One important thing to note is that one of the Canadian Trusts (Harvest Energy) no longer does business by that name. It was purchased by Korean National Oil Corporation (KNOC) at the end of last year. It was perhaps the first casualty of Canada’s ill-fated decision to change the taxing structure for Trusts and it was a big one. Harvest was one of very few vertically integrated Oil & Gas operations, meaning that it owned refinery operations in addition to its exploration and production program. It was viciously attacked by short-sellers during the months leading up to the acquisition and when shareholders were offered a roughly 40% premium over the then $6 and change trading price, they jumped and Harvest was lost.

Trimming your Hedges

The hedging tool used in this particular Portfolio Model was the UltraShort Oil & Gas ETF since it correlated fairly well with the mix of assets represented. However, one of the drawbacks of these ETFs is their propensity to leave gains on the table based on the objectives they pursue. This reality has become somewhat better understood by investors, but let’s go over it again if for no other purpose than to reinforce the point.

From the ProShares website:

“This ETF seeks a return of -200% of the return of an index (target) for a single day. (Emphasis theirs) Due to the compounding of daily returns, ProShares’ returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period. Investors should monitor their ProShares holdings consistent with their strategies, as frequently as daily. For more on correlation, leverage and other risks, please read the prospectus.“

What they’re saying is if you purchase this type of fund and it moves 2X the inverse of the correlated index or security, that if the underlying issue moves down 20%, you would expect the price of the 2X inverse fund to go up 40%. It doesn’t always work that way. Depending on the price action, you could actually end up with a much lower gain, especially if the price action is volatile and choppy.

Again, this is not meant to be an indictment of these types of funds, but rather to point out that no hedge is going to be perfect and you’d better keep your eye on the ball if you want to be successful.

The Sample Portfolio Model

Let’s see how our components have faired over the past 18 months:

For the 18 months ended June 2010, the portfolio model is up substantially not counting dividends. Assuming the purchase of the same 100 shares each and 250 shares of DUG as in the original article, our portfolio on 11/20/2008 would have cost us $31,969. As of 7/8/2010, it would be worth $47,964 for an increase of 50%. During the same time, the portfolio threw off $2,634 in dividends making the effective yield of the portfolio 8.24% and bringing in $146.33/month in dividend/distribution income. $146 doesn’t sound like a lot of money, but when you consider deploying a $100,000 or $200,000 portfolio in this fashion, suddenly you’re talking about some very nice cash flow – certainly in excess of what can be found at the local bank. The performance metrics stated above assumed that the positions were all started on 11/20/2008; a significant market bottom. Waiting until 3/6/2009 to begin them would have resulted in slightly higher gains. We put a few of these positions to work in our newsletter portfolio on 3/13/09 and they have performed in spectacular fashion.

During the same period of time, the Dow Jones Industrials are up just 34%, with well under one-half the yield of this model. The S&P500 is up only 33% with just over one quarter the yield of the model.

Conclusions

One thing that has worked extremely well for me in practice is the strategic placement and removal of hedging devices. I am not talking about trading hedges; that is a completely different animal. What I am talking about is searching for multi-month trends and then placing or removing hedges based on the results of that research. For the average investor who has neither the time nor the inclination to get involved at this level, selecting a solid hedge, putting it in place, and monitoring once a week should suffice.

Still other investors who don’t mind potential wild fluctuations in their core holdings, but are interested merely in yield, will construct a similar portfolio and put 100% of their capital to work earning dividends. We could have pumped the yield of our sample model up considerably by doing that, but decided on a more conservative approach and were willing to leave a point or two of yield on the table in favor of more stable performance.

One thing to note is that many of these components have had their dividends cut since 11/20/2008. Several have been cut significantly. A few were cut, and are now beginning to increase again. One of the lesser-known ramifications of the ongoing credit crisis is that many small and midsize companies have had a difficult time raising capital at reasonable rates. This resulted in a more protective position taken on by management as they’ve sought to preserve cash for operations. This has led to dividend cuts in many cases. Falling share prices in 2008 and 2009 made it easy to do so since they could cut the dividend and still maintain a similar yield for new investors. The argument could certainly made that this is irrelevant since 8% is 8% no matter what the price/distribution levels, but I think it needs to be mentioned to maintain a spirit of objectivity.

Disclosures: Long PWE, PGH, KMP

Inflation

There are two camps and they argue bitterly. One claims that prices rise because of supply and demand factors (which is partially true) and as a function of a healthy economy, which is patently false. The other side argues correctly that prices rise because the supply of money and/or credit has increased – effectively monetizing demand, which pushes up price levels. Some analysts have argued that there is no inflation because the price of electronics always seems to drop. In the second half of 2008 they argued that there was no inflation because petroleum prices were falling. They made the tragic mistake of substituting a single good for the concept of ‘general price level’.

It is categorically impossible for general price levels to increase in the long run without a commensurate increase in the supply of money and credit. It is important here to make the distinction between short and long run. In the short run, an increase in general prices can be absorbed without a growth in the money supply because it could, in theory, be sustained by devouring savings. But in practice, generally speaking, that isn’t how things work. People tend not to expand spending unless they feel comfortable that money and (particularly) credit are readily available. The housing bubble of the early 21st century is a prime example.

