I decided to post snippets of my cycle theory. If any of you have read my prior posts or rants on other blogs, components of this will resonate. Much of my cycles work is a result of my frustration at the incoherent and incomplete ramblings of those who were supposed to know yet clearly didn't. You get free snippets. You want the whole treatise? Cough up five or six figures and I'll give it to you. Or, hire me as your chief investment officer and you'll get more detail. This will probably be my only post for a week or so since my forearms and fingers hurt from typing so much. You must remember this is a hypothesis which I believe has substantial supporting evidence. Much of what you will read is based on sound economic theory and generally accepted monetary policy theory. Does that mean it is a totally accurate hypothesis? Well.....I don't even believe we can necessarily prove 1+1=2 has any merit as a universal truth anywhere except in our mind let alone our unwaivering faith in advanced science so..........
Every single asset in the world is synchronized over this cycle. Real estate, equities, global equities vs domestic, bonds, commodities and cash rates all moved in the same direction. Why? Because the global economies have effectively outsourced monetary policy to the U.S. with dollar denominated global trade in commodities and, in China's case, a pegged currency exchange rate. What does this tell you? Well, there are many potential interpretations but don't expect this to last. At some point the markets will decouple. In any event, so far it's a good thing. For now, it's a brave new world and there is no need for asset allocation as a hedge. This cycle you just buy all of it and enjoy the ride.
Along those same lines, we really started to see an expansion of the market into this cycle's leaders over the last two weeks. Prior to that, the 2002-2006 leaders had been dogs during this recent climb. Oil, transports, energy, metals, etc. The exception was broker/dealers which as an index had tested its old high before dumping pretty hard this last week on an earnings disappointment. Individually Goldman is up 23% in a month and pierced its old high. This was done on some pretty heavy volume which was no doubt helped by short covering. Shorts have had a fascination with broker/dealers for over a year. I actually remember a hedge fund manager on a financial channel who had shorted Lehman, as I recall, and was crushed on a fantastic earnings announcement a while back. That same hedge fund manager has been bearish for a few years now. I believe he will likely have the last say but his premise is wrong. In fact, the premise of most bears is totally wrong but they will likely be proven right for the wrong reasons. There is no doubt the bears got ahead of themselves over the last few months. I would be extremely surprised to see Goldman move much higher here as it is now sitting right on a long term resistance line. Here's a question. Is Goldman's trading desk allowed to buy its own stock and ram the shorts? I would assume that is somehow forbidden but I'm not an SEC attorney and these issues haven't historically been worth pondering. That is, before your banks were allowed to trade against you in the markets.
So, what we have over the last few weeks is an expansion to this cycle's leaders as well as the expectation of next cycle's leaders rising. There's no oil/semi play anymore. It's long oil and long semis. It's long everything. Buy it all! Even homebuilders. Valero, one of my most beloved stocks this cycle yet one of my most hated stocks for the last six months hit a short term buy a week ago if I was so inclined to trade its volatility-which I am not. It's an extremely attractive stock as long as the market is going higher in my estimation. Even if oil sinks further. So, why an expansion of breadth to include those stocks? Well, it could be many things. It could be a general feeling of confidence amongst investors to nibble on cheaper leaders as the market goes higher. It could be that the Fed is pushing a little more money out the door and dollar denominated commodities are rising in sympathy but I doubt it because the dollar is strengthening. Or, it could be that the global economy really isn't feeling much of an effect of higher rates and our old friend inflation is rearing its ugly head. Or, it could be all of the above.
My vote? We have sold off in anticipation of awful economic data. That is part of a normal topping process. And, yet, so far there is little awful data. You must remember that the market leaders peaked six months before the market started selling off in 2000. That would put us at a very risky time into November and December. As I have said repeatedly, topping is a process. not a date and time. Am I surprised the mega caps made new highs? Yes and no. But, since they are the most defensive and undervalued stocks, ultimately no. Back to 2000. What caused the market to finally sell off in 2000? The bulls had to actually see they were wrong. The data had to confirm. Today is no different. There is "not so good" data and "reasonably moderate" data. There isn't really any data truly confirming the economy is headed for a hard landing in the economic reports. Yet. Don't get too excited about earnings. You must also remember earnings grew at a faster pace in the 1970s than in the 1990s. But your reward in the 1970s was a zero percent return (not including dividends) for equity markets from peak to peak.
So, let's take a look at what is next. There are three scenarios we have to contend with on a go forward basis.
@The economy re-accelerates
@The economy muddles through
@The economy craters
First, if the economy re-accelerates. What can we expect? Commodities will likely mount another assault higher. The dollar will likely weaken or remain limited in its upside. The current account deficit will continue to rise beyond its already unprecedented 5% of GDP and eventually the Fed will have to raise rates putting more pressure on stock valuations and the economy. Stocks, already massively overvalued by any measure, receive more pressure from global central bankers as they raise rates. The S&P with a dividend yield mighty damn close to zero competes with guaranteed investment returns of greater than 5% and rising. The Transports and Russell 2000 with PEs as extended as the S&P in 2000's bubble and no dividends to speak of, become even more of a high risk holding. Do you want to pay for 35 years worth of earnings with no predictable cash flow and dividends?
