Thursday, April 10, 2014

It's Risk On.....Regardless

By John Mauldin


When Gary Shilling was with us here last fall, he and I were feeling considerably more sanguine about the near-term propects for the US and global economies. In fact, I said about Gary that “that old confirmed bear is waxing positively bullish about the future prospects of the US. In doing so he mirrors my own views.”

In today’s excerpt from Gary’s quarterly INSIGHT letter, he tackles head-on the shift in sentiment and economic performance that has ensued since then. He steps us through the ebullient headlines and forecasts that dominated at year-end, and then remarks,

It’s as if an iron curtain came down between the last trading day of 2013 and January 2014. A headline in the Feb. 5, 2014 Wall Street Journal screamed, “Turnabout on Global Outlook Darkens Mood.”

Don’t get me (and Gary) wrong: many of the positive factors that he and I identified last fall are still in play; but they are longer-term, secular factors such as technological transformation and a tectonic shift in the energy landscape rather than the cyclical factors that will dominate for most of the rest of this decade.

In today’s OTB, Gary does an excellent job of summarizing and analyzing those cyclical factors. In this extended excerpt from INSIGHT, you’ll be treated to sections on investor and consumer behavior, deleveraging, housing, income polarization, unemployment, Obamacare and medical costs, the prospects for inflation, the Fed, emerging markets, and much more.

Be sure to see the close of the letter for Gary’s special offer to OTB readers.

I find myself in the lovely tropical city of Durban, South Africa. The hotel where I’m staying, The Oyster Box, is a lovely old throwback properly set on the Indian Ocean, where you can see the continual shipping traffic queuing up to get into the port, which is the largest in Africa. The hotel reminds me of the Raffles in Singapore, with a better view and somewhat more Old World charm. Or at least what I romanticize as Old World charm from movies I saw as a kid (though some of my younger readers are probably sure I lived in that era!).

I sleep now, then get up in less than five hours to catch a plane to Johannesburg, where I will spend the next three days doing more of the speeches and interviews that I’ve been doing for the last two, for my host Glacier by Sanlam. Anton Raath, the CEO, has that quintessential ability to make everyone feel welcome and keep them on goal. I am continually impressed with the quality of South African management, whether here or among the South African diaspora. If the government here could ever figure out how to get out of their way… I wrote a Thoughts from the Frontline almost exactly seven years ago that I called “Out Of Africa.” It was a very bullish take on a country that I could see had wonderful prospects. And indeed investing in South Africa would have been a good move at the time – a solid double in seven years.



But this trip I’ve seen things and talked to people that don’t give me the same feeling. We’ll talk about it this weekend, after I have more meetings with both stakeholders and analysts of the local economy. South Africa seems to me to face many of the same problems that have beset Brazil, Turkey, and others in the Fragile Six. Why is this? Why should a country with this many resources, both physical and human, be falling behind? I think some of you can guess the answer, but I will wait to tell the rest of you in this week’s letter.

Once again, for the fourth time in my life, my hot air balloon trip was canceled! Sigh. I am not sure what the travel gods are trying to tell me, but I will not give up, and one day I expect to soar above the earth on something other than my own hot air.

Have a great week,

Your wanting to come back to this hotel and pretend to be genteel for a few days analyst,
John Mauldin, Editor
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Risk On, Regardless

(Excerpted from the March 2014 edition of A. Gary Shilling's INSIGHT)

U.S. stocks leaped 30% last year, continuing the rally that commenced in March 2009 and elevated the S&P 500 index 173% from its recessionary low (Chart 1). By late 2013, many investors were in a state of euphoria, even irrationally exuberant about prospects for more of the same this year and seized on any data that suggested that robust economic growth here and abroad would underpin more of the same equity performance.


 

Optimistic Forecasts

 

Many forecasts from credible sources accommodated them. The Organization for Economic Cooperation and Development in January said the leading indicators for its 34 members rose to 109.9 in November from 100.7 in October, foretelling faster economic growth in the first half of 2014 for the U.S., U.K., Japan and the eurozone.

The International Monetary Fund in mid-January raised its global growth forecast for 2014 real GDP from its October estimate by 0.1 percentage points to 3.7%, with the U.S. (up 0.2 points to 2.2%), Japan (up 0.4 to 1.7%), the U.K. (up 0.6 to 2.4%), the eurozone (up 0.1 to 1.0%) and China (up 0.3 to 7.5%) leading the way.

Outgoing Fed Chairman Ben Bernanke on January 3 said that the fiscal drag from federal and state fiscal policies that restrained growth in recent years was likely to ease in 2014 and 2015. Other deterrents such as the European debt crisis, tighter bank lending standards and U.S. household debt reductions were easing, he said. “The combination of financial healing, greater balance in the housing market, less fiscal restraint and, of course, continued monetary policy accommodation bodes well for U.S. economic growth in coming quarters.”

A Wall Street Journal poll of economists found an average forecast of 2.7% growth in 2014, up from 1.9% in 2013 and the official forecast of the perennially-optimistic Fed, made before Christmas, called for 2.8% to 3.2% real GDP growth this year. Also, chronically-optimistic Barron’s, in its Feb. 17, 2014 edition, headlined its cover story, “Good News. The U.S. Economy Could Grow This Year At A Surprisingly Robust 4%. Forget The Snow. Consumers And Businesses Are Ready To Spend.” Many investors also believed that the U.S. economy was about to break out of the 2% real GDP rises that have ruled since 2010.

Sentiment Shift

 

It’s interesting that Barron’s ran this headline after investor sentiment shifted dramatically. It’s as if an iron curtain came down between the last trading day of 2013 and January 2014. A headline in the Feb. 5, 2014 Wall Street Journal screamed, “Turnabout on Global Outlook Darkens Mood.” As stocks flattened and then fell, people started to realize that economic growth last year was weak, rising only 1.9% from 2012 as measured by real GDP.

The fourth quarter annual rate was chopped from the 3.2% “advance estimate” by the Commerce Department to 2.4%, and one percentage point of the 2.4% was due to the jump in net exports as imports fell due to domestic shale oil and natural gas replacing imported energy. Nevertheless, exports remain vulnerable to ongoing weakness in American trading partners. Also in the third quarter of 2013, 1.7 percentage points of the 4.1% growth was due to inventories. Given the disappointing Christmas sales, these were probably undesired additions to stocks and will retard growth this year as they are liquidated.
Even the stated GDP numbers show this to be the slowest recovery in post-World War II history (Chart 2). And real median income has atypically dropped in this recovery, largely due to the slashing of labor costs by American business.



Pending home sales, which are contracts signed for future closings, peaked last May and had dropped considerably before cold weather set in this past winter while housing starts fell for a third straight month in February.

Wary Investors

 

While stocks soared in 2013, investors didn’t dig too deeply into corporate earnings reports, but now they are. As we’ve discussed in many past Insights, with limited sales volume increases in this recovery and virtually no pricing power, businesses have promoted profits by cutting costs, resulting in all time highs for profit margins. Many investors are now joining us in believing that the leap in profit margins, which has stalled for eight quarters, may be vulnerable.

They’re also paying more attention to the outlook for future profits and cash generation as foretold by acquisitions and spending on R&D. Shareholders favor those companies that invest while penalizing companies that fall short. Per-share profits gains due to share buybacks are no longer viewed favorably. Furthermore, investors are aware that two-thirds of the 30% rise in the S&P 500 index last year was due to the rising P/E, with only a third resulting from earnings improvement.

