Why It Is Good Not To Be First

April 30, 2010
By John M. McClure†

Our Monthly Performance Update
Dr. Howard Bandy Has Joined Our Team
An Important Change to Our Equity Allocations
The Most Important Charts of the New Century
Surfing the Money Tsunami
Bubbles of the Far Away Kind
Making Everyone Else Rich...
If You Can't Beat the Fed, Join Them
Interesting Reading
Spokane, Reno, and Orlando

The United States is very fortunate to have a front row seat to Europe's, and soon Japan's, sovereign debt crises.  Going through the second phase of the credit crisis will be difficult short-term, but learning hard lessons from our neighbors will soon turn our ship out of harm's way and ensure the long-term economic viability of the United States.  It's not that we're smarter than our comrades across the pond, it's just that our economic cycle is five to ten years behind theirs. 

When this sovereign debt crisis finally plays out, socialism as currently defined by Europe, will no longer exist.  As the book, The Fourth Turning clearly documented, humans have a nasty habit of hitting the reset button every 80 to 100 years.  The Romans and Greeks recognized and documented this destructive and rebuilding phenomenon in their own culture. 

This consistent cycle has been going on so long in human history, it appears that social recalibration is just part of human society.  It is almost like we can't help ourselves as we strive to throw out the old and bring in the new.  The last three 80-year cycles in American history are the Great Depression and World War II era, the Civil War and the Revolutionary War.  I sure hope this cycle doesn't involve people shooting at each other. 

Simply watching events play out in Europe is not enough on its own to cause the United States to change our debt-laden ways. There are a lot of very painful changes we must make to get us on the right track.  We are as guilty as the next deficit-induced country.  Change will occur only when there are no other choices, and watching Europe's demise just might motivate us to fix our problems. 

Here is a recent update from the United States Government Accountability Office (GAO):  "Roughly 93 cents of every dollar of federal revenue will be spent on the major entitlement programs and net interest costs by 2020."

When looking for clues to figure out a difficult problem, I try to find undeniable facts in the data.  With 93% of every tax dollar paying for entitlements and interest payments, our country cannot survive, so we have to change.  Don't be surprised if the Tea Party becomes its own political party.

The problem is so enormous that we can't simply tax our way out.  We must cut spending to the bone and raise taxes.  It will require both to survive as a country.  In government, it seems to require difficult circumstances to force change because politicians naturally avoid choices that are unpopular with their constituents.  Passing health care legislation will seem like a walk in the park when you have to sanction laws that reduce Medicare and Social Security payments to people who are just barely getting by.  The next 10 to 15 years are going to be history in the making.

I am encouraged by what I am seeing because of our front row seat.  The United States is going to benefit by not being first.  The process we are about to go through is going to be difficult, but in the end, these changes will make the United States stronger than we have ever been in the past.  I have pondered for months what the other side was going to look like and I now feel for the first time I understand how it is going to play out.  In the end, we either change or we become Greece.  Knowing America's glass half full culture, we will not become Greece!!! 

Welcome Dr. Bandy!
Before we jump into our fact-filled letter, I wanted to bring to your attention that I have recently hired Dr. Howard Bandy as Director of Research at ProfitScore.  Dr. Bandy is one of the best and brightest quantitative analysts in our business.  Dr. Bandy has been working with ProfitScore for months on a proprietary project used to adjust our portfolios based on regime changes in the market.  If you are curious, and want to learn more, please read the section below discussing Dr. Bandy and the recent changes to our equity allocation techniques.    

Quote of the month
"We used to think that you could spend your way out of recession and increase employment by cutting taxes and boosting government spending. I tell you in all candour that that option no longer exists and that in so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy, followed by a higher level of unemployment as the next step."
- Jim Callaghan, UK Labor Prime Minister in the 1970s (Economist, April 8, 2010)

Our Monthly Performance Update

This letter is later than normal due to the launch of our new equity allocation trading strategies.  Since I will be sending out April's letter in 15 days, I am going to scale down the performance section of this letter.  In summary, March and April were down months for our equity portfolios but positive for our fixed income strategies. 

For those that are interested in our portfolios monthly performance, please click on the portfolio links found in the top right hand margin of this letter.  The normal detailed performance reports will pull up once you click on the link. 

