Much has been made about the death cross of late, the 50 day moving average crossing through the 200 day moving average, although I think and know it is a significant event it is nothing compared to something else I have noticed. We are all aware of the primary reason of the bull run over the past 12 months, massively oversold markets, combined with marginally better economic data and, most importantly, a weakening dollar. Why the dollar weakened is important to note, quantitative easing via the Federal Reserve’s asset purchases or the printing of money. Although we will not know the long-term implications of QE for some time to come it is safe to assume it accomplished its goal, weaken the dollar and boost the economic data through negative interest rates, essentially.
We all know the market action of late, a horrendous selloff which was only a surprise to the parade of bulls on CNBC and those who kept their heads buried in the sand, but those out in the real world knew it was coming. What was unexpected was the 4th of July rally that took us back up some 7% on the backdrop of pretty bad economic data. Some of the bounce was because of a technical bounce and some of it was because of the expectations of stronger earnings which started last week. I fully expected 2Q10 earnings to be good, but I expected to see more top line misses and the outlook from CEO’s to be downgraded as well. So far, it is a mixed bag, but the outlook or guidance remains very bullish for many firms, however, a look back through prior earning announcements, particularly 2000 releases, as Mark forwarded to me, shows that Intel did not foresee a slowdown there either, so trust the economic data rather than CEO guidance going forward.
Back to what is going on in the equities market and why the dark cross is less important than the other ‘grey swan’ that is going on. First, everyone and their grandmother knows or knew about the dark cross, not that it takes away from its importance, but when everyone knows about it very rarely does the market deliver the results we are looking for. Except the market kind of did deliver, but stopped short and rallied all the way back to some important moving averages where it failed to break through, very bearish from my lens. At the same time we saw the selloff begin the dollar was moving towards the 89 mark on the DXY, but it stalled after a dramatic breakout and reversed course. Not only did the DXY reverse course, but it got crushed moving down from 89ish to about 82.5, not an insignificant move.
Exhibit 1-1 2 Month DXY Chart
Why is this a big deal? It is a big deal because stocks went up on a weak dollar trend which meant a better environment for U.S. companies to sell products abroad. Basically, a weaker dollar is better for U.S. exports and sales as we become more competitive in the world. It made sense for the markets to not like the move of the DXY from the low 70’s to 89, but to not like the move from 89 to 82.5, well, I am perplexed. The market should love this and we should be flying to at least 1,100 on the S&P 500, but we are not. This is a huge warning sign that stocks cannot rally on a weak dollar and it means more than the dark cross.
Exhibit 1-2 1 Year S&P 500 and DXY
The charts show the trends pretty clearly, lower dollar higher equity prices, higher dollar, lower equity prices, but over the past couple of months things have been out of whack. What else is going on during this time period? Treasury yields are collapsing to historic lows. We have the 2 year treasury under .60%, the 10 year under 3% and the 30 year under 4% which is a sign of 2 things, risk aversion and fear of deflation. My belief is deflation is the clear danger as of right now, it is fairly evident from my lens and the market is pricing it in as we speak. The credit markets have been pricing it in for some time and will continue to, I am bullish on debt securities, have been for some time now, but the equities markets, well, it has not priced in any real deflationary pressure at all.
Exhibit 1-3 Yield Curve
Granted, we have not seen total deflation yet, just the beginning sign of it, but the evidence is pointing towards it. Here is the rub, everyone says the Fed will do QE2, but they won’t do it. See my other posts as to why they will not do it, but from my lens they would be insane to even attempt QE2 at this point. The problems in the U.S. economy has nothing to do with what is happening in Europe, a little I suppose, but not directly related. My past posts about Europe relate directly to actual defaults by countries and to corporate earnings. I think anyone will find it hard to believe that the Jones’s are not buying that new car because they are worried about Hungary being kicked out of the IMF-EU rescue package. They are not buying a car because they are worried about their job and do not want to take on much debt or because their credit score is so lousy they cannot get financing, 25% of Americans have a credit score below 600 now. Instead the Jones’s are paying off debt and buying what they need, not what they want which is deflationary.
