This blog is written weekly by Dock David Treece, a registered investment advisor with Treece Investment Advisory Corp. It is meant to share insight of investment professionals, including Dock David and his father, Dock, and brother, Ben, with the public at large. The hope is that the knowledge shared will help individuals to better navigate the investment world.

Wednesday, August 25, 2010

Fed Hangs Dems out to Dry

Roughly a year ago I penned an article titled “How Obama Saved the Economy.” That article garnered quite a bit of attention, including e-mails and comments from readers, many of them angry or hostile.

It seems this readership did not include many folks in Washington, including the current administration, which chose not to follow the simple path I laid out that could have turned our economy around in short order.

Instead, the White House, Federal Reserve, and Congress went the other way on nearly every issue that I discussed in the article.

The results tell the story:

• Americans are infuriated at continued job losses
• The housing market has largely stagnated, and is showing signs of a possible double dip
• Cheap money has continued to fuel a massive bubble in bonds
• Companies have started issuing 100-year bonds to lock in cheap interest rates while investors continue to pile into debt securities, which will certainly take a beating over the next 5 years (Norfolk Southern selling 100-year bonds, CNBC)
• Money supply (M3) year-over-year growth has recently turned up, but is still negative (

Maybe I’m out of touch, but these examples hardly sound to me a like a job well done.

Don’t get me wrong; I’m no cynic. Economist David Rosenberg of Gluskin Sheff recently announced that the United States is not exiting our recent recession, but has simply been in an upswing of what he thinks will prove to be a severe Depression.

I hate to tell Gluskin Sheff that they are paying a substantial salary to someone who is simply wrong. The United States is not in a depression, as Rosenberg would have us believe. True, the market has pulled back somewhat as the economy has stagnated (not double dipped), but at this point the market is right around the bottom of a trading range (10,000 to 10,500 on the Dow) where it has spent roughly 80% of the trading days over the past 12 months.

The real question to ask is where the Fed has been during all this.

Over the past two years the Fed has lacked both the direction and the decisiveness to help restore confidence in the US economy or make any meaningful headway on key indicators like employment, housing, or money supply.

History will show that typically the Fed supports the party in power in pursuing fiscal and monetary policy. The Fed can almost always be relied on to stimulate the market leading up to an election in order to bolster support for incumbents. This time has been markedly different.

Now it seems doubtful there is anything the Fed can do to save Democrats come November. At this point there is simply nothing Fed can do to help bolster the economy in any significant way that will be noticeable on Main Street (where the voters are) before the election.

Under Carter the Misery Index became a useful tool in measuring economic activity. Consisting of the inflation rate plus unemployment, this index contributed greatly to Ronald Reagan’s campaign, and no doubt helped him defeat Carter.

Generally speaking, it is nearly impossible for a party in power to remain in power with the Misery Index in the upper teens. Under Carter this number reached an all-time high at nearly 22 before dropping to just below 20 at the end of his term. During Reagan’s 8 years in office, this number fell by more than 10 points. Bush’s (H.W.) term in office saw the index peak around 12.5, and Clinton around 10.5.

At this point the Misery Index, using stated unemployment numbers, is roughly 11. Unfortunately, we all know how accurate stated unemployment numbers are. In fact, the index is actually much higher, taking into account true unemployment numbers. With this revision, the true value of the misery index is likely in the upper teens, about 6 points higher than it is currently.

Note: It is a little known fact that the stated unemployment rate has historically been measured by U5, which includes those worker whose hours have been cut, those who have quit looking for work, and several other categories that aren’t included in U3 (a much more narrow measure of unemployment). However, in 1994 the US Bureau of Labor Statistics changed its policy, making U3 the stated level of unemployment.

Recently CNBC anchor Mark Haines has taken up the argument that there exists no cause and effect link between fiscal and monetary policy, directed by Washington, and economic activity. He contends, instead, that any link between the two is simply coincidence. Unfortunately for Mark, I’d bet that he’s a whole lot better at reading a teleprompter than he is at forecasting, analyzing, or assessing the markets, much less economic policy.

Wednesday, August 18, 2010

Excess Information Slows Learning Curve

Scanning the horizon of the investment world, it is becoming increasingly easy to distinguish a coming wave of inflation and economic growth, which should be arriving in the not-so-distant future. Though many academics and ‘market experts’ have lately debated the likelihood of deflation, they seem to be chasing the train’s caboose.

As many will [hopefully] come to learn, the United States has been in undergoing deflation (defined as shrinking money supply, in this case M3) for the last year. This has been the result of demand for loans drying up as businesses refuse to carry the burden of added debt. Money simply hasn’t been turning over in the US economy; not even the billions of dollars the government created in response to the 2008 financial crisis.

