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Saturday, February 5, 2011
by JEFF GREENBLATT
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The theme of last week was divergence. Relationships that we’ve seen hold water for months if not years have stretched the rubber band, almost to the breaking point. We have an important change developing in gold and the Greenback. You could’ve set the inverse relationship between the precious and the US Dollar to your Bulova, it was that precise. Within the metals themselves, we’ve seen a divergence between Copper and Palladium. But perhaps no where was it more prevalent than on Friday with the SOX/BTK and the BKX.
Finally, it was the NDX that did not confirm a new high in the Dow. What that means is a correction has started. What that means is I have some good news and some bad news.
I know, I prefer bad news first as well. If you are following inflation, one would think the best hedge against it is the precious metals. Well, that’s not working right now. So if gold is not working, that must mean deflation is waking up. With a lower Dollar, we don’t have deflation working either. I know that Corn is still through the roof and we have a CRB at relative new highs. But Copper is not confirming.
So if the Dollar is dropping and the Gold charts getting absolutely creamed, something isn’t adding up. I get concerned anytime I see something new develop. Everything you’ll see in the headlines later this year as economic fact first materialized on a chart. So by the time the media and economic think tanks get around to it, the new direction will entrenched. So let’s talk about it while it’s in the infancy stage. The fact that Gold and the Greenback are going the same direction means one of two things. Either the US Dollar or the precious metals are in a larger degree sideways pattern and it just so happens they are both going the same way for a short spell; or the Dollar is trying to tell us something really serious. The fact of the matter is the Dollar never gave us even a truncated C wave up in its move off the November low. It appears we are headed for a retest of that low and now the best case scenario is a larger degree trading range above the November low and below the December high. Right now the 38% retracement, 3rd rail of deflation up at the 90 handle is light years away. More likely is a breakdown that could take us to a climax this summer as the chart squares out at 121 months off the 121 bull market top from a decade ago. If that were to happen, we could end up with a test of the bottom of the long term pitchfork channel I’ve shown you from time to time. We are not in danger of that yet, but prices right now are in the process of a major failure at the long term median line.
We’ve discussed in this space last year what would happen if the Dollar were to breakdown. This time, I think we would be looking more to hyperinflation than inflation. Think about it, this is a feast or famine type of market. It does not appear to give us middle ground. Truly the best thing that could happen is the Greenback holding the lows as the economy continues to recover. We certainly do not need any new crisis to worry about. I don’t think the Fed can handle it. One thing is for sure, the Dollar will square out this year just like the Gold market did earlier this month.
Getting back to the stock market, the reason tech is pulling back is because the 2 most important components of technology hit key points in their development. The SOX hit an important intermediate term time window off the 2006 high and the BTK hit an important Gann square of 9 level off its 2002 bottom. There is every chance we can now have a repeat of what happened last January. You’ll remember that tech pulled back while the BKX stayed even. What I told you at that time was as long as the banks didn’t participate to the downside, the market would eventually recover. At that time, most people were looking for a return to the bad old days of 2008. While we did suffer a serious shake of the trees into the middle of the year, markets recovered as some important Gann levels fired off in August, one of which we will discuss in February at the New York Traders Expo in my price and time breakout session.
What is most interesting about last week is the fact banks started to participate in the move off the high but held the line on Friday. They literally HELD THE LINE. It is the banks holding the line which gives one hope we are not going to see the worst case scenario in the Greenback. IF the currency goes over the cliff I don’t see how it would be possible for banks stocks to go higher. But sometimes storms start slowly and develop into monsters. A hurricane was once a tropical depression. But you can usually tell if conditions for the perfect storm are setting up. We have a couple of elements in place but an incomplete picture. I’ll tell you the same thing I did 12 months ago. Nothing seriously bad happens to this market unless banks are leading to the downside.
