Archive for July, 2010

Gold: Something worse than GLD?

With Gold on the radar of most investors, much of the conversation has switched from whether to buy gold to how to buy gold.

To date, the ETF GLD has been the most popular option for investors seeking to add some yellow metal to their portfolios. It is liquid and easy to store (unlike bullion). But for true believers, GLD is not good enough because its claim on actual metal is far from absolute enough for a hardened gold bug. Several sponsors have jumped in to offer products with tighter links to physical gold.

Wherever you lie on the gold buyer’s spectrum, there is at least one method of acquiring gold that seems worse than holding onto a bunch of GLD shares…

Fools Gold: Inside the Glenn Beck Goldline Scheme

Peek Inside an ETF

While most of us are happy to just buy ETFs that cover a region, market segment or sector that looks promising in our investment universe, we have received a number of requests to make it easier to evaluate the constituent members of the ETFs. This should allow you to use a simple top-down method to identify stocks that are well positioned to outperform in broad market rallies.

We start with 11 ETFs from the State Street’s SPDR Brand of ETFs because they cover well known market segments and liquidity is generally pretty good.

A note of caution: we built the Fund King System with Mutual Funds and ETFs in mind because these investment vehicles offer some built in diversification of company specific risk. The methodology we use works with individual stocks as well but make sure that any portfolio you build is diversified enough so that a specific company problem (say an undersea oil well gusher) does not wreck your portfolio.

Click Here To Get Started!

The Bad Magician

One of the joys of having children is arranging birthday parties. Excited little friends, games, presents, sugary drinks, junk food, birthday cake and maybe a swimming pool are the time honored ingredients for a successful party. But, occasionally, we try to take it up a notch by hiring a Magician. This can work wonders the first time or two because a decent Magician can mystify the children and keep them quiet for as long as 30 minutes. But as the years go by, the kids figure out the tricks, the magician is not as brilliant as we remember and the kids are running amok only a few minutes into the show.

That is where we are now with government policy in most of the G7 countries. In the US and EU, we were fascinated with the magicians who were able to perform magic tricks like the Great Bull market of 1982 to 2000 or the economic revival of Europe and the creation of the Euro. We were less thrilled with the show being put on by Japan after 1989 but even there we have witnessed a few brief rallies of enthusiasm during the otherwise Lost Decades.

But now, we are no longer fooled or even impressed by the Magicians. As a result, the markets are not responding to all the old tricks. This may confuse Nobel Prize winning economists who continue to ask for more of the same, but it would not be a mystery to a child who has seen one too many magicians at a birthday party.

What are the old tricks?

Zero Interest Rate Policy (ZIRP) and Taxpayer Guarantees are the two magic tricks still being trotted out on the stage today. A third magic trick, coordinated government stimulus, got booed out of the room at the G20 summit in Canada. Unfortunately, these two policy tricks are no longer as potent as when the financial system was spiraling down into the pit of doom in 2008.

Let’s start with ZIRP. This trick was employed several times by the “Great Maestro” himself, Alan Greenspan, to pull the US financial markets out of trouble. Since financial services were becoming an ever larger part of the US economy at the time, what was good for Wall Street turned out to be sort of good for Main Street as well. But, as pointed out by the Austrian School of Economics for years and Andy Kessler last week, as interest rates approach zero, investors lose the most important input in the investment calculation. When we were younger and more gullible, this led to malinvestment. Now that we know how the trick turns out (Global Financial Crisis), investors are not so easily duped. From a corporate point of view, a near zero risk free rate of return suggests that all but the craziest investment projects are economically viable. But with capacity utilization in the low 70’s, that conclusion is irrational. The result: US corporates have rationally piled up an estimated US$1.8 trillion in cash. From an individual point of view, historically low mortgage rates are telling us to borrow as much as we can, despite the evidence of continued property market distress all around us. In the past, we might have “bought the dips” but this time, we are still applying ointment to our burned fingers. And lest we forget the other side of the equation, the banks, which still have lots of losses to write off, do not have the balance sheets or the intestinal fortitude to accommodate such a lending boom.

The second trick is Taxpayer Guarantees. This trick used to be called Government Guarantees and when they were smaller relative to GDP and/or times were dire, almost everyone was willing to suspend disbelief. Now, as even normally docile German voters have reminded us, these “guarantees” are going to cost us dearly as taxpayers. The biggest manifestation of this fading magic trick was Freddie Mac and Fannie Mae which currently guarantee up to 90% of the new mortgages being written in the US. But a bigger attempt is happening in Europe in sovereign debt. Recently, Ireland was able to raise €1.5 billion in six and ten year bonds despite a recent downgrade by Moody’s. The press noted that Ireland had to pay punitive rates of 5.5% on the ten year paper. The only reason that they did not have to pay credit card interest rates is because the debt is implicitly guaranteed by the European Central Bank. No bank would touch the paper without that guarantee. And, since the German consumer knows that he or she will be on the hook for these guarantees for years to come, the natural response is to export more and consume less.

How do we get out of this mess?

