I recently read the 2011 edition of Burton Malkiel’s classic book on investing called ” A Random Walk Down Wall Street”. Originally published in 1973, it has been updated nine different times. It is chock full of  history, wisdom, academic studies, and also has a lot of humor. In his book he states ” That through the past 30 years more than two thirds of professional portfolio managers have been out performed by the S&P 500 Index”.

With all the evidence from numerous academic studies dating all the way back to 1900 showing the superiority of passive investing, why don’t more people use this strategy? As Princeton professor Burton Malkiel explains in his book, ” It’s hard for people to accept because it’s like telling someone there is no Santa Claus, and people don’t like to believe that.”

Being a little cynical, and having had a six year stint on the dark side as a stockbroker way back in my past from 1968 to 1974, I think the conflict of interest of stockbrokers selling the latest hot performing managed mutual fund to earn a commission is another reason why investors are convinced. Never underestimate the power of Wall Street’s marketing machine.

Have things changed recently? Not really. A recent article in the February 4-5 weekend edition of the Wall Street Journal by Ben Levishon, pointed out that mutual fund managers had a miserable 2011. He stated that ” Last year, just 23% beat their relative benchmark, according to investment research firm Moringstar – their worst record in at least 10 years. A record like that could drive many investors out of actively managed funds and into funds that merely track an index” I agree Ben.

Maybe the answer is to move up a notch and choose a hedge fund, instead of an actively managed mutual fund. After all hedge funds are managed by Wall Street’s best and brightest money managers. True, you have to pay an arm and leg with the typical management fee being 2% annually, and 20% of the profits. But isn’t this just a case of getting what you pay for? Not according to Simon Lack my former colleague at JP Morgan Chase.

Simon wrote a book called ” The Hedge Fund Mirage: The Illusion of Big Money and Why It’s To Good to Be True” It is a very recent book published in January 2012. This book has been garnering a lot of attention in the financial press with reviews by the Wall Street Journal, The Economist, Forbes, Bloomberg, and others. He has had extensive experience in dealing with hedge funds. Much of Lack’s career was spent in North American fixed income derivatives and forward FX trading both as a trader and as a manager. He also sat on JP Morgan’s investment committee which allocated over a $ 1 billion to hedge fund managers.

A January 7th article in the Economist on Simon’s book stated ” There is no doubt that hedge fund managers have been good at making money for themselves. Many of America’s recently minted billionaires grew rich from hedge clippings. But as a new book by Simon Lack, who spent many years studying hedge funds at JP Morgan, points out it is hard to think of any clients that have became rich investing in hedge funds. Indeed since 1998, the effective return to hedge fund clients has only been 2.1% a year, half the return they could have achieved by investing in boring old treasury bills”

Another article on Simon Lack’s book in Forbes magazine’s Personal Finance column discussed some other interesting points. They stated that  Lack was an industry insider, having spent part of his career at JP Morgan helping to allocate more than $ 1 billion to hedge funds and seed emerging hedge fund managers. Immersed in the industry, he eventually came to the conclusion that: ” While the hedge fund industry has generated fabulous wealth and created many fortunes, it has largely done so for itself ” This article also points out that  during the 1998 – 2010 time frame the HFR Global Hedge Fund Index puts the industry’s annualized return at 7.3%. In Lack’s mind, those return figures are distorted by several factors. So Simon performs his own asset weighted calculations (similar to the internal rate of return methodology of measuring private equity or real estate fund performance) using Barclay Hedge data to measure how the average investor, as distinct from the average fund, has done.

His conclusion: ” from 1998-2010 the index returned only 2.1% annualized on a money weighted basis, not 7.3%. During that time frame, he estimates that hedge fund managers earned $379 Billion in fees, while real investors earned only $70 billion in profits. Thus, the operators earned 84% of the investment profits and investors only 16%. Those figures don’t account for funds of funds which add another layer of fees. Funds of funds account for about one third of hedge fund purchases. He estimates that this brings the industry fees up to $440 billion, or a whopping 98% of the profit pool, leaving only $9 billion for investors.”

Whether one agrees with all of  Simon Lack’s conclusions and the math in his book, the points he raises should give pause to investors who think that hedge funds are the answer to getting great returns. Simon has some company in his conclusions. In 2010 two academics, Ilia Dichev from Goizueta Business School at Emory University and Gwen Yu from Harvard Business School, published a research paper titled ” Higher Risks, Lower Returns: What Hedge Fund Investors Really Earn” This study went back to 1980 and performed a very detailed analysis. It concluded that overall industry returns have been a disappointment for hedge fund investors.

I think this a very big example of “Costs Matter”. While there have been some big winners among hedge fund investors, overall the majority of investors have found themselves on the short end of the stick. Just another example of how hard it is to find active managers who can consistently outsmart the market over the long term.

Some things change, Some things don’t.

Pat Manning

One of the main reasons I remained optimistic about the US economy last fall was the rise in the dollar and the fall in commodity prices, particularly oil. Reduced gasoline prices along with a dramatic fall in natural gas prices were a boon for the US economy that more than offset the potential fallout from a European recession. I also assumed the ECB would be forced, one way or the other, to print enough Euros to prevent a banking crisis and deflation outside the periphery. Unfortunately, I underestimated the degree to which the world’s central bankers would embrace the warmth of their overworked printing presses. It isn’t just the ECB that has resorted to printing press finance. The US Fed has committed itself to easy policy as far as the eye can see, the Bank of Japan recently announced they would buy bonds until inflation hits 1% in a bid to weaken the Yen, China has reduced bank reserve requirements for the second time and most of the emerging markets are also easing monetary policy.

This global easing has had predictable effects. Oil prices are nearing $105 – gas prices $4 – and natural gas, even in the face of a glut of domestic supply, has stopped falling. Gold has risen $200 since late last year and other commodities are also off their lows. Inflation takes time to work its way through the economic system but commodities, the most sensitive indicators of monetary excess, tend to move immediately and often dramatically. Investors seek to protect themselves from further devaluation of their hard earned money by moving to hard assets that can’t be manipulated by central banks. One of the reasons China recently reduced reserve requirements is an outflow of deposits from Chinese banks where rates are held below the rate of inflation, ensuring a loss of purchasing power. It isn’t a stretch to think those deposits will or maybe already are finding their way into the commodity markets. Japan recently announced a record trade deficit – yes, deficit – primarily a result of high energy costs (but also, ominously, due to a 20% drop in exports to China). Why the BOJ believes even higher prices will fix what ails the Japanese economy is a mystery.

Capital tied up in commodities to protect against the depredations of the world’s central bankers is capital not invested productively and not spent on consumption. The recent boomlet in the US economy will burn itself out when either the inflation stops or oil prices rise enough to again choke the economy back into recession. As I said recently, this isn’t the recovery we’re all looking for. That will only come with a major change in fiscal and monetary policy that at present still looks a long way off. In the meantime, enjoy this stock rally while it lasts.

