Bill Gross Plays Defense, but May Leave Himself Open for a Bomb

Bill Gross's monthly investment outlook letter to PIMCO's investors is interesting. He makes many of the same points I have been arguing in this blog. Here are his summary points:

• Over the past 30 years, an offensively minded Federal Reserve and their global counterparts were printing money, lowering yields and bringing forward a false sense of monetary wealth.
• Successful investing in a deleveraging, low interest rate environment will require defensive in addition to offensive skills.
• The PIMCO defensive strategy playbook: Recognize zero bound limits and systemic debt risk in global financial markets. Accept financial repression but avoid its impact when and where possible. Emphasize income we believe to be relatively reliable/safe; seek consistent alpha.

Mr. Gross and I are in complete agreement through much of his argument, until he reaches his final point. At the end of his argument he believes there is a zero bound limit for nominal interest rates that offer a negative real yield due to inflation. I believe his argument doesn't fully consider a deflationary environment as a possible outcome, potentially leaving his defensive strategy open "over the top."

Mr. Gross begins his argument by stating,

"the gradual decline of yields over the past three decades has allowed P/E ratios, real estate prices and bond fund NAVs to expand on a seemingly endless virtuous timeline."

I clearly agree that falling interest rates have enabled valuations on multiple asset classes to appreciate. Mr. Gross goes on by stating,

"Yet an instant replay of these past few decades would have shown that accelerating asset prices weren’t due to any particular wisdom on the part of academia or the investment community but an offensively minded Federal Reserve and their global counterparts who were printing money, lowering yields and bringing forward a false sense of monetary wealth that was dependent on perpetual motion. “Rinse, lather, repeat – Rinse, lather, repeat” was in effect the singular mantra of central bankers ever since the departure of Paul Volcker, but there was no sense that the shampoo bottle filled with money would ever run dry. Well, it has."

I am still with him with the portion of my Sagflation theme that argues an overly aggressive monetary policy has been the primary driver of excessive growth in the economy. His main point is thus made as,

"Low yields, instead of fostering capital gains for investors via the magic of present value discounting and lower credit spreads, begin to reduce household incomes, lower corporate profit margins and wreak havoc on historical business models connected to banking, money market funds and the pension industry. The offensively oriented investment world that we have grown so used to over the past three decades is being stonewalled by a zero bound goal line stand. Investment defense is coming of age."

At this point I'm thinking that he will make the next step in my argument that deflation may take over as banks and other financial businesses begin to shut down lines of businesses that are unprofitable in this low rate environment.

"It is Main Street that has failed to keep up with Wall Street and corporate America in the race to see who can benefit more from lower yields. As the interest component of personal income gradually weakens, the ability of the consumer to keep up its frenetic spending is reduced."

Good, I'm thinking, he's highlighting deflationary pressure on Main Street as incomes fall from lower savings rates. But then he states,

"If these firms can’t cover inflation with historical real returns from their float, then they begin to downsize in order to stay profitable. The downsizing is just another way of describing a transition from offense to defense in a zero bound nominal interest rate world where almost any level of inflation produces negative real yields on investment."

At this point I pause. Okay, Mr. Gross is assuming aggressive monetary policies like quantitative easing likely continues to drive inflation, essentially pushing real interest rates negative. He then goes on to illustrate how negative real yields likely force financial firms to downsize. He further emphasizes the point by arguing investment strategy should be more defensive in this environment. But, I'm left with two questions in his argument, which are:

(1) For how long is a negative real yield environment sustainable? 
(2) What happens when this environment ends?

Mr. Gross's argument appears to set up a seemingly endless wicked timeline, or the opposite of virtuous. The central banks drive yields closer to zero and increasingly print money, raising inflation, destroying real yields. It is implied that this becomes a difficult investment environment. I'm with him there. 

But, the issue I have with the conclusion is its avoidance of a discussion of deflation. It stands to reason that fundamental forces take-over if the Fed runs out of room to encourage inflation through either interest rate manipulation or political willingness to print money. If we enter a clearly recognizable deflationary environment, in which the CPI does actually turn negative, real yields actually begin to rise for lenders and borrowers. The real yield on cash goes positive and many other pretty funky things begin to happen.

Mr. Gross makes his points with the help of football analogies. I believe a cosmic metaphor may be in order. Where does our universe end? And, what is on the other side?

Could Deflation Blindside the Market? Sold Gold.