Bubbles

Out of fear of destroying a very easy point, I am going to let the three charts shown below along with a very brief narrative speak for themselves. Then you decide what fueled the housing bubble, and drove up house prices along with general price levels.

As can easily be seen in the above chart, 30-year mortgage rates dropped steadily from 1981 through the present. Not surprisingly, low rates and readily available credit led to a massive price expansion by monetizing demand.

Clearly the expansion in money had to come from somewhere to fuel lower mortgage rates and the expansion in home prices. The chart below, with brackets for the 1990-2007 period shows exactly where it came from. M3 in the US nearly tripled during that 17-year period.

Deflation??

One thing that should be utterly frightening is the recent freefall of M3 growth. Most folks understand that inflation has been responsible for the vast majority of our economic ‘growth’ over the past century. Inflation fueled the dotcom and real estate bubbles. In short, our economy is set up to run in an inflationary environment. Unfortunately, there is a predictable end to this scheme. At some point, the monetary environment devolves into hyperinflation, then a deflationary collapse. We certainly haven’t experienced hyperinflation yet in the US, and we know the Fed can win a battle with deflation because it can create as much money as is necessary to overwhelm deflationary forces. The current Chairman didn’t get his nickname because he used to fly puddle jumpers. So we’re left to ask: what exactly is going on here?

I think the answer lies in the fact that there are roughly 20 countries right now that are on the verge of bankruptcy and an outright default – the US and UK among them. The US clearly isn’t the only nation in hot water with debt. Greece is a pitifully minute example of what is really a systemic problem for much of the West. In my opinion, we are likely moving towards a coordinated outright default, which will involve the devaluation of currencies followed by central banks capping money growth, which in turn will trigger a second deflationary depression. Most people realize that we now have a fiscal gap of around $100 Trillion just in the US alone. It cannot be filled via conventional means consisting of tax increases and program cuts. I and many others wrote years ago that we needed to address those issues right then or lose our chance. We didn’t do it. There are two choices now: hyperinflation or default. While the collapse in M3 growth does not yet constitute de facto proof that we’re headed for the default scenario, it is certainly something that has to be considered. The good news in that scenario is that cash money would be worth more because it would be in short supply. The bad news is that there won’t be enough of it to maintain our current standard of living – especially in a situation where there is a concurrent devaluation.

Gold

Many will be wondering how I can be an advocate of Gold and Silver in such an environment? The benefits of precious metals are well documented in the case of hyperinflation, but not so much so in the case of deflation. It is a pretty simple and logical conclusion that if there is a shortage of cash, then the presence of cash ‘substitutes’ will be very beneficial. This is especially true in local commerce as in the 1930’s when many areas saw the widespread use of ‘co-ops’ or local trading blocs. The rationale for holding precious metals will be different than if we experience hyperinflation, and their use would be different as well, but I think it is foolish to assume that they’d be a detriment in either case.

Hopefully everyone reading this understands the importance of watching the monetary aggregates for clues as to what is coming down the road. Thanks to nowandfutures.com for providing the continuation of the M3 series depicted in the chart above. Ultimately, our monetary destiny now lies in the hands of global banking interests. We will proceed down the path that best serves them, not our national interest. Congress abdicated its responsibility for our money, as outlined in Article 1, Section 8 of the US Constitution, when it passed the Federal Reserve Act back in 1913. The best thing this Congress could do with the rest of its time is craft and pass legislation to repeal that Act in its entirety.

This tax day, April 15th, we’ll be releasing the next issue of The Centsible Investor. Our focus this month will be on the President’s Working Group on Financial Markets, aka the Plunge Team. We’ll also examine the prospects for $100 oil and analyze a company that makes its money selling electrical generation, process automation, and a vast array of other products to industries ranging from petroleum exploration and pharmaceuticals to automobile manufacturers. Don’t miss it! Click Here for more information.

Venezuela’s $16 Billion Oil Deal

On 9/17/09, Venezuela President Hugo Chavez announced in a brief statement that his country had entered into a $16 billion oil deal with the Chinese to further develop the Orinoco project and ramp up Venezuelan production by 900,000 barrels per day. This agreement is separate from a similar deal inked in October of last year that promised an unspecified amount of Venezuelan production to the Chinese. The important thing to note is that Venezuelan state-owned PDVSA not only committed to ship oil East, but will essentially operate a joint venture with Beijing for the purposes of developing further reserves. At the time, Chavez was optimistic that his country would become China’s top oil supplier.

Of important note in the oil space is the fact that the #3 supplier of oil to the US is Mexico and its production has experienced a steady decline since 2004 and is now in a full state of export destruction. While much ado has been made of the Bakken formation in the western US, some reality must be brought to bear on all the misinformation being disbursed. The US Geological Survey has stated that the formation could contain 4 billion barrels of oil. While getting every drop is impossible, let’s assume for a moment that we can. Even in the throes of the worst economic contraction since the 1930’s the US still burns up about 19 million barrels of oil each day. Using that as a basis, the Bakken contains a whopping 210.53 days of US supply – about 7 months worth. Not really a big deal is it? For comparison, the USGS estimates Alaskan oil reserves including the North Slope to contain 90 billion barrels. Again, let’s assume we can recover every drop of it. The situation here is a bit better and we’ll get about 13 years of supply at current burn rates. Note that doesn’t account for any economic growth, which carries a proportional increase in petroleum consumption under our current transportation, power, and living systems.

