Month: September 2016

InnOvation Capital & Management, LLC

IntelDigest

LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR

SEPTEMBER 28, 2016

Contact Richard Power with comments or questions. IntelDigest is intended for the use of our clients and colleagues. Material may not be reproduced, forwarded or shared without express permission.

In this issue of  IntelDigest,  we focus on the National Debt, its consequences, and steps which you can take to protect yourselves from the likely 2017 recession.  In reality, we have been in a recessionary environment for many months, but the artificial buoying of the stock market has clouded the perception of many investors.

We can start with the state of our official National Debt, which stands at approximately $20 Trillion.  Additional future unfunded government liabilities … Social Security, Medicare, Medicaid … would increase the true National Debt to hundreds of Trillions of Dollars over the coming decades.

The official Debt can only increase, as the federal government continues to spend much more than it brings in.  Boston University professor Laurence Kottlikoff has written that over 90% of federal tax revenues go to cover entitlement programs plus interest on the Debt.  ALL other federal government expenditures … including the cost of the largest military in the history of the world … has to be funded from the remaining 8-9% of revenues, PLUS more and more borrowing.

Interest rates are expected to rise … VERY SLOWLY … beginning in December. Considering the state of the public debt, imagine what would happen if short-term interest rates rose to more “normal” levels, such as 4%.  Sure, we would all be able to earn a reasonable return on our bank deposits.  But, the federal government would have to spend more than $500 Billion per year on interest payments alone.

So, unless the Congress and president (both current and future) suddenly “get religion” and decide to make serious attempts at cutting and balancing the Federal Budget, don’t expect the Federal Reserve to raise interest rates with any speed or decisiveness.  The Fed will also move very slowly in raising rates because of a general fear that moving too quickly will result in a stock market crash.
As we discussed in our August 24 issue:

“The Fed’s efforts to avoid small, cyclical recessions have created bubbles in the debt and equity markets, skewed the economy, encouraged consumers and investors to engage in extremely risky behaviors, and resulted in larger, more dangerous recessions, such as 2008.  There is a high probability that a recession in the next year will dwarf the 2008 downturn.”

We also wrote that “… interest rates are not just the cost of borrowing liquid capital; ultimately, interest rates are the “price” of money.”  The Federal Reserve and other major central banks tried to stimulate the world economy … mainly through interest rate cuts … and failed.  Lowering the “price of money” to Zero, and printing “money” out of thin air, have done nothing to increase value or wealth.

The central banks’ actions created Trillions of Dollars worth of “credit” around the world, which is becoming a credit “bubble.”  Many people see the flood of credit and confuse it with wealth, which it is NOT.  It is “fake” money, which is not backed up by production or tangible assets.
The Current Situation
Negative Interest Rates are becoming more prevalent around the world. In major economies … Germany, Japan, France, Italy … 10-year bonds are already Under Zero. Other countries … United Kingdom, Switzerland, South Korea, India … are intervening in currency markets and lowering interest rates to Zero or Negative in attempts to fight deflation.

Here in the U.S., we are left with an artificially-inflated stock market … which is in danger of a severe fall in the coming year … and the inability to earn anything on traditionally-safe assets such as bank deposits.  There is huge risk in the bond market, especially as interest rates begin to inch up, which will probably begin in December.

Many investors have already moved money to safer assets:

– U.S. Treasuries (as U.S. interest rates are still positive and the 10-year U.S. Treasury earns around 1.50–1.60%)

– raw land and rental real estate

– municipal bonds

– dividend-paying stocks (the dividend yield on the S&P 500 stocks is 25% higher than the 10-year U.S. Treasury)

 

Time To Take Care

Increased investments in dividend-paying stocks have driven certain sectors, such as Utilities and Telecom, to extreme highs, so investors should be wary of putting new money into shares which may be overvalued.

Increased investments in dividend-paying Real Estate Investment Trusts (REIT) and Master Limited Partnerships (MLP) have also driven these sectors higher, and there are dangers in these investments.  In the most recent quarter, a substantial number of REITs have paid out dividends which EXCEED their net income; this is not sustainable.  Be wary of investments in commercial real estate (growing bubble in this sector) and commercial REITs, as well as REITs heavily involved in mortgages and loans;  a small rise in interest rates can stunt their profits.
In our August 31 issue, we set out the following advice:

Steps to Take Now

1.  All investors should analyze their portfolios to determine if the dividend is sustainable in each of their dividend stocks.  A sure sign of trouble is a company which pays more in dividends than it earns in profits.

