The Blumenthal Viewpoint: February 1, 2013

February 1, 2013
By Steve Blumenthal

The Race to Debase

“I think they can pull it off”, he says. “Pull what off”, I ask? “The Fed, you know, the printing of all this new money to bail us out of our debt mess. I think it just might work.” I cringe and quietly think my friend has drunk too much of Krugman’s spiked cool-aid. I respond, “There is abundant historical evidence on how this likely plays out. The outcome is somewhere between bad and really bad.”

I hung up the phone, closed my office door and started to reflect. Where are valuations, where are we in the cycle, what is the global fundamental picture, what does the supply/demand picture look like and where are investor emotions? Everything in me screams that this is not normal. Ultimately, if there isn’t sound business sense to a transaction, then something is off.

Stay around long enough and you’ve got experience. Stay around long enough with real money on the line and you’ve got real life experience. Give me the guys with real life business experience.

I’ll first jump to the conclusion of this piece.

The global central banks are driving 150 miles per hour. Accelerators pressed to the metal in a race to debase. Victory is the mission. The consequences to trading partners are secondary. This is a piece about watching what they are doing vs. what they are saying. We humans tend to focus our vision on the immediate; justifying unprecedented action (global printing) with short sighted data while failing to look farther over the horizon.

My conclusion is that the creation of currency units is unquestionably inflationary. What lies ahead are significantly higher interest rates – just not right away. With rates at historic lows, the impact to those unprepared will be disastrous, yet for those prepared, the investment opportunities are tremendous. For the deeper discussion, please read on.

Who’s right, who’s wrong, whom do you believe and when?

I wondered what my friend was thinking in 2007. It was clear what most were thinking. It was the “goldilocks” time. An economy that was not too hot, not too cold but just right. Remember that goldilocks mantra? Yet beneath the surface as Greenspan’s rock-bottom rates encouraged Americans to load up on debt to buy homes, even when they had no savings, no income and no job prospects, the storm was building. Individuals leveraged up and the banks rolled up the loans. No docs, no money down, interest only mortgages. It made no sense.

The experts told us all was ok and the big guy backed it up. Greenspan’s confidence supported the market. Nothing to worry about folks – just look here and watch for the light. (I picture Will Smith in the movie Men In Black flashing his memory erasing light beam .)

Whom do you believe and when? Shortly after Greenspan’s comments, housing collapsed and brought the global economy to its knees. There are unintended consequences to policy action or inaction and markets have a funny way of correcting the imbalances.

In testimony before congress, Greenspan addressed Congressional Committee Chairman, Henry Waxman. “You found that your view of the world, your ideology was not right, it was not working”, Henry Waxman said. “Absolutely, precisely”, Greenspan replied. “You know, that’s the reason I was shocked, because I have been going for 40 years or more with very considerable evidence that it was working exceptionally well.”(1)

To me and others, the sub-prime bomb was obvious (detailed in my writings at that time). John Mauldin was the first to turn me onto the risk. I remember thinking to myself, how bad could it be? I dove into the research to better understand the money flow into various tranches of mortgage derivatives called CDOs. It was a deep dive to understand the risk. We have the resources and, more importantly, the relationships (global macro, hedge fund, distressed credit, mortgage managers, etc.) to get answers. I needed to see where and if to what degree we had exposure.

There were mortgage pools layered on top of mortgage pools. The derivative structure made the exposure systemic. Banks exposed to other banks in ways they didn’t see. Easier to take the underwriting fees and look the other way. “Follow the money trail” my father used to always say. “Watch what they are doing and not what they are saying.” Good advice – a smile and a nod to dad (miss you).

Who kept buying the stuff, I wondered? As it turned out, AIG and others relied faithfully on our credit rating agencies and got hammered. These derivative structures truly were weapons of mass destruction and you and I ate the bill.

“You’re so bearish” I was told a hundred times over. How does one explain this to the lay person? How does my mechanic explain to me the problem deep within my cars engine? Like I’d get it. The Wall Street derivative factory was operating absent of ethical grounding. It was clear to me that what was happening made no sense but that didn’t stop prices from moving higher – then the system and global economy broke. Imbalances build and at the end of the day it comes down to buyers and sellers. Find the inflection points – follow the money trail.

Clients and readers would point out how good things were (focused on the present). I pointed my focuse on the horizon. The imbalances were big and systematically unhealthy. What followed were the great recession, a 50% decline in equities and the near collapse of the global financial system. Whom do you trust and when?

