Winter 2015 – Newsletter

Just when I thought I was out… they pull me back in. – Michael Corleone, Godfather III

When my sister was 15 years old, a neighbor commented to my father that kids grow up so fast these days, having just seen my sister drive around the neighborhood a day earlier. It seems that she had made a copy of my father’s car keys, took to the streets of Manhattan and taught herself how to drive without my parents’ knowledge – at least, that is, until our neighbor spilled the beans.

If it isn’t one thing it’s 50. While the United States seems to have gotten its groove back, geopolitical risks, international grudge matches and currency wars have investors searching for peace of mind the way paranoid people peruse produce at the market. Good grief. America created more jobs in the last four years than all the other industrialized nations combined – who needs distractions?

graph11Meanwhile, oil prices have sunk like a rock. Thumbs up for pain relief at the pump, but there’s a lot more to it than meets the eye. Energy jobs have been a shot in the arm for growth, but it goes without saying that when oil prices drop by 50 percent, oil companies tend to lay off workers, many of whom lack transferrable skills.

Some of the recent slide can be traced back to our longstanding relationship with Saudi Arabia. If you’ll recall, President Nixon abandoned the gold reserve in 1971 so we could print money and live like rock stars, paying for popular social programs and the feckless Vietnam War. In fact, one of the reasons inflation was so high in the 70’s and early 80’s is because the dollar declined in value once it wasn’t backed by anything of value – we needed more greenbacks to buy the same loaf of bread.

Without the gold standard, foreign creditors and trading partners knew the U.S. dollar was collateralized by wishful thinking, driving the U.S. to strike a deal with Saudi Arabia in 1974. In this arrangement, Saudi Arabia agreed to only accept U.S. dollars for the purchase of oil in exchange for military weapons, protection from its enemies and a pledge that we won’t export domestic oil.

America had punked the financial markets by manufacturing global demand for the U.S. dollar because no other currency could be used for the purchase of oil. By 1975, all oil producing OPEC countries also signed the deal and so began the era of bling bling, with drunk ol’ Uncle Sam running up the debt and using the cold war as a reason to spend more money on a military required to keep the peace in the Middle East.

As global economic growth increased, so too did the demand for oil, U.S. dollars and our debt instruments. This allowed us to increase the supply of paper dollars with no immediate consequences, boosting economic activity while avoiding sky high inflation. For an added bonus, Saudi Arabia agreed to deposit their revenue in western banks and buy treasury bonds for good measure.

Having established our currency as the only means to buy energy, foreign nations were incented to sell us cheap goods manufactured in their countries because our consumers paid them in U.S. dollars that provided the greenbacks they needed for oil transactions, and in the process, allowed American households to increase consumption. Tricky Dick made one hell of a good deal!

$18 trillion of government debt and 40 years later, falling oil prices might be a sign of discord with Saudi Arabia. A deal is a deal, except when the United States becomes one of the largest oil and gas producer in the world, producing 9 million barrels per day versus the 9.5 million in Saudi Arabia. In response, Saudi Arabia has increased oil production to protect its market share, fully aware that lower prices make our energy companies less profitable.

We’re no worse for our wear, since America loves watching Russia’s biggest export revenue decay and its economy unsuccessfully challenge the laws of gravity. Putin might intend to take over Ukraine; I’m just not sure he can afford to do it with Rubles. And for what it’s worth, we’re probably more concerned that he threatened to sell oil in another currency than we are his military endeavors.

Indeed there’s more than one way to skin a cat, as Iran’s breakeven point is $130 a barrel of oil , and unless they have another multibillion dollar industry we’re unaware of, it looks like leverage is on our side. Venezuela, to its credit, hasn’t been in the market for anti-American rhetoric either; apparently too busy mopping up the red ink considering 95 percent of their export earnings comes from oil revenue.

graph12Nevertheless, we really should be careful about what we wish for. Lower commodity prices puts money in the pockets of consumers, but it also gives investors the impression that an economic slowdown is in the works. A funny thing happens when real estate is 20 percent of China’s economy and logs its slowest growth in more than two decades. It would be one thing if oil were the only thing falling off a cliff, but coal is down 52percent from its peak in 2010, copper slipped 14 percent in 2014, and last year iron ore declined 41 percent.

