Relative Strength Indicates a Short Term Correction is Likely

Wednesday, September 19th, 2012

by Don Vialoux, Timingthemarket.ca

Pre-opening Comments for Wednesday September 19^th

U.S. equity index futures are higher this morning. S&P 500 futures are up 2 points in pre-opening trade. Index futures gained from news that Japan has launched a US126 billion economic stimulus program.

Index futures were virtually unchanged following release of August Housing Starts report. Consensus was an increase to 765,000 from a downward revised 733,000 in July. Actual was an increase to 750,000.

MMM eased $0.93 to $92.50 after commenting that previous third quarter sales guidance is a “stretch”. ‘Tis the season for companies to lower guidance.

Autozone fell $4.34 to $353.50 after announcing less than consensus fiscal fourth quarter sales.

General Mills added $0.42 to $39.73 after reporting higher than consensus fiscal first quarter earnings.

Needham downgraded the U.S. toy manufacturers on weaker than expected industry sales. Recommendations on Mattel and Hasbro were lowered from Buy to Hold.

Waste Management is expected to open lower after JP Morgan downgraded the stock from Neutral to Underweight.

Monsanto added $1.39 to $90.45 after Goldman Sachs upgraded the stock from Buy to Conviction Buy. Target is $110.

Shoppers Drug is expected to open lower after Morgan Stanley downgraded the stock from Equal Weight to Underweight.

Technical Watch

Shoppers Drug Mart Corp. (TSE: SC) – $41.59 Cdn. is expected to open lower after Morgan Stanley downgraded the stock from Equal Weight to Underweight. The stock has a negative technical profile. Intermediate trend is down. The stock recently fell below its 20 and 50 day moving averages and likely will open below its 200 day moving average. Short term momentum indicators are trending down. Strength relative to the TSX Composite has been negative since mid-July. Seasonal influences are about to enter a negative period. Better opportunities exist elsewhere.

Shoppers Drug Mart Corporation (TSE:SC) Seasonal Chart

Autozone Inc. Nevada (NYSE:AZO) – $353.50 fell 1.2% after the company reported less than consensus fourth quarter revenues. The stock has a negative technical profile. Intermediate trend is down. The stock recently fell below its 20, 50 and 200 day moving averages. Short term momentum indicators are trending down. Strength relative to the S&P 500 Index has been negative since early June. Better opportunities exist elsewhere.

Interesting Charts

More evidence of a pre-third quarter report slump in equity markets has appeared. Negative guidance by FedEx yesterday set the stage. Overbought broadly based equity indices and economically sensitive sectors saw their RSI fall below the 70% level yesterday. A break below the 70% level frequently is an early warning sign of at least a short term correction.

Third Quarter Earnings Outlook for S&P/TSX 60 Companies

The third quarter earnings outlook for S&P/TSX 60 companies is less promising than the outlook for S&P 500 companies and Dow Jones Industrial Average companies. Consensus (Average Median) shows that third quarter earnings on a year-over-year basis are expected to decline 7.78%. Thirty two companies are expected to report lower earnings per share, two companies are expected to report no change and twenty six companies are expected to report higher earnings. Energy and Mines & Metals are expected to record the largest declines. Financial Services are expected to record the largest gains.

* Median companies

Source: Zachs Investment Research

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Silver Futures (SI) Seasonal Chart

FP Trading Desk Headlines

FP Trading Desk headline reads, “Central bank easing good for cyclicals: Scotia strategist”. Following is a link to the report:

http://business.financialpost.com/2012/09/18/central-bank-easing-good-for-cyclicals-scotia-strategist/

FP Trading Desk headline reads, “Net redemption of equity funds a drag for mutual funds”. Following is a link to the report:

http://business.financialpost.com/2012/09/18/net-redemptions-of-equity-funds-a-drag-for-mutual-funds/

FP Trading Desk headline reads, “Semiconductor sector downgraded as inventory cycle stalls”. Following is a link to the report:

http://business.financialpost.com/2012/09/18/semiconductor-sector-downgraded-as-inventory-cycle-stalls/

Disclaimer: Comments and opinions offered in this report at www.timingthemarket.ca are for information only. They should not be considered as advice to purchase or to sell mentioned securities. Data offered in this report is believed to be accurate, but is not guaranteed.

Don and Jon Vialoux are research analysts for Horizons Investment Management Inc. All of the views expressed herein are the personal views of the authors and are not necessarily the views of Horizons Investment Management Inc., although any of the recommendations found herein may be reflected in positions or transactions in the various client portfolios managed by Horizons Investment Management Inc

Horizons Seasonal Rotation ETF HAC September 18^th 2012

Tags: ETF, ETFs, Gold, Indices
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Rotation Continues Under the Surface

Wednesday, September 19th, 2012

by Mark Hanna, Market Montage

The indexes are holding up here even as a lot of the hot sectors of last week are being hit quite hard.  (I noted those groups were very overextended last Friday)  Oil related, housing, metals, some financials, and transports are being hit especially hard this week thus far but you wouldn’t be able to tell from the indexes.  Meanwhile healthcare and consumer staples are taking the baton this week – these are defensive areas, but they are joined by biotechs which are high beta.  So while the type of sectors are more defensive in nature this week, the fact that money is trying to rotate into new areas is more constructive than the action we saw in June and July when it was either “IN” or “OUT” of the market on a 3-7 day basis.

