Janet Yellen Strangling Future and Current Retirees…

During Janet Yellen’s recent Congressional testimony, she once again indicated she’s looking carefully at the possibility of a negative federal funds rate.

This is important to income investors and retirees who must protect themselves from this very real possibility. It requires an understanding that should rates go negative, investors must find safe alternatives, while avoiding riskier asset classes.

So let’s start with one truly terrible investment group – banks.

That’s right. Banks do very badly in the presence of negative interest rate policy (NIRP) because they remain unable to pass the negative interest rates on to their depositors. Should they even attempt to do so, customer deposits would vanish into mattresses across the U.S.

Unfortunately, this means that their profits will be squeezed to the point of invisibility. The result is that the cost of their funding will exceed what they receive on risk-free assets – making banks very bad investments.

And that’s just one of many reasons why negative interest rates are a dangerous idea.

Such rates would also cause banks to reduce their leverage and cut back on their lending, because the spreads between deposit and lending rates would no longer be sufficient to cover their expenses. Bank layoffs are already ratcheting upwards.

Ironically, by pushing interest rates negative, central banks actually achieve the opposite of their stated goals.

Of course, the world’s central banks, along with various Keynesian hacks, are pushing the idea of getting rid of cash altogether. The thought here is that by banning cash, depositors would be unable to keep their cash out of the hands of banks. In addition, this gives central banks the ability to set rates at any level they deem necessary.

For retirees and other income investors looking to supplement their income, negative rates have devastated older savers. Japan illustrates the idiocy of going negative on rates.

Japan has suffered with zero interest rates longer than any other country and recently went to a negative rate. How has it worked out?

Fourth-quarter GDP was down at 1.7% (annual rate) and January exports were down 12.9% from a year earlier. Clearly, negative rates have failed miserably at spurring economic growth.

What’s more, Japan Post Bank shares are down 18% from their price in November because Japan’s negative interest rates hamper the bank’s business model (its assets are almost all low-risk Japan Government Bonds, which now yield zero for a 10-year maturity).

Now we’re witnessing Japanese investors becoming increasingly annoyed at their government that lured them into supposedly safe investments, while simultaneously decimating valuations with monetary policies that destroy wealth.

But that doesn’t mean there’s no hope for income investors…

Negative short-term interest rates will produce a few winners, such as large dividend stocks and a group of stocks that pays spectacular dividends: residential mortgage real estate investment trusts (REITs).

Residential mortgage REITs fund themselves in the short-term markets and invest in home mortgages guaranteed by Fannie Mae and Freddie Mac. By using leverage, they’re able to turn the 3-4% yields on mortgage bonds into 10-20% returns, most of which are paid out as dividends.

Now, I’ve been fairly pessimistic on the mortgage REIT sector. They remain relatively high-risk investments when interest rates are rising. You see, if interest rates go up, the “gap” between short-term funding costs and long-term bond income disappears, and the value of the REIT’s bond portfolio declines.

This is exactly what happened in 2012-13, when American Capital Agency Corp. (NASDAQ: AGNC) shares lost half of their value in six months.

But with negative interest rates, the opposite happens. The cost of funding, being based in short-term money markets, declines – probably below zero (the REITs can borrow cheaply because they can “repo” their low-risk bond portfolio).

At the same time, the yield on assets stays well above zero. And if mortgage rates, in fact, decline, the value of the portfolio increases, giving the REIT a capital gain. Thus, either net income increases or capital appreciates – a win/win.

The two largest pure home mortgage REITs are AGNC and Annaly Capital Management Inc. (NYSE: NLY).

AGNC, with a market capitalization of $6.1 billion, is trading at 79% of book value and offering a dividend yield of 13.7% based on quarterly dividends of $0.60 per share.

NLY, which has a market capitalization of $9.4 billion and is trading at 83% of book value, offers a dividend yield of 12.3% based on a quarterly dividend of $0.30 per share.

Neither of these companies earns enough to cover their dividends, based on trailing four quarters earnings, because short-term rates have been trending upwards, narrowing spreads and pressuring capital value.

