April 29, 2011

Here’s the news of the week – and how we see it here at McAlvany Wealth Management:

1. The Fed Telegraphs Its Punches.
Of note, not only for its importance this week, but in a larger, 100-year context, is the Fed’s new public effort towards transparency and openness. This is a good thing, on the surface. Everyone today champions openness, honesty, and transparency – in fact, requires it on the heals of deceptive practices and misleading statements from all quarters of the corporate world (Arthur Anderson, WorldCom, Enron, Madoff, Stanford, etc.) and from the political elite, as well (though its often argued that D.C. is not a den of thieves and liars, but merely dolts and dimwits).

For the record, we don’t think the Fed should go down this road. This is not a defense of unlimited prerogatives for the Fed – we don’t think the Fed should exist in the first place. But assuming it will continue in operation, we suggest the Fed governors go back to the pre-Greenspan practice of allowing nary a whisper from the secretive inner sanctum and its committee meetings.

To explain, let’s be anthropomorphic. Imagine the market with a real personality. Assume that this personality is somewhat dysfunctional, selfish, and greedy. Did I forget to mention manipulative? While Mr. Market has many good characteristics, it’s the bad ones that seem to crop up and cause problems now and then, so we’ll focus on these for the purposes of our discussion.

The market wants the ability to accurately see into the future. If information can be deduced from annual reports, 10-Ks, sentiment indicators, or even tea leaves (some people do actually trade on the basis of astrology), then conclusions will be drawn and actions taken to trade on these data.

But what if you had better information than someone else? That would be a huge advantage. In fact, this advantage has allowed for some of the most profitable trades of the decade. However, if the information was not publicly accessible and you traded with it, you might get into trouble – insider trading and all. That’s illegal.

What the Fed is now offering is insight into how they are going to manage the economy. Seems okay. But if Mr. Market (the manipulative character we were earlier describing) takes that information and twists it to his advantage, he will be betting on a predetermined outcome. An asymmetrical bet – capturing all the upside gain without the potential of loss – like knowing that a fight is being thrown. Maybe even like the sumo wrestling scandal uncovered, where at least one party knows what the outcome will be. The bets would no doubt be large, and the payoffs equally so. But in this case it’s not so much a bet – where probabilities and odds would still be a factor. Rather, it’s determined by the course being set in motion.

In the old days, central bankers tried to keep their distance from the markets and, if possible, political pressure. While never successful at the latter, there have been long periods of time where the Fed avoided directly creating these asymmetrical bets in the investment markets. Now, it seems they’ve adopted a third mandate: market rigging. Sure, they’ve done this on and off as an “emergency measure,” but now all bets are off. An asymmetrical bet is not really a bet at all – it’s more of a plan.

2. Stable Vessels in a Rising Tide. The metals saw great volatility this week, and their price action hinged on the Fed’s honest and forthright disclosure. Looking at technical charts, silver needs to cool off (finishing the week at $48.00); gold, not so much (new closing high of $1566.70). But technicals, and the patterns of buying behavior captured in charts, don’t take external pressures into account.

Liquidity creation is inflationary. Inflation – the process of creating too much money and credit in the market (which the Fed has firmly committed itself to) – and the consequent repricing of goods and services to reflect this dilution of currency value, has now been accepted as the new investment backdrop. Mainstream investors will no longer quibble over the possibility of inflation, but only the degrees to which it will destroy purchasing power. As the Fed inflates, gold and silver will now become popular items to own (a necessary insurance).

Not only did the Fed reverse a fairly prudent posture of opacity, but, in the immediate term, they’ve told us the hand they are playing and how the market should place its bets. With regard to speculative stocks, junk bonds, commodities, foreign currencies, gold, and silver, we knew that the correlation could go to +1, as it did in the 2008 market panic. (Statistical correlation is either +1 or -1, which indicates whether two securities or asset classes are moving in the same direction or opposite directions, respectively.)

Perhaps we shouldn’t be surprised to see all assets soar, with the Fed creating a one-way bet: the correlation is back to +1. With this new spirit of transparency, perhaps they’ll be good enough to broadcast a tightening of credit and more responsible monetary policy (when it’s forced on them), so the world can bet on that, too. This new mandate (market rigging) is going to make things interesting!!

