december 2014 icecap global outlook

Our view on global investment markets: December 2014 – The Third Law Keith Dicker, CFA Chief Investment Officer [email protected] www.IceCapAssetManagement.com

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December 2014 The Third Law

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Three hundred years ago, physicist Isaac Newton, compiled the Third Law of Motion. Ever since, people everywhere have noticed how every action does indeed have an equal and opposite reaction. This Third Law of Motion is certainly evident in the music world where The Rolling Stones gathered a lot of moss. The hoodlums of rock & roll seduced the world into sympathizing with the devil as well embracing the emotion of never being satisfied. At the time, the Rolling Stones represented the dark side of music and life. The Beatles on the other hand represented the opposite reaction - they wanted nothing more than to simply hold your hand. They embraced the rising of the sun and were seemingly always twisting and shouting about love. At the time, the Beatles represented the bright side of music and life. Of course, as time passed the social infatuation and rejection of each band, swung dramatically and often in opposite directions, just as Newton’s Third Law of Motion predicted it would. The pendulum of the money world also swings from side to side, yet most of the time, most investors, mostly see what they want to see. The good times are always just around the corner and any bad times were simply the luck of the draw. Astonishingly, Newton’s Third Law seems to be either forgotten or dismissed altogether, and this is a shame because the world’s

Moves like Jagger financial pendulum is the process of reaching that ever so brief pause, after which it then begins to swing in the other direction. To many thoughtful investors, it has become crystal clear that the world is indeed on the cusp of a dramatic change in direction. There will be extreme cases of financial, social, political and economic losses. But there will also be extreme cases of financial gains – the secret is understanding how and where global capital will flow. Applying Newton’s Third Law of Motion will help you realise that for every negative action, there will also be an equal positive reaction is crucial to both preserving and growing your wealth. Unfortunately, many investors make the mistake of taking a singular stance without the thoughtful consideration of Newton’s Third Law. Of course, this one dimensional thinking is deeply rooted in our recent past – the one that dominates our investment expectations to this day. We’ve written and presented before that practically everyone in the investment business today earned their stars and stripes during the famous 1982-1999 bull market (see Chart 2, page 4). We’ve experienced countless occasions and situations where investment firms would use market data with 1982 as the starting point to flog their newest mutual fund to the unsuspecting public. Better still are the moments when a grey haired, industry veteran

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Beware the starting the point begins lecturing us with the all too predictable “...I’ve been in this business for 30 years, and ...”. And since 30 years is a long time, they must be right. But, and this is a pretty big BUT – they are only right if you use the early 1980s as the starting point. Otherwise, they are pathetically wrong. For those not in the know, both the stock market and the bond market enjoyed their greatest runs ever when using 1982 as the starting point. In fact, almost every investment fund ever created produces perfectly, perfect returns using the magical 1982 start date. Yet, simply shifting the start date back to 1952 and counting forward 30 years will give you a not so rosy story - and most likely, fewer clients. It appears that IceCap is not the only one to observe this seemingly obvious point. Chart 1 on the next page perfectly illustrates this exact same concept. The point we make is that many investors in the world today are too trustworthy of their local banks and advisors, and have swallowed the industry sales pitch hook, line and sinker. Instead, respecting and understanding that financial, economic, social and political histories actually predate 1982, will provide you with a different perspective on how the world is now shaped.

The belief and hope (there’s that word again) that the world will continue along a upward trend with a few bumps here and there has been grossly miss-sold. Instead, the pendulum is changing direction and this change in direction will create untold losses for the Euro currency, government bonds, and banks & insurance companies around the world. Yet, the brighter side of the investment world will see untold gains for the US Dollar and US stocks. The key to understanding this paradigm shift is respecting Newton and his Third Law of Motion. As Europe further disintegrates down its rabbit hole, private sector money will seek safety. And, the only market big enough in the world to absorb this kind of capital movement is the US Dollar. The Biggest Fallacy The world is riddled with many untruths, and none compare to those perpetuated by the investment industry and its staunch belief that economic growth is the driver of stock market growth. On the surface, it is a nice story – after all, if a company makes profits, pays out dividends and then makes more profits and pays out even more dividends, it has to be good for the stock price. Yet, if any half-respected investment analyst sharpened their pencil just a little, and researched economic growth and stock market


