Squeezed Between A Budget Rock And A Fiscal Hard Place

Our Monthly Performance Update
The Golden Rule - Does It Still Apply?
Gold vs. Treasury Bills
Treasury International Capital Flows Jump
Real Estate Update
Who Pays the Taxes?
No Recovery in Tax Receipts
Portfolio Performance Analysis
My Boise State Broncos

Is the real economy truly turning up or are recent upward ticks in the data caused mostly by government stimulus programs?  One thing for sure is that betting against the American consumer has historically been a very bad idea.  Are gross amounts of government spending trying to make this a better trade?

Left to their own devices, free economies, with minimal governmental intervention, typically solve most problems they face.  This is not to say that we should let people go hungry in the streets or minimize the effects of systematic risk, but when it comes to successful economies and governmental intervention, less definitely means more.  Governments-even those governments with the best of intentions, have a bad habit of getting in the way of the natural economic process.  They either make problems worse or they extend the amount of time it takes for a damaged economy to heal its wounds, or both.  I can't think of a situation where this is not the case. 

In recent academic literature, it has been clearly documented that tax increases have a negative effect on GDP and that government stimulus has a short-term, but no long-term positive effect on economic growth.  Here is the latest working paper on this topic http://papers.nber.org/papers/w15369.pdf

What recent academic research clearly demonstrates is that taxes have a 3X multiplier on GDP and that government spending works short-term, but has no long-term positive effect on the economy.  More specifically, a 1% tax increase decreases GDP by 3% and vice versa.  Since government spending produces short-term positive effects but no long-term positive gain, any short-term gains caused by government spending has to have a negative intermediate-term effect to take long-term gains back to zero.  In other words, a positive lift in the economy caused by government spending must revert below the mean intermediate-term to take the long-term effect back to par. 

Since excessive amounts of government spending almost certainly cause tax increases, it looks like the good intentions of the government will either make our current situation worse or extend the length of time it takes for the natural economic process to heal itself. 

Quote of the month:

"It is far too natural for us humans to make socially acceptable choices in life. We are punished via negative reinforcement for making decisions that are not conventional.  As it is often said - it is better to fail conventionally than fail unconventionally, for the blame will be placed on the individual versus the circumstances when taking the path less traveled. If you buy and hold, you can always blame a poor market for your losses, in contrast you will typically get credit for skill in good markets. In contrast, the trader will face intense scrutiny for underperforming in good markets and receive credit for performing well in a poor market.  Trading is no different from any other endeavor that is crippled by our primitive decision-making facilities. For all the intelligence that exists in the world, few of us wish to be different, and the logical few are only too aware of the severe costs of making unconventional decisions that fail-even when they know it is the right choice."
David Varadi - CSS Analytics

Our Monthly Performance Update

November was yet again another positive month for global equity markets.  Due to our cautious stance in these markets, our hedged and net short positions kept us from participating in the market's advance.  Fixed income continues to be our shining star, eking out its 8th winning month in a row.    

Below are recent performance returns on the four portfolios we currently offer:

Past 12









Income Builder  (IB)





The Guardian  (GRD)





Harmony Plus  (HMY)





The Expedition  (EXP)





S&P 500  (SP500)





Important Performance Disclosure

ProfitScore provides its separately-managed accounts to individuals, advisors and institutional investors.  If you would like to hire us to help you navigate this difficult bear market, below are three ways to contact us:

  1. Complete our Private Client Group request form by clicking here: http://profitscore.com/insight.aspx and submitting your contact information. (This is the most preferred method.)
  2. Call us directly at (800) 731-5690.
  3. Simply send us an email to info @ profitscore.com.
Someone will contact you within 24 hours of receiving your information.

The Golden Rule - Does It Still Apply?

With Black Friday 2009 now in the history books, markets have become jittery of late. Not only have stocks encountered increasing headwinds, precious metals are under pressure as well.  Does it mean the rally is over?

In his 1977 book, The Golden Constant, Roy Jastram traced the price of gold from the Middle-Ages in Britain and in the U.S. during the 1800's.  He concluded that gold tended to return to an historic rate of exchange or purchasing power parity with other commodities in an index that bears his name.

In a paper entitled "Gold as a Store of Value" for the World Gold Council in 1998, Stephen Harmston updated this gold measure and offered the following long-term view of the yellow metal:

"If gold is to function successfully as a store of value it must either maintain its rate of exchange with other goods and services or, at least, be expected to return to an historical rate of exchange. It is said that an ounce of gold bought 350 loaves of bread in the time of Nebuchadnezzar, king of Babylon, who died in 562 BC. The same ounce of gold still buys approximately 350 loaves of bread today. Across 2,500 years gold has in other words retained its purchasing power, relative to bread at least, and has had a real rate of return of zero."