More from Greenspan, “Regulators underestimated the scale of the asset price bubble”. But he attributes the failing, among others, to overseas regulators, the U.S. credit rating agencies, financial houses and mainstream economics. “In the growing state of high euphoria, risk managers, the Federal Reserve, and other regulators failed to fully comprehend the underlying size, length, and impact of the negative tail of the distribution of risk outcomes.”(2) Thanks, Mr. Greenspan, thanks.

How about Tim Geithner: Top policymakers at the Federal Reserve felt for most of 2007 that problems in housing and banking were isolated and unlikely to tear down the economy as they ultimately did. “We have no indication that the major, more diversified institutions are facing any funding pressure,” Geithner said. “In fact, some of them report what we classically see in a context like this, which is that money is flowing to them.”(3) Whom do you trust and when?

Similarly, Fed Chairman, Ben Bernanke underestimated the risks of a looming financial blow-up. “I do not expect insolvency or near insolvency among major financial institutions,” (3) he said in December 2007.

The world broke in 2008. The system was insolvent. It all looks so clear to everyone now.

Are we any less foolish today? I reflected on the conversation with my friend and share my thoughts on what I believe we are failing to see today. The idea is to be prepared and positioned to take advantage of opportunity vs. emotionally driven reactionary behavior (buying at the top with the emotion of missing out or selling at the bottom tied to emotional fear – wash, rinse and repeat over and over again).

My friend’s confidence (or surrender) matches perfectly with the extreme level of investor bullishness we see today (see 1-30-13 Trade Signals for charts). He feels safe now. “Sell when everyone is buying” is pounding in my head.

Big picture

The next recession will present a generational buying opportunity and a reset of both dividend and fixed income yields at higher levels.

Looking forward I see the following: My best guess is it occurs within three to five years and, by the way, it won’t feel like a generational buying opportunity at that time. It never does when you buy in after market declines. I expect more attractive valuations and higher dividend yields. In short, a new long-term secular bull market trend will begin. For now, patience is required. As PIMCO’s Mohamed El-Erian says, “we are moving towards a better secular destination”. I agree.

Until then, it remains to build a diverse portfolio that includes a broad set of diverse risk drivers. Proactively risk protect long equity exposure (I like covered calls and puts tied to investor sentiment extremes – like today), think differently around fixed income as yields are far too low, and add other non-correlating tactical strategies and other alternatives to your portfolios. I also like gold. Three buckets: I favor 30/30/40.

The biggest single risk I see on the horizon is the deepening of what is a global currency war and its unintended consequences.

Currency Wars – this is the single biggest risk I see and it is already “game on”

In 2006, it was sub-prime, CDOs and 60:1 leveraged banks. In 2010, the biggest risk was Europe with unmanageable debt and entitlements and a new unified structure that continues to take form.

Today, while Japan is moving into crisis, the bigger risk I see involves the global currency war between the U.S., the EU, the UK, China and Japan as well as the collateral damage to the periphery (emerging economies like: Russia, Brazil, South Korea, India, and everyone else). This is a war that I believe has already started.

The culprit is a developed world awash in unmanageable debt and unmanageable entitlement promises. We have reached an inflection point between unmanageable debt and austerity and the simple human behavioral response is to protect its own. Lacking political will and a broader unified global vision, it has become country vs. country, us vs. them. It is here that forward thinking requires solid common sense. Behaviorally, we are already following the predicted script. Watch what they are doing and not what they are saying.

There are unintended consequences of global currency creation with paper money backed by nothing. Here I think Greenspan is right on the money, “under the gold standard, a free banking system stands as the protector of an economy’s stability and balanced growth… The abandonment of the gold standard made it possible for the welfare statists to use the banking system as a means to an unlimited expansion of credit… In the absence of the gold standard, there is no way to protect savings from confiscation through inflation.”(4)

The war begins

A currency war starts when there is simply not enough growth to go around. Add in unmanageable debt, not enough income to pay your bills and high unemployment and a country finds itself in a tough spot. Lowering one’s currency makes its goods cheaper to buy. The hope is to stimulate growth.

If you can buy the same item at Bloomingdales for $150 that you can buy across the street at Macy’s for $125, you’ll go to Macy’s. The same thing happens with world trade and manufacturing. If our dollar goes up against the Japanese Yen, our dollar buys the same item at a lower price. Countries use currency manipulation as a way to make their products less expensive.

