Mrs. Magoo, Deflation, and Commodity Woes

By Tony Sagami 

Did you read my September 22 issue? Or my July 14 column? If you did, you could have avoided the downdraft that has pulled down stocks all across the transportation sector or even made a bundle, like the 100% gain my Rational Bear subscribers made by buying put options on Seaspan Corporation, the largest container shipping company in the world.

Don’t worry, though. Transportation stocks still have a long ways to fall, so it’s not too late to sell any trucking, shipping, or railroad stock you may own—or profit from their continued fall through shorting, put options, or inverse ETFs. This chart of the Dow Jones Transportation Average validates my negative outlook on all things transportation and shows why we’ve been so successful betting against the “movers” of the US economy.

However, the bear market for transportation stocks is far from finished.

Federal Express Crashes and Burns

Federal Express, which is the single largest weighting of the Dow Jones Transportation Average at 11.6%, delivered a trifecta of misery:

1. Missed on revenues
    
2. Missed on earnings
    
3. Lowered 2016 guidance

I’m not talking about a small miss either. FedEx reported profits of $2.26 per share, well below the $2.46 Wall Street was expecting. Moreover, the company should benefit from having one extra day in the quarter, which makes the results even more disappointing.

What’s the problem?

“Weak industry demand,” according to FedEx. By the way, both Federal Express and United Parcel Service are good barometers of overall consumer spending/confidence, so that should tell you something about the (deteriorating) state of the US economy. Oh, and Federal Express announced that it will increase its rates by an average of 4.9% beginning in January 2015. Yeah, I bet that rate increase will really help with that already weak demand. The decline is even more troublesome when you consider that gasoline/diesel prices have fallen like a rock this year.

Speaking of Falling Commodity Prices

Oil, which dropped by 23% in the third quarter, isn’t the only commodity that’s falling like a rock.

• Copper prices plunged to a six-year low.
   
• Aluminum prices have also dropped to a six year low.

• Coal prices have fallen 40% since the start of 2014.
   
• Minerals aren’t the only commodities that are dropping. Sugar hit a 7-year low in August.

Commodities across the board are lower; the Thomson Reuters CoreCommodity CRB Index of 19 commodities was down 15% for the quarter and 31% over the last 12 months. Since peaking in 2008, the CRB Index is down 60%.

That’s why anybody and anything associated with the commodity food chain has been a terrible place to invest your money. Just last week:

Connecting the Dots #1: Caterpillar announced that it was going to lay off 4,000 to 5,000 people this year. That number could reach 10,000 by the end of 2016, and the company may close more than 20 plants. Layoffs are nothing new at Caterpillar—the company has reduced its total workforce by 31,000 workers since 2012.

The problem is lousy sales. Caterpillar just told Wall Street to lower its revenues forecast for 2016 by $1 billion. $1 billion!

How bad does the future have to look for a company to suddenly decide that it is going to lose $1 billion in sales? “We are facing a convergence of challenging marketplace conditions in key regions and industry sectors, namely in mining and energy,” said Doug Oberhelman, Caterpillar chairman and CEO.

Like the layoffs, vanishing sales are nothing new. 2015 is the third year in a row of shrinking sales, and 2016 will be the fourth. Caterpillar, by the way, isn’t the only heavy-equipment company in deep trouble.

Connecting the Dots #2: Last week, UK construction machinery firm and Caterpillar competitor JCB announced that it will cut 400 jobs, or 6% of its workforce, because of a massive slowdown in business in Russia, China, and Brazil.

“In the first six months of the year, the market in Russia has dropped by 70%, Brazil by 36%, and China by 47%,”said JCB CEO Graeme Macdonald. Caterpillar, the world’s biggest maker of earthmoving equipment, cut its full-year 2015 forecast in part because of the slowdown in China and Brazil.

Connecting the Dots #3: BHP Billiton announced that it is chopping its capital expenditure budget again to $8.5 billion, a stunning $10 billion below its 2013 peak. Moreover, BHP Billiton currently only has four projects in the works, two of which are almost complete, compared to 18 developments it had going just two years ago.

Overall, the mining industry—according to SNL Metals and Mining—is going to spend $70 billion less in 2015 less than it did in 2012. And in case you think metals prices are going to rebound, consider that the previous bear market for mining lasted from 1997 to 2002, which suggests at least another two years of shrinking budgets and pain.

Repeat After Me!

I have said this many, many times before, but repeat after me.....ZIRP (zero interest rate policy) and QE are DEFLATIONARY!

The reason is that cheap (almost free) money encourages over-investment as well as keeping zombie companies alive that should have gone out of business. Both of those forces are highly deflationary, and unless you think that Mrs. Magoo (Janet Yellen) is going to aggressively start jacking up interest rates, you better adjust your portfolio for years and years and years of deflation.

While the rest of the investment world has been struggling, here at Rational Bear, we’ve been doing just fine.

Here are the results of six recent trades: 38% return from puts on an oil services fund, 16.6% return from an ETF that shorts industry sectors, 200% return from puts on an auction house, 50% return from puts on a jeweler, 50% return from puts on a social media giant and 100% return from puts on a container shipping company.

And we still have more irons in the fire. It’s time to be bearish, so I suggest you give Rational Bear a try—like it or your money back.

Tony Sagami

30 year market expert Tony Sagami leads the Yield Shark and Rational Bear advisories at Mauldin Economics. To learn more about Yield Shark and how it helps you maximize dividend income, click here.

To learn more about Rational Bear and how you can use it to benefit from falling stocks and sectors, click here.

The article Connecting the Dots: Mrs. Magoo, Deflation, and Commodity Woes was originally published at mauldineconomics.com.

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Muddling Through Shanghai

By John Mauldin

“He who knows when he can fight and when he cannot, will be victorious.”

– Sun Tzu

A couple of weeks ago I was complaining about 47,000 China reports clogging my email. The number now feels like it is well into six figures (perhaps a slight exaggeration). Maybe my memory is going, but there wasn’t nearly as much China talk on the way up. Funny how that works.

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Is China collapsing? I think parts of China are under severe pressure if not outright recession, and clearly the stock market is a disaster. Anyone who bought Shanghai or Shenzhen stocks on margin this year is probably on the brink.

That said, China itself is not collapsing. There are parts of China that are doing just fine, thank you very much. It does have serious problems, though. The Pollyannas and the Cassandras are both wrong. The change in tone in the Financial Times is quite amusing. Their recent hyperbolic, bearish section called “China Tremors” is a case in point. Of the last 30 articles on China on their website, I found less than a handful that were positive on China. My take? China will muddle through, at least for the near term.

China is in transition, a transition that was clearly telegraphed if you have been paying attention. Our recent book on China (A Great Leap Forward?) clearly laid out this new path. Today we are going to talk about this precarious, difficult transition, which may impose profound impacts on much of the rest of the world. This transition is going to change the way global trade has worked in the past. There will be winners and losers.
But first, a brief comment on today’s employment report and how it impacts the need for a rate hike by the Federal Reserve in September. I offer a little different perspective on the coming decision.

To Hike or Not To Hike – That Is the Question

Today’s unemployment report was lackluster, as has been the case for the initial reporting for the last two Augusts. Both were revised significantly upward – August 2012 was eventually revised up 96,000 jobs, while August 2013 saw a final revision upward of 69,000 jobs, and August 2014 saw a final count of +213,000 jobs. Part of the reason for the major revisions is that only some 70% of the potential survey participants actually responded (hat tip Joan McCullough).

Evidently the United States is becoming like Europe, and we are all going on vacation in August. Or at least the department personnel responsible for handling employment figures are. Expect to see significant upward revisions in the coming months, just as July saw another 30,000 added and June saw a plus 14,000.

This report was not so ugly that it would take the breath away from hawks wanting to raise rates or force doves into agreeing to a rate increase. Nothing changed, really. That is illustrated by the two articles below that were side-by-side on the New York Times website within an hour of the release of the report (hat tip Brent Donnelly). Everybody got to see what they wanted to see.

I can’t remember a time when there was such serious disagreement over what the Federal Reserve should do regarding a rate hike. I have been in several groups of analysts and economists in the last few months, and I must confess to being surprised at the split in opinions.

