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THE LOGIC IN MASS CONFUSION

The sharp decline in bonds and precious metals, coupled with a very strong dollar have left many investors feeling a sense of panic without understanding why. Commodity price declines and stock market corrections have left cash (in U.S. dollars) as the only undisturbed asset class over the last month. Over the last two quarters, however, returns for the U.S. stock market are distinctly positive, but the recent correction has cut the previous five-month results significantly.

While payroll reports are somewhat positive, mortgage rates have moved sharply higher, threatening to impact housing affordability.

Sequestration’s effect has been less than feared while deficit and debt ceiling battles have been deferred. The U.S. macro scene is seemingly quiet…. Slowly, job numbers improve…so what gives?

First of all, investors who have been convinced that Bernanke’s QE1, 2, 3, etc., would lead to a weakened currency with rising inflation, fueled a stream of investments into gold and other commodities. This left us with excess capacity and a “bubble” in these asset classes. Bernanke’s manipulation of interest rates has also precipitated a bull market in bonds (which also wears the signs of a bubble). Recent sharp corrections in these asset classes have already taken much of the air out. The corrections could, in fact, represent a final “bursting,” but we will withhold our opinion of that for a bit.

In a piece entitled Rolling Bubbles – April 2, 2007, I described the “new normal” that we envisioned six years ago:

Financial manias, more commonly called bubbles, are nothing more than a period of excess involving a particular asset class. Most often, bubbles occur as unintended consequences of political decisions, which in turn trigger behavioral responses on the part of investors. It is difficult to know when one is in a bubble because rationalization and rhetoric from advocates serve to distort the truth and perpetuate the bubble. As sound reasoning prevails, markets begin to react and a correction ensues. The magnitude and depth of the correction depends on the size of the bubble. As one Wall Street maven quipped in the middle of a market decline several years ago, “If they ain’t scared yet, they’re either stupid or just don’t know what’s going on!”

Yes, the world is dicey, and yes, our domestic capital structure is risky, and yes, the current politics are frightening. Yet interestingly, I have every confidence about how we at Cadinha & Co. are approaching this new world and our ability to offer you continued safe steerage along with greater profitability in the future. We can see a lot of opportunity in this confusing environment, but must exercise patience and discipline in order to capitalize on that vision.

In another piece entitled The Next Bubble – August 28, 2008, two apparent bubbles were identified that have since suffered severe corrections:

Commodity prices have boomed in bubble-like fashion. Dollar denominated commodities such as oil, construction commodities and agricultural crops have attracted investors and speculators chasing the scarcity thesis, believing that China and India, as maturing viable economic entities, will devour all remaining critical commodities on the planet. This same train of thought has fueled speculation in many foreign stock markets, especially the emerging and less mature ones.

American investors have been told for many years to invest a significant portion of their savings overseas. This theme has been repeated over and over to investment professionals, retail sales forces and the financial media to the point where virtually everyone has followed the same advice. Our weakened currency has helped deliver decent returns to Americans in foreign markets over the last few years. The sheer magnitude of American investment in these markets suggests that foreign stock markets could well represent the next bubble to be concerned about.

If we accept the fact that the financial crisis is indeed a global phenomenon, and that the American version of this problem is being aggressively addressed by government and may well be in a curing phase, it is logical to conclude that America will be first to survive and remain the world’s largest and most liquid market. This conclusion is likely to be manifested through a surprisingly strong dollar.

These quotations are not being reproduced in order to “toot” our own horn, but rather, to make sense out of current market movement and volatility. For the last five years, we have entered and exited all of these markets, while managing to provide our clients a rate of return far exceeding the risk free return of Treasury Bills or overnight bank deposits.

Currently, our work tells us that in a coordinated money printing effort, the central bankers of the free world have brought us to a final point of inflection that promises to be significant. Our client portfolios have recently transitioned to equities and cash (in U.S. dollars) preparing to catch the next wave. While performance may have lagged specific asset targets in recent quarters, we are pleased to have maneuvered safely to this point. Other inflexible investment strategies featuring gold, bonds, and emerging markets have quickly crippled investors. With a big-picture perspective, we like our current position.

Much of the recent decline in markets centers on Fed Chairman Ben Bernanke’s “Taper Speech.” Markets are clearly fearful of a change in Fed policy. Coincidently, overnight interest rates in China jumped from 3% to 14%. At the same time, the Chinese Government was unable to attract lenders for its normal borrowings. We think this quiet China problem had as much to do with the rout in bonds, commodities, gold and equity markets around the world, as did Bernanke’s taper comments. Fortunately, things have since quieted down in China.

The critical question at this point in time is whether the banking industry can pick up any liquidity slack caused by the Fed’s “Taper Policy.” We believe that our banks can provide the necessary liquidity to the system through more lending. Credit can be expanded through the multiplier effect in our private banking system. Government regulations and regulators are the key to allowing this to happen, however, if they persist in tighter banking regulations, we don’t think Federal Reserve “tapering” can work.

Recent proposals advocating for more regulations of bank leveraging is not a good sign. Four years ago, in our piece entitled Inflation or Deflation – June 19, 2009, this issue was discussed:

Economists describe inflation as too much money chasing too few goods. It is true that the Federal Reserve has been printing money and throwing it into the system in an attempt to stem a financial crisis. Many are seeing this monetization as representing the “too much money” piece of the inflation equation. The “too few goods” piece of the equation can be explained by inventory and production cutbacks in response to the recessionary slowdown. But how about the “chasing” factor in the equation? Can we be sure that the sheer printing of money will precipitate higher demand for goods “chasing” these objects of production?

The reality of the current environment is that banks are reluctant to lend. They are fearful of getting “stuck” with another round of bad loans and having to return to bail-out status and more government control.

All in all, it is not a growthy outlook and one that seriously challenges the ability of consumers to “chase” fewer goods.

It is our belief that the American economy is resilient enough and ready to grow in a “handoff” regulation and monetary environment (with the Fed handing off the ball to the private banking sector). In such an environment, the pent-up demand for under owned equities will likely give us a very strong bull market for U.S. stocks. However, failure to coordinate regulation with monetary policy will cause a fumble, likely tipping us into a deflationary spiral featuring “cash as king.”

After all, with the help of recent historic perspective, it’s easy to understand the markets…they are truly reacting in a logical manner. We are simply rolling with the “bubbles,” as they are created through faulty policy. There will likely be more, and rest assured, the budget deficit and debt ceiling issues will return. But for now, the issue of monetary policy brings us to a critical juncture. Stay tuned…

About the Author


Harlan J. Cadinha
Founder, Chairman and Chief Strategist
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