2.  Look for companies with proven dividend track records.  For example, if a company has increased its dividend for more than 10 years in a row, you know it can manage its dividend through ups and downs of the business cycle.  Those are the companies that we want to hold for the long haul.

3.  Try to avoid companies with significant indebtedness.  If there are serious problems in the economy over the next year or two, many companies will struggle to make money.  Companies with too much debt may have to cut their dividend, or stop paying dividends entirely, in order to pay their debts.

4.  In these “unusual” times, investors should have positions in gold, and should consider holding 10% to 15% of their money in gold.  This small position could protect against catastrophic losses if stocks plunge.
As we enter 2017, we will “crash-proof” our portfolios.  We will cut back our investments in companies which need a growing economy to make money … airlines, retailers, restaurants … anything which relies on consumer discretionary spending.  We will hold more cash, so that we can employ it AFTER the stock market downturn to buy shares of the best businesses at lower prices.

We expect the values of gold and silver to rise substantially, so we will hold gold and silver … both in shares and in physical form … as well as shares of mining companies.

Finally, we will take a close look at the underlying investments in our money market accounts and mutual funds to be sure that we are not invested in dangerous instruments unknowingly.

 

 

InnOvation Capital & Management, LLC

LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR

SEPTEMBER 21, 2016

Contact Richard Power with comments or questions. IntelDigest is intended for the use of our clients and colleagues.  Material may not be reproduced, forwarded or shared without express permission.

In this issue of IntelDigest, we focus on an update of “Brexit.”  The separation of Britain from the apparatus of the European Union is a major development, affecting world economies outside the geographical boundaries of Europe.

For economic and political reasons, the United Kingdom and the European Union will want to maintain close ties.  The U.K. is still a major European power, and a major trading partner of most of the countries in the European Union.  Approximately 44% of U.K. exports go to members of the E.U., and 53% of its imports come from the European Union.

There are three existing frameworks for relations between the European Union and non-E.U. neighbors, referred to as the “Norwegian” model, the “Swiss” model, and a more open free trade agreement.  All of these are on the table as the United Kingdom negotiates its withdrawal from the Union, while at the same time establishing a framework going forward.  The final resolution may be a different framework entirely, reflecting the special standing of the U.K. in Europe.

The Norwegian Model

Under the Norwegian model, Britain could preserve its membership in the European Economic Area, which allows the free movement of goods, services, people and capital within the E.U. single market.  The U.K. would have to join Norway, Iceland, Switzerland and Liechtenstein in the European Free Trade Association (EFTA).  Such an arrangement would offer many of the advantages of E.U. membership without requiring the United Kingdom to participate in the E.U. Common Agriculture and Fisheries policies, or prohibiting it from signing free trade agreements with outside countries.

Adopting the Norwegian model could be the most expedient and least disruptive action.  It is unlikely that it would result in any punitive tariffs between the parties, and many services, including financial services, could continue unabated.  This “soft landing” would also ease concerns in Scotland and Northern Ireland, where the majority voted to have the U.K. “remain” in the European Union.

However, there are negative factors.  One sticking point … at least for those who voted to “leave” because of immigration concerns … is that this resolution would require Britain to continue to accept E.U. workers.  In addition, EFTA member states are required to contribute to certain parts of the E.U. budget, without having a say on E.U. policy.  Being forced to accept rules that it cannot influence while contributing to a budget that it can’t reform … these were reasons for the Brexit vote in the first place.

The Swiss Model

Switzerland is not a member of the European Union, but it has over 100 bilateral agreements with the E.U. and its member states, so it has ready access to the E.U. single market.  These agreements have been negotiated over decades.

But, this access comes with a trade-off … Switzerland must accept E.U. workers. This is a hot issue. The Swiss public voted in a 2014 referendum to limit immigration from the European Union. The vote specified that the Swiss government must implement the changes by February, 2017.

The Swiss parliament is now trying to prepare legislation that would honor the referendum results without violating the E.U. deal.  The proposed laws would give priority to hiring Swiss citizens for jobs in Switzerland, but impose no rigid limits on immigration.  However, there is stiff opposition in parliament.  And, the European Union is adamantly against such quotas.

