Tag Archives: bear

Seth Levine: COVID-19 Is Not The Last War

These are truly remarkable times in the investment markets. The speed, intensity, and ubiquity of this selloff brings just one word to mind: violence. It would be remarkable if it wasn’t so destructive. Sadly, the reactions from our politicians and the public were predictable. The Federal Reserve (Fed) faithfully and forcefully responded. Despite its unprecedented actions, it seems like they’re “fighting the last war.”

Caveat Emptor

My intention here is to discuss some observations from the course of my career as an investor and try to relate them to the current market. I won’t provide charts or data; I’m just spit-balling here. My goal is twofold: 1) to better organize my own thoughts, and; 2) foster constructive discussions as we all try to navigate these turbulent markets. I realize that this approach puts this article squarely into the dime-a-dozen opinion piece category—so be it.

Please note that what you read is only as of the date published. I will be updating my views as the data warrants. Strong views, held loosely.

The Whole Kit and Caboodle

Investment markets are in freefall. U.S stock market declines tripped circuit breakers on multiple days. U.S. Treasuries are gyrating. Credit markets fell sharply. Equity volatility (characterized by the VIX) exploded. The dollar (i.e. the DXY index) is rocketing. We are in full-out crisis mode. No charts required here

With the Great Financial Crisis of 2008 (GFC) still fresh in the minds of many, the calls for a swift Fed action came loud and fast. Boy, the Fed listen. Obediently, it unleashed its full toolkit, dropping the Fed Funds rate to 0% (technically a 0.00% to 0.25% range), reducing interest on excess reserves, lowering pricing on U.S. dollar liquidity swaps arrangements, and kick-starting a $700 billion QE (Quantitative Easing) program. The initiatives are coming so fast and so furious that it’s hard to keep up! The Fed is even extending credit to primary dealers collateralized by “a broad range of investment grade debt securities, including commercial paper and municipal bonds, and a broad range of equity securities.” Really?!

Reflexively, the central bank threw the whole kit and caboodle at markets in hopes of arresting their declines. It’s providing dollar liquidity in every way it can imagine that’s within its power. However, I have an eerie sense that the Fed is (hopelessly) fighting the last war.

The Last War

There are countless explanations for the GFC. The way I see it is that 2008 was quite literally a financial crisis. The financial system (or plumbing) was Ground Zero. A dizzying array of housing-related structured securities (mortgage backed securities, collateralized debt obligations, asset-backed commercial paper, etc.) served as the foundation for the interconnected, global banking system, upon which massive amounts of leverage were employed.

As delinquencies rose, rating agencies downgraded these structured securities. This evaporated the stock of foundational housing collateral. Financial intuitions suddenly found themselves short on liquidity and facing insolvency. It was like playing a giant game of musical chairs whereby a third of the chairs were suddenly removed, unbeknownst to the participants. At once, a mad scramble for liquidity ensued. However, there simply was not enough collateral left to go around. Panic erupted. Institutions failed. The financial system literally collapsed.

This War

In my view, today’s landscape is quite different. The coronavirus’s (COVID-19) impact is a “real economy” issue. People are stuck at home; lots are not working. Economic activity has ground to a halt. It’s a demand shock to nearly every business model and individual’s finances. Few ever planned for such a draconian scenario.

Source: Variant Perception

Thus, this is not a game of musical chairs in the financial system. Rather, businesses will be forced to hold their breaths until life returns to normal. Cash will burn and balance sheets will stretch. The commercial environment is now one of survival, plain and simple (to say nothing of those individuals infected). Businesses of all sizes will be tested, and in particular small and mid-sized ones that lack access to liquidity lines. Not all will make it. To be sure, the financial system will suffer; however, as an effect, not a primary cause. This war is not the GFC.

Decentralized Solutions Needed

Given this dynamic, I’m skeptical that flooding the financial system with liquidity necessarily helps. In the GFC, a relatively small handful of banks (and finance companies) sat at the epicenter. Remember, finance is a levered industry characterized by timing mismatches of cash flows; it borrows “long” and earns “short.” This intermediation is its value proposition. Thus, extending liquidity can help bridge timing gaps to get them through short-term issues, thereby forestalling their deleveraging.

Today, however, the financial system is not the cause of the crisis. True, liquidity shortfalls are the source of stress. However, they are not limited to any one industry or a handful of identifiable actors. Rather, nearly every business may find itself short on cash. Availing currency to banks does not pay your favorite restaurant’s rent or cover its payroll. Quite frankly, I’m skeptical that any mandated measure can. A centralized solution simply cannot solve a decentralized problem.

Fishing With Dynamite

The speed and intensity at which investment markets are reacting is truly dizzying. In many ways they exceed those in the GFC. To be sure, a response to rapidly eroding fundamentals is appropriate. However, this one seems structural.

In my opinion, the wide-scale and indiscriminate carnage is the calling card of one thing: leverage unwinding. It wouldn’t surprise me to learn of a Long Term Capital Management type of event occurring, whereby some large(?), obscure(?), new (?), leveraged investment fund(s) is (are) being forced to liquidate lots of illiquid positions into thinly traded markets. This is purely a guess. Only time will tell.

Daniel Want, the Chief Investment Officer of Prerequisite Capital Management and one of my favorite investment market thinkers, put it best:

“Something is blowing up in the world, we just don’t quite know what. It’s like if you were to go fishing with dynamite. The explosion happens under the water, but it takes a little while for the fish to rise to the surface.”

Daniel Want, 2020 03 14 Prerequisite Update pt 4

What To Do

This logically raises the question of: What to do? From a policy perspective, I have little to offer as I am simply not an expert in the field (ask me in the comment section if you’re interested in my views). That said, the Fed’s response seems silly. Despite the severe investment market stresses, I don’t believe that we’re reliving the GFC. There’s no nail that requires a central banker’s hammer (as if there ever is one). If a financial crisis develops secondarily, then we should seriously question the value that such a fragile system offers.

Markets anticipate developments. I can envision a number of scenarios in which prices reverse course swiftly (such as a decline in the infection rate, a medical breakthrough, etc.). I can see others leading to a protracted economic contraction, as suggested by the intense market moves. Are serious underlying issues at play, even if secondarily? Or are fragile and idiosyncratic market structures to blame? These are the questions I’m trying to grapple with, weighing the unknowns, and allocating capital accordingly.

As an investor, seeing the field more clearly can be an advantage. Remember, it’s never different this time. Nor, however, is it ever the same. This makes for a difficult paradox to navigate. It’s in chaotic times when an investment framework is most valuable. Reflexively fighting the last war seems silly. Rather, let’s assess the current one as it rapidly develops and try to stay one step ahead of the herd.

Good luck out there and stay safe. Strong views, held loosely.

Technically Speaking: Risk Limits Hit, When Too Little Is Too Much

For the last several months, we have been issuing repeated warnings about the market. While such comments are often mistaken for “being bearish,” we have often stated it is our process of managing “risk” which is most important.

Beginning in mid-January, we began taking profits out of our portfolios and reducing risk. To wit:

“On Friday, we began the orderly process of reducing exposure in our portfolios to take in profits, reduce portfolio risk, and raise cash levels.”

Importantly, we did not “sell everything” and go to cash.

Since then, we took profits and rebalanced risk again in late January and early February as well.

