April 25, 2014
By Steve Blumenthal
“The Fed’s manipulations have left it in the position of a tightrope walker with no net; one who must exert all his energy in a concentrated effort just to keep moving forward, even as the slightest slip or unexpected gust could cause a catastrophic end to the enterprise. The Fed must promote inflation (while not acknowledging it) and must inflate asset prices (without causing bubbles to bust). It must exude confidence while having no idea whether its policies will work or when they might end.
In short, the Fed is caught between its roles as proprietor of the debt-as-money contract and as the singular savior of sovereign debt. It is unlikely to succeed in only one of these roles: it shall succeed, or fail, at both.”
I share the above quote from James Rickards’ new book as I believe it best summarizes the systematic risk we face today. It is this gigantic academic experiment undertaken by the Fed that puts the system at a tipping point. As investors and stewards of our clients’ money, it is the awareness of risks and the opportunities such risks create that we seek. How you position your portfolios to profit and defend (hedge) is paramount.
You may find yourself, like me, unable to put Jim’s book down.
Included in this week’s On My Radar:
- James Rickards – The Death of Money: The Coming Collapse of the International Monetary System
- What you can do today
- Trade Signals – Aged Bull
James Rickards – The Death of Money: The Coming Collapse of the International Monetary System
The Death of Money is about the demise of the dollar. By extension, it is also about the potential collapse of the international monetary system because, if confidence in the dollar is lost, no other currency stands ready to take its place as the world’s reserve currency. The dollar is the linchpin. If it fails, the entire system fails with it, since the dollar and the system are one and the same. Some highlights:
- To understand the threats to the dollar, and potential policy responses by the Fed, it is necessary to see the dollar through the Fed’s eyes. From that perspective, inflation is not a threat; indeed, higher inflation is both the Fed’s answer to the debt crisis and a policy objective.
- Inflation is coming. Central banks have to get inflation – they cannot tolerate deflation. On the way to creating inflation they may just create a collapse in confidence.
- Jim believes we have misplaced a confidence that central banks can save the day: in fact, he believes they are ruining our markets. While we refuse to face truths about debts and deficits, dozens of countries all over the globe are putting pressure on the dollar.
- Since potential risk is an exponential function of system wide leverage, and since the size of such leverage as measured by derivatives is unprecedented, it follows that the risk, too, is unprecedented. Collapse is simply the loss of confidence by citizens and foreign central banks in the future purchasing power of the dollar. The result is that holders dump dollars either through faster spending or through the purchase of hard assets. This rapid behavioral shift leads initially to higher interest rates, higher inflation and the destruction of capital formation. The end result can be deflation (1930s) or inflation (1970s), or both.
- He states the coming collapse of the dollar and the international monetary system is entirely foreseeable and notes that the international monetary system has collapsed three times in the past 100 years (1914, 1939 and 1971). Each collapse was followed by a difficult period.
- His book looks at the most imminent threats to the dollar, likely to play out in the next few years, which are financial warfare, deflation, hyperinflation and market collapse.
Perhaps it is simply human nature to get lulled to sleep. It’s hard for people to understand that after 30 years of fighting inflation, the Fed now wants to create inflation. Frankly, it is beyond most individual investor’s desire to understand how the economic system and markets work. I remember one time I impatiently told my electrician, who was trying to kindly teach me about wiring, that I really didn’t care – just make it work. Maybe many of your individual clients feel the same about their 401ks and other investment portfolios. They look at you and say, “Just make it work”.
In the deflation/ inflation battle, it is deflation that the Fed fears most (think depression). They will avoid it at all costs. Their agenda is to get inflation up to 3.5% while keeping borrowing costs low. This combination of low rates and inflation will kick the velocity of money into gear. I believe that is their end game and, unfortunately, all of their printing and market manipulation has created a dependent fragility in the system so great that, like a mountain after many winter storms, the landscape looks beautiful but the snow is far from stable. Which snowflake triggers the next slide is unknown, but the risk of avalanche is high.
This leads to our greatest risk – higher interest rates in a leveraged world (unimaginable derivative exposure and record equity margin). Think 2008, only this time we are exponentially more leveraged. The right spark sets the participants running to the exit. Bids evaporate and then crisis and panic ensues. There may be no time to hedge once the slide begins. Fortunately, there are things you can do today using the liquid tools available to both broadly diversify and defend.
As investors, we are trying to discern what truths exist about the world around us. It is not just a question of discerning what is going on politically or where we are in the economic business cycles. It is understanding the current behavior and the likely actions of the major players sitting at the table. The Fed is in uncharted territory. Their end game is inflation at all costs. I believe they’ll win. Thus, the problem.