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Chart 1: Comparison of two different 30 year periods of investing



1984 1954

30 years = 0% return

30 years = 400% return

2014


Weird, but true

movements, their objective conclusion would be a jaw-dropper to say the least. Yes, there certainly are times when stock markets do well when our economies are growing, but there are also times when the exact opposite happens, and even more times when there is no rhyme and reason to connect one with the other at all.

To demonstrate the truth about economic growth and the stock market, consider the experience in the US since 1927. Over this 87 year period, the median annual profit growth has been 8%. Yet, when companies grew their profits by more than 8%, their stock performed less than periods in which their profits grew by less than 8%. In other words, less economic growth equaled higher stock prices and vice-versa. Weird, but true. (Source Ned Davis Research). From a different perspective, consider Chart 2 on this page which details US Economic growth by decade, side by side with the growth in the stock market during the same period. As you can see, there is no consistent link whatsoever between economic growth and stock market performance. It’s still weird, but still true. On a related note, compare the returns during the glorious 1980s and 1990s, to other decades. This illustrates our previous point about how client and industry return expectations have been significantly skewed due to most investment professionals and their mentors gaining their experience from this specific time frame. Now, there are always people who will say this 87 year time period is too long – WW1, the Great Depression, WW2, the baby boomer years, the Vietnam War years, the Star Wars 80s years, the Tech bubble years and the housing crash years shouldn’t count. For those market seers, we offer Chart 3 (next page) which shows economic and stock market growth for the last 12 months.

Source: Crestmont Research

Chart 2



It’s still weird

Again, there has been no correlation or pattern connecting economic growth to stock market returns. If you can find a clear pattern let us know. Interestingly, a year ago we spoke with global managers based out of London and they were absolutely positive that UK GDP would accelerate and that it was a real nice time to buy UK stocks. In hindsight, they were 100% correct about the UK economy, but the UK stock market was nothing special at all. Unsurprisingly, we also encounter this economic growth-stock market fallacy in academia. Walk into practically any business school today

and you’ll find students analyzing GDP models and then allocating their investment decision to the fastest growing economies. This is wrong of course. Because if you think about it, this would mean your investments should always be allocated to the China’s and India’s of the world. After all, these countries have consistently created faster growth than any of the western world countries, yet their stock markets have certainly not been the best performing. Now, this isn’t to say you cannot make money in faster growing economies. Yes, you absolutely can – but you have to be the business owner. The one who earns and receives the profit. The distinction of course, is that success in growing your business isn’t necessarily reflected in your stock price. This confusion between correlation and causation has stumped the industry veterans for a long time. Some simply ignore it, while most others have no idea the phenomena even exists. Still not convinced? The next time your advisor tries to justify their sales commission, ask them about correlation and causation and how it relates to the stock market and economic growth. The most likely response will be the one full of confusion and misdirection. In other words, your question doesn’t reconcile with what they’ve been taught and fed throughout their career, or worse still – you are paying a whole lot of fees for nothing. Weird, but it is true.

CountryGDP Last 12

months

Stock Market Last 12 months

UK 2.9% 2.5%France 0.4% 6.6%

USA 2.4% 17.3%China 8.4% 3.2%

Source: OECD, Market Watch

Chart 3


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If a recession occurred in the forest would an economist hear it?