Our clients, their families, their financial and emotional “well being,” rest in our hands. We take that responsibility very seriously, and work closely with our clients to ensure that not only are they financially successful, but they are emotionally stable in the process.

This is, and has been, our biggest argument against “buy and hold,” and “passive investing.” While there are plenty of case studies showing why individuals will eventually get back to even, the vast majority of individuals have a “pain point,” where they will sell.

So, we approach portfolio management from a perspective of “risk management,” but not just in terms of “portfolio risk,” but “emotional risk” as well. By reducing our holdings to raise cash to protect capital, we can reduce the risk of our clients hitting that “threashold” where they potentially make very poor decisions.

In investing, the worst decisions are always made at the moment of the most pain. Either at the bottom of the market or near the peaks. 

Investing is not always easy. Our portfolios are designed to have longer-term holding periods, but we also understand that things do not always go as planned.

This is why we have limits, and when things go wrong, we sell.

So, why do I tell you this?

On Friday/Monday, our “limits” were breached, which required us to sell more.

Two Things

Two things have now happened, which signaled us to reduce risk further in portfolios.

On Sunday, the Federal Reserve dropped a monetary “nuclear bomb,” on the markets. My colleague Caroline Baum noted the details:

“After an emergency 50-basis-point rate cut on March 3, the Federal Reserve doubled down Sunday evening, lowering its benchmark rate by an additional 100 basis points to a range of 0%-0.25% following another emergency meeting.

After ramping up its $60 billion of monthly Treasury bill purchases to include Treasuries of all maturities and offering $1.5 trillion of liquidity to the market via repurchase agreements on March 3, the Fed doubled down Sunday evening with announced purchases of at least $500 billion of Treasuries and at least $200 billion of agency mortgage-backed securities.

In addition, the Fed reduced reserve requirements to zero, encouraged banks to borrow from its discount window at a rate of 0.25%, and, in coordination with five other central banks, lowered the price of U.S. dollar swap arrangements to facilitate dollar liquidity abroad”

We had been anticipating the Federal Reserve to try and rescue the markets, which is why we didn’t sell even more aggressively previously. The lesson investors have been taught repeatedly over the last decade was “Don’t Fight The Fed.”

One of the reasons we reduced our exposure in the prior days was out of concern the Fed’s actions wouldn’t be successful. 

On Monday, we found out the answer. The Fed may be fighting a battle it can’t win as markets not only failed to respond to the Fed’s monetary interventions but also broke the “bullish trend line” from the 2009 lows.  (While the markets are oversold short-term, the long-term “sell signals” in the bottom panels are just being triggered from fairly high levels. This suggests more difficulty near-term for stocks. 

This was the “Red Line” we laid out in our Special Report for our RIAPro Subscribers (Risk-Free 30-Day Trial) last week:

“As you can see in the chart below, this is a massive surge of liquidity, hitting the market at a time the market is testing important long-term trend support.”

It is now, or never, for the markets.

With our portfolios already at very reduced equity levels, the break of this trendline will take our portfolios to our lowest levels of exposure.

What happened today was an event we have been worried about, but didn’t expect to see until after a break of the trendline – “margin calls.” This is why we saw outsized selling in “safe assets” such as REITs, utilities, bonds, and gold.

Cash was the only safe place to hide.

We aren’t anxious to “fight the Fed,” but the markets may have a different view this time.

Use rallies to raise cash, and rebalance portfolio risk accordingly.

We are looking to be heavy buyers of equities when the market forms a bottom, we just aren’t there as of yet.”

On Monday morning, with that important trendline broken, we took some action.

  • Did we sell everything? No. We still own 10% equity, bonds, and a short S&P 500 hedge. 
  • Did we sell the bottom? Maybe.

We will only know in hindsight for certain, and we are not willing to risk more of our client’s capital currently. 

There are too many non-quantifiable risks with a global recession looming, as noted by David Rosenberg:

“The pandemic is a clear ‘black swan’ event. There will be a whole range of knock-on effects. Fully 40 million American workers, or one-third of the private-sector labor force, are directly affected ─ retail, entertainment, events, sports, theme parks, conferences, travel, tourism, restaurants and, of course, energy.

This doesn’t include all the multiplier effects on other industries. It would not surprise me at all if real GDP in Q2 contracts at something close to an 8% annual rate (matching what happened in the fourth quarter of 2008, which was a financial event alone).

The hit to GDP can be expected to be anywhere from $400 billion to $600 billion for the year. But the market was in trouble even before COVID-19 began to spread, with valuations and complacency at cycle highs and equity portfolio managers sitting with record-low cash buffers. Hence the forced selling in other asset classes.

If you haven’t made recession a base-case scenario, you probably should. All four pandemics of the past century coincided with recession. This won’t be any different. It’s tough to generate growth when we’re busy “social distancing.” I am amazed that the latest WSJ poll of economists conducted between March 6-10th showed only 49% seeing a recession coming”.

The importance of his commentary is that from an “investment standpoint,” we can not quantify whether this “economic shock” has been priced into equities as of yet. However, we can do some math based on currently available data:

The chart below is the annual change in nominal GDP, and S&P 500 GAAP earnings.

I am sure you will not be shocked to learn that during “recessions,” corporate “earnings’ tend to fall. Historically, the average drawdown of earnings is about 20%; however, since the 1990’s, those drawdowns have risen to about 30%.

As of March 13th, Standard & Poors has earnings estimates for the first quarter of 2020 at $139.20 / share. This is down just $0.20 from the fourth quarter of 2019 estimates of $139.53.

In other words, Wall Street estimates are still in “fantasy land.” 

If our, and Mr. Rosenberg’s, estimates are correct of a 5-8% recessionary drag in the second quarter of 2020, then an average reduction in earnings of 30% is most likely overly optimistic. 

However, here is the math:

  • Current Earnings = 132.90
  • 30% Reduction = $100 (rounding down for easier math)

At various P/E multiples, we can predict where “fair value” for the market is based on historical assumptions:

  • 20x earnings:  Historically high but markets have traded at high valuations for the last decade. 
  • 18x earnings: Still historically high.
  • 15x earnings: Long-Term Average
  • 13x earnings: Undervalued 
  • 10x earnings: Extremely undervalued but aligned with secular bear market bottoms.

You can pick your own level where you think P/E’s will account for the global recession but the chart below prices it into the market.

With the S&P 500 closing yesterday at 2386, this equates to downside risk of:

  • 20x Earnings = -16% (Total decline from peak = – 40%)
  • 18x Earnings = 24.5% (Total decline from peak = – 46%)
  • 15x Earnings = -37.1% (Total decline from peak = – 55%)
  • 13x Earnings = 45.5% (Total decline from peak = – 61%)
  • 10x Earnings = 58.0% (Total decline from peak = – 70%)

NOTE: I am not suggesting the market is about to decline 60-70% from the recent peak. I am simply laying out various multiples based on assumed risk to earnings. However, 15-18x earnings is extremely reasonable and possible. 

When Too Little Is Too Much

With our risk limits hit, and in order to protect our clients from both financial and emotional duress, we made the decision that even the reduced risk we were carrying was still too much.

One concern, which weighed heavily into our decision process, was the rising talk of the “closing the markets” entirely for a week or two to allow the panic to pass. We have clients that depend on liquidity from their accounts to sustain their retirement lifestyle. In our view, a closure of the markets would lead to two outcomes which pose a real risk to our clients:

  1. They need access to liquidity, and with markets closed are unable to “sell” and raise cash; and,
  2. When you trap investors in markets, when they do open again, there is a potential “rush” of sellers to get of the market to protect themselves. 

