This note was originally published at 8am on March 23, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.
“It would be impossible, therefore, to introduce into society a greater change and a greater evil than this – the conversion of the law into an instrument of plunder.”
Bastiat wrote that in his treatise on individual liberties titled “The Law” in 1850. If you are in the business of having an open mind and teaching yourself alternative economic frameworks to the Keynesian Kingdom of thought, I highly recommend taking the time to read it.
I certainly don’t agree with everything Bastiat wrote. Nor do I disagree with everything Keynes wrote. What I’ve tasked myself with in writing to you each morning is exploring my interests in markets out loud while maintaining some sense of a moral compass. My Mom inspired me to do that.
Anytime one uses the words “moral” and “interest” together in writing something to Washington/Wall Street, one must tread carefully. When one considers America’s Declaration of Independence and the principles embedded in the Constitution however, one must not contradict our high society’s self-interested group-think with the underpinnings of our citizenry’s morality.
It’s only fitting to ask this question today, because on this day in 1775 an American patriot by the name of Patrick Henry delivered a famous speech in defense of liberty to the Virginia Convention when he proclaimed, “Give me liberty or give me death.”
I’m too self-centered to ask for death over liberty this morning, but I will remind those who are begging for bailouts in order to get themselves paid that this country’s new Transparency & Accountability Tools (YouTube, Twitter, etc.) will most likely smoke you out of your hole of contradiction.
If only because he was born early enough to say it first, Bastiat nailed this fundamental point down early in “The Law” when he wrote:
“When the law and morality are in contradiction to each other, the citizen finds himself in the cruel alternative of either losing his moral sense, or of losing his respect for the law.” (Bastiat, “The Law”, page 7)
When I think about that quote and the timing of revolutionary event risk in this world, I just can’t stop thinking. I do not profess to have the answers to all of this, but I can definitely tell these Government People what not to do. Stop compromising the “fairness” and “free-ness” of market systems by making new laws that implicitly choose winners and losers.
Back to the grind…
As always, this morning’s Global Macro news-flow is multi-factor and multi-duration. In summary, I think the points I am about to rattle off speak pointedly to the Instruments of Plunder being used by Big Government Interventionists who fundamentally believe issuing Fiat Fool paper is the best path to prosperity:
Of course, there is both causality and correlation being imputed into market prices on these factors across durations:
Then you have countries with pseudo-conservative fiscal and monetary policy getting less confident in US, Japanese, and European stock markets as Price Volatility ramps (so they invest more at home):
Finally, you have SP500 and WTI Crude Oil futures whipping around like Pac-Man attempting to absorb all of this and stay ahead of what some Central Planner With Tan Socks at the Fed is going to do next.
What I’m going to do this morning is at least consistent. That usually starts with what I am not going to do – and one of those things is not cheering on Big Government Intervention and using the US Dollar as an Instrument of Plunder. All that does is drive The Inflation and The Price Volatility higher. After seeing the globally interconnected “Black Swans” that were born out of the early 2008 US Dollar destruction, I’ve seen enough of that.
From an asset allocation perspective, this week I’ve sold all of my US Equity exposure (Energy and Healthcare – XLE and XLV), ramped up my allocation to Fixed Income to 9% (bought long term US Treasuries yesterday), and have taken my CASH position back up to 55%.
If you are a Central Planner looking to protect the liberties and properties of The People, Bastiat said “it is absolutely necessary that this question of legal plunder should be determined, and there are only three solutions of it:”
My solution remains. For starters, just stop. Stop what you are doing with The Inflation policy to enrich the few. The money isn’t worth it to me.
My immediate-term support and resistance levels for WTI crude oil are now $101.32 and $105.98, respectively. My immediate-term support and resistance levels for the SP500 are 1293 and 1310, respectively.
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
“It is the nature of inflation to give birth to a thousand illusions.”
Last week, despite the US Dollar posting a rare gain, The Inflation didn’t come down. It’s sticky – and that’s unfortunate because Deflating The Inflation is what America needs to get her confidence back. Not another low-volume stock market rally to lower-highs.
Here’s how the week-over-week Macro scorecard looked for Americans:
Not to put a wet Kleenex on your morning, but the reality is that well over half of America wakes up to not really caring so much about the US stock market. We, as a profession, have ourselves to blame for that. Many Americans think this game is rigged.
“So inflation turns out to be merely one more example of our central lesson. It may indeed bring benefits for a short time to favored groups, but only at the expense of others. And in the long run brings ruinous consequences to the whole community.” (Henry Hazlitt, “Economics In One Lesson”, page 170, 1946).