Will the Markets get Blindsided? 
The markets are increasingly worried about rising oil prices slowing economic growth. The rise in oil prices appears related to supply worries associated with Iran, rather than strong demand. However, the increase in the PPI for crude materials has slowed to less than 5% annually, after rising at a rate greater than 15% for the past two years. Aggressive actions by the ECB and Federal Reserve may continue to drive inflationary pressures, but I believe deflation may ultimately take over as the market driver later in 2012.

Is Deflation to the Market what Lawrence Taylor was to the Quarterback?

Twenty-to-Thirty Years of Healthy Deflationary Forces I estimate Have Built-up...

(1) Technology advancements - Advancements continue but the pace of economic change relative to the pace during the periods of the personal computer, internet and enterprise software is likely slowing.
(2) Manufacturing outsourcing to China - As wages rise in China, commodity prices increase, and the yuan appreciates the deflationary pressure may actually switch to inflationary.
(3) IT outsourcing to India - Wages in India continue to rise and much of the low-hanging fruit has been harvested.
(4) Business reorganization - Really a derivative of the previous three trends, but as businesses find less opportunities to increase revenue or reduce costs through reorganizations, the economic impact slows.

But, Unhealthy Deflationary Forces are Also Building...

(1) Housing overhang - The Economist estimates that American households have lost a "whopping $9.2 trillion." This loss despite mortgage rates near historic lows that make financing the purchase of a house more affordable.
(2) Excess retail space - From 1999 to 2009 the shopping space per person in the US increased almost 30% from 18 square feet to 23 square feet, driven largely by inexpensive construction financing and unsustainable rising consumer debt, in my view. This increase occurred despite the percentage of online shopping increasing from 5% in 2006 to around 9% currently.
(3) Contracting number of bank customers - Meredith Whitney estimates that the number of "unbanked" Americans is rising, from 1 in 4 in 2005 to close to 1 in 3 currently. The problems facing banks include less access to securitization, increased regulation, and low interest rates. This trend of a shrinking customer base implies higher transaction costs for unbanked individuals and a lower savings rate, both drags on economic activity.
(4) Unemployment - At over 8%, the unemployment rate has been a drag on the economy.

And Bad, but Necessary, Timing of Dissipating Artificial Inflationary Forces...

(1) Diminishing power of central banks - With historically low interest rates I believe the ability of the central banks to boost economic growth through the expansion of credit is nearing an end. Furthermore, I believe the central banks are reaching a point in which printing excessive money is one of their remaining choices to offset deflation. With the GOP proposing "The Sound Dollar Act," which would eliminate the Fed's mandate to promote full employment, I believe the expansionary position of the Fed may lessen.
(2) Fiscal stimulation retreating to austerity - As I outlined in Taxmageddon, at the end of 2012 the US economy is set up to bear significant tax increases and spending cuts. As witnessed in Greece, and increasingly Portugal, fiscal austerity likely results in slowing GDP.

Likely Results in Falling Prices.

(1) Financial markets - Based on the 10-year average earnings, the PE ratio of the S&P 500 is over 40% above the long-term median. While this measurement does include the fallout of the dotcom and housing bubbles, depressing earnings, it does suggest the market does not expect another bubble to burst. I believe the main reason why the equity markets are this high is because of the actions of the central banks and governments.
(2) Commodities - Print more paper money and there is more currency per hard assets like gold, oil and copper, driving up prices. Driving up prices on major resources of the economy (see chart below) results in companies attempting to pass along these rising prices (consumer inflationary) and aggressively cutting costs in other areas (deflationary), enabled by technology advancements, access to lower cost labor, and falling financing costs. As the effects of an expansionary monetary policy diminish the more volatile commodity prices may begin to fall, reducing the bottoms-up inflationary pressure. The annual growth of PPI for crude materials has slowed to below 5% after remaining well above 15% for most of the past two years.

Sold Gold.
Because of my growing worries about deflationary forces driving future market movements, I decided last week to sell my ~5% position in gold. I fully recognize that actions taken by the central banks could offset deflationary pressures, but I simply feel more comfortable following fundamentals rather than possible government actions.

Taxmageddon - Is This What the Mayans Predicted?

