Broker Check

The Chronicles of Reflation (Part II)

March 01, 2013

"Preserve sound judgment and discernment, do not let them out of your sight; they will be life for you, an ornament to grace your neck. Then you will go on your way in safety, and your foot will not stumble." - Proverbs 3:21-23

Come on, Jack - first it was Japan you were comparing the U.S., to - now it's Sweden? And you're comparing the U.S., 2013 to U.S., 1947 ? Come on - we're the modern, U.S. of A, man!

We're not like anybody else and that was then and this is now...


"Genuine money is more than crystallized pleasure. It doesn't come easy, except to those who print it." Dr. Emanuel Derman (developer of the Black-Derman-Toy Interest Rate Model and former managing director and head quantitative strategist at Goldman Sachs -Models Behaving Badly - p.88)

I sincerely hope that you and yours are healthy and that you are enjoying your 2013 thus far. Thank you so much for your trust and for your business. I have a great job and people like you make it possible.


"I am so clever that sometimes I don't understand a single word of what I am saying." - Oscar Wilde

We are going to cover this list of topics this go-'round:

1) Updates from last Insights;

2) Portfolio updates:

  a) Income Now;

  b) Income Later (green lines are good);

   b-1) Social Security - we can help you optimize it (thanks to Dr. Laurence Kotlikoff'scalculator) - in other words: don't just "turn it on", at age 62;

c) Capital Appreciation; + 10.47% in 2012 (net of fees); U.S., stocks may turn in another good year due to Fed reflation, recovery, GDP growth in 2013, profit margins, equity fund flows, and stock buybacks despite sequester; Highlighted U.S., Themes: Farming, Manufacturing, U.S., Energy;

3) Are we in a bull market or a bear market?

4) We are entering a "fiscal retrenchment period very similar to 1947" (Harvard professor: Ken Rogoff), and a "consumer retrenchment period" (me);

5) Turning over rocks works: Bernanke's 2002 roadmap deflation speech;

6) Big charts that matter:

  a) How much longer until unemployment reaches 6.5%?;

  b) Where we may be in the deleveraging process compared to episodes in Sweden and Finland - reflation post their household credit bubble bursts;

  c) Margin debt to S&P 500 chart

  d) Corporate profits as a percentage of overall GDP (1947-2012);

  e) Housing doing much better, yes - be careful about drawing two conclusions: 1) long-term vs.. short-term context, and 2) delinquency rate (update);

  f) Corporate cash on hand nice, but, (5X debt to cash accrual growth), over last 10 years;

  g) What's causing me to not be uber-bearish on U.S., equities: Bernanke & M2 money velocity (chart);


1) Updates from last Insights (last April):

 a) I said that the reported hyper-inflation, interest-rate-inflation was NOT looming that we would just have bond yield spasms and we have; I also said that demand for quality income from senior corporate bonds and quality municipal bonds would increase exponentially, and it has (this demand has driven prices up and yields down to lower levels);

b) I said that Dudley and others at the Fed who are in power (namely Bernanke, Dudley and Yellen), didn't like the unemployment figures and the lack of inflation they were seeing; And we saw a decision from the Fed on December 12, 2012 that targets those two data points: 2.5% inflation and 6.5% unemployment with respect to when they may begin to raise interest rates that are currently at zero.

c) I said we'd be in a global recession around now - we are pretty dadgum close to being in one if we're not already there - What? How can I say that? Stocks are up, housing is improving, consumers are spending money and corporate profits are huge right now. Those things are true; feel free to roll your eyes and disagree, or just read on...

Recession update:

Europe's solid, productive engine, Germany, is very close to a confirmed recession - and they would be joining Japan, Spain, Italy and the UK - currently in recession. The French are in denial, but you'll see their numbers over the next few months. The United States of America is NOT DECOUPLED from the rest of the world. We are more coupled than ever. When Europe enters recession, it doesn't necessarily guarantee that we will be, (because we certainly do have a number of very positive things going on here), but it sure increases the chances by quite a bit.