Keep in mind I am being purposely US centric here to frame the issue in simple terms. The recent strategic agreements the Chinese have entered into should take on a whole new significance when looking at the information through the lens of what is actually available to us domestically. Sure, they might have a large find in Brazil. Is it really safe to assume that we’ll command it? The Dollar is already looked upon with contempt thanks to decades of abuse and there is no indication that is about to change any time soon. Unfortunately, the strategic accumulations don’t stop at oil.

China’s Rare Earth Metal Monopoly

While much of the talk in the US recently has shifted to green technology, there is a glaring oversight being made. These new technologies, while solving one complex problem, create another. Much of today’s array of battery technology, fuel cells, wind turbines and solar panels requires an available supply of rare earth metals (REMs) for production. For the past decade and a half, the Chinese have been quietly accumulating large, unrivaled stockpiles as well as a near monopoly in the production of these critical metals. So successful were they that 95% of the lanthanide (periodic table) series metals are produced in China. These metals are used in everything from iPods to hybrid cars. China’s 1987 pledge to become the Saudi Arabia of REMs has come true says Jack Lifton, a REM specialist. The Japanese government sees REMs being the turf for future trade wars, especially since the island country imports almost 100% of its supply from China.

As the above chart illustrates, China has a near complete stranglehold on the supply of REMs as a group and a healthy stockpile to boot. Even more importantly, mainland demand is now eating away at exports. And unfortunately, unlike oil, large deposits of REMs are not scattered all over the globe. The only real bit of good news that can be attained from the chart is that supply is still growing. Unfortunately there are no meaningful stockpiles to speak of outside mainland China.

We used to have some domestic sources of these critical metals, but unfortunately, many of those mining operations were scuttled during the price wars of the early 1990s and expensive overhauls would be necessary to get them back in production. Many industry analysts fear that Beijing will be able to affect a serious supply crunch before any meaningful competitive supply can be brought to market. Another shining example of how supply doesn’t automatically appear to quench demand even though the textbooks suggest otherwise. This has resulted in a frantic scramble throughout Southeast Asia as Japanese car and electronic manufacturers try to lock down alternative sources.

Meanwhile the Chinese have sought to solidify their position as the REM capitol of the world. A state-owned investment company recently purchased a 25% stake in Arafura the Australian REM miner. In August, China Minmetals Rare Earth Company made an investment of $310 Million to lock in its dominant position in an already tight industry.

The REM situation has massive implications for the United States and our desire to go green. Without these metals, many green alternatives are not possible given current technology constraints. It also has implications for our consumption of electronic consumer goods, many of which end up in landfills when they no longer work.

Some possible conclusions that can be drawn from these activities don’t paint a good picture for the continuation of activities here in the US as we’re used to. If the countries that supply us with many of our products are locking in stockpiles, it would be rather foolish for us to assume that they’ve done so in order to continue exchanging these dwindling resources for green paper tickets as they have been doing. This becomes even more evident when one considers that much of this stockpiling didn’t exist just a few years ago.

Certainly another contributing factor is that the perceptions of the dollar have grown so pessimistic that many countries are diversifying into hard assets. However, rather than creating a speculative bubble, the strategy being invoked is a longer-term accumulation strategy. They buy the dips and take delivery. This is a testament of the growing disdain of paper assets, particularly currencies. The paradigm shift, which happened not too long in the recent past, is now moving into a higher gear.

Even if this activity ends up being nothing more than a global diversification strategy, which isn’t likely, then the law of unintended consequences kicks in and America will likely face nasty resource shortages as a result sooner than most are willing to admit.

If you go to the NYSE website, you will be able to find what is called an Industry Classification Breakdown or ICB. There are ten major industries with varying numbers of supersectors, sectors, and subsectors under each major heading. Now let’s say for example, in your reflections on what the major economic and investing themes happened to be that you zeroed in on consumer staples as an area that is positioned for success. At this point we are assuming that you’re not interested in just finding an ETF or Closed-End Fund that gives exposure to firms that produce consumer staples, but are interested in becoming more acquainted with some of the individual firms themselves. Once you have performed your basic analysis, you’ll know which firms you’d want an ETF or other Fund to include or can purchase them outright and will be an informed shopper so to speak.

That said, when you go to the ICB listing for Consumer Goods, you will find the following:

Clearly you are not interested in examining all of these areas. Your focus as decided above is on staple goods. Immediately, the broad category of Leisure Goods can be eliminated. Automobiles can probably be eliminated as well if we’re focusing totally on staples or necessities. This leaves a wide sampling of categories. For the purposes of this discussion and in the interests of brevity, we’ll limit our analysis to a single sub sector – Food Products.