Those higher gas prices may already be having an effect as both the Goldman and Redbook retail reports showed weakness last week. Although the monthly retail report did show a good gain, the weekly reports are more timely. The Goldman report was down 2% week to week although the year over year gain is still 2.8%. That isn’t worrisome yet, but definitely worth keeping an eye on. For now, inventories are lean after rising less than sales in December. The inventory to sales ratio is a low 1.26.

Oil prices also had an outsize impact on import prices which were up 0.3% in January and 7.1% year over year. Export prices were also up but just 2.5% year over year. Producer prices rose a more subdued 0.1% in January but are up 4.1% year over year. Consumer prices also rose, up 0.2% at the headline and core levels. While the Fed now uses the PCE deflator for policy purposes, it should be noted that core prices year over year are up 2.3%, higher than the Fed’s inflation target of 2%. The scope for further easing would seem to be limited if the Fed actually sticks to its target.

Housing continues to slowly heal with the homebuilders sentiment index up another 4 points to 29. Builders’ optimism isn’t yet reflected in housing starts which rose a modest 1.5% in January with most of the gains in multi-family. That might explain the still subdued builder sentiment since most of them are not building apartments. Permits were also up but only by 0.7%. Year over year gains in starts are now running at 9.9% so construction is recovering but with the recent foreclosure settlement, there may be more price pain to come. Housing is better but a long way from good.

The one area of the economy still performing well is manufacturing with both the Empire State and Philly Fed surveys rising in February. The NY Fed survey rose to 19.53 but new orders growth fell somewhat. Employment readings in both surveys were essentially flat. Both surveys showed less optimism about future business, probably due to concerns about Europe. Industrial production was flat in January but that was primarily due to a drop in mining and utilities. Manufacturing of durable goods was up a robust 1.8% although non durables fell 0.2%.

Jobless claims were the star of the week, falling to 348k in a continuation of the pattern we’ve observed since late last year. It will be interesting to see what happens to claims over the coming weeks as higher oil prices work their way through the economy. The high frequency data we monitor continues to show an economy growing at a modest pace but the inflation that is at its root is cause for concern. I would not be surprised at all to start seeing more disappointment in the data over the coming months.

Stocks rose again last week with the S&P 500 up 1.38% and foreign markets up similarly. Sentiment surveys remain overly bullish at both the individual and adviser levels. It is an interesting phenomenon though with only sporadic inflows to equity mutual funds. Investors seem to be saying one thing and doing another. It is also particularly worrisome to see continued robust inflows to bond funds considering the inflationary backdrop. I can only guess that individual investors are looking at last year’s performance and concluding that bonds are the better bet. With the world’s central bankers easing en masse, that is a bet with low odds of success.

The Nasdaq Composite is straddling its upward trend line. The Nasdaq is a market on fire, but will it come crashing down, or continue to make multi-yr highs?

Crude oil has been inching higher for the past two weeks on developments in Iran over its nuclear program.It bounced off its 200-day MA and pushed through the 50-day  MA in one fellow swoop, and may be ready to make new short-term highs.

As predicted, the US Dollar quickly recovered to the 80 level, before failing at the 50 day MA. What is very peculiar is that despite a stronger dollar, oil still proceeded to go up.

The international real estate market has improved of late and crossed the 50 week MA after straddling the 200 week MA for some time.

Despite all the turmoil in Greece, the European stock market is performing really well. It crossed over the 200-day MA and held the upward trend line last week.

Joseph Gomez, Sr. Investment Advisor and Portfolio Manager

Of the nineteen economic indicators released this week, nine were weaker than expected, eight were stronger, and two were in line. Once again this week, strength was concentrated in employment and housing related indicators. Thursday’s initial jobless claims report showed that the nation’s employment picture continues to improve. In terms of expectations, this week’s total of 348K was well below consensus expectations of 365K. More importantly, it was also the lowest reading in nearly four years.

The Nasdaq has not been this high since December 2000 and Dow 13K watch is in full effect as that index is at its highest levels since May 2008. Underlying breadth has also gotten a bit less overbought over the last week. The cyclical sectors remain strong. As long as this trend continues, this bull has legs.

Are you missing out on this rally? A lot of investors on the sidelines have watched helplessly as this market has rallied. The big question for these investors is do they get in now and risk getting in at the top? Or do they sit tight and wait for a pullback? I offered an explanation of this in my report, Why is Investing so Difficult?  However, if you’ve been following our weekly updates, you would have been enjoying this recent rally. Below are some of our recent comments from our weekly updates:

October 30th - I pay particular attention to stocks that beat earnings and revenue estimates and also raised guidance. In our client accounts, these include: Citrix (CTXS), Philip Morris Int’l (PM), and Baidu (BIDU).

November 14th – I believe that a break above the 1285 level on the S&P 500 will result in an impressive rally through year-end. We always hear investors saying that they would love to pick up some Apple (AAPL) shares if it would only pull back a little bit. Well, now it has pulled back a bit and here’s the chance.

December 11th - Among the standouts in our client portfolios this week, are: AMBEV (ABV)

January 22nd - Standouts in our portfolios last week include Barcalys (BCS), iShares Emerging Market ETF (EEM) and Panera Bread (PNRA).

January 29th - Surprisingly, one mega cap that has been in a stealth rally this year is Microsoft (MSFT).

Below are some charts of interest, an earnings calendar, economic calendar and key interest rates. Next week, we get earnings from Walmart (WMT), Macy’s (M) and Salesforce.com (CRM). I have included a partial list of important new highs this week. Many are positions held in our Global Opportunities Portfolio and other client accounts. The list includes:

Philip Morris (PM) – Apple (AAPL) – Chipolte (CMG) – Qualcomm (QCOM) – AMBEV (ABV) – Lowe’s (LOW) – Tata Motors (TTM) – Microsoft (MSFT)

Have a pleasant and productive week.

Important earnings next week

Economic Calendar by Econoday.com

Monday Feb 20	Tuesday Feb 21	Wednesday Feb 22	Thursday Feb 23	Friday Feb 24
US Holiday: Presidents’ DayBond, Equity Markets Closed	Market Focus » Chicago Fed National Activity Index 8:30 AM ET 4-Week Bill Announcement 11:00 AM ET 3-Month Bill Auction 11:30 AM ET 6-Month Bill Auction 11:30 AM ET 2-Yr Note Auction 1:00 PM ET	Bank Reserve Settlement MBA Purchase Applications 7:00 AM ET ICSC-Goldman Store Sales 7:45 AM ET Redbook 8:55 AM ET Existing Home Sales 10:00 AM ET 4-Week Bill Auction 11:30 AM ET 5-Yr Note Auction 1:00 PM ET	Weekly Bill Settlement Jobless Claims 8:30 AM ET Bloomberg Consumer Comfort Index 9:45 AM ET FHFA House Price Index 10:00 AM ET EIA Natural Gas Report 10:30 AM ET EIA Petroleum Status Report 11:00 AM ET Kansas City Fed Manufacturing Index 11:00 AM ET 3-Month Bill Announcement 11:00 AM ET 6-Month Bill Announcement 11:00 AM ET 7-Yr Note Auction 1:00 PM ET Fed Balance Sheet 4:30 PM ET Money Supply 4:30 PM ET	Consumer Sentiment 9:55 AM ET New Home Sales 10:00 AM ET

Key Rates by Bloomberg.com

Clients, principals and/or employees of Alhambra Investment Partners may have long or short positions of any above-mentioned securities. For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joseph Gomez  can be reached at jag@alhambrapartners.com. 