In mid-February, the S&P 500 stocks were trading at 14.6 times the next 12 months earnings, higher than the 10-year average of 13.9. As Insight readers may recall, we take a dim view of this measure since it amounts to a double discount of both future stock performance and analysts’ perennially-optimistic estimates of earnings. In December, Wall Street seers, on average, forecast a 10% rise in stocks for 2014, the average of the last 10 years. But the average forecasting error over the past decade was 12% with a 50% overestimate in 2008. That 12% error was larger than the average gain of 10%.

Besides cost-cutting, the leap in profit margins has been supported by declining borrowing costs spawned by record-low interest rates. Low rates have also made equities attractive relative to plenty of liquidity supplied by the Fed and Chinese banks and shadow banks.

Last May and June, stocks, bonds and other securities were shaken by the Fed’s talk of tapering its then-$85 billion per month worth of security purchases, in part because many assumed that also meant hikes in the central bank’s federal funds rate. But then the Fed then went on an aggressive offensive to convince investors that raising rates would be much later than tapering, and investors have largely shrugged off the credit authorities’ decision in December to cut its monthly purchases from $85 billion to $75 billion in January and by another $10 billion in February.

The Fed’s decision in January came despite the recent signs of weak U.S. economic activity, weather-related or not, and indications of trouble abroad. Furthermore, although the Fed is still adding fuel to the fire under equities, it is adding less and less, and is on schedule to end its quantitative easing later this year.

The Age of Deleveraging

 

So the zeal for equities persists but we remain cautious about the spread between that enthusiasm and the sluggish growth of economies around the globe. As in every year of this recovery, the early-in-the-year hope for economic acceleration that would justify soaring equities may again be disappointed, and real GDP is likely to continue to rise at about a 2% annual rate.

Deleveraging after a major bout of borrowing and the inevitable crisis that follows normally takes a decade. The process of working down excess debt and retrenching, especially by U.S. consumers and financial institutions globally, is six years old, so history suggests another four years of deleveraging and slow growth. And, as we’ve noted many times in the past, the immense power of deleveraging is shown by the reality that slow growth persists despite the massive fiscal and monetary stimulus of recent years. Furthermore, although the Fed hasn’t started to sell off its immense holdings of securities, as it will need to in order to eliminate excess bank reserves, it is reducing the additions to that pile by tapering its new purchases.

Consumers Retrench

 

In the U.S., some have made a big deal over the uptick in domestic borrowing in the fourth quarter of 2013. Auto loans have risen, the result of strong replacement sales of aged vehicles, but sales are now falling. Student debt and delinquencies continue to leap (Chart 3). The decline in credit borrowing may be leveling, but what’s gotten the most attention was the rise in mortgage debt.



Since housing activity is falling, the mortgage borrowing uptick is due to fewer foreclosures and mortgage writeoffs as well as easier lending standards by some banks. They are under continuing regulatory pressure to increase their capital and slash their exposure to highly-profitable activities like derivatives origination and trading, off-balance sheet vehicles and proprietary trading, so banks are eager for other loans. Furthermore, the jump in mortgage rates touched off by the Fed’s taper talk has slaughtered the profitable business of refinancing mortgages as applications collapsed.

Household debt remains elevated even though, as a percentage of disposable personal income, it has fallen from a peak of 130% in 2007 to 104% in the third quarter, the latest data (Chart 4). It still is well above the 65% earlier norm, and we’re strong believers in reversion to well-established norms. Even more so considering the memories many households still have of the horrors of excess debt and the losses they suffered in recent years.



Furthermore, given the lack of real wage gains and real total income growth, the only way that consumers can increase the inflation-adjusted purchases of goods and services is to reduce their still-low saving rate or increase their still-high debts. Furthermore, consumer confidence has stabilized after its recessionary nosedive but remains well below the pre-recession peak.

So, in rational fashion, consumers are retrenching, with retail sales declines in December and January and slightly up in February. That’s much to the dismay of retailers who appear to be stuck with excess merchandise, as reflected in their rising inventory-sales ratio. And recall that retailers slashed prices on Christmas goods right before the holidays to avoid being burdened with unwanted inventories. Of course, there’s the usual argument that cold winter weather kept shoppers at home. But that's where they could order online, yet non-store retail sales—largely online purchases—actually fell 0.6% in January in contrast to the early double-digit year-over-year gains.

We’re not forecasting a recession this year but rather a continuation of slow growth of about 2% at annual rates. But with slow growth, it doesn’t take much of a hiccup to drive the economy into negative territory. And indicators of future activity are ominous. The index of leading indicators is still rising, but a more consistent forecaster—the ratio of coincident to lagging indicators—is falling after an initial post-recession revival.

Housing

 

Housing activity is retrenching, with pending sales, housing starts and mortgage applications for refinancing all declining. Also, as we’ve discussed repeatedly in past Insights, the housing recovery has never been the on the solid backs of new homeowners who buy the starter houses that allow their sellers to move up to the next rung on the housing ladder, etc. Mortgage applications for house purchases, principally by new homeowners, never recovered from their recessionary collapse. Multi-family housing starts, mostly rental apartments), recovered to the 300,000 annual rate of the last decade but single-family starts, now about 600,000, remain about half the pre-collapse 1.1 million average.

Many potential homeowners, especially young people, don’t have the 20% required downpayments, are unemployed or worry about their job security, don’t have high enough credit scores to qualify for mortgages, and realize that for the first time since the 1930s, house prices nationwide have fallen—and might again. Prices have recovered some of their earlier losses (Chart 5), but in part because lenders have cleaned up inventories of foreclosed and other distressed houses they sold at low prices. In any event, prices weakened slightly late last year.



Some realtors complain that existing home sales are being depressed by the lack of for-sale inventory. Nevertheless, inventories of existing houses rose from December to January by 2.2%. Fannie Mae reported that its inventories of foreclosed properties rose for the second time in the last three months of 2013 as sales fell and prices dropped for the first time in three years. Also, with the percentage of underwater home mortgage loans dropping—to 11.4% in October from 19% at the start of 2013—potential sellers may emerge now that their houses are worth more than their mortgages.

Income Polarization

 

Rising equity prices persist not only in the face of a weak economic recovery, including a faltering housing sector, but also a recovery that has been benefiting relatively few. The winners are found in the financial sector and those with brains and skills to succeed in today’s globalized economy that put the low-skilled in direct competition with lower-paid workers in developing lands. The ongoing polarization of incomes illustrates this reality eloquently.

Chart 6 shows that the only share of income that continues to increase is the top quintile. All of the four lower quintiles continue to lose shares. Income polarization is very real in the minds of many. It probably doesn’t bother people too much as long as their real incomes are rising. Sure, their shares of the total may be falling but their purchasing power is going up. But now both the shares and real incomes of most people are falling.



Resentment is being augmented by huge pay packages of the CEOs of big banks that were bailed out by the federal government. The number of billionaires in the world, most of them in the U.S., rose from 1,426 in 2012 to 1,645 last year, far surpassing the 1,125 in 2008.

The leaders of financial institutions and other businesses appear to be setting themselves up as easy targets for President Obama, who is fanning the flames of income inequality with some rather pointed rhetoric. Last year, he said, “Ordinary folks can’t write massive campaign checks or hire high priced lobbyists and lawyers to secure policies that tilt the playing field in their favor at everyone else’s expense. And so people get the bad taste that the system is rigged, and that increases cynicism and polarization, and it decreases the political participation that is a requisite part of our system of self government.”

