Coronavirus and the Perils of Pricing Stocks for Perfection

The past week's tailspin of stocks into a correction is a reminder that the law of gravity has not been repealed in the financial world.  Until just recently, the high flying stock market, having steadily risen since 2009, was priced for perfection:  everything had to go well or gravity would assert itself.  In such circumstances, bad news can have an outsized effect.

Not surprisingly, the trigger for the downturn was a black swan--a stock market term for an unexpected event that is very bad for the market.  Typically, black swans are the triggering events for sudden market nosedives.  The 2008 bear market that coincided with the beginning of the Great Recession was triggered by losses hitting a poorly understood cobweb of linkages between and among the real estate, mortgage, bond and derivatives markets that concentrated real estate lending risks into the heart of the financial system.  Large mortgage losses were magnified into a tsunami of financial pain by daisy chains of supposedly offsetting derivatives contracts that wound up consolidating risk instead of dispersing it.

Coronavirus (or COVID-19) is today's black bird.  It calamitously began in the world's factory, China.  This meant that it would spread quickly because so much global commerce--and therefore global travel--would circulate through China.  Its high rate of transmission was not fully appreciated at first, and those giving early warning were treated as Cassandras instead of being taken seriously.  So the disease spread quickly and a massive shutdown of major parts of China was imposed.  Commerce slowed precipitously and corporate losses are piling up fast.  The World Health Organization has warned that the disease has become a very high risk.  In short, coronavirus is on the verge of becoming a pandemic, and the prognosis is guarded.

The stock market finally got the message, and had a hissy fit, dropping into a correction in five trading days.  More losses are likely in the near term future.  Opinion is divided on whether the current market is a buying opportunity or a septic facility to be avoided.  If you're set on putting money into this market, make sure it's money you won't need for at least ten years.  Medical science is getting a better understanding of COVID-19 by the day, and chances seem good that eventually we will learn to cope with the disease and contain its impact.  But when that day will be remains speculative, and you should speculate only with long term money that you can afford to lose.

How Donald Trump Could Create a Stock Market Crash

Stock market crashes, such as in 2008, emanate from inflated asset prices.  While economic recessions and other events, such as war, can trigger market downturns, large, sharp market drops (a/k/a crashes) are the result of artificially high asset prices that often have started bubbling.  In 2008, the asset bubbles resulted from overly generous prices being paid for real estate, the resulting mortgages, stocks that seemed like good bets in light of all the real estate activity, and stocks generally because market averages kept rising.  It didn't help that the U.S. government guaranteed almost all mortgages on a de facto or de jure basis.  The easiest way to get people to pay too much for an asset is to make it seem like a sure bet.  Con men know this and profit from it because, despite all the evidence that there is no such thing as a sure bet except taxes and death, people remain suckers for sure bets. 

Donald Trump bet the image of his Presidency on the rising stock market.  Stocks rose briskly right after Election Day in 2016 and maintained their upward momentum for over a year.  Trump noisily celebrated the huzzahs he thought he heard from the financial markets and wore out the fabric of his suit jackets patting himself on the back.

But Trump, despite decades as a New York businessman, hasn't absorbed a simple lesson that he should have learned about stocks a long time ago:   that stocks go up and stocks go down.  There is no such thing in the stock markets as continuing upward momentum.  There is no endless applause.

So, when the stock markets got tummy trouble in 2018, and began to burp, belch and make other inelegant noises, Trump became discombobulated.  He berated the Federal Reserve Board for raising interest rates, manipulated oil prices down by persuading the Saudis to keep pumping large volumes, and condemned American businesses that closed down domestic operations.  Sometimes, on down days in the market, he made statements about trade talks that turned out to be optimistic or premature.  He seemed indifferent to widening federal deficits, instead suggesting a further tax cut for the middle class.  All of these actions seem linked to a desire to support stock prices.  But stocks have remained gloomy.  So we can expect that Trump will keep searching for some way to boost the metric that he thought made him look so good.

Persistent efforts by governments to support and boost asset prices have tended to end badly.  There is no free lunch, and governmental distortion of asset prices inevitably leads to misallocation of capital and other resources.  Pushed far enough, this mispricing eventually becomes too much for investors to stomach, and they back away from the asset. Then, bad things happen to the asset's price. That happened with real estate and mortgages in 2008 and it may be happening with stocks now.  If Trump pushes too hard on maintaining and increasing stock prices, he could foster a bubble in the stock markets, and nothing good for him will result from that.  If you're an investor, don't bet on governmental action to make stocks great again.  Remember:  in the final analysis, stocks go up and stocks go down.

The Best Asset in a Time of Volatility

All markets are volatile these days.  Stocks are gyrating, bonds are falling as interest rates increase, oil is bouncing up and then down, bitcoin has fallen all year, and even the real estate market seems to be going wobbly.  Gold and silver have been slipping away.  And foreign markets look even gloomier.

Investors naturally look for opportunities when prices fluctuate.  Whether you're a buyer or a short seller, price movements create the potential for profit.  Volatility is gut wrenching if you're taking losses, and can stimulate panicky selling when prices are low.  But it can be exhilarating if it looks like a lucky break.

That's why cash is often the best asset to hold in a time of volatility.  It gives you the means to take advantage of fortuitous price movements, while its stability insulates you from the emotional roller coaster that often drives people to sell when prices are dropping.  Don't think that you have to remain fully invested all the time.  What you have to do is remain unemotional, as emotion is the enemy of careful investing.  A nice, comforting cushion of cash can prevent an unwanted flood of adrenaline.

Cash may appear to have a low rate of return, with greedy banks still paying miserly rates of interest on deposits even though interest rates have been rising.  But cash also offers the potential to profit from price volatility.  You can dive into an asset when its price is low and make a bundle when it rebounds.   That potential makes the effective return from cash much higher.  So don't be afraid to hold a lot of cash in a time of volatility.  That's when it's an investor's best friend.

Will Trump Help Us Profit From the Jobs Numbers?

