Where's the Boogeyman?  Rising Volatility?

Where's the Boogeyman? Rising Volatility?


With the markets on a roll and volatility still at record lows, my prose may at times appear overly cautious as I assess the markets, but remember that’s my job. Portfolio managers are essentially professional worriers, looking around every corner and under every data point for the hint that a major shift is on its way as our primary job is to protect. These days many of us feel like we are in a CNBC version of a thriller, with the ominous music getting louder and louder as our handsome hero approaches the dimly lit house. When is the boogeyman going to jump out!?

“For as long as I can remember, veteran businessmen and investors – I among them – have been warning about the dangers of irrational stock speculation and hammering away at the theme that stock certificates are deeds of ownership and not betting slips… The professional investor has no choice but to sit by quietly while the mob has its day, until the enthusiasm or panic of the speculators and non-professionals has been spent. He is not impatient, nor is he even in a very great hurry, for he is an investor, not a gambler or a speculator. The seeds of any bust are inherent in any boom that outstrips the pace of whatever solid factors gave it its impetus in the first place. There are no safeguards that can protect the emotional investor from himself.” J Paul Getty (Hat tip to John Hussman for helping us recall this sage sentiment.)

Looking at today’s markets, “Never have investors reached so high in price for so low a return. Never have investors stooped so low for so much risk.” Bill Gross of PIMCO on May 14th, 2013. Ouch!

On May 22nd the markets became exceptionally jittery, the boogeyman soundtrack getting a tad louder.  Concerns over a withdrawal or reduction of the Fed’s bond buying program from Ben Bernanke’s comments before Congress coupled with the minutes of the FOMC added to increasing nerves over the level of data fakery coming out of China, which has turned up the volatility volume considerably.  Keep in mind that if the stock market were to be reflective of the fundamentals and not experiencing a Fed induced bubble, why the tizzy fit at the slightest whisper that the Fed could reduce its bond buying program, a program which has seen the Fed’s balance sheet increase a mind-blowing 40% year-to-date?  Whether this is the beginning of a correction or a temporary blip remains to be seen, but the dramatic swings during the day warrant caution.  Is that the theme from Halloween I hear in the distance?

2013-06-03 NikkeiMay 22nd the Japanese Nikkei fell 7.3%, its biggest drop since the tsunami/nuclear disaster in March 2011.  Before Thursday, the Nikkei has risen 50% this year and 10% in less than two weeks.   Kudos to ZeroHedge for the chart at right which points out how similar the recent run up has been to the boom and following bust in 1987.

After the tumult in Japan, investors quickly jumped out of riskier assets. Spanish and Italian government bonds weakened, as did more-speculative currencies like the South African rand. Havens such as German government bonds and the Swiss franc gained. Gold rose.

Hong Kong’s Hang Seng dipped by 2.5%. Shanghai maintained a moderate fall at just 1.2%.  The following day all the major European markets dropped by over 2%.

2013-06-03 FedBalanceSheet
Bottom LineI doubt the past few rocky few days are the start of the correction we’ve been expecting as the primary drivers of the market run, namely Central Bankers, are still putting pedal to the metal, despite the nerves over yesterday’s FOMC meeting notes, (see charts at right).  I do think that it is likely we will continue to see volatility increase in the coming months before we see any potential significant correction. 

We Aren't Out of the Woods Yet

We Aren't Out of the Woods Yet

The growth of an economy is dependent primarily on just two factors, (1) the quantity and quality of the labor pool and (2) the amount of available investment capital. With the current unemployment rate, clearly the quantity of the labor pool is not a problem. The quality of that pool is a discussion for another time. So what about the amount of available investment capital? The talk in the investment world is about QE2, and unfortunately they aren’t referring to the Cunard ocean liner. QE2 refers to the second round of “Quantitative Easing” by the Federal Reserve, which is a politically savvy way of describing the Fed printing money. (Please see “U.S. Banking System” on this blog for more details.) At its November 3rd meeting, the Fed is expected to announce the launch of QE2. Expectations are for an initial level of $500 billion, with room for upward revisions. Last week Goldman Sachs opined that $4 trillion is quite possible, according to their analysis using the Taylor Rule, which is a measure of inflation, GDP and the impact of Fed rate cuts. This rule has been fairly spot on so far in tracking the Fed’s rate decisions so their analysis warrants attention.
When credit contracts, the economy is contracting, when credit expands, the economy is expanding. The Fed is hoping that by increasing banks’ ability to lend, it can jump start the economy. Mr. Bernanke is a bit like 49er and Charger fans in the 4th quarter. This time it will be different! Anyone who saw the 49er and Charger games on October 24th understands our pain. For credit to expand, borrowers need to want to borrow, and banks need to want to lend. According to an August 23, 2010 article in the Wall Street Journal, non-financial companies in the S&P 500 are sitting on a record $2 trillion in cash.  Doesn’t sound like the problem is that businesses are lacking the funds necessary to expand, now does it? So what about existing bank reserves? This chart, using data from the Federal Reserve, shows that bank reserves are at record highs, so that seems unlikely as well.