That risk, combined with the issue that major moves in markets are happening outside of transaction hours, are outside of our ability to hedge, or control.

This is what we consider to be an unacceptable risk for the time being.

We will likely miss the ultimate “bottom” of the market.

Probably.

But that’s okay, we have done our job of protecting our client’s second most precious asset behind their family, the capital they have to support them.

The good news is that a great “buying” opportunity is coming. Just don’t be in a “rush” to try and buy the bottom.

I can assure you, when we see ultimately see a clear “risk/reward” set up to start taking on equity risk again, we will do so “with both hands.” 

And we are sitting on a lot of cash just for that reason.Save

RIA PRO: Risk Limits Hit

For the last several months we have been issuing repeated warnings about the market. While such comments are often mistaken for “being bearish,” we have often stated it is our process of managing “risk” which is most important.

Beginning in mid-January, we began taking profits out of our portfolios and reducing risk. To wit:

“On Friday, we began the orderly process of reducing exposure in our portfolios to take in profits, reduce portfolio risk, and raise cash levels.”

Since then, as you know, we have taken profits, and rebalanced risk several times within the portfolios.

Importantly, we approach portfolio management from a perspective of “risk management,” but not just in terms of “portfolio risk,” but “emotional risk” as well. By reducing our holdings to raise cash to protect capital, we can reduce the risk of our clients hitting that “threshold” where they potentially make very poor decisions.

In investing, the worst decisions are always made at the moment of the most pain. Either at the bottom of the market or near the peaks. 

Investing is not always easy. Our portfolios are designed to have longer-term holding periods, but we also understand that things do not always go as planned.

This is why we have limits, and when things go wrong, we sell.

So, why do I tell you this?

On Friday/Monday, our “limits” were breached, which required us to sell more.

Two Things

Two things have now happened which signaled us to reduce risk further in portfolios.

On Sunday, the Federal Reserve dropped a monetary “nuclear bomb,” on the markets. My colleague Caroline Baum noted the details:

“After an emergency 50-basis-point rate cut on March 3, the Federal Reserve doubled down Sunday evening, lowering its benchmark rate by an additional 100 basis points to a range of 0%-0.25% following another emergency meeting.

After ramping up its $60 billion of monthly Treasury bill purchases to include Treasuries of all maturities and offering $1.5 trillion of liquidity to the market via repurchase agreements on March 3, the Fed doubled down Sunday evening with announced purchases of at least $500 billion of Treasuries and at least $200 billion of agency mortgage-backed securities.

In addition, the Fed reduced reserve requirements to zero, encouraged banks to borrow from its discount window at a rate of 0.25%, and, in coordination with five other central banks, lowered the price of U.S. dollar swap arrangements to facilitate dollar liquidity abroad”

We had been anticipating the Federal Reserve to try and rescue the markets, which is why we didn’t sell even more aggressively previously. The lesson investors have been taught repeatedly over the last decade was “Don’t Fight The Fed.”

One of the reasons we reduced our exposure in the prior days was out of concern we didn’t know if the Fed’s actions would be successful. 

On Monday, we found out the answer. The Fed may be fighting a battle it can’t win as markets not only failed to respond to the Fed’s monetary interventions, but also broke the “bullish trend line” from the 2009 lows.  (While the markets are oversold short-term, the long-term “sell signals” in the bottom panels are just being triggered from fairly high levels. This suggests more difficulty near-term for stocks. 

This was the “Red Line” we laid out in our last week, in the Special Report Red Line In The Sand:

“As you can see in the chart below, this is a massive surge of liquidity hitting the market at a time the market is hitting important long-term trend support.”

It is now, or never, for the markets.

With our portfolios already at very reduced equity levels, the break of this trendline will take our portfolios to our lowest levels of exposure. However, given the extreme oversold condition, noted above, it is likely we are going to see a bounce, which we will use to reduce risk into.

What happened today was an event we have been worried about, but didn’t expect to see until after a break of the trendline – “margin calls.”

This is why we saw outsized selling in “safe assets” such as REITs, utilities, bonds, and gold.

Cash was the only safe place to hide.

This also explains why the market “failed to rally” when the Fed announced $500 billion today. There is another $500 billion coming tomorrow. We will see what happens.

We aren’t anxious to “fight the Fed,” but the markets may have a different view this time.

Use rallies to raise cash, and rebalance portfolio risk accordingly.

We are looking to be heavy buyers of equities when the market forms a bottom, we just aren’t there as of yet.”

On Monday morning, we took some action.

  • Did we sell everything? No. We still own 10% equity, bonds, and a short S&P 500 hedge. 
  • Did we sell the bottom? Maybe.

We will only know in hindsight for certain, and we are not willing to risk more of our client’s capital currently. 

There are too many non-quantifiable risks with a global recession looming, as noted by David Rosenberg:

“The pandemic is a clear ‘black swan’ event. There will be a whole range of knock-on effects. Fully 40 million American workers, or one-third of the private sector labor force, are directly affected ─ retail, entertainment, events, sports, theme parks, conferences, travel, tourism, restaurants and, of course, energy.

This doesn’t include all the multiplier effects on other industries. It would not surprise me at all if real GDP in Q2 contracts at something close to an 8% annual rate (matching what happened in the fourth quarter of 2008 which was a financial event alone).

The hit to GDP can be expected to be anywhere from $400 billion to $600 billion for the year. But the market was in trouble even before COVID-19 began to spread, with valuations and complacency at cycle highs and equity portfolio managers sitting with record-low cash buffers. Hence the forced selling in other asset classes.

If you haven’t made recession a base-case scenario, you probably should. All four pandemics of the past century coincided with recession. This won’t be any different. It’s tough to generate growth when we’re busy “social distancing.” I am amazed that the latest WSJ poll of economists conducted between March 6-10th showed only 49% seeing a recession coming”.

The importance of his commentary is that from an “investment standpoint,” we can not quantify whether this “economic shock” has been priced into equities as of yet. However, we can do some math based on currently available data:

The chart below is annual nominal GDP, and S&P 500 GAAP earnings.

I am sure you will not be shocked to learn that during “recessions,” corporate “earnings’ tend to fall. Historically, the average drawdown of earnings is about 20%, however, since the 1990’s, those drawdowns have risen to about 30%.

As of March 13th, Standard & Poors has earnings estimates for the first quarter of 2020 at $139.20/share. This is down just $0.20 from the fourth quarter of 2019 estimates of $139.53.

If our, and Mr. Rosenberg’s, estimates are correct of a 5-8% recessionary drag in the second quarter of 2020, then an average reduction in earnings of 30% is most likely overly optimistic. 

However, here is the math:

  • Current Earnings = 132.90
  • 30% Reduction = $100 (rounding down for easier math)

At various P/E multiples we can predict where “fair value” for the market is based on historical assumptions:

  • 20x earnings:  Historically high but markets have traded at high valuations for the last decade. 
  • 18x earnings: Still historically high.
  • 15x earnings: Long-Term Average
  • 13x earnings: Undervalued 
  • 10x earnings: Extremely undervalued but aligned with secular bear market bottoms.