If you’re into numbers, this means that out of the last 7 recessions, this un-eclectic group of big bank economists expected none of them to occur. This is serious stuff – even the worst teams in sports win a game every now and then, but not the big bank economists. In some ways, it should have you thinking - if a recession occurred in the forest, would an economist hear it? In other ways, this shouldn’t be a surprise at all. When you think about, if your big bank investment professionals believe that stock market success is driven by the growth of the economy, and the big bank economist predicted a recession was about to occur, it would mean that you should sell your stocks. And, we know for a fact that despite numerous stock market drops of 50% or more, most investment advisors have never recommended, suggested or even hinted that you should make appropriate adjustments to your portfolio. Now, if the industry were on trial and they were sitting in the witness stand, it is at this point their attorneys would be screaming objections - anything to distract you from the truth. We suggest you re-read this again, because as the world’s financial pendulum begins to change direction, and all of the energized actions create equal and opposite reactions – do not expect the vast majority of the investment industry to understand nor correctly communicate what is happening. History shows they simply do not understand it, it isn’t in their DNA and you shouldn’t expect this to change.

What should you believe? If economic growth doesn’t drive stock prices – then what does? A whole host of things actually. Unfortunately, when you dig deeper you’ll find that there are no constant drivers of the stock market. What we mean by this is that there are times when yes, the economy does strongly influence the stock market. But as we have already demonstrated, there are also times when the economy can have the complete opposite effect on the stock market. To make matters even more confusing, there are periods when other factors have a greater influence on stock prices. In fact, there are many times inflation, interest rates, politics and military conflicts can be the dominant driver of your wealth. Now, when you think about it this way, perhaps it is no wonder the global investment industry has steered investors into believing that a singular, tunnel-visioned factor is the key to achieving stock market success. Yet, when we think of it this way, the industry fascination with the belief that economic growth creates stock market wealth still doesn’t make sense. After all – as Chart 4 on the next page shows, over the past 44 years, professional economists as a group, employed by the very same investment firms who proclaim that economic growth produces stock market growth, have never, ever predicted that a recession would occur.


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Chart 4: Economists track record vs actual economic growth


• Professional economists have predicted 0 of the last 7 recessions

• Professional economists have NEVER expected a recession to occur

• Since 2001 professional economists have been accurate 12.7% of the time

Recession

Expansion


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Stronger, higher, faster


The Next 12 Months Over the next 12 months, the world will see a see-saw battle between those believing and hoping that America can pull the rest of the world out of its economic funk. Currently, the entire Euro-zone is rolling into recession, China is growing 47% slower than its 2007 peak, and commodity sensitive economies such as Canada, Australia, and Brazil are all producing less growth than expected. Meanwhile, we expect the United States will continue to produce 2.5-3.5% economic growth during the next year. And during this period, we expect the US Dollar and US stock markets to continue to march higher relative to practically every other currency and stock market. However, do not attribute better currency and stock market performance to better economic growth – this will be a mistake. We have already demonstrated that economic growth has no bearing on financial market performance, yet this show of US strength will incorrectly be attributed to investors seeking to maximise their investment returns. Instead, the strength in American markets should be attributed to international capital seeking safety. Note this distinction, because the end result will have booming consequences that will be both unexpected and highly unusual. The investment world has taught most people that that returns are

driven by investors always seeking the best return. This is true sometimes – but not all of the time. Remember that the world is actually a dynamic place and linear thinking will give you one-dimensional perspectives. A dynamic perspective shows there are also periods when investment returns are driven by investors running away from certain losses, and this is the environment that has been created in Europe today. Although the economy is not a consistent contributor to stock market growth, it is an enormous contributor to social and political change – and this is the key to following the decline of the Eurozone. Enormous economic, political and social change is happening in Europe and the smart money will not be sticking around to see what happens. Now, despite 6 years of increasingly “stronger” stimulus programs, 6 years of “stronger” worded communiqués, and 6 years of “stronger” policy programs, IceCap fully expects Europe’s economy to become even weaker as it heads into the 2nd half of 2015. Investors, politicians and policy makers have to be reasonable here. There is zero evidence that the subscribed economic policies are working. Instead of targeting the disease of bad debt, decision makers continue to target the symptoms of bad debt – deteriorating unemployment, deteriorating fiscal balances, and rising popularity of extremists political parties.


