Trader’s Narrative

For economic and market news and to see what interesting reading you may have missed last week, check out the list below. To see it all, go to news.tradersnarrative.com:

• Wall Street’s New Gilded Age
• NASDAQ’s own sentiment tool: Velocity & Forces
• Our Lost Decade
• Lehman Had to Die So Global Finance Could Live
• Get a FREE Subscription to Futures Magazine (limited time for US residents only)
• Be Cautious About Joining the Gold Band Wagon
• What exactly did the Fed do with $2 trillion?
• Reports of the US Dollar’s Demise Are Premature
• Get the free 47-Page eBook: How to Spot Trading Opportunities (limited time offer)
• The Theory of Interstellar Trade
• Keep an Eye on the Big Picture (long term Fibonacci levels)

For the complete list, follow the graphic link below to news.tradersnarrative.com:

And remember to check back regularly since there are interesting links added throughout the week. If you are a twitter user, add the Trader’s Narrative news twitter stream to get the updates in real time.

The Week Ahead

I have no idea why Geithner agreed to this. Maybe he thought he would be able to clean up his image or maybe Rahm Emmanuel took him aside and told him unless he did the interview, an atomic wedgie was coming his way. In any case, the digg community pulled no punches in drafting a list of questions for the current US Treasury Secretary. Alan Murray of the Wall Street Journal tried his best to soften the caustic tone of the interrogation.

The result is disappointing but not surprising. For the most part, Geithner either totally avoids answering the question or he sets up a straw man argument. For example, rather than actually addressing the revolving door between the US government (especially the Treasury Department) and Goldman Sachs (GS) he reiterates how important it is that civil servants be impartial and capable. And when asked about the recent campaign to audit the Federal Reserve, he asserts that we need to keep politics out of monetary policy.

None of these answers are actual answers. He substitutes the real issue with his own fantasies and chooses to addresses questions which are not asked. If anything, he missed his true calling as a shrewd politician. He somehow even manages to completely avoid answering the questions regarding his repeated and flagrant inability to pay his taxes from 2001 to 2004.

You can watch the video (press play on the left hand, bottom corner):

His assertion regarding transparency from the Federal Reserve is the most blatant and outlandish lie in the whole interview. Unfortunately, Alan Murray is not up to the task. If he were, he would have followed this flimsy assertion by pointing out that just one day ago the Fed was taken to court by Bloomberg and a judge ordered them to release information on what they did with $2 trillion of US government money.

Left to their own devices, the Fed was perfectly happy to draw a lead curtain over this matter and prevent any information to be made public about how much money went to who and when. The amount is gargantuan - being enough to provide universal health care coverage for all US citizens. But the public, the media (with the exception of Bloomberg) and the US government have no qualms about a secretive and insular quasi-governmental agency, such as the Fed, making decisions on such amounts with zero hesitation, zero accountability, zero oversight and zero discussion.

As well, his claims that the US government cut good deals on TARP (and is making 16-20% returns) is again, just laughable. According to Elizabeth Warren, the accounting for the TARP funds is extremely complex because valuing the toxic assets is far from clear cut. As well, we can easily compare the deals that were negotiated with the government with those that were negotiated at the around the same time by private institutions such as Berkshire Hathaway (BRK.A) - such a comparison shows that the Treasury Department cut ’sweetheart’ deals with Wall Street firms that they would never have gotten from truly arms length transactions.

As a corollary to yesterday’s deflation discussion, I thought I’d cover the consequence for gold and gold stocks. The relationship between gold and deflation is a contentious one so I don’t think it will ever be put to rest. In any case, I wanted to point out an interesting relationship which you’ll be hard pressed to find elsewhere.

Referring back to the chart in our previous discussion on the consequences of deflation you can see that we’ve had several periods of negative real interest rates. Naturally, these are when the inflation rate is higher than the nominal interest rate.

These periods coincide with great opportunities for buying gold and gold stocks. For example, in early to mid 1970’s and again in 2003. This doesn’t always hold true however. For example, the gold mini-bull of the mid 1980’s happened without a negative real interest rate environment.

In the 1970’s inflation was rampant and pushed real interest rates below zero. Until Volcker’s ‘take-no-prisoner’ style of monetary policy choked off inflation and brought real rates above zero. But of course, the situation in 2003 wasn’t that we had excess inflation but that nominal interest rates were being kept much lower than they should have been by the Federal Reserve (and we all know how that played out eventually).