You can pick your own level where you think P/E’s will account for the global recession but the chart below prices it into the market.

With the S&P 500 closing yesterday at 2386, this equates to downside risk of:

  • 20x Earnings = -16% (Total decline from peak = – 40%)
  • 18x Earnings = 24.5% (Total decline from peak = – 46%)
  • 15x Earnings = -37.1% (Total decline from peak = – 55%)
  • 13x Earnings = 45.5% (Total decline from peak = – 61%)
  • 10x Earnings = 58.0% (Total decline from peak = – 70%)

NOTE: I am not suggesting the market is about to decline 60-70% from the recent peak. I am simply laying out various multiples based on assumed risk to earnings. However, 15-18x earnings is extremely reasonable and possible. 

When Too Little Is Too Much

With our risk limits hit, and in order to protect our clients from both financial and emotional duress, we made the decision that even the reduced risk we were carrying was still too much.

One concern, which weighed heavily into our decision process, was the rising talk of the “closing the markets” entirely for a week or two to allow the panic to pass. We have clients that depend on liquidity from their accounts to sustain their retirement lifestyle. In our view, a closure of the markets would lead to two outcomes which pose a real risk to our clients:

  1. They need access to liquidity, and with markets closed are unable to “sell” and raise cash; and,
  2. When you trap investors in markets, when they do open again there is a potential “rush” of sellers to get of the market to protect themselves. 

That risk, combined with the issue that major moves in markets are happening outside of transaction hours, are outside of our ability to hedge, or control.

This is what we consider to be unacceptable risk for the time being.

We will likely miss the ultimate “bottom” of the market?

Probably.

But that’s okay, we have done our job of protecting our client’s second most precious asset behind their family, the capital they have to support them.

The good news is that a great “buying” opportunity is coming. Just don’t be in a “rush” to try and buy the bottom.

I can assure you that when we see ultimately see a clear “risk/reward” set up to start taking on equity risk again, we will do so “with both hands.” 

And we are sitting on a lot of cash just for that reason.Save

Technically Speaking: On The Cusp Of A Bear Market

“Tops are a process, and bottoms are an event”

Over the last couple of years, we have discussed the ongoing litany of issues that plagued the underbelly of the financial markets.

  1. The “corporate credit” markets are at risk of a wave of defaults.
  2. Earnings estimates for 2019 fell sharply, and 2020 estimates are now on the decline.
  3. Stock market targets for 2020 are still too high, along with 2021.
  4. Rising geopolitical tensions between Russia, Saudi Arabia, China, Iran, etc. 
  5. The effect of the tax cut legislation has disappeared as year-over-year comparisons are reverting back to normalized growth rates.
  6. Economic growth is slowing.
  7. Chinese economic data has weakened further.
  8. The impact of the “coronavirus,” and the shutdown of the global supply chain, will impact exports (which make up 40-50% of corporate profits) and economic growth.
  9. The collapse in oil prices is deflationary and can spark a wave of credit defaults in the energy complex.
  10. European growth, already weak, continues to weaken, and most of the EU will likely be in recession in the next 2-quarters.
  11. Valuations remain at expensive levels.
  12. Long-term technical signals have become negative. 
  13. The collapse in equity prices, and coronavirus fears, will weigh on consumer confidence.
  14. Rising loan delinquency rates.
  15. Auto sales are signaling economic stress.
  16. The yield curve is sending a clear message that something is wrong with the economy.
  17. Rising stress on the consumption side of the equation from retail sales and personal consumption.

I could go on, but you get the idea.

In that time, these issues have gone unaddressed, and worse dismissed, because of the ongoing interventions of Central Banks.

However, as we have stated many times in the past, there would eventually be an unexpected, exogenous event, or rather a “Black Swan,” which would “light the fuse” of a bear market reversion.

Over the last few weeks, the market was hit with not one, but two, “black swans” as the “coronavirus” shutdown the global supply chain, and Saudi Arabia pulled the plug on oil price support. Amazingly, we went from “no recession in sight”, to full-blown “recession fears,” in less than month.

“Given that U.S. exporters have already been under pressure from the impact of the “trade war,” the current outbreak could lead to further deterioration of exports to and from China, South Korea, and Japan. This is not inconsequential as exports make up about 40% of corporate profits in the U.S. With economic growth already struggling to maintain 2% growth currently, the virus could shave between 1-1.5% off that number. 

With our Economic Output Composite Indicator (EOCI) already at levels which has previously denoted recessions, the “timing” of the virus could have more serious consequences than currently expected by overzealous market investors.”

On The Cusp Of A Bear Market

Let me start by making a point.

“Bull and bear markets are NOT defined by a 20% move. They are defined by a change of direction in the trend of prices.” 

There was a point in history where a 20% move was significant enough to achieve that change in overall price trends. However, today that is no longer the case.

Bull and bear markets today are better defined as:

“During a bull market, prices trade above the long-term moving average. However, when the trend changes to a bear market prices trade below that moving average.”

This is shown in the chart below, which compares the market to the 75-week moving average. During “bullish trends,” the market tends to trade above the long-term moving average and below it during “bearish trends.”

In the last decade, there have been three previous occasions where the long-term moving average was violated but did not lead to a longer-term change in the trend.

  • The first was in 2011, as the U.S. was dealing with a potential debt-ceiling and threat of a downgrade of the U.S. debt rating. Then Fed Chairman Ben Bernanke came to the rescue with the second round of quantitative easing (QE), which flooded the financial markets with liquidity.
  • The second came in late-2015 and early-2016 as the market dealt with a Federal Reserve, which had started lifting interest rates combined with the threat of the economic fallout from Britain leaving the European Union (Brexit). Given the U.S. Federal Reserve had already committed to hiking interest rates, and a process to begin unwinding their $4-Trillion balance sheet, the ECB stepped in with their own version of QE to pick up the slack.
  • The latest event was in December 2018 as the markets fell due to the Fed’s hiking of interest rates and reduction of their balance sheet. Of course, the decline was cut short by the Fed reversal of policy and subsequently, a reduction in interest rates and a re-expansion of their balance sheet.

Had it not been for these artificial influences, it is highly likely the markets would have experienced deeper corrections than what occurred.

On Monday, we have once again violated that long-term moving average. However, Central Banks globally have been mostly quiet. Yes, there have been promises of support, but as of yet, there have not been any substantive actions.

However, the good news is that the bullish trend support of the 3-Year moving average (orange line) remains intact for now. That line is the “last line of defense” of the bull market. The only two periods where that moving average was breached was during the “Dot.com Crash” and the “Financial Crisis.”

(One important note is that the “monthly sell trigger,” (lower panel) was initiated at the end of February which suggested there was more downside risk at the time.)

None of this should have been surprising, as I have written previously, prices can only move so far in one direction before the laws of physics take over. To wit”

Like a rubber band that has been stretched too far – it must be relaxed before it can be stretched again. This is exactly the same for stock prices that are anchored to their moving averages. Trends that get overextended in one direction, or another, always return to their long-term average. Even during a strong uptrend or strong downtrend, prices often move back (revert) to a long-term moving average.”

With the markets previously more than 20% of their long-term mean, the correction was inevitable, it just lacked the right catalyst.

The difference between a “bull market” and a “bear market” is when the deviations begin to occur BELOW the long-term moving average on a consistent basis. With the market already trading below the 75-week moving average, a failure to recover in a fairly short period, will most likely facilitate a break below the 3-year average.

