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Did Government Try To Murder The Canary Before It Could Get Sick?

The Canary In The Coal Mine

The expression “canary in the coal mine” derives from the use of canaries in coal mines as a form of an early-warning for the miners. Wikipedia canarycoalmine (2)explains:

An allusion to caged canaries (birds) that mining workers would carry down into the mine tunnels with them. If dangerous gases such as methane or carbon monoxide leaked into the mine, the gases would kill the canary before killing the miners, thus providing a warning to exit the tunnels immediately.

Financial and economic analysts often use this metaphor to describe key variables. When the particular element representing the canary begins to misbehave, it is time to get the hell out of that situation. Depending upon the market, different variables can serve as the canary. Gold is often considered to be the King Canary, at least for those who are focused on maco-economic events, especially those resulting from massive government interventions in markets, money creation and interest rates.

The Take-down of Gold

The recent take down of gold appears to have been orchestrated by government via the banking system. Numerous websites discuss the circumstantial evidence that suggests government was involved. Simple statistics support something other than normal market behavior happened. Other analysts discussed reasons why a take-down of gold was important for government, the Federal Reserve and the banking system.

In a world of paper gold (ETFs and futures), it is not difficult to engineer a manipulation.

The gold crash occurred over a two-day period and received enormous publicity. That is exactly what you would expect if you wanted to frighten people away from gold. Contrast that with the silence that accompanied gold’s rise from $250 to almost $1,900. It was the best-kept secret bull market in history. Gold averaged about a 16% gain per year for 11 years and the public hardly knew.

So what happened since the collapse? Gold has made a rather nice rebound.

The Recent Movement In Gold

I will use GLD, the gold ETF, as a proxy for gold. On Thursday April 11, GLD closed at $151.26. Friday and Monday were the crash days. At the close on Monday (April 15), GLD was at 131.31. It was as low as 130.51 intra-day. Yesterday (April 25) GLD closed at 141.63. It hit 142.08 intra-day. The following daily chart summarizes the action:

goldapril

The huge drop was terrifying for many gold investors. Stops were triggered and gold went into free-fall.

In the eight trading days since the bottom, gold was up seven of the eight days. Of the twenty points GLD lost in two days (about 200 points in the price of Gold), more than 50% of the loss was recovered in the subsequent eight days. Whether this recovery is an elongated “dead-cat” bounce is for you to judge.

Political Importance

Three important factors likely motivated the recent take-down of gold:

gold and fiat mages (2)1. Gold as The Anti-Currency

Market manipulations by government are rarely telegraphed and often surreptitious. There are good reasons to believe that government was behind this plummet in gold prices and innumerable articles on the Web discuss this likelihood in great detail. Gold is government’s nemesis. When gold is doing well, it means fiat currencies are being counterfeited. That is exactly what is happening all around the developed world.

If you measure the dollar against the Euro or other currencies, one will always appear stronger because you are using a relative measure. In reality,  both are being debauched, the one being destroyed at a slower rate will appear stronger. Measuring fiat currencies against one another is like measuring the particles floating in a septic tank. At various times particle “A” will float higher than particle “B,” but so what! We all know what is in a septic tank!

Gold is not in a septic tank. It is an absolute measure that cannot be counterfeited. Its value is reasonably fixed in terms of other real goods. When gold appears to rise in terms of some fiat currency, it means that fiat currency is depreciating. Government does not want you to know this. Hence, when things are not good, break the thermometer that we call gold or remove the canary from the coal mine.

2. Cutting Off An Escape

A related event of importance, which I believe has not received enough attention, is the Cyprus bank “bail-in.” Telegraphing to Europe and the rest of the world the fact that deposits in banks are no longer safe was a government act of idiocy. For those who believe government is terminally stupid, Cyprus was an act which exceeded even these low expectations.

Actions regarding the confiscation of assets (retirement accounts, pensions and other wealth) are routinely discussed by those who know there is no way out of this mess. The actions in Cypress validated these ideas to a large portion of the masses who otherwise believed such talk to be “kook-babble.” Cyprus demonstrated government’s willingness to do anything to survive. It telegraphed the danger to non-believers.

Gold is a natural escape for storing wealth. It has been for thousands of years. It cannot be debauched like fiat currency, and it is easy to hide or transport. In short, it is the perfect money (and this is why government always tries to discredit it).

The reason to flee banks was established. Once that cat was out of the bag, it was necessary to destroy the key means of escape — gold. Not attacking gold ran the risks of bank runs and wealth disappearing from government control.

I do not believe that Cyprus and the signal it sent to citizens around the world can be overstated. It revealed the true nature of government and the danger that we all face.

3. The Dishonesty in the Gold Markets

The amounts of gold claimed to be held by various financial intermediaries, including the US Federal Reserve and perhaps Fort Knox, seem to be fallacious. There has been no public, physical audit of these stocks for many decades. Rumors have been circulating for years that the Fed has leased out its gold to bullion banks, who then have sold it into the marketplace partly as an effort to depress gold prices.

Sovereign countries store a lot of their physical gold in the US. Recently, Germany requested a return of their physical gold, a process that should take about a week to accomplish. Germany was told that it would receive its gold over a period of seven years! Does that make you wonder whether the gold is actually where our authorities say it is?

