Wednesday, February 11, 2015

Europe's Greek Showdown: The Sum Of All Statist Errors

by David Stockman

The politicians of Europe are plunging into a form of ideological fratricide as they battle over Greece. And “fratricide” is precisely the right descriptor because in this battle there are no white hats or black hits—-just statists.

Accordingly, all the combatants—the German, Greek and other national politicians and the apparatchiks of Brussels and Frankfurt—- are fundamentally on the wrong path, albeit for different reasons. Yet by collectively indulging in the sum of all statist errors they may ultimately do a service. Namely, discredit and destroy the whole bailout state and central bank driven financialization model that threatens political democracy and capitalist prosperity in Europe——and the rest of the world, too.

The most difficult case is that of the German fiscal disciplinarians. Praise be to Angela Merkel and her resolute opposition to Keynesian fiscal profligacy and her stiff-lipped resistance to the relentless demands for “more stimulus”   from the likes Summers, Geithner, Lew, the IMF and the pundits of the FT, among countless others. At least the Germans recognize that if the EU nations are going devote 49% of GDP to state spending, including nearly a quarter of national income to social transfers, as was the case in 2014, then they bloody well can’t borrow it.

Notwithstanding the alleged German led austerity regime, however, that’s exactly what they are doing. Germany has managed to swim against the surging tide of EU public debt, lowering its leverage ratio from 80% to 76% of GDP in the last four years. Yet the overall debt ratio for the EU-19 has continued to soar—meaning that the rest of the EU drifts ever closer to fiscal disaster.

Euro Area Government Debt As % of GDP

quick view chart

Indeed, Germany’s frustration with the rest of the European fiscal sleepwalkers is more than understandable, as is its fanatical resolve not to give an inch of ground to the Greeks. Or as Merkel’s deputy parliamentary leader, Michael Fuchs told Bloomberg,

There is no way out” for Greece from its treaty obligations….. conditions set for Greece by The Troika (EU, ECB, IMF) for bailout funds “have to be fulfilled…. That’s it, very simple.”

This isn’t just teutonic rigidity. It’s actually all about the so-called capital contribution key—-the share of the EU bailout fund that must be covered by each member country in the event of a default.

At dead center of Greece’s $350 billion of debt is $210 billion owed to the Eurozone bailout mechanism. Germany’s share of that is 27% or roughly $57 billion. Yet the prospect of tapping the German taxpayers for some substantial part of that liability in the event of a Greek default is not the main problem—-even as it would mightily catalyze Germany’s incipient anti-EU party.

The real nightmare for Merkel’s government is that the next two largest countries in the capital key are on a fast track toward their own fiscal demise. So what puts a stiff spine into its insistence that Greece fulfill the letter of its MOU obligations is that if either France or Italy is called upon to cover losses, the whole bailout scheme will go up in smoke.

There is not a snowball’s chance that the already faltering governments of either country would survive a capital call from the EU bailout funds. Indeed, the prospect of a partnership with Marine Le Pen and Beppe Grillo is undutedly what was on German Finance minister Schaeuble’s mind when this picture was snapped during his meeting with Varoufakis.

Just consider the delusionary partners Germany has at present—even before any Syriza-style election upheavals. In another of his patented outbursts of truth over the weekend, the Greek finance minister suggested that Italy was next and that it too, will discover “it is impossible to remain inside the straightjacket of austerity.”

That drew an immediate response from Italy’s Economy Minister, Pier Carlo Padoan, who tweeted to the world that Italy’s debt is “solid and sustainable”. 

Is he kidding? Italy’s GDP is dead in the water and has been since 2007. Yet it has continued to run massive budget deficits—about $75 billion this year alone–so its debt to GDP ratio has gone nearly vertical.

Indeed, the very notion that the trend shown below has any resemblance to a “solid and sustainable” fiscal posture is indicative of  the sheer corruption of discourse that has been introduced by the Keynesian commentariat and the policy apparatchiks of the EU, IMF and Washington.

Their specious claim that all is well in Italy rests on the fact  that it has close to a “primary surplus” before interest payments.