There’s one other problem we haven’t discussed. It’s the bond market which has consolidated sideways for a whole month. At this stage of the game, the longer it consolidates, the greater the opportunity it’s going to have to drop in price and it should test the far end of a downward sloping pitchfork line in exactly a week. That brings up the state visit of the Chinese last week. Sentiment was interesting to say the least as our media and Congress maintained a high level of hostility pointed at the Chinese President. It seems we are having a hard time understanding our new role as debtor to the developing new superpower of the world. We have a society open to debate, that’s where our strength as a democracy comes from. However, when we don’t show a united front to our largest competitor that can’t be viewed as a good thing. The way it looks to me right now, if the Chinese or the Treasury doesn’t start buying our bonds pretty soon that is another component that will add to the storm.
With the divergences the way they are, we could be all over the map this week. [..]Click charts to enlarge
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by Cullen Roche
If I were a benevolent dictator, I would strip the Fed of its obligation to worry about the economy and ask it to limit its meddling to attempting to manage inﬂation. Better yet, I would limit its activities to making sure that the economy had a suitable amount of liquidity to function normally. Further, I would force it to swear off manipulating asset prices through artiﬁcially low rates and asymmetric promises of help in tough times – the Greenspan/Bernanke put. It would be a better, simpler, and less dangerous world, although one much less exciting for us students of bubbles. Only by hammering away at its giant past mistakes as well as its dangerous current policy can we hope to generate enough awareness by 2014: Bernanke’s next scheduled reappointment hearing.1) Long-term data suggests that higher debt levels are not correlated with higher GDP growth rates.
2) Therefore, lowering rates to encourage more debt is useless at the second derivative level.
3) Lower rates, however, certainly do encourage speculation in markets and produce higher-priced and therefore less rewarding investments, which tilt markets toward the speculative end. Sustained higher prices mislead consumers and budgets alike.
4) Our new Presidential Cycle data also shows no measurable economic beneﬁ ts in Year 3, yet point to a striking market and speculative stock effect. This effect goes back to FDR, and is felt all around the world.
5) It seems certain that the Fed is aware that low rates and moral hazard encourage higher asset prices and increased speculation, and that higher asset prices have a beneﬁcial short-term impact on the economy, mainly through the wealth effect. It is also probable that the Fed knows that the other direct effects of monetary policy on the economy are negligible.
6) It seems certain that the Fed uses this type of stimulus to help the recovery from even mild recessions, which might be healthier in the long-term for the economy to accept.
7) The Fed, both now and under Greenspan, expressed no concern with the later stages of investment bubbles. This sets up a much-increased probability of bubbles forming and breaking, always dangerous events. Even as much of the rest of the world expresses concern with asset bubbles, Bernanke expresses none. (Yellen to the rescue?)
8 ) The economic stimulus of higher asset prices, mild in the case of stocks and intense in the case of houses, is in any case all given back with interest as bubbles break and even overcorrect, causing intense ﬁnancial and economic pain.
9) Persistently over-stimulated asset prices seduce states, municipalities, endowments, and pension funds into assuming unrealistic return assumptions, which can and have caused ﬁ nancial crises as asset prices revert back to replacement cost or below.
10) Artiﬁcially high asset prices also encourage misallocation of resources, as epitomized in the dotcom and ﬁber optic cable booms of 1999, and the overbuilding of houses from 2005 through 2007.
11) Housing is much more dangerous to mess with than stocks, as houses are more broadly owned, more easily borrowed against, and seen as a more stable asset. Consequently, the wealth effect is greater.
12) More importantly, house prices, unlike equities, have a direct effect on the economy by stimulating overbuilding. By 2007, overbuilding employed about 1 million additional, mostly lightly skilled, people,
not counting the associated stimulus from housing-related purchases.
13) This increment of employment probably masked a structural increase in unemployment between 2002 and 2007, which was likely caused by global trade developments. With the housing bust, construction fell below normal and revealed this large increment in structural unemployment. Since these particular jobs may not come back, even in 10 years, this problem may call for retraining or special incentives.
14) Housing busts also help to partly freeze the movement of labor; people are reluctant to move if they have negative house equity. The lesson here is: Do not mess with housing!
15) Lower rates always transfer wealth from retirees (debt owners) to corporations (debt for expansion,
theoretically) and the ﬁ nancial industry. This time, there are more retirees and the pain is greater, and corporations are notably avoiding capital spending and, therefore, the beneﬁ ts are reduced. It is likely that there is no net beneﬁ t to artiﬁ cially low rates.