If that occurs, the “bear market” will be official and will require substantially lower levels of equity risk exposure in portfolios until a reversal occurs.

Currently, it is still too early to know for sure whether this is just a “correction” or a “change in the trend” of the market. As I noted previously, there are substantial differences, which suggest a more cautious outlook. To wit:

  • Downside Risk Dwarfs Upside Reward. 
  • Global Growth Is Less Synchronized
  • Market Structure Is One-Sided and Worrisome. 
  • COVID-19 Impacts To The Global Supply Chain Are Intensifying
  • Any Semblance of Fiscal Responsibility Has Been Thrown Out the Window
  • Peak Buybacks
  • China, Europe, and the Emerging Market Economic Data All Signal a Slowdown
  • The Democrats Control The House Which Effectively Nullifies Fiscal Policy Agenda.
  • The Leadership Of The Market (FAANG) Has Faltered.

Most importantly, the collapse in interest rates, as well as the annual rate of change in rates, is screaming that something “has broken,” economically speaking.

Here is the important point.

Understanding that a change is occurring, and reacting to it, is what is important. The reason so many investors “get trapped” in bear markets is that by the time they realize what is happening, it has been far too late to do anything about it.

Let me leave you with some important points from the legendary Marty Zweig: (h/t Doug Kass.)

  • Patience is one of the most valuable attributes in investing.
  • Big money is made in the stock market by being on the right side of the major moves. The idea is to get in harmony with the market. It’s suicidal to fight trends. They have a higher probability of continuing than not.
  • Success means making profits and avoiding losses.
  • Monetary conditions exert an enormous influence on stock prices. Indeed, the monetary climate – primarily the trend in interest rates and Federal Reserve policy – is the dominant factor in determining the stock market’s major decision.
  • The trend is your friend.
  • The problem with most people who play the market is that they are not flexible.
  • Near the top of the market, investors are extraordinarily optimistic because they’ve seen mostly higher prices for a year or two. The sell-offs witnessed during that span were usually brief. Even when they were severe, the market bounced back quickly and always rose to loftier levels. At the top, optimism is king; speculation is running wild, stocks carry high price/earnings ratios, and liquidity has evaporated. 
  • I measure what’s going on, and I adapt to it. I try to get my ego out of the way. The market is smarter than I am, so I bend.
  • To me, the “tape” is the final arbiter of any investment decision. I have a cardinal rule: Never fight the tape!
  • The idea is to buy when the probability is greatest that the market is going to advance.

Most importantly, and something that is most applicable to the current market:

“It’s okay to be wrong; it’s just unforgivable to stay wrong.” – Marty Zweig

There action this year is very reminiscent of previous market topping processes. Tops are hard to identify during the process as “change happens slowly.” The mainstream media, economists, and Wall Street will dismiss pickup in volatility as simply a corrective process. But when the topping process completes, it will seem as if the change occurred “all at once.”

The same media which told you “not to worry,” will now tell you, “no one could have seen it coming.”

The market may be telling you something important, if you will only listen.

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Technically Speaking: Sellable Rally, Or The Return Of The Bull?

Normally, “Technically Speaking,” is analysis based on Monday’s market action. However, this week, we are UPDATING the analysis posted in this past weekend’s newsletter, “Market Crash & Navigating What Happens Next.”

Specifically, we broke down the market into three specific time frames looking at the short, intermediate, and long-term technical backdrop of the markets. In that analysis, we laid out the premise for a “reflexive bounce” in the markets, and what to do during the process of that move. To wit:

“On a daily basis, the market is back to a level of oversold (top panel) rarely seen from a historical perspective. Furthermore, the rapid decline this week took the markets 5-standard deviations below the 50-dma.”

Chart updated through Monday

“To put this into some perspective, prices tend to exist within a 2-standard deviation range above and below the 50-dma. The top or bottom of that range constitutes 95.45% of ALL POSSIBLE price movements within a given period.

A 5-standard deviation event equates to 99.9999% of all potential price movement in a given direction. 

This is the equivalent of taking a rubber band and stretching it to its absolute maximum.”

Importantly, like a rubber band, this suggests the market “snap back” could be fairly substantial, and should be used to reduce equity risk, raise cash, and add hedges.”

Importantly, read that last sentence again.

The current belief is that the “virus” is limited in scope and once the spread is contained, the markets will immediately bounce back in a “V-shaped” recovery.  Much of this analysis is based on assumptions that “COVID-19” is like “SARS” in 2003 which had a very limited impact on the markets.

However, this is likely a mistake as there is one very important difference between COVID-19 and SARS, as I noted previously:

“Currently, the more prominent comparison is how the market performed following the ‘SARS’ outbreak in 2003, as it also was a member of the ‘corona virus’ family. Clearly, if you just remained invested, there was a quick recovery from the market impact, and the bull market resumed. At least it seems that way.”

“While the chart is not intentionally deceiving, it hides a very important fact about the market decline and the potential impact of the SARS virus. Let’s expand the time frame of the chart to get a better understanding.”

“Following a nearly 50% decline in asset prices, a mean-reversion in valuations, and an economic recession ending, the impact of the SARS virus was negligible given the bulk of the ‘risk’ was already removed from asset prices and economic growth. Today’s economic environment could not be more opposed.”

This was also a point noted by the WSJ on Monday:

Unlike today, the S&P 500 ETF (SPY) spent about a year below its 200-day moving average (dot-com crash) prior to the SARS 2003 outbreak. Price action is much different now. SPY was well above its 200-day moving average before the coronavirus outbreak, leaving plenty of room for profit-taking.”

Importantly, the concern we have in the intermediate-term is not “people getting sick.” We currently have the “flu” in the U.S. which, according to the CDC, has affected 32-45 MILLION people which has already resulted in 18-46,000 deaths.

Clearly, the “flu” is a much bigger problem than COVID-19 in terms of the number of people getting sick. The difference, however, is that during “flu season,” we don’t shut down airports, shipping, manufacturing, schools, etc. The negative impact to exports and imports, business investment, and potentially consumer spending, which are all direct inputs into the GDP calculation, is going to be reflected in corporate earnings and profits. 

The recent slide, not withstanding the “reflexive bounce” on Monday, was beginning the process of pricing in negative earnings growth through the end of 2020.

More importantly, the earnings estimates have not be ratcheted down yet to account for the impact of the “shutdown” to the global supply chain. Once we adjust (dotted blue line) for the a negative earnings environment in 2020, with a recovery in 2021, you can see just how far estimates will slide over the coming months. This will put downward pressure on stocks over the course of this year.

Given this backdrop of weaker earnings, which will be derived from weaker economic growth, in the months to come is why we suspect we could well see this year play out much like 2015-2016. In 2015, the Fed was beginning to discuss tapering their balance sheet which initially led to a decline. Given there was still plenty of liquidity, the market rallied back before “Brexit” risk entered the picture. The market plunged on expectations for a negative economic impact, but sprung back after Janet Yellen coordinated with the BOE, and ECB, to launch QE in the Eurozone.

Using that model for a reflexive rally, we will likely see a failed rally, and a retest of last weeks lows, or potentially even set new lows, as economic and earnings risks are factored in. 

