John Mauldin – Dennis Tubbergen

Artificial Markets

To sum up last week’s market action in a word, markets were absolutely ‘crazy’ last week.

The NASDAQ stock market index is down for three consecutive weeks but the late surge in stocks on Friday lifted the Dow and the Standard and Poor’s 500 into positive territory for the week as noted in the data box above.

The chart on this page illustrates the stock price action from Friday, March 5. It is a 5-minute chart of an exchange-traded fund that tracks the Standard and Poor’s 500. Notice the market dropped nearly 3% at the open before finishing positive for the day.

This is certainly not ‘normal’ market behavior.

Past radio guest, John Mauldin, publisher of the widely read weekly newsletter “Thoughts from the Frontline”, noted last week that “everything is broken”. An observation that I’ve been making here in “Portfolio Watch” for a long time although I’ve used the word artificial to describe the current climate rather than broken. In my humble opinion, the word artificial more accurately describes the situation.

Mauldin points out that the credit market is broken. Here is a bit from Mauldin’s piece (Source: https://www.zerohedge.com/markets/mauldin-everything-broken):

Obviously, lenders take more risk on mortgages than they do when buying Treasury bonds. We would thus expect mortgage rates to be higher, and they are. But does that risk really swing so wildly? Should it double, or fall by half, in only a few years’ time? Of course not. But that’s what happened, and there’s no mystery why. Mortgage spreads collapsed in 2009 and 2020 because the Federal Reserve bought truckloads of mortgage-backed securities.

Economic fundamentals didn’t do this. A committee decided to encourage home purchases and did so by making it cheaper to finance those purchases. The predictable result is a housing boom. Or, in the current case, amplification of a boom that was already happening for demographic and other reasons.

Mauldin states that the traditional concept of retirement is also broken. For one basic reason, yields have collapsed; they’ve been held to artificially low levels. While retirees were once able to invest their retirement savings in interest-bearing vehicles and live off the interest and their Social Security, those days are a fond memory.

Presently, many retirees and soon-to-be retirees are taking too much investment risk with their nest egg because they think they have no other alternative. And, it’s not just many retirees who are overallocated to stocks and low-quality bonds, the same could be said about pension plans.

Mauldin makes the point that stocks are also broken. He states that prices in any market are determined by supply and demand. Because many otherwise conservative investors have gravitated to the stock market looking for a decent return on investment, demand has been artificially created.

When it comes to stocks, that is definitely the case in my view. But this artificially created demand isn’t the only thing keeping stock prices up even though valuation levels are at historical heights, when stocks decline, it’s now known that the Fed through the “Working Group on Financial Markets” or the Plunge Protection Team as it is often called, will step in and prop up stocks. To digress for a moment, given the price action of stocks on Friday, this may have been the handiwork of the PPT.

Another factor responsible for driving stock prices higher is that many companies are loading up on debt because interest rates are artificially low and using the newly borrowed money to buy back the company’s stock. These stock buybacks are a form of financial engineering, creating artificial demand for stocks and artificially increasing the earnings per share of a company.

When examining in detail everything that Mauldin states is broken, there is one primary reason – the Fed has intervened in these markets, either directly or indirectly, with its artificial money policies.

Artificial money creates artificial markets.

While recognizing that markets are artificial or broken is important, you can’t stop there. You need to ask yourself some very important questions – the most important being how will these artificial markets return to reality?

As I have contended for a very long time, there will have to be a reset. This reset will be proactive or reactive. A proactive reset would have politicians and policymakers conclude that continuing with the current artificial money policies will end badly and action needs to be taken sooner rather than later to bring things back to reality. A reactive reset would be a forced reset that would be required because the artificial money policies have caused those using the currency to lose confidence in it and move from the currency to other ways to store their wealth.

It is this tipping point that sees hyperinflation emerge. There are those analysts, many of whom I’ve interviewed, respect and appreciate, that take the position that we cannot see inflation without demand. That is true.

But, it’s important to remember that there are two ways that demand builds. The first is a desire to own an asset the second is a desire to store wealth in something other than the currency that is used in commerce.

The current artificial housing boom has been driven by artificially low-interest rates and low down payment requirements. This is demand from a desire to own an asset, in this case, the asset is a home.