Both corporate and household lending rates are at historical lows. So the lack of borrowing can’t be because the interest rates are too high, yet the Fed is intent on lowering these already historically low rates. Be wary as history shows that excessively low interest rates inevitably lead to asset bubbles as those who have cash desperately seek some place to generate returns.

Household income is showing slight improvements, savings is trending up while spending is trending down. This doesn’t seem to indicate a desire by households to borrow. (The following chart is derived from Data from the U.S. Department of Commerce, Bureau of Labor Statistics)

What is QE2 likely to accomplish? The Fed will once again create money out of thin air and most likely use it to purchase Treasury bonds to send long-term interest rates even lower. If this works, bond yields should fall, the dollar will fall and stocks and commodities should rise. A good deal of this has already been “baked in” to the market, meaning since the markets are convinced Bernanke is going for round two, they’ve already adjusted as if it were a done deal. Shorting the dollar has become a favorite pastime of many market professionals, so we could even see a rally in the dollar if QE2 doesn’t come on as strong initially as some have predicted. In the short run, things could go in a variety of directions, all of which are becoming increasingly difficult to anticipate. In the long run, inflation and potentially high inflation is a real possibility with all this expansion of bank reserves. I recently attended a meeting of the Mont Pelerin Society, (an international organization composed of economists, Nobel Prize winners, philosophers, historians, and business leaders) in Sydney, Australia. A topic of discussion at this conference was the possible destructive consequence of the developed nations’ seeming race towards the bottom through currency debasement. The investing world is becoming a more challenging jungle to navigate as the actions of individuals in governments around the world have increasing impact on the global economy, rather than market fundamentals. This past weekend the finance ministers of the G20 countries met in Korea to discuss “re-balancing the world.” When 20 fallible human bureaucrats, with imperfect knowledge under great political pressure try to impact the world, it usually doesn’t turn out well. For investors a defensive position that does not rely on strong GDP growth or economic stability is in our opinion, a wise choice.

Now how about those banks that Bernanke wants to nudge along with increased reserves? This past week PIMCO, Black Rock, Freddie Mac, the New York Fed, and Neuberger Berman Europe, LTD., collectively sued Countrywide for not putting back bad mortgages to its parent, Bank of America. This is surely the first in a series of suits aimed at getting control of the mortgage-backed security portfolios. Then there is the testimony from Mr. Richard Bowen, former chief underwriter with CitiMortgage given in April to the Financial Crisis Inquiry Commission Hearing on Subprime Lending and Securitization and Government Sponsored Enterprises, (why are government activities always so wordy!?). He stated that, “In mid-2006 I discovered that over 60% of these mortgages purchased and sold were defective. Because Citi had given reps and warrants to the investors that the mortgages were not defective, the investors could force Citi to repurchase many billions of dollars of these defective assets….We continued to purchase and sell to investors even larger volumes of mortgages through 2007. And defective mortgages increased during 2007 to over 80% of production.” Does anyone really believe that Citibank was the only one up to this mischief, and we use the term mischief generously! We could see substantial level of lawsuits launched against these institutions, which would further serve to undermine an already weakened economy.

As for the banking sectors’ recent financial performance, there were mixed results with Bank of America posting a $7.3 billion loss in the third quarter and Goldman Sachs profit down 40% and Morgan Stanley’s profits fell 67%. Regional banks have shown some positive results, but smaller banks continue to close. There have been more than 300 bank failures since the recession began with 132 this year alone. There is considerable opportunity in the banking sector for mergers and acquisitions and all this tumult provides some opportunities, but again, defensive posturing is the name of the game for those investors who want to be successful in the long run.

