Posted by Don Martin on Fri, May 27, 2011 @ 12:51 PM
Bond market rally hints at a top for stock prices
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Today the 10 year U.S. Treasury bond yield got as low as 3.055%, going slightly below the 200 day moving average of 3.07%. This is a bullish indicator for bonds and thus a bearish indicator for stocks. The stock market has had trouble making new highs and has been looking toppy. The stock market has a 10 year P.E. of 24 (normally it is fair value at a PE of 15, so that implies a 70% over-priced market). 
Are bond yields going to be as low as this coin?
Today the market had light pre-holiday trading. The bond market closed early today for the holiday. Bond interest rates today were not that different than yesterday’s market, which is important since yesterday was a normal trading day.
I have written about these topics in “U.S. equities are 70% overpriced”.
Investors should seek independent financial advice.
Posted by Don Martin on Thu, May 26, 2011 @ 11:14 AM
Why use a bearish investment advisor during a bear market?
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Why bother to pay for investment advice from an advisor who says the market is going down? Why not simply put all of your money in the bank and avoid the advisor’s fees?
The problem with bear markets is that when they go down as they get close to the bottom they become very scary and investors become demoralized and mentally tune out investment advice. So the risk of not working with an advisor is that an investor could miss out on getting advice to buy stocks at the bottom of the cycle. What happens at the bottom is known as the “capitulation phase” where investors psychologically give up on investing and capitulate. It is that moment when an investor should do the opposite. Unfortunately investors tend to follow the herd behavior of the masses and thus are afraid to buy or hold stocks at the bottom of the market.
So investors who accept the views of a bearish advisor should work with the advisor even if the best strategy is one of holding very low yielding bonds. This is because investors need to have a coach that can prepare them for both going into and then also coming out of the crash.
Perhaps investors feel they can simply read a free blog post or a financial newspaper subscription to decide when to get back in the market. The problem with that is that the overwhelming amount of negative emotions experienced during a crash require personalized coaching and encouragement from a seasoned adviser who can provide the emotional fortification to encourage clients to be fully invested in equities at the bottom of the market.
Emotional exhaustion leads to failure
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When someone is emotionally drained that increases the chance of a failure. For example airline pilots on long flights are required to rest after a certain amount of working time. Mountain climbers on Everest report they are much more energetic when they have the comforts of home such as a hot shower and good food in camps on the mountain.
So these situations are similar to the idea that an investor who is emotionally battered by a crash may be tempted to follow the herd and panic sell at the bottom and panic buy at the top of the market. Investors need to find emotional comfort so that they can think more clearly during times of market stress.
Dalbar did a study saying that in the booming 1990’s that individual investors made 3% annualized and the market returned 17% annualized. So the individual investors bought when the market was high and sold when the market was low.
Investing makes people feel emotionally beaten up
Market timing and bubble detection
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It is not possible to time the market. However it is a reasonable goal to attempt to estimate that the market is extremely overpriced or extremely underpriced and then get prepared. Unfortunately bubbles can last for several years and can get even bigger. However, one must try to move out of overpriced assets during a bubble even if the bubble is still going up and one must do this even if it is not possible to time the market.
I have written about these topics in “U.S. equities are 70% overpriced”.
Investors should seek independent financial advice.
Photo by Gregory Szarkiewicz
Posted by Don Martin on Wed, May 25, 2011 @ 12:33 PM
Investment advisors may be able to help during a bear market
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Why use an investment advisor if it is time to take a bearish, defensive posture? Why not simply put all of one’s money into insured bank accounts and thus avoid paying for advice?
If an investor accepts a bearish opinion but does not get professional investment advice then he may miss out on advice when it is time to become bullish. The time to become bullish is at the “capitulation phase” when most people feel despondent about stocks. It is at that time that one’s emotions are affected by the emotions of the crowd who advocate a bearish attitude at precisely the moment that it is time to become bullish. So investors can benefit from listening to a professional advisor and tuning out the emotional of the crowd. A study by Dalbar showed that during the 1990’s boom that retail investors made 3% a year when the market went up 17% a year. The reason for underperformance was that retail investors would buy only after the market had already gone up and then sell when it went down, thus they bought high and sold low.
Unlock investing secrets
An investment advisor may be able to give a client the emotional fortification to stand firm and hold onto an investment during times when the general public may be panic-selling an investment. Having a coach may enable a client to insulate himself or herself from the “madness of the crowds”.
I have written “Can independent investment advice protect investors from a crash?”
The Emerging market economies are more fiscally sound than the U.S., so they may be a place to invest for the purpose of reducing the risk of dollar devaluation, or the risk of developed country government insolvency.
Investors should seek independent financial advice.
Posted by Don Martin on Tue, May 24, 2011 @ 01:59 PM
Does the U.S. government have too much debt?
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An article recently published in the Atlantic Magazine by Daniel Indiviglio said that US government debt priced in gold has not changed since 1971 when the dollar stopped being convertible into gold. In 1971 and today it takes about 800 million troy pounds (there are 12 troy ounces per a troy pound) of gold to pay off the debt.
Of course gold went up from the official price of $35 in 1971 to approximately $1,500 today, an increase of 42.8 times, or 9.43% annualized.
Read my post "U.S. government debt rating cut to negative".
Important: Get more information in my free Special Report about emerging market currency investing.
Investors should seek independent financial advice.
