The Great Experiment - Will It Work Long-Term?

Our Monthly Performance Update
Doing Things Better
Welcome to Keynes' Grand Petri Dish
Money, Money Everywhere...
Why Isn't the Money Getting to Where It's Needed?
Treasury International Capital Flows
Interesting Reading
Portfolio Performance Analysis
A Boise View on Commercial Real Estate

So much changes in the economic picture from month to month that it is hard to write about it in one letter.  I have tried to send out letters more often, but research demands have made it almost impossible.  In order to communicate with my readers more often, I will soon be joining the blogsphere and begin publishing my thoughts in smaller bites through my blog, and then follow up with a monthly summary of my thoughts in this newsletter. 

So for those of you who like smaller, more focused content sent out more often, you can subscribe to my blog.  If you enjoy reading a summary of my thoughts once a month, we will still be publishing this newsletter for our long-term readers.  For those who like both, then you will have access to both.  I will keep you posted on the launch of our blog. 

In last month's letter, we mentioned that our intense research over the past several months had turned up some encouraging quantitative edges in the data we use to run our models.  The first implementation of our findings was put to work a few days ago.  I will explain more about what we are doing to improve our consistency in the section below titled Doing Things Better.

We will also be discussing the greatest economic experiment of all time.  Will it work out over the long-term, or will we fall into a Japanese-style deflationary spiral?  No one knows for sure and there are passionate arguments on both sides.  As long as demand for our country's debt continues, then the experiment can go on and will hopefully work out.  If demand subsides, then very painful decisions will have to be made. 

As we demonstrate below, demand for our nation's treasuries is decreasing, but still high enough to buy us time.  This downward trend has got to be making the Treasury a little nervous as they continue to pump in what were once unimaginable amounts of stimulus into our economy. 

Making our largest purchaser of our debt, China, mad at us over currency manipulation cannot help the situation.  The talk of currency manipulation and finger pointing at our nation's largest creditor has most everyone scratching their head.  If a trade war does ensue, I can guarantee you that this economic experiment will go up in flames and we will surpass the economic calamity experienced during the Great Depression.   

Quote of the month
"Short of digging Karl Marx out of his London grave, and putting him in charge, it is hard to see how the state could get more involved in the economy." - Matthew Lynn, Bloomberg

Our Monthly Performance Update

Stocks are roughly 30% overvalued and housing data is rolling over.  Am I too cautious or is there a real disconnect between reality and value?  February was a good month for our portfolios, but unless we make up a lot of lost ground, March is going to sting for our equity portfolios.  Below are our updated numbers through February.

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

Jan 08 to









Income Builder  (IB)





The Guardian  (GRD)





Harmony Plus  (HMY)





The Expedition  (EXP)





S&P 500  (SP500)





Important Performance Disclosure

ProfitScore provides its separately-managed accounts to individuals, advisors and institutional investors.  If you would like to hire us to help you navigate this difficult bear market, below are three ways to contact us:

  1. Complete our Private Client Group request form by clicking here: and submitting your contact information. (This is the most preferred method.)
  2. Call us directly at (800) 731-5690.
  3. Simply send us an email to info @

Someone will contact you within 24 hours of receiving your information. 

Doing Things Better

In last month's letter, I mentioned that we had added to our research staff a battle-hardened PHD with over 20 years experience developing quantitative models for the hedge fund industry.  In June of 2009, I decided to allocate an additional percentage of ProfitScore's gross revenue to hire seasoned consultants in our industry to challenge everything we do.  Our investment is about to pay off.

This research has taken us in a lot of different directions as we dissected the quantitative-based strategies we use, the managers we employ, and the asset classes we manage.  It has also taken us down many dead-end paths in our pursuit of alpha, but every now and again we have uncovered a significant edge in the data.  Some of our computational research has been so intensive, that we have had to rent mainframe time to do our analysis.

Quantitative-based investment research is grueling business.  A hit rate of 1 out of 100 is considered good.  To make matters more difficult, the edge you find is a moving target, so adapting to change is critical to your success.  Hundreds of hours turn into thousands of hours of research to squeeze out an ounce of alpha juice. 

Some of the smartest people in the world are in the absolute return business, and as a result, outsmarting the other guy has turned into a never-ending chess match.  What worked last year rarely works today, and the pace of change seems to be increasing monthly.  Adjusting to changing market regimes has become the most important part of producing consistent return streams over time.    

