Andy Sutton's Extemporania

Weekly Commentaries and Occasional Observations

About Sutton & Associates

Tags: investing

January’s Centsible Investor is Available

by TwoCentsEditor

Published on: 01/15/2011

Categories: Current Events, Economics, Financial Markets

Tags: investing, portfolio, precious metals, profits, stock, stock picks

Comments: No Comments

January Issue Highlights

A quick status update on the Original Model Portfolio: Currently, the dividend-producing segment has a total return of 13.92% including dividends. This while the major indexes are off around 20% during the same time period.

Our speculative rare earth pick has netted a 57% gain in less than 8 weeks. We added another just a few days ago on what looks to be a nice pullback in the complex. Please take the time to read the analysis in this month’s issue; there are compelling reasons to look at this company.

Since our dispatch on November 2nd regarding Treasuries, the 10-year Note’s yield increased by nearly a full percentage point. Our model has gone sideways the past 2 weeks now, which makes sense given the back and forth in the bond markets. There is no doubt that the shortened weeks during the holidays have had something to do with this, so we’re expecting to see something break in terms of a trend.

This month’s energy report focuses on the structural imbalances in many of the key markets, particularly crude oil. The consumption-production gap here in the US baloonned out to almost 4 MPBD in the past four weeks and like many others, we are wondering where all the oil is coming from to fill the gaps.

In precious metals, we talk about China’s new Paper (gold) Tiger, and some of the constraints on the Silver markets. We made another addition to our Silver holdings last week and the volatility in the metals has been spectacular to say the least.

Since the rest of the letter went so long this month, we’re going to do the market report in two pieces. The first, abbreviated piece will be in the newsletter as always, but we’ll be producing a Camtasia multimedia presentation sometime next week for release to subscribers. We’ll dispatch when that is ready. Click Here for more information.

Club Med and the Dollar

by TwoCentsEditor

Published on: 02/12/2010

Categories: Current Events, Economics, My Two Cents

Tags: bonds, debt, deficits, greek debt, investing, national debt, stocks

Comments: No Comments

News junkies, currency buffs, and economists of an Austrian tilt have been having quite an entertaining few weeks. Between massive blizzards from Virginia to New England, another baseless Dollar rally, and the hilarious notion that a little Greek debt could unwind the Euro, there certainly has been plenty to talk about. These ‘black swan’ events are certainly becoming more and more commonplace these days; almost to the point where they can’t even be called black swans anymore. What would previously have been considered ridiculous is now normal, and what was normal is now considered ridiculous. Such is the way of things as empires unwind. Our circumstance today is no different.

The Dollar – The Ultimate Opportunist?

It should not be lost on even the most casual of observers that the US Dollar is dead. How can I say this when it is in the middle of yet another ‘rally’? And aren’t the folks in Washington telling us how strong the Dollar is more and more vapidly and with greater frequency? The fact of the matter here is that the Dollar has, for quite some time now, not been able to rally itself based on its own merits. Remember that currencies are essentially a zero-sum game. Their value is measured in terms of other currencies. One goes up, another must go down. Taking a look at recent Dollar rallies, they’ve happened essentially because bad things have happened in Euroland or elsewhere, whether it is the latest debt crisis with the PIGS (an unfortunate acronym, but who wants to be called a BRIC anyway?) or the massive liquidation of 2008. These were not exhibits of the Dollar’s strength, but rather of a mental model that still hasn’t adjusted to the fact that the Dollar’s run is over. Add to that the lack of an available substitute and voila – instant dollar ‘strength’.

Think of it this way: if our currency were strong for fundamental reasons, say for example gold backing, genuine budget surpluses free of accounting chicanery, trade surpluses, and similar positives, then countries wouldn’t be sneaking around backrooms around the globe forging agreements to sidestep it. Foreigners wouldn’t be twisting their brains trying to figure out how to get out from under their pile of US Treasuries without upsetting the apple cart. Put mildly, a wheelbarrow full of plutonium would be received better in most financial centers these days than one filled with US Dollars.

Beware of Greeks bearing Debt?

If anyone here in the US still has doubts about what ultimately happens when a nation abuses credit and engorges itself with debt, all they need to do is look at Greece. The small Mediterranean nation needs to raise about $73 Billion in new money this year. While that seems like a mere pittance, it constitutes about 20% of Greek GDP. Greece also faces bond redemptions of $8 and $9 billion in April and May respectively. While Greece has by far the worst debt problem (at the moment) in the EU, it doesn’t stand alone. Portugal, Italy and Spain are also having issues of their own and the whole mess is threatening Euro stability, and by function helping the US Dollar.

PIGS Debt

These are real problems for sure, but what is amazing is the continued complacency by media and policymakers alike when it comes to the US and our debt levels. Our level of official borrowing will tally around 12% of GDP in 2010, however, if you look at the GAAP deficits and the resultant borrowing, it is always much higher than advertised. There is an important distinction to be made between Greece and the US, however, and that is the fact that Greece is essentially a hostage of the European Central Bank where the USGovt has a bank willing to issue as much rope as we can possibly need to hang ourselves. We’re hostages of the Fed, but most people aren’t easily inclined to look at it that way. We’ve been trained to believe that when we run deficits we’re borrowing from ourselves. Back in the era when we used US savings bonds to fund government activities, there was at least a modicum of truth to that. However, since we’ve gone overseas and to the internationally-owned Fed for more and more help, we’ve been slowing ceding our national sovereignty to foreigners much in the same way Greece et al have given themselves over to Brussels.

US Debt Levels

This is why every freedom-loving person should have a healthy fear of global central banks and even regional currency blocs. The very survival of the PIGS now rides on the whims of Merkel, Sarkozy, and Trichet. Flashback to the weekend of September 13th 2008 when Lehman Brothers here in the US was in the same shoes as Greece is today and then ask yourself how much we’ve really learned over the last 18 months. This is what happens when you globalize and intertwine the fortunes of nations and then base it on the fraud of a fiat currency system, the casino mentality, and a healthy dose of public ignorance.

So now the Europeans are left in a pickle. They have to come up with the right words to soothe the markets. They’ll need to offer words that promise all sorts of coordinated actions and large applications of money while actually doing nothing because they can’t afford it. Their economies are now stumbling out of recovery because there never was a recovery, just a shell created by inflation and debt.

America should take heed. It was easy to ignore when it was Argentina, Zimbabwe, and Iceland. However, we’ve done the same thing here. Our government believes that borrowing and saber rattling will force the economy to grow. Europe is the latest shining example of the utter failure of such thinking.

Keeping Your Options Open (and Valuing Them)

by TwoCentsEditor

Published on: 01/28/2010

Categories: My Two Cents, Technical Analysis

Tags: Binomial option pricing model, black-scholes, dividends, income, investing, stock options, stocks

Comments: No Comments

It is often said that there is nothing new under the sun. Truly, economic events of late have demonstrated this in spades. There is little that is new, just different flavors of the same. So, in the absence of anything substantially new to add to the collection of events this week, I am going to take an opportunity to return to some of the analytical topics that I’ve had but a few precious chances to deal with over the past three and a half years. The last foray dealt with some hedging strategies involving options and inverse funds. This week I’m going to dig deeper into the options side of hedging and look at some of the various pricing models available for consideration. Then we’ll take the models for a spin and create ourselves a hypothetical situation and see how things play out.