Where a number of critics get hung up is in the short-term fluctuations that tend to render this argument flawed. For example, a loaf of bread cost 33 pence in the UK in 1980. Today, that same bread costs roughly three times more, around £1. Gold sold for around $800/oz in 1980, but still has a ways to go to reach $2400/oz.

So does this render the historic gold value measure invalid?

Today, a loaf of whole wheat bread starts around $1.60 on up to more than $3.00. Using the 350 loaf measure above, at a price of around $1150, 350 loaves would cost $3.28 each, so the ancient measure is not far off.

But Rastram's work and the research by Stephen Harmston confirm that over the long haul, by smoothing out the volatility, gold has been a good measure of inflation. For example, the Jastram gold index set the value at 100 in 1717 when Britain went on the gold standard. The index was also 100 in 1930, three years before FDR temporarily took the U.S. off the gold standard to devalue the dollar. And although the index has enjoyed some wild rides since its first measure in 1343, it remains a good standard of value, a conclusion again confirmed by Harmston.

"Gold functions as a long-term store of value. That is the key finding of this report. This analysis may not have established the veracity of the claim that gold has held its value since the time of King Nebuchadnezzar, but it has proved that gold has maintained its real purchasing power in terms of commodities and intermediate products since the early days of the United States of America, since the reign of Queen Elizabeth I, and since shortly after the end of the First Republic in France. It has also maintained its value since the late 19th century in Japan and since the time of the political unification of Germany in the early 1870s."

Gold vs. the Other Safe Haven - Treasury Bills

There is little doubt that the rapidly rising price of gold and other precious metals is a vote of no-confidence in current global fiscal policy, especially in the U.S. But, owning gold is a double-edged sword, as those who held it from 1985 through 2001 learned the hard way. The metal may be a good way to protect against inflation, but it also offers no real return.

However, over the last three years, it certainly has been better than owning Treasury bills or T-bonds.  They pay nearly zero nominal return, and a very big minus real return, as the next chart shows comparing gold performance with the inflation-adjusted T-bill returns since 1960.

Figure 1 - Chart of the price of gold since 1960 versus real interest rates.

This chart clearly shows that during tough times when real inflation rates wreaked havoc on real bond returns, gold performed very well. During the last two big recessionary periods (late 1970 to early 1980s and today), gold had done best when T-bills lost money.

There are some very compelling reasons to suspect that the worst may still lie ahead. This next chart shows the incredible explosion in U.S. debt and how this tendency has impacted government receipts (black line) versus expenditures (red line). As debt levels soar and tax revenues decline, governments are increasingly squeezed between a budget rock and a fiscal hard place.

Figure 2 - Growth chart from SocGen report showing U.S. debt versus GDP from 1947 to present.

Unfortunately, this greatly enhances government (Fed) temptation to print its way out of the mess, and the bigger the debt gets, the greater the print temptation becomes.

By the way, the above chart comes to us courtesy of Société Générale from a sobering Q4 report to clients entitled, "Worst- Case Debt Scenario." The report opens with a chart that shows the new fiscal "inconvenient" reality - global debt has jumped 250% in the last decade. But then in a rather puzzling twist, the report recommends selling the dollar (ok that makes sense) and buying government bonds (buy at historic low yields with only one direction left to go? we must assume this does not include U.S. bonds following recommendation # 1) and cherry picking equities and commodities. It then drew some compelling similarities to the Japanese malaise that has plagued that country since the early 1990s. Could it really be all that bad here? Certainly the charts included in the report suggest more headwinds to come.

This next chart, on page 8 of the report, of the price of gold versus the monetary base (amount of money in circulation) shows that even at its current, rather lofty nominal price, gold is undervalued compared to the amount of printed money sloshing around the financial system.

Figure 3 - A useful chart showing monetary base divided by the price of gold.

Treasury International Capital Flows Jump - Yeah!

After eight months of outflows, punctuated by the occasional anemic inflow, US treasuries appear to be back in favor with foreigners, as the net inflows jumped $133.5 billion in September versus a revised gain of $25.3 billion in August. However, this still amounts to an average monthly decline of $39 billion in 2009, but at least it's up from the average decline of $60 billion as of August.

Figure 4 - Monthly Treasury international capital flows with latest data from September.

What remains puzzling is the apparent strong demand from indirect bidders in government bond auctions. Bid-to-cover ratios continue to hover around three (three times as many bids as there are bonds available), which is utterly amazing considering that bonds are paying almost nothing in interest. So here is the question of the year:  Why are investors running for the cover of bonds denominated in a falling currency for an effective return of zero? Answer:  They must believe it's a safer place to be than in equities or any other asset class! I don't know about you, but I ‘m having a hard time buying that argument.