This trend will continue and so far only the credit markets are pricing this in, the equity markets are in La-La Land, still. The DXY – S&P cross is very bearish if the trend continues and will mean a big correction in the near future especially if commodities head lower as well. Commodities are not performing well and that is reflected in the Baltic Dry Index and combine that in with the above information and it is putting the explanation point on the whole theory. So far the only strategist I know for sure who is putting all of these pieces together, and has been ridiculed relentlessly by the bulls on CNBC and such, is David Rosenberg. All of the rest of the strategists are telling you to buy the dips even when they see everything I presented to you, they know what it means and, to top it off, they know the ECRI is rolling over and housing is going down the tubes. It is incredible to say the least. Be ready for some fireworks soon unless this trend breaks.
What works in a deflationary environment? Income and dividends, pure and simple. I like (and own) the following: CTL, MO, PM, WM, PFE, MRK, LLY, BPT, RYU, PEY, INB, DNH, CGO, VZ, high quality corporate bonds, strategic income bond funds, emerging market debt funds (PCY has been good to me), short and intermediate term treasury funds. Many of the above mentioned stocks have underperformed, which I like, and pay very nice dividend yields, which I love, but may not do well in an inflationary environment. This is why one has to hedge with precious metals or, at the very least, TIPS.
The privatization of any social program always brings a hot debate between conservatives, liberals and, well, anyone in the middle. Many free market minded individuals think Social Security should be privatized while liberals say no way. Who is right and is it even possible to privatize such a huge chunk of the Federal pie?
First, let’s answer whether or not Social Security could be privatized. The answer is simple, it cannot be and privatization will never, ever happen. Why? Anyone who has been alive for more than 15 years knows that the federal government takes a nice chunk of your paycheck for FICA, basically Social Security and Medicare/Medicaid, but what they do not know, usually, is that the Social Security portion does not go where you might think. There is no actual account for your Social Security benefits instead you build up credits and your payout is determined by what age you retire. The size of your check will vary some depending how long you have worked and who much you put into the system. This is a very 30,000 foot view.
You receive credits into your Social Security account and not a “cash balance” report because there is no cash actually in your account. Believe it or not the government borrows against Social Security assets all the time and gives you an I.O.U. instead – the Social Security Administration is now cashing in some of those I.O.U.’s because they are now broke. You should know this because it means that if the cash flow into Social Security was ever stopped the whole house of cards would come crashing down. In effect, your entitlement program is the largest Ponzi Scheme in the history of scams. It is for that very reason Social Security will never be privatized because all of the lies would be exposed. But, what if we could privatize it?
Is it a good idea to privatize Social Security? That is a complex question and I am inclined to say yes, but with severe limitations. I do not think it is a great idea to put it into an account with only equities because people do dumb things when equities are involved. In my opinion I believe that using a deferred income annuity product would be the best option or some other type of account that has guarantees attached to it. An income Annuity would give the investor much higher lifetime income than you might think. I am also inclined to believe that insurance companies would create a product that would create a greater stream of lifetime income than what Social Security could ever provide.
However, I think some products should never be considered as an investment option. On my list I believe products that involve higher fees should be excluded such as equity index annuities and variable annuities. I am a believer in Variable annuities, but I feel that the current product fees are too prohibitive to make them a suitable option, a new one would have to be created. I am not a believer in equity index annuities, call me crazy but monthly or daily averaging which intentionally lower the rate of return is not a good idea and then throw on caps, yields or spreads and you have a product that is just not good. I am sure someone will disagree with me about indexed annuities, but that is their opinion and I have not seen a product I actually like. Plus when you exclude the dividends for these products it will drastically underperform the market rate of return. In short, these types of insurance products, which I am sure are valuable, are just too complex for a self directed Social Security account and I do not have faith in the government to choose the best products if they were allowed.
I think a hybrid product with a living benefit, which would payout 5% for as long as the owner lives regardless of account value, might be a decent option. They have a lower cost compared to a variable annuity, but provide similar lifetime income guarantees. These accounts also would mandate an asset allocation model that would have to be adhered to or all guarantees are off. Contrary to belief, asset allocation did work throughout the market crisis. Yes, you took a loss even in a diversified portfolio, but a balanced fund only lost 19% and has a standard deviation of 12.7, not bad.