If the gold was leased and then sold into the marketplace by bullion banks, then these banks have to buy it back to be able to return it. Most of this gold was sold at much lower prices than today, making it virtually impossible to buy it back without bankrupting many of these institutions. Similarly, rumors of massive short positions in gold by large investment banks suggest further bankruptcies or financial hardships should this gold have to be delivered.

All of these political problems are lessened when the price of gold falls.

Did Government Shoot Itself in the Foot?

The reaction to the gold take-down has been rather remarkable. The manipulation of the paper market in gold has created enormous demand in the physical markets. Gold dealers have seen runs on their inventory by customers. Many have trouble keeping gold in stock. Michael Snyder reports:

The crash of the price of paper gold on Monday has unleashed an unprecedented global frenzy to buy physical gold and silver.  All over the planet, people are recognizing that this is a unique opportunity to be able to acquire large amounts of gold and silver at a bargain price.  So precious metals dealers now find themselves being overwhelmed with orders in the United States, in Canada, in Europe and over in Asia.

Will this massive run on physical gold and silver soon lead to widespread shortages of those metals?  Instead of frightening people away from gold and silver, the takedown of paper gold seems to have had just the opposite effect.  People just can’t seem to get enough physical gold and silver right now.  Those that wish that they had gotten into gold when it was less than $1400 an ounce are able to do so now, and it is absolutely insane that silver is sitting at about $23 an ounce.  If the big banks continue to play games with the price of gold, we are going to see existing supplies of physical gold and silver dry up very quickly.

And once reports of physical shortages of gold and silver become widespread, it is going to absolutely rock the financial world.  But this is what happens when you manipulate free markets – it often has unintended consequences far beyond anything that you ever imagined.

It seems that government’s attempt to discredit gold has served to awaken the awareness of gold’s value as a protection against predatory government and an economic future unlike anything we have seen before.

Jim Sinclair summarizes my feelings with two quotes from a recent email:

“Nothing will unnerve the paper gold shorts more quickly and do more to undercut their confidence than to strip them of the real metal and force them to come up with more hard gold bullion to make good on deliveries. “Stand and Deliver or Go Home” should be the rallying cry of the gold longs to the paper gold shorts.” –Trader Dan Norcini

QE to Infinity, followed by Gold balancing the balance sheets of the sovereign balance sheet disasters. Just as there is no tool other than QE to feign financial solvency, there is no tool to balance the balance sheet of the offending entities other than Gold. It is just that simple. –Jim Sinclair

Nothing is simple in investing or trading. Matters are especially more complicated when markets are no longer dominated by economics but by interventions. The closest thing to a sure thing (and there are none) was gold, given the bankruptcy of sovereigns around the world. That sureness played out as gold rose from $250 per ounce to a high of $1,900 in the space of eleven years. Whether it was ever a sure thing is irrelevant. It is a better thing today than it was two weeks ago. Nothing has changed except that it is cheaper.

It will be a bumpy ride and one with institutional ambushes along the way. But it may be the only vehicle that can get you through the chaos ahead. A friend of mine (NII), summarizes your choice quite succinctly:

So who do you trust; a 5,000 year history of GOLD persevering over fiat currencies in preserving value or a handful of MIT academics controlling some of the largest Central Banks in the world openly admitting they are experimenting with your currencies/savings? The game is far from over as to who or what determines the price of GOLD.

 

When Suckers Finally Realize

governmentinsolvThe fleecing of the American public continues.

The theft takes different forms, but it all serves one purpose — to transfer wealth from the average Joe to the crony corporatists and their political lackeys. Here are but a few examples of how this has been accomplished:

  • Bailouts for the wealthy and well-connected are paid for by the unconnected middle class.
  • Subsidies are provided for unworkable schemes submitted by political donors and favorites. These schemes inevitably fail and the tax-payer is left holding an empty bag.
  • Laws are routinely ignored when “friends” need help. In identical circumstances, would you receive the same treatment as Jon Corzine?
  • Despite the biggest theft in world history, no one was prosecuted. The Savings and Loan crisis in the 1980s was trivial in comparison to the recent financial crisis. More than a thousand S&L executives were prosecuted.
  • Ever-increasing sacrifices in the form of higher taxes from the productive sector are demanded to continue the plush living of the ruling class.

Capitalism and free markets depend upon trust, integrity, property rights and the rule of law. Without these, there are no advantages to free markets. Nor are there any incentives to create wealth. Instead, an economy becomes little more than a massive plunder scheme where the powerful exploit the weak. No economic recovery is possible under such circumstances.

french revolutionWhen Suckers Revolt

As people recognize what is happening, they alter their behavior. Three reactions are to be expected:

1. Some will become discouraged when they realize the game is stacked against them. They will diminish their efforts to succeed, even perhaps dropping out of the game altogether. Given the enhanced returns to not working, it should not be surprising that this alternative has become popular.

2. Others will adopt the same behavior as the ruling class. They will exploit those lower on the food chain than themselves.  Justice Brandeis warned of the implications of government misbehavior:

In a government of laws, the existence of the government will be imperiled if it fails to observe the law scrupulously. Our government is the potent, the omnipotent teacher. For good or ill, it teaches the whole people by its example. If government becomes a lawbreaker it breeds contempt for law: it invites every man to become a law unto himself. It invites anarchy.