Posted by Don Martin on Tue, May 24, 2011 @ 12:52 PM
Reasons why passive “buy and hold” investing does not work
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Why buy and hold investing does not work. The advocates of “buy and hold” investing claim that you should simply buy a portfolio of stocks and hold on through crashes. However the economy makes significant paradigm shift every 15 to 30 years and many companies refuse to give up what made them successful in the past and thus they fail to transition into the new economy and end up being marginalized.
A good example is to example the changes in the Dow Jones Industrials since 1970 only 20% of the stocks are still in the Dow. Thus buying the components of the Dow in 1970 and holding would have resulted in a holding today that has 80% unsuccessful investments and only 20% successful. (When I say unsuccessful in most cases they became unworthy of remaining in the Dow but did not go bankrupt; only a few actually went bankrupt). The stereotype of a DJIA company is that they are very strong, healthy, with a powerful moat to protect from competition. But the reality is that 80% of the constituent parts were not good investments. This demonstrates the importance of “active management” instead of passive ETF style investing.
I remember during the 1972 boom the news media was full of stories about the Nifty Fifty stocks that were similar to the Dow. They were called “one decision” stocks because the idea was you merely had to decide to buy them and then never decide to sell. Unfortunately these companies were overpriced and their prices dropped significantly in the crash the next two years. During the two years from 1972 to 1974 the market’s value plunged by 50%.
Open the doors to carefully selected investments
Strategies to protect yourself
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- Use several diversified actively managed no load open-end mutual funds
- Use mutual funds that attempt to buy companies that handle paradigm shift well
- Have a fiduciary fee-only investment advisor select mutual funds for you
I have written about these topics in “Which is best: ETF’s or mutual funds” and "Fundamental investing rules”.
Important: Get more information in my free Special Report about emerging market currency investing.
Investors should seek independent financial advice.
Posted by Don Martin on Mon, May 23, 2011 @ 04:38 PM
A thoughtful reader sent me a kind comment that he prefers the Sortino ratio over the Sharpe ratio to estimate the risk of stocks. The Sortino ratio only penalizes the downside risk, whereas the Sharpe ratio judges risk by both upside and downside risk.
The reason I do not favor the Sortino ratio is because I feel there is the risk that an investor, in seeking to pursue capital gains, may subconsciously fantasize that a stock is a winner that can only go up and then he may engage in confirmation bias by only in taking news that supports his view. For example here in Silicon Valley during tech bubbles investors fall in love with tech stocks that have high P.E. ratios and which may have stock price that is rapidly ascending. Suppose a stock has been going up a lot with minimal down days. Then a database composed only of downward movements would miss key data about potential risk that is embedded in the “good news” of a parabolic stock price increase. During a bubble some investments that are incorrectly favored by crowds of naïve investors will have the stock price bid up to excessive heights. It is important to be aware of extreme upward movements and to incorporate that data as a measure of risk. Surely, if a stock goes up way too fast that is a tip off of a potnetial risk.
Life is unfair. Investors sometimes behave in a herd-like manner and make irrational emotional mistakes and overpay for stocks, creating a bubble and spoiling the attempts of rational analysts to predict the market. To attempt to become aware of risk it is vital include the parabolic upward movement of an investment into a database as one of many tools to use to assess risk. Imagine an airplane climbing and never dropping in altitude and going parabolic. Eventually it will lose its airfoil and stall out and it may not be able to pull out of steep decline caused by the stall out before crashing. So the pilot needs, as one of many tools, to gauge risk by examining the excessive rate of ascent. This is not available in Sortino ratios.
Prepare for a stall out
Prepare and test for stall outs
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A better way to gauge downside risk might be to look at fundamentals as Buffett does. For example look at the corporate moat to see how well can the company defend against competition. Look at earnings growth and look at stability of earnings during the last recession to see how well the firm can withstand a recession. Examine the ratio of debt to income to see if the company will have trouble servicing debt.
The problem with Sortino, Sharpe, and Information ratios is that they use the stock price as a key part of their data. But stock prices are frequently the domain of irrational investors caught up in the emotions of a bubble mania. By contrast, corporate earnings, sales, and liabilities are easily documented facts, are more steady and less influenced by emotional investors. (Corporate assets can be overvalued due to a bubble or due to refusal to use mark-to-market accounting). So by seeking to judge a company on the quality, durability, stability of its earnings is a better way to judge risk than following the results of the "Keynesian beauty contest" popularity vote also known as the stock market's price.
I have written about Sharpe ratio and Information ratio in "Increasing results using risk aware investing" and "Sharpe versus Information ratio" on February 16, 2011.
Investors should seek independent financial advice.
Posted by Don Martin on Mon, May 23, 2011 @ 01:24 PM
The economy is ripe for a disinflationary crash
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People inquire about investments for devaluation, financial planning for a dollar crash, they ask how does devaluation affect the housing market, is a dollar collapse unlikely, how will a dollar crash affect mining stocks?
My answer is that it finally appears that a new consensus is beginning to develop that the economy has topped out and will head in a growth recession, with commodities and stock due for a crash. Prominent experts Jeremy Grantham and John Hussman have indicated that the SP is worth about 920 points, not the current 1300 range. Nobel winning economist Robert Mundell was quoted in the WSJ today as expecting the economy to cool off and the dollar to go up against the currencies of the other developed countries.