Dr. Howard Bandy has Joined Our Team

Dr. Bandy is very unique in this business because he is as bright as the sun but passionately believes experience trumps intelligence.  Working with excessively smart people can be a real challenge because they are overcome with confidence.  Dr. Bandy has been developing quantitative strategies since the early 90's and has learned how humbling this business can be.  When it comes to developing trading systems, he believes nothing and doubts everything until it can be statistically proven to be very significant.  His disciplined rigor is both refreshing and tiring for my brain.   

Dr. Bandy has written several books on quantitative investing, gets asked to speak around the world, and has a pedigree as long as your leg.  In working closely with Dr. Bandy, I have come to the conclusion that it's simply unfair to put all that intelligence in one person's brain.  If you want to learn more about Dr. Bandy, you can read more of his Bio by clicking on this link: 

Dr. Bandy is in the process of moving to Eagle, Idaho where he will lead our research efforts, developing better ways to use quantitative mathematics to manage risk and harvest profits for our clients.   

An Important Change to Our Equity Allocations

2009 was a disappointing year for our equity returns.  The market changed course in March and we did not participate in the move higher because our models and traders were trading a different market regime.  Looking at the charts in hindsight makes it seem obvious, but adjusting in real-time is anything but easy.  Dr. Bandy has helped us create processes to identify these changes and adjust our allocations accordingly.  Between Dr. Bandy, Mike Mann, and me, we have over 1000 man hours in this project and many sleepless nights.  The research got so intense, that it was not uncommon to wake up in the middle of the night to write down an idea you had in your dream, or simply get up because your mind wouldn't let you sleep. 

When your strategies are underperforming against the benchmarks you track, it is easy and dangerous to rush to conclusions.  As a quantitative money management organization, everything must be run by the numbers.  If it can't be quantitatively proven, then no changes are made!  This rigor, and Dr. Bandy's discipline, extended our time lines to make sure every possible scenario was considered.  In the end, we developed something more robust than I thought possible. 

Implementation of our equity allocation model went live late last week.  Our core discipline has not changed. We will continue allocating to multiple strategies and traders, but our methods for making these allocations have become much more adaptive.  Hindsight is always 20/20, so you can probably guess I wish I would have started this project much sooner so we could have participated in last year's powerful rally. 

Historical walk forward returns are impressive and the equity line charts are a thing of beauty, but the most exciting aspect of this new allocation methodology is the way it adapts to changes in the market.  By focusing our research on adaptation, we have built something that should stand the test of time. 

The system is not perfect and will of course have losing months.  Given our equity underperformance over the past several months, I am hoping Europe doesn't implode next month and cause an overnight collapse of the market in the first full month we go live. 

Heads Up
ProfitScore will be partnering with a Canadian-based portfolio manager to offer an exciting new quantitative-based stock portfolio.  More details will follow shortly on the strategy, including a white paper and information on how to invest.  I began trading the strategy in April, and it has significantly outperformed the indexes.  This project has been in the works for several months and I can't wait to offer this exciting new product.  Please expect more details on this strategy soon.

The Most Important Chart of the New Century

Figure 1 - Updated chart of the Money Multiplier (MULT) from the Federal Reserve. As of our last newsletter, the MULT was 0.788, which is the lowest reading on record so far. It has since come up, if ever so slightly, hitting a reading of 0.817 as of March 24, 2010.

Last month we discussed the incredible surge of the money in circulation, thanks to Federal Reserve efforts to reflate the economy, and examined the impact it is having on the economy. The money multiplier (MULT) measures how much the money supply (in this case M1 money supply) increases or decreases in relation to the monetary base (money in circulation as measured by the Adjusted Monetary Base or AMB - see Figure 1A).

Figure 1A - Bi-weekly chart of the Adjusted Monetary Base (not seasonally adjusted) showing explosion in the amount of money in circulation. 

As we discussed last month, the Adjusted Monetary Base has expanded nearly 250% over the past 18 months, but as the MULT chart above shows, this money is not being lent by banks to get it circulating into the economy.

This month we examine this relationship in more detail in an attempt to see how this trend is impacting the economy as a whole. It is a topic that the more relevant economists like David Rosenberg, Senior Economist for Gluskin Sheff, and Marc Faber, author of the "Gloom, Boom & Doom" report, have been watching carefully for good reason. It also tells us how well our economy is working.

This next chart from Nathan's Economic Edge blog was labeled "The Most Important Chart of the Century" for good reason (see link below). Marc Faber presented a similar chart at a Vancouver seminar in March 2009 with the same trend target for zero debt benefit by 2015. This chart and the money multiplier (Figure 1) are two parts of a similar puzzle.