Should the present monetary policies continue, many who are storing wealth in US Dollars or another fiat currency may move to store that wealth in another form. This phenomenon will create demand also, but for a different reason. Rather than demand to own an asset it’s demand to exit an asset, in this case, a fiat currency.

By all accounts, present monetary policies will continue and probably intensify. On March 6, the Senate voted to approve its version of the $1.9 trillion stimulus package. Now, the Senate bill goes back to the House for approval.

From where will the funding come for this additional expenditure of nearly $2 trillion?

The Fed of course. Through additional money creation.

I can see the aforementioned tipping point from here.

As a side note, the Senate version of the stimulus package would make the first $10,200 in unemployment benefits tax-free for the tax year 2020. It would also extend the additional, enhanced unemployment benefits of $300 per week through September 6. (The House version was $400 per week in additional, enhanced unemployment benefits)

If you received unemployment benefits in 2020, you may want to wait to file your 2020 tax returns or risk having to file an amended return once/if congress gets the tax status of unemployment benefits sorted out. (Source: https://www.zerohedge.com/markets/senate-passes-19-trillion-stimulus-package)

The provision to raise the minimum wage to $15 per hour was eliminated from the bill.

Finally, this week, completely unrelated, did you see the story of the Tom Brady rookie card that recently sold at auction for $1.32 million?

It was the highest price paid for a football card ever. Less than 100 of the cards were produced and this card was in impeccable condition. The card purchase was made by a card collector and long-time fan of Tom Brady.

If you know of someone who could benefit from our educational materials, please have them visit our website at www.RetirementLifestyleAdvocates.com. Our webinars, podcasts, and newsletters can be found there.

The Relationship Between Stocks and Grocery Prices

Stocks declined last week as I anticipated they might. Last week I wrote this:

Stocks at this juncture are overbought in my view. The chart below illustrates the Standard and Poor’s 500. It is a weekly chart with Bollinger Bands. Bollinger Bands track price extremes. Notice that stock prices are currently near the top Bollinger Band on the chart. Often, when this chart pattern occurs, a pullback in price follows.

That is precisely what happened as the Dow and the S&P 500 declined. More decline from here to move stock prices closer to their longer-term moving average of price would not be surprising.

“Barron’s” reported that stocks experienced their worst weeks since August. (Source: https://www.barrons.com/articles/stocks-catch-a-cold-after-fed-stops-expanding-its-balance-sheet-51579916069). Here is an excerpt from the article (emphasis added):

Interest rates remain the primary underpinning for stocks, as equity valuations look stretched, except when compared with the paltry returns offered by the debt market. Much of the credit for that is owed to the world’s central banks, notably the Federal Reserve. In addition to last year’s three one-quarter percentage-point short-term rate cuts, the central bank has expanded its balance sheet by over $300 billion since September, when ructions in the repurchase-agreement market led it to inject liquidity. Since then, U.S. stocks’ value has jumped by more than $3 trillion.

The Fed prints and stocks rally. It’s a predictable pattern. More from the Barron’s article (emphasis again added):

The Fed insists that its operations don’t constitute quantitative easing, as it calls its purchases of long-term securities intended to boost stock and bond prices. Its recent operations consist of adding liquidity to the money markets through repurchase agreements and by buying short-term bills. Others call this a distinction without a difference, given the impact on stock and bond prices.

Interestingly, the Fed’s balance sheet contracted by $25 billion for the week that ended last Wednesday, and stocks declined.

Coincidence?

Probably not in my view.

Money creation and stock rallies occur in tandem.

Since September, the Federal Reserve has been ‘injecting liquidity’ into the repo market. What does that mean exactly?

Simply put, the repo market is the overnight or short-term lending market between banks. In September, for some reason that has not yet been disclosed, some banks refused to lend to other banks or financial institutions on an overnight basis.

In our view, there is only one reason for this – the lending banks were concerned that the borrowing banks could not pay them back. In other words, it’s a red flag of trouble that may be brewing in the banking sector.

To ensure that the banks could get the short-term loans that they needed to meet reserve requirements, the Fed stepped up and provided the loans that the borrowing banks and financial institutions couldn’t get from other banks.

Where does the Federal Reserve get the money to loan to these borrowing banks?

They print it.

Of course, it’s not reported as straightforwardly as that in the news. As the “Barron’s” article above states, “the central bank (the Fed) has expanded its balance sheet by over $300 billion since September”.

