Fed Credibility

[jk]

Re: Fed Credibility

There are of course risks to assuming everything will be the same - as noted, it's not so much a matter of repeating but of rhyming! The main one is the possibility that things may resemble Japan time-shifted forwards by 10 years, rather than the US by 32 years. In other words, a long protracted period of deflationary malaise.

IMO such a course can't be ruled out, but is definitely a lower probability likeness. The main argument in favor is the extremely high debt level of the American consumer and American government. This creates a high latent demand for dollars. And given that the Fed's modus operandi for creating money is to lend it into existence, could be difficult for it to counter.

On the other hand, we have "Helicopter Ben" at the helm! That traditional modus operandi could change, and money might be created with no corresponding debit entries. The Fed could, for example, simply purchase and extinguish government debt. Even if that were not resorted to, the momentum behind inflation at this time seems sufficient to undergird its continuation. Interest rates - even after this Fed hiking cycle - remain below inflation (the real rate of inflation, not the government's representation). Regardless it seems virtually inevitable that hard assets will continue to rise relative financial assets. That, for example, the stock market will decline as measured in gold. Personally I favor inclusion of as much as 25% hard money (gold, silver, copper, platinum) in one's portfolio, along with about 25% cash and bonds, and 50% stocks. And the latter including a liberal proportion of energy and commodity producing companies and dividend paying stocks as well as being globally diversified.

Thoughts?

re helicopter ben- in his famous "can it[deflation] happen here" presentation, in which he used the helicopter image, he made reference to "unconventional" interventions available to the fed. in theory they could buy real estate, equities, commemorative medals and porcelein figurines to put money into circulation. most likely, and an intervention that was specifically mentioned, is to start buying treasuries further and further out on the yield curve, instead of restricting themselves to the short end. as long as there is an asset for sale, in other words, the fed can put cash into the economy. they don't have to wait for borrowers to appear. now, i am sure they would like to avoid doing any of these things. but if they need to, they will.

re: your model portfolio - you are much more optimistic about equities than i am. my concern is that in a big drawdown everything gets correlated, and that even dividend payers, global, energy and commodity related investments will all go down together. precious metals may go down as well in a recession/maybe deflation scare/big sell-off environment.

my own major equity exposure is 30% via hussman's strategic growth fund which is variably hedged and in fact has been fully hedged for some time. hussman did quite well in 2000-2002, making good money on the spread between his equities and his hedges. then i have about 12% in canadian income trusts, mostly energy related. but this is overhedged by shorts of about 8% [tech and financials mostly] and long dated puts with a nominal exposure of about 22% [actual value about 2%]. this also provides some hedge against my 23% pm position. i also have about 26% nominal exposure to other currencies [actual value 14%], 4.5% short [not short dated, but sold short] junk bonds, 1.5% long dated zero tbonds, 1.5% uso [crude oil tracking stock]

god knows if this potpourri makes any sense, but there it is.

[Finster]

Re: Fed Credibility

re: your model portfolio - you are much more optimistic about equities than i am. my concern is that in a big drawdown everything gets correlated, and that even dividend payers, global, energy and commodity related investments will all go down together. precious metals may go down as well in a recession/maybe deflation scare/big sell-off environment.

Well "optimistic" would have to be a relative term. It's a little like Winston Churchill's comment about democracy: It's the worst system of government except for the rest.

If we were in normal times (whatever that is), my equity exposure would be quite a bit higher. In actuality, my current target is a pretty low 45% (the above are long term defaults). But bonds and cash aren't looking all that attractive either. Hard money and commodities appear to be the most attractive of all, but then again, in "normal" times, I'd have a lot less than my current combined 40%. And keep in mind that this, although it is providing current income, also is expected to be good for the long term, decades, as well.

The problem with allowing for a drawdown in the equity area such as that which you describe is this. You might get such a hefty drawdown. On the other hand, cash is an almost guaranteed drawdown. A nice and easy one, but the chances of any kind of sustained appreciation are almost nil.

[jk]

Re: Fed Credibility

If we were in normal times (whatever that is), my equity exposure would be quite a bit higher. In actuality, my current target is a pretty low 45% (the above are long term defaults). But bonds and cash aren't looking all that attractive either. Hard money and commodities appear to be the most attractive of all, but then again, in "normal" times, I'd have a lot less than my current combined 40%. And keep in mind that this, although it is providing current income, also is expected to be good for the long term, decades, as well.