Figure 2 - Chart showing diminishing productivity of debt. Chart courtesy of http://www.swarmusa.com/
Here is how Nathan explains Figure 2 on his blog:

"This is a very simple chart. It takes the change in GDP and divides it by the change in Debt. What it shows is how much productivity is gained by infusing $1 of debt into our debt backed money system.

"Back in the early 1960's a dollar of new debt added almost a dollar to the nation's output of goods and services. As more debt enters the system the productivity gained by new debt diminishes. This produced a path that was following a diminishing line targeting ZERO in the year 2015. This meant that we could expect that each new dollar of debt added in the year 2015 would add NOTHING to our productivity.

"Then a funny thing happened along the way. Macroeconomic debt saturation occurred causing a phase transition with our debt relationship. This is because total income can no longer support total debt. In the third quarter of 2009 each dollar of debt added/produced NEGATIVE 15 cents of productivity. At the end of 2009, each dollar of new debt now SUBTRACTS 45 cents from GDP."

So, what has caused this GDP/Debt ratio to come off the tracks six years ahead of schedule? Clearly, it is the result of skyrocketing public debt that has been taken on in a Keynesian attempt to reflate the economy.  But if Nathan and Faber are correct, instead of helping out the economy, these efforts are hindering it. And without herculean efforts to reduce public debt, we should expect below trend economic growth at best, continued high unemployment levels, and a deteriorating standard of living - in other words a situation similar in many ways to the conditions that have plagued the Japanese during their last two "lost decades."

Surfing the Money Tsunami

Reaching the goal of having sustained economic growth could be as challenging as shoveling water. However, that doesn't mean there won't be investment opportunities. While the Fed and government have been doing their level best to devalue the greenback in the name of quantitative easing, some asset classes have been surfing the reflation tsunami.

If what mainstream economists are saying about deflation being the greater threat were true, commodities (and commodity-rich economies) would be experiencing deflationary pressure too. However, as commodity-rich economies such as Canada and Australia clearly show, deflation is certainly not the problem if the values of their currencies are any indication. Take a close look at the next chart of the US Dollar-Canadian Dollar currency pair ($USD-CAD) versus the S&P500.

Figure 3 - Weekly chart of the $USD-CAD currency pair and its relationship to the S&P500 Index including the correlation (red) between the two.  Chart courtesy of http://www.genesisft.com/

This chart also reveals another very interesting relationship.  Over the last two years, the relationship between the USD-CAD and the S&P500 Index has grown strong, hitting negative 0.95 in April (a perfect negative correlation of -1 means that for every point drop in the USD-CAD, the SPX moved up a point). As the US dollar has dropped in relation to the Canadian dollar, US stocks have soared. On the flip side, periods of Canadian dollar weakness against its American counterpart were accompanied by falling stock values. A similar relationship exists between the $AUS-USD and the S&P500, which enjoyed a positive correlation of close to 0.95. Strong Canadian and Australian dollars have been good for US stocks.

Yes, US stocks have been rallying, but they were doing so at the expense of the USD to commodity-based currencies. It was another clear indication of the diminishing marginal productivity of debt.

What would happen if the US dollar was able to manage a rally? Would stocks pay the price?

Bubbles of the Far Away Kind

First, there was the Internet bubble. Next, was the property bubble. Although home prices across much of the US have since experienced their worst declines in history, there are troubling signs that another correction may be in the cards (see Shiller - "Don't bet the farm on a housing recovery" article below). In other words, the US bust is still very much in play.

I wonder how many of us in the USA are aware of what is happening to home prices in commodity-rich countries? Prices in a number of major Canadian cities are now higher than they were before dropping in the face of the approaching recession. In Toronto and Vancouver, the two hottest cities in Canada, average home prices recently hit new all-time highs. Just like the real estate bubble that happened here, they are courtesy of quantitative easing policies led by the Federal Reserve.

By April 2010, Vancouver's detached home prices had risen nearly 20% from their recession low in May 2009, and prices in Toronto are up nearly 15% over the same period. In the exclusive Vancouver West Side, the average price of a detached home surpassed $1 million in March for the first time ever. It has gotten to the point that qualifying for a standard low ratio mortgage (75% loan to value) on the average home in Vancouver requires 75% of the average income - worse than just about any US market at the peak in 2007! This has prompted action by both banks and the government to try and cool the market by cranking mortgage rates more than 60 basis points and increasing sales taxes on everything from new homes to real estate fees in Ontario and British Columbia.

