The financial markets are definitely not showing much direction overall but the relatively calm surface is hiding turbulent and conflicting currents not far beneath the surface. The Fund King System remains in a “risk off” stance with recommendations across our main portfolios all tending towards US government bonds (TLH & TLT), cash, gold and silver. None of the readings on these individual asset classes are particularly compelling…but they are positive. So, as we wait to see just how awful US 3Q GDP numbers might be, the System is not recommending any risky positions. What currencies do you want to be in? It looks like the US Dollar and Japanese Yen are the best for now. The Euro has staged a bit of a comeback on the completion of EU wide bank “stress tests” but is still weak. A bet on the Euro is certainly a bet on the health of the European Banking system which remains overly dependent on potentially fickle wholesale financing (as opposed to deposits). The Australian Dollar is also a bit weak largely due to a potential economic slowdown in Mainland China (a huge consumer of Australian minerals).

The currents underneath the surface derive from the powerful forces that are struggling to define the next phase of global economic development.

Option 1: Deflation

Long Term US Government Paper is attracting money from those who see the current lack of consumer demand growth as an intermediate trend and a signal that we will enter a period of sustained deflation. When the Global Financial Crisis started in 2008, analysts who suggested that the US or European economies might experience some of the deflation and stagnation that Japan has endured since 1990 were summarily dismissed. However, that dismissal now seems to have been premature. Even in the early 90’s, investors had a hard time believing that Japan would not shake off the slump in short order. The country that had given us the economic miracle, just in time inventory, quality circles and firms that could buy up Rockefeller Center and Pebble Beach would surely continue their inexorable rise as the leader of the dawning “Pacific Century” (now redubbed the “Asian Century”). Deflationary fears are also driven by the evidence that massive government stimulus combined with very accommodating monetary policies has not delivered as advertised. If the Fed is “pushing on a string”, then perhaps it has run low on viable options. With Middle Class America taking serious hits on income (high unemployment) and wealth (underwater mortgages), the deflation camp is betting on continued sluggish consumer demand. The main risk to a deflation geared portfolio is a change in consumer demand. Signs of a positive change in consumer demand will send investors scrambling out of Treasuries (and the US dollar) and back into riskier assets (High Yield, Equities and eventually Commodities).

Option 2: Inflation

On the other side of the debate are those who see governments (particularly in the US but also in Europe and Asia) increasing their weight in their respective economies. Governments are beholden to voters and usually choose paths that lead to the least amount of pain in the short term. That suggests a risk of currency debasement and sustained inflation. Debtors prefer to pay back money far in the future after inflation has worn away the value of future dollars. Since the big debtors include most of the G7 Governments and their Mortgage Paying Electorate, there is no doubt about which way political will is positioned. The fear of currency debasement is at the core of the Gold Trade. So, while both Gold and Treasuries have been moving up together over the past few years, their performance should diverge sharply once it becomes clear whether we are heading into deflation or inflation.

Option 3: Healthy Global Growth

And what about the middle road between these two outcomes…decent growth with inflation at 2-4%? That outcome is the only one on which very little is being wagered because it seems the least likely. This recession is different from what most of us are used to because it is due to a financial crisis, not the usual manufacturing inventory overstock. The NBER, the official arbiter of recession timing, has yet to declare an end to the recession which started at the end of 2007. Perhaps their caution, which was criticized toward the end of 2009, was justified after all.

What should investors do?

For now, one would be wise to follow the advice first given by Oliver Cromwell:

“Put your trust in God; but mind to keep your powder dry.”

There is no reason to embark on risky or illiquid trades now. Avoiding a nasty drop is just as important as participating in market rallies to the overall health of your portfolio. At best, you will rack up a big commission bill, at worst, you could get stuck in a position that looks wrong footed in the autumn. Despite all the promises from internet penny stock newsletters, this is not the right time to go chasing after “the next big thing” with any more than a few percentage points of your portfolio.

Riskier assets have taken a pounding in the last month or so as investors calibrate the extent of the damage in Europe. Whether a Greek default will happen is almost irrelevant at this point because almost three quarters of investors think that a Greek default is highly likely. That is why Developed Europe is at or near the bottom of all the representative portfolios that we monitor. In the ETF Long/Short Portfolio, the Short EAFE ETF (Europe, Australasia, Far East or EFZ) is now joined by the Short Commodity ETF (DDP) at the top of the list. Please note that the readings for short products can change quickly so unless you are willing to follow those trades closely, the Long/Short Portfolio may not be for you.

