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Goldilocks and the Three Potential Bears


We must constantly recall that as Keynes once said that "markets can remain irrational longer than you can remain solvent."

Over the past few months we have witnessed a relentless run in virtually every major stock market average. The reasons are vast as I listen to TV, read the paper and talk to fellow professional money managers. The most often mentioned is that the Fed will engineer a 'soft landing,' where we experience a slowdown in economic growth but not a hard landing with negative economic growth, otherwise known as a recession in these parts. Another is 'performance anxiety' for under-invested managers (they chase).

We all know that the Fed's stated objective is to have a growing economy with limited and controllable inflation. Inflation is important as it inhibits growth of the 'real' return of financial assets over time. My case over the past 10 years or so, ever since I believe Greenspan began targeting asset prices in addition to economic growth and inflation is that we are walking a fine line between inflation and deflation. We know from current Fed Chairman Bernanke that he would 'drop money from helicopters' in order to stave off deflation. Deflation is the worst economic scenario-just ask folks from the 30's in the US or Japan. It is particularly dangerous when debt is piled up so high in every area that we need ever rising asset prices to support the debt and debt payments that go along with them. Currently, inflationary pressures are turning deflationary in my view.

Consider this. If one took the Net Present Value of out budget deficit looking out 75 years (thanks to our friends at Ned Davis Research for the data), including future costs of Social Security, Medicare, etc., it would total $50 trillion. Yes, trillion. That is in addition to the fact that total credit market debt resides around 320% of GDP and the typical household has debt up to its eyeballs. So far, we have seen a bubble in stocks, a bubble in commodities and a bubble (now busted) in real estate. So you see, we need inflation to be sure that the right side of the balance sheet (assets) doesn't overtake the left side (liabilities). It is why I believe the Fed talks hawkish (tough on inflation) and acts dovish (stoking asset inflation). They do this because they must. It maintains their global credibility, and hence keeps the dollar from collapsing (an inevitable outcome I am afraid).Why do they say that they are acting dovish? It is simple-the money supply continues to grow at an absurd 10% annualized rate-hardly tight monetary policy. All in a desire to grow asset prices. We need them.

Now, to Miss Goldilocks. The Goldilocks economy is one that is judged to be 'not too cool, not too hot, and just right'-like a bowl of porridge. Market participants have embraced this theory like they did in 1999-2000 and stocks seem to rise every day in the face of awful economic statistics, inflation that is turning to deflation, no fear, the lowest volatility on record (options are the cheapest in my career), a severely inverted yield curve - usually a precursor to recession - and the hedging 'smart money' crowd short the S&P 500 in record size. Keep in mind that the S&P data is released on Fridays at 3:30 PM with data as of the previous data and combines the open outcry contracts and electronic e-mini contract (we net them out to give a proper representation.)

So here are the Three Bears: Curve inversion, hedgers, and record low volatility (VXO). I hope you find the charts as interesting and thought provoking as I did.

Yield Curve Inversion (10 Year Note – Fed Funds Rate) vs. S&P 500

Hedgers (Total Position) vs. S&P 500

VXO (Market Estimate of Future Volatility) vs. S&P 500

In conclusion, most indicators I use have been and get further into cautious territory. My firm has been admittedly underweight equities for a little while and have not reaped as much of the gain as others. Keep in mind we are not short stocks and are not fighting the tape, simply following indicators that have worked for me for my entire career. My firm continues to buy high quality preferred stocks in the 6.5-6.6% area as well as short to intermediate term government agencies. We must constantly recall that as Keynes once said that "markets can remain irrational longer than you can remain solvent." While I am not saying the market is irrational, I am simply stating that Goldilocks and the Three Bears are at odds at present. We are entering a very strong seasonal time of year, particularly this week, but I would note that we did very well in the worst seasonal time of the year (mid August-mid October). So, people are positioned for the positive seasonality and could be disappointed this year, but I really don't know (that would be guessing).

What I do know is that my firm is a protector of other people's wealth and the risk/reward seems tilted to risk. This by no means suggests that the market cannot continue higher, as that would be a foolish prediction. I just know risk when I see it.

Wishing you and yours a happy, safe and healthy Thanksgiving Holiday.
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