The world economy today is a highly interconnected system as the process of integration has been greatly accelerated by the technological and political changes that globalisation have brought in recent decades. While the overall trend of progress has contributed to higher living standards and a better quality of (political) life and rights, we now face a period of time that will require extraordinary skill by our leaders to avoid chaos. In the aftermath of the financial crisis, mountains of debt and money have been created out of thin air in order to keep the major financial institutions solvent. Interest rates were practically abolished and liquidity given to any entity deemed systemically important.
Six years have passed since the financial crisis began in 2008 and now the world economy faces a new problem: How can monetary policy be readjusted to normal levels of interest and debt without causing economic chaos? The Federal Reserve in America alone added $3,000,000,000,000 to its balance sheet while interest rates are at 0.25%, about 5% below the average historical short-term rate. Picture a million dollar house and think 3 million of these and then you understand the excess debt the Federal Reserve has added to its balance sheet. Who can it sell these government bonds and mortgages to without collapsing the bond market and housing markets and spiking interest rates? Some people claim the Fed could simply let these bonds expire but that would require the Federal government to run huge budget surpluses for decades which is unrealistic at best.
The new Fed Chair, Janet Yellen, has announced the continuation of the so-called “taper” in which the Fed will slowly print less and less $ every month to add onto their balance sheet. This is the right policy but the ripple effect can already be seen in the emerging markets of the world. Whether it’s Venezuela, Thailand, Indonesia, Argentina, Brazil, Ukraine or Turkey, the idea that less new money will be added to the global economy means that the “hot” money is in full retreat and looking for the safe havens of the world. Those would be blue chip stocks, real estate, commodities and AAA bonds. This is exactly what we observe today and it follows the pattern of previous financial crises where the periphery’s assets crumble before the core catches the flu. Take a look at the Turkish lira and -interest rate below:
The lira has lost almost 25% of its value against the dollar in 2013 which prompted the Turkish central bank to nearly double its interest rate from 6.75% to 11.5%. As western central banks announce a future contraction of liquidity, money flows out of emerging markets and seeks a safer home at the core of the world economy. As a result, western stock markets are rising along with commodities and interest rates there appear to be in check, for now.
While this stage of global economic development appears to be normal growth for people at the core, it is merely the calm before the storm. If global central banks are unable to reduce balance sheets and raise interest rates steadily, it is likely that what we witness in emerging markets today will be seen everywhere once the central banks lose control over the markets. Imagine what 11% interest rates and 25% inflation in a year would do to your economy. Having said that, I do not see the contagion effect that I described here to the “core” before the end of 2015 as the market trend is clear and must be respected. However, sooner or later we will be forced to face the consequences of the decisions of the past 6 years and deal with them. Let us hope Mr. Putin does not create a “sooner” scenario.
In the absence of significant financial news this week I would like to use today’s post to simply say “thanks” to all the readers that have followed my musings for the past 15 months. Seeing that “Market Owl” has reached people in 120 countries encourages me to continue with this site even when other (weekend) activities might appear to be more alluring.
World Map of readers by country.
The past week was marked by a grueling six-hour session with the new Fed chair, Dr. Janet Yellen, in which Congress grilled the decorated professor on many levels of the economic and monetary policy spectrum. Readers of this blog know that I have been highly critical of Fed policy ever since the financial crisis was arrested in 2010. However. Mrs. Yellen did a remarkable job to reassure Congress, markets and anyone listening that she is in control and fully aware of the real economic issues that are somewhat misleadingly reported from time to time.
This first public appearance as Fed Chairwoman was well received by financial markets around the world and deservedly so. Keep in mind that when Alan Greenspan took over the Fed in 1987, he was faced with the crash of 1987 within the first year in office. Likewise, Ben Bernanke took over in 2006 and we know what happened after that. In my opinion, Mrs. Yellen faces a near impossible task to juggle the Fed’s money printing activity with a gigantic Fed balance sheet but to her credit, she seems better fit for the job than anyone else I know.
At some point in the future and in my personal opinion in late 2015, the Fed will eventually lose control of market confidence and we will enter a major global financial crisis. The trigger will most likely be either an out of control bond market or chaotic currency movement as outlined in “The trigger for the next financial crisis”. Until signs of a break down appear, do not fight the trend and stay the course. Caveat Emptor.
