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Gold Digger started his career in financial services with Bloomberg LP in New York. He played a key role in fixed income analysis for Bloomberg professional services with specific focus on corporate and municipal bond markets. Currently he is the Chief Investment Officer of a private wealth... More
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  • "Bernanke High" And S&P Trend Have Room To Go

    In my last article here I had clearly articulated how market swoon in May (that continued in June too) was a good buying opportunity. And now S&P 500 (SPX, SPY) is making a new high every day. Currently at 1676 it is 100 points higher than the lowest point in June when market was selling on Bernanke's comments. As I identified in my previous article, Federal Reserve officials are too scared themselves to scare this stock market. They will do anything to support their hypothesis that QEs work in the long term. And the only evidence they have to show as the success of ongoing QE is the stock market performance. But in reality QE has zero to minimal effect on the real economy contrary to the firm belief of our central bankers. More on that in the later part of this article. But let's start with the short term investment strategy in the light of central banks all around the world obsessed with QEs.

    Short term strategy - As we saw last month, a paltry 200 points drop (which is less than 2% at these levels) in Dow Jones index (DJIA) is more than enough to bring out Fed officials in droves to say that they are really not talking about making any changes to QE. They even hinted at increasing QE if market did not immediately start going up. With so much artificial and unprecedented support, the next target for S&P 500 (SPX, SPY) is 1750 in the next 3 months.

    Also, we are looking at the next level of S&P 500 as a conditional variable of the choice of next Fed chairman (or chairwoman). We want a person at the helm who can not think beyond QE and/or increasing QE for the next few years. So far, all the proposed names fit that criteria very well. If we can get more clarity on the final choice of next Fed chief then S&P 500 can even hit 1800 by the end of this year. In fact, choice of Larry Summers or Tim Geithner can help S&P 500 hit 1800 level within a week of their nomination. Essentially we want a Fed chief who has no idea of real economics, mathematics or any other subject for that matter. He should also have a firm belief in utilizing the special powers of printing money that are vested in him/her by our political structure. We want the Federal Reserve to bring forward all the earning and saving potential of the future generations to the present value so that the current investors can maximize their return on investments in the next 12 months.

    Given the almost blind faith of our central bank in QE, S&P 500 can even hit 2000 within next two years before markets, technology (bitcoin and other alternatives) and public (mainly the top 10% who control 90% wealth) become mature and start discounting the credibility of our central banks. Until then investors should take long positions on a continuous basis and add new positions in any market weakness.

    In the rest of this article as I'll try to explain why QE really does not work outside of financial markets.

    Lets consider the following to understand that QE has no impact on the real economy:

    1) The job number based proof - (click to enlarge)

    As the details of US unemployment rate above show, it has normally taken three to four years for the unemployment rate to drop below 7% in the past four recessions/contractions (1975, 1982, 1992 and 2009). Now if we recall correctly, in the past three of these recessions we did not have any QE and still unemployment rate fell below 7% after a certain period. We can also see in the above picture the cyclical nature of unemployment rate that can not be controlled by QEs. In fact, this time QE is creating more economic distortion as on one hand asset prices are rising up like we have a very strong economy but on the other hand our central banks are acting as if we have a very weak economy. So any future action to reduce this distortion and align asset prices with the real picture of the economy is bound to disrupt the financial markets and thus create more employment troubles for the broader economy as well.

    However, our central bankers have started to harbor this foolish idea from Allen Greenspan's time that stock market drives the economy. So by manipulating the stock market through central bank interference, we can have a strong economy. But the history of market tells us that companies are formed and stocks are traded because of the economic activity and not vice versa. Economies have existed much before the time the stock trading began. In fact, most important inventions of our times (light bulb, airplane, engines and electronics) happened before central banks and markets existed. And as the market events of 2007-2008 showed us, the asset price manipulation was actually hemorrhaging the economy internally.

    Now Bernanke has brought the idea of QE through his myopic study of economic history which for some strange reason stops in 1930s. And his ideas are plaguing the central banks all across the world. And now asset prices are being distorted artificially at an unprecedented level as central bankers have become activist investors.

    But internalizing this idea that central banks create or drive economies is FATAL. This is fatal not so much for the economy but for the existence of central banks themselves. Central banks were created and exist because of the trust of people in the "fiat money" that they control. If that "fiat money" starts distorting fundamental economic incentives established much before these central banks came into existence then those incentives will eventually drive people to other alternative systems of economic exchanges (i.e. another form of "money"). If that process starts then central banks will quickly become obsolete.