During a world-wide recession people flee risk assets and seek the safe haven status of the dollar.
Commodities have usually only gone up during wars or the great inflation of the 1970’s and rarely have they gone up for more than a decade, even though the commodity cycle lasts about 17 years from bottom to peak. Commodities performance in the past decade has been the best in 100 years, even though the past decade had many disinflationary crashes from burst bubbles. Since the private sector credit creation (ex-student loans) has been declining in the U.S. and is unlikely to grow that adds to the probability of Japan style deflation in the U.S. The U.S. government may have budget cuts, which are already being done by some states. So the implication is that commodities went up too much, can’t be supported by the fragile economy and were partly propelled upwards by a speculative bubble rather than intrinsic demand.
As I have written before, when a crash comes then over-leveraged hedge funds can’t buy put options that their banks require the hedge funds to buy. This is because during a crash the cost of put options increases to prohibitively expensive levels. So the bank increases the margin requirement, the hedge fund will try to sell assets to meet margin calls and can only sell high quality liquid assets because illiquid ones can’t be sold. Thus high quality assets could go down without justification due to panic selling by over-levered hedge funds. The market is very ripe for a flash crash.
Pandora's box opening may lead to crash
Seven strategies to protect yourself
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- If you insist on owning stocks then hold only quality investments (quality is defined as low debts, high corporate moat, consistent earnings growth, good dividends, low P.E. ratios, etc.)
- Don’t use leverage
- Have plenty of cash or mutual funds that hold short term high quality bonds
- Short selling is dangerous because the bubble could get bigger
- Avoid the Euro or Yen currencies
- Avoid European bonds
- Don’t chase after investments with allegedly high rates of return, instead pursue investments that have the lowest risk, which may mean accepting a lower rate of return
I have written about these topics in "Copper bubble explained" and "U.S. equities are 70% overpriced".
Investors should seek independent financial advice.
Posted by Don Martin on Fri, May 20, 2011 @ 11:02 AM
Effect of QE 2 and technology stocks IPO bubble on real estate
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The effect of QE 2 was to stimulate the stock market and commodity market making wealthy investors feel richer. It has worked for the upper class. Now they may take some of their stock market assets and invest in a house to live in. However the risk is that QE 2 created a false boom or as the Austrian economists describe it a “crack-boom”. QE 2 is ending in a few weeks. The Congressional budget showdown over the debt ceiling may lead to government budget cuts. So a reduction in stimulus is coming.
When QE 2 ends then stocks and commodities will go down. Wealthy people who used a stock margin loan to buy a house without a mortgage may find themselves in a cash flow squeeze. If they were preparing to buy a home then they will have to suddenly cancel the purchase.
I fear that the new Social Media is simply a fad that will end badly as did the tech bubble of 2000 where people thought that if a website can get “eyeballs” then the company can sell ads to its viewers. That turned out to be false.
Tech stock crash coming?
Warren Buffet said in 100 years of aviation the industry’s stocks have merely broken even when all losses and gains are netted. This means investors overpaid to buy into the glamour of owning an airline. It happened with tech stocks in 2000. It probably will happen now. The resulting crash will be deflationary or disinflationary and will make bond prices go up.
Eventually after many years of deficit spending the government many finally succeed in creating substantial inflation, plus “crowding out” of the bond market, resulting in a massive crash in bonds. Since stocks are not a very good pass-through for inflation then investors will need to learn more sophisticated strategies to protect themselves from inflation.
I have written “Real estate deflation continues" and "Housing not comparable to the past".
The Emerging market economies are more fiscally sound than the U.S., so they may be a place to invest for the purpose of reducing the risk of dollar devaluation, or the risk of developed country government insolvency. Important: Get more information in my free Special Report about emerging market currency investing.
Investors should seek independent financial advice.
Posted by Don Martin on Thu, May 19, 2011 @ 01:22 PM
Sign of dangerous bubble top
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Today LinkedIn had its IPO. As with other tech stocks, I like the product, I simply dislike ludicrously high PE ratios. The stock is trading up far higher than its IPO offering price. The WSJ said "At 641 times the 2010 net income of Exxon — that’s the multiple for LinkedIn’s stock right now — Exxon would have a market value of $19.8 trillion."
The stock is trading today at roughly 39 times its annual 2010 revenue, by contrast the software industry trades at a five year average of 3.4 times revenue.
This is a sign of a market frenzy - a bubble top - which implies a crash in all types of stocks will occur. Remember Nasdaq in March 2000 at over 5,000 and then it crashed to 1200?
Investors should be ashamed of themselves for paying these type of prices. This is why I like bonds becuase they are more logically priced then equities.
Read my posting "Wall Street revalued imperfect markets and inept central bankers". Today's IPO is verification that th emarket is not efficient.
Investors should seek indepedent financial advice.
Posted by Don Martin on Thu, May 19, 2011 @ 12:32 PM
Effect of disinflation on investing
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People inquire about disinflationary investments, real estate bubble deflation, reducing inflation. The economy is starting to slow down due to anticipation of the end of the Fed’s QE II stimulus. QE II ends June 30 but the funds allocated for it will be exhausted a few weeks earlier than that so it is almost over. State and federal governments are tightening their budgets. 20% of the population has borrowed against their retirement accounts. Private sector borrowing (except for student loans) has continued to decline as those who need a loan can’t get one and those who can qualify don’t want a loan. I am concerned that the Fed will try QE 3 and get a reputation for cheapening the value of the dollar in order to prop up asset prices and then eventually QE4 and QE 5 will be unable to stimulate economic activity because investors will not trust its ability to stimulate the economy.