So what! The undeniable fact is that Italy is borrowing heavily year after year to pay its interest, and is thereby impaling itself in a debt trap. That is, a situation so hopeless that no imaginable Italian government can stop the fiscal hemorrhage—- owing to the fact that the vast scale of the tax increases and spending cuts that would be necessary to reverse the debt spiral would be too toxic politically to accomplish.

And that’s the crucial point. The Keynesian modelers can always make the debt curve bend downward by assuming that the vigorous application of more of the same poison—deficit finance—can magically cause Italy’s “aggregate demand” and GDP to spring upwards and grow out from under the debt. But Europe’s fiscal crisis is no longer about whiteboard policy options; its about the absolute breakdown of fiscal governance.

Historical Data Chart

To their great credit, the Germans do not believe in magic napkins of either the supply side or Keynesian varieties. Accordingly, the last thing they want to test is the capacity of Italian politicians to come up with even a tiny fraction of the approximate $37 billion of Greek debt they have guaranteed. For avoidance of doubt, here is the post-crisis trajectory of Italy’s real GDP—–a curve which is heading, not surprisingly, in a decidedly southward direction.

Historical Data Chart

Moreover, Germany’s nightmares as to who will ultimately pay the piper most surely do not end with the Five-Star Movement descending on Rome. France’s share of the Greek debt is appximately $42 billion. But like the case of Italy its economy is flatlining, having gained only 1% in real terms since its crisis peak.

Historical Data Chart

The truth is, the French state has been meandering toward economic stasis and fiscal bankruptcy for several decades under governments of the left and right. With the state now consuming nearly 60% of GDP, it cannot reasonably expect any measureable economic growth. None. Capitalism doesn’t function when it is smothered by taxes, bureaucracy, cronyism and welfare state torpor.

Historical Data Chart

So France is now experiencing a breakdown long in the making. Its rapidly deteriorating  fiscal condition has nothing to do with the financial crisis or the current flurry of so-called deflation. Its economy has finally succumbed to the destructive toll of statist economics, while its public debt continues to rise inexorably. Accordingly, it too has a debt to GDP burden that is rapidly heading beyond the 100% level.

Historical Data Chart

So Germany’s unbending position on the Greek debt is understandable. If the default barrier is breached, it will start a EU-wide voter run on the parliaments. Even the Dutch would be stranded high and dry in the event of a capital call—-finance ministers Dijsselbloem’s lectures to Varoufakis about fiscal rectitude notwithstanding. Indeed, just how long would he and the current Dutch government remain in office after a capital call given the debt spiral already in motion?

Historical Data Chart

In short, the EU outside of Germany and rounding error states like Finland has passed the point of no return on the fiscal front. No government that has to raise it share of the default cost will survive.

Germany will be left holding the entire bailout bag. And that serves them exactly right.

Merkel and her disciplinarians may be fiscally virtuous, but they are downright dense on the matter of central banking and the monetary order. In fact, they don’t have a clue about what capitalism in the financial system even means.

To be sure, they jabber endlessly about the impermissibility of central bank finance of “state deficits”. But this whole ideology amounts to a ritualized and intellectually vacant assault on a monetary straw man. Germany went along with the ECB’s $1.3 trillion LTRO program, for instance, apparently because it did not involve the “purchase” of sovereign debt.

In fact, the ECB injected into the European financial system this massive flow of cash made from thin air by advancing three-year discounts to EU banks that were strictly collaterized by the public debt of Germany, France, Italy, Spain etc. Accordingly, the credit risk assumed by the ECB was not that of BNP-Paribas, for example, but that of the French state bonds it hocked.

Needless to say, that’s state financing by any other name. Moreover, this is not merely evidence of German hair-splitting hypocrisy on the monetary policy question.

Had they really been committed to sound money they would never have permitted the ECB to go on the money printing rampage that occurred after German governments mesmerized by the “European Project” swapped the monetary quietism and rectitude of the Bundesbank for what quickly became the energetic, Keynesian macro-management regime of the ECB.