Copyright © Market Montage

Tags: energy, Natural Gas, oil
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“The Philosophy of Tops” (Saut)

Wednesday, September 19th, 2012

“The Philosophy of Tops”

by Jeffrey Saut, Chief Investment Strategist, Raymond James

September 17, 2012

“Everyone kept saying ‘a top is not in place yet.’ They persistently pointed to the ‘normally reached’ levels of this or that statistic that were not yet there to reinforce their desire to remain bullish. … Apart from statistical measures of increasing blindness, this unwillingness to acknowledge what they themselves were already feeling revealed a comfortableness, a confidence, a conviction that whatever was happening – short-term survivable dips – would continue … until ‘the top,’ like a strip tease artiste of our youth would with decorum appear on stage, bow, and then, accompanied by applause from all the bulls eager to cash in on their excitement, would begin to twirl its statistical tassels in front of everyone.

I’ve gotten so old I can’t remember the names of those ladies at the Old Howard, but I can remember that all you got was a flash of this or that, before they waltzed off. Stock market tops are like that. You know it’s there somewhere if you squint hard enough, but you never quite see it, so you keep waiting for more. And then, in the end, as the curtain comes down on the bull market you realize that the one rule about tops is not that they provide this or that signal, but that they come before anyone is ready.”

… Justin Mamis

I recalled this quote from historian, author, and stock market guru Justin Mamis last week while contemplating the probabilities of a “top” for the recent stock market rally. Of particular interest is his last sentence, “One rule about tops is not that they provide this or that signal, but that they come before anyone is ready.” In the current case very few are ready for a “market top” given the consensus opinion that the recent Dow Wow is the start of another leg to the upside. Our analysis, however, suggests the extreme oversold condition that spawned the rally has evaporated, leaving all of our indicators just about as overbought as they ever get (see chart on page 3). To be sure, the S&P 500 (SPX/1465.77) has gone parabolic over the past few weeks, while the Russell 2000 (RUT/864.70) is challenging all-time highs. An overbought condition can be resolved in one of two ways. First, the SPX can pause and move sideways while the overbought condition is remedied. Second, the SPX can pull back to what had previously been an overhead resistance level, but now becomes a support zone. In the current case that would entail a pullback to 1400 – 1422 for the SPX. Importantly, when the stock market generates an overbought condition of this magnitude it suggests there is more strength coming in the future after the overbought condition is rectified. Indeed, uptrends typically do not end on really high overbought readings from the NYSE McClellan Oscillator. So, while I think we are reaching for a short-term “trading top,” I believe that following some kind of pullback the major market indices will go higher.

Of course, the rise in equity prices, combined with an improving real estate market, has bolstered consumer confidence. That certainly was reflected in Friday’s University of Michigan Confidence report, which came in 5.2 points above expectations. Normally one would think that is good news, but as the sagacious folks at Bespoke Investment Group write:

“The most positive report of the week was Friday’s University of Michigan Confidence reading that came in at 79.2, which is just below the multi-year high of 79.3 made back in May. While the actual reading came in just below its highs from May, the amount that the number beat expectations by was the highest seen since late 2008. … Since 1999, this sentiment reading has only beaten expectations by more than 5 points 11 other times. Below we highlight how the S&P 500 has performed over the next week, month and three months following the 11 other times that Michigan Confidence has beaten expectations by more than 5 points. Unfortunately, big upside surprises in the reading haven’t been great for stock prices. Over all three time frames, the S&P 500 has averaged declines. (Although the median change over the next month and 3 months has been positive due to big declines following periods in 2008 and 2000.)”

So while I am not bearish, I would be cautious about plowing into new positions. And, we saw some of that caution on Friday as sellers showed up in many of the strong momentum stocks.

Meanwhile, the U.S. Dollar Index (@DX.1/78.84) continued its decline as it fell through its 200-day moving average and looks destined to visit 75.00. In past missives I have commented on my sense that we would see a weaker dollar for a multiplicity of reasons. Plainly, the dollar’s weakness has helped our bullish recommendation on gold of a few weeks ago. In fact, I have written that gold has been telegraphing QE3 for weeks as it began to rally rather sharply. What is particularly interesting to me is for the first time in a long while gold bullion and gold stocks are rising together. That doesn’t always happen and it leads me to think the recent gold rally is for real. Moreover, many of the gold stocks are breaking out to the upside in the charts and they are doing so on expanding volume. We were early to gold’s party back in 4Q01 when China joined the WTO and decided Chinese per capita incomes were going to rise with a concurrent rise in “stuff stocks” (energy, timber, cement, precious metals, etc.). While I doubt gold is going to stage a percentage move like it did back then, as we approach the strongest seasonal period for precious metals (October – January) we are thinking that if you don’t have some exposure to the precious metals complex, now would be a good time to start. While there are a number of ways to get at said exposure, I have tended to use mutual funds. Last week while in New York City I met with the good folks at Van Eck. And a month ago I actually had dinner with the portfolio manager of Van Eck’s International Gold Fund (INIVX/$20.36), namely Joe Foster, who spoke about some his favorite gold stocks, like Gold Corporation (GG/$46.20) and Eldorado Gold (EGO/$15.75).