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Volume II, Number 7:  F.A. Seiberling, Goodyear, and How the Federal Reserve Can Wreak Havoc in Life     

By John L. Chapman, Ph.D.                                                                                                                     Washington, D.C.

I am one of the old men of rubber ….rich and poor again by turns…..I have seen life from the mountaintops and the valleys.  I fear there will be hard times ahead for America….but what happiest of days were those former times [of building Goodyear]….my baby — my giant!   – F.A. Seiberling, Goodyear Tire & Rubber Co. founder, looking back at age 88 

Introduction: Though Not Well Understood, Stable Money is Critical for Economic Growth and Prosperity

Readers of our column, and indeed all output from the investment research team at Alhambra Partners, well know that we are fans of sound money – that is to say, money that is dependably-valued over time, such that it allows for proper calculation of profits and losses, for investment planning and entrepreneurial deployment of scarce capital resources in an uncertain future, and for the maintenance of its worth in exchange so that it continually encourages such forward-looking — and thus risky — investment.  As stewards of other peoples’ money, in any “macro” or global assessment of investment choices where a paramount goal is preservation of purchasing power, this is the first consideration for us, in fact.  Russia, for example, is a country teeming with natural resources, a well-educated and hungry populace, and improving mechanisms to safeguard property rights — but without assurance that the ruble will not again go the way of its valuation path in the 1990s, the country remains a question mark for foreign direct investment.

The fact that the Russian government and its central bank cannot seem to understand this — or choose to ignore it, in order to optimize political manipulation of the ruble for the internal domestic benefit of the (de facto) Putin-led ruling class, is of course a loss both for the world and for the Russian people at large: much in the way of mutual gains from trade and investment is lost.  And indeed, this is the best way to size up any currency, and better understand the crucial function of money in civilized society.  For only a well-functioning medium of exchange, one in which its users have strong and enduring confidence in its exchange value over time, permits the smooth trade and exchange of literally billions of different goods and services (both in the present, and across time, between present and future),  via concomitantly permitting a deep division of labor and specialization in order to produce these billions of different goods.  And in turn it is this specialization and division of labor that are themselves the primary driver of an ever-increasing productivity of labor, which is the root source of increase in output and real wealth.  In other words, a well-functioning monetary unit is critical to improving standards of living and prosperity, along with the protection of property rights and an effective tax system that incites work, saving, and investment.

We take pains to mention this because at the moment we are deep into investigation of the short-term path of U.S. Dollar value both abroad and as it concerns latent domestic inflation, and hence its impact on global asset prices (and the U.S. stock market in particular).  Sadly, this is now an ongoing project for us because we fear that the fundamental importance of sound money as a necessary condition for prosperity is lost on the modern political class in the United States, including the President, the Treasury Secretary, and the leadership at the Federal Reserve.  Lip service is paid to promoting a “strong dollar”, but not since Rubin’s Treasury in the late 1990s has this been an overt policy concern in Washington (and as we showed in Chart IV last week, the trade-weighted value of the dollar has fallen sharply in the last decade as confirmation of this neglect, explaining more than anything the sclerotic growth of the U.S. economy — 1.9% per annum — since 2000, likely the worst stretch in U.S. history for growth).  Republicans are hardly better on this issue; Mitt Romney never mentions monetary issues and ignores them completely in his published plans for economic revival, for example (though in this election season Messrs. Paul, Johnson, Cain, and now Gingrich have all talked about the importance of monetary stability as a key factor in restoring sustainable prosperity in the U.S.).

And again, stating the obvious, monetary instability in Germany in 1922-23, when the price level rose more than one billion times in the 15 months leading up to the November 1923 destruction of the German Papiermark (and not coincidentally, the Munich beer hall putsch that landed an obscure rabble-rouser named Hitler in jail, but portentously paved his future ignominious destiny), is understood by all to be an unambiguous example of bad monetary policy.  Less obvious, however, are cases of milder monetary mismanagement that nonetheless sow seeds of disaster in future years — this, in fact, this “zero-interest rate policy” for three more years, is a dagger pointed at our future, if not repealed.

A Case Study in Capricious Policy by the Federal Reserve That Greatly Damaged Lives

Indeed, monetary policy is often seen to be well-executed in the United States when measured solely by the yardstick of consumer prices — and as adjudged by members of the political class themselves – even as subterranean turmoil at the level of wholesale prices and errant investment decisions by entrepreneurs create economic havoc by causing distortions in capital allocation (i.e., waste of scarce resources), and subsequent losses and unemployment.  To this day, for example, Alan Greenspan obfuscates matters by maintaining that he did nothing wrong to cause any of what became a global financial markets disaster and deep recession in 2007-2009, which confusion Messrs. Obama and Geithner ratify by blaming private sector greed and unscrupulousness that called for Dodd-Frank and a new, more intensive level of federal government oversight.

Perhaps then a concrete illustration of a real life example of Federal Reserve malfeasance that distorted entrepreneurial decision-making and led to malinvestment, job losses, and destroyed lives will best make the case that the Bernanke Fed is now playing with fire.  For perhaps in showing the human toll can monetary manipulation be best seen for what it is — no better than a zero-sum game, and often one involving huge individual and collective losses.

The Founding of Goodyear Tire & Rubber Company

In the spring of 1898 Frank Augustus (F.A.) Seiberling was in Chicago on business when he quite by chance ran into a business executive from Piqua, Ohio, H.C. Nellis.  Mr. Nellis’ firm owned an abandoned straw-board factory in Akron, Seiberling’s hometown, that had been shuttered for 4 years, in the midst of the 1893-96 recession (that was the most severe in history prior to the Great Depression — there had been massive labor strife and 10%+ unemployment for an extended period, and debate about expanding the money supply to include silver in order to relieve debtors had animated the 1896 election), and Nellis asked Seiberling if he knew of any buyers.  $140,000 in capital had been sunk into the factory buildings and equipment, but Nellis would part with it for $50,000.  Seiberling told Nellis he would be lucky to get $25,000 for it, and he himself would not pay more than half that.

Nellis then offered to sell it for $13,500, $3,500 down and the rest on a four-year note,  and Seiberling agreed.  That night he rode the train back to Akron, lying awake and thinking about what to actually do with the facility.  By mid-morning the next day, as he talked to family and friends in order to raise the necessary $3,500, Seiberling had decided to go into the rubber business, focusing on bicycle tires, and other assorted products such as rubber bands.  He also decided to name the firm after Charles Goodyear, the inventor who had discovered the vulcanization process.  The firm was profitable almost immediately as the bicycle craze led to an exploding market, and by 1901 had also entered the burgeoning market for pneumatic tires made for “horseless carriages” — a nascent industry centered at the time in Cleveland and Detroit, where the big early producer was Henry Ford.