During the 10 years culminating in Draghi’s “whatever it takes” ukase of July 2012, the balance sheet of the ECB exploded by nearly 4X. It matters not one wit that this eruption was based on sovereign collateral rather than “outright” purchases of government debt, and whether the underlying cash injections to the EU banking system were deemed to be permanent or multi-year “temporary” loans.

Under today’s worldwide money printing mania, central bank balance sheets never shrink; they metastasize endlessly. The differences between outright purchases and repo-style transactions are merely technical.

Like all central banks, the ECB has become a monetary roach motel right under Germany’s nose. The bonds go in, but they never come out. And as explained below, the recent nominal shrinkage of the ECB’s balance sheet, which Draghi has now vowed to reverse with full German concurrence, was an accounting illusion, anyway.

The fact is, the ECB has been engaging in monetization on a massive scale from its inception. So doing, it has drastically distorted price discovery in the euro bond markets and thereby aided and abetted the fiscal profligacy that rages over the entire continent.

Historical Data Chart

As indicated above, the fact that the ECB’s balance sheet appeared to shrink sharply (by about 1 trillion euro) during the two years after Draghi’s ukase, and in consequence of the pay down of the LTRO discounts, was merely an exercise in monetary sleight-of-hand. The ECB’s massive haul of assets was just temporarily parked off balance sheet in the accounts of hedge fund punters and national bank fellow travelers.

These speculators were more than eager to front run Draghi’s warranted word that the ECB would implicitly monetize any and all sovereign issues that might be required to keep the debt markets open to EU borrowers at the most congenial rates imaginable. Since this included, especially, all of the fiscal profligates of the periphery, the front-runners feasted heartily. Capturing the soaring value of the bonds they had funded on zero cost repo or deposits, they essentially rented their balance sheets to the Frankfurt apparatchiks at what amounted to obscene profits.

Yet none of the explicit bailout of Greek debt, or the defacto bailout of Italian, Spanish, Portuguese etc. debt via the Draghi ukase, would have happened had the ECB enabled honest price discovery in the debt markets during the phony boom years prior to the crisis. In effect, the ECB became a tool of the EU superstate, flooding member state ministries and parliaments with false prices on their sovereign debt.

Actually there was no reason for government bond rates to fall drastically during the decade run-up to the 2010 crisis. Prior to the recent downward blip of the euro zone CPI owing to the global oil and commodity crash, the trend level of inflation had not changed since the turn of the century. So in massively inflating its balance sheet by nearly 4X between 2002 and 2012, the ECB was the active agent that unleashed fiscal profligacy throughout the EU.

Over that period, the euro zone CPI rose relentlessly at a 2.3% compound annual rate, while public leverage ratios climbed steadily. There was no reason, therefore, either by way of declining inflation or improving fiscal performance for bond rates to fall— in the periphery or the core for that matter.

In fact, under a sound money regime, the ECB balance sheet would have grown hardly at all after the turn of the century. What the EU countries needed more than anything else was an honest bond market to bring home to its constituent governments the true cost of permitting public debt to spiral in the face of faltering growth and a relentless tide of crippling demographics. That is, a soaring population of social insurance recipients versus plunging birth rates and future labor force shrinkage.

Stated differently, the EU states desperately needed a monetary regime that required their deficits to be financed out of private savings and capital inflows, not the central bank printing press. That would have caused a visible “crowding out” of private investment, rising interest rates and political opposition to fiscal free-booting in the EU capitals.

Indeed, central bank financial repression and monetization of sovereign debt is the arch-enemy of Germanic fiscal rectitude. But the successive governments in Berlin had no clue and still don’t.

Not surprisingly, peripheral country interest rates during the post-2000 course of the ECB’s massive monetization became a snare and delusion. In this context, it doesn’t matter whether the ECB was actually buying Italian or Greek debt at the time (it wasn’t) or what the precise composition of its balance sheet eruption actually entailed. Debt market instruments are arbitraged and fungible. The adverse impact of the ECB drastic financial repression would have happened whether it was buying Italian debt, Spanish road bonds or Greek seashells.

