September 12, 2014

A N G E L F I N A N C I A L’ S

Freedom & Capital

September 12, 2014 IssueA N G E L F I N A N C I A L’ S

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The next Federal Open Market Committee (FOMC) meeting will conclude on September 17. We can expect the Fed to “taper” by another $10 billion per month, which should bring the monetary inflation down to “just” $15 billion per month.

If nothing earth shattering happens between now and October, then the Fed should complete its taper at the end of October, meaning there will be no more monetary inflation — at least for a little while.

I believe we have been in a mini-artificial boom over the last few years, although I know it doesn’t seem like that for much of middle-class America. But stocks have shot up, and housing has recovered to a large extent in much of the country, fueled by a quintupling of the adjusted monetary base.

As the rate of monetary inflation continues to slow, we can expect that the malinvestments (misallocated resources) will begin to show. If the Fed doesn’t fire up the digital money printing again, then we will likely face a recession. It could be imminent, or it may take several months to a year to show up.

I say this not to be pessimistic; I am actually a long-term optimist. But it is important to be prepared for more financial turmoil ahead. While I expect more inflation down the road and recommend inflation hedges, I also believe it is important to get out of debt and to maintain some cash reserves.

If you feel your job or main source of income is vulnerable, it is also good to have a couple of backup plans, just in case. Meanwhile, we must be smart and somewhat conservative with our investments at this time, waiting for clearer roads in the future. Capital preservation should trump profit potential, especially now.

The 10-year yield is around the 2.5% mark as of this writing. It is a mild indicator that we might be heading into a recession. Gold has also pulled back a little, although this is far less of an indicator at this point because the pullbacks seem to be mild and temporary.

While I don’t think the stock market is a good gauge of how the American people are doing, it can be an early indicator of a recession. If stocks start to fall hard, then a recession is far more likely. But stocks won’t be the cause of it — they’ll just be the canary in the coal mine.

The malinvestments are already there due to the Fed’s massive monetary inflation and the government’s massive spending. These misallocated resources will have to be corrected at some point to reflect true consumer demand. It is just a question of how fast it will happen and whether the Fed will allow it to happen without causing more damage.

We will keep following the economic indicators, along with the Fed’s response to each thing. Meanwhile, I am also following Europe, where Germany is now finding trouble and the European Central Bank is getting desperate to create price inflation.

It will be interesting to see if the ECB is “successful” in getting price inflation higher. It may be something of a precursor of what happens in the U.S. I am also paying attention to Japan, where things are also getting interesting. We will wait and see how bad it gets there too.

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Harry Browne: A Man of Many Talents

I am a strong advocate of the permanent portfolio. I recommend that every investor have a minimum of 50% of his investment portfolio in a setup similar to it. This does not necessarily include investment real estate.

The permanent portfolio was introduced by Harry Browne in his little book Fail-Safe Investing. Harry Browne originally gained renown in the early 1970s when he correctly predicted a devaluation of the U.S. dollar. He went on to become politically active, getting the Libertarian Party’s presidential nomination in 1996 and again in 2000.

But Harry Browne was really the anti-politician. He freely admitted that he had almost no chance of becoming president. He also admitted that it wasn’t his goal. He did not want to exercise power over others — he wanted to repeal government. But his main purpose in running for president was educational. He wanted to show people the benefits of liberty.

Aside from politics and investments (which included writing several books), Harry Browne had some other talents that influenced people. He wrote a self-help book called How I Found Freedom in an Unfree World, which helped many people view their lives and life situations differently.

Harry Browne had also written a manuscript that was published as a book after his passing in 2006. The book is titled The Secret of Selling Anything.

I should also mention that if you want a good primer on money and economics, the first 70 pages of his 1970 book How You Can Profit from the Coming Devaluation is a great place to start. It is timeless.

If you are interested in money, economics, investments, politics, marketing, or self-help, then you probably won’t go wrong finding a copy of one of Harry’s books on Amazon.com or other sites where some of these are available.