Is Quantitative Easing full of holes?
As liquidity is withdrawn from the market then investment prices will decline. Add to this the risk that leveraged investors such as hedge funds are supported by the ability to buy reasonably priced Put options on equities and they could suddenly lose this vital support and be forced into margin selling which could trigger more “Flash Crashes” or October, 1987 crashes.
I have written “
QE2 and the Fed losing credibility” and “
Odds of another Oct. 1987 crash”.
The Emerging market economies are more fiscally sound than the U.S., so they may be a place to invest for the purpose of reducing the risk of dollar devaluation, or the risk of developed country government insolvency. Important: Get more information in my free Special Report about emerging market currency investing.
Investors should seek independent financial advice.
Posted by Don Martin on Wed, May 18, 2011 @ 02:31 PM
Effect of QE II on the devaluation of the U.S. dollar
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People inquire about Swiss currency as hedge against declining dollar, 1970’s US$ devaluation, how to hedge against falling dollar, dollar collapse. People ask will QEII devalue the US dollar? (QE II is "Quantitative Easing" or increasing the money supply through bond purchases by the Federal Reserve bank). People want to know: How much did the dollar get devalued by since start of QEII in August 31, 2010?
Some mutual funds that invest in foreign currency could be used to measure the effects of QE II since it was announced August 31, 2010. (These funds are not necessarily recommended for investing. I am merely commenting on the economy and using these funds as a reference point.) “CYB” which invests in Chinese Yuan futures up 2.6%; “PLMIX” Pimco’s Emerging Markets bond fund up 8.7%; “MEAFX” Merk’s Asia currency fund up 2.9%; the NYBOT:DX index showed the dollar went from 82 to 75.45, an 8.7% decline, by contrast it all time low was on 3-17-2008 when Bear Stearns failed, with a reading of 70.7. In 2008 it moved by 10 points (12%) from the high to low, so the 8.7% decline is not a record. A recent low was 73. The DX index is composed of developed countries and is weighted by trade volume. So the dollar declined by a range of 2.6% to 8.7% since QEII, even though other countries tried to devalue their own currencies against the dollar so as to keep the dollar from being devalued.
Money Supply
As I have previously written the dollar has dropped against the developed countries currencies by about 0.8% a year in the 40 years since the dollar was cut loose from the gold standard. Attempts by the U.S. government to devalue have often been offset by competitive devaluations from other developed nations with similar problems which may be worse than our own. However, one must be careful not to rely upon what happened in the past (slow, gradual devaluation) because there is always the chance that a new paradigm shift could occur resulting a new, substantial devaluation. I have written “Investments for a dollar collapse” and “Hedge against a falling dollar”.
Investors should seek independent financial advice.
Posted by Don Martin on Tue, May 17, 2011 @ 11:40 AM
Russell Napier forecasts SP dropping to 400
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Russell Napier on was interviewed on Financial Times. He said real rates are negative in most countries and once they go up to normal then that will create deflationary shock, leading to SP 500 plunging to 400 points from the current 1300 range. He favors, as I do Emerging Market currencies.
He said U.S. Treasury rates to go up but the increase could be modest. He likes PE 10 and Q ratio as I do. Fair value in 2009 was 666 for the SP, but it was not a true bottom because no capitulation phase attitude of despair had developed. Negative real interest rates distort equities and when rates are reset up to normal levels that will cause equities to crash. This reminds me of my blog post “U.S. equities are 70% overpriced”.
Unstable pyramid?
Shadow banking in China still done by trust companies
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Financial Times ran an article today about non-bank trust lending in China. This is like what I wrote in yesterday’s blog post “7 things about deflation you must know” about shadow banking creating a crack-boom that ultimately leads to a crash. The article said “Traditional trust products surge because of property related products.” So, as in America when the economy booms a borrower tells the lender that based on rising value of collateral the lender should be encouraged to make the loan. This in turn leads to excessive growth and creates statistics that imply strong growth. However some (not all) of the growth would never have happened if it were not for incorrect lending. The ultimate source of the funds are naïve business owners with excess cash who do not understand loan underwriting and merely seek to get a higher rate of return by lending it to a real estate developer. Interest rates of 17% are being paid by developers. This is a symptom of a bubble. It is hard to make a return on assets in excess of 15%, so when someone pays 17% that type of borrower is very risky. This risk implies a crash may follow when the over-idealistic borrower realizes his business can’t produce enough profit to pay the interest he is forced to liquidate, possibly at panic-sale prices, thus leading to downward pressure on asset prices. This in turn would be deflationary or disinflationary especially on commodities since China is using a huge amount of commodities to construct buildings.
Investors should seek independent financial advice.
Posted by Don Martin on Mon, May 16, 2011 @ 05:00 PM
Dominant macroeconomic paradigm is deflation/disinflation
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Edward Lazear in WSJ on 5-16-2011 said a healthy labor market hires a gross amount of 5.5 million people a month, but now only a gross amount of 4 million a month are being hired, thus hiring is only 70% of normal numbers. The net growth of jobs is about 200,000 a month, and we need to get to 300,000 new net jobs a month to solve the unemployment problem. The number of gross new monthly jobs today is the same as during the bottom of the recession in February, 2009. The reason why gross hiring is more than net hiring is because of labor force separations. Think of McDonald’s employees quitting after a few months of employment.