The problem with allowing for a drawdown in the equity area such as that which you describe is this. You might get such a hefty drawdown. On the other hand, cash is an almost guaranteed drawdown. A nice and easy one, but the chances of any kind of sustained appreciation are almost nil.

you raise an interesting question relative to timing investments. you think of your equity exposure as being core to your portfolio and having a multi-decade time horizon. you discuss cash in similar terms when discussing its inevitable inflation-based drawdown in value.

i think in somewhat shorter time periods [perhaps i'm significantly older - i'm 59]. i think of my hussman position as core, and long term, but the only way i'm comfortable with that is my trust in his ability to hedge in times of heightened risk. if the market's internals improve he will reduce the hedge.

richard russell has written many times about the importance of avoiding major drawdowns as the key to long-term success. this is obvious in the observation that a 50% drawdown requires a 100% gain to recoup.

i actually think of my portfolio primarily in defensive terms - how can i hedge against what i perceive are significant risks? precious metals hedge the inflationary scenario. my small zero-tbond position is a small hedge against deflation, my cash is a hedge against deflation, and i even think of hussman as a hedge against deflation. re hussman: this is based on the fact that he at least won't get killed in a severe downturn, and he might actually make something in that circumstance. thus the assets will be preserved in at least a cash-like way. my currency positions hedge against the dollar's decline, my dollar based holdings hedge against dollar strength [which could happen, esp in a deflationary scenario]. so far, at least, this approach has generated decent returns [e.g. 12-13% compounded over the last 1, 2, 3 and 4 year periods with a max drawdown of 8%. i didn't keep such detailed records for the prior decades, but i've done ok, including cashing in all my domestic and foreign equities in the 3 mos prior to the '87 crash, and making money in the 2000-2002 period. during the 90's i made about 15% compounded.]

the time horizon for my investments seems to be from months to years, not decades. have you actually remained in any asset class for decades?

[Finster]

Re: Fed Credibility

you raise an interesting question relative to timing investments. you think of your equity exposure as being core to your portfolio and having a multi-decade time horizon. you discuss cash in similar terms when discussing its inevitable inflation-based drawdown in value.

i think in somewhat shorter time periods [perhaps i'm significantly older - i'm 59]. i think of my hussman position as core, and long term, but the only way i'm comfortable with that is my trust in his ability to hedge in times of heightened risk. if the market's internals improve he will reduce the hedge.

richard russell has written many times about the importance of avoiding major drawdowns as the key to long-term success. this is obvious in the observation that a 50% drawdown requires a 100% gain to recoup.

i actually think of my portfolio primarily in defensive terms - how can i hedge against what i perceive are significant risks? precious metals hedge the inflationary scenario. my small zero-tbond position is a small hedge against deflation, my cash is a hedge against deflation, and i even think of hussman as a hedge against deflation. re hussman: this is based on the fact that he at least won't get killed in a severe downturn, and he might actually make something in that circumstance. thus the assets will be preserved in at least a cash-like way. my currency positions hedge against the dollar's decline, my dollar based holdings hedge against dollar strength [which could happen, esp in a deflationary scenario]. so far, at least, this approach has generated decent returns [e.g. 12-13% compounded over the last 1, 2, 3 and 4 year periods with a max drawdown of 8%. i didn't keep such detailed records for the prior decades, but i've done ok, including cashing in all my domestic and foreign equities in the 3 mos prior to the '87 crash, and making money in the 2000-2002 period. during the 90's i made about 15% compounded.]

the time horizon for my investments seems to be from months to years, not decades. have you actually remained in any asset class for decades?

I am a bit younger, but my stage-of-financial-life positioning may be similar to yours. I am 48, but retired last year, so am depending on my investments as a source of long term income.

So I have to think both long term and short term. I am very risk averse, but take a broad view of risk so that the risk of loss includes loss of real value to inflation, not merely loss in dollar terms alone.

So like you, I think of my portfolio primarily in defensive terms. Oddly enough, though, at least from the perspective of modern portfolio theory, my pursuit of safety has turned out surprisingly nice returns. In trying to avoid losing to inflation, I bought a lot of real estate and energy stocks and precious metals three or four years ago and they have done very well.

I've never been all in just one asset class for very long. The markets just aren't that predicable. The only time I can think of since I started investing was going into all cash at the end of 1998. It just seemed that stocks had gotten so richly valued the prospects were bleak. So I missed out on the stellar gains of 1999. Fortunately, I also missed out on the losses of 2000-2002, as I did not buy again aggressively until October 2002-March 2003.