The call for this week: To me the only question is if the stock market is going to correct its current overbought condition by going sideways, or if it is going to correct back to the 1400 – 1422 support. In either event I have been pretty confident that the Fed has already begun printing money. That has been eminently evident by the overall action in the commodity markets, the dollar, and the fact that stocks were unable to correct in the normal timing band for a daily cycle low. Indeed, I actually expected an easing of monetary policy out of last month’s Fed meeting. At this point, we need to watch the pricing action of crude oil, for if it spikes higher it is going to be a decided drag on GDP. As Gary Savage points out:

“Since QE is open ended this time there’s no telling how far the rally could go before traders get nervous enough to initiate a profit taking event. As I said above, we aren’t going to begin a bear market until oil spikes, so any corrective move is only going to be a profit taking event that will quickly be recovered by more QE. At this point I wouldn’t expect any real profit taking until the S&P tests the all-time highs. I really doubt any sane traders are going to look for a significant correction immediately following the confirmation of QE unlimited. At this point any rational trader is getting long so they don’t get left behind.”

Click here to enlarge

Click here to enlarge

Copyright © Raymond James

Tags: Bullion, energy, Indices, Natural Gas, oil, Qe, Quantitative Easing, Saut
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Us and Them: Household Sector Deleveraging vs. Public Sector Leveraging (Sonders)

Wednesday, September 19th, 2012

September 18, 2012

by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

Key Points

• Households have been in deleveraging mode steadily since 2008.
• The Fed has stepped in to ease deleveraging’s pressures on economy, but its zero-interest-rate policy has hurt savers.
• Public-sector deleveraging is up next, while the total process will take a very long time.

In October 2008 I wrote a report, in the wake of the fall of Lehman Brothers, titled “A Transformational Era of Deleveraging.” It happened to be one of the most widely read reports I’ve written, and in today’s report I want to revisit the topic—specifically how far we’ve come within the US household sector.

The global credit crunch that was brewing before Lehman imploded kicked into high gear with the fall of that institution in mid-September of 2008. It began with the household sector, upon which a massive era of deleveraging was forced. Since then the Federal Reserve has stepped in with three rounds of quantitative easing (QE) to stem the natural tide of deflation that’s historically accompanied nearly every global debt crisis.

At present, there’s growing pressure on the public sector to begin its deleveraging process, either because we fall off the “fiscal cliff” at year-end or our politicians step up to the plate and begin the process on their own. So what we face is a standoff between monetary and fiscal policy-makers that are attempting to inflate … with a private sector that’s in the process of deflating.

To put numbers to the battle, at the peak in the debt bubble there was $42 trillion in private-sector debt and $14 trillion in public-sector debt. The private sector is deleveraging as fast as it can while the public sector is inflating. History shows that the private sector typically wins the deflation-inflation battle, and that’s why the Fed has been as aggressive as it ever has historically.
Higher debt … lower growth
Total credit-market debt is the broadest and most inclusive measure of debt, and as you can see in the top chart below, the recent improvement is barely a dent when looking longer-term. The massive increase in debt also helps to explain not only this cycle’s anemic recovery, but the string of relatively weak recoveries since the early 1980s’ double-dip recession.
Rising Debt = Faltering Recoveries

Source: Bureau of Economic Analysis, FactSet, Federal Reserve; credit-market debt as March 31, 2012, nominal GDP as of June 30, 2012.

The second chart above shows the rolling 10-year rate of growth of gross domestic product (GDP) since 1960. Up until about 1980, nearly every rolling 10-year period was more prosperous than the prior period. That trend came to an abrupt halt, not coincidentally, at the point the total debt began its steep ascent.

The reasons behind the debt ascent are well documented:

• A 30-year record-breaking decline in interest rates allowed borrowers to carry more debt.
• Financial innovations/debt securitizations and politicians pushing for broader home ownership led banks to dramatically loosen lending standards.
• Housing and consumer-durables demand accelerated sharply coming out of World War II (WWII).
• Increased use/availability of credit cards and home equity lines/mortgage refinancings.
• The Fed’s easy-money policy, particularly since the 1990s.

With the notable exception of the last reason, most of these trends are no longer in play. That said, there’s ample pent-up demand for housing and it appears that headwind is slowly becoming a tailwind.

Adding salt to the debt wound, the last cycle’s debt binge was largely for extra consumption and housing. When excess lending is used to finance investments, it creates an income stream for paying debts down the road. On the other hand (as in Europe more recently), when debt is used for extra consumption and housing, it does not create a future income stream and as a result, interest and repayment obligations take a larger bite out of income.

We now have a clash underway between a household sector that’s been in deleveraging mode since 2008 and a government sector that’s seen debt blow out to historical levels, largely as it has tried to support an economy suffering under the weight of household-sector deleveraging.

The paradox of thrift

The US consumer has had a growing and disproportionate impact on GDP for decades. When the subprime mortgage market began its epic unwinding in mid-2007, the attendant ripple effects came into view. Even today, real per capita personal consumption expenditures remain 13% below the long-term trend. No other post-Depression recession came close to matching that contraction and can easily be explained by the busting of household balance sheets.

In the post-WWII period, private -sector debt grew more rapidly than nominal GDP in nearly every year except those during recessions. The result was a peak in the outstanding level of private-sector debt at nearly 180% in 2007, up from a little more than 50% in the early 1950s. Both household debt and business debt have decreased from their peaks, but much more work needs to be done.

The biggest problem remains existing mortgage debt. According to BCA Research, mortgage debt is currently about 60% of the value of household real-estate assets, compared with a pre-crisis average of about 40%. And because about one-third of homeowners have no mortgage, the position of mortgage holders is much worse than the aggregate data suggest. According to Zillow, more than 30% of mortgage holders were underwater with their mortgages in the second quarter of this year.