Sure, stocks going down again last week (like they had in 3 of the 4 weeks prior) would have been bad. But the US Dollar going down for the 10th out of the last 13 weeks would have been worse. Despite the massive week-over-week drawdown in market volatility (VIX) and a relative easing of headline news coming out of both Japan and the Middle East, the price at the pump hit a new weekly closing high for 2011 and this part of the economic cycle.
What part of the economic cycle is this anyway? The Big Government Interventionists would have you believe that this is the “growth” phase of the American dream. Last week’s revisions had US GDP growth running at +3.1% for the 4th quarter of 2010. But that’s using a joke of a deflator of 0.4% for inflation (you need to subtract inflation from nominal growth to get the reported number) – so what part of this joke are Americans missing?
Americans get the joke.
Whether you want to look at the weekly or monthly readings on American Consumer Confidence, they tell you the same story:
At least stocks were rising alongside The Inflation in February. For the month of March, US stocks look like they’ll close flat to down. So my question is, As Growth Slows And Inflation Accelerates, what’s next?
Answering that question from a Macro Catalyst Calendar perspective, here what’s on tap in the immediate-term (this week):
Consumption will continue to be borrowed; Housing will continue to deteriorate; and High-Frequency Data (PMI, ISM, Confidence, etc.) will continue to remind us that markets are looking forward, not behind.
While I’ll be the first to acknowledge that a 7-day record drawdown in US stock market volatility was bullish for stocks last week, I was also the first US stock market bear to write “Short Covering Opportunity” at the SP500’s YTD low. I don’t Short-And-Hold.
Today, with the VIX -41.6% lower and the SP500 +4.5% higher, I’m a seller again. After moving the Hedgeye Portfolio to 16 LONGS and 4 SHORTS on Wednesday, March 16th, I closed last week with 15 LONGS and 13 SHORTS.
I also sold all of our exposure to US Equities in the Hedgeye Asset Allocation Model last week (sold Energy and Healthcare – XLE and XLV). Zero percent is now something The Bernank and I share in common. There’s always common ground to find somewhere.
On last week’s overall inflation of stock and commodity prices, I took our Cash position back up to 52%.
Here’s the Hedgeye Asset Allocation Model:
If you want to modernize a “Thousand Illusions” about The Inflation, check out MIT’s “Billion Prices Project” and hit the USA tab. It should provide you with some hope that reality will eventually be measured in real-time. In the meantime, as Hazlitt predicted, “The political pressure groups that have benefited from the inflation will insist upon its continuance.”
My immediate term support and resistance levels for the SP500 are now 1307 and 1323, respectively.
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
Hosted by Hedgeye CEO Keith McCullough at 9:00am ET, this special online broadcast offers smart investors and traders of all stripes the sharpest insights and clearest market analysis available on Wall Street.
Keith bought Brinker in the Hedgeye Virtual Portfolio today at $24.34.
As I wrote in this morning's Early Look, Brinker is my favorite name in the restaurant space. Top-line stabilization and an ongoing remodeling initiative will add to the ground the company has already made from a margin perspective. After meeting with senior management and viewing remodeled stores in Oklahoma this past week, I am confident that this turnaround story has legs to carry on further. The remodeling and “team service” initiatives will benefit both margins and employee morale. The strides being made in food preparation processes will likely improve traffic and customer loyalty, and the kitchen technology improvements will enable the units to operate more efficiently.
On the DRI earnings call, senior management emphasized that industry sales trends continues to get better. While DRI may be underperforming today due to some issues specific to the company, it is possible that the improved performance of Chili's could be exacerbating some of Darden's problems!
Conclusion: Buying the dip in advance of the recovery story in Japan is as consensus as buying the top in Japanese equities was in February. Don’t be pulled into this value trap. Further, we use historical data to show how current Japanese monetary and fiscal policy may have Japan en route to 1930’s-40’s-style stagflation.
This morning, it was confirmed that foreign investors bought a net ¥955B ($11.8B) worth of Japanese equities last week – the most since 2004 – as “buy the dip” took on a whole new meaning. In comparing the week ended March 18th to similar weekly data, Japan’s Ministry of Finance confirmed that this is “substantially the most on record”.
