Economic Indicators Up For Second Month In A Row

The economy has been sending mixed signals for most of 2013. May-Investments developed its own Leading Economic Indicator to help our firm understand the current economic environment. Today’s LEI readings are again forecasting continued economic growth during the months ahead. After weakening earlier in the year, the month of May proved to be the second straight up month.

May-Investments developed its in-house indicator rather than rely on the Conference Board’s traditional LEI. With the Federal Reserve adopting Enron-style off balance sheet financing vehicles in order to move the government’s new bond issuance out the doors into buyers’ hands, the old economic indicators became obsolete and the Conference Board’s new indicator is untested. In the meantime, investors are having difficulty understanding whether today’s economic growth is a mirage, an encouragement, or a house of cards about ready to fall and take investors down with it.

Our economic indicator peaked a year ago when activity in the drilling patch declined, small business owners retrenched, and purchasing manager new orders dropped off. Whereas eight of ten component indicators were rising in March of 2012, by the end of May only half of the indicators were on the rise. In October, 2012, only three were moving higher. As 2013 began, in spite of our positive economic forecast for the year, the May-Investments Leading Economic Indicator began trending down again.

In April, however, small business optimism improved slightly and the decline in drilling activity was less significant than it had been a few months back. Overall, the upturn represents less of an “improvement” than it does a less forceful downtrend than at the beginning of the year.

Retail sales are still an area of strength, but they are not as strong as they were a year ago, or in January, and are what we are watching mostly closely for signs that the recovery will continue. Global shipping rates remain weak and bank lending is not growing as fast as it did in 2012. A slowdown in the growth rate of the money supply is also surprising, and worrisome, given the moves that the Federal Reserve continues to make to try to flood the economy with money. We are thrilled that the LEI moved up, but it is too early to conclude that there is much strength there.

As things are now, we stand by our forecast for continued economic growth during 2013. We had projected Gross Domestic Product (GDP) growth of +2.5% this year. We projected an economy that would be making progress in its move back toward normal. As of the most recent GDP report at the end of May, the U.S. economy is growing at a +2.4% rate, pretty much as we expected. Hopefully this recent upturn in our Leading Economic Indicator suggests that slow steady growth rate can continue throughout the rest of this year.

Douglas B. May is President of May-Investments, LLC and author of Investment Heresies.

Japan ETF Trade

The Japanese stock market has been on a tear since Prime Minister Shinzo Abe initiated his own version of Quantitative Easing (printing money) which appears to be QE100X (quantitative easing “on steroids”).  Money has to flow somewhere, it seems, and these days the money seems to flow directly into the stock market.  In response to the rapid printing press strategy, the value of the yen promptly and materially declined in value.  Japan’s twenty-year bear market seemed finally to come to an end, and it did (for a few months).

As we mentioned in our Tuesday Noon Classes in April, our strategy calls for moving money toward asset classes that are working.  The strong and seemingly sustained strength in the Japanese market led to our initiating positions at the beginning of May.

The Japanese market kept rallying into mid-May, and then the short-lived rally came to an end.  The Nikkei 225 turned down and never really looked back, entering bear market territory this week.  At the moment, to generalize, we have small losses in our positions and are frankly not in the mood to take a big loss. 

The Japanese market ran up fast in furious in 2013.  The iShares Japanese Index ETF (ticker symbol EWJ) is still up about 11% year-to-date, in spite of the market currently being in “bear” territory.  The Japanese market is another QE-driven asset class with an ETF that is quickly attracting widespread hedge fund interest, somewhat reminiscent of gold in 2011.  The main difference is that gold wasn’t just coming out of a 20-year doldrum when it ramped up.

For the most part, I have viewed the recent sell-off as somewhat appropriate given how fast the Japanese stocks moved up earlier in the year.  Some “consolidation” would actually be a good thing.  Stocks don’t go “straight up,” typically.  Those that do go parabolic usually do so just before crashing back down again.  A little correction would have been welcomed.  At the beginning of the week, it seemed more like a time to add to positions, rather than a time to bail out.

