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The Dismal Outlook For 2014

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I do not think the US stock market is in a bubble. If you do not think you have a good alternative for your money, do not sell your stocks. The US stock market as measured by the S&P 500 rose by 29.6% percent in 2013.

Many investors who were perspicacious enough to participate in this rally might be tempted to take profits and sell. Given the high tax cost of this strategy, I would argue this is a bad strategy given what in my opinion appears to be the paucity of attractive alternatives. I am not going to get into stock market valuation issues since the numbers can be manipulated to produce whatever conclusion the analyst wants. Other than to say that, while stocks are not at 2008 (with hindsight) give-away prices, I do not think the US stock market is massively overvalued. This is not 2000.

The US economy will continue to recover albeit at a subpar rate. The resiliency of the US economy will continue to show itself despite the impediments thrown its way by the Obama Administration. The economy has to deal with such things as Obamacare, higher taxes, the Administration’s war on coal, misallocation of resources to less efficient “green energy” projects, the continued harassment of the banking system via endless lawsuits and Dodd Frank, spikes upward in minimum wage laws and the Administration’s refusal to approve the Keystone project. Add to this lackluster foreign growth.

Technology is accelerating at an accelerating rate. Investors – including retirees – need to be invested in growth in one form or another. Investing in tech companies is one approach. But it is not the only one. The tech revolution underlies the prosperity of all major global companies, from Starbucks to Caterpillar to Citibank. They are the beneficiaries of the tech revolution. Reviled by the left, I view the global corporation as one of the major achievements of mankind. Major global companies are the place to look for conservative investors who lack the sophistication and information to play the tech game. The global companies reinvest for you and avoid the double taxation of dividends. And buy and hold strategies avoid capital gains taxes. Of course not all major global companies are great investments. Some, like Microsoft or Proctor and Gamble, get stuck in long periods of stagnation. Management, products and valuation count as well.

The acceleration of technology — which makes possible things like the internet, artificial intelligence, globalization, biotechnology — benefits all humankind but it especially favors the talented and the well-educated. But, based on objective family income and educational achievement metrics, substantial segments of modern populations cannot be considered talented and well educated. Rightly or wrongly they may view themselves as unfairly left out as beneficiaries of the technology revolution. This situation is aggravated when – as in the US – there are racial differences between high performing and low performing groups in terms of family income and educational achievement. Investors, who generally belong to the higher performing groups, can expect lower performing groups to pressure their elected representatives to confiscate via taxes on their incomes and possibly their wealth. The various “rights” asserted by activist groups — e.g. education, health care, food, shelter, none of which are mentioned in the American constitution — can be viewed as confiscatory claims on the incomes of higher income groups who pay the bulk of the taxes. This situation is further aggravated by the fact that the major democracies are already overloaded with entitlement obligations and face longer term solvency issues. The elections of populists Barack Obama, Francois Hollande and now Bill de Blasio (as mayor of New York) reflect this trend. Investors must therefore carefully plan their investment strategies with taxes and populist politicians in mind.

Investors should applaud the removal of Quantitative Easing although under Fed Chairperson Janet Yellen it may never happen. Of course this statement flies in the face of current market beliefs. Trained like Pavlov’s dogs, any talk of tapering and the stock and bond markets go down. My own view is that QE is an irresponsible monetary experiment that offers dubious short term stimulus gains. Investors should think of the Federal Reserve (and the world’s major central banks) as just another government agency, in this case the one in charge of printing money. The Fed is not a real bank and but is a massive ATM machine financing the government. Since it is part of the government, the Fed’s spending in an economic sense should be consolidated with the Federal Government budget. When the Fed buys government debt, this adds zero to government spending. When the Fed buys non-government debt or non-government assets of any kind, this is an addition to government spending. Removal of these non-government purchases under a tapering program will have an insignificant contractionary effect on the economy. But when the Fed prints high powered money under QE that represents substituting Fed money printing for (currently) low interest on government debt borrowing. The Fed is simply an alternative source of funds for the government. But with the potential to destroy the currency

Stay away from investments that do not have a growth component. That means stay away from longer term bonds and purely fixed income products. The Quantitative Easing programs haven’t produced the inflation that the simple monetarist models predicted – yet. But the reserves added to the banking system sit in the Fed like a bomb, ready to go off sometime in the future. Hybrid fixed income products like REITs and MLPs have a growth possibility as do (less tax efficient) dividends. But straight fixed income products will be left out of the party if we move back to a world where inflation is a significant factor. The traditional advice for retirees is to buy bonds. I think this is bad advice when we have central banks that actually target positive inflation rates and think they can manipulate their currencies to suit current political objectives. The world does not operate under the gold standard. It operates under a fiat money standard run by a group of central planners called central banks.

I am not calling for a major collapse of the Chinese economy. But the Chinese economy is no longer a shining star. Unfortunately nobody really knows how bad things might be in China and there is a real chance things could be worse than I am expecting. George Soros has said the Chinese economy represents the greatest risk to the global economy. I would agree with this. Other than some of the Chinese internet stocks that trade mostly in New York and which cater to the Chinese consumer and private sectors, Chinese stocks should be avoided. And given China’s size and importance, this puts a damper on all emerging market stocks especially those in Asia. There are two offsetting factors regarding the Chinese economy. The first is that the Chinese economy is structurally unsound. Via expansive state owned bank lending, massive resources have been misdirected into municipal infrastructure, real estate and state owned companies. Environmental costs have been disregarded and have become very significant. The banking system, which finances all of this, sooner or later will require a bailout since so many of its borrowers cannot repay their loans. The non-bank financial system, which has evolved in response to this state sponsored misdirection of resources, is itself filled with risk. China with over three trillion dollars in reserves can probably afford this bailout but this not a healthy situation. The offsetting factor is the character of the Chinese people. The Chinese people are hardworking, driven by materialism and a love of technology and modernity and devoted to improving their educational levels. Economists, partly because of the need to be politically correct, pay little attention to the character of a people in evaluating countries’ potential for economic development. My own view is that the character of a people is very important. In Southeast Asia and Hong Kong Chinese have made huge successes of themselves in environments where the rule of law and respect for property prevail. But can these hardworking people continue to offset the damage caused by their malfunctioning, government (Communist Party) directed economic system?

I have argued that the euro would not break up even if the Europeans were going about saving it in the wrong way with money printing and bailouts. So far that forecast is correct and I see no reason to change it. Europeans are overall well educated and with first class work skills. But Europe still remains a group of nations whose economies are tied down by socialist restrictions.

Gold will make a comeback someday but only when the world starts worrying about inflation. 2014 does not not look to be a year to worry about inflation. Overcapacity, lingering debt overhang and technology/globalization productivity gains will keep inflation off investors’ near term radar screens.

Bitcoins are the new internet gold. Their popularity has already provoked negative reactions in several countries notably China. Bitcoins compete with national currencies. So far the Obama Administration for some strange reason has not been hostile. Bitcoins like Teslas are “cool” especially in Silicon Valley. Obama has other things to worry about right now and perhaps he does not want to lose his vaunted cool status. But sooner or later, if bitcoins prove a big success and start to threaten the status of the dollar, odds are the US government – maybe led by some uncool Republicans – will turn against bitcoins.

 

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