The European Union will likely strike a hard bargain with Switzerland on these points, so as not to encourage such concessions in its upcoming negotiations on the U.K. withdrawal.

Free Trade Agreement

A free trade agreement with the European Union would address many of the issues central to the Brexit campaign, giving the United Kingdom full control of its immigration policy and greater control of its foreign policy, eliminating its financial contributions to E.U. structures, and restoring full parliamentary sovereignty.

However, negotiating free trade agreements tends to be a lengthy undertaking, often taking 5-10 years to come to fruition.  In the meantime, trade between the European Union and United Kingdom could suffer … both parties would likely introduce tariffs during any interlude between the U.K. withdrawal and adoption of new agreements.

Also, free trade agreements are easier to negotiate for goods than they are for services.  And services comprise a significant percentage of the British economy.

The Migration Issue

The free movement of people within the European Union has become a hot issue across the Continent, and anti-immigration parties in several E.U. member states continue to lobby for Withdrawal Referenda in their homelands.  This will likely make the European Union wary of granting the United Kingdom access to the single market, while allowing the U.K. to reject E.U. workers.  This would set a provocative precedent for other members.

The Brexit Agreement

Finding a balance between migration policies and market access will be the priority for the European Union in negotiating the Brexit.  Because of the size, relevance, and importance of the United Kingdom in Europe, the resulting settlement will most likely be unique.

The settlement will be shaped by national economic interests on each side of the negotiating table.  France and Germany hope to attract financial services operations relocating to the Continent from London.  The Swedish government recently warned that the U.K. suggestion to entice investors by reducing corporate taxes could complicate its negotiations with the E.U.

On the other hand, countries with strong economic links to the United Kingdom, such as Ireland, will advocate for the broadest possible deal with London.

Negotiations will probably far exceed the two-year period established by E.U. rules.  But, the resulting agreement will probably reflect the “special status” that Britain has retained for generations.

 

 

InnOvation Capital & Management, LLC

LAW  –  POLICY  –  FINANCE  –  MARKETS

INFORMATION FOR THE ENTERPRISE AND INVESTOR

September 14, 2016

Contact Richard Power with comments or questions.  IntelDigest is intended for the use of our clients and colleagues.   Material may not be reproduced, forwarded or shared without express permission.

Over the last three weeks, IntelDigest has focused on The Federal Reserve and its policies … and the similar policies of central banks around the world … because these policies have had an enormous impact on the world economy.

In effect, the central banks have been fighting a futile battle against the business cycle … amounting to not much more than a Holding Action … but the outcome will most likely be extremely negative for lots of people. The Human Cost has already been too high for people who have worked hard all their lives and made sensible financial decisions, but now find themselves falling behind.

In this issue, we will summarize the effects of ultra-low and negative interest rates. In coming weeks, we will discuss asset management, allocation, and diversification; the International Monetary Fund and significant developments in currencies; free trade and protectionism; updates on “Brexit” and related developments; and a variety of topics dealing with finance, markets, government policies, and legal issues.

The primary result of central banks’ creating ultra-low interest rates has been to shift wealth … from savers and retirees to borrowers, and from middle class workers to upper-income investors. In fact, the primary beneficiaries of ultra-low interest rates are governments, which can continue to run massive deficits and continue to borrow at ultra-low rates to fund those deficits.

If only we had some sort of legislative body in this country tasked with oversight of government spending and other fiscal matters!!!

Let’s focus on The Federal Reserve. The stated mission of the “The Fed” is to manage monetary policy “… in pursuit of maximum employment, stable prices, and moderate long-term interest rates.” Over the last eight years, the primary method employed was pushing short-term rates down to levels never before seen, creating a number of serious problems in our economy.

Has this stimulated the economy?

As we wrote in the August 24 issue of IntelDigest

“Interest rates are near Zero or Negative in many places around the world. Central bankers postulated that reducing rates would encourage spending and produce inflation; instead, low and negative rates appear to induce more saving (to compensate for lost interest) and deferred spending (in anticipation of lower prices due to deflation).”

Short-term interest rates are at their lowest point in recorded history! But, lower interest rates did NOT stimulate demand. They did NOT create higher demand for goods and services. Instead, they seem to have reduced demand, as people save more and spend less.

