Introduction
“Doing the same thing over and over again and expecting different results.”

Albert Einstein said that this was the definition of insanity.  Al might be right, but for me it’s also the definition of golf.  Of late, my golf game has deteriorated.  Those of you who are familiar with my game are probably saying “Impossible.”  Those of you who are unfamiliar with my game may want to review the incident report from my 50th birthday golf trip to Ireland.  It can be found in the October 2007 edition of the Plumb Performance Portfolio©.  Spending last year in Paris, having a season away from the game, I came alarmingly close to putting things into perspective.  I was cogitating cogent thoughts like, “If I haven’t figured out the game after the first 1,346 times I played it, the 1,347th is probably not going to generate some magical transformation.”  I was just about ready to try something different, thereby preserving my sanity.  But this spring, I had a golfous breakdown.

What, you ask, caused me to totally abandon rationality and forge back onto the golf course?  Didn’t I have even a modicum of shame about my stubborn disregard for the lunacy of returning to the game?  What on God’s green earth gave me the right to take out my clubs for another assault of God’s green earth?  It was …

THE CERTIFIABLE INSANITY OF U.S. MONETARY POLICY
A PLUMB PERSPECTIVE EDITORIAL

Stay with me here.  This is not an excuse, it’s just an explanation. I knew I was doing the same thing over and over again and expecting different results.  I simply took solace in the fact that at least I wasn’t doing so as a central banker.  When I looked at it through that lens, my decision to give golf another try seemed positively compos mentis compared to the criminal insanity of trying to solve the problems caused by too much debt and credit with massive amounts of debt and credit.  My return to the game of golf was merely a brief respite from my senses when I stacked it up against the acute mental disorder evidenced by our country’s monetary authorities.  Let’s take a peek at how our monetary policy is working out so far.

Last month we looked at a variable that I’ve been calling the Yield-Adjusted M3 Growth Rate. To calculate the Yield-Adjusted M3 Growth Rate, I took the five-year compound annual growth rate of the M3 money supply and I subtracted the yield on the 3-month T-bill at the end of the five years.  As shown in these graphs from last month’s editorial, it turns out that the Yield-Adjusted M3 Growth Rate has done an excellent job of predicting the subsequent five-year returns on gold.

As I write this, the Yield-Adjusted M3 Growth Rate is 9.3%.  This puts us on the far right-hand side of the graph and gets us very excited because that’s where the high gold returns live.  But, I also left you with a caution that this is only one piece of information.  It doesn’t, for example, take into account any valuation measures . ((For a complete explanation of the relationship between growth in the money supply, interest rates and gold returns, please review my editorials from January 2009, ‘HOUSE OF MIRROR IMAGES” and May 2009, “INFLATION—THE THIEF THAT REALLY SENDS A CHILL UP MY SPINE.”))

This month, we’re going to expand this analysis to look at the relationship between the Yield-Adjusted M3 Growth Rate and other assets besides gold.  But first, it’s important to understand why we’re on the far right-hand side of the graph and why I think we will be setting up housekeeping here for the foreseeable future.

The Certifiable Insanity of Our Monetary Policy

As shown in the graph below, on December 11, 2001 Alan Greenspan’s insanity became certifiable:

From 1971 through 2001, interest rates moved with the growth in the money supply.  This makes sense.  If dollars are being printed rapidly, investors should be compensated for this inflation in the money supply with high interest on their savings.  This is exactly what Paul Volcker did in the early 1980’s to curb runaway monetary and price inflation.

In 2001, however, Alan Greenspan was panicked by the bursting of the tech bubble.  He lowered the Fed Funds rate from 6% to 2%, the lowest in four decades.  The insane part is that he didn’t stop!  On December 11, 2001 he lowered the Fed Funds rate to 1.75%.  The last time the rate was this low was the middle of 1961.  He kept going.  He took it down to 1% and he kept it below 2% for three full years.   He did this despite the fact that the M3 growth rate over the previous five years had been 10%.  The last time the M3 growth rate was above 10% was 1986 and, back then, the Fed Funds rate was 7%.

From 2002 through 2004, Greenspan set the Fed Funds rate way below any rate that would have prevailed in a free market – especially with an M3 growth rate of 10%.  From 1964 through 2001, the Yield-Adjusted M3 Growth Rate averaged 1.5%; from 2002 through 2004, it averaged 7.5% – FIVE TIMES AS HIGH!