In terms of investing and the permanent portfolio, I thought it would be important to review a few questions that often come up.

Do Assets in the Permanent Portfolio Offset Each Other?

The permanent portfolio is designed for “safety, stability, and simplicity.” Those three things come right out of Harry Browne’s book. The portfolio is designed to protect you from virtually any economic environment including prosperity, inflation, tight money (or recession), and deflation. The economy is usually in one of these phases, transitioning from one to another, or else in a combination of them.

With the permanent portfolio, there are investments to cover all categories. At least one of the investments should perform well in any economic environment. The only exception can be the tight money/recession category. But these are short lived and will turn into one of the other categories.

The inevitable question comes up: Do these investments neutralize each other? In other words, won’t the bad investments just offset the good ones? For this, I will quote directly from Harry’s book Fail-Safe Investing:

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“It might seem that a Permanent Portfolio containing these four contradictory investments would be neutralized: As one element rose, another would fall — and nothing would be gained.

On a day-to-day basis, that can be true. But over broad periods of time, the winning investments add more value to the portfolio than the losing investments take away.

For example, during 1973-77, stocks generally lost about 20%, but gold rose by 153%. During 1981-86, gold fell 34%, while stocks rose 80%. During these periods, stocks and gold didn’t cancel each other out; the winner had a bigger impact on the overall outcome than the loser did. The portfolio continued to appreciate in value — no matter what the climate.”

I will add to Harry’s commentary here by saying that you are also tending to buy low and sell high with the permanent portfolio. It is recommended that as one investment class outperforms others, you rebalance the portfolio to keep the percentages roughly equal: 25% stocks, 25% gold, 25% cash, and 25% long-term government bonds.

Therefore, you will tend to sell things when they have gone up in value, and you will tend to buy things when they have gone down in value — or at least down in relation to the other investments.

If you feel you are too undisciplined to do this, or if you feel you are still learning about this portfolio and don’t know the exact steps to take, then you can always invest in the permanent portfolio mutual fund. The symbol is PRPFX. It is not a perfect imitation of the true permanent portfolio, but it is the closest thing I know of in terms of mutual funds.

While I recommend you generally stick to the formula, there are times when a little tweaking may be ok. I want to avoid trying to predict the future with my permanent portfolio (I leave that up to my speculative portfolio) because doing otherwise defeats its purpose. But I think in certain situations, you can make little adjustments to fit your own personal financial situation.

Let me give one example of this…

Holding Cash Productively in Your Permanent Portfolio

The one aspect of the permanent portfolio that can seem the least productive is the cash portion. I use the term “cash” in reference to liquid assets that won’t lose value, with the exception of losing value to a declining currency. You don’t actually hold your cash portion in cash. It will be in the form of digits in a savings account, money market fund, or some other short-term instrument that is highly liquid.

In an era of high price inflation, as was seen in the 1970s, your cash portion will not lose as much as you think. That is because interest rates will typically be high to compensate for high inflation. There may be a lagging effect where inflation is rising ahead of interest rates (negative real interest rates), but it won’t be that much.

The place you will lose some ground is through taxes on interest earned. If price inflation is 5% and interest rates are 5%, then you will keep up the purchasing power of your money with inflation on a before-tax basis. Unfortunately, if you have to pay taxes on the 5% that you “earned,” you will actually

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lose purchasing power over time. (This is one reason it is beneficial to hold some of your cash portion in a 401(k) plan or some kind of tax-deferred account.)

Our current situation for cash investors is tough because interest rates are so low. They are near zero for short-term instruments. And while price inflation is running relatively low, it is still around 2%. And that is only if the government numbers are accurate.

It also does not account much for asset price inflation. If you are only going to buy consumer items such as food, electronics, and clothing, then you may be fine. But what if you want to buy a house or a piece of land?