"The correlation between GDP growth in most large developed countries and the US is high - typically between 70 and 90%." - William Hester, CFA - Hussman Funds - February 2013

And doesn't that make sense? If you have 20 customers that make up 80% of your business and 7 of them are delaying placing orders with you for next year, doesn't your business feel that sharply?

Don't get me wrong - that doesn't mean that global stock markets can't go higher due to reflationary efforts from the Fed, the Japanese, and the ECB. But when this (below), happens to Ford Motor Company...

"In Europe, Ford lost more than US$1.75 billion in 2012, about in line with its outlook for a loss of more than US$1.5 billion. Ford deepened its 2013 loss estimate in the troubled region to US$2 billion." Source: Thomson Reuters - January 29, 2013'd better take notice. Now this doesn't mean that there's not a big opportunity in Europe for Ford - because there is - and they are planning on losses - it's in their business plan - I am long-term bullish on their stock and their bonds both - and I believe (as do many analysts who cover Ford), that they will actually do well there eventually - it's just that at this point in the cycle - you've GOT to be aware of it. Do you think that ONLY Ford's European unit will lose money this year in Europe?

Fed Update - 2-26-13

!Bernanke Watch 2013! That's my CNN headline grab - do you remember how Wolf Blitzer (CNN news reporter), used to always throw out those zingers? - "So and so on the run - this time, it's serious" - stuff like that? I thought I'd join in, too. : )

In all seriousness, I just finished watching Bernanke's testimony today and thought I'd point out a few things he said:

"We can't just increase the Fed Funds rate to 3, 4, or 5 percent. It would hurt the economy so badly. We would enter into a severe recession. We could face a Japanese style deflation". (Ben Bernanke - February 26, 2013)

Bernanke gave no sign at all that he is about to back away from the program.

From 0-0.25% on Fed Funds to 2%

So parenthetically, let's consider that he's not (and the other two - Yellen and Dudley), opposed to moving it to 2%. I've been thinking that for 6 months or so now. By the way, this is not immediate, this is just when he/they decide to move the needle.

Reflation chart update

He won't be the one to do it in all likelihood. It will most likely be Janet Yellen some time between 2015 and 2018 to move the needle to around that 2% level because Bernanke will most likely step down in early 2014 when his term ends just like Tim Geithner (former Treasury secretary), did. Can you blame him? Would you want that job?

That job responsibility reminds me of a movie quote from 1962.

"Your job is to do the impossible." - Brig., Gen., Frank D. Merrill from 1962 WWII movie, Merrill's Marauders

"The Fed is not extraordinary. We are not unlike many other countries in the rest of the world." (Ben Bernanke - February 26, 2013)

"There is no risk-free approach to what we are doing." (Ben Bernanke - February 26, 2013)

Well said. I'd like to go fishing with that guy some time.

I wonder if he'll just retire and spend time with his family or if he'll go into business. Bernanke & Co., sounds like a boutique investment firm to me. I hope that this Bernanke talk and focus does not have a dishonoring tone to it - seriously - would you want that job?


Moving along...

2) Portfolio Updates

a) Income Now

Nearly all of our corporate bonds and municipal bonds invested in between April 2012 (lastInsights), and as of this writing have seen slight to significant capital appreciation. That was not our goal - our goal was to build safe (above-market-yield level), income-generating portfolios.

The GapWeyerhauser, and other high-quality senior corporate bonds that we invested in (and highlighted in the last edition of Insights), with either ~10 year call protection or non-callable features all appreciated between 5% and 20% while promising to pay a 6%+ dividend for those upcoming years. Some of our bonds feature locked in rates and can't go higher in terms of yield; but some are bonds with "kicker" and "step-up" features.

These terms, "kicker", and "step-up", mean that if the bonds are not "called", or refinanced by the issuer, due to a rise in interest rates, the amount the corporation or municipality pays you may actually increase - this is helpful in case I'm wrong and we see a rise in interest rates. It means we are positioned in case of interest rates going lower from here (with callable and non-callable bonds), and it means we've got some protection / ability to see increasing yields from our bonds if interest rates go higher.