As previously discussed, options can be used to hedge portfolios against moves that are contrary to that portfolio’s orientation. For example, buying put options can be used to hedge a portfolio that is on the long side of the trade. Oppositely, buying calls can be used to hedge a portfolio that is primarily focused on the short side.

The difficulty in assessing options is figuring their value at a given point in time since they lose part of their extrinsic value as their witching (expiration) day approaches. Fortunately, there are a couple different models we can use to make quantitative predictions.

Binomial Option Pricing Model

The Cox, Ross, and Rubenstein Binomial Model is probably the simplest of the mainstream models available, and is flexible in that it works both on options that can be exercised over a period of time such as American options, but also on options with specific exercise dates such as Bermudan options. The model is built on the simple assumption that a stock can move in one of two directions in a given time period. The price can move up Su with a probability of p or it can move down Sd with a probability of (1-p). The figure below shows 3 generations of such binomial possibilities at each stage. Once the binomial lattice is constructed, the probabilities at each time point can be calculated at various standard deviations from the mean.

Binomial Lattice

When pricing options, it must be considered that you’re really dealing with several axes; the first being the price of the underlying asset as it compares with the option’s strike price and the second being the time factor. Let’s look at some other models, and then run a few live examples.

Black-Sholes Option Pricing Model

The Black-Sholes Model applies to equities whose price follows Geometric Brownian Motion or a stochastic price process. For simplicity’s sake, the prerequisite for using the model is price action characteristics that are often observed in financial instruments such as equities.

There are several assumptions that the Black-Sholes model makes, some of which are not able to be met in the real-world investment environment, but similarly to the notion of the perfect competition / pure monopoly continuum, such constructs can be valuable despite the fact that they are seldom achievable in their purest forms.

• Borrowing can happen at will at a constant and known risk-free rate.

• The price follows a Geometric Brownian motion with constant drift and volatility. (This is extremely rare in our markets)

• Transaction costs are set to zero.

• There are no dividend payments to navigate. (Dividend harvesting strategies often upset predictable Brownian motion)

• All securities are perfectly divisible. (Fractional shares such as in a DRIP type setting are available)

• There are no restrictions on short selling.

• There is no opportunity for arbitrage.

There are several variations of the Black-Scholes model; one that deals strictly with the price of the equity security, and a partial differential equation (PDE) that deals with derivatives of an underlying equity. While the formula is shown only for reference purposes, the general idea is to understand that one can use this modeling process to estimate the value of the derivative security (in this case an option) at a specific known point in time.

Black-Scholes Partial Differential Equation

Bjerksund-Stensland Model

This model comes in handy if you happen to be dealing with options whose underlying securities pay dividends. It is a hybrid of the Black Model, the Black-Scholes Model, and the Garman-Kohlhagen Model. However, there are still some assumptions that are not realistic. The model depends on constant dividend yields, discrete dividends, and continuous dividends. While there is a negligible amount of securities (if any) that fit these assumptions entirely, the model has through repeated study shown itself to be more accurate than the Quadratic Approximation Formula in nailing the value of long-dated options.

I mention this model due to its applicability to dividend paying stocks and its affinity to long options for those interested in using it for analysis of LEAPS options.

Exercises

For the purposes of this piece we’re going to run two simulations; one with the Diamonds as our core investment and a single protective put option and the second (also with the Diamonds) using what is known as a Butterfly, which actually involves buying two options and selling a third. We’ll see how the various strategies predict gains at different price levels a year from now according to the three aforementioned models.

Let’s list our assumptions for the first exercise:

-We’re going to buy 1000 shares of DIA

-We’ll buy 25 puts on DIA, which expire on 12/21/2012 with a strike price of $90.

-We will setup our price point analysis as follows:

$140.00 (assumes the Dow makes a new high – bullish case)

+10%, live, -10% of today’s price

$65.00 (assumes a retest of 3/6/2009 lows – bearish case)

-Interest will be set to the “risk-free” (sic) rate of 4.56%, which equals 30-year Treasury Bond yields on 1/27/2010.

-We assume the trades are made today at market prices and we’re looking at P/L one the trades one year from today.

Here are the results:

Black-Scholes Model

Black-Scholes Results

Binomial Model

Binomial Model Results

Bjerksund-Stensland Model

Bjerksund-Stensland Model Results

What all three of these models are telling us is that the best way to make money with this setup is if the Dow moves big in one direction or the other. If the Dow maintains the status quo and stays within +/- 10% over the next year, this allocation will lose money. The tools are predictive, but the user has to provide the assumptions. If you have a strong belief that the market is going to go down and retest those March 2009 lows, then you can use these models to build yourself a hedging program and then predict the results of such a program. You can tweak the variables, interest rates, etc as well. You can even add additional positions and see how the scenarios play out. This is one of the techniques that we’ve used over the past few years to mitigate periods of market downturn in our newsletter’s portfolio model.

Changing the Strategy

Obviously the first exercise provided a significant amount of risk and depended greatly on us being right in our prediction. If we’re wrong, we could lose a significant amount of money. Clearly there has to be a better middle ground; and there is.

Let’s change up the variables a bit and see if we can’t get something a little more balanced. For this comparison, we’ll use what is known as a Butterfly. Essentially what a Butterfly does in our case is purchases 1000 shares, buys 10 puts at $100 strike price, buys 10 more puts at $80 strike price and sells 10 puts at $90.

Let’s look at the results; again. We have added some price levels between the $65 and the $92 range to give a better illustration, however, all computational variables are the same as before.

Black Scholes – Butterfly

Black Scholes Butterfly Results

Binomial – Butterfly

Binomial Butterfly Results

Bjerksund-Stensland – Butterfly

Bjerksund-Stensland Butterfly Results

Obviously the butterfly strategy worked very well in terms of smoothing the returns across a wide variety of prices. Keep in mind in both cases we were working with around a $100,000 corpus of capital and limiting the action to +/- 1% is especially beneficial if that capital happens to yield more than the Diamonds and you’re collecting significant dividend income.

So, depending on your intentions and purposes, you can either use your option strategy to make a bet on the overall direction of the market and try to make a profit off of it or use an option strategy that allows you to collect dividends without worrying so much about a major market downturn diminishing the value of the underlying assets.

Some Potential Pitfalls

If you decide to investigate any of these types of strategies, you are going to want to keep your eye on a few things:

1) Does the derivative security appropriately represent what it is you’re trying to protect? For example, in our newsletter’s model portfolio, we have 21 dividend producing assets. Obviously, creating a butterfly strategy might be to our advantage. Not all of our components are equities, and many don’t have option chains so we’ll need to find something that does. But what options should we use? Using the Diamonds puts discussed above might work IF the relationship between my portfolio and the Diamonds is somewhat analogous. If it isn’t, then I might not end up where I should be even if the models happen to be spot on. The importance of this issue cannot be emphasized enough.