Cash plays an important role in the permanent portfolio, but it is probably the least important role. Its main purpose is to smooth out the recessionary periods. It really helps in the stability part. It is also important to have cash on the sidelines to buy other assets that are down, especially when coming out of a recession.

When things fell apart in late 2008, the permanent portfolio went down for a period of about six months. The bond and cash portions of the portfolio kept the losses low, however. They helped offset the losses in stocks and gold.

But the key here is that there was cash available in rebalancing. When stocks and gold went down and put the permanent portfolio out of balance, you could have used part of your cash portion to buy stocks and gold when they were down.

With all of that said, I have thought for quite a while that the cash portion of the permanent portfolio could be reduced for really aggressive investors. This would still be far less aggressive than investors who put all of their money in stocks or some other asset class.

You could put 30% in stocks, 30% in bonds, 30% in gold, and 10% in cash. This would be a modified, aggressive version of the permanent portfolio. However, of the three main tenets of the portfolio — safety, stability, and simplicity — it would take away stability the most. It would not take away the simplicity, and it might make it a little less safe, though still safe compared to most other investment strategies. But in terms of stability, there would be a big loss. It would make the portfolio far more volatile. There would be much higher swings in both directions.

I don’t really recommend this strategy for this reason. One of the main points of the permanent portfolio is so you can sleep at night and not have to worry about losing your shirt. I sometimes call it the “sleep-at-night portfolio.”

But in today’s environment of extremely low interest rates, I am uneasy about having a large cash portion in certain situations. In particular, I am thinking about someone who has debt on which they are paying interest — which is most debt.

Let me use an example of a man who has financial investments of $200,000. He goes ahead and sets up a permanent portfolio, with $50,000 put in to each asset class. And for this discussion, let’s say that most or all of this money is not in some kind of a retirement account.

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In today’s environment, this person will be lucky to earn 1% interest per year on his $50,000. Actually, it will probably be 0.5% or less. So he will have $50,000 sitting in a money market fund or savings account in his bank, and he will make a couple of hundred dollars per year in interest (and then pay taxes on it). In other words, he will basically make nothing on it — less than nothing when you factor in inflation.

Meanwhile, let’s also say this same guy has owned a car for two years and still has a car loan. He has three years left on the car loan, which now has a balance of $15,000. The interest rate on the loan is 4%.

If I were in this position, I would likely use $15,000 out of the $50,000 in cash to pay off the loan. I would then take the monthly car payment I was making and put that back into the cash balance of the permanent portfolio each month. I find it a waste to keep money in the bank paying almost nothing in interest, while paying 4% interest on a car loan.

This is under the assumption that I did not fear a job loss in the next year or so or anticipate any imminent major expenses. Why? Well, the cash portion also acts as something of an emergency fund. But in a way, the whole permanent portfolio can be something of an emergency fund because you can also sell stocks, bonds, and gold. (I would not include retirement accounts in this.)

If you thought you might need the money in the next year or two, then you might want to hold onto the cash. But in this scenario, I still might consider paying off the car loan because I would still have $35,000 in cash, plus the rest of the permanent portfolio.

You must consider that when you pay off your car loan, your monthly cash flow will go up, at least in the sense that your monthly expenses have gone down. That is why you do not have to consider your circumstances beyond two years. If you didn’t pay off the loan, then you would be making those monthly payments for the next two years anyway, which would include the interest.

Using this strategy, you have to make sure you are disciplined in building up the cash portion again. If interest rates go up over the next two years, then you want to be sure to have that cash portion built up again to $50,000 in two years.

One thing I have really emphasized in past newsletters, and that I will continue to emphasize, is that you don’t get rich by paying interest — you get rich by collecting interest, which would include any kind of return on your investments. My exception to this rule is in investment real estate, but even here you are getting cash flow from the rent collected that more than offsets any interest you pay.