Interesting article in the Washington Post titled "'Taxmageddon' looms at end of payroll tax holiday." Basically it highlights the concern I addressed in the February 14 post "Fiscal Stimulation" that the economic outlook includes significant tax increases in 2013. Here is a summary of tax increases on January 1:

- Tax rate rise on investment income, estates and gifts, and earnings at all levels
- Marriage penalty for joint filers returns
- Value of the child credit drops from $1,000 to $500
- Tax rate everyone pays on the first $8,700 of wages jumps from 10 percent to 15 percent
- Social Security payroll tax goes up to 6.2 percent from 4.2 percent
- Medicare taxes under health-care initiative will begin to impact high-income households

In addition, the automatic spending cuts also begin in 2013.

Both Democrats and Republicans appear to be preparing for the battle. Given it is a Presidential election year, I expect a vicious tax and spend debate starting in the summer. I do not believe the market has fully digested the impact of the potential removal of fiscal stimulus, or at least is waiting for politicians to address it. Either way, by about June of this year I expect the market to begin focusing on the issue and its potential impact to the markets.

For all the dooms day prognosticators out there, Taxmageddon does closely coincide with the end of the Mayan calendar on December 21, 2012. At least we won't need to buy Christmas presents this year.

Regulatory Environment Contributing to Sagflation

The Economist has devoted multiple articles of this week's edition to examining some of the issues with the regulatory environment in the US. In the February 14 article titled "Fiscal Stimulation," I argued within the framework of my Sagflation theme that there is a build up of excess capital in the economy due to an aggressive monetary policy over the past few decades, as well as recent expansionary fiscal policies. In this article I highlight the additional costs to businesses created by the regulatory environment, as well as the impact on the economy within my Sagflation theme.

My main point in this post is that I believe perversions in the legislative process are resulting in greater burdens for the US economy, which likely contributes to slowing growth in the future and compressing company margins. 

Regulatory Issues

There are plenty of examples of the burdens of poorly designed regulations, but the cause seems to boil down to a political system rigged more towards dollars than votes. Politicians spend excessive time fund raising and listening to micro interests from their donors, and less time devoted to crafting thoughtful and intelligent laws. I believe a secondary issue, either caused by the dollars or by the politicians themselves, is the effort by the legislative branch to over-step its authority and attempt to dictate to the administration how to administer the government. As a result, lawmakers create overly complex laws that attempt to cover every eventuality raised by their donors, instead of laying out broad goals and focusing only on what is strictly required to achieve the goals. Lobbyists seem to favor this system because overly-complex laws offer opportunities for special interests to insert language favorable to them, in my view. This is not a party-specific issue, in my mind, it is a systemic issue that needs to be addressed.

All this additional complexity costs money, of which there is a growing list of examples. The additional burdens of compliance with Sarbanes-Oxley has resulted in a precipitous drop in the US's share of IPOs, from 67% in 2002 to 16% in 2011. Jamie Dimon of JP Morgan Chase estimates the annual direct costs of Dodd-Frank to the bank will be around $400-600 million. The EPA estimates the cost of new mercury standards may cost businesses $10 billion per year, the interstate air pollution rule an additional $2.4 billion per year, and the ozone rule at least $20 billion per year. However, as The Economist points out, the "real costs may be found in the hard-to-calculate perversion of behavior that over-regulation causes." An example of the perversion is that some regulated companies, which have already sunk the costs into compliance, may actually encourage on-going regulation to maintain a higher barrier to entry against new entrants.

While I do not consider myself a libertarian, I do believe that the process by which laws are crafted has become perverted, resulting in growing inefficiencies within the economy. 

Incorporating Regulatory Burdens into Sagflation Theme

Putting together my previous message of sustained mis-allocation of capital with this post's message of rising regulatory costs suggests return on capital could compress significantly if growth slows. It is likely, in my view, that economic growth slows over the next few years due to austerity. Should interest rates begin to rise due to either a Fed policy change or market forces, companies would also confront a rising cost of capital. Slowing growth, excess capital, shrinking margins, and a higher cost of capital could lead to larger write-offs over the next few years than witnessed in 2008, in my view.

The Wall Street Journal points out that the P/E valuation of the S&P 500 based on Robert Shiller's 10-year average earnings calculation is potentially inflated due to the large write-offs impacting earnings after the dot-com bust and the housing bust. Excluding these write-offs, the P/E under Shiller's formula is 18.9x, about in-line with the 50-year average. I believe the market ignores these write-offs at its own peril because the write-offs are the result of the build-up of excess capital in the economy, partially reported as "overstated profits," associated with an overly aggressive monetary policy. Since the policies have not changed, why should we expect the write-offs to be "one-time?"