Low rates may hurt more than help

Indeed, today’s near-zero short-term interest rates, and record low longer-term rates ease the loan-delinquency problem and improve debt-servicing capabilities, as the charts below show.
Plunging Delinquencies

Source: FactSet, Federal Reserve, as of June 30, 2012.
Plunging Debt-Service Ratio

Source: FactSet, Federal Reserve, Ned Davis Research, Inc. (Further distribution prohibited without prior permission. Copyright 2012 (c) Ned Davis Research, Inc. All rights reserved.), as of March 31, 2012. Household debt service ratio is an estimate of ratio of required debt payments to disposable personal income. Required minimum payments of interest and principal on outstanding mortgage and consumer debt are included. Circle indicates current range.

But before you get too excited about the table above—showing that we’re presently in a debt-service zone that’s historically been met with strong economic and job growth—remember that the burden of public-sector debt has never been higher and is beginning to bear down on the economy.

In addition, there’s a rub to low rates. BCA notes that the household sector has more interest-earning financial assets than liabilities: $13.8 trillion versus $12.8 trillion respectively, as of the first quarter of 2012. Extremely low interest rates represent an overall negative in income flow terms. And that problem has now been extended thanks to the Fed’s recent announcement of QE∞ (with infinity a symbol of its open-ended structure). Indeed, debt-servicing costs have dropped by 3.1% of disposable income in the past five years, while interest receipts have dropped by 3.9% of income over the same period.

That’s why, as seen below, the net of interest receipts minus debt service payments remains in negative territory. This is an even bigger problem for the elderly.
Debt Service Down … But So is Interest Income

Source: BCA Research, Bureau of Economic Analysis, FactSet, as of June 30, 2012.

Most of the data above highlight the likely long path ahead for what could be deemed a full recovery in private-sector balance sheets. In addition, given the uniquely severe nature of the debt crisis, it’s unlikely that a simple reversion to the longer-term trend will suffice. Given the massive upside overshoot in debt, one can expect a downside undershoot relative to the trend. This is why when I look at household debt as a percentage of disposable income, I note both the standard trend line and a trend line that excludes the bubble years (see below).

Debt Breaks First Trend Line

Source: FactSet, Federal Reserve, as of March 31, 2012. Orange and green lines represent trend lines.

The future

Trying to extrapolate trends into the future is difficult. Attempting to simplify the process, BCA assumes that nominal household income will grow at about 5% a year, and that the level of outstanding debt remains flat. On that basis, the debt-to-income ratio would return to its current upward-sloping trend line by the end of 2014. If the ratio were to return to its average of the 1990s, then it would take until the end of 2018 to return to that level, assuming zero debt growth over the period. If debt levels continued to contract, then the deleveraging process would end more quickly. That scenario, of course, would be more disruptive to the economy.

In sum, it’s going to be a long slog. As hard as they may try, neither the Fed nor the federal government can “create” strong economic growth; at best, they can keep the economy from sliding back into a recession. But the drag on growth from household deleveraging is easing and housing is again becoming an economic “green shoot.” At the same time, corporate balance sheets are in great shape and the financial sector’s health has improved markedly since the housing bubble burst. So, it’s no longer all bad.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

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Bernanke, The Blind Archer

Wednesday, September 19th, 2012

Via Sean Corrigan of Diapason Commodities

The Blind Archer

Finally, the great day has come and gone when the Fed would once again ride to the action, not daring to be left behind by the ECB’s perverse vaunting of its new ‘unlimited’ programme of bond purchases and too impatient to attend the continually postponed policy shifts so long expected from both the PBOC and the BOJ. A few months of less-than-stellar macro numbers, coupled with a lull in the rise of the price indices which was helped along by the last cyclical downturn of commodity prices (alas, for the ordinary American housewife, long since reversed) and the Mighty Oz was free to rummage deep into his carpetbag of gewgaws and conjuror’s props, once more.

The rationale for this latest enormity is, frankly, hard to determine lest it be Bernanke’s eagerness to present whoever might replace him under an incoming Republican administration with a fait accompli and so to ensure his legacy as the worst economic ‘experimenter’ to be empowered since the dark days of Roosevelt himself (he of the breakfast egg gold price fixing; the alphabet soup price and wage dictatorship; and the enforced famine of mandated crop and livestock destruction).

So, when we received a little insight into the fevered mind of the Chairman – coming in the form of what he told an interlocutor from Reuters, when asked to explain how exactly he envisaged that his new, open-ended, $45-billion a month QEII programme would work – our first urge was to utter the obsecration: “Spare us, Lord, from the scheming of idiot savants!”

Apart from the fact that Blackhawk Ben here seemed to hew to a particularly crude version of the Phillips curve largely disavowed by even the most unreconstructed mainstreamers (one which imagines that extra jobs can be bought if only prices can be made to rise fast enough), after five years of ever more desperate flailing to restore false, Boom-time levels of activity, he appeared to have staked his all on bursting the piñata of the labour market by smacking it with the rough-hewn pole of the so-called ‘wealth effect.’

As he told the journalist in Thursdays’ post-FOMC Q&A:

”The tools we have involve affecting financial asset prices… Those are the tools of monetary policy. There are a number of different channels. Mortgage rates, other interest rates, corporate bond rates. Also the prices of various assets….”