But if Yellen does decide to lower rates below zero, both companies are poised to benefit spectacularly, probably giving you a capital gain as they come to sell above book value.

Still, don’t put too much in them – they remain above average risks.

 

Has Oil Finally Bottomed?

According to a Bloomberg report quoting the International Energy Agency, oil prices have finally bottomed. And if you believe them, it’s time to pile back into oil stocks that have been hard hit over the past couple of years.

Their assumptions are based on crude prices showing relatively solid support just shy of $40 per barrel. The IEA says a combination of events have shored up prices:

  1. Lower than expected Iranian oil output following its re-entry into world markets;
  2. A tentative production “freeze” at current levels between Russia and Saudi Arabia; and
  3. Growing numbers of shale producer bankruptcies, which is forcing lower domestic production.

But investors should remain cautious about trusting pronouncements from “oil experts,” whose accuracy remains questionable. The chart below illustrates five previous calls of a bottom in oil since mid-2014.

chart01

In each case, the call was premature – by a wide margin, too.

So, are the experts are wrong again?

The answer, of course, is nobody knows.

What we can say is that market timing is a fool’s game. Investing success comes from making long-term decisions about a specific investment thesis – not making bets about market tops or bottoms.

We remain bullish on oil companies over the long term. If you have a longer-term perspective, many oil stocks are bargains at current prices. But until the price of oil solidifies, you will want to stick to the major players, like ExxonMobil (NYSE: XOM), Chevron (NYSE: CVX), and ConocoPhillips (NYSE: COP). These businesses are diversified and cash-rich enough to weather additional downturns.

But from a safety point of view, clear evidence of a real bottom in oil prices is required before risks to smaller oil plays are mitigated enough to justify the exposure.

How To Buy Gold Like a Pro…

Gold is 2016’s top-performing asset to date. At current prices, it’s up about 19%, while the S&P 500 has earned a paltry 1.6%.

Gold is the world’s oldest medium of exchange, and unlike currencies, it can’t be created by central banks. In fact, its finite supply is why developed countries abandoned the gold standard last century.

But massive central bank intervention in credit markets over the past decade make it imperative that prudent investors hold some gold in their portfolios to insure against potential currency crises.

That’s why it is recommend to hold between 1-5% of your portfolio in this safe haven.

But as you likely know, buying gold while the value of the dollar rises can be dangerous to your wealth. And we believe the U.S. dollar is going to outperform all other currencies for another year or two.

That’s because America is the only major economy raising interest rates. That makes our currency very attractive to foreign buyers.

But this makes buying gold tricky…

Because the price of gold is quoted in U.S. dollars, as the dollar rises, the price of gold goes down… since it takes more foreign currency to buy the same amount of dollars.

And as gold gets increasingly more expensive to foreign buyers, it can cause gold prices to drop or stagnate. So if the dollar continues rallying, you’re likely to lose money buying gold.

But our fundamental thesis remains intact, investors need to hold some gold in their portfolio as a form of insurance against financial chaos. We just want to do so in a way to avoid losing money.

That’s why we recommend a “pairs trade” as a way to hedge gold purchases. We want to buy gold, while shorting the Japanese Yen – known as a ‘long gold and short Yen trade.

Now, the yen has fallen 17% against the U.S. dollar since 2013. And until the Japanese people wake-up to the failure of “Abenomics,” it will continue to fall.

This is because Japan is an “export economy.”  The country benefits from a weaker yen, which makes its exports cheaper to other countries, like the United States. So Japan will continue to devalue the yen to boost Japanese exports.

And for us, we can take advantage of this trend and use it to protect our gold purchases.

Here’s how…

First, we want to take a long position in gold. But we want physical gold – not the ‘paper gold’ of mutual funds or ETFs. Those are nothing more than IOUs for future gold payments, and in a currency crisis, may not be available for redemption.

Instead, we want to have physical gold. But that poses problems for most investors: finding reputable gold bullion dealers and the subsequent storage of the gold.