    2) Market based proof - I don't have to write much about it as the events of past two months are a clear indicator that markets are not setting new highs because of the economy but because of the QE. A mere talk of tapering is enough to roil the markets from Japan to Brazil. And our central bankers still seem to believe that their policies are making real economic improvement around the world.

    Well, house prices in US have gone up and global markets have gone up to benefit the current owners and holders of these assets.

    But who is paying the price? It's the people who are buying these assets now. Like a young couple who is now being forced to buy a house which has already appreciated 20% in value in the past two years. Or like a young 401(K) investor who is being forced to buy S&P 500 which has already soared 38% in the past two years. Unless these newcomers sell these investments very quickly (also called "flipping"), they will be left holding the bag. Because eventually, if ever, central banks remove the liquidity after what they call the "foreseeable future", asset appreciation will revert to real economics driven appreciation. A lot of which has already been brought forward by the foolish policies of our very short-term oriented central banks. Essentially central banks are distorting the economic incentives of the next generation of investors through their myopic policies.

    3) Numbers based proof - Federal Reserve is printing $85 billion of "fiat money" every month. This is in addition to our regular economic activity. Consider the facts that currently there are 11.8 million unemployed people (i.e. 7.6% unemployment rate) and average US worker salary is $45,000/year. This implies that if there were a ghost program that automatically employed all the currently unemployed people irrespective of their qualifications and willingness to work then such a program would cost only $45 billion monthly. Such a program will bring unemployment rate to 0%.

    With $85 billion/month, Federal Reserve is printing money at double of that rate. Still we have seen only marginal improvements in unemployment rate. Such improvements also seem to take place naturally as shown in the unemployment rate picture above.

    Essentially, Federal Reserve officials seem to have absolutely no idea where the money that they are printing every month is going. We have to keep in mind that this is the same Fed that claims being capable of monitoring huge financial institutions. How a Fed which is so clueless about its own actions and programs can justify its capabilities?

    4) Relying on an equation - Most central bankers seems to rely on the money equation to justify their actions. The money equation MV=PQ governs modern day monetary policies. In this equation, M is the money supply, V is the velocity of money, P is the aggregate prices and Q is the real output. Essentially it says that total supply of goods and prices charged for them should equal the total money available and how many times it was used. It's that simple. But what is not so simple is realizing the fact that while left side of this equation is somewhat controlled by central banks today, the right side of it is totally independent and driven by real economy.

    But our central bankers seem to treat this equation as a two way street. They are exerting all their power to change the left side of equation in the hope that it will drive the right side of the equation. However, this is not a physics equation (e.g. F=MA) which holds true in both directions, but this is rather like a chemical equation (e.g. 2HCl + 2Na -> 2NaCl + H2) which holds true for one direction but not as much for the reverse direction. Unfortunately this kind of critical thinking is not imparted in our Ivy Leagues today from where we seem to be importing most of our central bank chiefs, treasury secretaries, and other officials off late.

    MV=PQ will be better understood if it is written as PQ=MV. That is, for a given price and output, we need to have an adequate base of money supply. If output or prices are more than the money supply then they can be restricted. But not vice versa. Or think about a picture where you control a tap on a pipe, you can restrict the water flow by turning the valve. But trying to open the valve beyond the width of the pipe will not increase the water flow. In the process we might just break the valve itself.

    This "Bernanke Plague" aka. the money printing disease is also infecting other central banks. Which will eventually prove FATAL not so much for the economies but for the central banks themselves. But right now, central bankers are reveling in the state of "Bernanke High" which makes them believe that they control the economies through asset price manipulation.

    However, none of this reasoning is going to dissuade our central bankers from doing what they are doing. So as an investor we have to play the market accordingly. We have a long term strategy to deal with the eventual outcomes described above but in the short term buying S&P 500 is the right choice. Of course, at the expense of those unfortunate folks who will buy this market later.