Minimum Wages

 

Nevertheless, pressure to reduce income inequality remains strong and the Administration’s attempts to raise minimum wages are an obvious manipulation of its efforts in this area. The President issued an executive order raising minimum wages on new federal contracts and in his State of the Union address called for an increase in the federal minimum wage from $7.25 per hour to $10.10 in 2016.

The effects of the minimum wage have been hotly debated for years, no doubt since it was first introduced in 1938, and during each of the nearly 30 times it’s been raised since then, the latest in 2009. Liberals argue that it increases incomes and purchasing power and lifts people out of poverty. Conservatives believe that higher labor costs reduce labor demand, encourage automation, the hiring of fewer high skilled people and result in more jobs being exported to cheaper areas abroad. A new study by the bipartisan Congressional Budget office found that both arguments are true.

The report predicts that 16.5 million workers would benefit from the President’s proposal and lift 900,000 out of poverty from the 45 million projected to be in it in 2016. Earnings of low paid workers would rise $31 billion. Since low income people tend to spend most of their paychecks, higher consumer outlays would result.

But the CBO also predicts that the proposed rise in minimum wages would eliminate 500,000 jobs and because of their income losses, the overall effect on wages would be an increase of only $2 billion, not $31 billion. Also, 30% of the higher pay would go to families that earn three times the poverty level since many minimum wage workers are second earners and teenagers in middle and upper income households. And higher labor costs would retard profits and result in price increases, muting the effects of more spending power by higher minimum wage recipients.

In any event, it appears that the proposed jump in the minimum wage from $7.25 to $10.10 would cause a lot of distortions and no doubt unintended consequences for a net gain in low-wage earnings of just $2 billion. That’s less than a rounding error in the $17 trillion economy and would do almost nothing to narrow income inequality. Regardless of the merits, the evidence suggests that higher federal minimum wages are probably in the cards.

Unemployment

 

By his promotion of an increase in the minimum wage, the President reveals his preference for higher pay for those with jobs over the creation of additional employment. This seems strange politically in an era when unemployment remains very high, especially when corrected for the fall in the labor participation rate (Chart 7).



As also noted earlier, the cutting of costs, especially labor costs, has been the route to the leap in profit margins to record levels and the related strength in corporate earnings in an era when slow economic growth has curtailed sales volume gains, the absence of inflation has virtually eliminated pricing power and the strengthening dollar is creating currency translation losses for foreign and export revenues.

Obamacare

 

One reason for the Administration’s emphasis on income inequality and raising the minimum wage may be to divert attention from the troubled rollout of Obamacare. True, big new government programs always have bugs but the Administration’s overconfidence in initiating Obamacare and the lack of testing of its website is notable. Also, Obama promised that "if you like your plan, you can keep it," but many, in effect, are being forced into high-cost but more comprehensive policies. To reduce the flack it is receiving, the Administration plans for a second time to allow insurers to sell policies that don't comply with the new federal law for at least 12 more months.

Another problem for the Administration is that Obamacare will reduce working hours by the equivalent of 2.5 million jobs by 2024, according to the CBO. People will work less in order to have low enough incomes to qualify for Obamacare health insurance subsidies. Also, older workers who previously planned to keep their jobs until they could qualify for Medicare will cut back their hours or leave the workforce entirely in order to qualify for Medicare, the federal-state programs for low-income folks that are being expanded under Obamacare.

Hospitals may benefit from Obamacare. Under a 1970s-era law, they must shoulder the emergency room costs of the uninsured, but those risks are being shifted to insurers and taxpayers. Taxpayers will also pay more since 25 states have refused to expand Medicaid, leaving the federal government to set up and run the enhanced programs.

More Medical Costs

 

Not only is Obamacare proving unaffordable for many but also promises huge additional costs for the government. Healthcare outlays have been leaping and were already scheduled to continue skyrocketing under previous laws as the postwar babies retire and draw Medicare benefits while Medicare costs leap.

The original projected jump in insured people under Obamacare was not projected by the Administration to increase the government’s health care costs appreciably from what they otherwise would have been. You might recall, however, that when Obamacare was enacted, we noted in Insight that after Medicare was introduced in 1967, the House Ways and Means Committee forecast its cost at $12 billion in 1990. It turned out to be $110 billion—nine times as much. Obamacare is no doubt destined for the same cost overruns.

Acting in what they perceive to be their best economic interest, elderly people and those in poor health—but not healthy folks—have persevered through the government website labyrinth to sign up for healthcare exchanges. They're taking advantage of the law's ban on discrimination based on health conditions and age-related premiums. Many healthy people, on the other hand, don’t want to pay higher premiums than on their existing policies, and many of those who are uninsured want to remain so.

So, to make insurance plans economically viable, in the absence of younger, healthy participants to pay for the ill ones, insurers will need to be subsidized by the government or premiums will need to be much higher and therefore much less attractive to all but the chronically ill. This self-reinforcing upward spiral in health care insurance premiums would no doubt also require substantial government subsidies. Aetna expects to lose money this year on its health care exchanges due to enrollment that is skewed more than expected to older people.

Many of the young, healthy people needed to make Obamacare function as a valid insurance fund would rather pay the penalty, which begins at $95 for this year, and continue to use the emergency room instead for medical treatment. Even the escalation of the penalty from $150 in 2014 for a single person earning $25,000 to $325 in 2015 and $695 in 2016 may not spur sign-ups. In total, there are 11.6 million people ages 18 to 34 who are uninsured, a big share of the 32 million Obamacare is intending to insure.

Some employers, especially smaller outfits, plan to encourage employees to sign up for exchanges and drop company plans. The government could push up the now-low penalties for not signing up to force participation, but we doubt that the Administration would risk the ire of an already-unhappy public in pursuing this approach. On balance, the taxpayer cost of Obamacare seems destined to exceed vastly the $2 billion originally projected gap.

The Fed

 

The Fed is on course to continue reducing its monthly purchases of securities and at the current rate, would cut them from $65 billion at present to zero late this year. The minutes of the Fed’s January policy meeting indicate that it would take a distinct weakening of the economy to curtail another $10 billion cut in security purchases in March.

The tapering of the Fed’s monthly security purchases only reduced the ongoing additions to the staggering pile of $2.5 trillion in excess reserves. That’s the difference between the total reserves of member banks at the Fed, created when the central bank buys securities, and the reserves required by the bank’s deposit base. Normally, banks lend and re-lend those reserves and each dollar of them turns into $70 of M2 money.

But with banks reluctant to lend and regulators urging them to be cautious while creditworthy borrowers are swimming in cash, each dollar of reserves has only generated $1.4 in M2 since the Fed’s big asset purchase commenced in August 2008.

At present, those excess reserves amount to no more than entries on the banks’ and the Fed’s balance sheets. But when the Age of Deleveraging ends in another four years or so and real GDP growth almost doubles from the current 2% annual rate, those excess reserves will be lent, the money supply will leap and the economy could be driven by excess credit through full employment and into serious inflation. So as the Fed is well aware, its challenge is, first, to end additions to those excess reserves through quantitative easing and then eliminate them by selling off its huge securities portfolio. This will be Yellen’s major job, assuming she's still chairwoman in coming years.

Raise Rates?