After all, the government fed money to so many troubled banks, and then offered to pay them interest if they held that money in the Federal Reserve System as excess reserves. Why, then, would the banks ever want to walk away from riskless interest income to lend out money, when it might not be paid back? Where’s the incentive?

Despite this apparent lapse in judgment, the market has been responding well lately as anti-business rhetoric has calmed down substantially. Corporations are beginning to form a clearer picture of the world they now face, and their investors seem to be gaining confidence for their prospects going forward, as evidenced by stock prices.

In fact, many corporations have lately begun issuing high-yield, or so-called “junk” bonds. As many investors fear a double-dip recession, these risky instruments that pay higher-than-average interest rates have been flying off the shelves in recent weeks.

Many corporations have been using cash raised from these issues to pay off debt they had outstanding at higher interest rates, while others are simply stockpiling cash for future expansions projects. In either case, the decision for many of these companies to issue such debt has been wise. Unfortunately, the decision for investors to buy such debt will have terrible results.

As we’ve detailed in previous articles, the odds of our economy seeing a double-dip are low, and falling every day, making this protection unnecessary for investors. Even more importantly, however, is the fact that interest rates are currently at long-term lows. Investors buying bonds now will see the values of their bonds decline substantially once interest rates begin to climb.

Even investors looking to hold their bonds until they mature (these investors wouldn’t be unaffected by rising interest rates) will find themselves exposed in high-yield bonds. That’s because junk bonds are a form of subordinated debt. As creditors, junk-bond-holders will find themselves rather far down on the totem pole. In fact, they’ll probably be the first creditors to get stiffed if their companies ever run into financial difficulty.

As stated above, we see inflation as being much more likely going forward than its counterpart. This does NOT mean, though, that we are calling for the end of the dollar. In fact, we doubt people will suffer as a result, at least not any more than people are suffering today, despite the fact that the dollars they hold are worth only a tiny fraction of what they were more than a century ago.

Unfortunately, the biggest hindrance to most investors today is not a lack of information, but a surplus. Few realize that just as education does not inherently bestow intelligence, more information does not necessarily import more knowledge. Never before in history has information been more widely available than it has been for the last ten years or so; and yet the markets as a whole have declined in value during that time. The average investor, despite so much information at their fingertips, is worse off.

If more information were necessarily an advantage, Warren Buffett would be sweeping streets in Omaha, and traders on the floor of exchanges would be the wealthiest folks in the world. The rest of us would be penniless. Look no further than Long-Term Capital Management. Never before in history had such an amalgamation of doctorates, researchers, and Nobel Laureates ever been assembled. LTCM was a man amongst boys in terms of access to information, and even that could not save the firm or its investors.

In Ubiquity, author Mark Buchanan cites numerous academic studies to arrive at the conclusion (one of many) that more information, particularly irrelevant information, actually causes people to decrease the accuracy of their decisions, while simultaneously increasing the confidence in their choices. In other words, more information makes people feel more confident in their poor decisions.

The lesson, then, is that investors need to be careful to do their own research, but to avoid exposing themselves to so much information that they (a) obscure the nature of the markets, or (b) grow arrogant. Either of these results is extremely dangerous financially, but both of them together can be catastrophic.

Wednesday, August 11, 2010

Convoluted Economy makes Maze of Markets

Both leading up to and in the wake of the Federal Reserve meeting on Wednesday, there has been a greatly deal of fear among investors that the market may be headed for a bout with either deflation or a wave of inflation. These suspicions have lead to a wave of irrational fear, and resulted in increased market volatility as investors grow skittish.

First, to clarify: fears that deflation may be on the way are essentially unfounded. Not that deflation is impossible, but simply because it is unlikely going forward. It is particularly unlikely because the US has been experiencing deflation (defined as a decrease in the money supply) for the last nine months.

What is especially interesting about the growing fear of deflation is that it seems to be coming just as money supply numbers – namely M3 – appears to be bottoming ( Although the Federal Reserve stopped reporting M3 several years ago, its components are still published. Different groups of economists have used those components to recreate an accurate picture of M3, which can be found at websites like and

Much of this fear is focused on US savings. After all, since 2007 many Americans have seen their net worth cut by half or more and many failed to take advantage of the 2009 rebound. People have been wanting, wishing, even praying to see their portfolios return to post-crash levels.

Years ago Americans lamented at their inability to buy affordable homes at low interest rates. They failed to understand why their parents could buy homes at reasonable prices with mortgage rates around 6.5%. Now Americans can buy homes that are, in many cases, half their prices from two years ago, and at rates below what their parents paid (as low as 4.5% for a 30-year mortgage). Unfortunately, most are missing out on abundant opportunities in housing because they are focused on stock prices and economic phenomena like credit deflation or oil futures contango.