“Expanded its balance sheet” means printed money.

A visit to the Fed’s website illustrates where the balance sheet was at the beginning of September and where it is presently. At the beginning of September, prior to ‘injecting liquidity’ into the repo market, the Fed’s balance sheet was just over $3.7 trillion.

Presently, it’s approaching $4.2 trillion.

Over that same time frame, the S&P 500 has increased from about 2,850 to about 3,350.

I’ve long suggested that Fed policy is driving stocks and while this relationship between stocks and the Fed’s balance sheet level does not prove anything conclusively, it is, at the very least, interesting.

The bottom line is this.

Money creation to price inflation.

Price inflation occurs in stocks and in consumer goods.

John Mauldin, best-selling author and publisher of an excellent weekly newsletter “Thoughts from the Frontline” had this to say on the topic of inflation in his newsletter this week (I’ve pulled excerpts) (emphasis added):

Wonks tell us, with all sincerity, things like “the US cost of living rose 2.1% last year.” Really? To an actual numerical decimal place? On something as vague and as complex as inflation? Now, to give them credit, they are looking at the total national inflation rate and it is extraordinarily complex. They do the best they can.

But the inflation you and I experience? They don’t know that. They can’t know it, at least not with any precision because the cost of living is so individualized. Everyone spends their money differently, and the things they spend it on vary in price for many reasons.

I believe the analysts try to be fair and scientific. They have to work within boundaries that don’t always make sense. So, we get crazy things like “hedonic adjustment.” That’s where they modify the price change because the product you buy today is of higher quality than the one they measured in the past.

According to Consumer Price Index data, a television set that cost $1,000 in 1996 is now $22. You can’t buy any such product today, but the fact you can spend the same amount of money and get a better TV depresses the inflation rate.

They do the same thing for cars, as Peter Boockvar noted earlier this month.

Last week Edmonds.com said the average price of a new vehicle sold in 2019 was $37,183, a new record high and up 30% from where it was 10 years ago. Within today’s CPI, the price of a new car reflected a 2% increase in TOTAL since 2009. This is magically done via hedonic adjustments which discount the value of new add-ons with each subsequent iteration of cars.

The Fed relies on hedonically-adjusted data points and not the price that people are actually paying out of pocket.

Hedonically-adjusted prices exist only in theory. They don’t reflect what people actually have a choice of spending.

The Chapwood Index might be a better measure of the actual inflation rate.

This index compares the retail price of 500 consumer items that consumers most frequently purchase over different time frames.

Using this arguably more practical measure of inflation, one finds that the average annual inflation rate over the past five years ranges from 8% annually in Dallas, Texas to 13% annually in San Jose, California. Mesa, AZ on the low end of the metro areas tracked, had an average annual inflation rate over five years of 6.6%. On the high end was Oakland, CA with an average annual inflation rate over five years of 13.1%.

The dollars used to purchase consumer items are the same dollars used to purchase stocks.

I believe the driving force behind higher consumer prices and higher stock prices is largely Federal Reserve policy.

The changes in the way the official inflation rate is calculated has masked this reality.

Given higher debt levels at the government level and trillion-dollar-plus deficits as far as the eye can see, this money creation will have to continue in our view.

To protect yourself, I’d urge you to consider ‘going tangible’ with some of your assets. Tangible assets have physical characteristics and intrinsic value.

Stocks Up, Metals Down and the Inevitable Reset

Stocks finished higher last week while metals and long-term US Treasuries finished significantly lower.

The Dow rose by 1.22% as noted in the databox above while gold declined more than three and a half percent.

Yields on the 30-Year, US Treasury Bond rose to 2.43% as bonds significantly declined.

My opinion is that there could be a little juice left in this stock rally, which could mean a little more downside for metals and US Treasuries, but the fundamentals haven’t changed. Long-term I am bullish metals and US Treasuries.

With sovereign debt in much of the rest of the world yielding negative rates, it’s my opinion that there is a lot of room for a US Treasury rally especially given where stock valuations are presently and the high likelihood of a future stock price correction.

We live in interesting times and the word interesting is an understatement.

