Peter Dag & Friends: 2013

12/23/13

A great table by Carter Worth

This table shows the percentage total returns for each year. I found interesting to see what kind of returns you can expect the next year when the current year had a return of 20%-30%. (Click on the chart to enlarge it).

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.

STRATEGIC INVESTING FOR UNCERTAIN TIMES.
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12/19/13

Technical analysis and investment strategies

The historical spread between the S&P 500 high and the 125-day moving average is about 5%-6% (click on the chart to enlarge it).

Right now the spread is close to 5%. Does this mean the market is going to decline and touch (or go below) the moving average?

Possibly. Another alternative is for the market to continue rising and maintaining the 5% spread with the moving average.

One thing is sure, however. Eventually the S&P 500 and the moving average will have to touch.

Pick your strategy. PS. The market outlook of our service is not necessarily that provided by this indicator.

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12/16/13

Is this a bull market?

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12/10/13

Inflation and your investments: Commodities and the business cycle

The price action of commodities such as copper, natural rubber, aluminum, and steel provides very useful information to investors. Commodities are very sensitive to demand. Since demand for commodities depends on how strong the economy is, they provide very timely information on the direction of the business cycle. Their importance comes from their price sensitivity to demand. As demand increases because of stronger business conditions, commodities provide immediate, unbiased information to the investor on what is happening in the economy. If commodities decline, they tell the investor that the economy is not as strong as it used to be. Their action, therefore, provides an objective measure on how the markets are responding to economic conditions. The importance of commodities is that they provide prompt feedback to the investor on what is happening to the economy. It is an objective and unbiased measure as reflected by the markets.

Economic indicators assembled by the government are available with at least one-month lag after the facts. They come in too late. Commodities are available every day and are not subject to revision. For this reason every financial newspaper around the world has many, many pages devoted to the price of commodities. They provide the sophisticated businessman and investor crucial input to make important decisions based on their understanding of the behavior of commodity prices. Trends in commodity prices such as copper, aluminum, natural rubber, crude oil, gold, silver, palladium, platinum and steel give the investor important clues on what is happening in the economy. The CRB commodity indices are also very useful in assessing trends in business conditions because they represent the action of a basket of most commonly used commodities. The rise in price of these commodities suggests the economy is strengthening considerably. On the other hand, their weakness suggests business is slowing down in a visible way.

Another important feature of commodities is that they all tend to move in the same direction. It is very unusual to see one commodity strong and all the other commodities weak. Eventually, the commodity that has risen too fast will decline and display a rate of growth similar to the rate of growth of other commodities. For instance, in the 1999-2000 period, although crude oil soared from $10 to about $32, gold prices remained stable around $300 while other commodities displayed small changes. This was a sign that commodity price increases were not wide spread. Commodities are a lagging indicator but they do not lag changes in economic growth by much. As such, the increase in commodity prices is a sign the economy is strengthening. A weakening or slowdown in the growth of commodity prices signals the economy is slowing down.

Another important element is that commodity prices rise only when the economy is strong, but we saw that the economy is strong only when the Fed has eased aggressively and real interest rates are low. If real interest rates are high it is very unusual to see firm commodity prices for an extended period of time. The odds are that commodity prices will either stay stable or decline when real interest rates are high.

In the 1970s all commodity prices rose due to easy monetary policy: strong growth in money supply, and low real short-term interest rates. Commodities are more volatile than producer or consumer prices. As a result, their change provides clues on the future direction of inflation. If commodity prices accelerate across the board, this is a signal that inflation will eventually start rising. Sharply rising commodity prices are the outcome of too much growth in the money supply, low real short-term interest rates, and a strong economy. This is the perfect combination of ingredients driving up inflation in a major way. If the economy slows down and commodities decline or slow down, this is a signal that the forces of inflation are subsiding. This is particularly so if the slowdown in the economy and in commodities has been preceded by a slowdown in the growth of the money supply and by high real short-term interest rates.

(From Chapter 7 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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12/3/13

Chart of the day

We are following closely this proprietary indicator because it gives an early warning sign for the market. The market is close to a pause when this gauge is rising. The ideal time to own stocks is when this gauge is declining. (Click on the chart to enlarge it). PS. The market outlook of our service is not necessarily that provided by this indicator.

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11/30/13

A bullish indicator

This proprietary intermediate-term indicator (several month between signals) will signal the market is going to pause when it stops rising. Until then...enjoy! (Click on the chart to enlarge it)

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11/24/13

Are we in a bull or bear market?

This video shows you the indicators we follow to establish the main trend of the market. Click on the thumbnail to review the video.

Are stocks in a bull market? Are they in a bear market? The indicators reviewed in this short video help us answering these important questions. (Click on the thumbnail to review the video).

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11/22/13

Inflation and your investments: inflation and the business cycle.

Inflation is mainly a monetary phenomenon. This means that inflation is caused mainly by the action and the policies of the central bank. The action of the Fed is crucial in determining the growth of the money supply and the level and trend of interest rates relative to inflation - that is, real interest rates (Fig. 5-2).

