Weekly Economic Update 06-23-2017

The Worst Crash in our Lifetime is Coming

Recently, legendary investor and author Jim Rogers said that the worst crash in our lifetime will be coming sometime later this year or next. There’s something Jim knows that most people don’t, which is what I’m going to share with you this week. And if history holds true, Rogers will be right. It’s also why I wrote the article, “What is Your Exit Strategy?” in last week’s update.

I mentioned last week that Warren Buffett is holding 70% of the money he manages in cash. Also, Jim Rogers isn’t even investing in the United States right now and, furthermore, other industry experts are starting to warn that stocks are in a bubble. What do these experts know that you don’t? Is it that we are overdue for a recession because this is the third longest business cycle in history? Is it because the growth during this cycle has been the worst in our history? Or is it because the debt burden is now bigger than it was in 2008? It is all those things and more.

What those titans of the investment industry know and understand is how Quantitative Easing works. They also know that it has never worked and is unlikely to work this time. Ever since man created currency he has looked for ways to manipulate it to create prosperity. In every instance in history, when a government expanded the monetary base or money supply of their nation, it has always led to a prolonged economic downturn. Every single time.

The reason Rogers and others are concerned is that this is the first time in the history of the world that the central bankers around the world have combined efforts to create the largest expansion of money in history. And they are all hoping that this time, expansion of money works. If it doesn’t, which it doesn’t appear to be, then the ensuing crash will be bigger and longer than the last two recessions. You might be wondering, what is Quantitative Easing and why are we doing it?

In the years following the Great Depression, some of the best and brightest economists debated on what our government could have done differently to avoid the economic collapse they had just experienced. The prevailing theory was developed by John Maynard Keynes which is referred to the Keynesian Economics. He believed that monetary policy, through the expansion of the money supply, could be used to prevent recessions. Even through there are flaws in his theory, Keynesian economics is the most widely taught economic theory in western schools. It is also the same economic theory that every member of the Federal Open Market Committee (FOMC) or Fed was taught. Those teachings are the basis for our current monetary policy.

The purpose of “Quantitative Easing,” which is a fancy phrase for expanding the money supply or printing more money, is to create inflation. When more money enters an economy, commonly through the banking system, it causes asset prices to rise, such as houses, cars, and stocks.

The reason central banks do this is to discourage people from saving money. Inflation devalues the money you have today. If you want to buy a new TV next year, due to inflation it will cost more. If you knew inflation was rising because the Fed was printing money, then the logical course of action would be to buy the TV today. And that is exactly the purpose of Quantitative Easing: To increase asset prices and inflation, to get people to spend money today that they would have otherwise spent in the future. But the Fed didn’t stop there.

Because they pumped the banks full of money, they needed the banks to lend it out. To encourage the banks, the Fed drove the Federal Funds rate to zero which caused lending rates to fall. This was referred to as ZIRP or Zero Interest Rate Policy. The purpose of ZIRP was to create inflation.

Low-interest rates motivate businesses and consumers to borrow money that they wouldn’t normally borrow if interest rates were normal. It also encourages savers who are earning nothing on their savings accounts to move their money into risk assets that are rapidly appreciating. Increased spending and investments lead to increased demand.

The increased demand means businesses will need to hire back their former employees, who will demand a higher wage due to the rising costs of inflation. Those higher wages will then validate the higher prices created by QE and ZIRP, thus completing the circle. As the economy moves out of the recession or slump, there is no further need for QE and ZIRP which is then slowly unwound.

Sounds good, right? It is a good theory, but only if it works. Unfortunately, it has never worked. You might be wondering why it is we are doing it now if it has never worked. The answer is quite simple, the Fed believes that this time they can get it right. They have reviewed the policy mistakes of prior generations and come up with a better plan. For their sake, I hope they are right, but history is not on their side.

For the past eight years, homes, cars, stocks and other assets have increased in value. Many remember the go-go years of the 1990’s and draw a parallel to today. When in fact is was QE and ZIRP that led to an increase in asset prices. If there’s any doubt, there are charts people have put together showing how the stock market moved up in line with each expansion of the monetary base – there were three QE’s. Today the Fed is slowly unwinding their balance sheet and stocks are still rising. For now.

Back to the original question. What do Buffet, Rogers, and these other experts know that we don’t? They know that expansion of the monetary base to create prosperity never works. They also know that when the economy does recess again, it will be bigger and longer than any recession since the Great Depression. And they also know that asset prices will fall. Buffet isn’t holding 100 billion in cash because he’s old and out of touch, as some people believe. He’s doing it because he knows there’s a high probability that asset prices will plunge and when they do, he’s going to buy.

I don’t know what’s going to trigger the next recession, but I can tell you that the reason I follow the economic data so closely each week is so I can tell you about how these policies aren’t working. The stock market won’t have a gradual decline. The first move down will be sharp. Most won’t see it coming.

Next week I’ll discuss the flaws in QE and ZIRP, along with what happens to the economy and asset prices when monetary policy fails. Once you understand the big picture of this global monetary experiment, I think you’ll fully understand my investment decisions.