Spanish 10-Year Bond

Historical Data Chart

Italian 10-year Bond

Historical Data Chart

Greek 10-Year Bond

Historical Data Chart

Needless to say, there is always a counter-party. By the time the peripheral debt crisis reached fever-pitch in 2010-2012, European banks and insurance companies had gorged on the vastly mispriced debt that had been enabled by the ECB’s drastic financial repression. Accordingly, that was the moment when the scales should have fallen from Berlin’s eyes, and when its should have recognized that the cause of the crisis was not merely profligate Latin politicians, but the Keynesian money printers at the ECB which had tossed the Bundesbank’s sound money standards into the dustbin of history.

Instead, it stumbled into a monumental error. At the peak of the crisis, all of the big German, French and Italian banks were economically insolvent because the embedded mark-to-market losses on peripheral sovereign and private debts alike were orders of magnitude larger than the balance sheet equity of these institutions.

In the case of Deutsche Bank, for instance, its $1.9 trillion balance sheet at the end of 2010 was balanced precariously on just $34 billion of tangible equity. In effect, it was leveraged at 56X. The big French banks were not much better. BNP-Paribas had $60 billion of tangible equity pinned beneath $2.1 trillion of assets including more than $600 billion of exposure to high risk loans and bonds.

Yet the insane leverage ratios sported by the big EU banks were the product of another statist policy scheme in which the German fiscal conservatives were fully complicit. Namely, the regulatory regime known as risk-based asset accounting. Under the latter, sovereign debt is not counted for the purpose of computing capital adequacy.  In short, the ECB midwifed vast losses on drastically mispriced sovereign debt and the EU bank regulators said not to worry. It doesn’t count!

Outside the primitive world of Keynesian GDP flow mechanics where financial markets and balance sheets do not even exist, there are three extremely dangerous “givens” in the real world of finance.

The first is that banks are not free market institutions, but dangerous wards of the state that must be strictly regulated and supervised lest they gamble recklessly with depositor funds, investor capital and the various insurance and safety net schemes of the state.

The second is that politicians must face the true economic cost of borrowing or they will be endlessly tempted to perpetuate their power and prerogatives by dispensing free lunch entitlements, subsidies and tax subventions to organized interest groups and crony capitalist plunderers. State borrowing has to hurt real world constituencies, not merely offend the requisites of fiscal virtue.

Finally, financial markets are the vital core of capitalism, but by their very nature they attract gamblers and risk-takers. Accordingly, the most dangerous enemy of capitalist prosperity is not really the political left. Instead, it is the insuperable “moral hazard” that results when agencies of the state—-including the fiscal authorities and central banking branches alike—-bailout the mistaken wagers, soured bets and excesses of reckless greed that inexorably arise in the financial markets.

It goes without saying that the German fiscal disciplinarians ignored all three of these cardinal rules when they partnered up with the Keynesian apparatchiks in Brussels and Frankfurt to bailout the entirety of the soured peripheral country debt at 100 cents on the dollar. So doing, they committed an immense act of statist folly.

In the first instance, they stripped European financial markets of whatever vestiges of discipline and honest price discovery which then remained; allowed the financial executives and traders responsible for loading their institutions’ balance sheets with drastic losses to go unscathed; and taught the gamblers unleashed by the ECB and EU bailouts that the sky was the limit.

No longer was their any risk of loss. In the event of even brief spats of market turmoil and modest sell-offs, the Germans made it clear that the EU superstate would come running with safety nets and subventions. The sorry spectacle of the hedge fund gamblers buying up Italian and Spanish bonds, and even Greek bank equities prior to Syriza’s emergence, and riding them for massive gains after Draghi’s ukase was the inevitable result of what amounts to the EUs quasi-nationalization of the sovereign debt markets.