Sometimes an international or domestic crisis, like the savings and loans and real estate debacle in the early 1990s, forces the Fed to ease and provide liquidity to cushion the crisis. The careful investor recognizes what is happening if he can observe a sharp increase in the growth of the money supply, accompanied by lower real interest rates. Such conditions happened seven times since 1960, most recently in 1984, in 1989, and in 1995. In all these instances the money supply accelerated from growth levels below 3% to close to 15% as short-term interest rates gradually declined.

It is not unusual under circumstances of crisis that the level of real short-term rates falls at or below the level of inflation. When this happens, it should be interpreted as a sign that the Fed has decided to solve the crisis using an easy monetary policy. A similar situation happened in 1997 during the financial crisis in Asia. The Fed at that time aggressively eased by increasing the growth of the money supply and lowering real short-term interest rates. Those were the years when Thailand, South Korea, Malaysia, and Indonesia attracted capital to their countries by offering cheap labor and guaranteeing fixed exchange rates to the dollar. By doing so, they were eliminating the foreign exchange risk from the hands of foreign investors. The problem was created by the fact that the capital that entered the country was not used to improve the overall conditions of the economies, but was squandered in unproductive projects. Eventually, loans could not be repaid and a financial crisis occurred. Currencies had to be sharply devalued, creating huge losses for the original investors, mainly banks. Because of these crises, the Federal Reserve was compelled to stabilize the international banking system by allowing the money supply to grow more rapidly.

There are times when the economic cycle slows down and the Fed is forced to increase liquidity to raise the growth of the money supply to more normal levels. The ideal growth of the money supply in a non-inflationary environment is close to 5-6%. A protracted period when the growth of the money supply is below this range is likely to cause the economy to grow too slowly and the unemployment rate to rise. On the other hand, a protracted period of growth in the money supply well above 5-6% is likely to stimulate too much economic growth and place pressure on productive resources, creating pronounced inflationary risks. The strong growth in the money supply is an important signal that the business cycle will soon turn around, and economic conditions will improve. Inflationary pressures increase when the growth of the money supply rises to around 10%, the economy is growing at well above potential and real short-term interest rates are low or below their historical average of about 1.4.

In the second half of the 1990s the U.S. experienced high growth in the money supply and robust economic growth with low inflation. The main reason was the high level of real short-term interest rates. High real short-term interest rates above 1.4 suggests the real cost of money was high and provided discipline in the way it was spent or invested. However, the strong growth in the money supply and the strong economy that took place late in the 1990s suggested that inflationary pressures were strong, thus creating a high-risk environment for the financial markets. Because of rising inflationary forces, interest rates moved higher, causing lower growth in the demand for money as business postponed new investments due to higher interest rates. Lower demand for money slows down the expansion of the money supply, which has a negative impact on stock prices. The point is that inflationary pressures eventually have a negative impact on monetary aggregates and stock prices.

In chapter two we examined two measures of inflation - the growth in consumer prices and the growth in producer prices. Consumer prices measure the increase in prices at the consumer level, while producer prices measure changes in prices at the producer level. The cyclical timing of consumer and producer prices is that of a lagging indicator. The difference between producer and consumer prices is that producer prices are more volatile than consumer prices, meaning that they rise faster and decline faster. The main reason producer prices are more volatile than consumer prices is that their change is affected mainly by changes in commodity prices. They are more sensitive than, say, changes in medical costs, changes in housing costs, which are included in consumer prices. But the cyclical turning points of the two inflationary measures are the same. This means that when the economy is too strong and there are inflationary pressures, one should see growth in consumer prices rise, accompanied by higher growth in producer prices. When growth of consumer prices declines, one also should see a decline in the growth of producer prices.

Producer prices do not add additional information to the inflation process. They only confirm that inflation is on the way up or on the way down. It is important to recognize that all the goods at the consumer level and at the producer level - from foods to apparel to medical services - tend to accelerate and decelerate together. Their growth rate may be different, but the cyclical timing is that of the lagging indicators.

Let's see how the process of inflation evolves during a typical business cycle. The risk of inflation arises when the economy is growing very rapidly or real interest rates are low. A strong economy is characterized by intense use of resources and strong demand for money. For instance, during such times it’s quite typical to experience a sharply declining unemployment rate. The reduction of available skilled labor places upward pressure on wages, which tend to grow faster. In these cases, GDP is found to grow well above 2 ½ - 3%.

Declining or low unemployment rates suggest the labor market is becoming tight. Under these conditions wages rise faster. Initially, business can absorb these increases in wages by increasing productivity. However, this can be achieved as long as new capacity can be added and skilled labor is plentiful. But when capacity is close to being fully utilized and labor is difficult to find, productivity begins to slow down. This development places upward pressure on unit labor cost - that is, wages adjusted by productivity.

Another development caused by a strong economy is the increase in demand for raw materials. They are the first prices to rise as an economy grows more rapidly (Fig. 7-1). The increase in these prices can be initially absorbed through process efficiency. The third factor that has an important impact on inflation when the economy is strong is the demand for money. Short-term interest rates are very sensitive to credit demands as raw materials are sensitive to production requirement demands (Fig. 7-2).