16) Quantitative easing is likely to turn out to be an even more desperate maneuver than the typical low rate policy. Importantly, by increasing inﬂ ation fears, this easing has sent the dollar down and commodity prices up.
17) Weakening the dollar and being seen as certain to do that increases the chances of currency friction, which could spiral out of control.
18) In almost every respect, adhering to a policy of low rates, employing quantitative easing, deliberately stimulating asset prices, ignoring the consequences of bubbles breaking, and displaying a complete refusal to learn from experience has left Fed policy as a large net negative to the production of a healthy, stable economy with strong employment.The saddest truth about the Fed’s system is that there can be, almost by deﬁ nition, no long-term advantage from hiking the stock market, for, as we have always known and were so brutally reminded recently, bubbles break and the market snaps back to true value or replacement cost. Given the mysteries of momentum and professional investing, when coming down from a great height, markets are likely to develop such force that they overcorrect. Thus, all of the beneﬁcial effects to the real economy
caused by rising stock or house prices will be repaid with interest. And this will happen at a time of maximum vulnerability, like some version of Murphy’s Law. What a pact with the devil! (Or is it between devils?) [..]
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I trades di Survivor System del 4 February. I risultati real-time sono a disposizione al seguente link: http://www.box.net/shared/5vajnzc4cp
Trades of Survivor System on 4 February. Real-time results are available at the following link: http://www.box.net/shared/5vajnzc4cp
Trades of Survivor System on 4 February. Real-time results are available at the following link: http://www.box.net/shared/5vajnzc4cp
By Chanyaporn Chanjaroen
(Bloomberg) -- Rice, the staple food of more than three billion people, may as much as triple in 18 months as flooding in exporters including Thailand tightens supplies and demand climbs, according to Duxton Asset Management Pte.
“Rice will blow out the stocks,” said Ed Peter, chief executive officer, who co-founded the company last year with Managing Director Desmond Sheehy. Both worked at Deutsche Asset Management and the Deutsche Bank AG unit owns 19.9 percent of Duxton, while Peter, Sheehy and staff own the rest. Duxton, based in Singapore, invests in farmland, Asian stocks and wine.
Peter’s forecast, in an interview on Nov. 29, would put rice at more than the peak during the 2008 food crisis, which triggered social unrest in poorer states. Wheat and corn also surged that year, while record oil prices boosted fertilizer costs. Kiattisak Kanlayasirivat at Novel Commodities SA, which trades rice, said farmers can replant quickly as floods recede.
“A price increase of 10 percent to 20 percent would be considered quite a lot, not to mention double or triple,” said Kiattisak, a director at Novel Commodities’s Thai office, which handles about 1.5 million metric tons of rice a year.
Thai 100-percent grade-B white export rice, the Asian benchmark, peaked at $1,038 per ton in May 2008. The grain was at $551 last week, up 15 percent since the end of June, according to the Thai Rice Exporters Association. “Prices will triple over the next 18 months,” Peter said in the interview.
Duxton oversees about $600 million, allocating 50 percent to farmland in Australia, Argentina, Zambia and Tanzania and about 45 percent to Vietnamese shares. Peter had headed Deutsche Asset Management for Asia Pacific, Middle East and North Africa, while Sheehy was in charge of that unit’s complex-asset team, which focuses on non-traditional investments including farms.
The most severe floods in five decades in Thailand, the top exporter, may trigger a 7 percent fall in rough-rice production, which accounts for 70 percent of its total output, the Agriculture and Cooperative Ministry has said. Crops in Vietnam and Pakistan have also been hurt by severe weather, while a typhoon cut harvests in the Philippines, the biggest importer.
Rice inventories held by the world’s five biggest exporters will likely decline next year, tightening supply, Concepcion Calpe, senior economist at the Food & Agriculture Organization, said in October. Prices were “unlikely to fall,” Calpe said.
Global production will be 697.9 million tons, 6.5 million tons smaller than previously estimated, as crops around Asia “deteriorated,” the FAO said in a report yesterday. That’s the third forecast cut since April.