Home prices in a number of Australian cities are similarly buoyant, prompting the Reserve Bank of Australia (RBA), the nation's central bank, to raise the key lending rate again to 4.25%. Brazil, another commodity-rich country (that has also been fuel self-sufficient since the 1970s), is in a similar situation.

Inflation is not just a problem in a few commodity-based economies; it is a world-wide concern. According to the latest Economist's commodity-price index (April 8), commodities around the globe have risen 29.9% from a year ago in US dollar terms. A basket of industrial commodities is up 78.3%, the Sterling (UK) all items commodity index is up 26.1%, the Euro index up 28.8%, gold is up 29.2%, and a barrel of West Texas intermediate has gained 76.8%.

If deflation were truly a problem, why have commodity prices risen so strongly and why are some nations being forced to raise interest rates to fight inflation? If inflation is dead, why are precious metals like gold, silver, and platinum again rallying with a vengeance? Technical traders will tell you that these charts all look very bullish indeed. Answer - inflation isn't dead, it's just been sleeping here. But in some parts of the world it has awoken and taken flight.

Making Everyone Else Rich...

Why, after spending trillions in stimulus, increasing the money in circulation 250%, and enacting a host of new laws that punish outsourcers and importers while rewarding companies that create jobs at home, are the greatest beneficiaries outside the USA?  After so much effort from so called "experts" trying to fix our broken economy, how is it that we now find ourselves in a position in which our very recovery depends on an ever weakening dollar to drive it? 

The answer to both questions may be simple, but the solution is anything but. These problems have been created by a combination of the unprecedented issuance of new debt and Fed-driven inflation. While the Fed has been furiously pumping out fresh minted cash and trillions in new debt instruments, stronger economies have been exploding. No matter what any Ivy-League economist may try to tell you, printing money and issuing debt is inflationary. Like a lurking monster in the deep, it will one day raise its ugly head and have to be slain.

The most obvious solution is debt reduction. But, the solution will take years to fix, assuming the powers that be see it as a priority. The problem is that given the Keynesian epidemic sweeping Capitol Hill these days, debt reduction is off the table. Nature has a nasty way of eliminating those who cling to worthless and irrelevant theories when the reality calls for pragmatic action. Nature can only be ignored for so long before the pain of not taking the correct action becomes too great to ignore any longer.

If You Can't Beat the Fed, Join Them

We've all heard the saying, "Don't fight the Fed." But many, including yours truly, have found it a hard lesson to internalize. In March 2009, while earnings were still plummeting and the Fed had the quantitative easing lever on full-forward, most investors were selling. In spite of evidence more than a year ago that printing presses had been kicked into turbo drive, gut instinct would be to get your money out of the market.  But those who trusted in the power of money (even the devalued kind), were buying along with some of the pros who had a better sense of what the Government and Fed were doing.

Now, the Fed (courtesy of the FOMC) is telling us that due to the continued weak economy, quantitative easing is still the flavor of the month and there are still no plans to change it for the foreseeable future. 

Long-term PS-IQ readers have heard me mention one of my favorite trading quotes from currency trading giant George Soros. It is one I repeat to myself at least once a week.

"Economic history is a never-ending series of episodes based on falsehoods and lies, not truths. It represents the path to big money. The object is to recognize the trend whose premise is false, ride that trend, and step off before it is discredited."

I'm as patriotic as the next guy. The problem is that money isn't. It does best where it, or the assets in which it's invested, are appreciated (and appreciating) the most. Yes, US stocks very well could continue to rally, but the gains will come at a price. While stocks rise, their real value will be diminished by a falling greenback.

Here is the challenge from a trading perspective. How many will know when the current trend is being discredited in time to step off?

One useful strategy is to look further a field. Stocks in Canada and Australia (as well as other commodity-rich markets) have also been rallying. Thanks to rising currencies, vis a vis the US dollar, their value in real terms is rising faster. 

So by all means, ride the cash tsunami courtesy of the Fed and government, but be sure to do so in a way that gives you the greatest chances for success. Like any market, it's important not to overstay your welcome!

Interesting Reading

Shiller - "Don't bet the farm on a housing recovery."

Waiting for the other shoe to drop - Fears of a second dip in the housing market grow - Economist 

New and Existing Housing Gap Updated... Wow!