Rally To Sell

As expected, the market rallied hard on Monday on hopes the Federal Reserve, and Central Banks globally, will intervene with a “shot of liquidity” to cure the market’s “COVID-19” infection.

The good news is the rally yesterday did clear initial resistance at the 200-dma which keeps that important break of support from being confirmed. This clears the way for the market to rally back into the initial “sell zone” we laid out this past weekend.

Importantly, while the volume of the rally on Monday was not as large as Friday’s sell-off, it was a very strong day nonetheless and confirmed the conviction of buyers. With the markets clearing the 200-dma, and still oversold on multiple levels, there is a high probability the market will rally into our “sell zone” before failing.

For now look for rallies to be “sold.”

The End Of The Bull

I want to reprint the last part of this weekend’s newsletter as the any rally that occurs over the next couple of weeks will NOT reverse the current market dynamics.

“The most important WARNING is the negative divergence in relative strength (top panel).  This negative divergence was seen at every important market correction event over the last 25-years.”

“As shown in the bottom two panels, both of the monthly ‘buy’ signals are very close to reversing. It will take a breakout to ‘all-time highs’ at this point to keep those signals from triggering.

For longer-term investors, people close to, or in, retirement, or for individuals who don’t pay close attention to the markets or their investments, this is NOT a buying opportunity.

Let me be clear.

There is currently EVERY indication given the speed and magnitude of the decline, that any short-term reflexive bounce will likely fail. Such a failure will lead to a retest of the recent lows, or worse, the beginning of a bear market brought on by a recession.

Please read that last sentence again. 

Bulls Still In Charge

The purpose of the analysis above is to provide you with the information to make educated guesses about the “probabilities” versus the “possibilities” of what could occur in the markets over the weeks, and months, ahead.

It is absolutely “possible” the markets could find a reason to rally back to all-time highs and continue the bullish trend. (For us, such would be the easiest and best outcome.) Currently, the good news for the bulls, is the bullish trend line from the 2015 lows held. However, weekly “sell signals” are close to triggering, which does increase short-term risks.

With the seasonally strong period of the market coming to its inevitable conclusion, economic and earnings data under pressure, and the virus yet to be contained, it is likely a good idea to use the current rally to rebalance portfolio risk and adjust allocations accordingly.

As I stated in mid-January, and again in early February, we reduced exposure in portfolios by raising cash and rebalancing portfolios back to target weightings. We had also added interest rate sensitive hedges to portfolios, and removed all of our international and emerging market exposures.

We will be using this rally to remove basic materials and industrials, which are susceptible to supply shocks, and financials which will be impacted by an economic slowdown/recession which will likely trigger rising defaults in the credit market.

Here are the guidelines we recommend for adjusting your portfolio risk:

Step 1) Clean Up Your Portfolio

  1. Tighten up stop-loss levels to current support levels for each position.
  2. Take profits in positions that have been big winners
  3. Sell laggards and losers
  4. Raise cash and rebalance portfolios to target weightings.

Step 2) Compare Your Portfolio Allocation To Your Model Allocation.

  1. Determine areas requiring new or increased exposure.
  2. Determine how many shares need to be purchased to fill allocation requirements.
  3. Determine cash requirements to make purchases.
  4. Re-examine portfolio to rebalance and raise sufficient cash for requirements.
  5. Determine entry price levels for each new position.
  6. Determine “stop loss” levels for each position.
  7. Determine “sell/profit taking” levels for each position.

(Note: the primary rule of investing that should NEVER be broken is: “Never invest money without knowing where you are going to sell if you are wrong, and if you are right.”)

Step 3) Have positions ready to execute accordingly given the proper market set up. In this case, we are adjusting exposure to areas we like now, and using the rally to reduce/remove the sectors we do not want exposure too.

Stay alert, things are finally getting interesting.

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Seth Levine: Commoditizing My Framework For A New Paradigm

When it comes to investing it’s never different this time; nor, however, is it ever the same. This difficult-to-navigate paradox creates a scarcity of longevity. Today’s persistently low yield environment has upped the ante and put many marquis names out of business. To be fair, alpha’s been elusive of late. It’s not that anyone suddenly became dumb. Rather, traditional methodologies are less robust today. Perhaps adopting a commodity framework can help generate returns in these investment conditions.

Let’s face it, investment yields are scarce. Those on sovereign bonds evaporated. Corporate credit interest rates are numbingly low. Earnings yields on stocks are paltry (i.e. multiples are high). Real estate cap rates are tumbling. No matter what the cause—central banks, safe asset shortages, the proliferation of passive investing, a lack of growth, whatever—cash flows derived from invested principals are small. Unfortunately, this is the current state of the investment markets. It’s our job to play the hand.

Money Now for Money Later

Valuation lies at the heart of my investment framework … at least it did, historically. As Warren Buffett famously said, “Price is what you pay. Value is what you get.” This resonates with me; however, I’m currently rethinking my position. Price is easy to determine, just look at it. What about value?

Before answering this seemingly simple question, it’s helpful to clarify just what investing is all about. Making money, right? Well, one can make money in lots of ways. I can perform a service for my employer in exchange for a paycheck; I can bake some cookies and sell them on my corner; I can also buy a bond and earn its yield. In all cases I make money, yet in different ways. (Note, that’ll use money interchangeably with currency, despite a pet peeve).

In the first case (the job), I trade my time and labor for money. In the second (the baker), I also buy raw materials in order to produce higher value goods. In the investment case, however, I purchase an (assumed) income stream using money that I currently have in order to earn even more over the course of time; it’s money now for (more) money later. Thus, investing is the act of making money from money.

With a clear definition of investing in hand, we can get back to our question of valuation. Valuation is a way to assess the attractiveness of an investment. In other words, it’s a way to frame how much money we expect to make (or lose) in the future in return for our money today. More later for less now is the objective—risk aside.

Today, however, cash flow yields are low when compared to history. Thus, investing appears less attractive under a traditional valuation framework. Yet, the “show must go on”, especially for us professionals. We must find a way to grow our capital in spite of these challenges.

Herein lays the dilemma: What to do when one’s approach no longer applies? Abandoning discipline is simply not a satisfactory solution for serious investors. We all need investing principals to guide our actions. Luckily, my friend Daniel Want, the Chief Investment Officer of Prerequisite Capital Management and one of my favorite investment market thinkers, offers some helpful advice.

Everything’s Commodity-like

In a recent client letter, Want notes that:

“When ‘everything’ is commodity-like… when bonds, fixed income securities and even most equities have minimal to no yield … , then it’s not a ‘valuation’ paradigm you need, but rather you need more of a merchant-type trading philosophy to guide your portfolio operations – you need to focus more on capital/money flows and positioning in order to harvest the natural swings in market prices driven by the underlying behaviours of participants …”

Prerequisite Capital Management’s January 10th, 2020 Quarterly Client BRIEFING

According to Want, traditional valuation-based frameworks are less efficacious in low yield environments. Rather, the supply and demand dynamics of capital flows matter most. I’m certainly sympathetic to that! However, I think this view can be harmonized with a valuation approach without overhauling one’s entire investment philosophy.

When everything is “commodity-like”, the final price dominates its return profile. Remember, the purpose of investing is to earn money, not to hold the underlying assets. Thus, as yields converge to zero (and below, absurd as it may be), positive returns increasingly require the selling at a higher price; or as Want puts it, to “harvest the natural swings in market prices.” In essence, all assets become “trading sardines.”