If this were to happen, privatization of Social Security, it would lead to bad products being created since the government has no sense of what is and what is not a good investment for people. It would also lead to great confusion by investors since many have no idea how any type of guaranteed products work or their drawbacks. There is also the possibility that if/when we have another meltdown in the markets the losses incurred by investors would bankrupt insurance companies or whoever is offering guarantees. It is clear that traditional pension funds have not worked, the taxpayer is already making good on those guarantees, which leads me to believe that any type of equity investment options are simply a bad idea.
The only feasible option for privatizing Social Security would be using a traditional income annuity. The risk is manageable and the returns are predictable as well. However, this is all a moot point because it will never, ever, happen simply because if the government did not receive that income from your paycheck they would fold. While I think some investors would benefit from this the larger population would not and the only real winner would be Wall Street, as usual.
What no one wants to talk about, ever, in terms of retirement planning is the sequence of returns and the impact on retirement planning. I am bringing this up now as we wrap up the worst 10 year period ever in the S&P 500 we have ever had. In fact, technically, this is the only official 10 year period of time the S&P 500 has ever been negative. I say officially because the 10 year period is subject to interpretation, but regardless we are looking at a period of time wrapped by 2 of the worst periods ever to invest in the equity markets. In other words this decade had the mother of dumbbell negative returns ever.
What the impact of this 10 year period has had on retirees will be felt for the next couple of decades. Essentially, many retirees or pre-retirees have been wiped out or will have to drastically alter their lifestyles in order to make their money last. While I could easily blast the likes of Scott Burns, Suze Orman and a million other drive by financial advisor writers for dispensing horrible advice that they likely did not even follow themselves, I will not. They simply told people what they believed to be true because they used flawed logic and ridiculous assumptions that normal financial advisors would have dismissed as idiocy, not that they are innocent either, but they were the targets of these writers inept ridicule for long enough.
The simple fact is this, everything has a cycle whether we are talking about the Earth, the moon or the markets they all of a cycle. When we look at market returns sometimes the cycle shows an unmanaged index does substantially better than managed money while at other times managed money does better than the unmanaged index. Over the past 15 years we saw the unmanaged index do better than managed money, but will that trend continue? Unlikely. That cycle has run its course from my point of view, sure there will be stand out sectors, but that is it. If you go back in time to the 1970’s it is fair to say that this theory of mine pans out and managed accounts did better than the unmanaged indexes, but you know me, let’s not let the facts get in the way of what they pawn off as the truth.
The beginning of this decade should have been the warning sign for those following the advice of the financial rags who themselves have never ran money or witnessed what it is really like to lose someone money. Instead they blast brokers for making money and tell you to buy an index fund because over the long-term “nothing outperforms the S&P 500,” how’s that working out for you? Simply put, they did not know their history and they over simplified a very complex thing, your retirement planning. Retirement planning is complicated and deeply personal and no one, I really mean this by the way, should ever take their retirement planning advice from the TV or newspaper.
With hindsight on my side, unfortunately, it is now clear that these people did not know what they were talking about. Not only that, but their intentions are now out for everyone to see. One person mentioned already, who always advocated Vanguard index funds, opened an RIA firm and will gladly manage your money for a small fee, even though he said brokers were crooks before, unless he is the broker I guess. The other person sells binders for $50 or $100 that you can buy at Staples for $10 or $20, but since they are branded with their logo or some other nonsense they are worth more, I am still trying to figure out why that is. Either way, to their legions of devoted followers their betrayal means nothing or they will continue to mindlessly follow them, which is astounding to me, even though they destroyed their wealth. Here is what I mean.
The sequence of returns is the timing of returns, either good or bad, and the impact on your portfolio. This is the most important aspect of investing and the biggest ‘Black Swan’ there is because it is out of your control. This is why asset allocation is so important when you are talking about your serious retirement money. I have a larger portion of play money that I speculate with, but you better believe that my real money, my retirement money, is not in some E-Trade account with my finger on the buy/sell button all day long. I have a plan with my real money and I do tinker with it occasionally, but only when I feel the need to be more conservative or more aggressive, but it is professionally managed, not by me, to keep my emotions out of the game. However, the sequence of returns is always ignored by most gurus I read or listen to and it will devastate you if you are not careful.