On Monday, financial markets around the world seemed to be losing their grip and news commentators were nervously calling for a variety of interesting near apocalyptic financial scenarios. Who can blame them? If you assumed that financial markets were based on fixed money supply, current stock valuations would surely be too elevated as dire economic conditions around the world today are simply not reflected in nominal values of assets globally. By the end of the week, the fear had subsided somewhat(look at the VIX below) and to add confusion to many minds, the big move up that we witnessed in stock markets on Friday was due to the fact that the US employment numbers were awful(and would imply more future money printing). Why do the markets not reflect economic reality anymore?
Readers of this blog know that ever since my first post, I have stated that we live in stagflationary times in which economic output sputters along while prices increase. While we can endlessly argue about the actual rate of inflation, it is clear that it exceeds the nominal rate of interest that can be earned in a bank account, currently about 0.1%. Bonds don’t fare much better and considering the global monetary base below, why would anyone in their right mind want to hold cash or bonds below their level of depreciation?
When governments around the world issue more and more debt(bonds), the price of them should fall and this would be the case were it not for the global central banks printing money to purchase government debt. Needless to say, this policy will end at one point in the not so distant future and lead to grave losses for bond investors.
A rational investor will come to the conclusion that the bond market is artificially propped up by central banks globally and cash is undesirable because it yields nothing while it loses purchasing power. Keep in mind that Mr. Bernanke printed lots of US$, Mr. Kuroda Japanese Yen and Mr. Draghi Euros, Mr. King Pounds… Nobody has printed houses or Pepsi Shares. Herein lies the attraction in real assets. While no asset is entirely detached from monetary and fiscal policy, real assets can only be devalued through taxation and economic conditions, not outright supply expansion as we see in cash and bonds. Therefore, I continue to see the stock market surfing wave 5 of the Elliot wave I wrote about a few articles ago(Surfing the Elliot Wave). Trends in general do not change without an accelerated spike both on the upside(greed) and on the downside(fear). So far, we have not witnessed the near vertical, enthusiastic push to the upside and while the economy looks weak, stock prices are likely to continue going up as more fresh money is pumped into financial assets, hence stagflation.
I would like to point out that this is a wonderful time to purchase gold as an insurance product against any financial portfolio. It is currently trading at roughly the cost of production, historically speaking a great entry point because if the price drops, there will be less gold mined pushing up future prices. Should the financial markets ever get out of the central banks’ control you will find yourself clinging to the 5-10% gold hedge as your financial life boat. And in case utopia sets in and there is never another downturn in the future, you will still hold the same amount of ounces rather than pay insurance every year. Given that over time, all asset prices increase nominally, I would assume that gold will as well or otherwise it will not be mined anymore which would certainly boost the price.
Finally, I would like to add that if you consider buying gold, please buy the physical product. The gold market is very interesting as it exists in many different forms. If you choose to buy a gold certificate from a bank that entitles you to a certain amount of ounces, the gold is yours only in thought. After all, the central bank owns the physical metal, leases it to a bank and that bank then sells you the right to that gold. The problem with this mode of accounting is that the gold you think you own now has three owners: The central bank, the retail bank and you, the customer. If there ever were a financial panic, do you think you would be able to go to the bank and pick up your coins? “Probably not” would be my answer as we are used to having “bank holidays” when markets are in disarray. As for buying futures at an exchange and not taking delivery, keep in mind that the COMEX has only about 10% of gold in storage against its outstanding claims meaning that if customers actually took delivery, the COMEX could not comply and would have to settle in cash as its rules allow.
Stagflation in conjunction with financial repression(negative real interest rates) is a monetary phenomenon that is widely misunderstood. As long as the global financial system chugs along and Mrs. Yellen does not crash the party by reversing QE, expect all real assets to rise in price as smart money attempts to avoid the loss of purchasing power through cash and bonds. Within the wide array of real assets, it takes due diligence to find the right mix of these assets. Good luck!
When politicians and central bankers discuss growth in the economy, we usually hear about GDP and its progression. Devised as a simplified measure to account for a nation’s economic activity, it is made up of the following equation:
GDP= C(onsumption) + I(nvestment + Savings) + G(overnment Spending) + NX(Exports – Imports)
In theory, this calculation reflects economic activity and prowess rather well and can be adjusted for inflation known as “real GDP”. However, there is a serious flaw in this equation and it comes from Government Spending. Clearly and correctly, G is added once as the third input of the equation yet the wages paid for government workers are then also added in “C” or “I” as all wages are either consumed, invested or saved. As a result, any government wages generate twice the GDP that they do in reality, thus they massively overstate GDP(growth). In recent years, government spending globally has increased significantly and therefore current GDP statistics are inflated and far from correct.
