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On My Radar: Cows, Capitalism and Japan

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November 7, 2014
By Steve Blumenthal

“Traditional Capitalism: You have two cows. You sell one and buy a bull. Your herd multiplies and the economy grows. You sell them and retire on the income.

“American Capitalism: You have two cows. You sell three of them to your publically listed company, using letters of credit opened by your brother-in-law at the bank, then execute a debt/equity swap with an associated general offer so that you get all four cows, with a tax exemption for five cows. The milk rights of the six cows are transferred via an intermediary to a Cayman Island company secretly owned by the majority shareholder who sells the rights to all seven cows back to your listed company. The annual report says the company owns eight cows, with an option on one more. You sell one cow to buy a new President of the United States, leaving you with nine cows. No balance sheet provided with the release. The public buys your bull.” Quote source: http://m.tickld.com/x/capitalism-explained-this-is-so-accurate-it-hurts

I laughed (ok, laughed really hard) when an associate shared the above quote with me and, of course, it got me thinking about Fed QE and Japan’s Kuroda’s “whatever it takes” move. Here is my quick two cents: If you are a speculator and want to ride this wave, I can’t blame you (I too remain in the bull market camp – see Trade Signals posts). If you believe this is based on sound fundamentals, you are setting yourself up for an epic collapse.

“If you take away these elements and put the bulk of power in a society in the hands of a central authority, bureaucracy and/or central banker, then all of the natural imperfections of human decision-making – including the problem of unintended consequences, the inability of central planners ever to have enough information to make wise decisions about the allocation of resources across an entire society, corruption, arrogance, and the fallibility of human nature – are exacerbated and concentrated.” Famed hedge fund manager, Paul Singer

The Japanese central bank is deflating its currency to buy stocks all over the world. Creating new Yen out of thin air and using that money to prop up as many global currencies as it can (relative to its own currency). Print money, buy pounds, buy euros, buy dollars, depress yen, inflate stocks – wash rinse and repeat. This is desperation.

Today, let’s go a little deeper into the Bank of Japan’s (BOJ’s) announcement (it’s big) and what the implications might mean for the markets. I share a few trading ideas in this week’s conclusion and note that the cyclical trend evidence for equities remains positive. Also, I share two charts I think you’ll find interesting: one on seasonal returns and the other on the presidential election cycle. (Hint: Full steam ahead)

Included in this week’s On My Radar:

  • The Bank of Japan
  • Stockman’s Rant
  • Paul Singer On Capitalism
  • November 1 Starts the Best Six Months to be in Stocks – Data Provided
  • Presidential Election Cycle – The Best Three Quarters of the Cycle Immediately Ahead
  • Trade Signals – Trend Still Positive and Sentiment Favorable – 11-5-2014

The Bank of Japan

“On October 31, the BOJ unleashed a surprise round of further stimulus to its monetary policies. As part of its efforts to reach 2% inflation, the BOJ now plans to increase its monetary base by ¥80 trillion per year ($720 billion U.S.) and it tripled the size of its annual purchase of exchange-traded funds (ETFs) to ¥3 trillion per year ($27 billion U.S.) as well as tripled the size of its real estate purchases to ¥90 billion per year ($810 million U.S.).

Then the second surprise: Further boosting risk sentiment, Japan’s Government Pension Investment Fund (GPIF), the largest pension fund in the world with more than $1.1 trillion in assets, announced later on October 31 a new targeted asset allocation plan:

  • Japanese government bonds reduced from 60% to 35%
  • Japanese stocks increased from 12% to 25%
  • Foreign bonds increased from 11% to 15%
  • Foreign stocks increased from 12% to 25%

These allocation shifts mean the Government’s Pension Investment Fund looks set to buy approximately ¥10 trillion ($90 billion U.S.) of Japanese equities and foreign assets of ¥16 trillion ($145 billion U.S.). However, these numbers are just direct assets held by the Pension Fund. It is widely thought that there will be many follow-on pension funds that adopt this allocation shift and even double those numbers.

Note, the type of flows that caused Japan to be the best performing market in 2013 were approximately $150 billion of foreign investor inflows into Japan. The Government Pension Investment Fund and follow-on offerings are likely to rival this allocation—but this time purely from local Japanese buyers. Additional foreign buying could compound this increase in assets toward Japanese equities.” I share this view.

