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eNewsletter 5/2/2014

I was recently quoted in MarketWatch, a Wall Street Journal online publication in the article, "Beware these IRA rollover mistakes" by Robert Powell. You can read the article at http://www.marketwatch.com/story/beware-these-ira-rollover-mistakes-2014-01-28?pagenumber=1.

Market Update

Stocks have been overbought for some time now and the recent sharp decline in January may be only the beginning of this massive bubble bursting. People, government officials, and economists alike are simply in denial about how bad things are and there will be an end to this craziness eventually. Year to date stocks have not really done much over all except the bounce around record highs. The trend has clearly shifted from an upward market to sideways. Typically after a run up the market will "consolidate" and level out until it either breaks up or down. This recent change in the trend could just be a pause on the way to more record highs or we could be setting up for a downward change in direction.

We've all been to a social gathering where after a while the first person decides to leave which causes other people to feel comfortable to leave and then shortly thereafter everybody clears out except for the usual stragglers. This is basically a description of "The Minsky Moment" named after Hyman Minsky, an economist who suggested that markets are inherently unstable. This is based on the idea that long periods of speculation tend to lead to crises and the longer the speculation the worse the crisis gets. So we can see markets going up until the first start to leave which is usually the "smart money" which causes others to leave and then we get a "Minsky Moment" like 2008.  If we look at past bubbles of almost any kind, we see two results: first, bubbles always burst, and second they tend to return to about where they started.

The U.S. Government has been putting in $2 Trillion in stimulus annually; $1 Trillion in deficit spending and another $1 Trillion in monetary stimulus (QE). Stimulus has been a huge tailwind in keeping the economy afloat and causing the financial markets to rise to all time highs. These tailwinds will become headwinds at some point when the stimulus is stopped and the deficit spending becomes unsustainable and our debt burden too high. For now it seems that Quantitative Easing has been working but may be showing signs of fizzling out as the stimulus is tapered.

Interest rates have finally began a meaningful rise from a low of 1.38% to over 3% and recently hovering around 2.6%. As the stimulus continues to be tapered, we are likely to see bond rates rise which is not good for long-term, intermediate term, and high-yield bonds. As the FED continues to taper, this means they will purchase few bonds which will likely mean a decline in demand. As the demand declines prices go down and yields go up.

Increasing rates will hurt the housing recovery, large purchases using debt such as cars, consumer spending on credit, etc. Once this happens, expect to see significant economic slowdown. Increasing rates will also make our ability to pay government debt more difficult. Then what does the FED do? Stimulate again to juice the economy again? The problem is the law of diminishing returns which says that the more you have of something (in this case stimulus), the less value we get from it. Think about that first cup of coffee in the morning; it wakes you up but you eventually get tired so you take another cup, but the second cup doesn't have the same effect as the first. I think we are getting closer to a point where it will be evident that the stimulus didn't work long-term and our ability to stimulate more will be hampered and the deleveraging and deflation will commence.

For bond investors this creates some problems. The stock market is risky so the conventional alternative is bonds however rising rates will hurt bonds. A typical intermediate term bond fund has a duration of about 4-5. Duration is a indicator of sensitivity to interest rates. A duration of 5 means that for a 1% increase in rates, you would expect a decline of about 5% in your bond fund. The conventional way to reduce this risk is to shorten your duration by going to shorter term bonds. Unfortunately the yield on short-term bonds is quite low and are still negatively affected by interest rate increases. The real question continues to be what the markets will do when rates start rising again and we see even lower or negative growth with this stimulus.

Recently housing has shown some positive price gains however it appears that almost half are cash sales which implies that it is speculators, investors, and financial institutions are behind these purchases. These positive gains could explain the recent surge in pending home sales last year. It's clear that sales have been going up and inventory has been going down which is typically a healthy sign for housing.

