Post on 06-Apr-2018
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DAVE JANNY JULY 2016 INVESTMENT LETTER
2016 Volume 7
“TAKE A STEP BACKWARDS TO TAKE TWO STEPS FORWARD”
If you have a mechanical problem with your car, it would be best to stop driving and pull over into a
garage to get your car fixed before you continue to drive forward. Effectively, you’d be “taking a step
backwards” to insure that you can eventually safely go forward. Similarly, if you’re headed somewhere
and you find yourself having taken a wrong turn, it would be best to go back and figure out what the
“right” way is before you further veer off track and get lost. Thus, the expression, “take a step
backwards to take two steps forward”. Simply put, you understand you have a problem and you try to
fix it before you keep haphazardly hurdling forward.
If I were creating the platform for a new national political party today, I would use “take a step
backwards to take two steps forward” as the central theme for the platform. In the “instant
gratification” and “short term thinking” world that we live in today, it would probably be political suicide
to adopt that theme. Politically, it would be close to impossible to win an election that way, despite the
fact that it may be the exact right strategy the country needed. No one wants to take a step backwards
and take a long term view of things even if things are broken or we are lost.
But wait a second, maybe things are really broken! Maybe, more people will be contemplating the idea
of “taking a step backwards”! The “Brexit” vote may be the first significant example of people voting to
“take a step backwards”. I’ll explore this idea with some thoughts, articles and analysis on the “Brexit”
amongst other things. I’ll also provide more evidence, as I’ve been doing in all my Investment Letters
since last year, of why I feel that things are broken economically around the world and why we’re lost.
My overarching investment thesis is that we are in a central bank bubble. Central banks keep pushing
forward with more and more aggressive intervention that is obviously not producing the desired results.
The clock is ticking, but the bubble hasn’t burst yet. There are some signs that confidence in central
banks has been waning. More people (voters) are starting to question the actions of these central banks
and the “status quo” policies of the governments they represent. It may be a good idea for central
bankers to start to contemplate the idea of ”take a step backwards to take two steps forward”.
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In the meantime, the “risk on” vs. “risk off” battle of the markets continues with “risk on”, surprisingly in
vogue after the Brexit . Don’t be fooled by short term moves. Despite the continued possibility of further
stock market rallies, there are some glaring inherent risks in the markets that at some point can be
realized in a potentially big way. I’ll support those views in this Letter with plenty of pertinent thoughts
and comments from some of the resources that I regularly utilize.
THE”BREXIT”
What do British government leaders (former), EU leaders, the IMF, President Obama, Japanese
President Abe, Chinese President Xi Jinping and central bankers all have in common? They have two
things in common. Firstly, they urged British citizens to vote to “stay” because many bad things would
happen if they voted to “leave”. Secondly they were all part of the “status quo”. The”Brexit” vote was a
referendum against the “status quo”. It is a “status quo” that tells us everything is “good” despite the
fact that economic growth has been subpar and continues to struggle in basically all corners of the
globe. It is a “status quo” that continues to increase global debt at a staggering pace without any
commensurate economic benefit. It is a “status quo” that includes central bankers who are running the
largest financial experiment in the history of the world. It is a “status quo” that continues to implement
more of the same policies that aren’t working. It is a “status quo” that is responsible for the “wealth
gap” widening at a historic and alarming pace where the “elite” are doing well at the expense of the rest
of the population. There is no income growth for people not in the “elite” class. This lack of income
growth can become a bigger and bigger issue.
The “Brexit” squarely represents a threat to the EU. The EU is basically a large unelected bureaucratic
body of government that represents the views of the “elite” or entrenched political class. They are
making decisions for a wide range of members on far ranging issues from monetary policy to
immigration policy. These decisions are not a “one-size fits all “. The euro currency is not necessarily a
“one-size fits all” solution. The currency wasn’t even an issue for the Brits and they still voted to “leave”.
Rifts amongst EU members on some of these issues have been increasing. Overlay on that the fact that
economic growth continues to be difficult and the aforementioned “wealth gap” continues to widen,
and it’s pretty easy to see why the “Brexit” could lead to other defections from the EU. The Brits felt it
was better to “take a step backwards to take two steps forward”. Ironically the large British pound
devaluation actually represents a big short term positive for the Brits generally at the expense of the EU.