Daniel Patrick Moynihan described the process of declining moral values as “defining deviancy down.”

3. Others may resort to acts of violence. These reactions could be isolated domestic terrorist acts against government and corporations seen as the exploiters. Or the acts might be broader based where the poor see fit to attempt to take from the wealthy. They also could manifest in wide civil unrest against the government if it is seen as the cause of misery or if it is seen as intending to default on promises made. 

All of this behavior is anti-social and it is unproductive. It reduces the output of the economy, further exacerbating the problems. 

How Does This End? 

It is difficult to know how the current condition ends. Here are a few possibilities, with some opinion added: 

  • Will our ruling class alter its behavior? That is very unlikely. History provides no examples where power is willingly relinquished.
  • Will our economy collapse? That is a likely outcome, although the process could take years or decades. 
  • Will social unrest occur? Probably. The government, at some point will be unable to honor its promises. It is broke and left with the printing of money as its primary source of funds. Stopping the printing means dishonoring promises and likely plunges the country into civil unrest.
  • Will hyperinflation occur? If the government continues to print, that seems to be the inevitable result. 

Issues That Need To Be Solved

We are too far into this economic disaster to escape without an economic collapse of some sort. Return to normal economic times is impossible without a complete and thorough purging of the economic distortions and capital mis-allocations produced from decades of government interventions.

The following issues prevent a recovery:

  • No economy can prosper without a strong middle class. They are the productive class in society. They are the small businesses and job creators. Without them, society does not produce. Without production, there is only poverty.
  • Inflation, the cruelest tax of all, is driving up prices while wages and salaries do not keep pace. For those without wealth, there is no way to protect against this theft. For those with wealth, they can rearrange investments to take advantage of inflation, particularly if they are privy to what is coming next.
  • The economy is dysfunctional. It no longer functions efficiently as a result of the burdens it is forced to labor under. The price system has been made less efficient as a result of inflation, manipulated interest rates, subsidies, penalties and other impediments. It no longer provides the information needed by economic actors to make proper decisions.
  • Regime uncertainty discourages action. When economic actors are unable to judge the future, they pull back. Money goes to the sidelines or out of the country.
  • US economic policy and the uncertainty of what comes next has been a great job creator for other countries.
  • Economic growth cannot be forced by central diktats. It occurs only in a climate that is receptive and friendly to risk-taking. It is hard to imagine a worse environment than the current one. That is why there is no investment and no hiring.

What Is The Outlook?

There should be no optimism regarding government changing its ways. History suggests it never does.

The recent plunge in the gold market suggests government has gone all in in its attempt to continue exploitation. Chris Martenson commented on this event:

I am very disappointed by, but not surprised at, the latest transfer of weath to the bankers from everyone else. The most recent gold bear raid has vastly enriched the bullion bankers, once again, at the expense of everyone trying to protect their wealth from global central bank money printing.

Gold is considered a safe-haven against government plunder. It is one of the few escapes from fiat currency debauchery that the small investor has. Whether this latest attack on gold was to make the bullion bankers better off or to scare those trying to protect themselves against government exploitation is irrelevant. When government intervenes (assuming it did, and the circumstantial evidence is pretty strong) in markets in such a manner, it is no longer a referee. It has chosen a side and is a participant in the game. There can be no fair competition when one team owns the referee. That is what happens when government participates in markets.

Historians judge that it took Rome almost two hundred years to die. That determination depends very much upon what you mean by “die.” Arguably Rome died much earlier than historians acknowledge. Rome was dead-man walking before the couple of hundred years it took for it to fall down. 

The US is in similar position. Unless you believe in the miracle of sovereign resurrection, the US is over. The coroner-historians have not pronounced death yet, but they, like with Rome, are behind the curve. This dead man too will eventually fall down. 

The Country Is Over

america us-sinking-shipData are hard to deal with when your vision is on the wrong side of it. Those wanting to claim there is a recovery underway are having just this problem. These people either have no understanding of economics or they believe falsely that they can inflate “animal spirits” with their hyped reports and that will initiate a recovery.

There will not be an economic recovery given the economic policies of this country. A recovery is not unlikely, I would argue it is closer to impossible if not impossible. The reasons for this position are not complicated. In short, the nation has become an out-of-control welfare state that is rapidly destroying the incentives to work or create jobs. Government policies appear designed toward this end. One doesn’t need a high IQ or  an advanced degree in economics to understand the problems.

There are innumerable factors responsible for the decline of the US. Only three important ones will convey why the economy is dying:

1. The rule of law and property rights are under attack. cyprusbankrobbery(2)

What do you really own? The depositors in Cyprus believed they owned what was in their bank accounts. They found out otherwise. Bondholders of General Motors believed they were protected by bankruptcy laws when GM was bankrupted by the government. They found out otherwise. Do you own your pension plans and IRAs. Well you always believed you did except now there is talk about confiscating a portion or all of these funds.

How much of your income do you own? For those doing well, let’s say 60%. But that portion is under attack with the “need” for higher taxes and “fair share” gobbledegook. What about Social Security? Although the government sold it as a retirement policy and told you it is yours, the government says in fine print it is not. That is their excuse for not treating it as a liability on their balance sheet.

