Arcadia Economics Consulting
Thursday, December 27th, 2012
by Chris Marcus
Thursday, December 27th, 2012
by Chris Marcus
Most of the questions we received this week were regarding predictions for 2013 and that is the topic of today's column. As 2012 comes to a close it's an interesting one to look back on as in many ways it felt like a yearlong holding pattern. While there was a presidential election, a lot of talk about a fiscal cliff, and new unheard of rates of money printing around the globe it still feels that in some ways very little changed. In Europe where certain parts of the union are living in daily crisis there has still not been any sort of resolution in either direction. In Japan reports that conditions are deteriorating continue to emerge yet still things continue largely the same. Many of these situations will finally change in the coming years.
Today we will look at some of the key asset classes and think about what can be expected going forward. Currently markets around the world are experiencing a very non-standard price distribution that has never really occurred to this extent. As usual, timing the correction of an asset price in a distorted market is never easy. It's one thing to recognize a bubble but figuring out when the market will correct is more difficult because you also have to figure out when other people will start to understand what you already know. Sometimes it takes longer than we think. Maybe you saw in 2005 that the real estate market was due for a correction but it took another few years before it was realized by the market.
Many of the forecasts made by Arcadia this year fit into this type of distribution. This is not an attempt to lump the outcomes into any particular category but rather a reflection of how most of the markets currently operate. It is not a typical investing environment but that can be ok as long as the situation is diagnosed accurately. Opportunity still exists and understanding the landscape can give you an incredible advantage.
Given the current market dynamics many of these forecasts can best be as an outlook for the next two years and were written with that intention in mind. With that said many of movements and developments could well take place in 2013, but in either case it is safe to say that we are no longer looking at events that are decades away.
The United States Treasury Market
Interest rates will eventually rise on U.S. debt regardless of the Fed's desire to keep them suppressed. Currently if you lend money to the US government for 10 years you get a 1.7% return. However when inflation is factored in your return becomes negative (if your money grows by 1.7% per year but the cost of the goods you buy goes up by 2% then you are actually able to buy less). Additionally the credit quality of the debt continues to deteriorate as the borrowing continues to accelerate. At the same time there is no end in sight to the political dysfunction. The most recent example is how Washington spent the last 2 months talking about how apocalyptic it would be if any spending restraints were actually implemented. Yet this time they couldn't even agree on how to increase spending! Traditionally that's been the only thing they have been able to agree on.
This particular point is one that many economists have already missed in their 2013 forecasts. I keep reading forecasts that are largely predicated on the possibility of "the US getting its fiscal house in order in 2013". The conclusions they make are not necessarily incorrect but they are somewhat misleading since they based upon an assumption that can and should be discounted. There is not going to be a last minute cure-all solution that allows a politically convenient escape from the necessary economic restructuring. The situation has progressed past the point of an easy graceful solution.
It is also important to always consider the skew and odds implied by an investment. Bond yields are not far off their historic lows and there is very little upside to the trade while real interest rates are already negative. The downside is that eventually people will begin to realize that the treasury market is not a safe haven and the value of the debt will drop substantially. You want high return and low risk, not high risk and low return.
The U.S. Equity Market
There is an incredibly important concept that affects the equity markets. If investors knew nothing else but only understood this one point they would be able to consistently be at an advantage whenever they are interacting with the market.
In 2007 the Dow Jones was trading over 14,000. It dipped as low as 6,600 in early 2009 yet now it closes 2012 just below the 13,000 level. Do you remember what else occurred at the exact time the turnaround began? On March 18, 2009 the Federal Reserve launched what has come to be known as QE1. Technically it should have been known as QE2 as it was actually an expansion of the Fed's initial bond buying program in response to the Lehman Brothers failure. But in either case the connection between the Fed policy and the stock market run-up over the past 4 years has been unmistakable. (If you haven't heard comedian Jon Stewart's analysis of Fed policy it's pretty funny and points out just how ridiculous the entire situation is).
In an inflationary environment like the one that we are currently experiencing, all of the quantitative easing (money printing) programs also pump a lot of money into the stock market. If it sounds bizarre that the Federal Reserve is monetizing government debt so that they can goose the stock market I understand how you feel. It's hardly a free market in action. But Ben Bernanke continues to monetize government debt and mortgage paper with the goal of boosting nominal stock market prices. In Bernanke's own Washington Times op-ed in 2010 he actually used this as a defense of QE2.
"This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action.... higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion."
So far the circle of virtuosity has not developed quite as Bernanke had hoped for. It is unclear why a stock market bubble caused by debt monetization would be a good thing but in either case we are up to round 4 of quantitative easing and there is no end in sight. The Fed has already committed to printing over $1 trillion in the next year alone and a lot of that money is going to go into the stock market.