To understand where housing is going we need to look at demand; who is buying versus who is selling. When a person goes into a nursing home or dies, they become a seller by default. Therefore a great way to get an idea of where demand is headed is by looking at the number of buyers vs. dyers. People tend to buy their trade up home in the US around age 42 on average and die at age 79 on average. The projection clearly shows a greater number of dyers than buyers and thus the net demand for housing should begin to decline again starting next year. The decreased demand and increased  supply will push housing prices down. This is not for all housing however and does not apply to all regions. For example, those in the northeast tend to migrate to Florida as they age which could cause a net decline in demand to happen sooner than expected.

People don't buy homes based on prices or interest rates, rather they purchase a home based upon a payment which is determined by both prices and interest rates. With interest rates beginning to rise and if prices stay the same, payments rise thus housing will become less affordable unless median incomes rise substantially which doesn't seem to be likely anytime soon. US real (inflation adjusted) disposable income fell 9% in the past 12 months (as of June 2013). Consumer spending typically drives about 2/3rds of our economy. With disposable income falling, this means less money to spend, especially on discretionary items. Another warning sign. This certainly will not help housing. An increase in supply coupled with increasing interest rates is a recipe for declining prices which we will probably start to see in the not too distant future. In addition, the shadow inventory of homes continues to be the biggest hidden threat to the housing market. If the economy begins weakening again, the institutions that have been holding out for higher prices may finally begin to sell that inventory if prices start declining. Increased borrowing rates should also have negative impacts on car loans as well.

Traditional economists don't seem to understand why we are not seeing inflation despite the massive amount of money being pumped into the economy. The reason is that when an economy is at this stage of the cycle after a credit crisis, people don't borrow as much and banks don't lend as much. This slowdown in the fractional reserve system means less money in the economy which is the offsetting deflationary force to all the money printing.

The average bull market lasts nearly 4 years. If you take out the one extremely long bull market which lasted about 12 years and the shortest from 87. These bull markets are followed by an average 36% decline. The current bull market is over 5 years long. Volatility tends to increase at major long term tops such as 1966 - 1974. The first decline after 1965 saw a 26% decline, the second after 1968 was 37%, and the third after 1972 was about 50%. Take notice of the current secular bear market since 2000 which saw a 51% decline after 2000 and a 58% after 2007. So if the pattern continues and we see a third decline, it could easily be 65% or more.

Warning signs we're near a top:

  1. Margin Debt at $400 Million: Margin debt is approaching the 2007 peak at $430 Million and higher than the $390 million at the peak of the Tech Bubble in 2000. This suggests we are seeing more speculation and leverage in this bubble.
  2. Stock Buybacks close to 87%: Companies are aggressively buying back their own shares using super low interest rates. This has the effect of artificially boosting Earnings Per Share (EPS) because the number of shares outstanding has been reduced. Currently 83% of S&P 500 companies are buying back their own stocks which is getting close to the 87% it was in the 2007 peak.
  3. Corporate Profit as a percentage of GDP is above 11% and is at record levels. Fed stimulus via low interest rates has boosted corporate profits more than any boom in history. At the 2007 peak, corporate profits/GDP were 10%.
  4. P/E Ratios between 24 and 27: Most major stock peaks happen when P/E (Price to earnings) ratios are between 22 and 27 except for the extreme tech bubble when they reached about 45 and the peak in 1929 at 32 and these periods had the advantage of strong demographic trends and accelerating productivity from new technologies which we do not currently have. At the 2007 peak P/E's were 27. We're currently about 24 and moving higher.
  5. Market value of non-financial stocks divided by GDP ratio above 1.3: During major market peaks, this ratio tends to be between 1.0 and 1.5.
  6. 62% Bulls vs. 20% Bears: Many of the people that got scared out of the markets in 2008 have been returning since 2012. When Bulls vs. Bears gets to this level, that tends to suggest peaks although we did reach this level in 2010 before backing off back to about 40% Bulls. As everyday investors continue to pile in, we watch for the "Smart Money" to start exiting and when that happens, watch out!
  7. As January goes, so goes the year: When January is a negative month often that forebodes a negative year. After 5 years of a stimulus led bull market that is long overdue for a correction, this saying may be true this year.
  8. The second year of a 4 year presidential cycle tends to be bad for stocks.