 

Last spring, when the Fed began to talk of tapering its monthly security purchases, investors assumed that to mean simultaneous increases in interest rates, so Treasury notes and bonds sold off as interest rates jumped. In the course of 2013, however, the Fed’s concerted jawboning campaign convinced markets that the two were separate policy decisions and that rate-raising was distant. Still, as in almost every year since the great rally in Treasury bonds began in 1981 (Chart 8), the chorus of forecasters at the end of 2013 predicted higher yields in 2014.



“Treasury Yields Set To Resume Climb,” read a January 2 Wall Street Journal headline. It cited a number of bond dealers and investors who expected the yield on 10-year Treasury notes to rise from 3% at the end of 2013 to 3.5% a year later or even 3.75%. They cited a strengthening economy, Fed tapering and higher inflation. Many investors rushed into the Treasury’s brand new floating rate 2-year notes when they were issued in January in anticipation of higher rates. About $300 billion in floating-rate securities already existed, issued by Fannie Mae and Freddie Mac as well as the U.K. and Italian governments.

Nevertheless, Treasurys have rallied so far this year as the 10-year note yield dropped to 2.6% on March 3 from 3.0% at the end of 2013. U.S. economic statistics so far this year are predominantly weak, as noted earlier. Emerging markets are in turmoil. China’s growth is slowing.

Inflation

 

Besides concerns over the sluggish economic recovery and chronic employment problems, the Fed worries about too-low inflation, which remains well below its 2% target, and over the threat of deflation.

As discussed in our January 2014 Insight, there are many ongoing deflationary forces in the world, including falling commodity prices, aging and declining populations globally, economic output well below potential, globalization of production and the resulting excess supply, developing-country emphasis on exports and saving to the detriment of consumption, growing worldwide protectionism including competitive devaluation in Japan, declining real incomes, income polarization, declining union memberships, high unemployment and downward pressure on federal and state and local government spending.

Very low inflation is found throughout developed countries (Chart 9). It ran 0.8% in the eurozone in January year over year, well below the target of just under 2%. In Germany, where employment is high, inflation was 1.2% but lower in the southern weak countries with 0.6% in Italy, 0.3% in Spain and a deflationary minus-1.4% in Greece in January from a year earlier. In the U.K., inflation in January at 1.9% was just below the Bank of England’s 2% target.


 

Chronic Deflation Delayed

 

We’ve noted in past Insights that aggressive monetary and fiscal stimuli probably have delayed but not prevented chronic deflation in producer and consumer prices (see “What’s Preventing Deflation?,” Feb. 2013 Insight). Still, this year may see the onset of chronic global deflation. And it will probably be a combination of the good deflation of new technology- and globalization-driven excess supply with the bad deflation of deficient demand.

Why do the Fed and other central banks clearly fear deflation and fight so hard to stave it off? There are a number of reasons. Steadily declining prices can induce buyers to wait for still-lower prices. So, excess capacity and inventories result and force prices lower. That confirms suspicions and encourages buyers to wait even further. Those deflationary expectations are partly responsible for the slow economic growth in Japan for two decades.

Central banks also worry that with deflation, it can’t create negative interest rates that encourage borrowers to borrow since, then, in real terms, they’re being paid to take the filthy lucre away. Since central bank target rates can’t go below zero, real rates are always positive when price indices are falling. This has been a problem in Japan many times in the last two decades (Chart 10). Furthermore, credit authorities fret that if chronic deflation sets in, it can’t very well raise interest rates. That means it would have no room to cut them as it would prefer when the next bout of economic weakness threatens.



Central banks also are concerned that deflation raises the real value of debts and could produce considerable financial strains in today’s debt-laden economies. In deflation, debt remains unchanged nominally, but as prices fall, it rises in real terms. Since the incomes and cash flows of debtors no doubt fall in nominal terms, their ability to service their debts is questionable. This makes banks reluctant to lend.

Governments also worry about the rising real cost of their debts in deflation, especially when slow growth makes it difficult to reduce even nominal debts in relation to GDP. This is the dilemma among the Club Med eurozone countries. Deflationary cuts in wages and prices make them more competitive but raises real debt burdens.

Emerging Markets: Sheep and Goats

 

As noted earlier, the agonizing reappraisal of emerging economies by investors commenced with the Fed’s taper talk last May and June. Investors have been forced to separate well-managed emerging economies, the good guys, or the Sheep that, in the Bible, Christ separated from the bad guys, the Goats with poorly-run economies.

Our list of Sheep—South Korea, Malaysia, Taiwan and the Philippines—have current account surpluses, which measure the excess of domestic saving over domestic investment. So they are exporting that difference, which gives them the wherewithal to fund any outflows of hot money. The Sheep also have stable currencies against the U.S. dollar, moderate inflation and fairly flat stock markets over the last decade. Also, with their current account surpluses, the Sheep haven’t been forced to raise interest rates in order to retain hot money.

In contrast, the Goats have negative and growing current account deficits. These countries include the “fragile five”—Brazil, India, Indonesia, South Africa and Turkey—with basket case Argentina thrown in for good measure. They also have weak currencies, serious inflation and falling stock markets on balance. These Goats rely on foreign money inflows to fill their current account deficits, so when it leaves, they’re in deep trouble with no good choices. They’ve raised interest rates to try to retain and attract foreign funds. Higher rates may curb inflation and support their currencies but they depress already-weak economies while any strength in currencies is negative for exports.

The alternative is exchange controls, utilized by Argentina as well as Venezuela. That’s why Argentina hasn’t bothered to increase its central bank rate. But these policies devastate already-screwed up economies. In Argentina, artificially-low interest rates and soaring inflation encourage Argentinians to spend, not save. Inflation is probably rising at about a 40% annual rate this year, up from 28% in 2013 but officially 11%. Purchasers are frustrated because retailers don’t want to sell their goods, knowing they’ll have to replace inventories at higher prices—if they can obtain them.

Who Gives? Who Gets?

 

In some ways, even the Goats among emerging economies are better off than they were in the late 1990s. Back then, many had fixed exchange rates and borrowed in dollars and other hard foreign currencies. So they didn’t want to devalue because that would increase the local currency cost of their foreign debts. Consequently, they all were vulnerable and fell like dominoes when Thailand ran out of foreign currency reserves in 1997. That touched off the 1997-1998 Asian crisis that ultimately spread to Russia, Brazil and Argentina.

Today, less foreign borrowing, more debts in local currencies and flexible exchange rates make adjustments easier. Still, as discussed earlier, the sharp currency drops that are seen promote inflation, but raising interest rates to protect currencies depresses economic growth. Either way, it's no-win in Goatland.

Furthermore, as our friends at GaveKal research point out, current account balances globally are a zero sum game, so if the Goats’ current account deficits decline, other countries’ balances must weaken. This is difficult in an era of slow growth in global trade. Which countries will volunteer to help out the Goats? Not likely the Sheep. Not the U.S. As noted earlier, the Fed has said clearly that the emerging countries are on their own. China isn’t likely as overall growth slows and both import and export order indices in China's Purchasing Managers Index have dropped below 50, indicating contraction. Furthermore, China maintains her mercantilist bias and isn’t overjoyed with her much diminished recent current account and trade balances.
A collapse in oil prices would transfer export earnings from OPEC to energy-importing Goats but oil shocks as a result of a Middle East crisis or an economic collapse and revolution in Venezuela seem more likely. Japan is going the other way, with the Abe government’s trashing of the yen designed to spike exports, reverse the negative trade balance and the soon-to-go-negative current account. The eurozone is also unlikely to help the Goats due to its slow growth and attempts by the Club Med South, mentioned earlier, to become more competitive and improve their trade balances.