Yes, this papered over the insolvency of Europe’s banking sector. But even on that score, the Germans are deeply culpable. There was no necessity whatsoever to shield banks and other investors from losses on their holdings of Greek and other peripheral debt. If they had wanted to protect purportedly innocent depositors and the financial system generally, they could have permitted Greece to tumble into bankruptcy back in 2010 and the losses to be taken on other peripheral debt in the years thereafter—and then recapitalized the banking system with public money, new leadership and an effective and honest regime to insure bank safety and soundness going forward.

At the end of the day, the statist road chosen by the Germans has become a dead end. And it was the German government that ultimately choose the route of money printing and bank bailouts because no other EU country had the financial resources and credibility to make it happen.

The massive transfer of bank and speculator losses to the peripheral nations has inherently resulted in the destruction of democratic sovereignty in the bailed-out nations. And this  extends far beyond the blatant usurpation that occurred when Brussels virtually deposed the elected governments of Italy and Greece during the heat of the crisis.

The fact is, the hated Troika “program” and MOU would not exist absent the statist depredations of the Germans. In its absence, by contrast, the elected governments of the bankrupt EU nations would have needed to design and impose their own “austerity” programs in order to compensate for the absence of borrowed cash and to earn their way back into the capital markets on the basis of their own credit profile.

So Syriza is right to say that the devastated citizens of Greece do not owe Deutsche Bank and the rest of the bankers and punters a dime for the Greek bonds that their earlier governments imprudently issued and which the traders and managers of these institutions foolishly bought. The fact that German government caused these debts to be transferred to their own taxpayers is Berlin’s problem, not Athens’.

Indeed, that is the towering irony of the current fiasco. At the end of the day there will be no “mutualization” of the bailout debt of Greece or any other peripheral nation. It will all end up on Germany’s account because any other government which attempts to pay its share will end up like the Samaras government two weeks ago—that is, running off with the state’s internet passwords and office supplies in the middle of the night.

So the bailouts were one of the greatest acts of fiscal folly of all time—performed by the only fiscal disciplinarians left in Europe.

There could now be only one greater act of statist folly left on Berlin’s docket. The German’s could loose their nerve, allow Greece to stay in the EU without adherence to its commitments, and embrace Syriza’s out-and-out socialist plan for a modern day “New Deal” in the entire EU funded by the European Investment Bank (EIB).

Well, that would be debt mutualization of an even more cancerous type. Surely by now Frau Merkel has learned her lesson and will decline the offer to jump from the fiscal frying pan she has created into the raging fires that the populist left in Europe will otherwise stoke-up if given the chance.

In short, Germany has no choice except to let Greece go and to allow the entire EU bailout state to unravel, and then to pay the piper for its statist follies.

The alternative is an all-powerful superstate in Brussels and Frankfurt that will necessarily extinguish whatever remains of political democracy and capitalist prosperity in Europe.

The latter would also permanently bury German taxpayers in other people’s debt. The fiasco in Greece has already proven at least that much.

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VIX up 37% while SPX is flat, house of cards or house of fear?

by Chris Kimble



Do some investors think the market is a "House of Cards?" Humbly I don't know. It sure seems like something has them concerned, as fear levels remain lofty with the market making little progress up or down!

Over the past 90-days the S&P 500 is pretty much flat (up less than 1%). During that time the VIX (Fear Index) remains elevated, as its been up the majority of the time the market has been going sideways.



The VIX looks to be creating a pennant pattern over the past few months. How this pattern resolves itself could point to which direction SPY heads out of this sideways chop.



This table highlights what happens to the VIX after its up 40% in 90-days when SPY is positive. Majority of the time 90-days out the VIX is lower.

Falling fear can be positive for stocks and for XIV. If the VIX falls during the next 90-days, XIV could do fairly weel. Let's see what happens from here!

See the original article >>

Some Thoughts on Greece's Exit from the Euro (Grexit)

by Charles Hugh Smith

Greece has the potential to be the small domino that ends up toppling much larger dominoes.

A number of readers pointed out difficulties with my suggestion that Greece adopt the U.S. dollar (USD), the primary one (as pointed out by Tyler Durden) being that Greece needs a weak currency for its re-set, not one that's strengthening.