Thankfully, there’s an alternative…

Sprott Physical Gold Trust (NYSE Arca: PHYS) provides investors a convenient way to buy physical gold from the convenience of their online brokerage account. Better yet, you don’t have the hassles of worrying about storage, coin premiums, or finding a reputable broker.

It holds all of its assets in physical gold bullion—and stores it securely in a third-party vault in Canada. In other words, Sprott buys physical gold and then stores it in giant safes.

The physical gold is periodically inspected and audited. This means you can be certain it’s actually there (unlike some other gold funds).

And as an investor, you can opt to take delivery of your gold anytime, as long as the amount you want is greater than Sprott’s minimum redemption amount.

You can even buy it and hold it in an IRA—or a Roth IRA. If you hold it in one of these accounts, your capital gains won’t be taxed.

It’s the best way to buy gold and actually own the physical metal. All while protecting your portfolio from the currency wars being waged by the world’s central bankers.

And if you ever decide to sell in a taxable account, you are only taxed at 15% (or whatever your capital gains rate is)—not the higher 28% rate at which most coins and ETFs are taxed.

To execute the second half of this trade, we recommend you buy an “inverse” Japanese fund that goes up in price as the Japanese yen goes down in price. The name of the inverse Japanese currency ETF is called ProShares Ultrashort Japanese Yen ETF (NYSE: YCS).

The fund actually generates about twice the “inverse” return of the Japanese yen against the U.S. dollar. That means if the yen drops by 25% against the dollar, this fund will return approximately 50%.

Based on economic reports originating out of Japan, we believe the fund has the potential to increase another 50% over the next two years as the yen declines by another 20-25%. That gives us a price target of $117.33 (from about $78 today).

So, what’s the takeaway of all this? Well, we get to invest in the safety of gold, without worrying about a stronger dollar. It’s the best of both worlds.

Now, to be properly hedged, you want to own an equal amount of PHYS and YCS. For example if you want to own $5,000 worth of PHYS, but you want to “hedge away” your dollar risk, you would need to buy $5,000 worth of YCS as well.

No matter the amount you want to invest, so long as you own an equal amount of YCS, your currency risk will be fully hedged like a pro.

Best of all, you’re immune to the craziness of central bankers.

Are You a Slacker, too?

I don’t often take other free market economists to task for a lack of intellectual rigor, but that’s exactly my plan today.

You see, it’s tax season and that always brings rumblings about how many Americans actually pay taxes versus the number of freeloaders who are content to let others do the heavy lifting of supporting our fat, stupid, and lazy Uncle Sam.

In a recent article, libertarian economist, Ryan McMaken, takes issue with a Tax Policy Center report indicating that roughly 45% of Americans pay no income tax. McMaken claims the statement is “obviously” untrue.

His evidence for the inaccuracy of the report is his insistence that 73.1% of all Americans pay either an income tax, payroll tax (FICA), or some combination of the two. Unfortunately, McMaken is guilty of missing the trees for the forest.

While it is true that FICA taxes are no different from any other general revenue of the government and are used to fund government operations, it is a mistake to assume that just because a person pays into FICA they are technically taxpayers.

Here’s why…

In the United States, there are two entities: taxpayers and tax consumers. You can’t be both. Either you pay taxes or you don’t. There’s no middle ground.

Now, before we go deep enough to piss off all the country’s slackers, let’s define some economic terms. In economics, we must distinguish between things that are real and things that “appear” to be real.

Real things are called, you guessed it, real – as in “real GDP.” Things that “appear” to be real are called “nominal.” Thus it isn’t uncommon to hear economists talk about the difference in nominal GDP numbers versus real GDP numbers.

What’s the difference?

Real numbers have a real value. For example, when Barack Obama gets word that nominal GDP grew by 3% at some particular time – he gets excited and claims his programs are working great. That is… until an economist wakes him up to the reality that inflation over that same time was 2%. That means the real GDP was just 1% – and even a Harvard Law grad could understand that’s a terrible number.

