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.