Expect Buybacks to Sustain Markets

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With uncertainty swirling around the financial markets right now, many are warning about a financial storm brewing and how to navigate through it.

Let’s consider the storm elements in the world right now. The ongoing trade war is obviously a major concern, which is nowhere near being resolved. Growth is slowing in many parts of the world and central banks are preparing to begin cutting rates again.

Geopolitical tensions are also rising again, especially in the Persian Gulf. Late last week, Iranian forces seized a British-flagged tanker in the Strait of Hormuz, one of the world’s most important chokepoints. Britain has demanded the ship’s release.

On the U.S. domestic front, we are facing government dysfunctional, trade war uncertainty and a looming debt ceiling deadline. A deal will likely be reached, but that is not a guarantee. If a deal isn’t reached, the federal government would run out of money to pay its bills.

That’s why you should consider the tactics of Warren Buffett along with the strategy used by some of the most skilled sailors.

Buffett, one of the most successful investors in history, has made billions by knowing how to steer through storms. One of my favorite Buffettisms has to do with keeping your eye on the horizon, a steady-as-she-goes approach to investing. It also happens to relate to sailing.

As he famously said, “I don’t look to jump over seven-foot bars; I look around for one-foot bars that I can step over.”

What that means is that you should carefully consider what’s ahead and choose your course accordingly. Buffett doesn’t strive to be a hero if the risk of failing, or crashing against the rocks (in sailing lingo), is too great.

In a storm, there are two possible strategies to take. The first one is to ride through it. The second is to avoid it or head for more space in the open ocean. In other words, fold down your sails and wait it out until you have a better opportunity to push ahead.

While there is no perfect maneuver for getting through a storm, staying levelheaded is key.

We are at the beginning of another corporate earnings season, which is the period each quarter when companies report on how well (or poorly) they did in the prior quarter.

The reports can lag the overall environment but still give insight on how a company will be positioned in the new quarter. But to get the most out of them requires the right navigation techniques.

This season’s corporate earnings results have been mostly positive so far. But what you should know is that Wall Street analysts always tend to downplay their expectations of corporate earnings going into reporting periods. That because corporations downplay them to analysts. It’s Wall Street’s way of gaming the system.

When I was a managing director at Goldman Sachs, senior members of the firm would gather together each quarter with the chairman and CEO of the firm, Hank Paulson, who went on to become the Treasury secretary of the United States under President George W. Bush.

He would talk with us about the overall state of the firm, and then the earnings figures would be discussed by the chief financial officer.

This would be just before our results were publicly disclosed to the markets. There was always internal competition amongst the big investment banks as to what language was being provided to external analysts about earnings and how the results ultimately compared with that language.

You couldn’t be too far off between “managing expectations” of the market and results of the earnings statements. However, there was a large gray area in between that was exploited each quarter.

When I was there, it was very important for Goldman to have better results than immediate competitors at the time like Morgan Stanley, Merrill Lynch or Lehman Bros.

It was crucial to “beat” analysts’ expectations. That provided the greatest chance of the share price rallying after earnings were released.

The bulk of our Wall Street compensation was paid in annual bonuses, not salaries. These bonuses were in turn paid out in options linked to share prices. That’s why having prices rise after fourth-quarter earnings was especially important in shaping the year’s final bonus numbers.

Here’s what that experience taught me: There’s always a game when it comes to earnings.

Investors that don’t know this tend to get earnings season all wrong. However, successful investors that take forecasts with a grain of salt will do better.

Years later, I realized this was also Warren Buffett’s approach to analyzing earnings. As he has told CNBC, “I like to get those quarterly reports. I do not like guidance. I think the guidance leads to a lot of bad things, and I’ve seen it lead to a lot of bad things.”

We’ll have to see how earnings season turns out. But good or bad, markets are finding support from the same phenomenon that powered them to record heights last year: stock buybacks.

Of course, years of quantitative easing (QE) created many of the conditions that made buybacks such powerful market mechanisms. Buybacks work to drive stock prices higher. Companies could borrow money and buy their own stocks on the cheap, increasing the size of corporate debt and the level of the stock market to record highs. Corporations actually account for the greatest demand for stocks..

And a J.P. Morgan study concludes that the stock prices of U.S. and European corporations that engage in high amounts of buybacks have outperformed other stocks by 4% over the past 25 years.

Last year established a record for buybacks. While they will probably not match the same figure this year, buybacks are still a major force driving markets higher.

And amidst escalating trade wars and all the other concerns facing today’s markets, executing buybacks makes the most sense for the companies that have the cash to engage in them. If companies are concerned about growth slow downs in the future, there is good reason to use their excess cash for buybacks.

What this means is that the companies with money for buybacks have good reason to double down.

As a Reuters article has noted, “the escalating trade war between the United States and China may prompt U.S. companies to shift money they had earmarked for capital expenditures into stock buybacks instead, pushing record levels of corporate share repurchases even higher.”

So buybacks could prop up the market through volatile periods ahead and drive the current bull market even further.

Of course, buybacks also represent a problem. They boost a stock in the short term, yes. But that higher stock price in the short may come at the expense of the long run. It’s a short-term strategy.

That’s because companies are not using their cash for expansion, for R&D, or to pay workers more, which would generate more buying power in the overall economy. Buybacks are not connected to organic growth and are detached from the foundation of any economy.

But buybacks could keep the ball rolling a while longer. And I expect they will. One day it’ll come to an end. But not just yet.

Regards,

Nomi Prins
for The Daily Reckoning

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Why Powell Might NOT Cut Rates

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The market’s been bouncing around lately, anxiously waiting to see it the Fed cuts interest rates next week. All indications now suggest that it will. The question is by how much?

Minutes from June’s Federal Open Market Committee (FOMC) meeting that were released earlier this month indicated support for a rate cut. Certain committee officials noted that as long as uncertainty still weighed on its outlook, they would be willing to cut rates.

