April 6, 2010
The Government Fiddles While Rome Burns
The Administration says things are looking up because there were some jobs added this month, breaking a long string of bad news on the job front. This is a good thing.
However, I am still worried about our economy.
First of all, a large portion of the jobs added recently were temporary census hires, government workers and employees of temp firms. What is clearly missing is corporate hiring on a scale that can really make a difference.
When corporations are unsure of the future they don’t commit to taking on big overhead. They don’t build new plants and they don’t add to payroll.
Businesses don’t get to be successful by gambling on things they can’t control, like government imposing changes on their industry. Successful businesses tend to be pretty conservative when it comes to taking risk.
When faced with uncertainty they pay down debt, hoard cash and get as lean as they can so they can react to and survive whatever comes down the pike.
It has been two years since the financial crisis became obvious – even to Congress – and so far the government has done nothing to keep it from happening again. Businesses know change is coming, but in absense of clear rules they can’t assess their business risks. They can’t make plans when the government is dithering. So they wait and watch and don’t hire.
This is the essence of a jobless recovery. There are signs that businesses are getting healthier, but there is still virtually no real job creation in the private sector because businesses can’t get a clear vision of the future.
If the government is determined to change regulations to try to keep economic problems from recurring, it would be much better for all of us if they would get on with it, so business could get on with their businesses, and out of work Americans can have a better chance of finding jobs.
We’re just coming out of one of the wettest winters I can remember in Arizona. I haven’t heard anyone use the term drought-buster, but we are all hoping to hear it proclaimed as one.
Last week’s really big storm was supposed to deliver 30 hours of rain, and 7″ of snow. Imagine my surprise to wake up after a night of howling wind to a clear blue sky and not a drop of moisture to be seen! I have a hard time getting used to these “Arizona blizzards”.
The nice thing about Arizona is even when it rains, it is a dry rain.
Reflation in The Stock Markets
In past columns I have talked about the struggle between inflation and deflation. But what the heck is reflation?
A little background from Econ 101:
Inflation is too many dollars pursuing a limited supply of goods, so the cost of the goods gets bid upward as buyers line up to buy.
Deflation is the opposite: Too many goods competing for a limited supply of dollars so the cost of the goods keep coming down as sellers slash prices to entice what few buyers there are to part with their scarce dollars.
Ironically, deflation can be made worse by efficiency. Producing more goods, more efficiently – which can be interpreted as using fewer workers, by the way – actually increases the number of goods competing for the dollars being spent making the forces of deflation stronger.
An interesting issue with deflation is that it does not have to be an actual shortage of dollars that creates it, it can exist where there is a lot of cash if the holders of that cash are not willing to spend and invest.
Japan, over the past 20 years, has struggled mightily to get out of a deflationary funk despite the fact that the Japanese have prodigious savings ethics. They have a lot of money. But Momma-San and Papa-San refused to part with their money, perpetuating the deflation that is still holding the entire country back economically after two decades.
The reason that the term depression is used to describe deflationary recessions is that they become a psychological problem as much as a monetary one. Cash becomes a security blanket and savers refuse to spend it.
Reflation is the effort to drive cash from its hidings places (CDs, money market funds and coffee cans buried in the back yard) into the markets where it will be spent.
The driver behind reflation is absurdly low interest rates on savings vehicles. Near-zero rates are forcing savers to reenter the markets at the pain of watching purchasing power of savings dwindle under the eroding forces of inflation, the need to earn a certain rate of return to be able to retire, or the worry about savings just gathering dust as other markets begin to move up.
The idea is to change the warm and fuzzy feeling savings vehicles were giving into a feeling of pain, enough to force money out of savings and encourage savers to take a little risk with their money by buying stocks, bonds, iPods or houses to help offset the forces of deflation.
It seems to be working as the stock market creeps up and up on the steady trickle of new money coming in.
The only interest rates that the government directly controls are the very short term rates, and it is using them very effectively to force money out of safe havens and reflating the markets.
Riddle of The Week:
Q: What does man love more than life?
Fear more than death or mortal strife?
What do the poor have, what the rich require,
And what contented men desire?
What does the miser spend, the spendthrift save,
And all men carry to their graves?