Second, the economy muddles through. Or, if you are a perma-bull, we walk hand-in-hand with goldilocks. Earnings go up forever to unprecedented levels as a percentage of GDP, long rates remain in check, commodities abate significantly and we likely remain somewhat range bound with more of the yo-yo action we've experienced in 2004-2006. In this scenario the bias would be mildly to the upside in equities because of strong fundamentals yet the valuations would likely limit the upside potential.
Third, the economy slows significantly. There are two possible scenarios here. a) The Fed cuts rates immediately or b) The Fed keeps rates as is. Now, you may ask why the Fed wouldn't immediately cut rates. Well, it's pretty simple. Sans the conspiracy pundits who would have you believe the Fed is out to ruin the American way of life and the dollar, the monetary policy of the Fed is much different than it was in the 1970s. There was a general awakening amongst central bankers as to their mistakes and how they contributed to the malaise and eventual runaway inflation during that period of time. The Fed today has not repeated the mistakes of the 1970s. Yet. I've commented on here that I am actually very glad Ben Bernanke is leading the Federal Reserve through this time in our economy and I truly believe that. But, that doesn't mean I believe the Fed is our savior. Forget about the lunatic fringe and their position. They are always wrong for the wrong reasons. Even when they are right, they are right for the wrong reasons.
So, when the pundits tell you the Fed is going to save the day by cutting rates, I believe that exposes a general lack of understanding of cycles, economics and intermarket analysis on their part. The Fed is not a miracle worker. If they were, each time the Fed cut rates, we would make a new high in the equity markets and we'd all be retired. Instead we spent 50% of the time over the last century retracing old highs. The reality is there are cycles when the Fed really has little power other than to make the economic situation worse. I believe we are now at that precipice and I believe the Fed understands this by their recent hawkish statements. And, what am I referring to? One can easily see that capex spending has been in a depression since 2000 as I had written in a post some time back. But, why is this? Because I believe we are in an innovation depression. Business is the driver of innovation not the consumer sector. Business innovation trickles into the consumer sector as we have seen with Apple, video games, etc, in this cycle. Evans & Sutherland was building sophisticated video games for the military twenty year ago when I interviewed with them for a research position. They were just as sophisticated as today's games but they cost hundreds of millions of dollars. And for those of you who believe YouTube and MP3 players are major transformational innovations, might I recommend you never invest in technology for the long term. Streaming video and MP3 technology in usable form is as old as dirt and you are driving your car looking out the rearview mirror.
Before you panic, innovation is a cyclical process just like every rhythm in this universe be it your heart, the stock market, the seasons, time and everything else imaginable. We've been here before and the world didn't end. So, what happens when we hit this type of cycle? There is a lack of demand for money by business. And, where does money go when we are in an innovation winter? Why, low and behold it flows into the consumer sector as economic theory 101 would tell you happens when business enters a recession. And what happens when the Fed adds liquidity into this type of cycle with a lack of monetary demand by business? It sloshes in the system without any productive business-to-business demand. So, with a lack of demand and too much supply what happens? The dollar drops in value because there is too much money just as anything drops in value when there is too much of it. And, what does that mean? You need more dollars to buy dollar denominated commodities. So, what happens to commodities? They go up in price. Not because China needs more commodities but because it costs more dollars to buy dollar denominated assets. And, since the business innovation leaders aren't innovating, where does Wall Street investment money go? Into consumer stocks as economic theory 101 would tell you and into commodities and hard assets which now require more dollars to purchase the same unit of material. Simply put, the rise in commodities is exacerbated by monetary phenomenon and the resulting excess cash Wall Street puts to work more than anything else. Didn't you ever wonder why it was post 2000 when the dollar started cratering that commodities skyrocketed and not when China was actually growing at a faster pace years before? And, since we are in an innovation depression, where does excess business cash end up? Mergers and acquisitions, share buy backs, investment in emerging markets and into economies where a disproportionate share of wealth is derived by rising hard asset prices. And, what do we hear from the pundits during these cycles?
@America is losing its competitiveness.
@Generalized bashing of American technology companies and business innovators as past their peak dinosaurs.
@America is kaput.
@China is taking over the world.
@We are running out of oil.
@We need China to change its trade policy.
@We need to slap tariffs on Chinese goods.
@We are slaves to China as they now hold our debt.
Sound familiar? How about the "American consumer-centric" Japanese economy in the 1970s? How many people understand this? Well, since it's my thesis, I know of no one. Although I surely understand that hardly an original thought and others before me or around me have likely hypothesized a similar thesis but I've never met anyone or read any such thesis. But I suppose nary a soul on Wall Street and very few economists have developed such hypotheses. Why? What does Wall Street or economists understand about business and innovation? Nothing. They are in the staid business of pushing money around or dialing their economic knobs.