It still amazes me how many people think they are making a good investment when they are paying out interest on something. I have seen people buy land and pay a mortgage on it while doing nothing with it, only in the hopes of getting capital gains one day. Even if they do get capital gains one day, it will probably never be enough to offset the interest paid on the loan. And that doesn’t even consider the opportunity costs of locking up the investment money.

I have also been told by people — who happen to understand the workings of the Fed and the dangers of inflation — that it is OK to run up debt because you will pay it off in depreciating money. This may be a good argument for investment properties, but not much else.

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If you buy a consumption item on credit, you will still have to pay the interest costs, regardless of inflation. It is still money you are losing. In order to get wealthy, you need to be on the collecting end, not the paying end.

Going back to the strategy of using cash to pay down debt, this could apply to a car loan or credit card debt. It may or may not apply to student loan debt and mortgages — these tend to be longer term and bigger in nature.

In the same scenario above, if the person has a mortgage of $150,000, then I would be very cautious in using any of the $50,000 to pay down the principal balance on the mortgage. I would need to feel more secure about my income. After all, you are locking this money up until you sell your house, refinance, or pay off the mortgage. It is not like the car loan, where you will relieve yourself of the extra monthly payment immediately.

Every individual’s situation is different, but I want to give you some ideas on how to think through your own situation. It bothers me that cash is so unproductive right now in the permanent portfolio other than giving it some overall added stability.

If you have any kind of debt — car loans, student loans, credit card debt, a mortgage, or anything — then consider using extra cash balances to pay down your debt. But do it carefully in the context of having an emergency fund. If you can avoid paying interest, then you will be way ahead of most Americans.

The Current Status of the Permanent Portfolio

Over the last six years, the permanent portfolio setup has probably seen the lowest returns in its history. The returns are still quite positive, but they have not been as great as in periods past.

This is because we are living in a time of low interest rates and relatively low price inflation. The permanent portfolio has an inflation bias — it tends to have higher returns during periods of higher price inflation. This is actually a great thing because you want higher returns when you are losing purchasing power at a greater rate. When prices are relatively flat, you don’t need high returns.

While we do not currently have a situation of tight money, monetarily speaking, it is still somewhat recessionary due to fear and the high demand for money (low velocity). This is one of the reasons that we have relatively low consumer price inflation despite high monetary inflation. The significant price inflation that we do have is in asset prices, particularly stocks.

I also believe it is a good thing that the permanent portfolio tends to have an inflation bias because I think we will tend to see more inflation over time. I think we will have periods of inflation and periods of deleveraging. The deleveraging may not be deflationary in a monetary sense, but these periods will be recessionary conditions and may even cause prices to fall slightly due to increased money demand. Still, I believe the overall trend will be one of inflation. And if you don’t believe me, then perhaps you will believe former Federal Reserve Chair Ben Bernanke.

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An Important Speech by Ben Bernanke Before He was Fed Chair

On November 21, 2002, more than three years before he was chairman of the Fed, Ben Bernanke gave a speech before the National Economists Club in Washington, D.C. It is one of his most famous speeches, and it earned him the nickname “Helicopter Ben.”

First, let me quote small portions of his speech so that nothing is taken out of context. On the subject of fiscal policy, Bernanke cites the idea of a helicopter drop of money. His statement is as follows:

“Each of the policy options I have discussed so far involves the Fed’s acting on its own. In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices. Even if households decided not to increase consumption but instead re-balanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman’s famous ‘helicopter drop’ of money.

Of course, in lieu of tax cuts or increases in transfers the government could increase spending on current goods and services or even acquire existing real or financial assets. If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets.”

So that is where Bernanke got the nickname “Helicopter Ben,” justly or not. Based on this speech, maybe it was an unfair characterization. But based on his actions as the Fed chair, the nickname is quite deserved.

The nickname implied that Bernanke thought the Fed could always just print money and drop it from a helicopter. But when the fall of 2008 came, the only helicopter drop was in the form of digits, and the drop occurred over a bunch of large commercial banks and financial firms.