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It just isn’t working


The critical point to understand is that deteriorating social and political conditions are being caused by the chronic debt crisis. And as the debt crisis continues, the social fabric begins to change dramatically. And it is the dramatic social changes that is causing the financial pendulum to begin swinging away from Europe and breaking apart the Euro. As an example, consider the following: • Spain – 80% of Catalonia voters support separation from Spain. • France – For the 1st time ever, the leader of the Euro sceptic party, the Front National finished ahead of leaders from France’s main two political parties. • Italy – Five Star Movement has begun process of preparing the country for a referendum on leaving the Euro. • Greece/Spain/Italy – 40% to 50% of youths are unemployed. The fact that the popularity of separatists parties is increasing simultaneously with a deterioration in unemployment definitely has every European government shaking in their boots. And when you also consider that tax revenues are no where close to keeping pace with spending, and therefore increasing the need to borrow even more money, there should be little wonder that people, companies and their wealth are leaving the Eurozone. Since our last writing, economic conditions in Europe have

deteriorated even further and not just in southern Europe and France, but in Germany as well. While European government leaders have to remain positive in their message – those government leaders have everything to lose, the message from the European Central Bank (ECB) remains LOUD and CLEAR. The ECB will continue to throw everything possible at the debt crisis, hoping that it will disappear. Well, throw everything that is, except for the only thing that will resolve the crisis – losses for bond holders. It’s the losses to bond holders that is really scaring Europe, and the one that will likely create snowball-like havoc around the financial world. Together with the European Commission, the ECB has supported and launched over a dozen significant and meaningful stimulus programs and strategies to yank the Euro-zone right out of its economic misery. At the time, the ESM, ESFM and the ESFS were touted as being more innovative than the invention of the wheel. Next, the world was introduced to LTRO1, and then LTRO2, and then another strongly worded pronouncement – all of which were lauded as being more innovative than the internet. And of course, we shouldn’t forget efforts to simply change the definition of debt and the reclassification of illegal drugs and


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FAILED


prostitution as strong contributors to the economy. While this move didn’t quite earn the label as being innovative, it did demonstrate how the folks in Brussels can whip out new policy papers on a moments notice. Today of course, no-one is talking about any of these programs anymore. Yes, they still exist but they have obviously been rendered useless against this tsunami-wall of debt that continues to both accumulate and cause people (and their money) to flee the Euro-zone. Two months ago, the ECB announced that interest rates will now be NEGATIVE. Yes, negative. Americans, Canadians and the British complain about getting next to nothing on their bank cash balances and deposits. Imagine for a minute that you had to pay the bank to hold your cash and deposits. Well, that is exactly where Europe is headed. The hope (there’s that word again) of course, is that people and companies will start to spend their savings, instead of hoarding their savings. It is also hoped that European banks will lend money to these same people and companies. The trouble is, these people and companies have no interest in borrowing any money. As a result the ECB’s negative rate strategy is akin to pushing on a string or worse still leading a horse to the water. The fact that the ECB continues to create new and more aggressive policy plans, validates our view that all previous plans have failed to

FAILED

FAILED

FAILED

FAILED FAILED

IceCap Prediction: will FAIL

Chart 5

Source: ECB & IceCap Asset Management Limited

solve the debt crisis. Chart 5 above details previous strategies, our grade as well as details for future plans. Next up for the ECB, is the one plan every central banker has been dreaming of since the entire debt crisis started – money printing. It will happen in Europe, and we’ll have more comments and analysis as the old world ventures down this path. Meanwhile not to be outdone, the European Commission in Brussels has also embarked on their latest stimulus program. As usual, it