Upon reflection, I think I can actually understand both positions. First, the Fed keeps reiterating that they are “data dependent” – thus the focus on every little bit of data, no matter how trivial. Let me see if I can explain why both sides can feel they are right and then why, to my way of thinking, they are missing the point.

On the side of those who feel that a rate hike should be postponed at the September meeting, it must be remembered that most rate hikes are in anticipation of an economy beginning to pick up speed. The Fed has said they want to see low unemployment, and under the leadership of Bernanke and now Yellen, they have a 2% inflation target. Remember, their congressional mandate is to promote stable prices and full employment.

While unemployment did drop to 5.1%, that is a “soft” unemployment figure. The participation rate is down. The number of part time workers wanting full time jobs is still high. And the new employment trend is not encouraging.

August's gains were well below trend. The average of the previous five months is 211,000; for the previous six before that it was 282,000. The yearly employment gain, 2.1%, is off 0.2 point from the late 2014/early 2015 rate. The private sector gain is 60,000 below the average of the previous six months. (The Liscio Report)

We are not close to 2% inflation; and, frankly, it doesn’t look like we’re going to get there for a while. The economy is, at best, stuck in a low, Muddle Through gear (as I predicted years ago); and getting back to a stable 3% growth rate, let alone the occasional 4–5% that we used to see, seems out of reach. The dollar is strong and getting stronger and is not only holding down inflation but also, anecdotal evidence suggests, slowing down exports in various sectors of the economy.

There were those who argued that a bubble was developing in the stock market, but it appears the stock market is taking care of itself to make sure it doesn’t become overheated. There is no need to pile on to see if we can drive asset prices even lower. Further, we are just in the beginning of a housing recovery. Why raise mortgage rates, etc., at the beginning?

In such an environment, why would you raise rates in order to keep the economy from overheating? The last thing we seem to be doing is overheating, let alone even getting to a slow boil. Instead, we may already be cooling down. If the economy does start to pick up and inflation becomes an issue, we could raise rates then as fast as we would need to. Or so Kocherlakota and his friends on the FOMC say. And thus we should postpone a rate increase until we see a reason for it. Kind of like, don’t shoot till you see the whites of their eyes.

Those who think we should raise rates likewise have an array of data to support their case. GDP grew 3.7% in the second quarter. If you take out the weather related first quarter 2015 GDP figure, GDP growth is running well over 3%. Given the global headwinds currently buffeting economies, that’s about as good as it’s going to get.

This economy has weathered tax increases and the abrupt changes of Obamacare, as well as a significant drop in capital spending related to oil production and has “kept on ticking.” If there is a recession in our near future, as David Rosenberg points out, it would be the first recession ever that did not see consumer spending or employment go down for the count.

We’ve always been able to find negatives in the unemployment rate. Even if unemployment were somehow to ratchet down to less than 200,000 per month, it will be for only two quarters at the most; and it may be that before the end of the year we will be under 5% unemployment. We just set a record for all measures of corporate profits in absolute terms. We finally set a new record for real disposable personal income in July, again in absolute terms. As Jim Smith says,

What all this means is that when the FOMC meets on September 16 and 17, they will be looking at a US economy in which more people are employed than ever before, earning more money than ever before, producing more goods and services than ever before, and with personal consumption expenditures and corporate profits at the highest levels ever seen. If that is not a prescription for finally raising the Fed Funds rate, then I can't imagine what it would take to get them to move. (source)

Despite the significant slowdown in the oil patch, the level of investment in the second quarter was almost 4% higher than last year. Businesses are optimistic. Even given the turmoil in Canada, China, the Eurozone, and the rest of the BRICS, and even though global trade is beginning to fall off a little bit, the US economy seems to be doing quite well in spite of it all.

What else do you need in order to begin to normalize rates? Inflation is under control and according to most Fed economists seems to be ticking higher. Unemployment is moving lower. The economy is doing quite well. If not now, when? How much better do you want things to get before rates are taken back to something close to normal?

I must confess that I personally lean toward the latter argument, but I have a few additional reasons for thinking the Federal Reserve should act in September. As I have presented in previous letters, there are real reasons to think that low interest rates are not only creating malinvestment but also encouraging companies to use financial engineering and to buy their competition rather than purchasing the tools of production and actually competing head on. These behaviors distort an economy over the long term. They frustrate Schumpeter’s forces of creative destruction.

Further, what policy tools does the Federal Reserve still have available if we enter a recession? I admit that doesn’t seem to be a likely possibility today, but there are many potentials for exogenous shocks to the US economy that could cause a recession. Further, in the history of the United States we have never had a period longer than nine years without a recession. This recovery, relatively weak though it is, is getting long in the tooth. Do we want the Fed to confront the next recession with another round of massive quantitative easing as the only policy tool left to deploy? When their own research shows that QE wasn’t very useful and when we can clearly see the distortions caused by QE in emerging markets around the world?

The Federal Reserve is functionally incapable of not feeling the need to “do something” in the midst of a recession. If the only tool they have is further massive quantitative easing, they will use it. Damn the distortions, full speed ahead!

I would not argue for a rapid rate hike. In fact, I would prefer 1/8 of a point at every meeting, rather than the typical quarter point. But there is no reason not to raise a quarter of a point at this meeting, skip a meeting to make sure everybody can take a deep breath, and then raise once more before the end of the year.

I mean, really? Does the Fed think this economy is so fragile that it can’t take a lousy quarter of a point increase in interest rates? The Federal Reserve needs to begin to restock its policy tool chest now. While I personally think we are a long way from ever seeing 5% Fed funds rates again, a 2% rate can probably easily be absorbed if it comes slowly. And that rate would give the Fed some policy tools when, not if, we enter the next recession.

Now, let’s turn back to China.

Repeat After Me: Chinese Stocks Are Not the Chinese Economy

It’s easy to assume that a country’s stock market reflects the condition of its economy, but that is not always the case. Further, what the stock market really does reflect is the consensus estimate of an economy’s future condition. More specifically, stock prices reveal future expectations for corporate profits.

This generally applies to both the United States and China. One key difference, though, is that most American stocks represent companies that seek to make profits. In China, that isn’t necessarily the case. The Chinese stock market includes many state-owned enterprises (SOEs), whose executives answer to bureaucrats in Beijing. The government views them as public policy tools. Everyone is happy if the SOEs make a profit, but profit is not the first priority.

If US stock prices generally tell us more about the future than the present, except in times of serious over- or undervaluation, then Chinese stock prices tell us even less about either. Just as last year’s incredible run-up in Chinese stocks did not signal an economic boom, the ongoing decline does not signal an economic bust. The correlations aren’t just weak, they are nonexistent. China’s official economic data is also questionable and would be so even if GDP were a precise measurement tool. As we discussed last week, it usually isn’t.

It is no stretch to say we are flying blind about China.

Fortunately, we have diligent researchers like Leland Miller of China Beige Book, whose research firm does the hard work of gathering reliable data each quarter from thousands of companies in China and assembling it in comprehensible form. His data shows that China’s economy has actually been in good shape since China stopped acting Chinese last year. But even then, you have to separate the Chinese economy into several categories.

China Good, China Bad, & China Ugly

Among the many letters and reports on China that I received over the last month, I’d like to single out an excellent research note that the team at Gavekal Dragonomics published last week, called “What to Worry About and What Not to in China.” I appreciated this piece, because it really helped me structure my worrying. I dislike spending energy worrying about the wrong things. Further, worrying about the wrong things can be dangerous. It’s when you are paying attention to the wrong things that what you should have been paying attention to jumps up and bites you on the derrière.

In the spirit of the Gavekal note, here is the good side of China. We’ll get to the bad and the ugly below.
Chinese real estate prices will stabilize. We hear a lot about China’s massive infrastructure boom and the resulting “ghost cities.” These aren’t just rumors. The government mandated the construction of entire cities to house the formerly agrarian population as it shifts to industrial jobs. Provincial governments earned as much as 80% of their revenues from land sales. Essentially, this is a process where they take possession of rural land that has very little value in price terms, declare it to be available for development, and can make profits several orders of magnitude greater than their costs. Nice work if you can get it.

The ghost cities will not stay empty forever. They will fill with people over the next few years (in some cases more than a few). The recent housing bubble is more a function of young people wanting to cram into certain popular areas. The broader internal migration will support housing prices even as the bubble areas pop.