In reading John Mauldin’s excellent “Thoughts from the Frontline” newsletter this week, I found Mr. Mauldin referenced an article published by Ray Dalio who is a billionaire hedge fund manager. Mr. Dalio’s article is titled, “The World Has Gone Mad and the System is Broken”. Among the things Mr. Dalio Points out in his piece (Source: https://www.linkedin.com/pulse/world-has-gone-mad-system-broken-ray-dalio/):

-Presently, money is free for creditworthy borrowers. Investors making the loans are willing to get back less than they loan at some future point. And, there is no requirement to pay back principle ‘for the foreseeable future’.

Mr. Dalio states (emphasis added):

“They are doing this because they have an enormous amount of money to invest that has been, and continues to be, pushed on them by central banks that are buying financial assets in their futile attempts to push economic activity and inflation up. The reason that this money that is being pushed on investors isn’t pushing growth and inflation much higher is that the investors who are getting it want to invest it rather than spend it. This dynamic is creating a “pushing on a string” dynamic that has happened many times before in history (though not in our lifetimes) and was thoroughly explained in my book Principles for Navigating Big Debt Crises. As a result of this dynamic, the prices of financial assets have gone way up and the future expected returns have gone way down while economic growth and inflation remain sluggish.”

At the same time, large government deficits exist and will almost certainly increase substantially, which will require huge amounts of more debt to be sold by governments—amounts that cannot naturally be absorbed without driving up interest rates at a time when an interest rate rise would be devastating for markets and economies because the world is so leveraged long. Where will the money come from to buy these bonds and fund these deficits? It will almost certainly come from central banks, which will buy the debt that is produced with freshly printed money. This whole dynamic in which sound finance is being thrown out the window will continue and probably accelerate, especially in the reserve currency countries and their currencies—i.e., in the US, Europe, and Japan, and in the dollar, euro, and yen.

At the same time, pension and healthcare liability payments will increasingly become due while many of those who are obligated to pay them don’t have enough money to meet their obligations. Right now, many pension funds that have investments that are intended to meet their pension obligations use assumed returns that are agreed to with their regulators. They are typically much higher (around 7%) than the market returns that are built into the pricing and that are likely to be produced. As a result, many of those who have the obligation to deliver the money to pay these pensions are unlikely to have enough money to meet their obligations.

Mr. Dalio goes on to say that while pensions have some funding, healthcare obligations are typically ‘pay as you go’ and there is an ever-smaller pool of workers to support an ever-growing group of retirees who expect that these benefits will be paid. Mr. Dalio points out, as I often do, that there are only three ways to deal with the funding shortfall: raise taxes, cut spending or print more currency with the easiest option being the latter one. Mr. Dalio points out that this course of action threatens the value of existing currencies as a store of wealth.

Short of printing money to solve these problems, Mr. Dalio says, the rich and the poor will quarrel about how much benefits get cut and to what extent taxes get raised. He adds that the wealthy will have the option to move to another jurisdiction with more favorable tax rates, but he sees politicians doing more to trap the wealthy before such a move is possible.

Mr. Dalio concludes his article with this conclusion:

This set of circumstances is unsustainable and certainly can no longer be pushed as it has been pushed since 2008. That is why I believe that the world is approaching a big paradigm shift.

I agree.

What that paradigm shift will look like remains to be seen, but no matter how you look at things politically, centrist politicians are becoming rarer as the voter base is becoming more frustrated.

On this week’s RLA Radio program (now available at www.RetirementLifestyleAdvocates.com), I interview long-time “Forbes” columnist, Dr. A. Gary Shilling who makes the point that much of this voter frustration is rooted in the fact that weekly earnings growth is down from one year ago.

Couple that with the fact that the real median income of 25 to 34-year-olds has gone down since 2000 and one can understand the source of the frustration.

Mr. Dalio says it well in his piece when he states (emphasis again added):

At the same time as money is essentially free for those who have money and creditworthiness, it is essentially unavailable to those who don’t have money and creditworthiness, which contributes to the rising wealth, opportunity, and political gaps.

As I have long stated, central banking policies are to blame for this wealth gap that is likely to grow as central bankers pursue the same policies.

Central bankers are unlikely to change course until a reset occurs. The only option that you have is to be as ready as you can be when the reset occurs.

That’s why I suggest a two-bucket approach to managing assets.

One bucket containing assets that are selected to survive a reset and another bucket containing assets that are chosen to protect purchasing power from money printing.