Today, Bloomberg News makes a very strong and creatively presented case for deflation. We now have some serious validation….but no joy.

• Extrmely low probability
• Extremely high impact
• Unimaginable a priori

Given this BSE, we have had a massive “pivot” from the health care fiasco in the making to focus on USA economy and jobs. The reason for this change is simply the one new Republican vote that can stop disastrous congressional economic policies.

OK, so how can this BSE save us? Bear with us for a bit.

We recently came upon this quote and find it quite descriptive:

“A democracy is always temporary in nature; it simply cannot exist as a permanent form of government. A democracy will continue to exist up until the time that voters discover that they can vote themselves generous gifts from the public treasury. From that moment on, the majority always votes for the candidates who promise the most benefits from the public treasury, with the result that every democracy will finally collapse due to loose fiscal policy…”

by Alexander Fraser Tytler, Scottish lawyer and writer, 1770.

Now, consider this fact:

~50% of USA workers pay $0 taxes, while the rest of the workers (the “rich”) pay all the taxes.

We think it fair to conclude:

Half the population has incentive to free-ride on the others and will cheerfully vote for increasing burdens on those “rich”.

Our country is in peril from financial catastrophes and very poor political decisions. Most pertinently, the Scott Brown BSE may enable the inevitable lunge by Democrats for more taxation and thus massive class warfare to be avoided.

We think the stock market is a good system for measuring value. We also know our RSGSI includes both power utility companies publicly committed to smart grid investing, and also vendors to those utilities. But we thought there might be a difference between utility and vendor valuations, reflecting a market estimate of who will “win” in future. So we refined our index into two component indexes to dive deeper. We now have these indexes to compare:

• RSGSI     = Rocketcap Smart Grid Stock Index
• RSGSI_U= Rocketcap Smart Grid Stock Index of utility companies
• RSGSI_V= Rocketcap Smart Grid Stock Index of vendor companies to the utilities

The utility and vendor indexes are simply comprised of the utilities and vendors which make up the RSGSI, so that

RSGSI=(9/21)*RSGSI_U  + (12/21)*RSGSI_V

• ^GSPC   = S&P 500 Index ETF
• PUI= PowerShares Dynamic Utilities ETF consisting of power utility firms. The top 10 holdings of this ETF, which comprise 46% of it’s whole market value, has only one utility from our own RSGSI (SRE-Sempra Energy). Those top 10 holdings range from 3.02% to 5.33%, with SRE at 5.25%.

Consider this graph, which shows the annualized returns for each of these indexes since 3-13-09, a 206 day time period.

The beginning of this time period corresponds with the market bottom last March (would we have invested then!). The graph shows the wild volatility of returns for the three months ending in June. The returns settled down after June 09. Now let’s consider the various cross correlations:

From the graph of returns and the correlation matrix, we can make these informal conclusions:

• RSGSI is highly correlated with S&P500, and their ROIs have tracked well.
• RSGSI_U and PUI are highly correlated and RSGSI_U has had superior ROI
• RSGSI_V and PUI are weakly correlated and RSGSI_V has had superior ROI to PUI
• RSGSI_V has best overall ROI of all the indexes, particularly superior to the utility indexes, RSGS_U and PUI

These vendors have so far gotten the greatest market valuations, yet have minimal implementations (sales) of Smart Grid systems! Thus, this value may reflect the market’s future valuation, including that of the vendors’ Smart Grid intellectual property.

This is not rigorous analysis, but it is suggestive. The innovation value of the Smart Grid vendors may be key to Smart Grid evolution.

Further Reading and Explanations

Introduction, definitions and meaning of the RocketCap Smart Grid Stock Index©

What annualization means

“Investing and speculating are widely confused. Investing is “to allocate capital into productive activities with the anticipation of operating profit.” Speculation is “to allocate capital in order to profit from politically caused distortions in the market place.”

If you can think of any counter-examples, please let us know!

She says

The Fed’s asymmetrical thinking extends as well to its treatment of financial assets—such as equity and debt instruments—en route to a bubble. As prices surge and markets soar, the Fed is reluctant to raise interest rates lest it be accused of hindering growth. But when the bubble bursts and asset prices begin to tumble, the Fed quickly steps in with dramatic interest rate reductions to “restore investor confidence” in hopes of avoiding a meltdown.

and concludes with

Now here’s the scary part: Even though more than half of all American households now own equities directly or through mutual funds, an increase in equity prices does not figure into the Fed’s calculation of inflation. So while measures of core inflation (which exclude food and energy) carefully register minute gains in the price of a fixed basket of goods and services meant to reflect what a typical family buys to achieve a minimum standard of living, they ignore massive price surges in what has effectively become a widely held consumer good: stocks.

Read the full article here

We set forth a somewhat formal answer in our post on the three main economic scenarios, deflation, neutral and inflation. We want to present a more intuitive answer below.

First, we need to set the stage.

