“What Deflation?”

One of the Federal Reserve’s primary justifications for next week’s expected second dose of quantitative easing (QE2) is that inflation is actually too low in the current environment. In effect, they are worried about deflation setting in, which history shows can be difficult to break free from. The latest readings of the Core (ex- food & energy) Consumer Price Index have usually been used to back this assertion up, since they’ve been less than 1% for several months. Therefore, it was very interesting to see embedded in this morning’s initial release of third quarter GDP that the GDP price index, at 2.3%, was the highest it’s been since the third quarter of 2008 – just before the Great Recession began. Over the past four quarters, the price index has steadily marched higher from -0.2%, to 1.0%, to 1.9%, to 2.3%.

In recent weeks, one of the analysts who we read daily, Bill King of The King Report, has highlighted numerous examples of increasing price pressures, from individual companies raising prices, to soaring commodity prices, to certain foreign central banks actually raising interest rates. In his trademark colorful style, he has typically preceded each example with the rhetorical question “what deflation?” as he questions what it is that the Fed is actually trying to accomplish with QE2. He’s certainly not alone in being skeptical, as it seems that there’s been a growing chorus of opinion that the Fed is headed down a slippery slope that will undoubtedly result in significant unintended consequences as they dramatically expand their balance sheet for a second time. While the details and effectiveness of QE2 remain to be seen, the trend in the GDP price index (among other things) certainly challenges the notion that inflation is too low.

GDP Price Index

What the Fed Could Learn from Moms at Halloween

Today brought news that the Federal Reserve (Fed) is passing a survey around to its primary dealers (i.e., large Wall Street institutions). Get this one, it is asking them for a projection of central bank asset purchases (aka, “QE2”) over the next 6 months, as well as potential effects on market interest rates and possible impacts on growth going forward. I’m sorry, but I don’t get it. Just yesterday, a Wall Street Journal author who some believe is used to leak the Fed’s intentions, printed an article that implied the Fed would take a very measured approach to QE2 rather than a shock and awe-style round of buying. It seemed to be a strategic move by the Fed to reduce expectations that have built up in risk markets over the last few months. The worry is that if the Fed disappoints in terms of the size or scope of QE2 following its November 3rd meeting, perhaps the markets will sell the news, which could undermine the asset reflation that they are looking to foster.

So, what happens when you ask these dealers for their “projections?” They shoot for the moon, of course! Not surprisingly, I just read an article that said at least four of the primary dealers are predicting QE2 will entail over a trillion dollars in buying. Why the Fed would seemingly look to manage expectations down on one day, only to let these dealers undermine those expectations the next day, I have no idea. What I do know is this: this weekend is Halloween, and something tells me that no mom in America would ask her kids how many bags of candy she should be buying. Seems like common sense, but then again, who said our Federal Reserve would use such a thing when setting monetary policy? Happy Halloween, Ben Bernanke…

Gold Extension in Pinnacle Portfolios

Is gold in a bubble? There are a multitude of opinions on this topic, and of course, no one knows for sure if this is a bubble or not. Pinnacle feels that it is definitely a possibility although this bubble is more likely in the middle innings and 2011 could be another great year for the precious metal. However, over the last week or two, we had a decision to make as our rebalancing software suggested we take profits in the gold ETF owned in client accounts (GLD - the SPDR Gold Trust). Do we let the position stand and hope the outperformance continues, or do we trim the position and invest the proceeds in an underperforming position?

Our rebalancing program allows us to create models with designated weights. When the weight of the security exceeds our designated weight by 1%, the rebalancing tool suggests either a buy or sell of 1% to get back to our model weight. In this instance, GLD is currently a 5% model weight, and when the position falls to 4% or rises to 6%, the software will suggest a trade. After the vertical rise in gold to $1350 per ounce, portfolios weights in many accounts had moved to 6% and the program suggested we sell the position back down to 5%.

We decided to trim our GLD positions back to 5%. It feels like we may be approaching a short-term top as the market gets ever closer to next week’s Federal Reserve meeting. Momentum indicators have started to fall, sentiment is very optimistic, volatility has made a new low, etc. In the past, the rebalancing feature has alerted us to many overbought positions in client portfolios, and we feel gold may be due for a trend change (to a down trend or a flat trend) in the near term.