Apple Computer manufactures iPhones and iPads in China. It is cheaper as a result of inexpensive labor and a currency pegged to our dollar. Our manufacturing moved to China and we, for years, imported lower priced goods and benefited from their extremely low labor costs. However, tension builds. We need jobs here at home to lift employment and cry foul at China’s “unfair” currency manipulation. In need and upset, we respond to force inflation on them. We unleash unlimited Quantitative Easing (QE) (creation of dollars). The goal is to force them to unpeg their currency and/or to force inflation on them, leveling the competitive playing field.

The Fed wants inflation. Watch what they do and not what they say.

In a debt distressed, low growth, high unemployment environment, the simple temptation is to steal growth from your neighbors (global trading partners) by devaluing your currency. Japan, China, the U.S., the EU and the UK are all in the frying pan at the same time. Watch what they are doing and not what they are saying. Never before has the developed world printed so much at the same time. The problem is that there are a number of unintended consequences:

Here in the U.S. we import much more than we export. A lower dollar means the price of what we buy/import goes up. Essentially we are importing inflation.
Other countries cheapen their currencies to fight the loss of competitiveness.
In the case of smaller countries, they defend by putting on capital controls. Switzerland, Brazil, Thailand, South Korea and others are doing this today.

On top of importing inflation and capital controls, currency wars quickly morph into trade wars where countries tack on excise taxes and put up other gates to trade that effectively reduce world trade and economic output. None of this is healthy.

When you make too much of anything the prices goes down. The same goes with currencies. The ultimate outcome is inflationary as cost of exports rise (excise taxes) as do costs of imports. Past currency wars have all ended badly and I suspect this one will prove to be challenging as well.

I feared this when I wrote, “The Race to the Bottom” in April 2011. What I wrote about then is now happening today. I believe the most important book I have read in the last year is “Currency Wars” by James Rickards. Jim spoke at our 2012 CMG Investment Forum here in Philadelphia. Here is a link to a presentation he gave last year just prior to QE3. It is outstanding. http://www.cmgwealth.com/ri-category/news/ Click on Jim Rickards, “Currency Wars” full presentation posted 01-30-2013.

The “race to debase” – the currency war has begun. Here are some signs:

It likely began in 2010 with QE1 and a zero interest rate policy. We now have unlimited QE3 – the Fed’s $85 billion monthly purchase of mortgage and government bonds. The Fed has increased its balance sheet from $800 billion to $3 trillion in just the past three years with money created out of thin air.
Deflation is a central bank’s biggest nightmare. In response, the Fed continues with its clear intent to inflate and monetize the debt. The Fed owns nearly 50% of all outstanding mortgage paper and continues to buy $45 billion per month until unemployment nears 6%. They could end up owning the entire market in three to four years. Print and buy – the newly created money goes directly into the system. Unprecedented – a grand experiment.
The Fed is buying over $40 billion worth of Government Treasury Notes and Bonds each month with newly printed money mostly to finance trillion dollar U.S. deficits. This is not normal or healthy.
While not yet out of control, inflation is picking up here at home. The government is cooking the CPI data. Inflation is building. Click here for “Inflation Propaganda Exposed”.
The Fed’s intent is to break the peg of the Yuan (China). Either they devalue or we force them to devalue by driving their inflation higher. Unfortunately, this action is inflationary and will show up in the cost of goods we import. Watch this build.
China quietly has grown to be the world’s number one gold producer, now owning an estimated 1000 tons (up from a reported 200 tons in 2008). The U.S. owns 8000 tons.
Two weeks ago the Bundesbank (the German central bank) surprised markets around the world by announcing that it will repatriate a sizable portion of its gold bullion reserves held in France and the United States. To many, the news from the world’s second largest holder of gold signaled a growing, if clandestine, mistrust among central banks, possibly fueled by diverging policy goals. The Germans have attempted to tone down the alarm by highlighting the myriad of logistical, practical and historical reasons that qualified the announcement as unremarkable. The size, scope, and timing of the move makes it hard not to draw more strategic conclusions. Watch what they are doing.
In the past, 70% of U.S. reserves were held in U.S. dollars. Today that number is 60%. While the world’s reserve currency is the dollar, the world does in fact have multiple reserve currencies.
Japanese Prime Minister Abe plans an additional $113 billion in asset purchases on top of the 2013 ongoing asset purchases of $1.2 trillion. Apparently in bed with the Japanese central bank, the goal is to cheapen its currency by printing newly created currency units in order to make its goods lower priced hoping to stimulate growth to get them out of their economic slump. Japan is suffering as the European recession deepens and slow growth persists in the U.S.

