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Market Shadows: Group of writers and investors: Paul Price, Lee Adler, and Ilene.
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  • Ben In A Box

    Ben In A Box

    Courtesy of John Nyaradi of Wall Street Sector Selector

    After nearly five years of quantitative easing, Ben Bernanke and his Federal Reserve now find themselves in a box.

    For several years, the only game in town has been "The Reflation Trade," engineered by the U.S. Federal Reserve's quantitative easing program and the Fed's unprecedented effort to jumpstart the U.S. economic recovery. Now it seems that Dr. Bernanke wants to dial back the $85 billion/month in bond buying but finds that market forces and current conditions have him trapped in a spot from which there might be no escape.

    Regarding the potential end of quantitative easing, Warren Buffett has said it would be the "shot heard round the world," and markets got a little taste of what that world might look like when Ben made comments in May that sent markets on a wild ride.

    Equities dumped, gold dumped, interest rates spiked as investors contemplated just the possibility that Ben might pull the punchbowl away.

    Since then, we have seen a parade of Fed Presidents and even the Chairman, himself, saying, in effect, that they were "just kidding" and that their easy monetary policies were here to stay for a long, long time. Clearly, the trial balloon regarding the end of quantitative easing went over like a lead balloon.

    Today's unfortunate situation:

    1. The Fed can't withdraw easily from quantitative easing, if at all. Markets have made this more than clear with the sharp response to even the hint of quantitative easing coming to an end, i.e., the "taper tantrum." All recent market action reflects today's environment which is all about the Fed. Recent assurances that the easy money would continue have been successful--major indexes are now back at levels last seen before Dr. Bernanke's first comments.

    2. The Fed has to withdraw from quantitative easing eventually. The long run of easy money has created asset bubbles and is laying the framework for higher inflation. Continuing down the current path will only make the eventual withdrawal even more painful and dramatic.

    [Economatters argues that QE Policy has been a failure when it comes to the economy, anyway. The economy is not the stock market... Lee Adler predicts "Bernanke will eventually go down as the most reviled Fed chairman in history."]

    3. The Fed is quickly descending into confusion and disarray. Last week saw yet another Bernanke Rally triggered after his mid-week comments, while Friday saw dueling Fed Presidents Charles Plosser and James Bullard presenting conflicting views of "to taper or not to taper." In between, Fed Governor Elizabeth Duke, resigned and her departure further muddies the waters. On top of that, it's now becoming widely accepted Dr. Bernanke will also be leaving the scene when his term expires in January and markets will be eagerly watching to see who his replacement will be. The first hint of this came when Dr. Bernanke announced that he wouldn't be attending the Fed conclave in Jackson Hole in August which is like Santa Claus missing Christmas, and any uncertainty regarding his successor will likely be met with significant volatility in global markets.

    This confusion and disarray within the Fed could prove to be dangerous should investors lose faith in the central bank's seemingly invincible power. The markets will continue to be whipsawed by Fedspeak and "taper talk" and we're due for another significant round this week when Dr. Bernanke treks up to Capitol Hill on Wednesday and Thursday for testimony before the House and Senate.

    So "Ben in a Box" presents the potential for danger as well as opportunity. We've already witnessed the adverse reaction from markets as they threw a temper tantrum at just the thought of the easy-money punch bowl running dry. One can only imagine what market reaction might be if and when the $85 billion per month in Federal support actually starts seeping away.

    Over the past several years, "buy the dip" has been the name of the game, but there could soon be a new game if Ben can't get out of the box and a new age of austerity and even recession is at hand.

    Put options: Just because the "Bernanke Put" might be history, doesn't mean you can't go out and buy your own to protect profits or hedge against potential downside moves.

    Inverse/bear ETFs and mutual funds: Bear ETFs and mutual funds are designed to help investors avoid the risks of falling markets and might also offer downside hedges to long positions should the market continue its recent decline.

    Cash: Cash is the ultimate hedge in times of stress, and when markets go south in a big way, cash is always king.

    U.S. dollar/Treasury bonds: While there will be few safe havens if things get really ugly, the U.S. dollar and U.S. Treasury bonds will most likely be the ultimate flight-to-quality trade. The United States might be a passenger on the Titanic, but it will be the last passenger to drown. If Titanic goes down, we can only hope that the Carpathia will arrive in time.