Keep in mind that currency devaluation has been one of the main goals of all global central bank policy.
The threat of other countries feeling the same way is certainly rising.
In the 6/26/16 edition of Mauldin Economics “Outside the Box”, highly regarded geopolitical analyst
George Friedman of Geopolitical Futures (formerly Statfor), does a great job following up on some of my
thoughts:
http://www.theboxisthereforareason.com/wp-content/uploads/2016/06/This-Week-in-Geopolitics-Is-
Brexit-the-End-of-the-EU.pdf
POST “BREXIT” REACTIONS, HEADLINES AND HELICOPTERS
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The lead up and subsequent market action around the “Brexit” has been very interesting. Most political
and investment pundits were warning of dire market consequences in the event of a vote for “leave“.
Despite the fact that polling was close right down to the end, most experts expected the Brits to vote to
“stay”. The “leave” result was certainly a surprise. The first two days caused a huge decline in the British
pound and a sharp negative global stock market selloff. At the same time, global government bonds and
gold rallied. Then came the warnings of further widespread central bank interventions and guess what?
Stocks rallied.
A 7/4/16 article in Action Forex put it this way:
“A strong sense of relief elevated the global markets during trading on Monday
with major stocks showing stability as expectations mounted over central banks
intervening to quell the post-Brexit chaos.”
Porter Stansberry of the Stansberry Digest in his 7/11/16 edition had these comments after Japanese
Prime Minister Abe’s party election victory:
“Just as we predicted, the Japanese government is set to "do more"… Following an
election win over the weekend, Japanese Prime Minister Shinzo Abe ordered a new
fiscal stimulus package. He didn't share details on its size, but news service Reuters
reports it will be more than 10 trillion yen (about $100 billion). In addition, current
Bank of Japan ("BOJ") Governor Haruhiko Kuroda met with former Fed Chair Ben
Bernanke over lunch in Tokyo this morning.
Bloomberg reports the BOJ did not issue a statement on the substance of the talks,
but it's believed that Bernanke was there to discuss "monetary-financed fiscal
programs." These are a form of so-called "helicopter money," where the central
bank prints new money out of thin air and gives it to the government to spend
directly.
But Japan may not be alone in seeking new stimulus measures for long… A
separate report from Bloomberg shows Europe may soon have to expand its QE
program. Because of eurozone rules, German bonds must make up the largest
percentage of the European Central Bank's ("ECB") QE bond purchases.
Unfortunately, nearly 70% of Germany's $1.1 trillion in sovereign debt is no longer
eligible to be purchased today. This is because the yields on these bonds have
plunged below the ECB's short-term rate of -0.4%. Said another way, the ECB is
literally running out of bonds to buy. Don't be surprised if the ECB soon follows
Japan… and begins buying stocks as well.”
The Key phrase from the above excerpt was “helicopter money”. Here’s why ( from Investopedia):
DEFINITION of 'Helicopter Drop (Helicopter Money)'
Also known as helicopter money, a helicopter drop is a hypothetical,
unconventional tool of monetary policy that involves printing large sums of money
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and distributing it to the public in order to stimulate the economy. Helicopter drop
is largely a metaphor for unconventional measures to jumpstart the economy
during deflationary periods. While “helicopter drop” was first mentioned by noted
economist Milton Friedman, it gained popularity after Ben Bernanke made a passing
reference to it in a November 2002 speech, when he was a new Federal Reserve
governor. That single reference earned Bernanke the sobriquet of “Helicopter Ben,”
a nickname that stayed with him during much of his tenure as a Fed member and
Fed chairman.