The dominant macroeconomic paradigm is deflation/disinflation. The evidence:
- Persistently high unemployment: only 20% of jobs lost have been recovered
- Huge overhang of foreclosed and about to be foreclosed inventory of real estate
- Shrinkage of private sector credit (excluding student loans)
- No growth in real private sector GDP since 1998
- Overpriced stock market with “PE 10” at 24 instead of 15
- The evidence in favor of inflation/economic recovery is commodity prices, but that is a misleading signal caused by speculators
- Higher oil prices act to depress the economy, with OPEC funds recycled into bonds which may drive down interest rates.
I have written "Prices, assets going down" and "real estate deflation continues".
Is cash king during a crash?
Shadow banking trying to manifest itself in China reminds me of the Lehman real estate bubble
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Shadow banking (where a non-bank lender provides loans usually in a manner that is difficult to see or to regulate) continues in China, despite attempts by their government to shut them down. This could causes bubbles in commodities which would send out a false inflation signal. See the article in the Financial Times on May 16, 2011. Bank clerks in China get a commission for these. (Sounds like the American mortgage bubble!) The interest rate in China, for a Letter of Credit to buy copper, is 1.4% in a country with inflation at 5% so that means it is a negative “real” rate of interest, which is clearly a sign of a bubble or a false boom. People are being paid to borrow (metaphorically speaking) and they use it to speculate. This drives up commodities causing Western economists to think that increased demand for copper is a sign of growth.
Remember when Bernanke said at the top of the housing bubble that rising house prices were a sign of increased personal prosperity? Well he was wrong, real estate went up because of artificially low interest rates and artificially lenient lending rules created by shadow banks. In fact incomes in 2000 to 2007 were declining which forced Americans to gamble and speculate in real estate in hopes of making extra money. Thus a scenario of worsening personal income helped contribute to the housing bubble and the resulting bubble was misdiagnosed by the Fed as a sign of improving income!!! I remember hearing from people during the housing bubble that they intended to make money with short term real estate investing because they were temporarily unemployed. I told them they should sell their home rather than borrow more money. I may have lost a potential client, but I'm glad I did the right thing.
Important: Get more information in my free Special Report about emerging market currency investing.
Investors should seek independent financial advice.
Posted by Don Martin on Fri, May 13, 2011 @ 02:36 PM
Risks of a dollar devaluation: what if the old paradigm has been broken?
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People worry about the dollar being devalued and how a dollar devaluation effects the stock market, how a dollar devaluation effects real estate and what to invest in to protect against a devalued dollar.
As I have written before the goal of the government is to devalue the dollar as a way of making it easier to create jobs (we have more unemployment than Europe or Japan or Asia). Economist Martin Wolfe said in the Financial Times that in terms of competitive devaluations that the dollar “must win” this currency war with other countries and will win because of the power of the U.S. dollar and the U.S. Federal Reserve.
Of course the old model is that if the world falls into a recession then everyone sends their assets to the U.S. But that old model was based on decades old behavior where in the old days the U.S. had a huge share of the world economy. Now the Emerging Markets have 52% of the world economy, the U.S. has 25% So the old paradigm is probably broken and so a recession won’t help make the dollar go up because its alleged safe haven status not as good as before.
Over-paying for inflation insurance
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Investors have panicked about the risk of inflation and investor greed has caused some to panic buy and overpay for inflation sensitive investments, especially in commodity futures markets, with the result that allegedly inflation-protected investments are prohibitively expensive. Further there is the risk that the fear of inflation could be wrong. What if the economy falls back into recession and demand for commodities, which has been mainly from China, turns out to have been a “misunderstanding” caused by speculators. I wrote about this in “Inflation protected investments overpaying for insurance”.
If commodities go down this will reduce inflation which in turn reduces the ability of the government to devalue, since inflation is one of the reasons for a currency to become devalued by the marketplace.
A pyramid of money:
analogious to the pyramid scheme of excess money printing.
These two things (paradigm breakage and a commodities bust) will affect the dollar in opposite ways. The question is which one will be stronger? My guess is that commodities will eventually recover and so will the Emerging Markets. Meanwhile the U.S. is mired in intractable unemployment (only 20% of the lost jobs have been recovered-at this rate it will take several years in the future to get back to normal) and a huge inventory of foreclosed homes with an inadequate amount of qualified buyers. So the balance is weighted towards the U.S. government's need to stimulate through devaluation is greater than for a commodities bust to create panic buying of dollars.
Investors should seek independent financial advice.
Posted by Don Martin on Thu, May 12, 2011 @ 02:47 PM
Housing, Banks, Bonds under stress
Housing market getting weaker for upper-middle segment
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The housing market continues to weaken, threatening the economic recovery. Today an article in the WSJ repeated a theme I have frequently blogged about: that the baby boomer generation needs to downsize their homes in order to pay for retirement but who will buy the homes being sold?
