Herd Theory - What If?

One of my investment barometers is The Herd. The Herd is the group of momentum investors that speculate in the financial markets during times of economic volatility. The Herd does not use valuation or economic variables to make investment decisions. Fear and greed push The Herd in and out of financial investments.

In 2007 The Herd was my biggest consideration when I sold my home and decided to rent for a while. This started when I asked a question to which I already knew the answer:

What if housing is overpriced compared to rents and household income?

The response seemed delusional. Everyone said it was impossible for homes to be overpriced. At the time I thought it seemed mathematically impossible for homes not to be vastly overpriced.

I have noticed a few periods of mass delusion in the past 20 years but 2007 seemed like the worst... well the worst until now.

I pose 4 questions that the stock market, the bond market and The Herd have already responded with: "That's impossible".

What if interest rates move sharply upward in the future?

Presently the bond market is betting that interest rates will remain low for an extended period of time.

In reality the Federal Reserve is spending trillions of dollars to keep interest rates at historic lows creating a bubble in long term treasuries. This is devaluing the dollar and creating a super-bubble in carry-trade as risky assets are purchased in dollar denominated debt by other countries. Also the federal reserve is financing new debt in short term vehicles. Eventually all of this debt will have to be re-financed into longer term treasury bonds. So there is a bubble on top of a bubble while the federal reserve is asleep at the wheel holding short term debt vehicles for our country's long term debt. I can't see a scenario where this is not a problem. The worst case would be a snap back of carry-trade investments cascading into a bursting of the treasury bubble with worldwide debt markets rushing to refinance short term debt into long term debt as interest rates spike. It would make the skyrocketing interest rates of the 1980's look like a cakewalk.

If interest rates rise in this manner it will be due to risk aversion of the bond market and not from inflation. There are many people that are predicting inflation in our future. I am not investing with an eye toward inflation because we are presently in a deflationary environment. Increased interest rates plus deflation will equal stagflation. Very similar to the 1980's.

The Federal Reserve is presently "betting the farm" with the hope that they can create inflation in the future. Since the bet is already on the table, for our country's sake let's hope that they are right and I am wrong. But either the fire of inflation or the ice of risk aversion will have the same shocking effect on the bond market. Neither scenario is priced into present long term yields.

What if the unemployment rate rose to 13%?

Presently the stock market has priced in a recovery in the economy early next year. The Herd expects the unemployment rate to quickly trend downward back to normal in 2011 or 2012. Nine months after the "end of the world" selling of March, 2009 the stock market and The Herd have priced in a 100% recovery in the economy.

In reality the unemployment rate is still trending upward and could easily hit 13% in 2011. It is a distinct possibility that it will take decades to come back down to the 5% to 6% range of 2007 and that is only with the most optimistic economic assumptions. If we remain in the same trend as the past 10 years we will never get back to 5%. Since 1999 there has been a net loss of 300,000 jobs in the private sector. We have drunkenly gone through the biggest private debt binge in our country's history, created the most fiscal stimulus that any country has ever attempted, with the loosest monetary policy in history and still we have negative private sector job growth. We have also stimulated the economy by starting two wars in the past 10 years. Even after all this stimulation, we still have fewer private sector jobs today than a decade ago.

Although there has been no increase in private sector jobs there has been a huge increase in government jobs, government pay and government benefits over the past ten years. Taxes to pay for this government largess will be a massive drag on the private sector for generations to come.

What if the present monetary and fiscal policy does not help the economy?:

Presently the Financial Elite of our country are using massive spending programs to jump start the economy. They are 100% focused on increasing debt as opposed to the historical norm of using debt destruction to heal the economy.

In reality there is no point in history that one can pinpoint to prove that the Keynesian "prime the pump" theory has ever worked. Our Financial Elite use The Great Depression as their only example. But they can't explain why The Great Depression lasted over ten years as Hoover and then Roosevelt poured government money into the economy and devalued the dollar by 50%. This policy is exactly what our government is doing today except Roosevelt's stimulus was directed at jobs and markets. Today money is directed toward gimmicks or given directly to Wall Street.