And during his much-awaited biannual testimony before the House Financial Services Committee, Federal Reserve Chairman Jerome Powell hinted — strongly — that a rate cut was around the corner.

Powell told the committee, “It appears that uncertainties around trade tensions and concerns about the strength of the global economy continue to weigh on the U.S. economic outlook. Inflation pressures remain muted.”

But the subsequent release of better-than-expected June employment figures complicated the matter of rate cut size and timing.

They raised the possibility that those positive jobs numbers would keep the Fed from cutting rates. After all, it doesn’t make a lot of sense to cut interest rates when the job market is so hot and unemployment is at 50-year lows.

But despite that concern, markets are still placing the odds of a rate cut of 25 basis points at 100%, with lower expectations for a 50 basis point cut.

This means a rate cut is already “baked into the cake.” However, the risk is that if Jerome Powell and the FOMC don’t cut rates next week, it could cause a sharp sell-off.

We’ll have our answer next week. But despite the overwhelming market expectations for a rate cut, I think there’s a chance the Fed won’t cut rates yet. That’s because Powell may still want to signal the Fed’s ability to act independently from White House pressure.

I realize that puts me in the extreme minority. But that’s OK, it certainly isn’t the first time.

But there’s something else going on right now that could trip up markets.

Earnings season is underway. Over the next few weeks, all of the S&P 500 companies will be rolling out their earnings figures. And more than a quarter of them will report earnings this week.

Firms from Google’s parent company, Alphabet, to Amazon, McDonald’s and Boeing are among the more than 130 companies that are reporting.

Even with a rate cut, poor corporate earnings could spell trouble for stocks. The trade war would be partly responsible. Certainly, there remains no resolution on the U.S.-China trade war front. And the trade war combined with slowing growth could amplify the effects of weak earnings.

As one article reports, “Stocks could struggle if the earnings message from corporate America focuses on the murky outlook for the economy and negative impacts from the trade wars.”

Earnings so far have been positive, but that can be misleading. That’s because second-quarter earnings expectations were kept low so that corporations could easily beat them.

Their actual earnings may not be underwhelming. But if they beat expectations, that’s all that counts.

And as I learned on Wall Street, corporations often talk down their earnings estimates in order to set a low bar. That way they can easily beat the forecast, which produces a jump in the stock price.

As Ed Keon, chief investment strategist at QMA explains:

No matter what the economic circumstances are, no matter what the backdrop is, there’s this dynamic that companies like to lowball and analysts like to give them headroom. The fact that numbers are coming in better than expected — it’s been the case for decades now.

Of the 114 companies that provided second-quarter guidance as of last week, 77% released negative forecasts, according to FactSet.

But it’s still early and there’s a long way to go.

Most industrial companies haven’t reported earnings yet. And they could reveal extensive damage from the trade war. As CFRA investment strategist Lindsey Bell says:

As we get more industrials in the next couple of weeks, I think that will create more volatility and drive the market lower in the near term… Chemicals and metals are two areas where I expect pressure.

We’ll see. But if markets do stumble, you can expect the Fed will be ready to cut rates at its meeting in September. That means more “dark money” will be coming to support markets, even if the Fed doesn’t cut rates next week.

And that’ll keep the bull market going for a while longer. One day the music will end. The imbalances in the system are just too great.

But we’re not at that point yet, and you can expect markets to rise on additional dark money injections.

Enjoy it while you can.

Below, I show you one major factor that will continue to support stocks this year. It doesn’t have to do with the trade war or earnings. What is it? Read on.

Regards,

Nomi Prins
for The Daily Reckoning

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Free-Riding Investors Set up Markets for a Major Collapse

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Free riding is one of the oldest problems in economics and in society in general. Simply put, free riding describes a situation where one party takes the benefits of an economic condition without contributing anything to sustain that condition.

The best example is a parasite on an elephant. The parasite sucks the elephant’s blood to survive but contributes nothing to the elephant’s well-being.

A few parasites on an elephant are a harmless annoyance. But sooner or later the word spreads and more parasites arrive. After a while, the parasites begin to weaken the host elephant’s stamina, but the elephant carries on.

Eventually a tipping point arrives when there are so many parasites that the elephant dies. At that point, the parasites die too. It’s a question of short-run benefit versus long-run sustainability. Parasites only think about the short run.

A driver who uses a highway without paying tolls or taxes is a free rider. An investor who snaps up brokerage research without opening an account or paying advisory fees is another example.

Actually, free-riding problems appear in almost every form of human endeavor. The trick is to keep the free riders to a minimum so they do not overwhelm the service being provided and ruin that service for those paying their fair share.

The biggest free riders in the financial system are bank executives such as Jamie Dimon, the CEO of J.P. Morgan. Bank liabilities are guaranteed by the FDIC up to $250,000 per account.

Liabilities in excess of that are implicitly guaranteed by the “too big to fail” policy of the Federal Reserve. The big banks can engage in swap and other derivative contracts “off the books” without providing adequate capital for the market risk involved.

Interest rates were held near zero for years by the Fed to help the banks earn profits by not passing the benefits of low rates along to their borrowers.

Put all of this (and more) together and it’s a recipe for billions of dollars in bank profits and huge paychecks and bonuses for the top executives like Dimon. What is the executives’ contribution to the system?

Nothing. They just sit there like parasites and collect the benefits while offering nothing in return.

Given all of these federal subsidies to the banks, a trained pet could be CEO of J.P. Morgan and the profits would be the same. This is the essence of parasitic behavior.

Yet there’s another parasite problem affecting markets that is harder to see and may be even more dangerous that the bank CEO free riders. This is the problem of “active” versus “passive” investors.

An active investor is one who does original research and due diligence on her investments or who relies on an investment adviser or mutual fund that does its own research. The active investor makes bets, takes risks and is the lifeblood of price discovery in securities markets.