Real Estate Update

We also got some reasonably good news on the property front with the latest Case-Shiller report showing a September gain of 0.33% over August for the 20-city composite price index. Annually, prices are still down more than 9% and as the above chart shows, this marks the fifth consecutive month of gains.

However, all is not well in Camelot as the next chart shows. Government stimulus programs, especially the first-time and new existing home owner (homeowner) tax credits, have caused a run on existing homes, many of which are distressed sales or bank default short sales. But the new home market, which has traditionally moved nearly hand in glove with existing homes, is now trailing the existing market badly. This is an unhealthy situation as long as it persists.

Figure 5 - Chart showing growing gap between existing homes sales in response to the stimulus programs compared to new home sales.

Trillions in stimulus is having a much more powerful reflation impact in other nations as the article from Vancouver, Canada entitled, "B.C. home affordability takes a hit as prices rise in tightened, hot market," demonstrates (see Interesting Reading). Is this yet another example of a bubble in the making as a result of the never-ending stream of global quantitative easing programs?

Figure 6 - Case-Shiler Home Price Index and the year-over-year rate of change in housing prices for the 20-city index. Although the worst in home price declines appear to be over, home prices are still dropping.

Our next chart (Figure 6) shows the relationship between builder sentiment, according to the National Association of Home Builders Housing Market Index (HMI), and single family housing starts. The HMI (red) has clearly led housing starts, but after a number of months of gains, the index fell in October, as did housing starts in October.

This drop is a concern given the extension of the first-time home buyer tax credit and initiation of the grant for existing homeowners. There is even talk on Capital Hill about a new program called Cash for Caulkers (see link below) to issue grants to homeowners to reduce energy bills and make the homes more environmentally friendly.

If all this tax money is having an impact on the construction industry, this effect has so far been muted as Figures 5 and 7 demonstrate.

Figure 7 - Chart showing the National Association of Home Builders survey of the housing market index (red) leading single family housing starts (blue).

Who Pays the Taxes?

The next graphic that comes to us courtesy of the U.S. Mint shows the breakdown of who paid what portion of the tax bill last year. As we see from the pie chart on the right, income earners in the top 10% pay 71.2% of all taxes while the bottom 46.9% with incomes below $10,000 pay no federal income taxes.

A conversation about of the fairness of our progressive tax system is sure to generate a rousing debate at any cocktail or dinner party. But no matter what your opinion on the matter, one thing is sure, the combination of an aging population and rapidly accumulating federal and state debt will mean that tax rates will go up and the burden borne by those in the upper tax brackets will continue to get more onerous.

Graphic courtesy of the U.S. Mint.

Tax Receipts under Pressure

Exactly how the taxes are paid and who pays it is interesting. But what has been happening to tax receipts? There has been much ado about how the economy has improved and the stock market has rebound thanks to continued government quantitative easing and trillions in government stimulus programs. However, tax receipts tell another, more troubling tale.

As this next chart from ZeroHedge.com shows, individual withholding taxes have fallen nearly 8% in the last year and corporate withholding taxes are down a whopping 64% in the same period.

Here is a synopsis from ZeroHedge.com that brought this report to the public's attention.

"On a rolling 12 month basis, individual tax withheld has dropped by nearly 8% YoY, from $1.42 trillion to $1.31 trillion, while company withholdings are down a walloping 64%, from $274 billion to just under $100 billion! This is money that will never be used to pay down the skyrocketing U.S. deficit, because the U.S. consumer and average U.S. corporations are simply not collecting the required cash to line the Treasury's pockets with the one traditional way to pad the deficit: taxes. Expect much, much, much more debt issuance in America's short, medium and long-term future."

Interesting Reading:

Gold is rallying because...

Why is the price of bread important?

Gold as a Store of Value, Stephen Harmston

Does the price of gold rise or fall in a deflation?

A parable on gold from Jim Grant

Lessons on Monetary Reform

SocGen Report Worst-Case Debt Scenario

B.C. home affordability takes a hit as prices rise in tightened, hot market

Dollar's Demise Traces Roots to U.S. Tax Trap

Japan's Deflation Concern Mounts Even as Growth Accelerates

Cash for Caulkers?

Who Pays the Taxes?

Collapse in Tax Withholdings Refutes Improvements in Unemployment/Profitability

More about withholding taxes from the recent Financial Management Service report

Portfolio Performance Analysis

Risk & Reward
Each of our portfolios is strategically allocated across one or more of the Investment Pillars of Strength discussed below.  Each Pillar is managed by multiple, uncorrelated, absolute-return investment managers to produce a return stream that is consistent, negatively correlated with the major market averages in down markets and non-correlated with each of our core Pillars of Strength.  Commentary found in this newsletter is for informational purposes only and does not effect how our portfolios are traded.   