If you invest and instantly lose 10% for the first couple of years it takes you a very long time to regain those losses or exceptionally high returns for a few years. It is even worse if you are taking income from your portfolio which is the case for many retirees, unfortunately. I am going to concentrate on those taking income from their portfolios in this example, just 5% income I might add, because many Boomers retired either in 2000 or in the last few years, either way you will get the point. I am not even going to show you the double whammy of the dumbbell negative returns because that is so depressing it is not even funny. In fact, this will be and is such a serious problem I am not sure what can be done about it because literally millions of Boomers are in serious trouble now.
Here we see someone who decides to retire and rolls over his 401K and listens to a buy and hold indexing guru. They decide to invest into a generic fund and let it all ride thinking that 5% withdrawals should suit them just fine, since he is told the market averages 10% over the long-term, another farce I might add. Unfortunately for this investor he got suckered into a bad time to invest and the market fell 10% for the first 2 years he owned his fund, but no problem writes the financial guru, just hold on and everything will be fine, really? Well, you tell me if everything looks fine to you.
Exhibit 1-1
Keep in mind, I am not showing any other negative returns, not even a negative 1%, and I am showing +8% returns for every other year in this illustration. I am also showing a straight 5% withdrawal rate, not ever a little more for the grand kids, to pay the taxes or medical bills, just 5%. This person runs out of money in about 20 years with 2 negative years right off the bat and they did not even look that bad, 10% market declines are, well, normal right? That is just one illustration of the sequence of returns and how they can impact the investor, not imagine if I put in the 2008 50% decline in there, there would not be anything left. I also ran this with 6% withdrawals, but the only difference is it gets uglier faster.
There is nothing you or I can do about the sequence of returns, but I have never seen something so important ignored before. While we are wrapping up the worst decade on record for stocks don’t you think we should talk about this stuff a little bit, especially since Boomers are about to retire in droves, well they were at least. Frankly, those bond funds everyone is slamming right now, do you know why they are so popular, not that I agree with it I might add, but they are so popular because they have positive returns on the 5 and 10 year benchmarks. Look at equity portfolios, most funds look horrible, except some managed funds I might add, but in comparison investors are saying, well sure this fund only did 5%, but it is better than the -3% I did over 10 years, so buy it.
I may sound bitter, but this is serious stuff that people just take so lightly and it drives me nuts. CNBC is now all about entertainment, not about serious news anymore which is a shame. The personal financial gurus are all about selling their latest book rather than helping people do real things, but maybe it is the peoples fault when you have to have a segment called can I afford this. People, if you have no money in the bank, in debt up to your eyes, make $50K a year, then no you cannot afford a $700K house, it is common sense. However, even though they are getting calls like this it does not justify giving out poor advice, ignoring history, not understanding the sequence of returns, the basics of asset allocation, vilifying brokers, picking on products – yes folks a variable annuity turned out to be the best product in the world to buy in 2000, and simply recommending index funds because they are index funds – a monkey could do that.
We have commented on the dollar’s weakness for a while now, but today we are seeing surprising strength in the dollar index. This is telling to the markets potential future behavior as investors tend to move into the dollar when the economy is questionable or they foresee potential problems.
For an example of this move just look to last fall when the dollar had huge gains against all major currencies. Why do people move to the dollar during economic turmoil is a very important question and the answer is fairly obvious, we have the most liquid market in the world, you can buy whatever term of government debt you want from 1 day to 30 years, and you will get your money back since we have never defaulted on our debt. However, while we guarantee your money back, we do not guarantee the buying power of that money.
The dollar’s strength today, in the face of a “better employment report” or the latest “green shoot” the dollar should be declining in value as the risk trade should be on. The problem is that it is up over 1% for the day and, in my opinion, is signaling that some major players think there could be some rough days ahead in the risk trade. I do not think you need to be a rocket scientist to figure out that it is nearly impossible for the markets to go straight up, but it has since July.
I do not have any data on who is buying, but my spidy senses are tingling and when you see a contrary indicator go off, equal to the markets move, you have to react. I am reacting by reducing my US equity exposure to 15% and I may take all US equities off the table by the end of the day. The other point of interest is that even with such a move in the dollar commodities are rather tame, gold is down slightly, silver is up and oil is down slightly. With such a move in the dollar these commodities should be crushed today.
