There Is An Urgent Need To Inflate Our Deflating Economy

In This Issue:

An Update on Our Performance
A Modern Day Depression
The Value Crisis
The "New Deal" Experiment
Roosevelt's Redistribution
The Bernanke Ultimatum
Getting Real
Should We Be Worried?
Reducing the Risk of Outside Days
Portfolio Performance Analysis
My New Buddy Jack & Another Tennessee Christmas 

The miserable environment of trench warfare experienced during World War I is the best description I can come up with to describe how difficult it has become to trade these markets.  I have been actively trading the markets for many years and I can't remember a more challenging time.  Most everyone I know in the business says the same thing and that includes experienced traders who were around during the 70's. 

In this month's letter, I will try to prepare you for the economic events that are about to unfold as the Fed and Treasury go to war to flight deflation.  It is the strong belief of Ben Bernanke and the Fed that deflation is enemy number one and should be aggressively fought with every economic tool in their arsenal.   

In the words of the legendary Alabama football coach Bear Bryant, you need to be "mobile, agile and hostile!" with the management of your investment assets!

An Update on Our Performance

When the elephants are on the dance floor, the mice should leave the room!  The markets are no longer free as the Treasury and Fed try to pump life into a dying corpse.  Saving Citibank on November 24th and the proposed $800 billion plan to buy up the mortgage debt on the 25th got us on the wrong side of a painful trade-it is statistically impossible to model the effects of governmental intervention in the markets.  This is not the first time this year we have been caught on the wrong side of a government bailout, but because it happened in the last week of November, we just didn't have enough time to recover. 

Unfortunately, all of this interference by the government has negatively affected our performance for the month of November.  We were down across all our portfolios in a very difficult month.  However, on the positive side, December is shaping up to be one of our best months of the year. 

To protect our clients from these kinds of events in the future, we have implemented a quantitative process for limiting our exposure during volatile times.  You will find an explanation of the process in Reducing the Risk of Outside Days section.

Below are recent performance returns on the four portfolios we currently offer:


Past 12

YTD

Nov

MTD Dec

Name

Months

2008

2008

2008

Income Builder  (IB)

-1.70%

-4.34%

-2.37%

-2.15%

The Guardian  (GRD)

-4.15%

-3.36%

-6.61%

1.19%

Harmony Plus  (HMY)

-2.51%

1.12%

-10.21%

3.91%

The Expedition  (EXP)

-5.01%

3.23%

-13.02%

7.56%

S&P 500  (SP500)

-38.09%

-38.81%

-7.18%

-1.84%

Important Performance Disclosure



 

 



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A Modern Day Depression

In looking back over the last 12 months and trying to forecast for the coming year, I have come to the conclusion that we are currently living through a modern day depression.  Many analysts say that recent events are similar to the 1982 recession, but I would argue that it is much worse.  The circumstances are just as grave as what our economy faced in 1929 - 1930, but the situation is different due to safe guards and the $10 trillion (and still counting) that have been pumped into our deflating economy.   

I say modern day because economic disasters are never the same.  Every recession we have seems to be different from any we have had before.  The cause and effect always seems to be different, but the result is largely the same.  Based on the research gathered for the content  of this letter, I have formed a different perspective of where we are today as it compares to the Great Depression that our grandparents lived through.

"We would get a knock on the door from a complete stranger who would ask us if he could work for food.  If we didn't have work for him to do, my father would create a task so the poor gentleman would feel like he was earning the food my father would pay him to feed his family."
Annabelle Trewhitt - My Great Grandmother

To help put things into perspective, let me highlight some similarities between now and then.  First, it is important to understand that the circumstances we are in are just as grave as they were during that depression, but the safe guards and constant government intervention are cushioning the blow

  • One of the biggest differences is FDIC insurance.  It did not exist during the Great Depression.  In 1929, there had been a total of 25,000 banks operating in the United States.  By the time the government stepped in with the Emergency Banking Act in 1933, only 12,000 banks remained.  I would argue that if we didn't have FDIC insurance in place today there would be few banks left today.  If we would have lost 90% of our banks, what do you think the unemployment rate would be?
  • During the depression, the economic driver in our economy was manufacturing and not services like it is today.  The unemployment rate during the depression reached 25% at its peak.  If our economy was based mostly on manufacturing, how high do you think our unemployment rate would be?  The housing sector is one of the biggest and most important sectors in our economy today.  Job losses in the housing sector exceed 25%. 
  • During the depression, the government didn't believe in helping out troubled companies or financial institutions.  The opinion of the day was survival of the fittest.  Currently, the government has committed approximately $10 trillion to bail out our economy.  If this had not taken place, how far do you think the Dow Jones would have fallen this year? 