However, the implications are important for all investors. As we have mentioned in the past few newsletters, the global “liquidity bathtub” has been tilted towards the US dollar. Most of the new money flooding into the US dollar is going into short term US Treasuries rather than equity, property or other assets, so it is short term in nature. On the equity side, money is flowing from the Big Caps to Small Caps. The reason for the small caps preference can be traced to the relatively large proportion of earnings that come from overseas in indices like the S&P500.

A strong US dollar does not bode well for export-led recoveries in the US or in most of Asia (where currencies show a “high correlation” to the US dollar). Copper prices had a bit of a bounce (an important leading indicator for construction and manufacturing in China), but commodities are generally still soft across the board. The only exception is Natural Gas (UNG) which is probably due to the continuing disaster in the Gulf of Mexico.

All of these developments send us scrambling to our favorite economic indicator, the ECRI Weekly Leading Index. A critical question in investors’ minds is the likelihood of a second dip into recession. Although the WLI has not signaled an upcoming recession yet, the trend is definitely not comforting. Like any leading indicator, major equity indices are going to have a weighting and certainly much of the drop from 12% in May to -3.5% in June is due to the sharp correction in major market indices. We will have to wait a few weeks to see how much a market bottoming will impact upon the numbers.

Source : ECRI

Will we go into a double dip recession? There is no doubt that GDP growth rates and corporate profits will slow for the rest of the year. Looking at a new set of indicators developed by Richard Davies at Consumer Metrics Institute, which uses a modern, updated approach to gathering sales data from the US economy, consumer demand is turning negative. Although these data series have not been around as long as ECRI, the approach is very interesting, the series leads GDP figures and the conclusions are also not positive.

Source: ConsumerIndex.com

So, what is the answer? Bear or just a correction?

Unfortunately, the jury is still deliberating. The System is designed to favor cash and cash equivalent asset classes when everything else is falling. We are not there yet and the risk of getting out of the market at a short term bottom is high when sentiment is as negative as it is now. Overall, our system is still showing a preference for some classes of equity over money market related investments although the readings are approaching a turning point. One sector which has fallen out of favor is the Biotechnology both in our mutual fund and ETF portfolios. But US stocks remain at the top of the portfolios with a skew towards small caps.

New research tool

For intrepid readers who are interested in seeing how some of our numbers are put together, we have developed an application which is still in the testing stage. Try it out here. For now, it only works with US equities, ETFs and Mutual Funds and you need to know the ticker (which can be found on Yahoo Finance). We would appreciate any feedback might have; please that you send it here.

As we pointed out last week, the yield curve in the US dollar is just too attractive for any profit seeking financial institution to ignore. Until the trade becomes less attractive or something better comes along, expect continued US dollar strength. (DXY is the dollar index; UUP is an ETF which closely tracks the DXY).

Source: Bloomberg

Why is the yield curve so steep?

The short term (or left hand) end of the curve is anchored by government fiat (in the US through the agency of an independent Federal Reserve). Many pundits, experts and others expend tremendous resources to divine the inner thoughts of the men and women in charge of that decision. However, it does not take away from the fact that the Fed Funds rate is set by committee and not the market. The rest of the curve is determined by pure supply and demand. Will this always lead to a steep curve? No. Sometimes the Federal Reserve needs to squeeze inflation out of the system in which case, a higher than otherwise expected Fed Funds rate is decided upon. Under the right circumstances, that can lead to an “inverted curve” of high short rates and lower medium and long term rates.

Supply

On the supply side of the equation, with a US Federal deficit running well over 10% of GDP per annum for the foreseeable future, it is clear that we will not run out of US government debt instruments any time soon. Such a large and growing supply should and does fuel downward price pressure (and upward yield pressure) on the long end of the market. Those investors who fear that ever larger government spending programs will eventually lead to system wide inflation are amongst those who worry about the supply dynamics of the treasury market. When you hear a “Treasury Bear” argument which is framed entirely in terms of future supply, be careful with the recommendation because it is build upon only half the story. Supply is not the only factor.

Demand

Demand is driven by rational economic calculation and emotion.

The rational economic calculation is a long term estimate of growth and inflation rates by which investors weigh the purchase of a medium or long term Treasury against alternative investment options. Those considerations are well discussed in the market and tend to change slowly on a quarter by quarter basis. Has something fundamental changed in the last three or four weeks? Possibly. The Euro’s foundation has been show to be a lot weaker than previously expected. That doesn’t impact US treasuries directly but it does reduce the attractiveness of Euro Government Debt instruments that compete for investor attention. Right now, the biggest source of demand comes from the banks who are able to borrow at the short end rate and “lend” it back to the US Government in the form of 2,3 and 4 year Treasuries.