It might be helpful to think of the Chinese ghost cities as analogous to the overbuilt condos in Florida. Prices in Florida did in fact collapse, and places were selling for a fraction of their construction cost. I wrote at the time that I thought they would be very good investments, because the number of people wanting to retire to Florida is actually a fairly steadily growing figure. Low taxes, good weather, positive infrastructure, excellent medical care – what’s not to like, other than it’s not Texas? Just saying…..

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

The article Thoughts from the Frontline: Muddling Through Shanghai was originally published at mauldineconomics.com.

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Buy the Dip? Hell No.....Sell the Rip Instead

By Tony Sagami

Are you worried about the stock market? You should be; at least according to your local Starbucks barista.
Starbucks CEO Howard Schultz told his 190,000 employees in his daily “Message from Howard” email communication: “Today’s financial market volatility, combined with great political uncertainty both at home and abroad, will undoubtedly have an effect on consumer confidence and … our customers are likely to experience an increased level of anxiety and concern. Let’s be very sensitive to the pressures our customers may be feeling.”

You can’t make this stuff up!

Hey, maybe I shouldn’t be too harsh on Mr. Schultz, because the stock market is in a lot of trouble… and not for the reasons the mass media and Wall Street experts are telling you. The know it alls on CNBC are pointing their fingers at the Chinese stock market meltdown as the reason for our stock market turmoil, but that is just the catalyst… not the root problem.

The source of the meltdown is deeper, more problematic, and more painful. What I’m talking about is that the Federal Reserve—from Greenspan to Bernanke, to Yellen—thought they possessed Wizard of Oz powers to fix whatever ails the economy with their menu of monetary tools.

In 2000, the Fed thought it could solve the bursting of the dot-com bubble with massive interest rate cuts and repeated that playbook again for the 2008-09 Financial Crisis. And when they ran out of room by cutting interest rates to zero, they trotted out Operation Twist and QE 1, 2, and 3.

Those three rounds of QE added about $3.7 trillion to the Federal Reserve’s balance sheet since 2008, which now totals a mind boggling $4.5 trillion. The problem is not China; the problem is Janet Yellen and her Federal Reserve buddies.

The Fed—beginning with the original monetary Mr. Magoo of Alan Greenspan—created a bubble, then rolled out more of the same to deal with the bursting of the bubble, and like the shampoo bottle says: Rinse, Lather, Repeat. Zero interest rates plus QE1, QE2, and QE3 created a massive misallocation of capital that has affected everything from home supply, ocean-going freighters, the US dollar, and wages, and pushed stock prices to a bigger than ever bubble.

The recent weakness is the painful process of deflating that bubble, but the Federal Reserve refuses to learn from its mistakes. It won’t be long until we hear about QE4 and/or a delay to the overpromised interest rate liftoff. Former US Treasury Secretary Larry Summers had this to say yesterday: “A reasonable assessment of current conditions suggests that raising rates in the near future would be a serious error that would threaten all three of the Fed’s major objectives; price stability, full employment and financial stability.”

Honestly, I don’t know what the Federal Reserve will do next. Heck, I bet they don’t know what to do either… but they will do something. Central bankers are arrogant know-it-alls who think they can fix the world’s financial problems with a couple of pulls of a monetary lever.

So pull they will.

And so the stock market damage will continue, albeit with some powerful up moves along the way.
Bulls, whether in a Spanish bull-fighting arena or roaming the floor of the NYSE, are a tough animal to kill. They won’t surrender until they make a few more desperate attempts to push the market higher.
Look at what happened last Tuesday after the 588-point Monday meltdown. The Dow Jones Industrial Average shot up by as much as 441 points before ending the day with a 204-point loss.

My point is that you’re going to see a lot of powerful up moves in the coming months… but I’m telling you, these are nothing more than bear market traps to lure you into buying at the wrong time. The stock market is falling into a bear market, and that means big swings both up and down, similar to 2000–2003.

The Federal Reserve, along with the rest of the world’s central bankers, has puffed stock valuations into an epic bubble, and the stock market has a long, long ways yet to fall…..just not in a straight line. That’s heart attack material for both buy-hold-and-pray and buy the dip investors, but it is a goldmine if you adapt your strategy.

Instead of buying the dip, the right strategy going forward is SELL THE RIP.

When the stock market gives you a big rally, the right move will be to sell into strength.

And if you have some risk capital, that will be the time to load up on inverse ETFs and put options, like my Rational Bear subscribers did in July.

The biggest short-selling opportunity of our lifetimes is knocking on your door.

Tony Sagami

30 year market expert Tony Sagami leads the Yield Shark and Rational Bear advisories at Mauldin Economics. To learn more about Yield Shark and how it helps you maximize dividend income, click here.

To learn more about Rational Bear and how you can use it to benefit from falling stocks and sectors, click here.

The article Connecting the Dots: Buy the Dip? Hell No! Sell the Rip Instead was originally published at mauldineconomics.com.

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Why Stocks Could Fall 50% if the Fed Makes the Wrong Move

By Justin Spittler

One of the most brilliant investors in the world just made a stunning call…..


Ray Dalio is the founder of Bridgewater Associates, the world’s largest hedge fund. Dalio manages nearly $170 billion in assets. He has one of the best investing track records in the business. When he speaks, we listen. Dalio has been saying for a long time that governments and businesses around the world have borrowed far too much money. He thinks their high levels of debt have created an extremely fragile and dangerous situation.

The stats back up Dalio’s view. In the United States, government debt as a percentage of gross domestic product (GDP) is 102%...its highest level since World War II.

Countries around the world are in a similar position. Japan’s debt-to-GDP ratio is at 226% and climbing. In Italy, government debt/GDP jumped from 100% in 2007 to 132% in 2014. Dalio explained how these extreme debt levels are one reason for the recent market volatility we’ve been telling you about…

These long term debt cycle forces are clearly having big effects on China, oil producers, and emerging countries which are overly indebted in dollars.

•  In an article published yesterday, Dalio said the Fed should start another round of quantitative easing...…

Quantitative easing (QE) is when a central bank buys bonds or other assets to lower interest rates and boost asset prices. It’s mostly just another name for money printing. The Fed started QE in a desperate attempt to stave off disaster during the 2007-2008 financial crisis. It launched the first round in November 2008…a second round in November 2010…and a third round in September 2012. It stopped its last round of QE last October.

The first three rounds of QE fueled a big bull market in US stocks. The S&P 500 has gained 113% since the Fed started QE in 2008. Dalio thinks the Fed should bring QE back. It’s a bold call, and one that most economists disagree with. Most economists expect the Fed to raise rates soon. Raising rates would tighten monetary conditions…essentially the opposite of QE.

•  Dalio is worried the Fed won’t get it right..…

Dalio thinks the Fed will raise rates, even if it’s just to “save face.” He pointed out that the Fed has threatened to raise rates so many times that not raising rates would hurt its credibility. Dalio’s big concern is that the world is too indebted to handle a rate hike. He thinks it could cause a financial disaster like a stock market crash, or worse.

In a letter to clients earlier this year, Dalio made a comparison to 1937, when the world was in a similar situation of having way too much debt. He explained that the Fed made a huge mistake by raising rates, and it caused the stock market to plummet 50%.

The danger is that something similar could happen if the Fed raises rates today.

•  We asked Dan Steinhart, executive editor of Casey Research, for his take..…

Here’s his response…...

I don’t know what the Fed’s going to do. That’s a guessing game. What’s important is Dalio’s point that we’re in an extremely fragile situation. The world has too much debt, and the Fed’s margin for error is tiny. If it takes a wrong step and stocks plummet 50%, it could cause a bigger financial crisis than in 2008.

So the real question is, do you trust the US government and the Fed to manage this dangerous situation?

I don’t. This is the same Fed that blew two huge bubbles in the last twenty years. First the 1999 tech bubble…then the even bigger housing bubble, which almost took down the whole financial system when it popped in 2007.

And keep in mind – this is all a gigantic experiment. The Fed is using tools, like QE, that it had never used before the financial crisis. No one in the Fed, the US government, or anywhere else knows how this is going to work out.

Who knows…maybe the Fed will surprise us and successfully guide the economy through this dangerous period. But that’s not an outcome I’d bet my savings on. Dan went on to explain two things you can do to prepare for another financial crisis. One, own physical gold. Unlike stocks, bonds, or cash, it’s the only financial asset that has value no matter what happens to the financial system.