I hope the economic community takes notice and fixes this flaw as it poses a significant error in result, analysis and policy in the world economy. For now, we have to live with the figures we receive…
2014 has started with record low volatility and slumbering financial markets. Commodities and bonds are trading in a sideways to down-trending theme while global stock markets are in the continuous process of climbing the well-known wall of worries. Who can blame investors of being scared to join the equity rallies? 50 million Americans depend on food stamps to put dinner on the table, 60% of young people in Southern Europe are hopelessly unemployed, daily demonstrations and riots are to be found in Ukraine, Thailand, Brazil and virtually everywhere in the Middle East as the economic back drop overall appears desperate for so many. Yet, take a look at the “fear index” or VIX below and you will find a record low and ever descending graph:
Is this the calm before the storm or are the markets “wrong”.? Well, it all depends on your time frame but as of now, the markets are correct as they trade in ample liquidity at current prices. The trend is the clear market opinion comprised of millions of market participants who currently state that all is well. At some point down the road this will change of course but right now, there are no signs of pending financial stress. Once the trend changes it will be worth following the “changing winds” similar to the ship on top. However, keep in mind that the market is never efficient in the long run and the equilibrium state that economists like to refer to is a nice theoretical construct that simply does not reflect reality. Markets are not perfect and the world constantly changes. Economists that claim perfect market efficiency run the risk of not picking up a $20 bill on the street when they see one because they conclude rationally that in an efficient environment it would be impossible to find a $20 bill on the street, thus it can’t be there.
Next month, the Federal Reserve will change leader ship and it will be very interesting to see how Janet Yellen continues or changes current policy. As an excellent scholar in monetary history, Mrs. Yellen is surely aware that Mr. Greenspan presided over the 1987 crash in his first year in office and Mr. Bernanke took over the Fed right before the financial crisis. It will be up to Mrs. Yellen to convince the global markets that she can and will continue on a path of liquidity injections in order to keep the markets in the current slumber that they are. As for the feared “taper”, let us not forget the Fed has already fully “tapered” several times in recent years as previous monetary injections were temporarily suspended and led to a decline equities. That in turn convinced the Fed to print ever more money. The current taper from $85 billion a month to $75 a month of money printing is a drop in the bucket and still amounts to gigantic monetary stimulus. The charts below explain the cause and effect behind the history of QE.
While I don’t know Mrs. Yellen’s thoughts, I highly doubt that she is in favor of causing a global crash by reversing QE and raising interest rates. It will be a dangerous balancing act of hers to take over the hopelessly inflated Fed balance sheet and try to painlessly unwind it. By the way, the same issue haunts all major central banks around the world as you can see below. Good luck Mrs. Yellen!
The chart below is evidence to all of us that global central banks have taken over the financial markets in an attempt to restore calm and economic prosperity after the financial crisis from 2008. They have clearly succeeded in restoring confidence in the markets yet not so much in the economy at large. In the long run it remains to be seen whether the QE’s in America, Abenomics in Japan and LTRO’s in Europe will bring economic prosperity or just another historic asset bubble but that will not unwind tomorrow or next month. At least, that is what the market is telling me. Check out the most important benchmarks below.
First, the S&P500, the American stock market index is in the healthiest chart pattern I have ever seen. If I were to write a book about technical analysis this chart would surely be a candidate to describe a healthy up-trending market with no parabolic rise which usually precedes a top of enthusiasm. Unless I see a meaningful deterioration or an exponential rise in this chart there is no reason to fight the tape no matter what you think of monetary policy or the economy. In fact, I would like to point out that 60% of profits in the S&P500 are earned overseas and to that extent the S&P500 is really a global equity index. Given that fact, the European and Emerging Market Indices appear poised to go higher and follow “Papa Dow”.
Bonds and Oil
As I have written before, the main risks to the current financial recovery lie in the absurdly low-interest rates reversing to the upside and in “out of control” inflation. So far, we have neither seen the bond markets spiral down nor my favorite measure of inflation, energy, spike to new highs. While I would not recommend buying long-term bonds at record low yields and fully expect increased inflation over the coming years, we do not observe imminent out of control markets at this stage. Take a look at the bond and oil markets below and you will find a slowly declining bond market and a sideways energy market, very much helped by the “energy revolution” in America.