Rough rice on the Chicago Board of Trade gained as much as 1.7 percent to $14.115 per 100 pounds today, extending an advance from the year’s low of $9.55, which was set on June 30. In 2008, the price peaked at $25.07 per 100 pounds.
“Rice is a long-term bet,” Duxton’s Sheehy said. Farm products including rice may outperform metals and fuel over the long term as the global population expands, Sheehy said. [..]
With assistance from Luzi Ann Javier in Singapore and Supunnabul Suwannakij in Bangkok. Editors: Jake Lloyd-Smith, Matt Oakley
To contact the reporter on this story: Chanyaporn Chanjaroen in Singapore at email@example.com
To contact the editor responsible for this story: James Poole at Jpoole4@bloomberg.net
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by Mary Bottari
With a $4.7 trillion dollar bailout under their belts with no harm done to their billion-dollar bonuses, don’t expect Wall Street bankers to be chastened by the 2008 financial crisis. Below we list eight things to watch out for in 2011 that threaten to rock the financial system and undermine any recovery.
1) The Demise of Bank of America
Wikileaks founder Julian Assange is promising to unleash a cache of secret documents from the troubled Bank of America (BofA). BofA is already under the gun, defending itself from multiple lawsuits demanding that the bank buy back billions worth of toxic mortgages it peddled to investors. The firm is also at the heart of robo-signing scandal, having wrongfully kicked many American families to the curb. If Assange has emails showing that Countrywide or BofA knew they were recklessly abandoning underwriting standards and/or peddling toxic dreck to investors, the damage to the firm could be irreparable.
2) Robo-signers Wreaking Havoc
With lawsuits abounding, new types of fraud in the foreclosure process are being uncovered daily, including accounting fraud, fake attorneys, destroyed promissory notes and false notarizations. The crisis not only calls into question the legality of untold foreclosures, it also calls into question the value of trillions of dollars worth of mortgage-backed securities held by banks, pension funds, federal, state and local governments. The only government report on the topic by the feisty Congressional Oversight Panel for the TARP acknowledges that “it is possible that ‘robo-signing’ may have concealed deeper problems in the mortgage market that could potentially threaten financial stability.”
3) MERS Madness
In addition to outright fraud, numerous state Supreme Courts have questioned the legal standing of the Mortgage Electronic Registration or “MERS” system. MERS is listed as the mortgagee for 60% of U.S. mortgages. It is an electronic clearinghouse created by industry to bypass the property registration system developed by our forefathers in precolonial days to ensure that the King could not easily rob the subjects of their land. Wall Street turned to MERS to speed securitizations (and now foreclosures), but its legal standing is now in doubt and its shoddy processing of documents has major ramifications for the securitization process as well. Look for a rotten “MERS fix” in the new Congress. Let’s hope it gives consumer advocates some leverage to demand justice for Americans being robbed by the new Kings on Wall Street.
4) Flash Crash Calamity
The “flash crash” of May 2010 rattled the markets and caused a stunning 700 point drop in the Dow within minutes. Regulators think they know what occurred, but they are moving too slowly to put the brakes on hair-trigger trading. Seventy percent of Wall Street trades take place in milliseconds, so it is no surprise that mini-flash crashes are becoming a constant. With traders now gearing up to trade on raw news feeds and Twitter, we can anticipate even more volatility. A small financial transaction tax targeting high-volume, high-speed trades is long overdue. It would throw sand in the roulette wheel and raise much needed revenue for the federal government.
5) Bigger Behemoth Banks
The Federal Reserve is planning to “stress test” the big banks again. The same 19 banks that underwent the first stress tests in 2009 will be tested again, but this time the Fed says it won’t release the results. Why not? Banks with toxic mortgages and mortgage-backed securities on their books and concomitant legal exposure to “put back” law suits are being kept afloat by accounting tricks, TARP and Fed loans. Honest stress tests of still weak financial institutions may well result in sales and buyouts that will further consolidate the already concentrated banking industry and create larger and more unwieldy “too big to fail” behemoths — backed by the guarantee of the American taxpayer.
