real life needs active management ee..qq … short-term liquidity problems can often be alleviated...

Real life needs active management

EE..QQ TTrreennddwwaattcchhTTTMMM

This publication is intended to convey information only. It is not to be construed as a solicitation or offer to buy or sell and of the securities mentioned in it. The author has taken all usual and reasonable precautions to determine that the information contained in this publication d to summarize and analyze such information are based on approved practices in the industry. However, the market forces underlying investment value are subject to sudden and dramatic changes and data availability varies from one moment to the next. Consequently, the author cannot make any warranty as to the accuracy or completeness of information, analysis or views contained in this publication or their usefulness or suitability in any particular circumstance. You should not undertake any investment or portfolio assessment or other transaction on the basis of this publication, but should first consult your advisor. The author accepts no liability of whatsoever kind for any damages or losses incurred by you as a result of reliance upon or use of this publication in contravention of this notice. All performance data represent past performance and are no indication of future performance.

MARCH 31, 2012. ISSUE 3

31, 2007 • ISSUE 1

Debt before dishonour

“The road to deleveraging will be long and hard. It is essential to map out that road, including towards fiscal consolidation. It is more important still not to think one is near the end when one is still at the beginning.”

-Martin Wolfe, Economist, March 14, 2012

A common human response to insufficient revenue is to increase debt rather than decrease spending. We have seen this repeatedly through time in individuals, corporations and governments. Poor managers frequently first pretend and extend with more debt rather than accept the perceived dishonor of necessary downsizing and cutbacks. While short-term liquidity problems can often be alleviated with a loan—to the extent that adding credit postpones needed spending discipline—longer-term, more debt is usually fiscally fatal.

Five years after the global consumer credit bubble burst with the US housing market, the world has more debt than ever before. Rather than accept and adjust to the reality of slower growth, governments and central bankers have chosen to treat the plight of excess debt with more debt. Global credit has grown exponentially over

Cory Venable CIM, FCSI, CMT Technical Market Analyst

Danielle Park LL.B., CFP, CFA Portfolio Manager

Venable Park Investment Counsel Inc.

33 Clapperton St. Barrie ON L4M 3E6 Tel: (705) 792-3991

Toll Free: 866-792-3991 Fax: (705) 792-3992

This publication is intended to convey information only. It is not to be construed as a solicitation or offer to buy or sell and of the ssecurities

mentioned in it. The author has taken all usual and reasonable precautions to determine that the information contained in this publication d to summarize and analyze such information are based on approved practices in the industry. However, the market forces underlying investment value are subject to sudden and dramatic changes and data availability varies from one moment to the next. Consequently, the author cannot make any warranty as to the accuracy or completeness of information, analysis or views contained in this publication or their usefulness or suitability in any particular circumstance. You should not undertake any investment or portfolio assessment or other transaction on the basis of this publication, but should first consult your advisor. The author accepts no liability of whatsoever kind for any damages or losses incurred by you as a result of reliance upon or use of this publication in contravention of this notice. All performance data represent past performance and are no indication of future performance.

2

VENABLE PARK INVESTMENT COUNSEL INC.

the past decade. For some people and sectors more credit has bought some time. But shortsighted policies of extension are coming under increasing criticism. That which cannot continue must end. More organic, realistic paths are pressing hard upon us.

Excessive debt is a brutal master. Unless revenues can grow faster than debt service costs, more debt necessarily equates to lower cash flow for everything else—jobs, infrastructure, stimulus, education, innovation, technology, health, arts, resilience, and peace. More debt leaves less for everything.

Central banks were designed to serve the banks. Banks are owed a lot of money by customers, governments, counter-parties and each other. For this reason they have spent the past 5 years intervening on behalf of creditors everywhere trying to keep the wheels of liquidity moving.

Unfortunately, grease to a few is not sufficient to boost the global engine. Bankers can release more credit but not more demand. Consumer demand is needed to move the global economy and consumer demand, after the credit bubble, is now in a multiyear decline.

As graphed to the left, at the end of 2011 the global credit market debt stood at about US$220 trillion, having grown 11% annually since 2002. Over this same period, nominal GDP growth averaged just 8% a year. Demonstrating the law of diminishing returns, as debt rises, it takes increasingly greater amounts of debt to have the same marginal impact on GDP.