On May 11, 2011 a blog on FinancialSense.com warned that on September 30, 2011 the temporary large balance conforming loans offered by Fannie and Freddie will be reduced from about 20 to 40% depending on each county’s needs. This will increase pressure on people who own homes worth between $700,000 to $1,000,000 and affect all homeowners. Of course one can still get a jumbo loan whose funds came from private sector investors instead of funds coming from Fannie or Freddie but since those private sector jumbos have higher rates then few people will want them. So my model for real estate is that, due to the credit bubble that began in 1984 and lasted until 2008, there was a quarter century of housing and debt bubbles that still have not been resolved, so my estimate is that the bubble may take just as long to repair as it took to be created. This means that the market for real estate won’t become robust until 20 years from now.
Congress will end the mortgage tax deduction which mainly benefits people with homes between $500,000 and $1,000,000. (Even if someone in that price level has no debt his home when sold it will probably be sold to a buyer who needs a jumbo loan, so any difficulties in getting a loan or the loss of mortgage tax deductions will reduce the value of a home.) When a bubble has been busted and the economy eventually recovers investors avoid the busted bubble for a long time, so real estate will be a pariah asset class for at least 20 years. One of the ratings agencies did a report about two months ago saying some parts of Florida will not recover in price until 28 years from now. I found an article before the 2007 real estate crash showing that some housing bubbles that occurred a century never fully recovered a century later!!!
I have written “Housing not comparable to the past” and “Housing crash lasted longer than Great Depression of 1930’s”.
Housing market under stress
Banking and sovereign debt risks
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The banking industry stocks are going down while interest rates are also going down, which is not a good indicator. Normally, if interest rates drop, then banks make money. However, if interest rates drop during a severe crash then banks loose more money from bad loans than the profits they make from borrowing at wholesale rates very cheaply and lending at retail interest rates.
The market has not fully realized how bad the Eurozone debt crisis is. When the market becomes aware of the true problems then that will add to deflationary worries.
The dollar may crash and get devalued against Emerging Markets currencies but it may go up against the other major developed nation’s currencies.
Investors should seek independent financial advice.
Posted by Don Martin on Wed, May 11, 2011 @ 12:36 PM
Devaluation’s effect on domestic inflation
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Inflation is less influenced by a weak dollar than in the past says WSJ article published 5-10-2011. My opinion is that this means the effect of devaluation will not be that bad. Suppose that the average country’s currency goes up 20% against the dollar with some going up 40% and some at zero. Multiply 20% times 17% which is the amount of imports into the U.S. This is 3.4%, which could be the one-time increase in CPI due to devaluation. Or if spread over five years it would add 0.7% a year to inflation that otherwise might be 1% for a total of 1.7% inflation. This calculation of mine is similar to a Merrill Lynch study cited by the article showing that a 30% dollar decline caused consumer import inflation to increase by three percent but the total impact to inflation was only 0.5% extra, which happens to be a 17% ratio, the same ratio of imports to total consumption.
The difference between consumer’s problems versus investor’s devaluation problems
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Don’t be fooled, by the softened impact of devaluation on CPI, in to being complacent about the investment risks it will trigger. However, simply because a devalued dollar may not cause that much inflation is not reason to be complacent about investments. If other currencies go up against the dollar then investors should protect themselves by diversifying into foreign investments including foreign currency denominated bonds. To find out what are some investment strategies please see “Emerging market currency investing”. I have also written “Investments for a dollar collapse”.
Investors should seek independent financial advice.
Posted by Don Martin on Tue, May 10, 2011 @ 02:41 PM
Investors enquire about Shiller investment valuations, copper bubbles, hedges against dollar devaluations and crashes. They wonder what happens to real estate if the dollar is devalued?
Methods to estimate the value of gold
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The Economist Magazine’s Buttonwood column had an excellent article on May 9, 2011 which helped to understand how to value gold by comparing the cost of housing to gold. The commodity is hard to value because has no cash flow. Assuming U.S. homes are in need of a 10 to 20% drop before reaching equilibrium then one could start to calculate what is a fair value for gold. The implication is that gold is worth about $700. I wrote in “Deflation strikes marketplace” that gold is probably worth $1,000.
Methods to understand the difference
between the markets
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The article was concerned about why UK real estate had not gone down as much as the U.S. market and sought to explain the difference between the two markets. Regarding the divide between the two countries' real estate markets I think the UK housing market is dominated by the London urban area which contrasts with America where the vast majority live away from densely populated coastal high income cities. If you look at California coastal cities, Manhattan and Washington the prices are still high, land is scarce and these areas seem more like the U.K. than the rest of the U.S. Another idea: the UK's reputation as a safe haven for wealthy foreigners - by contrast U.S. tax law scares away wealthy foreigners.
The problem with quantitative analysis of the U.S. housing market is that the use of Easy Qualifier stated income loans from 1984-2008 warped the ability of economists to measure who could qualify for a loan, thus old paradigms from that era about affordability ratios are not applicable. I mentioned this in “Housing not comparable to the past”.
I think in the U.K. there was a lot less use and abuse of so-called "self-certified" or "Easy Qualifier" loans than in the U.S. In America many states allow foreclosure with no court judgment against the borrower; further many banks waive their right to sue the borrower for damages when they deem it impractical.
Investors should seek independent financial advice.
Posted by Don Martin on Mon, May 09, 2011 @ 11:47 AM
Investors enquire about asset allocation and black swan investing; will a falling dollar lead to economic collapse; what to invest in case of dollar collapse? They ask: how to protect against dollar devaluation? What happens to my investments if the dollar collapses? I have written “Dollar devaluation investing”.