Heaven help us if the Federal Reserve raises rates when global economies are contracting. Aside from the higher cost to borrow money, business valuations are predicated on projected cash-flow. The present value of $1,000 a month payment received over 10 years at four percent is $98,770. Bump that interest rate up to six percent and that same cash flow is worth $90,734. Apply this logic to the cash flow of a public company and you see the concern – stock prices go down to account for higher rates without more revenue.

Needless to say, we couldn’t have international suspense thriller without Europe’s participation. Germany has always been afraid of hyperinflation, but having watched three rounds of Quantitative Easing in America, Mario Draghi, President of the European Central Bank, rolled his eyes like dice and hatched a plan to begin printing money with a $1 trillion bond buying program to devalue the Euro, all so they can export more domestic products abroad and jump start their economy.

Switzerland, a fiscally responsible country with manageable levels of debt, has seen its currency go through the roof, such that products made in its country are more expensive when consumers in other nations wish to buy it. In response, Switzerland had been buying Euros to inflate the price of that currency so the Swiss Franc wouldn’t increase.

diagram3Netflix better be paying attention. Turns out the EU’s latest announcement to devalue the Euro was too much to bear for the Swiss, who abandoned the practice of propping up the Euro, watched the Swiss Franc jump 30 percent against the Euro and put a hedge fund out of business . The “fine line” business is booming!

Of course, a sinking Euro increases the value of the U.S. dollar too, and anything our companies sell to Europe is paid for with a currency that keeps losing money. If only my old neighbor had seen this one coming: profitable domestic companies are getting a haircut because America is recovering faster than the rest of the world.
Who is John Galt? Commodity prices suggest the economies of industrialized countries offering fewer high wage jobs are shrinking, and currency manipulation, a solution once protected by glass, is being used as an elixir to the everyday common cold. Sprinkle in a little foreign policy potpourri, reserve currency stew and a side order of ideological ping pong between competing nations, and there you have it, the current economic environment that’s too complicated for its own good.

I’m exhausted just writing about this stuff; I can only imagine how you feel – but that’s the point. The more complex a system becomes the harder it is to fix if something goes wrong. One would think that 57 straight months of private sector job growth would carry a little more weight, but contending variables overseas add a few more twists and turns in this action flick than we bargained for.

In response, we own a small position in the volatility index, just in case things get dicey without warning. The hedged futures position has a track record of keeping pace with the market while protecting against a bumpy ride. Lastly, several low cost ETF’s in select defensive industries that pay dividends, along with some growth opportunities, have a history of offering appreciation. Keep in mind that the past is no guarantee of future performance.

In a sense, we’re juggling potential outcomes self-acclaimed experts don’t fully understand. Everything is a good idea until it isn’t, today’s hedge is tomorrow’s bad idea and chances are that if you relax, do some planning and exercise a little common sense, everything is gonna be all right.

Securities offered through LPL Financial, Member FINRA/SIPC ( Investment advice offered through Delancey Wealth Management, LLC, A registered investment advisor and separate entity from LPL Financial.

Quantitative Easing is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.

International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

The Dow Jones Industrial Average is comprised of 30 stocks that are major factors in their industries and widely held by individuals and institutional investors.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

The opinions expressed in this material do not necessarily reflect the views of LPL Financial.

1 International Monetary Fund
2 Why oil is more likely to test $50 than $100 again next year; CNBC; 11/16/14
3 By boosting production and lowering prices, Saudi Arabia has helped create a bear market in oil; Bloomberg; 10/23/14
4 Which Oil Producers Are Breaking Even?; Wall Street Journal; 11/27/14 5 OPEC
6 China Real Estate, Industrial Production To Take Biggest Hit From GDP Slowdown; International Business Times; 10/21/14
7 China’s property problems weighs on growth; BBC; 1/20/15
8 Plunging oil prices will starve the world of its economic fuel; Market Watch; 12/5/14 9 The really scary thing about Europe’s QE plan; CNBC; 1/15/15
10 Swiss-Franc Move Crushes Currency Brokers; Fox News; 1/16/15
11 Everest Capital falls victim to Swiss franc, shutters largest fund; CNBC; 1/17/15