After eight months of intensive research, we finally implemented round one of what will be an adaptive adjustment to what we do.  We literally just went live with this process a few days ago, therefore you won't notice a substantial change in our return numbers for a few months.  At that time, I am confident that our performance charts will begin to move up and to the right. 

Due to my careful conservative nature, we will implement slowly as we introduce this adaptive process into our management techniques.  This first change will be focused on our long/short equity exposure, with other asset classes to soon follow.    

Expect a stock and ETF portfolio from us in the very near future. 

Welcome to Keynes' Grand Petri Dish

Few would argue that we are currently involved in the biggest economic experiment in history. On the hot-seat are the economic policies of economist John Maynard Keynes, first put forward in the early twentieth century and which gained widespread political support post World War II. In a nutshell,and at the risk of oversimplifying, Keynes proposed that decisions made by the private sector sometimes lead to macroeconomic inefficiencies, thereby requiring government intervention to stabilize capital markets. He postulated that during times of economic slowdown, it was the government's responsibility to spend public money to create jobs and to stimulate public demand for goods and services to re-energize the economy-ideas that were taken to heart by the administration of Franklin Delano Roosevelt in the late 1930s and early 1940s.

Figure 1 - Our updated chart of total credit market debt (debt at all levels of the economy) to GDP. As we see, this ratio has dropped (from a high of 375% in early 2009) for the first time since the early 1980s, which is a good thing. The problem is that government (public) debt has grown much faster (see next chart).

Although many present day economists would argue that FDR's policies were successful in bringing the Great Depression to an end, that conclusion is debatable. The reality is that economic performance remained strained at best, until the onset of the second World War and it was the demands of the war, not economic policies that were responsible for bringing the economic debacle to a final end. Be that as it may, this is clearly not the conclusion of policy makers today around the globe who have taken Keynes' ideas and propelled them and the printing presses into overdrive.

Figure 2 - Chart showing changes in Federal debt and annual rate of change (red). As of February, the debt stood at $12.4 trillion.

Money, Money Everywhere...

As Bloomberg's Matthew Lynn points out in his article, "Deathbed of Keynesian Economics Will Be in U.K.," most industrialized nations have taken Keynes' ideas to heart, but none have done so to the degree that the British have. Lynn makes a convincing argument that spending their way out of recession, ideas that have been vociferously endorsed by economists such as Joseph Stiglitz and Paul Krugman, are now attracting a growing cadre of opponents who are alarmed at the state.  The Keynesian-driven U.K. budget deficit is already at 12% of GDP - on par with that of Greece. But as Lynn points out, as the Greek deficit is narrowing, that of the U.K. is ballooning.

Here at home, the situation isn't much better. Based on the real budget shortfall of $1.84 trillion in 2009, our budget deficit is approaching 13% of GDP and the economy remains challenged at best, in spite of gargantuan stimulus programs and the more than doubling of the money in circulation (as evidenced by the Adjusted Monetary Base) in the past 18 months.

So at what point will we be forced to admit that the current Keynesian-driven approach is not working? Before I attempt to answer it, let's get an update on the financial situation in the U.S.

Figure 3 - Comparison of the annual rates of growth for total debt versus government debt. Total credit market debt declined in nominal terms in 2009 for the first time since the 1950s, while public debt soared at the greatest rate in twenty-six years.

As others have pointed out, in spite of trillions in stimulus being pushed into our economy, it's not getting to those who need it most. Figure 4 is the current chart of the money multiplier on the Federal Reserve's website. As the chart shows, the multiplier in the mid-1980s was above 3. But it has been declining since 1987, and according to the most recent data (February 24, 2010) is now just 0.786.

So Why Isn't the Money Getting to Where It's Really Needed?

In other words, despite the fact that the money in circulation is nearly 250% of what it was 18 months ago, it is not being effectively circulated into the economy. Banks and lending institutions are not lending it out or putting it into the hands of consumers. And when consumers do get money, they are instead opting to save it, due to the uncertain employment situation (see The Geography of a Recession Chart in the links below). Both responses are understandable given the economic environment, but this creates a big problem given that two-thirds of our economy depends on consumer spending!