Video Topic of the Week

This week I touch on the effects of QE & ZIRP and I also talk about the beta test on my new momentum strategy. I developed an algorithm that looks back over the past 6 months of return day on a list of ETFs I selected, takes the top 25% based on return and allocates them based on volatility.

On a test of the past five years using Morningstar for the back-end data and analytics, it generates returns like a growth portfolio (about 70-80% stock portfolio) with the risk profile of a conservative portfolio. For those that took my retirement planning class, it has a high alpha and very low beta. It works very well.

The next test will run back over a 10-year period to see how it performs in a down market. I expect it to do well in 2007-2008 because I built in options that can generate positive returns in a down market. I’ll keep you posted on the results.

For more information please tune into this week’s video.

Chart of the Week – Global Credit Impulse

To give you a good idea of how QE & ZIRP has affected asset prices, we’ll look at the median sales price for new homes versus the homeownership rate.

Client Update

Big update is the listed under the “Video Topic of the Week” on the development of my new momentum strategy.

I thought this week I’d cover the various broad sectors and discuss the risk vs reward outlook for each.

US Equities

Pick the metric you like and this market is overvalued and completely detached from its fundamentals. However, there is a great deal of excitement about how the stock market is finally going up forever, which is giving it upward momentum.

Reward: Possibly +3-7% depending on who you ask.

Risk: Bear markets usually experience somewhere between -20-80%.

Risk clearly outweighs the reward. When market turn they turn fast and this post-election rally could disappear very quickly. There is a potentially bigger opportunity to be short US equities when the market turns.

6/23/17: Money supply continues to fall. Mergers and acquisitions are drying up. Corporate stock buy backs are drying up. Not a positive outlook for equity prices going higher.

International Equities

Looking at Europe specifically, they trail our business cycle, meaning many believe there is significant upside potential. It also helps that the European Central Bank is continuing to dump money into the economy and is willing to keep interest rates low. There still seems to be a high correlation between US equities and European equities, meaning when the US falls, they do too. As much as I want to like this, it concerns me that we could drag them down.

Reward: +50% to get back to prior all-time highs.

Risk: Unknown due to correlation with US equities; possibly -40%.

Too many unknowns here.

6/23/17: Some experts are now saying that European equities will be the ticket for the next 12-18 months. Not too much evidence based on how the foreign ETFs are moving.

Emerging Markets

I do have a potential buy signal on emerging markets equities. There is a correlation emerging markets and oil. Unless there’s a clear break between the two, there’s a high amount of risk here if oil prices continue to fall. The upside is their inverse correlation to the US dollar could trigger a sustainable rally.

Reward: +25% or more depending on how close they track a declining dollar.

Risk: Potential correlation to falling oil prices means there could be a significant drop in price.

6/23/17: I want to like emerging market stocks due to their inverse correlation to the US dollar, but so far they are stuck going nowhere.

Gold/Silver Miners

I like the miners over the metals, but the rally I had hoped for hasn’t started. In 2008 gold and gold miners dropped with the market, but I’m not sure that will happen this time. Central bank policies have weakened the global banking system and with massive money printing, I believe investors will seek out precious metals as a means to protect their wealth when the next financial crisis hits.

Reward: +200% (for the miners)

Risk: -10%

6/23/17: I’m just waiting for prices to bottom.

Agricultural Commodities

These performed will during the last recession, nearly doubling in a 12-month period as stocks plummeted. Prices are currently trading below momentum and technical breakout levels, but are holding a price level established back in early 2016. Recently legendary investor Jim Rogers said he’s invested in agricultural commodities and he’s well known for making investments in asset classes that generate large returns.

Reward: +100% if a new bull market breaks out and prices return to their prior all-time high, which is normal in bull market rallies.

Risk: -5% which is back to all-time lows.

This is one asset class where the risk-reward scenario makes sense and is why we have bought in.

6/23/17: Prices have slipped, but are still within the target range. In the chart pack, you will see the long-term inverse correlation between the US dollar and agricultural commodities. The reason I choose this sector is that I don’t feel comfortable trying to identify which currency will trade inversely the dollar. Some say the Euro, others the Yen, but it could be some other currency. Commodities hold a long-term inverse relationship. Plus, when stocks (paper) go down in value, investors tend to run into hard assets (commodities), which we can see back in 2007-2008. Since agricultural commodities can’t go to zero and we have multiple data sources showing a larger move down in the US dollar, this is a long-term position to take advantage of a declining dollar and a recession.

US Treasuries

Every time there has been a recession yields make a new all-time low and bond prices make a new all-time high. While many have called for the end of the secular bull market in bonds, with a weak global economy and record levels of debt, it’s more likely that interest rates will fall during the next recession.

Reward: 5-6%+

Risk: The risk was that yields would break out but stopped twice at 2.6% and have fallen since. I believe the downside risk on Treasuries has been established.

Given the high probability there will be another recession and that it will be one of the worst in history, I like US Treasuries. I also expect the Fed to quickly react and cut interest rates which would be very bullish for Treasuries.