Today, President Trump tweeted around 7:24 am that he was "looking forward" to the jobs numbers.  Some traders in the financial markets apparently saw this, sold Treasuries, and bought stocks.  When the jobs numbers came out at 8:30 am, they were better than expected.  Jobs increased by 223,000, about 33,000 more than economists had estimated.  https://nypost.com/2018/06/01/how-trumps-pre-jobs-report-tweet-moved-the-market/. The stock market rose more than 250 points in morning trading.  Whoever bought stocks before the jobs report made money--good money.

It turns out the President learned the jobs numbers last night.  The federal government, including the White House, has historically refrained from any comment on the jobs numbers until they are officially released at 8:30 am.  The President broke with tradition.  Whoever among financial markets aficionados were monitoring the President's Twitter address got an advance hint about the jobs numbers.  It's implausible to think the President would have tweeted if the jobs numbers had been tepid or discouraging.  His "looking forward" comment could only mean the numbers would be good.

 Trump shouldn't have tweeted about the jobs numbers before they were officially released.  But it's just in his nature to keep his mouth moving and the Tweeter going.  So maybe this gives us a way to make money from the jobs numbers.  If the President tweets about jobs before the official release, invest in a way that would profit from good numbers.  If the President is silent before the official release, invest in a way that would profit from tepid or bad numbers.  Will this work?  No guarantees, but you never know.  Maybe you could make a nickel or two.

Why You Should Worry About the Rising Stock Market

The stock market keeps rising, setting new records just about every week.  The S&P 500 has risen over 15% since Election Day 2016, and shows no signs of slowing down.  That's an annualized rate of over 20% a year, which is exceptionally good for an aged bull market as we have.

The election of Donald Trump as President was seen as a major reason for the rally.  He promised infrastructure spending, tax reform and other measures that should stimulate the economy.  But his Presidency has sunk into a quagmire of chaos, incoherence and unpredictability. These, coupled with the legal risks emanating from special counsel Robert Mueller's investigation, should have triggered market retrenchment.  But stocks have hardly blinked before levitating some more.  Whatever is driving the market, it doesn't have much to do with the Trump Presidency.

Accommodative monetary policy in Europe and Japan is also said to be a reason for the market's buoyancy.  Foreign central banks have been printing money, and some of it supposedly has found its way into the U.S. markets.  But the dollar has been falling recently, indicating liquidity is flowing out of our markets, not in. That's not a formula for a rally.

Corporate earnings, although pretty decent, aren't dramatically better than last fall.  They don't explain the lighter-than-air quality of stocks today.

So what's going on?  Let's consider that over half of all stock market transactions consist of computerized trading.  Machines are trading with machines, using algorithms known to very few.  These algorithms verge on alchemy.  They rely on statistical correlations that may or may not hold true in the future.  These correlations can be disrupted by unexpected government policy, political upheaval or conflict, economic change (such as the effective collapse of OPEC as a functional cartel), and technological change (such as the fracking that just blew up OPEC).  They also utilize artificial intelligence, seeking to learn from their ongoing experiences in the market and modifying their algorithms as a result of what they learn.  Thus, the humans may have difficulty anticipating what the programs will do tomorrow.  And the programs may produce a positive or negative synergy or other interaction that humans have not foreseen.

Computerized trading is opaque.  That is, in real time, no one knows for sure if a trade or a series of trades involved a machine or two machines or none.  One should avoid anthropomorphism in today's stock markets.  In other words, one should not ascribe human motives, intentions or characteristics to market activity.  There may be no reason comprehensible to humans for today's stock prices.  When computers use artificial intelligence to trade stocks, the valuation of financial assets may be fundamentally changed, and changed beyond human comprehension.  You may think that stock prices are whacked out--and you could be correct from the human perspective.

Homilies like stocks are excellent long term investments and will protect against inflation were derived at a time when people dominated the financial markets and established the asset valuations on which these notions were based.  If machines that function opaquely suddenly become dominant, how can humans understand the valuations determined by the machines?  More succinctly, how can you tell what's a good price and what's a bad price anymore?

There are many more questions than answers in a machine-dominated market.  When the market keeps setting new record highs in machine-dominated trading, be careful.  We are bravely, or not, going where no investors have gone before.  And no one really knows what's going to happen.

Is the Fed Undermining Portfolio Diversification?

A basic investment strategy for investors is to diversify.  Typically, investors put some of their money into stocks, and most of the rest into bonds.  Small portions may go into gold or other commodities, or be held as cash.  Stocks and bonds historically have tended to offset each other.  When stocks rose, bonds would fall, and vice versa.  A diversified portfolio would be hedged, ameliorating the ups and downs of the market and making investing less stressful. 

Today, though, central bank accommodation--in the form of ultra low interest rates, negative interest rates and quantitative easing--has distorted this historical relationship.  As the Fed and other central banks print more and more money, both stocks and bonds rise in value.  They no longer offset, and diversified portfolios are becoming unhedged.  If and when the era of easy money ends, both stocks and bonds could fall, and perhaps precipitously.   

By unhedging diversified portfolios, the central banks are heightening investor risks.  Many wealthy and institutional investors, apparently sensing the danger, have been increasing their levels of cash.  But ordinary mom and pop 401(k) investors may not be able to shift gears so easily.  They may face increasing exposure, and perhaps not know it.  If they sustain losses when they expected to be hedged, they could lose confidence in the markets.  The result could be rapid and ugly.  That's what happened on Black Monday, October 19, 1987, when the stock market crashed and fell 22.61% in a single day because many institutional investors thought they'd be hedged by a financial product called portfolio insurance and found out unexpectedly that portfolio insurance didn't work. 

The central banks could reduce accommodative policies in order to raise rates and normalize the financial markets.  But that process could cause investor losses and trigger selling that leads to a market meltdown.  If, on the other hand, central banks keep printing money, they may worsen the problem.  You could shift more assets to cash (or at least refrain from committing fresh cash to the markets).  Otherwise, understand that diversification, like everything else in the financial markets, is starting to look a little hinky.