The active investor may make money or lose money (usually it’s a bit of both) but in all cases earns her money by thoughtful investment. The active investor contributes to markets while trying to make money in them.

A passive investor is a parasite. The passive investor simply buys an index fund, sits back and enjoys the show. Since markets mostly go up, the passive investor mostly makes money but contributes nothing to price discovery.

The benefits of passive investing have been trumpeted by the late Jack Bogle of the Vanguard Group. Bogle insisted that passive investing is superior to active investing because of lower fees and because active managers can’t “beat the market.” Bogle urged investors to buy and hold passive funds and ignore market ups and downs.

The problem with Bogle’s advice is that it’s a parasitic strategy. It works until it doesn’t.

In a world in which most mutual funds and wealth managers are active investors, the passive investor can do just fine. Passive investors pay lower fees while they get to enjoy the price discovery, liquidity and directional impetus provided by the active investors.

Passive investors are free riding on the hard work of active investors the same way a parasite lives off the strength of the elephant.

What happens when the passive investors outnumber the active investors? The elephant starts to die.

Since 2009, over $2.5 trillion of equity investment has been added to passive-strategy funds, while over $2.0 trillion has been withdrawn from active-strategy funds.

The active investors who do their homework and add to market liquidity and price discovery are shrinking in number. The passive investors who free ride on the system and add nothing to price discovery are expanding rapidly. The parasites are starting to overwhelm the elephant.

There’s much more to this analysis than mere opinion or observation. The danger of this situation lies in the fact that active investors are the ones who prop up the market when it’s under stress. If markets are declining rapidly, the active investors see value and may step up to buy.

If markets are soaring in a bubble fashion, active investors may take profits and step to the sidelines. Either way, it’s the active investors who act as a brake on runaway behavior to the upside or downside.

Active investors perform a role akin to the old New York Stock Exchange specialist who was expected to sell when the crowd wanted to buy and to buy when the crowd wanted to sell in order to maintain a balanced order book and keep markets on an even keel.

Passive investors may be enjoying the free ride for now but they’re in for a shock the next time the market breaks, as it did in 2008, 2000, 1998, 1994 and 1987.

When the market goes down, passive fund managers will be forced to sell stocks in order to track the index. This selling will force the market down further and force more selling by the passive managers. This dynamic will feed on itself and accelerate the market crash.

Passive investors will be looking for active investors to “step up” and buy. The problem is there won’t be any active investors left or at least not enough to make a difference. The market crash will be like a runaway train with no brakes.

The elephant will die.

Regards,

Jim Rickards
for The Daily Reckoning

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Robot Trading Will End in Disaster

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Today, stock markets and other markets such as bonds and currencies can best be described as “automated automation.” Here’s what I mean.

There are two stages in stock investing. The first is coming up with a preferred allocation among stocks, cash, bonds, etc. This stage also includes deciding how much to put in index products or exchange-traded funds (ETFs, which are a kind of mini-index) and how much active management to use.

The second stage involves the actual buy and sell decisions — when to get out, when to get in and when to go to the sidelines with safe-haven assets such as Treasury notes or gold.

What investors may not realize is the extent to which both of these decisions are now left entirely to computers. I’m not talking about automated trade matching where I’m a buyer and you’re a seller and a computer matches our orders and executes the trade. That kind of trading has been around since the 1990s.

I’m talking about computers making the portfolio allocation and buy/sell decisions in the first place, based on algorithms, with no human involvement at all. This is now the norm.

Eighty percent of stock trading is now automated in the form of either index funds (60%) or quantitative models (20%). This means that “active investing,” where you pick the allocation and the timing, is down to 20% of the market. Although even active investors receive automated execution.

In all, the amount of human “market making” in the traditional sense is down to about 5% of total trading. This trend is the result of two intellectual fallacies.

The first is the idea that “You can’t beat the market.” This drives investors to index funds that match the market. The truth is you can beat the market with good models, but it’s not easy.

The second fallacy is that the future will resemble the past over a long horizon, so “traditional” allocations of, say, 60% stocks, 30% bonds and 10% cash (with fewer stocks as you get older) will serve you well.

But Wall Street doesn’t tell you that a 50% or greater stock market crash — as happened in 1929, 2000 and 2008 — just before your retirement date will wipe you out.

But this is an even greater threat that’s rarely considered…

In a bull market, this type of passive investing amplifies the upside as indexers pile into hot stocks like, for example, Google and Apple have been. But a small sell-off can turn into a stampede as passive investors head for the exits all at once without regard to the fundamentals of a particular stock.

Index funds would stampede out of stocks. Passive investors would look for active investors to “step up” and buy. The problem is there wouldn’t be any active investors left, or at least not enough to make a difference. There would be no active investors left to risk capital by trying to catch a falling knife.

Stocks will go straight down with no bid. The market crash will be like a runaway train with no brakes.

It comes back to complexity, and the market is an example of a complex system.

One formal property of complex systems is that the size of the worst event that can happen is an exponential function of the system scale. This means that when a complex system’s scale is doubled, the systemic risk does not double; it may increase by a factor of 10 or more.

This kind of sudden, unexpected crash that seems to emerge from nowhere is entirely consistent with the predictions of complexity theory. Increasing market scale correlates with exponentially larger market collapses.

Welcome to the world of automated investing. It will end in disaster.

Regards,

Jim Rickards
for The Daily Reckoning

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Into the “Tractor Beam” of Zero Rates

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“We’re probably never going to go away from zero rates.”

So concludes hedge fund grandee Kyle Bass.

Mr. Bass believes the economy will plunge into recession next year. And the Federal Reserve will hound interest rates back down to zero.

There they will remain forever and ever… world without end.