While there are countless socioeconomic problems in the world today, the financial markets are protected by global monetary policy. For now, the central bankers have convinced the capital markets that all is under control. While it may be interesting to discuss all these issues from a critical angle, financially speaking you should always remember to never fight the trend. I remain highly skeptical of the eventual outcome of all the money printing in the world but as of today, the effects are clearly found in the prevailing trends. Once they change, it will be time to adapt, for now stay disciplined and open-minded. Finally, a great quote from a great man:
On December 5, 1996, then Fed Chairman Alan Greenspan gave a now famous speech in which he claimed that asset markets had reached a level of irrational exuberance. In effect, Dr. Greenspan pointed to equity fundamentals that did not reflect the valuations of the time. While he was surely correct about the rising stock prices, it took another three plus years and a near 500% increase in the Nasdaq until the peak was reached and the Dot Com “bubble” burst in 2000. These days, the financial media seems obsessed with bubbles and everything that goes up in value is immediately deemed to be in a bubble. While this may be good news reporting, it may not be good for your portfolio if it influences your emotions to a level of “irrational” fear.
So how do you know what is a financial bubble and what is healthy valuation growth? Clearly, this post will not be able to fully examine this issue but let me point out that the current search for bubbles in the general public usually means that there is no bubble in the underlying asset. Why? Think about what it takes to burst a bubble as shown below.
When an asset rises in price faster than the fundamentals would suggest, the speed of the gains will accelerate reflecting euphoria and “irrational” exuberance. However, while a market might become a bubble due to unrealistic valuation, we may see a large bubble become larger without bursting as the NASDAQ displayed from 1996 to 2000.
In every historical instance that I have studied, eventually the euphoria seen has maximized and exhausted every potential buyer’s purchasing power of a particular asset after which there is simply no more demand to further increase price. At that point, the parabolic rise plateaus and then goes into a nose dive as stretched holders of the assets create an avalanche of selling while no new/few buyers can be found. Take a look at the NASDAQ chart above and you will see the exact same pattern.
As for today, I can assure you that many asset markets are fundamentally overvalued but the mere fact that public news channels are calling for bubbles everywhere is proof that many potential buyers haven’t bought at this point. Therefore, do not confuse a bubble with a rising or overvalued market. Unfortunately, in order to get these calls right, you have to be the small minority that does not own an asset at its high and buys it when nobody wants it at the lows. In other words, successful investing in volatile markets is for lonely wolves rather than sheep following the herd. Ahh-wooooooo, I mean Caveat emptor!
It has been a year since I started this blog and to those of you that have read my musings and still return, I would like to say thank you. As I had announced in the beginning, I have written many articles that incorporate my economics back ground into the financial thinking process which I employ to survive and strive in the financial market place. To that extent, I think most of the theories have been explained in detail and now is the time to focus on finance and game changing events rather than theory. As a consequence, the frequency of my posts will depend on the flow of events that are worthy of discussion and action.
In the past month, the financial markets have been extremely calm. I want to use today’s post as a personal outlook to what lies ahead in 2014. In the end, this is a finance blog and as an active trader who participates in all major markets, I have an opinion that I want to share. Having said that, be careful to follow my advice. The financial market is a set of “moving targets” and what I think today is based on today’s facts. If I change my mind tomorrow due to changing fundamentals, things may look different. I shall revisit this article in a year to see how my “crystal ball” has performed and if the name of the blog should be changed to “market mole”…
As I have written in my latest post “Surfing the Elliot Wave”, the developed world’s stock markets have been the best performers in any investment class in 2013. Corporate balance sheets are relatively healthy, government policy remains friendly and fixed income yields little to zero. Looking at the chart of the S&P500, you can see a healthy uptrend in which both the 50 day moving average(medium term trend) and the 200 day(long term trend) point up with the 50 day above the 200day MA. This is a very healthy chart and I don’t expect a trend reversal below the 200day average anytime soon. A correction of 7% to the 1650 level is possible and even likely at some point but as long as (government) bonds yield little and interest rates have no place to go but up, the trend in stocks will continue to be up. If economic numbers should improve I would not rule out a stock mania in a year or two.
The seed of the next financial crisis lies here. Governments all over the world are hopelessly indebted and the future pension obligations alone cannot be honored. As you can see below, the Federal Reserve now holds roughly 30% of all long term US debt. Needless to say, this situation is unsustainable and will be at least a $4 trillion dollar issue down the road. Considering $4 trillion is roughly 25% of the entire economy’s annual output, the next crisis will surely be a big one. On top of that, this is the US situation alone. Add Europe, Japan and emerging market indebtedness to the mix and the consequences will surely be historical. Therefore, stay away from long term bonds, if you need security, you are better off holding short term debt or stocks that yield about the same as government debt.
Now, take a look at the chart below and you can see the opposite trend as in the stock market. Both 50 and 200 day moving average are trending down and the 50 day is below the 200 day average. Stay away.