Methods to reduce investment risk
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One way investors could hedge against these risks is by diversifying internationally. Another way is to diversify into higher quality assets. For example, if you like bonds then reallocate your bond portfolio into high credit quality bonds even if the yield is lower. If you like stocks then reallocate out of risky small cap stocks and into large cap stocks that have higher standards of quality. The fingerprints of a quality stock are: bigger than average dividends, growing profits and sales, low level of debt, moderate amount of standard deviation (variance), moderate P.E. ratios, good corporate governance, a corporate “moat” against competition. These type of companies tend to be old, large cap companies. My preference is to avoid equities until the overall market 10 year P.E. ratio goes below 15; it is now at about 23. I have written “Increasing results by using risk aware investing”.
Risk of more deflationary events
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Currency risks
Greek debt is trading at 60% of face value, which implies a 133 billion Euro loss. Eventually the truth will come out and someone must post the losses on their books instead of marking it at par. This will weaken Europe’s economy, especially if the owners of Greek debt are thinly capitalized European banks. This may help make the dollar look better by comparison, however, the dollar could still depreciate against the Emerging Market currencies.
Rob Arnott published an excellent chart showing that since 1998 that real (inflation adjusted) private sector GDP has declined over the past 13 years. Looking at the chart one can see that the past decade has been the first flat or downward period since the end of the Great Depression. So the U.S. has experienced a Japanese style soft depression or “Lost Decade”, and there are no assurances that things will get better.
Investors should seek independent financial advice.
Posted by Don Martin on Fri, May 06, 2011 @ 01:38 PM
Causes of structural unemployment
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There was an excellent article by Gavyn Davies in Financial Times on 5-5-2011 about structural unemployment. The rate of unemployment is much worse in proportion to the drop in GDP than in normal cycles or in other countries. I really appreciated his insight about the 2% excess unemployment (the excess is the amount exceeding that forecasted by Okun’s law) shown on the graph. One explanation is that a recession caused by a financial crisis is usually deeper than a traditional inventory cycle recession. My hypothesis is that in the U.S. there has been no increase in private sector GDP since 1998 and during the past decade there was an excess amount of employment and personal earned income in the mortgage, real estate, and construction industry which could have temporarily over-employed 2-3% of the labor force who engaged in unneeded real estate bubble activities. Further, some of those jobs were artificially high paying due to the real estate bubble, so when the bubble burst the job losers were unwilling to accept lower paying jobs in a new career, preferring instead to stay home and sulk in hopes of someday recapturing their lost income. In a normal inventory cycle recession people think they can wait a year for the economy to heal itself and then go back to their old job. However, this time the unemployed former beneficiaries of the burst bubble need to realize that a fundamental structural shift has occurred and learn to adapt to it.
Unlocking the mystery
Today’s monthly unemployment report
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Today the monthly unemployment report was issued showing 244,000 new jobs. However the economy needs to produced 300,000 a month consistently for several years to get out of the situation of excess unemployment and this has not been done since the 1990’s, which was an exceptionally prosperous decade.
The employment to population ratio dropped by 0.1% and is close to 28 year lows. Headline unemployment and the broad U-6 measure both increased by 0.2%. The number of unemployed increased by 205,000 to 13,800,000, an increase of 1.5%. Household employment fell by 190,000. Despite the fact it has been two years since the bottom of the recession, only 20% of the lost jobs have been recovered. Usually two years after the bottom the job market has fully recovered.
Effect of this on interest rates and bond prices
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This is why interest rates should be at today’s low levels and why there is no significant inflation. Because the market does not understand this that means bonds are mispriced - when the market becomes efficent and understands this, then bond prices will rise.
I have written about this topic in “Hidden economic weakness” and “Don’t be fooled by jobless report”. This is why investors need independent financial advice.
Posted by Don Martin on Thu, May 05, 2011 @ 01:12 PM
Deflation of commodities shook the market today.
Today commodities plunged sharply. Oil down is 10%, gold down 3.3%, silver down 10.4%, SP down 0.9%, copper down 3.8%. By contrast, the TLT long term Treasury ETF is up in value 1%, the yield on 30 year U.S. Treasuries is down 50 BP since Feb. 8.
There was a chart published by pragcap.com showing the real (inflation adjusted price of gold) should be about $890; also Cranberry Capital was quoted in CFA Magazine May-June 2011 saying that the theoretical value of gold based on money supply is $886. The article also cited gold’s relation to the CRB Index as ranging from 1.25 to 2.5 times, but now it is at 4 times, which in my opinion implies a $950 to $480 value. Edward Chancellor of GMO wrote an article a few months ago estimating gold’s fair value is about $1,000. My own calculation is that using the 1980-1999 price of roughly $400 and adjusting for inflation since gold settled down in the early 1980’s it should be about $1,000. Since people who panic may overpay for inflation protection then perhaps the increase over $1,000 is the panic premium which represents the amount of over-pricing due to inflation hysteria.
It looks like much of the world’s growth is in Emerging Market countries with high and growing rates of inflation which their Central Banks are moving to suppress. This will cool off demand for commodities and since there has been a lot of speculation in commodities then speculators will panic sell their leveraged hoardings. This will be like a crowd trying to rush to get through a narrow fire exit.
I have written about this in “Copper market looking weak” and “Odds of another Oct 1987 crash”.
Independent financial advice is what investors need.