Major turning points in commodity prices reflect changes in economic conditions caused by fluctuations in the growth of monetary aggregates. p>The cyclical turning points in commodity and short-term interest rates coincide. The amplitude of the move depends on the level of real short-term interest rates which has preceded them. However, there is a point when increases in raw material costs impact the profitability of businesses. The process can be better visualized by using the logical model tying together leading, coincident and lagging indicators. By using the growth of the money supply as a leading indicator, the growth of the economy as a coincident indicator, and commodities and the change in the producer and consumer prices as lagging indicators, the relationship between these forces can be summarized as follows.

• A peak in the growth of the money supply is followed by
• A peak in the growth of the economy, which is followed by
• A peak in commodities, in the growth of producer and consumer prices, which is followed by
• A trough in the growth of the money supply, which is followed by
• A trough in the growth of the economy, which is followed by
• A trough in commodities, in the growth of producer and consumer prices, which is followed by
• A peak in the growth of the money supply

And the cycle starts all over again.

A strong economy, therefore, causes prices of resources such as labor, raw materials, and money to increase. Initially, business tries to absorb these increases in cost, but eventually profit margins start decreasing. This is the time when corporations need to pass these cost increases on to the consumer. The costs of labor, raw materials, and money represent the cost of running a business, and therefore, their upward trends have a negative impact on profitability.

From the consumers’ viewpoint, rising inflation reduces real income and decreases their purchasing power. Therefore, the reaction of consumers to rising inflation is to decrease the level of spending, causing the economy to slow down.

Because of the negative effect of inflation on profitability, business attempts to cut costs as profitability declines. The implications are a) less borrowing by delaying the implementation of planned projects; b) lower inventories to cut raw material costs; and c) layoff of employees to reduce labor costs.

The outcome of the action of business and consumers is to slow down the economy. This slow down will continue until the causes that initiated it - that is, rising commodities, rising labor costs, and rising interest rates - decline. Only then will lower inflation improve consumers' income and induce them to buy more. On the other hand, lower costs improve business margins, encouraging business to implement those projects that were shelved because of rising costs and lower profitability.

The Federal Reserve has an impact on the inflationary spiral if they keep real short-term interest rates too low and the money supply growing too rapidly for too long. In the typical financial cycle, the growth of the money supply rises from a level below 3% to above 10%, well above the average growth rate of about 6-7%. The fluctuations of the business cycle arise because of the sharp accelerations and decelerations in the money supply. The challenge for the Fed is to keep the growth of the money supply as close as possible to 6-7% and to try to avoid the sharp fluctuations in liquidity which cause the volatility of the business cycle. It is very important for the investor to follow these two parameters of monetary policy to determine what type of inflationary cycle to expect.

(From Chapter 7 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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11/15/13

WHAT HAPPENS DURING A BULL MARKET

IT IS A HISTORICAL FACT THAT BULL MARKETS ARE ACCOMPANIED BY DECLINING OR STABLE SHORT-TERM INTEREST RATES.

THE TIME TO WORRY ABOUT THE END OF THE BULL MARKET IS WHEN SHORT-TERM INTEREST RATES HAVE BEEN RISING FOR A FEW MONTHS. (Click on the chart to enlarge it).

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11/13/13

INFLATION AND YOUR INVESTMENTS - INTRODUCTION

As we expand our analysis of the behavior of economic and financial indicators, it should become increasingly clear that all of these gauges are closely related to each other. They all help to understand how business and financial cycles go through their different stages. It is also helpful if readers remind themselves that all of these indicators discussed belong to one of three categories.

The overwhelming majority of economic and financial indicators are either leading indicators, coincident indicators, or lagging indicators of the business cycle. It is also important to be aware of the relationship between these three groups of indicators. Once one knows what group an indicator belongs to, it is easy to understand and easy to use it as a tool for forecasting and assessing the risks presented by the financial markets.

In the previous chapter we saw that important financial variables, such as growth in the money supply and short-term interest rates, belong to a specific classification. The growth of the money supply is a leading indicator of the business cycle and short-term interest rates are lagging indicators. We also hinted that stock prices, since they reflect the amount of liquidity in the banking system, are also leading indicators of the business cycle. Inflation is a lagging indicator.

You already have a powerful model tying together these crucial variables. This model allows you to tie together the behavior of the economy, the money supply and short-term interest rates. A rise in the growth of the money supply is followed, after one to two years, by a stronger economy. A stronger economy, characterized by business growth rising above its long-term average, is eventually followed by higher short-term interest rates. The reason, as discussed earlier, is that these are times when there is considerable pressure on resources, such as productive capacity, employment and commodities. As a result, strong demand for credit places upward pressure on short-term interest rates.

After a few months of rising short-term interest rates, the growth of the money supply declines due to the increased cost of credit. This development is followed, after about one to two years, by a slowdown in the economy and eventually by lower short-term interest rates. Lower short-term interest rates are followed after a few months, by rising growth in monetary aggregates, and the cycle starts all over again.