Governments keep borrowing at below market rates to run budget deficits by purchasing their own bonds, companies buy back their own stock with super low interest rates to boost earnings per share, banks take QE stimulus money to boost their reserves in anticipation of the massive losses they expect when the economy turns back down and to speculate in financial securities with 30-50 times leverage causing margin debt for stocks to near and all time high; You tell me, are these signs of a bubble? Looking back I suspect all the "experts" will say we should have seen this coming. 

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Driving Your Taxes Ever Higher

Driving Your Taxes Ever Higher

I really don’t care for Flo. She is that all-too-cheerful lady that wants to sell you a particular brand of car insurance, one that she claims will save you lots of money. She would also like you to know that you have the option to plug a small device into your vehicle. This device monitors your every move for what is called usage-based insurance. If this device shows the company that you are a safe driver, then the insurance company will offer you a discount. Sounds like a good deal, right?

Unfortunately, Flo’s little device has other, less beneficial uses. A similar device, no longer optional, may one day help the government tax you based on how, when and where you drive your vehicle. Even George Orwell would have been shocked by this level of Big Brother-ness.

The Great Recession has led to many structural changes in our economy and how we behave. One of those changes has been in how we drive.

According to a recent study from the University of Michigan, Americans’ driving habits have changed dramatically in recent decades. The average driver travels 1,200 fewer miles per year than he did in 2005. We also use less gasoline per person than we have in nearly 30 years. The decline in miles driven and fuel consumption has meant a serious loss in revenue for local, state and federal governments.

The United States Highway Trust Fund was created in 1956 and is used for the construction and maintenance of the Interstate Highway System. The Trust Fund receives its money from the federal fuel tax. The tax on a gallon of fuel has been raised over the decades and is now over 18 cents per gallon of gasoline.

But the tax is not enough. The Congressional Budget Office estimates that the Trust Fund will be insolvent this year and will continue to be so for the foreseeable future. By 2023, the Trust Fund is expected to have a shortfall of nearly $100 billion.

The current mechanisms for funding transportation services are already failing. With Americans driving less miles and consuming less fuel the situation will only get worse. This means governments must find ways to gather more tax revenue from drivers.

The most straightforward solution is to increase the fuel tax. The problem with this idea is that the tax will be chasing ever-more fuel efficient vehicles that are being driven less. As a result, a tax hike is unlikely to meet funding needs. This is where the number crunchers will start getting creative.

Luckily for them, and unluckily for us, our friend Flo’s usage-based insurance device can be converted to a usage-based tax calculator. Currently, most use-based vehicle taxes operate as a type of sales tax. With more data, governments will be able to tax our vehicle usage in a multitude of different ways that would get around decreasing vehicle usage and increasing fuel efficiency. Heavy commuters might feel the tax pinch on how many miles they drive, whether they drive in cities or what time of day they drive. On the other hand, those with short commutes will not be able to escape taxes on vehicle speed, condition of the roads used, driving in high-volume areas, driving during harsh weather, etc.

By taxing a variety of usage patterns that are independent of miles driven and fuel efficiency, governments can supplement revenue from the fuel tax. The only way to avoid these taxes will be to turn in your keys.

Our change in driving habits is emblematic of how our behavior has shifted since the economic downturn. Traditional funding pathways for government services are falling behind. This means that we can expect our government to look for more creative and intrusive ways of taking our wealth to fund their services.

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Demographics Are in Good Spirits

Demographics Are in Good Spirits

The world seems to be running dry. Vintners are ramping up wine production, trying to keep pace with ever increasing demand. This means the bottles you are buying today could be significantly more expensive in the next couple of years. But before you run out to the store to load up on your favorite vino, take a minute to consider what caused the casks to run dry…and what might lie ahead.

Global wine production has slackened over the last decade as the industry tried to recover from a glut of supply in the mid 2000s. Some farmers, such as in California, turned their soil over to more profitable crops, with almonds and walnuts paying more per acre.

