Saturday, May 3, 2014

Year To Date Asset Returns & The Only Asset I Am Currently Buying

The chart below shows the performance of various asset classes year to date. Corn and wheat have been the year's two best performers, which I was fortunate to be buying to start the year and reviewed in the Investment Opportunities Outlook. I discussed a few weeks ago why I was no longer adding to agriculture positions. See: An Update To Agriculture Buying

Silver is the only asset class I am currently adding to positions. It is in my personal sweet spot for acquisition: (1) Prices have recently declined, (2) it is deeply despised as an asset class, (3) the long term fundamentals are strong. Beyond the steady silver accumulation I am just raising cash and watching closely for sales on my shopping list. Boring, I know.

Click for larger image:

Diana Olick Explains Housing Affordability

I reviewed this topic earlier in the year in the Outlook For U.S. Housing, but it is good to see there is someone on TV who can help explain it to the CNBC cast, which has been very confused by the horrible stream of housing data now emerging.


Costs For Americans

Interesting chart this week from the New York Times showing that the cost of living for essentials (child care, health care, vehicle maintenance, food) has risen significantly over the last decade, while the cost of extra "stuff" Americans enjoy has declined dramatically. While cell phones and TV's are bought every few years at the most, the cost of child care, health care and food hit every single month.

This can be weighed against the real median income which has tracked sideways for 15 years.

Wednesday, April 30, 2014

U.S. Home Prices Experience Fourth Consecutive Monthly Price Decline

The Case Shiller non-seasonally adjusted home price index has now declined for the fourth month in a row (data is an average of December, January and February), but as the chart below shows it is more of a flat line. This type of behavior occurred around this time last year before prices blasted higher through the remainder of the year.

Will this occur again in 2014? As Shiller discusses below, the picture is less clear due to the horrific stream of housing data we have received over the past few weeks (sales, permits, starts, etc.). The fundamentals behind a housing catalyst are nonexistent. Incomes are flat and home price affordability is falling as interest rates have moved significantly higher over the last 12 months in tandem with prices. The market is counting on a resurgence of demand from institutional investors, which have cut back their purchases drastically.

Tuesday, April 29, 2014

The Adjustment Phase Of QE Removal

Back in 2011, the Bank of England (the U.K.'s central bank) released a paper titled The United Kingdom's quantitative easing policy; design operation and impact. In that paper they included a chart titled "The qualitative impact of QE," which you can see below.

This chart has turned out to be an accurate forecast of the impact phase (left area of the vertical dotted line), which is where we still find ourselves today. This is the phase where QE is still being administered (the heroin is still being injected).

The impact phase shows the huge increase in the monetary base (broad money) due to the printed money injected into the system by central banks and the simultaneous explosion higher in asset prices due to the euphoria that the heroin injection creates. During this phase there has been a small nominal rise in demand and real GDP, while inflation and consumer price increases have remained mostly dormant.

If the Federal Reserve continues their tapering process at $10 billion per meeting, they will have ended the current QE program this fall. Their next step would be to begin raising interest rates, and the final step would be to remove the excess liquidity from the system (shrink their balance sheet by selling bonds).

I don't believe the Fed will get even remotely close to the completion of that last step. To understand why see: Why The Fed Can Never Exit.

The conclusion of the Fed's current QE program in the fall (if we even get there before they reverse course) would bring us to the adjustment phase in the graph above. The goal is to have nominal demand continue to rise while carrying real GDP and consumer prices higher. This would be the hand off from the asset price boom to the real economy.

While this hypothetical hand off would be great for certain areas of the economy it would come at a cost to real asset prices, which would collapse back down toward earth. To think that the explosion of asset prices from their current ridiculous levels (see stocks, bonds, and certain sectors of real estate in the U.S.) will not have a far greater impact on real demand seems like a bit of a stretch.

This example looks at the United States and their central bank within a vacuum. In reality you must anticipate the future moves of the Bank of England (most likely to follow a similar path as the United States), Bank of Japan (most likely to increase QE), European Central Bank (most likely to increase QE) and the People's Bank of China (god only knows how they will react to their credit bubble bursting). Each one of these paths could change at a moment's notice due to a change within that country. For example, it is not difficult to see that there is a massive real estate bubble in the city of London. If that were to burst, it could create problems for the Bank of England's current plans.

Capital moves freely across borders so a trillion printed by the Bank of Japan and a trillion printed by the Fed can be seen as a 2 trillion addition to global liquidity washing around the planet. This is why the Fed's taper has an impact on real estate developers in Brazil. It is also why the chart above cannot be looked at as simply as "impact" followed by "adjustment."