So “helicopter money” (basically giving money to the people) is the next frontier of “extreme” central
bank intervention and quantitative easing. It is where central banks are threatening to go after they
recognize that even negative interest rates are not enough. The speculation was that this is what that
Bernanke/Kuroda meeting was about. Therefore, in the warped current world of “bad news is good
news” investing, I believe this was a catalyst for the latest market rally move. Short term thinking
without regard for long term consequences is again the order of the day. Here’s the Bloomberg account
of the meeting:
http://www.bloomberg.com/news/articles/2016-07-11/japan-turns-again-to-bernanke-as-fruits-of-
abenomics-wither
Value Walk did a 7/11/16 story on a Jeffries research report on the topic of Japanese “helicopter
money”:
http://www.valuewalk.com/2016/07/helicopter-money-explained/
Scott Minerd who is the sharp Chief Investment Officer at Guggenheim investments put out this
prescient note on the potential for Japanese “helicopter money” on 5/26/16:
https://www.guggenheiminvestments.com/perspectives/macro-view/why-the-g7-may-be-hastening-
helicopter-money
That brings us back to Europe. The ECB has already relaxed rules to be able to buy corporate debt. It
doesn’t seem to be that much of a stretch to be able to buy stocks like the Bank of Japan (BOJ, People’s
Bank of China (PBOC) and Swiss National Bank (SNB) are doing. We’ll see over the short term if the BOJ
can live up to elevated market expectations for more radical intervention. Saying that global bond and
stock markets are distorted due to central bank intervention would be an understatement. David
Stockman has written some terrific articles at his website, David Stockman’s Contra Corner, about this
distortion. Here are a couple of excerpts from his 7/1/16 article entitled “Price Discovery, R.I.P.”, that
discusses just how distorted Stockman thinks the current state of central banking intervention and
investing has become.
Between the $21 trillion already owned by the central banks, and the trillions more
held by front-running speculators who expect them to buy more, there is a big fat
thumb on the scale; and, as a consequence, there are hideously large and unearned
windfalls being captured by these same speculators.
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Needless to say, the vast falsification of sovereign debt prices has not happened in
a vacuum. It has caused a massive scramble for yield among bond managers and
homegamers alike which in turn, has distorted and deformed the corporate debt
markets like never before.
Much of the headline news since the “Brexit” has not been very good. A number of UK commercial real
estate funds have halted redemptions for investors. The Italian banks are really struggling with bad debt
and the Italian government and the EU are debating ”bail out” vs “bail in” proposals . The bottom line is
Italians banks have plenty of bad loans on the books. These headlines are reminiscent of headlines that
we saw during the financial crisis. So approximately 8 years and trillions of dollars of central bank
intervention later, we’re still in the same boat. As I’ve stated before, there were plenty of stock rallies in
2007 and 2008 before the final March 2009 bottom. Don’t let rallies fool you into thinking that things
are “fixed”.
Former Fed adviser and now proprietor of Money Strong LLC, Danielle Martino Booth, has been
generating some great economic and market observations (I’ve included her work frequently lately). She
put out another a great piece on 6/29/16; this time on the political, economic and banking issues facing
Italy aptly called “The Italian Job”. Read it to understand the issues facing Italy and the significance of
the national election in Italy coming up in October:
http://dimartinobooth.com/the-italian-job/
THE CASE OF THE DIVERGENT JOBS REPORTS
On July 8th, 2016 the Bureau of Labor Statistics (BLS) report the widely followed June Nonfarm Payrolls
report and revised the May report. The June report came in at 287,000jobs while the May report was
revised from 38,000 to only 11,000. Talk about outliers, how could the disparity be that large from
month to month? It’s tough to take those numbers seriously, especially when there is so much ill-
advised short term market focus on them. The report supposedly sparked a stock market rally. Morgan
Stanley U.S. Economist Ted Wieseman had a more realistic take. (Morgan Stanley Economic Data
Bulletin, 2016)
“Mixed report. Nonfarm payrolls rose a larger than expected 287,000 overall, or
253,000 excluding returning Verizon strikers, but other key aspects of the report
were softer. With as much of an upside surprise as there was in June payrolls, it
was abnormal to see a net downward revision to May (11K v. 38K) and April (144K
v. 123K). Concurrent seasonals spread upside in the current month partly to prior
months, but that was offset this time by the underlying NSA change over April and
May being cut by 35,000. The unemployment rate backed up 0.2pp to4.9% from
4.7%. That partly reflected a reversal of a steep drop in the labor force in May, but
the household gauge of employment ‐‐ +67,000 or ‐119,000 after adjustment to be
more comparable with payrolls concepts ‐‐ was weak again, and the employment‐to‐
population ration fell for a third straight month. Average hourly earnings growth
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surprisingly slowed to 0.1%; aggregate earnings gained 0.3%, which will be close to
zero in real terms.
