Peter Dag & Friends: October 2012

10/30/12

Observations

A few days ago I received the following eight Haiku 3-line poems from a close relative and dear friend. What is this? I asked myself, as I was concentrating on the market, interest rates, and selecting asset classes. What is the Fed up to?

Wait a minute. Stop. Read. Are you forgetting something? What is happening to you? Where are you going? Don’t you remember why you liked reading about Zen, Taoism, and Buddhism?

Rainbows are just
To look at,
Not to understand.

The night is descending,
The birds are silent,
I think of my life that flows.

Suddenly a butterfly.
I breathe the fragranced air
Of my youth.

The evening haze.
Thinking of past things
How far they are.

A life is gone.
The dewdrop
Has returned to the ocean.

A dewdrop has returned to the ocean.
Soon it will be a cloud
And rain over my garden.

In the evening of a spring day
The trees are shining.
How serene we are.

The winds that blow.
Ask them, which leaf on the tree
Will be next to go.

I found a quiet place. I read and re-read the short eight poems. Slowly I began to understand and see new things. New places. New meanings. The Tao? I remembered the spirit of Zen meditation. You will never know unless you get there. Why don’t you try?

(This Observations appeared in the 1/24/05 issue of The Peter Dag Portfolio ).

George Dagnino, PhD Editor,
The Peter Dag Portfolio.
Since 1977
2009 Market Timer of the Year by Timer Digest
Portfolio manager

Disclaimer.The content on this site is provided as general information only and should not be taken as investment advice nor is it a recommendation to buy or sell any financial instrument. Actions you undertake as a consequence of any analysis, opinion or advertisement on this site are your sole responsibility.

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10/28/12

A superb website to track hurricane Sandy

Just click here.

10/26/12

THE BUSINESS CYCLE: INTRODUCTION

In Chapter One we discussed the concept of risk and the importance of protecting your portfolio from losses. Managing your investment risk should be the primary objective of your strategy. Looking at games of strategy like poker, investors can learn how to develop an investment strategy centered on flexibility and sensible risk-taking. As poker players plan their bets, depending on the odds of winning, the investor has to change the amount invested in each asset depending on the odds the investor has to make money in that particular investment.

One of the main objectives of this book is to show that prices of most assets are driven by changes in economic conditions. As the economy moves from a period of fast growth to slower growth, assets prices change to reflect the evolving economic conditions. Understanding how and why prices change is the main step in developing an investment strategy leading to risk management.

In Chapter Two, we began the process of understanding the forces acting in the economy and how these forces are related to each other. Economic indicators were introduced and sub-divided into categories. This subdivision did not have any specific purpose except to make it simpler to explain and introduce these indicators. They were categorized into consumer-related indicators, manufacturing indicators, construction indicators, inflation indicators, and finally, measures related to productivity and profitability. We purposefully did not discuss indicators related to interest rates and the stock market because they will be discussed in much detail in the following chapters.

In Chapter Three we showed how these indicators are related to each other in a cause and effect type of chain reaction. This was achieved by discussing some examples of business cycles. One of the objectives was to show how the process of feedback develops in the phase of acceleration of the business cycle and how forces leading to a slowdown eventually develop to bring growth back to its long-term average.

But the mosaic is still not complete. In this chapter we will attempt to put the pieces together and show how all indicators impact the growth of the business cycle and how the financial markets react to changes in economic growth. In the following chapters we will discuss how to develop investment strategies that take advantage of economic changes.

But first, we have to introduce the concept of leading, coincident, and lagging indicators. Their introduction greatly simplifies the understanding of cyclical forces and makes it easier to understand what is happening in the economy. In the late summer of 1937, then Secretary of the Treasury, Henry Morgenthau, Jr., asked the National Bureau of Economic Research (NBER), an organization devoted to studies in business cycles and other economic problems, to compile a list of strategic indicators that would best indicate when the recession would end.

Wesley C. Mitchell, then NBER's Director of Research, enlisted the help of Arthur F. Burns who later headed the NBER and then became Chairman of the Federal Reserve. The report presented to the Secretary discussed a list of the most reliable indicators of business expansions, explained how they were selected, and included a record of their past performance. This report was published in May 1938. The first set of leading, coincident, and lagging indicators was born.