    I think the easy money party will be coming to end soon, and that Dr. Ben is set to turn out the lights. We'll find out more this week, but no central banker in history has ever attempted to do what he is doing, and nobody can know how this will turn out. But, as always, danger and opportunity arrive hand in hand, and this time will be no different.

    Wall Street Sector Selector remains in "yellow flag" status, expecting a high risk environment ahead.

    ****

    For another view on the death of QE and the Treasury market, see Lee Adler's No, Joe, No One Owes Bernanke An Apology.

    John Nyaradi and Lee Adler present somewhat similar views of Chairman Bernanke's unprecedented QE policies. However, their projections of how the game will end are different.

    John speculates that cash and Treasuries will be the last refuge for investors when the SHTF (Ben In A Box).

    Lee believes that Bernanke's foolhardy actions will torpedo the bond market. "As a serial bubble blower, he already should be, but he has Joe Weisenthal and the rest of the Fed apologist crowd spinning the facts and misleading people prone to believe in the tooth fairy, Santa Claus, and helicopter money as a cure for economic ills. Their illusions will face a day of reckoning soon. As the collapse of the US Treasury market, the greatest Ponzi scheme of all time, progresses, it will reach an inflection point that will take the stock market bubble, the latest housing bubble, and the economy with it. Bernanke's legacy will be sealed once and for all." (No, Joe, No One Owes Bernanke An Apology).

    Paul Price of Market Shadows votes to avoid bonds: "Holders of long-term bonds are taking huge risks. A 1% rise at the long end of the yield curve could send 30-year bond prices down 17%. A 2% increase could drop principal values much more. Years of coupon payments could be wiped out on a total return basis." (Death by Leverage.) Paul has no idea of when the bubble will burst, but believes that it will.

    What do you think?

    Picture via: Jr. Deputy Accountant

    Jul 16 9:14 PM | Link | Comment!
  • Say Hello To Inflation, Inflation Is Dead
    Say Hello to Inflation, Inflation is Dead

    By Paul Price with Intro by Ilene

    Quantitative easing (QE or "money printing") will continue despite Bernanke's rhetoric about cutting back. (See Don't Fear the Taper). Funding trillion dollar annual deficits requires monetization of debt. America is almost $17 trillion in debt. Interest rates rising just a few ticks closer to their long-term, normalized levels, would be an insurmountable strain on future budgets.

    Admitting the true rate of inflation would trigger Cost of Living Adjustment (COLA) raises for government workers, pensioners and social security recipients. Private sector unionized labor and nonfederal government employees would likely demand raises too. Bond buyers would insist on higher coupon rates.

    Our leaders have sacrificed integrity over fixing the underlying problems. Paul Price discusses the situation in Inflation Will Never Go Up Again. In his view, there is no plausible exit strategy from QE without risking societal breakdown as lifelong promises get broken (pensions, salary adjustments and social security payments). Civil uprisings have already occurred in Greece, Iceland and Cyprus. The masses are rebelling in Egypt today. The U.S. has avoided riots because QE is holding interest rates artificially low. The Bureau of Labor Statistics' (BLS) manipulation of Consumer Price Index (CPI) allows the government to pretend inflation is not serious. When the public realizes the true extent of inflation, bond buyers will likely demand much higher coupon rates pushing up the government's cost of debt service dramatically.

    Inflation Will Never Go Up Again

    By Paul Price

    Really? My health insurance premiums have skyrocketed. My kids' pre-college and university tuitions have been ramping up. The cost of filling my gas tank has soared. Shiny new menus at restaurants mean higher prices - cash-strapped operators do not print them just to offer exciting new entrees.

    Obamacare's implementation will make matters worse. Franchisees won't be able to absorb the added cost of healthcare coverage, or the $2,000 per worker penalty. This expense will be passed along as higher prices.

    Despite these anecdotal experiences and predictions, the government's Bureau of Labor Statistics (BLS) tells us each month that the Consumer Price Index (CPI) is barely above neutral year-over-year. It all comes down to how 'inflation' gets defined.

    People generally think of annual inflation as the cost of a basket of goods and services today versus the cost of the identical basket one year earlier. While that makes sense, it is NOT what the BLS measures and reports.

    If you want the details of the BLS report, read the fine print (below). The CPI-U is said to represent the index for all urban consumers.