As I highlighted earlier, the circumstances are just as bad and it could be argued that they are worse.  When Roosevelt began bailing out our economy in 1933, we were not burdened with the overwhelming national debt that we have today. 

It saddens me to think how the lives of my children and grandchildren will be effected by the financial mess we have made.      

The Value Crisis

Will the dollar again be the government's scapegoat?

Once Rooselvelt took office, the Federal Reserve and U.S. government took some drastic steps to try and fix the economy. In the final analysis, it took more than a decade and a world war to finally get it back on track. We are in a similar predicament once more and there is a risk of history repeating itself.

In 1834, the U.S. Congress put the country on the gold standard fixing the price of an ounce of gold at $20.67. This followed a similar move by England in 1819 but other industrialized nations did not follow suit until the 1870s. Until World War 1, western nations enjoyed a period of "unprecedented prosperity with relatively free trade in goods, labor and capital.

But the situation began to unravel following the war. England was forced off the gold standard in 1931 following massive outflows of both gold and capital after the stock market melt and speculative bubble broke in 1929. Faced with a deteriorating economy and falling revenues, Herbert Hoover, U.S. President from 1928 - 1932, signed the Smoot-Hawley Act in a protectionist move that decimated global trade. When this only made things worse, he drastically increased taxes and raised interest rates to stop a speculative run on the dollar and shore up government revenues. The move saved the dollar but exacted a terrible economic toll in the process.

Uncertain about the health of the U.S. economy, investors in other countries holding deposits in U.S. banks began to withdraw gold. This was possible because U.S. government policy was that it would exchange dollars for gold at the fixed price of gold and vice versa. Between 1931 and 1933, these withdrawals climbed, which was a critical reason why the money stock fell. It was a situation that called for rapid action. 

The "New Deal" Experiment

 "There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose."  
- Lenin

On the day after Franklin D. Roosevelt was sworn in as President (March 4, 1933), his first official act ordered all banks to close and declared a banking holiday. Only after each bank received a government license would they be allowed to re-open. It was a move designed to stop the removal of money from panicked depositors. 

But that was only the first step to try and fix the broken economy.

During the 1932 presidential election campaign against Republican incumbent Herbert Hoover, Roosevelt gave the nation a hint to what direction he would take in an October speech if he were to become president.

"We have two problems:  First, to meet the immediate distress; second, to build up a basis of permanent employment.  As to immediate relief, the first principle is that this nation, this national government if you like, owes a positive duty that no citizen shall be permitted to starve.  In addition to providing emergency relief, the federal government should and must provide temporary work wherever that is possible."

It was all part of his pivotal election message.

"I pledge you, I pledge myself, to a new deal for the American people."

Among his first efforts to address the economic woes, FDR signed into law The Emergency Banking Act (March 9, 1933) to inspect the financial health of all banks and later the Glass-Steagall Banking Act to tighten control over the investment practices of banks. This was followed by the creation of the Federal Deposit Insurance Corporation (FDIC) to insure all deposits in banks up to $2,500, increased to $5,000 in 1934.

But the most controversial step, considered by many to be a dark moment in U.S. economic history, was the Gold Reserve Act of 1934 passed on January 30th, making it illegal for U.S. citizens to own gold and requiring them to exchange it for U.S. dollars. The very next day, Roosevelt fixed the value of gold to $35/oz. from $20.67 the day before, which instantly devalued the dollar by 69%. It meant that now it took 69% more dollars to buy the same items after the change. Without a doubt, this was the single most dubious act by government in U.S. history. 

With gold now around $850/oz. (where gold was trading on December 16th) means that it now takes $41.12 to buy something that cost $1 in 1933. This works out to a devaluation of 97.6%. But as we shall see, the situation will get a whole lot worse. The only question is when.

Roosevelt's Redistribution

"Inflation is probably the most important single factor in that vicious circle wherein one kind of government action makes more and more government control necessary. For this reason all those who wish to stop the drift toward increasing government control should concentrate their effort on monetary policy... I do not think it is an exaggeration to say history is largely a history of inflation, usually inflations engineered by governments for the gain of governments.""
 - Friedrich Hayek

Between 1930  and 1938 the government took drastic action in an attempt to address the deteriorating economy and mounting jobs losses. I counted 24 major measures (not including The Gold Reserve Act or the 1931 rate hikes and other actions by the Federal Reserve) which were the most powerful set of economic stimulus packages to occur in U.S. history.

