Six Months of Chicken Little

In 2013, I published my first PBS Making Sen$e article worrying about the economy and financial markets. Over the subsequent period, my fearful articles caused Paul Solman, business and economics correspondent for the PBS NewsHour, to label me the “Chicken Little of Finance”.

The Chicken Little of Finance

Six months ago, I embraced the Chicken Little moniker and revealed my own investment positions. I have been publishing monthly performance updates. This article takes a slightly longer-term perspective and reviews Chicken Little’s macroeconomic views and the Chicken Little Investment Portfolio over the full six months. (You can compete against Chicken Little, and see the Chicken Little portfolio performance in real time by clicking here; you have to register with the website that hosts the contest) .

The article has four parts.

Part I: Chicken Little’s Perspective on Government Policy.
Part II: The First Six months of Chicken Little’s Investment Portfolio.
Part III: Chicken Little’s Current Investments.
Part IV: Advice for other Chicken Littles.

Part I: Government economic policy is poison

An ounce of prevention is worth a pound of cure.” So reads a vintage cigarette ad.

For decades, cigarettes were sold as healthy supplements. “Doctor recommended” smoking purportedly improved digestion, soothed throats, and sharpened the mind. We now view smoking as the leading, avoidable killer of people.

In the case of cigarettes, a purported medicinal supplement has been revealed to be poison. Similarly, I believe the government actions to “support” the economy are actually causing the problems.  

Since 2008, the three pillars touted to support the global economy are increased government debt, stimulative Chinese government policy, and loose money created by Central Banks. Loose money comes in two forms: low interest rates and the creation of money through asset purchases (‘quantitative easing’).  

I believe that all three of the pillars of economic ‘support’ actually decrease wealth.

Poisonous Pillar #1: Government Overspending.

More new Federal Debt in a decade than in prior centuries
The average government debt level in the OECD has climbed from 53% of GDP in 2007 to over 80%. Good news has been reported recently in that the US Government deficit had declined to the lowest since 2008.

One major reason for good news on the US deficit is that the Federal Reserve has kept interest rates low (Read my 2014 article). Low interest rates are good for borrowers and bad for savers. The US government is largest borrower in the world. A Wall Street Journal headline last week, read, US borrows “$1.17 Trillion at Zero Percent Interest.” Keeping interest rates low, suppresses the reported US government deficit.

I continue to believe that spending more than one earns, is not a path to prosperity.

Poisonous Pillar #2: Chinese Investment.

chinese overspending.jpg
Ghost Cities with empty roads

In China, trillions of dollars have been invested by government decree without regard to the value of the projects. Ghost towns and excess production make people poorer both in China and elsewhere.

Alcoa is one of many of companies that have suffered as a consequence of China's misdirected investment. Facing severe competition from China, Alcoa’s stock price has declined by 90% since 2007. The company was kicked out of the Dow Jones Industrial Average, and will now morph into two entities. Alcoa was an industrial giant; now it has ceased to exist in its prior form. There are hundreds of similar stories.

Poisonous Pillar #3: Low interest rates.

Yellen feeds Wall Street.jpg

© Terry Burnham
Low Interest Rates help the wrong people

While government overspending and Chinese financial mistakes are terribly costly, loose money might be the worst government economic policy. Monetary policy is particularly destructive in that its negative effects are delayed and misunderstood.

Consider the impact of low interest rates on housing and savers. Mortgage rates have dropped from above 6% in 2007 to around 4% today. People who refinance their loans at lower rates spend fewer dollars on mortgage payments each month, and consequently, have more to spend on cars and other items. Similarly, new home buyers are able to pay more for houses with a 4% mortgage than they could under the same circumstances with a 6% mortgage. Lower mortgage rates have helped US housing prices rise in recent years.