In the summer of 1938, the indicators were put to their first test. The recovery began in June, and the first signs of their appearance were registered by the leading indicators identified by Mitchell and Burns.

Many new theories relating to various aspects of business activity became available and new findings about cyclical upturns and downturns were published. The original list of indicators was revised several times.

At present, The Conference Board maintains and updates monthly the latest data concerning the leading, coincident, and lagging indicators and is made available free through the Internet by The Conference Board. Most industrialized countries have copied the system developed by the United States because it is one of the most sophisticated and timely ways of collecting information to develop economic and monetary policies.

Additionally, the advantage of looking at composite indices is that instead of examining the behavior of hundreds of indicators, a composite index summarizes their action. The analyses of just three indicators provides the analyst with a fairly good idea of what is happening in the economy. However, a better understanding of what is happening is derived by examining the detailed action of the components.

(From Chapter 4 of my book Profiting in Bull or Bear Markets. Published also in Mandarin and on sale in China. The book is available at Amazon.com).

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The history of Europe in a nutshell

A country grows and generates wealth for its citizens.
Wealth gradually concentrates in the hands of fewer and fewer people.
The country grows more slowly.
Income inequality increases.
Unemployment rises.
Discontent and protests become a daily affair.
Things get out of control.
The country collapses economically and politically without a needed rudder.
The country accepts dictatorship as the only viable option.
The dictatorhip eventually collapses.

Back to square one.

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10/25/12

Question

The monetary base is declinng since June. This development has happened very rarely in our history. Is the Fed too tight? Why?

The monetary base should be growing (roughly) at the same pace as the economy.

DEFINITION OF MONETARY BASE - The total amount of a currency that is either circulated in the hands of the public or in the commercial bank deposits held in the central bank's reserves. This measure of the money supply typically only includes the most liquid currencies.

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The exception to the rule

Yesterday was a very exceptional day for the markets. Why?

Everything declined - stocks, commodities, high-grade and low-grade bonds.

Very strange. It looked like investors were eager to raise cash. Let's hope it does not mean bad news. A black swan?

One thing is sure - the number of advances is plunging since September.

The good news is that bonds are holdng up better than stocks.

Fascinating environment. You cannot sit on your hands. This is the time I recall a Taoist say - when in doubt act.

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10/23/12

The inimitable Mr. Farage

Market patterns

It looks like an ugly day. But the patterns remain the same.

*** Stocks weak.
*** Commodities weak.
*** Agriculturals weak.
*** Gold weak.
*** Bonds firm.

I like to believe that gold, agriculturals, and all other commodities behave exactly in the same way. And their near-term trend depends on the strength or weakness of the business cycle. The long-term trend is a function of real interest rates.

Another pattern that seems consistent is that bonds act much better than the market when stocks are weak.

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RELATIONSHIPS BETWEEN ECONOMIC INDICATORS: CONCLUSIONS

In this chapter we examined the interaction between various indicators. In the next chapter we will try to put all these different cycles under one process and see how growth and changes in business cycles take place.

As we have discussed in the previous example, it will become clear that the main driver of a business cycle is the financial cycle. The financial cycle represents the pattern of growth in monetary aggregates or money supply, which is controlled by the Central Bank. An increase or decrease in the money supply creates ripple effects through business activity and prices of assets for years to come.

We have seen that in 1992 through 1994 the Federal Reserve eased aggressively, because of problems that the economy had with real estate and savings and loans. Although we will discuss this in more detail, the Fed kept interest rates artificially lower than what the market would have set these rates. The outcome was a sharp increase in credit, a powerful stimulus for business to borrow and to invest.

The business cycle eventually started in full force and employment, income, and sales grew more rapidly, inventory-to-sales ratio declined to reflect strong growth, the unemployment rate declined to reflect more favorable hiring conditions, and the process fed on itself. However, in 1994 as the economy grew very strongly, eventually it had an effect on prices (the price of money, the price of labor, and the price of raw materials).

In 1994, therefore, the economy experienced sharply rising interest rates, and commodity prices, and some upward pressure in labor costs. Because of the strong sales, earnings per share grew very rapidly. However, the strong growth of the economy created the seeds for the following slowdown. This is the phenomenon of negative feedback. As costs of running a business increased - specifically interest rates, labor, and raw materials - business slowed down its investment activities and hiring. It also started to cut inventories and production. The outcome was slower economic activity in 1995 and lower earnings per share. The slowdown in the economy and the decline in the costs of running a business were the seeds for the next acceleration in the business cycle.