Two, put some of your wealth outside the “blast radius” of a financial crisis. We wrote a new book with all of our best advice on how to do this. And we’ll send it to you today for practically nothing…we just ask you to pay $4.95 to cover our processing costs. Click here to claim your copy.

The article Why Stocks Could Fall 50% if the Fed Makes the Wrong Move was originally published at caseyresearch.com.

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Phil Flynn on the Growl of the Crude Oil Bears

While the bearish oil traders have been missed out on a rally for almost $20 a barrel, they are now doubling down on their bearish calls .This comes after today may set a near record 9th week of gains for the most consecutive weekly gains in at least 30 years. Yet despite that prices run bearish, market talk is getting louder and at least for right now some market participants are starting to listen. As oil tried for new highs for the years this week the bearish calls came from high and low and the press has been widely covering them and may have caused some traders to take profits. Many Bears still think that the market has been wrong for the last 9 weeks and an inevitable price collapses is just around the corner.

Bearish traders focused on the fact that U.S. production had held steady last week and talk that refiner demand has fallen. Refiners cut runs by the most in four months but have been refining product at a near record pace for this time of year. They point out that even though that U.S. supply is starting to fall it does not take away from the fact that we put away over 117 million barrels in storage over the last 6 months. Yet oil has rallied 9 weeks in a row in spite of that. Or that refined product increased in March despite the fact that normally refined product falls. Yet it may not be the lack of demand that caused that but strong refining margins that is encouraging refiners to ramp up production ahead of what should be an uptick in demand.

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We also hear some bears complain that the only reason that oil did not go down to $25 a barrel was an increase in the value of the dollar! Well they might also argue that oil would not have gone down into the $40 handle unless the dollar soared. If you look at the chart of the dollar it went straight up after the November OPEC meeting because of the thought that the U.S. was going to start raising interest rates while the rest of the world either lowered rates. While that is going to happen the fear that the U.S. would start rate increases almost immediately obviously is not going to happen. So know these dollars has adjusted by falling as U.S. data is weaker than expected. Still today an uptick in the dollar is weighing on oil.

Oil is also anticipating an uptick in demand as global easing will spark demand. Despite talk of weak demand in China they just imported a record amount of oil. Oil products did show strength as RBOB futures rallied off of refining problems. Glitch in the Mid-west could help provide some back door support for oil.

Uncertainty about the success of President Obama's Camp David Iran Deal initiative. The President tried to assure Mid-East Leaders that the U.S. would rise up and defend them from any attack. It looks like we could have an arms race in the Middle East. Gold is giving back a big part of its recent rally as the dollar tries for a comeback. The talk that India's demand was rising had been a supporting factor. Support also came from The World Gold Council report that said that Germany's demand for gold and coins spiked by 20% in the first quarter from the year before. Do you think the average German is a little worried about the impact of QE and a Greek bail out on their purchasing power? Yet global gold demand fell 1% in the first quarter, as Chinese jewelry demand fell hard. The Report now expects India to overtake China as the world's largest gold consumer.

Phil Flynn
The PRICE Group

See Phil on the Fox Business Network! Market Watch says he is a must follow, follow him on Twitter @energyphilflynn or email Phil at pflynn@pricegroup.com.

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The Third and Final Transformation of Monetary Policy

By John Mauldin

The law of unintended consequences is becoming ever more prominent in the economic sphere, as the world becomes exponentially more complex with every passing year. Just as a network grows in complexity and value as the number of connections in that network grows, the global economy becomes more complex, interesting, and hard to manage as the number of individuals, businesses, governmental bodies, and other institutions swells, all of them interconnected by contracts and security instruments, as well as by financial and information flows.

It is hubris to presume, as current economic thinking does, that the entire economic world can be managed by manipulating one (albeit major) subset of that network without incurring unintended consequences for the other parts of the network. To be sure, unintended consequences can be positive or neutral or negative. This letter you are reading, which I’ve been writing for over 15 years and which reaches far more people than I would have ever dreamed possible, is partially the result of a serendipitous unintended consequence.

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But as every programmer knows, messing with a tiny bit of the code in a very complex program can have significant ramifications, perhaps to the point of crashing the program. I have a new Microsoft Surface Pro 3 tablet that I’m trying to get used to, but somehow my heretofore reliable Mozilla Firefox browser isn’t playing nice with this computer. I’m sure it’s a simple bug or incompatibility somewhere, but my team and I have not been able to isolate it.

However, that’s a relatively minor problem compared to the unintended consequences that spill from quantitative easing, ZIRP, and other central bank shenanigans. We have discussed the problem of how the Federal Reserve has pushed dollars on the rest of the world and is playing havoc with dollar inflows and outflows from emerging markets. More than one EM central banker is complaining aggressively.
My good friend Dr. Woody Brock makes the case that an unintended consequence of QE is that the Federal Reserve’s normal transmission of monetary policy through periodic changes in the fed funds rate has been vitiated. He contends that soon we will no longer care about the fed funds rate and will be focused on other sets of rates.

This is an important issue and one that is not well understood. Woody has given me permission to reproduce his quarterly profile. For Woody, this is actually a fairly short piece; but as usual with Woody’s work, you will probably want to read it twice.

Woody is one of the most brilliant economists I know, and I make a point of spending time with him as our schedules permit. We are making plans to get together at his Massachusetts retreat in August. He is restructuring his business in order to spend more time writing and less time traveling, and he intends to lower the price of his subscription. It will still be pricey for the average reader, but for funds and institutions it should be a staple. You can find his website at www.SEDinc.com or email him at SED@SEDinc.com.

Before we go to Woody’s letter, if you’re going to be at my conference this coming week, you’ve already made arrangements. I know a lot of people wanted to go but just couldn’t work it into their schedules. I won’t say it’s the next best thing to being there, but you can follow me on Twitter, where my team and I will be sending out real time tweets about the important ideas and concepts we are hearing, not just from the speeches but from all the conversations that spring up during the day and late into the evening. If you’re curious as to who will be there, here’s a page with the speakers. If you’re at the conference, look me up.

The Fed Funds Rate: R.I.P.
‒ The Third and Final Transformation of Monetary Policy
By Woody Brock, Ph.D.

Strategic Economic Decisions, Inc.
The policy announcements of the US Federal Reserve Board are dissected and analyzed more closely than any other global financial variable. Indeed, during the past thirty years, Fed‐Watching became a veritable industry, with all eyes on the funds rate. Within a few years, this term will rarely appear in print. For the Fed will now be targeting two new variables in place of the funds rate. One result is that forecasting Fed policy will be more demanding.

To make sense of this observation, a bit of history is in order. During the last nine years, US monetary policy has been transformed in three ways. To date, only the first two have been widely discussed and are now well understood. The third development is only now underway, and is not well understood at all. To review:

First, the Fed lowered its overnight Fed funds rate to essentially zero, not only during the Global Financial Crisis of 2008–2009, but throughout nearly six years of economic recovery thereafter. The average level of the funds rate at the current stage of recovery was about 4% during the past dozen business cycles. It was never 0% as it is in this cycle. In past essays, we have argued that this overutilization of “ultra‐easy monetary policy” reflected the failure of the government to utilize fiscal policy correctly (profitable infrastructure spending with a high jobs multiplier), and to introduce long‐overdue incentive structure reforms. It was thus left to monetary policy to pick up the pieces after the global crisis of 2008. This development was true in most other G-7 nations, not just in the US.

Second, the Fed inaugurated its policy of Quantitative Easing whereby it increased the size of its balance sheet five‐fold from $900 billion to $4,500 billion. Such an expansion would have been inconceivable to Fed watchers during the decades prior to the Global Financial Crisis. In the US, QE is now dormant, and the only remaining question (answered below) is how and when the Fed will shrink its bloated balance sheet back to more normal levels.

Third, the way in which the Fed conducts standard monetary policy (periodic changes in the funds rate) is currently undergoing a complete makeover. In particular, the traditional tool of changing the funds rate via Open Market operations carried out by the desk of the New York Fed no longer works. For as will be seen, the vast expansion of the size of its balance sheet (bank reserves in particular) has rendered traditional policy unworkable. From now on, therefore, the Fed will conduct monetary policy via two new tools that were not even on the drawing board of the Fed prior to 2008.