The economy will fall within the inescapable “tractor beam” of zero rates:

As we have all learned, once an economy falls into the tractor beam of zero rates, it’s almost impossible to escape them… Growth numbers are going to come down and real growth might go to zero. We’re probably never going to go away from zero rates.

We fear Bass is correct.

Like a man hooked to a respirator, the economy cannot breathe on its own.

The financial crisis collapsed its lungs.

The Federal Reserve rushed over, plugged in the oxygen… and never took it out.

The economy’s natural breathing apparatus has atrophied from disuse.

Yank the oxygen now… and you will have a situation on your hands.

Dr. Powell attempted to wean the patient off support. But it gurgled, sputtered and flailed.

He will not try again. He is in fact preparing to pump in more oxygen.

But the economy might breathe freely today… if they had only let it recapture its own wind post-crisis.

The initial gasping might have been frightful.

But it would have coughed out the excesses of the previous boom… and gradually filled its lungs with the invigorating air of honest capitalism.

It would have come around on its own.

In went the breathing tube instead…

United States debt — public and private — has moonshot some $21 trillion this past decade.

It presently totals an impossible $73 trillion.

Meantime, GDP equals $20 trillion.

That is, each dollar of GDP holds up nearly $3.65 of debt.

The economy pants and sweats mightily under the burden.

And rising interest rates would increase the cost of that debt.

Any meaningful interest rate increase would pile on too much weight… and the economy would buckle under the strain.

Compare today’s debt-to-GDP with 1970’s — when the Federal Reserve was still jailed in by the gold standard:

Read more here.

No, the economy cannot withstand higher interest rates — or even historically normal interest rates.

The Federal Reserve is trapped.

But here is the problem:

The Federal Reserve cannot raise interest rates, as we have attempted to establish.

But like trying to breathe life into a corpse… or Hillary Clinton… lowering rates will not work the trick.

Today’s debt load is simply too behemoth.

Explains our former colleague David Stockman:

[We are at] a condition best described as Peak Debt, which reflects the fact that a large share of domestic household and business balance sheets are tapped out.

Accordingly, cutting interest rates has increasingly less potency on Main Street due to the crushing absolute level of debt. As of Q1 2019, in fact, total public and private debt weighed in at $73 trillion and is up by $21 trillion from the pre-crisis peak in Q4 2007…

There are now two turns of extra debt on the national income (3.47x versus 1.48x) compared to the long-standing leverage ratio which prevailed during the century between 1870 and 1970. In quantitative terms, those extra turns amount to $40 trillion of extra debt being lugged around by the U.S. economy.

Needless to say, it is becoming ever harder for the Fed to stimulate more borrowing and spending relative to the nation’s $21 trillion of nominal income. It’s simply a matter of diminishing returns to small reductions in what are already rock bottom rates coupled with the exhaustion of balance sheet capacity.

And so the Federal Reserve wields far less wallop than commonly supposed.

As we have argued before…

The Federal Reserve is a helpless giant, a man behind a curtain, a tissue-paper tiger.

That is why we expect it to flunk the inevitable recession.

And also why we expect a fiscal rescue attempt next time — not monetary.

Read on to see why central banks do not much matter these days. As you will see, there is no actual money in monetary policy.

But if central banks are largely irrelevant, then who… or what… is pulling the monetary strings?

Answer below…

Regards,

Brian Maher
Managing editor, The Daily Reckoning

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New Multi-year Gold Rally Has Emerged

This post New Multi-year Gold Rally Has Emerged appeared first on Daily Reckoning.

The dollar price of gold has been on a roller-coaster ride for the past six years. But the past six weeks have been a turbocharged version of that. Investors should expect more of the same for reasons explained below.

The six-year story is the more important for investors and also the more frustrating. Gold staged an historic bull market rally from 1999 to 2011, going from about $250 per ounce to $1,900 per ounce, a 650% gain.

Then, gold nose-dived into a bear market from 2011 to 2015, falling to $1,050 per ounce in December 2015, a 45% crash from the peak and a 51% retracement of the 1999-2011 bull market. (Renowned investor Jim Rogers once told me that no commodity goes from a base price to the stratosphere without a 50% retracement along the way. Mission accomplished!)

During that precipitous decline after 2011, gold hit a level of $1,417 per ounce in August 2013. It was the last time gold would see a $1,400 per ounce handle until last month when gold briefly hit $1,440 per ounce on an intra-day basis. At last, the six-year trading range was broken. Better yet, gold hit $1,400 on the way up, not on the way down.

The range-bound trading from 2013 to 2019 was long and tiring for long-term gold investors. Gold had rallied to $1,380 per ounce in May 2014, $1,300 per ounce in January 2015, and $1,363 per ounce in July 2016 (a post-Brexit bounce).

But, for every rally there was a trough. Gold fell to $1,087 per ounce in August 2015 and $1,050 per ounce in December 2015. The bigger picture was that gold was trading in a range. The range was approximately $1,365 per ounce at the top and $1,050 per ounce at the bottom, with lots of ups and downs in between. Yet, nothing seemed capable of breaking gold out of that range.

The good news is that gold has now broken out to the upside. The $1,440 per ounce level is well within reach and the $1,400 per ounce level seems like a solid floor, despite occasional dips into $1,390 per ounce territory. Gold’s trading at $1,416 today.

More importantly, a new multi-year bull market has now emerged. Turning points from bear to bull markets (and vice versa) are not always recognized in real time because investors and analysts are too wedded to the old story to see that the new story has already started.

But, looking back it’s clear that the bear market ended in December 2015 at the $1,050 per ounce level and a new bull market, now in its fourth year, is solidly intact. The recent break-out to the $1,440 per ounce level is a strong 37% gain for the new bull market. This price break-out has far to run. (The 1971 – 1980 bull market gained over 2,100%, and the 1999 – 2011 bull market gained over 650%).