2) Use options that come from well defined option chains and are not thinly traded whenever possible. If you are working with an option that has just a few hundred contracts of open interest and low volume, authentic price discovery can be a problem because of wide bid/ask spreads. This is not to say it is impossible if the options are thinly traded, but it makes life more complicated.

3) The options pricing models are not always correct; especially in times of acute distress in the markets since the normal Brownian, stochastic oscillations of securities are disturbed and therefore, a portion of the predictive value of the models is lost.

Conclusions

It must first be pointed out that you don’t need fancy trading platforms or expensive financial software to use these models. While it is exceedingly complicated to do the calculations manually, there are websites on the Internet where you can download Excel Macros and add-ins that will allow you to enter the parameters and the custom software will do the rest. Go to your favorite search engine and key in the name of the model you’re interested in and you’ll quickly find a plethora of potential solutions.

We have presented two approaches to hedging, both with options and with drastically different results. For our purposes here at the firm, the Butterfly strategy obviously makes a lot of sense since a growing portion of our work centers around income investing. Being able to mark time with capital while raking in stellar dividend income is obviously something every fixed income investor would like to be able to do. In this era of near-zero interest rates, which just got stretched out by at least another month by the Fed today, it is not always an option to bail out of a sick market, especially when the income is needed to finance someone’s standard of living.

Hurricane Hunter

by TwoCentsEditor

Published on: 09/25/2009

Categories: Financial Markets, My Two Cents

Tags: capital, finance, Hindenburg Omen, investing, investment, money, nyse, stocks

Comments: No Comments

As global stock markets navigate through the eye of the ongoing financial hurricane, it becomes increasingly important for investors still impacted by these markets to be able to gauge when the storm’s fury will reassert itself and plan accordingly. By all measures, there are a healthy number of individual investors still in the stock markets in one way or another who are hoping to recover everything lost in 2008. The good news is they’ve gotten a nice chunk back. If they’ve been proactive as we’ve advocated, then they’re ahead of the game. However, it is important to note that we are operating within the context of a bear market rally; and this bear market still has a lot of teeth left. I am writing this article now, before the DJIA cracks 10,000, because once it does no one will be listening and the opportunity will have been lost.

The Hindenburg Omen

Once it has been established that we are in fact looking for a top, the next order of business is to try to get a handle on when that top might occur. This week we’ll take a look at once such indicator; the Hindenburg Omen. Before we even start it must be said that this indicator is not a be all end all and should only be used in conjunction with other technical indicators, a broad understanding of the macroeconomic environment, and a healthy dose of common sense. It is merely a tool. It is not a magic wand. Such things do not exist.

Essentially, the Hindenburg Omen is an indicator of underlying divergence in the movement of the issues traded on the New York Stock Exchange (NYSE). It is stock market sonar, meant to scan underneath apparently placid waters, searching out turbulence beneath the surface. Merely looking at the daily progression of the price of the major market indexes will not glean any light whatsoever on the actual internal condition of the markets. Examples of such divergence generally happen around major tops, which is what the Omen has been rather good at sniffing out. In the past 25 years there has not been a major market crash event without a confirmed Hindenburg Omen. However, to be fair, it must also be said that every Hindenburg Omen has not resulted in a market crash during this same period of time.

Hindenburg Omen Criteria

There are 5 criteria that must be observed on a particular day in order for a Hindenburg Omen to be registered. They are:

• 52-week Highs and Lows must both be greater than 2.2% of the issues traded on NYSE.

• The lower of the Highs/Lows must be greater than 75.

• The 10-Week NYSE Moving Average must be increasing

• The McClellan Oscillator must be negative.

• The 52-week Highs cannot be more than twice the number of 52-week Lows, but the number of Lows can be more than twice that of the Highs.

• An optional condition for the Hindenburg Omen, which has been found to be extremely beneficial in honing the accuracy of the indicator, is a confirmation within 36 trading days of the initial observation. So in order to have a confirmed HO, two observations need to be made within 36 trading days of each other.

NYSE 10-Week MA

Let’s take a look at the Hindenburg Omens of the past 25 years. It is important to note that the indicator is not exclusively prescient. It will sometimes trigger prior to a crash event, sometimes it is coincident with the beginning of the crash event (the market top), and sometimes it comes slightly after the crash has begun.

Historical Occurrences

In the past 25 years, there have been 27 confirmed Hindenburg Omens and 191 individual occurrences of the Omen. Thus, the rate of occurrence was around 3%. Here’s the breakdown of what happened after those 27 confirmed Hindenburg Omens:

DJIA decline of 15% or more: 8 times or 30%

DJIA decline of 10-14.9%: 3 times or 11%

DJIA decline of 5-9.9%: 10 times or 37%

DJIA decline less than 5%: 6 times or 22%

Of the last group, 2 of the declines were less than 2% and therefore considered ‘failures’ in terms of the predictive value of the signal. Looking at it a different way, there is a near 78% chance that a confirmed Hindenburg Omen will result in a 5% or greater decline in the DJIA. In the context of the current position of the DJIA, we would have a 78% chance of at least a 480 point drop if we had a confirmed HO. Fortunately, as of this time we do not, and in fact do not have even an unconfirmed observation.

Below is the chart of data for the Confirmed Hindenburg Omens shown.

Hindenburg Omens Since 1990

Incidentally, there is no relationship at all between the number of observations and the magnitude of the resultant decline (Correlation between series: -0.01)

Date of First Signal	Number of Observations	Drop in DJIA – %
6/6/2008	6	47.3%
10/16/2007	9	16.3%
6/13/2007	8	7.1%
4/7/2006	9	7.0%
9/21/2005	5	2.2%
4/13/2004	5	5.4%
6/20/2002	5	23.9%
6/20/2001	2	25.5%
3/12/2001	4	11.4%
9/15/2000	9	12.4%
7/26/2000	3	9.0%
1/24/2000	6	16.4%
6/15/1999	2	6.7%
7/2/1998	1	19.7%
2/22/1998	2	0.2%
12/11/1997	11	5.8%
6/12/1996	3	8.8%
10/09/1995	6	1.7%
9/19/1994	7	8.2%
1/25/1994	14	9.6%
11/03/1993	3	2.1%
12/02/1991	9	3.5%
6/27/1990	17	16.3%

Where do We Stand Currently?

Based on 9/24/2009 closing numbers, this is where the various requirements for a Hindenburg Omen stand:

52-Week Highs: 157 (4.97%) – Met

52-Week Lows: 3 (.10%) – Not met

Lower Greater than 75? – Not met

52-Week Highs < 2X greater than 52-Week Lows – Not met

10-Week MA: Rising – Met

McClellan Oscillator: -112.34 – Met

The above analysis indicates that while some requirements have already been met, that the level of bearish divergence necessary to generate the required number of 52-week lows still doesn’t exist. Keep in mind that these numbers change daily and therefore, must be watched continuously.