Summary: In this PROFILE, we explain in Part A why traditional (non‐QE) monetary policy has been vitiated by QE. In Parts B and C respectively, we discuss the two new tools that will be used in the future to conduct standard (non‐QE) monetary policy: what exactly are these tools, and how do they work? In Part D, we discuss why these new tools will not be required by the European Central Bank, which has a different institutional structure than the US Fed. Finally, in Part E, we turn to QE and discuss when and how the Fed will shrink its balance sheet back to a more traditional size in the years ahead.

In this write‐up, we largely rely on the remarks set forth in a recent paper by Fed Vice Chairman Stanley Fischer, formerly chief economist of the IMF, Governor of the Central Bank of Israel, and professor of economics at MIT. We also benefitted from clarifications by Professor Benjamin Friedman at Harvard University.

Part A: So Long to Setting the Funds Rate via Open Market Operations

Prior to the financial crisis, bank reserve balances with the Fed averaged about $25 billion. With such a low level of reserves, a level controlled solely by the Fed, minor variations in the amount of reserves via Fed open market sales/purchases of securities sufficed to move the Fed funds rate up or down as desired. Analytically, the market for bank reserves (Fed funds) consisted of a demand curve for bank reserves reflecting the nation’s demand for loans, and a supply curve reflecting the supply of reserves by the Fed.

The so‐called Fed funds rate is the point of intersection of these two curves (the interest rate). If the Fed targeted, say a 2% funds rate, it achieved and maintained this rate by shifting the supply curve left or right by adding to/subtracting from the quantity of reserves. As the Fed was a true monopolist in the creation/extinction of reserves, it could always target and sustain any funds rate it chose.

These operations constituted “monetary policy” for many decades. But this is no longer the case, as was first made clear in a FOMC policy pronouncement of September 2014. To quote Dr. Fischer in his 2015 speech, “With the nearly $3 trillion in free bank reserves (up from pre‐crisis reserves averaging $25 billion), the traditional mechanism of adjustments in the quantity of reserve balances to achieve the desired level of the Federal funds rate may not be feasible or sufficiently predictable.” What new mechanisms will replace it? There are two.

Part B: The Use of Interest Rates Paid by the Fed on Free Bank Reserves

“Instead of the funds rate, we will use the rate of interest paid on excess reserves as our primary tool to move the Fed funds rate.” The ability of the Fed to pay banks an interest rate on their free reserves dates back to legislation of October 2008. This rate has been set at 0.25% during the past few years. (“Excess” or “free” bank reserves are defined as the arithmetic difference between total reserves and required reserves. Currently, as of March 30, required reserves were $142 billion, and total reserves were $2.79 trillion.)

The Logic: Whatever the level of the reserve interest rate that the Fed chooses, banks will have little if any incentives to lend to any private counterparty at a rate lower than the rate they can earn on their free reserve balances maintained at the Fed. The higher the reserve remuneration rate is, the greater will be the upward pressure on a whole range of short‐term rates.

Part C: The Use of the Reverse Repo Rate

“Because not all institutions have access to the excess reserves interest rate set by the Fed, we will also utilize an overnight reverse repurchase purchase agreement facility, as needed. In a reverse repo operation, eligible counterparties may invest funds with the Fed overnight at a given interest rate. The reverse repo counterparties include 106 money market funds, 22 broker‐dealers, 24 depository institutions, and 12 government‐sponsored enterprises, including several Federal Home Loan Banks, Fannie Mae, Freddie Mac, and Farmer Mac.”

The Logic: Fischer continues: “This facility should encourage these institutions to be unwilling to lend to private counterparties in money markets at a rate below that offered on overnight reverse repos by the Fed. Indeed, testing to date suggests that reverse repo operations have generally been successful in establishing a soft floor for money market interest rates.”

Summary

Due to the explosion of the size of its balance sheet (bank reserves in particular), the Fed has been forced to abandon management of the Fed funds rate via traditional open market operations. This activity is now being replaced by two new policy tools, both of which are somewhat “softer” than the older tool. First, bank’s free reserves now earn an interest rate on excess bank reserves which is available to banks with access to the Fed’s reserve facility. Second, financial institutions such as money market funds lacking access to the reserve facility will be able to lodge funds overnight (not necessarily merely one night) at the Fed and receive the reverse repo rate offered by the Fed.

Part D: Irrelevance of these Developments to the European Central Bank

Interestingly, the European Central Bank does not need and will probably not implement the policy innovations now being implemented by the US Fed. The reason is that in Europe, lending is dominated by banks far more than here in the US. Moreover, most all European financial institutions can in effect deposit funds with the central bank. Finally, the ECB has long been able to vary the reserve remuneration (interest) rate that it pays for excess reserves. As a result, the ECB does not need to utilize the reverse repo rate tool that the Fed is introducing.

One final point should be made. Whereas Professor Fischer above asserts that the primary tool of the Fed will be variations in the reserve remuneration rate applicable to banks, other scholars believe it is the reverse repo rate that will be the primary tool of US monetary policy. This is partly because of the ongoing reduction of the role of banks in lending to private sector borrowers, a longstanding development that has accelerated with the new regulations imposed on banks since the Global Financial Crisis.

Part E: Will the Fed Shrink its Balance Sheet Back Down? If So, How?

Professor Fischer answers this point directly. Yes, the Fed will shrink its balance sheet, but not to the size of yesteryear. More specifically:

“With regard to balance sheet normalization, the FOMC has indicated that it does not anticipate outright sales of agency mortgage‐backed securities, and that it plans to normalize the size of the balance sheet primarily by ceasing reinvestment of principal payments on our existing securities holdings when the time comes... Cumulative repayments of principal on our existing securities holdings from now through the end of 2025 are projected to be $3.2 trillion. As a result, when the FOMC chooses to cease reinvestments of principal, the size of the balance sheet will naturally decline, with a corresponding reduction in reserve balances.”

Hopefully these remarks have helped clarify past and future changes in Fed policy—changes that amount to a thoroughgoing transformation of US monetary policy that would have been unimaginable a decade ago.
In the future, we suspect that the press will refer to the Fed’s targeting of the “reverse repo rate” in place of the Federal funds rate when analyzing prospective monetary policy.

San Diego, Raleigh, Atlanta, New York, New Hampshire, and Vermont

I am excited about going to the 2015 Strategic Investment Conference on Tuesday. If for some reason you get there early on Wednesday, I intend to be in the gym at the hotel about 2:30, so come by and let’s work out together. Again, don’t forget to follow me on Twitter while I’m at the conference.

In the middle of May I go to Raleigh to speak for the Investment Institute and then on to Atlanta, where I’m on the board of Galectin Therapeutics. I’m going to New York the first week of June, then up to New Hampshire, where I will be speaking with a number of friends at a private retreat. I will then somehow get to Stowe, Vermont, to meet with my partners at Mauldin Economics. The rest of the summer looks pretty easy, with a few trips here and there.

Next week I intend to share my speech at the conference, or at least the gist of it. I have been thinking about it and working on it for some time. I had dinner this week with Mari Kooi, former fund manager who has become deeply imbedded with the Santa Fe Institute, an intellectual hotspot famous for its maverick scientists and interdisciplinary work on the science of complexity. Some of their people are working on something called complexity economics, which is an attempt to move on from the neoclassical view of general equilibrium.

If you wonder why the theories and models don’t work, it is because traditional economists are still busy trying to describe a vastly complex system by assuming away all the change except for that they believe they can control with the knobs they twist and pull. Their model of the economy resembles some vast Rube Goldberg machine where, if you put X money in here at Y rate, it will produce Z outcome over there.

Except that they don’t really know how the actions of the market will play out, since the market is made up of hundreds of millions of independent agents, all of whom change their behavior on the fly based on what the other agents are doing. Not to mention the effects of herding behavior and incentive structures and a dozen things beyond the ken or control of economists. There is only equilibrium in theory.

And that’s why it is becoming increasingly difficult to predict the future. The agents of change are multiplying and changing faster than we can keep up. But next week I will throw caution to the wind (unless I give up in despair), and we’ll see what my very cloudy crystal ball suggests lies in our future.

I am really looking forward to seeing old friends and making new ones at the conference. Have a great week.