    Disclosure: I am long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

    Jul 17 7:04 AM | Link | Comment!
  • US Debt deal and stock market implications
    US Congress finally voted on a debt deal as expected on the eleventh hour and debt ceiling increase was promptly signed into law by the President. That puts an end to the first chapter of this long debate that has just started and hopefully will bring out some intelligent choices for the nation going forward.
    However, association of debt deal with debt downgrade fears was totally uncalled for. Though rating agencies jumped into the debate to gain some political clout, we don't believe that US debt downgrade is imminent. In fact, it will be a major failure for rating agencies if they downgrade US debt at this point. The reason is very simple: with all said and done, US still generates almost 5 times the tax revenue than the outstanding bond interest liabilities in any given month.
    We don't understand how the bond holder interest and principal payments are affected if US government is able to reduce the pension, Medicare, Medicaid and other liabilities. The job of rating agencies is to make sure that bond holders are made whole and not to make sure how a country is run unless they can establish a reason why some policies will have a negative impact on the repayment commitment to bond holders.
    As of now, reneging or skimping on the social entitlements like social security, Medicaid etc. does not seem to affect the revenue generation power of US. This is mainly by design as the beneficiaries of these social programs make very small or absolutely zero contribution to the economy as a whole. Now this may sound little insensitive as a person but that is the truth and reality for an investor.
    So rating agencies should not have linked together these issues as a basis for credit rating of US treasury bonds unless they have a good model to show us how reduction of government liabilities for social entitlements will have a negative impact on government's revenues.
    Let us consider an analogy from corporate bond market: if a corporation decides to lay off some employees or reduce its pension liabilities to balance its budget then it will be considered as a positive event for both bond holders and equity holders rather than a negative event. And ratings get a positive boost unless rating agencies are convinced that laying off those workers would significantly reduce the profitability and revenue generation capabilities of the company.
    In fact, if congress successfully implements a plan to reduce the liabilities in the social entitlements then we would advise investors to go long US dollar. Now that debate will not be clear until at least November so a decisive direction is hard to predict until then. But if we see dollar weakness then it is time to start building some long positions in US Dollar (UUP).
    Another big positive for UUP might come if Congress is able to identify some measures for increasing the revenue itself. We can see immense opportunities in that area when we thoughtfully analyze just the foreign trade structure of the country. We should evaluate imports and their sources to start with.
    Though one negative overhang on US dollar might be Federal Reserve actions. And if we get any indication of another round of quantitative easing of some sort then this will be a catastrophe for US economy due to its big negative impact on small businesses. So before I advise my investors to start building position in US Dollar I would at least wait till end of August as it was this time last year that a panicked Fed chairman announced QE2 without any due diligence of its impact on small businesses. If that turns out to be the case again this year then an opposite trade is warranted of shorting the US Dollar by buying UDN ETF. That is why I would advise investors to wait till the end of August to take a decisive position in UUP or UDN.
    Strengthening dollar will help small businesses and big businesses equally. Because most big US business do not compete globally on prices rather they compete on quality and innovation. So while weaker dollar inflates their profits in the short term but on the other hand it hampers their longer term investment capacity. Also higher dollar keeps significant fuel costs under control for both corporations and individual consumer.
    Overall debt deal and closure of fed programs is a big positive for US stocks as well.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
    Tags: UUP, UDN
    Aug 03 3:29 PM | Link | Comment!
  • Tech sector selling opportunity
    Nasdaq has run higher in past seven sessions straight with Nasdaq 100 gaining more than 6% in past seven trading days. Compare that to the yield on 10-year treasuries hovering near 3%. So tech sector trade is now looking very crowded as all the yield seekers pile into the sector. Most of the major contributors in the Nasdaq 100 have gained too much in this short period with Google (GOOG) up 10%, Apple (OTC:APPL) up 10%, Priceline (PCLN), Microsoft (MSFT) and Baidu (BIDU) also contributing to the gains. However, as these stocks price-in the best earnings scenario, Nasdaq composite is looking toppy here.
    We are concerned about Netflix (NFLX) in particular as the company's stock ran up almost 10% in just two days on the news of expansion plans into Latin America and Caribbean. However, looking at Netflix's business model, we wonder why they want to do that while they are not making big money in their primary market itself here in US. Netflix seems to be playing a trick on investors as investors worry about customer count while completely ignoring the other side of the equation: the cost associated with that customer acquisition. There is a tendency among the tech sector investors to reward investment by the firm with a fake promise of future earnings potential.
    This is because, unlike any other industry, cost of switching for customers from a tech company is almost negligible.
    Though there is no cheap service like Netflix around at the current time but if another ponzy schemer, who doesn't care about the cost to the company, comes around offering me $6/month unlimited movie streaming, I'll definitely switch immediately. Assuming every logical customer will do the same, I don't understand how long Netflix will be able to justify these huge investments if they are not striking exclusivity contracts with its content providers.
    Same logic applies to cloud service offerings. While cloud does have slightly higher switching costs than a DVD rental and streaming service, that cost is still not that high due to the whole model of cloud. So Amazon (AMZN) justifying cloud investment does not make sense either.
    While with current yield fishing environment, yield seekers are willing to ignore business models for the sake of extra yield. This reality will come to bite investors sooner rather than later. Sometimes gaining 4% is much better than loosing 50%. We should always be aware of the competition in tech sector as well as in our investments. We are advising investors to start taking profit in above mentioned technology names before rally fizzles out.
    Jul 06 4:55 PM | Link | Comment!
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