In Chapter 5, we will discuss the analysis of long-term trends and how the U.S. economy went from low inflation in the 1950s to high inflation in the 1970s to low inflation again in the 1980s and 1990s. This analysis will provide important information on the essential features that characterize the volatility of business cycles and its relationship with inflation and monetary policy.

(From Chapter 3 of my book Profiting in Bull or Bear Markets. Published also in Mandarin and on sale in China. The book is available at Amazon.com).

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10/20/12

Market seasonality

• The first half of the year is the most profitable one.
• The period June-September is likely to show little or no profit.
• The gains from September to December are not a sure thing, but the downside risk is minimal. In other words, it pays to be aggressive.
• The first few months of the year set the tone for the whole year. If the market is not in positive territory by May-June, the odds favor a losing year.
• The comparison of the current year to that of previous years provides useful information on the future risk/reward of the market.

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10/19/12

Stock prices and copper

I am fascinated by the relaionship between copper and the stock market. I also find trading volume to be a valuable tool. Let me explain.

The above chart shows what I mean (click on the chart to enlarge it). Strong volume following a sharp decline suggests a bottom is close.

A parabolic price rise accompanied by soaring volume spells lower prices ahead.

What is the relantionship between copper and stocks? Stocks bottomesd in June following a stable copper price. Stocks began trading in a range after the spike in copper.

What is copper saying about the future of the market?

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Macro thoughts

Those of you who follow my writings know that at least since 9/11 I have been saying that poverty and slow economic growth is found in countries where political and economic power is highly concentrated. Italy, a country I am very familiar with, comes to mind. India? Middle East? Soviet Union? Russia?

There is no way to escape this truth. It is a well proven fact. I just started reading “Why Nations Fail”. The book covers with great detail the historical evidence.

Slow economy means high dependency on government help, thus reinforcing the reach of the people in power. A new form of slavery.

Fascinating book.

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Thought od the day...as the market sinks

Commodities soared from June to September. The have gone nowhere since then. Now they are sinking. Including gold. Are they telling us the economy is not so strong after all?

Stocks ...same story. Strong move from June to September. Now they are sinking.

Bonds? They have strengthened. A great hedge if the market heads lower.

Time to place your bets.

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10/16/12

This is the bottom line

From The Telegraph .....Swiss rating agency I-CV stripped Germany of its AAA rating last month. “Germany has taken on contingent liabilities of €2 trillion. When you create these backstops, the money comes from somewhere and it can all go wrong,” said I-CV’s Rene Hermann.

The southern European countries owe a lot of money for the imports from Germany financed by borrowing at low interest rates. Now Germany wants to be paid. This is the bottom line.

A must-read article

These are some thoughts you may find interesting. We did. To read the complete study just click here.

****..... the Fed expects the U.S. togain any economic traction from higher stock priceswhen rising commodity prices are curtailing realincome and spending is puzzling. This is particularlyrelevant when econometricians have estimated thatfor every dollar of gained real income, consumptionwill rise by about 70 cents.

**** When the Fed actions lead to higher food and fuel prices,the shock wave reverberates around the world, withmany foreign economies being hit adversely.

**** Economic fundamentals will notimprove until the extreme over-indebtedness of theU.S. economy is addressed, and this is in the realmof scal, not monetary policy.

**** Until the excessive debt issues are addressed, the multi-year trend in ination, and thus the long Treasury bond yields will remain downward.

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Earnings and stock prices

10/15/12

The inimitable Mr. Farage

10/14/12

Technical patterns

Heavy volume after a protracted decline in prices is a reliable signal the decline is almost over and a bottom is near. In other words ...it signals capitulation. There are no more sellers and the asset has moved from weak hands to strong hands.

On the other hand, heavy volume following a sharp and parabolic rise in prices is a sign of distribution. In other words ... the asset has moved from strong hands to weak hands.