More recently I've been following a sort of modified Harry Browne Permanent Portfolio approach. If you haven't read his last book Fail-Safe Investing, it's highly recommended. It's sort of a hybrid permanent portfolio - variable portfolio adaptation where the target proportions of the various asset classes are allowed to vary within limits depending on the financial outlook.

What attracted you to Hussman? I'm not that familiar with his work. Russell of course is highly regarded as well. His admonition to emphasise TBills and gold several months ago has worked out well.

[Jim Nickerson]

Re: Fed Credibility

Russell of course is highly regarded as well. His admonition to emphasise TBills and gold several months ago has worked out well.

jk,

how long has Russell been in T bills and gold?

[brunt]

Re: Fed Credibility

my mainline and not too-pessimistic scenario is also a replay of the 70's. but i think now it would be worth our whiles to try to focus on the differences from the 70's.

with the reappearance of the word "stagflation" not all that long ago, i have been reading more and more commentators analogizing to the 70's.
i don't think the 70's analogy has become the standard assumption set YET. [i think the "common wisdom" is a somewhat more benign muddle-through.] but the 70's analogy is spreading rapidly and was the driver of gold's move up to recent levels.

so stagflation is not yet old news, but is becoming so. during this process inflation hedges should do ok. but now we need to think of how it might diverge from our 70's analogy, what signs or symptoms we need to watch for in order to monitor the value of this analogy, and how to take advantage of deviations from the 70's path.

There is also a significantly different demographic profile than in the 70's. In 1970, the oldest boomers were only 25 years old, broke and still working their first job after college. There was a lot of pent up consumer demand to grow the economy in those demographics.

Unfortunately, the oldest boomers are now 60, and looking to retrench, retire and save their money for their meds.

[jk]

Re: Fed Credibility

There is also a significantly different demographic profile than in the 70's. In 1970, the oldest boomers were only 25 years old, broke and still working their first job after college. There was a lot of pent up consumer demand to grow the economy in those demographics.

Unfortunately, the oldest boomers are now 60, and looking to retrench, retire and save their money for their meds.

that sounds more contractionary, doesn't it? the other big difference i can think of is globalization, including both the more complicated financial flows and imbalances we now have, and the growth of the emerging markets as both producers and consumers. that sounds more inflationary, doesn't it? hmmm.

[jk]

Re: Fed Credibility

I am a bit younger, but my stage-of-financial-life positioning may be similar to yours. I am 48, but retired last year, so am depending on my investments as a source of long term income.

So I have to think both long term and short term. I am very risk averse, but take a broad view of risk so that the risk of loss includes loss of real value to inflation, not merely loss in dollar terms alone.

So like you, I think of my portfolio primarily in defensive terms. Oddly enough, though, at least from the perspective of modern portfolio theory, my pursuit of safety has turned out surprisingly nice returns. In trying to avoid losing to inflation, I bought a lot of real estate and energy stocks and precious metals three or four years ago and they have done very well.

I've never been all in just one asset class for very long. The markets just aren't that predicable. The only time I can think of since I started investing was going into all cash at the end of 1998. It just seemed that stocks had gotten so richly valued the prospects were bleak. So I missed out on the stellar gains of 1999. Fortunately, I also missed out on the losses of 2000-2002, as I did not buy again aggressively until October 2002-March 2003.

More recently I've been following a sort of modified Harry Browne Permanent Portfolio approach. If you haven't read his last book Fail-Safe Investing, it's highly recommended. It's sort of a hybrid permanent portfolio - variable portfolio adaptation where the target proportions of the various asset classes are allowed to vary within limits depending on the financial outlook.