The same idea works in your investments, too. If you earn a 10% return on an investment and inflation for the year is 3%, your ‘real’ rate of return is actually 7%. Real numbers matter.

Now, in examining taxes, economists do something similar. That is, we distinguish between real taxes and nominal taxes. Real taxes are real revenues paid to the government. Nominal taxes are taxes that appear to be real, but are, in fact, not real.

Let’s take a closer look…

Let’s say you’re an FBI agent making $75,000/year in salary. For this illustration, we’ll ignore the impact of any employee benefits or state income taxes.

Depending on the number of exemptions claimed by the employee, an FBI agent should expect to pay approximately $13,238 in taxes to the federal government. This includes an effective income tax rate of about 10% and another $5,738 in FICA taxes. In McMaken’s eyes, the FBI agent is a bona fide taxpayer.

Only he isn’t…

You see, the FBI agent’s salary actually cost the government nearly $81,000 (including FICA taxes). In return, the government is ‘refunded’ just over $13,000 as a tax over-payment (nominal taxes). This means the FBI agent consumed roughly $68,000 ($81,000 – $13,000 = $68,000) of the nation’s wealth.

Now, because the government received no new revenues from the FBI agent, the agent cannot be considered a taxpayer. In pure economic terms, the FBI agent is equivalent to a freeloader (that should get me some hate mail).

Unfortunately, it’s not just government employees who don’t pay real taxes, either.

Any person in the United States who gets more money from the government than they pay to the government is a tax consumer – not a taxpayer. In short, they contribute nothing to the operation of the government, while often demanding ever-increasing benefits from those actually paying the nation’s bills.

At the end of the day, no nation can long continue whereby half the population lives at the expense of the other half. But don’t expect to see changes anytime soon, regardless of which party is elected in November. Both parties benefit from maintaining the immorality of the status quo, and nothing short of bankruptcy will ever change that.

Not even the hopeful writing of a libertarian economist.

Economic Risks Growing…

Economists use many tools to quantify economic activity. Some are better than others, but all are useful to some degree.

But one of the most useful, yet underutilized, tools is a relatively obscure measure of economic health and vitality called M2 Velocity. M2 Velocity is a ratio of nominal gross domestic product (GDP) to the money supply (M2). Pretty boring, I know, but think of it as the number of times one dollar is used to purchase final goods and services in the economy.

Now, despite this gauge’s superb value in measuring the health of an economy, very few people outside of the field of economics grasp the importance of M2 Velocity. Instead, most pundits prefer to discuss more widely understood economic measurements, such as GDP.

And that’s exactly what happened this morning when the government revised its fourth quarter GDP estimates from 0.7% growth to a 1.0% (both are terrible numbers, by the way). Many pundits breathed a sigh of relief to see some evidence that the U.S. didn’t fall into recession late last year as some economists feared.

But M2 Velocity indicates we’re not out of the woods yet – not by a long shot…

As you will see in the chart below, the velocity of money ebbs and flows like many economic indicators. When the gauge rises, it indicates greater levels of economic activity as a dollar changes hands much more frequently. On the other hand, when the gauge declines, it indicates that fewer goods and services are being purchased with that same dollar.

M2 Velocity

Since 1958, the M2 Velocity has roughly channeled between 1.7 and 1.9. The gauge rose above its historic average in the 1980s and 1990s as the economy experienced healthy expansion rates. On the few occasions that M2 Velocity fell below the bottom of the channel of 1.7, it was a relatively short-lived occurrence.

But even a casual glance at the gauge will tell you there is a problem. The M2 Velocity has been falling for more than a decade and now sits at 1.482, the lowest level ever recorded.

So what does this mean?

A declining velocity of money means people are spending less disposable cash than ever despite a massive expansion in the money supply by the Federal Reserve. More importantly, it’s an indication that the economy is being pulled down by cyclical deflation.

Now, I’m not given to apoplithohorismosphobia (love that word!). For the uninitiated, apoplithohorismosphobia is the fear of falling prices leading to uncontrolled deflation. So, while falling prices isn’t the bogeyman many people think it is, to Keynesian economists, it is to be avoided at all costs.