In May 2011 gold experienced the same patterns - parabolic rise and heavy volume. Gold peaked. Copper is acting in the same way since mid-September (clisk on the chart to enlarge it). Heavy volume as copper spiked - and copper has been going nowhere since then.

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Observations

How did I do last year [2004]? My forecasts in the 1-12-04 issue had several themes.

I was correct in anticipating a strong economy because of the need of the manufacturing sector to replenish inventories. Sales were rising rapidly. I also suggested that the economy would slow down again because of “the ominous trends in the dollar and monetary aggregates”. The slowdown did actually take place and we are in the midst of it (see below).

I was correct in suggesting that low real short-term interest rates and a strong economy would result in “sending commodity prices and gold to new highs”. I also wrote that “they are an important investment theme”.

I expected bond yields and inflation to stay “close to current levels”. These forecasts, quite correct in retrospect, allowed me to develop an investment strategy that proved to be very attractive for our clients. Recognizing that credit spreads were still high, I focused on an investment strategy based on commodity driven stocks (various types of energy and real estate) with a considerably high yield. It worked.

This strategy, and a constructive outlook for the market, produced an above average return for our equity clients, a return well above the market (as of early December).

I was right and wrong in saying that “this ideal investment climate will unravel in March-April”. We had a sharp correction in the market in March-May, but our “high dividend paying stocks” kept rising at a nice clip as I anticipated.

I have too much experience to gloat based on what I said and did.

(This Observations appeared in the 12/20/04 issue of The Peter Dag Portfolio ).

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10/11/12

RELATIONSHIPS BETWEEN ECONOMIC INDICATORS: PRODUCTIVITY AND PROFIT CYCLES

In order to examine the behavior of productivity and profits during a typical business cycle (Fig. 3-5), let’s start as usual with the fact that inventories are low and business decides to increase production to replenish inventories. In order to increase production, business needs to borrow money to buy raw materials, to pay wages as employment increases and to invest in new processes.

As production increases, the demand for money also rises, raw material prices move up, and as employment grows, the unemployment rate declines and eventually wages start to increase faster.

Furthermore, as production increases, capacity utilization also increases. At first, business puts the most efficient machines and processes into the production line or into the manufacturing of the product. As capacity utilization continues to rise, the less productive machines and processes are utilized. Also, as the unemployment rate declines, the skill level of the residual labor force decreases. For this reason, as the economy strengthens, productivity slows down.

As growth in productivity declines, business is not capable of absorbing the increase in wages, so unit labor costs that were initially stable because of strong productivity growth, start rising. The increase in unit labor costs, in raw material prices, and interest rates have a negative impact on profits that start to decline. Labor costs, raw material prices, and interest rates are in fact the main costs of running a business. The outcome is that as the strong economy places upward pressure on wages, raw materials, and interest rates, corporate profitability is at risk. These increased costs erode the profit margins of a company. The opposite is also true. When these costs decline, the profitability of the company improves as margins increase.

Initially, lower profits are being offset with price increases. This results in higher inflation. Of course, as we have seen in the previous section, rising inflation is followed by lower real income and slower growth in sales. Business, therefore, needs to adjust inventories downward to match the slower demand for their goods.

Also, the reaction of a typical business to declining profits is to cut costs of money, raw materials and labor. The lack of productivity also needs to be solved. Business has to think in terms of what investments have to be made to increase capacity and make the production process more effective. However, this is a long-term strategy.

In the short-term, business has to cut employment to minimize the effect of rising wages, cut raw material purchases and borrowing. However, by decreasing the costs of borrowing, the decision has to be made to delay those investments needs to improve capacity at a later date. Of course, layoffs, a cut in production and raw material purchases, and less demand for money cause a slow down in the economy.

Business will continue to cut until profit margins improve. They will improve when wages slow down quite sharply and raw material prices and interest rates also decline.

This is the time when margins improve. Business, therefore, in spite of a weak economy, recognizes that there are still opportunities in the marketplace and they will soon start rebuilding inventories and making new investments encouraged by the improving profitability, and the cycle of productivity and profit starts all over again.

