Archive for October, 2019

Bizarro World – When Did It Start?

Friday, October 11th, 2019

Negative DebtDouble Click on Image for a Full Size View

In my opinion, we have officially moved into Bizarro World.  What is that?  If you are a fan of Seinfeld, you will recall that Elaine breaks up with her boyfriend Kevin but they decide to “just be friends.” Much to Elaine’s surprise, Kevin is thrilled at the idea, and starts becoming a much more reliable friend than Jerry. Jerry suggests to Elaine that Kevin is “Bizarro Jerry”, and explains the comic book concept of Bizarro World.  In popular culture, “Bizarro World” has come to mean a situation or setting which is weirdly inverted or opposite to expectations.

This week, we entered Bizzaro World when Greece, the least credit worthy country in Europe and one that continually teeters on the edge of bankruptcy, started issuing negative yielding bonds.

What does that mean?  Someone (in this case most likely the European Central Bank, the “ECB”) loans Greece money when they buy their bonds – but instead of earning interest on the loan, they agree to negative interest which means that instead of getting all of their money back at the end of the loan term, the get back less than they invested.

For a number of years, various European countries and corporations have been issuing negative yielding bonds.  It is definitely a concept foreign to us here in the states, but the European Central Bank came up with this scheme as a way to stimulate the economy in Europe.  Over time, the negative interest rates have worked their way into the banking system, with European banks issuing loans with negative rates and charging people interest to deposit money with them.

The banks in Europe are by and large in terrible shape, not able to make enough money to maintain or grow their capital base.  Yet, the ECB continues to double down on their negative interest rate policy in spite of its failure to stimulate the economy.  In the chart above, you can see that Switzerland has negative yielding debt that they are issuing for 30 years.  Would any sensible investor lock up their money for 30 years knowing that in 30 years they will receive back less than they invested and they will have not received any cash flow from it during all those years.

In calculating what a $1,000 30-year Swiss Bond with a negative yield of -0.058% would give you in 30 years, the formula is:  $1,000*(1-0.058)^30 = -$166.54.  Now, I may just be a poor country banker, but even I can see that receiving a -$164.54 reduction to my original capital in 30 years in return for my $1,000 loan to them today is a bad deal for whomever buys this bond.  So why are people buying them, let alone the less credit worthy European countries like Greece?

The ECB is buying the bonds to inject liquidity into its constituent countries to try to stimulate growth.  This policy has failed since they started it a decade ago, but they are now trapped and cannot resume a normalized rate policy for fear of causing a world-wide economic depression.  Oh, and in case that news is not bad enough, in June our own Federal Reserve announced through much government double-talk that they had adopted new rules for the “lower band” of interest rates – which means they are now prepared to take rates negative here in the states if they deem it to be advisable.  God forbid they close their failed Keynesian Economics textbooks and actually look at the damage that policy has done to Europe.

From the bond traders I’ve talked to, they tell me that the investment houses and mutual funds focused on European fixed income investments buy these to trade them, hoping that yields will get more negative which will drive the price higher.  Over the 35+ years that I’ve managed money for clients, I’ve always called this the “greater fool” theory of investing:  buying an investment that has no fundamental way to make you money just because you believe you can sell it to some sucker for more than you paid.

It is very similar to how the big investment houses operate when they manage your money.  In June they were planning to sell to their clients an IPO of a company named We Work which they had valued at $50 billion.  Since then, and credit to the independent investment analysts out there who exposed the company’s problems – it is not a technology company as the company and the Wall Street banks were marketing it as but rather a real estate company that owns no tangible real estate and has long term leases at top of market pricing across the world.  As of last week, We Work was selling its corporate jet, firing its CEO and founder, and trying to secure lines of credit to avoid bankruptcy.

We are economically in a very difficult position.  Our Fed continues to pump liquidity into the US economy, but we continue to see economic reports of slowing in both the manufacturing and service sectors of the economy.  Third quarter corporate earnings reports start hitting the wire next week, and all forecasts are for continued softness in earnings which are being called by many an earnings recession.  There is a very good chance that the Fed will lower rates once again at its meeting later this month, yet the stock market remains close to its all time high.

Every move to add liquidity to the US economy is cheered by Wall Street yet the market peaked in July prior to the initial rate cut and has not been able to move above that level.  The trade war with China which is definitely having a negative impact on corporate earnings for companies that export a significant portion of their product to China.  However, with every tweet out of the White House announcing an end to the trade war or that a deal is imminent – believable or not – the market seems to rally and keep us near the July high.

In a world that has turned into the opposite of logical, with Bizarro economic policies and Bizarro investment decisions by many institutions, we will continue to play defense with cash equivalents, bonds, and precious metals.  Hard assets and longer dated treasury bonds have consistently over time been the best insurance with the best investment returns as asset classes during times of crisis.  Cash Equivalents have provided outsized returns when viewed as your opportunity to buy undervalued assets when everyone else is forced to sell.

Until we return to a more normalized economic and investment environment, playing defense is the wise move and following the herd by buying stocks at all time highs is being the greater fool.


Third Quarter Update & Fourth Quarter Strategy

Monday, October 7th, 2019


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After a difficult summer for equity investments, investors returned from their summer holidays in a bullish mood and drove stock prices higher in September.  The quarter was marked by a continued slowdown in the global economic data, offset by further monetary easing from the US and Europe.

In the US, the Federal Reserve (Fed) cut interest rates in July and September in an attempt to prolong the economic expansion in the face of an economic.  While the economy continued to add jobs, the pace of growth of aggregate hours worked in the economy has slowed meaningfully.  Consumer confidence also declined from elevated levels.  US equities delivered 1.7% over the quarter but have been unable to break above the July all-time-high.

Many economists are calling for a recession in coming months due to the continued weak economic data – the manufacturing sector has been contracting for a few months, but until last week the services sector of the economy has remained in expansion mode.  Last week, the services sector reported contraction as well.  If the combination of a weak manufacturing sector combined with a weak services sector turns GDP negative for two consecutive months, we will indeed be in an economic recession.

We have seen the bond market act accordingly – the yield on the 30-year treasury bond today has again dropped below 2%.  The yield curve is inverted from 3 months to 10 years while roughly flat from 2 years to 10 years.  The inverted yield curve is considered historically to be a leading indicator of a potential recession – its track record is not 100% accurate, but at roughly 80% it is something we definitely need to be watching.

In spite of the slowing economy, the stock market continues to trade near its all-time-high.  In the graph above you will see that since the July high of 3,027 on the S&P 500 Index, we have moved up and down within a tight price range, but there has been no significant move either up or down – price rallies are sold and price dips are bought.

Investors are clearly confused – the ones with a positive view see the Fed lowering interest rates and buy the dips while the ones with a negative view see the weak economic data which causes the lowering of rates and sell when prices move higher.    Who will win this tug of war?  That is the question we are all waiting to see – will the bearish minded investors get their recession, or will the Fed rate cuts strengthen the economy and move the stock market higher?  There is no way to know until the economic data is reported.

However, with the market near all-time-high, the risk is clearly to the downside.  Given that, we continue to be cautious and maintain above average allocations to cash and fixed income.   One issue that we are watching closely is the lack of liquidity in the markets – the Federal Reserve has recently increased its activity in the overnight lending markets that the big financial institutions participate in when they need access to significant liquidity to balance their books.  Right now, the Fed has it under control, but a liquidity driven market correction is something we want to avoid as they are fast and brutal.  By being suspicious of the stock market at these levels we are remaining cautious, overweighting precious metals, bonds, and cash equivalents, we are protecting our clients’ investment capital while the current uncertainty plays out.