While this part of his speech was amusing, particularly because of the Fed critics giving Bernanke a nickname that caught on, it was not the most significant part of his speech. That came a few paragraphs earlier. Bernanke said the following:

“The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. A little parable may prove useful: Today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject’s oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days. What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal.

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What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”

This little portion of Bernanke’s speech is probably the most important thing he ever publicly said. Of course, the gold price is no longer $300 per ounce, but everything else is just as relevant today.

I don’t like Bernanke, I think he did a terrible job at the Fed, and I think he is a shill for the Establishment. But what he said here was right, and it is important to know and understand.

I can’t count the number of Fed critics I have spoken to or read who believe that we are going to see some kind of a sustained deflation. While I am not denying that this is technically possible, I do believe it is highly improbable.

As Bernanke said, the Fed just has to create money out of thin air. Actually, it really just needs to threaten to create money out of thin air. If this is a credible threat, meaning that people believe the Fed will do what it says, then this will be enough to increase prices in nominal terms.

The Fed can always get out of a deflationary situation if it wants to. This does not hold true on the other side of the spectrum with hyperinflation. If the market loses all confidence in the dollar (or any other money), it will result in hyperinflation.

The Fed stopped the massive inflation that was occurring in the late 1970s. Paul Volcker and the Fed had to slam on the monetary brakes hard. They did not want to risk a hyperinflation scenario. They had to make sure they did not lose control of the situation. They succeeded in stopping the massive price inflation, even though it resulted in multiple recessions in the early 1980s.

But I can’t stress enough that the Fed can always cause prices to rise if it really wants to accomplish this. Janet Yellen could announce tomorrow morning that the Fed intends to start another round of quantitative easing at the rate of $500 billion per month (or pick some extraordinary number). You would see stocks and commodities jump almost instantly. Consumer prices would not be far behind, assuming that people believed her.

This doesn’t mean we can’t have any deflation. It doesn’t mean we can’t have recessions or depressions. The Fed can’t always increase the money supply at a rapid rate, or it would eventually face a hyperinflation scenario. Therefore, it goes in bursts and cycles. We will still see periods of deleveraging.

But my overall point is that we are highly unlikely to see a sustained period of deflation. The Fed can reverse this at any time.

It is not in the Fed’s interest to have hyperinflation, as it would be destroying its own power and

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legitimacy. The Fed officials would also be destroying their dollar-denominated pensions.

But it is also not in the Fed’s interest to have long periods of falling prices, unless those prices are falling only because of increased technology and productivity. The Fed’s main purpose for existing (contrary to what it says) is to help the big banks and to help Congress fund its deficits. This can only be done by monetary inflation and artificially low interest rates, which tend to go hand in hand.

For this reason, I expect inflation more than deflation. I like that the permanent portfolio has a slight inflation bias. It tends to perform better in inflationary conditions. Of course, you don’t need to have as high of returns in a period of deflation because your purchasing power should be increasing or at least maintained. You need higher returns when your dollars are losing purchasing power faster.

For the long term, if I had to bet on one or the other, I would definitely bet on inflation over deflation. But again, we still need to prepare for both because we will see periods of both, even if they are somewhat brief.

How Does the Federal Reserve Create Money?

While more and more people are beginning to understand that the Federal Reserve creates money out of thin air, most do not understand the technical details behind it. I believe a good understanding of this subject is important, just so you don’t take the advice of someone who doesn’t understand it.

We sometimes say the Fed prints money, but it doesn’t really. The U.S. Treasury prints currency to represent a portion of the money that was created out of thin air by the Fed. The Fed creates money out of thin air on a computer with digital accounting. I like to call it digital money printing.

While the technology is fairly new, the idea of inflation isn’t. Many centuries ago, a king would debase his country’s currency by clipping coins. The coins that weren’t clipped would disappear out of circulation due to Gresham’s Law, something I discussed in a previous issue.

