The Big Bad Wolf
Porter Stansberry smells inflation, and last month, Porter glimpsed two items that bolster this conclusion.
The title of this essay comes from one of my favorite Warren Buffett quotes. This one is taken from his 1988 annual report. It was written just after the great leveraged buyout and junk bond boom. Said Buffett, about volatile markets and people doing foolish things with OPM (other people’s money), "But we do know that the less the prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs." What would Buffett say about the Federal Reserve today as they do foolish things with everyone’s money? I’ll show you what I mean. But before we get to the facts about the Fed’s currency debasing, consider that Warren Buffett is now holding $34 billion in cash – with most of it in foreign currencies. In his previous 50 years as an investor, he’d never bought foreign stocks or currencies. Now he owns billions of both. He didn’t suddenly see the advantages of global asset allocation. He’s just doing his best to protect his assets from the confiscatory policies of the Fed.
Other notable money managers – the best in the business – have allocated heavily into cash and foreign securities too. Mason Hawkins of Longleaf Partners is the best mutual fund manager in the United States. He’s holding 25% of his fund’s assets in cash now, and his largest equity holding is Vivendi, a French media conglomerate.
Bill Gross, the "bond king," who manages $400 billion in bonds for PIMCO, says he’d own more foreign bonds if he could, but his funds’ charter prevents him. Meanwhile, he personally sold his own flagship bond fund and is buying commodities and, more recently, tax-free municipal bonds, another way of holding a cash-like asset.
Mutual Fund Buyers: Piling Into Stocks and US Bonds
Ironically, as the world’s best investors get out of stocks, move out of U.S. bonds, and move heavily into cash and foreign securities, Mr. and Mrs. Mutual Fund are still piling in. But that’s par for the course. Mutual fund buyers tend to have all their money in stocks and bonds at the market top and all their money in cash at the market bottom. They’re right on track once again.
In 1981, after a 15-year grinding bear market, Mr. and Mrs. Mutual Fund held 77.1% of their investable assets in money market funds (cash). Said another way, at the bottom of the market, Mr. and Mrs. Mutual Fund only held 22.9% of their investable assets in stocks and bonds.
Today the average mutual fund buyer holds 72.3% of his investable assets in stocks and bonds. Only 27.7% of his mutual fund assets are in cash.
This bullish level of asset allocation was only slightly exceeded at the last market top, in 1999, when money market fund assets, as a percentage of all mutual fund holdings, hit a cycle low of 23.7% (76.3% in stocks and bonds).
In their own ways, the world’s best investors and the world’s patsies are telling us it’s time to be cautious in stocks and bonds. Why?
Mutual Fund Buyers: Expensive Stocks and Inflation Don’t Mix
I began this year with a warning about the stock market and I’ve returned to the theme frequently over the last several months. I think it’s very important: Expensive stocks and inflation don’t mix.
And last month, I saw two things that make me think inflation is going to continue to grow and be a much bigger factor this year and next than most people realize.
The first thing I saw was research by Ed Yardeni on something he calls "Super Money." Super Money is a measure of global money supply. It’s the sum of the U.S. monetary base plus dollars held by foreign central banks. You can think of this as a good measure of the world’s supply of dollars.
It’s important to measure foreign dollar holdings as well as the U.S. monetary base because many of those foreign dollars are invested here, influencing our economy and our bond market. Specifically, foreigners now own 40% of all U.S. Treasury debt. Over the last 12 months, foreign central banks bought $198 billion of U.S. Treasury securities, financing 49% of the U.S. deficit last year (the largest annual deficit on record). Additionally, foreigners bought enormous amounts of U.S. agency debt (Fannie Mae and Freddie Mac) – a total of $170 billion in agency purchases in the last 12 months.
Federal credit creation (deficit spending) and foreign investment increases the money supply in the United States, which leads to faster rates of economic growth and inflation.
What’s worrisome to me is that "Super Money" is now growing at a faster rate than at anytime in the last 30 years.
It’s hard for me to believe that foreign central banks will continue to be such large holders of U.S. currency, especially considering that China is now the world’s largest buyer of U.S. government paper (debts).
China buys tons of U.S. paper in order to maintain its currency peg to the dollar. Eventually, the Chinese government will have to stop buying so many dollars and let the yuan rise in value in order to afford the raw materials China needs – oil in particular. When this happens, foreign central banks could begin selling their Treasurys. The result would be a financial catastrophe for the United States – a run on the dollar. That would cause drastically higher interest rates for U.S. consumers and businesses.
I’m not predicting this will happen tomorrow… but it should be clear to anyone with a brain that foreigners will not continue to subsidize our economy’s massive deficits forever. The most likely trigger for a reversal in foreign investment is the falling purchasing power of the dollar, especially in the market for oil.
