A glimpse into the past
Beginning with the Panic of 1907, perhaps the first financially engineered crisis by the New York City bankers, has led to where we are today with central bankers controlling the world’s major economies. It has taken one hundred years from the creation of the Federal Reserve Bank in 1913, inclusive of several important incremental concessions of power, to get to where the central bank has complete dictatorial powers of the U.S. economy absent of Congressional oversight and outside of the U.S. Constitution. Throughout these last one hundred years, the Federal Reserve Bank has managed to reduce the purchasing power of the dollar by 96%, confiscate America’s wealth and transfer the power to an elite power base that has enabled chaos to ensue in the financial markets and perpetuate the war machine to cripple the U.S. taxpayer with insurmountable debt.
Throughout the last one hundred years since the creation of the Federal Reserve; there have been 16 recessions, 1 Great Depression and 1 Great Recession. The 18 economic downturns over the past 100 years have averaged one economic disturbance every 5 ½ years despite the fact that the Federal Reserve was created and sold to the American public with the concept of engineering stability. The facts and history however prove otherwise. As Edmund Burke stated over two hundred years ago, “For those who don’t know history are destined to repeat it”. The bursting of the asset and debt bubble, artificially inflated by actions of central bankers, will be of no surprise for those with knowledge of history.
Today the Federal Reserve, through their massive manipulation of interest rates and reckless money printing in the form of various stimulus packages has created an enormous asset bubble most notably in bond and equity prices. The Federal Reserve and other world central bankers have artificially reduced interest rates to levitate asset prices in an effort to bail out their member bankers; all in the name of saving the financial system. The irony of course is that the saviors are indeed the culprits that created the need for government interference with the free markets; a cycle that has been repeated continuously but perhaps coming to a dangerous conclusion.
The Goals of Quantitative Easing (QE):
The goals of Quantitative Easing, from the perspective of a central planner, are to repair economic conditions by making the financial system more solvent. Slashing of interest rates to near zero has repaired the toxic assets held by banks. However, this has failed to promote sustainable economic recovery simply because the banks have not reciprocated by lending their assets (new loans). To be certain, this monetary phenomenon is experimental and there are no known successful exit strategies.
To carry out QE, central banks create money by buying securities, such as government bonds or mortgage backed securities (MBS’s) from banks with electronic cash created with a mere “push of a button”. This money printing, or new money, swells the size of the bank reserves in the economy by the quantity of the assets purchased, hence “quantitative easing”. The effect, similar to ZIRP (Zero Interest Rate Policy), is expected to stimulate the economy by encouraging banks to make more loans to qualified creditors.
The theory extends that the banks will take the freshly printed electronic money and buy assets (loan creation) to replace the ones that they have sold to the central bank. The fear of central planners (Federal Reserve and other central banks) is that deflation spirals uncontrollably turning into an economic tantrum with low (or negative) productivity, high unemployment and decreasing asset prices thus threatening existing loans (assets) of member banks.
The deflation cycle is a vicious cycle in the mind of monetarists which can implode a financial system and should be averted at all costs. The significantly unknown variable in the present monetary experiment is what the costs are and when the piper will need to be repaid.
The concerns of QE are numerous but most center around the facts that the flood of cash has encouraged reckless financial behavior and has directed a torrent of money to emerging economies that are incapable of managing the cash. Two profoundly polarized views also prevail as to the expected outcome of QE, they are:
| 1 | The reversing of the asset binge (over $3 trillion) by the Fed, as they sell the assets accumulated, will result in a soaring of interest rates and a choking off of economic activity thus creating a severe recession. | ||
| 2 | The incapacity of the central bankers to keep inflation in check if the money printing actually produces what they hope for, more rapid circulation of the money. The feared results of this camp allege a high, if not a super inflationary cycle combined with economic stagnation. | ||
| Other peripheral goals of this monetary experiment, although unstated by central bankers, are: | |||
| 3 | To create an illusion of wealth through the levitation of asset prices and thus by default higher stock market prices. The continuous echoing of equity indexes achieving new all-time highs is meant to produce euphoric sentiments to the masses even though only a small percentage actually have the means to participate. | ||
| 4 | To divert the attention from the lack of jobs and the historic lows of job participation. | ||
| 5 | To avoid the awareness from the repressive economic and structural inefficiencies perpetuated by a “do-nothing” Congress. | ||
| 6 | Hiding the massive unfunded legacy debt from numerous government social programs which now include more than 50% of all Americans. | ||
| 7 | Disregarding, by “kicking the can down the road”, that our insurmountable national debt burden inflicted upon the American public is not a current concern. | ||
| 8 | The funding of our national debt is manageable, providing the interest on the debt remains less than revenue received. This manipulation of interest rates perpetuates the illusion of managed finances but also threatens the status of the American dollar as the world’s reserve currency. | ||
The effects of Quantitative Easing (QE):
There are many significant effects of QE. To be fair, some have produced the desired objectives of the central planners. To be critical, they have encouraged reckless behavior and will result in undesired consequences. Manipulation, and by extension any government intervention of free markets, will always result in corrective adjustments with oftentimes the pendulum swinging wildly and much further in the opposite direction to compensate for the malfeasance so induced.