It was an experiment that effectively launched John Maynard Keynes' General Theory of Employment, Interest, and Money (1936) that espoused his left-leaning, interventionist theory that government spending, tax cuts and monetary expansion could be used to counteract economic slowdowns. In other words, Keynes believed that during economic malaise, the government should act as buyer of last resort to provide the aggregate expenditures sufficient to achieve full employment. At the time, both FDR and Keynes ironically proclaimed to be "saviors of capitalism."

But even though the government intervened in an unprecedented and massive way in the economy, many today argue that not enough was done. So was FDR's New Deal approach successful? And could more have been done to avoid the problem at the time by the Fed?

As the next figure shows, by the time FDR came to power in March 1933, the damage had been done to the Dow Jones Industrial Average. After hitting rock bottom in early July, 1932, at which point the Dow had seen nearly 90% of its value destroyed, confidence began to slowly recover. But it was during this period of wide-spread pessimism that the fate of incumbent Herbert Hoover was sealed. Given that stock prices rallied around the time that campaigning for the 1932 election got effectively going, there is a link between improving national sentiment amid hopes that FDR provided a workable solution and stock market performance.

 


Figure 1 - Weekly chart of the Dow Jones Industrial Average from 1929 to 1944 showing how stocks moved during the Great Depression. As this chart shows, stocks got decimated between 1929 and 1932, staged an impressive bear market rally to 1937, then got cut in half again to 1942. The Dow would not rise above its 1929 highs until late 1954. Fourteen years after Black Monday in October 1929, stocks were still worth less than half of their peak highs. Chart by Metastock.com.

Stocks hit rock bottom on July 9, 1932 then rallied 50% to September before giving much of it back, rallied briefly with FDR's victory but then fell until March 3, 1933.  Once FDR took office however, voters liked his tough stance and quick action. In 1929, there had been a total of 25,000 banks in the U.S. After FDR's mandated bank holiday imposed by the Emergency Banking Act in March, only 12,000 remained according to Ivan Pongracic in The Great Depression According to Milton Friedman.  Of the fifteen most industrialized countries of the day, the U.S. suffered the greatest in terms of industrial production decline, which fell 46.8% between 1929 and 1933, at which point one in four men were unable to find work.

Stocks subsequently doubled in price over the next four months even though the unemployment rate hit a high that year (see Table 2). As we see from the table, unemployment was slow to respond dropping to 14% in 1937, which was still many times higher than it had been in the late 1920s.

Growing tensions in Europe were in part responsible for the 1933-37 recovery. According to Encyclopedia Britannica, U.S. money supply increased nearly 42% during this period stemming largely from "a substantial gold inflow to the United States caused in part by rising political tensions in Europe that eventually led to World War II."


Table 1 - Table showing the unemployment rate, GDP and federal spending through the Great Depression.

From a stock market perspective, it could be argued that Keynes' new theory and FDR's New Deal had been successful - after all, by 1937 the Dow had rallied more than 400% from the 1933 bottom. But then something strange happened. Stocks hit a wall and started to decline. Unemployment climbed back to nearly 20% in 1938 as the economy again entered recession and by mid-year, the Dow had fallen back to 100 and were still down 70% from their 1929 highs. What had gone wrong?  It was clear that there was more to Keynes theory than had originally believed.

Massive government intervention had put men back to work, raised minimum wages, reduced the number of foreclosures and saved banks. But these benefits came at a tremendous cost.

Taxes remained high, and higher mandated wages and a minimum work week imposed by the National Recovery Act and Fair Labor Standards Act made it more difficult for private businesses to survive in uncertain economic times. This resulted in the double whammy of slower private sector growth and reduced tax revenues for government. Public works projects competed with private enterprise for workers who were instead engaged in "economically wasteful activities such as carving the faces of dead presidents into the sides of mountains," according to Pongracic.

In the final analysis, "the economy improved after Franklin D. Roosevelt's inauguration in March 1933, but unemployment remained in the double digits for the rest of the decade, full recovery arriving only with the advent of World War II," according to Ben Bernanke in a March 2004 speech.  In other words, despite the hundreds of billions of dollars (trillions in today's dollars), it took more than a decade and a world war to finally get the economy back on track. It would take another nine years after the war ended before the Dow again reached its 1929 highs.

