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Monthly Archives: November 2017

In this past weekend’s newsletter I discussed the market hitting “the wall” last week. This failure at the downtrend resistance keeps us on a defensive posture for now, but still allocated to the market as the longer-term bullish trend remains intact.

I know. It’s confusing.

However, this is the difficultly in navigating potential turning points in the market. It is also the juncture where the majority of investing mistakes are made.

This week, I want to review 5-indicators we are currently watching very closely. Importantly, these are NOT “market-timing” indicators as they are based on longer-term time frames and are slow to change. However, they do have a very strong record of determining important turning points in the market from “bull” to “bear.”

Since we are longer-term investors, our portfolio management process is driven less by short-term volatility, although we do hedge for such, and more towards changes in the trend of prices. While such analysis is “less predictive” and “more reactive” it is important to act accordingly within the portfolio management process when “signals” are issued.

The Stock-Bond Ratio

Something that should be of little surprise to anyone is the relationship between interest rates and equities. When interest rates rise, particularly sharply, it negatively impacts the costs of borrowing, the valuation of capital expenditures from the return on investment, and consumption. This eventually translates into slower rates of economic growth, not to mention recessions, which ultimately translates into a repricing of equity valuation.

The chart below shows that every time rates have reached the top of the long-term downtrend; the market has been impacted within the next 12-month period. Currently, that level on the 10-year Treasury is just a little above 3% on a log-scale.

One way to see this relationship more closely is by looking at the ratio between stocks and bonds. Again, we see that when the ratio, the difference between $SPY and $TLT, is at exceedingly high levels, it has been a good indication of more important inflection points in the market.

The next series of charts focuses on the S&P 500 index and related price indicators on various time scales. Again, as I stated above, we are looking at very long-term measures (quarterly, monthly and weekly) to determine potential changes in market dynamics. This analysis should NOT be used to make shorter-term trading decisions as these indications will take some time to develop. 

As noted, this is where the majority of mistakes are made by investors as in the short-term (days and weeks) the market can certainly seem to defy the analysis. It is at this point where much of the analysis is dismissed under a “this time is different” scenario. However, these signals have, more often than not, given investors “fair warning” to modify inherent portfolio risk.

Quarterly RSI

Quarterly analysis is only useful on an extremely long-term basis as it is extremely slow to change as the data is only valid as of the end of each quarter. However, since the first quarter of 2018 recently ended, we can take a look at the relative price measures for an update.

The top part of the chart is the 3-year relative strength indicator. Via

“Developed by J. Welles Wilder, the Relative Strength Index (RSI) is a momentum oscillator that measures the speed and change of price movements. RSI oscillates between zero and 100. Traditionally, and according to Wilder, RSI is considered overbought when above 70 and oversold when below 30. RSI can also be used to identify the general trend.”

Currently the RSI is registering levels of “overbought” conditions that have only been seen a few times in history. At every one of these points the market has experienced a correctionary period. What separated the price correction from just a “correction within an ongoing bull trend” and an outright a “full-blown mean reverting event” resides on valuation levels when signals were triggered. With valuations currently at the second highest level in history, one should be able to surmise the most likely outcome.

Monthly MACD

If we look at “monthly” price indications we can speed up the signals a bit. This chart looks at the Moving Average Convergence Divergence (MACD) of the 3-year moving average (bottom panel). Via

“Developed by Gerald Appel in the late seventies, the Moving Average Convergence/Divergence oscillator (MACD) is one of the simplest and most effective momentum indicators available. The MACD turns two trend-following indicators, moving averages, into a momentum oscillator by subtracting the longer moving average from the shorter moving average. As a result, the MACD offers the best of both worlds: trend following and momentum. The MACD fluctuates above and below the zero line as the moving averages converge, cross and diverge. Traders can look for signal line crossovers, centerline crossovers and divergences to generate signals.”

Importantly, while the actual signal to occur provided sufficient warning to protect capital, the current signal combined with extreme overbought (top panel) conditions and deviations (3-standard deviations of 3-year average) has not previously been linked to “bull market” continuations. With both quarterly and monthly measures suggesting much higher levels of capital risk, the question of “timing” becomes more important.

Weekly Stochastics

The question of “timing” is where speeding up our measures to a “weekly” basis provides more beneficial analysis. In this analysis we look at the 1-year full Stochastic Oscillator.  Via

“Developed by George C. Lane in the late 1950s, the Stochastic Oscillator is a momentum indicator that shows the location of the close relative to the high-low range over a set number of periods. According to an interview with Lane, the Stochastic Oscillator ‘doesn’t follow price, it doesn’t follow volume or anything like that. It follows the speed or the momentum of price. As a rule, the momentum changes direction before price.’”

As shown by the vertical blue lines, “sell signals” from high levels, as we are at now, have been good predictors of both corrections and bear markets. The problem is that it doesn’t distinguish between the two. Therefore, as stated, it is best combined with the monthly and quarterly data above to confirm longer-term trends.

Putting It All Together

The chart below pulls all the measures above into a monthly chart. We also add two more confirming indicators – the Coppock Curve and the Ultimate Oscillator. Via

The Coppock Curve is a momentum indicator developed by Edwin ‘Sedge’ Coppock, who was an economist by training. Coppock introduced the indicator in Barron’s in October 1965. The goal of this indicator is to identify long-term buying opportunities in the S&P 500. The signal is very simple. Coppock used monthly data to identify buying opportunities when the indicator moved from negative territory to positive territory.”

The Ultimate Oscillator, developed by Larry Williams in 1976, is a momentum oscillator designed to capture momentum across three different time-frames. The multiple time-frame objective seeks to avoid the pitfalls of other oscillators. Many momentum oscillators surge at the beginning of a strong advance and then form a bearish divergence as the advance continues. This is because they are stuck with one time-frame. The Ultimate Oscillator attempts to correct this fault by incorporating longer time-frames into the basic formula.”

What is most important about technical analysis is not to rely solely on one indicator. Such can, and often does, lead to false signals that can impair performance over time though higher volatility, turnover, and emotional wear. This is especially the case with shorter-term signals (daily and weekly) which tends to lead to the assumption that price analysis doesn’t work. However, when several indicators begin to produce the same signals, that “confirmation” provides for a more reliable outcome. (Note that I said “more reliable” not “perfect.”)


With more and more signals on a longer-term basis all sending the same message, investors should be substantially more cautious. This is particularly the case when those longer-term signals are combined with excessively high valuations combined with weak economic growth and rising interest rates. Historically, the combination of these events has led to rather horrible outcomes for investors over the longer-term.

If the market is going to reverse these signals, and reinstate the longer-term bullish trend, the “bulls” need to re-engage immediately and push prices to new highs. However, the longer the market continues to languish, the risk of a deeper correction rises markedly.

Let me restate that we currently maintain short-term equity exposure to the markets as the bullish trend that begin in 2009 remains intact. However, we currently holding a higher level of cash than normal as a hedge against volatility and the lack of a positive risk/reward backdrop with which to deploy “risk” capital.

As I stated in “8-Reasons To Hold Cash:”

“I am suggesting that holding higher levels of cash during periods of uncertainty provides both stability and opportunity. With the fundamental and economic backdrop becoming much more hostile toward investors in the intermediate term, understanding the value of cash as a ‘hedge’ against loss becomes much more important. “

Just remember that while markets are typically irrational in the short-term, they often become rational quicker than you can “sell” in the long-term.

  • With mounting private and public debt, the U.S. economy is poorly positioned to reach consensus economic growth expectations
  • The Bond Vigilantes are saddled up and ready to make a comeback – and it’s market unfriendly

“I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”
– James Carville

In “The Great Bond Massacre” from late 1993 to late 1994, the yield on the US ten year note rose from 5.2% to 8.0% as investors grew fearful about the implications of large federal spending increases.

For the first time in years the bond vigilantes, “a self-appointed group of citizens – the bond vigilantes – who undertake law enforcement in their community without legal authority, typically because the legal agencies are thought to be inadequate” have surfaced – with the ten year U.S. note yield now approaching three percent.

This morning the yield on the ten year U.S. note has hit a new four year high of 2.99%.

As I see, though rates still appear low by historic standards – the sizable climb in debt loads (in both the private and public sectors) and the continued fiscal profligacy – will likely exacerbate the impact on the recent rise in yields by providing a governor to economic growth and by stirring a number of other adverse outcomes:

* Ballooning Deficits and A Large Supply of Treasuries Loom: A $1.2 trillion 2018 U.S. deficit (and borrowing requirement) coupled with $600 billion of the Fed’s Quantitative Tightening means that there will be, according to David Stockman’s most visual phrase, “the bond pits will be flooded with $1.8 trillion of ‘homeless’ government paper.”

Never in the history of modern finance has a near decade old domestic economic recovery faced a financing hurdle that represents almost nine percent of GDP. How large is this hurdle relative to history? At the top of the last U.S. economic expansion, the Federal Deficit was 87% lower (at $160 billion) – which represented only one percent of U.S. GDP at a time that the Fed was still buying Treasuries (in 2007 the Fed purchased $15 billion of Treasuries) and not selling them (or letting them rollover without replacing). So, this time around, the flow of Treasuries will represent supply that is nine times larger (relative to GDP) than was the case in 2007.

* Protectionism and The Chinese Debt Bomb Threaten The U.S. Treasury Markets: The Administration’s assault on China and its trade policy threaten the demand/supply for U.S. treasuries, as the possibility that China sells down their U.S. Treasury holdings looms as a potential Chinese tool in the latest trade war with America. As well, the large stated and shadow debt in China when coupled with the capital flight issues suggest more selling of U.S. Treasuries is probable.

* The ECB Also is a Source of Treasury Supply: The ECB is also pivoting away from monetary ease in late 2018 and towards quantitative tightening in 2019. It’s balance sheet of $5.5 trillion compares to only $1.5 trillion eleven years ago. This means the ECB, like the Bank of China, will not be soaking up anywhere the amount of Treasuries that it has in the past.

* Total Public Debt as a Percent of GDP is Near An All Time High: Back in 2007, when the debt load was well under $10 trillion, government debt service was about $350 billion/year. With debt of about $21 trillion today, a rise in interest rates could take debt service to nearly $1 trillion in the next 1-2 years. See, here.

* Non Financial Corporate Debt is At an All Time High: See, here.

* “Borrowed Prosperity”: In looking at the last two charts (above) it should be clear that we are borrowing more to produce less output. In the last decade, credit market debt, at $69 trillion, has risen to 3.5x GDP, and has increased by almost $16 trillion. Unfortunately that $16 trillion has only produced about $5 trillion of GDP. In other words it is taking more and more debt to move the US economy:

Bottom Line

Given rising private and public debt to levels never seen, an imminent pivot by global central bankers away from easing, the threat and possible consequences of trade policy and the poor demand/supply balance for Treasuries, among other factors – the return of The Bond Vigilantes will have an outsized and negative impact on the trajectory of domestic economic growth.

Despite protestations from the bullish cabal that interest rates are still low (by historic standards), the return of The Bond Vigilantes (who are now saddled up and ready for a comeback) is another threat to the decade old Bull Market in stocks.

After a brief post-Presidential election surge in 2016, the U.S. dollar has been in a steady downtrend since early-2017. The dollar’s grind lower has helped to boost non-U.S. currencies as well as commodities prices, which trade inversely with the dollar. Now that the “short-dollar, long everything else” trade has been going on for so long, it has become extremely crowded: the consensus view is that this trade will continue for much longer and even accelerate. On the other hand, the “smart money” are betting heavily on a reversal of this trade, as I will show in this piece.