The price action over the past six weeks has been even wilder than the price action over the past six years. As late as May 29, 2019, gold was languishing at $1,280 per ounce. Then it took off like a rocket to $1,420 per ounce by June 25, 2019, an 11% gain in just four weeks.

Gold just as quickly backed-down to $1,382 per ounce on July 1, rallied back to $1,418 per ounce on July 3, and fell again to $1,398 per ounce on July 5. These daily price swings of 1.5% are the new normal in gold. Again, the good news is that the $1,400 per ounce floor seems intact.

What’s driving the new gold bull market?

From both a long-term and short-term perspective, there are three principal drivers: geopolitics, supply and demand, and Fed interest rate policy; (the dollar price of gold is just the inverse of dollar strength. A strong dollar = a lower dollar price of gold, and a weak dollar = a higher dollar price of gold. Fed rate policy determines if the dollar is strong or weak).

The first two factors have been driving the price of gold higher since 2015 and will continue to do so. Geopolitical hot spots (Korea, Crimea, Iran, Venezuela, China and Syria) remain unresolved and most are getting worse. Each flare-up drives a flight-to-safety that boosts gold along with Treasury notes.

The supply/demand situation remains favorable with Russia and China buying over 50 tons per month to build up their reserves while global mining output has been flat for five years.

The third factor, Fed policy, is the hardest to forecast and the most powerful on a day-to-day basis. The Fed has a policy rate-setting meeting on July 31. There is almost no chance the Fed will raise rates. The issue is whether they will cut rates or stand pat.

The case for cutting rates is strong. U.S. growth slowed in the second-quarter to 1.3% (according to the most recent estimate) from an annualized 3.1% in the first-quarter of 2019. Inflation continues to miss the Fed’s target of 2.0% year-over-year and has been declining recently. Trade war fears are adding to a global growth slowdown.

On the other hand, the June employment report showed strong job creation, continued wage gains, and increase labor force participation. All of those indicators correspond to higher future inflation under Fed models. The G20 summit between President Trump and President Xi of China led to a truce in the U.S.-China trade war and the prospect of continued talks to end the trade war.

In short, there’s plenty of data to support rate cuts or no cuts in July. The Fed is biding its time. Meanwhile, the market is highly uncertain. A good headline on trade results in a stronger dollar and weaker gold. The next day, a bad headline on growth results in a weaker dollar and stronger gold.

This dynamic explains the erratic up-and-down price movements of the past week. The dynamic is likely to continue right up until the July 31 Fed meeting in two weeks.

With so much uncertainty and volatility in the dollar price of gold lately, what is the prospect for a rally in precious metals prices and stocks that track them?

Right now, my models are telling us that the gold rally will continue regardless of the Fed’s action on July 31.

Expectations today are that the Fed will cut rates at the next FOMC meeting, but the probabilities are far from a sure thing. If the Fed cuts rates, the market will simply move its expectations of further rate cuts to the next FOMC meeting (September 18). The weak dollar/strong gold rally will continue.

If the Fed does not cut rates, gold may suffer a short-term drawdown, but markets will assume the Fed made a mistake. Expectations for a 50bp (0.5%) rate cut in September will start to build.

That new forward expectation will power gold higher just as surely as the missed July rate cut. That covers gold. But what about silver?

Many investors assume there is a baseline silver/gold price ratio of 16:1. They look at the actual silver/gold price ratio of 100:1 and assume that silver is poised for a 600% rally to restore the 16:1 ratio. These same investors tend to blame “manipulation” for silver’s underperformance.

That analysis is almost entirely nonsense. There is no baseline silver/gold ratio. (The “16:1 ratio” is an historical legacy from silver mining lobbying in the late 19th century, a time of deflation, when farmers and miners were trying to ease the money supply by inflating the price of silver with a legislative link to gold.

The result was “bimetallism,” an early form of QE. The ratio had nothing to do with supply/demand, geology, or any other fundamental factor. Bimetallism failed and was replaced with a strict gold standard in 1900).

This does not mean there is no correlation between gold and silver prices. As Chart 1 below reveals, there is a moderately strong correlation between the two. The coefficient of determination (expressed as r2) is 0.9.

This means that over 80% of the movement in the price of silver can be explained by movements in the price of gold. The remaining silver price factors involve industrial demand unrelated to gold prices.

Chart 1

Read more here.

Recently, a huge gap has opened up between the rally in gold prices (shown in blue on Chart 1 with a right-hand scale) compared to silver prices (shown in orange on Chart 1 with a left-hand scale).

Given the historically high correlation between gold and silver price movements, and the recent lag in the silver rally, the analysis suggests that either gold will fall sharply or silver will rally sharply.

Since I have articulated the case for continued strength in gold prices, my expectation is that gold will continue to outpace silver.

Either way, both metals are heading higher.

Regards,

Jim Rickards
for The Daily Reckoning

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Trump Declares War

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Trump has had it!

He is apparently declaring a currency war on the rest of the world. Trump resents China and Europe cheapening the yuan and the euro against the dollar in order to help their exports and hurt ours.

He says it’s time for the U.S. to cheapen the dollar also. Trump has a point. If you put a 25% tariff on many Chinese exports to the U.S. (as Trump has done) or a 25% tariff on German cars exported to the U.S. (as Trump has threatened to do), it can be a powerful way to reduce the U.S. trade deficit and generate revenue for the U.S. Treasury.

But a trading partner can undo the effect of the tariff just by cheapening its currency.

Let’s say a Chinese-made cellphone costs $500 in the U.S. If you slap a 25% tariff on the imported phone, the immediate effect is to raise the price by $125.

A simple solution to tariffs is to devalue your currency by 20% against the dollar. Local currency costs do not change, but the cellphone now costs $400 when the local currency price is converted to U.S. dollars.

A 25% tariff on $400 results in a total cost of $500 — exactly the same as before the tariffs were imposed. Tariff costs have been converted into lower production costs through currency manipulation.

