Froth Above, Reefs Below And A Portfolio Built For Both

Includes: MGC, TMQ, VWO, VYM
by: Emmet Kodesh

This column presents an allocation strategy that accounts both for this year's roaring but unsteady markets and the fact that socio-economic conditions for most Americans do not prompt them to share the cresting optimism some executives and analysts expound.

The consumer confidence index of January 29 shows citizens worried to a degree that in some lands might make a "revolutionary situation." The CCI dropped eight points to 58 (1985 = 100) last month despite the rushing bull indices and 2-day inaugural coronation. Consumer expectations declined nearly 9-points from 68 to 59. Only 8.6% of Americans say jobs are "plentiful" while about 38% say they're "hard to get." This counterpoints the modest 4% increase in CEO confidence. About 14% of Americans think business conditions are good while the 27% who are sober say they are deteriorating. These findings shadow the secular triple top the markets have made and which after some big red days and intra-day volatility seems shaky like Wile E. Coyote when he realizes the Road Runner has left him hanging in mid-air. With dividends included, the S&P is at an all-time high. The markets go 'beep, beep, coming through' but the economy is the canyon below.

Meanwhile the putative leader poses before a thick gold curtain like a saint in a Byzantine mosaic. American, ECB and Japanese Bankers are waging currency wars and public debt is growing. Talking heads term it "unthinkable" that America repudiate its debt because it is indeed possible and America is quite capable of being entirely self-sufficient. But that is not the intended outcome for a game of chutes and ladders which increasingly resembles musical chairs. Perhaps this explains reports of a 9-1 ratio of insider selling, "the highest level of insider selling since March 2012." Like governmental terms of art, the markets are Titanic; reality is an iceberg. While individual investors provided net inflows into equity mutual funds, albeit in diminishing amounts as January progressed, those in the know are lowering the lifeboats. The fear and greed index passed 90 though it has subsided a bit to 84.

In this era of liquidity injections and cheap borrowing for "systemically important institutions," one must ride the bull carefully and briefly because "that's the only place for money to go. The marginal increase in money supply is going into stocks [although] the global economy is not in good shape" commented Michael Pento in his February 06 report. We have a "Financial Stability Oversight Council" to deepen the moat around the 1% and "prevent crises." Orwell would appreciate the irony. Those at command center know that you can't manage a crisis unless there's a crisis to manage so expect more crises. Call it the 'Reichstag fire' syndrome in which the outcome is pre-determined and an incident provided to drive the target audience into the net.

Before considering a portfolio based on preservation of capital while capable of joining periods of market growth, note economic realities beneath the record levels of corporate cash (much of it parked overseas to avoid taxes), government's links to those 'too big to fail' and its penchant for more regulation and taxes as well as tax uncertainty. Tax payers have been and will be forced by government to fund its financial surrogates until society breaks into the pre-planned feudal structure. But don't let the autocratic drift of American governance distract you from its impoverishing aspects.

Daniel Amerman writes:

"In an extraordinarily cynical act, the government is effectively saying that because the job situation has been so bad for many millions of unemployed people in their 40s, 30s, 20s and teens, they can no longer be considered to be potential participants in the workforce. Because there is no hope for them, they no longer need to be counted. This steady statistical cleansing from the workforce of the worst of the economic casualties - these very real millions of individual tragedies - is being presented as a rapidly improving jobs picture." This is done inter alia by relentless harping on the "employment rate" a term of art based on estimates from telephone surveys and other 'sampling techniques.'

Amerman's charts give results similar to those of John Williams at shadowstats. Amerman shows a genuine jobless rate in 2011 of about 21.2%. Last year, 2012 saw further deterioration of workforce participation. Williams was citing out of work rates consistently at 22.3 - 23%. Amerman focuses particularly on the employment crisis for Americans aged 26-54. These people have been "defined out of existence" he writes in this excerpt:

"What the government's statistical deception is hiding is a catastrophic change in generational employment levels... As the force of aging Boomers increasingly collides with the employment disaster among younger Americans, the results may change everything we think we know about economic growth, budget deficits, Social Security and Medicare as well as all categories of investments."