If our Fed’s course is not changed, silver may see $60-75 this year and gold $1750-2000. Hold onto your hat! As an MWM client, you are well positioned to preserve purchasing power and grow wealth in this environment. As always, we will endeavor to see the end from the beginning and position ourselves ahead of the next emerging trend. For now, we are standing firm with existing investments.

3. Point of No Return. Much has happened over the last two weeks, so I will try to limit comments to more significant matters.

Economic data (over the last two weeks) was mixed, but still indicated the economy has a long way to go just to get back to normal. Real Estate data was marginally better, with an improvement in new home sales, building permits, pending home sales, and existing home sales – but prices also dropped, perhaps explaining the pick-up in sales. Durable Goods Orders showed some improvement, up 2.5% (in March) from a reading of -0.9 the month before, citing strength in machinery, automobiles, and computers. We believe the improvement may be commodity sector-related and/or the plight of consumers to “downscale” in the face of higher costs (i.e. buy a cheaper car).

The job front worsened once again, with initial jobless claims leading the charge higher. The week ending April 23rd, claims were 403,000 – the highest since late February of this year. GDP expanded at a less-than-expected rate of 1.8% on a decline in state, local, and federal spending – along with austerity measures to reduce deficit issues. Gaming with the price deflator actually made the GDP figure look better. The PCE Deflator (inflation indicator) showed a 1.8% increase instead of the 2.3% previously expected.

The earnings season, which is now well underway, has seen most companies “beat the number” in what will be another record quarter. However, not all firms were rewarded with share-price gains, as skepticism over the quality of the earnings continues to build. As we have mentioned several times before, inflation is beginning to take its toll on margins, but there still seems room enough for nominal gains in the overall picture of things. Last quarter, nearly 25% of the reporting companies cited these problems. This quarter, that percentage may grow to nearly 50%. The standouts in terms of earnings growth seems to favor select groups and/or specific companies.

Sector-wise, industrials (Caterpillar) and Consumer Staples continue to be hot spots. Caterpillar has benefitted from increased mining production globally, and Proctor and Gamble continues to show strength, since no one can refuse higher prices for the sake of personal health.

On the company-specific side of the equation, electronic giants such as Apple and Intel (and related companies) continue to punish PC makers and mobile phone makers for their lack of innovation.

On the flip side, and perhaps more importantly, financials and retailers are feeling the pinch. Lending continues to be stagnant, and earnings are “massaged” – or rather boosted – by the reversal of loan-loss reserves taken in the 2008 and 2009 crisis. Solid profits, if any, in this sector have been from trading revenues derived from, in our opinion, the “transparency” of the Fed (discussed above).

Retailers such as Amazon and Walmart have expanded their product lines at the expense of the bottom line, probably to compete with discount retailers (like Family dollar Stores) as consumers continue to scale down. Amazon, although reporting a jump in sales of $2.7B to $9.857B in the quarter, saw a 33% decline in earnings.

We still maintain the opinion that the markets are in transition to the downside, and that the wildcard holding things up, especially this week, has been money printing by the Fed. The Fed can certainly escalate its efforts and postpone the inevitable, which is what it seems to be doing at the moment. In Bernanke’s recent comments at the Fed’s press conference, he said that accommodation, or QE, will be removed when the Fed deems it appropriate and that commodity price inflation was “transitory.” References to the removal of QE2 as planned were also weak, which added to the confidence of speculators.

One thing about Bernanke’s comments that struck me in particular had to do with his insistence that commodity inflation was due to global supply and demand imbalances. In other words, demand is fueling the price increases due to economic growth (emerging markets) around the world. But, if this is the case, why have inventories of oil grown consistently since late 2007? – chart below…

The second question to ponder is: Why, then, has the price of oil risen to near record levels over the same time period? It may be hoarding, but then again it could be that money printing in dollar terms is growing faster than all other factors combined. It’s something to consider when pondering the validity of Bernanke’s claims.

Regardless, we think it’s safe to say that the chairman is either ignorant or bearing false witness on this crucial issue. At some point, we must admit that this is instead a dollar issue and/or currency crisis that we are facing – nothing less. What is of concern is that the Fed still doesn’t realize that money printing is now the cause of our economic weakness. Recognizing this may help avoid a self-perpetuating hyperinflationary cycle.
Have a great weekend!

David McAlvany

President and CEO


David Burgess

VP Investment Management



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