To demonstrate this point we note that between 1953 and 1984 in the US, 1 unit of debt generated 0.63 units of GDP. Between 1985 and 2000, that same 1 unit of debt generated 0.24 units of GDP. Since 2000, 1 unit of debt has generated just 0.08 units of GDP. Now debt saturated, our modern global economy requires constant economic expansion just to service the outstanding debt.



3


This next chart shows how the stock market (S&P 500) has responded with shorter and shorter price gains following each round of monetary intervention now infamously named “QE”. These efforts at monetary extension buy less bang-for-the-buck each time. And yet, with no magical potions to employ, they seem to be the Central banks’ only idea.

The chart to the left captures the plight of debt-choked Greece since 2008 but the same dynamic is now at work in most countries, states, provinces and counties on earth. As the red line of debt rises, the blue line of economic growth stagnates and falls.

With global interest rates in the world temporarily forced to the zero-bound by central bankers, there is most certainly only one way for carrying costs to go—up from here. The debt drag will grow larger and larger unless and until principle owed is written down or paid off over time.



4


The liquidity trap

In the absence of enticing investment opportunities and attractive valuations, liquidity has nowhere productive to go. In these conditions cash does not move through the economy (“velocity”) but rather builds on balance sheets like antiquated inventory. This chart shows the velocity of money in the banking system falling from 1994 all the way to a recession-like low again in 2012.

The next two charts show the record cash-build since 2008 (black line) presently mounting idle on US bank balance sheets. The red line at the bottom, shows the level of cash reserves they are required to hold.



5


The next chart shows the same trend of cash piling on non-financial corporate balance sheets, here shown since 1982 and now at all time highs.

At the same time, retail investors (or “Muppets” as Goldman likes to call us little folks) have been exhibiting a similar preference for building cash over the past few years. This next chart shows (in red) the steady exodus of retail money flow leaving equity funds week over week for 5 years, even as the S&P 500 (black line) has lost, gained, lost and rallied once more.



6


These charts also help to explain why even during periods of dramatic rallies in stock prices, we continue to see declining participation in the form of sub-normal trading volumes. The preference for liquidity dominates.

In addition, we also see that a majority of those who have been “trading” or speculating in these markets have been doing so on increasing leverage or margin as captured in this next chart showing margin use by stock investors from 1999 to 2012 (blue bars). The S&P price level is marked in red.

We don’t yet have this month’s data, but we note that February’s margin use was approaching speculative peaks seen at market tops in 2000 and 2007. The more margin used by participants, the more unstable and vulnerable prices are to sudden drops. Once prices begin to fall, levered players sell several dollars of stock for each dollar owed on margin loans.

Investment opportunities: timing is everything

There is no way to know how long excessive liquidity rallies can endure before succumbing to the inevitable gravity of the next economic downturn. They always succumb eventually.

Liquidity forces are awesome and incredibly dangerous all at once. If we were day traders or speculators, we might want to just dive in and try our luck to surf the wave as long as it can last. But while wild abandon or blind bravery certainly looks like fun from time to time, we know that in the longer run, the return data for such attempts is near perfectly horrible. Just think of the overwhelming majority of hedge funds, traders and active managers who reported negative cumulative returns now for the past 12 years as at the end of 2011. They may look busy and aggressive, but their results are mostly poor and worse considering the extreme volatility they have subjected their capital to en route to nowhere.



7


The inescapable trouble with asset markets today is that they have been prodded, plumped, goosed and tortured by intervention and leverage to such an extent that their price discovery mechanism is basically broken. At present prices, markets are moving in a world rather all of their own.

Central bank intervention has now succeeded in reducing the expected returns for pretty much every asset class to virtually zero or even negative from present price levels. Return-free risk—how attractive! The truth about these conditions is well captured in the following quote by long-time, respected money manager Howard Marks in his book “The most important thing” (2011):

“You simply cannot create investment opportunities when they're not there. When prices are high, it's inescapable that prospective returns are low. That single sentence provides a great deal of guidance as to appropriate portfolio actions. Investment risk comes primarily from too-high prices, and too-high prices often come from excessive optimism and inadequate skepticism and risk aversion. Contributing underlying factors can include low prospective returns on safer investments, recent good performance by risky ones, strong inflows of capital, and easy availability of credit. That same pattern of taking new and bigger risks in order to perpetuate return often repeats in a cyclical pattern. The motto of those who reach for return seems to be: 'If you can't get the return you need from safe investments, pursue it via risky investments.' It takes a lot of hard work or a lot of luck to turn something bought at a too-high price into a successful investment.”