The Market Dropped 3%, So What's For Dinner?

On Monday, Oct. 19, 1987, the U.S. stock market nose-dived, with the Dow Jones Industrial Average falling 22.61% in a single day.  That was volatility.

Recently, the market has been bouncing around, losing as much as a few percent a day, and edging into correction territory (a loss of over 10% from the latest high).  This turbulence isn't surprising, given the six year age of the longstanding bull market.  Indeed, in the summer of 2011, the market dropped around 17% on account of various investor jitters.  Then, it recovered.  Markets regularly have downturns, even bull markets.

So what does the future hold?  Nothing that anyone can reliably foretell.  The direction of the financial markets today is determined first and foremost by central bank policies.  The key players are the U.S. Federal Reserve, the European Central Bank and the Bank of China.  Predicting central bank policies is difficult in the best of times.  These days, with the data unusually uncertain, central bank policy is harder to predict than one's luck at the  roulette wheel.  This is especially so since politics appears to infiltrate central bank policy, making prediction even harder.  But one thing you can expect is they'll be cautious about doing anything that isn't accommodative.  If the Fed raises rates in 2015, it will probably do so once, and be done with rate raising for quite a long while.

The Chinese stock markets have a bubbly aura, making further volatility in Shanghai and Shenzen likely.  But China's economy is not heavily dependent on rising Chinese stock prices--and neither are Europe's economy or North America's.  Many individual savers in China are getting hosed, but the Chinese economy doesn't rely on domestic consumption. If Chinese investors lose their savings, Chinese manufacturers will still keep exporting to the rest of the world.  So the acid reflux in the Chinese stock markets may, ultimately, have only so much impact and not more.

Keep an eye on the market, but don't miss any meals over it.  If you're nervous, stay the course and don't invest more right now.  On the other hand, if you're feeling lucky, think about adding a bit to your stock holdings as the averages move down.  You know what they say about not letting a good crisis go to waste.

Is there a black swan lurking?  Maybe.  Since China has been the major source of world economic growth in recent years, any major upheaval in China could be the black swan.  What could happen there?  Well, President Xi Jinping has been aggressively consolidating power.  He may be the most powerful leader China has had since Mao Zedong.  But the market turmoil in China, and the recent slowdown in its economic growth, may be causing some to question his leadership.  The secretive nature of China's Communist Party makes it impossible to know for sure how strong Xi's grip on power may be.  While there are no overt signs of change, if Xi is forced out of power and there is a struggle for control in China, then all bets are off and you might want to do some hard thinking about how much risk you care to hold in your portfolio.

The Zen of Investing

How do you allocate your investment funds in times like these?  Stocks bound upwards for a couple of days when statistical data indicates the economy is slowing or a Fed governor smiles.  Then, the market nose dives crazily the next couple of days when oil prices rise or unemployment falls or another Fed governor frowns.  Bonds slump and then surge, or surge and then slump when inflation expectations rise or fall.  One constant in the financial markets is volatility.  Another is unpredictability.  And a third is no net gains--as in, for all the hysteria, stocks have hardly done squat this year.

The financial media is full of conflicting predictions--the market will boom, the market will crash--and conflicting advice--buy this, sell that, short the world and stock up on survivalist gear.  To paraphrase former Fed Chairman Ben Bernanke, things are unusually uncertain.

At times like this, the best option may be to step back from the chaos and cleanse your mind of desire.  At least, of desire for short term gains and avoidance of losses.  It's impossible to make money all the time, or to avoid all loss.  With entropy seemingly on the increase, any effort to make every day a good market day will have you believing six impossible things before breakfast and doing battle with windmills.

There's nothing wrong with holding cash, maybe even a lot of it.  Cash is beautiful.  A goodly amount in a federally insured bank account or U.S. Treasury debt promotes equanimity and sound sleep.  You will smile more.  There may be some who would argue that a fully invested, well-diversified, periodically rebalanced portfolio will provide better returns than a partially invested portfolio with a lot of cash.  This may be true in theory, but an awful lot of investors don't have the nerve to stay the course with a fully invested portfolio through the periodic mania of the markets.  They sell and freeze up, never again to invest, and potentially lose a great deal of future gains.  All the nice theory in the world doesn't amount to diddly if you're too stressed to implement the theory.  To maximize returns in real life, you have to be calm and unemotional.  And if doing that takes having bundle of greenbacks under the mattress, then so be it.  Don't feel the need to allocate every last dollar to something or other right away.  Hold off on betting your last buck until you feel comfortable.  Be zen, and increase your chances of becoming rich.

Easy Money: Reinvesting Dividends

Some of the easiest money comes from reinvesting dividends.  Over long periods of time (such as 20, 60, or 80 years) dividends accounted for a little more than 40% of total stock market returns.  Stated otherwise, if you spent dividends, as opposed to reinvesting them, your portfolio would have enjoyed only a little more than half the return it could have gotten with reinvested dividends.  Remember that reinvesting dividends has a compounding effect, and compounding is very, very good for your net worth (see http://blogger.uncleleosden.com/2009/09/if-you-love-compounding-compounding.html).  Your total return can be greatly magnified with compounding, accounting for well over half the long term return.

It's easy to reinvest dividends when you invest in mutual funds.  On the account opening form, just check the box for reinvesting dividends and interest, and the mutual fund's administrator will do the rest. Dividend reinvestment plans (DRIPs) offered by the company issuing the stock are clumsier, since you have register with the company and the shares are less liquid (not so easily sold).  Some brokerage firms will reinvest dividends received in your account.  However, you may not have from DRIPs or brokerage accounts the diversification that offers a reasonably steady flow of dividends.  The easiest way to reinvest dividends is through mutual funds (make sure you choose a fund with low costs).