Transports Foreshadowing Pullback? Sold GE.

The Dow Jones Transportation Average has been sliding for a couple days, under-performing the broad market. Typically the transports are a leading indicator of a slowing economy because fewer goods are moving around the country. It is only 2 days, but worth keeping an eye on as an early tell of the economy.

Sold my ~3% position in General Electric Corporation (Ticker GE). The stock has appreciated about 15% since I bought it in mid-October. I continue to move my IRA towards more conservative waters as my post on Sagflation suggests deflationary pressures are building. In addition, I believe there the potential growth inhibitors in the US of higher taxes, lower spending and falling liquidity over the next year provide the catalyst for a market correction. Of course, there is always European debt or Middle east unrest to send the market lower as well. GE has large international exposure, increasing the risk the company is hurt by events outside the US. The stock is reasonably prices at 12x this year's consensus EPS estimate, although I believe the 15% anticipated growth rate in 2013 is somewhat aggressive.

Sold DOW Chemicals

Sold my ~4% position in Dow Chemical (Ticker DOW), which had appreciated about 20% in the 3+ months I have owned it. The stock has been bouncing around $34 for most of February after running up in January, suggesting to me that it has peaked out. The consensus analyst estimate in 2013 assumes a 25% EPS growth rate, which I believe is quite aggressive should my Sagflation theme play-out of deflationary pressure. Furthermore, with excess capital in the economy and growing consumer debt, I believe demand may slow for large segments of the company. Finally, about 1/3 of revenue comes from Europe, to which I would prefer to lower my exposure. The P/E on the consensus 2012 EPS estimate is about 12x and the dividend yield is around 3%, both reasonable in my mind. I just believe the company may face stronger headwinds going forward.

Fiscal Stimulation, Fed-Reliant Liquidity, and Debt-Driven Spending

Sagflation Remains in Play

Throughout last year my main theme of Sagflation was very macroeconomic and top-down. This theme of fundamental deflationary forces in the economy offset by an aggressive monetary policy led me into my large position in 30-year Treasuries last spring. Last April, when I began buying large positions in longer duration treasuries, I received a few raised eyebrows from friends in the investment world who felt treasuries were over-priced. It is at these times, when I'm taking a contrarion view, that I rely on my analysis and knowledge of the markets to provide the intestinal fortitude. I also make sure I have a defined release point, should the markets move against me, in order to cover some downside risk.

Going forward, I continue to use my Sagflation theme as a back-drop for 2012. Fundamental deflationary forces remain in play, in my opinion, due to (1) multiple decades of over-investment fueled by declining interest rates, and (2) slowing demand as a result of the consumer and sovereign debt burden.  Examples of over-investment include (1) the Baltic Dry Shipping Index down over 90% from 2008 due partially to over-building in ship yards, (2) the on-going weakness in housing, which may have spread to Canada and China, and (3) a glut of retail space, despite recent strong performance by retail REITs, exasperated by a shift to online shopping (eg. the Borders and Blockbuster bankruptcies).

In the following section I review the past thirty years and present my hypothesis that the full deflationary pressure from technology advancements in the 1980's and 1990's went unrecognized by the Federal Reserve. This, in turn, resulted in a targeted inflation rate above what was sustainable, leading to excessive investment and "irrational exuberance." By 2000 there was pent-up deflationary pressure but a combination of extraordinary events and stimulative policy changes have until now offset these deflationary pressures. Indeed, in my view, the deflationary pressure has actually increased over the past decade, resulting in an escalation in the aggressiveness of stimulus measures that increasingly pervert the efficient allocation of capital in the economy.

A Brief Overview of my View on How Deflationary Pressure Built-up

I believe the fundamental deflationary pressure has been building for years, likely beginning in the 1980's with the significant technology advancements during the decade, and continuing through to present day with the business reorganizations that the on-going advancements enabled. Yet the Consumer Price Index averaged around 2.5% for the past 3 decades due largely, in my opinion, to an expansionary bias in the Federal Bank combined with aggressive monetary easing during recessions. On the one side I believe the economy enjoyed falling operating costs within businesses due to improving efficiencies. On the other side the Federal Reserve was targeting an inflation rate around 2-3%, which it expertly maintained by expanding credit in the economy through declining interest rates.