For all these reasons (and more) we find ourselves still cautious and protective of capital as we enter another April—the third since 2009. We long to see more of a bright side. But as we carefully measure growth prospects at present price levels, we find no defensible case for blind hope.

In the charts: US dollar Index 1990 to 2011: 78 now support, 88 still upside target

The US dollar continued to receive safe haven inflows for the month. $88 remains our upside target. At the



8


same time, the Canadian dollar (below) weakened on the month as the slowdown in China and Europe attracted more attention.

Canadian dollar 2001-2012: Par proves resistance

Canadian stock market currently range bound, with overall trend bias still down



9


An unconventional thought: what if 2007 was the peak of this commodities cycle? As we layer price plots of the credit bubble peak in 2007 over stock and commodity charts we cannot help but wonder whether we might not already have seen the peak of commodity prices for some years to come. From 2005 to 2007, as financial engineering and credit derivatives literally blew their top, we saw a similar surge up in most stock and commodity prices. The next chart of the Chinese stock market reflects our point well: the blue box below highlights a 500% gain in the Shanghai market in just 2.5 years from June 2005 to November 2007.

Chinese stock market peaked with the credit bubble in 2007

Some of this gain was on expansion of Chinese infrastructure and more workers moving out of the countryside to higher wages in urban centers. But even more, this was a reflection of easy credit and the demand bubble it fuelled in western consumers around the world. Recall that with the assistance of crazy credit, western consumers were spending 10 to 1 for each unit of consumption in the developing world.

Even as most commodity prices went parabolic over a handful of years (copper from .60 cents to $4.64 a pound, oil from $10 to $147 a barrel—to name just a couple of key ones), many participants rode the surge up and did not sell, but held as prices collapsed into 2009. Today these same people are still waiting for the big bull-run in commodity prices! Many are hoping for a return to those glory days. We are frequently asked, when do we think the commodities bubble is coming? Recently we had a thought—what if 2007-8 was the peak of this secular run in commodities, and now post-credit bubble, we will continue to see a mean reversion of prices lower as new organic levels of demand take hold.



10


As the world struggles to recover to a new sustainable growth trajectory, lower commodity prices at least for the next few years would be a huge help. Right now the resurgence in energy costs is creating a large drag on the profitability of all kinds of companies. Hopefully the world’s central bankers will soon cease and desist their efforts at further liquidity pumping. The unintended consequences of their efforts are increased input costs that squeeze profit margins just as revenues fall in a natural state of decline with the slowing global economy in 2012.

Bonds: North American bond yields moved lower this month, as investors continue to flee other international markets in favour of US and Canadian bonds. Our thesis of short-term deflation and growth slowed by government debt and austerity remains in tact. There is significant upside resistance for higher bond yields noted at the dotted line below shown on a chart of the bellwether US 10 year Treasury yield.

10 year Treasury Yield 2001 to present- yield downtrend still supportive of bond prices

We will continue to watch the medium trend carefully. So far, the bond market is still signalling “risk-off”. The trend of falling inflation is supported by a continuing lack of wage pressure, weakness in housing, contracting GDP expectations and historic slack in economic capacity.

All of these issues are economic headwinds moving into 2012. At the same time, the data continues to suggest that the stock market may well offer a valuable cyclical bottom some time this year. This may also afford us the catalyst to shorten up our fixed income duration, while adding dividend paying equities to increase portfolio yields as we row our way through the next cyclical recovery phase, whatever length it turns out to be.



11


Spring has sprung!! Quotes of the month: “We all have dreams. But in order to make dreams come into reality, it takes an awful lot of determination, dedication, self-discipline, and effort."

Jesse Owens (1913-1980) Olympic Gold Medalist

“Do not value money for any more nor any less than its worth; it is a good servant but a bad master.”

~Alexandre Dumas fils, Camille, 1852

“Leadership used to be about ideas, setting an example and doing the right thing. Today, if you make enough money for the firm (and are not currently an ax murderer) you will be promoted into a position of influence.”

Greg Smith, in his Goldman Sachs resignation letter published in the New York Times this month

Don’t forget to visit our market blog www.jugglingdynamite.com for daily commentary, articles and media clips.

real life needs active management ee..qq … short-term liquidity problems can often be alleviated...

Documents