Wednesday, December 25, 2013

Investing in '14: Coping with 100 Years of Fed Blundering

On the 100th anniversary of the founding of the Federal Reserve Bank, the coming year's investment climate is complicated by the residue of historical interest rate policy.  The low interest rates that have been favored from Nixon through Obama subsidize asset holders, business interests, and the wealthy, and they penalize savers, pensioners, and workers. The Obama bailout of 2008-10 has pushed real interest rates to historically low levels; such levels are unlikely in market-based economic systems.  They have resulted in misallocation of wealth, increased income inequality, excessive risk seeking by the elderly, bullishness in the stock market, and volatility in the gold market.


I pulled out of gold in April 2013 because the gold market was reacting to the tripling of the nation's money supply much as it reacted to the monetary expansion of the Volcker-and-Greenspan Fed.  As the Fed pushed down interest rates in both periods (1983-2000 and 2008-2010) gold production expanded.  In both periods production also expanded in response to rising gold prices.  Paradoxically, though, increased commodity exploration and production  cause lower prices. Declines  in the gold price occurred in 1983-2000 and 2012 even though both were periods of monetary expansion. The 2008-2011 period was still riding the prior cycle, but the monetary expansion of 2008-2013 has been so large as to create an entirely new cycle in a short period of time.

As gold producers collapse during the current period, the scene is set for a new increase in commodity prices.  Nevertheless, the gold market has yet to capitulate. That might occur in 2014.  I currently have a small short position in gold and am otherwise out of gold and silver.  I am hoping for a sharp downturn in gold prices sometime in 2014. 


The recent past has seen advances in energy technology, notably hydraulic fracturing or fracking. That has led to a sharp decline in natural gas prices for the past few years (see chart, courtesy of Google):

15 Years Later Natural Gas Prices at 1999 Level

As fracking proceeds, the price can fall even further, leading to the potential for exports of energy from America.  Hence, natural gas infrastructure investments through Master Limited Partnerships (MLPs) have an intriguing outlook, except for the matter of interest rates.  MLPs, the vehicles by which investors invest in natural gas pipelines, tankers, and depots, are leveraged. That creates interest-rate risk. However, the good-quality MLPs have pricing flexibility and earn significantly more than their interest cost.  As a result,the long-term risk is limited.  When the stock market tanks, so will the MLPs, though.

I listened to a conference call for Legg Mason's Clearbridge American MLP Fund.  The price had fallen sharply, ostensibly in reaction to concern about rising interest rates in response to the Fed's tapering of its monetary expansion program.  The fund's representatives made a convincing case that the underlying MLPs have good coverage ratios and that they have flexibility to increase payouts in case interest rates rise.  The fund's managers claimed that part of the recent declines have been due to end-of-year, tax-loss selling.  Within a few days  after the conference call the price has risen several percent.I am eager to see the fund's performance in January.  If it continues to rise, then the representatives' point is proven.

For now, I am still positive about MLPs.  I am also positive about tech stocks and health care stocks, at least for the beginning of 2014.  I am also bullish about real estate into 2014. The information about interest rates is already built into the stock market, and the monetary expansion that has already occurred contributes to bullishness.  Of course, the bailout and quantitative easing will result in unhappy monetary results, but who cares if the average American goes hungry?  The stock market is going up!

Hedging Rising Real Interest Rates

At the same time, low real interest rates give me pause about stocks, MLPs, and real estate because rates are going to rise, which causes declines in financial markets.  Princeton economist, Nobel prize winner, and former ethics consultant to Enron, Paul Krugman, did a quick-and-dirty pictorial estimate of historical real interest rates in his column in The Times:

Enron Consultant Paul Krugman's Quick Estimate of Real Interest Rates

 Notice a few things:  First, there was a slight increase in real rate volatility following Nixon's election in 1968.  Second, when the international gold standard was eliminated in 1971, the volatility in real interest rates heated up.  Nixon was manipulating rates by influencing Columbia economist and Fed chief Arthur Burns.  Third, there was a sharp downturn in rates in response to Nixon's reelection bid.  Fourth, there was a sharp upturn as the Fed under Paul Volcker raised rates (tightened the money supply) to squeeze out inflation. That resulted in an economic downturn, but by 1983 Volcker reopened the monetary spigot, initiating a 30-year decline in real rates, the modestly high inflation rate of 1983-2008 (see chart), the impetus for military aggression in the Middle East in the millennial period, the rising stock market of the 1983-2000 period, the millennial bubbles, and current economic volatility.

