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Comments on Q1 2012

Equities got a year's worth of return in the first ninety days of this year, but the glide path that took us there was not encouraging. We take what we can get, however, we have not had a recovery:

The current recovery began in the second half of 2009, but economic growth has been weak. Growth in 2010 was 3% and in 2011 it was 1.7%. Who knows what 2012 will bring, but the current growth rate looks to be about 2%, according to the consensus of economists recently polled by Blue Chip Economic Indicators. Sadly, we have never really recovered from the recession...During the postwar period up to the current recession (1947-2007), the average annual growth rate for the U.S. was 3.4% - The Worst Economic Recovery in History

Money supply is growing at nearly 10% p.a., and Fed policy is synchronized with foreign central banks. 

 Excess money supply transmitted the infusion to financial asset prices. Enjoy the ride in equities but absent real economic growth, it's illusory.

 Inflation is picking up:

Zero bound nominal rates have masked negative real US interest rates which have moved significantly lower, by almost 1% across the curve from one year ago:

M2 velocity is droping like a stone which may evidence to the Fed that macro economic behavior is hard to manipulate.  The attempt to force investors out the risk curve is apparently having some unintended consequences on commercial/money demand. As we've said before this is not good, if not very bad. Do not most recoveries evidence a demand for money?

We do sense some tectonic movement in the economy, some upwards drift, but we won't call it a recovery for it is not. Meanwhile, just as the Fed has done everything in its power to force investors out the risk curve, and we include in its targeted audience unsophistocated retail investors who neither understand nor can tolerate the risk of duration, do we see the beginnings of a burst in the bond bubble? Think of the red line below as the bonds owned by your insurance company, bank, or pension. Think of the losses in terms of their capital.

This may turn out to be a false start, but we do know that when it starts it will be Only the Beginning of a long and destructive bear market in bonds.  Don't even think about pensions who own massive amounts of bonds and who further plan on earning 8% on their portfolios. And certainly don't think about the elderly living on fixed income or the young or the freshly retired or fired who can not prudently tolerate equity risk as they start to accumulate what precious little capital they can. We lay this at the feet of the Fed, and fully anticipate a continuation of the cycle of good economic number  -> bad number -> leaked chat of the next round of QE.

Oh, and speaking of the Fed, did we mention oil prices?

 We're not too concerned and tend to agree with Mr. Brusca.

We now know the risk in oil. It has geopolitics, domestic politics, corporate politics and maybe a touch of economics hidden there some where. Oil prices do threaten the economy but not through $4/gallon gasoiline. The economy is coping and will cope with that, it's all the other stuff. And that my friend is still in play. The Fed still needs to show us that in the wake of the oil spike and its own balance sheet blowup it will not repeate the monetary mistake of the 1970s. That is one of the most devious aspects of oil, it entices policy makers to play with it and that is where the real danger lies. Watch that. - Oil shock is a real shock and bigger than a bread box

We do note with optimism the political significance of the country recognizing the clamity of what passes for domestic energy policy.

All these issues pale in importance when compared to the problem of managing our unfunded liabilities and federal debt. The other factoids will be irrelevant because like Icarus, if you get too close to the limit, you can not recover.

 source: Paul Ryan's budget plan, PONR added by ed


And how will this be fixed? People will vote in November 2012.

We remain convinced of our fixed income bias to short duration corporate spread product. We view TIPs as an unsatisfying but helpful component. We remain skeptical as to who's keeping score of inflation.  Long duration Treasuries remain a viable uber hedge against deflationary calamity, but frankly we sense there is more opportunity on the liability side of that trade. We simply lack confidence in the Fed, and we keep staring at it's balance sheet. We are furious at what we consider to be the abusive, and we would argue unlawful, transfer of wealth from savers/investors to borrowers.

On to equity: corporate infrastructure is the most efficient it has been in history. Any aggregate uptick in the top line will translate into an object lesson in operational leverage. Buy low comes to mind for the long term investor with any confidence. Europe stinks and everyone knows it. From that we conclude there is no informational advantage (we set aside, of course, the whole new & exciting asset class of returns based on soverign or regulatory inside information).  The Eurocrats have decided to lower the standard of living of all their citizens, and they will do it, but consider that one is buying EPS, not real GDP/capita. We're considering slowly revisiting under weighted positions over time.

As to domestic equity consider the hypothesis of a fundamental shift in long term investor expectations to declining real energy costs driven by US production. Consider the geopolitical impacts on foreign and often hostile sources of supply that have long been subsidized by ill considered US energy policy. Consider the impact of essentially decapitalizing them by a transformation of US & North American supply. Now add to that some sensible tax reform and start to remove some of the destructive regulatory burden placed on business. This delerium, if continued, begins to take the aroma of a bull market and not just here. The aphorism: buy on the sound of cannons, sell on trumpets?

But to get there we first have to decide whether we want to be a market & innovation driven economy or an economy based on redistribution of declining stocks of wealth.  In the meantime the debt will compound, the spending will compound, the demographics of the country will age, domestic capital formation will stagnate, investment will decrease, interest rates will go up (barring another recession), and investors will look for ways to mitigate the morass of financial & regulatory oppression.

Lastly, we have a new gizmo, a slide show (below, includes those above ... and two important ones not above). We think the pictures are a little small. Please let us know if you think so too.


Reader Comments (1)

Spot on commentary....Things are getting better because they are getting worse slower!!!..I am pessimistic..
April 17, 2012 | Unregistered CommenterRichard A Erlanger

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