Unfortunately, there is no way of knowing how long the recovery would have taken in the absence of government intervention, but there is little doubt it would have taken any longer. The big difference is that this option would have occurred without putting the government (and the taxpayer) so seriously into debt.

The Bernanke Ultimatum

"The monstrous credit and debt bubble in the United States, through years of over-accommodation by the Federal Reserve, has created an economy with an array of horrible and massive dislocations and imbalances that make a sustained recovery impossible." 
- Kurt Richebacher

Why is this argument important today? It is clear based on actions taken since the current market and economic meltdown began that the Keynesian approach is very much alive and well in Washington.

It is interesting to note that Fed Chairman Ben Bernanke is an expert on the economic history of the 1930s and has even written a book about it called Essays on the Great Depression, a depression that he blames in large part to a failure of the Federal Reserve to act given their monetary powers and the gold standard that existed at the time. In his March 4, 2004 Fed speech entitled Money, Gold and the Great Depression, Bernanke explained how the gold standard restricted the Fed's ability to control money supply and forced them to raise interest rates just as the economy was failing to defend the dollar. As proof of his contention, he cites the fact that those countries that left the gold standard earliest suffered the least economic pain.

In concluding his Fed speech, Bernanke cited two important "lessons" of the Great Depression which reveal much about his approach to a similar situation taking place on his watch.

 

  1. "The gold standard orthodoxy, the adherence of some Federal Reserve policymakers to the "liquidationist" thesis (that weak banks should be allowed to fail as a harsh but necessary prerequisite to the recovery of the banking system), and the incorrect view that low nominal interest rates necessarily signaled monetary ease, all led policymakers astray, with disastrous consequences."
  2. "Price and financial stability should be a key objective of monetary policy. By allowing persistent declines in the money supply and in the price level, the Federal Reserve of the late 1920s and 1930s greatly destabilized the U.S. economy and, through the workings of the gold standard, the economies of many other nations as well."


To any serious student of the Bernanke doctrine, his outspoken support of supply-side economist Milton Friedman, a staunch opponent to the Keynes interventionist approach, would seem to put the Fed chairman firmly on the side of the free market. But his words, policy statements and recent actions place him at the polar opposite. As we have witnessed since markets began to falter in late 2007, when the chips are down, Ben Bernanke's true Keynesian colors come shining through. His solutions, "technology called the printing press" and his not-so-subtle references to Milton Friedman's famous helicopter money drop, have earned him the moniker, Helicopter Ben.

So what more can we expect from Dr. Bernanke in making good on his promise in the ongoing economic chaos?

Getting Real

"The Fed has already increased its liabilities (bank reserves) from roughly $800 billion a few months ago to approximately $2.5 trillion today. If we were on a gold standard, this would be the equivalent of the Fed tripling its gold reserve holdings."
- Paul Brodsky & Lee Quaintance

Before we consider what might be, let's first look at what is.

Debt-Asset Collision Course


Figure 2 - Comparison of total credit market debt versus household income, both expressed as a percentage of GDP. As this chart shows, household net wealth remained more or less stable from 1952 into the mid-1990s, after which it jumped during the formation of the internet stock market bubble, fell then skyrocketed again during the housing bubble. Total credit market debt on the other hand has steadily grown as a percentage of GDP, doubling from 162% ($4.8 trillion) in 1981 to 350% ($49.6 trillion) by 2008. Source - Federal Reserve

Debt at all levels has grown dramatically since the 1980s. As we see from the next chart comparing total household net wealth and total credit market debt (debt at all levels of the economy) to GDP. Household net wealth remained more or less stable relative to GDP between 1950 and 1996, but then started to build as the internet and tech stock market bubble gathered momentum. This bubble peaked and began to deflate in 2000. It then dropped to 2002, but thanks to the gift of 50-year low interest rates to address the deflating bubble from Mr. Greenspan, a new bubble began to form. The housing and asset bubble peaked in 2006 and is now in the process of deflating.

Contrast this with total debt. It began to grow dramatically relative to GDP in the mid-1980s and has continued to expand at an alarming rate. But the real growth began in 2000. Between that year and 2008, debt grew 25% faster than the economy, as measured by GDP.  As Figure 2 shows, the debt to asset relationship is on a collision course and it is only a matter of a few years before debt overtakes net household wealth. A slowing economy will accelerate this convergence.