Consumer confidence, which improved to August to 53.2, dropped to 48.5 in September. According to Lynn Franco, Directors of the Conference Board Consumer Research Center: “September’s pull-back in confidence was due to less favorable business and labor market conditions, coupled with a more pessimistic short-term outlook. Overall, consumers’ confidence in the state of the economy remains quite grim. And, with so few expecting conditions to improve in the near term, the pace of economic growth is not likely to pick up on the coming months.”

Is there any hope? I attended an investment conference in July where Niels Veldhuis of the Fraser Institute discussed the Canadian success story. Canada came through the recent financial crisis with no major bank failures, stronger GDP than the U.S. and the Canadian dollar is now selling at close to par against the USD. It has one of the lowest debt to GDP ratios among industrial nations and one of the fastest economic growth rates since adopting fiscal reforms in 1995. The Heritage Foundation/WSJ Economic Freedom Index ranks Canada No. 7, the U.S. is now at No. 11.

In 1995 Canada faced a crisis similar to the one facing the U.S. today with a downward spiraling currency, huge deficits, a tripling of the national debt since 1965, ballooning entitlements, government spending approaching 53% of GDP, and rampant inflation. The government cut spending by 10% over two years, laid off 60,000 federal workers over three years and eliminated the deficit in two years. For the next 11 years they ran a surplus, cut the national debt in half and reduced the size of government from 53% of GDP to today’s 39% all without raising taxes.

There is hope, but it will require discipline and an end to kick the can down the road solutions. We are positioning our clients to be able to take advantage of and be protected from the inevitable volatility as sovereign nations take actions that are impossible to predict in addressing their economic and financial problems. We are also cognizant of and prepared for impending inflation, that while unlikely in the short-term is highly likely in the longer-term and will be devastating for those who are not prepared.


Gross Domestic Product (GDP): GDP dropped to 1.7% annualized rate in Q2 from 3.7% in Q1 and 5.0% in Q4 of 2009. GDP is expected to remain at 1.5% in Q3 and drop to 1.2% in Q4. Traditional buy-and-hold strategies struggle with such dismal growth prospects.

Unemployment continues to be the biggest economic concern and appears to be stagnating. The Bureau of Labor Statistics reported a rate of 9.6% in September with the number of unemployed persons at 14.8 million, essentially unchanged from August. There are currently 1.2 million discouraged workers, defined as persons not currently looking for work because they believe no jobs are available for them, which has increased by a staggering 503,000 over the past year.

Housing: Mortgage rates have dropped nearly 1% in the past year to a historic low of 4.42% for the 30-year, yet existing home sales dropped a record 27% (measured month-over-month) to an all time low, since data tracking began in 1999, of 3.83 million units at an annual rate. If record low rates cannot stimulating housing, pay attention!

Market Volume: CNBC recently reported that currently 90% of all trading volume in the markets is in 5% of the stocks. This means that a very small number of stocks are moving to manipulate the indices, which calls in question the meaning of the trends. In addition, the majority of the trading that is taking place is now generated by high-frequency computers and these programs can enter more orders in one second than a whole trading room of traders can enter in a month. Just one more reason to maintain a defensive portfolio.

The Case for Optimism

A friend of mine pointed out what he considered a rather surprising contradiction between what I write in this blog and my usual cheerful and optimistic demeanor, so I thought I’d share just why I still walk around with a considerable sense of optimism.

To understand why I am in no way surprised by the behavior of most governments in response to the collapse of the financial markets and later the sovereign debt crisis, it is necessary to understand the various schools of economic thought.  If you have taken any economic courses, you were most likely taught just one school as if it were The Truth, when in fact, we are still learning.  I’ve posted in the Investing Aids section a description of these various schools of economic thought.

So why am I optimistic?

The markets are volatile and yet I still sleep well at night.

  • The S&P dropped 3.9% yesterday, which is the biggest drop since April 2009.  It is now 24% below where it was a decade ago, just after the peak of the Internet bubble.  It is just 3% above its close on the first trading day after the Sept. 11th, 2001, terrorism attacks.
  • The S&P 500 is off about 12% from a 19-month high on April 23rd.  A correction is considered a 10% retreat.  The Nasdaq Composite Index, the Dow Jones Industrial Average and S&P500 have now all erased their 2010 advances.