For the past several months, the U.S. Dollar Index formed a triangle consolidation pattern as it digested the financial market volatility. The index broke out of this triangle pattern today, which is a bullish sign as long as the breakout remains intact (ie., the index remains above the top of the triangle pattern).

USD Daily

The longer-term chart shows how the “smart money” or commercial hedgers (see the green line under chart) have built up a bullish position in the U.S. Dollar Index futures. The last several times the hedgers built similar positions, the Dollar Index has rallied. The dollar’s downtrend since early-2017 has occurred within a channel pattern, and the triangle pattern discussed in the prior chart can be seen within this channel. The Dollar Index needs to break out of both the triangle pattern and the channel pattern in a convincing manner in order to signal the end of the downtrend.USD Weekly

The euro, which trades inversely with the U.S. dollar, formed a similar triangle pattern over the past several months and has broken down from this pattern today. This breakdown is a bearish sign for the euro and a bullish sign for the dollar as long as the euro’s breakdown remains intact (ie., it doesn’t reverse and break back into the triangle pattern).

Euro Daily

The “smart money” or commercial euro futures hedgers have built their largest bearish position in at least a half-decade, which increases the probability of a bearish-euro/bullish-dollar move in the not-too-distant future. The commercial euro futures hedgers have a short position of nearly 200,000 net futures contracts, which is far larger than their relatively bearish position in 2013 and 2014 before the euro weakened sharply against the dollar.

Euro Weekly

The “smart money” or commercial futures hedgers are also bearish on the Japanese yen, which would also be bullish for the dollar if they are proven right. The yen experienced bearish moves the last couple times the commercial hedgers positioned similar to how they are positioned now.Yen Weekly

The “smart money” are currently bearish on the British pound as well and have a strong track record of positioning bearishly ahead of major pound routs over the past half-decade.Pound Weekly

If another wave of dollar strength occurs, it would be very bad news for crude oil and the overall energy sector (crude oil and the dollar trade inversely). The U.S. dollar’s surge in 2014 and 2015 was the trigger for the violent crude oil bust. Even more concerning is the fact that the “smart money” are more bearish on crude oil now than they were immediately before the 2014 oil bust, as I discussed in greater detail last week. While oil’s short-term trend is still up for now and I believe in respecting the trend, there is a very real risk that another violent liquidation sell-off may occur when the trend changes.

WTI Crude Monthly

For now, I believe everyone should keep an eye on the U.S. Dollar Index to see if today’s triangle breakout has legs and if the index can break out of its longer-term channel pattern. While most market participants currently believe that further bearish dollar/bullish commodities action is practically guaranteed, they need to be aware of the tendency for the market to “tip over when everyone gets to one side of the boat.”

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At the end of February, I discussed the impact of the tax cut and reform legislation as it related to corporate profits.

“In October of 2017, the estimates for REPORTED earnings for Q4, 2017 and Q1, 2018 were $116.50 and $119.76. As of February 15th, the numbers are $106.84 and $112.61 or a difference of -$9.66 and -7.15 respectively. 

First, while asset prices have surged to record highs, reported earnings estimates through Q3-2018 have already been ratcheted back to a level only slightly above where 2017 was expected to end in 2016. As shown by the red horizontal bars – estimates through Q3 are at the same level they were in January 2017.  (Of course, “hope springs eternal that Q4 of this year will see one of the sharpest ramps in earnings in S&P history.)”

That was so yesterday.

Despite a recent surge in market volatility, combined with the drop in equity prices, analysts have “sharpened their pencils” and ratcheted UP their estimates for the end of 2018 and 2019. Earnings are NOW expected to grow at 26.7% annually over the next two years.

The chart below shows the changes a bit more clearly. It compares where estimates were on January 1st versus March and April. “Optimism” is, well, “exceedingly optimistic” for the end of 2019.

The surge in earnings estimates gives cover for Wall Street analysts to predict surging asset prices. Buy now before you miss out!

“While earnings season has only just gotten started (only 10% of the S&P 500 companies have reported so far), a whopping 84.6% have beaten their earnings estimates, and 78.8% have beaten their revenue estimates. Those are impressive stats. And this earnings season looks like it could be even better than the lofty expectations going into it. This sets the market up for all-time highs just ahead.” 

Sure, that could well be the case as a momentum-driven market is a very tough thing to kill. Despite the recent “hiccup” over the last month or so, the market remains above it’s 200-day moving average and there are few signs of investor panic currently.

However, there are two major concerns with the current trajectory of earnings estimates.

The first is that Wall Street has historically over-estimated earnings by about 33% on average.

Yes, 84% of companies have beaten estimates so far, which is literally ALWAYS the case, because analysts are never held to their original estimates. If they were, 100% of companies would be missing estimates currently. 

At the beginning of January, analysts overestimated earnings by more than $6/share, reported, versus where they are currently. It’s not surprising volatility has picked up as markets try to reconcile valuations to actual earnings.

Furthermore, the overestimation provides a significant amount of headroom for Wall Street to be disappointed in future, particularly once you factor in the impacts of higher interest rates and slower economic growth. 

But economic growth is set to explode. Right?

Most likely not.

As I discussed last week, the short-term boost to economic growth in the U.S., driven by a wave of natural disasters, is now beginning to fade. However, the same is seen on a global scale as well. To wit:

“The international slowdown is becoming increasingly obvious from the widely followed economic indicators. The most popular U.S. measures seem to present more of a mixed bag. Yet, as we pointed out late last year, the bond market, following the U.S. Short Leading Index, started sniffing out the U.S. slowdown months ago.”

Furthermore, the economy is sensitive to changes in interest rates. This is particularly the case when the consumer, which comprises about 70% of the GDP calculation, is already heavily leveraged. Furthermore, with corporations more highly levered than at any other point n history, and dependent on bond issuance for dividend payments and share buybacks, higher interest rates will quickly stem that source of liquidity. Notice that each previous peak was lower.

With economic growth running at lower levels of annualized growth rates, the “bang point” for the Fed’s rate hiking campaign is likely substantially lower as well. History suggests this will likely be the case. At every point in history where the Fed has embarked upon a rate hiking campaign since 1980, the “crisis point” has come at steadily lower levels.

But even if we give Wall Street the benefit of the doubt, and assume their predictions will be correct for the first time in human history, stock prices have already priced in twice the rate of EPS growth.

There are few, if any, Wall Street analysts expecting a recession at any point in the future. Unfortunately, it is just a function of time until a recession occurs and earnings fall in tandem.

More importantly, the expectation for a profits-driven surge in asset prices fails to conflate with the reality that valuations have been the most important driver of higher stock prices throughout history. Currently, despite surging earnings expectations, market participants are already revaluing equity and high-yield investments.

In our opinion, the biggest mistake that Wall Street is potentially making in their estimates is the differential between “statutory” and “effective” rates. As we addressed previously:

From 1947 to 1986 the statutory corporate tax rate was 49% and the effective tax rate averaged 36.4% for a difference of 12.6%. From 1987 to present, after the statutory tax rate was reduced to 39%, the effective rate has averaged 28.1%, 10.9% lower than the statutory rate.

In reality, a company that earned $5.00 pretax only paid $1.41 in taxes in 2017 on average, leaving an after-tax profit of $3.59, and not $3.25. Under the new tax law that after-tax profit would come in at the $3.95 as stated in the article and the gain would be 10%, or half, of the gain Wall Street expects.”

There is virtually no “bullish” argument that will currently withstand real scrutiny.

  • Yields are rising which deflates equity risk premium analysis,
  • Valuations are not cheap,
  • The Fed is extracting liquidity, along with other Central Banks slowing bond purchases, and;
  • Further increases in interest rates will only act as a further brake on economic growth.

However, because optimistic analysis supports our underlying psychological “greed”, all real scrutiny to the contrary tends to be dismissed. Unfortunately, it is this “willful blindness” that eventually leads to a dislocation in the markets.

Wall Street is notorious for missing the major turning of the markets and leaving investors scrambling for the exits.

This time will likely be no different.

Will tax reform accrue to the bottom lines of corporations? Most assuredly.

However, the bump in earnings growth will only last for one year. Then corporations will be back to year-over-year comparisons and will once again rely on cost-cutting, wage suppression, and stock buybacks to boost earnings to meet Wall Street’s expectations.

Are stocks ready to go parabolic?

Anything is possible, but the risk of disappointment is extremely high.

The steady gains accompanied by the historically low volatility of 2017 have vanished. Given this new trading atmosphere, we must contemplate whether the recent spate of volatility and lower prices is the beginning of a trend change or merely a temporary speed bump on the way to higher prices.

Despite a bull market and economic recovery that are historically long in the tooth, we recently read an interesting article that waived the all clear flag for investors. Hyper volatility in stocks suggest the market has bottomed, authored by Simon Maierhofer, points to historical bouts of volatility as well as money flows into stocks as a reason to be optimistic. The author argues that bottoms are typically formed when volatility surges and that view is currently bolstered because “money is flowing into stocks.

Relying on short-term and long-term graphs, Maierhofer argues that markets tend to bottom when volatility peaks. His short-term graphs show that volatility peaks in 2015 and 2016 were a perfect buy signal. If the current swoon and volatility spike are in fact short-lived like those in 2015 or 2016, then he may be correct. If, on the other hand, this is like 2008 or 2000, then volatility will continue to move higher and stay elevated for a long period, meaning the current sell-off may be just starting.

The author’s second point is based on previous relationships between peak volatility and positive money flows into stocks. “Even though the S&P 500 and Dow Jones Industrial Average tested their February panic lows last week, money is flowing into stocks. This is a sign of internal strength and generally bullish for stocks.”

Maierhofer’s characterization of money flows is flawed as it implies that there are more investors buying than those selling. Buyers always purchase shares from sellers and sellers always sell shares to buyers. As such, the amount of money flowing into and out of stocks must always equal each other. The issue is not whether money is moving into or out of stocks, but who is more determined to transact, buyers or sellers.

Given that prices are well below recent highs, we have to say the sellers are currently playing a larger role in setting prices. The concept of money flows that Maierhofer espouses is similar to the often stated “cash is on the sidelines and ready to be put to work” bit of nonsense. (For more on that see point number four in Lance Robert’s article 7-Myths of Investing.)

Valuations stand at or near the highest levels ever recorded. At the same time, the Federal Reserve is removing liquidity, and domestic and global political risks are on the rise. When volatility is signaling heightened concerns and possibly warning that the long-term trend might be changing, caution and attention are warranted. We do not advise you to sell and hide in a bunker. However, you should take all market analysis, bullish and bearish, with a grain of salt and have a plan of action in case the long-running bull market is finally coming to an end.

After experiencing weakness in February and March, crude oil spiked to three-year highs in April due to geopolitical fears associated with the Syria bombing campaign as well as falling inventories. Earlier today, President Trump tweeted that OPEC was to blame for “artificially Very High!” crude oil prices, which he said are “No good and will not be accepted!” In this piece, we will look at key technical levels and other information relevant for understanding crude oil prices.

Since the summer of 2017, crude oil has been climbing a series of uptrend lines, but broke below one of these lines during the market rout of early-February 2018. WTI crude oil broke above its $66-$67 resistance last week, which is a bullish technical signal if it can be sustained. If WTI crude oil breaks back below this level, however, it would be a bearish sign.WTI Crude Daily

A major reason for skepticism about crude oil’s recent rally is the fact that the “smart money” or commercial futures hedgers currently have their largest short position ever – even larger than before the 2014/2015 crude oil crash. The “smart money” tend to be right at major market turning points. At the same time, the “dumb money” or large, trend-following traders are the most bullish they’ve ever been. There is a very good chance that, when the trend finally changes, there is going to be a violent liquidation sell-off.