For example, many retirees (for generations) have tried to live off the interest earned on savings and super-safe investments. That is not possible in a low-interestrate environment. In order to earn income, the retiree has to take on more risk in stocks and bonds. He or she would then compensate for the increased risk by trying to save more … to have a bigger savings cushion. This reduces spending, which reduces demand.

Similarly, low rates have a depressing effect on household incomes of consumers and savers. Their savings accounts and pensions are stagnant. Even in relatively wealthy economies, people have to contend with rising healthcare costs, increasing longevity, and uncertainty over pension funding. Households likely respond to lower income by trying to save more.

At the same time, lower interest rates seem NOT to spur corporate investment. Sure, many corporations have borrowed (at very low interest rates) Billions of Dollars to buy back their own stock in the marketplace, but have low rates spurred investment in operations? Investment decisions have financial consequences over many years, and are more influenced by attitudes about risk and calculations of future growth … not so much by interest rates set by central banks.

In fact, some very successful companies have been hoarding cash … for example, some giant tech companies, including Apple and Microsoft, have Billions stashed outside the country for tax reasons. But, even if those tax disadvantages went away, such companies would probably still keep much of that money in cash.

If they determine that they have no good places to spend or invest that money, then the ultra-low interest rates are stimulating nothing.

Has monetary policy been well managed by The Fed?

Arguably, no. In 2008 the whole financial system was on the verge of collapse. The Chairman of The Fed, Ben Bernanke, fought that collapse with a number of tools, including cutting short-term interest rates and adding liquidity. That certainly made sense, under the circumstances, but there is less justification for continuing to reduce rates, year after year after year, until they are close to Zero.

Many central bankers are devotees of John Maynard Keynes. Even Keynes acknowledged that interest rates needed to reflect reality, that they could not be set so low that they inhibited business. Could the central bankers not see that low rates would punish savers and inhibit business?

As Walter Bagehot noted, the purpose of a central bank is to provide liquidity at a price in the middle of a crisis. (Bagehot … pronounced “Badge-it” … was a 19th Century British economist and editor of The Economist). In his influential 1873 book, Lombard Street: A Description of the Money Market, he described the “lender of last resort” function of the Bank of England, a model embraced by The Fed and other central banks. He said that, when necessary, the BoE should lend freely, at a high rate of interest, with good collateral.

In today’s world, central bankers certainly follow the “lend freely” part, but have ignored the rest. Bagehot said last-resort loans should impose a “heavy fine on unreasonable timidity” and deter borrowing by institutions that did not really need to borrow. Instead, central bankers around the world simply prop up banks by lending low-interest taxpayer money, even when management has made bad decisions.

In 2008, The Fed acted in contradiction to Bagehot’s rule, spraying money in all directions, charged practically nothing for it, and accepting almost anything as collateral.

Does The Fed have a plan, going forward?

The Fed .. over the last 15 years, but particularly since the 2008 financial crisis … seems to have been overly concerned with propping up the stock market (NOT in its mandate) and avoiding the recessions which come with the normal business cycle (also, NOT in its mandate).

However, restoring short-term rates to normal and reasonable levels will inevitably slam the stock markets and bring on recession, unless The Fed raises rates gradually over 5-6 years. Is this in the plan? Who knows?

How can Insurance Companies and Pension Funds survive?

Insurers make a profit by taking your money and turning it into long-term loans. They use the money they make, along with your premiums, to cover your insurance risk in the event of need.

Pension funds generate profits from long-term loans to grow the money they need, along with your contributions, in order to pay for your retirement. They have built into their models a reasonable long-term return (from a historical perspective) on bonds and the stock market.

This model can fall apart very quickly in a very-low-interest-rate environment. The returns insurers and pension plans make on their investments no longer adequately fund the promises they have made.

InnOvation Capital & Management, LLC

LAW  –  POLICY  –  FINANCE  –  MARKETS

INFORMATION FOR THE ENTERPRISE AND INVESTOR

September 7, 2016

Contact Richard Power with comments or questions.  IntelDigest is intended for the use of our clients and colleagues.   Material may not be reproduced, forwarded or shared without express permission.

This week in IntelDigest is a time to pause and reassess, specifically with respect to stock investments. To use a baseball analogy, we are in the 9th Inning of an investment ball game that began in 2009, as the economy began its “recovery” from the last major financial crisis.