Your trying to find simple in a complex world analyst,

John Mauldin

The article Thoughts from the Frontline: The Third and Final Transformation of Monetary Policy was originally published at mauldineconomics.com

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Bears Run For Cover!

From our trading partner Phil Flynn....

Ultra bears are starting to change their tune on oil as weak Chinese manufacturing data and strong manufacturing data in Germany both point to better demand. China's demand may rise as the Chinese government will be forced to act swiftly to reach their growth target and should soon add stimulus increasing oil demand. Factory activity in China fell to 49.2, according to HSBC, a number that should force the Chinese government's hand.

In Germany, we are already seeing the QE impact on oil demand. The Purchasing Managers Index for the manufacturing and services industries across the region rose to a much stronger than expected 54.1 ked by a 0.4 percent expansion in Germany. Germany is the beneficiary of being the strongest economy in the Eurozone at a time when the ECB central bank has launched unprecedented stimulus. On top of that you see the U.K. inflation rate come in at the lowest rate in history. The inflation rate fell below zero for the first time in history and all of a sudden this QE madness is likely to continue.

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Now one might think that might be bearish as the dollar might continue its historic upward move as the rate differential outlook could cause continued safe haven buying. But now it seems that the Fed may be influenced into not rating rates quickly as the dollar strength is causing more problems. We saw in the FOMC that Fed Chair Janet Yellen warned that the Fed will not be impatient in raising rates. The Fed's Stanley Fischer suggested that the Fed will be data, and perhaps dollar dependent on raising rates and warned that there would not be a "smooth upward path" for interest rates hikes.

Oil bears are also counting on another big inventory increase. Yet data from Genscape, the private forecaster, is suggesting that the build might be much less than the 4 million barrel builds that is being bandied about. Genscape reports that the increase of less than 2 million barrels are around 1.6 million. That should reduce fears of storage over flowing. In fact the Energy Information Administration reported that although inventory levels at Cushing are at their record high, storage utilization (inventories as a percent of working storage capacity) are not at record levels. Capacity utilization at Cushing is now 77%, a large increase from a recent low of 27% in October 2014. However, utilization reached 91% in March 2011, soon after EIA began surveying storage capacity twice a year, starting in September 2010."

See Phil on the Fox Business Network and follow him on Twitter @energyphilflynn!

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The Crazy Man’s Guide to the Bond Market

By John Mauldin

I invite you to inspect the following chart of 10 year interest rates in the US. If you don’t have a lot of experience with these things, let me clue you in: This is a very scary looking chart. It’s a classic head and shoulders bottom in yields.

If you’re one of those people who’s scornful of technical analysis, don’t be. Now, I don’t pay much attention to complicated stuff like Elliott Wave or Gann Angles, but there are some very basic technical formations that work reliably most of the time.

I had the good fortune of taking out a mortgage when 10-year rates were at 1.9%, which goes to show that the only time you get to top-tick stuff is by accident.

Now, this is actually not the low in yields. 10 year yields got to 1.4% a few years ago.

Of course, interest rates are even lower in Europe. Take Germany, for example:

I think that these interest rates (which are at 700 year lows in Europe) signify a bubble. Other people don’t, though—they point to x, y, and z as signs of deflation.

I’m very weary of the inflation/deflation argument. A lot of people lost a lot of money betting on inflation when there were obvious signs of inflation (QE). And I fear that a lot of people will lose a lot of money betting on deflation when there are obvious signs of deflation.

I’m a trader at heart, and I try not to get too attached to my views. I pay attention to price. And right now, the price action is telling me that the bond market might be in trouble.

Central Banks Buy High and Sell Low

The first thing you need to know about central banks is that they are the worst traders in the world. The worst. Probably the most famous example in the modern era was the Bank of England under Gordon Brown’s leadership puking its gold holdings—on the absolute lows, between 1999 and 2002. The idea was they had this gold sitting there not generating any yield, so why not sell the gold and buy paper that would generate some yield?

Whoops…..

A less famous example of bad trading by public officials would be the US Treasury’s decision to issue floating rate debt. Now, if the government has floating-rate liabilities, it should want interest rates to stay low, right?.......Whoops!

The all-time lows in rates. To the exact day.

So with all this in mind, don’t you think it’s interesting that the ECB is going to buy European debt—at 700-year low yields? At negative yields, in some cases? Central banks do not buy things on the lows. They buy things on the highs.

Of course, the ECB is not trying to make money on these transactions. Which is the whole point!

The Worst Investors in US History Strike Again

Betting on the end of what is a 30 year interest rate cycle is not a productive use of our time. This bond market has claimed the careers of many investors. It reportedly hastened the retirement of Stan Druckenmiller, arguably the greatest investor of all time, who bet against bonds heavily, thinking yields could not go any lower. They did.

Let me impart some wisdom here: The first rule of finance is that there are no rules in finance. Nothing works all the time. My favorite dumb rule of finance is the one that says your percentage allocation in bonds should be equal to your age. So if you are 60, you should be 60% in bonds.

My guess is that if interest rates rise 2%-3%, people won’t be saying that anymore.

You know what I worry about? I worry about the baby boomers. I worry about this generation, the worst investors in US history, who got carried out in the tech bear market in 2000 and got caned in the financial crisis of 2008, and after having been hammered twice in the span of 10 years in the stock market, went all-in on bonds.

Why? Bonds are safe. Everyone knows stocks are not safe.

Now, in retirement, none of these people expect their bond mutual funds to get cut in half, which would happen if interest rates went up about 3% - 5%.

Imagine if they did!

The disclaimer to all of this is that I’ve been a bond bear for many years, and I’ve been wrong. But for the first time, I think we have something approaching consensus that yields will stay low forever. People who think interest rates are going up are starting to sound crazy. I am starting to sound crazy. That probably means I’m close to being right.

If 10 year rates get above 3%, the previous high, we will know for sure. If that happens, pick up the Batphone, call the White House, sell everything. Why?

If you are still ignoring charts when they are making higher lows and higher highs, God help you.


Jared Dillian

The article The 10th Man: The Crazy Man’s Guide to the Bond Market was originally published at mauldineconomics.com.

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The Healthy Bull Market: Bah, Humbug!

By Tony Sagami

Are you a long term investor? Convinced that all you have to do is wait long enough to be guaranteed huge stock market profits? Take a look at the chart below of rolling 30 year returns of the S&P 500 and tell me if it affects your enthusiasm.

The reality is that stock market results vary widely depending on what your starting point is. For example, any investor who put $100,000 into the stock market 1954 was rewarded with roughly the same $100,000 30 years later in 1984.

Yup… 30 years in, and not a penny of profits.



With the stock market at all-time highs, you may find it hard to be pessimistic, but the stock market is doing as well as it’s ever done, with a rolling 30-year return of better than 400%.

How would you feel about earning 0% on your money for 30 years?

Could the stock market go even higher? Yes, it could—but the odds aren’t favorable after the QE fueled rally has pushed stocks to historically high valuations. High valuations? Despite what the mass media and the Wall Street crowd try to tell you, valuations are quite high.

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The most popular myth spouted on financial TV these days is the notion that the S&P 500 is trading at 19 times earnings. Baloney!

First, that 19 P/E is based on “forward” earnings, not trailing earnings. As unreliable as economists and self-serving analysts are, I’m surprised that anyone—especially you—believes anything they say.

Second, that forward looking earnings forecast is based on those 500 companies increasing their earnings by an average of 23% over the next 12 months. Yup… a 23% increase!

That’s extremely optimistic, but I think especially misplaced now that the steroid of quantitative easing is behind us. Consider this: everybody agrees that stocks responded extremely positively to quantitative easing, so doesn’t it make sense to be concerned now that the monetary punch bowl has been yanked away?

The first place to look for signs of waning enthusiasm are small-cap stocks. While the Dow Jones Industrial Average and the S&P 500 were setting all-time highs, the Russell 2000 wasn’t able to punch through its March, July, and September peaks.



This quadruple top looks like a formidable resistance level for small stocks and clear evidence that investors are reducing risk by rotating out of small-cap stocks and into big cap stocks.



Additionally, financial stocks are showing signs of exhaustion too. Healthy bull markets are often led by financial stocks, but the financials are lagging the major indexes now. That’s why I think last week’s 3.9% GDP print smelled fishy; some weak economic numbers are spelling trouble.