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More debt


sounds absolutely brilliant on the face of it. Yet, simply peel away a few layers of the European onion and you’ll discover that once again Europe is trying to solve its debt crisis by issuing more debt. The “European Fund for Strategic Investments” is being promoted as a EUR 315 billion fund which will create 1.3 million jobs over 3 years. It sounds and reads great, yet the devil is once again in the details which shows the Fund will receive EUR 5 Billion in cash and then, get this, borrow an additional EUR 310 Billion. This is the latest perfect example of how Europe is treating the symptoms of their debt crisis. Once again, the strategy of using more debt to fix a debt crisis seems a bit odd, but that’s exactly what their financial doctors have prescribed. The situation in Europe has not occurred anywhere of this magnitude over the last 100 years, let alone the past 30 years. IceCap’s view hasn’t changed – unless the Eurozone is willing to form a single country, with a single government, with a single financial plan where everyone is responsible for everyone else’s debt, then it will fail. This slow motion failure is happening before our eyes, with each passing day seeing increasingly more Europeans moving their wealth to safer markets. The good news is that there will be an equal and opposite reaction in US markets – this is where investors can benefit. Of course, not everyone sees it this way. Case in point, consider the worst investment idea ever.

The worst investment idea The investment industry is full of a lot of things, and without looking very hard you should not be surprised to see new mutual funds and new investment ideas flogged on an almost daily basis. Like all innovation – there’s some good and some bad. The really good will stick around for a long time, while the not so good, loses people a lot of money and then quietly sets with the sun. We often like to comment on the ineffectiveness of the investment industry, yet we rarely comment on a specific product – until now. Recently we were approached by a mutual fund company touting the merits of their newest and greatest investment fund – a European bank mutual fund. At first, we thought it was joke. But after a few minutes we quickly realised these guys really were trying to sell us a mutual fund stuffed to the brim with European bank stocks. The thesis behind the fund is that European banks are intrinsically under valued. In other words, the stocks are cheap and they should rise considerably faster than the broad market over time. We say fat chance. In fact, we believe European banks will become the worst investment idea of the decade, let us explain why. For generations, the surest, safest, most guaranteed events were commonly referred to as “money in the bank”. And for good reason,


12

Save George Bailey


after all the last memory anyone had of a bank going under was the one owned by George Bailey in “It’s a Wonderful Life.” And since that only happened in a movie – surely the odds of a bank going belly up were slim and none. Yet, since 1980 there have been over 2,100 American banks that have closed their doors or had to receive financial assistance (aka – tax payer bailouts) to get by. And that’s just in the United States. During the 1990s, Asia and Latin America saw 234 banks close it’s door. And even in Canada – 43 financial institutions have failed since 1967. The point we make is that bank failures happen all the time. Yet, most investors and their financial advisors only have a limited understanding of how a bank is actually taped together – and to give you a hint, just know that banks use very little of their own money to make money. In other words, they use your money to make money. Now, as the European debt crisis re-escalates, this iconic phrase of “money in the bank” will become an ironic phrase. To fully appreciate the magnitude of risk emanating from Europe’s banks, you must first understand how a bank is structured as a company. The most glaring difference between a bank and a Wal-Mart, Microsoft, Johnson & Johnson, or even your corner store is the amount of debt used to run its business. Banks are clearly not your typical company. They are aggressively levered businesses. What we mean by this is the average bank has

borrowed money equal to 10-30 times what they own. For comparison Wal-Mart has borrowed 1.7 times, Microsoft 0.9 times, while Johnson & Johnson has borrowed 0.8 times of their own money. These companies may struggle from time, but they are simply not structured to go KA-BOOM in the middle of the night. The easiest way to understand the inherent leverage within a bank is to consider a bank that has $5,000 cash and then borrows another $95,000 to give them a total of $100,000 cash to run their business. Now, most banks are very conservative with their money and in this example, they would invest the $100,000 in various things including lending for mortgages and lending to companies and governments. The problem arises when, despite prudent analysis and rigid enterprise risk management procedures, the bank suddenly experiences a loss. In the above example, imagine the bank losing 2.5% on their investments. This of course, would equal $2,500 which would be half of the bank’s original cash holdings. When this happens, the regulators rush in and demand the bank replace the $2,500 loss of capital with new capital. Simple enough. But look what happens if the bank loses 5% on their investment. This $5,000 loss completely wipes out the banks original $5,000 cash holdings. And that is just on a 5% loss.


