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Flip Flop

By: Beese Fulmer
Thursday, April 12, 2012

Flip Flop

Although 2011 was definitely a “risk-off” year, 2012 has commenced with an emphatic “risk-on” attitude. As you may recall, the S&P 500 Index returned just 2.1% last year, and the best- performing sector of the benchmark was the normally-moribund Utilities component, which lit up the other nine sectors with a 19.9% return. Take a look at the following two summary boxes, and you’ll get a good idea of how much differently stocks behaved in the first quarter versus last year! The economic environment has improved enough that last year’s worst-performing sector, the Financials, flipped from a loss of 17.1% in 2011 to a first-quarter gain of 21.5%! And last year’s star sector, Utilities, flopped to a loss of 2.7% from last year’s gain. How the worm turns! Two sectors closely associated with the “economic-recovery” trade, Industrials and Materials, also enjoyed sizeable reversals of fortune.

The same can be said for the S&P Index itself, since last year the Dow Industrials Average, thanks mostly to the outperformance of two stocks (IBM and McDonalds) and the absence of too many banks, posted an 8.3% total return. It is not often the Dow beats the S&P by a factor of four in one calendar year! In 2012, though, the more broadly based S&P 500 gained 12.6% versus the Dow’s 8.8% tally. Apple accounted for about 20% of the S&P’s gain for the quarter, and these results are the best for the benchmark since 1998. So far in 2012, it’s “risk on” gone wild. In fact, the S&P has rallied for over 80 straight days without a meaningful correction since its 10% pullback last November! The first-quarter return for the Nasdaq Composite proves our point once again: powered by Apple and all of its minions--those companies that provide Apple with components or associated services--the Nasdaq was able to post an incredible 19% gain during the period.

Now, the question on everyone’s mind is the same: can the stock market continue this kind of performance considering it has already reached the year-end targets previously forecasted by many analysts? It’s a great question, but it’s one we can’t answer with certainty. We can tell you that, in 80% of the years the market has enjoyed this kind of first-quarter gain, the second quarter’s results were positive by about 3%. As we stated in last quarter’s Outlook, we believe the economy is getting better, and it follows that the year will be positive for stocks. Don’t forget that folks in Washington will pull out all the stops to ensure their re-elections. Pass the pork! The issues that could cause stocks to pause in the interim are widely acknowledged: high oil prices, Iran, and Europe’s financial situation are certainly at the forefront. And there will be some sort of high drama once the election campaigns kick off in earnest. The big fiscal problems in Washington which will impact the financial markets are coming January 1, 2013, but that date is months away, so let’s enjoy our good results for a while longer!

Thank You, But No Thank You

You would think that this kind of stock-market rally--which began in March 2009--would be pulling in investors right and left, but it’s not. In fact, just the opposite is occurring: According to the Investment Company Institute, outflow from U.S. stock funds was over $3 billion in February--50% more than the outflow in January! In fact, despite the three-year bull market, mutual-fund investors have withdrawn money on a net basis from U.S. stocks for ten months in a row! And get this: Despite interest rates at record low levels for three years, bond funds have seen an inflow of $62 billion through February. Regardless of carnival barker Jim Cramer’s daily invitation to buy stocks “since there is nowhere else to go” for yield, Baby Boomers are taking as gospel Mr. Bernanke’s promise that he will hold interest rates low “at least until late 2014.” So, they believe there is still time to jump into the fixed-income pool. The instinct to protect what they’ve got is overwhelming their greed factor--which is normally necessary to keep a bull market going--and getting the retail investor to come inside the tent is a key component in Mr. Bernanke‘s vision of what will reignite the U.S. economy. He says it all the time: Please invest in stocks, and when they go higher, you’ll feel richer, and you’ll spend more money, and then companies will have to hire more workers, and voila, our problems are solved!

Despite his pleas for more fuel for the equity fire, last year’s volatility, two 50% stock-market declines in the last decade, and impending retirement for 80 million people over the next 20 years--who need to use their savings to live on rather than to gamble with--means folks are saying “no thanks” to Jim and Ben and, instead, want to know why Ben, if the economy is recovering as wonderfully as Joe Biden and Mr. Obama are proclaiming every day, is still stealing $400 billion a year from savers--interest we would be receiving if rates were back to anywhere near the pre-crisis levels! So, they are not ponying up their cash to go in and see the bearded bald man. Nevertheless, stocks continue their steady climb on declining volume, as hedge funds and high-frequency traders amuse themselves to no end.