Durable Goods Orders Not So Good: The headline number for October durable goods orders was strong with a +0.4% increase, but if you back out the volatile transportation sales, the picture is a lot uglier. If you exclude transportation—because just a few $100 million jet orders can skew the numbers—the 0.4% gain turns into a 0.9% decrease.

By the way, orders for defense aircraft were up 45.3%, but orders for non defense aircraft orders were down 0.1% in October. If not for some big government orders, the results would be absolutely horrible!

Unemployment Claims Rise Despite Holiday Hiring: The job picture, which had been improving, showed some deterioration last week despite going into the busy holiday hiring season. Initial jobless claims jumped to 313,000, a 7.2% increase from last week as well as much higher than the 286,000 forecast. It also broke a 10-week streak of claims below 300,000.

Before You Cheer Cheap Oil: After OPEC agreed to keep production levels unchanged, the price of oil plunged by 7% on Friday to less than $68 a barrel. That’s good news for drivers, but oil’s falling prices (as well as those of other commodities) are a very bad sign for economic growth. Moreover, the energy industry has been one of the few industries producing good, high-paying jobs. Thus, low oil prices could turn that smile into a frown in no time.



The Bond Conundrum: The yield on 10 year Treasury bonds was as high as 3% earlier this year but dropped to 2.31 last Friday. If our economy were rocking as well as the 3.9% GDP rate suggests, interest rates should be rising… not falling like a rock.

The stock market may not fall out of bed tomorrow morning, but the holiday season for stock market investors looks like it may be more Scrooge than Santa Claus.

30 year market expert Tony Sagami leads the Yield Shark and Rational Bear advisories at Mauldin Economics. To learn more about Yield Shark and how it helps you maximize dividend income, click here.

To learn more about Rational Bear and how you can use it to benefit from falling stocks and sectors, click here.

The article Connecting the Dots: The Healthy Bull Market: Bah, Humbug! was originally published at mauldin economics

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By John Mauldin

Two years ago, my friend Mohamed El-Erian and I were on the stage at my Strategic Investment Conference. Naturally we were discussing currencies in the global economy, and I asked him about currency wars. He smiled and said to me, “John, we don’t talk about currency wars in polite circles. More like currency disagreements” (or some word to that effect).

This week I note that he actually uses the words currency war in an essay he wrote for Project Syndicate:

Yet the benefits of the dollar’s rally are far from guaranteed, for both economic and financial reasons. While the US economy is more resilient and agile than its developed counterparts, it is not yet robust enough to be able to adjust smoothly to a significant shift in external demand to other countries. There is also the risk that, given the role of the ECB and the Bank of Japan in shaping their currencies’ performance, such a shift could be characterized as a “currency war” in the US Congress, prompting a retaliatory policy response.

This is a short treatise, but as usual with Mohamed’s writing, it’s very thought provoking. Definitely Outside the Box material.

And for a two-part Outside the Box I want to take the unusual step of including an op-ed piece that you might not have seen, from the Wall Street Journal, called “How to Distort Income Inequality,” by Phil Gramm and Michael Solon. They cite research I’ve seen elsewhere which shows that the work by Thomas Piketty cherry-picks data and ignores total income and especially how taxes distort the data. That is not to say that income inequality does not exist and that we should not be cognizant and concerned, but we need to plan policy based on a firm grasp of reality and not overreact because of some fantasy world created by social provocateur academicians.

This weeks new video "How you can Profit from ETFs on the Unexpected Move in the Dollar".....Just Click Here

The calls for income redistribution from socialists and liberals based on Piketty’s work are clearly misguided and will further distort income inequality in ways that will only reduce total global productivity and growth.
I’m in New York today at an institutional fund manager conference where I had the privilege of hearing my good friend Ian Bremmer take us around the world on a geopolitical tour. Ian was refreshingly optimistic, or at least sanguine, about most of the world over the next few years. Lots of potential problems, of course, but he thinks everything should turn out fine – with the notable exception of Russia, where he is quite pessimistic.

A shirtless Vladimir Putin was the scariest thing on his geopolitical radar. As he spoke, Russia was clearly putting troops and arms into eastern Ukraine. Why would you do that if you didn’t intend to go further? Ian worried openly about Russia’s extending a land bridge all the way to Crimea and potentially even to Odessa, which is the heart of economic Ukraine, along with the Kiev region. It would basically make Ukraine ungovernable.

I thought Putin’s sadly grim and memorable line that “The United States is prepared to fight Russia to the last Ukrainian” pretty much sums up the potential for a US or NATO response. Putin agreed to a cease-fire and assumed that sanctions would start to be lifted. When there was no movement on sanctions, he pretty much went back to square one. He has clearly turned his economic attention towards China.

Both Ian Bremmer and Mohamed El Erian will be at my Strategic Investment Conference next year, which will again be in San Diego in the spring, April 28-30. Save the dates in your calendar as you do not want to miss what is setting up to be a very special conference. We will get more details to you soon.

It is a very pleasant day here in New York, and I was able to avoid taxis and put in about six miles of pleasant walking. (Sadly, it is supposed to turn cold tomorrow.) I’ve gotten used to getting around in cities and slipping into the flow of things, but there was a time when I felt like the country mouse coming to the city. As I walked past St. Bart’s today I was reminded of an occasion when your humble analyst nearly got himself in serious trouble.

There is a very pleasant little outdoor restaurant at St. Bartholomew’s Episcopal Church, across the street from the side entrance of the Waldorf-Astoria. It was a fabulous day in the spring, and I was having lunch with my good friend Barry Ritholtz. The president (George W.) was in town and staying at the Waldorf. His entourage pulled up and Barry pointed and said, “Look, there’s the president.”

We were at the edge of the restaurant, so I stood up to see if I could see George. The next thing I know, Barry’s hand is on my shoulder roughly pulling me back into my seat. “Sit down!” he barked. I was rather confused – what faux pas I had committed? Barry pointed to two rather menacing, dark-suited figures who were glaring at me from inside the restaurant.

“They were getting ready to shoot you, John! They had their hands inside their coats ready to pull guns. They thought you were going to do something to the president!”

This was New York not too long after 9/11. The memory is fresh even today. Now, I think I would know better than to stand up with the president coming out the side door across the street. But back then I was still just a country boy come to the big city.

Tomorrow night I will have dinner with Barry and Art Cashin and a few other friends at some restaurant which is supposedly famous for a mob shooting back in the day. Art will have stories, I am sure.
It is time to go sing for my supper, and I will try not to keep the guests from enjoying what promises to be a fabulous meal from celebrity chef Cyrille Allannic. After Ian’s speech, I think I will be nothing but sweetness and light, just a harmless economic entertainer. After all, what could possibly go really wrong with the global economy, when you’re being wined and dined at the top of New York? Have a great week.

John Mauldin, Editor
Outside the Boxsubscribers@mauldineconomics.com

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The Return of the Dollar

By Mohamed El-Erian
Project Syndicate, Nov. 13, 2014

The U.S. dollar is on the move. In the last four months alone, it has soared by more than 7% compared with a basket of more than a dozen global currencies, and by even more against the euro and the Japanese yen. This dollar rally, the result of genuine economic progress and divergent policy developments, could contribute to the “rebalancing” that has long eluded the world economy. But that outcome is far from guaranteed, especially given the related risks of financial instability.

Two major factors are currently working in the dollar’s favor, particularly compared to the euro and the yen. First, the United States is consistently outperforming Europe and Japan in terms of economic growth and dynamism – and will likely continue to do so – owing not only to its economic flexibility and entrepreneurial energy, but also to its more decisive policy action since the start of the global financial crisis.

Second, after a period of alignment, the monetary policies of these three large and systemically important economies are diverging, taking the world economy from a multi-speed trajectory to a multi-track one. Indeed, whereas the US Federal Reserve terminated its large-scale securities purchases, known as “quantitative easing” (QE), last month, the Bank of Japan and the European Central Bank recently announced the expansion of their monetary-stimulus programs. In fact, ECB President Mario Draghi signaled a willingness to expand his institution’s balance sheet by a massive €1 trillion ($1.25 trillion).