“There is the old story about the market craze in sardine trading when the sardines disappeared from their traditional waters in Monterey, California. The commodity traders bid them up and the price of a can of sardines soared. One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The seller said, ‘You don’t understand. These are not eating sardines, they are trading sardines.’”

Seth Klarman, Margin of Safety via ValueWalk

Thus, as yields dissipate, all investment decisions converge to price speculation … even for bonds that can only return par. (Please see the Appendix at the end of the article for some illustrations.) However, valuation need not be cast aside whole cloth. Rather, it must be reframed to acknowledge that all the “value” lies in the asset’s terminal value, when it’s finally exchanged for cash—be that at maturity or an intermediate sales date.

I find Want’s framework of recasting financial assets as commodities to be clarifying. It helped me override my previously held notions of valuation and provided me with a more powerful framework with which to understand the current investment landscape.

The Commodity-like World

What might this commodity-like world look like? Well, perhaps more commoditized (pun intended). Want continues:

“… Such swings won’t always make sense to a traditional analysis paradigm, it’s likely going to be best to dispassionately view each ‘asset class’ category as simply ‘categories of inventories’ that you may or may not wish to hold at different times depending upon how capital is behaving, where the money is flowing (& why), and how participants are positioned. A more detached and objective approach to markets will be even more valuable than usual.”

Prerequisite Capital Management’s January 10th, 2020 Quarterly Client BRIEFING

In other words, as differentiations of cash flows diminish, investment decisions increasingly shift from allocation within asset classes to allocation among asset classes. Thus, the importance of (tactical) asset allocation increases in Want’s framework.

I can see other investment implications of a more commodity-like world. Perhaps:

  • Speculation in bonds increases and investment horizons shorten as investors take a more total rate of return approach in light of falling yields; volatilities could rise
  • Equity investment time horizons extend, as higher multiples force investors to look further into the future for required growth to materialize; volatilities could fall
  • Commodities appear more attractive as storage costs become less of a relative disadvantage in a world where bonds don negative yields
  • Correlations converge as interest rate sensitivities increase
  • Security selection’s role in portfolio construction shifts to risk management as the risk of loss dominates return profiles
  • Or, I’m wrong about all of the above!

Unfortunately, we’re short on historical precedents for the current paradigm. Hence, we can only guess what impacts might materialize. However, I suspect that focusing on capital flows as Want suggests is a useful framework.

Reframing for the New Paradigm

It’s an understatement to call these challenging times for active management. Many traditional investment frameworks simply don’t work as well. Is it truly different this time?

Rather than abandon valuation in my framework, I’m reframing my decisions. Commoditizing my investment approach has brought some clarity to these confounding times.

Rather than abandon valuation in my framework, I’m reframing it. Conceptualizing “’everything’ [as] commodity-like” helps. We must speculate on all assets, plain and simple, looking to terminal values for returns. While my acceptance has been slow, commoditizing my investment framework has brought some clarity to these confounding times.

Appendix: Speculation Rises as Yields Fall

In this section I show what happens to hypothetical bond returns (using IRR) when coupons fall, maturities shorten, and when a sale occurs at a higher price prior to maturity. Note that in all cases the value shifts more towards the final payment. Thus, the incentive for speculation rises as yields fall. Assume all values are in U.S. dollars and undiscounted for simplicity. This exercise is for illustration purposes only.

Example: Initial Bond

Below is the payment stream for a hypothetical bond that matures at par in 5 years with a 10% coupon.

Note that the holder receives $150 in total payments. The final payment ($110) accounts for 73% of all value received.

Example: Falling Coupon

Here, I illustrate the payments for the same hypothetical bond but with a lower coupon of 5%.

Note that only $125 is received—due to the lower interest rate—and that the final payment ($105) accounts for a greater percentage (84%) of the total value.

Example: Shortened Maturity

Next, I show the payments for our 5% hypothetical bond but with a 3 year maturity instead of 5.

Here, only $115 is received due to 2 fewer years of coupon payments, though the IRR remains constant. As a result, the final payment occurs in year 3. It also accounts for 91% of the of the total value received.

Example: Pre-maturity Sale

In this last example, I illustrate what happens to the 5% hypothetical bond with a 5 year maturity when sold at a higher price ($105) prior to maturity (shown year 3).

There are a couple of interesting points to note. Since it was sold for $5 more than the maturity value (par), our total payments amount to $120. While this is $5 less than had it been held to maturity, the IRR increases to 7% (from 5%). The final payment now accounts for 92% of the total value received—the highest percentage of all our examples.

Conclusion

Note that the pre-maturity sale example had the highest return for the hypothetical, 5%-coupon bond. The sale price also dominated the return profile, illustrating how the bond became a more effective total rate of return instrument, ripe for speculation.

It’s Not 2000, But The Market Is Mighty Narrow Again

For those of us who were around in 1999-2000 looking at charts and perhaps writing about them, there is an eerie familiarity with the market of today. Back then, when indices and the Nasdaq in particular, were rallying harder each day than the last, market breadth was looking fairly weak. In other words, the big the names were soaring, forcing indexers and ETFs to buy them just to keep their weightings, and the positive feedback cycle roiled on.

I remember, looking at this stuff for BridgeNews and having to forecast where resistance levels might be based on Fibo projections or the top of some trading band. Walking by my desk, it was not unusual for me to exclaim, “This is nuts!” By that way, a much funnier TV show than “This is us”.

Now, I am in no way comparing 2000 and 2020 in any way but they did have one thing in common. Big cap, and mostly big cap tech, was powering ahead while mid-cap and especially small-cap lagged far behind.

No, that does not show up in the advance-decline line, which just managed to set a new high after its late January swoon. A colleague had a good explanation for this, saying that plenty of stocks can be rising but by smaller amounts and far below previous highs. That would certainly explain why the a/d line is rising and up/down volume is mediocre, at best.

Have you looked at a small-cap advance-decline? Not pretty.

Check out these charts:

(Click on image to enlarge)

This is the regular, cap-weighted S&P 500 vs. the equal-weighted version. The trend has been accelerating higher for months. While it is not anything near what it looked like in 1999-2000, it is still quite significant.

(Click on image to enlarge)

Here is the Nasdaq-100 ETF vs. the equal-weighted Nasdaq-100 ETF. To the moon, Alice.

(Click on image to enlarge)

And then let’s look at a mega-cap stock. This is Microsoft MSFT and it looks just as nuts. Don’t forget this is a $1.4 TRILLION stock so every gain packs on huge amounts of market cap.

What happens when this stock finally decides to pull back? It scored an as yet unconfirmed bearish reversal this week on huge volume. And look how far above it is now from its 200-day averages. Nuts!

Considering that it is a member of the Dow, the Nasdaq-100, the S&P 500 and XLK tech ETF, what do you think will happen when this huge member (keep it clean, pervs) corrects? And there is a lot of correcting room before even thinking about a change in a major trend.

There you have it. A narrow market at all-time highs, ignoring news and having utilities among the leading groups.

But don’t worry, the Fed has already committed to more quantitative easing. Whoopee! Kick that can, Jerry.