Worth Noting

Two failures of a confirmed Hindenburg Omen to predict a more significant drop in the DJIA during the past 25 years were accompanied by significant liquidity injections by the Federal Reserve to stave off the decline. Chalk these up to either coincidence or overt market manipulation. These injections were $155 and $148 Billion and occurred in 2004 and 2005 respectively. Just three years later, multiple trillions were required and were still not enough to keep a 50% crash at bay. This alone should reinforce the notion of a hyperbolic growth in debt, leverage, and systemic risk.

August Centsible Investor Available

by TwoCentsEditor

Published on: 08/15/2009

Categories: Centsible Investor Info., Financial Markets

Tags: business, finance, investing, investment, investment newsletters, money, stocks

Comments: No Comments

August 2009 Issue Highlights

This month’s Keynote article deals with the US Bond market, the future of interest rates, and potential impact that the oversupply of Treasury bonds will likely have on the equity markets. We also update our powerful proprietary indicator, which has been front-running major turns in the 10-year yield market for nearly the past 3 years.

In the Energy and Precious Metals reports, we analyze the many mixed signals in precious metals, and take a much closer look at the supply-side of the energy markets. Our contention is that mainstream economists and analysts alike are making a critical error when assessing these dynamics. You need to be aware of these misconceptions.

Model Portfolio Recap: 15 of 20 active components are currently in positive territory. 9 of our current components are up over 25% and 4 are up over 50%. The Portfolio has a total return of 3.44% since 11/2007. The fact that we’re able to talk about gains when one looks at the performance of the major indexes during this period is quite remarkable. If you agree, please please consider subscribing.

For subscription information, please Click Here

Portfolio Diversification & Risk

by TwoCentsEditor

Published on: 07/25/2009

Categories: Financial Markets, My Two Cents

Tags: beta, capital, capital management, diversification, Economics, economy, finance, financial, investing, investments, money, portfolio, Portfolio management, risk, stock market, stocks

Comments: No Comments

The cliché’s are plentiful and well known. Putting all of one’s eggs in a single basket is probably the most popular example. One of the biggest manifestations is when an investor looks at their portfolio and realizes that it is grossly underperforming a particular market index or that the same portfolio has performed much worse than a given benchmark. Even if you’ve done everything right and selected the right themes, industries, and firms, if you get the portfolio mix wrong, you can still have problems. This is one of headaches that mutual funds are generally supposed to relieve investors of, but for a litany of reasons, it doesn’t seem to always work out that way. In truth, every individual portfolio is a mutual fund of sorts, and so the same rules apply.

Types of Risk

In general, there are two broad types of risk: systematic (non-diversifiable) and non-systematic (diversifiable). Keep in mind that what we are discussing here is slightly different from geopolitical risk, currency risk, interest rate risk, etc although each of those specific types of risk do contribute to the overall riskiness of a particular stock and as such cannot just be ignored.

The data in the chart below is from a 1987 study on diversification just after the market crashed. Obviously, at that time, diversification was a hot topic as investors scrambled to adjust portfolios and recoup the losses. The data below lists the number of components, the standard deviation of annual returns for each portfolio, and a comparison of the standard deviation of the portfolio to that of a single component.

Number of Components in the Model Portfolio Average Std. Deviation of Annual Portfolio Returns (%) Ratio of Portfolio Std. Dev. to Std. Dev. of a Single Component

Number of Components in the Model Portfolio	Average Std. Deviation of Annual Portfolio Returns (%)	Ratio of Portfolio Std. Dev. to Std. Dev. of a Single Component
1	49.24	1.00
2	37.36	.76
4	29.69	.60
6	26.64	.54
8	24.98	.51
10	23.93	.49
20	21.68	.44
30	20.87	.42
40	20.46	.42
50	20.20	.41
100	19.69	.40
200	19.42	.39
300	19.34	.39
400	19.29	.39
500	19.27	.39
1000	19.21	.39

Below is a graphic representation of the data in the chart above. It may clearly be observed that standard deviation of the portfolio is asymptotic (law of diminishing returns) as it relates to eliminating the systematic (diversifiable) risk. In fact, once the number of portfolio assets surpasses 30, the standard deviation does not drop appreciably, even when another 970 components are added! Obviously, this reality enforces that quality is better than quantity.

Think of the case of the individual investor who buys 100 stocks thinking he is diversifying away all his risk. He has borne a significant opportunity cost in the form of commissions without purchasing much in the way of additional protection from non-systematic risk. The upper portion of the chart deals with non-systematic risk, which can be largely diversified away. Notice though that even when the portfolio contains 1000 components that the standard deviation is still 19.21%. That constitutes the systematic risk.

Systematic vs. Non-Systematic Risk

A good example of systematic risk is pure market risk. Obviously if the capital markets crash again as they did in 2008, it will be exceedingly difficult to put together a basket of stocks that will withstand such a downward draft. There are other types of risk such as geopolitical, currency, inflation, interest rate, industry, and geographic. By using a crosscut approach to diversification, one is able to not only mitigate much of the non-systematic risk, but a good portion of the systematic risk as well. This is accomplished by looking at your themes selected several weeks ago, then addressing each type of systematic risk in your selection of assets. This approach is one of the main reason that our Centsible Investor Model Portfolio has done so well while the broad markets have languished.

Beta (ß)

Quantitatively, Beta is the generally accepted measure of systematic risk for a stock and is defined as the amount of systematic risk present in a particular risky asset relative to that in an average risky asset. Essentially what Beta does is compares a particular stock in this case with an average stock, or more accurately, a benchmark basket of stocks:

Beta

where ra measures the return of the asset, r_p measures the return of a portfolio of risky assets (often the stocks in an index), and Cov(r_a,r_p) is the covariance of the returns.

Interpreting Beta is rather simple. 1.0 is the Rubicon so to speak. Betas lower than 1.0 indicate that the stock in question has a lower level of systematic risk than the ‘market’ while a Beta of greater than 1.0 indicates a stock that has a greater level of systematic risk than the ‘market’.

Knowing this, it becomes a rather simple matter to calculate the Beta of your portfolio simply by ascertaining the weight of each component and then multiplying it by that component’s Beta. Let’s use a hypothetical example where we have a 3 stock portfolio; Stock A is 25% of the portfolio, Stock B is 40% of the portfolio, and Stock C is 35% of the portfolio. The Beta of Stock A is .75, Stock B is .50, and Stock C is 1.25:

Beta_portfolio= .75(.25) + .50(.40) + 1.25(.35)

Beta_portfolio = .83

This calculation indicates that this 3 stock portfolio has systematic risk that is lower than that of the market, however, its non-systematic risk would be considerably higher than one would desire since there are only 3 components. All else being equal, the ideal would be to find a portfolio of perhaps 25-30 stocks that has a Beta_portfolio of .83, as this would mitigate much of the non-systematic risk as well.

Beta and the Risk Premium

While using the term risk-free in today’s financial and economic climate might result in a shower of protest, the concept of the risk-free asset has an important place in the discussion of risk vs. reward, particularly when selecting portfolio assets.