Meanwhile, demand has been growing at a healthy clip. The increase in consumption has come primarily from two nations: China and the United States. China's rapid economic expansion has given millions of consumers the access to the global wine market in a way that was absent just a decade ago.

It is somewhat excusable for the wine industry to have missed the rise in affluence of China's upper and middle class. It far less understood how the industry failed to anticipate the growth of wine consumption in the United States. Since 2000, U.S. wine consumption has doubled on a per capita basis, and the trend was right there for everyone to see.

The reason for America's growing thirst for wine is, unsurprisingly, demographics.

Based on data from the Bureau of Labor Statistics’ Consumer Expenditure Survey, spending on alcoholic beverages hits a secondary peak during a person’s early-to-mid-20s, and then hits a primary peak during a person’s early 50s. One may not think of 20-somethings drinking wine, but data from the Wine Market Counsel confirms that millennials, along with baby boomers make up the core wine-drinking generations. It also turns out that when you divide the U.S. population into five-year age groups the two largest categories in our economy are those aged 20 to 24 and those aged 50 to 54. Is it any mystery that U.S. demand for wine would grow to its current levels?

Demographics are a powerful force on our economy. Companies and industries that understand their consumers will do well. Harley Davidson smartly reorganized its business model, knowing that its prime consumer base was shrinking. The diaper industry is increasing production of adult products to serve aging populations.

On the other hand, those who ignore demographics do so at their own peril. The wine industry may have just missed a huge opportunity to sell their goods to two very large audiences. As millennials and boomers move past their mid-20s and mid-50s, respectively, they will develop a thirst for something else.

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Why Labor Day Matters

For many Americans, Labor Day represents the unofficial end of summer. It’s a day for last trips to the beach, and for firing up our grills to cook some burgers and hot dogs. The holiday represents a break between the craziness of summer and the beginning of fall, when we all take work seriously again. For whatever reason, we need a day off to make the switch.

But Labor Day wasn’t always just a day off at the end of summer. In the late 19thcentury, organized labor was gaining strength across the country. Unhappy with wages and working conditions, they staged protests and strikes that would often end in violence. As a way of easing tensions, local governments and a handful of states passed laws to recognize what unions were calling "labor day." In 1894, President Grover Cleveland signed the law that made Labor Day a national holiday as a way to honor the American worker.

Over the years, our workforce landscape has changed, and with it, the meaning of Labor Day. Just over 11% of workers are members of organized labor, roughly half the level of 20 years ago. Most of us are so detached from organized labor, and the origins of the national holiday, that we simply enjoy having the day off work.

Now, as our workforce changes, this is a three-day weekend that fewer of us are able to enjoy.

Chances are that if someone got a new job in 2013 he won’t be celebrating a day off on September 2. With part-time workers making up 77% of new hires in 2013, it’s just another Monday on the job. 

These jobs typically don’t provide paid leave for holidays, like Labor Day. In fact, many retailers have sales promotions to draw in customers that may have the day off. Big-box retailers and department stores will be scheduling extra workers to meet anticipated demand.

This shift to more part-time work is indicative of greater changes to our labor force. It means workers have to accept lower levels of take-home pay than they’re accustomed to. So they’ll have less to contribute to payroll and income taxes. And they’ll have less money left over to grow the economy with their discretionary spending. 

People drive our economy. Personal consumption expenditures account for nearly 70% of the nation’s gross domestic product, by far the biggest share of its components.

We follow predictable spending patterns, which are largely dictated by our age and stage of life. Even so, there are limits. We can only spend what we have and borrow as much as our income allows.

With more and more people having to settle for part-time work and lower pay, consumers will choose the necessities over the luxuries. They will also delay making the big life purchases of a home or a new car. These workers will have less money to save and invest in the stock market.

It may sound bleak, but it isn't. By spotting the movements in the labor market, we can anticipate how it affects the broader economy. We can look out over the horizon to spot the risks and target the opportunities in the market. This puts us in a stronger position to maintain and grow your savings and investments.