    (click to enlarge)

    Core CPI specifically excludes food and energy costs, reflecting reality only for people who don't move, eat or buy any products requiring transportation.

    Rapidly rising income, property and sales taxes are not included in any of the BLS inflation numbers. Taxes add to the cost of living.

    I traveled to Iceland last September. Part of that country's post-2008 crisis management was the imposition of a 25.5% VAT (value added tax) on almost every retail purchase. Paying 25.5% in sales tax means each Krona can buy only 74.5% of the currency's face value in real merchandise or services. Money unspent does not go towards paying VAT. But never spending money is the same as not having it.

    Iceland imposed currency controls due to its banking industry failure. Citizens cannot move their wealth outside of the country; they cannot buy non-Kronur denominated securities without prior government approval. In practice, Icelanders will either pay the prohibitive 25.5% tax or forfeit spending their already-taxed earnings.

    The same plan, with slightly lower rates, is in effect all over the Eurozone. When VAT rates move higher, inflation - defined as the cost of living - increases. (Imposing a national sales tax in the U.S. is a terrible idea. Taking money away from those who need it or could use it productively, and giving it to government, will allow politicians to do more damage. Deficits and spending won't drop.)

    As an aside, 'temporary' taxes are rarely temporary. The June 29, 2013, Philadelphia Inquirer recounted the story of the Johnstown Flood Relief tax of 1936. A 10% surcharge on all alcoholic products was levied to help the townspeople. 76 years later the tax has risen to 18% and is built into all Pennsylvania liquor sales. None of it is earmarked for Johnstown. The hidden tax is part of the final retail price that then becomes subject to PA's state level 6% sales tax. After compounding both taxes, the final cost is 19.08% at the register. The price of booze is not included in official inflation lists even though government policies may be driving us to drink.

    Excluding food, energy and taxes from core CPI allows the BLS to understate increases in the true cost of living. After high inflation years in the late 1970s, the government changed how it calculated CPI. This happened again in 1990. Each time, the BLS manipulated the measurement techniques to downplay the extent of cost increases. This lessened the government's need to increase Cost of Living Adjustment (COLA) applied to employees and retirees.

    The excellent ShadowStats website provides monthly updates on what CPI would read if the rules were still the 1980 rules. The difference is startling.

    (click to enlarge)

    Some BLS tricks are even more devious.

    The BLS uses other tricks to lower reported inflation rates. The 'substitution principle' says that when the price of a particular item, e.g. rib-eye steak, rises, consumers will switch to lower-priced alternatives like ground beef. Under that scenario a 20% rise in rib-eye steak prices disappears completely if it can be offset with ground beef costing 20% less. If Lexus or Porsche MSRP's go up 30%, it doesn't matter because the consumer can buy a Kia or Hyundai instead. No inflation adjustment required.

    Our leaders also call improvements in quality with unchanged pricing 'deflationary'. The first iPads were crude by today's standards but cost $600. The newest iPad with Retina Display still costs $600 but packs more power and features. The BLS counts that as a drop in price even though the price is the same.

    Until consumers are walking to work and eating cat food, the substitution principle allows the BLS to call CPI anything it wants.

    A real-world consumer poll showed very large increases in the out-of-pocket cost of living over the period from Q1 2001 through Q1 2013. The official change in CPI is almost invisible over that same period.

    (click to enlarge)

    Anyone who pays their electric, tuition or grocery bills, or funds their own health insurance plan, is painfully aware that the CPI and CPI-U numbers do not reflect reality.

    The cost of living has been rising at a fast pace. Inflation, as measured by the CPI, will never go up significantly unless politicians abandon their deceptive practices. Unfortunately, Washington D.C. has a strong interest in keeping the public uninformed.

    (Featured in Market Shadows Newsletter, Fables and Fairy Tales. Also in the newsletter: The Crow and the Pitcher, Paul's recent selling of puts, an indicator turning bullish, Lee Adler with data on bond buying/selling, and more.)

    Jul 05 8:13 PM | Link | Comment!
  • Death By Leverage
    Death by Leverage

    By Paul Price

    [Adapted from this week's Market Shadows' newsletter, The Banker Who Was God, 6-23-13.]

    America's national debt exceeded $15 trillion [with a T] for the first time on November 15, 2011. Deficit spending since then has pushed the total national debt closer to $17 trillion.

