Gold Liquidation

The decline in gold over the last two trading days has been stunning.  But what is perhaps more significant about this recent move is its potential implications for broader investment markets including stocks and high yield bonds.

So what is the reason that has gold been declining so sharply since Friday morning?  Let’s first explain what are not the reasons, as the financial media has the tendency to want to assign fundamental reasons to why things are happening in financial markets that are often unfounded if not completely untrue.  It had nothing to do with China, the decline in gold was already well underway at that point and signs of economic slowing in China would actually be bullish for gold.  It also had nothing to do with reports that Cyprus may be forced to sell their gold to help fund their bailout, as China and India combined could easily buy up all of Cyprus’s gold and more in a single trading day.  And if global central banks were to force other countries to sell their gold to support bailouts, we would almost certainly be seeing gold prices soar higher not move lower to serve their own best interests, as central banks have the firepower to do it.  It also had nothing to do with money flowing out of gold and into stocks, as stocks have actually experienced a net outflow of -$700 million since the beginning of February including -$1.9 billion in net outflows in the first week of April alone (which, of course, begs the question as to why the stock market has been going higher if money on net has been flowing out of stocks over the last two months, but this is a topic for another article).  The fact that stocks have also been down over the last two trading days further refutes this notion.  And it also had nothing to do with the supply of gold outweighing demand, as a wealth of data continued to demonstrate sovereign, institutional and retail accumulation of gold over the past year and in particular since the middle of February despite the decline in price along the way.  Lastly, this is not just a story limited to gold, as the entire commodities complex including silver, platinum, palladium, copper and oil have also been in sharp decline since early Friday.

So exactly why is gold in such sharp decline over the last two trading days?  In a word – liquidation.  In order to highlight this point, it is worthwhile to review how the decline has unfolded over the last two trading days.

During the early morning on Friday, gold was behaving as it would on any normal day.  But the clock struck 10:28AM EDT and gold suddenly plunged into a cascading decline, shedding $40 in just over a half hour before steadying for the remainder of the trading day.  Following the weekend, after continuing lower during the overnight hours on Monday, the clock struck 10:25AM EDT that morning and gold once again cascaded lower by another $40 over the next 36 minutes before actually bouncing higher and moving sideways for the remainder of the day.  In short, nearly half of the entire decline in gold occurred over the course of one total hour in the last two trading days, with most of the remaining drop occurring from 4:30 to 6:00AM EDT on early Monday morning.  These details are informative in helping to pinpoint the exact cause of the gold sell off.

Did an extraordinary fundamental event take place at 10:28AM EDT on Friday morning that sparked the massive sell-off over the course of just 30 minutes?  Absolutely not.  And what is so special about half past ten in the morning on the east coast that another massive sell-off occurred at almost the same exact same time the next trading day on Monday?  The timing here is not a coincidence.  And the same can be said about the drop during the overnight hours on Monday.

All indications suggest that the massive decline in gold over the last two trading days has been the result of massive liquidations by major global financial institutions that have been forced to raise cash quickly.  What is the likely cause for this liquidation activity?  The increasing radioactive interest rate volatility associated with Japanese government bonds is the most likely culprit, as institutions have been forced to come up with sizable capital contributions to protect their massive positions against the recent wild swings in the second largest bond market in the world.  This situation in Japan is becoming increasingly worrisome that continues to require close monitoring for additional spillover effects.  More on this point in a moment.

When these types of situations suddenly arise, gold and other commodities are often sold first since they are among the most liquid investable assets in financial markets.  And the impact of these mass liquidations have spillover effects, as any investors that have purchased gold on margin are eventually forced to sell and cover their positions, which only exacerbates the downside move.  This helps explain why the entire commodities complex has also sold off sharply over the last two trading days.

Eventually the decline in gold and other commodities will cease.  While it is likely that much of the major institutional forced selling of gold has now played out, we may see further downside in gold over the next few days as more investors are forced to sell to cover their margin debts.  And once this selling is completed, it is just as likely that we will see an equally stunning bounce, as the precious metals complex already had short interest that was already multiples above the previous historical highs.  For once these massive shorts move to cover by buying back gold, the rush to the upside could be just as extreme.  But once this process is completed, an extended period of choppiness including aftershock declines should be expected, as the gold market still contains a huge number of weak cash longs that will be desperate to exit their positions at higher prices given the opportunity.  For this reason, I will be looking to use any such rallies to strategically reallocate precious metals allocations.

