2017, or 2018, or 2019 . . . But Higher Conviction than Ever . . .

More than ever before, I am convinced that a period of currency-debasement inflation is upon us. There are a few principal possible upcoming catalysts to my view on currency-based inflation turning into a consensus view. First, if President-elect Trump's first budget proposal in February is as aggressive on Keynesian spending initiatives on infrastructure and on public works, in combination with tax cuts that are unaffordable for the United States, then the strength and stability of the U.S. dollar likely comes into question. Unlike the United States balance sheet that Ronald Reagan inherited, when United States debt-to-GDP was well below 50%, the President-elect will inherit a balance sheet at more than 110% and normalized debt service expense (normalized for 4.5% interest expense over the long term) at $900 billion or roughly 25% of annual tax receipts. These statistics suggest that the optimism about the stimulative impacts of deficit spending under the upcoming administration in comparison to the impacts in the Reagan administrative may not be as valid as the 10% upward move (since the election) in the equity markets suggests. Second, to label China is a wild card is an understatement. Chinese central banking actions have been consistently erratic. For example, tighter credit lending policies have been followed by capital injections into Chinese banks, only to be followed by more regulatory actions to limit malinvestment of bank capital. This pattern of erratic actions is similar to the erratic series of events prior to the 2008-2009 financial crisis. However, in contrast to the relative transparency of the actions of the U.S. Treasury and Federal Reserve System, the Chinese Central Bank likely will act more covertly, if past is prologue. I sleep better knowing that my largest investment holding is real property in the form of homes. I also have more peace of mind owning my second largest investment, precious metals. When these holdings will outperform other investments will depend on when the consensus opinion on currency-debasement inflation materializes. I am very happy to wait patietly.

If you are confused by the positive Equity Markets reaction to the election . . . I think you are VERY smart.

I was excited to buy more of my favorite stocks on Wednesday morning when I heard that there was panicky, possibly fearful selling of stocks occurring upon the news of Donal Trump winning the presidential election.  Unfortunately, I did not get a chance, as the sell-off was short-lived and by the end of the day on Wednesday, November 9, I was selling some shares of stocks that overreacted positively to the news flow about the election.  While there are great bargains to be found in any stock market if one is a patient fundamental investor, today, November 10, I am selling more stocks for the following reasons:

(1) I trust the bond markets more than the equity markets;  bond yields are rising on the order of a 3 standard deviation event, according to Bloomberg;  while this sell off may be due to optimism that world economic growth may accelerate, I am skeptical because of overcapacity of aggregate supply in China, European banking woes, and the instability of the European Union with talk of an "Ital-leave" possibly as an encore to "Brexit"

(2) corporate earnings are not THAT good;  low expectations are being met in some cases, but corporate outlooks are subdued

(3) stocks of companies clearly in the eye of the storm of the Chinese economic slowdown (i.e. CAT, which I am short in a big position) are rising rapidly, which is inconsistent with their fundamental earnings outlooks

In my long-term retirement accounts, I remain partially invested in small positions in the stocks that I want to own for a long, long time (decades hopefully), but in my more trading-oriented cash account, I have a net short position that has increased by 5% in the last 24 hours due to short positions rising against me and my decision to sell many of my long positions.

Jim Lane

The New Utilities . . . EXCEPT Lower CapEx and Lower Valuations

It is very hard to argue that the so-called "market" does not crave predictability.  When valuations of Utility and Consumer Staples stocks rise to historically high levels, which has driven their dividend yields toward historical lows, predictability of earnings seems to be an insatiable craving.  This could change rapidly, as thing do in the financial markets on a day-to-day and week-to-week basis.  However, for the time being, volatility is a 'four-letter-word' and predictability is a virtue.