Since deflation usually arrives at times of economic slack, one way to try to measure the relationship between the performance of gold and deflation is to look at how it did during recessions. Click the thumbnail to the left to take a look at a spreadsheet showing this data since 1945. The data is courtesy of EWI - they are also giving away a free 60 page eBook on Understanding Deflation which is chock full of similarly interesting tidbits.

The average performance of gold during recessions since 1945 is a miserly 4.8%. What about this most recent recession? We know the start of it but while many are prognosticating its end, we don’t have an official end date from the NBER. So let’s see how gold has done since December 2007:

That’s much better than the average but much lower than the outlier from the mid-1970’s. Still, it is not even enough to marginally move the average over the past 11 recessions. So according to this, holding an investment in gold during deflation is not usually a smart idea.

Trading gold and gold stocks however is still lucrative. One of my favorite indicators is the K-Ratio which is a ratio of gold stocks to gold itself. Here are two long term charts of the K-Ratio (using the Philadelphia Gold Bugs Index and the CBOE Gold Index to approximate gold stock prices):

Right now, the K-Ratio is trading mid-way and not really giving any signals. If it does fall again to previous lows, then we could have another set up for a ramp higher. Until then, I’m not too excited about gold.

Just a few months ago we may have still been engaged in the economic debate of whether inflationary or deflationary forces would win out. On the one hand you had the credit collapse on a global scale which sucked the wind out of the economy and on the other hand you had the immediate and collective response of the Western world to inject mind-boggling amounts of money through monetary and fiscal stimuli.

But today the debate is over. In spite of the inflationary forces unleashed to fight it, deflation has cleary won. We are seeing this anecdotally on the ground as well as trickles of econometric data coming in from North America, Europe and even China.

The US economy is akin to a patient barely clinging to life in a critical care unit (insert US health care joke here). If the Federal Reserve is imprudent enough to raise interest rates from basically zero, it is not difficult to guess what might happen. Needless to say, they are not that stupid.

Even so, the Fed is pushing against a string at this point. They are basically observers like the rest of us, helplessly watching the largest decline in consumer prices in 50 years:

The chart below shows the real interest rate (interest rate minus inflation), rather than the nominal rate, its much more famous cousin:
Continue reading ‘The Necessary Consequence Of Deflation’

Here is this week’s sentiment summary, bursting at the seams with sentimental goodness:

Sentiment Surveys
According to this week’s AAII sentiment survey, the US retail investor is becoming outright bold. The bullish crowd surged to 50% while the bears increased slightly (4% points) to 35%.

ChartCraft’s measure of the average investment newsletter editor’s sentiment - Investors Intelligence - also showed a similar level of optimism: the bulls increased 5% points to 47.2% while the bears fell 5.3% points to just 25.8%.

Rounding out the trifecta near or at 50% was Market Vane (US equities) at 46% bullish. That’s the most bullish it has been since May 2008 when the S&P 500 was trading at 1400.

Ned Davis Research’s proprietary sentiment indicator, called the Crowd Sentiment Poll stands at 62% - just eking into the extreme optimism range (anything above 61.5%). In the past this measure has reached highs of 68% which would give the sign for investors to sell weaker holdings.

Finally, Jake Bernstein’s proprietary sentiment indicator, Daily Sentiment Index (DSI) is also showing an extreme level of bulls. For the Standard & Poor’s 500 index the sentiment reached a high of 88% bullishness. The Nasdaq 100 sentiment was marginally lower at 87%. Needless to say, this is indicative of a short term top.

The DSI is uncommon, especially outside professional settings. Partly this is because Bernstein keeps the method and calculation a secret but also because it is an extremely expensive report. But what I’ve heard from trading friends, it is well worth it as it has just about nailed the exact inflection points at every major move.

Fund Flows
In last week’s sentiment overview we briefly touched on the gargantuan amounts of cash sitting on the sidelines of the market. While we’re now seeing flows out of cash only a small fraction is going to equities.

In fact, it would be accurate to say that the powerful spring rally has been mostly driven by institutional traders and investors with very little juice coming from the retail ‘Mom and Pop’ investor. According to the Investment Company Institute (ICI) small investors have only poured in $4.1 billion into the equity markets (for July). That’s chump change, especially when we compare it to the flows from cash to bond funds which stands at $28.8 billion. More on the bond market below.
Continue reading ‘Sentiment Overview: Week Of August 7th, 2009′