From a central bankers view, I believe they view their role as maximizing real economic growth by spurring on new credit growth. The problem, in my mind, is defining "real" growth during periods of extraordinary fundamental change. By the central bankers failing to accurately quantify deflationary pressures produced by improving efficiencies, their targeted inflation rate of 2-3% was above what was sustainable in the economy, in my view. Businesses with significant information processing requirements enjoyed both falling expenses and potentially rising revenue, expanding their economic profit. The increased profit, in conjunction with falling financing costs associated with declining interest rates, led to heightened investment spending as businesses looked to expand and new competitors entered pursuing the attractive profits, in my view. Therefore, I believe that excess capital was building up in the mid-1990's, increasing demand for money and pumping up asset prices as investors competed for scarce resources, leading to Alan Greenspan's "irrational exuberance" comment in December, 1996.

After Greenspan's comments the markets sold off somewhat in the first half of 1997, as they likely started to factor in the Fed allowing for a recession that would work off the excess capital in the economy.  Indeed, the Fed did raise the target Fed Funds rate in order to cool the economy. However, a series of events including the Asian financial crisis in 1997, the default by Russia on its bonds in 1998, and the collapse of Long-Term Capital in September 1998 led the Federal Reserve to reverse course and once again aggressively drop the target Fed Funds rate. Once again US businesses enjoyed expanding profits due to operating efficiencies, which drove up demand for further investments in technology and consulting. Once the worst case scenario appeared averted, the Federal Reserve again began increasing the Fed Funds rate in order to address the rising excess capital, but likely not aggressively enough, in my view. Exasperating the issue was the Fed's decision to increase liquidity in the run-up to Y2K.

By 2000 the economy had about two full decades of excessive stimulus, in my opinion. The stock market was on a tear upwards and the dot-com bubble was almost fully inflated. For anyone who lived through the markets in those times, which I did in San Francisco working for an investment bank focused primarily on technology, it was simply crazy. Talk about excessive capital and inefficient allocations, anything with .com in its name could raise millions while companies generating healthy returns with good growth prospects in the "bricks and mortar" world struggled to be heard. The fuel for this exuberance appears to have been the real world cost improvements of technology investments synchronizing with both the required spending to prepare for Y2K and the dream of a new world created by the internet.

The excessive capital can be seen in the general decline in utilization rates, despite industrial production increasing about 5% annually during the 1990's. The Federal Reserve was now aggressively raising rates to deflate the bubble. Well, they succeeded and it popped, resulting in the stock market falling and the economy slowing. The dramatic nature of the slowdown was an indication of the excess in the system that needed to be worked off, in my view. We were in for a painful, but necessary in my opinion, rationalization of poorly allocated capital. Instead, the extraordinary event of the terrorist attacks on September 11, 2001 occurred and the world became a very scary place. President Bush cut taxes and the Federal Reserve cut rates.  Working off the economic excesses was put-off as the country focused on healing and responding.

By 2003 the Fed Funds rate was at 1%, the Bush administration had passed significant tax cuts, and the country had declared war on Iraq. Not only had the economy not had time to work off excesses, the economy was dramatically stimulated by the powerful combination of monetary stimulus, tax cuts and fiscal spending increases. In hindsight, it is not surprising that company profits increased, companies expanded, and housing and retail boomed as rising income and low financing rates made a potent combination. The CPI was creeping up closer to 4% but quickly fell below 2% by the end of 2006 after the Fed Funds rate had been increased above 5% near the start of 2006. I believe the fundamental deflationary forces remained in the form of greater efficiency in business with the maturation of the internet, outsourcing of IT and manufacturing overseas, inexpensive communication due to the excessive investments in fiber optics during the dot-com era, and reorganizations of companies and industries to adapt to the new technologies. However, by 2006 the economy now also had excesses in housing and retail, and was on its way to over-building in shipping.

To summarize to this point, the economy has benefited from "good" deflationary pressure associated with technology advancements. However, a Federal Reserve that has under estimated this fundamental deflationary pressure for decades has now encouraged excessive capital to build-up in segments of the economy. This build-up of excessive investment is now providing additional deflationary pressure on the economy. In short, deflationary pressure has built further, driving interest rates lower and neutering the effectiveness of the Federal Funds rate, in my view.