Call protection means that as yields remain historically low, you're in the driver's seat - the corporation has the ability to refinance some of their debt to take advantage of low interest rates, but with your's (meaning your bonds), they don't - they have to pay you the higher rate until they have the ability to refinance them - or, in several cases, we've been insistent and bought non-callable bonds to preserve that steady source of income.

Recent investments:

1) Vale Overseas (yankee-dollar denominated, no currency risk), at 5.5% YTW with an A- rating;

2) Con-Way Trucking bonds 6% BBB- rated (non-callable);

3) Aircastle BB+ rated bonds - to 2017 - this is the aircraft leasing company of which Peter Ueberroth (Independent Director of Coca Cola since 1986, and former Commissioner of Major League Baseball), is the Chairman. You can get 4.9% from the common stock and we're only getting 3.89% YTW to 2015 because we are going up the capital structure to be safe. I used that word "safe", on purpose.

You know how I found Aircastle? I was reading Barron's and I saw where Charlie Lieberman (former economist), had some stock picks in there. The article is titled, How to play it safe, and get a 5% dividend. I am a tad cynical at this late phase of the business cycle and when I hear "How to play it safe", I most assuredly, look closely to see how "safe"?. You can make a decent case for the stock at these levels, but I remember this same chatter coming from stock zealots in April 2008 who missed the runup in bonds and found themselves needing safe income for their clients and so they simply found some nice dividend paying stocks and compared them to bonds.

I remember vividly, when CNBC was comparing Proctor and Gamble stock to a bond (because of the solid dividend), and the stock went from $58 in January of 2000 to $26 in only two months.

Please receive this in the spirit in which I intend here - nice dividend paying stocks are great - it's just that they are not like bonds - they are different. They are like apples and oranges.

4) Dana Holding Corp - they make driveline parts for vehicles - axles, driveshafts and transmissions - the company has more cash in their account than they have in total outstanding debt, have a nearly 2X quick ratio (interest coverage), 20% debt to assets, 50% debt to equity, and a payout ratio on their common stock of only 14%. Bonds are BB rated:4% YTW if the bonds are called in two years and 4.993% if they go until 2019 and mature. So, if the bonds are not called, which they most likely will be and so you've got a two year investment (you've made 4% a year>the U.S. Treasury for two years is paying 0.232% per year). The five year US Treasury pays 0.749% vs nearly 5% for these Dana bonds. Based on risk/reward, bonds like these are a slam dunk from my lens.

"The first rule of investing is don't lose money. Rule number 2 is don't forget rule number 1." - Warren Buffett

Overall bond landscape

Why do you buy "junk bonds"? Are the ones we buy "junk"? Broadly speaking, the bonds we're investing in have shown to have over a 98% chance of paying their dividends on time and paying the investor back at maturity (Moody's Research). When you invest mostly in companies that have 0.2 debt to asset ratios, nice interest coverage ratios, many have between 50%-130% of their total outstanding debt sitting in cash, pay nice common dividends, with low payout ratios, so that they can cut the dividend if things get rough (like in the case of Vulcan Materials), to shore up cash flow, and in the cases where you buy a little riskier, the bonds you're buying are inside of the bulk of their maturing debt?

The times have changed (1980 vs 2012)

Also, let's consider that in 1980, 50% of all industrial corporate debt in the U.S., was rated A-. Fast forward the tape to 2012 and recognize that 46% of all U.S. industrial corporate debt is B rated. What does that tell you? It tells you that not only are governments and households VERY dependent upon debt, but corporations are as well.

Careful there, Skippy...