Given the above argument, increasingly-regulated industries are likely to increase in desirability among investors.   In fact, over time, despite our free-market ideals (however "rigged" things are on a regular basis), increasingly-regulated markets like health insurance and utilities and NOW banks usually generate massive stock returns while, in contrast, de-regulated markets attract too much capital from Wall Street investment banking which drives returns-on-invested-capital lower (Wall Street has rarely seen an opportunity not worth over-capitalizing.  In the case of airline de-regulation and utilities de-regulation in the 1990s, Wall Street overcapitalization of those industries led to lower returns that were inadequate to service debt levels, resulting famously in the massive bankruptcy of TXU.  The dot.coms rise and crash is another good example of this overcapitalization phenomenon, which the re-regulation in the Utility industry and in certain sectors such as Health Insurance has deterred new capital into those industries (other than company self-generated cash flows) and higher returns-on-invested-capital.

If the above analysis and argument is accurate, then the U.S. banking system should offer great returns for investors in the next several years.  Few, if any, sectors have been as aggressively and quickly over-regulated than the U.S. banking sector.  Various industry players periodically complain about the increased regulation, but in reality it is that regulation that drives those same companies to monitor, manage and streamline their businesses like never before.  Moreover, the increased regulation deters "shadow-banking" enterprises from being capitalized by those looking to invest in "growth" industries such as mortgage brokers, mortgage insurance, mortgage servicing companies and related financial services businesses.

Finally, this argument is not speculative in its entirety.  The benefits of increased regulation in the U.S. banking industry is already apparent.  Dividends are RISING in the banking industry in the United States, as companies understand that they must generate strong positive returns on internally-generated cash flows.  Moreover, moderate mergers and acquisitions (M&A) activity is occurring, albeit likely at an early stage;  however, this area may accelerate as existing-operations margins and returns-on-capital max out and managements look for opportunities to reduce costs by consolidating operations.  One additional impressive statistical difference between Utilities and Regional U.S. Banks is that the banks have negligible capital expenditures requirements relative to their profits;  this fact too also supports higher valuations and better dividend growth prospects for the regional banks.

I have increased my investment exposure to regional U.S. banks recently and will likely continue to do so opportunistically.

Brexit: It is 'just" a milestone in the ongoing global currency war AND a sign of growing wealth disparity

There was some possible market panic on Friday, June 24, as major world stock indices generally fell more than 3%.  However, some of the financial market turbulence was simply unwinding or reversals of investments established to possibly benefit if the United Kingdom had voted to remain in the European Union.

But it truly seems like the headlines about near-term ramifications to the world economy may be exaggeratedly negative.  More likely, it is the medium- to long-term periods that should be of concern, and those concerns should have existed prior to the Brexit vote outcome.

First, the UK does now have more flexibility to weaken its currency, and thereby make its exports more attractive.  While England did not use the Euro, there was an implied monetary support to the British pound from the European Union.  Without that support, Britain is now more free to exert aggressive fiscal policy (likely through higher government spending) to attempt to improve real GDP growth there.  Any further increase in debt-to-GDP or debt service costs for the UK will likely weaken the pound against the Euro, the US dollar, the Japanese Yen and other major world currencies.  Simply put, the UK just joined the global currency war that has been going on for several years now amongst the European Union members that used the Euro, Japan and the United States.  If in fact,the UK will more aggressively weaken the British pound in coming years, then the future of fiat currencies worldwide is even more uncertain than in prior periods.

Second, and just as concerning, the vote in favor of exiting the European Union was driven by the population outside of the major financial centers of the United Kingdom.   This is quite concerning because it is quantitative validation of concerns regarding the growing worldwide wealth disparity.  When the "have nots" have much less than the "have" by a wide margin, revolutionary forces such as this Brexit vote and in the USA the popularity of candidates such as Bernie Sanders can rise significantly.  This phenomenon is important to monitor because aggressive monetary policy actions (i.e. "printing money") tend to exacerbate wealth disparity; those who own land, stocks, and all forms of "dirt" such as gold and silver experience wealth increases in nominal terms, but those that are on fixed incomes and live paycheck-to-paycheck feel their reduced purchasing power is a growing injustice and form of inequality.

I expect that my views on the important ramifications of Brexit are not mainstream or consensus, which is nothing new for me and that is not something I am uncomfortable with.  Someone said (and I agree), great investments are made in the dark, and I agree.