It is also interesting to note that the proceeds from the sale, for the most part, were used to purchase non-cyclical equity sector ETFs. It is interesting because risk assets usually get rebalanced into non-risk assets as the two seldom move together. This year has been an exception to the rule as U.S. Treasury bonds have risen along with risk assets. QE2 and POMOs are certainly wreaking havoc with correlations, and that is why the markets are anticipating the Fed meeting on November 3rd even more than usual.

“The Great Mandelbrot”

That is how Nassim Taleb described his first encounter with the work of Benoit Mandelbrot. My own encounter with his work occurred when I read his book, The (Mis) Behavior of Markets, A Fractal View of Risk, Ruin, and Reward. I was very saddened to learn last week that Mandelbrot died of cancer on October 14th in Cambridge, Massachusetts. He was 85 years old. I have little to no idea how mathematicians and economists are nominated for a Nobel Prize, and recent winners like Paul Krugman lead me to be skeptical about the process. If there is any justice, Mandelbrot will be accorded the honor of the Nobel, even if he made it clear in life that he didn’t exactly revere the prior winners.

Mandelbrot’s genius was his ability to see risk differently from everyone else, and then to be able to express it in a new kind of mathematics called fractal geometry. His book goes into great detail about fractals, but for the purposes of this blog I will simply say that they look beautiful. My key take away from Mandelbrot’s work was to better understand the problems with standard deviation as a measure of risk. Mandelbrot helps us to understand that risk is actually a lot “wilder” than standard deviation implies, and that the odds of “fat tail” occurrences are actually much higher than is generally understood. He gives us a new measure of risk called Power Laws where the odds of an event occurring do not geometrically increase as you get further from the average or the mean, which is exactly what happens when you measure risk using a bell curve. The insight that financial risk (which should be measured by Power Laws) is different from the deviation from the mean found in nature (which can be measured by bell curves and standard deviation) leads to powerful new conclusions about how to manage risk in portfolio management. Today the problems with “fat tails” are part of the lexicon of informed portfolio managers, and “fat tail” investment strategies designed to hedge these risks are approaching the mainstream. I believe Mandelbrot is the “founding father” of our new appreciation of risk as portfolio managers.

His book is coauthored by Richard L. Hudson, and I wonder who should get the credit for writing a book about so difficult a subject that is so easy to read. I often thought that I would have liked to sit in his classes at Yale where he taught since 1987 after a long career at IBM. My best tribute to Mandelbrot is to ask you to read his book, which I quote liberally in my book, Buy and Hold is Dead (Again), The Case for Active Management in Dangerous Markets. Chapter XII is one of my favorites, called Ten Heresies of Finance. Here they are: 1) Markets are Turbulent, 2) Markets are Very Very Risky- More Risky Than the Standard Theories Imagine, 3) Market “Timing” Matters Greatly. Big Gains and Losses Concentrate into Small Packages of Time. 4) Prices Often Leap, Not Glide. That Adds to the Risk. 5) In Markets, Time is Flexible, 6) Markets Will in All Places and Ages Work Alike, 7) Markets are Inherently Uncertain, and Bubbles Are Inevitable, 8) Markets Are Deceptive, 9) Forecasting Prices May Be Perilous, but You Can Estimate the Odds of Future Volatility, and 10) In Financial Markets, the Idea of “Value” Has Limited Value. I’m not on the Nobel committee, but I can recognize the passing of a giant when I see it.

What’s a POMO, and Why Does it Matter?

Lately there’s been a new acronym running through investment research we have been reading, and it is “POMO.” POMO stands for Permanent Open Market Operation. When you hear the Fed is executing a POMO for a certain amount, they are simply buying Treasury securities and the proceeds add reserves to the banking system permanently, as opposed to other temporary measures they may use. The Fed is entering into these transactions to ensure that its balance sheet doesn’t contract at a time when economic growth is still lagging, and price stability is at risk to lower prices.

For weeks the Fed has been using these POMOs, and we’ve been reading certain analysts that believe the market is reacting to the size of the daily POMOs. We recently asked one of the analysts we follow, Bill King, why he thought these POMOs mattered so much to the markets given the fact that the Fed is simply maintaining the size of the balance sheet. Below is a summarized version of Bill’s response to our question.

1. The Fed is entering into larger POMO’s than necessary to account for the bleed off of agency mortgage-backed securities. In his opinion, the first round of quantitative easing (QE1) never ended.

2. Money desks that control Wall Street must invest this new liquidity in the system, and at very highly leveraged multiples.

3. Traders respond reflexively to more juice equaling higher assets prices.

At Pinnacle Advisory Group, we can’t claim to know exactly how much POMOs are affecting daily movements in the market. But we can claim to constantly be evaluating and adjusting our views of financial markets based on new information and constantly changing conditions.