For better or worse, the magic show is scheduled to end fairly soon. In Japan, the Post Office will stop buying JGBs in 2011 because the population is growing older and on balance will be consuming more than saving. Gaiatsu (“outside pressure”) will return to Japan after a two decade hiatus when interest rates rise. In Europe, Chancellor Merkel retains some of her popularity but her government is undergoing severe strain as voters push back in the regions. And in the US, the Democrats are on track to lose control of the House of Representatives, the constitution wellspring of spending bills.

On the US consumption side, we are seeing green shoots in the American Express 2nd quarter earnings report. As pointed out in the Bloomberg article, AmEx’s business model is largely immune from legislation proposed by Rep. Richard Durbin, which probably gives it a head start. Once Visa and MasterCard are able to lobby for loopholes through the new legislation, we could see credit flowing back into the consumer segment.

Once the corporate sector can see a path for a resumption of consumer led growth, we should see inventory building first, investment and employment should follow (with a long lag) and interest rates will rise.

The trail back to solid economic growth will not be straight as years of Magic Tricks and other quick fixes need to be unwound. We therefore continue to recommend an active portfolio management strategy which scans and reevaluates a broad investment universe for investment opportunities on a regular basis.

Government Spending

The market fell because Bernanke didn’t have any candy to throw to the markets. I think that misses the point entirely. Here are two people who know what they are talking about framing the debate in a sensible fashion. Keith McCullough’s comments make a lot of sense to me.


The big question in finance is whether we are heading for deflation or inflation.

In order to become a better investor, one must occasionally push aside all the heat and noise of today’s financial markets and plot out alternate courses for the future. But before we push it away, let’s look at what the bond market is telling us. Today’s bond markets are definitely pricing in deflation which appears to be a safe bet if you look at the GDP numbers in the US.


Price source:

Actual GDP growth in current dollars turned negative for the first time since 1949. Why is that important to the bond market? Because bond investors are paid in current dollars. The great fear of a bond buyer is that inflation will eat up returns and principal. US Treasury yields are below 3% (see Bloomberg chart) and almost any inflation above 2% would be detrimental to bondholders financial health. These investors are not writing editorials in the New York Times, they are risking real money.

Why are bond investors so confident now?

Because there is lots of money but no chasing. Milton Friedman and Anna Schwartz proposed that “Inflation is always and everywhere a monetary phenomenon.” In simple terms, inflation is caused by too much money chasing too few goods and services. The problem with Friedman’s dictum is that it has been mis-sold by Fed and Treasury officials of late. They sold the country on the idea that since inflation is a monetary phenomenon, one need only double the Fed Balance sheet (print money) and the threat of deflation will disappear with a few months lag.

So now there is too much money but still no inflation. Inflation is not kicking in because retail sales are telling us that there is certainly no chasing of goods or services going on in the United States. Consumption makes up almost 70% of GDP so one needn’t look too far for the answer. What about the Government stepping in? With all due respect to Nobel Prize economists like Paul Krugman, the Federal Government is good for a bit more than 20% of GDP and most of that is transfer payments (taking money from one group and giving it to another). However stimulus programs are packaged, the government will not get dollars to chase goods and services on its own.

The Road from Deflation to Inflation

So that is a wrap. The smart money in the bond market has figured out that all the noise coming out of Washington will not trump the bruised and battered consumer whose credit lines have been euthanized over the last two years.

But the road to inflation is not totally blocked. The money is still there. With corporates building cash piles, real estate mired in the foreclosure work out dumps, and some version of the Volker Rule likely to constrain the amount of money banks can punt in the markets, there are not many profitable places for a bank to turn. Once bank lobbyists have figured out how to gut the financial reform legislation, mailboxes should start filling up with credit card applications once again.

And once the credit taps are opened, we will see the excess money start to chase goods and services. Will the Fed step in to raise interest rates and preserve “sound money”? Perhaps when inflation gets into the high single digits but by then it will be too late. Current GDP will be growing at 10% or better, government coffers will be filling up as taxpayers are pushed into higher brackets and the Debt to GDP ratio will stabilize and then start to fall.

Who wins?

No one really. Bond investors are hit first and pay the most but inflation is a stealth tax on everybody and it tends to be a very regressive tax. The political will for cutting spending or raising taxes is almost non-existent so developed economy governments will fall back on inflation to get the job done quietly. Does that amount to a default? If one reads “This Time Is Different”, one might feel that way.

What should investors do?

Nothing today. With the weight of money on the deflation side of the trade, there are no points awarded for being early. This is a trade to watch out for and the indicators are retail sales and M2/M3. Once these turn, there are a number of funds and ETFs that can give you inverse exposure to bonds. But be careful about the tracking errors that can build with time. With inverse and leveraged products, it is easy to be right on the idea and get it wrong on the execution.

A simple way to hedge against inflation is to borrow as much as you can service at today’s low “deflation inspired” rates. A 30 year mortgage below 5% (check rates here) may not sound too sexy today but if inflation rises to 3-5% and hard assets start to appreciate, it could be a cocktail party bragging point for years to come.

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