That’s why the Federal Reserve constantly tries to drive inflation in the economy.

And it’s the reason this graph unsettles the Federal Reserve. After more than 5-years of zero interest rates and three rounds of quantitative easing, the Fed’s monetary policy has had no real effect on inflation – or in slowing the descent of M2 Velocity.

The continuing decline in the velocity of money indicates that consumers remain uncomfortable with the status quo. More importantly, if the low levels of demand continue unabated, central banks around the world risk a global depression if it isn’t resolved soon.

But to reverse the downward trend in money velocity, the federal government must shift into growth mode by removing the uncertainty that comes with excessive control and regulation of the economy. Even in the best times, government regulations make economic expansion difficult. But the sheer volume of regulations in today’s anemic economy threatens our very way of life.

The moral solution is for the federal (and state) governments to curtail their regulatory overreach, get spending under control, reduce taxes for individuals and corporations, and allow free economic activity to return.

It may be a pipe dream, especially listening to each party’s presidential candidates, but a downward economic spiral continues unabated, and time is no longer on our side.

 

Earnings B.S.

One of the most important truisms of investing is that stock prices follow earnings. Follow this rule and you’ll find success as an investor.

Unfortunately, most investors make a huge mistake in getting their earnings data from crackpot financial reporters that have no fundamental understanding of how companies manipulate data.

You see, most investors remain unaware that companies effectively maintain two sets of books. The first contains a comprehensive report of the company’s performance according to generally accepted accounting practices, or GAAP, for short. These results are required to be submitted to the SEC once a quarter, and require the signature of the chief executive.

The second set is for fun. Well, not really…

The second set is often referred to as “pro forma” or adjusted results.  Here a company can report their financial results to investors that contain ‘adjustments’ to the real results. And as you might expect, these adjustments are used to make the company appear more profitable than their results indicate.

proforma earnings

Now, I’m not saying there is never a good reason to make adjustments to a company’s results. There are times when a company is taking one-time expense for layoffs or plant closings, etc. Since these costs won’t recur every year, it’s perfectly acceptable to make the adjustments.

The problem is that some companies have a history of abusing the rules allowing them to make adjustments on items that aren’t one-time expenses. One such company is Salesforce.com (NYSE: CRM).

Salesforce.com frequently claims ‘one-time’ adjustments to expenses that are reported every single quarter. In their most recent 10-Q filing, the company reported that they lost $26 million in 4Q2015.

This should have put downward pressure on the stock price.   But that didn’t happen…

In fact, the stock rose more than 10.2% on heavy volume to close at $69.42 per share on Thursday. What accounts for the increase after the earnings decline?

The company adjusted its earnings to remove the cost of stock options it granted to its employees, which cost the company more than $159 million. And by eliminating the options costs, the company could magically report to investors that it earned $133 million in the quarter instead of the loss as reported to the SEC.

This is what gunned the stock higher.

But it’s a fraud. Employee compensation is a normal cost of doing business, and to treat it as a one-time expense is nothing short of dishonest. The company did it to make investors believe that management successfully grew their earnings in the quarter. And to hide the fact the company rewarded its employees with all of the company’s profits in the quarter.

Warren Buffet’s right hand man, Charlie Munger, has famously described adjusted earnings as “bullshit earnings.” And he’s right.

If you want to be a better stock picker, you need to pay attention to earnings. And the real earnings, not the earnings reported by ethically challenged corporate executives or incompetent financial journalists.

Everything else is a warm pile of B.S.

The Mark of the Beast Draweth Nigh…

Despite recent reports to the contrary, the Federal Reserve is actively engaged in bringing negative interest rates to the United States. By doing so, the Fed will bring its own monetary policy in line with central banks in Japan and most of Europe.

Why go negative on rates?

Well, current Keynesian models suggest that going negative will boost aggregate demand. And, we’re told by these folks that what this economy needs is a kick start to demand.