While the liquidation in gold has been notable, perhaps the far more significant issue looking ahead is what it may be indicating for broader investment markets including stocks.  Major global financial institutions do not simply enter into forced liquidations in a cascading market like gold over the last two trading days without good reason.  Such liquidations occur because something is becoming disconnected within the financial system.  And once these disconnects start to occur, they have the potential to spread like wildfire and unravel very quickly.  While commodities like gold are often sold first during these episodes, stocks and high yield bonds are almost always the next in line.  This is what happened in 2008 – commodities including gold began selling off sharply in August 2008 with stocks and high yield bonds following soon after in September 2008.  And this is the first time we have seen such rapid and massive liquidation activity since that time.

The fact that stocks and high yield bonds deteriorated lower throughout the trading day on Monday suggests that the liquidation problems plaguing gold and commodities may already be spreading into these markets.  This is a major risk that will take several days at least to see how it plays out, but the potential downside for both stocks and high yield bonds is considerable.  Not only can these declines become extremely swift once they take hold as demonstrated by gold over the last two trading days, but both stocks and high yield bonds are also in a far more precarious place on a much higher perch than from where the precious metals began their descent.  Unlike the precious metals that have been trading lower since mid January, stocks and high yield bonds are trading at fresh new highs.  In the case of stocks, this rise has occurred despite weakening fundamentals and valuations that remain well above the historical average.  Moreover, unlike gold that had relatively lower margin debt and massive short positions already in place, stocks are currently operating with their highest level of margin debt since July 2008 with relatively little short interest to spark any meaningful covering bounce.  As for high yield bonds, they are currently trading a premium that essentially represents one year’s worth of coupon payments, which is an unprecedentedly rich valuation for the asset class in an environment where economic data is showing increasing signs of weakness.  Thus, the potential downside in either of these categories is considerably more than the commodities complex in a liquidation event.  The fact that stocks dropped by -28% over the course of just eight trading days in early October 2008 highlights how swift and painful these downside events in stocks can be.

Given these risks, the opportunity was used today to lock in gains and close out a number of stock positions, particularly those that have enjoyed a recently strong run and are currently overbought.  This way, if the recent move in gold turns out to be an isolated event, the opportunity will exist to buy back into stocks particularly as first quarter earnings season progresses.  But if the recent liquidation in commodities spills over into stocks, instead of trying to get out of a sharply declining stock market, the powder will already be dry to seek high quality names at discounted prices on pullbacks.  As for high yield, this is a market that was exited early last month on extreme valuation but would warrant renewed interest on any solid correction.

I will be continuing to monitor these events across all markets as they unfold in the coming days and will follow up with updates.

The contents of this post are provided for information purposes only.  There are risks involved with investing including loss of principal.  GWM makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM.  There is no guarantee that the goals of the strategies implemented will be met.

Q2 Outlook: Straw On The Camel’s Back

The U.S. stock market posted strong results in the first quarter of 2013.  But what is perhaps more notable is that U.S. stocks were essentially alone in this advance.  Many non-U.S. stock markets fell for the quarter including the Euro Zone and Emerging Markets.  The investment grade bond market also edged lower and high yield bonds, which are highly correlated with stocks, were only incrementally higher.  And the precious metals including gold and silver sold off during the quarter.

What was perhaps more notable is that U.S. stocks pushed higher on their own despite considerable fundamental headwinds that would otherwise be expected to favor the bond and precious metals markets at the expense of stocks.  U.S. economic growth readings remain mixed at best and are slowing in many other parts of the world including the Euro Zone, which is already in recession.  And corporate earnings growth has not only declined on a year-over-year basis already over the past two quarters along with a rolling over of profit margins, but forward earnings projections have also been revised lower by -6% over the past year.  Never before have we seen U.S. stocks post such an advance amid declining corporate earnings growth and profit margins at this late stage of an economic cycle.

Of course, the U.S. stock market has been rising since the beginning of 2013 for one key reason.  On January 4, the U.S. Federal Reserve added daily Treasury purchases to its QE3 stimulus program.  And since that time, U.S. stocks as measured by the S&P 500 Index have risen on 64% of trading days, which is a +6 standard deviation event.  In other words, the daily stock market behavior witnessed in the first quarter is supposed to happen only once every 506 million years.  Clearly, the influence of the Fed on the U.S. stock market is strong.  But is it sustainable?

This is the key question as we move into the second quarter.  While U.S. stocks have continued to show resilience in the first few trading days, they are incrementally lower for Q2 to date.  And in each of the last three years in 2010, 2011 and 2012, the stock market opened the year strongly in Q1 only to plunge into a double-digit decline starting in April and extending into the summer.  With stocks already widely disconnected from fundamentals heading into April 2013, the potential for another sharp pullback is more than a reasonable possibility.