The reactions of most market participants to 2008 have been completely counterintuitive. Investors ought to have learned from that experience that the financial markets are indeed capable of declining on a broad basis, and diversified portfolios are quite capable of seeing substantial losses. Incredibly, investors have become convinced that they weren’t sufficiently diversified, and have begun spreading money not just across securities, but across asset classes, many of which they fail to understand.

Instead, investors would have done well to change their logic and realize that diversification as a theory is flawed, and adjusted their investment style accordingly.

Few people, even business school graduates, fail to understand that diversification hinders returns. The primary objective of modern portfolio theory is not to show gains, but to protect investors against losses. In other words, it is meant to maintain portfolio stability – in modern portfolio theory, “risk” is not defined by loss, but by volatility. In keeping with this theory, diversification serves to slow portfolio movement in EITHER direction. In guarding against losses, it also limits gains.

We’ll wrap up this week with an economic update. At this point we are thoroughly convinced that Washington is only thing holding the US economy back. Unemployment numbers, which have received far too much attention, remain high, in our opinion, mostly because the government is continuing to pay people NOT to work. However, at the same time many companies have admittedly been unwilling to take on additional employees because they are unsure whether their already-high costs will remain stable (Why I’m Not Hiring, Michael P. Fleischer). This does not excuse the fact that there is substantial demand for products that corporations aren’t willing to meet through expanded production (Dealers Beg for Cars as Automakers’ New Discipline Curbs Sales, Theo Keith).

As we’ve discussed repeatedly in previous articles, much of this stagnation on the part of business, their hesitation about expanding, is due to uncertainty about what new regulations Washington will heap upon their shoulders. For the most part, business in the US can be equated to a horse chomping at the bit, ready to break out of the gate. Unfortunately, they can do little until Washington gets out of the way.

Wednesday, August 4, 2010

Flying to Safety without a Compass

Over the last several months the stock market has worked its way into a trading range, and has basically been fluctuating within about 10% of its 12-month highs, despite the recent wave a positive economic data that has recently washed away the fears of many investors.

The most likely explanation for the market’s inability to follow-through on good news is that a good deal of the data now coming out may have been expected by the market, and been priced in. In any case, stocks are now likely looking ahead, with some consensus forming about the likelihood of another stimulus package, the sustainability of recent corporate earnings, and forecasting how November will play out in Washington.

While the broad market has assumed a sense of suspended animation, there are still several sectors that have been on the move. This is the big reason we have always taken a negative stance towards excess diversification. After all, an ability to forecast winning sectors is why money managers get paid.

While some sectors have been on a hot streak lately, the prospects for others are not nearly so bright. Gold, for example, has lately seen a slight rally, but we expect that its correction is not yet finished. In recent weeks we’ve tried to point out the recent inflation of gold’s price (Gold Loses Luster as Earnings Ignite, Glenn Beck-onomics and Rusty Gold), but judging by the influx of angry e-mails, our warnings seem to have fallen mostly on deaf ears.

Unfortunately the story has been nearly the same in the case of Treasury bonds. No one seems to want to see what is in front of their very eyes: Treasury yields are now at generational lows, and investors buying now will see a likely serious loss of principal over the next 5 years.

Yesterday on CNBC one commentator at the gall to argue that a bubble in Treasuries simply isn’t possible, that Treasury yields reflect nothing more than a flight to quality. This same argument has been used for gold at different points in history, as well as real estate in the early 2000s. Unfortunately the story always seems to end the same way, and it’s never very good for the client.

As a test for their advisors, clients should try posing the following question: “What would happen to the value of a given bond if interest rates on 30-year Treasury bonds went to 7% (which is hardly uncommon from a long-term perspective)?” If they say they don’t know, run; if they say it can’t happen, hide!

While many investors have lately been piling into bonds, gold, and other hedges against either inflation or deflation, we so far fail to see what is unattractive about equities. For the most part, companies still have good balance sheets; and though many have started assuming small amounts of debt, in most cases, any leverage is easily covered by cash and liquid assets.

Long-time readers will remember that around this time last year we cited an article from the Wall Street Journal that stated U.S. non-financials were, at the time, sitting on nearly $14 trillion in cash and liquid assets, approximately equal to one year’s worth of US GDP (Where Consumers Fail, Can Businesses Lead?, Gongloff).

While companies may have begun borrowing, our expectation is that it is to fund expansion projects, which will ultimately lead to falling unemployment numbers as America goes back to work. As such, borrowing by American companies, which had shunned debt after the 2008 financial crisis, may be something to welcome, rather than fear.