Considering that 75% of all of the investment transactions on the planet involve debt of some sort or another, it makes sense to understand debt a little bit. And as you might imagine (and this might be the understatement of the next 5 years), ALL DEBT IS NOT CREATED EQUAL. I am seeing investors ignore the fact that subordinated debt is much less secure than senior debt and they are reaching for yield. I am seeing bond managers buy CC and non-rated GARBAGE bonds (not junk, GARBAGE). Know what investments have performed the best in recent months? Greek GARBAGE corporate bonds and the like.

Wow. Careful there, Skippy...

So for a time, due to the printing press, the default rates on really bad, bad, overly speculative, not junk, but GARBAGE bonds, will be held artificially low for a time, but then will inevitably spike. People are definitely reaching for yield all over the globe and investors are going to get hurt. That will happen all over the world (including the USA).

Modified Duration calculations on our longer dated bonds:

Dell Computer (A- rated, but trading like (as it should, it's not an A- rated piece of paper after the deal is done, it's more like a BB- rated bond with the leverage)), 2028 Senior Bonds yielding 6.738% per year. The coupon is 7.1%, we paid $103.40 for the bonds and they were evaluated the night before we bought them at the close at $103.47. NO ONE is calling for 150 bps increase in rates from here, BUT if we saw an increase like that, these bonds would be evaluated in your statement at $91.025. So, we're giving the other side (the pending higher rate folks), the benefit of the doubt by providing you with an estimate of where the bond price would be if rates moved higher. But do you know what? I did that last April on some of the longer-dated ones, and you know what happened? Rates went in the other direction and those highlighted bonds are now showing ^15-20%.

Sell your losers and hold your winners

Just the other day, bondholders of the 2037 JC Penney Corp., sued JC Penney saying that they were in violation of their covenants and they were trying to prevent them from declaring bankruptcy so that they'd be guaranteed to get most/all of their money back in the event of a bankruptcy. BIG yellow flag for those of us who own their 2015 bonds that are JCP's nearest debt tranche due. I felt confident we were fine - with that particular company who wants 2037 bonds? You want the ones that are safest. That's why we went with the 15's. A few days after the lawsuit and bad same store sales news, several groups stepped in and offered JCP credit. That's good, but not good also...


We bought the bonds at $99.20 on August 16, 2012 at a better than 7% YTM (non-callable), bonds were to mature 10-15-15. That day the stock traded for $24.31. Today (2-28-13), the company reported a drop in same store sales of 30%! That is unheard of in the retail space. At this point in the "turnaround" for JCP, that is unacceptable. The transformation for some U.S., corporations is going to be extraordinarily painful. We sold the bonds today at $97.625 right before they were downgraded. Let's let someone else try to run into the middle of the road and grab a dollar bill. So, we picked up some dividends from the coupon payment in October of 3.5% and we took our gain all in of a whopping gain of 1.91%.

Comparatively, the stock was down 27% for the same period point to point. Sounds like a lot of work for 1.91% and it is, but I'll take +1.91% over -27%. How about you?

Some companies will make it through (not unscathed). Some will not make it through. One of the things that doesn't get sufficient airplay is the forthcoming "wave", of bankruptcies (may be a few years away). "Wave", may be strong, but, let's call it wave-ish. Ripply - how's that?

I just got off the phone with a gentlemen who is a few years from retirement and I'm asking him to transfer his bond funds over to us so that I can help him manage that money in individual bonds.

Know why?

Bear market for bond funds may be on its way

I don't mean this disrespectfully, but with many broker-dealers, it's "we're creative with fixed income". Uh-oh. I like creative. I just don't like my bond funds (or my stock funds for that matter), to be "creative". Should you just put a check in the "I've got some bond fund", box? In order to be diversified, I've got some leveraged, emerging country micro-cap debt-espresso-latte-frappacino fund.

Marilyn Cohen, who owns a firm like mine wrote a book called Surviving the Bond Bear Market. Great book. Very nice lady. Very smart lady.