The Entrepreneurial Drive, Actualizable Only in a Free Market Economy, That is the Mainspring of Human Progress

Seiberling had shown by the instinctual gamble he took in acquiring the facility sight unseen, and even more so with no business plan in mind, that he had the classic tacit judgment capabilities common to the most successful entrepreneurs.  That is to say, he literally “smelled” an opportunity in the form of an undervalued asset, and struck out in pursuit of exploiting it.  “Promoter, inventor, risk-taker, and charismatic leader” (according to Maurice O’Reilly, Goodyear historian), Seiberling capitalized on the resources at his disposal, including knowledge and history of the rubber business, which had come to Akron as far back as 1870 with the arrival of B.F. Goodrich.  Akron was uniquely positioned geographically to capture the rubber tire market, with transportation waterways, railroads to all major markets, and of course easy access to auto production (which within a decade was centered solely on Detroit).

Seiberling possessed other traits shared by Steve Jobs, Bill Gates, Andrew Carnegie, and other great American business legends: indefatigable energy and determined will to succeed.  He worked seven days per week and took no vacations for some thirteen years after founding the company, while at the same time branching his investment activities into other transport-related businesses.  Over the course of the next twenty years, Seiberling came to be thought of as a force of nature in the industry, acquiring the nickname of the “little Napoleon of rubber”, and growing Goodyear to become the largest tire company in the world.  The firm became leading edge in marketing innovation (e.g., licensing patents, agency deals), capital investment (invention of new and revolutionary tire-making equipment), strategy (regional sales offices and eventually regional production), and human relations (good wages for workers and company-subsidized benefits, including housing and recreation).

The company’s rise paralleled the industry’s, and helped drive explosive growth of the city of Akron.  In 1900, Akron had 42,000 residents, growing to 69,000 by 1910, and 208,000 by 1920; this matched the explosion of automobile registrations in the United States, which stood at 8,000 in 1900, 200,000 in 1908, and 7.5 million by 1920.  As for F.A. Seiberling himself, he was the company’s largest single share-holder, and a near-billionaire (in current 2012 dollars) by the end of World War I.  The company’s motto, “Protect Our Good Name,” was one flowing from his innermost core, an unquenchable drive-train to make Goodyear the world’s dominant rubber company.

The Federal Reserve Initiates a Century of Activism to Aid in Finance of World War I

When war broke out in Europe in 1914, all belligerent countries suspended their currencies’ links to gold.  This allowed governments to inflate currency stocks through the banking system’s fractional reserves, and while it assured higher prices in the future, it also ceded to government more direct control over societal resources, as the government and its agents were able to spend the newly-created money before anyone else.  The United States did not enter the war until 1917 as a belligerent, but suspended the gold standard in 1914 and again from 1917-19.  Special currency printing through the Aldrich-Vreeland Act (the 1907 legislation that led to the creation of the Federal Reserve, and in this case allowed for printing of currency in an emergency, to be backed by bonds) was authorized, and again thanks to fractional reserves the money supply (M2) expanded dramatically during the war – doubling between 1915-20.  This led to exploding commodity prices (as it had in all prior wars for the U.S., and would in later ones as well), shown in a few ways.  First, Chart I shows the Producer Price Index (PPI) since 1913:

Chart I.  Producer Price Index, 1913-Present, Log Scale

Note that the rise in producer prices was sharper between 1915 and 1920 than it has ever been at any other time in the last 100 years, rising by more than 150%.  And indeed, the PPI increased by another 150% again — between 1920 and 1978 (albeit not before falling all the way back to 1915 levels by the end of the great deflation of 1933.

This commodity price explosion is so critical to the lesson to be learned here that we ask for reader indulgence in looking at the PPI again “up close” during the era in question, between 1913 and 1926:

 Chart II.  Producer Prices, 1913-26, Log Scale  

The enormous explosion in producer prices was matched by increases in consumer and inflation-sensitive farm prices as well; agricultural land and asset prices were up 80% between 1915 and 1921, for example.  Reading these price signals, and not being aware of the Federal Reserve’s “looser” policies or the ramifications of decoupling the dollar from gold, Seiberling pushed Goodyear forward by committing to investments in a far-flung empire, including new factories or operations in Arizona, Brazil, California and Canada.  Because he did not trust (and never had trusted) New York banking syndicates, to fund this growth Seiberling raised new equity capital through two subscription offerings directly aimed at friends, family, and employees. He also bought rubber and other industrial commodities on forward contracts at these vastly-inflated prices by 1920; this seemed to be a prudent thing to do, to both lock in prices before they were raised yet again, and to gear up for what had seemed to be the likelihood of a long war.  Further, Seiberling reasoned, even if the war ended abruptly (which it subsequently did), demand would then shift back to civilian desires for more autos.

But the end of the war brought a big deflation, and as the graphs show above, rapidly declining prices.  The government cancelled huge long term contracts, but there would be a lag to convert to civilian demand and production.  A major recession began in early 1920 which was to carry over well into 1921 and Goodyear, which was so strong operationally and in terms of market share, was nonetheless caught in an extremely illiquid position.

Expectations of higher prices had led to expansion of inventories which now could not be liquidated due to the severe deflation fueling the 1920-21 depression and its steep drop-off in demand.  In terms of magnitude, Goodyear’s net profit level totaled $51 million in 1920 on sales of $192 million, but in 1921 sales fell to $105 million as the firm lost $5 million net.

The maddening thing of it for Seiberling was the company’s fundamentally strong market position.  By war’s end, for example, Goodyear supplied 60% of new inflatable and 35% of solid tires for trucks in the U.S.; 50% of the motorcycle market; and 60% of all carriage and buggy-maker needs.  Goodyear was General Motors’ single biggest supplier, owing to Seiberling’s close relationship with W.C. Durant (at the same time, Firestone was Ford’s biggest supplier for decades).  But the firm was reeling as the 1920 downturn turned into a mini-nightmare.  Over 100,000 businesses went bankrupt that year, many over-leveraged or too-extended like Goodyear.  Industrial production fell 21% between mid-1920 and mid-1921, and this was enough to ensure unemployment tripled, from 3% to over 10% in the U.S. in that same timeframe.  By the spring of 1921 Goodyear’s capital stock was nearly wiped out.

Seiberling’s downfall came in May of 1921 when, due to his lack of support in the New York banking community,  he struck out at getting support for working capital loans to bridge the firm until cash flow could again turn positive, as it surely would when longer term purchase contracts either ended or were re-worked, and the firm’s sales returned once the industry came back.  Along with Seiberling, 26,000 Goodyear employees lost their jobs in 1920-21, as the Board voted to bring in Clarence Dillon of Dillon, Read & Co. to bridge the firm and also offer up support for new managerial talent.

