Dear Diary,
Last Thursday, the Dow shot up 421 points, or 2.4%, following the Fed’s announcement that it would be “patient” about normalizing interest rates.
It was the biggest single-day gain for the Dow in three years. And the 13th biggest single-day gain ever.
No one knows what was in this package – probably not even the Fed – but speculators thought it had a ribbon and bow on it. On Friday, they drove the Dow up another 27 points for good measure.
We have our doubts about Santa. Does he really exist? Or is it just a myth we tell children, mental defectives and stock market investors?
A stock is a share in a business. Why would a business be more valuable because the Fed tells the world it is in no hurry to stop torturing interest rates?
We knew that already. And it shouldn’t improve the real worth of your business anyway.
Just the contrary: It will more likely depress the value of businesses. The more the central banks distort key price signals, the more your business is prone to make bad investment decisions.
Counterfeit Money
And so we begin the last installment in our series on the macro picture.
Our view, as we’ve explained, is not the one taken by Janet Yellen, Paul Krugman or Larry Summers. Ours is the minority opinion.
No Nobel prizes have yet been awarded to us and no central bank follows our recommendations. (Although, the German central bank seems favorably inclined.)
That is not to say that our opinion comes out of nowhere. Not at all. It is based on hundreds of years of thinking by classical and Austrian School economists. It is also supported by experience and intuition.
At its foundation are core principles that have never been disproven. “You can’t get something for nothing” is just one of them.
“A penny saved is a penny earned,” is another.
Most modern economists don’t believe either of these two things – at least, not when applied to an entire economy.
Remember how we were careful to understand what money really was?
It must have something real behind it – real savings, real work, real resources – or it is not worth the paper it is printed on.
Otherwise it is nothing more than counterfeit money. And yet when the Fed engages in “quantitative easing” – in which it buys bonds with money created specifically for that purpose – it tries to get something for nothing.
The Fed has no real savings or real money. Its “money” is created like that of a counterfeiter. And it is just as valuable! It passes throughout the economy just like real money.
The Paradox of Thrift
Most central bankers (and most economists, for that matter) also believe in the “paradox of thrift.”
Saving money may be good for an individual, they say, but it is bad for an economy. The more people save, the less they spend; the less they spend, the less consumer-led, demand-driven growth there is.
Nonsense!
There is no paradox. Saving is good for individuals and for groups. Economies do not become wealthier by spending; they become wealthier by saving.
It is the process of saving… and investing in productive capital goods… that makes spending possible. Not the other way around.
The more saving, the more capital the society has, which it can use to increase output and become richer. Then it can spend.
You might wonder why so many modern economists believe things that are so obviously untrue. It is probably because it is man’s nature to want to control things – even when control yields negative results.
The modern mainstream economist – heavily influenced by John Maynard Keynes – offers to manage the economy… to rescue it from its occasional crises… and to improve overall output by moderating cyclical downturns.
In return for pretending to do so, he earns status, compensation, university chairs, professional prizes and columns in major newspapers. From time to time, he even gets his photo on the cover of TIME.
Wilted Flowers
What happens as a result of his meddling can be studied by taking a quick look at the US shale-oil industry.The Fed’s ultra-low rates signaled to producers that capital was plentiful and cheap. So, why not use it to produce oil?
The frackers borrowed about $500 billion and are using the money to drill holes all over the place.
They hired people too. One figure we saw suggested that almost all the new jobs in the US created since 2008 were related to the energy boom.
Then commentators began to talk about the new oil boom… and how it would cause a new industrial renaissance in America. With cheaper energy costs, a thousand commercial flowers were supposed to bloom.
What happened?
The flowers wilted. The price of oil collapsed under the pressure of so much new supply. This is undermining the industry’s profitability and calling into question the value of the reserves oil companies use as collateral for their debt.
All of a sudden it looks like a lot of subprime energy debt is going bust. And that marks the end of the capital-spending boom that has been a highlight of the whole “recovery” folktale.
The Final Bubble
But look what else happens when first you practice to deceive. News reports tell us that consumers have changed their buying habits.”I’m buying gas at $1.99 a gallon,” said one of our sisters, who drove up from Charlottesville, Virginia, for a family reunion.