You'll have to pay taxes on the dividends if they're held in a taxable account (although possibly at a lower rate than what you pay for ordinary income).  If your investments are in a tax-sheltered account like a 401(k) or IRA, dividends will be reinvested as a matter of course and you'll pay taxes when you withdraw the money, or convert or transfer to a Roth account.  For money from tax sheltered accounts, taxes will be assessed at ordinary income rates.  But taxes are imposed on dividends even if you don't reinvest.  So they're don't really affect your decision whether or not to reinvest.

Reinvesting makes money for you while you're sleeping, cooking dinner, playing golf, mowing the lawn or indulging in more screen time than you'd ever allow your kids.  Don't pass up this chance to make easy money. 

The Next Market Bubble

Bulls and bears alike wonder when the next market bubble will emerge and pop.  In recent years, major stock market downturns have come from bursting bubbles.  Recessions, threats of war, terrorist attacks and other disturbances have caused market ripples.  But the big gut wrenchers--the nosedives that wrecked your retirement--have come from the popping of asset bubbles.  The gross over-valuation of tech stocks in 2000, the ridiculous real estate lending of 2005-07, those are the events that clobbered equities.  What does the future portend?

Today, the mess in the Middle East grips our attention.  Medieval atrocities by the Islamic State, a mosh pit with weapons in Gaza, mind-numbing slaughter in Syria and sectarian strife in Iraq appall and fascinate.  But none of them will significantly drive down stock valuations.  They just don't have the economic impact.  The Ebola epidemic is now raging out of control in West Africa.  But America's economic exposure to West Africa is miniscule.  And the disease isn't likely to present a major threat to the industrialized world.

Is there an impending market bubble that could burst and dynamite the world's financial system?  The answer is maybe, in Europe.   The European economy is slowing.  Growth is seen only on alternating Sundays.  The EU stays afloat on a cushion of sovereign and bank debt--a lot of it.  With Europe's slowing economy, it will be tough to pay down this debt and expedient to refinance by issuing even greater amounts of debt.  Risks to larger members like Italy and France are rising.  The EU is a financial and currency union without a unitary government.  Thus, it is tailor made to borrow in bulk without governmental controls to interfere.  We in America know from the 2007-08 mortgage crisis what happens when you bulk up on debt that can't be easily repaid.  The vast amount of European debt presents potential systemic risk, just like the vast amount of American mortgage debt outstanding in 2007.

Exacerbating Europe's problems is the war between Ukraine and Russia.  As Russia's direct involvement in combat is becoming increasingly clear, the war is likely to have ever greater impact on Europe.  Sanctions by the West will probably be heightened, and Russia's retaliation will likely hit Europe harder than America.  Europe's financial system could begin to totter as the EU is pushed into recession and capital flees the Old World.  (Indeed, part of the buoyancy of U.S. stocks can be attributed to the arrival of capital now fleeing Europe.)  A run on the Euro could be the straw that breaks the bubble's back.

The European Central Bank, as always, does a fan dance about how accommodative it will be.  While it's become much more interventionist in the past couple of years, it remains constrained by its anti-inflation charter and the stolid, ever-frowning Germans. Maybe the ECB will save the day.  Or maybe not.

Europe's economy, as a whole, is larger than America's.  A tummy ache there could affect the rest of the world.  if you're worried about where the next bursting asset bubble could come from, keep your eye on Europe.

The EU Bubble

Today's kerfluffle in the stock markets over the debt default of an entity affiliated with Portugal's largest bank reminds us that if there is a financial bubble anywhere, it's in EU sovereign and bank debt.  EU sovereign debt and the debt of EU banks have become almost synonymous.  That's because they are linked by a problematic circularity.  EU banks have invested heavily in EU sovereign debt.  EU nations, in turn, have pretty much become the guarantors of the debts of their banks.  Thus, the banks borrow to invest in sovereign debt, and the sovereigns in turn guarantee the banks' debt that funds the sovereigns.  It's rather clever, as long as nothing goes wrong.

However, one could note that EU banks and sovereign nations appear to be burdened with each others' liabilities, and that the guarantees of EU nations accordingly have limited efficacy.  Given that the EU and its banks, in toto, can be reasonably described as overleveraged, this circularity can become a circular firing squad if there is a run on a major EU bank or an EU sovereign member nation.  This is particularly so since no EU nation can issue its own currency and pay its or its banks' debts with printed money.

Of course, the European Central Bank has in recent years made a show of pointing to shining armor it could don and white horses it could mount to ride to the rescue if there is another European financial crisis.  And it has adopted accommodative, money printing-like maneuvers when the going got tough (like letting EU banks use sovereign debt as collateral for borrowings at the ECB without any discounting of their face value).  If the dustup across the pond is limited to Portugal, the ECB should be able to find one way or another to keep the cookie from crumbling.  But if other EU nations, particularly larger ones like France, begin to waver, the EU financial bubble could burst in a nasty way.  The economic consequences could be bad.  Given the growing extremism in Europe, the political consequences could be worse.

There are some asset classes in the U.S. that may be getting bubbly.  Many Internet stocks are suspect. Housing except for the $1 million and up price range seems to be struggling.  In addition, small cap stocks haven't been doing well recently and may turn out to be a bubble bursting.  But it's unlikely that the frothiness of these asset classes could re-trigger the Great Recession.   On the other hand, if the EU sovereign nations can't keep their banking systems on an even keel, then all bets are off. 

Why You Should Invest Like the Smart Money

One characteristic of the investing strategies of the wealthy is to diversify.  Stocks, bonds, money markets, real estate, alternative investments, collectibles, precious metals, jewelry, and so on are frequently found in the portfolios of the high net worth crowd.  Diversifying is a way to win no matter what's going on with asset values, and the wealthy want to stay wealthy.