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“Bye-Bye Minivans”

"It may be an exaggeration to say the minivan is dead,” writes Philip LeBeau for CNBC (March 22, 2013), "but make no mistake, it has been dispatched to the land of niche vehicles.”

Stop and think about that for a minute. When was the last time you saw a minivan on the road? You probably drove past one today (yes, I am assuming you passed the low-horsepower kiddiemobile), but they are a lot less common than they used to be. Back in the 1990s, it seemed that everyone drove one. Today, they are comparatively rare.

In 2000, Americans bought 1.4 million minivans, which made up 8% of all auto sales. But by 2012, that number had fallen by nearly two thirds, to just 500,000, and today just 3% of all auto sales are minivans.

What happened? Did American children stop playing soccer?

No, not quite. The answer is changing American demographics.

The peak of the post-World-War-II baby boom was in 1961. By the time we reached the 1990s, those baby boomers were 30-something parents with rug rats to cart around. And by the early 2000s, those baby boomers had hit 40.

Where are those baby boomers today? They are now in their 50s, and things like pizza parties and baseball practice are distant memories. Their children—the echo boomers or Generation Y—have long since moved out of the house and some already have kids of their own. The minivan was a vehicle created for baby boomer parents, and its rise and fall corresponded to their family formation cycle.

So, now that Gen Y is approaching the same stage of their lives, might the minivan be due for a comeback?

Don’t count on it. No one thinks their parents’ tastes are chic. The baby boomers rejected the wood-paneled station wagons that their own parents drove, and their children will reject minivans. A young woman might proudly take her children to soccer practice, but that doesn’t mean she wants to be called a "soccer mom.”

What will they drive instead? This remains to be seen, but you can bet that Ford, General Motors and the rest of the major automakers are asking themselves the same question.

Interestingly, the luxury auto brands are taking a different approach. For decades, Americans have had a "bigger is better” approach to luxury cars, with perhaps the highest profile example being the Cadillac Escalade — for all intents and purposes a luxury monster truck. In an attempt to impress higher-income and environmentally-conscious Gen Y drivers (and to appeal to their smaller budgets), Mercedes-Benz, BMW and several other high-end European brands are rolling out smaller luxury cars. These might also appeal to empty-nester baby boomers who have grown accustomed to a smooth ride but no longer need a car big enough for a mafia don.

We are still a few years away from the long awaited Generation Y baby boom; the largest cohort of this generation is just now finishing their education and entering the workforce. Due to a bad economy and due to Americans’ propensity to have children later in life, we don’t expect them to start settling down until the beginning of next decade.

But make no mistake: this is the single most important trend you are likely to see for the rest of your life. The boom of the 1980s, 1990s, and early-to-mid 2000s was a result of the baby boomers settling down and raising families. The 2020s may not enjoy a boom quite as large as, say, the 1990s. But if history is any guide, it will be a decade in which fortunes are made. And we’ll see it coming ahead of time.



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The Fate of the Twinkie

Perhaps no other product has captured the attention of Americans in recent months than the humble Twinkie, whose parent company is in the final stages of its bankruptcy proceedings.  If you are like me, you probably haven’t eaten one in years.  But there is something about the little yellow cake that is iconic and…well…American!

So, the bankruptcy of Hostess Brands late last year felt like a strong kick to the gut for many of us. The immediate cause of the bankruptcy was a labor dispute with the bakers’ union.  But Hostess’ problems ran much deeper and point to a much larger trend in the U.S. economy.

When was the last time you bought a Twinkie?

I ask not to belittle the brand but to make a point.  The poor Twinkie is a victim of changing demographics.

The Baby Boomers bought Twinkies by the millions for their children, the Echo Boomers.  The Echo Boomers were the second-largest generation in history (after the Baby Boomers themselves), so satisfying their sweet tooth was a profitable endeavor. 

Unfortunately for Hostess, the Echo Boomers grew up.  Most are out of college now, and many have started families of their own.  And as a generation, they—along with the smaller Generation X—are a little more health conscience as parents.  They are more likely to throw a banana into their child’s lunch box than a Twinkie.