But one important fact differentiates the stock market in 2013.  In each the past three years, a major central bank stimulus program was either ending or was drawing to a close in the month of April.  But this is not the case in April 2013, as the Fed has committed to continue QE3 for as long as it deems necessary.  As a result, it is also more than possible that stocks can defy expectations and continue to rise further in the months ahead, even if underlying fundamentals continue to deteriorate.  This is particularly true given that the Bank of Japan recently announced a massive stimulus plan of its own.  More on this in a moment.

Despite the recently good feelings for stocks generated by monetary policy, what may ultimately stunt if not completely derail the recent stock advance are the mounting structural problems that continue to breakout across the globe.  In short, the probability of a destabilizing financial event is rising, and if any such episode induces major global financial instutitions to retrench on risk assets to protect their capital position, the subsequent decline in stocks could be swift and sharp even with the Fed’s endless support.

This leads to the critical question as we enter the second quarter.  What if anything will be final the straw that breaks the camel’s back and shakes financial markets back to reality?  The following are some leading candidates in the months ahead.

Cyprus Spillover:  While the banking crisis in Cyprus has moved from the headlines, its effects are only beginning to be felt.  The final outcome of the Cyprus debacle was that uninsured depositors with over 100,000 euros in Cyprus banks ended up taking significant haircuts to secure the bailout deal.  And while the media cameras showed no evidence of bank runs in Cyprus once these institutions reopened, nobody expected the oligarchs and other major international depositors to get in line along side the average Cypriot citizen to withdraw their money.  Instead, these are individuals, corporations and foundations from around the world that are likely to be meeting in the coming weeks to discuss among other things whether it continues to make sense to maintain sizeable bank deposits in places like Greece, Portugal, Spain and Italy where the risk of taking a major deposit haircut has now risen substantially.  We are already seeing evidence of banking stress emerging in places like Slovenia, Malta, Ireland and Italy, and the more depositors opt to withdraw deposits, the more creeping electronic bank runs have the potential to pick up speed in the months ahead.  At minimum, this situation merits monitoring going forward.

Japanese Stimulus:  Japan is the world’s third largest economy and has been mired in a two decade long depression marked by seemingly unshakable deflationary price spiral.  New political leadership took over late last year with the commitment of finally shaking the Japanese economy back to life by creating inflation with a target 2% rate.  And keeping with this promise, the Bank of Japan announced late last week its monetary stimulus program that vastly exceeded already aggressive expectations including an extraordinary doubling of its asset base in the coming years.  But here is an illustration of one of the many key problems associated with this plan.  The Japanese 10-year government bond yield is currently 0.52%.  Yes, for every $1,000 you lend to the Japanese government, you receive $5.20 each year over the next ten years.  Quite a deal, and these Japanese yields have been exceptionally low for some time.  But if the Bank of Japan achieves its 2% inflation target, it means that everyone that owns Japanese debt will be left with holdings that provide a negative real yield (this of course assumes that they will be able to stop the rise at 2%, which will be a feat in and of itself).  And what are investors going to do with their Japanese bonds if they are suddenly an investment that is generating a real loss?  They will likely sell these bonds, perhaps aggressively.  Given the fact that the total public debt in Japan is 219% the size of the entire Japanese economy as measured by GDP, achieving the desired 2% inflation target if not much more has the potential of inadvertently collapsing the entire Japanese economy.  Thus, how events unfold in Japan currently present a major risk to the global financial system.

These are just a few of the many risks that global financial markets are currently navigating.  And while the fact that U.S. stocks are showing resilience in the face of these challenges is impressive, it is also disconcerting to a degree.  This is due to the fact that the lack of any reflex to negative news developments indicates a stock market that has effectively become disconnected.  And in such a state, just as stocks can rise beyond all comprehension without fundamental support, so to can they fall dramatically and persistently without seemingly any real reason.  As a result, while maintaining an allocation to stocks certainly makes sense in the current environment given the still strong upside momentum, any considerable overweights to the stock market are associated with far more downside risk than upside reward at this point.

Fortunately, capital markets offer a variety of asset classes to realize positive returns regardless of what stocks are doing at any point in time.  And a number of these categories stand to directly benefit if the stock market enters into correction for the fourth year in a row this April.

