Yellen – More Punch Anyone?

“By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens”.– John Maynard Keynes

Central bankers have an obsession with inflation. Inflation is the central banker’s temperature gauge for the economy. Inflation above a certain level is too hot and deflation is way too cold. The natural question is at what level is inflation too hot? Currently, the US Federal Reserve thinks that above 2% is too hot, so 2% is their target.

On Friday, in a speech in Boston, Janet Yellen, Chairperson of the Federal Reserve, stated that it might be wise to consider the upside of a “high pressure economy”. While the FOMC has targeted a 2% inflation rate it appears that they are preparing us to accept a higher than normal inflation rate in order to “heal” the economy. One is very quickly reminded of the Weimar Republic. Prophetically, our good friend Arthur Cashin from the NYSE had this to say in his blog this week.

Originally, on this day in 1922, the German Central Bank and the German Treasury took an inevitable step in a process which had begun with their previous effort to “jump start” a stagnant economy. Many months earlier they had decided that what was needed was easier money. Their initial efforts brought little response. So, using the governmental “more is better” theory they simply created more and more money.

In 1920, a loaf of bread soared to $1.20, and then in 1921 it hit $1.35. By the middle of 1922 it was $3.50. At the start of 1923 it rocketed to $700 a loaf. Five months later a loaf went for $1200. By September it was $2 million. A month later it was $670 million (wide spread rioting broke out). The next month it hit $3 billion. By mid-month it was $100 billion. Then it all collapsed.

By October of 1923 German citizens were burning cash instead of wood for heat. It was easier to get and less expensive.

In a normal environment it has been said that it is the Federal Reserve’s job to take away the punchbowl just as the party has started. On Friday, it appeared that Yellen not only doesn’t want the party to end she wants to spike the punchbowl.

We do not believe that the November meeting of the FOMC is live and that they will not raise interest rates at that time. Not days before a Presidential election. Traders are betting that there is a 65% chance that they raise rates at the December meeting. If they raise rates in December it could make for another rocky start to the New Year.

One of the most astute investors that we know is a long time friend who pops in on us time to time. He is a very patient investor and quite prescient in his market calls. He called us out of the blue this week. He senses caution and is taking money off of the table. When he speaks we pay heed.

Technical analysis, while voodoo for some, is a way of quantifying the current state of market psychology. The market has been forming what is called a wedge. A wedge is a state of an increasingly tighter price range. This tells us that the market has been forming pressure much like a volcano or earthquake fault line. The market may have broken out of that range this week. The market has been below its 100 day moving average for the last two weeks. What was once support for the market is now resistance. The next real level of support is the always critical 200 day moving average at 2070 on the S&P 500. That is about 3% lower from the close of 2133 on Friday. The market is currently up 4.6% Year to Date (YTD). Investors, and professionals who looking to keep their bonus checks, could get very anxious if this year’s gains are put at risk in an October swoon. Keep an eye on 2070.

I think we aspire less to foresee the future and more to be a great contingency planner… you can respond very fast to what’s happening because you thought through all the possibilities, – Lloyd  Blankfein

To learn more about us and Blackthorn Asset Management LLC visit our website at www.BlackthornAsset.com .

A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty. – Winston Churchill

Disclosure: This blog is informational and is not a recommendation to buy or sell anything. If you are thinking about investing consider the risk. Everyone’s financial situation is different. Consult your financial advisor.

Fed Up

The S&P 500 had its best week since mid July as central bank largess was increased yet again. On the menu this week was a buffet served up by not only the Bank of Japan (BOJ) but by the United States own, Federal Reserve. The BOJ refuses to give up on its intention to foster inflation north of 2% and in doing so announced that it will now attempt to control (manipulate?) the yield curve in Japan. Analysts that we follow are polar opposite on their views of where the new Japanese policy has us headed. We value both analysts’ opinions. We are facing a binary environment and either outcome is possible. Japanese central bank policy will only succeed in driving a vicious cycle. If price pressure does begin to mount this new central bank policy will only drive more inflation. If deflation begins to rise central bank policy will only bring more deflation. Here is more from George Saravelos from Deutsche Bank. One thing that we are fully confident in is that we are at the precipice of a decline in confidence in central bank policy.

In a note titled “It may be over for the BOJ”, DB’s George Saravelos writes that “by targeting nominal rates the BoJ is relinquishing control of real rates. This creates a policy asymmetry that becomes highly pro-cyclical. Consider a negative demand shock that raises demand for JGBs and depresses inflation expectations. The BoJ will end up reducing the amount of JGBs it buys and raising real rates.Consider the opposite: a huge fiscal stimulus from the government that puts upward pressure on yields: the BoJ would effectively monetize the debt raising inflation expectations even further. We worry that a self-fulfilling tightening is more likely than an easing in coming months.”

However, once the curve starts shifting substantially, either parallel-shifting or steepening the central bank would quickly lose control as its intervention would only exacerbate the underlying move.  

