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Rate Hikes...A Necessary Evil

All eyes are on the Federal Reserve this week. Will they raise rates on Thursday or not?  It’s important to understand what’s going on now, as events in the coming months are likely to push us further down the road toward the End Game of which I have spoken for almost two years.  The End Game, as it unfolds, is the next period when debt and leverage begin to unwind again.  It will be a period full of risks but ultimately, very profitable opportunities.  In that context, investors need to monitor their own decision making process to avoid some classic errors.


The Real Cost of Low Rates – Financial Engineering


I don’t know if the Fed will raise rates or not on Thursday.  Based on today’s price action with stocks up big and bonds down big, the market thinks they will do so despite the statistical odds of less than 25%.  Economic evidence is mixed but certainly not recessionary here in the US so unless China really has the capacity to derail the globe, the odds are still good that we’ll see rate hikes sometime in the next 3-6 months, maybe even Thursday!  Regardless, we believe they should raise rates.  Why?


The answer is really simple to me.  We need to provide the catalyst for money to become more productive than it has been in the last six years.  Let me explain.  Right now, not unlike other historical periods of very low rates, corporations are using (exploiting) very low interest rates to do some rather egregious financial engineering of their earnings.  I’ve spoken of this before and here it is again.  They (companies like Apple) issue bonds at today’s very low rates, effectively borrowing money from investors and institutions at little to no cost.  Then they use the money to do things like Mergers, leveraged buyouts, share buybacks, or pay dividends to stockholders.  All of these things boost earnings artificially or make stock shares seem more attractive when the companies themselves might not have any real organic growth.  Apple is probably a bad example but they are guilty of financial engineering as much as any of them.  The outcome is mysteriously strong earnings with little to no real aggregate economic growth (GDP at 2-3%) and historically low productivity of that same capital.  The valuations guys who have been arguing that the markets are overvalued have a very good point when current earnings are viewed as temporary and conditional on the availability of very cheap credit (aka low interest rates).  Now you begin to see the gravity of the situation.  If and when “cheap credit” goes away and the Federal Reserve begins to increase the cost of credit by raising interest rates, then we immediately begin to question future earnings unless they are rather instantly replaced with real and robust economic growth.  If the Fed does not raise rates soon, we will simply inflate our earnings and credit bubbles even further.  And as Jimmy Cliff says, “the harder they come, the harder they fall”. 


This is that time, the End Game, when the system must transition from a system of financially engineered earnings to actual demand driven profits earned the hard way – through productive use of capital.  We are way past the point where central banks could argue that they are supporting a weak economy.  Quite the opposite, they are likely supporting stock shares at the expense of the real economic growth with a zero interest rate policy! The good news is that there is a roughly $57 Trillion of capital out there in the hands of corporations worldwide.  The bad news is that it current represents 290% of actual global GDP.  This money needs to become more productive and won’t have a reason to do so until the cost of credit goes higher.  So what does all of this mean to investors?


Transition periods can be volatile with plenty of risks for investors including deep corrections and bear markets.  So far, the US stock market is down about 10% from the highs but we are the best looking horse in the glue factory.  Other countries are solidly negative in double digits with few exceptions.   This is that time when we need to banish preconceived notions about the future and follow our investing disciplines even if they argue with our emotions.  This week alone, I have heard strongly worded forecasts that stocks will run higher by 20-25% from here and others who say we should sell any rallies as we are now in the early stages of a bear market.  From our seat, we see a market that is in a new downtrend in the context of some longer-term indicators.  For instance, Lowry’s Buying and Selling pressure metrics show a market that has been under aggregate selling pressure since July (Red line crossed above the black line).   If Buying pressure can meaningfully retake selling pressure on any rebound in stocks, then the bull market can rage on but it’s going to take a lot of buying pressure and the Dow to trade above the 200 day moving average to get that done.


 



We don’t have an opinion on the possibility of that kind of buying enthusiasm, but we do know that we have just as much (I should say as little) money exposed to the market now as our system dictates through our Net Exposure analysis for each of our investment categories.  We also know that our Selection criteria is pointing us away from things that are interest sensitive like bonds and utilities and toward things that benefit in a rising interest rate, rising US dollar environment, like technology, banks and semiconductors.  Finally we know that taking concentrated bets on anything now is a huge gamble and our Position Sizing criteria does not have an overweight reading in anything.  When the selling is done and this correction or bear market ends, this same system will lead us into the right market exposure, the right sectors and some new convictions with overweight and underweight position sizes.  Our system is designed to avoid some of the classic and most costly investor errors and this is a good time to review those.


Types of Investment Errors (just the classics)


Type I – Buying High, Selling at the Lows


We are all familiar with this one but it continues to happen day after day after week after month.  Most investors are very unwilling to accept a small loss, say -5% as it represents some sort of personal failure.  Instead he holds his losing position, often bought very late in a trend, and then watches the stock fall another -20%.  Of course, he cannot accept a loss of that magnitude so the plan changes. Now he will wait for a rebound to sell at a better price – but it never comes.  The stock falls another 46% and he finally sells in total disgust for a massive loss.  We are seeing this now in energy and commodities stocks.  This is the domain of the Do-it-yourself investor and anyone who is a self-proclaimed long-term investor.  Now hear this; No one is a long-term investor.  They don’t exist.  Massive selling at the lows of every bear market, or more recently on August 21st, is all the evidence I need. The error again is not accepting the small loss and holding on to something that was obviously in a downtrend for way too long.


Type II – Not Letting Winners Run


This one happens to professionals more often.  Honestly, we’re working on systems to help us avoid the risk of this error but haven’t got it mastered quite yet.

This is that situation when we buy something for $20, sell it for $25 and then watch the stock go to $600.  How do we know which stocks to hold?  How high is too high?  This takes some deeper knowledge and experience including changing parameters once a significant gain develops and recognizing leadership in individual company names.   This error is really an issue for stock investors only (not indices, mutual funds or ETFs)


Type III – No Commitment


Everyone is guilty of this one.  “I bought Amazon at $10!  But I only bought 10 shares”.  As George Soros famously says, “When you see it, bet big”.  We own a single winner but have not real money in the trade while sitting on a six-figure balance in Well Fargo checking account earning zero % interest.  Once again, knowledge and experience helps us identify when “it” is in front of us.  Position sizing criteria is a relatively new dial in our systems- only two years old.  We are working to rank and sort our holdings based on our own conviction and ongoing evidence.  High conviction will get larger position sizes, and visa versa.


If I had to make a closing statement it would be this; Markets will always create risks and opportunities for investors.  Worry less about what the Fed may or may not do and work to improve your investment systems to avoid the classic errors like those above.  If the End Game is upon us, let the event work for you!


That’s it for this edition – I’m likely to send a quick note on Friday after the Fed meeting to digest the markets’ reaction.


Cheers

Sam Jones