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    *   Risk Management Tips
    *   Ways to Increase Your Account and Scale
    *   Using Mini and Weekly Options to trade the big names for a fraction of the cost
    *   An exact road map to follow to start trading options now
    *   Minimize risk but still participate for maximum upside
    *   Strategies for the small account trader to use now with options and a trading system with training included

Want to know how to do it?

Successfully Trading Options with a Small Account - Including High Flying Tech Stocks!

This Thursday, April 10th, 2014
Three times to choose from....12 pm EDT / 9 am PDT / 4 pm GMT

Register Online Right Now

In this webinar, we'll teach you the finer points on how to trade big name stocks with small time capital.

Just Click Here to Reserve Your Logins for Thursday!

See you in the markets!

P.S. Can't make it on Thursday?  Reserve your seat anyways and we'll send you the recording! 



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Tuesday, April 8, 2014

ETF Trading Newsletter - CORN ALERT

We have been watching the commodities index rally for a few weeks now with natural gas, coffee, sugar, gold, silver and several others jump in price. We have been watching the corn ETF "CORN" which is a basket of several commodities to get a feel for the commodities market as a whole.

While most of the commodities have posted some solid gains, corn has yet to pop in price. Corn looks to be forming a stage 1 basing pattern and the volume/money flowing into this fund suggest new money is moving into corn because it looks as though it will be the last to pop and rally in price.

This is similar to how we entered the silver trade a few weeks back. Everything else in the precious metals sector popped and silver lagged giving us a high probability setup.

Both the short and long term the charts of corn look bullish. As usual I will lock in some gains if we get a pop in the commodity, then let the balance ride with a break even stop. If corn is entering a new bull market phase (Stage 2) I want to hold some long term. There is potential for a 19%-30% rise in value.

Corn Trade Information:
 
Buy corn ETF "CORN", Stop $29.90, Downside Risk 6%, Portfolio Size 6%

ETF Trading Newsletter - Corn


Consider joining my group of happy traders today at: The Gold & Oil Guy

Chris Vermeulen


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Learn to Trust Your Own Financial Judgment


Keep this goal in mind as you read on: solid income and growth with minimal risk and no catastrophic losses. Just tuck it in the back of your head.


Subscriber Brian A. wrote sharing a common concern:

"I subscribe to your newsletter for the purpose of diversifying my portfolio as well as taking more responsibility for my investment future. … I look at the soaring S&P and Dow and wonder if both are appreciating from strong fundamentals, or from the Fed's easy money policy. … I listen to my broker who spouts out information of a resurgence of manufacturing coming back to US soil and (says) equities are the place to be for the near future. The other side spouts banks are insolvent, businesses are closing, (and) if it wasn't for the Fed propping things up we would be in a recession. Some say we are in a recession. I would like to see you devote an article on the subject of the 'don't worry be happy' crowd verses the 'doom and gloom' crowd."

Well, Brian, ask and ye shall receive. My recommendation, as always, is to look at the data, decide for yourself which camp you fall in—if either—and invest accordingly.

Folks who think things are turning around generally point to statistics published by the Congressional Budget Office (CBO). These numbers—the unemployment and inflation rates and the Consumer Price Index in particular—are used by the Federal Reserve to make or change policy. Those decisions affect the economy and the stock market.

If you swallow these numbers, you can point to a trend line going up. You may not think "happy days are here again," but you could make a case that we are headed in the right direction.

In contrast, the "gloom and doom" crowd point to data from statisticians like John Williams at Shadow Government Statistics, who make a good case against the accuracy of official government data. Williams' alternatives to the CPI, official inflation rate, and unemployment rate paint a much different picture.

Unemployment offers an easy example. When a person stops looking for work, the CBO no longer considers him unemployed. I guess that means if everyone just stopped looking, the unemployment problem would be solved.

Many in the gloom-and-doom crowd distrust the government and believe its statistics are produced for the benefit of politicians.

The gap between these two camps is wide. We recently published a special report called Bond Basics, offering safe ways to find yield in the current economy. Shortly after releasing our report, I attended a workshop with one of the top bond experts at a major brokerage firm. As I listened to his excellent presentation, I realized we agreed on many points: interest rates seem to be going up, the value of laddering and diversification, etc. We also agreed that investors (not traders) should buy bonds for one purpose: safe retirement income.

This speaker, however, recommended that baby boomers and retirees buying individual bonds only buy investment grade bonds and ladder them over an eight year period. Each year some would mature, and retirees would then replace them with other eight-year bonds. In a rising rate environment, retirees would eventually catch up he claimed. This expert mentioned inflation only once, remarking that it is "under control" and should remain low.

I went to the company's website and discovered that five year AAA bonds were paying 1.92%, and ten year bonds were paying 3.41%.

Then I went to Shadow Government Statistics. The official inflation rate as indicated by the CPI is hovering around 1.8%. However, using the same method used for calculating the CPI in 1990 (the government has changed the formula many times), the current rate comes to approximately 5.5%.
Now, it only makes sense to invest in long-term, high-quality bonds if you truly believe the government's CPI statistics. If, however, you that suspect inflation isn't quite so under control—even if you don't believe it's 5.5%—why would you invest in an eight-year bond that's virtually certain to lose to inflation?

The same logic applies to unemployment numbers. The official number is around 6.7% and coming down. Alternative calculations show a double digit unemployment rate that is rising. Should you invest heavily in stocks now? It depends again on whom you believe.

How should this affect your approach? If you hold the majority of your nest egg in cash or low-yield investments, you are losing ground to inflation. On the other hand, going all in the market if you are uncertain that the economy is improving could be equally disastrous.

A word of caution: do not let fear of getting it wrong immobilize you! It can be a very costly mistake. Keep learning and researching until you find investments you are comfortable with.

Let's look at the best- and worst-case scenarios with long term bonds. If you follow the advice of a bond salesman, you'll buy long-term corporate bonds. Ten year, AAA rated bonds currently yield around 3.41%. Assuming the bond trader is correct and inflation is not an issue, the best you could earn is 3.41%. Is that enough to get excited about when you factor in taxes and the risk of inflation?

In a recent article, I shared an example of a hypothetical investor who bought a $100,000, five-year, 6% CD on January 1, 1977. If he'd been in the 25% tax bracket, his account balance after interest would have been $124,600 at the end of five years. That's a 25.9% reduction in buying power because of high inflation during that five year period.

In that light, 3.41% does not look quite so appealing. Yes, inflation was particularly high during the Carter era, so apply a bit of common sense to the example. Nevertheless, what has caused inflation in the past? In general terms, governments spending money they don't have and printing money to make up the difference. Argentina is a timely example of this folly.

These concerns are why our research team and I paired up to produce Bond Basics. We think there are better risk and reward opportunities than long-term bonds available in today's market.

Investing in stocks is a different story. We cannot keep up with inflation and provide enough income to supplement retirement needs with bonds alone (unless you have a huge portfolio and are willing to buy higher-risk bonds). That's why our team picks stocks with surgical precision. We run them through our Five Point Balancing Test, recommend strict position limits, diversify across many sectors, and use appropriate stop losses.

Our premium publication is named Miller's Money Forever for good reason. We want to help you grow your nest egg in the safest possible manner under any market conditions. Neither the happy days nor the doomsday crowd can predict the future, so we prepare for all possibilities.