Lessons Learned and Application to Today’ Federal Reserve

For F.A. Seiberling, to have his heart and soul — 23 years of his life — ripped out of his chest at age 61, the time was devastating.  Further, because back in those days corporate finance practices were not formally developed, loans to the business were often made by the founder entrepreneurs in the form of full recourse — Seiberling had signed these loans opening his own net worth to exposure.  By the time he was removed from Goodyear,  he was allowed to keep his house, and little else.  He was, in a financial sense, wiped out, having just a few years earlier had a 9-figure net worth statement.

In a very real sense, the Federal Reserve brought Seiberling — and many tens of thousands like him — to complete ruination.  For had the Fed not intervened after 1915 to support the war effort with big increases in the money stock, prices would not have been distorted in relative terms.  And thus entrepreneurs like Seiberling would not have mis-read the false signals from wholesale prices after 1915, leading to massive malinvestment of capital in projects that could not pay off.  This is the Fed’s contemptible legacy that carries forward to the present day: policy activism that is in fact de-stabilizing in terms of prices, and the dollar’s value.

It’s never too late to do the right thing, however, and for the Federal Reserve, it is past time to “put a stake in the ground” and declare a value for the dollar (working with Treasury) that can be defended.  Even in seeming mild inflations such as we are now experiencing (i.e., roughly 3% currently), a terrible bond market collapse is now a distinct possibility, and certainly entitlement disasters await, too, absent any policy changes.  And there are in any case already many faceless names of people who have been unable to find work in the present economic torpor, or seen a decline in their standard of living because they were or are on the wrong side of the prior dollar-manipulation.  In short, Mr. Bernanke cannot much longer (if at all) rely on global investors to bail him out due to them having slightly worse currency management skills than Fed and Treasury economists or Beltway politicians.  Indeed the devastation caused for F.A. Seiberling and his employees all those years ago points to a canon law of classical political economy that must per force  be resurrected: sound money is as much a moral issue as it is one of prosperity-inducing efficiency.  And indeed, for this reason, the Fed and monetary policy ought to become a central campaign issue in 2012 once again, as it was in 1896 and again in 1980.

Epilogue

F. A. Seiberling was badly hurt by the events of May 1921 at Goodyear — his life was changed forever, losing nearly everything.   But he went forward stoically, and by that November had raised enough capital to start a new firm.  In time, Seiberling Rubber Company would rise to become the world’s 7th largest in this industry — nothing on the scale of Goodyear, but a comeback nonetheless, borne of sheer determination.  Seiberling died at age 96 in 1955, never fully apprehending what had happened back in 1920-21, and why there had been such a massive “clustering” of entrepreneurial errors such that a hundred thousand businesses would all fail at the same time.  Today, fortunately, the Fed’s errors are much easier to see.

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, John Chapman can be reached at john.chapman@alhambrapartners.com.  The views expressed here are solely those of the author, and do not necessarily reflect that of colleagues at Alhambra Partners or any of its affiliates.  

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Volume II, Number 6:   Is Inflation, a Stagnant Economy, and Lower Standard of Living in Our Future?? 

By John L. Chapman, Ph.D.                                                                                                                     Washington, D.C.

Despots and democratic majorities are drunk with power. They must reluctantly admit that they are subject to the laws of nature. But they reject the very notion of economic law . . . economic history is a long record of government policies that failed because they were designed with a bold disregard for the laws of economics…… True, governments can reduce the rate of interest in the short run.  They can issue additional paper money.  They can open the way to credit expansion by the banks.  They can thus create an artificial boom and the appearance of prosperity.  But such a boom is bound to collapse soon or late and to bring about a depression.      — Ludwig von Mises

There is the possibility…that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. ….if such a situation were to arise, it would mean that the public authority itself could borrow through the banking system on an unlimited scale at a nominal rate of interest.       –  John Maynard Keynes

Introduction: The Prologue to Today and the Current Situation Summarized

On August 15, 1971, President Richard Nixon unilaterally terminated U.S. obligations under the 27-year old Bretton Woods monetary framework, and with it the U.S. Dollar link to gold.  The world became at once a global economy based on government-run fiat currencies, that is, national currencies managed by government-dominated central banks.  Gold was, for the first time in 2700 years of recorded human history, nowhere in the world used as a universally-accepted monetary medium.

What followed was, for students of sound money, predictable.  The M1 money supply grew 17% in the next two years, until Nixon era wage-price controls were phased out.  And then, during the nine years between 1974 and 1982 inclusive, the money supply grew another 81%.  Real output (GDP) growth averaged 2.0% per annum in the United States during that time, and other than the 1930s, this was the worst sustained period for economic growth in U.S. history — until the equally sclerotic period after 2000 (1.9% GDP growth in the U.S. since then).  Two percent growth was well below the long-term 20th-century (and post-war) growth rate of 3.4%, and this period is remembered as a desultory time.  Book-ended by Watergate, a Middle East war, and the Arab oil embargo in the beginning, and the brutal 1981-82 recession at its end, it was also an era of terrible inflation in the U.S.: during those nine years annual price increases averaged just over 9% per annum, topping out at 13.5% in 1980 and dooming the Carter Presidency.

Unemployment was also elevated during that period, by historical standards: it averaged 7.3% across those nine years, topping out at 10.8% in late 1982, a post-war high that still stands.  Meanwhile private investment as a percentage of GDP averaged around 12% during this period, nearly 1.5 percentage points below the subsequent high growth years of 1983-2000.  Lastly, the Dow Jones Industrial Average, which had flirted with the 1000-level in both 1966 and 1972, sunk to a secular low of 776 in August, 1982, with U.S. equities having lost nearly 70% of their inflation-adjusted value across those 16 years.

Why do we recount a long-ago episode of torpor in U.S. economic history, a period so forgettable that it became known by its own unique moniker of “stagflation?”  Unfortunately, there is rising talk of a return of stagflation here in the U.S. in coming years.  Both the economics profession and the investment community are currently locked in intense debate about the future course of prices in the United States, what the implications might be for output and employment growth, and possible correlative effects on asset returns.  In the essay that follows we examine inflation signals such as they have surfaced in the context of updated policy (based especially on the Fed meeting January 24-25), and sort out the “possible futures” that might ensue, including investor implications.  We produced a fairly extensive review of current monetary policy and its likely impact just a month ago, and stand by the conclusions reached there, summarized here as a useful point of departure:

….we feel highly confident that there will be no recession in the U.S. this year, absent any panic-induced retrenchment from troubles in Europe or war in the oil-producing regions of the Middle East.  Indeed there are reasons to believe the U.S. economy will be solid across 2012 in terms of GDP and jobs growth, and hence rising stock prices seem likely in U.S. markets (tempered of course by countervailing challenges elsewhere around the globe)……

…..the Fed has been intensely monitoring developments in Europe for the last two years.  In stark language in November, in fact, the Fed expressed serious concern about Eurozone growth and financial system trouble in 2012.  It may well be that, anticipating the need to meet dollar demand in the Eurozone, the Fed has decided to create for itself “capacity” for lending and swap operations in Europe in the time ahead. Hence a decision may have been made to offload or not replace maturing MBS assets.  For now we do not see this as problematic for intra-U.S. economy issues.  It is, however, yet another warning about the serious trouble Europe may be in.  While frustrated by the opacity of ECB and major Eurozone bank balance sheets, and equally so by a concomitant lack of knowledge of the level of exposure of U.S. banks and corporations to Europe, we have wondered for some months now, what does the Fed know, that we do not know?  All this is to say, our prediction is we are going to see a rise in swap lines to Europe, and we think the monetary base may well float back to higher levels in the months ahead.