“For example, the prices of homes. To the extent that the prices of homes begin to rise, consumers will feel wealthier, they’ll begin to feel more disposed to spend. If home prices are rising they may feel more may be more willing to buy home because they think they’ll make a better return on that purchase. So house prices is [sic] one vehicle…”

“Stock prices – many people own stocks directly or indirectly. The issue here is whether improving asset prices will make people more willing to spend…”

“One of the main concerns that firms have is that there is not enough demand… if people feel their financial position is better… they’ll be more likely to spend, and that’s going to provide the demand firms need in order to be willing to hire and to invest…”

These few, brief sentences contain such a miasma of error that it is hard to know where to begin if we are to restore a fresh breeze of economic rationale to this swamp of non sequiturs and wilful misunderstandings. It is not enough that crude, Krugmanite Keynesianism clings to the cheap parlour trick of using money illusion to fool unemployed wage-earners into lowering the reservation price of their labour, but now we must battle against banal, Bernankite Bubble-blowing – the hope that money illusion will fool cash-constrained asset owners instead.

To show what we mean, indulge us while we parse the Chairman’s words:

“If we can artificially suppress interest rates to a low enough level, lots of people will forget that they got themselves into the current mess by borrowing too much the last time we did this and so they will begin to do so again – especially the would-be home-owners and condo-flippers.”

“If the price of homes begins to rise, those who have already borrowed to buy one will feel better off even though: (a) they will earn not one red cent in extra income because of that appreciation and (b) if they do manage to register a one-off capital gain, it can only come at the expense of the purchaser, whose acquisition of a durable store of shelter services will therefore involve a much greater, zero-sum call on his resources than otherwise would have been the case”

“The stock market should also rise just because there’s more easy money chasing after a parking place. Naturally, we at the Fed could care less about the quaint notion that equities should represent a sensibly valued claim on a company’s estimated stream of residual earnings, or that capital markets need genuine prices if they are to serve any useful social function by allocating scarce savings to the prospectively best investment projects.”

“To the contrary, from our perspective, if Joe Soap wants to splash out to celebrate the entirely notional, potentially only nominal, and probably ephemeral gains on his 401k which we can bring about – without wondering whether the increase represents any lasting contribution to the aimed-for security of his retirement – well, in the long run, we’re all dead, aren’t we?”

“Companies don’t have enough ‘demand’, don’t you know, so if we can only get people to wave their cheque books at them, they will be so sure of being able to profit from this that they will offer every one of their new customers a job, on the spot!”

“Incidentally, we Keynesians are big on portraying consumer demand as being the driver of the economy, even though we’ve never quite been able to explain why it is that the ‘demand’ inherent in the existence of millions of hungry people in the world – all pathetically eager for an extra morsel of food – has not automatically brought about the necessary increase in agricultural output, investment, and employment in precisely the same manner that we are now presuming will be the case for, say, WalMart once we start buying in its customers’ mortgages.”

Like most macromancers, what our esteemed Chairman is missing here is any concept of how a business actually functions, of how it and its peers interrelate in the overall structure of the economy, and of the critical role played by capital and time in the division of labour and the provision of goods. He is also prey to the superficial fallacy – a kind of inverted Say’s Law – that consumption somehow dictates the amount (rather than merely the composition) of production, something that has not been the case ever since Adam was condemned to earn his daily bread in the sweat of his brow and to till the ground from when he was taken.

Thus, rather than being fooled by the mantra that ‘(personal) consumption is two-thirds of the economy’, one should be clear about the distinction that its (imputation-boosted) count is actually only two-thirds of the highly-subjective statistical shorthand which is GDP – and that this is not the same thing at all! Gloves may well comprise 100% of the clothing I put on my hands in winter, but if they are all I don when I go out snow-shoeing, I’m not likely to get very far before some Good Samaritan of the Alps finds my half-frozen form and has to send forthwith for the nearest brandy-carrying St. Bernard so as to revive me.

This is a matter to which we have already devoted a great deal of time, but a brief synopsis here is probably in order.

Take, for example, the four years from 2006-9 inclusive which saw US GDP average just under $14 trillion while cash PCE came in at a mean $8.5 trillion (ergo, validating the shibboleth that the latter number equates to 60% or so of the first). Mainstream thinking may stop short here, smugly satisfied with this trivial – and circular – QED, but this is not even half the story.

We say this because, over the period in question, aggregate business revenues – i.e., the best representation of the overall circulation of goods and services throughout the economy – amounted to no less than $33 trillion a year (the vast bulk of which receipts were subsequently disbursed again, whether as above-the-line costs, below-the-line outlays, interest, dividends, or taxes).

Thus, not only was the ‘economy’ almost 2 ½ times as large as the GDP count, but every $1 of that supposedly crucial personal outlay was matched by $3 of business-to-business spending.

So, if Mr, Bernanke really wants to get ‘demand’ going, the foregoing drops a heavy hint that he would be three times as effective as he has been if he and his masters in Washington could manage to do something (or, conversely, to stop doing much of what they counterproductively have been doing) which ends up promoting greater managerial/entrepreneurial belief that not only can profits be made, but that, once made, more of them will be retained by their rightful owners.

It should also be recognised that the vast bulk of that $25 trillion in B2B expenditures is every bit as discretionary as the outlays of the most finicky of shoppers: no businessman can be compelled to keep his store open, or his factory running, if he finds the game not worth the candle, even though mundane economic analysis tends to assume without question that, far from being an adaptive, calculating, he is an unthinking automaton who can very much be relied upon to do just that, irrespective of his estimated remuneration.