Should We Be Worried?

According to Ned Davis Research, "the problem with large deficits is that over time, they weaken the Fed's ability to guide the U.S. economy. This occurs when the private sector must raise interest rates in order to compete with the financing needed by the public sector (the ‘crowding out' effect). Higher interest rates eventually slow economic growth, at which point the Fed must act with greater authority in order to direct larger amounts of borrowed capital. This leverage most likely increases economic risk by making the economy more volatile and more vulnerable to outside shocks.

High debt levels also have another side effect: disinflation. Because consumers and businesses have limited spending, they must retrench once they reach their saturation points. When the demand for goods and services diminishes due to the over-extension of credit, the result is disinflation."

Ben Bernanke's solution to this problem is clear. He outlined it in a 2002 speech to the Federal Reserve entitled Deflation: Making Sure "It" Doesn't Happen Here.

"Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services."

What impact has this approach of making and keeping the cost of money low had?  In nominal terms, the Dow Jones Industrial Average is down 25% from its 2000 highs. Given the tough economic environment, it could be a lot worse, couldn't it?

But in real terms, the Dow priced in gold, we've been in a brutal bear market since 1999. As the figure below shows, the Dow was down more than 75% at its November 2008 lows.

And the dollar? OK, so it's down from 2000 but it's been rallying in the last few months.  But, priced in gold, the picture looks a lot more depressing.  As we see from the next figure, the greenback was down a stunning 85% priced in gold before it began to recover in July.


Figure 3 - Monthly chart of the Dow Jones Industrial Average denominated in gold. As the chart shows, the Dow has been in a bear market in real terms since mid-1999 and was down more than 73% in real terms as of December 5, 2008. Chart by GenesisFT.com.


Figure 4 - In terms of gold, the U.S. dollar has taken it on the chin since 2000 and is still down more than 80%, even after the recent rally. Chart by GenesisFT.com.

No matter which way you look at it, the dollar has already been decimated. How much worse could it get?

Dr. James Conrad, an investor and trader of bonds, stock, options and precious metals for 37 years, proffered some interesting insights in a December 4 article entitled, "The Manipulation of Gold."

Anyone who reads the written works of our Fed Chairman knows that Bernanke's long term plan involves devaluing the dollar against gold. He often extols the virtues of former President Franklin Roosevelt's gold revaluation/dollar devaluation, back in 1934, and credits it with saving the nation from the Great Depression. According to Bernanke, devaluation of the dollar against gold was so effective in stimulating economic activity that the stock market rose sharply in 1934, immediately thereafter."

"It is only a matter of time before gold is allowed to rise to its natural level. Assuming that about half of the current increase in Fed credit is eventually neutralized, the monetized value of gold should be allowed to rise to between $7,500 and $9,000 per ounce as the world goes back to some type of gold standard. In the nearer term, gold will rise to about $2,000 per ounce, as the Fed abandons a hopeless campaign to support COMEX (New York Mercantile and Commodity Exchange) short sellers, in favor of saving the other, more productive functions of the various banks and insurers."

Why? Dr. Conrad provides an interesting explanation.

"Revaluation of gold, and a return to the gold standard, is the only way that hyperinflation can be avoided while large numbers of paper currency units are released into the economy. This is because most of the rise in prices can be filtered into gold. As the asset value of gold rises, it will soak up excess dollars, euros, pounds, etc., while the appearance of an increased number of currency units will stimulate investor psychology, and lending and economic output will increase, all over the world. Ben Bernanke and the other members of the FOMC Committee must know this, because it is basic economics."

What if the U.S. were still on the gold standard? What would an ounce of gold really be worth?

Paul Brodsky and Lee Quaintance, who operate QB Partners, a private New York-based investment fund, have done the math. They explained it in a December 10 article entitled, "The Shadow Gold Price."

"To identify the intrinsic value of the dollar today, we examine the corollary - the intrinsic value of gold in dollar terms, which we dub ‘The Shadow Gold Price' (SGP). To do so we assume that Federal Reserve Bank liabilities are again exchangeable into gold (recall, FRB reserves are bank assets - the stuff that used to have to be gold). [It is arrived at by dividing the dollar amount of current Fed liabilities by official gold holdings.] This calculation, while simple, is intellectually honest and produces a breathtakingly large ‘equilibrium' gold price of approximately $9500 per ounce today ($2.5 trillion divided by U.S. official gold holdings of 8100+ metric tons)." See the next chart.