These relationships can best be followed by using the concepts relating peaks and troughs of leading, coincident and lagging indicators. Since the growth of the money supply is a leading indicator, the growth of industrial production is a proxy for economic trends, and the level of short-term interest rates is a lagging indicator, the following lead/lag relationships tie these indicators together.

• A trough in the growth of the money supply is followed by
• A trough in the growth of industrial production, which is followed by
• A trough in short-term interest rates, which is followed by
• A peak in the growth of the money supply, which is followed by
• A peak in the growth of industrial production, which is followed by
• A peak in interest rates, which is followed by
• A trough in the growth of the money supply

And the cycle starts all over again.

In this chapter we will examine the process of inflation in more detail than in chapters two and three. We will look at how inflation is related to the business cycle, how and when it becomes a problem, and what are the conditions that will bring it under control again.

Commodities are important indicators of business cycle development. Their behavior can provide unique information. We will explore when one should expect a rise or decline in commodities and how this change in commodity levels is related to the business cycle and to inflation.

Because of the impact wages have on inflation, we will devote a section on their impact on inflation and on the conditions that cause wages to be inflationary. This issue is important because a tight labor market and rising wages are not necessarily inflationary. The level and trend of inflation also plays a major role on the value of the dollar against other currencies. Of course, this is an important subject because changes in the dollar have a major impact on returns of foreign investments.

Finally, in the last section we will recap the main points of the chapter and examine how they should be used to develop an investment strategy.

(From Chapter 7 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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11/11/13

An informative and scary article on Obamacare

To read this very interesting article on who is going to gain and who is going to lose just click here

If the author is correct, the game is all a big power play, There are big gainers and big losers.

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11/10/13

Observations

I was traveling with Richard and Rumpi. Rumpi asked me about Italy and Europe. Being deeply involved in the study of history and philosophy with Ed, I welcomed the question. Quite frankly I was surprised by my answer.

The history of the Western world overwhelms you once you focus on its major trends. The power and impact of the Roman Empire were gradually dismantled over 1400 years. As the Christian era began, dominated by the secular and spiritual power and reach of the Church, Europe fell in what the historians call the Dark Ages.

Europe shrank from the superb heights reached under the Roman leadership. Wars, diseases, and poverty accompanied the lack of great thinkers (except religious ones). It lasted 1400 years, 1400 unbelievable years.

It took that long for England to grow powerful enough to refute to pay tributes to the Church of Rome (thanks also to Wycliffe). It took an unbelievable 1400 years for giants like Erasmus, Luther, Zwingli, and Calvin to urge people to break from the traditional Church constraints and take responsibility of their thoughts and actions.

A momentous wave of events followed (about 200 years). The discovery of America. The circumnavigation of the globe by Magellan. The advance of the Ottoman Turks who destroyed Constantinople, the last remnant of the Roman Empire. The end of Latin as the official European language. The collapse of Genova and Venice caused by the Ottomans’ blockage of the trading routes with Asia.

Trade moving north, to the Atlantic states. The waning of the Italian Renaissance with the financial centers and culture migrating from Florence to Holland and England. Italy sinking again into oblivion. The secular power of the Church greatly reduced. These are magnificent and unbelievably great historical events. We are what we are because of what discoverers, thinkers, leaders, traders dared to do in just 200 years. The world order was never the same again.

Italy gave birth to this new order, but failed to unite, cut in two by the Papal States. For the next 500 years it has been struggling, trying to break the shackles of its past. Rumpi was surprised by the answer. I was too.

(This Observations appeared in the 10-23-2006 issue of The Peter Dag Portfolio ).

STRATEGIC INVESTING FOR UNCERTAIN TIMES.
Learn how to manage your portfolio risk and sleep comfortably. Improve the certainty of returns by taking advantage of business cycle trends. Learn to use simple hedging strategies to minimize the volatility of your portfolio and protect it from downside losses.
You will receive your user id to access 4 FREE issues – and all the previous ones - of The Peter Dag Portfolio. Email your request to info@peterdag.com. New subscribers, please.

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11/8/13

The trend continues

The chart shows government expenditures as a percent of GDP (blue line) and the unemployment rate (red line). (Click on the chart to enlarge it).

This is an interesting relationship. There is no causality, of course. But it makes you think.

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11/7/13

MARKET INDICATOR - AN UPDATE

This chart shows the updated version of a previously published stock market indicator. It looks like the market is still heading lower according to this gauge. (Click on the chart to enlarge it).

This is a near-term indicator. We have developed long-term indicators for the market and several other asset classes. They are regularly reviewed in The Peter Dag Portfolio.

We increase our investments in stocks when these gauges rise and we start selling when the daily and weekly indicators tell us to do so.

More details in The Peter Dag Portfolio. See offer below.

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11/3/13

STOCK MARKET INDICATOR

This is one of the many indicators reviewed each week in The Peter Dag Portfolio. They keep us abreast of market risk and market opportunities. They tell us when it is time to be conservative and when it is time to be more aggressive. We follow what they tell us. (Click on the chart to enlarge it).