In conjunction with the report, we also received more confirmation that the “flows” indeed drove the Nikkei 225 to its latest lower-high on February 21st, as foreign institutional investors were weekly net buyers of Japanese equities from Oct. 29 through Mar. 18 – the longest streak since the 26 weeks through Dec. 9, 2005. That’s not at all insignificant, as roughly 70% of the trading volume in Japan is the result of foreign institutional transactions – likely because most Japanese aren’t gullible enough to buy their own equities after two decades of lower-highs and lower-lows.
The comments provided by Richland Capital Management’s Alex Au to bloomberg.com support our view that foreign investors have been and continue to plow money into Japanese equities because they are “cheap”:
“Foreigners are probably not necessarily bullish, but are thinking they can buy some cheap stocks at that moment.”
Given that foreign investors have been net buyers since October, the phrase “doubling-down” certainly comes to mind.
Switching gears, our bearish thesis on the Japanese economy hasn’t changed since early October. If anything, the accompanying sovereign debt issuance acceleration resulting from the reconstruction costs (upwards of ¥25 TRILLION or $308.6B) further depresses Japan’s long-term growth prospects. Empirical studies have shown sovereign debt buildup past the Rubicon of 90% Debt/GDP structurally impairs an economy’s long-term growth prospects, and Japan, with its ~210% ratio, has been no exception.
Given the last eight centuries of history’s lessons, the following questions should be considered:
Regarding duration, anyone who’s in it for the long haul needs a refresher on history’s lessons, which indeed show us that buying and holding Japanese equities has been arguably the worst trade of the last twenty years.
Regarding growth, we’re almost certain the Keynesian Kingdom will find a way to pull-forward future demand to help finance this earthquake. We caution, however, that merely REPLACING what has been LOST due to the recent tragedy with unprecedented levels of government leverage is NOT growth. Using earthquakes, tsunamis, and nuclear meltdowns as catalysts on the long side are not investment processes we subscribe to at Hedgeye.
Regarding inflation, we got some positive news this morning that Bank of Japan Governor Masaaki Shirakawa is opposed to monetizing the aforementioned recovery-related sovereign debt issuance, out of fear it may stoke inflationary pressures. This is in stark contrast to the recent proposals out of the DPJ and LDP calling for the BOJ to monetize the incremental debt issuance, out of fear the additional supply wouldn’t be adequately absorbed by the market – i.e. the bureaucrats fear a higher cost of capital looms in Japan’s near future if more and more JGB supply hits the open market (exactly what the long-term component of our Japan’s Jugular thesis forecasts).
Currently, the BOJ limits itself to purchasing long-term JGB debt on the secondary market consistent with the amount of banknotes in circulation, meaning that the BOJ has "spare capacity" to purchase around ¥20 TRILLION yen to purchase long-term JGBs – on top of its current purchases of ¥21.6 TRILLION annually and its current Asset Purchase Facility, in which it is buying ¥5 TRILLION of short-term JGBs. The issue with the current political proposals lies in the fact that the BOJ is reluctant to outright monetize the government’s debt by funding it on the primary market.
In spite of Shirakawa’s warnings about the inflationary impact of debt monetization, as well as the potential blow to Japan’s international credibility, Japanese legislators have pushed on, invoking parallels to the Great Depression – the last time the Japanese government used a special circumstance to justify funding a substantial increase in debt and deficit spending via BOJ debt monetization:
“Bank of Japan bond underwriting is a policy that is evaluated highly worldwide because it helped Japan recover from the Great Depression before others.” – DPJ member Yoichi Kaneko
“If this isn’t a special situation, what is?” – LDP member Kozo Yamamoto
Shirakawa aptly responded:
“If a central bank starts to underwrite government bonds, there may be no problems at first, but it would lead to a limitless expansion of currency issuance, spur sharp inflation and yield a big blow to people’s lives and the economy, as has happened in the past.”
As a recap, in 1932, Japanese Finance Minister Korekiyo Takahashi boosted spending by 34% with the aid of BOJ monetization, which peaked a year later at 89.6% of JGB issuance and continued for the next 14 years until the end of WWII. Takahashi was later assassinated in 1936 when tried to rein in these expansionary policies to fight inflation. It appears that even 80 years ago, those that get paid by The Inflation don’t like it when the government pulls the plug any more than they do today…
All told, if Japan is to avoid the structural stagflationary problems that persisted throughout the 1930’s and 1940’s whereby consumer and producer prices eventually grew at YoY growth rates north of +40% and real GDP growth slowed sequentially for nearly 15 years, the bureaucrats would be well-served to heed Shirakawa’s warning. Unfortunately, with the yen trading down on the day in spite of the BOJ’s sobering comments, we, alongside the global currency market doubt they will.
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