Of course, Twinkies are not the only iconic brand that has been on the wrong side of a demographic trend.  Consider Harley-Davidson. 

Imagine the "typical” Harley rider: a white male in his 40s or 50s.  When the Baby Boomers entered this key age range two decades ago, it created the biggest boom in the company’s history.  But nothing lasts forever, unfortunately.  Those same Boomers who once bought Harleys are more likely to buy an RV today.  Generation X is not large enough to make much of a difference, and the Echo Boomers are still a few decades away from their motorcycle-riding mid-life crisis. 

As investors, it’s easy to get distracted by the headlines and by the fast pace of news that hits us every day.  But the truth is that the forces that ultimately matter most to a company’s health—and to the health of the entire economy—are slow moving and very predictable.  An understanding of demographic trends would have helped you foresee the difficult times for both Hostess and Harley-Davidson.  And they can also help you predict the next boom.

I expect a new baby boom at the beginning of the next decade that will be very profitable for those investors willing and able to get in front of it.  And that is exactly what I intend to do.

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Debt Detox

Some analysts/economists opine that government spending cuts will tip the economy back into recession. I couldn't agree more but not for the same reason. Without the massive stimulus, our economy would have tipped back into recession over a year ago and while it would have been due to spending cuts, those spending cuts would not have been government spending cuts rather consumer spending cuts. This is the trend going forward, make no mistake, that consumer will be spending less because the largest generation, the Baby Boomers, have reached their peak in spending and are now finally beginning to focus on saving for retirement and paying down debt.

This is a natural process when children begin to leave the nest. You just don't need to buy as much stuff as you did before and the stuff you do buy tends to be more cash as opposed to leveraged purchases using credit. Think about the products and services we tend to buy and don't buy at different ages and stages of life. It is common sense that what we want and what we buy changes over time. When we're young we spend a lot of money on clothing yet as we get older, keeping up with fashions tends to be less important especially as we enter retirement. When we're young our medical expenses are lower and as we age, medical expenses get more expensive. When we're in our early 30's and beginning to start a family we need a house. As the family grows, we may need a bigger house which is why the people tend to buy their trade up home on average around age 37-42. Just the same when the kids leave the nest, we don't need that big home anymore and opt to downsize in favor of a home that is more management and lower cost to maintain. There are many examples, just look at the people you know, friends and family that are at various stages of their life to see what their financial priorities are.

If you look at various studies on how prepared Americans are for retirement you would be surprised. According to the Retirement Confidence Survey by the Employee Benefits Research Institute, 56% of workers have less than 25,000 saved for retirement. According to the U.S. Federal Reserve's Survey of Consumer Finance from 2007 which is that latest available, the median value of financial assets held by Americans age 45 to 54 was about $42,000. Americans ages 55 to 64 aren't much better off at $85,700. No wonder that when the kids finally leave the nest, we focus on saving for retirement because we are way behind!

It is this very cycle that causes aggregate consumer spending to decline when generations peak on a 46-50 lag. The Baby Boomer generation peaked in their spending around 2007 and we are finally beginning to feel the effects of the slow moving demographic shift. What the Government via The Fed is attempting to do is to get Baby Boomers to spend more and borrow more and guess what? It just doesn't work. These people don't want to spend and borrow more and the generations behind them (Gen-X, Echo Boomers) are not large enough to replace them just yet; that will happen in about 10-13 years. No amount of stimulus is going to get people to spend and we've seen the results so clearly in a slowing economy despite the largest stimulus we've seen.

Debt is like a drug for our economy; it makes you feel good at first but then you need to take more and more just to get the same high and eventually if you take too much it kills you. This is where we are at as an economy; we need to get off the debt drug. In order to do so we will have to go through debt detox. Detox is painful and unpleasant however once clean of the drug; we can re-emerge stronger and able to grow again. So, will cuts in government spending tip us into recession? I think the answer is yes, but we're going there anyways so why not go there with less debt burden, get this thing over with already so we can detox and move on to more prosperous times.

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