* In addition to the 70,000 swing from the Verizon strike, upside in payrolls came
from a number of areas that were quite weak in May doing better in June, including
construction (0K v. ‐16K), manufacturing (14K v. ‐16K), temp help agencies (15 v. ‐
19), and leisure and hospitality (59K
v. ‐3K). Stronger results were also seen in retail (30K v. 3K), healthcare (58K v. 48K),
and government (22K v. 17K). With the June rebound, the average payroll change in
Q2 came to a four‐year low of 147,000, down from 196,000 in Q1 and 282,000 in
Q4.”
The key point to note is “the average payroll change in Q2 came to a four‐year low of 147,000, down
from 196,000 in Q1 and 282,000 in Q4.” Doesn’t sound that good, does it?
COMPARING STOCK MARKET PERFORMANCE
Let’s look at the stock market impact of some of the news that I’ve been writing about. You would think
that, with the continued unprecedented central bank interventions, most global stock markets would be
doing really well. Despite the recent rally, not so much. Take a look at these charts:
EUROPE
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The Euro Stoxx 50 (broad Europe), the DAX (Germany) and the FTSE (UK) are all at or below where they
were at the beginning of 2014. Incredibly 2 ½ years of aggressive ECB monetary policy hasn’t help
European stocks too much.
ASIA
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The Hong Kong Hang Seng, the Nikkei (Japan) and the Shanghai indices all trade materially lower than
where they were in 2015. Here’s an interesting fact to ponder, according to Wikipedia, the all-time high
for the Nikkei was 38,957 on 12/19/1989. Yes, 1989. By the way the 7/14/16 close for the Nikkei was
16,497 almost 27 years later.
United States
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Our markets have fared a little better since the beginning of 2015, but certainly not much to get excited
about. Some indices have done better than others. The DJ Transports., The Russell 2000 and the Nasdaq
Composite have not taken out their 2015 highs. The DJ Transports are still more than 10% off the high
they achieved in 11/14 (further back than in the above chart). The Russell 2000 peaked 6/15 while the
Nasdaq Composite peaked 1/15.
The S&P 500 and the DJ industrials just eked out new highs this month. These two indices are a little bit
of a mirage and make the markets look better than they really are. Since the 2/16 lows, it seems a
narrow swath of large dividend paying blue chips stocks have benefited those two indices. Investors
have gotten caught up in a “chase for yield”. The outperformance of those types of stocks (usually
slower moving) has outpaced the broader market in a big divergence. I’d be cautious with those types
of stocks because they may have gotten ahead of themselves on a valuation basis.
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MY DEFENSIVE ASSET ALLOCATION CLASSES
CBOT 30 Year U.S. Treasury Index represents long dated U.S. treasuries. The NYSE Arca Gold Bugs Index
is an index that represents exposure to precious metals miners. Since I started my Investment Letters
(mid 2015), long dated U.S. treasuries and precious metals miners, are asset allocation classes that I
have consistently preferred. They have outperformed the market in a meaningful way and I continue to
feel that they can be a better place to be than the other stock market indices shown above.
MORE AND MORE NEGATIVE RATE BONDS
It’s interesting that, generally speaking, global bond markets have outperformed stock markets.
According to the Daily Economist the amount of global bonds now trading at negative rates is $13
trillion. http://www.thedailyeconomist.com/2016/07/global-bonds-at-negative-yield-reach-13.html
That is absolutely mind boggling. The only reason to buy a negative yielding bond is because you think
the rate gets even more negative and you expect capital appreciation. There could be a currency
component as well, but price appreciation is definitely the motivating factor. Anyone that intends on
holding the bond to maturity would not buy it. Realistically individual investors aren’t buying these. I
believe the only people buying or holding these bonds are speculators and central banks. I believe the
speculators are front- running the massive ongoing bid that central banks have in place to continue to
buy these bonds. At $13 trillion dollars, it is one hell of a large speculation. Talk about insanity. Talk
about a bubble. How could things possibly be good? How could this possibly be unwound without dire
consequences?
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Peter Boockvar is the chief market analyst at Lindsey Group. He is highly regarded and frequently
interviewed. Here’s a portion of a 7/8/16 Yahoo article by Brian Price about Boockvar’s view on negative
rates:
“One of the most crowded trades on Wall Street is about to implode, says one
market watcher. “We’re in an epic bubble of colossal proportions,” Peter Boockvar,
managing director and chief market analyst at The Lindsey Group, said Tuesday on
CNBC ‘s “ Futures Now ” in reference to the fixed income market. Global yields have
been tumbling to record lows, with many dipping into negative territory. The U.S.