El-Erian of  PIMCO, who runs the world’s biggest bond fund, wrote “This is not a typical retracement,” in an e-mail to Bloomberg News. “We are in uncharted waters on account of several issues, including what is going on in Europe and other important structural regime changes. In economic terms, European developments are unambiguously bad for global growth.”

“It’s difficult trading Treasuries right now because we are trading almost solely on European political risk,” said Donald Ellenberger, who oversees about $6 billion as co-head of government and mortgage-backed securities at Federated Investors in Pittsburgh. “I do think that it’s safe to say that a lot of people have underestimated how far down yields could fall from a problem that started in a relatively tiny country.”

So in other words, it is impossible to tell exactly where we are headed over the short to medium term.  I like the visual presented in the PIMCO May 2010 Secular Outlook, “The world is on a journey to an unstable destination, through unfamiliar territory, on an uneven road and, critically, having already used its spare tire(s).”

What can we expect?

  • We have unsustainable debt at all levels, federal, state and household.  This debt must be paid down in order to have a healthy economy, the term typically used here is deleveraging.  We are a nation with an adjustable-rate mortgage dangerously close to or greater than our home’s worth and an unstable paycheck.  Think of living that way, or perhaps you sadly already are.  It is terrifying and nearly impossible to imagine taking the kind of calculated risks that lead to real wealth creation when living under those conditions.
  • We face frightening demographic transitions with the largest generations across the developed world heading into retirement, creating a shrinking buyer pool, and placing another unsustainable burden on the much smaller, younger generations to pay for the debt left behind and the ever growing government-created entitlement programs.
  • Despite the current climate of low inflation, the remarkable expansion of the monetary base is likely to cause higher inflation eventually.
  • Governments are likely to respond to the pressures they face by raising taxes which is always a headwind to growth.
  • We are facing a great deal more government intervention in the markets which creates instability as the rules of the game will be changed often.  The unpredictable nature of this behavior does not provide the stability markets require for sustained growth.  Business leaders are more likely to hunker down than expand when they are unsure if the new rules that will be put in place will harm or help them.
  • We face a political environment in which wars and terrorist attacks are increasingly likely.


All this leads me to expect increased volatility, meaning more of the markets racing up then down, with increased frequency.  A miracle could occur, governments could somehow get the Goldilocks scenario, but that’s pretty unlikely.

So why am I optimistic?

I look at the world in two ways, first as an investor and second as a citizen.

As an advisor and an investor myself, I am excited because all this volatility provides opportunity.  We’ve watched as the popular theories of investing such as the Efficient Market Hypothesis, Buy and Hold, and standard allocations according to Modern Portfolio Theory did little to help protect and grow portfolios over the past decade, yet most are still implementing those same strategies hoping this time it will be different.  More than ever, investment portfolios need to be positioned to protect from market downturns and even take advantage of them, while still providing upside potential.  A portfolio of this nature will most likely not ride the top of the market wave when things go up, but it will also not experience the gut-wrenching slides either.  This stability is more likely to produce better long-term results.  With a portfolio like this, the market roller coasterride doesn’t threaten personal financial stability, which frees one up to watch it all as a citizen.

As a citizen, I watch it all with a great sense of optimism as the logical conclusion of decades of overspending and over-promising come to their natural conclusion.  Households know that if they spend more than they take in, they have to borrow, which means in future years, more of their income will go to paying interest and paying down their debt than towards consumption.  Governments have behaved for decades as if some magical fairy dust will evaporate their debts as the years pass so that year after year they can spend more than they take in, borrowing more and more, without ever facing the consequences.  We’ve also watched as nations have seen there is a limit to how much taxation and government control can be placed on an economy before it falters.  Continually increasing taxes eventually leads to lower tax receipts and stifles the economy.  Onerous regulatory environments like the one in Greece kills entrepreneurialism, the lifeblood of any economy.

There are two simple lessons nations across the world are facing:

  1.  Don’t spend what you don’t have.
  2. There is a limit to how much taxation and government control an economy can withstand.


I have great optimism because if people everywhere understand this and have the confidence to pressure their governments into behaving responsibly, if people ask every time government promises something, “How will we pay for it?” our economies can once again thrive and hopefully these lessons will not be quickly forgotten.  I watch people across the United States and Europe, asking the tough questions and refusing to accept the obtuse responses that used to suffice.  As my mother always says, “That which does not kill us makes us stronger.”  This will not kill us.