Figure 5 - Graphic showing the spot price of gold compared to the Shadow Gold Price calculated to reflect the price of gold if the U.S. was still on the gold standard that existed before January 31, 1934 by Paul Brodsky and Lee Quaintance. The SGP has tripled in the last few months as Federal Reserve liabilities have skyrocketed from $800 billion a few months ago to more than $2.5 trillion recently, which is equivalent to the Fed tripling its gold reserves.

Going back to the chart of the Dow priced in gold (see Figure 3), if priced in the Shadow Gold Price instead of the spot gold price, the Dow is now worth less that it was during the last serious recession lows in 1982. 

Fiat Fiasco  

"Let's turn inflation over to the post office. That'll slow it down."  - Morris Udall

As we see from the next chart, the monetary base or money in circulation has increased an incredible 75% in the last year as the Fed kicks the printing presses and helicopters into high gear. How does it compare to the past?

The recent rate of increase in money supply is three-times higher than ever before with the second place high occurring in June, 1940, as the U.S. prepared for war (see Figure 6). Although the U.S. did not enter the war until December 7, 1941, the country was actively engaged in providing war materials and weapons to allies England and Russia through the lend-lease program. That required thrusting the printing presses into high gear to finance it.

It is also interesting to see what occurred in the aftermath of the 70% devaluation in the dollar following Roosevelt's Gold Reserve Act (1934). As we see, it marked the beginning of a new inflationary phase in American monetary history as governments learned how to use printing presses to kick-start the economy and finance deficits.

The next period in which printing presses were actively engaged occurred in the 1970s with the advent of stagflation. But it finally took actions by Fed Chair Paul Volker that included cranking the Fed funds overnight rate above 19% on two occasions in 1980 to finally tame the inflation beast and end stagflation. Like any deflationary period, the correction came at great economic and social cost but it did set the foundation for the twenty-year bull market that followed.


Figure 6 - Chart showing monetary source base since 1920 with the previous high year-over-year increase in money supply hitting 25.2% in 1940 as the U.S. ramped up the lend-lease program supplying war materials to her allies for World War II. As of the most recent data available to November 1, 2008, the Fed had nearly doubled monetary base in the last year (up 75%) from November 1, 2007. Data - St. Louis Fed.

Tough Love

"The gold standard would keep you from printing money and destroying the middle class. Every country where you have runaway inflation, there's no middle class." - Paul, Ron

Anyone who is a parent knows that it is sometimes necessary to discipline those in your care. Nothing is more difficult than seeing your child suffer, and any punishment doled out must be balanced with a good measure of love.

But just as damaging being overly harsh in disciplinary action, is it to give the child anything he or she wants whenever they want it. What would happen if you gave your child whatever they wanted and let him or her do whatever they wanted knowing that they would face no consequences for their actions? As any parent knows, this would result in a selfish, spoiled, inconsiderate and unhappy child with a high probability of being unable to build meaningful relationships and cope in the real world.

Recessions and sometimes depressions are necessary consequences when asset prices get out of whack with real metrics and soar beyond affordability or what is economically practical. Yes, they are painful and politically unpopular, but without these necessary periods of price and wage corrections, we would eventually fall prey to Zimbabwe-style hyperinflation where no matter how much money you had, it would not enough to purchase the necessities of life.

We now live in an era where governments and central banks either do not have the fortitude or wherewithal to do what is necessary. Printing tons of cash in an effort to keep bubbles from popping is like letting your child eat all the candy he or she wants and do whatever they want. It is a short-term, feel-good solution with serious long-term implications.


The challenge is that profligate and unprecedented printing of dollars will have a cost which will ultimately be far greater than the pain we would have to endure in the next few months or years to get our economy bank on track again based on sound monetary policy.

In lieu of this necessary corrective action, we face two outcomes. We will be doomed to a multi-decade long malaise like that which occurred in Japan (that did not use printing presses to correct the problem, but instead failed to address systematic failure and let weak banks and corporations go bankrupt). But more likely, given the amount of cash being pumped into the economy, we will see a return to double digit inflation in relatively short order, which will then require a Volker-style solution with interest rates moving rapidly higher-above the rate of inflation to cure it.