With higher US market interest rates attracting additional capital inflows and pushing the dollar even higher, the currency’s revaluation would appear to be just what the doctor ordered when it comes to catalyzing a long-awaited global rebalancing – one that promotes stronger growth and mitigates deflation risk in Europe and Japan. Specifically, an appreciating dollar improves the price competitiveness of European and Japanese companies in the US and other markets, while moderating some of the structural deflationary pressure in the lagging economies by causing import prices to rise.

Yet the benefits of the dollar’s rally are far from guaranteed, for both economic and financial reasons. While the US economy is more resilient and agile than its developed counterparts, it is not yet robust enough to be able to adjust smoothly to a significant shift in external demand to other countries. There is also the risk that, given the role of the ECB and the Bank of Japan in shaping their currencies’ performance, such a shift could be characterized as a “currency war” in the US Congress, prompting a retaliatory policy response.

Furthermore, sudden large currency moves tend to translate into financial-market instability. To be sure, this risk was more acute when a larger number of emerging-economy currencies were pegged to the U.S. dollar, which meant that a significant shift in the dollar’s value would weaken other countries’ balance of payments position and erode their international reserves, thereby undermining their creditworthiness. Today, many of these countries have adopted more flexible exchange-rate regimes, and quite a few retain adequate reserve holdings.

But a new issue risks bringing about a similarly problematic outcome: By repeatedly repressing financial-market volatility over the last few years, central-bank policies have inadvertently encouraged excessive risk-taking, which has pushed many financial-asset prices higher than economic fundamentals warrant. To the extent that continued currency-market volatility spills over into other markets – and it will – the imperative for stronger economic fundamentals to validate asset prices will intensify.

This is not to say that the currency re-alignment that is currently underway is necessarily a problematic development; on the contrary, it has the potential to boost the global economy by supporting the recovery of some of its most challenged components. But the only way to take advantage of the re-alignment’s benefits, without experiencing serious economic disruptions and financial-market volatility, is to introduce complementary growth-enhancing policy adjustments, such as accelerating structural reforms, balancing aggregate demand, and reducing or eliminating debt overhangs.

After all, global growth, at its current level, is inadequate for mere redistribution among countries to work. Overall global GDP needs to increase.

The US dollar’s resurgence, while promising, is only a first step. It is up to governments to ensure that the ongoing currency re-alignment supports a balanced, stable, and sustainable economic recovery. Otherwise, they may find themselves again in the unpleasant business of mitigating financial instability.

How to Distort Income Inequality

By Phil Gramm and Michael Solon
Wall Street Journal, Nov. 11, 2014

The Piketty-Saez data ignore changes in tax law and fail to count noncash compensation and Social Security benefits.

What the hockey-stick portrayal of global temperatures did in bringing a sense of crisis to the issue of global warming is now being replicated in the controversy over income inequality, thanks to a now-famous study by Thomas Piketty and Emmanuel Saez, professors of economics at the Paris School of Economics and the University of California, Berkeley, respectively. Whether the issue is climate change or income inequality, however, problems with the underlying data significantly distort the debate.

The chosen starting point for the most-quoted part of the Piketty-Saez study is 1979. In that year the inflation rate was 13.3%, interest rates were 15.5% and the poverty rate was rising, but economic misery was distributed more equally than in any year since. That misery led to the election of Ronald Reagan, whose economic policies helped usher in 25 years of lower interest rates, lower inflation and high economic growth. But Messrs. Piketty and Saez tell us it was also a period where the rich got richer, the poor got poorer and only a relatively small number of Americans benefited from the economic booms of the Reagan and Clinton years.

If that dark picture doesn’t sound like the country you lived in, that’s because it isn’t. The Piketty-Saez study looked only at pretax cash market income. It did not take into account taxes. It left out noncash compensation such as employer-provided health insurance and pension contributions. It left out Social Security payments, Medicare and Medicaid benefits, and more than 100 other means-tested government programs. Realized capital gains were included, but not the first $500,000 from the sale of one’s home, which is tax-exempt. IRAs and 401(k)s were counted only when the money is taken out in retirement. Finally, the Piketty-Saez data are based on individual tax returns, which ignore, for any given household, the presence of multiple earners.

And now, thanks to a new study in the Southern Economic Journal, we know what the picture looks like when the missing data are filled in. Economists Philip Armour and Richard V. Burkhauser of Cornell University and Jeff Larrimore of Congress’s Joint Committee on Taxation expanded the Piketty-Saez income measure using census data to account for all public and private in-kind benefits, taxes, Social Security payments and household size.

The result is dramatic. The bottom quintile of Americans experienced a 31% increase in income from 1979 to 2007 instead of a 33% decline that is found using a Piketty-Saez market-income measure alone. The income of the second quintile, often referred to as the working class, rose by 32%, not 0.7%. The income of the middle quintile, America’s middle class, increased by 37%, not 2.2%.

By omitting Social Security, Medicare and Medicaid, the Piketty-Saez study renders most older Americans poor when in reality most have above-average incomes. The exclusion of benefits like employer-provided health insurance, retirement benefits (except when actually paid out in retirement) and capital gains on homes misses much of the income and wealth of middle- and upper-middle income families.

Messrs. Piketty and Saez also did not take into consideration the effect that tax policies have on how people report their incomes. This leads to major distortions. The bipartisan tax reform of 1986 lowered the highest personal tax rate to 28% from 50%, but the top corporate-tax rate was reduced only to 34%. There was, therefore, an incentive to restructure businesses from C-Corps to subchapter S corporations, limited liability corporations, partnerships and proprietorships, where the same income would now be taxed only once at a lower, personal rate. As businesses restructured, what had been corporate income poured into personal income-tax receipts.

So Messrs. Piketty and Saez report a 44% increase in the income earned by the top 1% in 1987 and 1988—though this change reflected how income was taxed, not how income had grown. This change in the structure of American businesses alone accounts for roughly one-third of what they portray as the growth in the income share earned by the top 1% of earners over the entire 1979-2012 period.

An equally extraordinary distortion in the data used to measure inequality (the Gini Coefficient) has been discovered by Cornell’s Mr. Burkhauser. In 1992 the Census Bureau changed the Current Population Survey to collect more in-depth data on high-income individuals. This change in survey technique alone, causing a one-time upward shift in the measured income of high-income individuals, is the source of almost 30% of the total growth of inequality in the U.S. since 1979.

Simple statistical errors in the data account for roughly one third of what is now claimed to be a “frightening” increase in income inequality. But the weakness of the case for redistribution does not end there. America is the freest and most dynamic society in history, and freedom and equality of outcome have never coexisted anywhere at any time. Here the innovator, the first mover, the talented and the persistent win out—producing large income inequality. The prizes are unequal because in our system consumers reward people for the value they add. Some can and do add extraordinary value, others can’t or don’t.

How exactly are we poorer because Bill Gates, Warren Buffett and the Walton family are so rich? Mr. Gates became rich by mainstreaming computer power into our lives and in the process made us better off. Mr. Buffett’s genius improves the efficiency of capital allocation and the whole economy benefits. Wal-Mart stretches our buying power and raises the living standards of millions of Americans, especially low-income earners. Rich people don’t “take” a large share of national income, they “bring” it. The beauty of our system is that everybody benefits from the value they bring.

Yes, income is 24% less equally distributed here than in the average of the other 34 member countries of the OECD. But OECD figures show that U.S. per capita GDP is 42% higher, household wealth is 210% higher and median disposable income is 42% higher. How many Americans would give up 42% of their income to see the rich get less?

Vast new fortunes were earned in the 25-year boom that began under Reagan and continued under Clinton. But the income of middle-class Americans rose significantly. These incomes have fallen during the Obama presidency, and not because the rich have gotten richer. They’ve fallen because bad federal policies have yielded the weakest recovery in the postwar history of America.

Yet even as the recovery continues to disappoint, the president increasingly turns to the politics of envy by demanding that the rich pay their “fair share.” The politics of envy may work here as it has worked so often in Latin America and Europe, but the economics of envy is failing in America as it has failed everywhere else.

Mr. Gramm, a former Republican senator from Texas, is a visiting scholar at the American Enterprise Institute. Mr. Solon was a budget adviser to Senate Republican Leader Mitch McConnell and is a partner of US Policy Metrics.

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Important Disclosures

The article Outside the Box: The Return of the Dollar was originally published at mauldineconomics.com.

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