Indeed, bringing this commentary up to date does show that in the first six weeks of 2012 (through February 8), the monetary base is up more than 5%, back near its all-time high post-QE2 last year:

Chart I. Adjusted Monetary Base, 1984-Present (Log Scale)  

We prefer to display such graphical data over time in logarithmic form per the above, as it shows equiproportional changes in magnitudes across time.  We trust readers have by now gotten accustomed to this and similar charts depicting the recent explosion in the growth of the U.S. money supply, but it is still worth pointing out the “breathtaking” nature of this chart — and, as we discuss below, the gamble it represents.  Suffice it to say for now that the Fed’s move from roughly $800 billion in the base in the early fall of 2008, to $2.8 trillion after QE1 and QE2 last spring, is — literally — unprecedented in world history (for students of economic history, it is also worth mentioning how small the “blip” in the monetary base appears in this chart on the eve of Y2K — Chairman Greenspan had made a point of assuring global investors of heightened Fed liquidity at the time, but the $40 billion temporary increase in reserves around the 4th quarter of 1999 — at the time a 15% increase — looks minuscule in comparison to the fall of 2008 and beyond).

As readers know, the Fed began to pay interest on commercial bank reserves in October 2008 in order to have a tool available to modulate new money creation through the commercial banking system: banks now have a higher cash flow hurdle in creating loan assets, and this is one reason for the huge elevation in excess reserves parked at the Fed (now at $1.6 trillion).  Additionally, while the M2 monetary aggregate, which includes M1 (currency and checking deposits in the main) plus savings and time deposits along with money market deposit funds, has grown 25% in three years and 2% in the last three months, the velocity of M2 — its total annual turnover in the economy — hit a new all-time low (since the Fed has tracked the data back to 1958) of 1.59 in the fourth quarter of 2011, as shown in the chart below:

 Chart II. M2 Velocity (1958-2011)

M2 is of course a broad aggregate — now approaching $9.8 trillion — that entails a wide swath of foreign investors and dollar-holders, and so does not always move in close correlation even with the Fed’s changes in the monetary base; hence, the reasons for secular changes in M2′s velocity are many and varied.  But it is still fair to point out that the move down from 1.9 just four years ago implies nominal GDP is at an annual run rate of at least $2.4 trillion less than it would be had that stayed constant or been restored.  And in the present context this signifies heightened investor and consumer nervousness about the future.

This in our view is the single biggest data point Mr. Bernanke is viewing with respect to inflation expectations, which the Fed says remain “anchored” and “subdued”.  Combined with slackness in the economy led by housing, stunted real wages in the U.S., Eurozone and Middle East tension-led demand for global dollar liquidity, and slowing export growth, the Federal Reserve is confident that its long run inflation target — and targeting is now indeed a feature of Fed policy — of 2% can be met (year-on-year, consumer prices rose 3% in the U.S. through January, with non-core items in food and energy much higher).

Mr. Bernanke is also known to be worried, if not mystified, by the continuing slow recovery in private capital investment of all types.  The following chart shows the still-tepid recovery in gross investment in the United States:

 Chart III. Real Gross Private Domestic Investment, 1947-Present (Log Scale)

As a percentage of GDP, investment hit a 35-year low in 2009 at 11.4%, and is only back to the 13-13.4% range in the last two years (approaching $1.8 trillion in 2011, and down from the 15-17% range of recent years).  To the degree that investment drives new jobs which in turn raises incomes and consumption,  the Fed solons see continued relative flat-lining in consumer prices.  And the Fed has made no secret that it is concerned in general about the sclerotic level of corporate/investor and consumer confidence in recent years, as evinced by corporate cash on the sidelines and consumer liquidity (which, as a percentage of personal income, is 25% higher than it was before the recession).

And so as a result of all this, the Fed announced on January 25th some fairly major “new” news: an 18-month extension of its de facto zero-interest rate policy (“ZIRP”), now stretched out another three years, an explicit target for personal consumption expenditures below 2% in 2012, tepid long term growth in the 2.3-2.6% range per annum (well below historical norms above 3%), and a qualitative statement to the effect that if the Fed’s twin mandate of stable prices and full employment were ever a source of conflicting policy aims, that in the current environment the Fed would err on the side of economic growth.  Clearly there is little concern about inflation, which has averaged only 2.3% since 2000, for the next several years.

Is Mr. Bernanke Correct That Inflation Presents No Concerns? No.

It seems to us, however, that the Fed is being “too clever by half.”   There are several indicators that prices will increase with a concomitant pick-up in economic activity.  First and foremost, commercial and industrial loans are up 10.2% year-on-year through December 2011, and loan growth has risen steadily for 15 straight months, including through last year’s slow quarters.  Key leading price indicators such as the producer price index, auto sales, and raw employment growth (along with hours worked) are all up smartly across the last year.  Along with inflation-sensitive item categories such as food and energy, commodity prices are up across the board, and commercial bank credit extended (of all types) is now at $9.46 trillion and approaching its 2008 nominal high.

The most telling statistic of all, though, is the trade-weighted value of the U.S. dollar, against all currencies, as per the following chart:

Chart IV.  Trade Weighted Value of the U.S. Dollar, 1995-Present (1997=100) 

Since the beginning of the 2003 recovery, the dollar has lost over 28% of its value globally (that is to say, against all other currencies).  This can only portend rising prices and a declining standard of living in the United States over time, and markedly so as and when the burdens of U.S. fiscal policy come home to roost here in the U.S.  That is to say, what is remarkable is how a global reserve currency that is still used in over 63% of all international transactions (albeit down from more than 90% a generation ago), and that is thus the beneficiary of a persistent global demand for dollar-denominated assets including cash, is still nonetheless in long-term secular decline in value around the world.  This can only worsen as the U.S. grapples with a debt-to-GDP ratio that has now breached 100% and continues to climb, through higher taxes and lower profits, investment, and economic growth.

As global demand for dollars falls, velocity — still well below pre-crisis levels – will pick up.  Matched with a decline in excess reserves due to stronger demand for loanable funds here in the near term, M1 and M2 will continue to grow, leading to a jump in prices well above the current 3% range (the 2011 CPI in the U.S. will be finalized at close to 3.5%).  This is indeed the analogy we see to the 1970s:  M2 velocity jumped at the conclusion of Nixon’s price control program and inflation rates shot up, dipped through the 1974-75 recession, and then shot up again.  As we have pointed out in the past:

… gains in velocity are not necessarily harmful if matched with gains in productivity; in Fisherian terms, where MV=PY, V can increase when Y is increasing and not necessarily see P rise as well. If however M and V exhibit increases during a period when investment has been stultified, P may bear the brunt of increasing nominal income levels.