"If you're a big bond fund investor, you have a vested interest in watching this flow of funds indicator. When the cash flow into bond funds slows down, everyone pays attention. It means the nervous money is afraid of a drop in the bond fund value due to an expectation of higher interest rates. When you see a trend develop over a period of two or three months, you need to reduce your exposure to bond funds. We don't want you to be trampled by others rushing for the exits when they realize the bond fund bubble has finally burst." (p. 13 - Surviving the Bond Bear Market - Marilyn Cohen * Please note that Marilyn was very careful to say three words together, NOT only two. Bond-Fund-Bubble - NOT Bond-Bubble. There is a BIG difference.

Comment on Bank debt (subordinated bonds)

Out with the Bank "Bail-out", and IN with the Bank "Bail-In" Legislation

Bank Bail-In

"Should a bank fail, regulators would have the authority to convert bonds held by good-faith investors into equity-called a bail-in. The regulator's logic goes that converting debtparticularly subordinated debtto equity builds the bank's capital base and allows it to stay in business longer. This avoids government bailouts and costly rescues while giving bond investors upside potential should the troubled bank somehow survive. If passed, this authority will be devastating for many corporate bonds issued by financial institutionsBond investors should be careful not to overallocate to the financial industry. If creditor bail-in becomes law, beware." (p. 90 - Surviving the Bond Bear Market - Marilyn Cohen)


2) b) Income Later (green lines are good);

Global bond yields will be driven lower and stay in a lower yield trading range for many more years than anyone suspects and therefore the promises made by insurance companies will have to be lessened and the costs to insure these promises will have to rise. Here is an illustration of the effects of lower bond yields on private pensions. In this illustration , we are examining a couple - both of whom are 50 years old - due to the dynamics of their estate, it makes sense for them to invest $500k into one of the spouse's names into a fixed indexed annuity with a private pension-lifetime income rider. They would like to insure that both of them would receive income for both of their lives because they don't know which one will pre-decease the other so they'd rather be safe than sorry. If, the number the insurance company promises them went down by only 50 bps or 0.5% (from 6.5% to 6% compounded per year), and the percentage number that they promise to pay the couple off of that pension number went down only the same amount, the difference in income the couple would receive (assuming at least one of them lives to be age 95), would be $327,870!!! That's 65.5% of the original investment. Do you see why low rates are such a big deal on private pensions?

"Lower your return expectations on all asset classes." - Bill Gross - February 27, 2013

I think that the next several years are going to be much more volatile, if I'm right, wouldn't you want to have some money invested in a way that you could take advantage of that volatilityIndexing is a very smart way to do this. The cool thing is, you can book a positive return result in a given calendar year, but the worst performance year you could have would be a zero; but not a negative (illustrated below). This safe, creative investment strategy is offered by the 18'th fastest growing company in the world and, in my opinion, anyone who is between the ages of 50-79, has investable assets of $1mm to $50mm ought to have at least 20% of their investments in strategies like this. It's very low cost, guaranteed, performs well in volatile markets due to the indexing strategy, and will guarantee lifetime income.


2) b) 1) Social Security - ways to optimize it

This (below), is a picture of Dr. Laurence Kotlikoff and me in San Diego, CA at a conference. That guy knows as much about Social Security as the actuaries who administer the program (they trade emails frequently). And he has created the most advanced and sophisticated social security calculator available today (says Forbes magazine and PBS and others).

As an aside, when I was with Merrill Lynch and before that IJL-Wachovia, we planners/advisors, on the whole, were brought up to think that, well, you factor social security income into your planning, but I used to always just think, "here's what the client gets at age 62". That's not the right approach.

Our clients are typically the ones who have contributed the most of anyone (broadly speaking as a group), and so getting the most out of it, only makes sense to me.

Beginning in March 2013

As a service to our clients, in March, we will begin offering a social security optimization analysis (that takes into account your particular situation showing you the ideal age and technique to file for social security - there are many, many different ways to do it). We will be utilizing Dr. Kotlikoff's calculator. (Please note that if you're not yet a client and would like to schedule an appointment, we have a $500,000 minimum investable asset requirement at Vickery Creek).