Source: Double Dose of Stimulus Sending Japan Stocks Up, Yen Down by Jeremy Schwartz, Director of Research on November 4, 2014. http://www.wisdomtree.com/blog/index.php/double-dose-of-stimulus-sending-japan-stocks-up-yen-down/

I also note the following from my good friend, John Mauldin:

“If the yen depreciates only 10% a year, that exerts an inflationary force of less than 0.5% a year. Given the market dynamics already at work in Japan and given the stated goal of 2% inflation, that is nowhere near enough. There will come a time in the not-too-distant future when inflation again starts to recede uncomfortably below 1%, and the only way Governor Kuroda will be able to maintain his credibility will be to double down on even more aggressive QE. Whatever it takes, indeed!

These are not simple men at the helm of the BOJ. They fully will understand that they are eroding the value of their currency – and that, in fact, is part of their intention. In his comments after the meeting, Gov. Kuroda came right out and said, “Overall, a week yen is positive for Japan’s economy.” He hopes that by weakening it he will put some competitive zing back into Japan’s exporting industries. By targeting equities, Japanese leaders hope to alleviate much of the pain to investors and their pension funds by fomenting a rising market. And Japanese corporate profits are up significantly – far more than those of their European and US counterparts – over the last two years as the yen has fallen.

I am sure the “unintended” consequences of Japanese actions are discussed at the monthly meeting of central bankers at the Bank of International Settlements in Basel. Perhaps they are even discussed aggressively. But at the end of the day, all Kuroda-san can do is shrug his shoulders and tell the other members he has no choice.

And he doesn’t. If he does not continue in his present course, he will face a deflationary depression of the first-order, and that would have an even greater negative impact on the world than what he is attempting to do now.

But it is remarkably naïve for the market to believe in the illusion that the central bankers of the world have it all under control, that they have this all thought out, that they have modeled it perfectly, and that these new Japanese actions are simply part of the plan.” Thoughts From the Frontlines

Stockman’s Rant

Courtesy of Art Cashin

“In Monday’s Comments, I eluded to David Stockman’s critique….near rant….of the action taken in Japan. Here’s a bit of Mr. Stockman’s essay:

This is just plain sick. Hardly a day after the greatest central bank fraudster of all time, Maestro Greenspan, confessed that QE has not helped the main street economy and jobs, the lunatics at the BOJ flat-out jumped the monetary shark. Even then, the madman Kuroda pulled off his incendiary maneuver by a bare 5-4 vote. Apparently the dissenters——Messrs. Morimoto, Ishida, Sato and Kiuchi—-are only semi-mad.

Never mind that the BOJ will now escalate its bond purchase rate to $750 billion per year – a figure so astonishingly large that it would amount to nearly $3 trillion per year if applied to a US scale GDP. And that comes on top of a central bank balance sheet which had previously exploded to nearly 50% of Japan’s national income or more than double the already mind-boggling US ratio of 25%.

In fact, this was just the beginning of a Ponzi scheme so vast that in a matter of seconds it’s ignited the Japanese stock averages by 5%. And here’s the reason: Japan Inc. is fixing to inject a massive bid into the stock market based on a monumental emission of central bank credit created out of thin air. So doing, it has generated the greatest front-running frenzy ever recorded.

The scheme is so insane that the surge of markets around the world in response to the BOJ’s announcement is proof positive that the mother of all central bank bubbles now envelopes the entire globe. Specifically, in order to go on a stock buying spree, Japan’s state pension fund (the GPIF) intends to dump massive amounts of Japanese government bonds (JCB’s). This will enable it to reduce its government bond holdings—built up over decades—– from about 60% to only 35% of its portfolio.

Needless to say, in an even quasi-honest capital market, the GPIF’s announced plan would unleash a relentless wave of selling and price decline. Yet, instead, the Japanese bond market soared on this dumping announcement because the JCBs are intended to tumble right into the maws of the BOJ’s endless bid. Charles Ponzi would have been truly envious!

A little later Mr. Stockman suggests that demographics will doom the efforts of Abe and Kuroda.

Stated differently, Japan is an old age colony which is heading for bankruptcy. It has virtually no prospect for measurable economic growth and a virtual certainty that taxes will keep rising —since notwithstanding the much lamented but unavoidable consumption tax increase last spring it is still borrowing 40 cents on every dollar it spends.

So 5-year JGBs yielding just 11 bps are an insult to rationality everywhere, and a warning that Japan’s financial system is a disaster waiting to happen. But even that is not the end of it. Having slashed its historic holdings of JCBs, the GPIF will now double it allocation to equities, raising its investment in domestic and international stocks to 24% each.