As the economy becomes very strong, costs (wages, interest rates and raw materials) rise and eventually productivity slows down, due to the fact that business works closer and closer to full capacity. Initially, business tries to pass the increased costs, due to lower productivity, to the consumers. This causes inflation to rise but increasing inflation lowers consumers’ real income. This causes the consumer to spend less and the economy to slow down. This happens at the same time as business tries to cut costs to improve profitability, due to a slow down in profitability and higher unit costs. The new business cycle starts when costs decline due to the slow economy. At this time, profitability improves, due to lower capacity utilization, higher productivity and lower inflation.

1994 offers a great example of the cyclical nature of profitability. Since an investor is worried not only about profits but profits per share, which is the main driver in the price of a stock, we will discuss the example of what happened in 1992 to 1994 to earnings per share of the S&P 500. The main point of the following discussion is that changes in earnings per share of the S&P 500 follow very closely the change in raw material prices. Let’s see why.

The aggressive easing of the Fed caused the economy to expand very rapidly in 1994. The outcome of this growth was strong production, strong employment, strong income, and therefore, strong sales. As sales were increasing more rapidly than costs, profitability improved. As a result, earnings per share greatly improved with other cyclical indicators, such as interest rates and raw material prices. But eventually, the increase in interest rates and raw material prices had a negative impact on earnings per share. Business tried to control costs, and created a slowdown in 1995; as the economy slowed down, commodity prices and interest rates declined. Earnings per also slowed down with overall business conditions.

It is very important to realize this cyclical nature of earnings per share and its close relationship with trends and interest rates and commodities. This relationship is important in assessing the risk of the stock market. We will see that earnings per share is not a good timing indicator to time the overall market, but it is a more appropriate measure for selecting stocks.

(From Chapter 3 of my book Profiting in Bull or Bear Markets. Published also in Mandarin and on sale in China. The book is avalable at Amazon.com).

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10/10/12

Hedging market slumps

It looks like when the market slumps - as we noted many times here - LQD and other bond funds are strong.

It is a safe strategy to hedge lower stocks - buy bonds and do not keep your money in cash during such times.

But remember, this strategy depends on your outlook of the stocks market. It is definetely not a recommendation.

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10/8/12

Technical note

Watch commodities. Commodities have been closely correlated to stocks. They (DBC) have been weak since mid September.

Gold, crude, and copper are weak again. Are bonds going to strengthen further? These trends should be watched closely.

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10/7/12

Observations

It is simply amazing how much nonsense is being said and written about the dollar and the meaning of its demise.

Nonsense No 1. The President and the secretary of the Treasury have been going on record suggesting that the administration supports a strong dollar policy. What does it mean? What are the implications? I am not sure they know what the answers are.

Nonsense No 2. A weak dollar is good for the US because it makes our goods less expensive and more attractive to foreign customers. This is really a good one. I shiver every time I hear it.

Nonsense No. 3. The weak dollar is inflationary. It’s the other way around. It is the inflationary bias of our economy that weakens the dollar. Let’s start from the top.

The dollar/euro peaked at 0.86 in early 2002. At the same time the growth of the money supply topped at a torrid 20% pace, stocks were plunging, and credit spreads imploded from historical levels.

The synchronized peak in all these measures, by the way, is not a coincidence. It signaled the beginning of the cleansing of our system from the financial orgy of the late 1990s facilitated by the Fed. The decline of the dollar is just one expression of this cleansing.

Anyway, the dollar/euro is now at 1.33, a 54% decline. Commodities, meanwhile, soared almost 70%. (Not a coincidence. They rise when the dollar declines). The dollar declines because a) we sell dollars to buy foreign goods; and b) foreign and US investors sell dollars and invest the proceeds in other financially more attractive countries.

Why do we buy foreign goods? Because they are cheaper and more attractive. We sell dollars to buy the renminbis required to buy shoes or wind breakers made in China. We sell dollars to buy yens and euros needed to buy Lexus, Mercedes, and BMW cars.

What are the implications? The reason we buy foreign goods is because the majority of our industries cannot supply them. In other words, the reason we sell dollars to buy foreign goods is because the majority of our industries cannot make better products at a lower price when compared to our trading partners.

Some industries are advanced and they strive. The problem reflected by a declining dollar, however, is that most of our industries are not competitive.

A declining dollar is not going to solve the productivity/competitive problems. The dollar will strengthen again when the majority of our industries re-gains its competitive edge. This is the reason for the weak dollar. A weak dollar does not solve this problem. It is the symptom of the problem.