Why not see for yourself. See offer below.

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10/21/13

Gold and inflation

This chart may suggest that gold will go nowhere for many years (click on the chart to enlarge it).

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IF HISTORY REPEATS ITSELF.....

The stock market reaches a major top only after a period of several months of rising short-term interest rates (click on the chart to enlarge it).

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10/17/13

Observations

When I am on my boat I go up to the cockpit for a few minutes every night. I enjoy the sound of the water against the hull and looking at other boats at anchor in the creek. Last time I started thinking about my next publication and about John and Judy. John is kind enough to send me challenging articles. I save them because I want to address his concerns. John is a good man. Enough said.

He likes to think about major issues and he is not afraid of addressing the most sensitive ones. For instance, when I tell him that thinkers like K. Armstrong suggest the concept of God is evolving, he discusses the issue with calm. I appreciate his mature response.

John likes the cold weather and his dream is to contemplate the universe from a frozen, snow-covered mountain in Montana. Judy is his delightful, charming, sensitive, and elegant wife with a superb sense of humor. She instead likes warm weather. As I do. We always joke that she should leave John and run away with me to a tropical island.

They live in a college town near Washington. John therefore is easily exposed to speakers with national and global perspectives. A few weeks ago he sent me a paper by Dr. Bakhtiari, a leading authority on the subject, on why the price of oil could go to $100. Or even higher.

I doubt it. This is exactly what people were predicting in the 1970s and oil sagged to $10. When I took a course in technological forecasting a few decades ago, I learned that new technologies, even the most breathtaking ones like the transistor, find their use in industry very slowly due to the cost of switching to new technologies.

As the price of oil keeps rising, new technologies are introduced and become widespread. A typical example is the hybrid car. Years ago it was a concept, now it is an accepted technology. When a technology becomes obsolete (e.g. the propeller), new and revolutionary technologies are found (e.g. jet engines), to go faster and cheaper.

Technological innovation is an unforeseen event for the masses. It is risky to extrapolate prices. New unknown technologies will certainly appear and place a cap on oil.

(This Observations appeared in the 10-23-2006 issue of The Peter Dag Portfolio ).

STRATEGIC INVESTING FOR UNCERTAIN TIMES.
Learn how to manage your portfolio risk and sleep comfortably. Improve the certainty of returns by taking advantage of business cycle trends. Learn to use simple hedging strategies to minimize the volatility of your portfolio and protect it from downside losses.
You will receive your user id to access 4 FREE issues – and all the previous ones - of The Peter Dag Portfolio. Email your request to info@peterdag.com. New subscribers, please.

FOLLOW ME ON TWITTER @GEORGEDAGNINO FOR MY LATEST VIEWS.

10/11/13

The central bank and your investments: Investment Implications

A tightening of monetary policy implies a decrease in liquidity in the system. During such times financial assets tend to perform poorly. Because of the lack of liquidity, business and consumers tend to sell financial assets and use the proceeds to invest in their businesses and to raise cash balances.

On the other hand, when the Federal Reserve is following an easy monetary policy, injecting liquidity in the system, this increased liquidity cannot be used right away by the real economy. It is placed temporarily in the financial markets waiting to be used. This is the main reason why stocks and bonds usually rise during these times of expansion in monetary aggregates.

Monetary policy impacts two main crucial economic variables; the growth of the money supply and the level of real interest rates. It is important to recognize the impact of these two variables on the economy, because as we mentioned in a previous chapter, a strong growth in the money supply causes the economy to expand rapidly, creating a high-risk environment for the stock and bond markets. The reason for this high risk is that a strong growth in the economy is followed by increases in short-term interest rates, and an increase in short-term interest rates has always had a negative impact on stock prices.

It is also true that a strong economy creates great business opportunities, and therefore, business tends to borrow aggressively, thus placing upward pressure on long-term interest rates, thus having a negative impact on bond prices. This is also a time when inflation increases, raising the inflation premium embedded in bond yields. On the other hand, a slow economy creates investment opportunities. As the economy slows below its long-term average growth rate, upward pressure on interest rates declines, thus allowing short-term interest rates to decline and provide a very favorable environment for the stock market. Also, weak economic conditions convince business to borrow less, therefore, creating downward pressure on long-term interest rates. This is also a time when inflationary pressures subside, reducing the inflation pressure embedded in bond yields. This situation typically creates a favorable environment for the stock and bond markets. >p>In order to keep abreast of the trends and position of financial cycles, investors need to follow the money supply, for that matter, all the measures of money: M1, M2, M3 and MZM because their growth tells you what will happen to the economy. If the money supply begins to accelerate, and this is typically favored by the Federal Reserve during a period of slow economic growth, the investor should look for a stronger economy - one to two years into the future. If the money supply grows very rapidly, let’s say close to fifteen percent, the economy should be expected to be very strong. The good news for investors is that stocks will be strong because liquidity is growing rapidly.