These facts, combined with the skyrocketing, over 20% annual growth in "Super Money," mean investors must be on the lookout for rising commodity prices and higher interest rates.
We’ve already seen examples of both. Oil soared to over $44 yesterday. And U.S. Treasury bonds have just experienced their worst quarterly performance since 1980.
Mutual Fund Buyers: Not Paying Attention to Quantity
Looking at these facts, you might expect the Federal Reserve to make cautionary statements regarding money supply. It’s not. And that leads to the second scary thing I saw last month…
A report issued in June by the St. Louis Federal Reserve proclaims the supply of money is irrelevant to monetary policy. We found these views on the cover of the St. Louis Fed’s monthly publication Monetary Trends.
"Most central banks that were targeting money growth have stopped doing so," writes William Gavin from the Fed. "We no longer ask which measure of money is the ‘correct’ indicator for monetary policy. Instead, we directly examine measures of inflation and output for guidance about setting the stance of monetary policy."
"Since 1982, however, measures of the quantity of money have provided little useful information about the near-term outlook for spending or inflation," continues Gavin. "Our models and our discussions focus not on the quantity of money but on the purchasing power of the dollar."
Gavin concludes, "We do not have to pay attention to the quantity of money today because policymakers are paying attention to its price, by focusing on inflation and inflation expectations."
This is especially frightening because the Fed’s measures of inflation (primarily CPI) ignore many of inflation’s most important effects – such as asset price inflation.
The Fed took its overnight borrowing rate to a level unseen in the last 40 years (1%). And, thanks to the war on terrorism and Congress’ pork-barrel politics, deficit spending has soared. Meanwhile, Greenspan continues to insist that there’s little to no inflation in our economy. Apparently, he doesn’t consider soaring housing prices, a wildly expensive stock market and rocketing raw materials prices to represent inflation. And now the Fed is attempting to argue that the supply of money isn’t even a factor in the creation of inflation. They’re nuts.
Mutual Fund Buyers: The Money Supply Is Relevant
I can’t imagine a worse outlook for the future value of our dollar. Read the last paragraph of William Gavin’s report one more time: "We do not have to pay attention to the quantity of money today because policymakers are paying attention to its price, by focusing on inflation and inflation expectations."
Inflation, even measured by the Fed’s cross-eyed CPI measure, is running at about 3.5% right now. The Fed’s overnight interest rate is 1.25% annualized – nowhere near the rate of inflation. How can the Fed argue it is paying attention to inflation?
Gavin’s other comments are even more bizarre. How could anyone with more than a 10th-grade understanding of economics argue that the supply of money is irrelevant as an indicator of future inflation?
I’m not bearish by nature or philosophy. I’m sure things will be better in 10 years than they are now. Stocks could even be higher. But I can’t imagine a worse scenario for investors than the one I see developing right now.
Inflation is moving higher. But interest rates are still at near record lows. Prices for financial assets, real estate, stocks, and now commodities are at record levels. Yields on fixed income investments are not attractive, given the rate of inflation and the likelihood of it increasing. There’s almost nothing safe to do with your money… or anything to buy that’s likely to garner a good return.
There will be a time to speculate in stocks again – but it hasn’t arrived yet. Please, be cautious with your equity portfolio and don’t try to buy the dips…
We could still be a long way from the bottom.
for The Daily Reckoning
August 4, 2004
Tom Dyson, from 808 St. Paul St….
– Flippin’ Henry! Please forgive us, dear reader, if we’re beginning to sound like a broken record…but oil’s march to new heights continues. Yesterday light sweet traded up to $44.24, a level not previously seen in 21 years of trading on the New York Mercantile Exchange.
– OPEC’s president, Purnomo Yusgiantoro, prompted the move. He accused oil prices of being "crazy" and claimed that OPEC was powerless to do anything about it. "There is no more supply," he said.
– We cannot contain ourselves any longer. It’s time to short oil.
– Regular readers already know about the supply-side issues – we’ve been banging on about Yukos and terror threats and instability in Saudi Arabia for months. Certainly, these are grave concerns. But this "crazy" oil market has already fully discounted these factors.
– On the other side of the ledger, global demand has never been greater. Fueled by the lowest global interest rates and loosest credit of a generation, demand for oil is surging all around the world. The "emerging" populous nations, like China, India and Brazil, now have to compete with the "recovering" industrialized nations, like Japan, the United States and Euroland for energy. This is no secret.
– The case for high oil prices is easy, too easy. Therefore, today, your foolhardy Baltimore-based editor will go short by selling crude oil futures. As contrarians, we love to defy the market that thinks it has everything going for it. This seems to be just such a market.