The Year of The Bargain
On April 1, 2009, addressing the real estate market, I said: “The combination of low prices and low interest rates have made housing more affordable than in many, many years. . . Prices could still slip a little lower, but right now you have the best combination of quality properties and low prices that I can imagine.
“Next year, prices may be a little lower (my research shows prices bottoming next year, but the steepest declines are behind us . . .”
Fast forward to today, and the Case-Schiller housing index, shows that prices have been leveling off and are sort of “bouncing along the bottom” (the technical term of the week). They are not going up, but have stopped going down, too.
This means that more buyers and sellers are seeing eye-to-eye about price. In my judgment, this makes further big price declines in real estate unlikely.
The big issue going forward appears to be interest rates. They have begun to turn up in a meaningful way over the past few weeks. The government encountered trouble selling all the bonds it needed to sell at its March 23rd debt auction and had to pay higher interest rates to attract enough buyers for all the bonds.
This interest rate spike broke a 30 year trend in interest rates and I believe this may be the tip of a very large iceberg signaling a long term change in trend to higher interest rates.
Although price gains for real estate are still a few years off as we still need to work through all of the excess property for sale, interest rates may never be this low again.
The Year of the Bargain in real estate that I proclaimed a year ago, may continue for a while longer but any lower prices we see are likely to be offset by higher financing costs.
What’s Going On In Your Portfolio?
All of our portfolios are fully invested As of April 5, 2010 and doing well.
Flexible Income. Portfolios following my Flexible Income model* have a little more than half of their holdings in high yield bonds, with the balance spread among a floating rate bank loan fund, a foreign currency fund, a preferred stock fund and an inverse treasury fund – something that goes up as government bond interest rates go up.
Flexible Income is back to making money slowly and had a good month in March.
Careful Growth. We are fully invested for growth with 77% in stocks or stock funds, 10% gold, and 10% in an inverse Treasury-Note fund. Gold has not been performing as I expected so our holdings there have been cut back to allow for more stock holdings.
Accounts based upon my Careful Growth model have seen our progress lag the S&P 500 stock index during the first quarter. Between January 19th and February 8th S&P 500 dropped 8.13% in total and the Careful Growth model lost only 4.65% as my system of stop-loss measures did their work and moved us out of the market helping us miss almost half of the decline.
This is the risk avoidance my work is noted for. Since all big declines start out just like this one did, the only prudent thing to do is get out of the way when they begin. We did.
However, when the stock market rebounded on February 8th its gain over the next 8 days was at an annualized rate of 359% per year. And because we were out of the market when it began, we missed the beginning of that run, and have been trying to play catch up in the Careful growth accounts ever since.
That rate of increase is clearly unsustainable and invites a correction down to more sustainable rates of return. So perhaps you can understand why I did not get fully invested right away in the middle of the run up. I prefer to wait for a dip, buying after a correction instead of before of it.
The problem is that the dip never came, so we slipped further behind the market because we were not fully invested until the past few weeks.
Think of my work as the fire insurance you buy on your portfolio. This type of underperformance is the price we pay for the lower risk investing we enjoy.
I could keep you fully invested all of the time like the indexes or most mutual funds. If I did, in the short term you would have enjoyed the stock market’s full returns when it ran up like this, but in the long term you could also have lost 56% of your money (that means $500,000 becomes $220,000) by staying fully invested in the face of the declines during October, 2007 to March, 2009.
So, although we have come through a period of short-term underperformance our longer term performance over 3, 5 10 years or from inception still dramatically outperforms the stock market as a whole.
It is normal for us to underperform in straight up markets like we have had recently, but vastly out-perform in down markets as our risk management pays dividends. So please hang tight. I believe your patience will be rewarded as time goes on.
Our Spotlight Strategy:
market completely. This ability to get client money “out of harm’s way”, occasionally on short notice, is what makes HCM different from ordinary advisers.
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* The model accounts mentioned in this article are hypothetical examples of how the strategy may work as designed. Activity in client accounts may be different from that in the model in amount of each investment, specific timing of trades, and actual security used, which may vary from account to account. Not all trades are profitable. It should not be assumed that current or future holdings will be profitable. A list of all trades in these accounts for the past 12 months will be provided upon written request.
** The S&P 500 and Nasdaq Indexes are unmanaged lists of stocks considered representative of the broad stock market. Investors cannot invest directly in the S&P 500 Index.
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