Then came Wednesday night.

On Wednesday night, the Japanese market fell about -6.5%, overnight.  As you can imagine, this created a bit of consternation as I watched the sell-off unfold that night.  Moreover, the yen (currency) was also moving a lot.

When we bought the iShare (EWJ), we chose the exchange traded fund security that demonstrated the best liquidity characteristics.  There are other ETFs available that try to eliminate the impact of currency adjustments by hedging away currency moves.  We weren’t buying EWJ in order to speculate on the yen, one way or the other.  We have, however, seen futures-based ETFs disappoint investors as the constant and costly futures trading result in those securities underperforming our expectations.  We chose EWJ in order to avoid the currency issue, prioritizing liquidity and low expense ratios over currency strategies.

Instead, this week it became clear that one way or another, currency is going to be part of the equation.  To be honest, not understanding the currency impact as well as I should have, when I saw the dollar/yen relationship moving –1.5% on Wednesday night, the pessimist in me pretty much assumed that the currency was moving against us as well.  On Thursday morning, I came in to the office expecting to see EWJ moving down –8% (just days after doubling up on some of those holdings).

So, imagine my surprise when EWJ closed UP over 2% that day.

This caused me to do a couple of things.  First, I jumped for joy.  The security we owned performed 10% better (in a day) than I had expected.  Luck was on my side.

However, it also meant that I really didn’t understand how this ETF was working, not nearly as well as I needed to.  If it meant that I could be 10% lucky on one day, I could just as easily get a 10% disappointment on (literally) the next day.  That was unacceptable.  So the first thing I did was cut our position in half until I could get a better understanding of what was driving the performance of this security.  In theory, it’s really not that tough.  ETFs are usually pretty straightforward instruments.  The Nikkei 225 Index goes up or down, and this ETF should follow.  But at the end of Thursday, I had all sorts of questions.

Why is the Nikkei suddenly so volatile?  Moving –6.5% in a day is not the norm for a healthy market.  How could the U.S. market response to the previous night’s plunge be so different?  EWJ opened up, and just kept getting stronger.  It never reflected the sell-off at all.

There are four fundamental factors that I needed to monitor in order to come up with the answer.  First, the action on the Nikkei stock exchange is the primary influence on returns.  Second, the movement of the currency is significant – more significant than I had originally wanted to believe.  Moreover, in my shock at the –6.5% decline in the market, I had assumed that the currency was also moving against me.  In fact, the yen was increasing in value on Wednesday night, which reduced the dollar-denominated loss to a –5% market move.

Third, ETFs trade at a premium or discount to their net asset value and this, too, was having a bigger impact than I had expected.  ETFs normally trade pretty close to net asset value, by design.  If the computer-generated valuation of the stocks in the index is $10, then the ETF might trade at a discount of $9.98 or a premium of $10.02, but in general discounts and premiums aren’t material.  One of the reasons that we prefer exchange traded funds (ETFs) to closed-end funds, which also trade at discounts and premiums to net asset value, is that market makers can generally keep the gap to a minimum.

On Wednesday night, before the Japanese market opened, EWJ was trading at a pretty hefty 2.5% discount to net asset value.  As a result, the first –2.5% decline in the value of the Nikkei 225 was already “baked in” to the price of EWJ.  Now, instead of having to explain a 5% variance, I’m down to only a 2.5% variance in what happened to EWJ as compared to my expectations.

Finally, at the end of the day on Thursday, EWJ was trading at a 4% PREMIUM to the Nikkei 225.  As the trading day continued, it is quite possible that money was flowing INTO the EWJ exchange traded fund.  As buyers came in to “buy the dip” in the Japanese market, the demand for EWJ shares was so strong that they actually began to trade up versus the security’s intrinsic value (the “net asset value”).  Also, the U.S. market was trading up during Thursday, and certain large Japanese stocks like Honda and Toyota trade on the American exchanges, so the intrinsic value of the Japanese market was moving up even though the Japanese market wasn’t open at the time.