Leading among these is the precious metals market.  For as much as stocks have been artificially elevated thus far under the Fed’s latest QE3 stimulus program, precious metals including gold and silver have been artificially suppressed.  But knowing that the laws of supply and demand have not been repealed and that prices will eventually find their way to their true equilibrium over time, steady worldwide accumulation trends along with the fact that short interest is now at historically high levels for both metals suggest that both gold and silver have the meaningful potential to slingshot higher at some point in the coming months.

The bond market is also showing renewed life following a period of weakness over the past few months.  Ironically, the Fed QE stimulus programs that are supposed to result in lower interest rates have typically ended up producing higher interest rates, and the experience during QE3 has been no exception in this regard.  But this effect typically wears off after the first two and a half months following the start of a Treasury purchase program, as institutions retrench following the initial risk asset buying spree.  This timing has also held true under QE3, as the bond market rally kick started in mid March roughly two and half months after the Fed began purchasing Treasuries in early January.  And as long as history continues to provide a reasonable guide, the bond market generally and long-term bonds in particular have shown the propensity to advance strongly higher once the stock market enters into correction.

It promises to be an interesting few months ahead in the second quarter.  I will be checking back with periodic updates along the way as events warrant.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

Cyprus

The complacent calm that has overtaken financial markets thus far in 2013 will be put to a rigorous test in the coming days.  This is due to the news that came out of Cyprus over the weekend.  On Saturday, the tiny island nation and member of the European Monetary Union received a bailout in order to rescue their collapsing banking system.  It is not the fact that emergency action was required in an attempt to rescue yet another troubled European economy, however.  After all, such news has become almost commonplace in today’s post crisis world.  Instead, what is notable and potentially problematic for financial markets is the manner in which this latest bailout is being carried out.

So how can such a small place like Cyprus have any meaningful effect on the global economy?  After all, the United States will produce enough output in the next 12 hours to match the Cyprus GDP for the entire year.  It is because of the potential spillover effects resulting from how the bailout being imposed.

In short, Cyprus is receiving a 11 billion euro rescue package from the European Union (ESM) and the International Monetary Fund (IMF).  But in order to receive these bailout funds, the Cypriot government must impose a 5.8 billion euro tax on bank deposits.  Otherwise, the Cypriot banking system will be left to collapse and the country would likely have to exit the euro currency.  As the deal stands as of late Sunday night, this includes a 9.9% tax on uninsured deposits over 100,000 euros and a 6.75% tax on INSURED deposits up to 100,000 euros.  It is precisely on this point where the Cyprus rescue plan has roiled the markets heading into the trading week.  For the tax is not being applied to shareholders or bondholders where the risk of loss is understood.  Instead, it is being levied on depositors.  And not just uninsured depositors, but also INSURED depositors.  On this point alone, we are now moving into dark and murky unchartered waters in this latest phase of the post crisis period.

When I teach the chapter on money and banking in my macroeconomics classes, I conduct a case study on what happened to the banking system during the financial crisis.  This includes a detailed examination of how bank balance sheets work.  The case study explores how the investment value for stockholders and bondholders in certain banks were either wiped out or heavily impaired as a result of the crisis.  But the one part of the bank balance sheet that is always considered essentially bulletproof in the study is insured customer deposits.  In short, if a customer deposits money with a bank, these funds will be made good to the customer no matter what and for good reason.  The following example to better illustrate what is happening this weekend in Cyprus shows why protecting insured deposits is so important.

As a purely hypothetical illustration, imagine you have a checking account at your local bank here in the United States.  Not a long-term investment account with stocks, bonds and commodities where it is understood that prices fluctuate on a daily basis.  Not even a money market mutual fund where some incremental risk of principal is assumed to achieve a slightly higher interest rate.  It is a checking account that you are using to manage your daily budget including paying your bills and accessing cash for immediate required expenditures.  Suppose you have $100,000 cash in your FDIC INSURED checking account, which means that even if the bank goes bankrupt tomorrow your money is fully guaranteed by the United States government.  Going into this weekend, you would have $100,000 in cash in your checking account that you would understandably assume is completely safe.  But under the Cypriot bailout scenario, you find out after the bank closed on Saturday that your account is only going to be worth $93,250 when it reopens on Monday because the U.S. government has suddenly and unexpectedly taken $6,750 from your checking account in order to carry out an emergency bank rescue plan.  Not only would you likely be upset and your confidence shaken, but you may also be inclined to rush to the bank to withdraw the remainder of your money as quickly as possible to protect against the potential for any future and unexpected levies.  Such are the origins of bank runs, and this is exactly what is happening right now in Cyprus.