More fundamentally still, it is the relationship (strictly, the ratio) between his receipts and his disbursements wherein the lies the difference between our hero’s commercial success – and so, his role in hiring, commissioning and the onward generation of orders for his suppliers – and his failure – hence, his sad duty to undertake lay-offs, cut-backs, and cancellations. Even absent net, new investment to improve and deepen the capital stocks and so raise real incomes, the overwhelming preponderance of that $25 trillion (in fact, all of it less an average $1.5 trillion before – and only $250 billion after – depreciation) represents a voluntary sacrifice of the enjoyment of present goods, undertaken merely to keep things running as they are.

The idea that such a delicate network of relative prices and differential cash-flows can be not only maintained, but enhanced, by the clumsy process of artificially forcing arbitrary quantities of money and credit into the system is at best naïve and at worst astrological in its pseudo-rationality. At root, such gross interventions as these, no matter how greatly they excite the raptures of the mainstream inflationists, ensure nothing more than the confusion of those critical accounting algorithms which help ensure that capital and labour are not being squandered. This is so because, not having the noble pedigree of the free, unhampered market, the infusions – being nothing more than the bastard offspring of the central planners’ hubristic conception – bear no definitive relationship to the generation and subsequent movement of the real goods and services whose value-giving exchange it is the sole purpose of these media to facilitate, both across space and through time.

To see this, take the simple – if extreme – example of the post-Lehman crisis itself. The Fed, we are told, by the newly-respectable brotherhood of NGDP targeters, ‘only’ had to ensure that the gross flow of money out of the funnel at the end of the economy (the $14 trillion per annum, principally in the form of final, exhaustive spending) remained unaltered and all would have been well. [We shall here ignore the fact that this would have been an impossible task to have undertaken in real time even if all the various rivalrous sects and sub-sects of NGDPers had managed to agree upon what means should have been employed, upon whether levels or growth rates of the aggregate should have been controlled, and over what horizon this was to be brought about].

But look at the facts of what did happen that year as the economy swirled around the ragged edges of a maelstrom of total collapse. Total domestic, non-MFI credit rose a modest 2.9% as the private component of this fell 2.5% while Leviathan’s appetite grew by a monster 13.7% (counting GSEs in with government itself). Meanwhile, M1 jumped 18.1%, ‘Austrian’ Money Supply (M1+, if you will) rose 25%, and M2 added a more modest 9.1%. Confusion confounded, you might say, since we are being exhorted to act to control one or more of these aggregates, depending upon which particular ‘new’ monetary school you choose to believe. But the difficulties do not end there, for worse was to come in the ‘real’ economy.

Here, the hallowed NGDP measure fell 3.7%, implying the Fed should have added X, or maybe Y, or Z in order to offset the switch in emphasis from credit to money and the concurrent slowdown in the immediate use or ‘velocity’ of that money.

But this was not the end of it, for private-sector NGDP (the important bit) fell a greater 5.7%, while the total business revenue measure which we have argued above is the real key variable, slumped to a crushing 11.5% loss. Within this the disparities were even more marked. Revenues among the extractive industries plunged 50.6% at one end of the spectrum as those accruing to health & social care rose 4.4% at the other. For profits – and hence, for both the means and the incentive to expand output and employment – the spread was even more extreme for the trailing four quarters to our two end-dates, ranging from a 73% contraction for the extractive sector to a 68% gain for the utilities (which, in part, benefited from the formers’ woes in the shape of cheaper energy inputs, again underlining the point that it is relative costs and prices which count, not absolute ones).

Again, we have to ask the targeters and reflationists: how, where, and when was the central authority supposed to have intervened in order to lessen the economic pain; and how do we know that same pain was not either intensified or prolonged, rather than mitigated, by the actions which were taken since these could not have done other than to have interfered with the market’s attempts to find proper clearing prices, to excise dead capital stock, and to marshal its combined entrepreneurial abilities for the task of laying down new capital where the evaporation of the prior bubble had revealed it to be truly useful (and, by extension, profitable) to do so?

If the Bernanke Fed had any answers then – or, indeed if it has since achieved sufficient enlightenment to justify its present burst of activism – we should be delighted to hear them. Our breath is not being held.

As a practical matter, it should be noted that the final data which we use to plot these changes have only just begun to be made available on a delayed quarterly basis and, even then, a full check on their validity awaits the glacial progress of the statisticians at the IRS, whose findings can be up to four years in arrears!

Though we must always exercise caution regarding any use of aggregates, a reasonable proxy is therefore what we need if we are to monitor developments, albeit using the broadest of brushes. For us the widely-ignored business sales data fits the bill for overall activity, while the ratio of its sub-components—retail sales versus those made in the manufacturing and wholesale sectors gives us an idea of gross saving/investment v end-consumption. Another way of showing this is to plot the monthly personal consumption estimates against those for business revenues. As the plot shows, this latter is highly variable and has been in decline ever since the financialization of the economy began in earnest in the early-1980s.

A falling ratio implies, to an Austrian, that a greater degree of time preference appears to be developing and hence, a higher natural rate of interest (the ratio of intertemporal prices) has come to prevail.

In contrast, an examination of the path of BAA bond yields shows that market rates (after subtracting consumer price changes) have been steadily falling over time, due to a toxic mix of loose money and abundant speculative leverage. The gap between what should be and what is, is therefore a widening one, suggesting that a mix of overconsumption and malinvestment, fuelled by increased non-productive indebtedness, is to be expected.

Chronic and often highly elevated current account deficits (not to mention the dire fiscal situation) testify to the overconsumption element, while the series of ever-more violent booms and busts, coupled with lacklustre real net investment and stagnant real wages, are symptomatic of the second, while the level of debt itself should itself need no further comment.