The bottom line is that our positions in EWJ are still slightly below cost.  If EWJ goes down much more, we will cut our losses and sell out.

Second, the volatility the yen is having an enormous impact on the valuation of our EWJ investment.  We really wanted to ignore the currency impact on this investment.  That was naïve.  Just because we don’t want to be currency speculators, and use a security that doesn’t focus on currency hedging, doesn’t mean that we will be able to.  Once again, the political ramifications of easy money policies are creating enormous uncertainty in the markets.  There’s just no way around it, these days.

Third, the market makers aren’t doing a particularly good job of closing the gap between the price of EWJ and its net asset value.  This is a pretty new problem.  Normally, gap issues only impact investors during times of crisis.  In normal trading times, the gap is relatively immaterial.  Right now, that’s not the case.  Hopefully it’s just an unusual time for this particular ETF, rather than a sign of big underlying liquidity issues across all of the international markets.  Still, we’re going to have to treat EWJ almost like a closed-end fund, limiting buying opportunities to times when there is a significant discount, and taking advantage by selling into premiums, as we did on Thursday.

Lastly, I have a sense that the underlying fundamentals in Japan are not what’s driving the market.  The Nikkei was said to dive because U.S. quantitative easing policies are about to “taper” off.  Why would U.S. monetary policy cause a –6.5% mini-crash in Japan?  That doesn’t make much sense.  Unless, of course, what’s driving the Japanese markets higher are U.S.-based investors, using EWJ as the preferred speculative tool.

In watching markets, this week, it did not appear that EWJ (the U.S. trading tool) was following the Japanese market.  It appeared the EWJ was LEADING the Japanese markets.  It seemed, at times, like the entire Japanese market was responding to what EWJ was doing over here.  The tail seemed to be wagging the dog.

If that’s true (and I’m not at all sure that it is), then it would appear to be somewhat like when all of those U.S. investors bought gold ETFs in 2011, which drove the real markets higher as the financial demand for gold overwhelmed the actual supply in the physical markets.  Could it be that financial demand for the Japanese market, through hedge funds buying ETFs, is the source of Japan’s rally?  If the fundamentals in Japan aren’t improving, and the source of the Nikkei rally, then that’s a big deal and makes me much less willing to own shares of EWJ in the portfolio.

In any case, this week’s buy-then-subsequent-sale of EWJ shares is not something that I ever want to do again.  Because the Japanese market mini-crash wasn’t being reflected in the U.S. traded shares of EWJ, mostly because the ETF swung overnight from a 2.5% discount to a 4% premium, we took advantage of the gift and reduced the size of our exposure.

Soon we’ll have to decide if we’re going to completely eliminate it, or not.  If Abenomics works and this finally helps Japan begin to climb out of its twenty year recession, then we’ll get back in and just pay more attention to the yen and the gap between the ETF and its net asset value.

On the other hand, if we decide that the fundamentals in Japan aren’t driving the Japanese market, but rather it’s just U.S. speculators pushing that market around, then I’m not as inclined to stick around.  If trading in U.S. markets determines what the Japanese market does the next day, then something’s wrong.  If Japanese news causes its market to rise and fall, on its own, and then the U.S. ETF simply reflects these changes, then that’s an asset class in which I will consider investing.

Right now, it’s not clear what’s the driving force with this investment.  If trading activity doesn’t start making sense, and I mean soon, then we’ll just exit the rest of our position.

You know what they say about markets and poker.  If you don’t know who the patsy sitting at the table is, then it’s time to fold your cards and go home.

Douglas B. May is President of May-Investments, LLC and author of Investment Heresies.

A Question For Secretary Lew

I’ve met two U.S. Treasury Secretaries in my lifetime.  Technically, when the Stanford Committee On Political Education dined with G. William Miller, he was a former Secretary.  He was relatively disgraced at the time, so the campus speaker bureau paid a lower fee than we would have paid for Paul Volcker, his successor.  Volcker later became a national hero for having the courage to raise interest rates until the inflation beast was tamed.  Often times, doing the right thing requires a thorough understanding of what ails us, in order to do the unpopular, but ultimately necessary, thing.