The fact is that the rules are being changed at will by the side who has lots of guns. The number of rules and laws that have been changed or ignored in the past several years makes one wonder what laws will remain. We are  approaching the point where there are no rules which means there can be no society. Without cooperation, markets will cease to function efficiently or perhaps at all. Millions of people will starve to death under such conditions.

2. Obamacare has raised costs

The costs associated with Obamacare are still not known or calculable. The rules are still being written. Already there are thousands of pages. Even though we passed it as Speaker Pelosi suggested as a means to find out what was in it, we still don’t know as the rules are still being made up.

For sure the program is driving up the costs of medical care and driving down the quality. That is exactly the opposite of what was promised. Business firms face great uncertainty as to what this mandate will do to their costs and operating procedures. Obamacare is rising the cost of employees. When you penalize something, you get less of it. That is a prime reason why there is no employment recovery in this country.

Employers have frozen their hiring until clarity develops. The development of clarity is no assurance that they will change their behavior. If the costs are too high (and they appear to be for many smaller businesses who create the most jobs), then hiring will not return.

The effect on hiring is only one negative. Full-time workers are being made part-time in order that they be exempted from the Obamacare mandate. These steps are not something business wants to do, it is something they must do in order to survive.

3. Government policies have made the dole more lucrative than work

As we make it easier to get unemployment benefits for longer time periods, more people take advantage of the system. So too with food stamps and disability. All programs are at or near record levels in what is supposed to be four years into an economic recovery. For many, the benefits of becoming a government dependent exceed what they can earn. One study reported that a family of four, collecting all the benefits for which they were entitled, would have to earn $65,000 per annum to have the same after-tax purchasing power.

If you are a product of the government schools and are legal to work (i.e., have skills enough that you are affordable at the minimum wage or higher), at what point do you realize that there is no need to go through the hassle of actual work. You can live pretty well by staying home and taking advantage of the entitlements available to you. That is exactly what a larger and larger percentage of the population are realizing. In many cases, it is economically irrational to work.

This behavior creates a social pathology that only worsens over time. Kids learn from their parents that work is not necessary and the many ways to game the system. In this regard, look for this problem to become worse over time unless these programs are cut back.

There Can Be No Recovery

Despite all you hear coming from the government’s media megaphone, there is no economic recovery underway, nor can there be one. The policies in place ensure that one will not happen. Economics is not a top-down science as Keynesians and politicians want you to believe. You can throw as many Fed dollars into the system or devise innumerable government stimulus programs. These are all top-down. Economics is a bottom-up process that starts with individual decisions and behavior. Individuals respond to available choices and incentives. They act in their own self-interest not in the manner in which some government planner wants them to act. Top-down programs do not affect the incentives of the individual decision-makers.

We raise the costs on those who work (higher taxes) and the businessmen who provide the jobs. One of the basic laws of human nature is that when you penalize something or make it less pleasant, people will want less of it. It is not a mystery why business is not hiring and the number of workers is declining. The return to both is declining as a result of government policies.

We raise the rewards for not working. Another basic law of human behavior is that when you increase rewards for a particular kind of behavior, you will get more of it. It is not a mystery why more people are choosing the dole than ever before. Government has encouraged them to do by providing higher rewards.

Add in the regime uncertainty associated with unstable or unpredictable laws and regulations and you have the perfect storm. There is no incentive to hire. Business hunkers down not knowing what is coming their way next. They understand they are targets of this Administration. It is unlikely that there will be any improvement on this fron while Obama remains in office. This behavior has nothing to do with politics. Even businesses headed by Democrats are behaving in this fashion. It is self-interest as in the desire to survive that motivates this behavior.

Why The Economy is Dying

As government grows the private sector shrinks. As the private sector shrinks there are fewer goods and services produced (government produces no goods and few services). I believe it was Dick Armey who described this situation with the wagon analogy: there are more people riding in the wagon and fewer pulling the wagon. As the wagon becomes heavier, the remaining pullers must work harder to move it.

The pullers must support the riders. Government does not support the riders or anyone else for that matter. Whatever government has it has taken from the pullers. Whatever it doles out it must get from taxes, borrowing or printing new money. Regardless of which means it uses, it is all coming from the pullers. They pay the borrowing back. They have less as a result of higher taxes. They are made poorer by the rising prices from the printing of money.

As the burdens increase on the pullers and the benefits increase for the riders, more pullers decide to ride. The truly creative and talented can always make enough money to continue to work rather than ride. However, when their efforts can be expended in other countries that penalize them less, at some point they no longer pull the wagon. They leave the country to climes where they are treated better.

Each increase in government spending means requires more money from the private sector. That means greater distortions in the incentive-disincentive calculus that produces fewer people pulling the wagon. Now fewer people must support more non-producers. Every time someone gets in the wagon, the burden on the productive sector increases. More must be extracted from a smaller group to serve the increasing riders.

That is what is happening in this country. If it is not reversed, the economy will stagnate and eventually implode. This conclusion is dependent upon nothing more than simple arithmetic. How bad is the imbalance today? Tyler Durden provides some information (my emboldening in red added):

The punchline: 110 million privately employed workers; 88 million welfare recipients and government workers and rising rapidly.