Before we continue, some limitations of this search methodology must be identified as well. The NYSE search is only going to show the firms that are listed on NYSE. It will not show international firms that are listed on other major exchanges, but not on the NYSE. The good news is that many of the larger firms are dual-listed. The bad news is that by limiting your search to only NYSE-listed issues, you will likely miss some good possibilities. Many of the other major exchanges such as the TSX also have similar search capabilities and by spending a little time, you can quickly assemble a rather comprehensive list of investment possibilities within any given sub-sector.

A look into the Food Products sub-sector reveals no less than 46 US-listed companies and their related securities. The information provided is limited to the name of the firm, the ticker symbol, last trade / trade date, volume, change($), and change(%). At this point, the biggest tendency for individual investors is to scan the list, find the name of a firm they know and start their search there. This is not the way to go; emotion has already entered the equation and in your mind you’re already playing favorites and biases have taken control of the process. At this point, you must consider your own objectives:

• When will you need this money?

• What do you anticipate eventually using the money for?

• How much money do you have to work with?

• What is your risk tolerance?

The answers to these questions will help you decide on what types of firms you’re looking for. Do you want large companies with low volatility that pay high dividends? If you’re approaching retirement, this might be the way to go. If you’re younger and are looking for capital appreciation, you might consider looking at some of the smaller companies that are more volatile, but have more room to grow. Are you risk averse? The fact that you’re looking at consumer staples to begin with might say something about your willingness to accept risk (wait, I picked that category!).

This is an important part of the process. We are now connecting the economic themes that we decided will be important with our own personal situation. The worst thing anyone can do is take his or her own themes, then just grab someone else’s prepackaged strategy without considering if it actually fits. It is the financial equivalent of buying a pair of trousers without bothering to look at the size, choosing rather to buy them because you thought they looked good on somebody else.

So in our hypothetical analysis, we decided that the economy is in recession and is likely to be there for some time, and have come to the conclusion that people will cut back on discretionary spending (which they have). We realize that inflation is a problem, and so leaving our capital in a bank account is not the greatest idea if we expect to maintain our purchasing power. Food products will certainly not be the only theme we invest in, but it is a good starting point.

Large or Small?

The next issue becomes the determination of what constitutes a large company and what constitutes a small one. Obviously, there are a number of characteristics that may be used to determine this, but one of the most generally accepted definitions is the firm’s market capitalization. Market capitalization is the share price multiplied by the number of outstanding shares. Another way of expressing market cap is that it represents the public opinion of the value of the company. The sizing of companies can generally be lumped into the following brackets:

• Large-Cap Companies $10 Billion – $200 Billion (or more)

• Mid-Cap Companies – $2 Billion – $10 Billion

• Small-Cap Companies – $200 Million – $2 Billion

• Micro-Cap Companies – Less than $200 Million

Using the Food Products sub-sector as our continuing example, of the 46 issues in that category, the breakdown is as follows:

As is evidenced by the chart above, there is a solid distribution of firms in this sector according to size as measured by market capitalization with most of the companies (33) falling in the small or mid cap range. This distribution is good news as it means that no matter what your investment goals and risk profile, you should be able to find a reasonable number of firms that are desirable for addition into a portfolio, or are firms that should be looked for when looking at ETFs and open/closed end funds.

Using this methodology it is fairly easy to drill down to potential specific investment possibilities from a variety of economic themes. What we need to accomplish next is creating a definition of value and the parameters by which we will measure it. Next time we’ll take a look at some of the popular valuation metrics and develop a few of our own as well, which we can add to our toolbox as we continue to chase the oftentimes elusive concept of value.

Individuals interested in learning more about the major macroeconomic themes should take a moment to listen to some of our informative podcasts. We’ve recently had guest experts like Laurence Kotlikoff; John Williams of shadowstats.com, and Bill Murphy of GATA appear to discuss their areas of expertise. For more information or to listen, please take a moment to visit www.my2centsonline.com/radioshow.php

Adrian Salbuchi tells “Spin Cycle” the story of the assault by private banks on the economy of Argentina. Are we seeing the same thing again here in the US? Tune in to find out! Listen Here

On “Spin Cycle” Professor Laurence Kotlikoff discusses the fiscal gap of the United States and some possible solutions to the
mounting stack of unfunded liabilities that endangers the financial stability of our country. Listen Here

On “Spin Cycle” we discuss the energy side of the cube this week with Zapata George including a timely discussion of the ‘revelation’ that proven oil reserves have fallen. Stay ahead of the curve on Spin Cycle! Listen Here

Our special guest on “Spin Cycle” is John Williams of shadowstats.com. We break down inflation, money supply, GDP, and unemployment in an eye-opening discussion. Listen Here

Our special guest on “Beat the Street” is Fred Carach, author of “Forty Years a Speculator”. We discuss commodities and how our financial markets have become dysfunctional over the decades. Listen Here

Our guest on “Beat the Street” is Joe Cristiano of Liberty Talk Radio for a discussion on the impact of nationalization. We also tackle the long bond problem as yields head higher. Listen Here

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

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)

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

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

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’.