Real rates are at historically low levels.  According to the chart, there was a brief period in the early-to-mid 1970s when Nixon and Burns pushed them lower, but by the late 1970s inflation was in the teens.  It is the monetary expansion rather than the interest rate that potentially causes inflation. An uptick in inflation will motivate the Fed to raise interest rates.  That will probably harm the MLPs I mention above as well as bonds, fixed income securities, and likely the stock and real estate markets.  In other words, there is a narrow course of tapering that the Fed has outlined, but if there is an uptick in inflation, then there can be a spike in rates.  That will be unpleasant for people holding financial assets.

There is reason to be concerned about the financial markets as 2014 winds down and 2015 begins.  In a 2010 blog, the colorful Larry McDonald, author of A Colossal Failure of Common Sense, blogged about how to bet on rising rates. 

McDonald suggests these funds, which are mostly at all-time lows:

RRPIX  Profunds Rising Rates Opportunity Fund

RTPIX Profunds Rising Rates Opportunity Fund 10 Investor

RYJUX Rydex Inverse Government Long Bond Stratgegy

TBT Ultrashort 20+ Year Treasury Proshares

Ultrashort 7-10 Year Treasury Proshares PST

Horizon BetaPro 30 year Bond Bear HTD (on the TSX, not HTD on the American exchanges)

It seems to me that a partial hedge with one or two of these funds is a good idea at this point or in the near future.


Anonymous said...

It is really getting hard to invest, and for several reasons.

Can anyone now trust any investment house or brokerage to properly segregate client funds from house money? Seriously, recall that MF Global blew up, but there has been no prosecution and no attempt to rectify what went wrong or to find any sort of restitution for those directly effected?

If anything, SEC silence and inaction has given Dave Corzine's actions some legitimacy and validation.
That is scary, isn't it?

How about Bernie Madoff and the refusal to allow him to demand testimony by JP Morgan? We now find out that they knew, all along, that Madoff was gaming the system, yet they said and did nothing. Hmmm...

Upshot: if you don't have physical possession of your assets, you have reason for concern.

But then again, you could put your money in a bank at 0.25% interest. Gee, that's exciting, isn't it? Of course when a Cypriot style "bail in" takes place, then it will be exciting, but not in a good way.

While we are at it, are any of the big five banks (BOA, JPM, Wells Fargo, Citigroup, Goldman) solvent? Just wondering, but then again they seem awfully addicted to public money.

Can anyone please tell me what financial numbers are to be believed anymore? Unemployment? Inflation? Anything with Obamacare? How about stock prices given their earnings? How about the repeated flash crashes that seem to happen monthly now? Trading volumes are weak as more and more trading is now done by machines and not traders. Small investors are now at a clear disadvantage. How about leaking of highly sensitive economic data to the big shots a few minutes before release to the public, allowing them to front run the market and make a killing?

Can I bring up the very intentional manipulation of precious metals by banking elites and their subordinates in the government?

How about LIBOR? That stunt where banks deliberately gamed the interest rates to make money dishonestly. It cost EVERY homeowner in the US more than a few dollars, no doubt about it. I am still waiting for prosecution....which will come about the same time Obama comes clean on his own checkered past.

Look, I have money in the market, all managed professionally. But that is because there are few other places to go.

Be well.


Mitchell Langbert said...

While there are always instances of corruption in markets, the ongoing businesses of stock brokers depends on their adherence to fiduciary standards that enable their customers to maintain accounts. A brokerage house that commingled house resources with client accounts would not survive for very long. In contrast, reputable brokers like Smith Barney (now Morgan Stanley Smith Barney) have been in business for many decades and will not continue in business if they violate ordinary fiduciary standards.

You are right to be skeptical of financial markets, but manipulation of even a relatively small market like gold, while it might occur, cannot last for long. Witness the case of Bunker Hunt, who attempted to corner the silver market. He went from being one of the richest men in the world to relative poverty. He's back on the Forbes 400 now because he is working in an industry he understands in at least a somewhat ethical way.