August 21, 2016 2%

Risk/Reward Vol. 319

May I recommend an enlightening article by James Mackintosh in Tuesday's Wall Street Journal. Therein he observes that "In 1999, wild enthusiasm was elevating the market...Investors punished dividend payers for not having enough ways to spend money...The contrary is true this year. Wild pessimism...has led investors to chase dividend payments, demand buybacks and punish companies that invest." How can pessimism be a catalyst for new record highs? According to Mackintosh, the new highs reflect a belief by investors that the world economy is weak enough to keep central banks pumping out free money, but not so weak that company profits will plummet. This belief, which I share, found further support this week from the July meeting minutes released by the Federal Reserve. A fair reading of those indicates that the Fed will not raise rates until December at the earliest.

The above notwithstanding, the market looks very frothy to me. The S&P 500 is trading at 18 times projected earnings, much higher than its historic average. (N.B. Stock price/earnings per share= stock multiple. The higher the multiple the more "expensive" the stock.) Am I advocating that any of you exit? No. Why should you? I see nothing in the near or medium term that runs counter to Mr. Mackintosh's observations. Personally, my exit last month was motivated by my having achieved my goal for the year and by my desire to capture those profits---not by any great fear. That said, I am not anxious to re-enter at this point. I will await the inevitable pull back to begin buying again. Another opportunity may present after next month's OPEC meeting. Statements by Saudi Arabia's oil minister that his country may be amenable to limiting production have caused the price of Brent oil to reach $50/bbl. again. Whether a limit on production comes to pass or not, clarity from that meeting should provide me with enough visibility to buy. I have my list at the ready.

Gold continues to do well---and why not? If commercial banks in Europe and Japan follow through with their threat to pass negative rates onto depositors ( Remember, a negative rate on your savings account would require you to pay the bank for keeping your money on deposit), a very rational response is to buy gold. Gold is now viewed as an alternative currency and is much easier to store than cash. But even cash hoarding may be next. In Tuesday's Financial Times, it was reported that several European banks are considering expanding their vaults to accommodate mountains of cash instead of paying the European Central Bank negative interest to keep funds in ECB reserve accounts as they do presently

The Federal Reserve received some disappointing news this week as the consumer price index (CPI) rose only 0.8% on an annualized basis in July, far below the Fed's targeted 2% inflation rate. Have you ever wondered why the Fed targets 2% inflation? Here is the answer--as silly as it may be. Economists at the Fed contend that consumers are much more likely to purchase, even needed goods and services, if they believe that those goods and services will be more expensive in the future. Stated alternatively, the Fed economists assert that if consumers come to believe that the refrigerator or automobile or service they need will be the same price or cheaper in the future they will defer buying it. Really? Only an economist would believe such drivel. No consumer thinks that way. If a consumer needs a new refrigerator and can afford it, he/she will buy it irrespective of what the CPI registers. But that article of faith, namely the 2% inflation target, is one of the two major drivers of our monetary policy. Jeez!

And speaking of monetary policy take a look at reports out of Japan this week. Why? Because absent a change in Fed direction or a miraculous turnaround in demographics, Japan is our future. And that future includes a central bank program that purchases not only government bonds (as is done in the US now) but also corporate bonds (as the ECB does) and stocks These purchases are done to prop up a nose-diving economy born (no pun intended) of an aging and declining population. As a result, Japan's central bank, the Bank of Japan, not only owns more than 30% of all government debt but also is a top 10 shareholder in 90% of the companies in the Nikkei 225 stock average and at the current buying pace will be the largest shareholder in 55 of those companies by year end. In the short run this is good news for stocks, but ponder what it means longer term. Under the guise of monetary policy, Japan is nationalizing all of its major companies. And there is nothing preventing that from happening in Europe or, ultimately, here. Ponder that indeed.