How and When to exit Mr Bernanke?

Independent of whether the Feds Chairman will receive his confirmation vote for a second term in office or not, the Fed will have to think about how it should eventually exit from unconventional monetary policy. Story in short: Since August 2008 the Fed balance sheet has increased from $874bn to $2,190bn, with most of the increase financed by creating bank reserve. The Fed has in total accumulated assets for more than $1000bn and at the same time interest rates have been slashed to almost zero. Other central banks (e.g. the Swedish Riksbank) have taken a different route to improving liquidity and issued short-term loans with very low, fixed, interest rate. In this case the exit will take care of itself; the loans will mature (in most cases after one year) and as long as no further loans are issued things will return to normal. Not so for Mr Bernanke, who has to think about if he should tighten policy by selling back Fed’s assets before increasing the interest rate in order to curb inflation and prevent the formation of excess bubbles.

When contemplating these $1000bn and the low interest rate, it is easy to see that demand is manipulated and that the stock market has been on steroids for the last 10 months. Owning shares right now feels a bit like being in a chicken race. When all the fiscal stimulus around the world is being pulled back from the markets, share prices are going to be shaky for some time. If this exit isn’t handled with extra care, it can also severely hurt real demand in the economy and pull some countries back into a recession. But this is actually a good reason for staying in the chicken race for some time. Who wants to end the stimulus sooner rather than later if the stakes are so high? If you move slowly and save the world economy, who cares if you create a few asset bubbles along the way?

Leveraged ETFs: Why the Bear decays more than the Bull in a flat market

In a previous post I have shown how the market volatility destroys the value of your leveraged ETF over time due to the fact that the funds are rebalanced daily in order to maintain a constant leverage.

So, if the market trend is flat, the ETFs will lose value due to the inter (not intra) -daily movements around a certain index value. But if the index returns to the value X after one month of ups and downs, the loss in a Bull and Bear ETF would be the same, right?

This is maybe the intuitive answer, but the fact is that the Bear will be much more hurt than the Bull in that example. The reason for this is quite simple, while the sum of index points variations is zero (the index is back at the starting value), the sum of the percentage loss with leverage is not equal to (it is smaller than) the sum of the percentage gain with leverage.

Illustrated with an exemple: If the index gains 5% the first day to take it to 105 points, it needs to lose only 1-(100/105)=4,7619% on the next day in order to return to 100. Since a Bull ETF with 1,5 leverage gains 1,5*5%=7,5% on the first day and loses 1,5*4,7619%=7,1420% on the second day, while the reverse is true for the Bear, they start to divergate to the disadvantage of the Bear. This is illustrated in the graph below.

click to enlarge

Conclusion: the reasons to be careful with keeping Bear funds too long go beyond that of loss due to volatility. They have a built-in mechanism to make them lose compared to Bulls even in a completely flat market trend.

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Side note: the leveraged ETF topic has caught a lot of attention lately, but explainations in traditional business media are often messy, like this one (Swedish).

Peter Schiff: After two years of rally, the deluge of hyperinflation

All professional investors are asking themselves the same question right now: “Is the recent surge on the stock markets world wide just a bear market rally or does it mark the end of the financial crisis?”.

According to Peter Schiff, the financial crisis is far from over. In fact, the worst is yet to come, but first everyone will party on President Obama’s stimulus for two years.

Peter Schiff, President & Chief Global Strategist of Euro Pacific Capital, is according to himself one of the few non-biased investment advisors to have correctly called the current bear market in U.S. dollar denominated assets before it began.

Peter Schiff

As a result of his accurate forecasts on the U.S. stock market, economy, real estate, the mortgage meltdown, credit crunch, subprime debacle, commodities, gold and the dollar, he is becoming increasingly more renowned in the U.S. and world wide. His best selling book, “Crash Proof: How to Profit from the Coming Economic Collapse”, was published by Wiley & Sons in February of 2007.

It shall also be said that it seems like Mr Schiff has been unable to turn these predictions into investment returns for his clients. Allegedly, his strategy also caused huge losses in 2008. It is difficult to understand why he, if certain of the crash, didn’t centre his strategy around shorting U.S. stocks.

In a recently published article, Mr Schiff argues that the Bernanke/Obama massive stimulus will buy us a two year rush before the hangover sets in. According to him, we were already suffering from the doping injected by Greenspan/Bush in 2001, which “prevented a much needed recession and bought us seven years of artificial growth”. The multi-trillion dollar bill was due 2008.

He argues that inflation can sometimes look like growth but “it is no more capable of creating wealth than a hall of mirrors is capable of creating people.”

I do agree with him that the massive stimulus is a punishment for those holding cash and that these people need to seek more inflation-secure assets, such as common stock. As long as money is virtually free, it is burning in the pocket and asset market bubbles are inevitable.

In Swedish context, I have noticed few critical comments about the very-low-interest-rate-immense-stimulus strategy. Two articles (one recent) in SvD denote exceptions.

But if Mr Schiff is right about all this, even about the 2 years, you as an investor have no choice but to follow the trend and invest in the stock market or even in property. You just have to know when to exit.

Mr Schiff’s article in full.