Roosevelt never insulted the public with gimmicks such as "cash for clunkers" or moral hazards like bailouts for bankers. Roosevelt directly gave people jobs. He also took the high road and enlisted the Pechora Commission to dig to the root of the banking problems. The Glass-Steagall Act that came out of the Pechora Commission helped the economy for 50 years until lobbyists were able to coerce enough people in Congress to repeal it. Now Goldman Sacks is able to game the system by using depositor and taxpayer money to gamble in the financial markets. Most of Goldman's revenue from the last quarter is from these "trading profits".

Debt destruction would solve our economic problems a lot more quickly than what we are doing now. Definitely there would be a lot of pain for speculators and rightfully so. A quick deep recession would cleanse the system of the greed and speculation that has developed over the last 25 years of easy money from the Fed. It would reprice assets to fair value and could probably be over in a year or two. It might even get rid of our delusion that allows the Federal Reserve to exist at all.

But since we have decided to use debt to prolong the downturn I agree with Roosevelt and would like to help the down and out instead of the rich. Our present government's "rob from the poor and give to the rich" mentality seems like the antithesis of Roosevelt to me. I will be very surprised if there is any banking regulation that comes out of all of this economic pain. I have a feeling that our country's delusion will just turn to apathy. We are going down the wrong road and it is definitely not the high road.

What if the debt created by the government becomes a drag on the economy?

Presently our government says that easing the pain of this downturn in the economy is more important than the consequences of the debt in the future.

In reality our country as a whole is much more in debt than anytime in our history. We are piling on more debt to this record number every day. A small part of the debt is being used to fight a war, one could argue that it is necessary. A small part of the debt is being used to help the unemployed, which seems like a prudent thing to do. But the lion's share of the debt is being used to reward speculators, to bail out Wall Street and to make government bigger.

How can anyone think that loading our children with massive debt to fund bigger government and to bail out Wall Street is appropriate? Roosevelt's debt was funded by liberty bonds. The interest on these bonds were paid to Americans. A large part of our present debt is funded by China, Japan and The Middle East. If the trends that I have talked about continue, then in 30 years our biggest government expense will be interest payments to foreign nations. Our country's out of control dependence on debt is one of the biggest economic threats that our nation has ever faced. Looking back in history, most countries are not toppled by war but by debt. I hope we come to our senses soon. Our children's future is at stake.

Our present economic paradigm is built on assumptions that don't seem to be founded on reality:

• We learned during the housing bubble that we could not use the home ATM to create lasting wealth. But now we feel that the taxpayer ATM can create future prosperity.
• We are assuming that interest rates will stay low for a long time even though they are being kept artificially low through trillions of dollars of borrowing from foreign nations.
• We assume that the unemployment rate will go down to 5% even though it is almost mathematically impossible for that to happen and there is no period in history where our country has created enough jobs to fill this large of void.
• We are sure that Keynesian fiscal stimulus will "prime the pump" even though our water table of savings is historically low and Keynesian stimulus has never been proven to work in the past.

The financial markets could have a temporary "V" shaped recovery but long term recovery for our nation back to the prosperity of the last decade is mass delusion on a grander scale than the housing bubble. It is mathematically impossible to accomplish a repeat of this false prosperity without very high inflation. Presently we are experiencing deflation.

Investing

I purchased some SPY(Exchange Traded Fund that tracks the S & P index) during the recent stock market dip so my retirement account has increased 1% with the last 7% increase in the S and P. I am slowly selling SPY as the market rises. I have an overall gain of about 11% compared to the 2007 high point for the S and P. Now I feel it is prudent to protect my capital in a market neutral position. I will try to eke out some profits using tactical and generic hedges against the large stock portfolio that I presently hold.

The stock market is priced about 13% above fair value so it is not richly valued. My hesitation about being market positive now is due to The Herd. As I said above, The Herd seems to have some unrealistic expectations about the economy and could bolt from the stock market at any time. The only substantive change in our economy between the "end of the world" market low in March of 2009 and today is that the government is wildly running around throwing away large chunks of borrowed money. Most of this money is being funneled into our insolvent banking system. The same insolvent banking system that will shell out the largest amount of bonuses in the history of Wall Street this year. The same insolvent banking system that should have been liquidated in 2008.

The frenetic and manic policy by our government does not seem like the catalyst to a "V" shaped recovery in the economy. I am betting it will cause market volatility of historic proportions in the next few years. A once in a lifetime opportunity for traders. Hedge funds and Goldman Sacks could make monster returns. I would suggest to invest in them but unfortunately the executives always take most of the gains.