This, of course, is not happening in the United States, and Cyprus is a very small place.  So why does all of this matter to global financial markets?  Because Cyprus is a member of the European Monetary Union.  And they are being induced to take these actions against insured depositors along with political reasons in order to continue using the euro currency.  But Cyprus is not the only country in the euro zone that is dire financial straits and potentially in need of rescue funds.  So too is Greece, Portugal, Ireland, Spain and Italy.  And for a person that is living in any one of these other at risk European economies that is watching what is happening in Cyprus this weekend, their natural instinct is to wonder whether their bank deposits may suddenly be next.  As a result, many depositors across Europe are likely evaluating whether they need to get to the bank in the coming days to withdraw their own money.  If we were to see bank run activity pick up momentum in any of these European countries in the coming days, it could have a meaningfully destabilizing effect.  And the one thing more than anything else that financial markets including stocks dislike, at least in normal market environments, is uncertainty.

The potential fallout effects from the unexpected situation in Cyprus highlights the continued importance diversification in today’s post crisis investment markets.  The stock market has steadily risen in 2013, but they have been alone in this advance as bonds have been flat to slightly lower and precious metals have fallen into correction.  Unfortunately for stocks, however, the rally thus far this year is being almost exclusively driven by the flow of liquidity from the latest QE monetary policy stimulus program from the U.S. Federal Reserve, as economic growth has otherwise ground to a halt and corporate earnings have fallen into decline in recent quarters.  In short, the recent stock rally is built on sand and is now overextended from a technical standpoint.  Thus, any sudden shocks have the potential to evaporate the year’s worth of stock gains in a matter of days.  Whether the events in Cyprus ends up being such a shock remains to be seen – stocks futures are down -20, or -1.3%, on the S&P 500 heading into overnight, but stocks have proven remarkably resilient to any bad news under the influence of QE, so a positive close on Monday would not at all be a surprise.  But high quality bonds and precious metals are already well overdue to regress to the mean relative to stocks, particularly at this stage of the latest QE program, and these categories would stand to benefit most under any correction scenario.  Thus, a rotation of liquidity out of stocks and into these more defensive safe haven categories is also a more than likely outcome even without the Cyprus situation.

I had already reduced portfolio stock allocations considerably ahead of the weekend before the outbreak of events in Cyprus.  This was due in part to the fact that the stock market had arrived this past week at major long-term resistance in the 1555 to 1580 range on the S&P 500 Index, for this is exactly where the stock market first peaked in March 2000 and topped out again in October 2007 only to go on and decline by more than -50% in both past instances.  Given the fact that the recent move higher in stocks is already overextended and long overdue for at least some sort of correction, stocks are at a minimum likely to pause and face serious headwinds at these levels.  And this expectation coupled with the recent news out of Cyprus is supportive of waiting on the sidelines in cash with the proceeds from these recent stock sales into new investments is a prudent strategy at least for the moment until some clarity is gained on how these events are likely to play out in the coming days.  The next few trading days should help explain a lot on how things are likely to play out in the weeks and months ahead.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

The Fed’s Balance Sheet Picks Up Pace

The expansion of the Fed’s balance sheet is picking up pace. 

Although it has been four months since the launch of QE3 back in mid-September, the increase in the Fed’s balance had been relatively sluggish.  For example, the Fed’s balance sheet had actually contracted over the first seven weeks of the program through the end of October.  And it had only expanded by $36 billion over the first three months of the program even though the Fed had stated its commitment to purchase mortgage-backed securities (MBS) at a rate of $40 billion per month.

Despite the sluggish start to QE3, asset purchases are now accelerating at an increasing rate.  Over the last five weeks, the Fed’s balance sheet has increased by another $69 billion.  And the expansion over the next several weeks is likely to pick up even further for two reasons.

First, the Fed’s MBS purchase program is continuing to pick up steam.  The reason QE3 was slow to get going over the first few months is that it can take up to several months for MBS purchases to settle.  But with each passing month, more and more of these purchases are reaching settlement and the cash is changing hands from the Fed to the banks.

Second, the Fed’s outright Treasury purchase program announced in mid-December as a supplement to its existing MBS purchase program got underway on January 3.  So going forward, markets will receive a daily injection of liquidity from Treasury purchases to go along with the massive bursts that occur two to three times a month from the MBS purchases.

Why is this important?  Because investment markets including stocks, high yield bonds, industrial commodities and precious metals have all shown the propensity to drift higher behind the fuel of liquidity injections from the Federal Reserve.  And Treasury purchases have proven to be particularly supportive to risk assets due to the daily liquidity flows.

