Tuesday, November 3, 2009

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.

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