My best guess is another 2008-like crisis (or worse) prior to the end of 2016. Of course, it is just a guess but risk is high. At some point I believe the bond market will force its invisible hand (a spike in rates) on the markets. Banks will place blame on rogue traders – those same rogue traders they paid million dollar bonuses to the year before. Leverage is a drug – especially when you are deemed too big to fail.
There are things you can do and I quickly share a few investment ideas next. In short: I recommend that you broadly diversify, position in an inflation play (gold), add flexible tactical investment strategies. Importantly, have a process in place to hedge your portfolio’s long-term focused portfolio exposure.
I believe my friend, Jim Rickards, is correct, “we are halfway through this movie and it is going to end badly”.
What you can do today
In short, hedge long-term focused equity exposure and/or position more defensively.
Consider a portfolio allocation that is 30% Diversified Equities (hedged from time to time with a disciplined process), 30% Fixed Income (allocate to flexible bond investment strategies) and 40% Tactical-Other Investment strategies.
There are mutual funds and equity strategies that have built in hedging processes. We offer one such equity mutual fund. Diversify amongst a handful of such funds and/or strategies. Some strategies use collared option strategies and/or other risk management processes. One could also just buy deep out of the money put options. Some form of responsible hedge process is appropriate in my view.
As for Tactical strategies, they come in different forms. Here is a quick look.
Overall, tactical strategies are flexible in nature. They are investment processes that seek to identify and profit from price momentum. The idea is to position to securities that are exhibiting the strongest market leadership whether it be equities, global equities, various bonds (short or longer term exposure) and/or cash. Some are more conservative, some are more aggressive (size appropriately such as just 3% to 5% allocations to the more aggressive strategies). An abundance of academic research exists on the merits of price momentum. Click here for a link to our white paper.
The overriding idea is that you have strategies, funds and different forms of liquid resources available to you to create broadly diversified portfolios.
Also, each week I post two charts in Trade Signals you may consider following. One is Big Mo (attempts to identify the equity markets major cyclical trend) and the Zweig Bond Model (which attempts to identify the major trend in the bond market). I comment on Big Mo below.
Of course, I encourage you to learn about the tactical strategies we run available to advisor client portfolios on the various custodian platforms including: TD, Schwab, Fidelity, TCA, Pershing, Envestnet, Placemark, Folio FN, Folio-Dynamics and Wells Fargo.
For more aggressive investors, here are three targeted bets I favor:
- 10% allocation to physical Gold (inflation hedge). If the market dislocates as Rickards believes and gold moves to $7000 per ounce. A 10% allocation will serve as a mighty hedge potentially preserving your entire portfolio.
- A 3% to 5% allocation to Short Yen vs. the dollar or better short Yen vs. the Euro. YCS is one such ETF.
- Consider a short bet on Financials. Out of the money puts on JPM, Citi, or other highly derivative exposed banks. Or a non-leveraged inverse Financials ETF or out of the money puts on a Financial ETF.
Trade Signals – An Aged Bull
I received an email this week from a reader and I thought I’d share my response as his question is related to the Big Mo chart I post each week. I share some thoughts in my reply about trading.
Steve,
I really enjoy reading your pieces each week. They’re very clear and balanced, and they help me keep my head straight with all the information that’s out there.
Last year you mentioned Ned Davis’ “Big Mo Can Make You Dough” (http://www.cmgwealth.com/ri/trade-signals-big-mo-can-make-you-dough/) and mentioned that you and your team were going to take a deeper look at the strategy. The results seem incredibly impressive, and I wonder if you had any further thoughts about it. Were you able to deconstruct it or replicate it at all?
Anyway, thanks for all of your commentary.
Best,
DG
My answer:
Hi DG,
Here is a link to Wednesday’s website post – Trade Signals. In it, each week I share the Big Mo chart.
What we are doing with NDR is customizing a CMG version of Big Mo. I’m not really sure there is much need for change as the model has been around for years but we do want to see if we can improve and/or create a daily version of the data vs. weekly. Though the idea is to catch the major market cyclical trends, I believe weekly is fine. What I post to the website in Trade Signals each Wednesday is the weekly data.
I’m heading down to visit NDR for a few days in May. I’ll update via my letters. As it relates to trading and making money, it is important to keep in mind that the hard part is having the discipline to act on the signals. Not all are perfect and even if the signal proves correct, it may look wrong for several days or weeks before a cycle change is confirmed.
Systematic tactical trading requires a discipline to monitor the signals and the discipline to make the trades. Maybe that’s what makes the concept of buy-and-hold so appealing. Yet, unfortunately, that simple concept becomes all too challenging in times of great stress and greed. Evidence shows individual investors (and pros) buy and sell at the wrong time.