10-year (U.S.: US10Y) hit its lowest level ever this week as traders continue to seek
safety in the bond market. Yields move inversely to prices.
“However, Boockvar believes that this activity is a ticking time bomb for the global
economy. He reasoned that U.S. Treasury yields are being dragged down by
negative-yielding debt out of Germany, Japan and Switzerland and misplaced
monetary policy, and is therefore skeptical as to how much longer the rally can
continue. “It could be central banks that end this,” said Boockvar in regard to
upward momentum for bonds. In his recent coverage, he reacted to the newly
released FOMC minutes and further questioned the Fed’s ability to act effectively.
“They’ll call it being ‘patient.’
In Europe, concern for Italy’s economy continues to rise as that nation struggles to
maintain negative interest rates while simultaneously raising capital for its banking
system, which is straddled with mounting debt. Maybe Italian banks are telling us
that central bankers and their negative interest rate policies are actually destroying
the Japanese and European banking system?” asked Boockvar in the CNBC
interview. He reasoned that Bank of Japan Governor Haruhiko Kuroda and
European Central Bank President Mario Draghi could take a look at what’s
happening in Italy and decide that their respective monetary policies are the wrong
course of action. Ultimately, Boockvar warned of the fallout that could occur if
multiple nations opt to end what he referred to as a “negative deposit rate regime.
”“Even if they put it back to zero, imagine the carnage, at least in the short-term
bond markets,” concluded Boockvar.”
Compare negative rates to U.S. Treasuries; this why longer dated U.S. Treasury bonds have continued to
rally. If that remains the trend, yields still have a ways to go before they approach zero or negative.
OFF THE RADAR CHINA
As I’ve noted in past Investment Letters, China is the engineer of the largest debt binge the world has
ever seen. China has been very quiet on the news front recently. But in the shadows of all the other
global economic and market news, the PBOC has devalued the yuan even more than it did last summer.
The August 2015 stock market correction occurred with yuan devaluation in the headlines. In 2016 the
devaluation has been achieved in much smaller and gradual increments. Stay tuned. This could still turn
into big news as the slowing of the Chinese economy amidst continued debt accumulation and
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manipulation of bad debt continues. Two market prognosticators on this topic that garner much
attention are Kyle Bass and Andy Xie. Bass is the CIO of hedge fund Hayman Capital Management. Andy
Xie is a former World Bank and former Morgan Stanley economist who now provides independent
opinions. I urge you to read these two articles on their views on China. The China debt story is not going
away:
http://www.zerohedge.com/news/2016-07-01/kyle-bass-shares-stunning-thing-central-banker-once-
told-him
http://www.marketwatch.com/story/this-economist-thinks-china-is-headed-for-a-1929-style-
depression-2016-06-30
CONCLUSION
I continue to urge a cautious approach. There is no shortage of potentially negative catalysts out there
to change the current direction of this last stock market rally. If global economic weakness and further
earnings weakness persist, it will only be tougher to justify current U.S. stock market valuations. How
tough has earnings growth been for the S&P 500? According to a 7/8/15 Factset report by Sr. Earnings
Analyst, John Butters:
“As of today, the S&P 500 is expected to report a year-over-year decline in earnings
of 5.6% for the second quarter…. If the index does report a decline in earnings for
Q2, it will mark the first time the index has recorded five consecutive quarters of
year-over-year declines in earnings since Q3 2008 to Q3 2009.”
Stocks have rallied recently despite this. Central banks have no doubt distorted natural market cycles.
This is an already very long upcycle (3/2009) by historic standards. It could last longer than seems
reasonable, but don’t get caught up in the chase. Stay patient and defensive with exposure to U.S.
Treasuries and precious metals related plays. We will shortly be entering the seasonally tough
August/September/October stretch within the already- tougher May to October period. If I haven’t
already, I’d love the opportunity to review your portfolios that I am not currently involved with. Please
call me with any questions or observations. Enjoy the summer
David Janny Senior Vice President Financial Advisor NMLS# 1279369 Morgan Stanley Wealth Management 200 Nyala Farms Rd. Westport, CT 06880 203 221-6093
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with a divisor of 225. *We are using official divisor for this index
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