It has been a non stop blast of QE liquidity from every major central bank around the world since the fall of 2008 (other than the European Central Bank which has been reducing the size of its balance sheet modestly since 2012). As some of these banks try to reduce and then turn off the heroin injections (move into the adjustment phase), looked for seismic dislocations to appear within the financial system.

h/t John Mauldin

Sunday, April 27, 2014

Financial Markets: The Ultimate Complex System & Global Game

As I become an older man, I realize that I have already spent a significant part of my life studying and following the financial markets. I have studied history (which I believe is the most important area) as well as the philosophy and tactics behind the most successful investors, both present and past.

Something I came to understand a good time ago and continue to reinforce almost daily is that no one has any idea what is going to happen next. The absolute best in the financial world, those that steadily rise to the top of the financial universe, put a vague picture together of some of the most likely scenarios that could occur and then try to build a strategy around those potential outcomes. The reason the absolute best in the industry cannot tell you what will happen tomorrow is because the financial markets are a complex system, a topic I will discuss in more detail in a moment. Before we get there, let's take a brief walk through the ever fascinating human mind. 

If someone tells you they have a model for the exact moment when a market is going to do something (usually through some sort of technical analysis or trading system), you should politely excuse yourself and walk away. This person does not make a living "timing" or "beating" the market; they make a living selling the belief to others they can do so. Any short term gains based on technical strategy are in reality based on statistical luck. The only way someone can "time" the market consistently in the short term is through some unfair or illegal advantage.

A few years back I remember reading an article about a young man who quit his job and began trading currencies. He was a self-described "prodigy" and told clients the story of how he turned $500 into $2,500 in a month and then consistently grew that capital exponentially through his god given talent to trade currencies.

He payed a PR firm over $3,000 a month to promote his image as a successful trader, and he released pictures of bar tabs he ran up at clubs around the world. He famously spent more than $125,000 on a single bottle of champagne, then posted the picture of the bar tab that night online. He created movies and lavish photo shoots to promote his stature as the next big thing in the financial world. 

This week it was discovered that he had been running a ponzi scheme. Clients poured money (over $2 million) into his trading firm to receive a portion of his legendary gains, which he then used to party and promote himself. The investors lost everything. 

When you hear this story from start to finish it seems impossible that anyone would give this 23 year old kid their money. What causes people to do this? 

The reason lies in the fact that the human mind is a solution driven machine. The mind is constantly and exhaustively searching for the answer to a problem it receives. When an answer is discovered it allows the mind to turn off that assignment and move on to the next problem.

As a quick side tangent, this particular trait of the human brain is what makes goals so powerful; the subconscious is constantly looking for answers around you that will bring that goal into your life. 

Many financial advisors or experts provide an easy to understand model or solution of how they beat or time the market, and they show recent success combined to back this up. This provides a quick solution to the mind's problem of "where to put my investment capital," and it allows the mind to begin working on the next project. The strain is now gone.

If else someone tells you that the market cannot be beat, and the best option is a never ending lifetime of study combined with research and development of your financial intelligence; it is far less appealing to your mind. This provides no quick solution to the investing problem your mind is trying desperately to get off its work load. 

In a well written paper titled Financial Markets As Complex Systems Professor Amitava Sarkar describes a complex system as:

- a collection of many interdependent parts
- that interact with each other through competitive nonlinear collaboration
- leading to emergent, self-organized behavior

He goes on to say that:

Financial markets can be regarded as model "complex systems." In fact, they are fascinating examples of "complexity in action": a real world complex system whose evolution is dictated by the decisions of crowds of traders who are continually trying to win a vast global "game."

What makes markets even more fascinating is that they are impacted by a series of other complex systems: politics, organizations (businesses), economies and natural human behavior. It is incredibly difficult to figure out how a single one of these four pillars will shift in the future, yet all four add an additional layer of information needed to try and determine a future outcome for the financial markets. The investors most likely to put capital to work successfully must be masters of all four pillars. This illustrates why winning in the financial markets represents the ultimate global "game."

It should also illustrate why someone who tells you that they have a technical chart showing where the market will move tomorrow is delusional. Those that take the simple investing solution so their brains can move on to the next task will unfortunately be slaughtered over the long term.

The fact that the financial markets and investing take a lifetime to master is exciting to me personally because it provides a global "game" where I can compete throughout the remainder of my life (long after I'm too old to play pick up basketball and perhaps even after I'm too old to play golf). For others who do not want to put in the extensive time to learn, just understanding how complex the financial market system is will put you far ahead of almost everyone because you can walk away from those providing the next "easy" solution to the most difficult game in the world.