Considering the monumental money creation on a global scale it is truly baffling why the gold price has gone down considerably this year. That is until you realize that gold has gone up 12 years in a row and needed a break from hot money flows. While my opinion on gold as essential financial insurance hasn’t changed, AU too, is in a confirmed down trend as the chart below shows. Unlike bonds however, the future is likely to be rosier for the shiny metal. After all, average mining cost is $1250 an ounce and with the gold price right there, many mines are reducing production and/or shutting down and thus, future supply is decreasing. Lower future supply will lead to higher prices eventually. For the next 12 months, I wouldn’t be surprised to see a capitulation phase in which gold craters to $1000 or so which will wipe out any hot money interest in the metal. That should mark the end of the down trend and I do expect significantly higher gold prices a few years into the future as the government bond crisis unfolds.
Despite $1,000,000,000,000 trillion of money creation by the Federal Reserve in 2013 alone, the dollar’s value has only declined marginally against the rest of the world’s currencies. The main reasons for only a minor decline are to be found in the fact that most global central banks are creating currency at mind-boggling speed. Furthermore, the US economy enjoys an energy revolution that has led to a fast shrinking of the trade deficit which supports the US $. The most interesting currency to me remains the Japanese Yen. It has fallen 25% in 2013 alone yet Japanese bondholders are happy being paid less than a per cent a year to hold Japanese debt, for now… At some point, the decline in the yen will accelerate and a Japanese bond crisis will emerge. I’ll keep you posted.
As for trading the currency market, I would like to refer to Kyle Bass’ recent suggestion of which trade he would initiate for the next 10 years if he only had one option: Buy Gold in(short) yen. I concur.
In conclusion, I want to point out that I expect 2014 to be a largely benevolent year to stock investors but do not forget about the underlying seeds for the next crisis which will surely be upon us within a few years. For now, happy holidays and enjoy the New Year celebrations.
This week has been marked by record equity prices in the US, once again. As I have written in previous weeks, the short-term technical picture of the equity market is robust and continues to point to higher prices in the future. Furthermore, designated Fed Chairwoman Janet Yellen testified before the Senate Banking Committee on Thursday and reassured the world that continued monetary stimulus would be provided for as long as necessary. For additional information, please read Message From Yellen Is Full Speed Ahead on the Stimulus from the NY Times.
Clearly, the current Federal Reserve’s monetary policy is extreme and unsustainable. I can only scratch my head in worry when looking at the chart below that shows the fact that the central bank currently purchases 70% of all US Treasuries and Agency Debt with newly created money. Nonetheless, this monetary expansion supports equity and real estate prices with no end in near sight.
One of the most respected long-term technical methodology to identify and chart financial market movement is called the Elliot Wave(on top). So far, the pattern displayed in US equity prices since 2009 follows the Elliot Wave model very accurately(for further analysis and explanation please click here). We are currently in the beginning of the final wave (4-5, look at top image) of the up move and the model suggests a peak of around 2000 in the S&P500 and 20,000 in the Dow, most likely within 12-18 months. I think this prediction is well in line with the typical psychological pattern of market cycles depicted below. I find the prevalent psychology best described somewhere in between “Media attention” and “Enthusiasm”. Stock tips, IPO’s and high fliers have become fashionable, once again. Historically, this is the time when the biggest gains are made as the market rises in a near parabolic fashion as we are starting to witness today. It is also the most exciting time to be in the market but you have to know when to get out.
My goal is to ride the wave and hopefully be out of harm’s way by the time the wave comes crashing down. Feel free to surf along with me but make sure you understand the inevitability of the end. Caveat emptor!
Loyal readers of this blog know that I have been a harsh critic of quantitative easing across the globe ever since the immediate financial crisis was arrested in 2010. One of the leading professionals conducting QE on behalf of the Federal Reserve, Andrew Huszar, has now come out and explained his view of QE in a Wall Street Op-Ed with the title “Confessions of a Quantitative Easer” . For those of you unfamiliar with Mr. Huszar, he is a senior fellow at Rutgers Business School, is a former Morgan Stanley managing director. In 2009-10, he managed the Federal Reserve’s $1.25 trillion agency mortgage-backed security purchase program.
The article starts very tellingly with the following words “I can only say: I’m sorry, America.” This piece is concise in nature and explains the inner workings and effects of quantitative easing to the public. Please read this article as the consequences of QE will be with us for a very long time.
Should you experience problems opening the article on the Wall Street Journal website, please click on this yahoo link.
In 1913, President Woodrow Wilson signed the Federal Reserve Act into law and regretted doing so in his memoirs six years later. History rhymes…