Posted by Don Martin on Wed, May 04, 2011 @ 01:28 PM
Evidence continues to accumulate that the economy is softening and will head into a growth recession with lower interest rates and lower stock and commodity prices. Economist Gary Shilling is bullish on 30 year T-bond, forecasting that the yield will go from 4.4% to 3.0%. He forecasts that the 10 year T-bond rate will drop from 3.3% to 2.0%, matching the lows of the crash of 2009.
The yield curve is much steeper than normal because the market anticipates that short term rates are too low. However, if the market changes its assumptions and decides that short term rates should stay close to zero over the next two to three years then the yield curve will need to flatten, which means that long term rates will need to come down.
Emerging Markets stocks are a leading indicator. India and Brazil are down 12% this year, China is down 8%. (It went down 2.2% today).
Commodities such as gold, silver copper are all going down. Remember the great commodity bubble of mid-2008 which occurred just before the Lehman crash of 9-15-2008? Oil went from $146 in July, 2008 to 36 in six months. I am concerned the same thing will happen soon.
The PPI core crude producer price index (which is ex-food and energy) went down 2.3% in March. The PCE core rate went down in the past 12 months from 1.8% to 0.9%.
I have written “Inflation creation machine is broken” and “Bears should not capitulate”.
Independent financial advice is what investors need.
Posted by Don Martin on Tue, May 03, 2011 @ 01:09 PM
The economy is slowing down. Gasoline consumption is down 1.6% compared to a year ago. The stock markets breadth (the number of new highs) is slowing. The rapid rise in oil stocks is similar to the tech bubble of 2000 which masked broader weakness in the rest of the market. China is making progress on tightening with a reduction in the rate of growth. The world’s Central Bank’s reserves, except for China, may have been reduced.
In Bloomberg today an article titled “Bond vigilantes ignore next stage of Euro mess” where the article shows how investors may want to sell France’s government debt. If so then this would cause people to invest in U.S. Treasuries.
I have written “Finally the market begins to weaken” and “U.S. equities are 70% overpriced”.
This is an example of independent financial advice.
Posted by Don Martin on Mon, May 02, 2011 @ 04:38 PM
Six best blog articles in April, 2011:
Posted by Don Martin on Fri, Apr 15, 2011 @ 04:43 PM
Inflation can be created by three methods:
1. An increase in the money supply combined with tight labor markets and minimal excess capacity
2. Monetization of Treasury debt by the Federal Reserve
3. Quantitative easing, done to devalue the currency
Posted by Don Martin on Tue., April 12, 2011
I continue to believe that the main driving forces of the economy are disinflationary. These are excessive unemployment which has continued for a very long time, continuing contraction in bank lending, 50% reduction in velocity of money, no end in sight to the huge overhang of foreclosed housing and shadow inventory of housing.
Posted by Don Martin on Fri, Apr 08, 2011 @ 10:54 AM
People have been enquiring about the following: will the dollar be devalued, when will the dollar be devalued, will the dollar collapse? They want to know what to invest in when the dollar collapses. They worry what will happen if the Congress and President can’t sign a debt increase and spending authorization tonight and the government is shut down.
Posted by Don Martin on Wed, Apr 06, 2011 @ 04:15 PM
Despite all the inflation hysteria I still believe that it is transitory and the trend is toward no inflation or slight deflation. Labor costs per unit of productivity have not increased, real wages are stagnant, loan growth is depressed, the velocity of money fell off a cliff in 2008 and has not recovered. The combination of reduced lending, shockingly low velocity of money and high unemployment and stagnant wages, and unresolved housing crisis means that inflation can’t occur.
Today’s Wall Street Journal has an article titled "How Many Borrowers Qualify for New ‘Safe’ Mortgage Rules?"
The article said “About one in five mortgages purchased by Fannie Mae or Freddie Mac over the 1997-2009 period would meet the proposed standard of “safe” mortgages that would be exempted from costly new lending rules, according to a federal report published last week.”
Posted by Don Martin on Fri, Apr 01, 2011 @ 11:13 AM
Today the monthly non-farm payroll unemployment report was released. It is the most important report for bond investors. In the past 11 years the U.S. population has increased 1% a year by 30 million, yet number of people on payrolls are lower, so adjusting for population we have a long way to go to recover the lost jobs. Further the jobs that are coming back are predominantly low wage jobs. The employment to population ratio went from 58.2 at the bottom in 2009 to 58.4, which is virtually no gain at all two years after the economy reached the bottom. Compare this to the peak of 64.7 in 2000.
This is an example of independent financial advice
Posted by Don Martin on Sun, May 01, 2011 @ 09:04 PM
Osama Bin Laden was killed today in a raid in Pakistan. This will affect the markets by showing that the U.S. is capable of keeping its promise by taking the drastic step of attacking Bin Laden in the territory of another country, probably without permission from Pakistan, since asking permission would have resulted in a leak. So investors should increase their confidence in the ability of the U.S. government to make timely minimum payments on its debt. This increases the odds that President Obama will be able to negotiate with Congress to avoid a U.S. government debt default. So if T-bonds do better than expected this will lower interest rates more than QEII providing a needed boost to the economy just as it is entering a new soft patch.
Today's successful attack shows that if we Americans focus on a goal then after a long time we can learn how to solve a problem that seemed impossible.
If you are concerned about your finances then you should seek independent financial advice from a fee-only financial adviser.