What Looks Crazy at First Might Be the Ideal Solution: Meet Greece's New Currency, the U.S. Dollar.

Others pointed out the unlikelihood of the Left-leaning leadership of Greece adopting the USD.

Still others questioned the foreign-exchange (FX) mechanics of such a currency swap.

Here is a preliminary semi-random list of thoughts on Greece's exit from the euro.

1. I make no claim to expertise in this matter--but I don't think there are any experts in this, as there is no real analog in recent history.

2. This lack of analog (a nation with a small population and GDP leaving or being ejected from a much larger currency union) undermines all references to historical examples.

3. No offense intended to the hardworking people of Greece, but the population and GDP (gross domestic product) of Greece is quite small. Greece's population is 11 million and its GDP is about $240 billion. The modest scale of Greece also undermines any analysis or projection based on historic precedents involving much larger economies.

The European Union has over 500 million residents. Greece's population represents 2.2% of the EU populace.

Ecuador, which uses the US dollar as its currency, has 15 million people.

Los Angeles County, with slightly more than 10 million residents, has a GDP of $554 billion, more than double that of Greece.

4. A sovereign currency reflects not just the interest rate paid on its bonds, but on a host of other factors: fiscal and trade deficits/surpluses, currency pegs, national income, the vibrancy and resilience of the economy, the ability of the central state to manage the economy, private bank credit, transparency, costs of corruption, ease of doing business, how foreign investment capital is treated, the skill levels of its workforce and so on.

5. Thus the Grexit discussion of currencies leads directly to all the larger questions of the Greek economy, political order and society.

In other words, Greece faces not just a debt and currency crisis, but a systemic crisis of its social and political order, its machinery of governance, the legitimacy of its system of taxation and the flexibility of its economy. The currency and debt crises are reflections of these much deeper crises.

These include:

-- Does the structure of Greece's government lend itself to fragile coalitions that are incapable of implementing tough reforms?

-- The need to modernize the practical machinery of governance: record-keeping, taxation policies, transparency, processing of permits and other regulatory necessities, etc.

-- Does the central state have the wherewithal to effectively remake the culture to eliminate corruption as the default setting in the economy?

6. All other things being equal, a nation with a weak but stable currency that makes all imports costly to its residents invites investment in producing more goods and services locally. The keys to being attractive to long-term investment of foreign capital are:

-- A stable currency
-- A central state that isn't going to nationalize the investment the next election cycle
-- A stable, transparent regulatory and permit system
-- A stable, transparent system of taxation

7. Some readers suggested Greece could peg a new drachma currency to the U.S. dollar as a means of establishing much-needed stability. The key to any peg's sustainability is setting the peg low enough that the market won't force the central bank to defend the peg, which is what triggered the Asian Contagion Crisis of the late 1990s.

The nation establishing the peg must also avoid overborrowing, in essence free-riding the stability established by the peg, which is what brought down Argentina's dollar peg in the early 2000s.

8. The Greek people have a simple choice: "do whatever it takes" to stay in the euro, which means living with austerity for decades to come, or leave the euro. It's that simple. The majority of Greeks supposedly want to stay in the euro, but they must come to grips with the reality that the euro is a plutonium life preserver. It's one or the other: permanent austerity as the cost of keeping the euro or no austerity and no euro. You can't have it both ways.

EU Leaders Throw Europe a Plutonium Life Preserver (October 27, 2011)

9. Though the mainstream financial media is running a full-court propaganda campaign promoting the idea that "Greece doesn't matter any more," the much-feared reality is that Greece has the potential to be the small domino that ends up toppling much larger dominoes:

Domino Chain Reaction (1:10 YouTube video)

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What About the 1970s?

by Ben Carlson

Every time I write about commodities being a poor investment option over the long-term, I get a few comments such as this one:

Yeah, but what about the 1970s?

The 1970s were probably one of the most difficult decades for investors in the traditional asset classes. Stocks and bonds posted positive returns, but those returns were completey consumed by the sky high inflation which reached as high as 13% a year by 1979. Short-term T-bills even outperformed both stocks and bonds because of the rising interest rates environment. Basically the entire decade was a mess. Except for commodities, that is.