The conclusions I draw from what I see building simply leaves me in a place of concern. The actions are inflationary and to point to current data (even manipulated CPI data or an uptrend in the market) is near sighted. There are unintended consequences to policy decisions and the next one I see is the certainty of inflation.

The behavior of the developed countries of the world, each trying to find a way out of their own internal debt driven crises, is ultimately inflationary. Never before have all of the developed countries printed so much and all at the same time. The conditions are in place as each turns inward to protect its own. It is so easy to argue politically, a seemingly simple solution but loaded with powerful unintended consequences.

Inflation is a big risk I see on the horizon; however, please don’t go to a place of worry. That is not my intent. Simply, be risk minded and take advantage of the opportunities the movement creates.

Equities (hedged from time to time) are better than low yielding bonds. The Yen looks to me to be the worst currency in the global “race to debase”. I like shorting yen (but don’t oversize the bet), commodity-based emerging markets look attractive, tactical strategies, of course, and I favor 10% to 20% to Gold. I continue to favor a 30/30/40 allocation mix with hedging of long equity exposure from time to time (the low cost to insure is worth the expense).

Finally, what about timing for a secular bear market end and bull market beginning.

Demographics appear to point to a 2015-2020 market bottom

I’ll continue to show this next chart from time to time. If I had to take a logical guess on when the market might begin its next secular bull cycle, I’d say somewhere around 2017. It’s a guess! I’ll be focusing on buying at lower valuation levels around that time.

The chart compares the Ratio of U.S. Population Age 35-49 to Age 20-34. Note the high degree of correlation the market (dotted red line) has had with the Ratio of middle age to young. Also note the low in the demographic cycle is approaching – call it 2017. Kind of interesting…

This from NDR explaining the chart: Numerous studies have been done linking stock market performance to demographics, focusing on the MY ratio, which is the ratio of middle aged to young people. When people are young and just entering the workforce, wages and salaries are typically lower, they are starting families, and saving for retirement is less of a concern. As a result, spending makes up a larger share of income. When individuals start reaching middle age, incomes generally reach their peak and there’s greater urgency to save for retirement. The premise is that this additional income is put into asset markets, driving up prices. As a result, when the MY ratio is high, stocks should outperform, while a low MY ratio is consistent with lower stock performance.

It would be too simplistic to say that demographics have and will solely determine stock performance as other things, such as innovation, productivity, and fiscal and monetary policy surely determine returns. Specifically, in the case of the U.S., lower interest rates, greater availability of credit boosted by inflows of money from emerging economies have coincided with its rising MY ratio and inflation-adjusted stock prices. Demographics, however, are one of the few things one can predict on a long-term horizon and can give analysts some direction of where the best returns will be years from now.

My favorite chart on valuations is NDR’s S&P 500 P/E Ratio (normalized GAAP actual earnings). The most recent normalized PE is 19.6 on 12-31-2012. Note the -1.1% Gain/Annum when the PE is above 18.3.

If I’m correct, I believe the next recession (and we do get recessions) will set up an attractive long-term secular equity bull market. My best guess is that recession occurs this year and a secular bull begins within the next two to five years. I see recession this year. Markets decline more than 30% on average in recession. Of course, so much depends on the Fed, the timing of inflation and the knuckleheads in Washington. Keep in mind that 2012 GDP was just 1.5% in a period of unprecedented Fed stimulus. Taxes are now higher and spending needs to be cut. Be careful not to look into that Men In Black neurolizer flash pen. Bam – memory gone.

Conclusion

It is easy to be pulled into the present euphoria. It was easy in 1999 and it was easy in 2007. I believe we are in a time that requires patience, care and a clear focus on risk management. The U.S. Currency War plan is in action and arrogantly implemented with the confidence that we’ll be the best looking sister at the global currency manipulation dance. Maybe so, but we’ll get inflation anyway. We are all interconnected more than we think. Enjoy your weekend and stay away from Krugman’s cool-aid. It’s spiked.

Note: I have posted a number of articles and video links on this subject on our website as well as the above demographic chart and a powerful chart showing 10-year forward expected 60/40 returns. Here is the link: http://www.cmgwealth.com/research-insight/ Click on the News link.

If you have any questions or comments, please feel free to email info@cmgwealth.com or simply reply to this email.

With kind regards,

Steve

Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Suburban Philadelphia
1000 Continental Drive, Suite 570
King of Prussia, PA 19406
steve@cmgwealth.net
610-989-9090 Phone
610-989-9092 Fax

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The Blumenthal Viewpoint: February 1, 2013

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