Let’s use an example of a stock with an expected return of 20% and a Beta of 1.6. Let us also assume (entirely for illustrative purposes) that the risk-free asset has a return of 8%, with a Beta of zero since it has neither systematic nor non-systematic risk. In the case of expected return, we are relying on an educated guess, but in the case of stocks that pay dividends, one could easily plug the dividend yield into the expected return as well. When we plot out our stock and the risk-free rate and generate a Security Market Line (SML), we get the following:

SML - Single Stock

The chart above is relatively easy to interpret; we consider the ‘risk-free’ asset R_f with its corresponding Beta of zero and return of 8% and our stock with its Beta of 1.6 and its expected return E(R_A) of 20%. When we connect the dots and measure the slope of the line (rise/run), we get a slope of 7.5%. From this graph, we can ascertain that our stock has a reward to risk ratio of 7.5% meaning that our stock has a risk premium of 7.5% for each ‘unit’ of systematic risk. Obviously, the higher the reward to risk ratio, the better, meaning we’d want to see higher E(R_A) and/or lower Beta; either of which would increase the slope.

In a final example, let us now compare our stock in the previous example (called Stock A) with a second stock (Stock B). Stock B has a Beta of 1.2 and an expected return E(R_B) of 16%. When we construct our Security Market Line, we end up with a slightly different picture than we had with Stock A.

The reward to risk ratio (or slope of the line) for Stock B is 6.67%.

SML Comparison

What this tells us (all other things equal) is that in essence, Stock A is a ‘better’ choice than Stock B simply because it generates more reward for each unit of systematic risk undertaken.

This analysis is especially useful when one is selecting portfolio components and wants exposure to a particular industry or sector, has multiple candidates, but doesn’t want to include them all for fear of being overweight that particular area. In this manner, the candidates may be lined up and compared to see both visually and quantitatively where the best bang for the buck lies.

Of all the areas discussed in our sample exercise over the past few weeks, diversification and risk are the two areas where investors are most likely to stumble. Many fail to properly diversify because they don’t understand the value of it or because they don’t have enough capital to diversify by purchasing individual stocks and should look to ETFs, open-end or closed-end funds as an alternative.

While the analysis above was primarily for stocks, those investors seeking to hedge their portfolios with precious metals can certainly plug their favorite shiny coins into this analysis. For those so inclined, Betas may be hand/Excel-calculated for commodities using the major indexes, or commodity indexes, such as the CRB as the ‘market’ portion of the calculation.

In summation, probably the most important takeaway from this article should be that a portfolio doesn’t need 100 components to be adequately diversified in terms of non-systematic risk. 30-40 will do just fine. A second important point is that by using your economic themes and how they relate to systematic risks in your selection of an appropriate number of assets, you can mitigate a good deal of the systematic risk to your portfolio as well.

Basic Financial Analysis – Part III

by TwoCentsEditor

Published on: 07/10/2009

Categories: Economics, Financial Markets, My Two Cents

Tags: asset, bonds, business, Economics, economy, finance, inflation, investing, investment, money, personal finance, portfolio, Portfolio management, S&P500, stock market, stocks, xlp, xly

Comments: 1 Comment

Before we begin, it must be understood that there are many perceptions of value. In fact, if you took 10 investment professionals polled them individually; you’d likely get several very different definitions of value. If you put them together and forced them to come to a consensus, you would do well not holding your breath waiting for an answer. While there is no one right definition – especially in the investing world, what we are looking to do is select a metric or some group of metrics that applies to our particular situation. Again, investing should not be approached with a ‘one size fits all’ mentality. It must also be said that this list is not a comprehensive one, but rather a sampling of some of the methodologies available for ascertaining value.

The Mainstream’s Darling – P/E

If you turn on your television, perhaps the most popular measurement of ‘value’ is the price/earnings or P/E ratio. While P/Es are mentioned frequently, rarely does anyone stop to really think about what it represents. Simply put, the P/E ratio is the price of a share of stock divided by the earnings per share. In essence, it is how many dollars you will pay in share price for each dollar of earnings. I will be honest; I rarely use P/E as a decision tool simply because I don’t believe it is applicable in most situations. An average investor is not buying earnings. Sure, earnings may help drive the share price in the future, but they just as easily might not. News events about a company can drive price as much if not more than earnings, so perhaps a Price/News ratio would be appropriate too? And really, why would anyone ever want to pay more than a dollar for a dollar’s worth of earnings anyway? By definition then, a P/E of greater than 1.0 would mean the stock is expensive. The argument will also be used that one is not simply buying the earnings, but a claim on the assets of the corporation. While this is theoretically true, you can’t drive down to your local Home Depot and take a truckload of lumber out of the store without paying just because you’re a shareholder!

So there are many conceptual problems with the idea of P/E ratios yet once the P/E of the DOW goes below a certain point, we’re supposed to buy because stocks are now ‘cheap’. This to me is drawing some parallels that are eerily similar to herd mentality. All this should not be construed as an indictment of the P/E ratio, but rather to point out its limited relevance in terms of determining ‘value’.

Another frequently used, but less popular metric is the Price/Book ratio or P/B. Simply put this is dollars paid in share price for each dollar of book value. This is more of a liquidation metric, however, than an actual investing metric. Now there are some obvious instances where once might sniff out a bargain. Our example in the prior week’s issue of food companies is a bit lacking, but let’s use the example of a natural resource company. If for example, the company has proven resources in its properties and the P/B is .75, we might, in the absence of extenuating circumstances conclude that this is a bargain and that the stock is currently undervalued.

Some Situational Metrics – Cash Flow Generating Securities

One of my personal favorites is calculating the Net Present Value/Breakeven point for a stock that pays a stable dividend stream. This metric actually has relevance because the dividend is a cash payment that comes directly to the investor as a consequence of owning the shares. In the short-term, dividends are a known quantity. Obviously the metric only applies in the case where a dividend is paid. In the case where an investor is focusing on dividend investing for income purposes or simply for generating the maximum cash from their investing capital, these are important considerations.

An example is on order. Let’s say that an investor purchases 100 shares of a stock trading at $10/share that pays a $1/share annual dividend. The dividend yield on his investment is 10%. The P/Div ratio is 10. This means that the investor paid $10 for every dollar in dividends. Now the nice thing about dividends is that they are cash streams and we can use some common time value of money calculations to make determinations as to whether or not to invest. Let’s use the 100 shares as an example and do a net present value calculation with the following assumptions:

• Our time horizon is 25 years

• Dividends over the 25 years will average the current $1/year

• The Cost of Capital (COC or inflation) will be 6%/year for the duration of the exercise

Most popular spreadsheet programs contain the NPV function where you can set your COC and the value of the individual cash flows if you desire to perform this analysis for yourself.

The Net Present Value of this situation is $262.58, giving a positive indication or a ‘buy’ signal. This alone should not be used to make a buy determination, but should be used as a tool to validate or invalidate individual investment opportunities that arose from our analyses in parts I and II.