As we have discussed, the Efficient Markets Hypothesis (EMH) is an idea fiercely defended by a variety of senior finance professors, in spite of massive evidence to the contrary. Our post here gives a good summary of what the EMH is, why it is wrong and how it leads to mistakes.

The issue revolves around the implication of EMH that active management is a waste of time and money, since no amount of work can produce more insight than everyone else in market has or can get, and so an investor can get only the market ROI overall over the long run. Thus, according to the EMH, one should just invest in index funds.

OK, let’s stipulate EMH is useless. Now what? How should we invest? Before answering this question, let’s also stipulate, for obvious reasons, we cannot avoid this question.

One answer could be, just give our money to an advisor and let him invest for us. But of course, that raises the question as to how one chooses an advisor who if not sufficiently skilled, is sufficiently lucky. So we need to define an investment strategy.

In spite of all the confusion and uncertainties, one can still make some rational investments, while staying emotionally calm. Let’s define assumptions for a strategy:

The goal is to maximize our ROI, subject to a level of risk we can tolerate. Clearly, the ROI and the risk level are both subjective. We are willing to take more risk to get larger ROI. But the relationship between those two large factors is not known in advance.

We believe the current economic condition is mainly deflationary (prices are dropping and being a creditor is good).

We want to hold securities in such a way that when we discern inflation signs, we can switch easily from the current deflationary position to an inflation stance.

In our case, we want to preserve capital, but have growth reasonably better than that of money market rates (which are now ~0%/YR). This is the risk avoidance component of the strategy. Additionally, we want exposure to some upside to growth. The allocation between our risk avoidance securities and the upside-capture securities is where emotion enters the framework.

Our specific recommendation: account for deflation buy owning a variety of bonds and bond funds. Position the portfolio for upside by owning equities in companies in sectors which we believe are especially promising in the current political-economic environment. This idea, of course, is a standard approach, but modified by a strong emphasis on a small amount of very high risk/high payoff equities. The portion devoted to capturing future innovations or even disasters through equities can of course be enhanced by using various combinations of long dated puts and calls.

Using this broad approach, we can manage risk simply through the allocation between fixed income and equities, and focus on higher risk equities to be exposed to upsides from innovation.

This is not what is called well-diversified….rather, it’s a bet on specific beliefs. Remember, if you diversify enough, you effectively index everything.

Finally, some examples: First, the online, medical records sector, which will be quite actively converting old medical records to electronic format, as well as creating new records electronically, and the semiconductor industry, which continues to grow and also acts as a leading indicator of economic revival.

RSGSI for 10-30-09: 164 days annualized ROI

RSGSI Portfolio Correlation Matrix: 45 Days Ending 10-30-09

Further Reading and Explanations

Introduction, definitions and meaning of the RocketCap Smart Grid Stock Index©

What annualization means

Not really. Consider this excerpt from the article:

Prohibitions on insider trading prevent the market from adjusting as quickly as possible to changes in the demand for, and supply of, corporate assets. The result is prices that lie.

And when prices lie, market participants are misled into behaving in ways that harm not only themselves but also the economy writ large.

Remember the 1970s-era price ceiling on gasoline? By causing prices at the pump to lie about the scarcity of oil, that price ceiling led Americans to waste untold hours waiting in lines to fuel their cars. Similar wastes occur when corporate assets are mispriced.

Suppose that unscrupulous management drives Acme Inc. to the verge of bankruptcy. Being unscrupulous, Acme’s managers succeed for a time in hiding its perilous financial condition from the public. During this lying time, Acme’s share price will be too high. Investors will buy Acme shares at prices that conceal the company’s imminent doom. Creditors will extend financing to Acme on terms that do not compensate those creditors for the true risks that they are unknowingly undertaking. Perhaps some of Acme’s employees will turn down good job offers at other firms in order to remain at what they are misled to believe is a financially solid Acme Inc.

Eventually, of course, those misled investors, creditors and workers will suffer financial losses. But the economy as a whole loses, too. Capital that would otherwise have been invested in firms more productive than Acme Inc. never gets to those firms. So compared with what would have happened had people not been misled by Acme’s deceitfully high share price, those better-run firms don’t enhance their efficiencies as much. They don’t expand their operations as much. They don’t create as many good jobs. Consumers don’t enjoy the increased outputs, improved product qualities and lower prices that would otherwise have resulted.

In short, overall economic efficiency is reduced.

You can read the whole article here.

Want to hear a real laugher? Despite the current disharmony in politics, there’s one policy on which all of Washington agrees. Republicans and Democrats, House and Senate, president and Congress all agree that after last fall’s financial crisis, the federal government has to regulate the financial industry more closely to protect our economy from risk of systemic financial collapse.

Here’s the joke. As boom- and bust-prone as high finance always has been and remains, the greatest systemic risk to our economy is not Wall Street. It’s the growing federal debt (and weakening dollar) being enacted by those Washington politicians — the ones who want to protect us from Wall Street.

The piece was written by Tony Blankley and you can read it here.

Our financial situation is breathtakingly unsustainable. You really need to pay attention to preserve and grow your capital.

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