The 99% should do no different, and recent market activity illustrates why.  Bond values have improbably risen in recent weeks, while stocks are stuck in a trading range right about where they started the year.  Gold and silver went up earlier this year, but have slid back.  Real estate ended 2013 with a roaring comeback, but now seems to have stalled out in many markets.  International markets have delinked, with Asian markets generally falling over the past six months, while European markets have moved up slightly (Ukraine crisis notwithstanding).  It would not have been easy to predict this mix of events.  Indeed, it's rare to find financial analysts who predict much of anything right.  Few predicted the 2007-08 financial crisis.  Few predicted the 30% jump in stocks in 2013.  Few predicted that bonds would rise this year.

The investing patterns of the smart money reveal that the smart move is to diversify.  Don't look for a quick buck.  You'll probably get a quick loss.  Don't look to hit a home run with a single investment.  The financial press may glamorize the few who manage to do that, but generally pays little attention to the many who fail.  Don't try to predict the unpredictable.  There are rare situations, like 2008-09, when all asset classes seem to be falling in value.  That's what can happen when vast amounts of debt and other leverage enter the financial system in one-sided bets dependent on rising asset values.  When that debt begins to lose value, the assets it was used to buy are at serious risk.  But more typical is what we have today--a lot of uncertainty, but some of the uncertainty is about the upside and some about the downside.  Most of the time, diversification is the best way to play your cards. 

And if you're still unhappy about your net worth, save more.  Whether the markets are doing well or badly, adding to your pool of capital will pay off in the long run.

Why No Great Rotation?

A popular view among market aficionados is that, with bond prices falling while stocks have been rising, money would shift from bonds to stocks.  Stocks and bonds have historically often moved inversely.  When stocks rose, bonds fell, and vice versa. With bonds falling now, it would seem reasonable to expect investors to rotate their money into stocks.  But there has been no rotation.  Why not?

First, for the past five years, we've had a brave new Fed which has manipulated asset values in ways beyond historical experience.  Since early 2009, central bank easy money has helped to spur a stock rally accompanied by a bond rally.  Both asset classes rose simultaneously, instead of moving inversely.  With their traditional relationship out of whack, it is hardly surprising that they don't cha-cha when they're supposed to.  Investors would be understandably suspicious of stocks in a market that is seemingly dependent on the Fed's methadone program, especially when the Fed is talking about easing out of its role as Dr. Feelgood.

Second, the Great Rotation is an investment strategy for the medium to long term.  Today's stock market is dominated by high-speed, computerized trading, where the holding period for stocks is measured in milliseconds.  The long term human investors that might consider rotating greatly have mostly been supplanted, and many have chosen to invest on autopilot, buying index funds and throwing salt over their left shoulders.

So whither the markets?  That's the $64,000 question, and in truth nobody knows the answer.  With both stocks and bonds having enjoyed years-long bull markets, logic and experience, especially recent very painful experience, tell us that when markets can't keep rising indefinitely, they won't.

The Great Anxiety

The Great Recession has morphed into the Great Anxiety.  Economic growth is tepid, enough so that it inspires little confidence.  Unemployment, still high, is falling, but so slowly that consumers' animal spirits remain tame.  Individual investors, confronted by three year highs in the stock market, celebrate by fleeing.  The members of Congress devote their energies to calling each other finks, rat finks, double rat finks, and triple rat finks, while the nation veers toward a fiscal vortex.  Both candidates for the Presidency, although individually quite intelligent and accomplished, swap lies about how the other is lying and inspire little more than resigned sighs from their supporters.  The Federal Reserve is operating the only show in town, and its program consists of printing money, printing money while riding a bicycle sitting backwards, printing money while juggling eight balls and printing money while doing double somersaults on a trapeze.  But the Fed can't do much to resolve the problems in Europe, which is now sliding into recession even as the sovereign debt crisis gets kicked farther down the road.

If the Federal Reserve Board is correct in believing that public confidence is crucial to economic growth, then we are a long way from healthy, sustainable growth.  By all current indications, whichever candidate for President wins won't inspire much confidence.  Congress appears likely to remain divided between a Republican House and a Democratic Senate.  Gridlock isn't that big a problem when the economy is strong.  But it is deadly when the economy is moribund.  For better or for worse, a somnolent economy needs a decisive government, and we probably won't have one. Can kicking isn't a sound federal economic policy.  Both Japan, and more recently, the European Union, have vigorously kicked the can numerous times.  The problem, though, is that business people and consumers all know that the can is still there, and can bite them in the butt big time.  So they don't make big commitments; they don't go exuberant.  Can kicking virtually guarantees stagnation.  Yet can kicking has been the order of the day in Washington.

In a time when lukewarm coffee is all that you can hope for, invest cautiously.  It's not a bad idea to hold some risk assets.  But limit your exposure, and avoid the riskiest.  Hold a good dollop of stable assets, and don't stretch for yield.  One important way to give your net worth a boost is to save more.  Remember that the thriftiest squirrels have the best chance of surviving winter--and the coming winter could be cold indeed.

How Government Adds Risk to Risk Assets

The Federal Reserve has been on a tear, squashing interest rates in order to coerce investors into risk assets.  But investors, especially individual investors, have been zigging where the Fed wants them to zag.  They have succumbed to post traumatic stock disorder, and abandoned equities with abandon. 

Fear of stocks isn't just a product of the market busts of recent years.  It's also driven by too many known unknowns.  The role of government in pumping up asset prices has become so great that it receives more attention from financial news services than economic fundamentals.  But, as mandated by the law of unintended consequences, government actions have made risk assets less attractive.  Here's how.

The Fed has become less predictable.  In years past, the Federal Reserve was slow to reveal its thinking and the reasons for its policy actions.  Chairman Ben Bernanke has endeavored to be more transparent.  And he has been more transparent about the workings of the Open Market Committee and its thinking.  But what has been revealed only confounds.  The Fed is quite open about its intention to provide monetary stimulus in order to boost employment.  But no one knows what level of employment will cause the Fed to ease back, or what rate of inflation will lead it to move interest rates up.  No one knows what type or form of additional quantitative easing the Fed will employ if employment levels remain unsatisfactory (however unsatisfactory may be defined).  Will it buy car loans, credit card debt, bankers acceptances, commercial paper, corporate bonds, junk bonds, common stocks, or something else?  Whether or not, why, when, how, how fast, and how much are important, but unanswered, questions concerning the Fed's potential unwinding of its massive $3 trillion plus balance sheet. Any purchaser of risk assets would want answers to these questions.  But answers are unavailable.