In both processes emotion can get in the way. Therein lies the tough parts about investing. I have followed Big Mo for many years. I have that conviction to act on its signals and have removed the ego to be right every time. I have no problem buying back in at a higher price if a particular signal was wrong. It is about probabilities. I want them high enough in my favor but I realize nothing has a 100% win rate.
I also have the ability/confidence to buy in at market bottoms, though I can tell you I have been really scared each time (especially 2008). A lot of years and some hard knocks along the way have taught me much. Importantly, patience is required as those great opportunities present themselves infrequently. They don’t ever show up at the point we want them and it is important to remember that it never feels like a bottom at the bottom – the news at those points in time is extremely negative. Similar emotional indigestion occurs near market tops. Most stretch for that extra base.
I did a piece in late 2008 called, “it’s so bad it’s good”. I took a lot of heat. The financial world was falling apart. It was my fear at that time that convinced me to follow my process. The process said buy. I bought. It was emotional nonetheless.
I believe an investor can do well by following Big Mo but the key questions are:
- Do you have conviction in the process, through time, through all the market noise and be willing to reverse course if the signal says to do so? It is required as not every trade is a winner.
- Do you have the tremendous amount of patience required? In some strategies, like Big Mo, a signal may take years before it materializes.
- A great emotional self awareness is required. Do you have it?
- Time to monitor the positions on a daily or weekly basis is required. Do you have the time given your day job? Life can get very busy. A missed trade can be costly and throw you out of sync with the strategy. An “I’ll just wait for the next rally to exit” situation. Then no rally and a bigger miss.
Lacking the above, far too many will fail. I think that is why an advisor coach is so important for many investors. I often speak with our advisor clients about their role as a financial psychologist. They always smile and nod at the word psychologist. Money evokes all kinds of emotions. A great advisor coach is most important at points of emotional extreme.
In conclusion, Big Mo’s stats and history are impressive (twice the market’s return over time) but it takes time, conviction and discipline to follow for many years.
As a quick aside, NDR is one such resource our due diligence team search for outstanding investment strategies. There are others of course. We have looked at over 1000 different strategies and more than 600 managers since 2011. The over-riding idea is to find and invest in the very best tactical investment processes. We are always looking and evaluating.
Thanks for your email and kind words.
All the very best, S
Click here for a link to Wednesday’s Trade Signals. (LINK TO THE CORRECT TITLE)
Conclusion
Spain was simply beautiful. Seville is a town built around a castle erected more than 900 years ago. I think about the many wars, regime changes and growth over the years. The global debt crisis moves forward and the Euro and the EU seem to be finding some footing. Much of what we are seeing really is not that new.
I met with an economics processor at my daughter’s college in Seville. I wanted to get his thoughts on the high level of youth unemployment and his view of his country’s adoption of the Euro. Remember that Spain is one of the more troubled members of the EU. As you’ll learn in the Death of Money, there is positive progress and reason for optimism in Europe. It’s Rickards’ view that the Euro may just become the world’s next reserve currency – displacing the dollar.
When I had some down time, I found myself drawn to Rickards’ new book. He is a lawyer by training and capital markets expert by profession. He writes in a balanced and direct way. I like that. I read for almost six hours on the flight home and still found it hard to put the book down. The book had me captured and I believe you’ll find it includes important topics of discussion that will get you thinking.
The book talks about levels of complexity that is important to understand. Who are the major players at the table, what are their motives and what are their likely moves? Money flows from shore to shore in search of where it will be treated best. Trade is dependent on exchange rates and today the world is more interdependent and interconnected than at any point in history. I’m not sure of the death of the dollar but that risk looms large. I do hope we break up the banks and require derivatives to be traded on independent exchanges – lest you and I and 300 million Americans finance their next bailout.
Unfortunately, I don’t think a breakup will happen as there are too many bankers deeply imbedded in the pockets of our politicians. We are at a tipping point and it may just be another break in the system that forces the hand. Either way, whether it is the dollar or a banking system derivative related crisis, I have never been more confident at any point in my 30 year career that we all need far broader diversification and risk protection. You can get more concentrated in portfolio structure after the next crisis.
Walking on a tightrope with no net? Indeed.
I’m heading to Florida next week to speak at Randy Verlin’s advisor conference. He has a great group of about 60 independent advisors. Then I travel to Chicago in mid-May for Envestnet’s annual conference. Please let me know if you are going to be attending.
Kid number three is starring as Gaston in his middle school’s Beauty and the Beast play tonight. These are the important things in life. I’m really looking forward to watching him perform and then watching his brothers give him the post-play recap – as only brothers can do. It’s great to be home.
Wishing you a fun filled weekend!
With warm regards,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Philadelphia – King of Prussia, PA
steve@cmgwealth.com
610-989-9090 Phone
610-989-9092 Fax
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