WTI Crude Monthly

Similar to WTI crude oil, Brent crude has been climbing a couple uptrend lines as well. The recent breakout over $71 is a bullish sign, but only if it can be sustained; if Brent breaks back below this level, it would give a bearish confirmation signal.

Brent Crude Daily

It is worth watching the U.S. Dollar Index to gain insight into crude oil’s trends (the dollar and crude oil trade inversely). The dollar’s bearish action of the past year is one of the main reasons for the rally in crude oil. The dollar has been falling within a channel pattern and has recently formed a triangle pattern. If the dollar can break out of the channel and triangle pattern to the upside, it would give a bullish confirmation signal for the dollar and a bearish signal for crude oil (or vice versa). The “smart money” or commercial futures hedgers are currently bullish on the dollar; the last several times they’ve positioned in a similar manner, the dollar rallied.

USD Weekly

The euro, which trades inversely with the dollar and is positively correlated with crude oil, is also worth watching to gain insight into crude oil’s likely moves. The “smart money” are quite bearish on the euro, which increases the probability of a pullback in the not-too-distant future. The euro has been rising in a channel pattern and has recently formed a triangle pattern. If the euro breaks down from this channel, it would give a bearish confirmation signal, and would likely put pressure on crude oil (or vice versa).Euro Weekly

There has been a good amount of buzz about falling inventories and the reduction of the oil glut, but this week’s inventories report of 427.6 million barrels is still above average for the past 5 to 10 years. In addition, U.S. oil production continues to surge and recently hit an all-time high of 10.5 million barrels per daily.

For now, the short-term trend in crude oil is up, but traders should keep an eye on the $66-$67 support zone in WTI crude oil and the $71 support in Brent crude oil. If those levels are broken to the downside, then the recent bullish breakout will have proven to be a false breakout. Traders should also keep an eye on which way the U.S. dollar and euro break out from their triangle and channel patterns.

Please follow or add me on TwitterFacebook, and LinkedIn to stay informed about the most important trading and bubble news as well as my related commentary.

One of the worst possible outcomes for the U.S. economy, and ultimately for investors, is stagflation. Of course, if you weren’t around in the 60-70’s, there is a reasonably high probability you are not even sure what “stagflation” is. Here is the technical definition:

stagflation – persistent high inflation combined with high unemployment and stagnant demand in a country’s economy.”

How can that happen? Exactly in the way you are witnessing now.

While the current Administration is keen on equalizing trade through tariffs, trade deals, and trade deficit reduction, they have also embarked on a deficit expanding spending spree which has deleterious long-term effects on economic growth. At the same time, the administration is attacking our major trading partners, particularly China, leading to a push to shift away from the U.S. dollar as a reserve currency.

What does all that mean?

Here is the problem with the current trajectory.

  • A weaker dollar leads to higher commodity prices creating cost-push inflation.
  • As fears of inflation infiltrate the markets, interest rates increase which raises borrowing costs.
  • As the dollar weakens, commodity prices rise increasing input cost to manufactures.
  • Higher input costs, borrowing costs, and weaker profits ultimately force corporations to suppress wage growth to protect profits.
  • As wage growth is suppressed, particularly with a heavily indebted consumer, demand falls as higher costs, both product and borrowing costs, cannot be compensated for.
  • As demand falls, companies react by reducing the highest costs to their bottom lines: wages and employment.
  • As profits come under pressure, stock prices fall which negatively impacts the “wealth effect” further curtailing consumptive demand.
  • As the economy slumps into recession, unemployment rise sharply, demand falls, and interest rates decline sharply. 

As I discussed just recently, the bottom 80% of U.S. households are heavily indebted with no wage growth to offset the rising costs in “non-discretionary” spending requirements of rent, utilities, food and healthcare and debt payments.

However, as the dollar weakens, the input costs to manufacturers rise leading to concerns of inflationary pressures which pushes interest rates higher.

The biggest risk to the markets, and investors, is both the current Administrations trade policies, particularly as it relates to China, and the reduction of the Federal Reserve’s balance sheet. Combined, these two represent the largest buyers of U.S. Treasuries which is most inopportune at a time where the fiscal deficit is set to swell creating a surge in U.S. debt issuance. (The chart below is the annual rate of change of foreign holdings of U.S. Treasuries versus the annual change in interest rates.)

Furthermore, this is all occurring at a time when global liquidity is being withdrawn.

The removal of global policy stimulus has naturally come about as the world economy finally managed a couple of quarters of synchronised growth in 2017. But our view is that this growth is tenuous and very late-cycle, particularly in China and the US, as the credit cycle has already turned. And the next challenges for markets are just around the corner.”

While much of the mainstream media continues to promote expectations of a global resurgence in economic growth, there is currently scant evidence of such being the case. Since economic growth is roughly 70% dependent on consumption, then population, wage, and consumer debt growth become key inputs into that equation. Unfortunately, with real wage growth stagnant for the bottom 80%, demographics running in reverse, and consumers extremely leveraged, a sustained surge in economic growth to offset higher interest rates becomes unlikely.

So, to summarize, we have a depreciating dollar policy from the White House, which is inflationary, with the Fed and foreign purchasers of our bonds not keeping pace with burgeoning deficits. With inflation, not generated by economic growth but by a weak dollar instead, pushes interest rates higher, the combination is a deadly one-two punch for the economy. This is an outcome to which the market is currently ill-prepared for.

Just something to think about as you catch up on your weekend reading list.

Economy & Fed


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“The trick of successful investors is to sell when they want to, not when they have to.” – Seth Klarman

Questions, comments, suggestions – please email me.

“Peter Cook is the author of the ‘Is That True?’ series of articles, which help explain the many statements and theories circulating in the mainstream financial media often presented as “truths.” The motives and psychology of market participants, which drives the difference between truth and partial-truth, are explored.”

The Federal Reserve (Fed) regularly proclaims its decisions on monetary policy are “data dependent.”  More precisely, the Fed uses data as inputs for its economic models, which are thought to describe how the economy functions in the real world.  The complexity of Fed models probably couldn’t be explained in fewer than 50 pages of academic jargon.  But Keynesian economic philosophy, a belief that an economy’s health can be described by the aggregate annual amount of spending (otherwise known as GDP), is foundational to the Fed models.  For 2018, the Federal Open Market Committee (FOMC), which votes on monetary policy, predicts real GDP growth of 2.7%.

The Fed’s regional banks also produce economic research, which can differ from the FOMC’s forecasts.  For example, the Cleveland Fed (CF) also produces an estimate of the upcoming year’s GDP growth, but its model is based on observations of the U.S. Treasury yield curve.  No model can perfectly describe reality, and a potential weakness of CF model is that it is based on a single input; the spread between the yield on the 3-month Treasury bill and the 10-year Treasury bond.

Because the CF model is based on market-based data (not economic data), it is fundamentally different than the FOMC model.  As a result, the difference between the FOMC model and the CF model could be interpreted as a difference between what the FOMC believes and what the market believes.

The CF model is based on 60+ years of historical data between GDP growth and the shape of the yield curve, as shown below.  To achieve the best fit between the data series, the CF model assumes that changes in the spread of the yield curve affect GDP growth one year afterward.  Therefore, the chart below shows the real-time yield spread (orange line) versus GDP growth (blue line) one year later.

The chart below shows the CF model over the past 16 years, which makes it easier to see the changes in the yield curve and GDP growth.  The recent spread of the yield curve produces an estimate of GDP growth for the upcoming year (red line), which has been steady at 1.4% over the past several months.

The FOMC model estimates 2018 GDP growth of 2.7% while the market-based estimate is 1.4%.  So, what is the market seeing that the Fed is missing, or vice versa?  The most likely explanation is the effect of the recent tax cut/reform (TCJA).  The main components of the TCJA were a $200 billion annual tax cut for individuals, plus another $100 billion in additional government spending in 2018.  Keynesian economic theory assumes the total of $300 billion will be spent on items that will increase GDP by 1.5% during 2018 (1.5% equals $300 billion divided by $20 trillion, which is the approximate size of US GDP).

Also, Keynesian theory assumes a multiplier effect for government deficit spending, meaning that the theoretical boost to GDP in 2018 should exceed 1.5%.   But the theoretical multiplier isn’t the same for different types of spending and it isn’t stable over time, so it isn’t a useful concept for this analysis.

Looking at the difference between the FOMC model of 2.7% GDP growth and the CF model of 1.4% growth, the market appears to be saying that the TCJA will have a very little effect on 2018 GDP growth.  How could that be possible?  The market appears to believe that the $200 billion in individual tax cuts will not be spent during 2018; instead, that money will be saved or used to pay down debt, neither of which directly boosts GDP growth in the short-term.

What about the $100 billion in federal deficit spending?  Surely that should create an increase in 2018 GDP growth, under Keynesian assumptions.  It appears the market is no longer driven by Keynesian analysis, because the CF model shows that deficit spending may have very little effect, if any, on GDP growth.

If so, the market’s belief would coincide with the analysis in “Is the U.S. Economy Really Growing?”, which demonstrated a regime change has occurred since 2008.  Before 2008, deficit spending resulted in what Keynesians expected; an increase in GDP that exceeded the amount of deficit spending.  But after 2008, annual increases in federal debt far exceeded annual GDP growth.  The regime change may be the single-most important reason that the Fed has consistently overestimated GDP growth in its forecasts over the past decade.

Does the fact that the Fed has systematically overestimated growth in GDP and inflation over the past decade mean that it will do so in the future?  Not necessarily.  Will the market estimate of 2018 GDP growth be too low?  Again, not necessarily, and for the same reason; the past does not always predict the future.

But there are some clues to which may be more accurate.  The market-based estimate of the CF model incorporates bets by the world’s largest investors to forecast GDP growth (and inflation), and it hasn’t systematically overestimate or underestimated GDP growth over the past decade, as shown in the second chart.  In contrast, the FOMC model incorporates Keynesian assumptions on economic data to forecast GDP growth (and inflation), and it has systematically overestimated GDP growth over the past decade.  When there is a divergence between the two groups, it’s probably a better bet to follow the money, not the academics.


Today, two models that forecast 2018 GDP growth produce substantially different results. The 1.3% difference in GDP growth forecasts (2.7% – 1.4%) is roughly equal to the theoretical fiscal stimulus of the TCJA (1.5%).

The FOMC model is based on Keynesian assumptions that equate a boost in federal deficit spending with an increase in real GDP.  The FOMC model has consistently overestimated GDP growth over the past decade, probably because it has failed to grasp the regime change that has occurred in the relationship between deficit spending and GDP growth.

The CF model is based on the spread of the yield curve and appears to reflect a high degree of skepticism that federal deficit spending will produce a boost to GDP growth.  Over the past decade, it hasn’t systematically overestimated or underestimated GDP growth.

It is possible that GDP growth is 2.0%, and that both models will be incorrect by the same amount.  But probably not.  As we progress through 2018, the results of the models will converge.  The direction in which the convergence occurs will be crucially important to investors.

A few days ago, Neel Kashkari, president of the Minneapolis Fed, told an attendees at an event at Howard University that Wall Street is “forgetting the lessons of the 2008 financial crisis“:

“The shareholders got bailed out. The boards of directors got bailed out. Management got bailed out. So from their perspective, there was no crisis.”