A Bullish Contrarian Bonanza

Lately I’ve been considering that fact that “informed intuition” about investment markets, the very stuff we hope to warehouse in large quantities at Pinnacle, can be tainted by any one analyst’s appetite for risk. We train ourselves to see bullish and bearish investment opportunities when they appear, and with training our goal is to see the world differently from the consensus. As someone who is not a big personal risk taker, I have to go out of my way to not let my personal predisposition to avoid risk color my ability to see bullish opportunities in the risk markets when they appear. And since one of the most tried and true methods of identifying risk taking opportunities is to be a contrarian and recognize that investment opportunity is often born of despair, I’m wondering if this isn’t the most bullish investment opportunity of all time. It looks pretty dark out there to me.

For example: We don’t manufacture things in the U.S. anymore. The profits remain here for large corporations but the jobs go overseas. Does anyone believe that we are better off? We have deficits everywhere, from fiscal deficits to trade deficits and now the Federal Reserve is running a “print up some dollars and buy all kinds of stuff” deficit of their own. It seems obvious to me that we can’t afford the social contracts that we’ve made in terms of pensions, social security, and health care, but no one has the courage or political will to do anything about it. I suppose we can blame our politicians but we really have the political system that we deserve. Most Americans don’t vote, and many of those that do are frighteningly uninformed about difficult and nuanced issues that defy “sound bite” explanations suitable for the evening news. Nowadays we pay attention to some kid writing a blog at 3PM at his parent’s house where he lives because he can’t get a job. We have 10% unemployment where the percentage of Americans who want to work but who can’t find jobs is frightening. Corporate earnings are up on the back of cost cutting (meaning layoffs) and government stimulus plans that we can’t afford. It appears that we are throwing the dice that all of these programs designed to thwart the next Great Depression by manufacturing either asset inflation or price inflation will work out well. Everyone knows we are on a high risk path for curing our national malaise but we all seem to be shouting at each other at such a volume that if there is a reasonable solution to be had, we just can’t seem to hear it.

We have a national foreclosure problem that is a disgrace and could lead to hundreds of billions of bank write-offs as well as another 10-20% decline in real estate prices. At the moment there ain’t no one interested in insuring titles to homes anymore because with the originate and distribute model for mortgages no one knows who actually owns the note on your home. The dollar is falling on the back of our unofficial national economic policy of debasing the currency, and “beggar thy neighbor” fiscal and monetary policies are breaking out around the globe. They say that every generation in U.S. history had a better standard of living than the one that preceded it, and every parent along the way worried that their kids wouldn’t do as well as they did. Well, I’m wondering about my kids and their kids. I’m afraid we are messing this up so bad that they won’t be able to continue the streak. So….the obvious conclusion is to back up the truck and buy stocks. If you are a contrarian, it’s hard to see how it can get much better (or worse) than this.

Banks

We were tossing around a question yesterday regarding the current stock market rally from the July lows, and whether it can continue without the banks participating. The banks in this discussion are the big boys – JP Morgan, Citigroup, Bank of America, Wells Fargo, etc. The S&P 500 is up 15.5% from the July low (before today’s action which was a 4 point loss) while the banks, as measured by KBE (SPDR Bank ETF), were only up 4% from the July low (although down 2.5% today). Additionally, as you will notice in the chart below, the banks are still down over 19% from the April highs. The S&P 500 is the red line, which is approaching the April high after breaking through the June and August highs, and the KBE is the blue line, which has failed to make a new high!

Even so, at this time, the answer to our question is “yes.” The markets can and have rallied without the banks and it seems like they will continue to do so on the back of Federal Reserve stimulus. Consumer Staple stocks and Utility stocks have already surpassed the April high mark with Technology and Industrials hot on their trail. Material stocks are up 26% and Energy stocks are up 21% from the July lows. It is not only a rally but an incredibly strong one for many sectors and industries.

It seems this is just a bank specific issue at the moment as other financial industries like Capital Markets are fairing much better. Today, the cost of insurance for bank stocks is on the rise as indicated by rising Credit Default Swap levels. The fallout from faux-closure and a weak JP Morgan earnings report are causing investors to re-price risk in these stocks. All the while, investors in other stocks could care less.

But I can’t help but feel like it is 2007 all over again. The financials began selling off before any other sector in the market and we all know how that episode ended. Could MBS be the market’s downfall again?