You've likely heard the refrain, "Inflation or deflation? Yes." It's a favorite of our friend John Mauldin. With that, baby boomers and retirees are forced to become kitchen-table economists and to sift through statistics that may or may not be accurate.

I haven't been shy about my opinion: I don't think the economy is improving, so retirees need to risk more than they would like in the market. That's why our Bulletproof Income strategy prepares for all market possibilities as safely as possible.

Whom should you believe? Well, is the person speaking trying to sell you something? Stockbrokers trying to garner your business tend to be optimistic about the economy. If someone is trying to sell gold or foreign currency investments, they are likely to cite a history of rising inflation and explain how their product can protect you. It doesn't mean either is wrong. And yes, the same point applies to the humble authors of investment newsletters.

At Miller's Money we share the reasoning behind every recommendation we make. We want our subscribers to know as much as we do about every pick—pros and cons. If you agree with our reasoning, act on our advice. If not, or if you have additional questions, ask us or sit tight for another pick. Never invest in something you don't understand or are uncomfortable with no matter who recommends it.

The bottom line is you have to read, learn, do your own research, and make your own judgments. Listen to all sides of any argument, and then do what you think is best.

What could be more important to baby boomers and retirees than protecting their money? Take the time necessary to teach yourself. In time you will become more comfortable trusting your own judgment. If you were savvy enough to make money, you are savvy enough to learn how to invest and protect it. Give yourself credit where it's due.


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The article Learn to Trust Your Own Financial Judgment was originally published at Millers Money.


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Monday, April 7, 2014

The Lions in the Grass, Revisited

By John Mauldin


“In the economic sphere an act, a habit, an institution, a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them.

“There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.

“Yet this difference is tremendous; for it almost always happens that when the immediate consequence is favorable, the later consequences are disastrous, and vice versa. Whence it follows that the bad economist pursues a small present good that will be followed by a great evil to come, while the good economist pursues a great good to come, at the risk of a small present evil.”

– From an 1850 essay by Frédéric Bastiat, “That Which Is Seen and That Which Is Unseen”

I’ve come to South Africa a little bit ahead of my speaking tour next week to spend a few days “on safari.” Which is another way to say that I am comfortably ensconced in a game lodge next to Kruger Park, relaxing and trying to get some time to think. We’ve been reasonably lucky on the game runs: besides the usual lions, rhinoceri, water buffalo, etc., we’ve seen both cheetah and leopard, two animals that avoided my vicinity on every other trip to Africa. I’m here at the end of the rainy season, so everything is lush and green, and you have to get a little lucky to find the animals in the dense bush.

In several moments here, I was reminded of an essay I wrote two years ago called “The Lion in the Grass.” So I went back and read it and decided to update it fairly extensively in order to talk about the hidden lions we don’t see today that could catch us unawares tomorrow. Just like the African bush I am surveying at this moment, the economic landscape out there could harbor some serious but still unseen problems.

I have been captivated by the concept of the seen and the unseen in economics since I was first introduced to the idea. It is a seminal part of my understanding of economics, at least the small part I do grasp. It was introduced by Frédéric Bastiat, a French classical liberal theorist, political economist, and member of the French assembly. He was notable for developing the important economic concept of opportunity cost. He was a strong influence on von Mises, Murray Rothbard, Henry Hazlitt, and even my friend Ron Paul. (I will have to ask Rand about his familiarity with the Frenchman the next time I see him.) Bastiat was a strong proponent of limited government and free trade, but he also advocated that subsidies (read stimulus?) should be available for those in need. “[F]or urgent cases, the State should set aside some resources to assist certain unfortunate people, to help them adjust to changing conditions.”

Today we explore a few things we can see and then try to foresee a few things that are not quite so obvious. The simple premise is that it is not the lions we can see lounging in plain view that are the most insidious threat, but rather that in trying to avoid those we may stumble upon lions hidden in the grass.

But first, I really want to urge you to consider joining me in San Diego May 13-16 for my Strategic Investment Conference. We are continuing to fill out the strongest list of speakers we’ve ever had in our 11 years at this. My good friends George Gilder, Stephen Moore of the Wall Street Journal, and Neil Howe (who wrote The Fourth Turning) have all agreed to come and join Niall Ferguson, Newt Gingrich, Kyle Bass, David Rosenberg, and a dozen other A-list speakers from around the world. You can see who else will be there by clicking on the link above or here.

And I’m especially honored and pleased to announce that Vice Admiral Robert S. Harward, Jr., has agreed to join us on Wednesday night as a special keynote speaker. The three-star admiral (just recently retired) is a Navy SEAL and former Deputy Commander of the United States Central Command. In addition to his numerous other positions and awards, he also held the title of “Bull Frog” from 2011 until 2013 (longest-serving SEAL on active duty).

This is simply the finest economic and investment conference anywhere in the country. Don’t procrastinate; make your plans to come and register now.

The Lion in the Grass

When I was discussing this concept with Rob Arnott (of Research Affiliates and the creator of Fundamental Indexes) in Tuscany a few years ago, he mentioned the following photo, which he took on the savannah in Tanzania. I think it’s a perfect way to start out our discussion of the lions in the grass.



Going back to Bastiat, let’s look at that first sentence:

In the economic sphere an act, a habit, an institution, a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them.

It is natural to focus on the apparent dangers in front of us. That is part of our evolutionary heritage from the time when humans were first dodging lions and chasing antelopes on the very African savannah in Rob’s picture. But we soon learned that, if we were to survive, it wasn’t enough to dodge the lions we could see. It is the hidden lions that may spring upon us suddenly and take an arm or a leg.

Below I have once again reproduced Rob’s picture. Even when I knew there was a hidden lion, I couldn’t find it. But after it was pointed out to me, it is now the first thing I see. And there is a direct analogy there, to both economics and investing.

So, before you go to the next page, I suggest you go back and look one more time to see if you can spot the hidden lion. Just for fun, you know.

I showed this to a friend of mine who is a hunter, and he found it almost immediately. But then he has taught himself over the years to look for hidden game. And as Bastiat noted, it is the skilled economist who looks for the effects that are hidden, the surprises that are unseen. It should be a habit to look at the potential second- and third-order consequences of what we can see happening before our eyes. That way, we not only avoid the hidden lions, we also turn what would hunt us and do us harm into the hunted. Sometimes, the dangers themselves can be turned into a very nice trophy indeed – if you can act in time.

As I noted, that previously invisible lion is now the first thing I see. And that is the way with economic lions in the grass. Once someone points one out, it’s obvious, so obvious that we soon convince ourselves that we would have seen the lion without help. How many people told you they “knew” all along that subprime debt was going to end in tears? Or that the housing market was a bubble? Or that we would be plunged into the Great Recession?

I remember that in the fall of 2006 I was beginning to talk about the probability of a recession, in this letter, in speeches, and in numerous media interviews. (There is one such episode still up on YouTube.)  I was told I was ignoring what the market was telling us, and indeed the market proceeded to go up for another six months or so. Being early is lonely. Me and Nouriel. J

Today there are a lot of people who tell us they knew there was a recession coming all along. In fact, the farther we get from 2006, the greater the number of people who remember making that call. It now seems I had no reason to feel so lonely out there on that limb, scanning the tall grass of the savannah. In retrospect, it seems that limb was rather crowded.