Undoubtedly one of the biggest challenges we face is the state of the housing market. The foreclosure situation is fragile at best. According to Realtytrac, more than 300,000 American families are still getting foreclosure notices every month. Mark Zandi of Moody's believes that foreclosures will come in at 2.2 million for the year versus 1.7 million last year. There were 2.09 million vacant homes in Q4-02; up from 1.99 million in Q3-09, according to the U.S. Census Bureau.

So although there are house deals galore, the sales of existing homes fell 7.2% in January, according to the National Association of Realtors. The new home market is understandably worse. According to the latest data, housing permits dropped again in February.  Home builder sentiment dropped to 15 in March from 17 the month before, according to the National Association of Home Builders. Any reading below 50 is considered negative, as it means that respondents believe the market will continue to decline.

Figure 4 - Chart of the money multiplier (ratio of M2 money supply to bank reserves) has fallen steadily since 1987 through February 2010. Chart - Federal Reserve.

My point is that in spite of TARP, TALF, HAMP and a host of other stimulus programs totaling trillions of dollars, the economic situation remains tough. Yes, things are improving slowly in some sectors, while others have stopped getting worse. But how long is it supposed to take for these Keynesian efforts to take effect? Or will the outcome be the same as in the 1930s in the U.S. and the 1990s in Japan - they simply did not work at all, leaving behind mountains of debt?

One possible reason for the failure for Keynesian economics to provide a lasting solution is that it has the tendency to put added pressure on small and medium sized businesses, which are the real jobs generators in an economy, by making them pay more for labor, materials, and now health insurance. Another more insidious effect is the scapegoat approach the government is taking-blaming the meltdown on private enterprise and large corporations.

Are the economic optimists falling prey to Albert Einstein's definition of insanity - expecting that by doing the same thing they will see a different result? If so, we had better be prepared for years of challenging economic times. Stocks are doing well now, so we better enjoy it while it lasts. When the stimulus programs finally wind down, we will all be left with one heck of a bill to pay!  Since a 1% increase in tax decreases GDP by 3%, it is mathematically impossible to not have this debt be a burden to America's long-term growth prospects.

An In-Depth Look at Treasury International Capital Flows

The Treasury recently updated the international capital flow data for January 2010 and here are our charts to reflect the changes. Although the complete report is an interesting read, we have found line 30 to be the most accurate overall number to track to get a sense of the general capital flow trend.

The next two charts reflect monthly and yearly changes. Monthly net TIC flows is the most comprehensive category contained in the U.S. Treasury's reporting data set and includes nonmarket flows, short-term securities, and changes in banks' dollar holdings. Line 30 of the report is the sum of net foreign acquisition of long-term securities, increase in foreign holdings of dollar-denominated short-term U.S. securities, and the change in banks' own net dollar-denominated liabilities divided by net equities. In other words, it reflects whether foreign net investment in Treasuries is increasing or decreasing.

In January there was a net outflow of $33.4 billion versus an inflow of $53.6 billion in December 2009, according to the U.S. Treasury. Of this amount, net foreign private flows were $0.6 billion and net foreign official flows were negative $34.1 billion. As the next chart shows, the trend (yellow line) since 2005 has been down. Foreign holdings of dollar-denominated short-term U.S. securities, including Treasury bills and other custody liabilities, decreased $30.9 billion. Foreign holdings of Treasury bills decreased $44.4 billion. Banks' own net dollar-denominated liabilities to foreign residents decreased $3.5 billion.

Figure 5 - Monthly Treasury capital flows (line 30) showing trend since 2005. Also shown is the monthly Federal budget deficit (red).

Figure 6 - Annual Treasury international capital flows (line 30) showing that with the exception of outlier years 2004 and 2006, the trend has been down since 2002 and strongly negative in 2009 for the first time since 1982.

What about the annual trends? As the next chart shows, capital flowed out of the country in 2009 to the tune of $285.9 billion, as foreigners cashed in U.S. Treasuries and securities. Although we need to wait for the data to "settle" after future revisions, this trend is a concern, especially for a nation saddled with so much debt. This situation has the potential to strongly undermine economic growth in the years to come - a conclusion supported in the work of Ken Rogoff and Carmen Reinhart in their most recent book This Time is Different, published by Princeton University Press.