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

]]> http://www.sutton-associates.net/blog/2009/05/29/confirmations-and-conclusions/feed/ 5 http://www.sutton-associates.net/blog/2009/05/22/triple-a-or-bust/ http://www.sutton-associates.net/blog/2009/05/22/triple-a-or-bust/#comments Fri, 22 May 2009 18:02:12 +0000 TwoCentsEditor http://www.my2centsonline.com/blog/?p=225 If you take a short walk down memory lane, it will not take you very long to find the carcass of New Century Financial along the side of the road back in March 2007. It would be a full 12 months before the word recession would be mentioned in the US mainstream media and stock markets would roar into their all-time highs six months after the disintegration of New Century. Much of the early portion of the credit crisis as it was called focused on mortgages and after that, mortgage-backed securities. Wow, haven’t heard that term in a while, have we?

Much of the scuttlebutt at the time centered around the ratings which were assigned to these mortgage bonds and people started asking questions about how all of these Triple-A rated bonds could suddenly be worthless and why bonds with this high of a rating were paying historic spreads above and beyond US government debt of the same maturities (which are also rated Triple-A).

An Example of the spread between Triple-A rated securities

Of course the foundations for this comparison in the first place are the quality and status of US government debt, which, until recently, was sacrosanct in borrowing circles. In the past week there have been headlines galore (again) that the US is in jeopardy of losing its Triple-A credit rating. Given what we already know about the government’s finances, how can a pristine credit rating and Uncle Sam be mentioned in the same sentence? And perhaps more importantly, can ratings issued by the major agencies be worth more than a defaulted mortgage tranche after the ratings fiasco of the past few years? Consider the following:

“According to the Financial Times report, “Internal Moody’s documents seen by the FT show that some senior staff within the credit agency knew early in 2007 that products rated the previous year had received top-notch Triple-A ratings and that, after a computer coding error was corrected, their ratings should have been up to four notches lower.” Yet the ratings were maintained at Triple-A.”

So why the big todo about the US Government and its Triple-A rating? The point is it shouldn’t have one to begin with. While I am sure this statement doesn’t constitute a revelation to anyone, it is a point that most in the main stream media are once again missing. Some big names have lost Triple-A credit ratings over the past few months. General Electric and the venerable Berkshire Hathaway are two notable examples. AIG lost its Triple-A rating in 2005, and bond insurer Ambac lost its Triple-A rating in 2008.

In the case of normal businesses, the credit rating is a reflection of the firm’s financial position and the market forces that are likely to impact the firm over various periods of time. The firm’s balance sheet is examined. Its revenues and obligations are dissected. The credit rating is then assigned based on the preponderance of these factors and indicates to investors the likelihood of default on the firm’s debt. Investors are then able to make informed decisions. At least this is how it is supposed to work.

Moody’s / S&P Default Probability Models

However, there is one major difference between a normal business and the US Government. Unlike a normal business enterprise, the US Government has a bank on retainer that can create money from nothing and is willing to lend at ridiculously low rates. It can accomplish this task in many ways, but the most direct is called monetization, which consists of the Fed buying bond issues directly from the government. Ostensibly, this is done to prevent the government from having to fund its massive appetite for funds externally. As if there is something honorable about owing your future to a private bank as opposed to another sovereign nation. Further evidence of the Fed’s willingness to monetize additional debt emerged this week:

“Some members noted that a further increase in the total amount of purchases might well be warranted at some point to spur a more rapid pace of recovery.”

Is an entity that requires this type of arrangement for its financial survival deserving of the highest credit rating? How about an entity that is going to have to borrow 46 cents for every dollar it spends during FY 2009? How about an entity that is institutionalizing trillion dollar deficits for the next decade? How about an entity that has a bare minimum of $53 Trillion in contingent unfunded liabilities (nearly four times GDP)?

After this most recent bevy of news headlines regarding the rating situation, Treasury Secy. Tim Geithner promptly got on TV to talk about cutting the budget deficits.

“It’s very important that this Congress and this president put in place policies that will bring those deficits down to a sustainable level over the medium term,” He added that the target is reducing the gap to about 3 percent of gross domestic product, from a projected 12.9 percent this year.

Putting this in the context of our current situation, this would require the deficit to be cut from a projected $1.8 Trillion to just $418 Billion – which is where it was before the current blowout. This is an important distinction as promises by government officials to actually balance the budget are fading quickly into the ether. Now we’re only worried about carrying ‘sustainable’ debt. The problem is that none of these debts are ever paid back and as such, they accumulate all the while piling on interest.

In order to pay off our debt, not only would we have to stop running deficits, we’d actually have to run surpluses. If we ran could manage a surplus that was 3% of GDP each year, it would take us over 30 years to pay off what we already owe on the national debt. That is three decades of smaller government, bare essential expenditures, and the complete dissolution of the ‘cradle to grave’ mentality our government has espoused for the last half century.

Geithner, 47, also said that the rise in yields on Treasury securities this year “is a sign that things are improving” and that “there is a little less acute concern about the depth of the recession.”

This is nothing more than just economic pumping. What the rise in yields is really saying is that when the Fed doesn’t step in and buy US Government bonds that nobody else wants them either. Why would any sane individual lend to somebody that is up to their eyeballs in debt and isn’t even the least bit interested in changing their behavior? To make matters worse, why would any sane individual lend to an entity that proposes to repay the loan in currency that is losing its value?