So, with that in mind, let me show you where the other lion is. Then go back and look at the first picture. After a few times you will see the hidden lion almost before you see the obvious ones.



Black Swan or Hidden Lion?

I should note that a lion in the grass is different from a black swan. A black swan is a random event, something which takes us all by surprise. Economic black swans are actually quite rare – 9/11 was a true black swan. Other than Nostradamus some 500 years ago, who saw it coming?

The last recession and the credit crisis were not true black swans. There were those who saw it all coming, but few paid attention. They were dancing right along with Chuck Prince to the rousing music of a bull market and swelling profits.

As we know now, a few people saw the subprime crisis coming and made huge fortunes. Sadly, pulling that off generally required one to risk a small fortune to play in that game. So while I talk about the lions hidden in the grass, remember that if you can figure out how to play it, there can be large profits betting on that which is unseen by the markets.

Now, let’s look at a few obvious lions and then see if we can spot a few hidden lions lurking nearby.

The Lions in Europe

By some miracle, Mario Draghi and his team at the European Central Bank (ECB) continue to get from their communication tools what most central banks have to take by force. Widespread complacency has washed over the region in the months and quarters since July 2012, when Mr. Draghi introduced the Outright Monetary Transactions (OMT) facility and adamantly promised to do “whatever it takes” to preserve the euro system.

As a result, government borrowing costs are converging back to pre-crisis levels even as falling inflation brings the next debt crisis forward … and markets are clearly still responding to the ECB’s increasingly hollow commitments.

Without changing the ECB’s main policy rate at this week’s monetary policy meeting, Mr. Draghi once again attempted to talk his way to a policy outcome by suggesting that he has the broad based support to authorize quantitative easing, if and when it is needed. It will be needed – and maybe soon.

As I wrote late last year, European banks are in terrible shape compared to U.S. banks. We think of German banks as the epitome of sobriety, but they have been on a lending binge to creditors who now appear to be in financial trouble; and with 30- or 40-1 leverage, they could easily see their capital fall below zero. Despite modest bank deleveraging across the Eurozone since early 2012…



… public and non-bank private debt burdens have not improved:



Low inflation is also seriously disrupting government debt trajectories. The analysis below from Bank of America Merrill Lynch shows how low inflation, near 0.5%, raises debt trajectories in France and Italy that would be a lot lower under a normal, 2%, inflation scenario. As the charts show, persistent “lowflation” for several years could add another 10% to 15% to the public debt to GDP ratio in each country … even if rates stay where they are today.

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.

 


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Saturday, April 5, 2014

The Odds Are In Your Favor To Trade Gold This Quarter

Using MarketClub's weekly and daily Trade Triangles, I have found that over the last 6 1/2 years, the second quarter of the year has shown the most consistent profits in gold. These past results showed a quarterly gain on average of $7,104.83 on one futures contract.

Gold (XAUUSDO) enjoyed a nice move up earlier in the year, reaching a high of $1393.35 and has pulled back to an important Fibonacci support area. I want to watch this market very carefully and wait for the weekly Trade Triangle to turn green to get bullish on gold. That's not to say I am not longer term bullish, it only means that my timing will kick in when the weekly Trade Triangle turns into a green Trade Triangle.



Besides the Fibonacci support area, the RSI indicator is also at a very low level, similar to that of December 2013.

Trading Results

Q2 of 2008            $965.00
Q2 of 2009            $870.00
Q2 of 2010         $7,057.00
Q2 of 2011         $6,700.00
Q2 of 2012         $4,223.00
Q2 of 2013       $31,260.00
TOTAL             $42,629.00
AVE GAIN         $7,104.83

The results are based on signals using MarketClub's real time spot gold prices and margin of $8,333. This particular trading strategy and results are based on trading one futures contract, both from the long and short side. An ETF could be substituted, but I suspect the results would be quite different.

Trading Rules

How to use MarketClub's Trade Triangles to trade gold:

Use the weekly Trade Triangle to determine the major trend and initial positions. Use the daily Trade Triangles for timing purposes.

Gold entry and exit signals are generated from the spot Gold (XAUUSDO) chart.

Let me give you an example: if the last weekly Trade Triangle is GREEN, this indicates that the major trend is up for that market. You would use the initial GREEN weekly Trade Triangle as an entry point. You would then use the next RED daily Trade Triangle as an exit point. You would only reenter a long position if and when a GREEN daily Trade Triangle kicked in.

You would then use the next RED daily Trade Triangle as an exit point, provided that the GREEN weekly Trade Triangle is still in place and the trend is positive for that market. The reverse is true when you have a RED weekly Trade Triangle. You would use the initial RED weekly Trade Triangle as an entry point for a short position. You would then use the next GREEN daily Trade Triangle as an exit point.

Only Trade With Risk Capital

Even if the odds are in your favor, don't forget that there are no guarantees in trading and only funds that you can afford to lose should be used to trade with.

See you in the markets!
Adam Hewison

Make sure to catch Adam on INO TV



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Thursday, April 3, 2014

What Is Worse Than Being at Risk?

By Dennis Miller

You may have heard the old adage: “What is worse than being lost? Not knowing you are lost.” In that same vein: What is worse than being at risk? You guessed it! Not knowing you’re at risk. For many investors, portfolio diversification is just that. They think they are protected, only to find out later just how at risk they were.

Diversification is the holy grail of portfolio safety.

Many investors think they are diversified in every which way. They believe they are as protected as is reasonably possible. You may even count yourself among that group. If, however, you answer “yes” to any of the following questions, or if you are just getting started, I urge you to read on.
  • Did your portfolio take a huge hit in the 2008 downturn?
  • Was your portfolio streaking to new highs until the metals prices came down a couple years ago?
  • Do oil price fluctuations have a major impact on your portfolio?
  • When interest rates tanked in the fall of 2008, did a major portion of your bonds and CDs get called in?
  • Are you nervous before each meeting of the Federal Reserve, wondering how much your portfolio will fluctuate depending on what they say?
  • Has your portfolio grown but your buying power been reduced by inflation?
  • Do you still have a tax loss carry forward from a stock you sold more than three years ago?
There are certain lessons most of us learn the hard way—through trial and error. But that can be very expensive. Ask anyone who has a loss carry forward and they will tell you that the government is your business partner when you are winning. When you are losing, you are on your own.

The old saying rings true here: “When the student is ready to learn, the teacher shall appear.” Sad to say, for many investors that happens after they have taken a huge hit and are trying to figure out how to prevent another one.

Alas, there is an easier way. Anyone who has tried to build and manage a nest egg will agree it is a long and tedious learning experience. The key is to get educated without losing too much money in the meantime.

Avoid Catastrophic Losses

The goal of diversification is to avoid catastrophic losses. In the past, we’ve mentioned correlation and shared an index related to our portfolio addition. The scale ranges from +1 to -1. If two things move in lockstep, their correlation rates a +1. If the price of oil goes up, as a general rule the price of oil stocks will also rise.

If the two things move in the opposite direction (a correlation of -1), we can also predict the results. If interest rates rise, long term bond prices will fall and generally so will the stocks of homebuilders. At the same time, a correlation of zero means there is no determinable relationship. If the price of high grade uranium goes up, more than likely it will not affect the market price of Coca Cola, ticker $KO, stock. So, your goal should be to minimize the net correlation of your portfolio so no single event can negatively impact it catastrophically.