The emotional side is responsible for the short term moves. Emotional factors are almost always couched in fundamental terms. Sometimes those short term emotional excuses will become longer term rational economic calculations. However two things are for sure. They start out as emotions and investors often don’t realize they are reacting to emotions because they rationalize the decisions as fundamental changes in the economic landscape. Very rarely will a fund manager get on TV to announce that he or she is petrified by the market and plans to hide in two year treasuries for the time being. It is much more likely to hear the fund manager point out two or three recent datapoints as justification for making a mid-course asset allocation adjustment.

What are the emotional buttons today? Europe has certainly provided the bulk of them lately but one shouldn’t forget the employment figures in the US, the retail figures (both can be bundled into general “double dip” recession fears), China’s property bubble and a myriad of other worries lurk in today’s financial markets.

The Giant Sucking Sound

In the 1992 Presidential Campaign, Ross Perot warned that the NAFTA trade agreement would move so many jobs from the US to Mexico that the result would be akin to a Giant Sucking Sound. If Ross Perot were in charge of the European Central Bank, he might be hearing that sound today as European financial institutions fall all over themselves and other global players to participate in the US dollar yield curve trade. The reason we do not hear Mr. Trichet moaning too loudly is because a weaker Euro is precisely what political leaders in Germany, France and Northern Italy want to see. From luxury goods to machine parts to wine, cheese, ham and sports cars, Europe’s exports will receive a nice short term boost. With capacity utilization at 75% and rising however, the fun cannot be allowed to continue indefinitely as Europe’s banks will need to refocus on bread and butter loans. So, while it is fun to attribute some sort of deeper meaning to the Euro heading back to parity with the US Dollar, larger fundamental forces in Europe will likely remove some of the demand for US dollars when European manufacturers try to expand on the back of strong export sales.

So, what does this mean for investors?

A rising dollar means that commodities (mostly priced in dollars) are unlikely to rise soon. Part of that is the dollar price tag but another part is falling demand from the Eurozone. Oil in particular can be quite sensitive on the downside to a strong US dollar.

With petroleum products like gasoline not rising (contrary to what normally happens during the US summer driving season) and European imports on sale, expect the mushy US retail numbers to improve through Labor Day at least. Consumers won’t necessarily spend just because gasoline prices are low but if there is a sale on as well, wallets should open. Therefore, we are not surprised to see VCR and XLY in the top rankings of the system.

Will GLD perform well? Not likely. Short term Treasuries and Gold are competing for the attention of the panic stricken investor. If we toss in near term US dollar strength, the balance tips from non-yielding gold to low yielding treasuries. Of course, all of these conditions are reversible so if one sees gold correct nicely in the coming months ($800-900), a sensible investment opportunity may present itself on the next upcycle.

How about equities by region? Small caps are showing continued resilience in the US but there is not much conviction behind the trade. Large caps, as represented by SPY, are not going anywhere with a very slim preference for Value (slightly ahead) over Growth (slightly behind). Large Cap European stocks (FEZ, for example) are at the bottom of the rankings as the sovereign debt issues play out at large European banks, swamping the positive benefits accruing to the large export manufacturers. Emerging Europe is still promising as it will benefit from export driven outsourcing from Germany as well as M&A opportunities as mature European corporates are compelled to switch focus from expensive US dollar based assets to cheaper Euro linked asset markets.

Asia is a mixed bag. Japan’s equity market looks to be cooling off a bit as the Yen is the only other currency as strong as the US dollar. China is at the bottom of the list for largely internal reasons related to the unwinding of a property bubble while India is close to the top of the rankings. Other Asian markets, which are tied to the US dollar, are in the middle of the pack and can be safely underweighted at this point.

An unpleasant task but it is important to step back and remember where we are in the greater cycle of investing.

Here are the three questions:

1. Are we in a Secular Bear Market?
2. What does a Secular Bear Market look like?
3. Why are we in a Secular Bear Market?

The third question will help us to see the signposts for the next Secular Bull Market. The signposts are both political and interest rate driven.

Are we in a Secular Bear Market?