However, one should be aware that strong monetary growth is the seed that eventually will bring higher short-term interest rates and a weak stock market usually after two to two and a half years. The money supply is therefore a very crucial leading indicator for investors. Strong growth in the money supply is followed by strong growth in the economy and in industrial production, income, sales and employment which are the typical coincident indicators. Broad measures of money supply should be growing anywhere between 5-7%. Much higher growth rates than 5-7% create the conditions for strong economic activity. If the money supply grows too rapidly for too long, it will cause the lagging indicators: inflation, cost, commodities, and interest rates to rise.

As the price of money increases, it becomes more and more expensive to borrow. An increase in interest rates would gradually discourage businesses from making investments and expand capacity, thus reducing the demand for money. As a result, the money supply slows down. Only substantial weakness in the economy and lower interest rates will encourage businesses to start borrowing again. This is the time that costs (raw material, wages and interest rates) decline, thus improving margins. For this reason, following a decline in interest rates, the money supply starts accelerating again and a new financial cycle is under way.

What we are trying to emphasize here is the important interplay between money supply and interest rates. Their relationship is a typical relationship that exists between leading and lagging indicators. An increase in the growth of the money supply is followed by rising short-term and long-term interest rates after about two years the growth of the economy is rising. An increase in short-term and long-term interest rates is followed by a decline in the growth of money supply. A decline in money supply is followed by a decline in interest rates. The decline in interest rates is followed by more rapid growth in the money supply.

From the investor viewpoint, there cannot be a decline in interest rates without a substantial deceleration in the growth of the money supply. The reason is that a prolonged decline in the money supply is followed by a decline in the growth of the economy. Because of the slow growth in the economy, the demand for money subsides, thus allowing interest rates and commodities such as crude oil to decline (Fig. 6-4). On the other hand, strong acceleration of the money supply will eventually lead to higher interest rates. Strong growth in the money supply is followed by a strong economy, and because of the strong economy, business and consumers increase their borrowing activity, thus placing upward pressure on interest rates.

Interest rates are the fever chart of any economy. The higher they go above 5-6%, the more a country suffers major imbalances and rising inflation. The lower interest rates go below 5-6%, the more pronounced the imbalances become as deflation raises its ugly head.

This process can also be formalized in terms of leading, coincident, and lagging indicators. We have seen that the money supply is a leading indicator. What we call the economy, which is reflected by what happens to employment, production, income, and sales, is a coincident indicator. Interest rates are a lagging indicator. The interaction between these parameters can be visualized as follows:
• A trough in the growth of the money supply is followed by a trough in the growth of the economy.
• The trough in the growth of the economy is followed by rising interest rates.
• Troughs in interest rates are followed by a peak in the growth of the money supply.
• A peak in the growth of the money supply is followed by a peak in the growth of the economy.
• A peak in the growth of the economy is followed by a peak in interest rates.
• Which is almost immediately followed by an increase in the growth of the money supply.
And the cycle starts all over again.

How does the Fed fit in this process? The Fed cannot substantially change the trend in interest rates because they have been determined by how fast the money supply expanded, by the strength of the economy, and borrowing activity. The Fed can have an impact on the growth of the money supply through the level of interest rates relative to inflation. That is the other variable of monetary policy, real interest rates. They are impacted in a profound way by the Federal Reserve, because the Federal Reserve manages the rise in interest rates so that their increase or decrease does not become disruptive for the economy and the financial markets. What is important, crucial to remember for investors, is that the growth of the money supply, the amplitude and length of its cycle that determines business cycle conditions and trends in the financial market.

Real interest rates, as we have seen in a previous chapter, have a fundamental impact on inflation expectation and overall inflation. Changes in real interest rates affect the demand for goods and services because they impact borrowing costs, the availability of bank loans and foreign exchange rates. For this reason, real interest rates are an important tool of monetary policy. While real interest rates represent the difference between short-term interest rates and inflation, nominal interest rates are the level shown without adjustments for inflation.

In 1978, nominal short-term interest rates averaged about 8% and the rate of inflation was 9%. Even though nominal interest rates were high, monetary policy was stimulating demand with negative real short-term interest rates of –1%. Real short-term interest rates were very low. Money, as a result, was very cheap and monetary policy was very easy. That was the main reason inflation soared in those years.

In contrast, in 1998, nominal short-term interest rates were close to 5%. The inflation rate was about 2% and the positive 3% in real short-term interest rates reflected a fairly tight monetary policy. The point is that nominal interest rates don’t provide, per se, a true indication of monetary policy. The nominal funds rate of 8% in 1978 was much more stimulative than the 5% rate in early 1998. The reason is that in 1978 inflation was above 8%, thus making real interest rates very low and very simulative because the price of money in real terms was actually negative. On the other hand, in 1998 when interest rates were 5% and inflation was close to 2%, real interest rates were much higher, in relative terms, than in 1978 with nominal interest rates about twice the level of inflation. Thus, the high level of real interest rates in 1998 was one of the main reasons inflation was low.