Given this malign constellation of factors, the Fed’s eagerness to suppress all interest returns for at least the next three years and for as far out the curve as its tainted grasp can extend is not likely to do anything to restore a much-needed touch of balance to the world’s largest (and formerly most vibrant) economy.

Bond yields have already been forced far too low, making stocks seem relatively well-valued, even as the underlying conditions deteriorate and the fatal dependency on the sweet neurotoxin of stimulus deepens its grip on the patient. By progressively suppressing the economy’s intrinsically-generated price signals in this fashion, a wholesale paralysis of the system may one day result.

What Bernanke’s intellect cannot seem to encompass is the thought that if a man has lost weight through an illness related to his previously poor dietary regime, it will simply not do to try to fill out his now-baggy suit by tempting him back into over-indulgence. Some glimmerings of this idea do surface in the occasional expression of doubt about just how large such shadowy entities as the ‘output gap’ or the ‘structural growth rate’ may still be in the aftermath of 2008’s debacle, but none of these misgivings ever seem to penetrate the cranium of a man who thinks he can meaningfully reduce unemployment by stimulating junk finance in all its many forms.

It is not only that Bernanke’s policies will inevitably assist the zombie companies and the obsolescent industries to absorb scarce resources (not least on bank balance sheets) to a much greater degree than is justified, thereby denying greater returns both to their better-positioned rivals and to those nascent endeavours which could better reflect unalloyed consumer preferences and whose growth could come to replace yesterday’s failures as tomorrows’ providers of income. There is also the danger that lax money misleads even today’s supramarginal businesses into over-estimating the depth and duration of demand for their products, ultimately undermining many otherwise sound undertakings and reducing these, too, when the cycle next turns, to the ranks of the Living Dead.

Gather ye rosebuds will ye may, for the bloom on this Fed rally, too, will eventually wither and fall.

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Observations from Interstate 82 (and Thereabouts) (Scott Ronalds)

Wednesday, September 19th, 2012

September 18, 2012

by Scott Ronalds, Steadyhand Investment Funds

My wife and I love wine. While we try to support local Okanagan producers as much as possible, we’ve found that our neighbors in Washington also make some great juice, and at good prices. We hit the road last month to explore Washington wine country with Walla Walla as our base camp. Here are a few random observations from our trip.

Wind Farms

Driving through the Columbia Valley, we had our first up-close experience with wind farms. It felt a little like we took a wrong turn and were in some weird military zone; yet, it was eerily majestic. These huge turbines were a reminder that sources of clean, alternative energy are growing and technology will play an increasing role in a more energy efficient world going forward. Cool stuff.

Walmart

East of the mountains (Cascades), we could drive several kilometers without seeing another car. But Walmart trucks seemed to be everywhere, and the stores were a fixture in every mid-sized town. Sam Walton’s company is one powerful retailer (Disclosure: I own the stock through my holding in the Global Equity Fund).

Real Estate

Real estate is still a big topic of discussion. At the B&B we stayed at, it was a frequent point of conversation over bacon and eggs. As other guests from Seattle and Portland opined that the U.S. market has bottomed and swapped stories about housing prices and conditions in their fair cities, my wife and I were reminded that Vancouver is a different beast altogether. When we threw out some numbers on lotusland prices, jaws dropped. “Wow, that’s crazy!” was the common response. Hmmm.

Climate Change

In my opinion, Washington makes fabulous red wines. The cabernets, merlots, and syrahs are big and bold. Southeastern Washington gets plenty of sunshine and days where the mercury hovers around 100°F, with cooler nights to balance the fruit. Many winemakers told us it’s become the ideal climate for growing these grapes. In fact, climate change came up as one reason why Walla Walla is being touted the “new Napa” and some vintners opine that California’s famous wine region will eventually become too hot to produce good grapes (do they have an axe to grind or are they on to something?). Washington (and B.C.) will flourish, we were told. Stay tuned.

Free Trade

Tasting the wine was a lot of fun. Bringing it home, not so much. Canadians visiting the U.S. are only allowed to bring back two bottles of wine each (without penalty). Anything beyond is subject to duty, taxes and a “liquor mark up fee”. We brought back a case and were hit with a nasty bill. Whatever happened to free trade?

I’ll spare the clichés about wine and investing, but suffice to say you can learn a lot on a wine trip. Turns out that I wasn’t completely lost in the vocabulary either. Value hunting, technical analysis, verticals, and corkscrews are common to both industries.

Copyright © Steadyhand Investment Funds

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Fed to Debase Dollar?

Wednesday, September 19th, 2012

September 19, 2012

Is the Fed’s goal to debase the U.S. dollar? The Federal Reserve’s announcement of a third round of quantitative easing (QE3) might have been the worst kept secret, yet the dollar plunged upon the announcement. Here we share our analysis on what makes the FOMC tick, to allow investors to position themselves for what may be ahead.

We have heard policy makers justify bailouts and monetary activism because, as we are told, these are no ordinary times: extraordinary times require extraordinary measures. Acronyms are needed, as we are told that things are complicated. We respectfully disagree. It’s quite simple: we have had a credit driven boom; we have had a credit bust; and Fed Chairman Bernanke thinks monetary policy can fix it. Merk Senior Economic Adviser and former St. Louis Fed President William Poole points us to the fact that the Soviet Union, Cuba and North Korea have one thing in common: monetary policy could not have compensated for the shortcomings of the respective regimes. The successor nations to the Soviet Union, as well as China had economic booms because they opened up, not because of printing presses being deployed. Monetary policy affects nominal price levels, not structural deficiencies. In the U.S., the economy may be held back because of uncertainty over future taxes (the “fiscal cliff”) and regulation; monetary policy cannot fix these.