The Time to Cover or Breakeven point of this hypothetical investment is Year 15. What this means is that after 15 years, the dividends (after accounting for the deterioration in value due to inflation) will cover the cost of the initial investment. Whatever the investment itself is worth at that time is added value. So even if our stock is still at $10/share, it is paid for, we’re in the clear, making dividends for another 10 years before we need the funds, and can sell the stock at any time thereafter for a pure profit. And since inflation has already been figured in, we’re talking about real gains. We can easily modify the analysis to accommodate hypothetical taxation circumstances as well.

Another important point may also be made from the above analysis. Considering that we’re getting $1/year in dividends, in nominal terms, the Time to Cover/Breakeven would be 10 years. Inflation at a rate of 6% per annum increased the breakeven point by 50% or 5 years. While 6% doesn’t seem like that much, this example illustrates exactly how much of a burden on wealth it represents. If anyone really wants to see why clipping bond coupons isn’t such a hot idea, run this analysis on the 30-year Treasury Bond and it will become immediately obvious.

Moving forward, when looking at dividend paying investments, we are looking for lower P/Div ratios (higher yields), and consequently lower Time to Cover/Breakeven points. While looking at the yield gives some good insight, using the NPV and breakeven analysis allows us to quantify the deleterious effects of inflation over time. The yield alone doesn’t give us that ability since it is a snapshot in time and changes as the price of the underlying security changes. It is important to note that in this study, we are NOT valuing the firm. We are valuing the cash streams that the firm pays to shareholders and discounting them to the present.

The risks to the above analysis are obviously many. 25 years is a long period of time, and things can change dramatically. Firms can go out of business or eliminate dividend payments thereby rendering the above effort worthless. Also, the major types of risk such as market, currency, political, and systemic cannot be accounted for over such a long period of time. This is one of the reasons why it is never a good idea to buy today and walk away. Successful investing is a journey, not a destination. As soon as you think you’ve got it all figured out, that is when you’ll get bitten. Vigilance is the name of the game. Another obvious takeaway here is that we’re dealing with long term investing, not trading. Such studies are a moot point for the short-term trader since their focus is on a different goal. Realize I am not trying to be impertinent towards traders, but simply pointing out the difference between their objectives and those of long-term investing.

Non Cash Flow Generating Securities

For firms that do not pay dividends, the investor is limited to just one way to make money directly (other than writing options) from owning the stock and that is appreciation. In this situation, choosing appropriate themes becomes even more important because say for example, you selected a firm that pays no dividend and is in a market niche that relies heavily on discretionary consumer spending. When the economy entered into recession in late 2007, you would have had very little in the way of flexibility since there is in effect no longer anything supporting the price of your stock. You’re not being paid dividends while you wait out the business cycle. So you can either write covered calls and ride out the storm or just pull up stakes and get out of town. Below are charts of the XLY (Consumer Discretionary Sector) and the XLP (Consumer Staples Sector).

XLY

XLP

Let’s compare these two distinctly different themes.

From peak to trough, the loss for XLY was approximately 58% while the loss for XLP was 29%. For sure, 29% is not anything to write home about, but it does serve to illustrate the importance of picking the proper themes.

Earnings Growth

However, there is one quantitative metric that is very useful in determining the success of a firm’s operations in the absence of dividends, and that is earnings growth. I prefer using earnings growth to sales growth or margin growth simply because earnings are at the bottom of the income statement and represent the impact of the entire operation including all of its cost centers on the bottom line. Companies that are able to consistently grow their earnings even during troughs in the business cycle are obvious candidates for any investor’s portfolio. While it remains true that the investor isn’t paid those earnings, companies that make money and grow their earnings are generally looked on favorably by the market, and as such are positioned to do well, all else being equal. One spinoff of this methodology is the PEG ratio or price/earnings/growth, which is stated below:

P/E Ratio

——————– = PEG Ratio

EPS Growth

The PEG ratio gives some degree of relevancy to the P/E ratio because it factors in growth. Obviously, the lower the PEG ratio, the ‘cheaper’ the stock is because in essence, you’re paying less for growth. Or, put another way, you’re paying less for the likelihood that the stock will go up in the future all other things being equal.

When valuing firms that don’t pay cash streams to the shareholder, it also becomes important to focus on intangibles because many times, they are what will drive the share price, rather than solid fundamentals such as earnings growth. There is an old market saying that goes as follows: “The market can be wrong far longer than you can remain solvent betting against it”. If you have the luxury of a long time horizon and no immediate need for your cash, you can afford to buy into the themes you feel will do well in the long term, monitor them, and wait for the market to sort it all out.

This is one of the main reasons I prefer dividend-paying investments. First of all, from an analysis standpoint, they provide something quantitative to analyze. Secondly, if you’re a long-term investor and the market hasn’t gotten on board with you yet, you are being paid (in some cases very handsomely) to wait. Thirdly, if you come to a decision where you’d like to retire and need some income, you already have it coming in. You’re not forced to sell into a potentially bad market to find income.

Next time we’ll take a look at risk, diversification, and portfolio construction now that we’ve been able to select our themes, come up with some portfolio candidates, and use various metrics to make some value judgments regarding those candidates.

For investors who are concerned about battling inflation, and operating within our new economic paradigm of spiraling debt and taxation, we are hosing a complimentary seminar on July 28th in Bethlehem, Pennsylvania. For anyone who would like more details, information, or registration instructions, please visit www.sutton-associates.net/seminar_reserve.php

Basic Financial Analysis – Part I

by TwoCentsEditor

Published on: 06/19/2009

Categories: Economics, Financial Markets, My Two Cents

Tags: bonds, business, commodities, Congress, Economics, finance, investing, markets, money, personal finance, stocks

Comments: 2 Comments

In an age of green shoots, fluff, and spin, it is probably worthwhile to put our feet on the ground every so often and take a look at some old fashioned ways that we might value a project, a firm, or capital stock. Too many times over the past 15 years in particular, investors have been lured into various valuation traps. Probably the most noteworthy was the dotcom era of the late 1990’s and the first part of the 21st century. Not a great start to a new millennium. And so the trend has been that each time the investing public deviates from the ‘old fashioned’ rules of finance and analysis, there is always a good whipping waiting just around the bend.

Unfortunately, turning on the television won’t do much in the way of helping one to find answers in this regard. Much like the medical community, the financial and investing world is littered with incomprehensible jargon, which can be downright boring at best, and impossible to follow at worst.

The Elusive Concept of ‘Value’

So how exactly does one ascertain the value of a stock? This is absolutely the wrong place to start, and this is one reason why many folks never get their investing careers off the ground. You cannot start with the capital stock and back your way into the value of the company, its product pipeline, revenue streams etc. First of all, there are many flaws with stock prices, the biggest being the fact that there are emotional and irrational human beings involved in the formation of those prices.

Just think of the dotcom blowout a few years ago. Anything with ‘E’ in front of it headed for the Moon, but ran out of rocket fuel halfway there. Those carcasses of financial recklessness are still drifting in outer space and should be a testimony to the rest of us of what can happen when we allow our emotions and irrational nature to control our investment decisions.