That last point, investments is our focus amid the current froth and the flogging by financial media to get aboard the gain-train departing from the station just as insiders are exiting. What the cheerleaders fail to note is the brick wall straight ahead at the dark end of the street. The manipulation will not end until the crash and may even survive it. The spectacle of rapturous imperial display shows itself fully at the Super Bowl where the anchoring content disappears beneath digital illusions. It was similar with "Shock and Awe" and is similar with the economy. To enter 'screen world' is to encounter the "era of universal deceit." When workforce participation drops to levels impossible to ignore, millions of people will be cleansed from the era's virtual reality. They will be statistically liquidated.

Thus, Tyler Durden notes that about 88 million Americans have been counted out of the workforce to mask the employment facts. Participation is down to 63% and has been falling for months. This supports Amerman's and Williams' reports and charts. It also points to governance "that makes laying a universal principle" as "workforce" is redefined just as CPI and "employment" have been. It is an Orwellian situation like the latest "comprehensive immigration reform" that destroys what little remains of sovereignty, equality before the law and suppresses real wages. The official story is that making illegal mean 'legal' will ease pressure on social security (another oxymoronic term of art). In fact, it mainly scrambles nations into a global omelet in which generic human inventory can be more readily managed and misled.

The Consumer Comfort Index only recently has risen to -35 from -55 where it languished for four years. Its collapse in 2007 preceded and in effect predicted the market collapse of 2008. Given the stats discussed by Amerman, it is unlikely that last month's slight lessening of discomfort precedes a sustained bull though it should be watched closely, so should the flow of money into the basic asset classes which until very recently saw an enormous disparity between flow into money markets and outflow from equities and balanced funds. This reinforces the import of the Comfort Index and CCI stats. Mainstreet feels and knows what the masters of the media dissemble.

The Boom-Bust Barometer is near the triple top it made from spring to October 2007. With rising taxes, decaying median net worth and doubled debt, it is unlikely that 'this time it will be different.' The bull-bear ratio on January 29 was 2.43, high but it was higher before the 2008 collapse and also in spring 2011 before the slump during the latter half of that year. But it is the economic fundamentals quoted at the outset that haunts the current investing landscape.

Ed Yardeni shows the S&P outpacing international markets and the IMF has lowered its global growth estimate to 3.4%. Along with the rush to the bottom that most major Banks are pursuing (while China moves to back the Yuan with gold), it is important to keep a major but agile position in American equities. It will take 2-3 more decades to beggar this nation, so own productive land, love the one you're with and note the following suggestions.

Action to Take: If you have a good and reliable income stream, lean long into this rally and keep cash on hand for stumbles that will come toward month's end and later this year when European bond bubbles reappear beneath institutional disguises like the various "stabilization mechanisms." The game is insane like our own digital dollar casino and is setting investors up for a beating. Our indices will falter because the fundamentals are worse than unsound and because politics that pretend to address the systemic issues (without really doing so) will cause turbulence as America proceeds down the road to managerial autocracy and integration into an impoverished global system. The Wanting Seed by Anthony Burgess is essential reading to understand this decade and those upcoming. It features an endless attrition war in Afghanistan where the three major blocks grind their bearings and re-cycle the remains. It is a world in which population reduction is a dogma amid other sadly familiar trends. This has direct effect on investments and economics in places like Mongolia.