3) Capital Appreciation

The Capital Appreciation portfolio logged a +10.47% (net of fees), result for calendar year 2012. Approx., 35% of the move-up in the S&P in 2012 was due to bank stocks. We owned a couple of senior bank bonds in 2012, but no bank stocks. I am starting to buy some BB&T stock in here with a 3% common dividend and under an expectation that they are going to raise that dividend once again. I have recommended for years being very underweight bank stocks. I know they've, as a group run a bit in the last 12 months, but we didn't ride those things down for years, either (at all).

What about stocks? Why are you trying to keep me from making money? "Stocks are better than bonds"...

First of all - I am not - you see, IF I'm right, it's going to become even more difficult to secure safe income. Once your secure, safe income sources are in place, capital appreciation it up, baby. Most people, underestimate the amount of budgetable, predictable income they will need in retirement.

Stock update

I feel pretty good about the stocks that we own in the capital appreciation portfolios. You need to know, that yes, trailing earnings have been above average, but with a now 85% correlation with the Fed's monetary action, stocks have broadly moved under the premise of more money printing. The stocks, ETFs, and stock mutual funds comprised of U.S., companies that have reasonable price to sales, lower range dividend payout ratios, nice dividend rates and growth, and that have anemic borrowing costs make long term sense for folks that have sufficient income to help them live in their world.

The Fed's program has been working - it has dramatically lowered the cost of borrowing, created job growth, increased pricing in housing, and has created growth where there otherwise would've surely been significant contractionThe problem is, is that our entire financial system is so fragile due to the total outstanding debt in all categories and there is so much unused capacity and much of what seems real is artificial - that term "wealth effect" - it's that - an effect - an illusion - not real wealth. Now that doesn't mean you shouldn't own stocks and it doesn't mean that profits don't look great in some areas - because they do. Disclaimer here, though - you need to know that earnings growth momentum has slowed considerably - it doesn't mean we won't see earnings growth YoY - it just means the momentum has slowed considerably (broadly speaking). Here's a few of our January picks for 2013...

Highlighted growth themes:

- U.S., Manufacturing Renaissance Timken Corp

- Full-fledged bull market in Farming and Agriculture John Deere  -

- Fracking towards Energy Independence - Kanye Anderson (symbol KYN - this particular fund ), out of Houston, Texas

There are many things to be bullish and optimistic about in our economy and in the markets - we can take advantage through our investments in:

Stocks, ETFs, Mutual Funds, Bonds, and Annuities

Let's just be bullish on stocks for the right reasons.


3) Are we in a bull market or bear market?

Let's look at that - Equity secular bear market and Bond secular bull market

Bond bull market

You know, some in the markets thought that the Fed would exit their accomodative stance very soon - even this year. As you know, not me. When this talk starts up, sometimes, the yield on the 10 year US Treasury experiences a "trading spasm". I've mentioned these spasms before. You don't want to hear this, I know, but in all likelihood, the 10 year will go down to around 1.25% before too long and the 30 year down to around 2.25%. Again, they won't camp out there necessarily, and will be in a yield trading range like I've stated for years, but there's another leg down - that much is for sure. Now "leg down", may be hard to get your head around. A reminder here: as bond yields go down, the prices go up (generally speaking).

We are, however, headed lower still with respect to yields on both the 10 year and the 30 year. If I'm wrong, it won't seem like I'm wrong.

You see, despite the anemic yield level of corporate and municipal bonds, we are currently a tad-spread-wide on an historic basis. This means, as the recovery limps along, we will most likely see some spread compression.

Trading spasms back to 2007 - this most recent one is just that.

Bernanke has been trying to target and kill the secular bear market in equities

You see, it may seem like we're in a full-fledged secular bull market for equities. But did you know that Bernanke is actually trying to target the secular bear market in equities? The bull market you've seen over the last few years has been a cyclical bull market for equities. Not a secular bull market. The S&P 500 is back to where it was 13 years ago.

The difference:

Secular (definition - this particular connotation): of, or relating to a long term of indefinite duration.