We are in a very binary atmosphere. We could tip towards recession without the necessary tools to fight it in central banker’s hands or inflation could rise with central bankers without the political will to fight it. Central banks are losing credibility and that could spiral out of control very quickly. 

Donald Trump, while trying to bait Fed Chair Yellen into raising rates, proved that the Federal Reserve does make political decisions as a decision to do nothing is still a decision. Confused? Think about how Janet Yellen feels. Get the Tylenol ready for Monday night’s debate. While Yellen was damned if she did and damned if she didn’t she managed to come out looking political anyway. Maybe this is Trump’s true genius. He accused Yellen of running a political body in the Federal Reserve and she by not raising rates looked political. We never thought that the Fed would raise rates in front of the election but that is because we know they are a political body. Let’s be fair. They have to play politics. Congress is their boss. That, in the end, is the problem and why they will never meaningfully raise rates. They are boxed in. I think though you can now bet on rate rise in December if Trump pulls off a victory.

Professional investors are under invested and under performing. According to Goldman Sachs 16% of Large Cap money managers are beating their benchmarks. There are some very high levels of cash at mutual funds and under performing managers looking to protect their jobs. While we think that a tightening and a downward move in assets prices is more likely we could start to move out control to the up side as well. If under invested under performing mutual funds begin to chase the market and inflation begins to move higher central banks will be reluctant to take away the punch bowl. Ironically, a Trump win could be the cover they are looking for to take it away.

Vicious and virtuous spirals could be headed our way. While we think the line on this game is for a tightening and markets to head lower we think that move down might have to wait until after the election. In a repeat of last year we could see assets move higher until December while 2017 could have some early bumps.

Tiny Bubbles

The market may not be in a bubble but there have been pockets of such. The Biotech sector, 3D printing stocks and battery power stocks do seem to have “bubble” characteristics. Those bubbles also seem to be bursting. Biotechs which surged at the dawn of 2014 have now given back all of their gains from earlier in 2014. 3D printing stocks are now down 30-40% off of their highs of late 2013 and battery power stocks have recently taken one on the chin. While the market continues to struggle with new highs it is important to try and break down some of the internals of the market in order to see if this rally still has steam. Keep an eye on the bubblier portions of the market along with the performance of small caps vs. large caps and how the most shorted stocks perform against the broader market. A break down in these areas could portend a break down in the broader market and coincidentally make for a healthier market.

Since Janet Yellen’s comments about an earlier than expected rate rise in the US the best performing sectors have been financials and semiconductors while biotech and consumer durables/apparel have been the biggest losers. Surprisingly, utilities and telecom services have hung in there quite well. If we have had a seismic shift in the market post Janet Yellen’s comments we would expect the winners and losers to continue in these same directions. We will be keeping an eye on these sectors especially the financials.

FINRA is investigating the trading of Puerto Rico’s municipal bonds. As you may or may not know Puerto Rico is in sore financial shape. They were however able to access financial markets and float $3.5 B worth of bonds last week. Those bonds were to be sold in denominations of $100,000 or more in order to make sure that institutional buyers or very large investors were involved in the transactions. The authorities wanted to be sure that all investors involved were aware of the possibility of default by Puerto Rico. In the last several days transactions have been made below that threshold indicating the possibility of smaller investors getting into these bonds at par value. Red flags have gone up at FINRA and here at Blackthorn. Just last week I had a client ask me about these bonds as he received a phone call from an investment firm trying to sell him Puerto Rico muni bonds. We are not making an investment call either way on these bonds. We are just making you aware. Caveat emptor.

The market ended the week on a sour note with Friday’s close being a real clunker. Was the selloff from Friday morning’s highs about geopolitical risk or something more? We will find out next week. Charts are looking a bit rough. A break of the 1840 level on the S&P 500 could bring further selling. Will we get saved by end of the quarter window dressing?

US Treasuries had a back up in yield this week as Janet Yellen made comments about earlier than expected rate rises here in the US. Gold and Treasuries have been the flight to safety trade as Ukraine heated up. Now they took the brunt of the hit as Ukraine cooled off and Yellen promised higher rates sooner. Treasuries and Gold conintue to be our temperature gauge for both for rates and geopolitical risk. Keep an eye on how they act this week.

The Fall and Winter are the best performing seasons for the stock market but April is a standout if we look at monthly performance. Could we be in for one more move higher in the market before the summer doldrums kick in? Summer is statistically the worst season for gains in the stocks market. (Hat tip to Bespoke Investment Group.) http://www.bespokeinvest.com/

To learn more about us and Blackthorn Asset Management LLC visit our website at www.BlackthornAsset.com .

A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty. – Winston Churchill

Disclosure: This blog is informational and is not a recommendation to buy or sell anything. If you are thinking about investing consider the risk. Everyone’s financial situation is different. Consult your financial advisor.