As you know I am no bull in this market, a first time in years I might add, but this should make everyone pause and reflect on your current allocation. Corporate bonds are a good haven, in my opinion, as they are only pricing in flat GDP growth versus the S&P pricing in 4.5% GDP growth. I also like PCY which is an ETF sovereign government debt fund yielding over 6%, I do own this security, which could be a good place to go for 2 reasons:
It is out of the dollar, which I am a long-term bear on, and;
It has a nice yield and has performed fairly well during the last economic downturn, it recovered very quickly.
Whether it is really an intended consequence or not is up for debate, however what is clear is the dollars rapid rate of decent to the basement. The index has been lower in the past, but the economic crisis last year boosted the dollar’s strength against every major index until the early part of summer when the risk and inflation trade kicked into high gear.
The consequence of a weak dollar is of great concern to me as it has consequences that most Americans either do not know about or do not fully understand. A weak dollar is good for our exports, but it also has an inflation factor for us that can sneak up on people. Commodities are priced in dollars so when the currency declines everything we use on a day-to-day basis increases such as gas and food. While the government thinks that gas and food have no or limited inflationary effect on people, I have to disagree since most people like to eat everyday and occasionally fill up their gas tank.
There is no question between the correlation of a weak dollar and the upward momentum of the equity markets. There are various reasons why the market has gone up over the past few months, it was massively oversold, but clearly the weakness in the US Dollar was perhaps the largest contributor to equities gains. As you can see below, the correlation is obvious between the dollar’s weakness and rising equity prices. Although there seems to be a decoupling between the two over the last few days, the longer term correlation is still very evident.
Every time the dollar declines 1% we see about a 1% increase in equities which means there is no real gain in stocks as Americans buying power was simply reduced. The reason for the dollars decent, which has been years in the making I might add, is because of our loose monetary policy. That policy has become increasingly looser since the beginning of the financial crisis and the saving grace of the US dollar was its liquidity as investors bought up dollars at a record rate last fall.
There seems no sign from the Fed as to when interest rate tightening might happen although many think interest rate hikes are closer than we think. Tightening our interest rates is the best way to support the dollar along with fiscal responsible spending which would mean no more spending by our government at this point. However, personally, I do not think the Fed has the stomach to tighten rates anytime in the near future, perhaps in 2010, but the Fed has been influenced way too much by the markets. In my opinion the Fed has abandoned its original role
On top of a poor monetary policy we also have massive amounts of debt being issued by the Treasury which is diluting our dollar even more. At this stage, we are heavily dependent on foreign governments to buy our debt. We saw what could happen if foreign governments slow or stop their purchases during last week’s 2 year auction where the bid-to-cover was 1.92 and rates shot up. If foreign governments stop buying our debt we are in huge trouble and will have to do more “quantitative easing” than we currently do now.
If the dollar index continues to slip then we could be facing huge problems such as losing our status as the world’s reserve currency. The only thing preventing that now is the fact that there is no other market that can handle being the reserve currency. The Euro and Yen are contenders, but those markets still are not as deep and liquid as the treasury market.
However, if we do loose our reserve currency status or the dollar index slips into the 60 area it is possible that foreign bank’s start dumping the dollar which could start the beginning of a crisis in the US dollar. As of right now I see an orderly exit out of the dollar, but if the orderly exit turns into a run for the exit because someone smells a fire then that is when we will have a big problem. It could very easily turn into a dollar collapse and no one is really sure what would happen because it has been unfathomable at any other time in our history.
Not only have we never seen anything like that in our lifetime in America, but most people think it could never happen, presumably because we are America. Not only could it happen, but eventually it is more than likely a probability that it will happen. Clearly no one knows exactly when or how it will happen, if it happens at all,, but one thing is for sure it will be because of a lack of confidence in the US dollar.
I do not root for such a thing to happen and I hope it never does happen, but at the very least it looks as though that the greenback will have some tough times ahead. This is one of the reasons why I am bullish on international investments, gold, silver and other hard assets as they are a hedge against a weak dollar. Buying commodities is one of the best ways to protect your and preserve your buying power.
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