Kashkari, long an advocate of more stringent regulations to rein in major banks, said US labor groups, whose pension funds took major hits during the crisis, may have a role to play in countering the political influence of the nation’s largest banks.

They have been campaigning, fairly successfully, to roll back many of the post-crisis regulations known as Dodd-Frank, which President Donald Trump has vowed to largely repeal.

“We are forgetting the lessons of the 2008 crisis,” Kashkari said. “The bailouts worked too well.”

Financial crises keep happening “because we forget how bad they were,” he added.

What’s the solution? Making banks raise more equity to fund their investment rather than rely so heavily on debt.

“No other industry is levered likely the banking industry,” Kashkari said. “If we double the amount of equity banks have we could go a long way toward resolve the problem that too big to fail banks pose. If it were up to me we’d be increasing banks’ leverage ratio, not decreasing it.”

While I agree with Kashkari that Wall Street is forgetting the lessons of the 2008 financial crisis (and is participating in the development of another dangerous economic bubble), he seems to be absolving the Federal Reserve of its massive responsibility for inflating the mid-2000s U.S. housing and credit bubble as well as the current “Everything Bubble” that I am warning about. Make no mistake: by holding interest rates at artificially low levels and pumping large amounts of liquidity into the financial system, the Fed plays the primary role of creating bubbles – not Wall Street. The Fed is the dog and Wall Street is merely its tail – not the other way around. Of course, Wall Street is guilty for participating in bubbles originally created by the Fed – it takes two to tango.

The chart below shows how relative troughs in the Fed Funds Rate correspond with the formation of disastrous economic bubbles that pop when interest rates rise. The mid-2000s housing bubble inflated because the Fed helped to push mortgage interest rates to very low levels, which led to a borrowing binge that sent housing prices to unsustainable new highs. The U.S. housing bubble would not have occurred if the Fed didn’t meddle and distort borrowing costs and markets. The Fed is making the same mistake once again: though the current “Everything Bubble” hasn’t popped yet, it’s only a matter of time before it does…it’s just math.

Fed Funds Rate

By holding interest rates artificially low, the Fed has been encouraging the growth of the U.S. debt bubble. This debt bubble is significantly larger than it was in 2008, which means that the next downturn is going to be even more powerful, unfortunately.

Financial Leverage

The Fed’s pro-asset inflation policies have helped to push U.S. stock market valuations to 1929 levels. At some point, these valuations will revert back to the mean, as they always do, which will result in a powerful bear market.


The latest Fed-induced asset bubble (which is occurring in stocks, bonds, and some parts of the property market) has helped to boost U.S. household wealth in a manner similar to what occurred during the late-1990s Dot-com bubble and mid-2000s housing bubble. Unfortunately, this “wealth boost” is not a permanent gain or windfall, but a temporary increase until the latest asset bubble inevitably pops.

The latest asset bubble has the IMF worrying too – “IMF Warns of Rising Threats to Global Financial System“:

Threats to the global financial system are rising, with the price of risky assets surging in a manner reminiscent of the years before the global financial crisis, the International Monetary Fund warned.

Downside risks to world financial stability have increased “somewhat” over the past six months, the IMF said Wednesday in the latest edition of its Global Financial Stability Report. “Financial vulnerabilities, which have accumulated during years of extremely low rates and volatility, could make the road ahead bumpy and could put growth at risk,” said the Washington-based fund.

Investors “should not take too much comfort” in the fact there were no major disruptions from the sharp selloff that shook markets in February, the IMF said. “Valuations of risky assets are still stretched, with some late-stage credit cycle dynamics emerging, reminiscent of the pre-crisis period,” it said. “This makes markets exposed to a sharp tightening in financial conditions, which could lead to a sudden unwinding of risk premiums and a repricing of risky assets.”

Prices are frothy across a variety of assets, according to the IMF. Stock prices are high relative to fundamentals around the world, especially in the U.S., the fund said. Corporate bond valuations are also elevated, with signs of overheating in demand for leveraged loans from firms with low credit ratings, it said.

It is disingenuous for the Fed’s Neel Kashkari to place the blame solely on Wall Street for “forgetting the lessons of 2008” when the Fed itself is forgetting those lessons in such an egregious manner. This type of thinking at the Fed is why another massive financial crisis is already baked into the cake.

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The stock market has been rallying on the surge in global economic growth (recently monikered global synchronized growth) over the past year. The hope, as always, is that growth is finally here to stay. The surge in growth has also given cover to the Federal Reserve, and Central Banks globally, to start reducing the flood of liquidity that has been propping up markets globally since the “financial crisis.”

That optimism has bled over in recent months as improving confidence has pushed leverage back to record levels, investors carry the highest levels of risk assets since the turn of the century, and yield spreads remain near record lows. It certainly seems as “things are as good as they can get.”

But it is when things are “as good as they can get” that we find the rest of the story.

recent report from the Brookings Institute highlights one of the biggest risks to investors currently – global growth.

“The world economy’s growth momentum remains strong but is leveling off as the winds of a trade war, geopolitical risks, domestic political fractures, and debt-related risks loom, with financial markets already reflecting mounting vulnerabilities. The latest update of the Brookings-Financial Times TIGER index provides grounds for optimism about the current state of the world economy matched by some pessimism about the sustainability of the growth momentum.”

This has been a key concern of mine of the last several months. The recent uptick in the U.S. economy has been undeniably the strongest we have seen in the last few years. As Brookings notes:

The U.S. economy remains in robust shape, with growth in GDP, industrial production, and investment holding up well. In tandem with strong consumer confidence and employment growth, wage and inflationary pressures have picked up slightly, although less than would be typical at this stage of the cycle.

The issue, however, is that much of that uptick was attributable to a series of natural disasters in 2017. To wit:

“The Trump Administration has taken a LOT of credit for the recent bumps in economic growth. We have warned this was not only dangerous, credibility-wise, but also an anomaly due to three massive hurricanes and two major wildfires that had the ‘broken window’ fallacy working overtime.”

As shown in the chart below, the ECRI’s index and the Chicago Fed National Activity Index suggests that bump in growth may be waning. Historically, spikes in activity have historically noted peaks in the economic cycle. Such should not be surprising as growth breeds optimism which drives activity. Just remember, everything cycles.

While current optimism is high, it is also fragile.

For investors, when things are “as good as they can get,” that is the point where something has historically gone wrong. It is always an unexpected, unanticipated event that causes a revulsion of risk assets across markets. Currently, there are a host of competing forces at play within the markets and the economy. These competing forces weave a delicate balance that can be easily disrupted creating a reversion in behaviors.

As Brookings notes:

The U.S. is engaged in a perilous macroeconomic experiment, with the injection of a significant fiscal stimulus even as the economy appears to be operating at or above its potential. The Fed is likely to lean hard against potential inflationary pressures as this stimulus plays out. Export growth has been buoyed by a weak dollar and strong external demand, but the U.S. trade deficit has still risen over the past year. The large bilateral trade deficit with China remains a flashpoint, setting in motion trade tensions that could have implications for China, the U.S., and the entire world economy.”

But this isn’t just in the U.S. It is also on a global scale.

“In 2017, the Euro-zone turned in its fastest pace of growth over the last decade. Growth in overall GDP as well as in the manufacturing and services sectors remains solid but has cooled off slightly this year. Centrifugal political forces in many countries, rising global trade frictions, and the withdrawal of monetary stimulus could lay bare some of the unresolved structural problems and tensions in the zone.”

The last point was recently noted by Michael Lebowitz:

“Global central banks’ post-financial crisis monetary policies have collectively been more aggressive than anything witnessed in modern financial history. Over the last ten years, the six largest central banks have printed unprecedented amounts of money to purchase approximately $14 trillion of financial assets as shown below. Before the financial crisis of 2008, the only central bank printing money of any consequence was the Peoples Bank of China (PBoC).”

The central banks’ goals, in general, were threefold:

  • Expand the money supply allowing for the further proliferation of debt, which has sadly become the lifeline of most developed economies.
  • Drive financial asset prices higher to create a wealth effect. This myth is premised on the belief that higher financial asset prices result in greater economic growth as wealth is spread to the masses.
    • “And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”– Ben Bernanke Editorial Washington Post 11/4/2010.
  • Lastly, generate inflation, to help lessen the burden of debt.

QE has forced interest rates downward and lowered interest expenses for all debtors. Simultaneously, it boosted the amount of outstanding debt. The net effect is that the global debt burden has grown on a nominal basis and as a percentage of economic growth since 2008. The debt burden has become even more burdensome.

However, that liquidity support is now being removed.

That extraction of liquidity is potentially already showing up in slower rates of global economic growth. As recently noted by the ECRI:

“Our prediction last year of a global growth downturn was based on our 20-Country Long Leading Index, which, in 2016, foresaw the synchronized global growth upturn that the consensus only started to recognize around the spring of 2017.

With the synchronized global growth upturn in the rearview mirror, the downturn is no longer a forecast, but is now a fact.”

The ECRI goes on to pinpoint the problem facing investors currently which is a “willful blindness” to changes in the economic fabric.

“Still, the groupthink on the synchronized global growth upturn is so pervasive that nobody seemed to notice that South Korea’s GDP contracted in the fourth quarter of 2017, partly due to the biggest drop in its exports in 33 years. And that news came as the country was in the spotlight as host of the winter Olympics.

Because it’s so export-dependent, South Korea is often a canary in the coal mine of global growth. So, when the Asian nation experiences slower growth — let alone negative growth — it’s a yellow flag for the global economy.

The international slowdown is becoming increasingly obvious from the widely followed economic indicators. The most popular U.S. measures seem to present more of a mixed bag. Yet, as we pointed out late last year, the bond market, following the U.S. Short Leading Index, started sniffing out the U.S. slowdown months ago.”

While at the headline, things may seem to “firing on all cylinders,” there are many indicators showing rising “economic stress” such as:

The shift caused by the financial crisis, aging demographics, massive monetary interventions and the structural change in employment has skewed many of behaviors of politicians, central bankers, and investors. We are currently sailing in very unchartered waters where a single unexpected wave could easily capsize the ship. Not just domestically, but on a global scale.

As Brookings concludes:

“The era of growth fueled by macroeconomic stimulus, with no apparent adverse side effects such as high inflation, appears to be drawing to an end. In the absence of deep-rooted reforms to improve productivity, it will be difficult to ratchet up or even sustain high growth in the major economies.”

Mounting public debt in the U.S. and other advanced economies, compounded by unfavorable demographics, and rising external debt levels of some emerging market economies are risk factors that also reduce policy space for responding to shocks.”

There are a multitude of risks on the horizon, from geopolitical, to fiscal to economic which could easily derail growth if policymakers continue to count on the current momentum continuing indefinitely. The dependency on liquidity, interventions, and debt has displaced fiscal policy that could support longer-term economic resilience.

We are at war with ourselves, not China, and the games being played out by Washington to maintain the status quo is slowly creating the next crisis that won’t be fixed with another monetary bailout.

* Adding to my large SPY short
* Downside risk grows relative to upside reward

I have been shorting (on a scale higher) SPDR S&P 500 ETF (SPY) most of the day — adding to an already large short position.

There are a number of factors contributing to this move:

* Narrow market leadership. (We are back to the FAANG — Facebook (FB) , Amazon (AMZN) , Apple (AAPL) , Netflix (NFLX) and Alphabet (GOOGL) — market).
* The continued rise in short term interest rates. (The 2-year U.S. note yield is +1.5 basis points to 2.39%.)
* Seeing more investor complacency (anecdotally in the business media and elsewhere) — after the rally off of the lows.
* The rise in gold looks solid.
* Disappointing action in financials. (Though I continue to buy)

Finally, with S&P cash now at 2705 — the downside risk relative to the upside reward seems to argue in favor of a net short exposure.

