“Paper money eventually returns to its intrinsic value – zero.”
Almost 300 years after Voltaire made that statement, Jon Stewart repeated the message. As you can see on the The Daily Show video (see sidebar to the right), his humorous content contains an element of truth.
Interest rates continue to rise despite the Federal Reserve’s effort to keep yields low through the second round of quantitative easing. QE2 was supposed to stimulate the economy by helping push bond prices up and rates down.
As the opposite occurs, this policy is failing in a number of ways.
Gas prices are going up at the pump, mortgage rates are going up to levels that press real estate prices lower, and agricultural commodities as well as food prices are going up. The Fed Chairman wanted to stoke inflation to create nominal growth and he is succeeding with inflation. But, while stock prices have moved higher, the economy remains dormant and employment is stagnant. Most Americans see no benefit from Fed policies and the bond market is getting worried they will backfire badly. If the bond market continues to sell off, the stock market will eventually follow.
Meanwhile, the contempt for savings continues.
Fiscal policy emphasizes consumption as monetary policy penalizes prudent behavior by eliminating any return on savings in bank or money market accounts. Expropriating wealth from savers has done little to help the economy. The express belief that consumers benefit economic activity more than savers has proven to be mistaken. Our policymakers should remember the aphorism “a penny saved is a penny earned.”
Our model:
Misguided Fed policies are being matched by misguided policies from the European Central Bank. As a result, commodities should continue to benefit from weaker currencies. With that trend in mind, we purchased AngloGold Ashanti (AU) in each of the Hedged Equity, International Hedged Equity, and Christian Agape Hedged Equity accounts. This position provides exposure to the rising value of gold since AU holds some of the largest reserves in the gold mining industry.
The security we picked was a recent convertible issue (AU PRA) with an approximate yield of 5.6% at the time of purchase. Mandatory conversion is required within three years. During that time, significant income will contribute to our return and an investment tied to gold will diversify our holdings to protect against higher inflation as well as lower currency values.
We also just completed a sale of SPXU and a purchase of VXX to secure a loss for tax purposes and maintain our hedge against a market correction. Tax efficiency, substantial income, and downside protection are important characteristics of our investment strategies at Swan Asset Management.
The Federal Reserve has acknowledged that it is running monetary policy to promote asset prices rather than a sound currency.
Any effort to manipulate price levels inevitably results in false markets. Namely, securities prices reflect the anticipated effect of Fed intervention and not fundamental values conveying information that leads to sensible capital allocation decisions. It is the Fed, instead of profits and growth, which now drives the stock market. As Randall W. Forsyth stated in a recent Barron’s article, “the fix is in.”
Because of the reserve currency status of the dollar, the Fed has distorted trading markets around the world. Asset prices correlate so closely to the dollar (and, therefore, each other) that we are all currency traders now. According to German Finance Minister, Wolfgang Schauble,
“The American growth model…is stuck in a deep crisis. It doesn’t add up when the Americans accuse the Chinese of currency manipulation and then, with the help of their central bank’s printing presses, artificially lower the value of the dollar. With all due respect, my impression is that the U.S. is helpless. The problem of the U.S. is not a lack of liquidity and the decision by the Fed to add some $600 billion will not solve the problem.”
In other words, the real economy and jobs won’t be stimulated by a cheaper dollar even if global asset prices and inflation are.
Stocks of companies that are asset rich have performed especially well as the dollar has weakened.
Our models
Apache Corp. mandatory convertible preferred shares in our Christian Agape Hedged Equity model, Royal Dutch Shell in our International Hedged Equity model, and Spectra Energy in our Hedged Equity model have all traded up as the purchasing power of the dollar went down. All three investments generate considerable income as well as the upside potential that natural resource and energy stocks currently provide.
As opportunities develop, we will raise cash to be ready to add to our hedge positions. Bond yields have been trending up and may eventually cause stocks to top out. In the near-term, the market should continue to head higher as the Fed begins to implement the second round of quantitative easing through its schedule of Treasury purchases.
The skirmishes in the currency market have escalated into open warfare. According to Brazilian finance minister, Guido Mantega, the “international currency war” has begun. Although the United States Congress complains about China, the Federal Reserve has mounted the most aggressive campaign. By debasing the world’s reserve currency, the Fed has forced other central banks to respond in order to protect their own currencies. Productive growth in the U.S. requires fiscal policies that promote capital formation, regulatory policies that eliminate constraints and free resources for productive use, and sound dollar policies that promote confidence at home and abroad. These growth-oriented policies are not being pursued today.
Markets have responded to liquidity injections from quantitative easing (money printing) and the anticipation of further quantitative easing. Funds have gone into the financial economy rather than the real economy, resulting in higher prices for financial assets but no meaningful economic growth. This illusion of wealth may end at any time when traders stop gaming the Fed by front-running its weekly monetary moves (open market operations to buy Treasuries, flatten the yield curve by lowering longer-term rates, and push new money into the financial markets.) The diminishing returns from this front-running trade, in stocks and bonds, will ultimately lead to a correction in both markets.
We are hedged to protect against a downturn that we believe could be meaningful. Interest rates are artificially low and equity prices reflect earnings growth that will be difficult to achieve in a weakening economy. Our hedged positions will be increased as we judge the front-running trade to have run its course. Current equity holdings are characterized by their more defensively postured, cash generating operations. Sound balance sheets and significant dividend yields further characterize each of the three models we manage. All three yield more than 10-year Treasuries, have inherently more downside protection, and provide the opportunity to grow as well as preserve capital.
Fears of sovereign insolvency, massive devaluation and, ultimately, rampant inflation have led to a “growing” interest in farmland as an investment. We are participating through a derivative farmland play with positions in companies that sell seeds and related products to farmers. Monsanto (MON) has struggled since it lost patent protection on its RoundUp herbicide but still represents an attractively valued holding in our Hedged Equity model. Since good values are often found when profitable businesses stumble, we look for those opportunities. Syngenta (SYT) in International Hedged Equity and DuPont (DD) in Christian Agape Hedged Equity also represent companies well-placed to benefit indirectly from rising crop prices and farmland values.