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Return of the Lira


Now, if the bank has a loss >5%, three different things can happen. First, the bank can find new investors. Normally there is a high probability of this happening. But only if the reason for the bank’s losses is isolated to that specific bank. If these losses are rampant throughout the economy, then no new investors will ride in to save the day. Next, the bank can be bailed out. Here, the government would walk in using tax payer money to recapitalise the bank. This of course happened in 2008 and although tax payers (and voters) accepted this course of action back then, it is highly unlikely that tax payers will accept it a second time. Third, if no new investors can be found then the bank will go through a normal bankruptcy/out of business process whereby all of its assets are sold and then the proceeds are paid out to creditors who accept losses on their loans to the bank. Now, this is where it gets tricky for two reasons. Reason 1: all creditors who leant money to the bank are usually other banks, and insurance companies. Once these banks and insurance companies take a loss on their investment, it has the potential of causing them to lose capital and therefore run the risk of going under as well. Again, this is what happened in 2008.

Reason 2: and this is the main concern for everyone involved with European finance, the bank’s losses might actually be coming from one of the European governments. This is the scenario where one of the Eurozone countries decides to leave the Eurozone. As for which country could leave, simply close your eyes and pick. Any or all of Spain, Portugal, Italy, Greece, France etc could leave on a moments notice. To demonstrate the danger, assume for a minute that Italy decided to leave the Eurozone and return to using the Italian Lira as their currency. Immediately, Italy would announce that that all of the money it owes will now be owed in Lira and not Euros. But there would not be a fair market conversion. To make matters simple, Italy owes investors over EUR 2.1 Trillion. If Italy left the Eurozone, it would then tell investors they will be paid back LIRA 2.1 Trillion which would be significantly less than the original EUR 2.1 Trillion. Anyone doubting the scenario of Italy leaving should really go back to 2012 when then Prime Minister, Silvio Berlusconi told French President Sarkozy and German Chancellor Merkel that he was pulling Italy out of the Eurozone. What happened next was the political assassination of Berlusconi and therefore demonstrating the seriousness of the situation in Europe. So, this brings us back full circle to several important points. First of all, banks are leveraged and small losses have the potential to snowball throughout the entire industry.


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Our portfolios continue to build up USD positions


Second, the most important issue in Europe is the financial health of the countries – unless this is fixed, the banking sector is exposed to very serious things. And third, why would anyone invest in a European Bank Fund? Our Strategy Currencies: Throughout the year, we’ve been adding more and more exposure to the US Dollar within our currencies strategy. This has been the correct call and although the US Dollar has recently appreciated strongly relative to all other currencies, we believe this is just the beginning of a major move upwards. As result, we’ll likely be adding even more money to USD as we enter 2015. Equities: Since mid-year, we’ve also been increasing our exposure to the stock market with a big emphasis on the US markets and momentum strategies. This too has been value-added, and as long as markets remain in the current uptrend, we’ll continue with a focus on momentum strategies, with specific allocations to the US. Fixed Income: We’ve previously communicated that we exited our high yield bond strategies during the summer before the sell-off. The sector has rallied off its recent lows, but we believe the sector is priced to perfection with limited upside from its current yield. We’ll continue to avoid this sector, and remain with higher quality fixed income allocations.


Commodities: Our portfolios have small allocations to commodities, and although we expect a near-term rally, our outlook remains subdued for the sector as we enter 2015. We’ll likely be reducing these positions completely at some point in the near future. As always, we’d be pleased to speak with anyone about our investment views. We also encourage our readers to share our global market outlook with those who they think may find it of interest. Please feel to contact: John Corney at [email protected] Ariz David at [email protected] or Keith Dicker at [email protected]. Thank you for sharing your time with us.








december 2014 icecap global outlook

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