Lower mortgage payments are great for borrowers. However, every dollar saved by a borrower is a dollar not received by a lender. The most important impact of lower rates is not wealth creation; it is a transfer of wealth from savers to borrowers. While there may be some additional houses built because of low interest rates, the more important impact of loose money is simply transferring wealth from savers to borrowers.

If there is a saving loser for (almost) every borrowing winner, why aren’t savers “mad as hell”? While there is some expressed anger at the negative impact of Federal Reserve policies on senior citizens, on balance, the public seems to support low rates.

One barrier to recognizing the cost of loose money is that some savers benefit in the short-run from low rates. In particular, savers who own bonds see them go up in price when interest rates go down. Consider, for example, the 30-year Treasury bond sold on May 15, 2007 (one of the last 30-year auctions conducted before the beginning of super loose money). This 30-year bond pays 5% a year in interest. Any saver who owns this bond has seen its value increase by 40% since issue. (To see the current price of this bond, search for “912810PU6” on this long list of treasury security prices.)

So borrowers are happy with low mortgage payments, and savers may be fooled by the rise in value of the bonds they own. The fact that bond prices have gone up in recent years, cannot, however, hide the depressing set of options available to savers today. The 30-year treasury currently returns under 3%, and bank deposits pay 0%. Low rates are terrible for savers.

What is net impact of loose money? I believe it is negative. Wealth is transferred from savers to borrowers. There may be some financial stimulation as, for example, some houses are built that would not have been otherwise. However, loose money also destroys wealth because altering prices leads to bad decisions.

Consider the impact of Federal Reserve Policy on drilling for oil in the Arctic. Oil prices rose during the Fed’s program of quantitative easing from under $50 a barrel to over $100. Shell invested over $4 billion in Arctic drilling assuming relatively high oil prices. After the end of quantitative easing, oil prices have declined to below $50 again. Shell has cancelled its Arctic effort  and has wasted $4 billion.

While many of us are happy to see less Arctic drilling, we would all be richer if the $4 billion had not been thrown away. There are literally billions of decisions that have been distorted by the Central Bank policies, and the total cost may run to the trillions of dollars.

Janet Yellen may have increased Arctic Drilling

Many private economists describe the gradual reduction of Federal Reserve money creation as a “taper.” While taper is the term used outside the government, I have never seen a Federal Reserve official use the word. Why not? My guess is the government does not want to equate loose money with the more common usage of taper in the context of drugs.

It it walks like a chicken, and quacks like a chicken, it’s probably not a duck. So said Wall Street trader Peter Borish (See Peter in the famous Trader video). Low interest rates are like a drug in causing short-term stimulation and longer-term decline.

Drug stimulants are bad for people. Monetary stimulants are bad for economies.

No Good Outcome
I am Chicken Little cowering in fear, because I believe that current government economic policies are poisonous. Consequently, I believe the sky will fall in the form of declining financial markets and a bad economy.

Part II: The First Six months of Chicken Little’s Investment Portfolio.

As noted above, the Chicken Little Portfolio performance can be viewed in real time. I post monthly updates on my blog. The goal of this public investing is two-fold. First, to demonstrate that my money is in the same location as my mouth. Second, to help educate people.

Education can come in two forms. First, if Chicken Little performs well, people can see exactly what I own and how I express my macroeconomic opinions. Second, if Chicken Little struggles, the complexity of investing may be more apparent.

Making accurate economic and financial predictions is very hard. For example, in 2013 100% of economist predicted that interest rates would rise — this just before interest rates fell. Similarly, in December 2014, 100% of Wall Street pundits surveyed by Barrons predicted a booming 2015 stock market. These experts have been wrong so far in 2015 as stock markets all around the world have fallen.

So the Wall Street Gurus have been exactly wrong about the direction of biggest financial markets in the world recently (and throughout history).

While making accurate forecasts is challenging, making money in financial markets is *even* harder.This is the single most important message I strive to teach my college students. Going public with my failures and inner turmoil have the potential to educate.