Remember, I expect a 2200-2850 trading range for 2018, with a “fair market value” of about 2400.

So according to my calculus, currently, there is about 500 S&P points of downside risk (to the low end of my trading range) and 300 S&P points of risk to “fair market value” — as compared to the upside of only approximately 150 S&P points.

* Add the recent advance in oil stocks and a breakout in commodities as more reasons to be short term bearish


I can add two more factors that are contributing to my short term bearishness:

* Oil stocks have been the leading (non-FANG) sector in the stock market over the last few days/weeks – obviously in response to the rise in crude oil prices. Historically, a market being led by oil stocks is close to a top of what we can characterize as a mature Bull Market.

* As noted by my pal Peter Boockvar this morning, the CRB commodity index has broken out and now sits at the highest level since October, 2015. It’s not only oil – nickel, aluminum and other non-precious metals are rising. Peter also relates that the US ten year inflation breakeven is up by almost 1 basis point – and at the highest level since September, 2014. As noted earlier, the two year US note yield is now over 2.42%.

Caution is advised.

Trade negotiations and threatening global tariff volleys are contributing to significant volatility in the financial markets. Although applicable in many ways, the Smoot-Hawley protectionist act of 1930 is unfairly emphasized as the primary point of reference for understanding current events.

In 1944, an historic agreement was forged amongst global leaders that would shape worldwide commerce for decades. The historical precedence of post-WWII trade dynamics offers a thoughtful framework for understanding why trade negotiations are so challenging. This article uses that period as a means of improving the clarity of our current lens on complex and fast-changing trade dynamics.

The following article was originally published to subscribers of 720Global’s The Unseen. We are now releasing it to the public to provide a glimpse of our coming service, RIA Pro.

Triffin Warned Us

“We are addicted to our reserve currency privilege, which is in fact not a privilege but a curse.”  –James Grant, Grant’s Interest Rate Observer

Folklore states that Robert Johnson went down to the crossroads in Rosedale, Mississippi and made a deal with the devil in which he swapped his soul for musical virtuosity. In 1944, the United States and many nations made a deal at the crossroads in Bretton Woods, New Hampshire. The agreement, forged at a historic meeting of global leaders, has paid enormous economic benefits to the United States, but due to its very nature, has a flawed incongruity with a dear price that must be paid.

In 1960, Robert Triffin brilliantly argued that ever-accumulating trade deficits, the flaw of hosting the reserve currency and the result of Bretton Woods, may help economic growth in the short run but would kill it in the long run. Triffin’s theory, better known as Triffin’s Paradox, is essential to grasp the current economic woes and, more importantly, recognize why the path for future economic growth is far different from that envisioned in 1944.

We believe the financial crisis of 2008 was likely an important warning that years of accumulating deficits and debts associated with maintaining the world’s reserve currency may finally be reaching their tipping point. Despite the last nine years of outsized fiscal spending and unprecedented monetary stimulus, economic growth is well below the pace of recoveries of years past. In fact, as shown below, starting in 2009 the cumulative amount of new federal debt surpassed the cumulative amount of GDP growth going back to 1967. Said differently, if it were not for a significant and consistent federal deficit, GDP would have been negative every year since the 2008 financial crisis.  

Data Courtesy: St. Louis Federal Reserve (FRED) and Baker & Company Advisory Group/Zero Hedge

Bretton Woods and Dollar Hegemony

By decree of the Bretton Woods Agreement of 1944, the U.S. dollar supplanted the British Pound and became the global reserve currency. The agreement assured that a large majority of global trade was to occur in U.S. dollars, regardless of whether or not the United States was involved in such trade. Additionally, it set up a system whereby other nations would peg their currency to the dollar. This arrangement is somewhat akin to the concept of a global currency. This was not surprising, as a few years prior John Maynard Keynes introduced a supranational currency by the name of Bancor.

Within the terms of the historic agreement was a supposed remedy for one of the abuses that countries with reserve currency status typically commit; the ability to run incessant trade and fiscal deficits. The pact established a discipline to discourage such behavior by allowing participating nations the ability to exchange U.S. dollars for gold. In this way, other countries that were accumulating too many dollars, the side effect of American deficits, could exchange their excess dollars for U.S.-held gold. A rising price of gold, indicative of a devaluing U.S. dollar, would be a telltale sign for all nations that America was abusing her privilege.

The agreement began to fray after only 15 years. In 1961, the world’s leading nations established the London Gold Pool with an objective of maintaining the price of gold at $35 an ounce. By manipulating the price of gold, a gauge of the size of U.S. trade deficits was broken and accordingly the incentive to swap dollars for gold was diminished. In 1968, France withdrew from the Gold Pool and demanded large amounts of gold in exchange for dollars. By 1971, President Richard Nixon, fearing the U.S. would lose its gold if others followed France’s lead, suspended the convertibility of dollars into gold. From that point forward, the U.S. dollar was a floating currency without the discipline imposed upon it by gold convertibility. The Bretton Woods Agreement was, for all intents and purposes, annulled.

The following ten years were marked by double-digit inflation, persistent trade deficits, and weak economic growth, all signs that America was abusing its privilege as the reserve currency. Other nations grew increasingly uncomfortable with the dollar’s role as the reserve currency. The first graph below shows that, like clockwork, the U.S. began running annual deficits in 1971. The second graph highlights how inflation picked up markedly after 1971.

By the late-1970’s, to break the back of crippling inflation and remedy the nation’s economic woes, then Chairman of the Federal Reserve Paul Volcker raised interest rates from 5.875% to 20.00%. Although a painful period for the U.S. economy, his actions not only killed inflation and ultimately restored economic stability but, more importantly, satisfied America’s trade partners. The now floating rate dollar regained the integrity and discipline required to be the reserve currency despite lacking the checks and balances imposed upon it by the Bretton Woods Agreement and the gold standard.

As an aside, The Fifteenth of August discussed how Nixon’s “suspension” of the gold window unleashed the Federal Reserve to take full advantage of the dollar’s reserve currency status.

Enter Dr. Triffin

In 1960, 11 years before Nixon’s suspension of gold convertibility and essentially the demise of the Bretton Woods Agreement, Robert Tiffin foresaw this problem in his book Gold and the Dollar Crisis: The Future of Convertibility. According to his logic, the extreme privilege of becoming the world’s reserve currency would eventually carry a heavy penalty for the U.S.  Although initially his thoughts were generally given little consideration, Triffin’s hypothesis was taken seriously enough for him to gain a seat at an obscure congressional hearing of the Joint Economic Committee in December the same year.

What he described in the book, and his later testimony, became known as Triffin’s Paradox. Events have played out largely as he envisioned it. Essentially, he argued that reserve status affords a good percentage of global trade to occur in U.S. dollars. For this to occur the U.S. must supply the world with U.S. dollars.  In other words, to supply the world with dollars, the United States would always have to run a trade deficit whereby the dollar amount of imports exceeds the dollar amount of exports.  Running persistent deficits, the United States would become a debtor nation. The fact that other countries need to hold U.S. dollars as reserves tends to offset the effects of consistent deficits and keeps the dollar stronger than it would have been otherwise.

The arrangement is as follows: Foreign nations accumulate and spend dollars through trade. To manage their economies with minimal financial shocks, they must keep excess dollars on hand. These excess dollars, known as excess reserves, are invested primarily in U.S. denominated investments ranging from bank deposits to U.S. Treasury securities and a wide range of other financial securities. As the global economy expanded and more trade occurred, additional dollars were required. Further, foreign dollar reserves grew and were lent back, in one form or another, to the US economy. This is akin to buying a car with a loan from the automaker. The only difference is that trade-related transactions occurred with increasing frequency, the loans are never paid back, and the deficits accumulate (Spoiler Alert – the auto dealer would have cut the purchaser off well before the debt burden became too onerous).

The world has grown dependent on this arrangement as there are benefits to all parties involved. The U.S. purchases imports with dollars lent to her by the same nations that sold the goods.  Additionally, the need for foreign nations to hold dollars and invest them in the U.S. has resulted in lower U.S. interest rates, which further encourages consumption and at the same time provides relative support for the dollar. For their part, foreign nations benefited as manufacturing shifted away from the United States to their nations. As this occurred, increased demand for their products supported employment and income growth, thus raising the prosperity of their respective citizens.

While it may appear the post-Bretton Woods covenant was a win-win pact, there is a massive cost accruing to everyone involved. The U.S. is mired in economic stagnation due to overwhelming debt burdens and a reliance on record low-interest rates to further spur debt-driven consumption. The rest of the world, on the other hand, is her creditor and on the hook if and when those debts fail to be satisfied. Thus, Triffin’s paradox simply states that with the benefits of the reserve currency also comes an inevitable tipping point or failure.

Looking Forward

The two questions that must be considered are as follows:

  • When can our debts no longer be serviced?
  • When will foreign nations, like the auto dealer, fear such a day and stop lending to us (e., transacting in U.S. dollars and re-cycling those into U.S. securities)?

It is very likely the Great Financial Crisis of 2008 was an omen that America’s debt burden is unsustainable. Further troubling, as shown below, foreign investors have not only stopped adding to their U.S. investments of federal debt but have recently begun reducing them.  This puts additional pressure on the Federal Reserve to make up for this funding gap.

Data Courtesy: St. Louis Federal Reserve (FRED)

Assuming these trends continue, America must contend with an ever growing debt balance that must be serviced. In our opinion, there are two likely end scenarios. Either the resolution of debt imbalances occurs naturally via default on some debt and paying down of other debts or the Federal Reserve continues to “print” the digital dollars required to make up for the lack of funds the debt servicing and repayment requires. Given the Fed has already printed approximately $4 trillion to arrest the slight deleveraging that occurred in 2008, it does not take much imagination to expect this to be their modus operandi in the future. The following graph helps put the scale of money printing in proper historical context.

Data Courtesy: Global Technical Analysis and St. Louis Federal Reserve (FRED)  


In a 2013 interview, Yanis Varoufakis, economist, academic and the Greek Minister of Finance during the most recent Greek debt crisis, mentioned a manuscript that he had recently read.  The document, written in 1974 by Paul Volcker was directed to his then-boss, Secretary of State Henry Kissinger. Volcker stated that the U.S. need not manage its deficit as would be typical. Instead, he opined that it is our job to manage the surplus of other countries.

America’s ability to run deficits and accumulate massive debt balances for over 40 years, while maintaining its role as the global reserve currency, is a testimony to the power of our politicians and central bankers to “manage the surplus of other countries.” The questions to consider are:

  1. How much longer can the United States manage this tall and growing task?
  2. What is the tolerance of foreign holders of U.S. dollars in the face of dollar devaluation?
  3. Is the post-financial crisis “calm” the result of a durable solution or a temporary façade?

If in fact 2008 was a first tremor and signal of the end of this arrangement, then we are in the eye of the storm and future disruptions promise to be more significant and game-changing.

This concept has far-reaching implications well beyond economics and investing. We intend to provide future articles to extend the analysis on this topic and shed further light on how and when Triffin’s paradox may climax. We will also offer investment strategies to protect and grow your wealth during what may be tumultuous times ahead.

Admittedly, she was a seductress.

Who could blame him for falling in love?

I still remember how she glistened in the summer sun.

Hot to the touch.

I was as enamored as he was.

I was young, yet I remember like it was yesterday: “Her” name was “Tammy.”

