Weekly Economic Update 07-07-2017

Quantitative Tightening
We’re all familiar with Quantitative Easing, which are those three programs the Fed ran to expand the money supply in our country to pull us out of the 2008-09 recession. Imagine if the Fed announced that they were tightening, rather than easing. How might the markets react? Starting in December 2015, the Fed began shrinking the money supply when it increased the Federal Funds’ rate from 0% to 0.25%. (The Federal Funds’ rate is the bank overnight lending rate.) Since then, the Fed has increased rates three more times and, and on a year-over-year basis, the money supply has decreased 28% since October 2016. Yet nobody seems too concerned right now. However, a contraction in money supply does have huge implications on our economy.

Before we get too far, the M2 money supply is the total amount of money in cash, checking accounts, savings accounts, money market accounts, mutual funds and other time deposits. It broadly covers any type of savings account that can be readily converted to cash or to a checking account. The M2 is published every Thursday by the government and it is a useful tool to determine if the money supply is growing or shrinking. (One reason I cover the M2 money supply every week in my video update.)

The amount of money in an economy can tell us quite a bit. If the money supply is expanding, then the economy is likely growing. If the money supply is shrinking, then the economy will likely shrink. Let’s take a look at the following example.

Let’s say you and I form a new country and we establish a currency and name it the “Metremark”. We decide that our money supply will start with $100 Metremarks. After several meetings, we decide it would be prudent for our economy to grow at a rate of 5% over the next year. How many Metremarks will we need in the economy by the end of next year? Simple, $105 Metremarks. (5% of $100 is $5…add that to the original $100 and you get $105). Where the additional $5 Metremarks comes from doesn’t matter. We could print them ourselves or a bank could create them by lending them out. It doesn’t matter, as long as there are $105 Metremarks at the end of the year. If that happened, we could say our economy grew by 5% and our citizens (you and I) would have a combined net worth of $105 Metremarks. We increased our wealth. If we agree that our economy should grow, then each year an increasing amount of Metremarks would be introduced into the system to fund the desired rate of growth.

Let’s say at our end-of-the-year accounting meeting that we only have $95 Metremarks in our economy. Where those $5 Metremarks went doesn’t matter, other than they are no longer in our economy. What we can say is our fledgling economy contracted at a rate of 5% and the total net worth of our country is only $95 Metremarks. As a result, we got poorer. This means there are fewer Metremarks in the system to spend on goods and services. As you can see, an ever-expanding supply of money is needed to fuel economic growth, while a contracting money supply has the opposite effect.

On October 10, 2009, the money supply on a year-over-year basis was 957 billion dollars and has since dropped to 686 billion dollars as of June 2017 – a 28% drop on a year-over-year basis. To help make these numbers relevant, the Fed instituted Quantitative Easing 3, when the year-over-year change in money supply was around 600 billion. We’re not that far off. Perhaps this helps you understand why I believe the probabilities are high that there will be a Quantitative Easing 4 or something to that effect. The money supply is falling and that means the economy is contracting. When you have an over-indebted economy that is contracting, you get a recession.

What makes this interesting is that the stock market has risen since the November election, while the money supply has contracted. One of the two doesn’t add up. Either the stock market is going to run into a ceiling or the money supply must start growing. One of the two things has to happen. When I see the data showing that car sales have been falling over the past six months, or that retail sales are declining, or that inflation is falling, or that tax receipts are falling—it all comes back to the money supply! Analysts can’t figure out why growth is falling, but it’s just as simple as following the money. When there is less money circulating in our economy then our economy must contract.

The economic data indicates our economy is contracting. It should be contracting because the money supply is contracting. The timing is right. The money supply started contracting late last year and it finally hit the economy earlier this year. When I see the stock market making new highs and analysts trumpeting that it’s going to continue to make new highs for years to come, that doesn’t make any sense to me. The stock market goes higher as the next buyer of a stock pays a higher price than the previous buyer. Plain and simple. But if there’s less money in the system to buy stock, where’s the next buyer getting their money from?! And so you see why it’s more likely for the stock market to fall than it is to rise. Not only because the economic data is telling us that the economy is weakening, but because the money supply is contracting. With the economic data and the money supply contracting, the eventual fall should be rather large.

This takes us back to the Fed’s role in manipulating the money supply. While their goal is a gradual increase in the money supply at a rate of 2%, their policies are never successful at achieving that goal. By raising the Federal Funds’ rate, the Fed is contracting the money supply, which we can clearly see in the year-over-year change in the M2. There’s been a big contraction despite a historically low increase in the Federal Funds’ rate. Part of this contraction has to do with the massive contraction in bank lending, which is another series of data I cover every month in my video updates. Banks create money by lending, so when the rate of lending growth slows, or even worse, contracts, on a year-over-year basis, then the banks accelerate the contraction of the money supply.

You may have heard that the Fed is talking about unwinding their bond portfolio. Part of the QE 1-3 involved the Fed purchasing bonds, to the tune of 4.5 trillion dollars’ worth. Every month they take the dividends from that bond portfolio and buy more bonds. When the Fed buys bonds, it increases the money supply. Later this year, or early next year, the Fed is discussing their plan to start unwinding this by tapering a number of bonds they buy each month. The longer-term goal is to stop buying bonds and let the pool of bonds mature over time. When they start purchasing fewer bonds it will further decrease the money supply.