There’s only one problem with Trump’s currency war plan. There’s nothing new about it. The currency wars started in 2010 as described in my 2011 book, Currency Wars. 

As soon as one country devalues, its trading partners devalue in retaliation and nothing is gained. It’s been described as a “race to the bottom.” Currency wars produce no winners, just continual devaluation until they are followed by trade wars.

That’s exactly what has happened in the global economy over the past 10 years. But the final step in the sequence is often shooting wars. That’s what happened leading up to WWII. Let’s hope the currency wars and trade wars don’t turn into shooting wars as they did in the 1930s.

Meanwhile, the Fed is a critical player in the currency war because it has a major influence on the dollar.

The world is waiting to see what it does at its policy meeting on July 31. There is almost no chance the Fed will raise rates. The choices are to cut rates or keep rates unchanged. The market is betting heavily on a rate cut, for what it’s worth.

If the Fed cuts rates, we’ll have to see how other central banks react. But the Fed has many factors to consider when it meets later this month…

For the past 10 years, Fed policy changes have been relatively straightforward to forecast, based on a simple model. The model said the Fed would raise rates consistently in 0.25% increments until rates are normalized around 4% (the amount needed to cut in case of recession).

The exceptions (where the Fed would “pause” on rate hikes) would occur when job creation is low or negative, markets are disorderly or strong disinflation threatens to turn to deflation. Markets certainly became disordered late last year, when the U.S. stock market nearly entered a bear market. And so the Fed paused.

None of those conditions apply today. Job creation is strong, markets are at all-time highs and disinflation is mild. But a new factor has entered the model, which is the fear of causing a recession.

Estimated growth for the second quarter of 2019 is 1.3% annualized, compared with 3.1% in the first quarter. Using the Fed’s own models (which are different from mine), the Fed is concerned that if they don’t cut rates, a market correction and recession may occur.

But if they do cut rates, inflation may result due to tight labor markets and higher costs due to tariffs.

This Fed decision will likely come down to the wire. Second-quarter GDP will be reported on July 26, and personal income and outlays will be reported on July 30. Both data points (and underlying inflation data) will be available right before the July 31 decision date.

Markets will cheer a rate cut and probably sell off if the Fed does not cut rates. But both the markets and the Fed itself will have to wait until the last possible minute before this conundrum is resolved.

And the world will be watching very closely.

Below, I show you how Fed policy is one of three factors driving a new multiyear rally in gold. What are the other two? Read on.

Regards,

Jim Rickards
for The Daily Reckoning

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The Myth of Compounding Interest

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Editor’s note: It’s one of the oldest rules of saving and investing: the wonders of compound interest. But can you rely upon it to build wealth? Today eccentric former hedge fund manager gives you his surprising answer.

Dear Reader,

Albert Einstein supposedly said, “The eighth wonder of the world is compound interest.”

The idea is that if you put some money in the bank and let it sit there or invest it wisely, it will somehow “compound” into millions of dollars by the time you need it. At first take, it does sound somewhat wondrous.

This quote has been the underpinning of many books, shows, marketing campaigns and myths about personal finance for years. Too bad it’s total nonsense — and a myth that’s cost people millions of dollars.

First off, Einstein never said it. In 1983 The New York Times claimed that he did, but nowhere else before that (and he died in 1955) is there evidence he said it.

However, Johnny Carson said something about compound interest on The Tonight Show in the early ’80s that is very real and very true. He said, “Scientists have developed a powerful new weapon that destroys people but leaves buildings standing — it’s called the 17% interest rate.”

In other words, saving money is all fine and good. But when inflation hits and financial meltdowns happen and you’re in debt, chances are your money hasn’t compounded enough to help you when you most need the money.

Right now, in July 2019, the average interest rate being paid on “high-yield” savings accounts in the United States is nothing. (And don’t even talk to me about savings accounts at your typical bank.)

Worst of all, even the miniscule yields are often quoted in terms of annual percentage yield, which takes compounding over the course of the year into account, meaning the true interest rate paid is even less.

There are stories about some janitor who dies and it turns out he had $90 million saved up because he invested in Exxon in 1950 and he reinvested the dividends, etc. Maybe one or two of those stories are true, but that is not the norm.

Those anecdotes are mostly just used in commercials by people who want to capture your fees to build their own businesses, not because they’re inherently true.

First off, inflation is always going to rise faster than the value of money left in a savings account. There’s rarely been a period when that didn’t happen (the Great Depression and early 2009 are the only examples I can think of).

Second, nobody can merely reinvest his or her way to wealth, not even Warren Buffett. Warren Buffett is a legendary investor and has plenty of success to show for it, but the initial part of his wealth came from the fees he charged on his hedge fund and the money people put into his insurance companies. Then he invested those funds and kept 100% of the profits.

It wasn’t just reinvestment that pushed him into the realm of the billionaires.

So compounding, by itself, will never make you rich. The argument for saving money is that it then begins to work for you. But there are much better ways for your money to work for you than compound interest, which is the fool’s gold found at the end of a rainbow. You can chase after it but you’ll never find it.

Smart, value-driven investing is one part of the answer, and for the clearest example of this just look at Warren Buffett again.

He may not have compounded/reinvested his way to great wealth, but his value investing style has certainly helped him maintain and grow this wealth over time.

Buffett’s investment rules are famous. Rule 1: Never lose money. Rule 2: Never forget Rule 1.

This means that, as an investor, Buffett first finds out how much he might lose on a stake in a worst-case scenario, and once he’s satisfied with that, he looks at the potential upside. He’s obsessed with playing defense, not offense, because he knows that losses are far more common in the market than gains.

Paul Tudor Jones, another billionaire investor, is the same way. He’s more of a short-term trader than Buffett (and me), but has said time and again in interviews that as an investor, he is focused almost entirely on not losing money. On playing defense.