Cyclical (definition - this particular connotation): of, or relating to, or being in a CYCLE.

The secular bull market has been in bonds. Since 1982. At some point, we'll see a secular bear market in bond funds and a secular bull market in equities. That time is not now. Sounds counter-intuitive considering the fact that we have seen such a reflexive move in the S&P 500.

Secular bull market in bonds

"Those charts above seem weird" - is what you may be thinking. With another leg down in yields, the prices of bonds will continue to rise (generally speaking). So with this chart, it looks like someone has lost a lot of money for a long time (a secular trend). The opposite is true - the yields coming down like that has meant that the prices have gone up and in addition, and I've said this a lot recently - there's so much demand for quality bonds with above-market yields you can't imagine.

Go the middle chart of the three and look at 1947.

4) We are entering a "fiscal retrenchment period very similar to 1947" (Harvard professor: Ken Rogoff), and a "consumer retrenchment period" (me);

Ken Rogoff of Harvard University says that during this period of 1947-1974, that the "Real interest rate was 3.4 percentage points less than the real growth rate; in all other periods the real interest rate was higher than the real growth rate." - address to the American Economic Association in San Diego - January 2013.

See Fiscal Retrenchment 1947 (Rogoff)

Comparison of Q1 2013 and Q1 1947

10 more under 4

Bernanke and many others often cite Ken Rogoff's (Harvard professor), research on government debt and other things. Ken says that the time period we are entering into is akin to the 1947 time period - he calls it "Fiscal retrenchment". 1947 - for 16 years, the 10 year yield was under 4%. I am saying that there is a 90% + chance that we'll see the 10 year US Treasury yield at or below 4% for ten more years. That really helps us from a planning perspective. Why? Because with an historic corporate bond spread of 1.5% above the 10 year U.S., Treasury, we can understand the value of our bond investments better.

As an aside, Bernanke is delivering a speech tonight at a San Francisco Fed research conference called "The Past and Future of Monetary Policy". That speech is called "Low Long-Term Interest Rates."

So what?

The reason why this is important is because we can have some level of comfort in investing in intermediate/longer-term bonds that yield 5.5% +. Historically, the average spread of corporates above the 10 year US Treasury is 1.5%. 1.5% + 4% is 5.5%. So if we are able to score 5.5% with our bonds safely, even if the year moves up to the ~4% range, we should be okay.

Also Consumer Retrenchment (my term), on its way - (chart shows consumer as a percent of real GDP from 1947-2012)

The above chart shows the PCE (Personal Consumption Expenditures), index, that the Fed uses. It illustrates the PCE as a percentage of overall GDP. I believe that the consumer will also enter into a period of secular spending decline despite the lower interest expense on their mortgage debt and despite higher home prices. The consumer doesn't have enough money saved for retirement, still has way too much debt overall, and has a long-term financial illness.


The silver bullet is not in Washington, D.C.; it is in Golden, Colorado (that one's in there for you, Mike)


"Inflation targeting is not a silver bullet." Eric Swanson (Senior Economic Researcher - San Francisco Fed), March 1, 2006

Eric said that because this sort of thing has been done before: New Zealand, Australia, the U.K., Canada, and most analogously (to the U.S.), Sweden, and now the U.S. (as of Dec., 12, 2012).

In Sweden, their household credit bubble burst in 1989-1990. Their 10 year bond yield is still under 2%. Oh, and they just dropped their funds rate from 1% to 0.75% just last week.

There is powerful global deflationary pressure on basically every economy on the planet save a very few emerging market economies. That's why Bernanke is trying to apply a counter-pressure and create inflation.

See where yields have gone for Sweden  since embarking on the forward guidance with respect to inflation targeting.