So despite the fact that global economic growth remains sluggish and the upcoming earnings season promises to be lackluster at best, it would not be surprising to see stocks and other risk assets push to new post crisis highs for no other reason than an increasing sugar high thanks to the U.S. Federal Reserve.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

 

2013 Outlook: Lex Parsimoniae

“There are known knowns; there are things that we know

There are known unknowns; that is to say there are things that we now know we don’t know”

But there are also unknown unknowns – there are things we do not know we don’t know”

-Donald Rumsfeld, U.S. Secretary of Defense, 2002

The economic and market environment remains as uncertain as ever as we move into 2013.  One does not have to look far to find extreme risks that could propel us sharply in either direction at any given moment in time.  Given these vast complexities, examining investment markets as a whole can lead to many conflicting signals.  Thus, it is worthwhile to break the market down into isolated component parts to determine what is known as fact and what must be predicted.  And by working to simplify the markets, it should ultimately lead to a greater understanding of what we can expect from investment markets in the coming year.

The Known Knowns

The following forces are known as fact for investment markets in the coming year.  And none is more significant than the first.

Extremely Aggressive Monetary Policy – One fact we know heading into the New Year is that the U.S. Federal Reserve is ready to print money with wild, perhaps reckless, abandon.  Overall, the Fed will inject more than $1 trillion into financial markets in 2013 as part of its QE3 program at a rate of $85 billion per month.  And the Fed money printing is likely to be joined along the way by major programs from the European Central Bank, the People’s Bank of China and other major global central banks.  In recent years, such aggressive monetary stimulus programs have driven investment markets higher regardless of economic fundamentals or persistent threats of crisis.  And given the scale of monetary stimulus in the coming year, it is likely that we may see more of the same in 2013.  While some have questioned the efficacy of QE3 in this regard since its launch in September 2012, it is important to note that relatively little liquidity has been injected into the financial system to date under this program.  This is set to change in a big way starting in January 2013, however, as U.S. Treasury purchases are added just as mortgage backed securities (MBS) purchases under the existing program begin to pick up speed.  In terms of investment impact, this should benefit stocks (SPY), high yield bonds (HYG) and precious metals including gold (GLD) and silver (SLV) most.  These gains are likely to come at the expense of U.S. Treasuries, particularly Long-Term U.S. Treasuries (TLT), as capital flows out of the safety of U.S. government bonds and into risk assets.

Taxes Are Going Up – Regardless of what direction fiscal policy makers chose in Washington DC over the coming year, one thing we know for certain is that taxes are going up.  While the impact of these higher taxes may impact certain income earners more than others, everyone in the U.S. will be paying more in taxes than they have in previous years, even if its 2% more out of their paycheck once the payroll tax cut expires.  And if consumers and businesses are sending more of their money to the government to pay taxes, they have less money left over to spend on consumer and capital goods.  This is likely to place a drag on economic growth in the coming year, which should presumably weigh on stocks and high yield bonds in favor of precious metals and U.S. Treasuries.  But the heavy flow of liquidity from the Fed may help investors to ignore such fundamental truths for yet another year.

Fiscal Policy Paralysis – A fact that is repeatedly reinforced by the Federal government in Washington is that absolutely nothing of substance is going to be accomplished in addressing the critical issues facing the U.S. economy until politicians are up to their knees in the fire of the problem.  And even then they are likely to find a way to dither.  The recent fiscal cliff debacle highlights this point, as the media has been captivated by a debate over policy solutions that do not even begin to scratch the surface of the underlying problem.  For example, the Federal debt has increased by $6 trillion over the last five years, yet we have been tortured for over nearly two months on a debate that struggles to implement even $100 billion in spending cuts.  In short, nothing is going to come out of Washington to try and tackle the problems facing the U.S. economy in 2013.  Instead, solutions will finally come under consideration down the road when it’s potentially too late.

The European Crisis Remains Unresolved – The seeds of the European crisis were sown years ago and began manifesting themselves during the outbreak of the financial crisis back in 2008.  And the problem has continued to get worse with each passing year.  In 2010 the problem was Greece.  By 2011 it had spread to Ireland and Portugal.  And in 2012 it had fully infected Spain and Italy.  As debt problems continue to mount, economic growth remains insufficient to begin to reverse the trend, particularly as the global economy continues to slow.  While coordinated global monetary stimulus may help markets ignore the festering problem across Europe for another year, the problems facing the region and subsequently the world continue to mount.  But just like the Fed in the U.S., the ECB appears to stand ready to throw more and more money at the problem.  While one cannot solve a debt problem with more debt, the Europeans appear determined to continue trying.