Not only does focusing on the risk involved in market moves help with capital preservation, but it frees up these investors to make smarter and sometimes bolder moves with their money. To reach for bigger returns when they know that they’re operating on solid ground.

And that’s something that everyday investors can learn from as well.

Regards,

James Altucher

for The Daily Reckoning

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A “License to Buy Everything”

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Bloomberg captures the mood on Wall Street:

“Traders Take Fed Message as License to Buy Everything.”

Jerome Powell had his telegraph out yesterday… and wired a message of approaching rate cuts.

Federal funds futures give the odds of a July rate cut at 100%.

They further indicate three are likely by January.

And like sugar-mad 8-year olds amok in a candy store… traders are out for everything in sight.

Yesterday they drove the S&P past 3,000 for the first time. And today, freshly inspired, they sent the Dow Jones running to virgin heights.

The index crossed 27,000 this morning — timidly and briefly at first.

Comments by the president sent it temporarily slipping.

China is “letting us down,” Mr. Trump informed us.

Evidently China has not purchased satisfactory amounts of American agriculture — as it had agreed to at last month’s G20 summit.

And so the trade war menaces once again.

But the Dow Jones recalled Mr. Powell’s communique, rediscovered its gusto… and lit out for 27,000 once again.

It ended the day at 27,088.

Is Dow 30,000 Next?

We next await rabid and delirious shouts for Dow 28,000… 29,000… 30,000!

And who can say they will be wrong?

Dow 27,000 sounded plenty handsome not far back.

Yet here on July 11, Anno Domini 2019…  Dow 27,000 it is.

Don’t fight the Fed, runs an old market saw. It has proven capital advice…

The Fed does not box fairly.

It strikes beneath the belt. It bites in the clinches. It punches after the bell has rung.

Those unfortunates battling the Fed lo these many years have absorbed vast and hellful pummelings.

Justice may have been with them. But the judges were not.

“The Bears Have Been Damnably, Comedically, Infamously… Wrong”

With the displeasure of quoting ourself…

The frustrating thing about bears is that they make so much sense.

They heave forth every reason why stocks must collapse — all sound as a nut, all solid as oak.

Chapter, verse, letter, they’ll explain how the stock market is a classic bubble…

And how it has been inflated to preposterous dimensions by cheap credit.

P/E ratios haven’t been so high since the eve of the Crash of ’29, they’ll insist.

Market volatility has returned — and history shows trouble is ahead, they’ll warn.

Or that today’s sub-4% unemployment is a level historically attained only at peaks of business cycles.

And that recession invariably follows.

Et cetera, et cetera. Et cetera, et cetera.

But despite their watertight logic and all the angels and saints…

The bears have been damnably, comedically, infamously… wrong.

Since 2009, the Dow Jones has continually thumbed a mocking nose at them.

First at 10,000, then 15,000, at 20,000… then 25,000. 

Each point supposedly marked high tide — and each time the water rose.

It now rises to 27,000.

But is there some hidden pipe that could suddenly rupture, some unappreciated vulnerability that could send the Dow Jones careening?

Perhaps there is. But what?

The Dow’s Problem Child

Put aside the general hazards of trade war for now.

And turn your attention to Boeing…

Boeing has made the news in recent months — as you possibly have heard.

But its battering may continue yet. Explains famous money man Bill Blain:

Boeing has just announced its H1 [first half] deliveries in 2019 are down 54%. It has only delivered 90 new aircraft this year. Yet it is producing 42 new B-737 MAX’s each month and is having to store them on airport parking lots! It isn’t getting paid for these aircraft, but it still has supply chain commitments to meet. Boeing is hemorrhaging cash to build an aircraft no one can fly…

Boeing is trying to rush deliveries of other aircraft types to buyers to make up for the B-737 MAX cash slack. But there have been problems with B-787 Dreamliners built at its state-of-the-art Charleston factory “shoddy production and weak oversight” said The New York Times. At least one airline is said to be refusing to accept aircraft built outside Seattle. The U.S. Air Force stopped deliveries of new KC-46 tankers for a while when they found engineers had left hammers and other tools in wing and control spaces — a clear indication of “safety standards gotten too lax” said Defense News… This has massive implications for Boeing.

It may have massive implications for the stock market as well.

The Dow Jones is a price-weighted index.

Its components are weighted according to their stock price — not market capitalization or other factors.

And Boeing is the largest individual component on the Dow Jones. It presently enjoys an 11.6% weighting.

When Boeing goes up, the index often goes with it. When Boeing goes down, the index often goes with it also.

“The Likely Trigger for a Market Shock Will Be a ‘No-see-em’”

The bullet that fetches you is the bullet you don’t detect… as legend puts it.

And according to Blain,“The likely trigger for a market shock will be a ‘no-see-em.’”

He believes Boeing could be the “no-see-em” that knocks market flat:

I am concerned the market is underestimating just how bad things could go for Boeing, and when it does, the whole equity market will knee-jerk aggressively, triggering pain across all stocks… The crunch might be coming.

But perhaps Mr. Blain is chasing a phantom menace, a false bugaboo.

Scarcely a day passes that a fresh crisis-in-waiting does not invade our awareness.

Yet they all blow on by… “harmless as the murmur of brook and wind.”

We cannot argue Boeing will be different.

Hell to Pay

Perhaps we should raise a cheer today for Dow 27,000.

Yet the Lord above did not bless us with a believing or trusting nature.

Instead, we take our leaf from Mencken:

When we smell flowers… we look around for a coffin.

And as we have argued previously:

All things good must end, including bull markets — especially bull markets.

One day, however distant, there will be hell to pay.