With this motivation, on April 1st, 2015 I unveiled my portfolio as follows:

This portfolio is very defensive -- it has a lot of cash and has only one significant investment -- in Treasury securities. The logic behind the position was stated as, “I own U.S. Treasury bonds because I believe that the U.S. economy is still weak enough that the Federal Reserve interest rate increases will come later than expected. If Federal Reserve Chair Janet Yellen further postpones raising interest rates, Treasury bonds can increase in price substantially.”

What has happened in the past six months? My macroeconomic prediction that the Fed would delay rate increases has been 100% correct. However, as if to make my point the profitable investing is even harder than macroeconomic forecasting, Treasury bond prices have declined over the last six months.

Indeed, almost all financial assets -- stocks, bonds, and precious metals -- have declined in 2015.

Total Return
Jan 1-> Sept 30
Dow Jones Industrials
Non-US Stocks
Emerging Market Stocks
US Long-Term Bonds

From inception through September 30, 2015, the Chicken Little Portfolio lost 1.45% (see more details on my blog). In investing, there is a score, and that score is negative for Chicken Little.

Part III: Chicken Little’s Current Views.

Fears of economic doom continue to fill my head. Recently, I spent most of a day evaluating the likelihood that the US government will default on its debt. Most people assume this is impossible since the US can create money to pay its debts. The fact that I dwell on unlikely, negative, economic outcomes is a reflection of my dire mood.

If I fear a stock market collapse, why did I own a few stocks at the inception of the Chicken Little portfolio? Because financial markets exhibit momentum. That means that markets going up tend to continue to go up. Most famously, John Maynard Keynes quipped, “Markets can stay irrational for longer than you can stay solvent.”

John Maynard Keynes

Momentum investors do not short bull markets. In April of 2015, we were in a bull market for US stocks. How do I know? Because my fourth grader has a ruler, and she could show me that the chart for the US stock market went from the lower left to the upper right (Look for ‘Violet’ in the Chicken LIttle Stock Contest; yes I am being beaten by a 4th grader).

momentum pays.PNG
Being beaten by a 4th grader and a 1st grader
What does Chicken Little, the momentum investor, do in a bull market? Answer, look for an end to the bull market. While no one rings a bell at the top, the unmistakeable sign of the end of a bull market is decline in the market. Thus, earlier this year, Chicken Little was on the lookout for signs of the end of the bull in the form of declining stock market.

On May 8, 2015, I posted this chart on my blog wondering if we had seen the end of the bull market in US stocks:

Is the Bull Market Over? 

My May 8, 2015 chart was wrong in that the Dow Jones Industrial Average made an all-time high later in May. Because I was on the lookout for a top, however, I was able to sell my modest stock position before the August declines in global stock markets.

Now that the Dow is around 17,000, the chances that we have seen the end of the bull market are greater than they were earlier this year. Accordingly, the Chicken Little portfolio is now even more defensively positioned that it was six months ago.  

Currently, the Chicken Little portfolio remains ready for a deflationary depression. It retains its major position in Treasury obligations, and is modestly short (betting against) stocks. It is only modestly short stocks because I believe most of the declines will come in the future, and I hope to sell more stock before those declines.

Chicken Little is also short gold. This is because I predict a *deflationary* depression and because gold prices show momentum to the downside. (Some of my optimistic friends think we will have an inflationary depression and they tend to own gold.)

Part IV: Advice for other Chicken Littles

What should you do? If you share some of my Chicken Little fears, I have some advice.

Consider reducing your level of financial risk. Sometimes it is best to run away.

Run Away! 

In football, they say the first points are the hardest. In a bear market, the first decisions are the hardest. Trimming the level of financial risk, even a fractional amount, increases one’s options and, more importantly, opens the mind up to negative information (see my post “Sell without Panic”).  We tend to read (and believe) articles that confirm our prior decisions, so people fully invested in stocks are relatively close-minded to negative economic news.

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