6) Foreclosure Tsunami
Housing foreclosures may top nine million in 2011 and Goldman Sachs predicts the number will reach 12 million in the next few years. The result will be another significant drop in home prices in 2011 and even more families underwater. Civilized nations see the forcible migration of a city the size of New York as an economic and humanitarian catastrophe, but not the United States. The Obama administration and Congress have callously refused to take meaningful action to aid families facing foreclosure even in the face of widespread predatory lending and rampant foreclosure fraud. The only hope now for millions of American families is aggressive action by the 50 state Attorneys General who are actively investigating foreclosure fraud. Whether they have the guts to wrestle a settlement out of the big banks that slows the foreclosure machine and offers families meaningful options has yet to be seen.
7) Bankrupt Cities and States
Meredith Whitney, a research analyst who correctly predicted the credit crunch, is now warning that over 100 American cities could go bust next year. She anticipates billions worth of municipal bond defaults and warns: “next to housing this is the single most important issue in the U.S. and certainly the biggest threat to the U.S. economy.” States are also in dire straits. The economic shock of mass unemployment on top of years of population decline, deindustrialization and the like have left cities unable to meet their obligations to taxpayers and retirees. With an austerity anschluss underway in the House, it may take a bankruptcy of a major player to prod an appropriate federal response to this looming disaster.
8) Gas Prices above $4.00
The price of energy and other commodities shifted into high gear in late August when the Federal Reserve Chairman decided to stimulate the economy with quantitative easing. Speculators quickly began bidding up the value of asset classes like crude oil, metals and food commodities. In December, the Commodities Futures Trading Commission failed to apply position limits to these commodities, delaying rules that would crack down on speculators and aid consumers who are already seeing big price hikes at the pump. Without swift action, skyrocketing gas prices will further tank an already stalled economy.
As we hope for the best in 2011, let’s prepare for the worst. The big banks are sure to deliver. [..]
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by Michael Pento
On the Kudlow program dated Tuesday February 1st, Donald Luskin gave his version of the textbook definition of inflation as “an overall rise in the overall price level.” But my 1988 edition of the Webster’s Dictionary puts it differently. Their definition of inflation is, “An increase in the volume of money and credit relative to available goods resulting in a substantial and continuing rise in the general price level.”
But let’s put aside technical definitions of inflation for a moment and let me help Donald understand what inflation is in reality. Of course inflation is an increase in money supply and credit; but he should ask himself why that causes prices to rise. The reason is because the U.S. dollar isn’t backed by anything anymore; as Luskin is well aware. Therefore, its value depends upon our collective belief in its current and future purchasing power and the hope that its supply will be restricted. When its supply is increased, users of the currency lose faith in its buying power and prices rise.
In addition, if current holders of the dollar feel that in the very near future the U.S. has no choice but to monetize trillions of dollars of Treasury debt, the currency will falter as well. I like to use the Enron example to make this point. The share value of a corporation represents the strength of the company. Likewise, the strength of a currency represents the strength of a country. What may happen to the U.S. dollar is notdissimilar to what happened to Enron shares. Once the accounting scandal broke, the purchasing power of Enron shares plummeted. But it was not because of an increase in the number of shares outstanding, but because of an epiphany on the part of investors that the company was totally bankrupt. Logically, shares representing a stake in an insolvent company lost all of their value. Likewise, aggregate prices will soar if global investors lose confidence in the dollar due to the realization that the US is incapable of servicing its debt. If there is the mere perception that a massive dilution to the currency is inevitable, it will cause the dollar to tank and aggregate prices to rise. Inflation is also about the confidence in the purchasing power of the currency.
My contention is that the Fed and government have set out on a deliberate strategy of creating inflation in order to monetize most of the $14.1 trillion national debt—that is growing by well over a trillion dollars per annum. So let’s look at some charts that prove the dollar is being diluted and that prices are rising. First is a chart of the monetary base, which consists of physical currency and Fed bank credit.
No doubt here. The supply of high-powered money has exploded.
But it is not only the monetary base that has expanded; take a look at M2, which has grown as well. as well.