But this only adds to our worry: there have been spectacular gains in productivity in the last three years which must per force now slow.  This is one key reason, in fact, why the Congressional Budget Office recently issued its updated forecast for 2013 GDP growth and placed it at 1%.  This itself is a concern, for the CBO is notoriously optimistic (e.g., in August 2011, it revised its 2011 full year forecast for GDP growth to 2.3% — the final 2011 growth number will be around 1.7%)!  And so of course this is indeed a recipe for a stagflationary future.

Summary

Our colleague at Alhambra Partners, Joe Calhoun, likes to enunciate what we have come to refer to internally as ”Calhoun’s Golden Rule” for sustainable growth: that is, that long-term sustainable growth in the U.S. will be guaranteed when we see three simultaneous conditions met and maintained:  (1) a rising dollar, (2) rising equities, and (3) a falling gold price (and indeed, much is subsumed in the simultaneous attainment of the three: viz., a strong dollar encourages forward-looking investment that takes the air out of gold, even as it creates jobs that stoke profit growth and increasing wealth via rising equity prices).  Any one or two of the three conditions being met in isolation (which often, in fact, occurs) is by definition not stable or sustainable with respect to achieving and maintaining prosperity.   Absent a Eurozone financial markets blow-up and banking crisis, and assuming no war with Iran in 2012 (both assumptions, we concede, are less certain than when we made them a month ago), the U.S. economy is poised to show a decent year in terms of GDP growth and a gain in equities.  But investors should hardly be quiescent about all three of Mr. Calhoun’s conditions being met in the near term: the political class has continued to neglect urgent fiscal reforms and, if we can borrow a colloquialism, has trashed the U.S. dollar now for a decade.  This was the same dual-headed policy-error monster that led us into the 1974-1982 torpor referenced above, and amounted to nearly a lost decade for growth and spread of U.S. prosperity.

Mr. Bernanke has, as we say, been too clever by half in that he seems not to care about the dollar’s value, and feels he can reverse the Fed’s balance sheet growth at times of his choosing moving forward.  But he has also now stated monetary and price stability is less important to him than employment growth, and indeed he may well be setting up the conflicting policy aims that ensure his unleashing inflation in the U.S. economy.  For the fact is, there is no easy way to shrink the Fed’s balance sheet without inducing higher rates and a 70′s-style price spiral at the same time.  While in theory the money supply decrease will keep prices level, in fact, as per the ’70s and early ’80s, it will happen with a lag, and this time the foreign dollar redemptions will be more severe.  We think 2012 may well be in the 3-4% range for consumer price inflation, but fear an extended period of higher interest rates and 5-7% inflation (or higher still?) in the years ahead.  Inflation, remember, also has self-reinforcing propagation mechanisms once unleashed: consumers and corporate investors come to hear prices will be higher tomorrow, so they will want to buy today.  At first that may indeed increase the level of real activity, but in time it comes to represent nominal increases, in prices only.

Again, our best guess — and it is no more than that even though we state it with some confidence — is that 2012 will see another year of mild inflation that we nonetheless think might be north of 2011.  But this situation needs to be monitored closely over time here this year, via the high-frequency data that is reported weekly, as well as Fed balance sheet moves (which, we still worry, may well include a round of QE3, given Mr. Bernanke’s morbid fears about Europe and long term clamps on U.S. investor sentiment).  If conditions begin to evince a new era of rising prices, investors will seek to move to traditional havens including commodities, precious metals, and natural resource stocks, along with foreign assets and currencies.

Can the tragedy of 1974-82 be avoided?  Four years into an economic disaster created by the political class, the sure answer is, of course it can.  But for this to happen, better policies will be needed from Washington:  basic laws of sound economics must no longer be ignored, as Mises warned above, and sound money must once again become the cornerstone of pro-growth (that is to say, pro-capital investment) economic policy.  And this in turn implies that the temptation Keynes alluded to — unlimited borrowing and fiscal profligacy at the zero-bound for interest rates, which is in effect where we are now – must be resisted.  To say this differently, Keynes was describing (in his 1936 book) what he thought was a purely theoretical situation that even he conceded could end in an insane level of profligate spending.  Sadly, in the current era in Washington, D.C., life has come to imitate a long-ago theoretical conjecture even as it affirms the wise warnings of a great economist delivered through the mists of time.  Sorrowful history, sadly, only repeats itself when such warnings are ignored, in this case by an unrepentant and indeed arrogant political class, but it need not be so if Calhoun’s Golden Rule becomes the de facto policy target.

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, John Chapman can be reached at john.chapman@alhambrapartners.com.  The views expressed here are solely those of the author, and do not necessarily reflect that of colleagues at Alhambra Partners or any of its affiliates.  

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The Nasdaq Composite is still overbought and has a short-term gap to fill in the charts. But it held its uptrend line on Friday, so once again, tomorrow may be important as to the direction the market will take in the short-term.

The VIX bounced off support this past week. Look for it to bounce back to the 50-week moving average.

The US Dollar broke through its short-term downward trendline on Friday. Look for it to hit the 80-level soon.

Crude oil bounced off its trendline on its way to piercing the 50-day MA. The indexis forming a wedge, so a decisive move either way may come soon.

Joseph Gomez, Sr. Investment Advisor and Portfolio Manager

With a gain of 6.8% six weeks into the year, the S&P 500 is currently off to its best start to the year since 1990. The S&P 500 is currently 21 points away from taking out its prior bull market closing high of 1,363.61 made on April 29th of last year.

Surprisingly, if you want to know how well US consumers are doing, look at the US Consumer Goods (IYK) and US Consumer Services (IYC) ETFs. They are both at historic highs. We have seen impressive reports from railroad companies and credit processing companies like MasterCard and Visa. This week we hear from Nordstrom’s (JWN) and Weight Watchers (WTW). I think the new Jennifer Hudson campaign has had a positive impact for the company.

If you are looking for income and growth, my favorite vehicle has been the iShares Dow Jones Select Dividend Index ETF (DVY) with a current yield of 3.37%.

Shares of Apple (AAPL) have gone parabolic on news of the release of the iPad 3 in early March. Buy it on pullbacks. Key pivot points are the 10-day MA ($467) and the 20-day MA ($449). Below are some charts of interest, an earnings calendar, economic calendar and key interest rates. Next week, we get earnings from many utilities and broadcasters (see below).

Have a pleasant and productive week.