The Fed has two main purposes as I see it: It is there to protect and subsidize the big banks, and it is there is help the federal government spend money without raising taxes. I know Fed officials will not admit this and say the Fed has other missions, but any honest and intelligent person who really studies the Fed has to see that it is there for political purposes.

While the Fed acts as a lender of last resort and a backstop for the big banks, it does not just give money to banks every time it creates money out of thin air. Some mistakenly believe this, but it is now somewhat true some of the time.

Prior to 2008 (when things really changed), the Fed would create money out of thin air by buying U.S. government debt. It would buy Treasuries and bonds. It does not buy these directly from the government. The Federal Reserve Act specifies that the Fed buy and sell in the open market. There are a handful of major financial institutions that act as brokers, which are called primary dealers. They buy the bonds and then sell them to the Fed.

The Fed takes possession of these bonds by buying them with digits that previously didn’t exist. In this scenario, the broker had to buy the bonds from the federal government and then sell them to the Fed.

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So it didn’t really make any money, except for a commission.

It is basically the same thing as if the Fed just hands new money over to the federal government in exchange for some IOUs. There just happens to be a middleman in this transaction.

As a holder of the government debt, the Fed actually gets paid interest on the bonds from the government. The Fed uses this money to cover its operating expenses and any money left over is sent back to the Treasury. In other words, it is just a bunch of accounting transactions back and forth between the Fed and the federal government. But this enables the federal government to spend extra money without having to collect it first in taxes.

When a bond matures, the government has to pay back the principal to the Fed, just like it would pay it to any individual investor. But the Fed can just roll it over and buy another bond. If it doesn’t, then this actually reverses the previous monetary inflation. By letting the bond mature and not rolling it over, it is deflationary. The money disappears into thin air just as it originally appeared.

Since 2008, the Fed has bought other assets besides government debt. In particular, the Fed has been buying mortgage-backed securities. This really is handing money over to banks in a sense.

Let’s say a bank has some mortgage-backed securities that were originally worth $10 million. Due to the housing bust and a lot of people defaulting on their loans, let’s say the securities are only worth $6 million now. But the Fed comes in and buys them for the original $10 million. It is a bailout of $4 million for the bank. The only way to know what they are truly worth is by selling them on the open market. But the Fed is paying the previous price, which doesn’t reflect the new reality.

Some people will keep paying their mortgages, and this will go to the Fed, similar to interest payments. But some people will not pay on their mortgage, and this will be a loss to the Fed, which is really a loss to Americans and anyone who holds dollars.

If the Fed created $10 million out of thin air to buy mortgage-backed securities and then gets $6 million back (eventually), then the $4 million has been created and can’t be withdrawn. The Fed can’t take it back. The Fed’s “loss” is really just $4 million that was created out of thin air.

If you read each statement by the FOMC, you will see the same comment each time about it rolling over maturing debt. The last FOMC statement stated: “The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.”

When Janet Yellen talks about the Fed’s exit policy from all of its so-called quantitative easing, there really is no exit policy. It can’t really sell back the mortgage-backed securities to the banks or else it would sink the banks. It could sell them on the open market, but it would be for far less than what the Fed paid for them.

The Fed could stop rolling over Treasury debt, which would be deflationary over time, but this would really be sticking it to Congress. This would not only stop in its helping of deficit spending, but it may actually force the government to reduce the national debt. Congress can’t even come close to

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balancing the budget in a single year, let alone run a surplus to pay down the debt.

In conclusion, the Fed’s balance sheet will not get smaller by any significant amounts. The general trend will be more inflation. But as stated above, there will still be periods of deleveraging. There will be busts that follow the artificial booms, just as things have always been under the Fed. Our problem right now is that the booms and busts seem to be getting worse.

Stay tuned!

Coming Soon

Jim Rogers on Diversification

An Update on Shorting Bonds

Will We See an Inverted Yield Curve?

Two Easy “Investments” for the Ultimate Conservative Investor

Investments for the Aggressive Investor

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