And since nothing has changed in the past two years, and in fact the situation has gotten progressively (pardon the pun) worse, here is our conclusion on this topic from two years ago:

We have been writing for over a year, how the very top of America’s social order steals from the middle class each and every day. Now we finally know that the very bottom of the entitlement food chain also makes out like a bandit compared to that idiot American who actually works and pays their taxes. One can only also hope that in addition to seeing their disposable income be eaten away by a kleptocratic entitlement state, that the disappearing middle class is also selling off its weaponry. Because if it isn’t, and if it finally decides it has had enough, the outcome will not be surprising at all: it will be the same old that has occurred in virtually every revolution in the history of the world to date.

But for now, just stick head in sand, and pretend all is good. Self-deception is now the only thing left for the entire insolvent entitlement-addicted world.

Mr. Durden’s article is worthwhile and informative. I encourage you to read it in its entirety, including the PDF attached.

 

lawrenceIs The Decline Inevitable?

Of course not. As Lawrence of Arabia stated: “Nothing is written.”

The Economic Solution

The solution to solving the problem is quite simple for an economist. Merely reverse the process. Make it attractive for people to jump out of the wagon and begin pulling. For businesses, make it attractive for them to hire. Make it unattractive to be on the dole. Reverse the growth of government and you increase the size of the private sector. More capital is made available for productive activities rather than being squandered by government. Talent stops leaving the country when they are treated more favorably here, whether this be via lower taxes or less onerous regulatory burdens. Then, get government out of the way and let markets solve the problem.

The Political Barrier

For the political class, the solution borders on the impossible. Politicians have bribed the citizenry with goodies for votes. They have sold the notion that government is responsible for all good things. The economic solution runs counter to everything that politicians have peddled. Further it reduces their power and ability to retain office, at least in a manner in which they are accustomed. It shrinks their perquisites. It shrinks their vote-buying ability. In short, it is virtually impossible for them to go along with such a solution.

What politicians thrive on is what created the current problems. Reversing this behavior is alien to them. They would not know how to behave under such conditions. Yet the economic solution is the only solution!

Do I expect politicians to change and save the country? No! Is it possible they could? Probably not, but “nothing is written.”

 

Why You Should Stay In Markets Despite What Is Coming

markets14 (2)I have argued elsewhere that the risks of being out of the stock market may exceed the risks of being in it, even though a major drop may occur. This article will explore that position.

Why You Should Be Concerned?

Stock market investors should be wary, very wary. These times look and feel much like 1999 or 2007. The long-term chart of SPY, the ETF for the S&P 500 looks ominously similar:

spychart

Is this time different? Will we have another 50% plus leg down as happened twice in the first decade of this new century?

There is reason to be concerned.  Performance last decade ranked with that of the decade of the 1930s. Is this pattern going to continue this decade?

stockmarketreturns_grph

Adding to the worries is the fact that the economy is not right. It has not recovered in any normal sense. Despite trillions of dollars of stimulus, the recovery (some would say there has been none and that we are still in a recession/depression) has been the most anemic on record.

Are the recent highs in markets due to the liquidity blanket provided by central banks around the world? Should markets be at the levels they are when deficits and debt burdens seem intractable and destined to sink economies?

There is little logic in markets. Liquidity from central banks has made traditional valuation techniques almost useless. Markets have become increasingly like roulette wheels where your intellect and analysis have little bearing as to whether you win or lose.

What Do I Do?

We do not know what lies ahead for the stock market. Oh, we have expectations but they are merely guesses that only coincidentally will be met.

Logic tells us that the stock market cannot continue at these levels without a real economic recovery.  But the stock market is not ruled by logic, at least in the short-term and in these strange times of on-going liquidity injections.  Markets could easily double from here in the next couple of years or they could halve just like they did at the turn of the century and in 2008.

No one who went through the last two market corrections wants to deal with a third one. Yet, that experience is inevitable for someone who remains in markets over the long term. The difficulty is that we don’t know whether the repeat is close or off several years.

Stay in Markets, Regardless

My answer to the issue of staying in or getting out of markets is to stay in. This answer is independent of whether a correction is imminent or a few years down the road because we cannot possibly know that information.

This answer may seem strange, but I believe I can show you why it is the correct one, even when a correction is about to occur. In doing so, you may gain a better appreciation of why a buy and hold strategy is not appropriate for these markets.

The second part of this series will demonstrate what a buy and hold strategy would achieve.

The third part will provide a different approach using momentum selections to enter and exit markets.  It provides a way to participate in dangerous markets while reducing the downside risk.

There will be a time to completely flee markets. It is just not now or at least I don’t believe so.

Part II

In Part I, it was suggested that one should stay in markets, even though there appears to be substantial downside risk. The reason to stay is that no one really knows what is going to happen and the opportunity cost of missing an upside move can be large.

But, you reasonably ask, suppose the market craters? That is a real risk, especially given today’s economic situation.  Should I stay in markets if we are on the verge of another version of a dot-com bust or housing collapse? Both caused markets to drop over 50%. The graph below illustrates the severity of these corrections:spychart

Today looks eerily similar to the points which preceded both collapses.

No one wants to go through this kind of adjustment. Yet, they are part of the risks of participating in markets. These patterns repeat; we just don’t know when. Unfortunately they appear to be coming more frequently.

A Bad Drop

What happened in 2008 was especially bad and sudden. The SPY dropped 55% in less than a year. It was a very vicious decline.  As such, it provides a good scenario against which to stress test trading strategies.