CRE Cataclysm! Moody's/REAL Commercial Property Price Index

Office Vacancy Rate hits 17.7% in San Francisco

Another housing market concern - Residential fixed investment (RFI) has stalled

Canadian real estate market in a word - Overheated!

Public Debt/GDP Worldmap

Krugman spouts more pro-Keynesian inflationary policy drivel

Future of Public Debt - This BIS paper is a must read

Can the world's biggest debtor nation remain an economic superpower for long?

Absolute Return Partners - Beware of Echo Bubbles

Taxpayers to pay thru the nose for Obama's ‘gift' to autoworkers

Recessions and the birth rate. An interesting correlation

FOMC - Doubts on housing recovery and stimulus?

"The Most Important Chart of the Century"

Incomes Decline, Debt Increases: Why the Credit Bubble Cannot Be Reflated

The impact of housing on GDP growth...

Personal Bankruptcies Hit a High and May Keep Rising - Time

Rising Mortgage Rates: The End of the Refi mini-Boom?

More on the recent law on US capital controls - this can't be good...

A better view of the unemployment picture

A made in Japan recovery - Is this what we can look forward to?

New jobs post gains in March but so did personal bankruptcy filings...

One very big reason banks are reluctant to foreclose and kick the owners out...

Latest Case-Shiller Home Price Index reading

Latest Fed economic charts for what they're worth...

24-hour time elapsed graphic of global air traffic

Spokane, Reno, and Orlando

My oldest daughter, Sarah, is in the 5th grade and plays club basketball for a nationwide organization called Hoop Dreams.  You have to tryout to make the team because there is only one 5th grade girl's team in Boise.  Sarah has a tough-as-nails coach fresh out of Boise State.  The level of instruction that young kids get today in sports is incredible.  I was never trained as well as Hoop Dreams is training her today.  No wonder so many kids are leaving high school and going straight to the pros! 

Boise has an exceptional Hoop Dreams organization.  They are focused on fundamentals and building skills.  By the time these kids get to the 7th and 8th grade, they look like a smaller version of Duke or Gonzaga.  I saw their 6th grade boys team beat a 7th grade team at a recent tournament 87 to 28, and 40 of their points were three-pointers.  If their coach saw a player dribble the ball more than 3 times and not pass, he would pull them out of the game.  Their objective was to dribble the ball as few times as possible to score.  The pace of the game looked like the Lakers when Magic played.  Heck, I don't think my old high school team could beat their 8th grade boy's team. 

Sarah's team will travel to three tournaments this spring.  We just got back from Spokane and we leave for Reno at the end of May.  It is a lot of fun for the kids.  We all stay in the same hotel, so the there is a big pool party every night for the kids.  Instead of flying, we have been driving to give them the experience of a road trip. 

The trip to Spokane took us through three magnificent canyons, Payette River Canyon, Salmon River, and Clear Water Canyon.  We also crossed through the Camas Prairie and the Palouse, where the top soil is 300 feet deep in some places.  The Palouse is famous for growing more wheat per acre than anywhere in the world.  On the trip back, we stayed in a hotel located on the banks of the Salmon River.  We left the window open all night and let the river put us to sleep.  I haven't slept that good in a long time. 

I leave for Orlando on Saturday to attend the annual meeting for the National Association of Active Investment Mangers (http://naaim.org/).  I always pick up several ideas to throw into our research queue, so I can't wait to see what I learn this year. 

Working to grow your wealth,

John M. McClure
President & CEO
ProfitScore Capital Management, Inc.

P.S. ProfitScore provides its separately-managed accounts to individuals, advisors and institutional investors.  If you would like to hire us to help you navigate this difficult bear market, below are three ways to contact us:

  • Complete our Private Client Group request form by clicking here: http://profitscore.com/clientgroup.aspx and submitting your contact information. (This is the most preferred method.)
  • Call us directly at (800) 731-5690.
  • Simply send us an email to info @ profitscore.com.

Someone will contact you within 24 hours of receiving your information.

Posted 05-03-2010 10:09 AM by John M. McClure


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on 10-12-2014 2:41 PM

Why It Is Good Not To Be First - ProfitScore IQ - Investment Strategies, Analysis & Intelligence for Seasoned Investors.

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on 11-21-2014 11:24 PM

Why It Is Good Not To Be First - ProfitScore IQ - Investment Strategies, Analysis & Intelligence for Seasoned Investors.