The S&P Goldman Sachs Commodity Index (GSCI) does actually go back to 1970. And the returns in the 1970s were impressive – up 21% annually. These returns should be put into context, though. The price of oil was up 870% from the OPEC oil embargo. Once the price of gold became unpegged in 1973 it rose nearly 1,000% for the remainder of the decade.

Regardless, the 1970s did happen, caveats and all. If you look at the data on the GSCI starting in 1970 through 2014, commodities look like a pretty decent long-term asset class:

comm 1

Eight percent annual returns with little-to-no correlation to U.S. stocks (0.09 to be exact. What’s not to like? Sounds like the perfect portfolio diversifier. Now take a look at the returns from 1980 on:

comm 2

Commodities had nearly identical volatility characteristics in both periods, but after 1980 they returned less than ultra-safe cash equivalents. Cash-like returns with stock-like volatility for 35 years does not make for a very compelling long-term asset class.

That’s not to say that commodities won’t have huge gains at times. In fact, the sentiment is so heavily skewed towards deflation, low growth and low interest rates forever right now that an unexpected rise in inflation in the coming years could lead to great returns in commodities for a time. You can see the volatility in commodities throughout the years by looking at the large gains and losses since 1980:

comm 3

There are obvious supply and demand issues to consider, but I think the real reason they’re so volatile is because they’re basically in constant competition with technology. This is why I always say that commodities are trading vehicle, not a long-term investing vehicle. There’s a huge difference. If you’re truly worried about a 1970s-style price shock, then commodities will probably be your best bet. The question is: Can you wait that long for a low probability event that may never happen?

I think it makes sense to plan for a wide range of possible outcomes with any portfolio. But I’m not sure banking on 1970s-style inflation at all times is one of them. I’m not saying it’s not possible. Anything is possible. I’m just not sure you want to carve out a huge piece of your portfolio for a single situation like that which is unique historically. Almost 45% of the entire gains for the GSCI during the 45 year period from 1970-2014 were earned in the 1970s.

Also, oil currently makes up around 47% of the GSCI index, with the remaining allocation spread fairly evenly among agriculture-based commodities and metals (gold is actually only 2% or so of the index). That’s a fairly big bet on the energy sector.

There are alternatives that can protect investors from future inflation that are less volatile (TIPS) or offer a better return profile (REITs and even high quality dividend stocks) than commodities.

See the original article >>

US Stock Market: Trend Uniformity Still Absent

by Pater Tenebrarum

Consolidation or Topping Pattern?

From a technical perspective, the recent trading range in the US stock market is not really telling us much about what to expect next. It is possible to regard it as a drawn-out consolidation pattern prior to a renewed surge, but it is just as likely that it is in fact a distribution pattern.

We have discussed the sentiment backdrop a number of times recently. Although the public exuberance that was visible in 2000 is largely absent, virtually every other measure of sentiment, whether in terms of positioning, surveys or of the anecdotal variety, seems stretched like rarely before. In many ways it is the exact opposite of what was seen near the 2009 lows. Anecdotal evidence includes items like the stock market valuation accorded to a company that owns four mobile grilled cheese dispensers in the OTC market (a cool $100m.), which is discussed in more detail by Barry Ritholtz here.


However, sentiment data have looked quite stretched for more than a year already (although they have reached their greatest extremes to date late last year and early this year). This hasn’t kept the market from advancing, but there may be some information in the fact that sentiment has not (at least not yet) turned cautious in the course of the recent trading range. From experience, trading ranges that are destined to be resolved by upside breakouts tend to involve a deterioration in bullish sentiment.

Today we want to briefly look at trend uniformity and a few other simple technical data points though. It should be noted ahead of this exercise that since the market remains quite close to its highs, there are of course quite a few sectors and individual stocks that continue to look technically strong at the current juncture. The breakdown in energy stocks due to falling oil prices has gone hand in hand with a revival of sectors that looked weak previously, such as consumer discretionary stocks.