Stated differently, 50% of GPIF’s $1.8 trillion portfolio will flow into world stock markets. On top of that—the BOJ will pile on too—-tripling its annual purchase of ETFs and other equity securities. This is surely madness, but the point of the whole enterprise explains why the world economy is in such extreme danger…”

From Elliott Management’s Q3 letter, by Paul Singer

I weave into today’s piece Singer’s “A Brief Note on Capitalism” as I feel it apropos to our discussion today on central authority.

“From time to time we find ourselves compelled to write a few words in defense of capitalism. Capitalism is a system according to which capital is owned by private citizens, who in turn determine its price and flow by interacting with one another. Capitalism implies that private citizens get to keep most of the fruits of their labor or the profitability of their capital. Capitalism is neither a “state of nature” nor a primitive scrum. It can work (i.e., create value for owners and for society while being acceptable to the citizenry, including those without capital) only with appropriate rules of fairness and honesty, and workable standards of disclosure. To these factors must be added the ability for people, in a meritocratic way, to have a chance to participate in capitalism. The proper combination leads society to buy into the concept that the individual freedom to own property leads to the most efficient allocation of resources, which in turn results in the highest economic growth and prosperity. Capitalism is never perfect, but the closer society adheres to its general principles, the better it is for the population at large.

If you take away these elements and put the bulk of power in a society in the hands of a central authority, bureaucracy and/or central banker, then all of the natural imperfections of human decision-making – including the problem of unintended consequences, the inability of central planners ever to have enough information to make wise decisions about the allocation of resources across an entire society, corruption, arrogance, and the fallibility of human nature – are exacerbated and concentrated. It is no surprise that governments do almost everything worse than the private sector, and that private philanthropy has created so much more societal value per unit of human effort and wealth than governments have in terms of efficiently and creatively addressing problems. (Bold emphasis mine)

When the governmental impulse is to make all major decisions for people and control almost every aspect of their lives, the “cost” is inefficiency, ineffectiveness; unfairness and tyranny (see the old Soviet Union for details). Having the government choose winners and losers does not lead to better or fairer results than allowing merit and private effort to dictate those outcomes. When it is time to take an action related to life, health, work and career, there is no reason to prefer a government decision over a private decision. The distortions imposed by governments’ exercising control over things that do not need to be controlled by governments are almost without end. Shortages and inflation are traditional consequences of controlling prices. Poor growth, emigration and job losses are the repercussions of making the economic environment unattractive for employers and employees by taxation, regulation, corruption, disdain for the rule of law, and rigid employment policies. It is no accident that the more government does, and the more control government has or is given over people’s lives, the greater the level of corruption and cronyism – even (or especially) in those countries that have populism as their (phony) rallying cry.

The question that governments should always be asking is: How can we make the economy work better, grow faster, provide the best full-time job opportunities, allocate capital more efficiently, help the largest number of people get rich or pursue their destinies, and provide the fairest and most open platform for people to live their lives without interference and to experience the worthiness of achievement or career or parenthood and family? Sadly, we cannot think of many leaders in the developed world who are pursuing policies with that combination of goals in mind.”
Source: http://www.zerohedge.com/news/2014-11-04/brief-note-capitalism

November 1 Starts the Best Six Months to be in Stocks – Data Provided

11.7.1

 Presidential Election Cycle – The Best Three Quarters of the Cycle Immediately Ahead

11.7.2

Trade Signals – It was a Good Buy Decision – Sentiment Now Optimistic 11-5-2014

Technical evidence remains positive. Big Momentum (“Mo”) is in a buy signal since October 14, 2011 and trend evidence (as measured by the 13/34-Week EMA) supports the continuation of the current cyclical bull market move. This is despite last month’s short-term indigestion.

You’ll see in the charts that investor sentiment has moved from Extreme Pessimism back to Extreme Optimism. Let’s call this a bipolar experience. Sentiment suggests caution. As long as Big Mo and the 13/34-Week EMA remain bullish, I continue to be in the buy-the-dip camp.

