December 15, 2012 Get Back, Loretta

Risk/Reward Vol. 148

THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.

"Baby, I'm a man/And maybe I'm a lonely man"
Who's in the middle of something/That he really doesn't understand."---lyrics from "Maybe I'm Amazed" by Paul McCartney

"It's hard enough to wake up after awhile
And even though I say I'm feeling fine
I'm locked up, loaded down, short a try."---lyrics from "Short a Try" by O.A R.

"Big man, huh?/But just understand Uncle Sam knows the scam
Couldn't fool me long/I got it goin' on
I'm independent."---lyrics from "Independent" by Salt N Pepa

"Baby, I'm amazed!" On Monday and Tuesday when the only news story reported by the financial press was disappointment in the Fiscal Cliff negotiations, the Dow Jones Industrual Average (DJIA) advanced 93 points. On Wednesday, when the dominant story was the Federal Reserve's decision to extend quantitative easing (QE4), the type of news that one would expect to drive the DJIA higher, the index fell---and continued to fall through Friday even in the face of encouraging employment numbers. What gives with this? But then, what gives with the DJIA remaining above 13,000 points with no Fiscal Cliff resolution in sight? Clearly, "we're in the middle of something that I don't really understand." "Maybe I'm a lonely man" on the sidelines, but I am a content one.

In another attempt to spur economic growth, the Federal Reserve (Fed), with QE4, has commited to bid upon and to purchase $40billion worth of mortgages and $45billion worth of Treasury bonds EACH MONTH until unemployment (currently at 7.8%) falls below 6.5% or until inflation becomes a concern---whichever occurs first. Achieving that unemployment rate could take a very long time with all of the downward pressure on hiring (e.g. increased taxes, Affordable Care Act obligations, etc.). By printing $85billion of new money each month to pay for this up bidding exercise (see "Picasso Auction" Vol. 113 at www.riskrewardblog.blogspot.com for an explanation of this process) the Federal Reserve's balance sheet will exceed $4trillion by year end 2013. This is astounding considering its balance sheet did not reach $1trillion until September, 2008! QE4's resultant higher bond/mortgage prices and concomitant lower bond/mortgage interest rates (remember, higher asset prices means lower yields/interest) may make us "feel fine" for now, but necessarily we will "wake up after awhile" to find that we are "loaded down" with debt. The eventuality of this realization prompted Ray Dalio, the most successful hedge fund manager in history, to opine on Wednesday that his greatest profit opportunity in the future will come from "short(ing)" Treasury bonds. He is planning to do so come year end 2013 when he predicts that inflation will cause the Fed to stop QE. At that time, according to Dalio, the price of Treasury bonds will plummet. I will buy TBT, PST and/or TBF if and when it's time to short Treasuries. In the "shorter" run, I will be keep my exposure to agency morgage real estate investment trusts (e.g. NLY, AGNC, ARR) low. They simply cannot purchase mortgages profitably with the Fed using $40billion of newly printed money each month to keep mortgage bids high and mortgage interest rates low.

Almost unnoticed in this week's Fiscal Cliff fog was a report from the U.S. Energy Information Administration that in 2012, the United States will increase its crude oil production by 760,000 barrels/day (the largest annual increase in history), and that by year end 2013 U.S. crude oil production will exceed 7,000,000 barrels/day (the highest production since 1992). 'Uncle Sam knows the scam" that OPEC has visited upon us over the years, and should want to escape it. Thanks to cheap natural gas and crude oil from advancments in technology (fracking), we can become the economic "Big Man" again if regulations do not impede us. Until new pipelines are in place, which should allow us to really "get it goin' on", there will be supply and pricing inequities that may depress the stock of some domestic producers temporarily. But ultimately these plays will be big winners---and the U.S. should be energy "independent". ETF's and CEF's that play in this space are high on my re-entry list.

The DJIA remains surprisingly (to me) buoyant, dropping only 20 points this week. I continue to believe that the stock market will experience downward pressure until more clarity on the Fiscal Cliff is achieved. Whether that clarity is provided by a negotiated resolution or a plunge into the abyss, the time for clarity is fast approaching. Once clarity--good or bad---is achieved, I will reenter. Then, Loretta, in the words of Sir Paul, I will "get back to where I once belonged.