Below is a weekly chart of the S&P 500. In recent months, a noticeably divergence between prices, the RSI and MACD has formed on a weekly basis. This is noteworthy mainly because it hasn’t happened in quite some time – the last time a strong weekly price/RSI divergence was recorded was just before the hefty correction in summer of 2011 commenced.

This time, the divergence is more glaring, insofar as it has been put in place over a time period of more than a year:

SPX-weekly RSI,MACD divergences

Weekly divergences between price and RSI and MACD in the SPX – click to enlarge.

Trend Uniformity

Next a brief look at trend uniformity, or rather, the lack thereof. Usually trend uniformity tends to break down as an advance reaches its late stages. The reason as far as we can tell is that market advances tend to near their end when money supply growth rates decline below a certain threshold (this threshold is unfortunately not fixed – if it were, it would be very easy to forecast stock market turning points).

When this happens, there is not enough additional free liquidity available to bid up all, or most prices, so buyers tend to focus on an declining number of equities. The chart below shows three ratios: small caps (Russell 2000 Index/RUT) vs. big caps (SPX), tech stocks (NDX) vs. SPX and the broad market in the form of the NYSE Index (NYA) vs. the SPX.


The RUT-SPX, NDX-SPX and NYA-SPX ratio – click to enlarge.

Over the past year, the performance of small caps and the broader market has steadily deteriorated against that of big caps. By contrast, big cap momentum stocks as represented by the NDX have for the most part outperformed the broader big caps sector. In short, trend uniformity has steadily broken down over the past 12 months. Lately all three trends have begun to stall out a bit. It remains to be seen whether the rush into momentum stocks late last year will prove to be meaningful, but a similar phenomenon has been observed near prior market peaks.

Lastly, here is a chart of the NYSE index with its new high/new low differential (NH/NL) and the cumulative advance decline line (A/D line). The cumulative A/D line has recently made a new high; this is usually regarded as a positive, but it nevertheless represents a divergence with prices. Still, normally this measure tends to peak ahead of prices, and not after the price peak, so this indicator is still favorable to the bullish case at this point. The NH/NL differential meanwhile has deteriorated along with prices.

The NYA is probably a much better representation of the average portfolio return than narrower indexes like the NDX or the SPX, as most stock market portfolios tend to be diversified across a large number of industries, sub-sectors and market caps.

What makes this interesting is that although the broader market as represented by the NYA has put in what – so far anyway – appears to be a double top in July and September and has achieved no progress since the secondary peak in September, the enthusiasm of traders and stock market advisors has continued to increase since then.

In other words, instead of bullish sentiment weakening a bit in line with the broad market’s lackluster performance, it seems to have followed the narrower indexes that have managed to put in marginal new highs since the October correction. It seems to us that this makes a further advance much less likely, at least on a medium term basis.

In the short term, there is always the possibility of another marginal new high being reached, since the market is not too far away from new high territory and the major European markets have strengthened considerably recently (note however that this strength was not confirmed by peripheral European markets).


NYSE Composite Index (NYA) daily with NH/NL differential and the cumulative A/D line – click to enlarge.


In light of the market’s valuation (in terms of the median stock, the market has never been more highly valued than now, not even at the year 2000 peak) and extremely lopsided sentiment, the divergences and the lack of trend uniformity discussed above should be seen as signs that caution continues to be warranted.

On the other hand, US money supply growth still remains relatively brisk, as commercial bank lending has accelerated just as “QE” has been discontinued. As we have recently pointed out, in the euro area, money supply growth is accelerating quite a bit now, so there should soon be a revival in aggregate economic activity there. Over the past year or so, the European markets have tended to react positively to improving macro-data, and may therefore indirectly lend support to the US stock market.

On the other hand, the monetary pumping game is getting a bit long in the tooth by now; if the economy’s pool of real funding has suffered substantial enough damage, it may no longer suffice to drive stocks even higher. All the additional pumping that is in the offing may well already be discounted in prices. We certainly wouldn’t ignore technical warnings because of it.

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