A decrease in real interest rates lowers the cost of borrowing and leads to increases in business investments, consumer spending, and household purchases of durable goods, such as autos and new homes. This has inflationary implications because demand for goods and services increase considerably when the cost of money in real terms, that is after inflation, is low. This extra demand is what produces inflationary pressures.

When real interest rates rise at high levels, the reverse is true. The cost of borrowing increases and only those businesses that have projects with a very high return can make the investment, due to the high real cost of borrowing. What is the impact of real interest rates on the economy? Declining real interest rates is a sign money is becoming less expensive, and therefore, consumers and businesses tend to borrow aggressively during such times, causing the economy to grow rapidly, stimulating inflationary forces.

How do real interest rates and money supply impact the financial markets? High real interest rates help to keep inflation under control. This is a long-term determining factor for the stock and bond markets. From a business cycle viewpoint, the money supply has a more immediate impact for investors. When interest rates decline due to slow growth in the economy, credit expands because business and consumers borrow more aggressively due to the lower cost of money. As a result, the money supply grows more rapidly, positively affecting stock prices. An example of this situation occurred in 1995 when the money supply accelerated sharply as interest rates declined. This configuration was followed by strong economic conditions in 1998-2000 accompanied by sharply rising stock prices in the years from 1995 to 1999.

After a protracted period of strong growth in the money supply, the economy strengthens, the demand for money increases, placing upward pressure on interest rates. This is the time when investors have to be more cautious about the outlook of stock prices. When interest rates rise, the demand for money eventually declines and the money supply slows down. The stock market, which reflects trends in liquidity, cannot perform well under conditions of slower growth in the money supply. A good rule of thumb is to expect slow growth in the money supply, and therefore, poor market conditions after approximately two months of rising interest rates.

The investor has to keep in mind that only a slowdown of money supply of one to two years, followed by slower growth in the economy and lower interest rates, creates the conditions for the next bull market. From an investor viewpoint, it is important to be convinced that there is a close relationship between money supply and stock prices. And, since the level and trend of interest rates affect the growth of the money supply, they do have an impact on the stock market. The stock market is affected indirectly by the rise in interest rates, contrary to what is generally believed. It is quite typical for headlines to say interest rates are rising, therefore, the stock market is in a high-risk territory. That is indirectly true. The real impact on stock prices is actually due to the decline in the growth of the money supply, which is caused by the increase in the cost of money, which discourages borrowing, and therefore, reduces the amount of liquidity in the system.

An increase in short-term interest rates is followed by a decline in the growth of the money supply almost immediately and in stock prices after about two months. A decline in stock prices and in the growth of the money supply is followed by a decline in interest rates after about one year after the economy begins to slow down. A decline in short-term interest rates is followed by an increase of the growth of the money supply and in stock prices almost immediately.

These relationships are very important in determining the dynamics of risk, as far as investing in the stock market. In order to formalize this relationship, it is important to recognize that growth in the money supply and stock prices are leading indicators, the economy is a coincident indicator, and interest rates are a lagging indicator. Because of the relationship between leading, coincident and lagging indicators, the following occurs:
• A trough in the growth of the money supply or stock prices is followed by a trough in the economy, which is followed by
• A trough in interest rates, which is followed by
• A trough in interest rates is followed by a peak in the money supply and stock prices, which is followed by
• A peak in the growth in the economy, which is followed by
• A peak in interest rates, which is followed by
• A trough in the money supply and stock prices

The relationship between financial markets and money supply can also be formalized in terms of phases of the financial cycles.

In phase one of a financial cycle:
• Liquidity or growth of the money supply increases.
• The stock market rises.
• The economy is still slowing down.
• Commodities are declining.
• Interest rates are declining.
• Inflation is declining.
• The dollar is strengthening.

In phase two of the financial cycle it is quite common to see:
• Liquidity is increasing.
• The stock market is increasing.
• The growth of the economy is bottoming and then rising.
• Commodities are bottoming and then rising.
• Interest rates are bottoming and then rising.
• Inflation is bottoming and then rising.
• The dollar continues to strengthen.

In phase three of the financial cycle:
• Liquidity begins to decline.
• The stock market declines.
• The economy remains strong.
• Commodities continue to rise.
• Interest rates continue to rise.
• Inflation remains in an upward trend.
• The dollar weakens.

In phase four of the financial cycle it is typical to have the following:
• Liquidity, or growth in the money supply, declines.
• The stock market declines.
• The economy weakens.
• Commodities decline.
• Interest rates decline.
• Inflation declines.
• The dollar continues to weaken.

The decline in interest rates in phase four triggers the series of events which characterizes phase one.

(From Chapter 6 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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10/8/13

This indicator was correct.

The market has been tumbling. This indicator was right. More details in the next issue of The Peter Dag Portfolio.

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10/7/13

Sell in May and go away?

Perfect synchronism. All the major global stock market have performed poorly since May (click on the chart to enlarge it).

All stock market are closely correlated at major turning points.