 Important Earnings Next Week

 Key Rates from Bloomberg.com

 Economic Calendar from Econoday.com

Monday Feb 13	Tuesday Feb 14	Wednesday Feb 15	Thursday Feb 16	Friday Feb 17
Market Focus » 4-Week Bill Announcement 11:00 AM ET 3-Month Bill Auction 11:30 AM ET 6-Month Bill Auction 11:30 AM ET	NFIB Small Business Optimism Index 7:30 AM ET ICSC-Goldman Store Sales 7:45 AM ET Retail Sales 8:30 AM ET Import and Export Prices 8:30 AM ET Charles Plosser Speaks 8:45 AM ET Redbook 8:55 AM ET Business Inventories 10:00 AM ET 4-Week Bill Auction 11:30 AM ET	3-Yr Note Settlement10-Yr Note Settlement30-Yr Bond Settlement MBA Purchase Applications 7:00 AM ET Empire State Mfg Survey 8:30 AM ET Treasury International Capital 9:00 AM ET Industrial Production 9:15 AM ET Richard Fisher Speaks 9:15 AM ET Housing Market Index 10:00 AM ET EIA Petroleum Status Report 10:30 AM ET FOMC Minutes 2:00 PM ET	Weekly Bill Settlement Housing Starts 8:30 AM ET Jobless Claims 8:30 AM ET Producer Price Index 8:30 AM ET Ben Bernanke Speaks 9:00 AM ET Bloomberg Consumer Comfort Index 9:45 AM ET Philadelphia Fed Survey 10:00 AM ET EIA Natural Gas Report 10:30 AM ET 3-Month Bill Announcement 11:00 AM ET 6-Month Bill Announcement 11:00 AM ET 2-Yr Note Announcement 11:00 AM ET 5-Yr Note Announcement 11:00 AM ET 7-Yr Note Announcement 11:00 AM ET 30-Yr TIPS Auction 1:00 PM ET Fed Balance Sheet 4:30 PM ET Money Supply 4:30 PM ET	Consumer Price Index 8:30 AM ET Leading Indicators 10:00 AM ET

Clients, principals and/or employees of Alhambra Investment Partners may have long or short positions of any above-mentioned securities. For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joseph Gomez  can be reached at jag@alhambrapartners.com. 

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If one merely looks at the incoming aggregate data, it seems obvious the US economy is improving. It isn’t a surprise to us at Alhambra. We’ve argued for the last six months that the US economy would not fall back into recession even as some very smart people have said the opposite. Maybe we’ve just been lucky so far and the pessimists will be proven right in coming months, but for now, the US economy is performing pretty much as we expected. And absent an exogenous shock, such as a disorderly breakup of the Eurozone, I think the “recovery” will continue.

This “recovery” though is not the one we seek (apologies to George Lucas) . It is a manufactured, cyclical recovery and cannot be sustained in the long term. From a cyclical standpoint, the US economy has reached a point where two large sectors – housing and autos – are turning higher out of necessity. Household formation is rising again and while house prices are still falling, apartment rents are rising and vacancies are falling. With few new housing units built since the bust, construction is now inevitably recovering. The average age of the auto fleet is at a multi-decade high and replacement is more economic than continued maintenance for many individuals. While lending is not as free as it was during the housing boom, credit is available. Non-revolving credit, primarily auto loans, is rising at about 5% year over year. Even outstanding revolving credit, primarily credit cards, has stopped contracting.

The recovery is also being driven by malinvestment, a result of loose monetary policy. The global monetary expansion of the last few years – and especially the last year – was massive and was bound to have an effect eventually. The Fed’s repeated rounds of quantitative easing haven’t had much effect up to now except on financial and commodity markets but lending appears to be picking up as financial institutions are forced to find profits outside of trading thanks to the new Dodd-Frank rules. As noted above consumer lending is rising and commercial and industrial loans are also up 10% year over year. Meanwhile, the Chinese are lowering reserve requirements for their banks and consumer lending in emerging markets such as Brazil is still expanding. The one exception in the world is Europe where lending is contracting.

Unfortunately, we don’t know where interest rates would be today in a market free of central bank interference. With ZIRP (zero interest rate policy) seemingly ineffective in reviving the housing market, it is tempting to assume it is having no effect but I think the Fed’s low rate policy is having an impact. Austrian economics tells us that rates held below the free market rate will distort the investment decision process, create malinvestment and destroy capital.  The current boom in shale oil and tar sands as well as the disputed Keystone pipeline would seem to fit the bill perfectly. $100 oil prices, a product primarily of expansive monetary policy and a weak dollar, have produced a false boom in what should be non economic oil production. For now, oil can be profitably extracted from shale and tar sands and that has produced a boom in western Canada and North Dakota, among other areas. The oil producers are rushing in and investing billions in production that is only profitable at current prices. If and when we get better fiscal policy that hopefully leads to better monetary policy, the dollar will rise, oil prices will fall and the capital invested in these areas will be wasted. Just as it was the last time this happened in the late 70s, early 80s. If Keystone is built and oil falls to less than about $50, it will end up being a large empty pipe. He might have made it for the wrong reasons, but President Obama’s rejection of Keystone may end up being the best investment decision he’s made since taking office.

I should stress that this may be an example of malinvestment. There is no way to know whether this is malinvestment or investment that produces a long term return since we don’t know the true price of oil in a world free of monetary distortion. It may be that some areas opened to production from fracking will remain profitable even at lower oil prices but it seems unlikely that all will. The natural gas market may offer a glimpse of the future and a warning as increased production from fracking has produced a glut of gas and falling prices. Chesapeake Energy, a leader in natural gas production from fracking, is cutting production because prices have fallen to “economically unattractive levels”. The oil market is more global than the natural gas market so more US production may not affect prices as quickly but eventually oil prices will fall.

(By the way, to those who claim this is an example of new technology being put to good use, I would point out that the first horozontal well was drilled in North Dakota in 1987 and fracking was developed in the late 90s. It isn’t new at all and it is only being applied now because oil prices are high.)

True recovery based on fundamental changes in monetary and fiscal policy has not arrived yet and probably won’t for some time. That makes investing a particularly difficult task at present. We cannot know how long a recovery based on cyclical factors and monetary distortions will last. The housing boom lasted for years before the malinvestment was revealed.  While I suspect this expansion may have a more limited life, there is frankly no way to know. In addition, we still have the potential for that exogenous shock I mentioned above. I still see no way for Europe to keep all its members in the Euro and the consequences of a break up are impossible to predict.

Meanwhile, as investors, we must invest with one eye on this current cyclical expansion and one eye on the future and its eventual decline. We cannot invest long term with confidence until we see better fiscal and monetary policy, something that seems far off at present. If we are right and the effects of the Fed’s monetary expansion are starting to hit the markets, the result could be more spectacular than anyone currently expects. Considering the magnitude of the change in the monetary base and the difficulty of removing the excess reserves from the banking system, an inflationary boom is not out of the question. Those who expect the Fed to keep their promise of low rates until 2014 would be wise to review the Fed’s economic forecasting track record.

Because of the difficulty of divining the magnitude and/or duration of the current expansion, we continue to invest cautiously. As Doug Terry reports in his tactical update, we slightly reduced our risk positions last week, selling into the recent strength. If and when we finally get better policy that includes reduced government spending, tax reform, monetary reform and more intelligent regulation, we will start to think longer term. Until then, we will have to navigate a recovery that may not be the one we’re looking for but is the one we’ve found.

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@alhambrapartners.com

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