If you have moderate or limited investments, establish a low-beta core portfolio that will generate real returns despite interest rate suppression. A low-cost way to do this is by Vanguard's Wellesley Income Fund (MUTF:VWINX) which has averaged 10.17% annually for 42 years. Its large cap value equities and medium-term investment grade corporate bonds have minimal risk and can trot when bulls run. If you don't think this market is overbought yet, choose its kin the Wellington Fund (MUTF:VWELX) which has excellent management and is about 63% equities and 35% bonds. The small and medium cap indices are elevated, so play these with ETFs to build or add to a position slowly on pullbacks of which there will be many. The small cap index (MUTF:NAESX) has averaged 10.52%/year for 52 years and has tripled in value in the past decade. In the past year, it beat the S&P by returning 18.04%. Its ETF (NYSEARCA:VB) will serve well but if you're getting in, do so in nibbles. The Extended Market Index (VEXEX) has returned 10.54% since inception 25 years ago and also has tripled in the past 'lost' decade' and beat the S&P last year returning 17.04%. Its ETF (NYSEARCA:VXF) has strong weightings in Financials, Industrials, Consumer Discretionary and Info Tech to provide coverage in diverse sectors that will perform well while the socio-economic situation slides. The rich will get richer helping consumer discretionary outpace the staples (NYSEARCA:VDC) that occupy the 99%. If your time horizon is short, Wellesley Income Fund has proven it is a good place to park and enjoy the sunset. And if time is short this is a good point to cash out some of your bigger gains.

Vanguard's tiny expense ratios will be increasingly vital as the pie shrinks. The ETFs let you to nibble in the current overheated but still running environment, so here are a few that have been strong in recent years. In 2012, the stalwarts were Financials (NYSEARCA:VFH) at 24.34%, Consumer Discretionaries (NYSEARCA:VCR) at 24.02% and Health Care (NYSEARCA:VHT) at 22.93%. All are exceeding the indices this year-to-date with VHT best at a robust 8.45%. Note that in the 8 years since these ETFs were established, Energy (NYSEARCA:VDE) at 11.65% average annual return, Consumer Staples at 9.18% and REITs (NYSEARCA:VNQ) at 9.06 have been the steadiest performers. The coming turbulence will bring volatility to REIT and Energy but they should outperform if you can hold them through the storm. Consumer Staples overweighting will provide solid and low-worry performance. For the same reason, those who want minimal excitement can overweight the Mega Cap ETF (NYSEARCA:MGC) which beat the S&P last year and/or the High Dividend Yield Index (NYSEARCA:VYM) which pays quarterly at an annual rate of 3.25% and returned 17% in the past year. It is a large-cap value with emphasis on Consumer Staples (about 19%) and large, almost equal weightings in Energy, Health Care and Industrials. Actual health care already is and will become more costly and unpleasant as mandates subordinate the practice of medicine to a government-insurance cartel but the companies that work in this field will thrive in coming decades. Mid-cap coverage via Vanguard's ETF (NYSEARCA:VOE) brought 18.4% in the past year and 8.35% already this year. It overweighs financials, so it's there for those who think most of these companies can find ways to weather storms.

Choose three ETF's for a diversified international exposure: the broad-based Emerging Market Index (NYSEARCA:VWO) is the least over-extended at present; the Foreign Real Estate (NASDAQ:VNQI) will produce strong but volatile gains as 'global integration' jolts local and regional economies; and the international small cap ETF (NYSEARCA:VSS) gives low cost access to the most nimble global companies. All three of these funds pay substantial dividends ranging from 5% to 8.25% to 16.34%, so begin establishing or adding to positions on pullbacks. For VNQI, wait till the share price is about or below 50. If you park substantial funds at Vanguard, trading their ETFs is free.

Lastly, set aside 3-10% speculative funds (this is not for fun or thrills but an essential way to capture high reward with low risk) to invest in companies with models suited to cultural trends and demographics and/or that own great properties that will support hi-tech innovations that lets manufacturers produce more for less. For example, the exceptionally rich, hi-grade deposits of NovaCopper (NCQ), of graphite (for graphene) and gold of Focus Graphite (FSCMF.PK) in Quebec or the massive hi-grade mineral deposits in Madagascar of Energizer Resources (ENZR) are ways to establish a substantial stake at minimal cost in companies ripe for development and acquisition. Note also that Silver Wheaton's (SLW) recent deal with Vale (NYSE:VALE) enhances SLW's already excellent business model and growth prospects.

This diversified approach enables anyone with invest-able funds to participate in current growth and protect maximal wealth when things become chaotic and eventually decline. Most of our lives may become rather nasty, brutish and shorter but the strategy above will buffer these negatives by participating in racing markets increasingly detached from the facts of life with which most people live.

Disclosure: I am long NCQ, VWO, SLW. 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.