The two previous dips in the stock market in March and in November of last year came sharp and quick. It seems like the market has already forgotten these earth shaking downturns. The S & P index could rise to 1500 and it would not surprise me. But if it did I would be tempted to buy a large short on the market like I did in 2007. For now, I am content with just protecting my capital, making a little gain on the market volatility and sitting back to enjoy the show.

My investment advice:

My advice to the reader:

• Spend less than you make (save),
• Invest what you save in investments that are priced at below average historical value(avoid The Herd)
• Slowly move into and out of investment positions (dollar cost average)
• Diversify into a varied group of investments (diversify)
• Use debt and leverage sparingly and only if the investment and the market warrant the speculation (don't speculate with more than you can afford to lose)
  

I have not lost an hour of sleep in my investments since Enron collapsed in 2001. At $5 a share they had a fantastic looking balance sheet. I lost 4% of my retirement account and learned a lot. The Financial Accounting Standards Board came out with rule FAS-157(mark to market) after the Enron collapse. This rule states that companies must report their assets at market value. It was a great rule. Of course that great accounting rule has just been repealed and now our banks have become little Enrons. It's odd that the CEO of Enron went to jail but the banks that collapsed our financial system are being bailed out with trillions of dollars and will receive record bonuses this year. This is all a part of our country's present economic delusion.

I would like to suggest that one should never invest in anything that causes a lost hour of sleep. We are entering a period that could have more market volatility than anytime in our nation's history. Don't depend on the government or speculation to fund your retirement. Your savings will serve you in retirement and it could also help save our nation.

May you sleep soundly in a diversified mix of very safe investments with absolutely no debt.

That's what I do.

Wave Theory and Tactical Volatility Investing:

The graph above is a history of the 10 year treasury yield compared to federal funds rate. When the economy goes into a downturn especially during an election year the Federal Reserve always gooses the liquidity in the financial system by lowering the Federal Funds rate. There have been a few times in the past where Federal Reserve Governors have "spiked the punch" way beyond what is prudent and necessary. Alan Greenspan was the poster child for this action. He is almost single handedly responsible for the Tech Bubble and the Housing Bubble with his 250% and then 360% spikes in liquidity to prop up Wall Street. The wave of liquidity in 2003 that created the housing bubble was the biggest in history, at that time. It might be hard to see given that 6 years later the Federal Reserve is creating a wave of liquidity that is 10 times bigger than Greenspan's record setting wave.

The graph shows events very clearly. Every period of rampant speculation is preceded by monetary easing from the Federal Reserve. This creates excess liquidity in the system, followed by speculation and is then followed by an economic downturn. This cause and effect didn't start with the Federal Reserve, they have just perfected it. Tulip mania in Holland is one of the first recorded liquidity induced manias. The speculation in Tulips was caused by all of the gold that entered Holland via the new world trade. This increased the money supply and created perceived inflation and speculation in Tulips. The Great Depression on the other hand was not caused by excess gold coming into the country. It was fermented with speculation by the easy money minted from the newly created Federal Reserve.

I have always thought it would make much more sense to have the federal funds rate pegged to the 10 year treasury yield. In this way there would never be a temptation for our government to manipulate the nation's money supply for political and financial gain, as is happening now.

Throughout history there have always been business cycles. Periods of overproduction, speculation and debt followed by periods of underproduction, prudence and saving. The Federal Reserve was created to help keep liquidity in the financial system during periods of underproduction and remove liquidity during over productive periods. Seems pretty simple for anyone that has a little bit of common sense but here is my concern.

Our present Federal Reserve Chairman does not seem to understand basic concepts about business cycles:

1. 
   
   From 2004 through 2006 Bernanke spoke widely about our country's "great moderation" and how the Federal Reserve has eliminated the business cycle. (At the time my charts were showing the biggest bubble I had ever seen happening in our housing market.)


2. 
   
   In 2006 Bernanke denied the existence of the housing bubble. (At the time I was working desperately to fix my house so I could get it on the market. I was really worried about the bubble.)


3. 
   
   In 2007 he finally admitted that the bubble existed but said it would not have a significant impact on the economy. (At the time I took out a very large short position in the stock market to protect my retirement account.)


4. 
   