Heck, I named everything “Tammy.” I had a mad crush on my babysitter.

However, this “Tammy” was a 1969 Mercury Cougar convertible – a black-glazed exterior elegance with cool white leather underneath a rag top.

Great lines and tough to ignore.

Years later, I learned the source of the money to purchase the sporty model was set aside by my mother’s hard-working father who came from Italy and lived in two rooms above a Mulberry Street, New York grocer – also his employer.

I can’t imagine how long it took papa to save $4,000. I’m sure his entire life –a respectable nest egg on his measly wages. I still admire his strong saving discipline.

Before he died, Giuseppe Zappello instructed his daughter:

“This money I leave behind is to be used for Richard’s college education only.”

He wrote his last instructions on crumpled note paper and gave it to mom shortly before his death from pancreatic cancer.

For Grandpa Joe, it was important that I further my education; it was his only request. I know he wasn’t enamored with my father and felt it important to outline how he wanted the money utilized.

Shortly after his death she decided to hand over the money for the purchase of an automobile, taking an action grandpa would have hated.

I’m being kind here. I believe mom probably caused Papa Joe to roll over in his grave.

For years, it bothered me she made this decision; it was troublesome that dad was short-sighted, too. I can’t imagine blowing my daughter’s education fund on a car.

Bad money decisions tied to financial infidelity are not new. Family members can be affected by them for generations; money mindsets forever forged by them.

The National Endowment for Financial Education® (NEFE®) has been tracking financial infidelity for over a decade and the problem continues to be formidable.

The latest findings from a biennial survey conducted by Harris Poll on behalf of NEFE finds two in five (41 percent) of American adults who combine finances with a partner or spouse, admit to committing financial deceptions against their loved one. The survey also finds that three quarters (75 percent) of adults say financial deceit has affected their relationships in some way – Source:

From their latest survey:

Among the reasons survey respondents say they committed financial deceptions in their current or past relationships, over one third (36 percent) say they believe some aspects of their finances should remain private, even from their spouse/partner; a quarter (26 percent) said they had discussed finances with their spouse/partner and they knew they would disapprove; almost one in five (18 percent) were embarrassed/fearful about their finances and didn’t want their spouse/partner to find out; and 16 percent said that while they hadn’t discussed finances with their spouse/partner they feared they would disapprove.

I too have been negligent in the past about following fidelity rules when it comes to sharing my financial decisions with others. To be clear: I will share information however, I’m going to move forward on my decisions as long as no one is hurt financially, and it’s for the good of people I love.

I admit – my money “imprint” is based on mom’s willingness to turn over my college fund to dad just so he can purchase a depreciating asset. Even financial advisers have faulty money scripts. What’s a money script? It’s your financial bloodline, a heated mixture of observation, experience, perception, memory, subconsciously put to action. Occasionally, with negative financial consequences.

I ask:

Why is the definition of financial infidelity so narrow? Why can’t it occur between a parent and a child, friends, an individual’s actions vs. original intentions? Mom failed to follow through on grandpa’s last request. She gave away blood money for a want, not a need which makes it more painful for me to understand. She wasn’t strong enough to say “no” to my father.

Although, I believe a measured dose of financial infidelity can be healthy.

For example, what if mom never told dad about the money earmarked for me? I figured the $4,000 she gave willingly could have been conservatively worth $8,000 by the time I needed it for college. Not a fortune, but it would have helped.

What can you do to avoid money temptation and financial infidelity?

Broaden, outline and then communicate your definition of financial infidelity.

Before marriage, make sure you communicate (write out and share) with your future partner specific actions you would classify as money cheating. I met with a couple recently where the man thought it was money infidelity for his fiancé to pay more than $20 for lunch without communicating with him first. In this case, the couple decided not to wed.

Consider broadening your definition to include those you care about including children. For example, I have clearly explained to my daughter how her college funds are for her, nobody else. Her mom is in agreement with this, too. If your definitions conflict or financial rules established are too restrictive at least it’s all out in the open for discussion.

Keep separate.

It’s important that separate property remain separate property. Assets held in trust should remain separate per the instructions of the grantor. Document each asset you plan to maintain apart from a future spouse. Communicate your intentions but don’t cross boundaries. These assets are yours. Don’t be talked into sharing.

Money earned before marriage should be maintained separately. If single, direct all your earnings into an individual account since wages, salaries and self-employment income will be considered community property in Texas (and other states) once you’re married. At that point, you should halt transfers of money into the account and maintain it as separate property going forward.

Inheritances need to be separate. It’s in your control to share. Or not. Your choice. Consider carefully whether or not sharing an asset with a spouse or future partner was truly the intention of the provider. In other words, think twice. Then think again. If you do decide to share, document the specific assets in question and sign along with the other receiving party.

Segment the cash you require to make daily purchases like lunches, nights out with friends, and clothes. I know a married couple who have agreed-upon “allowances” they direct automatically to separate accounts monthly from their joint account to cover personal expenses.

If additional money is required, they communicate and then jointly approve or disapprove the requests. I found this method effective for record keeping and accountability. It’s also useful to early detect wayward spending patterns.

 Keep together. 

Property purchased during the marriage may be held in joint ownership. A bank, investment account, real estate held jointly is common and advisable if you intend to leave the asset to a spouse upon death. Depending on the size of your joint estate ($5.6 million or more), it’s advisable to seek an estate planning attorney to create trusts that will preserve estate-tax exemptions and outline your intentions for beneficiary distributions years after your death.

 Keep away.

If you establish a custodial account for your child keep in mind that the money placed into it is considered an irrevocable gift. In other words, at age 21, the custodian (you) must turn over the asset to the former minor regardless of how uncertain you are of your child’s maturity level at the time of the transfer.

Custodial accounts are easy to establish which is a reason why they’re appealing. However, once money is deposited, it’s no longer yours. There have been cases where former minors have sued parents when custodial assets haven’t been turned over in a timely basis or were not notified of the accounts.

The lesson here is that assets earmarked for children and other loved ones should be considered solely for their current or future benefit.

Keep your discipline. Strong mental boundaries should be maintained.

Make sure your intentions to keep away are clear to others.

And perhaps you’ll avoid being seduced by Cougars or other large purchases that drive across your path.

This past weekend, I recommended taking action as the market approached our target zone of resistance. To wit:

Nearly a month later, and we are watching the “pathways” play out very close to our “guess.” 

Chart updated through Monday’s close

“More importantly, we continue to trace out the ‘reflexive rally’ path. However, my guess is we are not likely done with this correction process as of yet. From a very short-term perspective, the backdrop has improved to support a continued reflexive rally next week. 

The problem which now arises is the short-term oversold condition, which supported the idea of a “reflexive rally,” has largely been exhausted. Furthermore, the now declining 50-dma, which has also crossed below the 75 and 100-dma as well, suggests that some variation of ‘Option 2’ noted above is likely.

Given the recent rally, and overbought conditions, we are using this rally to follow our basic portfolio management rules. As the market approaches the “neighborhood” of the 100-dma we are:

  • Selling laggards and raising cash.
  • Rebalancing remaining long-equity exposure to comply with portfolio target weightings
  • Rebalancing the total allocation model to comply with target exposure levels.

Note that we are simply rebalancing risks at these levels – not selling everything and going to cash. There is an early “buy signal” combined with the potential for “earnings season” to support asset prices. The goal here is simply to rebalance risks and let the market “confirm” it has re-established its bullish bias.

A Simple Method Of Risk Management

Ben Carlson recently wrote an interesting piece on selling out of the market when it breaks the 200-day moving average (dma). To wit:

“As the legendary hedge fund manager Paul Tudor Jones said:

‘The whole trick to investing is: ‘How do I keep from losing everything?’ If you use the 200-day moving average rule, then you get out. You play defense, and you get out.’

Investors need to be careful about blindly following any indicator that gets them out of the market. There is no guarantee that markets are headed for a crash just because this trend was broken. There are no market timing signals that work every single time, so there’s no telling if the current correction will morph into an all-out bear market.

There are no silver bullets in the stock market. The 200-day moving average will be breached at some point during the next bear market. That’s a given. But it’s not a given that the most recent signal can assure investors a bear market is right around the corner. The majority of the time corrections don’t turn into crashes. History tells us that a false breakdown is a higher-probability event that further deterioration in the markets.”

While there is nothing “incorrect” contained in the article, in my opinion, Ben dismisses the two most important points about the investing and the portfolio management process – capital preservation and time.

The point of using any method of portfolio risk management is to have a strategy, process and discipline to avoid excessive levels of capital destruction over time. Ben is absolutely correct when he states there are no “silver bullets,” but “false positives” from time to time are a relatively small price to pay to avoid the probability of a major “mean reverting event.”

“In fact, the S&P 500 has crossed the 200-day moving average 150 times since 1997. If this were a perfect signal, that would imply 75 separate market corrections.

In reality, in that time, there were only 11 market corrections when stocks fell 10 percent or worse. That means the majority of the time when the S&P 500 went below the 200-day it was a head fake, when investors sold out of the market only to buy back higher.”

Let’s take a closer look.

The chart below is $1000 invested in the S&P 500 in 1997 on a capital appreciation basis only. The reddish line is just a “buy and hold” plot while the blue line is a “switch to cash” when the 200-dma is broken. Even with higher trading costs, the benefit of the strategy is readily apparent.

It’s Not The Method, It’s You

To Ben’s point, what happens to many investors is they get “whipsawed” by short-term volatility. While the signal gets them out, they “fail” to buy back when the signal reverses.

“I just sold out, now I’m supposed to jump back in? What if it crashes again?”

The answers are “yes” and “it doesn’t matter.” That is the just part of the investment strategy. 

But such is incredibly hard to do, which is why the majority of investors fail at investing over time. Adhering to a discipline, any discipline, is hard. Even “buy and hold,” fails when the “pain” exceeds an individuals tolerance for principal loss.

Investing isn’t easy. If it was, everyone would be rich. They aren’t because of the repeated emotional driven investment mistakes over time. This is why every great investor throughout history has had a basic philosophy of “buy low, sell high.”  Of course, you can’t buy low, if you didn’t sell high to begin with?

While there are many sophisticated methods of handling risk within a portfolio, even using a basic method of price analysis, such as a moving average, can be a valuable tool over longer-term holding periods.

Will such a method ALWAYS be right? Absolutely not.

Will such a method keep you from losing large amounts of capital? Absolutely.

Let’s go back further in time. The chart below is WEEKLY data to reduce price volatility and smooth out the signals over time. What becomes readily apparent is that using a basic form of price movement analysis can provide a useful identification of periods when portfolio risk should be REDUCED. Importantly, I did not say risk should be eliminated; just reduced.

Again, I am not implying, suggesting or stating that such signals mean going 100% to cash. What I am suggesting is that when “sell signals” are given it is the time when individuals should perform some basic portfolio risk management such as:

  • Trim back winning positions to original portfolio weights: Investment Rule: Let Winners Run
  • Sell positions that simply are not working (if the position was not working in a rising market, it likely won’t in a declining market.) Investment Rule: Cut Losers Short
  • Hold the cash raised from these activities until the next buying opportunity occurs. Investment Rule: Buy Low

By using some measures, fundamental or technical, to reduce portfolio risk by taking profits as prices/valuations rise, or vice versa, the long-term results of avoiding periods of severe capital loss will outweigh missed short-term gains. Small adjustments can have a significant impact over the long run.

This is shown in the chart below. There is always a big difference between market prices and the impact of losses on an actual dollar-based portfolio. By using a simple method to avoid losses, the differential over the long-term on $1000 is quite significant. (Chart below is capitalization only for example purposes.)