The answer is Yes. Does that mean the market will go in a straight line down and there are no investment opportunities to be had? No…except, as we shall see, Japan. Just as certain asset classes surged and corrected during the Secular Bull Market of the 80’s and 90’s, certain asset classes will surge and correct during a Bear Market Phase as well.

What does a Secular Bear Market look like?

Here is the Dow and S&P500 which can be put together in a few minutes using Yahoo Finance and Excel. Charts and statistics can be manipulated to tell a particular story and these charts are no exception. We have used a logarithmic scale (so a 10% rise in the 1950’s looks like a 10% rise in the 1990’s) and have squeezed it to emphasize the long term time periods. On top of that, we have laid lines of our choosing to frame your thinking. Why bother describing this? Because it is important to think about the construction of any chart that might influence your investment process. Don’t be afraid to draw different lines and even conclusions.
Source: Yahoo Finance DJIA, SPX, Nikkei

The most interesting thing to note about the two US market charts is that a Secular Bear Market is not a smooth downward progression that the words imply. A Bear Market is generally defined as a 20% drop from the peak but that definition refers to a cyclical bear market. And, since many of those 20% drops happen quickly in otherwise Secular Bull Markets, one can see how the general perception of a Secular Bear Market is formed. However, the longer term beast that prowls the financial markets these days is a generally sideways affair. Generally, because one always has the example of Japan, which has gone to great efforts to make the last 20 years as dreary as possible.

Why are we in a Bear Market?

This is an important question because it will help us find the signposts for the next phase. Despite many sunny assurances that the Great Recession is behind us, the world does not feel like it is enjoying a strong recovery. A big part of the problem is the structure of the developed world’s economies. After a long period of globalization and attendant wealth creation, the demands for pensions, government programs, subsidies, worker protections and the like have finally taken a toll on the fiscal positions of many European and US states. The government’s share of GDP has grown dramatically, particularly in response to the Global Financial Crisis. Good growth is being crowded out by Government growth.

What should we look for? Dramatic action. The US and Europe did not break out of the malaise of the 70’s until dramatic actions were taken. Governments in the US and Europe will have to make some hard choices over the coming few years in order to set up for the next round of economic growth. What signs should one look for? Political reordering, sneaky pension cuts for public employees, a change in Social Security retirement age in the US and perhaps a government willing to stand up to public employee unions.

On the financial side of the equation, the big problem is that there is plenty of liquidity being created in the banking system but very little is being turned into money that businesses and individuals can use.

Courtesy of ShadowStats.com

Why isn’t money moving from the Federal Reserve to Main Street? Simply because it makes no sense for US banks to even look at making a loan.

This chart is presented in a fashion that one might not be familiar with because we are showing it from the bank’s perspective. To a bank with access to short term Fed Funds, the dramatically steep curve in US dollar rates means that the bank can make a bundle in the US by simply borrowing at next to nothing and lending it to the US Government for a few years. Compared to the complexities of a 30 fixed rate mortgage, this trade is the path of least resistance. Not only do you not need loan officers, you do not need an advanced degree to lay on the trade.
Data Source: Bloomberg

For now, it means that banks and other financial institutions around the world will continue to crawl over each other to get in on the trade. That means continued dollar strength (UUP) and weakness in the British Pound (FXB) and Euro (FXE) for the foreseeable future.

The signpost to look for is the flattening of the yield curve. When the long end comes down (because the FED appears determined to keep the short end anchored near zero) the loan officers will be out in force to recycle the profits that are being racked up today. Once that engine restarts, expect to see a huge surge in asset prices, economic activity and eventually, inflation.

What to do in the meantime?

As we pointed out in the beginning of the post, the next few years will be dominated by the Secular Bear Market. That means a general sideways drift with plenty of smaller bull and bear cycles along the way. To make money in rotational markets one must pay close attention to asset allocation and being ready to shift assets between classes. The old “Buy and Hold” formula which worked so well for almost two decades will only deliver very slim returns with lots of volatility. We continue to refine and test the Fund King System to meet the challenges of these markets.

Right now the System is telling us to stay in the following asset classes: Emerging Europe (TUR is back), High Yield, India, Tech, Reits, US Consumer, US Small Caps and Homebuilders. In our commodities only portfolio, only Gold (GLD) and Silver (SLV) look interesting.

For more information, go to our Portfolios Page. Gold members can see the most recent recommendations.

Disclosures: We eat our own cooking so you can safely assume that we own, have recently owned or are about to own the ETFs discussed here. In this particular post, we do not own GLD or SLV although we have owned both in the recent past.