But the above experiences have something else in common: they refer to lessons of recent decades. Bernanke, in contrast, is a student of the Great Depression, the 1930s. Bernanke firmly believes that tightening monetary policy too early during the Great Depression was a grave mistake, prolonging the Depression. Never mind that there had been major policy blunders by the Roosevelt administration that might have been driving factors; Bernanke’s research squarely focuses on how history would have evolved differently had his prescription for monetary policy been implemented.

The reason why Bernanke thinks tightening too early after a credit bust is a grave mistake is because a credit bust unleashes deflationary market forces. Left untamed, a deflationary spiral may ensue driving many otherwise healthy businesses into bankruptcy. Nowadays, we hear “it’s a liquidity, not a solvency crisis.” With easy money, the Fed can stem the tide. Whenever the Fed has the upper hand, the glass is half full, “risk is on” as traders like to say; but then it appears that not quite enough money has been printed and, alas, the glass is half empty, “risk is off.” The high correlation across asset classes is, in our assessment, a direct result of the heavy involvement of policy makers. Sure, markets may move up when money is printed; the trouble is everything moves up in tandem, making it ever more difficult to find diversification, so that on the way down, investors find protection. It’s for that reason, by the way, that we focus on currencies: why bother taking on the noise of the equity markets if investors buy or sell securities merely because they try to front-run the next perceived intervention of policy makers? In our assessment, the currency markets are a great place to take a position on the “mania” of policy makers. Note that if one does not employ leverage, currencies are historically less risky than equities.

So we know Bernanke wants low interest rates. But there’s more to it: as we saw earlier this year, a string of good economic indicators sent the bond market into a nosedive. Treasuries were bailed out by subsequent mediocre economic news, allowing bond prices to recover. The challenge here, in our assessment of Bernanke’s thinking, is that the bond market can do the tightening for you. When Bernanke bragged in his Jackson Hole speech in late August that a well-behaved bond market is proof that his policies are well received, we had a more somber interpretation: the reason the bond market is well behaved is because the economy is in the doldrums. Let all the money that has been printed “stick”, i.e. let this economy kick into high gear. Sure, Bernanke says he can raise rates in 15 minutes (he can pay interest on deposits at the Fed), but given the leverage in the economy, any tightening that comes too early might undo all the “progress” that has been achieved so far. Differently said – and we are putting words into Bernanke’s mouth here – Bernanke has to err on the side of inflation.

But how do you err on the side of inflation, without the bond market throwing a fit? A central banker is most unlikely to ever call for higher inflation. You do it with “communication strategy”, a commitment to keeping interest rates low; you do it with quantitative easing, i.e. buying Mortgage-Backed and Treasury securities; you do it with Operation Twist, depressing yields by buying longer dated Treasury securities. But, “when inflation is already low…” as Bernanke stated in his 2002 “Helicopter Ben” speech, “the central bank should act more preemptively and more aggressively than usual.” How do you do that? First, you create an open-ended buying program, so that the market cannot price in all easing within moments of the announcements. And more importantly, you break the link between monetary policy and inflation. Bernanke wants to make sure investors realize that policy is now tied to a “substantial improvement in the labor market” rather than its inflation target. It’s only then that the Fed can go all out on promoting growth without having the bond market sell off.

Does it work? Judging from the initial market reaction, no. Bond prices have fallen, inflation expectations as expressed in the spreads between inflation protected Treasury securities (TIPS) and underlying Treasuries have shot higher. It might be because the dust from the Fed’s bombshell hasn’t settled; or it might be that the Fed hasn’t had time to intervene in the market by buying TIPS (while not extensively, the Fed has been buying TIPS on occasion) depressing inflation indicators.

Either way, however, many observers have wondered whether lowering interest rates a tad further is really the panacea the economy needs. Part of it is that mortgage rates aren’t falling at this stage, if for no other reason than banks have such dramatic backlogs, that they have little incentive to open the floodgates even more for further refinancing activity. But even without such backlogs, how many more projects are worth financing with the 10-year bond trading at 1.6% versus 1.8%? Interest rates are low, no matter how one slices it.

That leaves one other interpretation open. Don’t take our word for it, but read the 2002 Helicopter Ben speech: “Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today [in 2002], it’s worth noting that there have been times when exchange rate policy has been an effective weapon against deflation.” The argument here is that a lower dollar boosts exports and thus the economy. Ignored is the fact that Vietnam might try to compete on price, but an advanced economy should work hard to compete on value added. As such, we are only providing a dis-incentive to invest in competitiveness if the Fed’s printing press provides the illusion of competitiveness. We use the term printing press because it is Bernanke in the aforementioned 2002 speech that refers to the Fed’s buying of securities (QEn) as the electronic equivalent of the printing press.

So don’t let anyone fool you. Things are not complicated. In our assessment, the Fed may be out to debase the dollar. Investors may want to get rid of the textbook notion of a risk-free asset, as the purchasing power of the U.S. dollar may increasingly be at risk. There is no risk-free alternative, but investors may want to consider a managed basket of currencies including gold, akin to how some central banks manage their reserves, as a way to mitigate the risk that the Fed is getting what we think it is bargaining for.

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Axel Merk
President and Chief Investment Officer, Merk Investments
Merk Investments, Manager of the Merk Funds

Tags: Equities
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