What A Crazy Knight

Shortly thereafter, in a fit of uncontrollable irony, Britain’s Queen Elizabeth II knighted Alan Greenspan in recognition of his “contribution to global economic stability.”  We continue to enjoy the benefits of Sir Alan’s contribution with each passing day.  Thanks to his crazy monetary policy, housing prices skyrocketed, debt ballooned throughout the economy and even the bursting of the stock market bubble was temporarily interrupted in mid-freefall (well before it had declined to anywhere near normal valuation levels).

Because interest rates were kept artificially low, there was a huge demand among fixed income investors (pension funds, endowments, insurance companies, etc.) for safe, but higher yielding investments.  They had to “reach for yield.”  Everybody rallied together to meet this demand.  Investment banks bundled, sliced and diced mortgages into collateralized mortgage obligations.  Ratings agencies blessed these products and the investors gobbled them up.  They couldn’t get enough of them.  To make more of these products, more mortgages needed to be created.  To create more mortgages, lending standards had to be lowered.  No problem.  Since mortgage lenders weren’t going to hang on to the loans, they didn’t need to care about the ability of the borrower to repay.  Governments and regulators were thrilled because since homeownership was a good thing, even more homeownership had to be an even better thing!

It all felt good while it was happening.  Everybody did what they have always done—they followed their rational economic self-interest.  This is the very basis of the free market.  The problem was that interest rates were not being determined by the free market; they were being set artificially low by the Federal Reserve.  This distorted all the normal free market checks and balances that made the housing market work just fine for centuries.

This is the critical point.  NONE OF THIS WOULD HAVE HAPPENED WITHOUT THE ARTIFICIALLY LOW INTEREST RATES GIVEN TO US BY THAT CRAZY KNIGHT!!!

Now, despite all the problems that were caused by printing massive amounts of money and forcing interest rates absurdly low, Bernanke & Company seem to think the cause of the problem can be the cure.  They’ve decided to do the same thing again in search of different results. Not only are interest rates again being set artificially low, but the problems are being compounded by the government’s ongoing efforts to bailout the parties most responsible for the problems in the first place.  While this “hair-of-the-dog” response will only make the problem worse in the long run, it doesn’t seem like there is any concern at all about the long-term consequences of trying to inflate our way out of this mess.

HOT DAMN!

That’s more or less what I said when I saw how this type of monetary policy impacts the expected returns on gold.  It also serves as an appropriate acronym for the policy – Hair Of The Dog Absurd Monetary Nincompoopouri ((Nincompoopouri – A noun I invented to describe a hodgepodge collection of policies and fixes cobbled together by incompetents that gives off a distinctive odor.  Formed by combining “nincompoop” and “potpourri.”)).  I’ve already explained how this HOTDAMN policy of inflating the money supply and keeping interest rates low bodes extremely well gold returns.  It also has a significant impact on the returns of many other assets.  Right now, the Yield-Adjusted M3 Growth Rate is 9.3%.  I did a very simple exercise.  I used regression analysis to see how well the Yield-Adjusted M3 Growth Rate (since 1971) has predicted the future five-year compound annual return on a broad range of assets.  Then I asked, “If the past relationship holds in the future, what would a Yield-Adjusted M3 Growth Rate of 9.3% suggest for the expected five-year compound annual return on these assets?”  The following series of graphs depicts these relationships.

Precious Metals

We’ve already seen that gold returns are very positively correlated to the Yield-Adjusted M3 Growth Rate.

The same is true for silver, but the correlation is not as strong.

The fact that silver is more weakly (but still positively) correlated to the Yield-Adjusted M3 Growth Rate makes sense.  Unlike gold, silver is valued as both a monetary and an industrial metal.  Sometimes these two forces can oppose each other.

Commodities

Like precious metals, commodities in general are positively correlated to the Yield-Adjusted M3 Growth Rate.  The next two graphs show the returns on oil and the returns on the DJAIG commodity index.

Currencies

To the extent that dollars are added to the financial system faster than other currencies, this should reduce the purchasing power of dollars relative to other currencies.  If the interest rate being paid on those dollars is low, that will exacerbate dollar weakness as savers convert their dollars to currencies that pay higher interest.  The graphs below show the 5-year appreciation of the euro relative to the dollar and the depreciation in the value of the dollar as measured by the Fed’s Broad Trade-Weighted Exchange Index ((Change in the value of the Fed’s Broad Trade-Weighted Exchange Index: http://research.stlouisfed.org/fred2/series/TWEXBMTH?cid=105))  that accompanies an increase in the Yield-Adjusted M3 Growth Rate.

