When the market kills

After the market collapsed in 2008, stress killed people according to research by the Economic Policy Institute.  

We’ve long known that a financial shock causes immediate distress. Suit-clad men leaping from buildings were dismal hallmarks of the Great Depression, and soon after a major recession began in 2007, there were notable spikes in clinical depression, substance abuse and suicides...

Loss of control was front and center for the 26% of those in the survey who had endured a wealth shock. They were 50% more likely to have died during the period of the study, compared with participants whose savings remained intact. The researchers statistically controlled for other causes of mortality, such as ill health, job loss, insurance loss and marital breakdown.

Interestingly, women were more likely to have experienced a wealth shock than men, but they were not more likely to die as a result. They were, in short, more financially vulnerable but more resilient physiologically.

Reality mugs mainstream economist – what it means for investors

A conservative is just a liberal (socialist) who has been mugged by reality. Reality can sometimes change an old economist, too. That happened to Richard Bookstaber and he writes about it in his latest book The End of Theory: Financial Crises, the Failure of Economics, and the Sweep of Human Interaction.

Bookstaber, a Ph.D. in economist from the Massachusetts Institute of Technology, ran risk management for Morgan Stanley, Salomon Brothers and Bridgewater and worked at the Treasury Department and the Securities and Exchange Commission. He is now the chief risk officer for the investments office of the University of California. Not a bad resume. He has a message for mainstream economists – the weakest part of mainstream economics is the math:

We are not robots with fixed, mechanistic responses to inputs. We face a changing world that, in turn, changes the context with which we view the world, and that changes us, again all the more so during periods of crisis. The critical implication is that we cannot plug numbers into a model and solve for the future. We cannot know where we will end up until we take the journey. And we cannot retake that journey once completed.

Couch potato investing: better that betting on a horse race

In Financial Bull Riding I wrote that annual percentage returns is the wrong measure of investment performance. The better metric is absolute dollar return. Naive investors, and most financial journalists, assume the two will produce the same results, but they don't. 

Josh Peters, Director of Equity Income Strategy for Morningstar and the author of The Ultimate Dividend Playbook, calls chasing percentage returns a horse race: 

Almost all of Wall Street is geared around this idea of a horserace. That it’s all about trying to beat your benchmark, beat the S&P 500 — to do it every quarter regardless of whether that quarter is up or down. That’s not what most people are looking to do. That’s only how money managers evaluate each other, maybe. But that’s not necessarily what’s going to serve the actual financial requirements or financial needs of people who are out there. The biggest demand out there is for income and it’s not just because interest rates are low, it’s because baby-boomers are retiring and most of them don’t have those defined benefit pension plans to count on.

The case for a raging market in 2017

Trumpeting a new boss in the White House wasn’t the only cause of the recent spectacular rise in the stock market. Several economic indicators improved in the fourth quarter. Nicholas Vardy wrote,

Consumer confidence stands at its highest level since August 2001. The unemployment rate is at nine-year low. The U.S. economy is close to full employment. S&P 500 earnings are coming out of an earnings recession, and are expected to grow by double-digit percentages in 2017. 

And the money supply jumped:

The supply of US dollars accelerated during late 2016 with October's year-over-year percentage increase in the money supply hitting a 46-month high of 11.2 percent. The YOY growth rate fell slightly to 10.3 percent in November.

This comes after a long period of relatively sedate growth in the money supply through most of 2013, 2014 and 2015.

The recent surge in money supply growth suggests that the likelihood of an economic contraction in the near future has been reduced, with the next downturn being pushed out further into the future. 

Stop dancing to the Fed's fiddle

For the first time in almost a decade the market shrugged off a significant move by the Fed when it increased its rate by 0.25%. Of course, the market had anticipated the increase for a year and so priced it in earlier. And euphoria over the president elect trumped Fed policy. This is a good time to reassess the logic of dancing to the Fed’s fiddle.

Mainstream economists used to dance to the tune of Keynes and fiscal policy until the disaster of stagflation in the 1970s. Fiscal policy, they cried, suffered from too many lags to be effective, as if the lags were the only reason it couldn’t be effective. There were no problems with lags during the 1930s under FDR and it still wasn’t effective.

Fickle as teenage groupies, mainstream economists switched their adoration to the Fed. The Fed could save us all when Uncle Sam failed. Adulation for the Fed climaxed with the financial media’s crowning of Fed chairman Alan Greenspan as the “Maestro” who could orchestrate the economy as he wished with a wave of his wand.