General Market Trends

An investor with mutual funds invested in Large Cap, Mid Cap, and Small Cap stocks may think he is well diversified with investments in over 1,000 different companies. Ask anyone who owned a stable of stock mutual funds when the market tumbled in 2008 and they will tell you they learned a lesson.

Mr. Market is not known to be totally rational and many have lost money due to “guilt by association.” When the overall stock or bond market starts to fall, even the best managed businesses are not immune to some fallout. While the Federal Reserve has pumped trillions of dollars into the system, there is no guarantee the market will rebound as quickly as it has in the last five years. The market tanked during the Great Depression and it took 25 years to return to its previous high.

If you listen to champions of the Austrian business cycle theory, they will tell you the longer the artificial boom, the longer and more painful the eventual bust. Mr. Market can dish out some cruel punishment.
Diversification is indeed the holy grail, but there are some risks which diversification cannot mitigate entirely. No matter how hard you try to fortify your bunker, sooner or later we will learn of a bunker buster. There are times when minimizing the damage and avoiding the catastrophic loss is all anyone can do.

Sectors

Allocating too much of your portfolio to one sector can be dangerous. This is particularly true if a single event can happen that could give you little time to react. While no one predicted the events of September 11, people who held a lot of airline stocks took some tough losses. Guilt by association also applied here. After September 11, the stocks of the best-managed airlines, hotels, and theme parks took a downturn.

When the tech bubble and real estate bubble burst, the stock prices of the best-run companies dropped along with the rest of the sector, leaving investors to hope their prices would rebound quickly.

Geography

One of the major factors to consider when investing in mining and oil stocks is where they are located. It is impossible to move a gold mine or an oil well that has been drilled. Many governments are now imposing draconian taxes on these companies, which negatively impacts shareholders. In some cases, this can be a correlation of -1. If an aggressive government is affecting a particular oil company, other companies in different locations may have to pick up the slack and their stock may rise in anticipation of increased sales.

Many governments around the world have become very aggressive with environmental regulation, costing the industry billions of dollars to comply. If you want to invest in companies that burn or sell anything to do with fossil fuels, you would do well to understand the political climate where their production takes place.
Investors who prefer municipal bonds must make their own geographical rating on top of the ratings provided for the various services. States like Michigan and Illinois are headed for some rough times. I wouldn’t be lending any of them my money in the current environment no matter what the interest rate might be.

Currency Issues

Inflation is public enemy number one for seniors and savers. One of the advantages of currencies is they always trade in pairs. If one currency goes up, another goes down. If the majority of your portfolio is in one currency, you are well served to have investments in metals and other vehicles good for mitigating inflation.

Tim Price sums it up this way in an article posted on Sovereign Man:

“Why do we continue to keep the faith with gold (and silver)? We can encapsulate the argument in one statistic.
“Last year, the US Federal Reserve enjoyed its 100th anniversary. … By 2007, the Fed’s balance sheet had grown to $800 billion. Under its current QE program (which may or may not get tapered according to the Fed’s current intentions), the Fed is printing $1 trillion a year. To put it another way, the Fed is printing roughly 100 years’ worth of money every 12 months. (Now that’s inflation.)”
It is difficult to determine when the rest of the world will lose faith in the U.S. dollar. Once one major country starts aggressively unloading our dollars, the direction and speed of the tide could turn quickly.


Interest-Rate Risk

The Federal Reserve plays a major role in determining interest rates. Basically they have instituted their version of price controls and artificially held interest rates down for over five years. Interest-rate movement affects many markets: housing, capital goods, and some aspects of the bond markets. While it also makes it easier for businesses to borrow money, they are not likely to make major capital expenditures when they are uncertain about the direction of the economy.

While holders of long term, high interest bonds had an unexpected gain when the government dropped rates, their run will eventually come to an end as rates rise. Duration is an excellent tool for evaluating changes in interest rates and their effect on bond resale prices and bond funds. (See our free special report Bond Basics, for more on duration.)

While interest rates have been rising, when you factor in duration there is significant risk, even with the higher interest offered for 10- to 30-year maturities. Again, having a diversified portfolio with much shorter term bonds helps to mitigate some of the risk.


Risk Categories of Individual Investments

While investors have been looking for better yield, there has been a major shift toward lower-rated (junk) bonds. Many pundits have pointed out that their default rate is “not that bad.”

At the same time, the lure of highly speculative investments in mining, metals, and start-up companies with good write-ups can be very appealing. There is merit to having small positions in both lower-rated bonds and speculative stocks because they offer terrific potential for nice gains.

So What Can Income Investors Do?

There are a number of solid investments out there that offer good return, with a minimal amount of risk exposure and that won’t move because of an arbitrary statement by the Fed. It’s not always easy to find them, but there is hope for people wondering what to do now that all of the old adages about retirement investing are no longer true.

There are three important facets of a strong portfolio: income, opportunities and safety measures. Miller's Money Forever helps guide you through the better points of finance, and helps replace that income lost in our zero-interest-rate world—with minimal risk.

This is where the value of one of the best analyst teams in the world comes into focus. We focus on our subscribers’ income-investing needs, and I challenge our analysts to find safe, decent-yielding, fixed-income products that will not trade in tandem with the steroid-induced stock market—or alternatively, ones that will come back to life quickly if they do get knocked down with the market. They recently showed me seven different types of investments that met my criteria and still withstood our Five Point Balancing Test.

My peers are of having holes blown in their retirement plans. While nuclear bomb shelter safe may be impossible, we still want a bulletproof plan. This is what we’ve done at Money Forever: built a bulletproof, income generating portfolio that will stand up to almost anything the market can throw at it.

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The article What Is Worse Than Being at Risk? was originally published at Millers Money


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Wednesday, April 2, 2014

Marc Faber: Don’t Keep Your Gold and Silver in the U.S.

Gloom, Boom and Doom Report publisher Marc Faber discusses the fragile state of the U.S. and global financial systems. How rising inflation will affect the average American. How soon the bubble will burst and why gold and silver will triumph.  

 

Here are a few highlights:

 

“The U.S. is a country that likes to create trouble, but they don’t like to clean up things.”

“We’ve now been five years into the bull market and the U.S. economy bottomed out in June 2009. We already had a crack up boom—not in the economy of the typical household, but in the economy of the "super well to do people", whose asset prices rose dramatically and as a result created a huge wealth inequality.”

“My view would be that we have already printed so much money, and to accelerate it will be bringing about numerous other problems, so my time frame is that the [bubble], maximum, will burst in three years’ time.”

“Once the collapse happens, the power of central banks will be curtailed greatly because people will realize who brought along first the Nasdaq bubble in 1999: The Federal Reserve. Who brought about the housing bubble between 2001 and 2007? The Federal Reserve. And who is bringing now along another great credit bubble and asset bubble? The Federal Reserve.”

“I don’t think that anything is very cheap, but if I have to compare different asset prices, say real estate, stocks, bonds, commodities, gold, art, and so forth—and old cars—then I think that gold and silver [are] relatively inexpensive because they have had big corrections already, and you should not forget that the global bond market now is over $100 trillion.”



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International Fight Club

By Grant Williams


Sometimes the sand shifts beneath your feet without your realizing it. Other times you can see it happening.

In November 1975, at a summit meeting in the picturesque Château de Rambouillet near Paris, leaders of the six richest industrial powers gathered to form a rather exclusive, though completely informal, little club.

The article Things That Make You Go Hmmm: Fight Club was originally published at Mauldin Economics



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