To be clear, central banks do not act in a vacuum. While the headline CPI inflation data maintains a somewhat inflationary level of around 3%, I believe a closer look shows fundamental deflationary pressures that are pushing interest rates lower. Food, energy and medical expenses are the primary drivers behind higher CPI figures. Both food and energy are directly impacted by the higher commodity prices encouraged by monetary stimulus. The growth in medical expenses is somewhat structural, in my view, due to aging baby boomers and the US health care system. The declining GDP deflator, now around 1% annual growth, offers a clearer insight into deflationary pressures over the past few decades and thus a fundamental reason for falling interest rates, in my view.

The Day the World Change

On October 9, 2008 the Federal Reserve made the extraordinary change that it would begin paying interest on both required reserve and excess reserve balances. One of the intended results of paying interest was that the balance of excess reserves held at the Federal Reserve spiked dramatically, making the money multiplier for now irrelevant. Traditionally, interest was not paid on reserves to encourage banks to lend out excess reserves for a profit, creating the money multiplier effect. The Fed increased the monetary base significantly to offset the decline in commercial bank money in the system due to the elimination of the multiplier effect. The change was made in order to enable the Federal Reserve to better control the Federal Funds rate. It also increased the reserves held by the Federal Reserve, providing more firepower to the Fed to use these reserves to purchase securities in the open market, providing liquidity and administering quantitative easing, without materially increasing the amount of credit in the system.

This new policy may eventually lead to a "floor system," in which the Federal Reserve raises the target rate for interbank loans, the Federal Funds rate, by several percentage points to prevent an abundance of credit at a lower interest rate. By setting a floor rate, the Fed removes the incentives for banks to lend in the interbank market or issue loans to the public. With enough excess reserves in the system, the floor system enables the Fed to set interest rates independent of the level of reserves in the system. It also enables the Fed to provide liquidity with additional reserves without impacting interest rates, which it has as liquidity provided by commercial banks has pulled back.

A logical question is why have markets become reliant on government-provided liquidity?

A Shortage of Money?

In my opinion, the Federal Reserve's policies over the past 20-30 years have been a form of price control, attempting to maintain "price stability" in a deflationary environment by aggressively lowering the Federal Funds rate and more recently buying longer-term debt instruments. In essence, for the past 30 years the Federal Reserve has maintained a "price floor" by consistently stimulating the economy through new credit growth in order to keep price rises around 2-3%. Economists generally agree that creating a price floor, which prohibits prices below a certain minimum, causes surpluses. I believe the dot-com bubble, housing bubble, and other excesses in the economy are results of these price controls.

The problem, in my view, is that the Federal Reserve has had diminishing success at stimulating new credit growth. From the commercial banks' perspective, I believe that as interest decline there is a diminishing incentive to make new loans, especially as the yield curve flattens and bad credits from the past accumulate. From the perspective of the renters of money, or businesses requiring financing, a build up in excessive capital in the economy results in a diminishing number of project opportunities offering attractive returns. In short, the demand for new money has slackened due to the build-up in excess capital and the central banks effort to stimulate credit creation is increasingly like "pushing on a string."

A side effect of the excess capital, and compression of return on capital as a result, is that liquidity dries up quickly if commercial banks believe other banks may have problem loans. In other words, the money supplied by commercial banks through the multiplier effect has dried up because lenders are less willing, or less able, to make loans. MZM is the broadest measure of money and is defined as money with zero maturity, or put differently, the supply of financial assets redeemable at par on demand. Monetary base measures the supply of notes and coins, as well as Federal Reserve bank credit. At the start of September 2008, just prior to the liquidity crisis amongst banks, there was about $10 of MZM for every $1 in the monetary base. Just three months later there was about $6 of MZM for every $1 in the monetary base. The ratio has continued to compress with now only $4 of MZM for $1 in the monetary base. While this composition shift in the money supply was largely enabled by quantitative easing, it highlights the growing reliance of the economy on central bank money for liquidity. At present I am unclear whether this increased reliance is good (providing more economic stability during a recession) or bad (a sign of weak demand for new credit due to excessive capital). For now, I simply note our greater reliance on the government for liquidity.

There is some concern among leading economists that the large spike in bank reserves may eventually cause inflation to spike should banks move to quickly increase loans issued, thus reducing reserves and increasing the money multiplier. This theory is very much an exogenous theory of money, which may dominate during normal times. I humbly believe the opposite, or a more endogenous theory on money, is now dominant. The spike in bank reserves is like sirens going off that there are fewer attractive investment opportunities in the economy and that poor performance of past capital allocations must be written off before the economy can re-establish itself on a healthy footing. In other words, I believe we must at some point go through a period of defaults and bankruptcies before moving forward. For a similar argument from a different angle, please refer to this article in EliteTrader.