5) Turning over rocks works: Bernanke's 2002 deflation/reflation roadmap speech;

"The person that turns over the most rocks wins the game. And that's always been my philosophy." Peter Lynch

Bernanke and Yellen's Printing Press

Check this out:

This is an excerpt from theBernanke speech in November 2002He was asked if the U.S., found itself in a Japanese style deflation, what would he do if he were chairman of the Fed. Here are some of his answers: (you can find the speech on the Fed's website), at:

"When the short-term interest rate hits zero, the central bank can no longer ease policy by lowering its usual interest-rate target. However, a principal message of my talk today is that a central bank whose accustomed policy rate has been forced dow to zero has most definitely not run out of ammunition. The U.S. government has a technology, called a printing press (or, today, it's electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation. As I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation. One approach, similar to an action taken in the last couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some time--if it were credible--would induce a decline in longer-term rates. A more direct method, which I personally prefer, would be for the Fed to begin to announcing explicit ceilings for yields on longer-maturity Treasury debt..."

This type of action (caps/ceilings on bond yields), is not without precedent.

During the time period that I have essentially pinpointed, 1947, "...the Fed maintained a ceiling of 2 1/2 percent on long-term Treasury bonds for nearly a decade." (Ben Bernanke Nov., 2002)


6) a) Big Charts that matter:

How much longer until unemployment reaches 6.5%?

The Bureau of Labor and Statistics (BLS), says that it'll be (chart is from their website), 2018-2022 at the current rate of job creation to get to the unemployment target that Bernanke has mentioned. Who knows?


6) b) Where we may be in the deleveraging process


6) c) Margin debt to S&P 500 chart


6) d) Corporate profits as a percentage of overall GDP (1947-2012):

Corporate profits as a percentage of overall GDP is at a record high. Look at what happened to the secular trend in the chart beginning in 1947 (not entirely analogous because of technological and productivity differences, you say?) - maybe not entirely, but it helps to know a tad about history and about profit cycles and what happens when earnings broadly disappoint? Because they might, right? Isn't that the definition of a profit cycle? Is there at least a tad more risk with the chart that high versus it being in the trough area? Is it any coincidence that the reflexive, steeply angular parabolic profits moves (on the chart), began in 2000 when Greenspan was talking about the "wealth effect"?


6) e) Housing doing much better, yes - be careful about drawing two conclusions: 1) long term vs., short-term context; and 2) delinquency rate (update);

 1) New home sales and housing starts long term verus short term chart;

 2) Delinquency rate (update), on mortgages (Jan., 2013);


6) f) Corporate cash on hand nice, but, (5X new debt growth to cash accrual growth), over last 10 years;

Be careful with the Wall Street adage "Cash on balance sheet", corporate bond adage. Check out this chart (below), that shows the amount of new debt issued by non-financial companies in the U.S. It illustrates that though the amount of cash on corporate balance sheets has grown by about $600 billion in the last ten years, it also illustrates that the amount of debt has increased by about 5 times that much.




6) g) What's causing me to not be uber-bearish on U.S., equities:  Bernanke & M2 money velocity (chart);

Bernanke's printing press and this chart of M2 (money velocity), is helping me not be uber-bearish on U.S., equities. The chart below shows that, just like in Japan, the money that the printing press is cranking out is simply sitting there doing nothing. At some point, it may find a home. It may broadly go into equities. Now, I don't care for that, I'd rather have organic growth as a backdrop - but, alas, I can't have it my way. And also, one of my old mentors is right when he says that there's never an "all clear" whistle that blows. So at some point, everyone's going to be forced to take more risk. Bernanke (and Yellen), are betting that investors who are sitting in cash will capitulate at some point.

Currency War quote

"There are many economists [in Asia and in the U.S.], that think the weakest currency is best for the economy. Which, of course, cannot work. [This] has been practiced between the two world wars and was a very, very poor recipe for stability and growth." - February 11, 2013 - Former ECB President Jean-Claude Trichet

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PS - Enjoy one of the latest KAL (The Economist), cartoons (CLICK HERE) on Chinese cyber-theft (no laughing matter, though)

- The next Insights edition (Part III of The Chronicles of Reflation), will be published in late January 2014.