That’s why there is an expression going around that carries some validity: Stocks aren’t owned anymore; they are just rented for their returns. Baby Boomers have made back some of what they lost in the latest crash and are pulling out. They are confused by the mixed messages being sent out: Mr. Bernanke plays bad cop every chance he gets, telling us that the recovery is okay but not great, and fiscal policy in Washington is a mess, so he’s got to do it all with basically one tool. We savers shouldn’t complain anyway, he believes, since debtors are getting such a great deal if they want to get another home loan--a loan banks are not making unless the borrower has an 80% down payment rather than the traditional 20% (or the untraditional 0% down, which got us into the mess in the first place). Several analysts have pointed out that the Zero Interest Rate Policy is a big reason the velocity of money circulation has plummeted: What bank wants to make a home loan when rates are so low? The irony in all of this, of course, is that when interest rates do rise, bond-fund investors will be vulnerable to losses. Most of us in the investment business have been saying that for a decade, and investors know that we’ve been wrong for a decade, just as they remember the two 50% stock-market declines during the period. So, Mr. Bernanke presses on and bets the greed factor will take hold so that stocks will soar to infinity and beyond! (Sorry about unleashing our inner James Joyce in this paragraph, but venting with stream-of-consciousness run-on sentences is known to relieve stress.)

Feeling Repressed?

There is a term for what Mr. Bernanke and the Fed and Treasury are doing to savers and the markets, and the term is financial repression. First coined in 1973 to describe the financial model used by the world’s major economies between 1945 and 1980, the term was resurrected last year by economist Carmen M. Reinhart. Financial repression is evident when a central bank uses various means to force interest rates below the inflation rate, thereby forcing down the real value of its debt. Despite what Mr. Bernanke continues to allege as fact, we know that “real-world” inflation over the last several years has probably averaged more than 2.5% on an annual basis. But the Fed is able to sell bonds to finance our huge debt load and annual deficits at rates much lower than that. So, 5-year Treasuries are foisted on buyers at yields of less than one percent, and savers end up receiving a negative real return on their investment. Buyers know they are getting the short end of the stick on this deal, but if they want the surety of a fixed-income flow with Uncle Sam’s guarantee, it’s the only game in town.

In order to pull off this scheme, a sovereign’s central bank must be able to force buyers to go along with the bad deal without going outside the system to get its funding. Japan has been able to do this for years because they finance their debt internally. Now, Mr. Bernanke is doing the same thing here. Savers buy the debt, banks regulated by and beholden to the Fed buy the debt (since they’ve been borrowing from the Fed for the last three years for next to nothing), and when necessary, the Treasury issues the debt, and then the Fed adds it to its own balance sheet. The Fed is buying about 70% of the longer-dated debt the Treasury issues as part of “Operation Twist.” And don’t worry about the forty cents of every dollar of our deficit being borrowed from the Chinese; it’s called vendor financing. For the central bank, it is a slick way to work out of a debt hole--especially when another method for doing so, austerity (or spending cuts), is unpopular with the powers that be. (This all comes out of Washington, the only town in America where a spending “cut” is defined as a cut in the growth of spending.) But there are repercussions when a central bank uses this policy.

Grant Speaks

Jim Grant, founder and editor of Grant’s Interest Rate Observer, is one of the most respected Fed historians in the business. He appeared on CNBC with Maria Bartiromo recently and voiced his strong opinions about current Fed policies. No fan of Mr. Bernanke, Grant states the Fed’s actions amount to market manipulation: “The Fed is manhandling the structure of interest rates…to the end of achieving what it takes to be desirable macro outcomes.  In the latest ‘twist,’ the Fed and central banks around the world are manipulating the value of the currencies they print.” Grant says the Fed “wants to manipulate long-term rates lower, but in so doing, it’s manipulating the perception of risk and is creating a real inflation in the sense that people who want to retire on their savings now need much more cash to do it.” We’re with Jim on that point!

And, as we know already, when stocks sold off after the initial round of quantitative easing ended, the Fed responded with QE2, and when it ended and stocks swooned, it launched “Operation Twist.” But each round of easing seems to elicit less response from the economy. Grant continues, “Rather than end the recession, these actions are creating an economy that does nothing but slumber, much to the chagrin of ‘twentysomethings’ who want to get into a job market that is dead in the water.” Indeed, according to Investor’s Business Daily, the U.S. has gone nearly six years without a single quarter of 4% growth or higher--the longest stretch since 1950.