Some of the most significant desired effects of QE have been:
| 1 | Member bank balance sheets have been repaired due to the artificial levitation of asset prices. | ||
| 2 | Public sentiment and optimism as measured by investor confidence has approached post-recession highs. See Graph below | ||
| 3 | Large multi-national corporations have been able to float loans at very low interest rates for extended periods enabling them to arbitrage the repurchase of their shares thus radically improving valuation metrics (PE’s, EPS, Book value, etc.). | ||
| 4 | As an interest arbitrage, induced the most robust issuance of M&A activity in stock market history allowing big business to buy their competition at a net purchase credit. This phenomenon has buoyed both stock index averages and investor sentiment to all-time highs. | ||
| 5 | Created an ever wider abyss in the wealth ownership of America. This “desired effect” has concentrated and centralized power allowing the government, by virtue of the central planners, to systemically shift risk to the taxpayer and reward the power brokers thus allowing their control to perpetuate and even grow during periods of inevitable collapse. | ||
Some of the most undesired or unintended effects are:
| • | The systematic punishment of savers. | ||
| • | A massive manipulation of the yield curve thus corrupting all market valuation models with artificially low capitalization rates and risk distortions with a distribution skew tilted dangerously positive. See Graph below | ||
| • | The pervasive creation of an American cast system where the upper 1% receive more of the wealth while the middle/lower classes receive a pronounced tax in the form of inflated asset prices, price of goods inflation especially in that what is used most (food and energy) and the inheritance of a massive debt that will enslave the young into servitude to repay it at progressively higher interest rates. | ||
| • | The eventual and persistent reduction of the middle classes’ standard of living as the cost of goods will rise as we are a net import nation. | ||
| • | More jobs will be exported to regions with lower capital costs of labor. | ||
| • | Fewer high paying jobs will be created from the suppression of technology due to the lack of access for financing. | ||
And most significantly:
| • | Enabling Congress to ignore the debt bubble. | ||
| • | The chasing of yield from risk adverse to risk on. | ||
| • | The chasing of yield from the largest demographic of wealth, the retiring baby-boomers, at the worst time in their lives and perhaps during the riskiest of market conditions. | ||
| • | Unfettered complacency as markets levitates upwards without a pullback. | ||
| • | The largest NYSE margin debt in history. See Graph below | ||
| • | The unknown and unregulated leveraged derivative usage by systemically important banks and hedge funds due to ZIRP extended to the distant future with the knowledge that the Fed has their backside covered. | ||
| • | The further centralization of risk from the 2007-09 collapse setting the stage for a dramatic systemic failure. | ||
Unwinding QE and the reduction of the Fed’s balance sheet:
As mentioned earlier, there are two dramatic and diametrically opposing views on what the likely outcomes of the Fed and other central bankers will be by removing the printing presses and monetary stimuli of quantitative easing. One thing remains certain throughout the history of monetarism; it’s never before been attempted because it’s never before been done on such a scale, both domestically and internationally.
The Fed maintains it has the tools to systematically unwind their massive asset accumulations; perhaps they do but there are nearly always unintended consequences of even the most benign reversals of historic magnitudes of government manipulation. As the pendulum swings from risk-on to normalization, risk-off may occur from several independent or concurrent factors. They are:
| 1 | The tools to normalize are inept, inert or ineffective. | ||
| 2 | The Fed loses control of the yield curve as global market forces drives short-term rates significantly higher thus flattening or reversing the yield curve. | ||
| 3 | The dollar loses its reserve status as the risk of holding dollars is perceived to be, or actually is, much higher than being paid to own them. A disintermediation of dollar denominated assets causing an avalanche of deleveraging dollar based carry trades. | ||
| 4 | Inflation tailwinds turn pervasive. The thought of higher inflation further ahead rapidly spreads throughout the pricing of raw commodities and raw materials. The Fed loses control of psychology and is forced to abandon benign rhetoric with dramatic increases of Fed Fund rates. | ||
| 5 | Leveraged debt and bailout debts collapse worldwide creating a massive deleveraging spiral of deflation. | ||
Finally, since the Federal Reserve was introduced in the dark of the night just days before Christmas in a secluded hideaway on Georgia’s Jekyll Island, this is the first time that no one at the Fed, no one at the Treasury or no one on the President’s Economic Advisory team has had any market experience. They are all academics working in a theoretical laboratory conducting a radical experiment with a hypothesis untested in the real world. What could possibly go wrong?
Where are we now?