30-Year Bond Yields

In the above chart, we can see the yield for the 30-year bond. The Fed began indirectly monetizing in the fall of 2008 as the proceeds of TAF, TSLF, etc. went directly to the Treasury window driving yields to nothing. Another spurt of direct Fed monetization in March led to a quick drop in yields, but since then they have been moving relentlessly higher. Foreigners have not stopped buying US Treasuries by any means, but they have certainly slowed their purchases. This leaves the Fed as the buyer of last resort. Certainly Secy. Geithner understands all this, especially considering he used to be the President of the NY Federal Reserve Bank.

Does any of the above sound financially virtuous and deserving of a pristine credit rating? In the end it matters not what Moody’s or S&P have to say about the creditworthiness of the US Government. Our creditors are already speaking. And they aren’t singing our praises.

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 debt. To listen, visit www.my2centsonline.com/radioshow.php

]]> http://www.sutton-associates.net/blog/2009/05/22/triple-a-or-bust/feed/ 7 http://www.sutton-associates.net/blog/2009/05/15/hedging-your-bets/ http://www.sutton-associates.net/blog/2009/05/15/hedging-your-bets/#comments Fri, 15 May 2009 19:44:52 +0000 TwoCentsEditor http://www.my2centsonline.com/blog/?p=221 05/15/2009

While it may seem rather inappropriate to talk about hedging strategies while the markets are retracing at least a portion of 2008’s devastating plunge, common sense continues to support the position that the worst is yet to come. Granted, focus has shifted to ‘less bad’ economic data and the anointing of government spending as the elixir that will return the American economy to prosperity. Yes, that whole “We’re going to spend our way to prosperity” mantra is once again in play. Make no mistake about it; what we are witnessing right now will be viewed years from now as the biggest suckers rally in history – so far.

That said, now is the time to start talking about protecting portfolios from the next move down. The techniques below were used either singly or in tandem to drastically limit losses in our client portfolios during the 2008 liquidation. Some of these strategies have been sold to the investing public as ten feet tall and bulletproof, but don’t work out too well unless the intricacies are understood. And still others are exceedingly complicated to execute and rely on a preponderance of difficult predictive successes to be beneficial.

Flight to Cash and Equivalents

This move is an obvious one and constitutes either a partial or total exit from the market in question and the capitalization of whatever gains/losses existed to that point. Depending on the type of account you’re dealing with you will have a taxable event. Under many circumstances, it may be detrimental to sell out of the market. This can especially be the case if you are one of those folks who have invested in a dividend-producing portfolio and need the income from those investments for living expenses. Obviously, people in this position don’t want to see their portfolio go down in value, but can’t necessarily afford to sell those assets either.

In terms of the average investor, this is undoubtedly the easiest hedge to execute with the opportunity costs being commissions, possible tax consequences, and the forfeited gains if you’re wrong.

Going Short the Market

Shorting shares and/or indexes is one way investors will choose to hedge portfolios during times when they believe markets will head lower. Let’s use the DJIA as an example.
Let’s say that an extremely prescient (and lucky) trader identified the last major top in the Dow Jones on 5/19/2008 at 13,028.16. That day he shorted 100 shares of DIA at a price of $130.23 for a total of $13,023 with a $10 commission. So our trader has $13,013 in his pocket, knowing he’ll have to cover those shares at some point. Let’s assume once again that our trader gets lucky and picks the precise bottom on 3/6/2009 with the DIA at $66.23 and decides to cover. He buys 100 shares for $6,633 ($10 commission) and has $6,380 as his gain.

Obviously, this is a best-case scenario, and ironically enough, this is often how many investment ‘get-rich-quick’ schemes are presented.

The following is the flip side of shorting the market.

In this scenario, our trader, having seen his brokerage account drop by 25% since the beginning of 2008 decides to short DIA on 10/22/08. He is scared to death of a further decline. He shorts 100 shares at a price of $84.59 on the DIA, pays the same $10 commission and has $8,449.00 in his pocket. Unfortunately, he has picked a short-term bottom and the market rallies substantially immediately after he takes his position and our trader is scared into covering on 11/4/08 at $95.19. Including commissions, his short position just cost him a quick $1,080 – in just 9 trading days.

With the benefit of 20/20 hindsight we can easily point out that our trader would have been much better off waiting a few more weeks to cover. He would not have lost anything, and in fact would have helped his portfolio.

The take-home point here is that shorting is not for the faint of heart. You’d best have a solid understanding of market behavior and fundamentals before even considering short-selling shares. As we learned above, the risk to the trader is unlimited. Lets say the DJIA would have gone all the way back up to its 2007 high after our trader shorted on 10/22/2008. He’d have been out over $5,700. In shorting, the rewards are finite (a stock can only go so close to zero) whereas the risks are theoretically infinite.

For the average investor, shorting shares is difficult in that you must pledge the balance of your account as collateral in case your bet goes bad. This nullifies the ‘qualified’ status of IRAs therefore IRA custodians will not extend margin privileges to IRA accounts. Standard brokerage accounts may be used to short stocks and such an account could be used to hedge other investments. While this strategy may bear occasional fruit, it is not for everyone, particularly those with short time horizons or a low appetite for risk.