And it won’t be the bears doing the paying…

Regards,

Brian Maher
Managing editor, The Daily Reckoning

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Jerome Powell Caves

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Jerome Powell chummed the seawater this morning. And the voracious sharks rose to the bait… 

In written testimony to Congress, Mr. Powell informed us that:

Crosscurrents have reemerged. Many FOMC participants saw that the case for a somewhat more accommodative monetary policy had strengthened. Since [the Fed meeting in June], based on incoming data and other developments, it appears that uncertainties around trade tensions and concerns about the strength of the global economy continue to weigh on the U.S. economic outlook… Growth indicators from around the world have disappointed on net, raising concerns that weakness in the global economy will continue to affect the U.S. economy.

What is more… he re-babbled his oath that the Federal Reserve would “act as appropriate to sustain the expansion.” 

Translated into good hard English: Expect a rate cut later this month.

Affirms Bloomberg Federal Reserve-ologist Steve Matthews: 

“Powell didn’t say so explicitly, but it’s hard to read this other than he thinks a cut in July would be appropriate.”

Powell’s dispatch, adds Peter Boockvar of Bleakley Advisory Group…

“…fully endorsed the July rate cut and did absolutely nothing to pull the markets back from that expectation.” 

The stock market was up and away on the news…

The S&P Tops 3,000 For The First Time In History 

For the first occasion in its 62 years… the S&P poked its head above the 3,000 mark this morning.

The Nasdaq registered a fresh record of its own. And the Dow Jones bounded nearly 200 points.

But the opening frenzy squandered much of the day’s energy… and the averages gradually lost their steam.

The Dow Jones ended the day up 75 points, at 26,859. 

After catching its first glimpse of 3,000, the S&P dipped back down to 2,992. The Nasdaq, meantime, closed the day with a 61- point gain. 

And so it goes…

100% Chance Of A July Rate Cut

Federal funds futures — incidentally — now give 100% odds of a rate cut later this month.

But what about the rest of the year… and next year? To what inky depths will the Federal Reserve lower rates?

Perhaps even lower than markets expect — if you take history as your teacher.

Markets presently expect Mr. Powell and his goons to cut rates 75 basis points by January.

Seventy-five basis points imply three rate cuts (a typical rate cut — or hike — is 25 basis points).

Three rate cuts by year’s end are plenty heady.

But according to Michael Lebowitz of Real Investment Advice, history argues even stronger drink is in prospect…

Markets Underestimate How Far Rates Could Sink

If the Federal Reserve undertakes a hike cycle, he maintains, it often elevates rates higher than markets project.

And when the Federal Reserve begins cutting rates… it hatchets them even lower than markets expect.

Lebowitz:

Looking at the 2004–06 rate hike cycle… the market consistently underestimated the pace of fed funds rate increases…

During the 2007–09 rate cut cycle, the market consistently thought fed funds rates would be higher than what truly prevailed…

The market has underestimated the Fed’s intent to raise and lower rates every single time they changed the course of monetary policy meaningfully.

Lebowitz says markets have underestimated rate cut intensity for the previous three cycles.

And Mr. Powell currently has his hatchet out.

In conclusion:

If the Fed initiates rate cuts and if the data… prove prescient, then current estimates for a fed funds rate of 1.50 –1.75% in the spring of 2020 may be well above what we ultimately see. 

And here Lebowitz seizes us by the shoulders… and gives us a good hard shaking:

Taking it a step further, it is not far-fetched to think that that fed funds rate could be back at the zero-bound or even negative at some point sooner than anyone can fathom today.

Who could? Fathom it, that is.

Just last year the monetary authorities gloated about “globally synchronized growth” and their march back to “normalcy.” 

Now they are preparing to about-face… and go scurrying back to zero? 

Who can take these gentlemen and ladies seriously?

The Fed Can Never Normalize Interest Rates

Here is our guess: Once they turn around, they will never come back. 

The Federal Reserve cannot return to normal. 

Returning to normal would knock the economy flat. And the stock market would come down in a thundering heap.

Only low interest rates keep it all vertical.

But as we have noted repeatedly… watch out for the next rate cut.

The past three recessions each commenced within three months of the first rate cut that ended a hiking cycle.

We find no reason to believe “this time will be different.”

The next rate cut — likely this month — starts the clock ticking.

We could be wrong of course. 

The inscrutable gods keep their own schedule. Who knows how long the show might run?

Out of Ammunition

But come the inevitable recession…

The Federal Reserve will have very little ammunition to hurl against it.

And the closer it gets to zero, the less ammunition it will hold.

History says it requires interest rates of at least 4% to wage a successful battle.

Rates are presently between 2.25% and 2.50%.

They are about to sink lower. Perhaps drastically lower. 

That is, the Federal Reserve is badly outgunned as it presently stands.

If the economy somehow pegs along until rates are zero — or near zero — the Federal Reserve would be on its knees… defenseless.

It will have another desperate go at quantitative easing. But multiple rounds did little (nothing) to raise the economy last time.

Why would it work next time?

The Next Crackpot Cure

That is why we expect the next anti-recession cure — disaster, that is — will not be monetary.

It will be fiscal.

The cries will go out…

“QE for Wall Street did nothing for the economy. The time for QE for Main Street has come.” 

The authorities will take to their helicopters, hover over Main… and begin shoveling money out the side.

The throngs below will haul it all in. They will proceed to go spreeing through the stores. The resulting delirium will give the economy a wild jolt.

That is the theory… as far as it runs.

It in part explains the loudening shouts for Modern Monetary Theory (MMT).  

Its drummers claim it can invigorate the wilting American economy.

They further claim it can fund ambitious social programs — all without raids upon the taxpayer.

And if interest rates are shackled down, without blasting the deficit.

The printing press will supply the money.

But as we have argued prior, MMT is the eternal quest for the free lunch… water into wine… something for nothing.

And that world has no existence.

MMT would likely yield a gorgeous inflation. But the economic growth it promises… would be a promise broken.

It will join the broken promise of monetary policy…

Regards,

Brian Maher
Managing editor, The Daily Reckoning

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