2014 Reality Returns

For investors, 2013 was a year like no other. Relentless one way market trends and yet confusion at the same time. Here are three examples of economic phenomena that are hard to reconcile:

1.How can the US stock markets rally so persistently while emerging market equities fall? This chart shows that the S&P 500 index outperformed EEM by around 35% just in 2013:


2. Is the labor market strong because the official unemployment rate fell over the year, or weak because the labor market participation rate fell to a four decade low?

3. Is the housing market strong because the Case Schiller index has risen around 11% over the last year, or weak because for the average American a house has never been more expensive:


and recently mortgage applications have fallen to a new 13 year low:


How is it possible to put all these apparently contradictory observations into a unifying explanation? These are all the signs of an aging fractional reserve banking system.

If fractional reserve banking is not contained, it becomes increasingly dominant. Boom bust cycles accelerate in both frequency and amplitude. Central banks becomes hyperactive and underlying economic conditions become increasingly confusing.

Once begun, fractional reserve banking incentives are so powerful that societal restraints are rarely effective over time. Events in 2013 once again demonstrated this. If you want to examine how the latest attempts at regulation have failed you can review the attempts of both Bart Chilton and Gary Gensler, who have both just recently left the CFTC, the Commodity and Futures Trading Commission:



Essentially, any fractional reserve banking system is built on money created from nothing. This extraordinary privilege provides enormous benefits to those who are permitted to use it, but it is a highly fragile system as there are air pockets in the financial structure. This means that when the inevitable downturns materialize the system would completely collapse without additional backup institutions. This is where central banks come in. If the premise of fractional reserve banking is regarded as a given, it creates the incentive for exponential growth of bank credit, and a growing imperative for central bank support each time there is a financial or economic collapse. The banking system then grows to an outsized proportion of the economy and becomes dominant. However, in its later stages central banks end up becoming hyperactive in an attempt to “maintain” the financial system and economy. The initial flawed premise, which our ancestors clearly understood, tried to outlaw, and abolished twice, has long been forgotten.

This is where 2014 comes in. The financial system has now become a cocktail of market distortions, consistent policy failures and economic illusions.

Market Distortions

FDIC reports show that QE, or money printing, has enabled banks to further increase their massive derivative books by around $1 Trillion per month over the last 12 months. The size and scale of their derivative books means that they now have extraordinary influence over US markets. This means that markets are increasingly engineered to generate increased trading profits, which is also clear from FDIC reports, as well as reflect an ever evolving economic narrative.

In 2013 this has become obvious, but as this thesis is examined in greater detail this first became noticeable going back to September 2011. The behavior of all markets clearly changed at that point. The catalyst seems to have been the gold price. The gold rally from the 2001 low to the September 2011 highs was unprecedented. Every single year was up and the total return was 642%, a massive outperformance of all asset classes.

Then 2 key events took place in September 2011. First China had a meeting which explicitly revealed its gold purchasing policy:


As we can see from the chart on page 23 in the report below China’s accumulation clearly did accelerate from that point on. Secondly we can also see that the gold price peaked at that time. Strangely it seems that China’s gold accumulation has mirrored the fall in gold prices, and record buying in 2013 coincided with a record fall in gold prices:


Furthermore, the Federal Reserve in September 2011 announced operation twist, an attempt to lower long term interest rates, followed a year later by the announcement of QE3 a more permanent money printing program, which is still ongoing:


So consider that the gold market has reversed for over 2 years now when:

1. Money printing has accelerated substantially, which fundamentally increases the value of gold relative to fiat money.

2. China’s gold purchases have accelerated, and probably fully account for world mining supply in 2013.

3. Gold has now fallen to what most experts regard as cost of mining production, which is why gold mines are now closing at a rapid rate, with Barrick Gold, by far the largest gold miner, announcing the closure of 8 gold mines in recent months. This means gold supply will now contract.

4. Interest rates have remained at zero and are forecast to remain so by the Federal Reserve.

5. Demand for physical gold across the world is massive and ongoing and clearly reached record levels in 2013. The evidence is hard to miss:




So in summary. Gold demand has risen to record levels and is ongoing, gold supply is falling, and dollar (and yen) money printing has accelerated making gold cheaper in global currency terms. Yet the price of gold has fallen and sentiment and paper gold positions are more negative than ever before!

At some point physical supply and demand will determine prices again. Most likely this reality will return in 2014.

Now lets turn to US equities. My recent note ( http://www.chrisbelchamber.com ) showed charts of earnings relative to the S&P 500, and also GDP growth relative to the S&P 500. In both cases you can easily see that the extraordinary rise in the S&P 500 over the last few years, has become disconnected from earnings and growth, as it is from almost any fundamental factor normally correlated to US equities. Another way to view this is that emerging market equities have far cheaper valuations and much higher growth than the US for the last 3 years. Yet emerging market equities have only gone sideways for 3 years, and have underperformed US equities by 62% since 2010, as measured by comparing SPY relative to EEM.

Most importantly real investors need to be aware that now valuations have become so excessive that long term expected returns on equities (see below) are below the near 3% yield on 10 year Treasuries. Obviously risks are now substantial in US equities. A return just to normal equity valuations could significantly damage long term investment returns. How could this not happen at some point in the next 10 years? An overweight equity allocation has increasingly become a dangerous trade, rather than an investment. These dynamics as well as the highly dangerous set of conditions in the US equity market are well set out in John Hussman’s excellent article here:


Meanwhile the real economy continues to struggle, and now real per capita disposable income has just turned negative:


Whatever the latest headline, or market reaction, the 42 year economic trend is clearly defined by the first 2 charts in this article:



We are in the advanced stages of a fractional reserve banking system and this a uniquely dangerous and confusing time for investors. Economic policy has become erratic and even absurd in a desperate attempt to sustain a failing system based on a flawed premise. Attempts to chase short term performance in this environment have become increasingly high risk, with poor prospective long term returns.

Increasingly, the markets are no longer reflecting fundamentals. However, this can only be a transitional phase, as market participants see the obvious dysfunction and contradictions and choose actions to protect themselves, which undermines false prices over time. Perceptions change all the time but fundamentals can not be changed or altered. So price distortions never last for long.

The best chance investors have of being successful through this extraordinary period is to understand underlying realities and base strategy on the most durable asset allocation they can find, and adjust this according to fundamental values and emerging trends. This can be examined in further detail here:


Ultimately, an understanding of the “All Weather” portfolio allocation will provide not only safely through difficult times but also become a strategy for substantial outperformance once reality returns.

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