As shown in the chart above, this method doesn’t avoid every little twist and turn of the market, and yes, were many “head fakes” along the way. But what it did do was avoid a bulk of the major market reversions and inherent capital destruction.

Yet, despite two major bear market declines, it never ceases to amaze me that investors still believe that somehow they can invest in a portfolio that will capture all of the upside of the market but will protect them from the losses. Despite being a totally unrealistic objective this “fantasy” leads to excessive risk taking in portfolios which ultimately leads to catastrophic losses. Aligning expectations with reality is the key to building a successful portfolio. Implementing a strong investment discipline, and applying risk-management, is what leads to the achievement of those expectations.


Chasing an arbitrary index that is 100% invested in the equity market requires you to take on far more risk that you realize. Two massive bear markets over the last decade have left many individuals further away from retirement than they ever imagined. Furthermore, all investors lost something far more valuable than money – TIME needed to achieve their goal.

While I have stated this many times before, it is worth reiterating that your portfolio should be built around the things that matter most to you.

  • Capital preservation
  • A rate of return sufficient to keep pace with the rate of inflation.
  • Expectations based on realistic objectives.  (The market does not compound at 8%, 6% or 4% every year, losses matter)
  • Higher rates of return require an exponential increase in the underlying risk profile. This tends to not work out well.
  • You can replace lost capital – but you can’t replace lost time. Time is a precious commodity that you cannot afford to waste.
  • Portfolios are time-frame specific. If you have a 5-years to retirement but build a portfolio with a 20-year time horizon (taking on more risk) the results will likely be disastrous.

In hindsight, it is easy to see that investors should have been out of the market in 2001 and 2008. However, remember just prior to those two major market peaks the Wall Street mantra was the same then, as it is today:

“This time is different.” 

The problem, as always, is trying to determine the difference between a “false positive” and a “valid signal.” By the time you know for sure, it is often too late.

Four years ago, I wrote a piece for Forbes called “This New Libor ‘Scandal’ Will Cause A Terrifying Financial Crisis,” in which I explained that the “real” Libor scandal wasn’t the Libor rigging scandal, but the fact that that Libor interest rates were simply too low for too long, which was helping to fuel dangerous economic bubbles around the world. I was frustrated that, despite all the attention the Libor rigging scandal had received, that almost nobody was paying attention to the even larger crisis that was looming. It’s not that I was trying to minimize or trivialize the Libor rigging scandal; it’s just that I believed that the mainstream financial world was missing the forest for the trees. As I explained, the Libor rigging scandal caused tens of billions of dollars worth of losses, but the eventual popping of global bubbles that formed as a result of ultra-low Libor rates would gut the global economy by trillions of dollars. I still firmly believe that.

“Libor” is an acronym that stands for “London Interbank Offered Rate,” which is an important benchmark interest rate that is used to price loans across the globe. As I explained in 2014:

As the world’s most important benchmark interest rate, approximately $10 trillion worth of loans and $350 trillion worth of derivatives use the Libor as a reference rate. Libor-based corporate loans are very prevalent in emerging economies, which is helping to inflate the emerging markets bubble that I am warning about. In Asia, for example, Libor is used as the reference rate for nearly two-thirds of all large-scale corporate borrowings. Considering this fact, it is no surprise that credit and asset bubbles are ballooning throughout Asia, as my report on Southeast Asia’s bubble has shown.

Like other benchmark interest rates, when the Libor is low, it means that loans are inexpensive, and vice versa. As with the U.S. Fed Funds Rate, Libor rates were cut to record low levels during the 2008-2009 financial crisis in order to encourage more borrowing and concomitant economic growth. Unfortunately, economic booms that are created via central bank manipulation of borrowing costs are typically temporary bubble booms rather than sustainable, organic economic booms. When central banks raise borrowing costs as an economic cycle matures, the growth-driving bubbles pop, leading to a bear market, financial crisis, and recession.

The chart I created in my original Forbes piece shows how historic bubbles formed during periods of low Libor rates (also, low Fed Funds Rates, as the two are highly correlated). What is particularly concerning is the fact that Libor rates have remained at record low levels for a record length of time, which I believe is helping to inflate a global bubble that is more extreme and potentially ruinous than humanity has ever experienced (I’ve named this bubble “The Everything Bubble”).

Libor Bubble

Similar to the U.S. Fed Funds Rate, the Libor has been rising for the last several years as central banks raise interest rates. While rising interest rates haven’t popped the major global bubbles just yet, it’s just a matter of time before they start to bite.


While most economists and financial journalists view the rising Libor as part of a normal business cycle, I’m quite alarmed due to my awareness of just how much our global economic recovery and boom is predicated on ultra-low interest rates. With global debt up 42 percent or over $70 trillion since the Global Financial Crisis, interest rates do not need to rise nearly as high as they were in 2007 and 2008 to cause a massive crisis.

Global DebtThough I am obviously concerned about rising Libor and Fed Funds Rates, I am a realist and pragmatist when it comes to investing and trading; I’m not a “permabear.” As I showed last week, most U.S. stock indices are still in an uptrend despite the volatility of the past several months. This is a time to be a nimble trader with a finger on the “sell” button if and when the primary trend breaks down in a serious way.

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The tech startup boom has been one of the most important and visible economic “growth engines” of the past half-decade. The boom was spurred, in large part, by the success and excitement over Facebook, Uber, Airbnb, and similar companies, which led to a widespread search for the “Next Facebook” or billion dollar “unicorn” company. Unfortunately, the tech startup boom has devolved into a dangerous bubble as a result of record low interest rates and the trillions of dollars worth of liquidity that is sloshing around the globe as a result of central bank quantitative easing (QE) programs.

As an Austrian economist, I believe that central bank manipulation of borrowing costs (typically by holding interest rates too low) creates false signals or “fool’s gold” business and economic booms that trick investors into jumping into “hot” trends, only to lose their shirts when borrowing costs are inevitably increased again. These bad investments are called malinvestments, and occur largely as a result of central bank market distortions rather than organic market forces. I believe that a very high proportion of today’s tech startups will prove to be malinvestments when the current boom turns into a bust.

A recent Wall Street Journal article describes the latest phase of the startup bubble quite well –

SoftBank’s Billions Spur Global Race to Pour Money Into Startups

Silicon Valley Venture Capital Chart

The Silicon Valley money machine is once again in high gear, thanks largely to SoftBank. The conglomerate is injecting billions of dollars into tech, in turn causing deep-pocketed global investors—and some U.S. venture firms—to arm up in response. A record level of late-stage money is flooding in, threatening to keep some startups out of the public markets even longer while heightening concerns that the sector is overvalued.

In recent months, hotly contested companies like ride-hailing service Lyft Inc. and dog-walking app Wag Labs Inc. have received hundreds of millions of dollars more than they sought. Bidding wars are re-emerging, and some once-staid foreign investors are expanding U.S. offices and ditching their ties and suits to court talented entrepreneurs.

“The top companies have as much heat around them as ever and continue to get bid up,” said John Locke, who runs late-stage investing for venture-capital firm Accel Partners.


The big-check bug has spread to U.S. venture-capital firm Sequoia Capital, which is in the process of raising up to $13 billion, including an $8 billion fund for late-stage companies, the largest ever for a U.S. venture-capital firm.

Sequoia was previously content with smaller sums; its largest fund to date is $2 billion. But it made the decision last year to go bigger, seeing an opening to keep investing in companies as they stay private longer and grow larger.

This flood of private investment has heightened concerns it will create a shaky foundation for startups. When money rushes into Silicon Valley, startups historically have overspent by advancing into expensive new markets or battling with competitors in price wars.

“We’re encouraging the excessive use of capital,” Bill Gurley, a partner at Benchmark, said of venture capitalists at a February tech conference. “We’re all doing it because it’s the game on the field.”

Softbank, a Japanese conglomerate, announced in October that it was planning to invest as much as $880 billion into tech startups. At the time of that announcement, I recoiled in horror at the idea of companies “throwing” money into tech startups just because it was a hot, heavily hyped sector:



Sound, long-term business decisions are not made by picking an arbitrary dollar or yen figure and throwing it into a hot sector. This behavior is the hallmark of a liquidity bubble in which there is too much cash clamoring into unprofitable investments. Throwing ever-increasing amounts of cash at unprofitable startups won’t make them profitable – it’s just “throwing good money after bad.” While this is common sense, many business leaders aren’t seeing the obvious because they’re completely drunk on the startup bubble euphoria. I have no doubt that Japan’s Abenomics stimulus plan (in which over $4 trillion worth of new Japanese yen was printed) has played an important role in encouraging Softbank to jump headlong into the tech startup bubble with gobs of cash.

Thanks to the tech sector hype and high tech stock valuations, VCs are looking to cash in on their tech startup investments by going public, just like during the late-1990s Dot-com bubble –

Silicon Valley Venture Capitalists Prepare for an I.P.O. Wave

 Investors, bankers and analysts said they expected a wave of initial public offerings to bring some of the most highly valued and recognizable start-ups to the public market over the next 18 to 24 months — and billions of dollars in returns to their executives and investors. The potential bonanza would follow years of waiting as a few dozen companies amassed valuations without precedent in the private market.

Already, 2018 has gotten off to a fast start. Two of the biggest start-ups still sitting on the sidelines — Dropbox, an online file storage company, and Spotify, the streaming music service based in Sweden — successfully went public over the past month. Tech I.P.O.s have already raised more than $7 billion this year — more than all of 2015 and 2016, and more than half the $13 billion they raised last year, according to the market-data firm Dealogic.

While the mainstream financial world sees the current tech startup boom as a legitimate technology revolution, I see it as a gigantic, liquidity-fueled malinvestment bubble. As the Fed and other central banks remove liquidity as the economic cycle matures, the stock market bubble will burst, which will spill over into tech startups. When the tech startup bubble pops in earnest, I expect thousands, if not tens of thousands, of startups to fold. While the world should have learned from the Dot-com bubble, today’s tech startup bubble proves that we didn’t, so we are doomed to repeat the lesson.

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As we approach “tax day” in the U.S., I wanted to take a moment to revisit the issue of taxes, who pays what, and why the “Tax Cut and Jobs Act” will likely have limited impact on economic growth.

This week, Laura Saunders penned for the WSJ an analysis of “who pays what” under the U.S. progressive tax system. The data she used was from the Tax Policy center which divided about 175 million American households into five income tiers of roughly 65 million people each. This article was widely discussed on radio shows across the country as “clear evidence” recent tax reform was having a “huge effect” on average households and a clear step in “Making America Great Again.”

The reality, however, is far different than the politically driven spin.

First, the data.

“The results show how steeply progressive the U.S. income tax remains. For 2018, households in the top 20% will have income of about $150,000 or more and 52% of total income, about the same as in 2017. But they will pay about 87% of income taxes, up from about 84% last year.”

See, the “rich” are clearly paying more. 

Not really, percentages are very deceiving. If the total amount of revenue being collected is reduced, the purpose of a tax cut, the top 20% can pay LESS in actual dollars, but MORE in terms of percentage. For example:

  • Year 1: Top 20% pays $84 of $100 collected = 84%
  • Year 2: Top 20% pays $78 of $90 collected = 87%

This is how “less” equals “more.” 

So, where is the “less?”

“By contrast, the lower 60% of households, who have income up to about $86,000, receive about 27% of income. As a group, this tier will pay no net federal income tax in 2018 vs. 2% of it last year.”