Inverse Funds – Not what they’re cracked up to be?

Before beginning this segment, a few things must be said. For those who read this column regularly, you know that I rarely use specific companies or funds in these discussions, and tend to stick to sectors, fundamentals, and macroeconomic conditions. However, in this article, specific examples are going to be used to illustrate the points made and to show investors how these funds don’t always perform the way they’d expect. This is not to imply that there is an attempt to deceive on the part of the fund sponsors, but rather a misunderstanding by the investing public of the stated objectives of these funds.

Dow Jones UltraShort Profund (DXD) – The stated objective of this fund is as follows:

The Fund seeks daily investment results, before fees and expenses that correspond to twice (200%) the inverse (opposite) of the daily performance of the Dow Jones Industrial Average.

Let’s use a couple of hypothetical examples to illustrate how a leveraged inverse fund works. We enter our position when the DOW is at 10,000 and the price of DXD is $100/share. For the purposes of the example, we’re going to forget about the expense ratio. While the expenses must be considered, they are not necessary to make our point.

So over the course of our hypothetical 10-day trading period, the DJIA lost 8.28%. Conventional wisdom would have expected DXD to come in at a 16.57% gain. However, it only returned 14.44% (before expenses). Granted, this is not a big difference, but when you start putting it in the context of a million dollar investment you’re talking about some serious money.

Now, for the sake of argument, let’s use DOG, which is the non-leveraged inverse ETF for the Dow Jones Industrial Average, and see what happens.

The performance of the non-leveraged inverse ETF wasn’t quite as bad as it netted 7.64% (before expenses) when compared to an 8.28% loss in the Dow Jones Industrials Average.

Now let’s apply a real-world example from earlier this year and watch what develops:

On February 9th, 2009, the Dow Jones Industrial Average closed at 8270.87. The Ultrashort DOW ETF (DXD) closed at $58.07 that same day. Now, shortly before close on 5/13/2009, the Dow Jones Industrials Average is at 8274.05, while DXD is at $51.33 – a difference of $6.74 from the 2/9/09 price. Conventional logic would have surmised the DXD prices would be within a few cents given the trivial difference in DOW levels. For comparison, the non-leveraged ETF (DOG) closed at $71.82 on 2/9/2009 and sits at $68.60 shortly before the close on 5/13/2009 – a difference of $3.22. Conventional logic would have also expected the price of DOG to be very similar. What is going on here?

Here’s what. It is all in the objective of the fund. Remember how it mentioned the daily performance? These funds track the index on a day-by-day basis, but as time goes on, the tracking becomes more and more sloppy. Volatility enhances this condition as was evidenced in our 10-day hypothetical study from above.

It is due to the fickle nature of mathematics that a 10% drop followed by a 10% gain doesn’t put you back where you started. This is where the inverse funds fail to protect portfolios in the longer-term. Now, if prices always moved in straight lines, the inverse funds would do fine. Obviously prices don’t behave that way. The above analysis should not be construed as an indictment of the DOG and DXD inverse funds, but rather suggests they only be used with a clear understanding of their objectives. Furthermore it must be realized that you might not get quite the level of protection you anticipated even if you’re right and the market goes down but takes a lazy path to get there.

For the average investor, inverse funds are an easy way to ‘short’ the market without actually taking the full risk of shorting. Think of it this way: if you invest in an inverse fund and the fund goes to zero, you’ve lost only your initial investment. Your actual risk is known going in. A second plus is that inverse funds may be bought in non-marginable accounts like IRAs. The major drawback, outlined above, is that you may not get the performance you expected for your buck – particularly over extended periods of time.

Using Options to Hedge Portfolios

Another potential strategy for hedging portfolios is through the use of options. We have previously discussed covered call writing for the purposes of generating income, but this week’s topic varies considerably and requires looking at things from a totally different perspective. This discussion focuses on using options for protection ONLY – not for day trading or other speculative activities.

While this is not intended to be a primer on options trading and involves prerequisite knowledge, there are some important concepts that must be highlighted when using options for hedging purposes. For most average investors, hedging with options involves the purchase of put options, which can be done from many types of accounts. However, individual brokers have their own restrictions on what can and cannot be done in particular types of accounts.

Time – Options are good for a specified period of time and after such time has passed expire worthless. Even in the month (or sometimes more) before their witching (expiration), options begin to degrade in value and investors find that they’re not doing their job in terms of protecting the portfolio. Options have ‘sweet spots’ and if you’re going to use them to protect a portfolio you’d better be able to align the option’s sweet spot with the period when the market’s decline will be most dramatic. Otherwise you’re not getting the full benefit of the option and your portfolio isn’t being protected. This is no easy task by any stretch of the imagination.

Strike Price – In the case of the Dow Jones Industrials Average, put options could be purchased on DIA. If you feel the decline will last 6 months and start today, you’d look at options that expire 11/2009 or beyond. In the case of DIA, 12/2009 put options are available. Now you must decide how far you think the market will fall. Buying an option with a strike price that is too low may result in it staying out of the money in which case you might not get the full performance; especially if the decline is not as steep as you anticipated. Buy an option at a strike price that is too close to the current price of DIA and you’re going to pay a hefty premium for the option. If your prediction ends up being right that won’t be an issue, but if you are wrong, you just wasted a lot of your money.