Jim Lane

Sometimes Conspiracy Theories Are Correct

My Concerns with the Dollar and What I am Doing About It

Two Competing Theories.  Among the most controversial conspiracies among financial market participants is the controversy over currencies and the related topic of inflation versus deflation risk.  In one camp, prognosticators argue that central banks are fighting a valiant fight against deflation;  the fight is considered valiant largely because global deflation was a dominant factor in the mid-1900s Great Depression and therefore a trend of declining asset prices should be prevented.  In the other camp, the less mainstream voices assert that aggressive deflation fighting through monetary and fiscal expansionary policies merely delay inevitable reallocation of less efficiently-deployed capital and merely raise nominal price levels;  longer-term, sustained increases in nominal prices at best enhance the per share earnings of publicly-traded companies, and at worst may drive increasing gaps in standards of living as low- and lesser-skilled workers' wages tend to rise more slowly than monetary-induced inflation.

So who is probably right?  I am convinced that the latter group is correct, and therefore I have invested 40% of my liquid assets in the currency that prevails when the prices (or as economists put it "opportunity costs") rapidly rise in nominal currency:   gold.  I own gold in physical bars, asset-backed (not derivative-backed) gold ETF shares, and through stakes in gold mining stocks.  In my view, gold likely has downside risk to $1000 (from recent prices near $1300) but upside of $10,000 given that the $3 trillion in excess U.S. bank reserves ultimately may be lent out approximately 10x given the current U.S. bank required reserve ratio of 10%.  My $1,000 downside risk estimate is based on the face value of $4,000 trillion in "printable" U.S. dollars today compared with the approximately $1 trillion of printed U.S. dollars before the financial crisis, and given that gold was trading around $250 per ounce in the late 1990s.  However, that $1,000 downside risk estimate is likely extremely conservative given that our U.S. banking system is a fractional reserve banking system in which one newly-lent dollar from a bank, can result is $10 of eventually-created new U.S. currency under current banking rules.

So what is the catalyst?  Currently, some of the most desirable currencies in the world include the Japanese Yen, the Chinese Yuan, and the U.S. Dollar.  There are possible good reasons for the preferred status of these currencies, including liquidity, tradition, government systems that value 'Rule of Law' and current widely-accepted business practices.  However, the countries that manage these currencies are not rich in basic materials natural resources, and have steadily-rising or rapidly-rising debt service dynamics.  While debt-to-GDP is a widely accepted ratio among financial market participants with regard to the fiscal health of a nation, debt service (the annual cost of interest and principal repayment requirements) expense risk is probably a more telling risk factor.  The debt service expense risk of Japan, China and the United States is rising.  I believe eventually this will become a consensus view and that will cause a global shift away from these currencies and toward the currencies of more resource-asset-rich countries, such as Australia, Canada, and others;  perhaps fiscally-conservative nations like Switzerland will also experience investment fund inflows.    However, those nations' currency liquidity and availability is much more limited than the existing preferred global currencies.  Therefore, the ultimate long-term global history currency, gold, is likely to benefit from substantial inflows as well.    While I cannot and don't even attempt to try to predict the timing of when this thesis will play out, global near-zero interest rates have lowered my opportunity cost of placing my savings into gold and related investments.  Similarly, every investor needs to determine their own ideal investment allocation mix, but I believe that every investor should should consider whether there are any risk scenarios that their current portfolio allocations do not incorporate.

Unconventional Wisdom: It’s a Friggin’ Fact – Buy Assets (including a home) When Interest Rates are High

Unconventional Wisdom:  It’s a Friggin’ Fact – Buy Assets (including a home) When Interest Rates are High

Like most of my best lessons as a teacher, this blog entry is inspired by a great conversation with my Economics students in the last few weeks.  One student, in response to my assertion that successful investments are more likely when interest rates are high than when interest rates are low, asked “Mr. Lane, is that your opinion or a fact?”  “It’s a friggin’ fact,” I replied.  After reflecting further on the student’s question, I decided to create an economic model theory to help illustrate my assertion to the class.  In mathematics, such mental exercises are called ‘proofs,’ and the longer that I teach Social Studies, the more convinced I am that we are all better off when we develop similar deductive theoretical proofs.