– Moreover, here at Daily Reckoning HQ, we believe that, because of the existence of a cartel, demand, not supply, is the important dynamic in this market. And we believe that demand for crude will gradually give way as the global rebound falters. The recovery is a sham, we keep reminding ourselves. A bogus illusion conjured up by those insufferable monetary meddlers.
– Yesterday’s news provided yet another straw to the poor camel’s back. "Spending by U.S. consumers fell in June for the first time in nine months," reports Bloomberg, "as auto sales declined and incomes growth slowed." The decline in spending was the largest since September 2001.
– Mr. Market was none too pleased with the day’s news and oil’s spike. The Dow Jones Industrial Average shed 59 points to end the session at 10,120, while the S&P dropped 7 points, or 0.63%, to 2,000. The Nasdaq earns the day’s dunce cap with a 1.7% decline. Tech traders clipped off a hearty 33 points, taking the average down to 1,859 by the bell.
– Bond traders relished the soft data and pushed yields down. Thirty-year and 10-year rates both declined 3 basis points to yield 5.16% and 4.42%, respectively. Elsewhere, December gold futures rose $2.10 to close at $394.50 an ounce, while the dollar was off 0.2% against both the yen and the euro. The euro currently buys $1.2048.
– "What makes [investors] more than a little antsy these days," writes Alan Abelson in this week’s Barron’s, "is a nagging doubt as to whether the recovery is the genuine article. No secret, we suspect it isn’t." With second- quarter GDP slowing sharply, June nonfarm payrolls well below expectations and collapsing consumer activity, it’s not hard to agree with Mr. Abelson.
– And should the recovery wither, it follows that demand for oil must also wilt. Not that falling demand guarantees a fall in price – supply must also cooperate. But realistically, how much tighter can oil supply be? More strikes in Venezuela, more taxes in Siberia or more bombs in Saudi Arabia would all certainly do the trick. But the one thing markets react to more than anything else is uncertainty. We must now be close to the point of maximum uncertainty.
– Furthermore, an attack on the United States would probably cause oil prices to FALL.
– "After 9/11 people stopped consuming because of uncertainty," explains Tony Nunan at Mitsubishi Corporation in Tokyo. "If the target is a consuming nation, you would expect an attack to affect the market to the downside."
– Buy the rumor, sell the news? We shall see…
[Ed. Note: Most of Tom’s clever colleagues think oil is only going to get dearer. In fact, they have prepared a special report detailing their findings. It comes out on Friday. Keep a lookout!]
Bill Bonner, back in Albuquerque…
*** We had giant breakfasts at Manny’s on Central Ave. in Albuquerque, and then, after a visit downtown – to the Museum of Natural History – we headed east.
Our first stop was Cedar Crest, on the eastern slope of Sandia Crest Mountain. As a very young man, your editor had lived here. Not knowing what to do with himself, after trying his hand at journalism as the European correspondent for a magazine that went bust without ever paying him a dime, he decided to go into the building trade. So he designed and built – by hand – a house.
He realized, gradually, that he knew as little then about homebuilding as he does now about economics. Then, as now, he nevertheless persevered and ended up with a house that was vaguely interesting and habitable. He had invested about $7,000 – this was the early ’70s – and was later able to sell the house for what seemed like a fortune, $25,000. He should have held on. Today, houses in the area go for $250,000 to $500,000.
But at the time, he felt lucky to get away from it. His lack of building skills haunted him like a crime; he worried that he had made mistakes that would be difficult and expensive to fix. And he was happy to take up a new profession…if he could find one.
"Let’s go up to the door and introduce ourselves. We will get a better look around. And they’ll probably be interested to meet the guy who built the house," Elizabeth suggested.
"Uh…no, I don’t think that’s such a good idea," we replied. The house looked good. It looked solid. At least, it was still standing, which was almost a surprise. The second floor balcony looked out over a vast expanse of forestland; the view must have been a joy for the last 4 decades. But we wondered what misery and expense it had taken the owners to get it in this condition. We wondered how many times they had wished they had the builder in front of them so they could give him a piece of their minds. We wondered what a fool thing it would be to present ourselves now…and risk a barrage of 40 years’ worth of complaints.
"Nah…let’s get out of here," we suggested.
We got back in the car and drove up the back of Sandia Crest.
Even the blasé, jaded teenagers in the car -Jules and Henry – were impressed. We had been trying to get them to look up from their books and take a peek out the window.
"This may be the first and last time you ever seen anything like this," we told them.
"Like what?" was their response. "There’s nothing to see but trees. We’ve seen trees before. Big deal."
But once at the top, the views, and the altitude, took their breath away.