What attracted you to Hussman? I'm not that familiar with his work. Russell of course is highly regarded as well. His admonition to emphasise TBills and gold several months ago has worked out well.

it's interesting you mention harry browne. i read his "inflation proofing your investments" in 1982, relatively early in my investing career. it had a major influence on my thinking -- i still use its multi-scenario approach. i started subscribing to hussman's newsletter in the 90's. he's a very smart and thoughtful guy, but back then he was just focused on values and didn't have a model to deal with the 90's bull. he folded his newsletter but opened a mutual fund in july, 2000. by then he had developed his "market climate" model to take non-valuation factors into account. he variably hedges his portfolio depending on his model's assessment of risk, and as i said he did quite well in 2000-2002. his returns during the bull move of 2002-2005 were less impressive, but over the cycle he does well. value line rated him the best risk-adjusted 5 return of over 800 funds in category. i recommend his weekly column, available at hussmanfunds.com.

i think modern portfolio theory is a crock, since it rests on notions of market efficiency that i think are overly simple.

my question about staying in an asset wasn't suggesting being totally in one asset. i mean just having a position and holding it for decades. if you look at what you own, is there anything there that you were holding 20 years ago? if not, you might want to re-examine your "decades" analysis of assets.

[Finster]

Re: Fed Credibility

it's interesting you mention harry browne. i read his "inflation proofing your investments" in 1982, relatively early in my investing career. it had a major influence on my thinking -- i still use its multi-scenario approach. i started subscribing to hussman's newsletter in the 90's. he's a very smart and thoughtful guy, but back then he was just focused on values and didn't have a model to deal with the 90's bull. he folded his newsletter but opened a mutual fund in july, 2000. by then he had developed his "market climate" model to take non-valuation factors into account. he variably hedges his portfolio depending on his model's assessment of risk, and as i said he did quite well in 2000-2002. his returns during the bull move of 2002-2005 were less impressive, but over the cycle he does well. value line rated him the best risk-adjusted 5 return of over 800 funds in category. i recommend his weekly column, available at hussmanfunds.com.

The first Browne book I read was his 1973 You Can Profit From A Monetary Crisis. Despite its title, the core of the book was a primer on basic market economics. Excellent. By comparison, it was really just gravy that his investment outlook and recommendations proved stellar for anyone who followed them for the rest of the decade.

i think modern portfolio theory is a crock, since it rests on notions of market efficiency that i think are overly simple.

I'm not religious follower when it comes to MPT. I do think it has some valuable insights, but folks who make it their entire investment paradigm IMO are making a big mistake. Investing is not only for the benefit of the investor, but also to allocate capital and resources in a free market economy. If everyone just blindly followed MPT tenets and made no attempt to intelligently allocate their portfolios, the capital allocation function of free markets would be neutralized and the benefits of free enterprise frustrated.

my question about staying in an asset wasn't suggesting being totally in one asset. i mean just having a position and holding it for decades. if you look at what you own, is there anything there that you were holding 20 years ago? if not, you might want to re-examine your "decades" analysis of assets.

Sorry I misunderstood. I guess I can't really answer that because I only started investing as such in 1993. Prior to that the only financial management issue I faced was that of managing debt!

The "decades" time frame really referred not to individual assets, but entire asset classes. Not that there would never be individual assets worth hold that long, but in general I'd imagine I'd have at least some exposure to, say, stocks, bonds, real estate and commodities, more or less permanently, even though the size of those exposures would vary.

[hayfield]

Re: Fed Credibility

that sounds more contractionary, doesn't it? the other big difference i can think of is globalization, including both the more complicated financial flows and imbalances we now have, and the growth of the emerging markets as both producers and consumers. that sounds more inflationary, doesn't it? hmmm.

Whether you're a peak-oil fan or not, higher energy costs should stunt the expansion of globalization due to growing transportation costs. Wage arbitrage becomes more localized phenomenon. Instead of comparing costs in China vs. Mexico, it may be Shreveport vs. St. Louis.

This would mesh well with the possibility of a new round of protectionism, but only as the policies came online. How it unravals as the tarrifs backfire and globalization reconstitutes? Maybe by that point energy will be so expensive that it won't matter.

[Jim Nickerson]

Re: Fed Credibility

I only started investing as such in 1993. Prior to that the only financial management issue I faced was that of managing debt!

I may not be correct in deducing that in your previous life you were the bond trader referenced elsewhere here by Thye Usual Suspect who perhaps to your dismay divulged that you hold a lot of Iragi War Bonds. What are they, and if you know about those bonds, how does one potentially profit from them?

[Finster]

Re: Fed Credibility

I may not be correct in deducing that in your previous life your were the bond trader referenced elsewhere here by Thye Usual Suspect who perhaps to your dismay divulged that you hold a lot of Iragi War Bonds. What are they, and if you know about those bonds, how does one potentially profit from them?