Then housing landed on the economy and caused the Great Recession (GR). Ben Bernanke waved his wand but the economy wouldn’t perform. It couldn’t get out from under the house. Eight years later, confidence in the Fed has evaporated and mainstream groupies are bailing out on the Fed and returning to their first love, fiscal policy.

Investors to get slapped by the invisible hand

The great American economist Benjamin Anderson wrote Economics and the Public Welfare: A Financial and Economic History of the United State, 1914 – 1946. Most mainstream economists get the history of that period, especially the Great Depression, wrong. If you want to know what really happened and why, read Anderson's book. In a chapter on the stock market crash of 1929, Anderson related the following story:

One able Jewish investment banker said in the summer of 1928 that he did not understand what was going on. He said, “When I do no understand I do nothing.” He had withdrawn from the market. He had turned his holdings into cash, and he was waiting until he understood.

Investors are becoming aggressively passive

Last week the Wall Street Journal ran several articles on the tectonic shift in investing from actively managed funds to passive index funds. In “The Dying Business of Actively Picking Stocks,” the Journal reported that “Over the three years ended Aug. 31, investors added nearly $ 1.3 trillion to passive mutual funds and their brethren— passive exchange- traded funds— while draining more than a quarter trillion from active funds, according to Morningstar Inc.”

Even Warren Buffet jabbed a knife between the ribs of active fund managers by stashing his wife’s inheritance in an index fund. One active manager proclaimed passive investing to be worse than Marxism for the future of capitalism.

The standard charges against actively managed funds are that only a few outperform indexes like the S&P 500 and they charge higher fees, says the Wall Street Journal.

Caterpillar needed the Austrian business-cycle theory

Caterpillar is facing its fourth year of declining sales, the longest in its history. It expects total revenue this year to be 39% below its peak in 2012 and profits will be down 68%. Its stock is now 25% below its peak. Through the first six months of 2016, the company’s overall revenue was down 21% from the same period in last year.

CEO Doug Oberhelman is stepping down, but when he took the reins in 2010 the world, especially China, couldn’t get enough metals. Prices were soaring and everyone thought the good times would last. That’s the first mistake most investors and businessmen make – linear forecasting instead of thinking in terms of cycles. Oberhelman should have understood cycles after working for Caterpillar for 35 years. The capital goods sector is the most volatile in the business cycle. But he didn’t understand them. Caterpillar’s problems began when it invested heavily at the peak of a cycle according to an article in the Wall Street Journal:

China inflates its real estate

I have a Chinese friend who used to teach in a university in China. He reads news from home that doesn’t make it into the US media and tells me the more interesting stories. 

Lately he has been reading about real estate. He is a frustrated that many of his family members in China have become wealthy through real estate speculation while he missed out. They had tried to get him to invest with them years ago but he was certain at the time that prices would never rise as they have.

He told me recently the Chinese media reported that total value of real estate in the top three cities, Beijing, Shanghai and Shenzhen, is priced more than all of the real estate in the US. Apartments with a thousand square feet in those cities sell for several million dollars.

My friend told me that China doesn’t have a property tax and just recently added a deduction for mortgage interest in order to encourage more speculation. He said the government wants prices to continue to rise because the state owns most of the land, so it reaps huge rewards when prices rise.

Deutsche Bank - the snowflake that could trigger an avalance

Avalanches build up one special snowflake at a time. The last snowflake launches the avalanche. Financial avalanche specialists are wondering if the troubled Deutsche Bank will earn the honor of being that last special snowflake, the Lehman Brothers of the latest recession.

After Brexit, the IMF warned that the bank was the most significant contributor to systemic risks. Experts have expressed fears about its undercapitalized state for several years. Alt-M’s Keven Dowd confirmed that those fears are justified in his post “Is Deutsche Bank Kaputt?” He wrote that the bank claimed a leverage ratio of 3.5 percent in its 2015 annual report:

What the market has in common with Trump

Watching this market is like watching Trump’s candidacy. Everyone is waiting for both to crash and burn but they keep climbing to greater heights. Even Fox News appears to oppose Trump without much effect just as the stock market sets new records in the midst of gloomy economic news all around.