Assume that we are at a point corresponding to the beginning of 2007. How would our investing/trading techniques weather the same conditions represented by this most recent market adjustment? Would we be able to mitigate the losses (or even avoid them)? That is what we will look at in Parts II and III of this series.

A traditional buy-hold, diversified investing strategy will be evaluated here. Then, in Part III, the same downturn will be traded using a simple momentum-based switching system. I think you may find the difference striking.

Simple Buy-Hold Strategy

To keep matters simple, assume there are only two assets: SPY (ETF for S&P500) and EFA (ETF for broad collection of International [ex US] companies). Each is well-diversified within the geographical boundaries they represent. We begin with a portfolio of $10,000 on January 1, 2007 (or today if you assume history repeats).

Investors choose an allocation between these two broad asset categories based on their preferences. For illustrative purposes, only three allocations are reviewed. These included the two extremes of 100% in one or the other of the choices and then a 50% allocation to both. The returns from January 1, 2007 through March 26, 2013 from the buy and hold strategy are as follows:

  • All SPY              25.8%
  • Half SPY – Half EFA  11.0%
  • All EFA      <3.7>% (LOSS)

The results, as expected, reflect the overall performance of markets during this period. To be polite, one can characterize them as poor. The returns seem more applicable to a one-year holding period than a six plus year span. It is difficult to recover from drawdowns of 50% which both ETFs incurred. Both had nice recoveries afterward although EFA closed with a small loss for the total period.

Let’s look at the pattern of equity over time. All US (100% SPY), All International (100% EFA) and an equal allocation (50-50) between US and International are shown in the graph below: 

PORTFOLIO EQUITY

stayinmarket1

For actual investors who went through this period with diversified portfolios, the results above are likely to be fairly representative. The high correlation among assets and asset classes limited the ability of diversification to help, at least diversification within stocks. That is apparent by how the equity curves above track one another.

Given the pain that began around the 20th month onward, one wonders how many investors actually stuck with whatever strategies they intended. When losses mount, the tendency is to take money off the table. Some reduce exposure by taking some funds out of markets while others take everything out. Those who didn’t stay with the buy and hold strategy did worse or better, depending upon their timing and nerve. Did they re-enter the market at a point below where they exited? Some undoubtedly did, but most probably did not.  Fear is a paralyzing emotion and there was a lot of it during this sell-off.

In Part III a simple momentum-based strategy will be reviewed. This strategy provides better returns and less risk. It is less emotional as a result of lower draw-downs and provides a mechanical discipline that reduces the danger of making decisions under emotional stress. The results are quite impressive.

 Part III stock_market_01

In Part I of this series, the character of current markets was reviewed. Part II hypothesized another stock market correction comparable to that of 2008. The performance of a buy and hold strategy under this scenario was tracked .

The final part of this series discusses a momentum investing strategy and applies it to the downturn of 2008. Its results are be compared with that of the buy-hold outcome.

The Momentum Approach

A momentum approach identifies which sectors or markets are performing well and then moves funds into these areas. This approach can be used with industries, sectors, within sectors (i.e., best performing stock(s) within a sector), ETFs, mutual funds etc.

For purpose of illustration, the simple two-asset world of EFA and SPY will be continued. Doing so allows a comparison with the buy and hold results achieved in Part II.

Proprietary Approach

The momentum approach uses multiple performance measures, including measures of rates of change and volatility, to rank assets. For selection purposes, high recent returns rank high while high recent volatility ranks low. Additionally, other minimum criteria are used to screen out assets that do not exceed an acceptable minimum threshold, regardless of the performance rankings.

The minimum threshold criteria mean that a portfolio may not be fully invested at all times. If not enough ETFs exceed the minimums, then cash replaces supplants them in the portfolio. Thus, for any given time period, a portfolio may be fully invested, partially invested or all cash. Market conditions and asset choices dictate.

To account for cash,  a third ETF is used as a cash proxy. SHY, a short-term bond ETF, is used in what follows. Cash itself or some other relatively risk-free, short-term bond fund would yield comparable results.

The Mechanics of Momentum Investing

Momentum investing requires regular updating of the performance measures. These measures are used to select the assets to be included in the portfolio. The time period for re-balancing is judgmental and situational. Commonly used re-balancing choices are bimonthly, monthly and quarterly. In some cases weekly or annually are appropriate.

This model uses monthly re-balancing. The reason for such a short re-balancing period is based upon the volatility and danger inherent in current markets. If you are “trading in front of Armageddon,” you cannot afford to overstay your welcome.

The monthly re-balance was a reasonable compromise between other alternatives. Quarterly re-balancing was deemed not frequent enough and bi-monthly did not add meaningful value while doubling the calculations and potential transactions.

The Results of Momentum Investing for January 2007 through March 26, 2013

Using the momentum algorithm, one ETF was selected at the beginning of each month and held for a month. One hundred percent of equity was put into that one asset. The selection process was repeated each month thereafter and the portfolio adjusted each month based rankings. In some cases the same ETF ranked highest for several consecutive months.

Each month either SPY, EFA or SHY was selected. SHY was only selected when neither SPY or EFA met minimum acceptance criteria.