Perhaps TUS was referring to a couple of previous occasions when I had expressed bullish opinions on US Treasuries. I am hardly a perma-bull in that area, but was pounding the table back in late-October-early-November on what I thought was an oversold condition due for a trading rally. It turned out to be almost the exact bottom for that cycle, and TUS has been needling me about it ever since. Even though I subsequently turned bearish on bonds earlier this year, he still has me pegged as a bond bull.

I last bought bonds back around the lows a couple months ago, and it seems possible they could continue to rally. Bond guru Bill Gross recently claimed we are in a new cyclical bull market for bonds. But I am not adding to positions in here as the odds just don't seem compelling enough to make outsized positions worth the risk. My latest additions only reduced the degree to which I am underweight. Repercussions of the inflationary momentum set in motion by the Greenspan Fed in 2001-2005 still seem to have the upper hand. I still favor hard money and commodities and am keeping bond maturities on the short side.

Thoughts? Curious as to your take on the various asset classes...

[Jim Nickerson]

Re: Fed Credibility

Thoughts? Curious as to your take on the various asset classes...

Finster (Funster)

Currently I am

22.7% short in Profunds USPIX (NDX), UCPIX (RUT), UVPIX(EMERGING MARKETS), & UKPIX (NIKKEI) all are -200% of the indices, currently down in total 4.23%, was down twice that a couple of weeks back.

20.6% in PMs (PMPIX, GLD, SLV, GDX) and DBC: down 0.08%

20.8% Currency-Bond & HSGFX. The currencies are in FXE and FXC, and RYWBX (-200% "Weak Buck"), bonds Profunds RRPIX (rising rates on long bonds--quite contrary to Gross' call, but only 2.83% of total portfolio): down 0.20%

The total of all these positions is currently down 1.67%

35.9% cash.

I am currently up 6.13% for year and -3.89% off recent high for year.

As always, I am nervous.

After putting up the above, I ran across Hussman's comments from Monday 08/07/06, which to a degree salves some of my anxiety.
http://hussmanfunds.com/wmc/wmc060807.htm

[Finster]

Re: Fed Credibility

Finster (Funster)

Currently I am

22.7% short in Profunds USPIX (NDX), UCPIX (RUT), UVPIX(EMERGING MARKETS), & UKPIX (NIKKEI) all are -200% of the indices, currently down in total 4.23%, was down twice that a couple of weeks back.

20.6% in PMs (PMPIX, GLD, SLV, GDX) and DBC: down 0.08%

20.8% Currency-Bond & HSGFX. The currencies are in FXE and FXC, and RYWBX (-200% "Weak Buck"), bonds Profunds RRPIX (rising rates on long bonds--quite contrary to Gross' call, but only 2.83% of total portfolio): down 0.20%

The total of all these positions is currently down 1.67%

35.9% cash.

I am currently up 6.13% for year and -3.89% off recent high for year.

As always, I am nervous.

After putting up the above, I ran across Hussman's comments from Monday 08/07/06, which to a degree salves some of my anxiety.
http://hussmanfunds.com/wmc/wmc060807.htm

Well you must have a stouter constitution than yours truly, because I am always too nervous to be short anything. DBC, however is interesting. I bought that a few months ago myself. For the first time with ETFs alone one can cover all the major asset classes. Not that investors shouldn't own the traditional gold & silver, but the commodity futures index funds are welcome diversifiers.

[Jim Nickerson]

Re: Fed Credibility

http://hussmanfunds.com/wmc/wmc060814.htm

It's clear that the prevailing thesis in the market is that slower economic growth will be coupled with slower inflation. That thesis is most probably responsible for the market's resilience in the face of recent day-to-day news events. While resilience in the face of negative news certainly can be a favorable sign, it's notable that we're really not seeing anything resembling “sponsorship” on the basis of price/volume behavior. Instead, the market is meandering on relatively tame volume, which suggests more of a “wait and see” attitude than any robust preference to accept market risk.
So though the market is expecting (and has effectively priced in) the idea that inflation pressures will abate soon, the market does not seem to have priced in the alternate thesis – principally, that the economy will continue to slow, but that inflation pressures will persist. That potential for a change in thesis is where the main risks to the market probably reside.

and

On the fixed income front, I recognize that our defensiveness in bonds is somewhat counter to the prevailing thesis that bonds are a “buy” here because the economy is slowing. But that's exactly the point. At least at present, the observable evidence suggests that the accepted thesis isn't correct. Either the evidence will change, or the thesis will.

Does anyone see it differently?