What created the bubble in 2000? It wasn't the Fed per se. It was the culmination of a massive innovation cycle leading to tremendous productivity gains, new business processes, new transformational technologies and new inventions in business. What fueled the blow off rally? A fractional reserve banking system where massive wealth creation fueled a self-fulfilling massive credit creation just now peaking. It wasn't the Fed flooding the money supply per se as the conspiracy theorists would have you believe.
Without a strong innovation cycle and without upward pricing pressure in the business-to-business economy, the only way to create permanent inflation is via destructive central banking policy as happened in the 1970s. Normal inflation starts in the business sector not the consumer sectors. ie, The only way to create permanent "abnormal" inflation in the current cycle is to debase the currency via unsound monetary policy. So far, we have not seen that. Yes it is true the Fed did aggressively stimulate the economy post 2000. But by then, the innovation cycle was over and they aren't rampantly printing new money either.
So, let's look at the two scenarios of the "savior theory" of the Fed cutting rates in this cycle. a) They cut soon. Well, the Fed can create more money but, they cannot direct where it will go. So, with commodities already extended upward in price and with weak demand for money in the business world, what would happen? If the Fed pushes on the accelerator too much, they could start to debase the currency. What would happen? We would see commodities kick higher as they did post 2000. Maybe significantly higher. Maybe $100+ oil depending on how hard they step. Believe me. The Fed understands this simple concept. Or b) The Fed does not cut rates immediately but waits for commodities to return to relatively normal levels as they sop up liquidity and, hence, the driver of inflated commodity prices. The economy sinks without excessive stimulus as the business cycle continues its innovation depression and the consumer sector, which enjoyed the benefits of liquidity over the last few years, joins in for a wholesale slow down and cleansing of the system. Should the Fed proceed with raising rates before such an outcome, we will see a resurgent rise in commodities and a continued yo-yo of likely shorter and shorter economic expansions followed by contractions until we culminate in a future cycle at some point where upward pressure caused by the next innovation cycle and resurgent demand for business investment and extended commodity pricing work harmoniously to truly instigate real and sustainable inflationary risks. This is likely what happened as Paul Volcker needed to apply brute force to the system as the business economy finally recovered and started its march into the next long wave positive expansionary cycle.
So, in conclusion, the Fed is not your savior. The Fed does not drive the economy. Expectation of lower rates is fraught with risk. And, at this time in the cycle, the Fed is at a time of most significant decision in the last thirty years. What will the Fed do? Given the proclivities of politicians and ongoing elections, it will be very interesting. And, don't underestimate the Fed's knowledge learned from prior cycles. Does that mean they will do the right thing? Well, what is the right thing? We might find it hard to build a consensus. Is it jobs? Letting the excesses purge? Price stability? More muddling? At the expense of debasing the currency? We likely cannot have happy endings to all cycles. And, in the end, what does all of this likely mean for the global economy?
@The finance industry has likely peaked as I outlined in a prior post.
@Insurance companies are highly risky regardless of their dividend.
@Financial institutions are highly risky right now regardless of their dividend.
@Banks are highly risky right now regardless of their dividend.
@Consumer stocks, especially cyclicals like Apple & Google, are where large cap technology was in 2000 and are highly risky right now.
@Anything other than megacaps with high dividends and price-to-book ratios of less than two are highly risky.
@China is living on borrowed time without major democratic reform which is the only way they will transform into a consumer driven economy.
@Commodities are likely going to be extremely volatile but are ultimately living on borrowed time if we have a responsible monetary policy.
@Your emerging market portfolio is living on borrowed time unless they are transformational, reform oriented and democratically driven economies.
The next positive, expansionary innovation cycle will be driven by the business-to-business sector and China is an economy built entirely on feeding the American consumer. Its cycle is not tied to global business-to-business innovation but to the American consumer. And who will lead that next innovation cycle? Clearly and undeniably the U.S. and to a lesser extent, Europe, Canada, Australia and Japan. So, in that end state, what is China's role? A worthless currency as the Politburo attempts to stave off ultimate crisis followed by a deflationary depression leading to social instability resulting in the final collapse of communist China followed by a rise of democratic China? Whew, that's quite a run-on sentence. I don't know for certain and neither does anyone else. But, I do suppose I would be scratching any names off of my potential investment advisor list if they were recently telling you to invest in China or countries benefitting from China's expansion or telling you the Fed is going to save the day by cutting rates. In either case, they are likely wrong. Very wrong.
It's good to have a generally bullish bias as markets do. It's bad to be bullish for the wrong reasons. Ditto on the flip side. America is not losing its competitiveness. It's massive research investments are preparing the foundation for the next major innovation cycle where we will likely experience innovation beyond most people's imagination. So, here's the $64 question. When is the next expansionary innovation cycle? 2007? 2011? 2015? 2050?