12 Steps to a Market Problem - Weekly Blog # 500

Two Markets Principles: “The law of unintended consequences is the only real law of history.” - Niall Ferguson. And when markets move from being investment fundamentals driven to sentiment, directional changes may be volatile and dramatic. I believe that governments are increasing the risks of more unintended consequences as they change policies to address political rather than strategic needs. After an extended period of stock markets rising with comfortable complacency that most numbers and attitudes will be pro-growth, we have entered a new phase.

I have recently written about forthcoming declines that may be either of the normal cyclical nature or the far less frequent abnormal declines. I don’t know which type will be the next decline that we will be facing. In each case declines are followed by recoveries. The key difference in terms of the recoveries is the level of damage the declines cause due to the psyche of both individual and institutional investors. The greater the damage the longer it takes for the full recovery to do its restoration of capital.

Currently there are a number of signals being produced. Some of them will have little or no longer term impact. However, some will be signposts to the future. As a contrarian I am going to be focusing on possible negative signals. This is appropriate for two reasons. First in the current period of rising enthusiasm and excitement there are fewer voices of caution. Second, I believe that I owe to our managed accounts to look for possible problems on the horizon that are not already in today’s prices.

In no particular order the following are input signals to my thinking:

1.  Before we awoke last Monday morning, Samsung Electronics stock price in South Korea fell 5.1%. Over the next few days the leading FAANG stocks were also weak. At times Ex-US markets can trigger US markets.

2.  Of the eight major ten year sovereign debt yields, only Canada’s higher yield was greater than the 10 year US Treasury bonds. This means that investors found that six countries’ debt was a better investment than the US.

3.  In the recovering repurchase agreements market it is difficult to buy both US Treasuries and German Bunds in quantity. I believe that this indicates that these markets are not being largely driven by investment needs, but the need to find acceptable collateral. Today only Bank of New York/Mellon is clearing repos.

4.  Some believe in the run up to year-end banks and some other financial institutions are dressing up their balance sheets by reducing their loans and trading inventory. This may impact available liquidity.

5.  “Liquidity is that which moves the market,” said Stan Druckenmiller, who is said to be one of the soundest investors for many years.

6.  The law firm Williams & Jensen is tracking the SEC’s interest in Fixed Income Market Structure changes as are the Federal Reserve Bank of New York and the Treasury Department. The current and evolving structure is very different from what was in place during prior financial crises even though the new Federal Reserve Board Chair-designate believes that there is no longer any bank that is too big to fail.

7.  The stock and bond markets are interrelated in many ways. Fixed income investors and dealers are crucial to the supply of short-term credit to finance dealers, authorized participants, Money Market funds, derivatives and trading. They also play a role in the high yield bond and loan market that is experiencing a wave of “covenant lite” issuance. Further, fixed income investors are providing debt being used to both buy back corporate shares and also to invest in their businesses.

8.  Marathon Global Investment Review out of London regularly discusses the impact of the capital cycle on corporate results and stock prices. When borrowers can borrow cheaply in an undisciplined way, they get too much money that expands capacity which eventually forces lower prices to create demand or buy market share which is destructive to the issuer’s stock prices. Recent examples include the oil industry and reinsurance companies. Possible current longer term risks could be two stock market darlings: Tesla and Amazon. A significant problem with either will not be likely treated as an isolated event.

9.  At the March 2000 peak of the MSCI Europe, the ten largest stocks in the Index fell in the next 12 months twice as much as the index declined and in the following 12 months fell four times what the index did. Some 17 1/2 years from the peak, only one of the ten, Royal Dutch, has regained its full value. This highlights the difference between a “normal “ cyclical decline and an absolute one.

10.  Central Banks are utilizing stocks as a substitute for bonds in their attempts to stabilize their economies. The Bank of Japan owns 2/3 of the equity ETFs in Japan. The Swiss National Bank owns $10,000 dollars of US stocks for every inhabitant in Switzerland. Perhaps the ECB (if it continues to manipulate the market) could buy shares as it already owns 3/4 of all the eligible bonds.

11.  While Power Shares in its NASDAQ 100 ETF has gained 41% in the top five stocks (See point 1), perhaps connected, JP Morgan has pointed out that some ETFs have short positions greater than the shares outstanding due to re-lending.

12.  Jason Zweig reports that the fifth most popular stock among the brokerage customers of Fidelity Investments was Bitcoin Investment Trust that holds bitcoins. The stock traded at a 70% premium over the value of the underlying holdings. There were 40% more buyers than sellers. ( Is this a South Sea Bubble ?)

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When will Long-Term Prices for Gold and Natural Gas Go Up?

