's just another small warning.

 

The head and shoulders pattern (H & S) in the US Treasury 30 year bond is impressive. Naturally no given H & S is a sure thing, but Professor Andrew Lo and others have shown that they are statistically valid for speculating on  profitable moves.

 

Insuring With Gold

I've been learning from Antal Fekete for fifteen years, but until recently I didn't know his preferred method of holding gold and why. Personally I agree with almost everything Fekete writes and strongly recommend reading his work which is clearly written but which requires thinking. Although he rarely puts mathematics in his writings, he is a mathematician, and he has the incisiveness and conciseness of his calling. His website can be accessed from the Blogs I Like list in the left column.

 

Since many will not have the stamina or taste for seven double-spaced pages of condensed brilliance, I have excerpted the very practical part about gold which is almost exactly what I have always done and what I think gold represents for an investor.  The entire seven page pdf file can be accessed here.

 

".....the attitude of most investors with regard to gold is faulty, not to say foolish. They keep talking about the "performance" of gold. They trade gold: buy it when they expect the gold price to rise; they sell it when they expect the gold price to fall. Many of them are finished with gold saying that "the bloom is off the roses". This attitude is akin to that of the property-owner who thinks that he is saving money by canceling his insurance coverage hoping to reinstate it later. It never occurs to him that it may not be possible to reinstate, if the external
conditions change drastically."

 

"The best policy concerning insurance is to buy it and "forget about it". No regrets if the occasion to collect insurance compensation never arises. It is not a loss: it should be looked at as a gain."

 

"A simple gold-accumulation plan, aiming at a gold hedge equivalent to 10-15 percent of net worth, with monthly additions will suffice, with the proviso that it is preferable to increase the hedge when the gold price is down. Gold investors typically get nervous as they listen to rumors that the volatility in the price of gold indicates that the value of gold has become unstable. They forget that it is not gold that is unstable, but the dollar in which the gold price is quoted. Gold has been, is, and will be the paragon of stability. Ultimately, the price at which you have purchased your hedges is unimportant."

 

"Buy anonymously and don't talk about it. Don't worry that you can't sell anonymously: you are not going to sell, just like you are not going to cancel your fire insurance policy as long as you own the house. Don't worry about capital gains taxes on your gold that you hold as hedges against paper assets. Since you never sell, you never incur a tax liability. There is no way the government can impose or collect taxes on paper profits. At any rate, those so called profits on your gold hedges should never be considered as profits. They should be looked at as advances on payments of insurance compensation for anticipated losses. It would be foolish to take these "profits" and spend them. Those losses may disappear, together with the gold profits, creating the impression that your hedges don't work. They do, but the results have to be interpreted correctly. Spending gold profits is tantamount to canceling the insurance policy prematurely. The big test is still ahead. The crisis is not over, not by a long shot."

Breakout?

US stock markets are now very close in energy and sentiment to the summer of 2004. There had been a good rebound run for a year and then a slowdown. The 2CS ran up to about 55 in April  2004 and then down to 110 in  May (2cs inverted to price). The bears were roaring  about the Iraq war and unemployment  like now.  Then the markets took off and broke out to new highs in early November on the run to 2007.

 

This year has been very similar. We can say and agree upon whatever we think about the wretched economic and political fundamentals, but if our interest is gaining profits in markets to benefit those we love (our job, as it were), then we must watch and listen and act.

 

Sentiment works best in trading ranges, large and small. Currently sentiment is at levels which can turn markets south during bear market rallies. But upside breakouts can and have and do occur under these same conditions. If you remember, I brought this up in early January of this year when the 2CS fell below 70. That's lower on new market highs than one typicaly sees in bear market rallies. To be sure it was extreme enough to turn the market down for a month, but the rally from 2008-09 wasn't killed. And now the market is making new highs in some indexes and countries.

 

We needn't look too far to see why markets might go up from now. Money supply has exploded nearly worldwide, but much of the money is sitting nervously on the sidelines and biting its nails. We can lament this and the possibilitiies of new market "bubbles" as a result, but this is what central banks and governments want to happen. It's "our duty" to help make prices go up and gain profits on it if we can. Cash in US banks is earning nothing.

 

Keep in mind always that this is my financial diary. I am not an advisor, and I'm not selling any financial product or advisory product. What I say and do is for my own family's accounts, and I am under no compulsion to be complete or fully forthcoming. These are just my thoughts and opinion on my way to deciding what to do.

 

This week I have sold off some of the leveraged high yield closed end funds and those trading at very much of a premium to net asset value. I wanted to raise some cash so I could take advantage either of an upside breakout or a decline. I am buying back some US oil and gas trusts on the sharp decline this week. They are now paying 8-9% again.

 

If the equity markets break out on top here, we could see  institutional and private money flood into the markets and send them much higher for years. We would not want to miss that no matter what our opinions and feelings about the current world situation. Don't forget that the banks are loaded with cash, and there are trillions of cash in investor US money market funds.

 

 

Normal and Abnormal Expectations

By normal standards the US equity markets are getting closer to a price high in the next week or so. I say this in the context of a bear market rally. However, in 2005 the market entered into a long term rally with consistently exuberant sentiment into the 2007 top. So we can't dismiss the bull scenario despite all the wretched news and fundamentals. The reason why is all that money creation throughout the world for the past 18 months. In the US much of it is sitting at the FED as free reserves of the banks. Trillions of cash that could be levered up 3-8 fold if the banks get more confident. Also don't forget that there are $2-$3 trillion in US money market funds similarly resting on the side of the playing field.