“Roughly one million households in the top 1% will pay for 43% of income tax, up from 38% in 2017. These filers earn above about $730,000.”

While the “percentage or share” of the total will rise for the top 5%, the total amount of taxes estimated to be collected will fall by more than $1 Trillion for 2018. As Roberton Williams, an income-tax specialist with the Tax Policy Center, noted while the share of taxes paid by the top 5% will rise, the people in the top 5% were the largest beneficiaries of the overhaul’s tax cut, both in dollars and percentages.

Not surprisingly, as I noted previously, income taxes for the bottom 2-tiers of income earners, or roughly 77-million households, will have a negative income tax rate. Why? Because, despite the fact they pay ZERO in income taxes, Congress has chosen to funnel benefits for lower earners through the income tax rather than other channels such as federal programs. Since the recent tax legislation nearly doubled the standard deduction and expanded tax credits, it further lowered the share of income tax for people in those tiers.

The 80/20 Rule

In order for tax cuts to truly be effective, given roughly 70% of the economy is driven by personal consumption, the amount of disposable incomes available to individuals must increase to expand consumption further.

Since more than 80% of income taxes are paid by the top 20%, the reality is tax cuts only have a limited impact on consumption for those individuals as they are already consuming at a level with which they are satisfied.

The real problem is the bottom 80% that pay 20% of the taxes. As I have detailed previously, the vast majority of Americans are living paycheck to paycheck. According to CNN, almost six out of every ten Americans do not have enough money saved to even cover a $500 emergency expense. That lack of savings can be directly attributed to the lack of income growth for those in the bottom 80% of income earners.

So, with 80% of Americans living paycheck-to-paycheck, the need to supplant debt to maintain the standard of living has led to interest payments consuming a bulk of actual disposable income. The chart below shows that beginning in 2000, debt exceeded personal consumption expenditures for the first time in history. Therefore, any tax relief will most likely evaporate into the maintaining the current cost of living and debt service which will have an extremely limited, if any, impact on fostering a higher level of consumption in the economy.

But again, there is a vast difference between the level of indebtedness (per household) for those in the bottom 80% versus those in the top 20%.

The rise in the cost of living has outpaced income growth over the past 14 years. While median household incomes may have grown over the last couple of years, expenses have outpaced that growth significantly. As Stephanie Pomboy recently stated:

” In January, the savings rate went from 2.5% to 3.2% in one month—a massive increase. People look at the headline for spending and acknowledge that it’s not fabulous, but they see it as a sustainable formula for growth that will generate the earnings necessary to validate asset price levels.”

Unfortunately, the headline spending numbers are actually far more disturbing once you dig into “where” consumers are spending their dollars. As Stephanie goes on to state:

“When you go through that kind of detail, you discover that they are buying more because they have to. They are spending more on food, energy, healthcare, housing, all the nondiscretionary stuff, and relying on credit and dis-saving [to pay for it]. Consumers have had to draw down whatever savings they amassed after the crisis and run up credit-card debt to keep up with the basic necessities of life.”

When a bulk of incomes are diverted to areas which must be purchased, there is very little of a “multiplier effect” through the economy and spending on discretionary products or services becomes restricted. This problem is magnified when the Fed hikes short-term interest rates, which increases debt payments, and an Administration engages in a “trade war” which increases prices of purchased goods.

Higher costs and stagnant wages are not a good economic mix.

The Corporate Tax Cut Sham

But this was never actually a “tax cut for the middle-class.”

The entire piece of legislation was a corporate lobby-group inspired “give away” disguised as a piece of tax reform legislation. A total sham.

Why do I say that? Simple.

If the Administration were truly interested in a tax cut for the middle class, every piece of the legislation would have been focused on the nearly 80% of Federal revenue collected from individual income and payroll taxes.

Instead, the bulk of the “tax reform” plan focused on the 8.8% of total Federal revenue collected from corporate taxes. 

“But business owners and CEO’s will use their windfall to boost wages and increase productivity. Right?”

As I showed previously, there is simply no historical evidence to support that claim.

Corporations are thrilled with the bill because corporate tax cuts immediately drop to the bottom lines of the income statement. With revenue growth, as shown below, running at exceptionally weak levels, corporations continue to opt for share buybacks, wage suppression and accounting gimmicks to fuel bottom lines earnings per share. The requirement to meet Wall Street expectations to support share prices is more important to the “C-suite” executives than being benevolent to the working class.

“Not surprisingly, our guess that corporations would utilize the benefits of ‘tax cuts’ to boost bottom line earnings rather than increase wages has turned out to be true. As noted by Axios, in just the first two months of this year companies have already announced over $173 BILLION in stock buybacks.  This is ‘financial engineering gone mad.’” 

The historical evidence provides a very different story than the bill of goods being sold to citizens and investors. There is no historical evidence that cutting corporate tax rates increases economic growth. In fact, as recently noted by Michael Lebowitzthe opposite has been true with high correlation between lower tax rates and slower economic growth. 

With the deficit set to exceed $1 Trillion next year, and every year afterward, the government must borrow money to fund the shortfall. This borrowing effectively crowds out investment that could have funded the real economy.

“Said differently, the money required to fund the government’s deficit cannot be invested in the pursuit of innovation, improving workers skills, or other investments that pay economic dividends in the future. As we have discussed on numerous occasions, productivity growth drives economic growth over the longer term. Therefore, a lack productivity growth slows economic growth and ultimately weighs on corporate earnings.

A second consideration is that the long-term trend lower in the effective corporate tax has also been funded in part with personal tax receipts. In 1947, total personal taxes receipts were about twice that of corporate tax receipts. Currently, they are about four times larger. The current tax reform bill continues this trend as individuals in aggregate will pay more in taxes.

As personal taxes increase, consumers who account for approximately 70% of economic activity, have less money to spend.”


This issue of whether tax cuts lead to economic growth was examined in a 2014 study by William Gale and Andrew Samwick:

“The argument that income tax cuts raise growth is repeated so often that it is sometimes taken as gospel. However, theory, evidence, and simulation studies tell a different and more complicated story. Tax cuts offer the potential to raise economic growth by improving incentives to work, save, and invest. But they also create income effects that reduce the need to engage in productive economic activity, and they may subsidize old capital, which provides windfall gains to asset holders that undermine incentives for new activity.

In addition, tax cuts as a stand-alone policy (that is, not accompanied by spending cuts) will typically raise the federal budget deficit. The increase in the deficit will reduce national saving — and with it, the capital stock owned by Americans and future national income — and raise interest rates, which will negatively affect investment. The net effect of the tax cuts on growth is thus theoretically uncertain and depends on both the structure of the tax cut itself and the timing and structure of its financing.”

Again, the timing is not advantageous, the economic dynamics and the structure of the tax cuts are not self-supporting. As Dr. Lacy Hunt recently noted in his quarterly outlook:

“Considering the current public and private debt overhang, tax reductions are not likely to be as successful as the much larger tax cuts were for Presidents Ronald Reagan and George W. Bush. Gross federal debt now stands at 105.5% of GDP, compared with 31.7% and 57.0%, respectively, when the 1981 and 2002 tax laws were implemented. 

However, if the household and corporate tax reductions and infrastructure tax credits proposed are not financed by other budget offsets, history suggests they will be met with little or no success.

Since the current Administration has chosen to do the exact opposite by massively increasing spending, having no budget offsets, or slowing the rate of growth of either deficits or debts, the success of tax reform to boost economic growth is highly suspect.

Policymakers had the opportunity to pass true, pro-growth, tax reform and show they were serious about our nations fiscal future, they instead opted to continue enriching the top 1% at the expense of empowering the middle class. 

The outcome will be very disappointing.

Mike ‘Wags’ Wagner: ‘You studied the Flash Crash of 2010 and you know that Quant is another word for wild f***ing guess with math.’

Taylor Mason: ‘Quant is another word for systemized ordered thinking represented in an algorithmic approach to trading.’

Mike ‘Wags’ Wagner: ‘Just remember Billy Beane never won a World Series .’ – Billions, A Generation Too Late

My friend Doug Kass made a great point on Wednesday this week:

“General trading activity is now dominated by passive strategies (ETFs) and quant strategies and products (risk parity, volatility trending, etc.).

Active managers (especially of a hedge fund kind) are going the way of dodo birds – they are an endangered species. Failing hedge funds like Bill Ackman’s Pershing Square is becoming more the rule than the exception – and in a lower return market backdrop (accompanied by lower interest rates), the trend from active to passive managers will likely continue and may even accelerate this year.”

He’s right, and there is a huge risk to individual investors embedded in that statement. As JPMorgan noted previously:

Quantitative investing based on computer formulas and trading by machines directly are leaving the traditional stock picker in the dust and now dominating the equity markets.

While fundamental narratives explaining the price action abound, the majority of equity investors today don’t buy or sell stocks based on stock specific fundamentals. Fundamental discretionary traders’ account for only about 10 percent of trading volume in stocks. Passive and quantitative investing accounts for about 60 percent, more than double the share a decade ago.

As long as the algorithms are all trading in a positive direction, there is little to worry about. But the risk happens when something breaks. With derivatives, quantitative fund flows, central bank policy and political developments all contributing to low market volatility, the reversal of any of those dynamics will be problematic.

There are two other problems currently being dismissed to support the “bullish bias.”

The first, is that while investors have been chasing returns in the “can’t lose” market, they have also been piling on leverage in order to increase their return. Negative free cash balances are now at their highest levels in market history.

Yes, margin debt does increase as asset prices rise. However, just as the “leverage” provides the liquidity to push asset prices higher, the reverse is also true.

The second problem, which will be greatly impacted by the leverage issue, is liquidity of ETF’s themselves. As I noted previously:

“The head of the BOE Mark Carney himself has warned about the risk of ‘disorderly unwinding of portfolios’ due to the lack of market liquidity.

‘Market adjustments to date have occurred without significant stress. However, the risk of a sharp and disorderly reversal remains given the compressed credit and liquidity risk premia. As a result, market participants need to be mindful of the risks of diminished market liquidity, asset price discontinuities and contagion across asset markets.’”

When the “robot trading algorithms”  begin to reverse, it will not be a slow and methodical process but rather a stampede with little regard to price, valuation or fundamental measures as the exit will become very narrow.

Importantly, as prices decline it will trigger margin calls which will induce more indiscriminate selling. The forced redemption cycle will cause large spreads between the current bid and ask pricing for ETF’s. As investors are forced to dump positions to meet margin calls, the lack of buyers will form a vacuum causing rapid price declines which leave investors helpless on the sidelines watching years of capital appreciation vanish in moments.

Algo’s were not a predominant part of the market prior to 2008 and, so far, they have behaved themselves by continually “buying the dips.” That support has kept investors complacent and has built the inherent belief “this time is different.”

But therein lies the “risk of the robots.”

What happens when these algo’s reverse course and begin to “sell the rallies” in unison?

I don’t want to be around to find out.

On Wednesday, during the Real Investment Hour, I discussed a recent comment by David Rosenberg regarding “the most important” number, right now.  His answer: 13,000,000.

That is the number of individuals that have entered the financial services industry since the end of the “financial crisis.”

Why is that important? These individuals have only lived in a market supported by repeated rounds of stimulus, low interest rates, QE and a seemingly “can’t lose” market.

Experience is a valuable teacher.

Yesterday, during the Real Investment Hour, I discussed the three components of any investment – safety, liquidity or return. Importantly, as an investor, you can only have 2 of 3 components at any given time. Therefore, determining which components are the most important at any given time is key to the investment decision process.