The second is that there is generally some level of incomplete information. The Internet has helped mitigate this to some degree, but at any given instant in time, there are some buyers who know a whole lot more about a firm than others. And to compound matters, occasionally firms will withhold negative information from the markets until a certain time such as the end of trading for the day or week. What was a ‘rational’ price at 4PM ET on Friday might suddenly become an irrational one when the market opens Monday morning as irrational people scramble to catch up with the information.

Irrational Exuberance?

In my opinion this is where the Internet has actually had a deleterious affect on accurate stock price formation. People aren’t investors anymore; they’re traders. They buy black box software that spits out red and green arrows, and then click mouse buttons based on those arrows. They know nothing about the underlying security, nor do they care to know anything. Just make me rich they say. I’d say the smart money would bet on their financial demise and be right more often than wrong. The proponents of such systems will be the first to tell you that their methodology takes the emotion out of trading. But they neglect to tell you that their system is based market data, which is the result of all the other emotional traders out there. So how devoid of emotion is it really? We could go on for pages on this topic, but I think the point is clear.

It would certainly seem that when the accurate (but by no means complete) analysis above is considered that the deck is stacked against someone who is truly inclined to be an investor. Not so at all. Navigating today’s markets is all about being a filter. Filtering noise. Filtering meaningless ‘events’ in favor of information that might change a trend or an assumption that one has made. It is about conviction. It is about being able to sit back and watch while the rest of the world goes absolutely berserk. It is also about recognizing that prices oscillate around the approximate tangible value of any financial instrument much like a sine wave. Obviously once you’ve identified your target stock, you want to buy when the price is oscillating below your measurement of its real value. In other words, you buy it on sale. Conversely then you would want to sell it when the price is peaking above the real value thereby selling it at a premium and maximizing your profit. If it were truly that simple however, I wouldn’t need to write this article at all. The market throws enough curve balls at investors as it is. If we can nail down an approximate real value of the financial instruments we are interested in purchasing, we have a fighting chance of doing well.

One important carryaway message from all this is that you must have patience. Our world has fallen prey to the doctrine of instant gratification. Everything must be instant or immediate. Processes that used to take days and weeks to initiate and complete now take minutes and hours. Two prime examples come to mind. The time it takes to purchase a home and the time it takes to invest money. It used to take weeks of shuffling papers to buy a house. Now it can be done in a few days’ time if everyone is properly motivated. The same is true for investing. People opened an account, purchased their stock and then watch the Sunday paper from week to week and charted their progress. Look at all that has happened because making large financial decisions has become too easy and the rational thought process became susceptible to impulse. The problem is that patience just isn’t cool anymore. It isn’t en vogue. After all, the rabbit always beats the turtle….right?

Foreclosures Plunge!

It is my goal over the next few weeks to give readers a window into valuing financial instruments. Once the value of an instrument is known, then it is just a matter of waiting for your price. However, it is not really appropriate to think in terms of things going on sale at your favorite electronics outlet. There are only two reasons someone buys a financial instrument. They are either purchasing a cash stream as in the case of a dividend-paying stock or they are purchasing the instrument in the firm belief that someone will come back at a time point in the future and buy it from them for a higher price than they paid. When you go to your favorite electronics outlet, you’re buying something to use and the thought process is different.

Zeroing In on Value

Probably the first mistake people make in beginning their search for suitable financial investments is they start with a preconceived notion of what is ‘hot’. They get a tip from a friend or see the name of a firm in the financial section of a magazine or newspaper and decide to begin searching. In reality, the best way to start valuing financial instruments is to first figure out which of them are actually worth valuing in the first place. This approach is often called the ‘top-down’ approach and it starts with coming to a general understanding of the economic environment under which one is operating. What is the direction of interest rates? Is the borrowing environment friendly or restrictive? Are consumers extending or retrenching? What is the condition of the labor market? Are trade conditions favorable due to currency and political factors? And what about energy costs for product transportation?

These are just a sampling of the questions that you will need to find answers for. It was by this process that it was easy for me to eliminate most things dealing with the consumer discretionary sector as the economy dove into recession in late 2007. Seeing that recession ahead of time prevented misallocations and the subsequent losses that would have occurred. There were other sectors though that had their problems. Some have already since emerged in dramatic fashion, while others have yet to.

Once you have some answers and a basic economic analysis, you can pretty much tick down through a list of industries and themes and find the ones that will be well-served by the current environment and those to stay away from. It is perhaps even more important to form something of a forecast for at least the next year to two years. Once you get past two years, it becomes exceedingly difficult for even the most gifted economist to be accurate given the complexities of a modern world and financial system.

Themes versus Forecasting

One of the biggest problems with economic forecasting is that it is both time and resource intensive and is a full-time job. That said, forecasts are easily purchased from a myriad of sources at a cost. Perhaps another way of looking at things and deciding on which areas are worth further scrutiny is by using themes. It is pretty simple. Take the debt situation that exists in the United States today at a government, state, local, and personal level. It would seem to be a pretty good bet that this will impede economic growth well into the future, and thus absent a lot of monetary creation and stimulus, it is unlikely to see consumer discretionary spending accelerate all that much. That is a theme. Realize we aren’t dealing with percentages, statistical analysis, or anything more fancy than sitting down and applying some common sense to our current realities and coming up with some likely outcomes. We can easily use such themes as a basis for either including or excluding certain sectors for further investigation and analysis.

Notice we haven’t even used one math formula, a calculator or pulled a single stock quote and I’ll bet you’re already thinking of a number of potential themes and comparing them to what is in your current portfolio. If so, congratulations! You’ve taken the first step in performing basic financial analysis. Next time we’ll take a look at identifying the players both large and small in a given sector and looking at the potential benefits and detriments of each. This will assist us in forming an appropriate mix given our risk tolerance and other objectives.

"Spin Cycle" Welcomes Laurence Kotlikoff

by TwoCentsEditor

Published on: 06/03/2009

Categories: Appearances, Current Events, Economics

Tags: bonds, budget deficits, energy, Fed, finance, fiscal gap, generational accounting, gold, hyperinflation, inflation, investing, money, personal finance, silver, stocks, unfunded liabilities

Comments: No Comments

Today’s special guest on ‘Spin Cycle’ is Laurence Kotlikoff, Professor of Economics and Research Associate for the National Bureau of Economic Research. In today’s show, we discuss the fiscal gap that exists in the United States from both a government and consumption perspective.

Professor Kotlikoff will be speaking at the Cato Institute on 6/8/2009 at 4PM and will address these issues as well as some common-sense solutions. Please contact your Senators and Representatives and urge them to attend.

The interview may be heard by clicking here

Professor Kotlikoff’s site may be visited here

Confirmations and Conclusions

by TwoCentsEditor

Published on: 05/29/2009

Categories: Current Events, Economics, Financial Markets, My Two Cents

Tags: bonds, business, credit, dollar, energy, finance, inflation, interest rates, investing, investments, oil, personal finance, precious metals, stocks

Comments: 5 Comments

In a mid-February editorial we took a look at some factors that were beginning to confirm one of our proprietary indicators that pointed to a bottoming in consumer prices in December 2008. Writing such an article at the time was a big risk since it flew in the face of a trend that had been firmly in place for the past half-year. The price of nearly everything was falling – or so it seemed. For those who understand and appreciate the function of money supply in the determination of prices, the article made perfect sense. However, for those who believe that economic growth or the absence thereof determines prices, there was a great deal of consternation regarding our assertions.