The beginning $10,000 equity grew to $18, 143 under the momentum method. This compares favorably with the performance of SPY ($12,576), EFA ($9,626) and a 50-50 weighted portfolio ($11,101) over the full period. For the six-plus years, the total return from momentum investing was 81.4%, dramatically outperforming the buy and hold strategies.

Graphically, the equity balances of all four portfolios are shown over time:

 PORTFOLIO EQUITYstayinmarket2

Take-Aways From The Chart

The superior outcomes exhibited by the momentum strategy are obvious. Less obvious, are the following observations:

  • The momentum strategy never went negative. That is, throughout the period equity never went below $10,000.
  • All of the buy-hold strategies saw equity nearly halved from its beginning amount. Around the 26 month mark the value of buy and hold strategies declined to around $5,000.
  • Around month 19, the buy and hold strategies plummeted while the momentum portfolio actually grew slightly.
  • The maximum drawdown of SPY and EFA were 55.2 and 61.0% respectively. Drawdown represents the largest drop in total equity in percentage terms. For buy and hold strategies, the largest drop occurred during the market selloff in 2008 (approximately months  12 through 28).
  • The maximum drawdown of the momentum strategy was 16.4%. Interestingly, the maximum drawdown occurred around months 40 to 47 (around the first quarter and second quarters of 2010) and not during the major market sell-off of 2008.

Digging Deeper

The following table provides the detail by month.

DETAILS BY MONTH

End Date Portfolio Return SPY EFA Best of 2
1/31/2007 EFA 1.39% 1.50% 1.39% 1.50%
2/28/2007 SPY -1.96% -1.96% -0.12% -0.12%
3/30/2007 SHY 0.45% 1.16% 2.90% 2.90%
4/30/2007 EFA 3.75% 4.43% 3.75% 4.43%
5/31/2007 SPY 3.39% 3.39% 2.36% 3.39%
6/29/2007 SPY -1.46% -1.46% -0.32% -0.32%
7/31/2007 SHY 0.90% -3.13% -2.29% -2.29%
8/31/2007 SHY 1.05% 1.28% -0.63% 1.28%
9/28/2007 SHY 0.55% 3.87% 5.32% 5.32%
10/31/2007 SPY 1.36% 1.36% 4.25% 4.25%
11/30/2007 EFA -3.62% -3.87% -3.62% -3.62%
12/31/2007 SHY 0.30% -1.13% -2.99% -1.13%
1/31/2008 SHY 1.65% -6.05% -7.85% -6.05%
2/29/2008 SHY 1.03% -2.58% -1.02% -1.02%
3/31/2008 SHY 0.25% -0.90% 0.42% 0.42%
4/30/2008 SHY -0.84% 4.77% 5.44% 5.44%
5/30/2008 EFA 1.19% 1.51% 1.19% 1.51%
6/30/2008 EFA -8.80% -8.35% -8.80% -8.35%
7/31/2008 SHY 0.43% -0.90% -3.32% -0.90%
8/29/2008 SHY 0.47% 1.55% -4.25% 1.55%
9/30/2008 SHY 0.78% -9.44% -11.44% -9.44%
10/31/2008 SHY 1.10% -16.52% -20.83% -16.52%
11/28/2008 SHY 1.10% -6.96% -6.37% -6.37%
12/31/2008 SHY 0.56% 0.98% 8.88% 8.88%
1/30/2009 SHY -0.44% -8.21% -13.73% -8.21%
2/27/2009 SHY -0.15% -10.74% -10.39% -10.39%
3/31/2009 SHY 0.50% 8.35% 8.39% 8.39%
4/30/2009 SHY -0.16% 9.93% 11.52% 11.52%
5/29/2009 EFA 13.19% 5.85% 13.19% 13.19%
6/30/2009 EFA -1.43% -0.07% -1.43% -0.07%
7/31/2009 SHY 0.11% 7.46% 10.04% 10.04%
8/31/2009 EFA 4.50% 3.69% 4.50% 4.50%
9/30/2009 EFA 3.80% 3.55% 3.80% 3.80%
10/30/2009 EFA -2.52% -1.92% -2.52% -1.92%
11/30/2009 SPY 6.16% 6.16% 3.92% 6.16%
12/31/2009 SPY 1.91% 1.91% 0.70% 1.91%
1/29/2010 SPY -3.63% -3.63% -5.07% -3.63%
2/26/2010 SHY 0.16% 3.12% 0.27% 3.12%
3/31/2010 SHY -0.27% 6.09% 6.39% 6.39%
4/30/2010 SPY 1.55% 1.55% -2.80% 1.55%
5/28/2010 SPY -7.95% -7.95% -11.19% -7.95%
6/30/2010 SHY 0.42% -5.17% -2.07% -2.07%
7/30/2010 SHY 0.19% 6.83% 11.61% 11.61%
8/31/2010 EFA -3.80% -4.50% -3.80% -3.80%
9/30/2010 SHY 0.12% 8.96% 9.97% 9.97%
10/29/2010 EFA 3.81% 3.82% 3.81% 3.82%
11/30/2010 SPY 0.00% 0.00% -4.82% 0.00%
12/31/2010 SPY 6.68% 6.68% 8.30% 8.30%
1/31/2011 SPY 2.33% 2.33% 2.10% 2.33%
2/28/2011 SPY 3.47% 3.47% 3.55% 3.55%
3/31/2011 EFA -2.39% 0.01% -2.39% 0.01%
4/29/2011 SHY 0.53% 2.90% 5.63% 5.63%
5/31/2011 SPY -1.12% -1.12% -2.21% -1.12%
6/30/2011 SHY 0.00% -1.69% -1.19% -1.19%
7/29/2011 SHY 0.29% -2.00% -2.38% -2.00%
8/31/2011 SHY 0.34% -5.50% -8.75% -5.50%
9/30/2011 SHY -0.10% -6.94% -10.81% -6.94%
10/31/2011 SHY 0.03% 10.91% 9.63% 10.91%
11/30/2011 SHY 0.04% -0.41% -2.18% -0.41%
12/30/2011 SPY 1.04% 1.04% -2.21% 1.04%
1/31/2012 SPY 4.64% 4.64% 5.27% 5.27%
2/29/2012 SPY 4.34% 4.34% 4.83% 4.83%
3/30/2012 EFA 0.42% 3.22% 0.42% 3.22%
4/30/2012 SPY -0.67% -0.67% -2.08% -0.67%
5/31/2012 SHY 0.06% -6.01% -11.14% -6.01%
6/29/2012 SHY -0.10% 4.06% 7.11% 7.11%
7/31/2012 SHY 0.22% 1.18% 0.08% 1.18%
8/31/2012 SPY 2.51% 2.51% 3.20% 3.20%
9/28/2012 SPY 2.54% 2.54% 2.71% 2.71%
10/31/2012 EFA 1.08% -1.82% 1.08% 1.08%
11/30/2012 EFA 2.79% 0.57% 2.79% 2.79%
12/31/2012 EFA 4.37% 0.90% 4.37% 4.37%
1/31/2013 EFA 3.73% 5.12% 3.73% 5.12%
2/28/2013 SPY 1.28% 1.28% -1.30% 1.28%
3/26/2013 SPY 3.48% 3.48% 1.32% 3.48%