To prove my theory to the students, I asked them to accept the following premises:

(   (1) there are a fixed number homes for sale at any one time, and that every home is for sale at a price of $1,000,000

(   (2) there are a fixed number of buyers for the available homes for sale, and every buyer has $5,000 per month (or $60,000 per year) in income available for a mortgage payment

(   (3) there is one single mortgage interest rate available to home buyers: 5%

Under these conditions, every buyer can “afford” to purchase one of the available homes because Year 1 interest would be $50,000 and the additional $10,000 of payments could be applied to modest principal repayment.  Therefore, sellers would not be deterred from buying, and all buyers would be able to achieve their asking price of $1,000,000.

However, I then asked students to consider what would happen if some of those premises change a s follows:

   (1) as in the above scenario, there are a fixed number homes for sale at any one time, and that every home is for sale at a price of $1,000,000

   (2) as in the above scenario, there are a fixed number of buyers for the available homes for sale, and every buyer has $5,000 per month (or $60,000 per year) in income available for a mortgage payment 

   (3) there is one single mortgage interest rate available to home buyers: 10%

Under these conditions, no buyers can “afford” to purchase one of the available homes because Year 1 interest would be $100,000, well above $60,000 that each buyer has to put toward annual mortgage payments.  Therefore, sellers would be completely deterred from buying, and all buyers would be required to lower their asking price of $1,000,000;  the result is downward pressure on the price of homes.

The simple example above proves that assuming “all other things equal,” home prices are lower when interest rates are higher.  Perhaps more importantly, the interest-rate relationship to asset prices is a truism such that “all-other-things-equal” assets can be acquired more cheaply when interest rates are high than when interest rates are low.  Therefore, by behaving in a fiscally-disciplined manner and waiting for prevailing interest rates that are substantially above long-term averages, one can buy assets that are quite likely to appreciate in value as prevailing interest rates regress toward long-term averages.  Therefore, the absolute truth is that the best time to buy an income-producing entity (a home, a rental property, or a business) is when prevailing interest rates are higher than long-term average rates.

Two Schools that Need New Curriculums: We Need to Replace Keynesian and Austrian Economics with a Standard of Living Paradigm

As an Economics teacher of some extremely bright students, I frequently am asked by some of the strongest, "Mr. Lane, are you a Keynesian or a Classical Economist?"   My first reaction is a laugh because I have convinced my students that I am an Economist at all!  But hearing this question every semester, I finally have a decent answer, "Neither, I am a standard of living economist."

These days Keynesian economics by and large encourage government deficit spending and central bank policies that maintain low interest rates, with the goal of muting the magnitude of the business cycles.  While most skilled business people prefer periodic downturns and upturns in economic growth rates due to the business cycle, Keynesians prefer government and quasi-government agencies to act to mute such cycles.  In contrast, laissez-faire Classical economists encourage a default response to economic recession or economic acceleration that demands patience of both households and firms to let markets and human behavior adjust to excesses and shortages.  As anyone who even periodically notices current events knows, Keynesian enjoy-today "because we're all dead eventually" economics is currently en vogue globally, but at some point the pendulum will swing toward the Classical school.

Despite the dominance of these two camps, in working with my students every day, I am becoming more optimistic that the a new camp may emerge:   Standard-of-Living economics.   If policymakers would pick and choose from existing policy options while carefully considering the potential long-term impacts of such options on the average citizen's potential to increase their standard of living over coming years, then it is more likely that policymakers will choose options that provide such a setting.  Unfortunately, I haven't seen or heard much about monetary or fiscal policy focus on standard of living mobility since the very early months of current Federal Reserve chairman, Janet Yellen, took office.  Hopefully these great students I get to teach will be part of a movement to shift economic policy toward upward social mobility tools and paths for the masses, rather than muting the natural business cycle associated with a capitalist economic system.