Known Unknowns

The following are forces that are known uncertainties that require careful monitoring and evaluation as the year progresses.

The Global Economy – All signs point to further slowing and the potential for recession in many parts of the world in the coming year.  But it remains possible that growth could surprise to the upside, particularly depending on the magnitude of monetary stimulus injected into the global economy in 2013.  Any such growth may prove fleeting, but it has the potential to influence investment markets and not necessarily for the better, for it may raise inflation concerns and the thought that monetary policy makers may withdraw stimulus sooner rather than later, which of course they will almost certainly not in the end.

Corporate Profits – Corporate profits have begun slowing with margins already at post WWII highs.  And with the global economy set to decelerate in the coming year, many signs suggest that we are likely to begin seeing meaningful profit margin compression as companies have little scope for further cost cuts.  Corporations have defied this trend thus far, but it remains to be seen how much longer they can continue to maintain profitability and margins at current levels during the quarterly earnings seasons throughout 2013.  Of course, the potential always exists for upside surprise as well, although the odds are becoming increasingly low for such outcomes.

Inflation – When central banks inject as much money as they have over the last several years into the global economy, inflation is an issue that should remain of paramount concern.  While policy makers cite that inflation pressures remain largely contained to this point, one could quibble with whether current inflation measures are truly capturing actual pricing pressures.  And once inflationary pressures take hold, they can be difficult to contain without a hard press on the monetary brakes.  Such a response, of course, has the potential to sharply rattle investment markets.

And the last known unknown is arguably the most important.

When Reality Finally Sets In  – Investment markets have floated higher for years under the influence of monetary stimulus.  For the freely flowing money from global central banks including the Fed has enabled investors to completely ignore the fact that little has fundamentally improved since the outbreak of the financial crisis several years ago.  In fact, much has gotten worse and precious time and resources have been squandered along the way.  At some point, investment markets will finally awaken to the reality of the situation.  Exactly when that will occur and what the final catalyst will be remains to be seen, but we will eventually arrive at this inflection point someday.  Perhaps this moment will come when stocks arrive at a triple top around 1576 on the S&P 500 Index.  But more likely, it will come quietly one day when the market least expects it.  Whether this occurs in 2013 or beyond remains to be seen.

Unknown Unknowns

It is the unknown unknowns, or the potential problems that we are not even aware that we should be monitoring, that have the greatest potential to result in a sudden and dramatic shift in investment markets.  Potential candidates include the following.

Another Flash Crash – Investment markets have been infested in recent years by high frequency trading programs, which are computer driven models that result in quotes and trades being executed down to the millisecond.  We have seen a number of instances in recent years where a breakdown or defect in these models has resulted in highly unusual and disruptive trading activity.  While most of these incidents to date have occurred on a small scale, the potential exists for a large-scale market disruption on any given day.

Institutional Meltdown – A good deal of trading activity today occurs in the darker corners of the market, and the potential continues to exist for another Long-Term Capital Management or London Whale type unraveling where a select group of traders or a hedge fund takes on a disproportionately large position that threatens to destabilize a major financial institution or the entire global market place.  One would have hoped in the aftermath of the financial crisis that measures would have been undertaken to diffuse these risks.  But unfortunately, such activities continue to go unabated if not encouraged in the current environment.

Geopolitical Event – Numerous challenges exist across the global political landscape.  The situation in the Middle East remains highly unstable with new leadership assuming power in a number of countries across the region.  And the recent events in Benghazi have reinforced the idea that the threat of terrorism remains pronounced.  Such events have meaningfully disruptive effects on investment markets at any given point in time.

Such is the economic and investment landscape as we enter 2013.  It is an environment that is fraught with risk and must be managed carefully.  But when considering all of these factors both in isolation and then collectively, we can draw the following conclusions.

Bottom Line

The Fed is set to stimulate aggressively in the coming year by printing over $1 trillion.  And other global central banks are likely to join in along the way with major stimulus programs of their own.  History has shown that during periods when monetary stimulus is being applied so aggressively and at such a massive scale, risk assets including stocks, high yield bonds and commodities will steadily rise regardless of how fundamentally weak the economy and corporate profits may be.  Thus, until this trend is definitively broken, it should be expected to continue.

This notion, of course, raises and important question.  What exactly could definitively break the trend of aggressive monetary stimulus supporting higher risk asset prices?  The answer is a number of forces may cause reality to finally set in on investment markets, and they all require close monitoring throughout the coming year.  These forces include the ongoing crisis in Europe, the potential magnitude of an economic slowdown or corporate profit contraction, the outbreak of inflationary pressures, or some other event that cannot be reasonably anticipated at the present time.