Managing risk is our most important consideration and it is reflected in the way our portfolios are built and managed each and every day.

Generating absolute-returns is a double-edged sword.  Your first job is to mitigate risk and your second job is to make money in all market environments.  Clients generally love you when the market is falling and wonder what the heck is wrong with you when it is going up.  The math works in our favor long-term, but it is just hard to explain to an emotional investor who has powerful heard instincts to chase the hot hand.  Because markets generally drop about 3X faster than they increase, it is just not possible to achieve both of our risk and return objectives at current nose bleed valuation levels.  Risk remains high and so we remain vigilant in our effort to mitigate this risk in client accounts.     

Our equity trading accuracy remained north of 50% for the month, but trading losses incurred from taking short positions continue to outweigh our overall portfolio gains.  Interest rate sensitive allocations continue their upward march higher.      

Index Advantage:

Although you can't tell it from our equity curve, our long trading accuracy has been north of 70% for the last three months.  Our short trading losses keep eating away at our gains, causing our overall gains to drop or remain flat.  In more normal market conditions, current trading accuracy would produce outsized gains, so we continue to be patient in our approach as we tightly managerisk in our portfolios.          

For the month, this pillar gained -1.0. 

Strategic Balance:

Very little trading is occurring in this tactical allocation, as our traders wait for better risk-adjusted trades to materialize.          

For the month, this pillar earned -0.09.      

Dynamic Income:

Eight winning months in a row and we are closing in on our ninth.  I can still remember the problems we had trading this important allocation in our early days.  Its non-correlated properties have made it a perfect fit for our equity portfolios, producing Sharpe ratios above 1.4 for our blended portfolios.    

For the month, this pillar earned .37.

Our portfolios are built using varying distributions to the strategic allocations discussed above.  To view detailed performance and risk statistics information about our investment portfolios for the month, please click on the links below: 

If You Are a Client, Don't Be Confused.
Actual management and performance fees are incurred monthly but are deducted from client accounts in the first month of every quarter (January, April, July, and October).  For performance reporting purposes, we deduct fees monthly as they incur and not quarterly, as they are reflected in client statements.  It all washes out in the end, but this may cause your account performance to deviate from our published performance reports on a month-to-month basis.  To be conservative, we also deduct the maximum fees we charge from our performance reports and your actual overall fees paid may be less than our maximum. 

My Boise State Broncos

America has always pulled for the underdog, and when it comes to college football, my Boise State Broncos have become America's favorite underdog football team.  College football rankings have been hotly debated for as long as I have been a football fan.  And today, it seems more debated than ever. 

Historically, smaller teams have had practically no chance of being picked as the number one team.  Boise State's famous win over Oklahoma in the 2006 BCS Fiesta Bowl may have changed the BCS selection process for a long time to come.  For those unfamiliar, here is an ESPN article on the Cinderella game http://sports.espn.go.com/espn/columns/story?columnist=forde_pat&id=2716979.  In my humble opinion, the Oklahoma Sooner's still haven't mentally recovered from this loss.  The game was voted by ESPN fans as the second greatest game in college football history, so Oklahoma will probably have to relive this game for longer than they care to remember.  I could go on, but you get the picture. 

Being from Tennessee, I am still an SEC Tennessee Volunteer at heart, but my Tennessee orange now comes in a shade of Bronco blue.  It saddens me to say this, but my Tennessee Volunteers would get trounced if they matched up against my Boise State Broncos this year.  How can a smaller school with smaller players consistently beat the major schools?  Big programs like the SEC typically recruit larger players.  Boise State typically recruits players that are a little smaller, but have an extra step in their stride.  What Boise State has proven to the rest of the college football world is that David can beat Goliath, especially when he is faster on his feet.   

This year Boise State faces off against Texas Christian University (TCU), another highly ranked, mid-major team, in the BCS Fiesta bowl.  It promises to be a fast-paced, hard-charging game.  If Boise State beats TCU and Oregon can beat Ohio State in the Rose Bowl, my Broncos will probably get ranked third in the country.  Not bad for a smaller, underdog team that few major programs want to play for fear of getting embarrassed.      

Working to grow your wealth,

John M. McClure
President & CEO
ProfitScore Capital Management, Inc.

P.S. ProfitScore provides its separately-managed accounts to individuals, advisors and institutional investors.  If you would like to hire us to help you navigate this difficult bear market, below are three ways to contact us:
  • Complete our Private Client Group request form by clicking here: http://profitscore.com/insight.aspx and submitting your contact information. (This is the most preferred method.)
  • Call us directly at (800) 731-5690.
  • Simply send us an email to info @ profitscore.com.
Someone will contact you within 24 hours of receiving your information.

Posted 12-18-2009 7:05 AM by John M. McClure
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