Know Your Portfolio - A common mistake of investors who use options for hedging is that they buy the wrong option. It is imperative to understand the components of the portfolio that you’re trying to protect. For example, hedging a portfolio of junior gold mining stocks with Dow Jones Industrials Average puts is probably not a great idea. While the junior gold stocks may trace the DJIA to a certain extent there are plenty of times when such is not the case. Using a simple statistical correlation study between your portfolio’s value and the value of different market indexes can help you identify which markets your portfolio tends to track and you can then hedge more effectively.

The major benefit of buying options is that you’re taking a known level of risk. Your outlay for the option and related commissions is the extent of your risk. If you are wrong and the market moves up your option will expire worthless and you lose your initial investment only. It must be noted that this defined risk does not apply when one is writing uncovered (naked) options. These types of activities are extraordinarily risky and are highly inadvisable merely for hedging purposes.

In conclusion, there are many other factors that play into hedging and would require a dissertation to elucidate all of them to proper justice. Each investor must consider their own objectives and risk tolerance and should also consult a qualified advisor before implementing any investment strategy.

The important thing to take away from this discussion is that if done properly, hedging can provide relative comfort during periods of market mayhem such as we just witnessed last year. However, if undertaken without a solid understanding of both the benefits and detriments of the hedging methodology you choose to employ, not only will you not enjoy comfort, you’re quite likely to be a regular in the antacid aisle at your local pharmacy as well.

Improper hedging techniques and use of hedging vehicles are some common mistakes investors make. Consider taking a look at our free report about 7 additional mistakes investors make – and how to avoid them. To get your copy click the following link: www.sutton-associates.net/7mistakes_report.php

Back in 2006, Marketwatch Columnist Mark Hulbert made the comment that those who had invested at the 2000 market top had finally gotten their money back.A long six years to get back nominal dollars that had decayed significantly by the time they were ‘gotten back’.

We wrote the pilot issue of the Centsible Investor in early November 2007; right after the market peak. Was this an accident? Hardly. Our keynote article in that issue dealt with our purchasing power coming under attack and we vowed to put together a portfolio model that would fight inflation by providing a high rate of current income with a secondary goal of capital preservation.

Today, I am proud to announce that while the Dow, NASDAQ and S&P are all down (38%, 39%, and 40% respectively), that the total return on our Portfolio Model is now positive at .51% as of close of business 5/8/09. Where traditional investors had to wait several years from the bottom to get their dollars back, our Portfolio Model has accomplished the same feat in just over 2 months – and has paid great dividends while we waited!

For those who have been subscribers over this 18 month roller coaster called the markets, I am hopeful that our publication has demonstrated its worth and you will consider renewing. For those who have not subscribed to this point, I am hopeful you will consider doing so. The attack on our purchasing power is only beginning and will feed on the inflation created to support unsustainable government spending and the various bailouts. Vigilence is required now – more than ever.

As an added incentive, we are currently offering $30 off our one year subscription. Get 12 issues plus interim updates for just $99. This special will last through Memorial Day.

The Centsible Investor’s Subscription Page may be found below. If you have any questions or need assistance, please reply to this email.

http://www.sutton-associates.net/newsletter.php

Best Regards,
Sutton & Associates, LLC

DISCLAIMER: The statements made in this communication are for informational and educational purposes only and do not constitute an offer to either buy or sell any security, nor should any statements herein be construed as investment advice. Neither Sutton & Associates, LLC nor any contributor to the materials contained in the above-referenced report shall be liable for any losses as a result of these or any other investments.

Recently, there has been more than idle talk about converting most of these loans to equity stakes, which do NOT need to be paid back. Furthermore, future disbursements would like be made by buying equity stakes in the firms rather than making loans. Sound the same? Not quite. Here are some reasons why:

1) In the event of bankruptcy, creditors are paid off before shareholders from any proceeds of liquidation. Given the vaporization of BSC and LEH, this is definitely worth mentioning. Historically, shareholders are left holding the bag in a true bankruptcy and subsequent liquidation.

2) Even if the firms remain solvent, there is significantly more risk in holding equity than debt. The taxpayer’s investment would be subject to all the risks generally associated with holding stocks. Taking a look at the performance of banking stocks during 2008 gives a pretty good idea of what I am talking about here.

3) Current shareholders are negatively impacted by dilution if more shares are created out of thin air for the government to purchase. And even if the shares are bought in the open market, the mere size of the stake could have a rather deleterious affect on existing shareholders should that stake need to be sold en masse.

4) By taking an equity interest, the government is consummating an incestuous relationship with the banking industry. Nationalization is the term typical used in this type of situation, but the term has become taboo in the mainstream media in recent weeks.

5) Also, bear in mind that the banks don’t really need this money at all. They have been printing their own currency for years now via unregulated, non-transparent OTC derivatives. Now that some of their bets have gone bad, the taxpayers have been forced to ‘legitimize’ this activity by the infusion of trillions of less-funny-money (dollars).

Sea changes can be either dramatic or subtle. The recent direction in terms of supporting the financial system sounds subtle enough, but with dramatic results.