The market has set new records even as profits are expected to have fallen for the fourth consecutive quarter. Earnings season is upon us and we will soon understand how bad the damage in the second quarter was. Thomson Reuters has predicted that profits in Q2 will be down about 5% from the same quarter last year. Revenue will have fallen 0.8%. It blames oil prices, low interest rates, and a saturated cell phone market.

How long can low rates last?

The charging of interest on loans is one of the most hated and worst understood concepts in human history. Aristotle claimed that money cannot beget money because it is dead, so charging interest on loans is immoral. Moses’ law forbid Israelis to charge interest on loans to the poor, but the Church interpreted that prohibition according to Aristotle’s economics and made charging interest on loans one of the worst sins that Christians can commit. Aristotle’s writings had almost equal weight with the Bible in many matters until Copernicus and Galileo trashed his astronomy.

But kings, nobility and popes needed to borrow money occasionally in order to keep up their conspicuous consumption, so Jews were allowed to commit the sin of usury. That gave Christians an excuse to persecute them regularly.

The church didn’t reform its economics until the 17th century when theologians from the University of Salamanca abandoned Aristotle for common sense. A letter from John Calvin to a friend on the topic may have helped. Calvin wrote that interest on loans was no different from charging rent on land, which everyone could understand.

Recently, an investing newsletter increased the confusion over interest rates for its readers. It claimed that interest rates have fallen naturally from roughly 50% in 5000 BC. “Fast-forward a bit and we see the Greeks expanded the credit system. In 600 B.C., they paid rates of around 16% in a quickly modernizing monetary system. By 100 B.C., though, a typical loan came with a rate of just 8%. And then things got interesting...”

The Damage that NIRP does

Bloomberg carried a story a few weeks ago on Denmark, which has been “blessed” with a negative interest rate policy (NIRP) longer than any other developed nation. The authors asserted that the horror stories about low interest rates with which economists have typically frightened us for decades haven’t come true in the Scandinavian country, so economics must be wrong.

Of course, the Bloomberg journalists have forgotten the primary caveat of economic reasoning – ceteris paribus, or all other things being equal. The horror of money printing, such as the disaster that nearly destroyed Germany in the early 1920s, caused hyperinflation and a plummeting exchange rate. Those haven’t afflicted Denmark, or any other major country, yet, because everything hasn’t remained ceteris or paribus.

When every nation reduces rates in concert, it has no impact on exchange rates. And it may not cause much inflation. The idea that it must cause price inflation or economics is wrong comes from a blockheaded view of the quantity theory of money. Again, ceteris paribus applies. Printing money (or technically credit expansion via low interest rates) will cause price inflation if nothing else in the economy changes. But money printing doesn’t work mechanically. Japan should know. The Bank of Japan has desperately tried to create inflation through money printing for the past 30 years.

Sector rotation confirms ABCT

Mark Skousen in his excellent economics text, The Structure of Production, shows that professions on the front line such as accountants and investing experts, follow the Austrian business-cycle theory (ABCT) often without know it. Schwab confirmed that in March of this year with a chart titled “The Business Cycle: How Does Each Sector Perform.”

The chart divides the business cycle into four segments – early expansion, maturing expansion, late expansion and recession – and shows which sectors perform the best in each segment of the cycle. I do something similar in Financial Bull Riding but use segments of the cycle described by Lord Overton in the mid-1800s.

How not to predict the stock market

Investing expert Bert Dohmen said that “Looking at earnings, dividends and P/E ratios in order to predict future stock prices are all a waste of time” in a recent Forecasts & Strategies email issued by the economist Mark Skousen. The email continued:

Dohmen explained, “If a P/E were meaningful for predicting future price performance, why is a stock like Facebook selling at a lofty P/E of around 90, and Amazon with a P/E of 300, both still highly recommended and rising, while other stocks, like Apple, with a low P/E of around 10, [are] declining and down 35%?”

He added, “Analysts tell us that ‘earnings’ are the most important thing affecting stock prices. Really?! Well, corporate earnings in 2015-2016 have had the largest decline since the crisis in 2009, but the DJI and the S&P 500 are within about 1% of making new record highs.”

Then Dohmen asked the all-important question, “So what is the major determinant of stock market trends?”

Of course, the answer is “future earnings.” Stock prices are always based on the forward-looking views of investors. That’s why high-priced stocks such as Facebook are selling for 90 times earnings. It also explains why Amazon is selling for 300 times earnings and Tesla is selling for $230 a share even though it has no earnings! Investors are upbeat about their future. Meanwhile, Apple is selling for only 10 times earnings because it’s not viewed as a growth stock anymore.