It will eventually stop deflation in its tracks. Subsequently, we will see an increase in inflationary pressure, which will be slow at first, but will gain momentum at a troubling pace. And by the time central banks recognize it and take action, the freight train will be traveling far too fast to stop it.

Reducing the Risk of Outside Days

Fighting a battle and managing money over the last three months are one in the same.  Conditions have been so challenging that instead of focusing on greater returns, we've been been more focused on protecting our capital.  Our biggest problem has not been the normal volatility or small arms fire, but the unexpected bomb that is randomly dropped on our position.  A picture is worth a thousands words.  Below is scatter plot diagram displaying the distribution of returns for the S&P 500 when the VIX volatility index reaches a certain value. 


The data in the graph has been offset by one day to highlight my point.  Each dot in the graph represents the one day percentage move of the S&P 500 one day after the VIX index reaches a certain value.  VIX values are represented on the left hand side or Y- axis and percentage moves of the S&P 500 are represented at the bottom of the graph or X-axis.  If you are unfamiliar with the VIX index, here is a Link.

 The normal distribution curve stops being normal when the VIX rises above 30.  Not only does it become random but there are larger than normal percentage moves--I call them outside days-and no one should tolerate them in their portfolio.  Because we take long and short positions, it doesn't matter if the outside day is positive or negative because the potential catastrophic consequences will be the same.

Let me give you another example.  Let's say that in a given month, we are correct on 70% of our trades and that our portfolio is up 3% for the month.  If we are positioned wrong on two of these random outside days, it could cause our portfolio to decrease 20% in value.  Because we mitigate this risk by investing across multiple assets classes, this kind of loss would be difficult to incur, but it is possible in our long/short index allocation.  It is not only possible, but that is exactly what happened in the month of November.  Isn't hindsight a beautiful thing?

We have reacted to this informative information by reducing our portfolio allocation based on a quantitative measure that identifies the environment when these random outside days are likely to occur.  I wish I could have anticipated this earlier, but I am grateful to have learned this valuable lesson now. 

Given the current environment, I guess you might say we figured out how to fix our gun while the enemy was shooting at us.

The goal of this enhancement is to lower portfolio risk so that clients are exposed to the same amount of risk in the current environment as they would have been in a normal market year.  Moving forward, I feel confident that we have developed a very important method for normalizing market risk across all types of market environments for each portfolio we manage.

Monty Web, a brilliant statistician was invaluable in this research.  Thanks for your help Monty!

Portfolio Performance Analysis

Risk & Reward
Each of our portfolios is strategically allocated across one or more of the Investment Pillars of Strength discussed below.  Each Pillar is managed by multiple, uncorrelated, absolute-return investment managers to produce a return stream that is consistent, negatively correlated with the major market averages in down markets and non-correlated with each of our core Pillars of Strength. 

Managing risk is our most important consideration and it is reflected in the way our portfolios are built and managed each and every day.

Constant government intervention in the markets has made my job incredibly difficult.  Our markets are no longer operating in a free-flowing manner, so we have reduced our exposure to compensate for the additional risk.  To reduce physical risk to myself and the people around me, I have also found it helpful to remove sharp objects from my office.

Mass liquidations continue to occur across the hedge fund industry.  After the Madoff incident I am certain it will only speed up the demand for capital.  Redemption requests will continue to put downward pressure on asset prices as leverage is taking out of the system.

The Madoff fraud is so scathing I want to clear the air.  ProfitScore clients do not investt in a hedge fund or limited partnership structure.  Our clients open an individual, managed account which they own and control.  As the manager of the account, ProfitScore is hired to make the trading decisions, but because the account is owned and controlled by our clients, it is impossible for your money to be stolen ProfitScore or any of our staff. 

The S&P 500 is down -1.9% month-to-date December.  The S&P 500 is now negative across all of the time periods we track, producing a negative 10 year return for traditional buy-and-hold investors.  One important change to the table below is a direct result of the recent financial collapse.  The Lehman Aggregate and High Yield Index is no longer Lehman, but instead Barclay.  Below is a performance summary for indexes we benchmark our portfolios to:

 


Cumulative Return

  

Average Annual Return

Indexes

Mth.

YTD

1 yr

  

3 yr

5 yr

10 yr

  

  

  

  

  

  

  

  

CSFB L/S *

-0.64

-19.98

-19.64


2.26

5.44

8.53

CSFB Multi-St. *

-1.45

-19.86

-20.11


0.98

3.64

6.39

Barclay F-of-F *

-1.57

-19.95

-19.67


-0.93

1.95

6.19

S&P 500

-7.18

-37.66

-38.09


-8.67

-1.39

-0.93

Barclay HY

-9.31

-31.42

-31.22


-7.62

-1.81

1.44

Barclay Agg.