What does it mean from the consumer viewpoint?

The decline of the dollar signals a momentous loss in the purchasing power of the US consumer. The average Joe/Jane Doe is getting squeezed, and is forced to buy all he/she can at Wal*Mart.

The government keeps reminding us that inflation is close to 3%. But commodities have soared, including gas. And wages are not keeping up with inflation.

You and I know how to hedge the ominous decline of the dollar by buying commodity based stocks. But the average person does not know all this. How much purchasing power did we lose? Wealthy parents pay outrageous fees to send their kids to good schools. How many people can afford this kind of education? In Europe the same type of education is almost free. Our schools are a disaster and are the main cause of our loss of productivity and purchasing power.

The point is that wealthy investors know how to fight this environment. They have the money. The majority of the people is just floating, hoping to land somewhere.

Which brings up another issue, dear to my friend SNS. Income differential is increasing. Social friction is bound to exacerbate. I am wondering if the resurgence of fundamentalism in the US and in the world is not just one aspect of what I am talking about.

Let me recap the main points.

 The dollar is declining because we and foreign investors are selling dollars to buy foreign currencies.

 We are selling dollars because most of our industries have become less competitive in the world markets.

 Our wages and purchasing power are adjusting downward to match the available skill level in the world markets.

 The decline of the dollar is the outcome of this process and is not going to solve the competitive issue.

 The peak of the dollar coincided with the implosion of the late 1990s financial bubble.

 The decline in competitive edge against our trading partners is also mirrored by higher inflation and loss of purchasing power. There is no cause/effect relationship.

 The dollar is not the cause of higher inflation. Higher inflation is the outcome of the loss of competitive edge as reflected also by the inflationary monetary policy followed by the Fed to keep the economy afloat.

 One of the main causes for the loss of competitive edge is the dismal state of our educational system relative to that of our trading partners.

 The outcome is increasing wealth segregation. Only the wealthy are able to maintain their purchasing power (they have money to buy the knowledge needed to survive), squeezing the rest of the population.

(This Observations appeared in the 12/6/04 issue of The Peter Dag Portfolio ).

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10/5/12

Question

If the economy is so strong as indicated by the sharp decline in the unemployment rate to 7.8%, how come commodities have been weak since early September?

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10/4/12

RELATIONSHIPS BETWEEN ECONOMIC INDICATORS: THE INFLATION CYCLE

The most important forces affecting inflation are monetary ones (growth in monetary aggregates and real short-term interest rates) as we will see in detail in Chapters 5 and 6. However, inflation has very distinct cyclical timing (Fig. 3-5).

The purpose of this section is to review how and why the forces of inflation develop, and above all, how they are part of the overall business cycle. The objective is to emphasize the positive feedback of inflation. When inflation declines, real income (income less inflation) increases and provides consumers with extra stimulus to spend. On the other hand, rising inflation sets in motion a negative feedback. Rising inflation decreases real income, and therefore, consumers become more cautious about their spending plans.

Let’s start again with the simple inventory cycle model. Inventories are low, but business recognizes the opportunities for future sales, so they start planning to increase inventories. In order to do that, they have to increase production and employment. But to increase production, they need raw materials.

Since raw materials are very sensitive to changes in demand, as soon as business improves, raw material prices tend to rise because activity eventually becomes very strong and raw material, interest rates, and wages begin to rise. These increased costs are initially absorbed by business, but eventually they are passed to the consumer by raising prices.

As consumer prices increase, consumer confidence declines. The reason is that as inflation increases, income after inflation, that is real income, decreases. The decline in consumer purchasing power has a negative impact on the consumer’s attitude towards the future. As a result, consumers begin to spend less. This has a negative impact on the inventory-to-sales ratio as sales slow down relative to inventory. As a result, the inventory-to-sales ratio starts rising.

Business recognizes that inventories are out of line so they start cutting production. Cutting production implies that they have to cut raw material purchases and employment. Because of this decline in raw material purchases and the decline in employment, raw material prices decline, wages slow down and eventually consumer prices also slow down.

The decline in consumer prices is good news for consumers because now their income after inflation improves. As a result, their outlook for the future becomes more optimistic and they start spending more. Because of the increased sales, the inventory-to-sales ratio declines, production is increased to replenish inventory, and the consumer cycle starts all over again.