The Fed is relentlessly driving its monetary wagon train under the motto "full employment or bust."  By acting so vigorously and creatively, however, it has created a lot of uncertainty even as it has stabilized the financial system.  There are so many uncertainties about the route the Fed is taking that individual investors don't want to hitch up their wagons and join the trek.  What the Fed will do next is anybody's guess, and because of its outsized impact on risk asset prices, this unpredictability makes risk assets riskier.

Fiscal funk.  Congress's dysfunction was on full display last year when those freakin' idiots--excuse me, the esteemed members of Congress--almost blew up America's creditworthiness in the debt ceiling debacle.  Things haven't changed.  Forecasting fiscal policy is like peering into a black hole.  It's impenetrable.  Whatever happens could make things worse.  Also, consider the permanently temporary nature of the Bush II tax cuts, which have fallen into the habit of being extended a year at a time.  The analysis of risk assets becomes labyrinthine when the tax system is established for only a year at a time. Another big, bad black hole is known as the fiscal cliff, which is huffing and puffing furiously.  Yet we don't know if we're in a house of straw, wood or brick.  All these fiscal foulups accentuate the risk in risk assets. 

Rational investors trying to reason their way to well-founded decisions haven't got a popsicle's chance in hell of figuring out the upsides and downsides of risk assets.  They just know that these known unknowns heighten the risks.  In such circumstances, digging the fox hole deeper and hunkering down all the more make sense.

Would You Invest in Government?

Investors have an unusual problem today:  should they invest in government?  No, that's not political rhetoric.  It's perhaps the biggest question facing anyone with cash to allocate.  Asset prices have been manipulated upward by central banks and other government policies.  Stocks and bonds would not be trading at today's prices had it not been for all of the merry money printing by the major central banks during the past few years.  Indeed, the Federal Reserve takes credit for over half the rise in stock prices since 1994.  See http://blogger.uncleleosden.com/2012/07/stocks-are-not-cheap.html.  If you buy stocks or bonds now, you're betting that central banks can continue this juggling act. Is that possible?  Let's look at real estate.

Real estate prices for decades received government support on a massive scale.  Beginning in the 1930s and 1940s, various government lending and finance programs (think Fannie Mae, Freddie Mac, Ginnie Mae, FHA, etc.), along with tax deductions for mortgage interest and property taxes, plus more specialized programs like federal flood insurance, have combined to create a vast support network for real estate, worth trillions of dollars.  Add Federal Reserve easy money policies starting in the 1990s going forward, and real estate prices were boosted leaps and bounds by government largess.  We know, however, how this story ends.  Humpty Dumpty had a great fall, and all the government's programs and bailouts since the financial crisis of 2007-08 haven't put Humpty together again.  To be sure, a great deal of private avarice and stupidity played central roles in the real estate catastrophe.  But the presence of the government, lending a helping hand at every turn, made it easy to believe that real estate prices would never drop. 

Stock and bond prices now seem similarly invincible.  Even though Europe is sliding into recession, China's growth is slowing, and America's economy sputters and coughs just above recession level, stocks keep bubbling up.  Any positive economic statistics add to the ecstasy.  Negative ones slip from short term memory.  Many investors skittish about stocks have no qualms about diving into bonds, even though bond values have been driven to extreme heights.  Central bankers worldwide issue virtual carbon copies of each other's press releases declaring their unswerving commitment to keep printing money until . . . well, until . . . well, it's not clear where the process will end because the printing presses are now set to run ad infinitum.

To invest today, you have to pay the government prescribed price. To assess the risks of financial assets, you have to give heavy weight to political considerations--and those ain't pretty.  Buying financial assets like stocks and bonds is essentially an act of faith--faith in governments, and especially in central banks.  But faithfulness in this respect may not get you through the Pearly Gates.

Maybe the Retail Investor is Retiring

A persistent trend for the past three years is that retail investors have been bailing out of the stock market. Even now, with the market reaching new post-2008 highs, individual investors continue their exodus. Stock market pundits scold shrilly, pointing out that these wusses have missed out on the big rally of the past six months. The same wusses are deemed to be short-sighted for piling into bond funds at a time of historically low interest rates following a 30-year bond market rally. The pundits pronounce retail investors foolish, or worse.

But stock market pundits often get it wrong. Very few of them predicted the 2008 crash. Most don't have investment records that beat the S&P 500. Retail investors may in fact be acting very rationally. The oldest Baby Boomers are reaching retirement age--i.e., 65. It's accepted wisdom that investors should ease out of stocks as they get older, and shift into bonds to stabilize their portfolios. This portfolio shift was recommended long before the 2008 crash, and nothing that's happened since then has made it seem less than wise.

The volatility in the stock market, resulting from its domination by short term, big money, usually computerized traders, would like nothing better than plenty of retail participation. That would give the smart money more sheep to shear. But having been just recently shorn, Boomers and other investors may be less willing to buy into the hype. Prices of risk assets have painfully proven to be ephemeral. Real estate, on the whole, is still falling. Stocks are bipolar. Just because the Dow tops 13,000 doesn't mean its worth 13,000 or anything near that, not unless you plan to sell tomorrow. Retail investors--or at least the Boomers among them--may be gradually retiring. And this trend could continue for a generation.

Are Stocks Still a Good Investment?

The latest jobs report, on Friday, which revealed no net job growth, confirms what a lot of people suspected: that the economy is stalled out. The prospects for the future are guarded, at best. Businesses don't want to hire. Consumers don't want to spend. Political pressure from the right prevents further large scale governmental intervention. Except possibly by the Fed, and its options don't look appealing. The most it can hope for is that further money printing might puff up the financial markets and create a "wealth effect" to spur spending by the rich. But Tiffany, Hermes and Louis Vuitton don't employ that many people in America's heartland, so more money for the rich won't do much to revive the overall economy.