Where to Now?

The key question is, in my view: How does it end? We could conceivably carry on our merry way for a prolonged period of time. Some market forces enabling the continuation include: (1) investors so worried about suffering loses that they are willing to pay the government for the perceived safety of US government debt, thereby driving yields lower; (2) prices, as measured by the GDP deflator, continue to decline and thereby make even lower yields on treasury attractive, (3) the Federal Reserve continues to monetize stimulative deficit spending by aggressively purchasing treasuries, enabled by a M1 money multiplier of less than 1 that helps avoid inflationary pressures.

While our fairy tale may continue for some time, my guess is that it begins to break down at some point this year. There are a number of issues that likely unfold over the next year that could trigger a rationalization of unattractive capital outlays in the economy, in my view. The European debt problems are a high-profile risk that could precipitate capital flows locking up in the US. How well the Federal reserve can offset liquidity issues should be interesting. However, I think we have enough issues closer to home. The Bush-era tax cuts are scheduled to expire at the end of 2012, which sets up another potentially nasty political fight over tax and spend policies leading to a new tax policy and likely a combination of spending cuts and higher taxes. Additionally, the spending cuts agreed upon to raise the debt ceiling begin to take effect in 2013. The Presidential election cycle this year likely magnifies the economic debates, possibly creating expectations of significant tax increases or spending cuts. These are some pretty strong headwinds for an economy living on fiscal stimulation, debt-driven spending, and Federal Reserve liquidity creation, in my view. We can probably "whistle past the graveyard" for part of 2012, but eventually we have to pay the piper.

Let us not forget that the Federal Reserve itself is under increasing political pressure as both parties look for conflicting outcomes of stimulus and reduced intervention. Does the Federal Reserve apply the brakes to the economy by backing off its actions? How could the Fed politically do such a thing when the near future likely holds some combination of growth inhibiting tax increases and spending cuts? The very existence of the Federal Reserve may be at stake should it appear to be slowing economic growth. While I support the existence of the Federal Reserve, I sometimes question how well its leaders understand the longer-term impact of their actions.

So we may continue falling down this rabbit hole to where one day my bank may actually pay me for the privilege of financing the ownership of my house...okay, not likely.

Sold Silver, Increased Short Position

Sold my position in silver (Ticker USLV) after it appreciated about 35% since January 12. After working through some thoughts surrounding my Sagflation theme (to be posted shortly), I am increasingly worried about deflation and a market pull-back. I have little conviction that silver would perform well in a deflationary environment, although it may perform well during a stock market pullback coupled with an uncertain economic outlook.

Increased my position in the ProShares Short S&P 500 ETF (Ticker SH) to about 15% of my IRA. This increases my hedge on my long positions in equity, which represent a little over 15% of my portfolio. The problems in Europe may come to a head soon and the equity markets are at the top of their one-year range. Europe may muddle its way forward, resulting in the equity market breaking out to the upside. Instead, the riots in Greece suggest this could get really ugly. Additionally, it appears as if deficit reductions are going to be main presidential topic. Both tax hikes from the Democrats and spending cuts from the Republicans likely slow the economy, so I do not expect to hear an  economic plan that boosts the markets. Finally, I am becoming more nervous about the continued decline in non-central bank money in the money supply. The Federal Reserve continues to provide increasing liquidity, which at best provides stability and at worst is an artificial crutch for the economy, in my opinion. Until we work off the excesses of the past, I fear our future is low return.

Review of January Performance and Allocation

For January my IRA increased 2.4%, relative to an increase of 4.4% in the S&P 500. A large cash position for most of the month and a portfolio under-weighted in equity were the primary reasons for the relative under performance. That said, my intent was to remove some of the volatility in my portfolio by over-weighting corporate bonds and cash. The goal is to hit singles and doubles for now and look for pullbacks in the market for opportunities, as well as attractive investment themes.

Currently my portfolio allocation is as follows:
~35% Corporate Bonds
~23% Cash
~18% Domestic Equity
~24% Other

Included in Other are ETFs that reflect changes in Gold prices, move Inverse to the S&P 500, Leveraged 2x to price movements in Natural Gas, and Leveraged 3x to the price movements in Silver.