Since the recession began in December or 2007 the M2 money supply has increased by over 18%.
Next is the chart of the CRB Index.
The prices of the 19 commodities included in the index clearly show that prices are surging in response to the loss of confidence in the USD.
But there is nothing better to show the value of the dollar than to put up a chart of the monetary metal. Below is a ten year chart of the dollar price of gold. It is self explanatory.
Now let’s throw up some charts of the U.S. dollar vs. a few other fiat currencies.
Here’s a two year chart of the USD vs. the Australian dollar.
Now let’s look at a two year chart of the U.S. dollar vs. the Canadian dollar.
Finally, we’ll look at a two year chart of the U.S. dollar vs. the Japanese Yen.
The above charts depict three important currencies from three different continents all clearly showing the weakness of the USD. Most dollar defenders point to the relative stability of the dollar index. But it is only against the heavily weighted Euro that the U.S. dollar has maintained its purchasing power.
So it’s isn’t at all that gold and commodity prices no longer give accurate inflation signals as Mr. Luskin claims. He stated during our “Kudlow Report” debate in reference to those rising commodity prices that, “…for the last decade or so it just hasn’t worked that way, the canaries [commodity prices] that we’re using in this mine shaft just aren’t functioning right.”
I’m not sure why Donald has decided to stop relying on market prices to determine the rate of inflation and instead is looking at Government and Federal Reserve inflation metrics. That doesn’t seem to be such a wise move. But he isn’t alone. Keynesians, the Obama administration and the Federal Reserve all share his views. But the sad truth is that global U.S. dollar holders are losing faith in the Fed’s 26 months worth of zero percent interest rates and the massive increase in its balance sheet. They are also losing confidence in the ability of the U.S. to service its debt. That’s why the dollar is in the process of losing its world’s reserve currency status and why inflation rates are rising. And will, unfortunately, continue to do so. [..]
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By Jordan Roy-Byrne, CMT, Daily Commodities
Commodities are a very volatile asset class and unlike stocks, high prices will reduce demand while low prices will reduce production and supply. While buying breakouts and momentum in stocks often works well with the right risk controls, buying weakness rather than strength is more advisable in Commodities.
The continuous commodity index (CCI) recently hit an all-time high and has continued to make new highs. The energy and agriculture sectors have been red-hot. Two things concern us in regards to the CCI. First, the market has had a single 8% pullback in the last eight months. Other than that, no weakness for more than a few days at a time. Second, the market is trading well above the 300-day MA. At the top of the chart we show the market’s distance from its 300-day MA.
Also, quite a bit of retail money has suddenly flowed into commodity-related shares. The chart below (from sentimentrader.com) shows the assets in Rydex’ Energy Fund. About two months ago, assets in the fund were less than $50 Million. Now, the total is $152 Million.
We see similar action in Rydex’ Materials Fund. Assets in the fund have tripled in the last six months.
The only aberration is the precious metals sector. We don’t show the chart but assets in that fund declined about 50% since the end of December. Moreover, we recently wrote about how the speculative money in the futures market remains heavily long all commodities (ex Gold & Silver).
We are in a long-term bull market and we believe commodities as an asset class will heat up in the coming years. That being said, commodities are very overbought here and the risk/reward for new longs is unfavorable. We see an intermediate top in the coming weeks or months. We’d advise lightening up on long positions and perhaps using stops to protect profits. This is a volatile asset class and if you exercise patience and use volatility to your advantage, you will likely find a few excellent long opportunities per year. This is not one of the times. [..]
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By John Mauldin, Investors Insight
The Burden of Lower Growth and More Frequent Recessions
We’re optimists by nature. The natural order of the world is growth. Trees tend to grow, and economies do, too. Real economic growth solves most problems and is the best antidote to high deficits, but the problems that we have now won’t be solved by growth. They’re simply too big. Unless we have another Industrial Revolution or another profound technological revolution like electrification in the 1920s or the IT revolution in the 1990s, we will not be able to grow enough to pull ourselves out of the debt hole we’re in.
