Thursday, May 14, 2015

When Can We Buy Put Options On Art?

This week someone purchased the piece of art below titled "Untitled (Yellow and Blue)" for 46.5 million dollars. The madness and euphoria that has taken hold around the world has surpassed the 2007 insanity by many multiples. It's everywhere. People have collectively lost their minds.

Negative Yields Peak In Europe: Is The Bond Market Top Finally In?

You know the world has gone mad when charts no longer measure the yield on bonds but instead measure the total volume of negative yielding bonds. Yes, those bonds where you give someone your money and pay them to hold it.

The total volume of negative yielding bonds in Europe peaked at 2.8 trillion euros on April 20 and has fallen to "only" 2 trillion euros this week. This is due to a sharp rally in interest rates across the board over the last month.

Was April 20 the final mania peak in the 34 year global bull market in bonds? Only time will tell. What we do know is one day yields will begin rising around the world and they won't stop, reverse course, and move lower to new record lows. Many people in both business and finance today have never experienced a period of rising rates in their working lifetime (usually starts around 22 years old). They would need to be about 59 years old today to have caught the last two years of rising rates in the late 1970's during their working years. We'll see how the world handles swimming against the current while it has a $200 trillion debt cinder block tied around its ankles. My guess is while the world is trying to deleverage (pay down debt) during a period of rising rates, there will be severe financial earthquakes along the way.

Tuesday, May 12, 2015

Rickards & Schiff - Why The Fed Is Always Wrong

Jim Rickards discusses why the Fed is always wrong on their forecasts (they are using incorrect models).