 

The table above consists of monthly data. It includes, reading from left to right, the selection made by the momentum algorithm, the return on that selection, the return of SPY, EFA and then the better return of SPY and EFA.

Some points worth noting from the detail:

1. Any time SHY was chosen, the portfolio was out of the stock market and into cash (cash equivalent). Some serious monthly losses were avoided by going to cash. SHY avoided at least a monthly loss of 2.3% in July of 2007. In the downturn of 2008, SHY was a regular selection. Note the massive losses that were avoided in September, October and November of 2008.

2. The column to the right needs some commentary. It represents the best return for that month between SHY and EFA. It was created to show what “perfect foresight” might produce. It required you to invest in stocks but allowed you to always select the better performing of the two choices. In some cases, “better” was “less bad.” Although such knowledge is unavailable in real investing, it provides an interesting benchmark to see the value of periodically leaving the stock market. This column grew equity to $23,205, higher than that of the momentum selections. While that should not surprise, the following point might.

3. The graph below adds the “perfect foresight” equity line (labelled omniscience) to the graph of the other lines.

PORTFOLIO EQUITYstayinmarket3

The two red arrows point to important conclusions. Even with “perfect” foresight, the equity line went negative. A drawdown from about $11,000 to about $6,500 occurred in 2008. The other red arrow shows that it took almost four years before the mythical “perfect’ foresight model overtook the momentum selection model. The important point is in volatile markets you must be able to go to cash when markets become dangerous. If you insist on staying in the stock market at all times, even perfect foresight cannot protect you. Without perfect foresight, your pain will be even greater.

This last point cannot be emphasized enough in the markets we faced thus far this century. If you expect these to continue as I do, then you must ensure that you have some objective means of leaving the scene of before tragedy strikes. That is exactly what the momentum selection model does well. It protects your capital on the downside and enables it to grow on the upside! To put this into perspective, a breakdown of the time spent in each asset is useful. The portfolio was all cash 29% of the time. It was invested in SPY 47% and EFA 24% of the time. On average, the portfolio was in cash about 3.5 months per year. The ability and willingness to periodically run away beats the macho strategy of holding on.

New Add For Premium Members 

This momentum model will be added to the information already provided to Premium Members at Trading to Armageddon. It can be used as a stand-alone trading system similar to what was presented here or can be used in conjunction with the Full Portfolio selections as a weighting tool to better allocate funds between US and International assets.

Disclaimer

These results are historical. They may or may not be repeatable. There is no assurance that the model will work as well in future periods. All investing is risky and subject to losses.  Any major investing decision should be reviewed with a qualified and trusted financial adviser

Sign Up

If you are interested in seeing the monthly selections, go to Trading to Armageddon and sign up for a Premium Membership. The cost is $11. 00 per month and can be cancelled at any time.

This article replaces “Staying in Markets” which appeared as a three-part series.

Monty Chats With Brian Wilson of Libertas Media

radiointerviewsI had the occasion to chat with Brian Wilson of Libertas Media  The discussion covered current economic events, particularly Cyprus, as well as some distinctly non-economic topics. You can listen to the podcast here.

Mr. Wilson’s new endeavor is needed and overdue. He will bring some of the strongest voices for liberty (Walter Williams, Lew Rockwell, Judge Napolitano, etc.) to the internet and I wish him well in his endeavor.

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