After the dot-com bust in 2000, the phrase “the muddle through economy” (a term coined by John) best described the U.S. economic situation. The economy would indeed be growing, but the growth would be below the long-term trend (which in the United States is about 3.3 percent) for the rest of the decade. (Indeed, growth for the decade was an anemic 1.9 percent annualized, the weakest decade since the Great Depression. Muddle through, indeed.)
The muddle through economy would be more susceptible to recession. It would be an economy that would move forward burdened with the heavy baggage of old problems while facing the strong headwinds of new challenges. The description of the world was accurate then, and it is even more accurate now. In March 2009, when almost everyone was predicting the apocalypse, it was hard to see how things could improve. The GDP turned around, industrial production has shot up, retail sales have bounced back, and the stock market rebounded strongly. Everything has turned up. However, GDP growth is slowing in the United States as we write in November 2010. Compared with previous recoveries, growth does not look that great, and people don’t feel the recovery. This is unlikely to change.
The muddle through economy is the product of a few major structural breaks in the world’s economies that have important implications for growth, jobs, and when we might see a recession again. The U.S. and most developed economies are currently facing many major headwinds that will mean that going forward, we’ll have slower economic growth, more recessions, and higher unemployment. All of these are hugely important for endgame since they vastly complicate policy making.
Lower growth will make our fiscal choices that much scarier. Importantly, these big changes also mean that governments, pension funds, and even private savers are probably making unreasonably rosy assumptions about how quickly the economy and asset prices will be able to increase in the future. As endgame unfolds, the reality of these big changes will set in.
Three Structural Changes
Investors are good at absorbing short-term information, but they are much less successful at absorbing bigger structural trends and understanding when secular breaks have occurred. Perhaps investors are like the proverbial frogs in the frying pan and do not notice long, slow changes around them. There are three large structural changes that have happened slowly over time that we expect to continue going forward. The U.S. economy will have:
1. Higher volatility
2. Lower trend growth
3. Higher structural levels of unemployment (The United States here is a proxy for many developed countries with similar problems, so much of this chapter applies elsewhere.)
1. Higher Volatility
Before the crash of October 2008, the world was living in “the great moderation,” a phrase coined by Harvard economist James Stock to describe the change in economic variables in the mid-1980s, such as GDP, industrial production, monthly payroll employment, and the unemployment rate, which all began to show a decline in volatility. As Figures 4.1 and 4.2 from the Federal Reserve Bank of Dallas show, the early 1980s in fact constituted a structural break in macroeconomic volatility. The GDP became a lot less volatile. As did employment.
The great moderation was seductive, and government officials, hedge fund managers, bankers, and even journalists believed “this time is different.” Journalists like Gerard Baker of the Times of London wrote in January 2007: Welcome to “the Great Moderation”: Historians will marvel at the stability of our era. Economists are debating the causes of the Great Moderation enthusiastically and, unusually, they are in broad agreement.
Good policy has played a part: central banks have got much better at timing interest rate moves to smooth out the curves of economic progress. But the really important reason tells us much more about the best way to manage economies. It is the liberation of markets and the opening-up of choice that lie at the root of the transformation. The deregulation of financial markets over the Anglo-Saxon world in the 1980s had a damping effect on the fluctuations of the business cycle … The economies that took the most aggressive measures to free their markets reaped the biggest rewards.
In retrospect, this line of thinking looks hopelessly optimistic, even deluded. We do not write this to pick on Gerard Baker, but rather to point out that low volatility breeds complacency and increased risk taking. The greater predictability in economic and financial performance led hedge funds to hold less capital and to be less concerned with the liquidity of their positions.
Those heady days are now over, and we have now entered “the great immoderation.” One can confidently say that 2008 represents a structural break, moving back toward a period of greater volatility. Robert F. Engle, a finance professor at New York University who was the Nobel laureate in economics in 2003, has shown that periods of greatest volatility are predictable. Market sessions with particularly good or bad returns don’t occur randomly but tend to be clustered together. The market’s behavior illustrates this clustering. Volatility follows the credit cycle like night follows day, and periods following credit booms are marked by high volatility, for example, 2000–2003 and 2007–2008.