    (click to enlarge)

    An official population of 316,110,225 (6-23-13) means every man, woman and child in America now owes $52,953 plus future interest costs.

    (click to enlarge)

    It should be noted that the nearly $17T debt does not include the enormous unfunded liabilities for Social Security, Medicaid/Medicare and federal pensions, or the potentially crippling burdens of ObamaCare.

    "The U.S. national debt comes out to about $16 trillion today [Nov., 2012]. That's something. But it's nothing compared to the extra $87 trillion in unfunded liabilities to Social Security, Medicare, and federal pensions. Here's how that works. If you add up all of the U.S. government's promises to pay retirement and health care benefits for the next 75 years and subtract the projected tax revenue dedicated to those programs over the next 75 years, there is a gap. A $87 trillion gap -- in addition to a $16 billion hole.

    "'Why haven't Americans heard about the titanic $86.8 trillion liability from these programs?' Chris Box and Bill Archer ask in the Wall Street Journal. The authors blame the U.S. government for using shoddy accounting and for misleading the American public on their finances..." (Is Our Debt Burden Really $100 Trillion?, by Derek Thompson, The Atlantic.)

    Incremental debt is being added at an unprecedented rate. Including future promises that have not come due yet, the total unfunded liability number is over five times higher.

    (click to enlarge)

    The Treasury bond auction market reveals nothing about the true state of interest rates (the cost of borrowing) as shill bids from the Fed have sucked up virtually all net government bond issuance this year.

    Europe is already in recession and drowning in debt. There are no solutions on the horizon. The idea that the Fed will cut back on money printing/bond buying programs is fantasy. The politically expedient solution is for quantitative easing (QE) to continue or even expand, both in the U.S. and abroad.

    The only alternative is the outright confiscation of wealth. That technique was beta-tested just months ago in Cyprus.

    Bubble valuations currently reside in the fixed income arena, and bonds appear riskier than stocks. Shares of highly levered companies have benefited from artificially low rates by refinancing old debt. They have also borrowed to pay for massive share buyback programs. Those times may be coming to an end.

    (click to enlarge)

    Holders of long-term bonds are taking huge risks. A 1% rise at the long end of the yield curve could send 30-year bond prices down 17%. A 2% increase could drop principal values much more. Years of coupon payments could be wiped out on a total return basis.

    Long maturity corporate paper issued just weeks ago as part of Apple's (AAPL) $15 billion debt offering have already been marked down by over 10%.

    A credit crunch, or a freeze, may be brewing that could be worse than what we saw in 2008. (A crunch implies credit is available at a high price. A freeze means it's nearly impossible to borrow at any price.) While it's a fool's game to try to predict the timing, we should be preparing.

    Preparing for a credit crunch or freeze

    Risk in the equity market is substantially lower than risk in fixed income. Especially compared to alternative investment vehicles, stocks are not overpriced (see Think stocks are overpriced? Think again and In Love with TINA).

    Avoid bonds. But if you must keep any fixed income vehicles, be sure they have short maturities.

    Make sure companies you own have enough predictable cash flow to service both bond interest payments and principal payments coming due within the next few years. 2008 taught us to avoid highly leveraged companies. When credit freezes, even healthier firms with maturing debt can be forced to issue highly dilutive shares or descend rapidly into bankruptcy.

    Even top-rated firms can be forced into coercive terms if they need to refinance when money is tight. For instance, in 2008, Berkshire Hathaway extracted 10% interest plus warrants from Goldman Sachs, GE and others. The next cycle could lead to even more punitive terms.

    Check balance sheet data by consulting subscription services such as Value Line, S&P or Morningstar. Free sites like Yahoo Finance and MSN MoneyCentral also offer access to up-to-date financial information. A firm that cannot meet its bond obligations is at the mercy of its lenders.

    Stick with shares of dominant companies with solid balance sheets. I favor the companies included in our Virtual Value Portfolio, especially those still trading at prices close to where we initially added shares.

    Avoid margin. Debt-free portfolios can wait out temporary storms. They allow for the possibility to add to your holdings after major selloffs.

    Adapted from this week's Market Shadows' newsletter, The Banker Who Was God (6-23-13).

    Jun 25 11:42 PM | Link | Comment!
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