Trucking and profits drive off a cliff

Not long after the 2001 recession I took a job at a large long-haul flatbed trucking company as a rate analyst and one of the first things I noticed on the job was a graph of truck tons/mile. The line grew to the right at a steep grade as a result of Greenspan’s artificial expansion of the economy through money printing in the late 1990s. Then just before the recession, tons/mile drove off a cliff and dived for months until crashing.

Last week, the WSJ reported that “orders for new big rigs plunged and inventories of unsold trucks soared to their highest levels since just before the financial crisis, as uncertainty about future demand and a weak market for freight transportation weighed on truck manufacturers.”

Another market head fake

In the world of real bull riding, as opposed to nominal bull riding, or investing, the cowboy (investor) must anticipate the spins and leaps of the bull. Riders often study video of bulls engaged in previous games of cowboy tossing. A wrong guess sends the cowboy flying then landing awkwardly absent a score and without money.

So what can we make of the January plunge and recent recovery of the bull market? I am betting that the bull’s real intention is to plunge into a bear and that the latest rise in stocks is a head fake to trick the cowboys to overcompensate in anticipation of a continued ascent. Instead, the bull will reverse direction and slingshot the cowboy (investor).

Some of us are mystified by the recent rise in stock prices, but as the great Austrian economist Ludwig Lachmann wrote, moving the deeply anchored expectations of investors out of their comfort range for prices on the market requires extraordinary events. Some of us have seen indicators as early as two years ago, such as the hedge fund manager Mark Spritznagel, author of The Dao of Capital: Austrian Investing in a Distorted World.

Central bankers made bull riding necessary for survival

Bull riding has become a lucrative sport for those with the talent to ride, earning the top riders hundreds of thousands of dollars per year in spite of a few broken bones. Central bankers have made learning to ride the leaps and spins of the stock market a necessity since the early 1980’s. Why has the market been so volatile since 1980? Two factors have caused it:

1. End of Bretton Woods and rise of floating FX.

2. End of fiscal policy and rise of monetary policy.

The existing international system of floating rates doesn’t have a cool name like Bretton Woods, but it came about after the death of the former fixed rate system. The Bank for International Settlements (BIS), the central bankers’ bank, doesn’t like what its member banks are doing under the current system. While the media and politicians, especially Bernie Sanders, preach fire and brimstone damnation of Wall Street and condemn it for the Great Recession, the BIS body slams the world’s central bankers:

Rescuing turtles - How the ABCT can help trend followers part II

Last week I introduced readers to trend following strategies of Michael Covel. Those who follow trends are sometimes called "turtles." Covel and others admit that trend followers have sailed into troubled waters lately.

The Austrian business-cycle theory can help trend followers by taking some of the uncertainty out of trend directions. During bull markets, such as characterized the first six years after the recession, the trend was up about 90% of the time with small dips because 1) the Fed was printing new money like a counterfeiter and inflation rose; 2) profits rebounded as the economy naturally turned around ,and 3) growing risk tolerance drove PE ratios to the sky.

Covel recommends trading the long term trends in his books and the expansion phase of the business cycle is one of the longest, lasting on average about six years. An trend following investor familiar with the ABCT will not mistake dips for trends.

Rescuing turtles - how the ABCT can help trend following investors part I

Futures magazine wondered in 2013 if trend following as an investing strategy was dead:

In 2012, the aggressive and persistent actions by central banks and other authorities worldwide served to maintain an unfavorable market environment that began in 2009 for most trend following systematic programs. Many short, medium and long-term trend following CTAs, as well as other trend following hedge fund strategies performed poorly... While these indexes all reported losses for the second year in a row, the S&P500's climb (+13.4%) continued through year end. Although markets for hedge funds generally were better than for CTAs,... the HFRX Global Hedge Fund Index rose only 3.5% in 2012...the Newedge Trend Following CTA Sub-Index is down 5.89% since the bottom of the financial crisis in March 2009. 

This performance contrasts sharply with longer term numbers, particularly in the CTA space. Since 1980, as measured by the Barclay Hedge Btop50 Index of CTAs, managed futures have returned three times that of the S&P500, approximately 32 times an initial investment vs. 11times an original investment for the S&P 500. And in 2008 the S&P was down 45% while the Btop50 was up 14%.