   In 2008 he started by far and away the biggest flood of liquidity into the financial system in the history of our country. Presently our Federal Funds Rate is 2,725% below the yield on the 10 year treasury yield and destined to go much lower as long term yields rise. This is only part of the story. There are also trillions upon trillions of dollars that are physically being thrown at the financial system willy-nilley as if thrown from a helicopter. (This is a Jekyll and Hyde manic moment, a complete 180 degree turnaround from ignorance, to apathy, to thinking that it is the end of the world. The "end of the world" policy response brings him all the way back to ignorance in my opinion.)


5. 
   
   Back in 2002 he gave a speech saying it would be good policy to drop money from helicopters to solve deflation problems in the economy. (I remember when Bernanke gave the helicopter speech. That was when Bush and Greenspan started creating the housing bubble with easy money, massive tax breaks and a war. I talked to my kids at the time and they understood my concerns. They were only 10 and 12 years old.)

Today my quandary as an investor is that I know that I can get a 12 year old child to understand the business cycle but Chairman Bernanke's actions make it seem that he is clueless and at least one step behind the curve. Therefore, in my mind, I have a Federal Reserve Chairman that I feel understands the business cycle on a lower level than a 12 year old child. Bernanke's research on the Great Depression is worthless in my opinion. His elegant 20 variable econometric models of a million variable world are not indicative of the real economy. He has consistently ignored behavioral economics even though this school of economics is the most useful in measuring economies in crisis and is the most accurate in predicting economic downturns. But his most damaging oversight in this current crisis is focusing on our nation's income statement when the balance sheet is the problem with our present economy. How does borrowing more money solve the problem of rampant speculation and a record setting debt burden?

Maybe Bernanke is eloquent, brilliant and focused but he lacks common sense. We need people with common sense guiding us through these turbulent times. Paul Volker, Elizabeth Warren and Shiela Bair have the brains and the common sense but are being underutilized in this crisis. Paul Volker is not a genius but he is loaded with common sense. Our nation owes him a debt of gratitude for his handling of our inflationary economy of the 1980's. Alas, but he is not Federal Reserve Chairman now. We have the brilliantly manic math whiz. What is an investor to do?

How do I invest in this market?:

I can not find a period in history that matches what we are going through now. Never before has the government spent so much of our future resources(debt) to try to keep the economy functioning normally. Never before has the economy been in such disarray. Our government is expending a vast amount of our future's national wealth to prevent current business cycles. This is the same mania as during the housing bubble when speculators were using their homes as ATM's. What our government is doing is not sustainable just like the homeowner ATM's. Bernanke and other policy makers do not understand that this short term manic behaviour is distorting the capital markets and is in no way sustainable in the long run. As a prudent investor I am resigned to an extended period of dysfunctional markets with government officials that have no common sense choosing the winners and the losers in our economy. Cash for Clunkers, Wall Street Bailouts, Tidal Waves of Cash to the banking system, Bailouts of home speculators, Health Care Reform, Higher Taxes fueled by massive government debt. None of it makes sense other than that the government feels that it must choose winners and losers. Presently, savers, prudent investors, seniors and future generations are being penalized. Speculators and Wall Street are the chosen winners. The message is very clear.

For prudent investors this is a brand new game. Not only do we have to worry about the basic investment variables of risk and reward. There are two new variables that for an extended period of time will usurp prudent investing. These new variables are the government and The Herd. The government is choosing the winners and the losers. The Herd is the group of speculators that is constantly trying to figure out where the rewards of the government are being placed. The capital market has been put on hold for a while. Buy and hold will not work anymore because of the massive volatility and dysfunction of the next few years.

I shorted the market in 2007 when it was overvalued and the recession was pending. I dived in at extreme value in March. The market is above fair value now so I am market neutral. My retirement account is presently 10% above the value of the 2007 stock market high which means I averted the recession. Now is the time to avert the government distortion in the capital markets. I am setting up trading bands and will move my positions incrementally toward market positive or negative as The Herd charges in and out of the market. My goal is to loosely trend with and against the S & P Index based on market valuation and volatility until just before the recession of 2011. Timing the recession of 2008 was easy to avoid because all of the indicators were pointing to a downturn. There will be no indicators pointing to the sharp downturn in 2011. It will be the "Minsky Moment" when The Herd realizes that Keynesianism can prime the pump but can't replace the water table, that our population can't use speculation as a retirement vehicle and that the period of easy money is over. This will be the Waterloo for speculators and the defining moment for the prudent investor.