As you see from this and the previous cycles, every time the economy expands, something else develops to correct the growth and eventually cause the business cycle to slow down. What is happening is an automatic self-correcting mechanism.

In all the cycles we have discussed, the main point to focus on is that every time the economy expands, it causes developments that will correct its excessive growth (negative feedback) and eventually bring down growth of the business cycle closer to the long-term average pace of the economy, which is close to 2.5-3.0%. The business cycle has delicate and pervasive self-correcting mechanisms to bring back economic and financial conditions close to their long-term patterns. Higher inventory-to-sales, rising inflation, rising short-term and long-term interest rates, and higher unit labor costs are the most important of these forces. It is just a matter of time before they impact the economy in a negative way.

As you can recognize from the previous examples, actions that happen at a certain point in time have a ripple effect in the economy through a cause and effect relationship. For instance, the strong growth in money supply that was induced by the Fed to solve the savings and loans and real estate debacles in 1992 and 1993, caused a strong economy in 1993 and 1994. However, the strong economy in 1993 and 1994 caused raw material prices and interest rates to move higher. Eventually these same trends caused the 1995 slowdown.

This slowdown had a negative impact on employment and on income, and the economy remained soft until 1996. This allowed interest rates and commodity prices to decline again, which caused the economy to strengthen in 1997 and 1998. As you can see, current events caused future disturbances that propagate. In the 1970s these ripple effects were violent because of rising inflation. Following early 1980s, these fluctuations were milder to due to declining and low inflation.

The forces of inflation increase following a period of strong growth in the economy. Depending on monetary conditions, which will be discussed later in Chapter 5 and Chapter 6, inflation could rise very much or remain muted. In the 1970s every time the economy strengthened, inflation rose considerably from 3% to 5% in one cycle to be followed by an inflationary burst from 6% to 8% in the following cycle. The causes of these trends will be discussed in detail later.

Since 1982, these conditions have changed and inflation has remained muted. However, its cyclical timing can still be recognized. For instance, following the strong growth in monetary aggregates from 1992 to 1993, the economy strengthened considerably in 1994 and the outcome of this strength has been rising commodity prices, due to strong production and strong sales. The CRB raw industrial price rose quite sharply through 1994 and this was accompanied by much higher interest rates. So you already see the prices of two basic assets, commodities and money, rise after a period of strong economic growth.

Unit labor costs also had a mild uptick, but very minor. The increase in these prices resulted in an acceleration in the producer price index of crude materials. This increase rippled through the chain, but in a very mild fashion, almost indistinguishable. The outcome was that consumer prices through 1994 and 1995 had a very small increase, but quite muted.

The slowdown that took place in 1995, that was caused by the increase in interest rates and inflationary pressures in 1994 kept commodities from rising further and remained fairly stable through 1995.

(From Chapter 3 of my book Profiting in Bull or Bear Markets. Published also in Mandarin and on sale in China).

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10/3/12

Is gold too precious?

I just looked at the chart of gold. I had a strange reactioon.

I will discuss my views in my website - subscribers only please.

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The problem wtith with austerity programs

The problem with austerity programs is that they hit the masses. They never deal with the enormous subsidies to special interest groups. And we are all guilty because our case is so special that cannot be touched.

The power groups in charge of the country rarely are those who suffer from the austerity. This article shows a classic example of what I mean. Just click here.

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Is the market too high?

The market is at a very interesting juncture. Is the market heading lower? One of the many indicators I follow is the rising blue trendline (click on the chart to enlarge it). As long as the S&P 500 stays above it everything is ok.

How low could stocks go in the near term? My guess is they may fall another 5% to the range identified by the two red dotted lines.

Will the market break the trendline on the downside? One reliable indicator we follow is our proprietary "financial risk" indicator. If this gauge rises the market will definitely suffer a loss.

We will answer these questions in detail when we publish our Market Update for our subscribers next Sunday .

Shouldn't you too subscribe to The Peter Dag Portfolio?

10/1/12

Good points.....

... supported by this chart. Disposable income per capita or GDP per capita have not improved in almost a decade (click on the chart to enlarge it).

Shouldn't you too subscribe to The Peter Dag Portfolio?