Last week, I had my 45 seconds of fame with Jack Lew, the current Secretary of the Treasury Department during the Colorado Capital Conference. 

I would have enjoyed having more time - enough time to have an extended discussion, but that wasn’t in the cards.  I decided, instead, to ask a question that sends a message, just in case the administration official with the most direct influence on my financial well being was in a mood to listen.

After noting that in 2009, bank examiners came into our neck of the woods and forced local banks to cut back their real estate loan books, forcing them to call in loans (even ones that were current) at the worst possible time – and making things worse than they needed to be – and then after noting that even now the mortgage markets remain much tighter than necessary, with even millionaire clients having difficulty getting loans that ought to be a lay-up, I told Secretary Lew that I did not blame him.  After all, he was just newly appointed to the position.

Prior to that, he’d been doing a bang-up job for the administration on debt reduction, as he is the author of sequestration.  Before that, he was a Chief Financial Officer at Citigroup, joining the firm just as the real estate bubble was getting going, shepherding that failed organization into the financial crisis and collecting multiple million-dollar bonuses funded by taxpayers as it unfolded, before finally jumping back to the mother ship to re-join the newly elected Democratic administration. 

Now this man who helped sink the ship at Citigroup is in charge of defending Americans against a Federal Reserve hell bent on impoverishing the elderly with 0 percent Certificate of Deposit rates in order to bail out a banking sector so flush with cash that it can’t think of anything to do with the money, other than return to the days of multi-million dollar bonuses for its hard working executive staff.  Is he up to the job?  Is he even trying to fix the problems in the banking sector?  Is he even vaguely aware that the problems exist?

Which is why I asked him if he was aware of the fact that the Treasury Department, itself, is part of the problem.  If he’s not aware of this, then he probably isn’t working too hard to find a solution, was my thinking.

Others heard his response, which was long-winded and in which he noted that we don’t want to return to the days of “no-income check and low-doc loans.”  I would agree with him on this point, which was (alas) irrelevant to the question that I asked.  He also pointed out that evidence of problems in 2009 is not important to today, however the mortgage loan example that I gave him happened only a month ago.

I didn’t want to be one of those people who demand 120 seconds of fame by asking a 3-minute question, so I left out a few other examples of why I believe that the Treasury Department, itself, is part of the problem.

For example, I’ve been told that banks which used to specialize in farm and ranch lending are now no longer allowed to have an above-average concentration in…farm and ranch loans.  Every institution must conform to the average, which is itself constantly declining because there is no longer any incentive to be particularly good at a certain type of lending.

These days, clerks at Fannie Mae and computers programmed to reflect the new bank Examiner requirements are making lending decisions, easily automating tough decisions that once required experienced credit analysts to decide.

Nor did I question the current regulatory imperative to consolidate the banking industry, forcing small community banks to merge into the fold of growing regional giants.  This, they think, will ease the burden on regulators.  However, it wasn’t the community banks that were the root cause of the sub-prime crisis.  Ground zero for those problems were the financial industry giants who packaged up toxic loans in order to sell them through their investment banking subsidiaries.  You know;  companies like, well, Citigroup.

The Treasury should be pushing back against the Federal Reserve.  The Fed’s charter is to protect the banking system.  The bankers in the system are doing quite well, frankly.  Wells Fargo’s CEO, on the backs of government subsidies and benefitting from Dodd-Frank regulations that have left it with nearly 100 percent market share of the local mortgage business, was paid $19.8 million in 2012.  Now, I happen to believe that Wells Fargo is one of the most profitable and rational of the big money center banks, but if they’re paying Stumpf $20 million bucks a year, I maintain that they are not in need of their free money subsidy.  Savers, most of whom are retirees and many of whom are low income elderly, are the folks in need of an advocate.

Logically, that advocate should be the Treasury Department, rather than the Fed.  The Treasury Secretary is the President’s key advisor on the people’s financial plight.  He’s supposed to be on our side, right?