 

Given recent signs that Obama will emulate FDR and pack the Supreme Court and FED with personal loyalists, and given the prayers of all insiders that banks will finally do something with all that money, we could easily have a new bubble or three for no other reason than the fact that all that money is there. "Use it or lose it" could well become the mantra, or reality, of Obama and the FED.

 

"Using it" would be the inflationary breakout which many thoughtful people anticipate, and if some start diving in, they all will do so since cash is almost literally trash at close to zero percent. I've read some comparisons this weekend  to the 1921-23 German hyperinflationary breakout. In 1921 one could buy a decent house for 500,000 Marks. In 1923  the same 500,00o marks would buy a loaf of bread....until it didn't. This isn't a prediction but a reminder that  events can develop much more rapidly than we suspect. Most American observers are saying that we won't have significant inflation starting  for several years, but sovereign debt fears can develop and play out quicker.

 

I am planning gold additions on a monthly or perhaps even a weekly dollar cost averge basis. Ideally one is lucky enough to do this into price declines, but I think it could be risky to wait for major pullbacks to buy more gold.

 

 

Economic Tectonic Plates

In this century two large economic forces have collided like geologic tectonic plates. The first is the longer term (2-3 decade) inflationary trend with lows set in place from 1998-2001. The second, currency debasement, implemented by artificially low interest rates used to "solve" a variety of debt crises around the world ever since 1997-98, reinforces inflation. So we have inflation heating up even as cooler deflationary recessions occur. This setting is very similar to the economic long wave transitional periods of the 1890's and 1940's.

 

Thus whatever the central banks and national governments do to ameliorate the debt and deflation issues (primarily by setting rates too low) the effect is an increase in prices by debasing the currency. Neither institutional nor private investors can make an "honest dollar" when rates are suppressed and currencies debased. So short term speculation and market volatility rule. Kiss stable growth good bye.

 

The capital of operating companies is also eroded and real balance sheets become tattered by taxes on phantom profits and inadequate depreciation. So even minor slowdowns  result in multiple bankruptcies and accelerating unemployment. As state unemployment insurance rates increase for all employers due to increasing unemployment claims, and various taxes increase to fund expanding nationwide "safety net" programs, companies look to foreign sites for refuge. And so the economic death spiral descends further even as prices accelerate up. (See my comment on Fekete's work below.)

 

Keynesians don't know real economics and theoretically don't need to since they already have at hand all the answers to every problem. So no one in an "official" position (or academia) learns from their mistakes nor can even see them. The markets therefore do what markets always do in response and are reinforced in volatility by stimulus and failure followed by more stimulus. On top of this we now have a quasi-Marxist government (administration) rolling out more wealth re-distribution and unfunded benefit plans and ignorant regulation/ownership of ever more market sectors. They are very reminiscent of the Brezhnev orthodox party's last ditch attempt to save the rotting Soviet Union before the cracks in the edifice became too large and numerous to ignore. Bad times are coming,,,but Andrew Mellon would disagree on their being bad times. So would Schumpeter. Both were advocates of allowing, even encouraging, the rotten debt and policy to liquidate itself.

 

We don't know when this will happen, but we many are now aware of sovereign debt default issues. Once this awareness is widespread, we can expect a replay of the serial currency attacks that played out in the early 1930's in Europe as country after country was forced by speculators to devalue and go off gold. Of course gold isn't an official issue now as no one is "on" it, but gold will still be the primary beneficiary.

 

On a more practical level, we may be coming closer to the end of the "Big Bounce" out of the grossly oversold all-asset market bottoms of November 2008 and the March 2009 re-test of November 2008. It's not clear that this past 15-18 months has been anything other than an oversold rally. Nor is it clear that so-called retail level stimuli have played a lasting role other than modestly tempering the pain of average citizens in the US and elsewhere.  ECRI reportedly predicted this past week that recession is not expected this year but that a slowdown is coming in the second half and that recurrent recessions may be expected in the new decade.

 

We don't trade on these longer term and shorter term economic fundamentals, but we do "invest" with them in mind. It's possible, and I hope, the markets will repeat the benign 2004 to 2007 recovery experience, but it's also possible they will not. Hussman Funds' Bill Hester describes how stock valuations are now out of line with recent inflation volatility, namely P/E's are historically too high. Look especially at his chart titled "Economic Uncertainty and Valuation" and the red dots representing the last six months of data.

 

At my lowly portfolio level I have some excellent capital gains in a variety of high yield instruments (closed-ends, open end bond funds, MLP's, preferreds, etc. as detailed in the recent portfolio update), and some are beginning to sell at premiums to NAV and sport dropping yields at market prices. For a lot of reasons many of these instruments trade as equities do. It's prudent to sell some of these with outsized gains whether at a premium or not. The same is true of some of the equity funds like FPACX, OAKBX and the Vanguard special sectors funds (health, energy, mining).

 

Although market technicians I respect, like James Stack and Terry Laundry, see no internal market deterioration yet and expect further stock market gains this year, my own sentiment and volume studies are getting to the edge of frothiness again, as in January. None of this means we must make an intermediate or longer term top now or even this year, but the longer term fundamentals are looming. But should one sell off a lot of this exposure to cash and near cash again as in 2007 and/or hedge the rest? And what would be the better short to intermediate term hedge? US Treasury's again as in 2008 or gold. I have some of each but much more in gold right now. Learned opinions vary on whether we'll first see a return of deflation fear or go right into currency devaluations and higher inflation IF a stock market downturn is coming. Preferably (to me) we'd see Treasury's zoom first and gold come off to 600-900 where I would double or triple up.

 

In any event I have only about 3.5% in cash now, and that's far too low after the good gains of the past15 months. So if the 2CS continues to drop (at 79 as of Friday), I plan to start peeling out of some holdings and looking to hedge.