When most people hear this news they assume interest-rates will rise. It actually tends to have the opposite effect. Right now there aren’t many bonds in the system to buy because the Fed and other central bankers have been buying them up. As the Fed tightens the money supply, it constricts the economy. Since the economy is heavily indebted, towards the end of the third longest business cycle in history, and has the weakest growth of any cycle, constricting the money supply will likely push the economy into a recession.

As that happens the value of risk-assets usually plummets. Those who have stocks will be eager to sell and they usually take those proceeds and buy bonds. Since the supply of bonds is already thin, when the flood of money comes out of stocks and seeks a safety of bonds, it will drive bond prices up and interest-rates down. Plus, in between each pause of QE 1-3, bond prices when up as yields fell. This is why I hold US Treasuries in the portfolios; it’s a hedge against the next recession, the mass exodus that will come out of equities and the unwinding of QE 1-3. This is why, as I see the money supply contracting, I choose not to play chase in the equity market. At some point the stock market players figure out what the Fed is doing and when the masses rush for the exit, prices will quickly fall. I’ll save that story for another week.

To wrap things up, people should be concerned when the money supply is contracting, but the Fed will never come out and directly say that’s what they are doing. After all, if the public knew that a contracting money supply leads to a contracting economy which then leads to a contraction of asset prices – people would be looking to sell out of the stock market and their other QE-inflated assets while they are still high. As we know the public buys most at the top and the least at the bottom, and this time is no exception.

Video Topic of the Week
I discuss what happens if the economy goes into a recession with the Federal Funds rate at 1% along with a few other topics.

Chart of the Week – Berkshire Hathaway Cash Position
Warren Buffett has been building up cash in his Berkshire Hathaway portfolio to take advantage of the next downturn. How much he’s holding might be surprising!

Client Update
I’ve spent quite a bit of time running different models to learn more about what works and what doesn’t. In the original version I used short equity funds and quite a few bond funds to “brake” the portfolio during market downturns. As it turns out, they weren’t really needed. Three US Treasury bond funds (long, intermediate and short) do the job very well. The other thing I learned is that more asset classes aren’t better. I thought giving the algorithm a larger pool to work with would increase the returns. It didn’t work out that way. The last conclusion I have is that highly volatile asset classes don’t work as well as I thought. There are periods where they generate excess return, but there are more periods where they generate excess losses.

The goal of any portfolio should be to generate high risk-adjusted returns while minimizing downside risk. Even someone who is high risk doesn’t want to lose money in a downturn. With that in mind, I realize that most people track the S&P 500, so their portfolio needs to move up as the S&P 500 does but hit the brakes when the market dives. This led to an epiphany.

In the most recent trial, on Thursday, I ran an allocation using a mere eight asset classes: five equity positions and three Treasury funds.

The results were staggering. It generated a more consistent market-like return on the upside and easily contained downside moves.

Returns (annualized):
1 YR: 15.28%
3 YR: 8.17%
5 YR: 10.91%
10 YR: 9.63% (S&P 500 did 4.89%)
Alpha 10 YR: 7.67 (this is very high)
Beta 10 YR: 0.28 (this is less risky than a low risk allocation)
R2 10 YR: 19.50 (meaning returns have less than 20% correlation to the broad equity market, which is very good)
Sharpe Ratio 10 YR 0.96 (S&P 500 did 0.29, higher is better)

I’m going to run some tests of adding a couple other lower volatility equity funds to see how it works. At this point I’m extremely impressed with the simplicity, performance and risk levels.

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% to -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.
6/30/17: Momentum appears to be drying up and volatility is starting to show up… not good for equity bulls.
7/6/17: Weakness is starting to get obvious as equity markets struggle to have more up days than down days.

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.
6/30/17: Wednesday’s US market selloff is a leading indicator because the International Equities section of my trading software was flashing red that day with big drops in international equities across all continents. I understand the narrative for why European equities should go up, but I am not seeing it happen. Perhaps in a future update I’ll outline the story.
7/6/17: Foreign markets continue to fall. No opportunity here right now.

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.
6/30/17: Emerging markets failed to close over the monthly momentum target, meaning I do not have a buy signal.
7/6/17: No sign of strength.

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.
7/6/17: Silver is breaking down. Gold should follow, as should the miners. Still waiting for a 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.
6/30/17: Strong rebound in prices and volume have brought prices about 12 cents below our average buy point. The move down was clearly to flush out the weak. This sector remains a long-term buy.
7/6/17: Prices bounced back strongly and are currently trading above our buy in point.

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.

6/30/17: Yields moved back up but it is not a structural change. Inflation data continues to fall and yields are likely to head back down. They remain a strong hedge against the next recession.
7/6:17: Yields have pushed up, but there aren’t any signs of inflation, meaning yields should head back down. If they break above 2.4%, the market will retest the recent highs around 2.6%. No indication that is happen as of today.