But, to fix a problem requires a certain amount of insight.  Enough, for example, to realize that a problem exists.

I asked Lew a “yes” or “no” question.  Is there an awareness at Treasury that they are part of the problem?  The Treasury Secretary’s long-winded statement should probably be interpreted as a “no” answer.  I sure didn’t hear a “yes” hiding in there anywhere.  Really, is it that hard in Washington to admit that the government is not perfect?  In any case, I was discouraged by his response.  I see no signs that the leadership at Treasury is going to do anything to fix the problems that he refuses to acknowledge.

Volcker had the knowledge to understand what it would take to whip inflation, the courage to take unpopular measures in the interest of restoring long-term health, and the integrity to do what was best for the people of America, even when they didn’t like him (or the Administration) for doing it.  Jack Lew, I’m afraid, is a political hack who neither understands the problem nor has the integrity to acknowledge there even is a problem.  His crowning achievement up until now, sequestration, is both foolish and cowardly, and designed to fail by relying on formulas instead of accepting responsibility for making responsible budget cuts.

He is unlikely to understand what ails us or take the unpopular but necessary actions required to make things better. 

Fortunately, worldwide, the resilience of America’s economy is still the envy of the world.  But someone in Treasury needs to start working on these problems.  As someone once said, what good does it do if we’re still nothing more than the best looking horse in the glue factory?

Douglas B. May is President of May-Investments, LLC and author of Investment Heresies.

2013 Colorado Capital Conference

I just returned from the Colorado Capital Conference, hosted by Colorado Mesa University, the University of Colorado, and Senator Mark Udall’s office.  Hopefully the conference organizers will post Congressman Tipton’s opening remarks, or even the session where Treasury Secretary Jack Lew dropped in for a quick visit.

There were several points where the legislators emphasized how well both parties work together to help Colorado, and how we need to work together to begin making progress on unemployment, the deficit, and other problems.  Senator Udall reiterated his support for a Simpson-Bowles type of compromise, as well as his support for a balanced budget amendment.  The Budget Hero exercise we discussed demonstrated just how hard it will be find a solution.  While meeting within our diverse groups, the face-to-face time led to a more civilized conversation, but it is also much more difficult to slash and burn programs when personally faced with an advocate for that issue in the group.

At the end of the conference, it was hard to understand how our legislators are having as much difficulty as they are.  The people I met were hard working, smart, open to other ideas – even from the other party.  Still, we asked them tough questions about the irrational formulaic budget cutting method we’ve adopted (sequestration), trillion dollar deficits, cumbersome and nonsensical education regulations and tax rules, and an arrogant bureaucracy that wants to dictate how many days a week the local school cafeteria can serve potatoes. (More than one day?  It literally took an act of Congress to get them to change.)

Should we blame Congressional leadership?  The Administration?  Is it the fault of Congressional gerrymandering?  Would redistricting or more open primaries help?

It was a fascinating opportunity to meet some of the problem solvers and public servants who are working together to solve some of these problems.  I came away with more of an appreciation for our representatives in Washington.  However, I am even more convinced that government has over-reached and is crazy out of control.  When even good people can’t make the bureaucracy listen, what hope to mere citizens have?  Because even the lawyers acknowledge that the laws are strangling the teachers and businesses and doctors trying to help people, there is hope that something might be done to change the status quo.  I do hope they’ll try more, smaller solutions and fewer 2,000-page legislative opuses (like Dodd-Frank).

Personally, meeting the lawmakers helped me come to terms with our blue state status.  While I may not have personally supported a number of the folks whom I met at the conference, these are sharp, experienced people, with Colorado-moderate tendencies, and worthy of support for the hard work that is ahead of them.  I wish them luck, but at election time we should hold them accountable, too.  While the problems are dire, I think that we’ve put capable people in charge.  I wish them the best and am far more optimistic about the future than I was before making the trek to the Capital.

Douglas B. May is President of May-Investments, LLC and author of Investment Heresies.