Easy Money Now, Hard Times Later

Following up on the last post, "Freight Trained," I wanted to highlight an article in Barron's that outlines quite well the expansionary monetary policies by most large central banks in the world. I agree with many of the concerns outlined in the article and believe these monetary policies, coupled with the fiscal austerity in many countries, lead to the following in 2012:

(1) Rising commodity prices into the first half of 2012, driving up prices for gas and food,
(2) Higher equity valuations into the first half of 2012 as liquidity inflates the stock markets,
(3) Rising interest rates on longer-term bonds due to inflation concerns and rising stock valuations,
(4) Declining wages as companies control headcounts to offset higher material prices, and
(5) Rising CPI by mid-2012 as companies pass along higher costs to customers,

All this leads to a potentially violent reset of the markets in the middle of 2012, in my view, in-line with my expectations under my Sagflation thesis of slow-to-negative growth combined with more volatile prices. During this phase of Sagflation there may be rising fear that we are entering a period of Stagflation, or high inflation, high unemployment and slow economic growth. I suspect this potential period of Stagflation may precede a period of negative growth and deflation in 2013 and 2014. While worrisome, I also believe the years 2013 and 2014 enable the political and economic re-structuring required to set-up for healthy growth in 2015 and beyond.

Returning to 2012, the potentially violent reset during the middle of the year may occur due to:

(1) Consumer spending falling due to a squeeze between rising food/gas prices and declining incomes,
(2) Debt stifling growth in European countries and with US consumers,
(3) Social unrest stemming from economic hardship in Europe and the US (Occupy movement),
(4) Additional austerity measures legislated in the US and enacted in Europe to reduce debt, and
(5) Diminishing impact, or even reversal, of expansionary monetary policies that appear to hurt growth.

These are my opinions and I lay them out in order to refer back to them in the future in order to track how my perception of the future evolves as unexpected events occur.

With all this in mind, I may exit a few positions that do not benefit from the anticipated rise in commodity prices and steepening of the yield curve. My portfolio currently includes the following:

Weight	Name	Ticker
~16%	Proshares Ultrashort 20+ Yr Treasury	TBT
~11%	SPDR Gold Trust	GLD
~4%	Base Metals Double Long	BDD
~4%	Rowan	RDC
~4%	Boardwalk Pipeline	BWP
~4%	Eaton Corp.	ETN
~4%	DOW Chemical	DOW
~4%	Huntsman	HUN
~4%	Prudential Financial	PRU
~4%	Brookfield Asset Mgmt	BAM
~4%	General Electric	GE
~4%	Vale SA	VALE
~3%	iShares Silver Trust	SLV
~3%	Tyson	TSN
~3%	Goldman Sachs	GS
~3%	Ferrell Gas Partners	FGP
~2%	ETFS Physical Palladium Shares	PALL
~2%	Citigroup Inc.	C
~2%	Morgan Stanley	MS
~2%	Pepsico	PEP
~1%	Teva Pharmaceutical Industries	TEVA
~1%	Computer Associates	CA

Market Turmoil Unfolding Largely as Expected

The dive in the equity markets coupled with the slide in the yields of treasuries is going largely as expected, as outlined in previous posts. A couple unanticipated trends included the sharp rise in gold and the rush of money headed to the Swiss Franc, although in hindsight both of these trends are logical as investors seek out places to hide.

As we likely go through the "thick" of the market turmoil over the next couple months it is important to layout the following: (1) clear signals to begin re-allocating assets, (2) identify potential investments in which to move, (3) a bail-out strategy should trends deviate from the expected.

Signals
As commentary on the markets increasing includes words like "emotion," "fear," and "uncertain," it likely suggests we are getting close to a capitulation. Another sign highlighted in the Wall Street Journal is that the benchmark M2 gauge of money supply spiked up 1.7% during the week ending August 1. This is both a sign of increasing panic and aversion to risk as investors move to cash positions, providing a deflationary pressure to economic growth. Additionally, investors removed $30 billion from equity mutual funds last week, suggesting more funds likely have to do forced selling and increasing the likelihood of downward pressure in the equity markets.

The clearest sign, in my opinion, is when yields on treasuries collapse, signalling desperate movement of money away from equities into treasuries. This may occur before the actual market bottom in equity markets since fundamentals may appear "not that bad" to equity holders. Sharp movements in yields often have severe ripple effects on currencies, debt markets, banks, and ultimately the economic outlook. So my plan is to sell into a panic buying of treasuries and begin establishing other positions.

Potential Investments
Specifically, I'm looking for quality companies at attractive valuations with a brightening outlook over the next year despite a potential economic slowdown. Ideally I would build a portfolio that likely benefits from the initial bounce back in the markets. So, from the top down one way to approach it is that I'm looking for U.S. companies positioned in more non-discretionary segments of the economy with opportunities ahead. An example might be Dunkin Donuts (ticker DNKN), a company hurt slightly during 2008 and with growth opportunities as it expands the number of units. Alternatively, a well managed company that could take market share in uncertain times whose customer base may provide choppy order flow, implying a high beta, but is healthy in a downturn. An example is Eaton Corp. (ticker ETN). Finally, looking for a company coming out of a negative period already that has scrubbed itself clean and sells into a healthy demand environment. An example would by WR Grace (ticker GRA).

Bailout Strategy
The markets are likely choppy going forward, implying there could be days and weeks in which the equity markets rally and provide a gut-check. If the yield on the 30-year treasury were to rise back above 3.75% I would begin to re-calculate my outlook. Since treasuries is over half my portfolio, it is the most obvious one for me on which to focus. It also offers a wealth of information about the economic outlook and money flows.