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August 2011 Investment Journal 


Volatility returned to the markets with a vengeance in August. The S&P 500 declined 5.7%, as fears of slowing economic growth and earnings took hold. The sell-off was not limited to the U.S., as foreign markets also swooned. Europe, in particular, was crushed, with the German DAX off 19% in August, and down some 30% from its recent early May highs.

Despite an unprecedented downgrade of US Treasuries from "AAA" to "AA+" by Standard & Poor's early in the month, US Treasury bonds rallied strongly, with the ten year note reaching a new modern era low of 2.07%. Mortgage rates fell also. Meanwhile, corporate bond yields rose, reflecting more uncertainty, and thus rising "credit spreads". The Barclays Aggregate Bond Index returned 1.2% in August.

The flight to quality drove gold up to repeated new record highs during the month, ending with an impressive 12% jump for the month overall. The safe-haven Swiss Franc also powered to another all-time high, indicating that fear is alive and well.

Stock markets began to gyrate wildly on Friday, August 5, and for the following week a roller coaster ensued. In technical jargon, volatility spiked (we advised last month that investors should expect just this sort of environment during a tense August, with much of the investment community and government on vacation, especially in Europe). While the storm had passed by month's end, the real news this month emanated from central banks.

The FOMC statement came out on August 9, and it contained a bombshell. While noting that their actions to date had not had the desired effect, the Fed for the first time ever put a time frame on the maintenance of their ultra-loose monetary policy, expecting that these "exceptionally low" rates would persist through at least 2013 (conveniently after the 2012 Presidential election). Bernanke also faced the most dissenting votes (3) of his tenure, indicating a real lack of consensus inside the Fed. (Chicago Fed Governor and noted policy dove Charles Evans later in the month emphasized the need for an even more accommodative Fed policy on a CNBC jawboning escapade. Markets interpreted his remarks as meaning lower rates to come, causing gold to rise as the primary beneficiary of these deeply negative real returns).

Late in the month at the Fed's Jackson Hole Wyoming conference for global central bankers and policymakers, Bernanke spoke and put the ball squarely back into the court of Obama/Congress for re-starting growth, calling for urgent action to address long term structural imbalances in the U.S. economy: "U.S. fiscal policy must be placed on a sustainable path that ensures that debt relative to national income is at least stable or, preferably, declining over time...without significant policy changes, the finances of the federal government will inevitably spiral out of control, risking severe economic and financial damage."

He also had some very harsh words for Congress: "The country would be well served by a better process for making fiscal decisions. The negotiations that took place over the summer disrupted financial markets and probably the economy as well, and similar events in the future could, over time, seriously jeopardize the willingness of investors around the world to hold U.S. financial assets or to make direct investments in job-creating U.S. businesses."

The FOMC Minutes were also released at about the same time, and they described how the U.S. economy had contracted more than previously thought during the 2008-09 recession. The Fed also meaningfully ratcheted down their growth outlook for the U.S. economy for the remainder of 2011 and 2012, as current conditions had weakened considerably. With comments like those, no wonder investors are getting antsy!

Investors should understand clearly that the Fed is nearly "out of bullets" when it comes to helping the economy. Short term interest rates are already zero, and the next move, if one can believe Bernanke's academic musings from an earlier life, are for the Fed to use interest rate targeting to keep longer term yields low. The bond market has anticipated this by driving down rates on longer term bonds, and we suspect eventually the Fed will get in the game by unleashing BUY programs whenever yields rise too much. We have pointed out before that a "Japan 2.0" scenario is a possible path for the U.S. as it struggles with its own version of a debt deflation, and the surprise may well be how low bond yields can go if another recession develops (Japanese bonds have sported a 1% "handle" for over a decade, accompanying the recovery that never came).

Turning back to stocks, the poster child for this month's equity carnage were European bank shares. French heavyweight BNP declined 21%, and Deutsche Bank sank 26%. On August 12, a 15 day short selling ban was imposed on French equities, as their bank shares plunged and authorities, as usual, blamed speculators. In the U.S., on the same day, the Chicago Merc raised margin requirements on their Gold futures contract, trying to force out speculators by requiring more money to be set aside to cover increased fluctuations in value. The authorities labor under the assumption that they can produce any outcome that is needed, but these short term artifices cannot hold back the tide of change sweeping through the markets or world. The simple fact is that banks of all kinds are stuck with huge amounts of questionable loans/bonds, and bank managements and governments don't want to take the necessary medicine to heal themselves, which would involve some serious bankruptcies and liquidations. The more fetid these assets become, the more investors embrace gold, a real store of value which is not subject to government manipulation or debasement. Until governments get real in addressing the debt problems, the bull market in gold will continue.

In closing, we believe the verdict of the markets in August was quite clear: investors have had it with the continual stalling and anti-growth policies of governments and central banks in the developed world. The USA's debt ceiling debacle and the endless haggling over bailouts in Europe have taken their toll. Stalemate used to be embraced by investors, but it is not going to be tolerated much longer. September will be a critical month for Europe, as Germany will decide through its courts and legislature the legality of further bailouts. Markets are on the verge of forcing politicians to make hard choices. Unfortunately, that usually means a crisis is imminent, so keep those seat belts fastened. We've got a well-built ship, but the weather is still stormy.

Thank you for reading our Journal, and we'll be back to you at the end of September.
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