Included in this week’s Trade Signals:

  • Cyclical Equity Market Trend: Cyclical Bullish Trend for Stocks Remains Bullish (as measured by NDR’s Big Momentum indicator and separately by the 13/34-Week EMA S&P 500 Index Trend Chart)
  • Weekly Investor Sentiment Indicator – NDR Crowd Sentiment Poll: Extreme Optimism (Bearish for the Stock Market)
  • Daily Trading Sentiment Composite: Neutral (Nearing Extreme Optimism – Caution)
  • The Zweig Bond Model: Cyclical Bull Trend for Bonds (supporting longer-term treasury and Corporate bond exposure)

Click here for the full link, including updated charts, to Wednesday’s Trade Signals post (trend and sentiment charts)

Conclusion

I begin today’s conclusion with the following quote from Michael Lewitt, The Credit Strategist, November 1, 2014.

“Despite their efforts to do so, central banks can’t repeal the business cycle (though they can distort it). While the 2008 financial crisis should have taught them that lesson, it appears to have led them to precisely the opposite conclusion.

There are limits to knowledge in every field, including the hard sciences, and economics is not a hard science; it is a social science whose knowledge is imprecise, and practitioners’ ability to predict the future is extremely limited. Fed officials are attempting to guide an extremely complex economy with tools of questionable utility, and markets are ignoring their warnings that their ability to manage a positive outcome is highly uncertain.

Markets are confusing what they want to happen with what is likely to happen, a common psychological phenomenon. Investors who prosper in the long run will be those who acknowledge the severe limits of economic knowledge and the compelling evidence that trillions of dollars of QE and years of zero interest rates may have saved the system from immediate collapse five years ago but failed to produce sustained economic growth or long-term price stability.”

So I found myself laughing at the cynical humor about cows and American capitalism and foresee a time in the not too distant future when words like SWAPs, derivatives and re-hypothecation will once again grace the front pages of our papers. There is too much debt, too much of the wrong kind of debt (unproductive debt) and far too much leverage is in place. We are witnessing the grandest of all economic experiments and, in my view, will, too, end in crisis.

For now, both the equity and fixed income trend evidence remains bullish and there is a pretty good new bid coming from Japan, Japan’s largest pension plan and I suspect other global pension plans. So ride the equity wave but be aware, be forewarned and be hedged.

I’m frequently asked my view on the timing of the next dislocation. I believe it begins after two consecutive rate increases by the Fed. Odds favor the first rate hike in June 2015. So a wild guess is October 2015. Other cycle work targets that date but really I am just making a guess. QE4 may show up and extend the runway but I do think it is tied to default and rate increases. Generally speaking, it is typically the second interest rate hike that leads to a bear market but it could be a sovereign debt crisis in Europe.

As a high yield market expert with over 20 years of watching the ebbs and flow of riskier credit, I see a coming default wave of unprecedented proportion. Rising interest rates and the inability of lesser quality companies to find additional funding (that up until now has kept them afloat), in my view, will lead to a new default cycle and the next recession. We should watch the high yield bond market for clues on timing. It will tell us a great deal.

Finally, I generally don’t do this but I promised I’d conclude with two aggressive ideas. In past letters, I’ve shared that my mother-in-law wanted to gamble with a small amount of money. She asked me what she should buy. I quietly cringed inside and told her about the mess Japan is in and how they will likely do all they can to print money in order to escape their impossible debt load (a whopping 250% debt to GDP), pension responsibilities and aging demographics. I told her about an ETF that is essentially short yen vs. the dollar. It is the ProShares Short Yen ETF and the symbol is YCS. That was early August 2013 and her gain since is approximately 36%. Hint: it is never smart to give your family investment advice; however, this coming Thanksgiving dinner looks to be a cheerful one. As you may conclude from today’s post, I continue to like shorting the yen vs. the dollar.

Further to the Japan story, I believe the Japanese equity will be inflated by Kuroda’s QE (similar to the Fed QE impact on U.S. equity and fixed income assets). So one last speculative idea for you today (to be weighted appropriately small within a portfolio) is the WisdomTree Currency Hedged Japan Equity Fund, symbol DXJ. They hedge out the downside currency risk seeking a purer play on Japanese equities. Go to ProShares and WisdomTree’s websites to lean more. Read the disclosures and go forward at your own risk. Most importantly, please know that this is not a specific recommendation for you as I have no idea as to your or your clients’ needs, risk tolerance and time horizon. If you are an individual investor, speak with your advisor and remember that past performance guarantees nothing.

I’m expecting I might just get another call from my mother-in-law…she is an active reader and fan! Another stock idea to share. I must be nuts.

Wishing you the very best.  Have a wonderful weekend!

With kind regards,

Steve

Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.

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