Bonds

A high Yield-Adjusted M3 Growth Rate is also a drag on U.S. bond returns.  This is because once bond investors start losing purchasing power due to inflation of the money supply, they begin to demand higher yields to compensate them for this loss.  When yields increase, the value of existing bonds goes down and bondholders suffer capital losses.

Stocks

Over the last almost four decades, the returns on the S&P 500 have also been negatively correlated to the Yield-Adjusted M3 Growth Rate.  I think this is because a high Yield-Adjusted M3 Growth Rate often occurs in response to a weak economy.  It also often leads to price inflation.  Neither are friendly to stocks.

My goodness!  That’s a lot of correlations.  But wait!!!

REITs

Lest you draw the conclusion that the Yield-Adjusted M3 Growth Rate has predictive power for everything from impending harsh winters to the likelihood of male pattern baldness, it is not omnipotent.  It doesn’t, for example tell us anything about REITs.

Housing

It has, however, often been positively correlated to the rate of U.S. residential housing appreciation.  The graph below shows this relationship from 1971 through 2006 (before the housing bubble burst).  If you want to understand the dangerously deranged thinking behind our current monetary policy, you need look no further than this graph.

This positive correlation is exactly the reason that the Yield-Adjusted M3 Growth Rate is currently at insane levels.  The government is trying to inflate the money supply and keep interest rates ridiculously low in an attempt to counteract the free market forces that are causing a freefall in home values.  The thinking is that if they can stop the fall in home values then things can start to get back to normal.  This is their priority; all other consequences are secondary.

It’s not working.  One look at the graph, once I’ve added-in the most recent three years, is all you need in order to grasp the dismal results of this stark raving monetary policy.

Despite rapid growth in the money supply and ultra-low interest rates, home values continue to plummet, confounding the relationship that was very solid for the previous 30+ years.  This illustrates an important point.  The Yield-Adjusted M3 Growth Rate is only one variable that can impact future returns.  While it’s often an important variable, at times, other variables can be even more important.  That’s the current case with housing.  Notwithstanding huge monetary inflation, house prices are declining because they were so overvalued.  Today, factors like a massive supply of homes for sale, record foreclosure rates and strict lending standards are overwhelming the efforts of the Inflationistas to use the dollar printing press to reinflate home values.

Summary

The table below summarizes the results of these analyses.  The first column shows the various asset classes.  The second column shows whether the subsequent five-year returns for the assets are positively or negatively correlated to the Yield-Adjusted M3 Growth Rate (“YAM3GR”) and by how much.  The third column shows the r-squareds of the regression equations.  The fourth column shows the calculated 5-year compound annual returns if I input today’s YAM3GR of 9.3% into the regression equations.  The table is sorted from the most positively correlated (Gold) to the most negatively correlated (Dollar)

Conclusion

These results are consistent with my expectations.  I have been stressing the importance of hard assets (precious metals and commodities) since I began writing this letter nearly five years ago.  Seeing the problems facing our economy, I thought that our leaders would resort to the political expediency of the printing press rather than raising taxes or cutting spending.  This is exactly what they have done and they have done it much more aggressively than I could have imagined.  This is especially disturbing since all the money that is being created isn’t even being used to address the main problems for which I thought we would be ramping up the money supply—the entitlements promised to the Baby Boomers.  These analyses just confirm that commodities and precious metals should continue to be an important part of our asset allocation.

In contrast, U.S. stocks and nominal U.S. bonds do not fare as well in an environment of monetary inflation.  This doesn’t mean that stocks and bonds shouldn’t be part of a diversified portfolio.  However, because monetary inflation is going to continue to erode the purchasing power of the dollar, we will continue to obtain a large portion of our stock and bond allocation with unhedged foreign stocks and bonds.  I have always advocated a significant allocation to unhedged foreign investments and this is more important today than it has ever been.

Finally, the results of these analyses suggest that real estate should do well.  I think this will eventually be true, but not yet.  Commentators who think real estate has bottomed have some confustipation in their brainal regions.  The other factors that I mentioned earlier will counteract the impact of monetary inflation and depress returns for some time to come.

In fact, that should be the cautionary note you take with you from this analysis.  It bears repeating that the Yield-Adjusted M3 Growth Rate is only one variable that can impact future returns.  With all of these asset classes there are many other variables that come into play.  I will be examining a number of these variables in coming months.  However, as much as I try to factor these variables into my asset allocation, many of them can’t be modeled.  Still, it’s helpful to know that we are investing in a manner consistent with the results of these analyses.  Sometimes the best we can do is to try to recognize the insanity and seek cover.