To the applause of many, to the chagrin of few we are:
| 1 | At all-time highs in most equity indexes in the major western developed economies. | ||
| 2 | At or near all-time lows in implied market volatilities as measured by volatility indexes. | ||
| 3 | Conversely, at or near all-time highs in complacency and investor optimism as measured by numerous sentiment barometers. | ||
| 4 | All-time lows in yields of junk bonds and credit spreads between Spain, Italy, Portugal and corporates vs. U.S. Treasuries. | ||
| 5 | A most prominent skew shift of equity options lowering the implied probability of negative tail risk. | ||
| 6 | Investor chasing yield to the abstract of normal risk aversions. | ||
| a | Purchasing and shifting allocation towards equities on a global basis as they can’t get paid for owning high quality debt. | ||
| b | Increasing duration risk by going further out the curve to acquire instruments that pay higher yields. | ||
| c | Reducing the quality of debt instruments in a reckless thirst for yield at any cost as the risks of ownership is overwhelmed by their desire to attain incrementally higher yields. | ||
| d | The selling of put premiums closer to current prices (at the money vs. out of the money) and further out the expiration curve (front month or week expiration to three months out or leaps) to achieve desired yields due to the shifting of the put skew and the reduction of implied volatilities. | ||
| e | Acquiring high dividend paying securities without the presence of mind that these issues significant stock appreciation has come with a class of investors chasing yield. This dominant allocation class has produced ever lower dividend yields from stock appreciation with higher stock valuations and significantly higher risks of ownership of over-valued securities due to momentum versus value investing. | ||
All of the above risk factors are concurrent to substantial domestic and geopolitical risks that in ordinary times would suppress even the most enthusiastic risk arbitragers. Some of these potential concerns and thus reasons for investors to remain cautious are:
| 1 | The unknown outcome and effects of Obamacare. | ||
| 2 | Geopolitical tensions prevailing in Crimea, Iraq, Syria, Iran, Israel, the countries of the Arab spring, the potential of an American autumn. | ||
| 3 | The numerous administration scandals left unresolved that could affect voting outcomes in the mid-term elections and general psychology of the American populace. They are: | ||
| a | Benghazi tragedy | ||
| b | The Veterans Administration mismanagement | ||
| c | The IRS scandal | ||
| d | Immigration/health risks. | ||
| e | The radical increase in Executive Orders. | ||
With all the stated risks the markets are at all-time highs; enthusiasm and optimism as measured by market participants are brushing euphoric levels; complacency to benign market conditions has trumped any fear that changes may even occur; and the chasing of yield has migrated even the most risk adverse investor into handsomely absorbing more risk with the absence of planning that outcomes may not go as perceived. What could go wrong? To the hopes and plans of many, maybe nothing will go wrong but we do not agree.
There are some positives
With everything said above and as a counter argument, there exist some very favorable conditions to support an ongoing (albeit slow) economic recovery once rates normalize and destructive financial leverage is effectively parsed out of the system. The markets do have a foundation in place to foster sustainable, if not dramatic, growth into the future. There are, however, structural improvements that need to be met in an effort to perpetuate the goal of meaningful and sustainable economic conditions.
Currently, corporate America has never been in better financial condition with respect to their balance sheets. New technology with the capability of transforming our culture and our economy is in place, a new focus on the optimization of energy is being discussed, innovative medical devices and procedures as well as technological breakthroughs in the fields of electronics, science and manufacturing await the deployment of capital and proper market-based financing. The private sector has never been stacked with more potential, yet arguably has never been more stifled with bureaucratic obstruction.
There currently exists several trillion dollars in European banks trapped from repatriation to the U.S. simply due to avoidance of punitive taxation. Corporate governance compels the status quo; keeping profits on international operations outside of the U.S. thus keeping innovation and jobs offshore.
We as a country and an economy desperately need new and high paying jobs, financially sound social protections for the indigent and aging demographic and a new focus on competitive vibrancy of our youth, perhaps our most important asset. We also need to release the stacked potential energy and tackle government interference and waste that is prevalent in the political and financial arenas. With all of this said, if real jobs begin to be created then real economic growth can be sustained and markets will rise in a more normalized manner.
Current Trading Strategy
Extremely low volatility and overbought conditions have returned to the financial markets. As such, we have begun to step up the level of trading (positioning) and risk (position size) proportionate to our confidence that our trading models will respond properly. We have a large trade (short position) on the market and are monitoring it full time. We are currently net short with several positions. The markets are moving in both directions, however they exhibit an unrealistic upward bias and we feel confident in our position as the markets normalize. With the markets fluctuating hourly, we have been trading around the core net short position and repositioning for a reversal that is long overdue.
The market’s overbought condition and investor complacency is significant as we enter the middle of the summer months especially after the frequently forecasted seasonal event “sell-in-May-and-go-away” did not come to fruition. We feel the correction has been delayed and that the summer months could still see a corrective period through late August when equities typically find a bottom, consolidate and prepare for a move higher in the fall months. With all of the historical research we follow combined with the headwinds that the markets are still facing (Fed tapering, reduced growth forecasts and potential geopolitical events), we have repositioned our portfolios to protect and prepare for a corrective move.
When the seasonal period runs its course and/or the markets tell us that they want to move higher based on our research, we will remove the hedge and begin the process of getting back into the markets and get fully invested. Until then we remain diligent in our research and will continually monitor the markets and report back as data become available.