 Peter Schiff of Euro Pacific Capital
Over the past decade or so, "transparency" has become one of the buzzwords that has guided the Federal Reserve's culture. The word was meant to convey the belief that central banking was best done for all to see in the full light of day, not in the murky back rooms of Washington and New York. The Fed seems to be on a mission to prove that its operations are benevolent, fair, predictable, and equitable. Part of that transparency movement took shape in 2007 when the Fed began publicizing its Gross Domestic Product (GDP) forecasts, which previously (to the frustration of investors) had been kept under wraps. Most of the Fed's policy moves are tied to how strong, or how weak, it believes the economy will be in the coming year. As a result, its GDP forecast is perhaps the single most important estimate it makes.
So the good news for investors is that the Fed now tells us where it thinks the economy is headed. The bad news is it has been consistently, and sometimes spectacularly, wrong. Talk about the blind leading the blind.
In the eight years that the Fed has issued GDP forecasts in the prior Fall, only once, in 2010, did the actual economic performance come in the range of its expectations (referred to as its "central tendency.") And even in that year, Fed forecasters did not manage to put the ball through the goal posts. Instead it just hit the upright (the low end of its range: 2.5% in actual growth vs. a central tendency of 2.5% to 3.5%). In all other years the Fed missed the mark completely on the downside. The tale of the tape tells the story: 
                              Central Tendency (The Fed)       Actual Growth (BEA)           
2007                       2.4% - 2.5%                                 1.8%
2008                       1.8% - 2.5 %                                -0.30%
2009                       -0.2% - 1.1%                                -2.80%
2010                       2.5 % - 3.5 %                               2.50%
2011                       3.0% - 3.6%                                 1.60%
2012                       2.5% - 2.9%                                 2.30%
2013                       2.3% - 3.0%                                 2.20%
2014                       2.8% - 3.2%                                 2.40%
The biggest misses clearly came during the recession years of 2008 and 2009. The Fed clearly had no idea that trouble was brewing, or that the trouble would last once it started. In 2008 the actual growth came in 2.1% below the low end of its forecast range and 2.5% below the midpoint of its estimates. In 2009 it was 2.6% below the low end and 3.2% below the midpoint. 2011 wasn't much better, with the Fed missing by 1.4% and 1.7% for the same criteria. The rest of the years had more pedestrian misses of less than a percentage point. But it never really hit the mark, and it consistently overbid by a significant margin.
And while we are only a few months into 2015, it doesn't look like they will be on target this year either.
                               Full Year Central Tendency        First Quarter GDP
2015 (Q1)              2.6% - 3.0%                                  0.20% (annualized)
With first quarter growth at just a scant .2% annualized, the remaining three quarters of the year would have to average 3.4% annualized just to get to 2.6% for the full year (the low end of the Fed's range). Furthermore, the latest data, such as the spectacular increase of the trade deficit in March (to $51.4 billion, the largest month over month growth on record and the biggest monthly gap since the crisis month of October 2008), and today’s report showing the largest consecutive quarterly decline in productivity in more than 20 years, will likely force a downward revision to Q1 GDP. With April data looking even weaker than what was seen in February and March, a strong second quarter rebound, like the one seen in 2014, seems increasingly unlikely. In other words, good luck getting to 2.6%. But even if we do get there, it is no cause for celebration. 2.6% growth would be indicative of a struggling economy (recall that for the 20th Century, annual growth averaged well north of 3%).
In the seven full years since the Fed brought rates to zero, and at times showered the markets with trillions of dollars of QE cash, GDP growth has averaged just 1.1%. Even stripping out the recession years of 2008 and 2009, to focus only on the five "recovery" years of 2010-2014, gives us an average GDP of 2.2%, a rate that has been below the central tendency every year. 
So what do we make of this? Are Fed economists just horrible forecasters? And if so, why not hire others who more competent? Or is something more troubling going on? The most benign explanation is that they simply failed to anticipate a string of unfortunate events that have supposedly prevented a real recovery from taking hold. First it was the European debt crisis, then it was the high energy prices, then it was Syria, then Ukraine, then the Polar Vortex, then it was the low energy prices, then it was the European recession, the strong dollar, and then another bad winter. Apparently, unbeknown to Fed forecasters, the world is a tricky place fraught with economic, political and meteorological crises. But hasn't that always been the case?
A more troubling possibility is that the Fed simply doesn't understand how its policy tools really impact the economy. It expects that zero percent interest rates and quantitative easing will stimulate aggregate demand, encourage consumers to spend and businesses to hire, thereby initiating a virtuous cycle that will propel the economy back to healthy growth. Since it believes its medicine will cure the patient, it builds a favorable outcome into its forecasts, which biases those forecasts in an upward direction. Based on that assumption, it's a bit of a headscratcher to the Fed as to why the economy has failed to deliver as expected. So cue the long litany of excuses.
But what if that's not the way it works?  What if, as I have argued many times, that stimulus in the form of zero percent interest rates and QE bond purchases, act more like economic sedatives than stimulants? What if, as I have argued, that these crutches prevent an economy from finding the solid footing needed to build a real recovery? This would explain why we have failed to recover after seven years of policies expressly designed to spur recovery.
A more sinister possibility is that the Fed is not really forecasting at all but cheerleading. The fact that all its forecasts have missed on the high side reveals that its misses may not be random. If the Fed were just wrong, one would expect some of its forecasts to be too low. An obvious explanation is that the Fed may be using its "forecast" to talk up the economy. By forecasting strong growth, the Fed may be hoping to engender optimism, with more spending and hiring hopefully to follow. Kind of like a field of dreams recovery -- if the Fed forecasts it; it will come. Plus the Fed may be hesitant to issue a somber assessment of future growth even if it expects it, fearful that its forecasts become self-fulfilling as businesses and consumers cut back to reflect that forecast. If so, its economics "forecasts" would be in actuality just another policy arrow in its quiver, and should never be taken seriously.
Another inconvenient fact that needs to be ignored in the string of GDP reports is the consistently low inflation numbers that the Fed uses. Remember, to get a sense of real growth, the bean counters need to subtract inflation from the nominal figures. Now I have always argued that the CPI itself has consistently underreported inflation, but I have also explained how the Fed's preferred gauge of inflation used in the GDP report, called the GDP deflator, is consistently lower than the CPI (a trend that goes back to 1977). But the GDP report for First Quarter 2015 really kicks that trend into another dimension.
To arrive at the .2% annualized GDP estimate, the Fed assumed inflation was running at minus .1% annually (Bureau of Economic Analysis). With the exception of two quarters during the depths of the Great Recession (2nd and 3rd Quarters of 2009), we have to go all the way back to the First Quarter of 1952 to find a negative deflator (BEA). If positive inflation data had been used, growth in Q1 would have come in negative.
Based on what we have seen thus far in the year, fantasies about a 2015 recovery should be evaporating. But, as of March 18, the Fed continues to hold to 2.5%-3.0% GDP forecasts and tangential assumptions that rate hikes will begin the second half of this year and will continue throughout next year. (A February 12th survey of economists by the Wall Street Journal shows a consensus 2.2% Fed Funds rate by year end 2016). With these assumptions baked into portfolio dispositions investors risk being caught wrong footed when the ugly truth is finally accepted.

Sunday, May 10, 2015

Janet Yellen Warns Equity Valuations Are High & Dangerous

On December 5, 1996 Federal Reserve Chairman Alan Greenspan gave what was considered a long, boring, and rather unusual speech. That was until the very end when the following words left his mouth...

"Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?"

This once sentence, implying that asset values had reached a level of irrational exuberance, sent the financial markets into a tailspin around the world. Japanese shares immediately fell 3%. The U.S. markets woke up the next morning to find futures sharply lower. With a simple sentence, Greenspan literally rocked the world.

Fast forward to this week and current Federal Reserve Chair Janet Yellen provided the following quote to the media:

“We've also seen a compression in spreads on high-yield debt, which certainly looks like a reach-for-yield type of behavior. I would highlight that equity market valuations at this point generally are quite high. Now, they’re not so high when you compare the returns on equities to the returns on safe assets like bonds, which are also very low, but there are potential dangers there.”

What followed Yellens very direct comments that equity valuations are "quite high" with "potential dangers?"


The markets did not even notice. Everyone is 100% confident the Federal Reserve will continue to artificially move asset prices higher that comments coming directly from the Fed on the danger within the markets are casually brushed away.

If we were in a period of "Irrational Exuberance" entering 1997 we have certainly entered a period of "Maximum Insanity" as we move through 2015.  The more complacent/euphoric market participants become the greater the sands of instability rise under their feet. When they finally shift, it will feel like an earthquake.