The period of low volatility of GDP, industrial production, and initial unemployment claims is now over. For a period of more than 20 years, excluding the brief 2001–2002 recession, volatility of real economic data was extremely low, as Figure 4.3 shows. Going forward, higher economic volatility, combined with a secular downtrend in economic growth, will create more frequent recessions. This is likely to lead to more market volatility as well.
You can measure economic volatility in a variety of ways. Our preferred way is on a forward-looking basis. We have seen the highest volatility in the last 40 years across leading indicators, as Figure 4.4 shows. These typically lead the economic cycle. This only means one thing, higher volatility going forward.
For far too long, volatility was low and bred investor complacency. Going forward, we can expect a lot more economic and market volatility. We have had a strong cyclical upturn, but we will continue to face major structural headwinds. This means more frequent recessions and resultant higher volatility.
If we look at Japan following the Nikkei bust in 1989, we can see that volatility increased. Note that before the peak in the Nikkei, volatility had been largely subdued, with periodic movements corresponding to increases in the level of the market. As Figure 4.5 shows, following the crash, stock market volatility increased markedly, and volatility to the downside became far more prevalent.
Equity volatility follows the credit cycle. If you push commercial and industrial (C&I) loans forward two years, it predicts increases in the Market Volatility Index (VIX) almost down to the month. We should expect heightened episodes of volatility for the next two years at a minimum. (See Figure 4.6.)
Fixed-income volatility also follows the credit cycle with a two-year lag. Figure 4.7 shows how the Fed Funds rate lags Merrill Lynch’s MOVE Index, which is a measure of fixed-income volatility, by three years.
Another very good reason to believe we’ll continue to have high volatility even after we recover from the hangover of the credit binge is that the world is now much more integrated. This is a paradox and may seem hard to believe, but increased globalization actually makes the world more volatile through extended supply chains! (See Figure 4.8.)
Production in Japan, Germany, Korea, and Taiwan fell far more during the 2007–2009 recession than U.S. production fell even during the Great Depression. Not only was the downturn steeper than during the Great Depression but also the bounce back was even bigger.
This is truly staggering. If you believed in globalization, supply chain management, and deregulation, you would have thought they would lead to greater moderation, but the opposite happened. This was due to the credit freeze that particularly hit export-oriented economies because trade credit temporarily dried up. It was not about globalization per se.
Why has the world economy been so volatile? One of the main reasons is exports. If you look at exports as a percentage of GDP since the end of the Cold War, you’ll see that in almost all countries around the world, exports have rapidly risen in the last 20 years. In Asia, they have doubled, in India they have tripled, and in the United States they have increased by 50 percent. This makes us all more interconnected, and it means that supply chains become longer and longer.
Longer supply chains have enormous macroeconomic implications. As the Economic Cycle Research Institute points out, we’re now experiencing the bullwhip effect, “where relatively mild fluctuations in end demand are dramatically amplified up the supply chain, just as a flick of the wrist sends the tip of a bullwhip flying in a great arc.” The bullwhip effect makes greater export dependence very dangerous to supplier countries, which only contributes to cyclical volatility. This is easily seen in Figure 4.9. That is why Asian countries had some of the largest downturns and steepest upturns in the Great Recession and the following recovery.
2. Lower Trend Growth
We are also seeing a secular decline over the last four cycles in trend growth across GDP, personal income, industrial production, and employment. You can see that in Figure 4.10.
Another view of declining trend growth is the decline in nominal GDP. Figure 4.11 shows that the 12-quarter rolling average has been on a steady decline for the last two decades.
A combination of lower trend growth and higher volatility means more frequent recessions. Put another way, the closer trend growth is to zero and the higher volatility is, the more likely U.S. growth is to frequently dip below zero. Figure 4.12 shows a stylized view of recessions, but as trend growth dips, the economy will fall below zero percent growth more often.
Higher volatility has very important implications for equity and bond investors across asset classes. Indeed, the last three economic expansions were almost 10 years, but in previous decades, they averaged four or five years. From now on, we are apt to see recessions every three to five years. [..]
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