Of course, they care not to be reminded of their previous failures to drive demand with several years of zero interest rate policy (ZIRP) and three attempts at quantitative easing (QE). For all their efforts at driving aggregate demand, the only results are inflated stock prices and another growing bubble in real estate. That doesn’t include the trillions in additional debt!

As for the economy, it continues to be the weakest recovery in American history. And any further efforts at driving aggregate demand with negative interest rates will fail miserably.

You see, with a global economy on the verge of recession, very few banks are able to find credit worthy customers. This includes major U.S. companies that have loaded up on trillions of low yield debt in recent years to increase dividends and share buybacks. They’re simply tapped out.

Now, central banks are getting ever more desperate to increase demand. But as central banks around the world are learning, negative rates don’t work either.

Here’s why…

Interest rates are subject to the same forces of supply and demand as any other commodity. And any economic theory that presupposes investors would buy a one-year T-Bill for $1,000 only to get $995 a year later falls short of being a financial genius!

You see, investors are smarter than the average Keynesian economist who believes that people will pay the government or bank to hold their money. After all, an investor would be better of putting their money under a mattress. A year later, the investor still has $1,000.

And herein lies the problem…

Global governments cannot allow investors to take their money out of the economy by placing it under a mattress or in a safe deposit box. That defeats the purpose of negative interest rates, which is to force individuals to do something… or anything.

And there is only one way to prevent individuals from hoarding cash…

Ban it! Force everyone to convert their paper money into bank deposits by eliminating the use of cash for any and all transactions.

Think this is a far-fetched idea?

Norway’s biggest bank is demanding a ban on all cash transactions in that country, as is the Bank of England’s chief economist. Other countries such as Japan, China, Sweden, Switzerland, and Germany are also considering banning the use of cash in their countries.

The Danish Parliament leads everyone and has proposed a law allowing stores to refuse cash payments for goods and services. A vote authorizing such a ban is expected to pass.

Don’t think for a minute that calls to ban cash stop at our shoreline. Harvard economist, Kenneth Rogoff, made a case last year to eliminate cash transactions in the United States. Almost immediately, Citibank joined the cause when their chief economist seconded Rogoff’s idea.

The writing is on the wall…

The elimination of cash in the United States is inevitable. Eliminating cash gives the government greater control over the money supply and the ability to “guide” the economy toward the goals of the state.

For those old enough to remember the old Soviet Union, it’s reminiscent of the politburo’s infamous five-year plans that never seemed to materialize. But each failure brought promises of a new five year plan – similar to the claims of central banks now.

Would a cashless society be a bad thing?

Many Americans like the idea of a cashless society. Of course, many Americans think Bernie Sanders’ ideas about socialism are valid, too.

Still, the idea of using a debit card or smartphone for making all your purchases sounds like a good idea. After all, the U.S. government could save billions by not printing bills and minting coins.

Crime rates for robbery and theft of cash would disappear, as businesses would no longer have cash on hand. Banks could get rid of their bullet-proof partitions that annoy so many people.

The government could improve its efforts to calculate the correct inflation rate and gross domestic product (GDP). Best of all, the government could theoretically eliminate the black market – including illegal markets for drugs and other illicit products and services like prostitution.

I mean how many crack heads are going to buy drugs on their debit cards, right? And I’m sure whore houses across the country would see far fewer politicians, too.

But at the end of the day, the move to a cashless society is nothing more than a power grab by elite politicians and the ruling class to regulate every area of American life.

Every transaction you make will leave a paper trail that can (and will) be tracked. Your every move will can be ascertained within seconds every time you buy gas or pass a McDonald’s drive-thru window.

The IRS will know instantly whether you filed tax returns – and whether you declared all of your income. They would also have instant electronic access to your bank records – including the ability to block or limit access to said funds.

Chapter 13 of the Book of Revelation references the ‘mark of the beast.’ Whether you give weight to the Bible or not, the world is fast approaching a point where liberty is subordinated to the goals of the state.

And only a true believer in the altruistic benevolence of the state would be foolish enough to fall for such a unworthy goal. But foolish is the new tolerant in America.