Introduction

One of the ways analysts attempt to get ahead of the market is by “connecting the dots.” The dots are stray pieces of seemingly unconnected bits of information which can lead to a useful insight. During World War II the US Marines were trying to estimate the size of various Pacific islands’ defense forces. As these islands had dense jungles, airborne photo reconnaissance didn’t work. As luck would have it, they were able to recover a bill of lading floating after an enemy ship was sunk. In this document there was the size of the shipment of volley balls that were being sent to the island. Knowing the normal table of equipment enabled them to estimate the size of the enemy forces that would oppose a landing by the Marines. With this new information, the decision was made to bypass the heavily defended island and land on less defended real estate.

The dots that I am trying to connect include a very insightful talk by Jim Grant to the Federal Reserve Bank of New York, actions of three different central banks, a comment by the CEO of Goldman Sachs in an interview, the financial leveraging by a CEO for his own account, and an almost recommendation by the highly respected Wall Street Journal columnist Jason Zweig.

Jim Grant

While I have known and admired Jim Grant for a long time, in a period of just two weeks I have encountered his thinking twice. First was at a small dinner party where he was the host. He spoke persuasively about the government’s attack on market-based pricing. While he was mostly focused on what is being called financial repression (of interest rates), it could also be applied on other areas of administered pricing. Second, John Mauldin, in his weekly letter, reprinted Jim Grant’s talk to the New York Federal Reserve Bank. He dwelt on how far the Fed has moved away from its founders and their philosophy. He points out that while the current Chair of the Federal Reserve System is a renowned scholar of the 1929-1933 depression, he and others would be wise to review the depression of 1920-1921 which was as deep as the “Great Depression,” and by 1922 the US had a vigorous recovery led by the government balancing its revenues and expenditures and not relying on any form of “quantitative easing.” However, his main thrust was that the founders of the Fed in 1913 believed in the gold standard and were horrified at the thought of a fiat currency.

A lot of credit should go to the NY Fed for inviting a well-known critic of its actions into the bank’s hallowed halls and perhaps listening to him. While I do not expect an immediate change of heart by our government manipulators, I am hopeful that this talk can have a ripple affect even if Ron Paul is not sitting in the White House. (Think about the various espoused policies the socialist Eugene Debs advocated in his numerous presidential runs and how over the succeeding years they were adopted by the two main political parties.)

Three central banks

As reported by US Global Investors, in March Mexico added 16.81 tons of gold to its reserves of 122.58 tons, Russia added 16.55 tons to its total reserves of 895.75 tons and Turkey added 11.48 tons to its hoard of 209.6 tons. (These purchases are after 2011, when in aggregate, central banks bought 439.7 tons, the largest increase in five decades.) What is significant to me is that all three of the buyers in the month would benefit if the price of oil went up and thus their economies would benefit. Perhaps they are addressing a more fundamental concern about fiat currencies in the US and Europe. Just possibly someone is listening to Jim.

Natural gas prices

Jason Zweig’s Saturday column in the Wall Street Journal is normally very balanced, describing the pluses and minuses of a topic often relying on some academic paper of interest. This week, I was shocked that the column called attention to the very low prices for natural gas and if an investor has a long-term orientation, like the accounts that I serve, there is significant potential in owning a number of the stocks. He included one where the CEO has borrowed substantial amounts to take up the provisions available to him to participate in various drilling opportunities. These are extraordinary times to see these kinds of situations.

Two weeks ago my blog speculated about the possibility of $1/gallon gasoline. This was a “think piece” not to be taken as a prediction, but recognition that the price of oil could go the other way and not climb to ever-higher prices. One of the foundations of this out-of-the-mainstream thinking was a belief that over a ten year period the US could become energy independent and possibly an exporter due to the potential of natural gas to fill its needs.

The bulls of Wall Street

For more than a decade in the past we have learned that when the large firm known as “the herd” was bullish on the US market, then look out. This time I am hearing a somewhat similar belief from a respected leader. Lloyd Blankfein was doing a number of cable television interviews on Thursday. On the one that I saw, he spoke about Goldman Sachs hedges, he thought that the risk was being on the sidelines rather than participating on the upside. Considering how well Goldman Sachs has positioned itself, I find this encouraging.

Conclusion: Putting the dots together

One of the lessons from both basic security analysis and Marine Corps intelligence is that one never gets all the dots to compile a complete actionable picture. While I would like to see more money placed on positive convictions than what I see now, I would use any significant declines to reposition various portfolios to be more aggressive. I don’t believe that we will get much positive momentum until we believe we see some clarity as to what 2013 will bring. Nevertheless, at some point we could see many investors decide all at once that the water is safe and jump in.

Next week’s blog

We are continuing our practice of attending the Berkshire Hathaway Annual Meeting. As usual the questions may be more enlightening than the answers (except when Charlie speaks). I plan to devote next week’s blog to my impressions and will write it on the return flights. Due to air schedules and my iPad, the timing of your receipt may be delayed.
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