Nearly three months have passed since then and almost every piece of data that has come across this desk has validated the claims made back in February.

Just aside of the factors we mentioned in the February article, which were the CRB Index, Gold, and West Texas Intermediate Crude, there is another major indicator of this phenomenon and that is the stock market. From the 3/6/2009 bottom through today, the Dow Jones Wilshire 5000 Index raced from 6935 to 9342; an increase of 34.71%. More importantly though, lets look at it in terms of dollars. The value of the Wilshire 5000, which is one of the broadest measures of US market capitalization increased by $2.407 Trillion during that relatively short period of time.

It is utterly preposterous to assume that Mr. and Mrs. America dug in the couch and found that kind of money and decided to invest it. It is even more preposterous considering the environment that the real economy is dealing with at this time. Job losses have been staggering and persistent, it is demonstrably difficult for the unemployed to find work, and house prices are still falling like an elephant dropped from the Empire State Building. How else do we know this increase didn’t come from the real economy? Let’s look at past behavior. When the government handed out $168 billion in stimulus checks – essentially ‘free money’ – did the public invest it in the stock market? No. The public paid bills, or saved it – much to the consternation of the government.

So where did this dramatic bear market rally come from? In my opinion, it came from large institutional investors – many of the same people who had their coffers stuffed with TARP money over the past 6 months and the same folks who were essentially given a free pass a while back when the rules for mark to market accounting were relaxed. So what we have here is largely an inflationary rally. Certainly, this is not the first such rally, and it will most assuredly not be the last.

But it isn’t just the stock market. It is the commodities markets as well, and this is where it gets bad for consumers. We are about to witness a wave of inflation, a magnitude of which has never before been seen in America. Dr. Marc Faber had this to say about the subject:

“I am 100 percent sure that the U.S. will go into hyperinflation,” Faber said. “The problem with government debt growing so much is that when the time will come and the Fed should increase interest rates, they will be very reluctant to do so and so inflation will start to accelerate. He also added, “The global economy won’t return to the “prosperity” of 2006 and 2007 even as it rebounds from a recession”.

Let’s revisit our charts and positions from February and see how much things have changed in just three months:

Reuters/Jefferies CRB Index

CRB Index

The 15% increase in just the past 3 months will not immediately be seen on store shelves, but it is already being seen at the gas pump and in the prices of many consumer items. It must be noted that the US economy contracted at a rate of 5.7% (annualized) in the first quarter of 2009, which is on the heels of a 6.1% decrease in the fourth quarter of 2008, yet consumer prices, commodities, and other inflation assets are rising. If this doesn’t strike down the notion that demand (economic growth) alone determines prices, then nothing will.

West Texas Intermediate Crude Oil (WTIC)

WTIC

This one says it all – a 45% increase in the price of oil just since the middle of February. Keep in mind this increase in price has occurred during a period of a contracting US economy. It is high time that the mainstream press and every one of us stop being US centric when it comes to oil – and everything else for that matter. World demand has remained robust, but at the same time has not exploded over the past six months for sure. The problem is there are untold trillions of dollars parked around the globe. Remember last fall that it wasn’t just the US Fed who was printing like crazy. The Europeans were following suit, much to the dismay of any country that possesses a scarce resource.

Gold – Contract Price

Gold - Contract Price

Despite a major rally in equities and assertions from media and government alike that the economy has bottomed and will begin to heal soon, Gold has not taken the bait. After once again breaking through the $1000/oz level for a brief period in late February, Gold was pushed down to the $860 area, but has rallied nearly $100/oz in relentless fashion and is looking for its fourth straight week of gains. It is very obvious that the powers that be would prefer if Gold remained below the psychologically critical $1000/oz mark. A serious breakout to the upside would once again light the 1970’s-esque fire of inflationary expectations.

The US Dollar – Heads they win, tails we lose

US Dollar Index

The story for the US Dollar over the past year has been a fairly simple one: if there is a major crisis and stock markets are falling 700 points in a day, then people want dollars. Otherwise, forget it. So the only way holders of dollars get a break is if the wheels are falling off everything else. During periods of relative calm, such as what we are seeing now, the Dollar has retaken its outcast position as the whipping boy among currencies. The damage done by numerous bailouts and stimulus packages is common sense. The future damage of persistent trillion dollar annual deficits and tens of trillions in unfunded liabilities from Social Security and Medicare still remains.

The 11% move in the Dollar from 2/20/09 to the present will result in higher prices paid for imports, and in part has been one of the reasons for oil’s recent surge. However, oil’s move has been far in excess of what would have been necessary to merely keep pace with the dollar’s decay. Look for a return to higher trade deficits unless demand drops concomitantly, which is entirely possible.

The return of the Bond Vigilantes

Perhaps worst of all has been the Fed’s inability to keep bond yields under control. Despite open monetization to the tune of $300 Billion, and the 2009 purchases of upwards of $1.25 Trillion in mortgage bonds in an effort to keep rates low, bond rates have shot up dramatically. Perhaps even worse, mortgage bond yields are now starting to move up as well. The most alarming trend is the 10-2 spread for 10-year and 2-year Treasury notes. It cannot be ignored that with each recession, the spread grows. That is because each time the fears of inflation as well as actual inflation itself increase dramatically. It cannot be ignored that with each spike we have seen a large bolus of inflation enter the system resulting in a period of ‘prosperity’.

2-10 Spread

Anyone care to stretch their thinking a bit and notice how those periods of ‘prosperity’ are getting shorter and shorter despite greater infusions of fiat cash?

It should now be apparent to all that a massive inflationary wave has been unleashed. Policymakers are aware of this and are already preparing the public by discussing deficits in the trillions rather than billions as the government will make a futile attempt to keep pace. What is most alarming in all of this is the precarious position of the consumer. Nearly wiped out in 2008 by job losses, falling home prices (which had previously been regarded as income), stagnant wages, and dramatic losses in retirement and other investments, the consumer is not in the position to deal with the inflationary blow that is now in progress.

The green shoots theory was a nice try, but those shoots are about to be buried under an avalanche of another type of green – the green of increasingly worthless fiat paper money.

In our ‘Spin Cycle’ podcast, we are currently doing a 7-part series in which we depict the factors affecting the US economy as sides of a Rubik’s Cube – independent, yet interrelated. On June 3rd, we welcome Professor Laurence Kotlikoff to discuss generational accounting and our mounting unfunded liabilities. To listen to this or other shows, visit www.my2centsonline.com/radioshow.php

page 1 of 4 »

February 2012
S	M	T	W	T	F	S
« Jan
			1	2	3	4
5	6	7	8	9	10	11
12	13	14	15	16	17	18
19	20	21	22	23	24	25
26	27	28	29