I place “recovery” in quotes because the increases in value of stocks and other assets are attributable more to manipulation by the Federal Reserve and other central banks than actual increases in productivity, earnings from operations, or other legitimate business activities.

So, as we enter the 9th Inning, we pause to try to determine if the bull market of the last seven years will come to an end next year …. or next week!

Looking Up?

On the Plus Side (from the standpoint of the stock market), we remain in a historically low interest rate environment, which could remain for quite some time, even if the Federal Reserve raises rates slightly after the Election.

This has encouraged investors to search for Yield in equities, rather than more traditional vehicles. You cannot remain a Fixed Income investor when bank savings accounts and certificates of deposit pay practically Zero and the 10-year U.S. Treasury earns only 1.50%.

Another Plus is that American corporations have been running aggressive and unprecedented stock buyback programs because they can borrow cash at ultra-low rates to fund buybacks. This has buoyed stock prices, and could continue to do so.

You could call this a “Goldilocks economy” … growth is not great, but the economy is growing … interest rates are ultra-low and not expected to go significantly higher for another few years …. inflation is low.

Equities could remain high for several more months

Looking Down!

On the other hand … there are plenty of Red Flags waving, indicating problems in the marketplace:

•   five consecutive quarters of declining overall corporate earnings

•   Bloomberg reported that cash and cash equivalents for S&P 500 companies dropped to a median $860 million last quarter – a three-year low

•   the top 50 companies in the S&P 500 accounted for more than half of that total

•   the remaining 90% of S&P 500 companies have fast-falling cash balances

•   much of that cash has gone to stock buybacks and dividends, but buybacks are slowing, as is growth of dividends

•   as cash balances decrease, companies can still borrow at low rates to keep up buybacks and dividends, but that increases their debt burden

•   Standard & Poors has reported that global corporate debt has already hit three times earnings before interest, taxes, depreciation, and amortization (EBITDA), the highest level since 2003, and nearly three times higher than last year

•   wages are stagnant, and low interest rates make it difficult to save for retirement

•   stock prices of many companies are at All-Time Highs, even as the company fundamentals continue to deteriorate

Add in other disruptions around the world:

•   the U.K. leaving the European Union, and the possibility of other countries following

•   aging populations in the developed world

•   political tensions involving war and migration

•   seemingly-clueless central bankers with enormous power

•   a truly wild presidential election cycle

•   an impending change in International Monetary Fund Special Drawing Rights (SDRs) which could have a severe impact on the U.S. Dollar within the next few years (we’ll discuss this, in more detail, in a late-
September issue)

Re-assess and re-evaluate

So, what do you do? Liquidate everything and go to Cash? Last week … in our discussion of Yield … we set out various investment possibilities, including real estate, gold & silver, and stock options. We will expand on these and other alternative investments … convertible bonds, preferred stocks, art, collectibles, et al … in the near future.

You should take the time now to reassess your investment goals and your portfolio. Are your goals and your holdings aligned? On track? Is your portfolio diversified for balance and safety?

Volatility will surely increase in the coming weeks. What is your comfort level? Can you endure losses in your accounts? Are you nearing retirement?

If you are more comfortable in traditional equities … stocks, ETFs, managed mutual funds, index funds … understand that now is not the time to be holding over-priced stocks with declining fundamentals. Expect to see your fellow investors in a general rotation into more defensive stocks in the coming weeks (this has already begun).

You would want to hold stock (either directly or through a fund) of the highest-quality companies with strong and improving fundamentals. You should look for consistent sales and earnings growth, strong support from institutional investors, and a history of paying and raising dividends.

Historically, regular dividend payments account for 40% of total stock market returns. Even when a general stock market downturn temporarily lops 15-20% off the stock values in your portfolio, regular dividends offset some paper losses and instill confidence that the company is strong enough to come back, and prosper again, in the near future.

Sell companies which do not reflect such strong fundamentals.

Act sooner, rather than later, to avoid a panic situation weeks or months down the road. It is time to plan for the inevitable downturn … if you haven’t already … and implement changes as soon as possible.

We will be writing every week about the problems that we see on the horizon, and possible solutions. We discuss finance, markets, government policies, and legal issues.

If you would care to call, we can discuss solutions which we are implementing for ourselves and for our clients. We would like to help you.