Sunday, July 26, 2015

Two Reversible Negatives


For some time I have been worried about a market top in stocks. In a classic sense, a major decline is less likely today for structural reasons than I had previously thought. Two obstacles to higher stock prices are Politicians and Commodities.  Both of  these drawbacks are reversible, but could cause the “once in a generation fall” of my fears.

The Enemy = Politicians

All politicians, as distinct from statesmen or stateswomen, wish to avoid being tagged with unpopular political decisions. The very nature of human and animal life is one of periodic successes and failures. A student of financial history recognizes peaks and valleys. The current crop of political leaders recognize that job preservation and job creation are critical to their reelection. To deliver on these goals they have adopted a policy of bailing out large employers who have sufficiently poor financial conditions that there is fear of substantial job losses. Such bailouts ignore the historical fact that it is natural for businesses to expand and contract, and in many cases particularly good for their customers. When a significantly large number of voters in key areas are employed by a company that is in distress, the modern reaction is to bailout the troubled company or industry with taxpayer money.

The recognized problems of late 2007 and 2008 in the US led to massive bailouts of both major auto makers and very large financial institutions. The public was revolted by this use of its hard earned money in the face of needs for spending on infrastructure, education, and defense. To avoid future bailouts and to protect themselves, the politicians came up with the doctrine of preventing large corporations from becoming “too big to fail” so that the government would be politically forced to bail them out. From the standpoint of protecting the politicians, the various “reforms” such as the Dodd Frank legislation appear to be doing a good job currently, as we have not had a major failure since the financial crisis.

The Price

To fund the bailouts, the Federal Reserve bought almost all of the debt the federal government put out and in so doing increased money supply which led to materially lower interest rates, particularly hurting the retired population, living on fixed income returns from their savings and pensions.

As harmful as that policy was to an important part of the population, a much bigger price was paid by the retail investor. Over the five years that the Dodd Frank bill has been operating there has been a withdrawal from individuals buying individual stocks. This has been caused by two simultaneous elements. The first by making the investment community seem to be the sole source of the financial crisis without regard for the contributions of government policies, labor unions, and inappropriate education.  By demonizing the financial community many otherwise rational investors voted with their feet. In the past, this kind of withdrawal would have brought a response from the financial community.

Because of greatly increased regulation on large financial institutions they needed to add highly paid compliance people and capital buffers that made the cost of serving the middle income public sky-rocket.

For many brokerage firms, the retail cash agency business has become unprofitable. This in turn has led to a change in the nature of the sales force serving the public. They have shifted into selling packaged products that have higher margins and often include borrowing (leverage). This shift has led to a number of the older and more trusted sales people leaving to become fee-paid advisors, replaced with younger sales people with increased sales quotas (this did not sit well with established clients or younger would be-investors). The net result is that far too many investors did not benefit from the doubling of market prices over the last five years. Their absence is being felt today by their lack of enthusiasm for investing to meet long term retirement needs.

Despite various politicians’ beliefs, human nature has not been repealed. Eventually the animal instincts will drive greed over fears and we will get enthusiasm for risk taking. While it is likely to be more muted than what we have seen in China, it will become a force that will override the damage to investors’ psyche caused by the Dodd Frank bill.  (Retail investors own 80% of the small Chinese market often with substantial margin debt. The Asian institutional market is a heavy user of equity derivatives which did not help in the last couple of weeks.)

Commodities, the Second Reversible

I have not owned any commodity future for more than thirty years. Nevertheless, whenever I see the media coverage of a major decline with the expressed view that it will continue, my investment instinct is to look for exhaustion on the part of the late sellers which will create a bottom. To most investors, commodities and particularly futures are of little importance in developing longer term investment policies. With high quality interest rates being manipulated by the central banks, I wonder whether the fixed income market will continue to serve its historic role of alerting the equity market of on-coming problems. If that is the case I am beginning to examine whether there is useful information in commodity prices.

According to Calafia Beach Pundit, while commodity prices are down they are still substantially up from their bottom. For example, Copper, often called Dr. Copper because of its economic ties, is down 40% from it peak but still 290% above its 2001 bottom. The price of commodities is a function of perceived and actual scarcity. One of the students of commodities recognized that in truth, the only scarcity of mankind is “human ingenuity.” Over time technology has eaten away at the use of any commodity through improved mining and manufacturing techniques plus growing substitution of less expensive elements. Also history reminds us that higher prices bring out more supply including new discoveries.

This is not going to become a “gold letter” for I believe that there are a different set of constraints on gold than on other commodities. Nevertheless, the price of gold hugged the CRB Raw Industrials Index in lock-step from 2001 to about 2007-2008. At that point the industrial commodities declined in sympathy to the then economic slowdown. Gold continued to rise until 2011. One might suggest it is when those that view gold not primarily as a commodity but a hedge against the decline in the value of currency became the dominant buyer as the US entered various phases of “quantitative easing.” Since that peak the price of the metal has had a parallel decline to the industrial materials. Gold bullion may have suffered the ultimate substitution by the increase use of “paper gold” in the form of futures and Exchange Traded Funds (ETFs) which absorbed some of the demand for currency safety.

China has become the pivot for commodity prices including grains. The command society shift from manufactured exports and internal infrastructure to consummation of goods and services has changed the global demand for industrial commodities. At some point this shift will meet its logical end and we will see growth in commodity imports into China. In the meantime the other developing economies will need to import commodities to fill the needs of their growing populations.

I do not know when commodity prices will turn upward, but as a student of history, I believe they will. If that happens at the same time as the lust to own securities deemed in short supply, we could have one enormous market rise which we will need before we have a generational type of decline.

Question of the week: Where are you seeing signs of growing demand? (The Mall at Short Hills was crowded on a warm and clear Sunday, today.) 
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