“I haven’t seen it that cheap,” said another. “But it’s just a little over $2. You really notice it at the pump. I decided to use the savings to buy the family a new television.”
Our sister wasn’t alone. News reports tell us that consumers are adjusting to a lower price of oil. Many people are buying large gas-guzzling new automobiles again. Others are cutting back on home insulation, solar panels and other energy-saving measures.
Oh, what a tangled web Mr. Fed has woven! The fabric of modern society has been changed thanks to his clever guidance.
But wait… What if the price of oil goes back up?
What if the oil price were lower only because the Fed artificially pushed down the price of capital?
If that is so, you might expect oil to go back up before long. By then, many producers will have been put out of business by the artificially low price.
And many consumers will have been lured by the low prices into a position where they are vulnerable to higher prices. Central bankers will have damaged producers and consumers, and misdirected the entire world economy.
Since 1987, central banks – led by the Fed – have pumped up one bubble after another.
The Final Bubble – the Big Kahuna of a bubble in credit itself – is still expanding. If our macro analysis is correct, central banks will continue inflating it as long as they can. Then it will blow up.
We have no way of knowing whether we will be right or wrong.
Still, you should be wary of stock market performance claims based on the last 30 years of experience; these years also saw a huge increase in credit. You should also distrust any projection of performance based on those years.
Finally, you should be on your guard. You don’t want to be caught unawares and unprepared if it turns out we were right… and the credit bubble finally explodes.
Your Macro “Flashlight”
Can you really use this sort of macro analysis to improve your investment returns?
The jury is out. But our bet is that it is like a flashlight in your automobile glove compartment – usually useless but occasionally essential.
Most of your gains come from being in the right market at the right time. (Look out for our Weekend Edition essay on Saturday on how value investing guides you to the right markets.)
Macro analysis is most helpful in showing you how to avoid the worst ones.
Counterfeit “money” cannot bring about real prosperity. There is nothing behind it – no savings, no resources and no real capital.
But it can bring about bubbles. We’ve seen that.
As bubbles inflate they can produce spectacular profits in certain markets – art, high-end real estate, collectibles and stocks. The problem is each bubble will pop. So generally speaking, these are no good for long-term investors.
The biggest and most dangerous bubble today is in debt. Here the risk is exceptionally large. The debt bubble will pop in one of two ways: inflation or defaults.
The government may let energy companies default on their junk bonds. (More on this from Chris below.) But when it comes to its own debt, most likely inflation will eventually reduce its value – perhaps to zero.
Bottom line: Stay away from bonds.
Regards,
Bill
Time to Review Junk Bond Risks
If you own a high-yield bond fund, now’s a good time to review the risk it poses to your portfolio.
High-yield corporate bonds – otherwise known as junk bonds – carry a higher risk of default than “investment grade” bonds (those with a credit rating of “BBB” and above, as Standard & Poor’s scores it).
To compensate investors for that higher risk of default, junk bonds carry higher yields.
But recently, yields of junk bonds issued by US energy companies have shot higher than the average junk-bond yield.
As of the end of last week, the average energy-related junk bond yield was 9% versus an average 6% yield for junk bonds in general.
This has been caused by panic selling of energy-related junk bonds. (Bond prices move in the opposite direction of yields.)
The worry for investors is that lower oil prices will put some of the higher-cost US shale-oil producers out of business. Or at the very least squeeze their cash flows to the point where they’re forced to default on their debt-service payments.
One thing in oil companies’ favor is that many of the smaller producers have hedged production at prices higher than current market prices.
That buys them some time. As their hedging contracts expire, they’ll be hoping that oil prices recover.
Also, the average 12-month default rate for junk bonds is still well below the long-run historical average.
According to data from Standard & Poor’s, the average junk-bond default rate over the past 12 months was 1.6% versus an historical rate of 4.2%.
But if oil prices continue to stay low, high-yield debt issued by US energy companies will be at risk.
One of the most popular junk-bond ETFs, the iShares iBoxx $ High Yield Corporate Bond ETF (NYSE:HYG), has 13.6% exposure to the oil and gas sector, according to financial data company Zacks.
It’s down 5.3% so far in 2014.
If Bill is right… and we start to see high-profile defaults in the US oil and gas sector, next year could bring more losses for junk-bond investors.