Are stocks still a good investment? Whatever the Fed does, it will have only a short run effect. QE2, announced a year ago, is already dissipating. If the Fed does QE3, it will likely have little or no impact beyond the months the Fed is running the money printing presses. After that, we'll probably stagnate again.

Japan's experience suggests pessimism. In the late 1980s, Japan had a real estate and stock market bubble that, if you can believe it, was more extreme than America's recent bubbles. Real estate prices went so high that people were taking out 100 year mortgages to pay for their homes. When it comes to encumbering future generations, that takes the cake.

The Nikkei 225 average peaked at 38,916 on December 29, 1989, and then popped a la Dow Jones Industrial Average circa 1929-1933. It eventually dropped below 8,000 (not a typo; we're talking a belly flop of more than 80%), and now putters around the 8800 level. Adjusted for inflation, that means the Nikkei 225 is still almost 80% below its all time peak. A minus 80% return for over 21 years is, no matter how you look at it, pretty stinky.

An example closer to home of the deleterious effects of an asset bubble is the Nasdaq stock market. The Nasdaq index peaked at 5,048.62 March 10, 2000. Since then it has dropped as much as 70% or so. It has never recovered more than half its peak value, after adjustment for inflation. Today, it trades around 35% of its 2000 peak, on an inflation-adjusted basis. A minus 65% return for 11 years is also pretty stinky.

The performance of other U.S. indexes isn't as bad as the Nasdaq. After adjustment for inflation, the S&P 500 trades around 54% of its all time peak on March 24, 2000 of 1527.46. The Dow Jones Industrial Average trades around 70% of its all time peak on April 11, 2000 of 11,287.08, after adjustment for inflation. Nevertheless, all of the major indexes are significant losers over the past 11 years.

Japan's government did a lot of the things the U.S. government has been doing since the 2008 financial crisis--deficit spending, money printing, zero interest rates, keeping downward pressure on its currency. None of it revived the economic locomotive that was the Japanese economy during the 1970s and 80s (although these measures may have prevented things from getting worse). The Japanese government protected jobs by keeping zombie corporations and zombie banks on life support. After ten or more years, the Japanese government began to eliminate zombie businesses. By the time it was done, however, the Japanese consumer was thoroughly beaten down, and China and other Asian nations had muscled into the export markets that Japan had previously dominated. While Japan remains a wealthy nation with a large export sector, it has limited potential for growth. Its stock market may not ever, in a time relevant to anyone reading this blog, recover its luster.

What of U.S. stocks? Economic growth is one factor crucial to future stock values--growth in America and growth overseas where U.S. corporations have markets. At this juncture, that's anyone's guess. Add to the mix downward pressure from Baby Boomers (in Europe and Aisa, as well as America) selling stocks to finance their retirements, and stocks appear to be a speculative bet. It is true that, after the 1929-33 crash, stocks recovered to about 50% of their pre-crash value after 21 years. But the enormous stimulus of wartime spending for the Second World War, plus the fact that America had most of the world's functioning industrial base immediately after the war, account to a large degree for that partial recovery.

Or course, not being in stocks means missing market upswings. If you buy today, you aren't paying the peak prices of 2000, but today's somewhat beaten down prices. Your basis is lower and future returns may be positive. It makes sense to have part of your portfolio in stocks. But don't think in terms of maximizing upside potential--that necessarily means maximizing exposure to downside risk. The past 21 years teach that risk of loss isn't a fictional bogeyman from fairy tales. You will lose money from time to time if you invest in stocks. But you may make some or all of it back, and perhaps enjoy net gains.

Put a good chunk of your portfolio in bonds and/or CDs. These investments add stability, and a bit of income. Reinvest the income (along with any dividends you get from your stocks) to get the benefit of compounding (for more on compounding, see http://blogger.uncleleosden.com/2009/09/if-you-love-compounding-compounding.html).

A portfolio invested 60% in stocks and 40% in bonds has historically performed pretty well in capturing most stock market gains while providing greater stability in value than stocks alone. As you get older, avoiding loss becomes more important than securing gains. So shifting as you age to a stocks/bonds and CDs ratio of 50-50, 40-60 and later 30-70 is prudent. None of this means you will necessarily make money. You may lose it. But you might lose more if you invest only in fixed income and money market instruments. Asset values, artificially inflated over the past 15 years by inordinate amounts of easy credit from central banks, have been deflating and may continue deflating for a long time. The only way to predictably increase your net worth is to save more. If you're nervous about the future, increase the amounts you're saving.

Stock Market Regresses

The stock market is behaving increasingly like a petulant teenager. It's moody, impulsive, flighty, delirious one moment, and despondent the next. Since the financial crisis of 2008, individual investors have fled while professional traders increasingly dominate. Today, computerized trading is a larger part of the market than trading by sentient human beings. Computerized trading to a large degree involves following trends (the stock market term is "momentum trading"). Does that remind you of high school?

Investing on fundamentals seems to be done more outside the market than in it. Look Warren Buffet's big deals--in negotiated transactions, he bought a railroad, and special preferred stock from Goldman Sachs and Bank of America. He doesn't bet big money (that is, big money for him) trading stocks.

The stock market has become a playground for professional traders, who use it for short term speculation. In that way, it has regressed back to the 19th Century. When the robber barons held sway, savers didn't put their money into common stocks. They made deposits in bank accounts and bought bonds. Common stock was viewed as a vehicle for gambling. The few stocks that savers might buy were those with a solid history of paying dividends, and perhaps preferred stock, which had rights to dividends superior to common stock but no voting rights. Either way, a stock's ability to deliver cash in the form of dividends was crucial to its attractiveness to savers.