3.25

1.46

1.74


4.55

4.10

5.28









* Note:

Estimated monthly performance



November was a fat tail event for our long/short equity allocation.  This allocation was fully invested while being exposed to three outside days in the same month.  Two of those days were in the last week of the month, making it difficult to recover.  Our long/short government bond traders also got stung by a similar event caused by the Fed's unprecedented manipulation of the long end of the yield curve, forcing long-term interest rates down for consecutive days in a row.  You would have to go back to the Great Depression to find rates this low.  Our mostly long only Strategic Balance broke its losing streak earning a small profit for the month.  In summary, our three legged stool got wobbled in November, but it still standing strong for the year.     

Index Advantage:

Random events finally caught up with us during November.  Our percentage of positive trades was actually 64% for the month, but our losing days were many times larger than our gains.  Moving forward, equity exposure for this allocation will be reduced based on a volatility scale we have implemented to protect against outside days.  To date in December this allocation is up 7.56%, making up for about a third of last month's loss.

For the month, this pillar gained -24.25%. 

Strategic Balance:

This talented group of mostly long-only traders somehow managed to accomplish the impossible in November.  I have mentioned many times how important this allocation is to the overall structure of our portfolio.  November was case and point as it moderated the fat tail event that happened in our long/short allocation.  Non-correlation is the name of the smooth return stream game.                  

For the month, this pillar earned 1.53%.      

Dynamic Income:

The long end of the yield curve has never been as manipulated as it has in the last 6 weeks.  The Fed is buying treasuries like a drunken sailor buys drinks at the bar.  Why you might ask?  To push down interests rates and to use them as an asset swap for the toxic waste on bank balance sheets.  It drove government bonds higher multiple days in a row (bonds and rates are inversely correlated so as bonds go up in value the spread decreases driving down rates) at a pace that would make the S&P 500 blush.  Quant models lose there way when random events occur, so we got stung.  Random events that happen multiple days in a row are more predictable, but the outside influence is not predictable. 

For the month, this pillar earned -2.09%.

Our portfolios are built using varying distributions to the strategic allocations discussed above.  To view detailed performance and risk statistics information about our investment portfolios for the month, please click on the links below: 


If You Are a Client, Don't Be Confused.
Actual management and performance fees are incurred monthly but are deducted from client accounts in the first month of every quarter (January, April, July, and October).  For performance reporting purposes, we deduct fees monthly as they incur and not quarterly, as they are reflected in client statements.  It all washes out in the end, but this may cause your account performance to deviate from our published performance reports on a month-to-month basis.  To be conservative, we also deduct the maximum fees we charge from our performance reports and your actual overall fees paid may be less than our maximum. 

My New Buddy Jack & Another Tennessee Christmas

To my surprise, I got a phone call from Bob Farris at Cedarwood Kennels in Boise.  They raise Pudelpointers.  Bob offered me a pup from a recent litter.  The reason for my surprise was because Bob placed me on a waiting list with 88 other names and I was told I wouldn't get a pup until the spring.  Because of cancelations, we are the proud new owners of a Pudelpointer pup. 

My two English Setters are both older than my daughters, so this is my daughters first puppy.  After about three days of brainstorming, my kids named him Jack.  My only input on the name was that I needed a name that was easy to yell so I could call him from a distance in the field.  Sarah, my oldest, thought that I should name him Annabelle after her sister since I have had so much practice yelling it over the years.  

It is fun having a puppy back in the house again.  We have had to remove shoes off the floor as Jack's teeth are as sharp as razors.  The kids can't get enough of him.  Sarah sets her alarm an hour earlier than usual in the morning just so she can play with Jack before she goes to school. 

It is hard to believe that Christmas is next Thursday.  The family and I leave on Christmas day to fly back to Tennessee to spend time with our family.  This year's trip will be about two weeks, so it promises to be a good time had by all.  The older I get, the more I cherish quality time spent with family and friends.  I wish each of you a wonderful holiday season. 


Working to grow your wealth,


John M. McClure
President & CEO
ProfitScore Capital Management, Inc.





Posted 12-23-2008 4:46 PM by John M. McClure
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