icecap global market outlook dec 2014

7/26/2019 IceCap Global Market Outlook Dec 2014

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Our view on global investment markets:

December 2014 The Third Law

Keith Dicker, CFA

Chief Investment Officer

[email protected]

www.IceCapAssetManagement.com
mailto:[email protected]://www.icecapassetmanagement.com/http://www.icecapassetmanagement.com/mailto:[email protected]


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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. Theyembraced 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

Newtons Third Law of Motion predicted it would.

The pendulum of the money world also swings from side to side, yetmost 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, Newtons Third Law seems to be either forgotten or

dismissed altogether, and this is a shame because the worlds

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 Newtons 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 Newtons 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.

Weve written and presented before that practically everyone in the

investment business today earned their stars and stripes during thefamous 1982-1999 bull market (see Chart 2, page 4).

Weve 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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2www.IceCapAssetManagement.com

Beware the starting the point

begins lecturing us with the all too predictable ...Ive 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 1on the next page perfectly illustrates this exact

same concept.

The point we make is that many investors in the world today are tootrustworthy 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 (theres 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 directionand 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 itsrabbit 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 FallacyThe 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



1984195430 years

= 0% return

30 years

= 400% return

2014


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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 isno consistent link whatsoever between economic growth and stock

market performance. Its 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 shouldnt 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



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Its 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 wouldaccelerate 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 youll 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 Chinas and

Indias 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 isnt 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 ofcourse, is that success in growing your business isnt necessarily

reflected in your stock price.

This confusion between correlation and causation has stumpedthe 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 howit 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 doesnt reconcile with what theyve 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 MarketLast 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 youre 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 gameevery 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 shouldnt 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 worlds 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 isnt in

their DNA and you shouldnt expect this to change.

What should you believe?If economic growth doesnt drive stock prices then what does? A

whole host of things actually. Unfortunately, when you dig deeperyoull 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 aremany 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 doesnt

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


Professionaleconomists have

predicted 0 of the

last 7 recessions

Professional

economists haveNEVER expected a

recession to occur

Since 2001

professional

economists havebeen accurate

12.7% of the time

Recession

Expansion



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Stronger, higher, faster


The Next 12 MonthsOver the next 12 months, the world will see a see-saw battle

between those believing and hoping that America can pull the rest ofthe 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 marketsto 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 communiqus, and 6 years of stronger

policy programs, IceCap fully expects Europes economy to become

even weaker as it heads into the 2ndhalf 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 isnt 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 changedramatically. 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 Frances 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 youalso 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.

Its the losses to bond holders that is really scaring Europe, and theone 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 wasintroduced 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 shouldnt 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

didnt quite earn the label as being innovative, it did demonstrate

how the folks in Brussels can whip out new policy papers on amoments 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 beNEGATIVE. 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 (theres 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 tothese same people and companies. The trouble is, these people and

companies have no interest in borrowing any money. As a result the

ECBs 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 beendreaming of since the entire debt crisis started money printing. It will

happen in Europe, and well 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 youll 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 moredebt to fix a debt crisis seems a bit odd, but thats 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. IceCaps view

hasnt 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 elses 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 ideaThe investment industry is full of a lot of things, and without looking

very hard you should not be surprised to see new mutual funds andnew investment ideas flogged on an almost daily basis.

Like all innovation theres 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 themerits 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,



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Save George Bailey


after all the last memory anyone had of a bank going under was the

one owned by George Bailey in Its a Wonderful Life. And since that

only happened in a movie surely the odds of a bank going belly upwere 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 thats just in the United States. During

the 1990s, Asia and Latin America saw 234 banks close its 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, mostinvestors 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 yourmoney 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 Europes banks, you must first

understand how a bank is structured as a company. The most glaringdifference 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 ownmoney. These companies may struggle from time, but they are simply

not structured to go KA-BOOMin 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 banks 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 highprobability of this happening. But only if the reason for the banks

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 willaccept 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 banks 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 themoney 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 pullingItaly 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 StrategyCurrencies: Throughout the year, weve 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 isjust the beginning of a major move upwards. As result, well likely be

adding even more money to USD as we enter 2015.

Equities: Since mid-year, weve 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, well continue with a focus on

momentum strategies, with specific allocations to the US.

Fixed Income: Weve 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. Well

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. Well likely be reducingthese positions completely at some point in the near future.

As always, wed 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 [email protected]

Ariz David at [email protected]

Keith Dicker at [email protected].

Thank you for sharing your time with us.
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icecap global market outlook dec 2014

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