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10/6/13

The central bank and your investments: Financial Cycles

The amount of money made available by the Fed is the main driver of the economy and the financial markets. Changes in the growth of money create huge waves, lasting about five years, that have a big impact on our lives and on the price of most assets. From mid 1955 to 1995 there have been seven major financial cycles, and each cycle started with the money supply accelerating rapidly from a low level close to 0.3% in a weak economic environment. Growth in monetary aggregates in a typical financial cycle has risen to 10-15%, to decline again to about 0-3%. A complete cycle includes two consecutive troughs and this period of time usually spans about five years.

The stock market performs well during the first half of the financial cycle, when growth in liquidity increases. However, stocks perform poorly in the second half of a financial cycle when liquidity slows down. The stock market closely follows changes in liquidity because its strength or weakness depends on how much money there is in the system. If money grows rapidly, some of it is invested in the economy by business and consumers and some is invested in stocks, and stocks rise. However, when liquidity slows down, stocks decline as investors sell stocks to raise money to be used for other purposes.

The eighth financial cycle began early in 1995 with the growth in MZM close to 0%. The first half of the cycle ended in March 1999 when the growth of most monetary aggregates peaked and MZM was expanding at a rate of about 15%. Most measures of money supply slowed down in 1999 and, not surprisingly, the overall market became much more erratic with a very large number of stocks forming major peaks. Broad market averages, such as the S&P 500, showed no change from March 1999 to March 2000. The stock market does not perform well in the second half of a financial cycle, and the eighth financial cycle since 1955 was no exception. The growth in monetary aggregates, which is a measure of liquidity provided by the Fed to the system, can be used to assess what is happening and what is likely to happen to the business cycle and the financial markets (Fig. 6-3). A financial cycle goes through four distinctive phases.

In phase one of a financial cycle, liquidity accelerates, accompanied by a strong stock market. In the meantime the economy grows slowly, commodities are weak, and short-term and long-term interest rates decline. It is quite typical for the dollar to strengthen during this phase in anticipation of strong economy and lower inflation. In phase two, the economy begins to pick up its pace and grows more rapidly. Commodities and short-term and long-term interest rates bottom. The stock market continues to rise. The dollar remains strong.

In phase three, the growth in monetary aggregates declines while the economy remains strong. Interest rates and commodities keep rising as the dollar sputters. Stocks begin to perform poorly. This is a critical phase for the stock market because it becomes much more selective. Investors should recognize that risk is at the highest level, and their investment strategy should become much more defensive. Short-term interest rates typically rise at least two percentage points (200 basis points) during phase three of a financial cycle.

In phase four, the protracted decline in liquidity and the sharp rise in interest rates which occurred in phase three cause the economy to slow down quite visibly. As the economy begins to grow slowly, interest rates and commodities peak and then decline. By this time the growth in monetary aggregates is very slow, close to 0-3%. The stock market bottoms as the dollar rises. The decline in interest rates stimulates new borrowing and a new phase one is under way again.

The cyclical turning points in short-term interest rates (rates on 13-week Treasury bills) coincide with important turning points in commodities, such as crude oil. They are both dependent on the strength of the economy and by previous expansion on monetary aggregates. This implies a limited lack of control the Fed has on interest rate trends.

Financial cycles are closely related to major crises. The real estate crisis of 1992-93, the Asian crisis in 1997, and the Latin America and Russia crisis in 1998 were all accompanied by aggressive easing by the Federal Reserve and by the strong growth in the money supply. The main reason, of course, is the concern of the Federal Reserve that a financial crisis of major proportions would affect in a negative way the banking system, and as a result, the rest of the country or the global economy. For this reason, it becomes a priority to provide liquidity to the banking system in the U.S. and global banks, in conjunction with central banks of other countries, so that a smooth operation of the economy could be maintained. Because of the strong relationship that exists between growth in the money supply and growth in stock prices, it is not unusual to see financial crises accompanied by a strong stock market. The main reason is that the aggressive injection of liquidity in the banking system spills over in the financial markets, thus placing upward pressure on stock prices. It is exactly what happened in 1992-93, in 1997 and 1998.

(From Chapter 6 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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10/3/13

LACK OF ECONOMIC DATA? THIS IS WHAT YOU SHOULD WATCH.

The economy started slowing down in 2011. Commodities peaked in 2011 and have been going down since then (click on the chart to enlarge it).

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ISM indices

The ISM indices suggest the economy is growing slowly (click on the chart to enlarge it). Services have slowed down quite sharply. Can interest rates and commodities rise with the economy so weak?

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Consumer confidence is weak ... very weak

The main issue with declining consumer confidence is that it brings a weaker economy, slower sales, and downward pressure on profits.

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Market indicator

This market indicator has been suggesting caution in the past several days. This is one of the many technical and fundamental measures we show our subscribers every week.

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10/2/13

Government spending and unemployment rate

Incredible relationship. Does this mean the unemployment rate declines when the government is not in our way and does not spend frivolously our money (click on the chart to enlarge it)? (Note: government spending as % of GDP is the blue line. The unemployment rate is the red line).

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9/29/13

IMF expects slow growth in Asia.

(Click on the chart to enlarge it).

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