"It says here," Elizabeth began imparting knowledge to us, "that you can see 100 miles on a clear day. Also – this is interesting – we are so high up that the climate here is nothing like the climate down in Albuquerque. It is more like the climate you’d find in Hudson Bay, Canada."
Elizabeth is an improver. She improves us every chance she gets by herding us to museums, points of interest and monuments and lecturing us; for our part, we act like a gang of seventh graders, hoping the schoolhouse will burn down.
"Do you know," she went on, sure that none of her listeners could answer in the affirmative, "that the Spanish were driven out of New Mexico not long after they got here? The Pueblo Indians revolted. They had been made into something like serfs by the Spanish. But what set them off was when the Spanish forbid them to practice their religion. The Indian priests were accused of sorcery. Several of them were executed. Others were whipped. One of those who had been whipped led the uprising. They massacred hundreds of Spanish settlers and burnt their missions. They besieged Santa Fe…the settlers were lucky to get out with their lives."
Elizabeth was right about Sandia Crest. It was so cold at the top we couldn’t stay long. We took a footpath that ran along the top of the ridge, but we were soon too cold to continue. So we got back in our car and continued on the Turquoise Trail toward Santa Fe.
Albuquerque is a bright, shining, growing, spreading, lively, empty, tasteless, efficient, convenient, grid-based metropolis…green lawns and gravelly lots…parking lots… …aluminum, plastic, vinyl…new cars, new people, new houses…new shopping malls. It is the present…and maybe the future.
There are many words that could be used to describe it.
But when we got to the little town of Madrid, New Mexico, only one word seemed to work: funky. Without it, the town couldn’t exist.
Madrid is an old mining town that had become a ghost town by the mid-1900s. It was rediscovered by hippies in the 1960s. The hippies were attracted by the remoteness and desolation of the place. They could do what they wanted here; nobody seemed to care. They lived in old school buses, teepees and abandoned mining shacks. They planted marijuana in the hills, sold tie-dyed Grateful Dead T- shirts to the tourists, collected junk…and enjoyed watching tumbleweeds blow through town.
Nothing is quite straight in Madrid. The houses lean. The floors sink. The people drift.
The houses and retail shops deserve description. They are encyclopedic in their illustration of dereliction, degradation, abject desolation, disrepair, trashy disintegration and makeshift decrepitude. One of them fascinated us. It was a "company house," no doubt, built for the miners who once inhabited the place. But it had not been touched by a paintbrush since the Coolidge administration. Windows were broken out; in their place were pieces of cardboard or plywood. And the porch roof had been entirely ruined, so that rain fell directly onto the floor, which was fast settling into a kind of rot. Some of the houses in Madrid seemed to be suffering from dry rot. Others from wet rot. And still others from kinds of rot that have not yet been cataloged.
The Madrilenos seemed to be a bit rotten too. The old hippies still hate corporate capitalism, but now their hair has grown gray…their beards are white… and their principles, whatever they once were, have given way to the general desuetude of the surroundings. They sell whatever the tourists will buy…though their main product is the counterculture itself. A T-shirt, for example, proclaims: "Homeland Security…fighting terror since 1492." The picture on it is of Geronimo with a group of armed Apaches.
The Mine Shaft Saloon is a local hangout. It is a friendly place with a broad bar and dollar bills pasted up on the wall…each one with someone’s name on it. Country music plays loudly…
Several cowboys sat on bar stools drinking their beer, when we came in. The barmaid seemed as busy as a firefighter – trying to keep up with the demand for beer. Cowboys and tourists sat at the tables. One man in a Stetson hat leaned on a walker as he made his way to the bathroom.
One of the men at the bar was a typical and unmemorable fellow in jeans and T-shirt. Another was a strange, big- bellied character with black muttonchop whiskers and eyes that hadn’t seen straight in years. But what caught our attention was the woman who moved between them. Flirting with the first man…and then, when he ignored her…she moved onto the second. If it was a paramour she was seeking, she seemed to be in the wrong place. Then again, she seemed to be the wrong woman, too. She had tattoos up and down her arm…and wore a dress that took all the form out of her. This left the viewer’s eye with nothing to focus upon but the hideous tattoos…and the face.
The poor woman was no beauty. She was no young filly either. Not that she was old; she simply looked as though she had been ridden too hard. She had long dark hair…which framed a bad complexion and a missing tooth.
After a few minutes, she was joined by another woman of about the same age. This one had just come in from outside, where a thunderstorm had caught her. She was wearing a pair of overalls with the legs cut off…and a pair of hiking boots. Her hair was plastered down from the rain…her clothes were soaked…and water glistened from her bare legs. The slippery, wet legs were pretty and well shaped. In fact, the woman might have been attractive, but she too looked as though she needed a vacation, and a tooth.