In real terms (instead of pricing the market in dollars you could price it in terms of gold or silver) the US stock market is going to decline significantly. The current monetary, fiscal, and regulatory environment has been particularly harsh on business owners and job creators as reflected by the elevated unemployment level. However in nominal terms (simply looking at the dollar price) the markets may well continue to rise. This is the result of the Federal Reserve's money printing. The value of your stocks will be higher but so will the price of the items that you buy. Your money literally won't worth what it used to be. There are some sectors like precious metals, base metals, miners, and natural resources that will fare well in this environment as they have a real value, but investing in the broader market indices is a risky strategy.
Investing in real estate has never been more complicated because of the overwhelming government involvement in the market. On one hand prices are significantly cheaper than at the top of the bubble. On the other hand the market is being heavily supported through various government programs and Federal Reserve asset purchases. As a result housing prices remain artificially elevated. Will the nominal value of your real estate go higher as real estate rises in response to the inflation of the money supply? Eventually yes. However will the actual value of your home increase in real terms? No.
Think of it this way. If your home is worth $100,000 and right now a vacation costs $1000, you can afford to take 100 vacations if you sell your home. In 5 years your home might be worth $200,000 but the cost of the vacation is $10,000 and now your house is only worth 20 vacations (you also would have to pay tax on the real estate gain while you would n a credit for the vacations). You have more dollars but they buy less goods. With real estate you also have to consider the liquidity of the market. In 2009 your house may have been worth $500,000 but you might not have been able to find someone else who was willing AND able to pay that much.
However if you have found a dream home that you love and plan to keep it for the long-term then some of the current conditions can actually work in your favor. In this case you don't have to be concerned about the liquidity of the market and you will actually end up making those payments 20 years from now in highly devalued dollars. With real estate you do also have the advantage that again you actually own something of real value. However keep in mind that you never actually completely own your home as you are always at the mercy of your real estate taxes and history shows that they can increase during at times of governmental fiscal distress (as seen in the current case with the Fiscal Cliff).
Real estate is an asset class that is very specific to each individual's situation and these are intended not as investment recommendations but as a set of parameters to consider. This way you can discuss them with your financial planner to make sure that a plan is developed that considers some risks that are not as frequently recognized.
Precious metals are always a favorite topic at Arcadia as I continue to feel that this sector is simply the best option currently available. While no one knows for certain when the American, European, or Japanese bond markets will finally reach their breaking points the attractiveness of gold and silver as the real safe havens increases daily.
2012 was a disappointing year for many precious metals investors who were correct in predicting unprecedented amounts of money printing yet saw both gold and silver finish well below their 2011 highs. As Arcadia has pointed out throughout this past year this is a reflection of short-term liquidity issues rather than a change in the fundamentals. A physical shortage is developing and the ultimate resolution will be a significant revaluation upwards in the price of both metals. There is a good chance of this happening in 2013 although a safer statement to make is on a three-year time horizon. The current price level of silver in particular will in due time be looked back upon as one of the greatest asset mispricings in history.
There are certain market reactions that can only be caused by distortive manipulations. The crash of the tech and mortgage bubbles could only have occurred because of the prior inflation that had occurred. Similarly silver has only been able to become this far misaligned from its true market value because of distortions in the market. The result is that between the unlimited money printing, growing demand (particularly out of China) for metal, and the unanswered question of where that metal is going to come from it is difficult to see how the market supply and demand will continue to meet at current levels.
More specifically, I would personally be stunned if you can buy an ounce of silver for less than $75 by the end of 2015. I also believe that a significant price correction of that extent or greater is possible well before 2015 and could easily occur in 2013 or 2014. The distortions currently being caused in the markets cannot continue indefinitely and I believe that we are nearing the point at which that correction will take place.
Gold will also do quite well in this environment. Obviously as citizens realize that the paper currencies they are holding are being debased at an increasingly rapid rate more and more people will move to the real safe havens of gold and silver.
The gold market also has its own mysteries including the growing speculation regarding the existence of Germany's gold. Austria and the Netherlands have also recently become concerned about the security of their gold. It's baffling why the Federal Reserve refuses to audit or even comment on the idea of an audit of their vaults. As with the secrecy around the vault at Fort Knox people are left to wonder what accounts for the lack of transparency. An unexpected resolution to any of these questions could completely reprice the entire monetary system. But regardless as to whether there is a shock of that nature the continued central bank printing that is already public that we do know about will by itself be enough to push gold well past the $2,000 mark. Gold should also clear the $2500 mark by the end of 2014.
And of course Happy New Year!
I hope that Arcadia Economics Consulting was of value to you in 2012. It was a particularly special year for me as Arcadia was finally created to help people understand what they are rarely told but need to know about the markets. It's been an honor and a pleasure to serve you and we are grateful for all of the feedback from Arcadia's readers and clients. We have some exciting developments planned for the coming year and I hope you have a happy new year full of abundance and success.
CEO and Founder of Arcadia Economics Consulting