The state of affairs today is comparable, with so much cash flowing into banks that at least one is charging large depositors for the privilege of making deposits. The U.S. Treasury market is rallying from the flow of funds out of stocks and into safe havens, in spite of S&P's downgrade. There remains some investor interest in stocks that are proven dividend payers. Otherwise, the thrill of capital appreciation is increasingly left to the Wall Streeters who let their computers do the trading.

The Federal Reserve's relentless campaign to crush all interest rates attempts to coerce savers to put their money into riskier assets, in the belief that if savers lose their life savings to market volatility, the economy will somehow recover. But the Fed seems to be missing a basic point about investing. It's done when savers have confidence in the investment. When savers think the putative investment is a tractor trailer laden with bullswaggle, they won't send in a buy order. Making savers feel poorer by taking away their only safe sources of interest income will make them more insecure, spend less and swear off stocks. People who can stash some of their savings in secure, income generating vehicles are more likely to risk other savings in stocks. People who are repeatedly frustrated in their quest for a port in today's financial storms won't unfurl the sails and hope that the gale will somehow propel them to calmer waters.

The Fed seeks a wealth effect by using lower interest rates to support and bolster stock prices. The problem is that lower interest rates make savers feel less wealthy, especially retirees who count on their savings. Has the Fed netted out the discouragement to savers it imposes against the encouragement it gives to stockholders? Since many people are both savers and stockholders, they'll net out the impact, understanding that you can never recoup interest that didn't accrue during a time of low rates, but that stock gains may be ephemeral. Then they'll boost spending--or not.

With the advent of derivatives, computerized trading and no end of structured financial products that are too complex for battered investors to truly understand, it's easy to overlook the regressing of the financial markets. But with that in mind, is it any wonder individual stock market investors are becoming an endangered species?

The Next Two Months: A Most Dangerous Time for the Financial Markets

We're now in the interregnum, with a Democratic President-elect to replace the Republican lame duck two months from now. The Republicans, grumpy about being clobbered in last week's elections, aren't eager to take up Democratic initiatives, like a bailout of GM. Treasury Secretary Hank Paulson has put the $700 billion bailout plan on hold. About $290 billion of it has been committed to supporting banks and other financial institutions, primarily through capital infusions. Another $60 billion is authorized to be spent by Treasury, but remains uncommitted. The rest of the funds, $350 billion, cannot be spent without further approval by Congress, and Paulson doesn't plan to ask for it. While the Federal Reserve and Treasury can use existing authority to lend to and invest in financial institutions, there won't be any significant new initiatives by the government until Barack Obama is sworn in.

In today's hyper volatile stock market, two months is a lifetime. The market dropped 17% in October. What will November be like? Within the past two and a half weeks, the market rose almost 20%, dropped 14% and then rebounded 7%. If there's one thing we've learned in the last six months, it's that we have no idea what will happen tomorrow, let alone next week or next month. This year, entire nations--like Iceland, of all places--have become insolvent. All the major investment banks in America have disappeared or been converted into commercial banks. Almost all major commercial banks in America have received capital infusions from the federal government. AIG, the nation's largest insurance company, has been virtually nationalized. The U.S. government, by taking control of Fannie Mae and Freddie Mac, effectively runs the mortgage business in America. Europe is on the ropes, with the Euro dropping like a rock against the dollar. Oil prices have been manic depressive. The recession, in America and overseas, promises to be worse than we expected yesterday.

Today's 552 point jump in the Dow may appear positive at first glance. But it seems to be mostly speculative frenzy. Not only did stock prices rise, but so did oil and wholesale gasoline prices. That doesn't make sense, since an increase in energy costs would only depress an already weakened economy. However, this kind of price activity could be explained as bottom fishers buying up any asset that has recently dropped a lot--in other words, speculation. Some market mavens claim there is a floor to stock prices at the 8,000 level of the Dow, because the market has twice hit that level this fall and rebounded. But it's risky to believe in talismanic stock index levels. Looking at the underlying economics makes more sense.

Good things could happen during the next two months. The sharp drop in oil prices may stimulate consumer spending, which is now lagging badly. Perhaps--just perhaps--truck sales might increase a bit, giving GM, Ford and Chrysler badly needed profits. The stronger dollar may bring in foreign investment, supporting U.S. stock and other asset prices. Japan and China may infuse capital into the IMF, which could lend it out to smaller nations with faltering economies and soften the worldwide recession.

Bad things could happen during the next two months. Consumer credit is tight and could easily get tighter. Consumers have started to realize that they haven't necessarily never met a debt they didn't like. They're deleveraging. That means lower consumption, which will lead to higher unemployment.

GM could go into bankruptcy. The outcome of such a bankruptcy is extremely difficult to game out. It's possible GM could successfully reorganize. But it's also possible that, with the auto industry severely burdened by overcapacity, GM wouldn't be able to attract enough new capital to effectively reorganize. The uncertainty of the situation would probably depress stock values, since the market hates uncertainty.

Housing prices could continue to drop. There is no reason to think that they've bottomed out. The Bush administration's latest mortgage relief proposal might help 10% of the homeowners who are underwater on their mortgages. And it wouldn't help those that are already in the foreclosure process, which includes a lot of homeowners. Mortgage rates are, if anything, rising.

Corporate earnings could fall more than expected. That's certainly been commonplace in the third quarter of 2008, as the nation and the world have slipped into recession more quickly than initially thought. Beginning in early December, we'll start getting indications as to how the winter earnings season will go. Much more information will come out in the two weeks before the Inauguration. The picture might be grim.

Thus, the next two months will be a most dangerous time for investors. There will be plenty of risks and no hope of any new major government initiatives to offset the risks. Don't think today's 7% market jump means much. Buy stocks, if you're feeling bold or your investment horizon is way off in the distance. Don't invest anything you can't afford to lose. At the same time, don't lose heart. There's nothing about the current economic crisis that tells us the U.S. can't recover. Recovery may be a ways away. But things were a whole lot worse in the 1930s. This, too, will pass.