Interesting Reading:

Deathbed of Keynesian Economics Will Be in U.K.

The Geography of a Recession


Realtytrac take on slowdown in foreclosures in Bloomberg interview

Soros Signals Gold Bubble as Goldman Predicts Record

U.S. debt overview by Bloomberg in charts

Most recent Monetary Trends publication from the Fed

Latest economic charts from the Fed

Housing Real-Estate Recovery Signaled as Fed Unwinds

U.S Treasury International Capital Flow report for January

BusinessWeek review of This Time is Different by Rogoff and Reinhart

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.  Commentary found in this newsletter is for informational purposes only and does not effect how our portfolios are traded.    

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

Five steps forward and one step backward has resumed with March's rally.   March looks like July 2009, producing multiple up days in a row.  We actually experienced 10 up days in a row in the S&P 500 futures market.  This many consecutive up days in financial futures hasn't been seen since 1987, so you might say that March is another historical reference point in a long list of statistical outliers encountered in this incredibly strong rally.   

Index Advantage:

February was a good month for our long/short index traders, but March has been a challenging month.  As discussed above in our "Doing Things Better" section of our letter, we have implement changes to this important allocation that should start to show dividends in the second quarter.  I am confident that this critical allocation will soon be a performance enhancer and not a drag for our portfolios moving forward.            

February performance was 2.03

Strategic Balance:

Trading activity continued to pick up in this allocation as opportunities materialized.  More good things will soon be added to this allocation in the near future.            

February performance was 1.23

Dynamic Income:

To my surprise, high yield bonds are once again on the move, and this portfolio is a direct beneficiary.  After producing eight consecutive winning months and a loss in December, this important alpha driver continues its upward move.  As of today, this important allocation is now sitting at new equity highs.

February performance was .50

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. 

A Boise View on Commercial Real Estate

I have recently been kicking around the idea of buying an office building with some other like-minded business owners.  In this letter I often discuss the demise of commercial real estate and negative headlines that are common in the financial press.  But, until you go out in the market and start negotiating with the banks who own these foreclosed properties, it is difficult to gauge how serious the problem has actually become. 

The metropolitan statistical area (MSA) of Boise, Idaho currently has approximately 55 months of vacant commercial inventory on hand.  This monthly metric of consumption is based on normal consumption patterns, so no one really knows what the new consumption metric should be during this recession/depression.  Is it fair to estimate that consumption is half of what it was during the manic years (2 x 55 = 110 months)?

Boise is not unique to America's view of commercial real estate.  Our market is in the top third of all MSA's for foreclosed residential real estate, so the real estate economy is a little worse than normal.  In other words, you would probably find similar statistics in your local market.  The bank we are negotiating with has a Texas Ratio greater than 125% and just got a love letter from the FDIC.  Small local and regional banks made their living lending to small businesses and making loans on commercial real state.  I estimate that over half of the small banks in our area will be gone by the time the dust settles. 

The building we are interested in was constructed about 2 years ago.  Land cost was $400k, with construction costs running around $1.2 million.  It appraised at $1.8 million after it was built.  After the foreclosure in January, the bank is underwater about $600k. 

We offered $400k in an all cash deal, and the bank is holding out hoping to cover their loan cost of $600k.  To date they have no offers in that range so we may be getting a phone call.  It is almost unimaginable that you can buy a Class A office building for one third of the construction value, including land.  Wow!  The press is stating that commercial real estate values are down over 40% from their peak.  In our market, the forecasts are overly optimistic-I would say the number is closer to 60%.

There is nothing prettier than the fresh green grass of spring contrasted by snow-capped mountains.  Idaho is breathtakingly beautiful this time of year.  My fly fishing hand is getting anxious with this warm weather, so I hope I can report back on a successful fishing trip in next month's letter. 

Working to grow your wealth,

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

P.S. ProfitScore provides its separately-managed accounts to individuals, advisors and institutional investors.  If you would like to hire us to help you navigate this difficult bear market, below are three ways to contact us:

  • Complete our Private Client Group request form by clicking here: and submitting your contact information. (This is the most preferred method.)
  • Call us directly at (800) 731-5690.
  • Simply send us an email to info @

Someone will contact you within 24 hours of receiving your information.

Posted 03-30-2010 7:35 AM by John M. McClure