Thus, a hedged investment strategy remains prudent as we enter the New Year.  An allocation to risk assets such as stocks, high yield bonds and commodities including copper, oil, agriculture, gold and silver are all warranted given the degree of money set to be printed in the coming year.  A position in TIPS (TIP) also makes sense along with precious metals and senior loans (BKLN) to protect against the threat of inflation and rising interest rates.  But in recognition that downside forces may eventually overwhelm the investment market euphoria over monetary stimulus or that the stark reality that underlying fundamentals remain woefully insufficient to support stocks and other risk assets at current levels, it also remains worthwhile to complement these exposures with allocations to areas of the market that should perform well under these circumstances.  This includes high quality nominal bonds (AGG), long-term U.S. Treasuries (TLT) and other longer duration assets such as Build America Bonds (BAB).  Holding allocations in cash or short-term bonds at selected points in time may also be warranted depending on the swiftness or seriousness of a change in market conditions at any point in time.

The coming year promises to provide more interesting times for investment markets and its participants.  But a broadly diversified strategy with components that are designed to participate in any further Fed induced upside but can also withstand any unexpectedly sharp and dramatic turns along the way remains a prudent approach in the current environment.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

Fed Balance Sheet Shrinks

The expansion of the Fed’s balance sheet took a step back this past week.  According to the latest balance sheet data released by the U.S. Federal Reserve for the week ended November 28, 2012, the Fed’s balance sheet actually contracted fairly sharply by -$19.8 billion to $2.853 trillion.  As a result, since the beginning of QE3 in mid-September, we have now seen a net increase in the Fed’s balance sheet to date of just +$27.7 billion.

So from where did the decline originate this past week?  Ironically, it came almost exclusively from the one line item that is supposed to be increasing at a rate of $40 billion per month under QE3.  During the past week, the Fed showed a net decline of -$17 billion in Mortgage-Backed Securities.  And this occurred despite the fact that the Fed through its Open Market Trading Desk at the Federal Reserve Bank of New York carried out $16.9 billion in gross purchases of MBS securities over the past week.

 

As has been discussed in past articles, the reason for the disconnect between Fed MBS purchases and its balance sheet expansion to date is due in large part to the nature in which MBS securities trade.  They have long periods until settlement and tend to come through the system in big chunks all at the same time.  This has certainly been true thus far with QE3.  Also, the Fed also continues to hold MBS securities from past purchase programs that are either being called or are reaching maturity, which is also dragging on the pace of the Fed’s balance sheet expansion.

But as each week passes, an increasing reservoir of liquidity is building behind the Fed dam.  To date, the Fed has made net purchases of $184.0 billion in MBS securities, yet a net increase of only $39.8 billion is currently reflected on the Fed’s balance sheet.  In other words, only 20% of the Fed’s MBS purchases to date have even started to make their way through the financial system. 

As the Fed continues to purchase MBS securities each week at an average rate of $17.4 billion per week, the liquidity flood waters will only continue to silently build behind.  And as the flood gates increasingly open and this liquidity flows into the financial system, the impact on stocks (SPY), high yield bonds (HYG) and precious metals including gold (PHYS) and silver (PSLV) is likely to become only more pronounced.

Disclosure: I am long HYG and both gold and silver through the Central GoldTrust (GTU) and the Central Fund of Canada (CEF), which holds a 55% gold to 45% silver allocation.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

Silver: Responded Well On A Difficult Day

Silver was receiving an absolute drubbing at the start of the trading day.  At one point during the morning hours, the white metal had fallen as much as -3.21%.  And while the exact reasons for the decline are subject to debate – perhaps it was the Greece debt deal, or then again it might have been a forced liquidation given the trading volume – the good news coming out of today was how well silver responded in the face of this initial pressure.

Silver briefly challenged its newly established support at its 50-day moving average (the blue line on the chart) before rebounding sharply higher.  By the early afternoon, it had recovered much of its losses and managed to hold its ground for the remainder of the trading day.  And at the end of the trading day, silver closed down only -0.76% to remain within close striking distance of its recent highs.

Overall, silver has been performing well since mid August when the winds of monetary stimulus from the U.S. Federal Reserve began whipping up in earnest.  And as the flow of liquidity from the Fed under QE3 steadily increases in the coming weeks and months, we may find that silver has much further to run to the upside before it is all said and done.

Disclosure:  I am long silver via the Central Fund of Canada (CEF), which has a 55% allocation to gold and a 45% allocation to silver, as part of a blended precious metals portfolio allocation.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.