Mr. Grant goes on to strike at the heart of the Bernanke plan: “Interest rates are the traffic signals of a market economy; they tell people to invest or not invest…we’re green, we’re constantly green, and they are prodding people to do something with money they might not otherwise do.” Will investors buy bonds with negative yields, while traders push up the prices of commodities or other speculative assets…or will they go outside their comfort zone to buy more stocks, since there is “nowhere else to go” for yield? Baby Boomers are not responding as Mr. Bernanke had hoped; they are too afraid of losses. So, absent any fiscal responsibility in Washington, the Fed Chairman pretends there is no inflation, gets away with the ruse by selling bonds to a captive audience, and waits for the retail investor to send stocks “to infinity and beyond.”

Folks, we’re now in the third bubble of the Greenspan/Bernanke era of easy money, and chances the Fed can get out of this one unscathed are not good. The first was the dot-com bubble, which ended with a 50% stock-market decline; the second was the housing bubble, which ended with a 50% stock-market decline and a housing crisis. Through both of these, though, bond investors made out extremely well, as interest rates (despite some hiccups) continued to decline and bond returns soared. Now, the Fed’s money printing, combined with its repressive interest-rate environment, has left it with a near-impossible task: When interest rates go up for whatever reason, bond investors will get burned, and the Fed will be right there with them, since there are so many on its balance sheet. If the Fed can’t engineer an economic recovery that will stick without its intrusion into the capital markets, stocks will sell off as corporate earnings plummet, and investors will remember who lured them into the sideshow. How the Fed pulls this one off will give an entirely new meaning to its traditional “dual-mandate” policy.

Regulate This!

There is another form of repression taking place now that is holding the economy back from the growth we need to work our way out of this recession, and it is the incredible number of new regulations coming out of Washington. The Heritage Foundation released a report a month ago that finds the Obama administration has issued 10,215 new federal regulations in its first three years in power, with 106 of them it considers “major.” They are costing consumers, businesses, and the economy $46 billion annually. Of course, this continues a long trend that was only temporarily subdued by President Reagan, but which has regained its mojo over the last decade. President George W. Bush was no regulatory piker in his first three years in office either; his administration issued 10,674 new ones in the same time period, but the cost to the economy was “just” $8.1 billion annually. This is the way of the world we know--big government ensures its survival by creating a need for more people to watchdog new rules. Allan Meltzer, Professor of Economics at Carnegie Mellon, and a true believer in capitalism, recently appeared on Bloomberg television and gave his views about the downside of regulatory zeal, and we’ll quote him because we couldn’t possibly say it better: “Instead of the rule of law, we have the rule of regulators. Regulation is the enemy of freedom. Corruption comes with regulation; special privileges come with regulation. People use regulations to achieve their own ends instead of social ends. It doesn’t work well.”

If you think about the last decade’s avalanche of regulations coming out of Washington, 2000-page bills “crafted” in a time of “crisis” that no one in Washington (except the lobbyists who wrote them) ever read and consider what these lunkheads have planned for our future, it’s just, well, “repressing.” That the I.R.S. is going ahead with plans to hire 4,000 new agents to oversee the Obamacare legislation, at a cost of more than $300 million (even though the law might be overturned by June), is just the most recent example of this craziness. More examples will follow, we’re sure (sigh). (Written April 1, 2012)

*If you would like to read more about the issue of financial repression, give these articles a Google:

“Financial Repression has come back to stay: Carmen M. Reinhart” (Bloomberg)

“Ray Dalio: Man and Machine” (The Economist)

“Financial Repression: A Sheep Shearing Manual” by Daniel Amerman, CFA (Financial Sense)

“Fed Leaves Investors Twisting with Risk” by Spencer Jakab (The Wall Street Journal)

“0.2% Interest? You bet we’ll complain” by Gretchen Morgenson (NYTimes.com)


We hope you enjoy this issue of our Investment Outlook. If you know of anyone whom you think might benefit from our investment management services, we would be pleased to add them to our Outlook mailing list as a way of introduction. Client referrals are our most valuable source of new business; they are especially gratifying because they mean you are pleased with the job we are doing for you.

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