Seth Levine: The Unsurprising Repo Surprise

Have you heard? There’s trouble in the repo markets. Even casual investment market participants probably know that something’s amiss. While only a handful of investors participate in repo, this obscure corner of the investment markets rests at the epicenter of the financial system—hence all the attention. The turmoil caught many by surprise, prompting the Federal Reserve (Fed) into emergency action. However, the real surprise is, in my opinion, why this took any of us by surprise to begin with?

What is Repo

Repo is financial jargon for a repurchase agreement. While it sounds complex, repo is simply a form of short-term, secured lending. The borrower sells collateral (typically a high quality bond) to a lender. At the same time, it agrees to repurchase the same collateral back at a later date for a predetermined and higher price; hence the moniker repurchase agreement. The borrower receives the use of currency for this short period. The lender receives interest in the form of the price difference.

If this sounds overly complicated, it’s because it is. The details, however, are unimportant for our discussion. One need only grasp that repo sits at the bottom of the financial system pyramid. It’s a primary funding source for many large institutions that comprise the plumbing of financial markets. Due to leverage, small disturbances in the repo (and other money) markets can ripple through the entire system. This is what some fear.

What Went Wrong

Repo rates dramatically spiked on September 17, 2019, more than doubling the previous day’s (using SOFR as a proxy). This is highly unusual for the most illiquid of all markets, let alone one of the most trafficked. Arbitrage should render this behavior anomalous as the rise in repo rates represented a highly profitable opportunity. Why weren’t the big banks picking up all this free money? With the Great Financial Crisis (GFC) still fresh in the minds of many, the rumor mill kicked into overdrive surmising why.

Repo rates (estimated with SOFR) unexpectedly spiked on September 17, 2019.

The cause of this unexpected rate spike is still a matter of speculation. The financial system is highly complex with innumerable inputs and outputs making it difficult to establish direct, behavioral links. However, it’s likely that routine balance sheet mismanagement by the Fed was the culprit (as discussed by George Selgin here and Zoltan Pozar of Credit Suisse).

The Fed’s responsibilities expanded as a result of the GFC. These, and other regulatory changes, might have created some idiosyncrasies that underpinned the unexpected rise in repo rates. One is that the Fed now banks the U.S. Treasury. The Treasury used to have bank accounts with private institutions. It now keeps its money at the Fed in an account called the Treasury General Account (TGA). Another important development is the increased size of the foreign repo pool. The Fed avails its balance sheet to “about 250 central banks, governments and international official institutions.” While not new, the aptly named foreign repo pool usage is up nearly 3-fold since 2014.

The significant growth in the TGA (blue) and foreign repo pool (red) after the GFC creates new balance sheet volatility for the Fed to manage.

The chart above illustrates that both the TGA and foreign repo pool are large and volatile. They are also relatively new in their importance to the Fed from an operational perspective. Let’s not forget that while the Fed is a central bank, it’s nonetheless just a bank. Unpredictable and violent swings in account balances are difficult to manage—community, commercial, and central bank alike. Too be sure, we may later discover different reasons for the repo rate spike … but not until later.

Centralization Breeds Instability

It’s easy to get bogged down in the details when analyzing the financial system. After all, it may be the most complex one we’ve built. Thus, applying some more macroscopic principles can help in understanding the system as a whole.

Generally speaking, decentralized systems are more stable than centralized ones. We intuitively get this and can witness its widespread application throughout the man-made and natural worlds. We diversify our investment portfolios, manufacturers source from multiple suppliers, organisms spawn many offspring, and successful animals eat varied diets. Decentralization is a primary thesis for Bitcoin, breeds a fear of monopolies, and is why I find capitalism so attractive (among other reasons).

Imagine if you kept your entire net worth in a single account at a single bank and it failed (ignoring FDIC insurance, which protect against just this). Your wealth would disappear overnight. What if your investment portfolio comprised of a single stock and it went bankrupt? Such reckless behaviors are rightfully condemned. Yet, we expect differently from our financial system; why?

For some reason we believe that centralizing our monetary system reduces volatility and increases stability. Thus, the financial system is either a complete outlier or the premise is false. Modern day economies are built on the belief of the former, yet the evidence is underwhelming.

Merely a Matter of Time

I find no reason to believe that centralizing our financial system holds unique benefits. It’s just another type system. From a stability perspective, all benefit from decentralization. It follows that our financial one should too. Thus, I believe it was (is) only a matter of time until the monetary system broke (breaks) again. It happened in 2008—which I see as a run on banking collateral rather than a housing market collapse (ask me to explain in the comment section if you’re interested in my view)—and it will inevitably happen again. It has to because the future is unknowable and risks are concentrated.

It’s not that decentralization breed omniscience. No, omniscience doesn’t exist. Rather, it allows for discovery. Decentralized systems have more actors striving towards the same goals. However, all will not proceed in the same way. Inevitably, some will fail and some will succeed and to varying degrees. Diversity ensures that the failures are inconsequential to the system as a whole. Yet, we all benefit from the knowledge that those who succeed discover. Hence, human prosperity advances.

Following the GFC we changed a bunch of rules and allegedly strengthened regulations. Despite the best of intentions, these actions further homogenized behavior ensuring that the system breaks again! Remember, centralized systems are most fragile. Further centralization—which is what laws and regulations actually do—limits diversity by raising the barriers to entry (compliance costs money) and conforms incentive schemes (to comply with regulatory demands). Thus, we got fewer actors behaving in more similar fashions. The financial system became more fragile as a result, not stronger. Here we are, a decade later, and low and behold trouble’s a brewin’ in financial markets again, and in new and unforeseen ways.

Principles Bring Clarity

In the end, the presence of a central bank and the myriad of rules and regulations are counterproductive. They work to limit competition, stymie diversity, and ultimately increase frailty. Progress requires failure and centralized systems are not flexible enough to allow for this. If a centralized actor goes down, so goes the whole. “Too big to fail” is only a feature of centralized systems.

While unexpected, the breakdown of repo markets should come as no surprise. Further centralization of the financial system increased its fragility qua system. Of course, predicting how and when it might fail ex ante is nearly impossible. If the current problems were obvious they wouldn’t have escalated to this point.

That said, the inevitability of a system failure doesn’t make it an investible theme, especially for casual observers. In fact, waiting for a repeat of the GFC may be expensive in opportunity cost terms and cause one to miss out on other profitable investments. Rather, I plan to simply keep this analysis in the back of my mind. If financial markets seize up (again), I know what to look for: decentralizing, market fixes.

Following causal chains of events is one of the many challenges of macro investing. While the spike in repo rates is perplexing, proper first principles can bring some clarity. Faulty ones, however, breed only surprises.

Mauldin: The Fed Has Quietly Started QE4

In September of last year, something still unexplained happened in the “repo” short-term financing market. Liquidity dried up, interest rates spiked, and the Fed stepped in to save the day.

Story over? No. The Fed has had to keep saving the day, every day, since then.

We Hear Different Theories

The most frightening one is that the repo market itself is actually fine, but a bank is wobbly and the billions in daily liquidity are preventing its collapse.

Who might it be? I have been told, by well-connected sources, that it could be a mid-sized Japanese bank. I was dubious because it would be hard to keep such a thing hidden for months.

But then this week, Bloomberg reported some Japanese banks, badly hurt by the BOJ’s negative rate policy, have turned to riskier debt to survive. So, perhaps it’s fair to wonder.

Whatever the cause, the situation doesn’t seem to be improving.

Something Wicked Is Going On

On Dec. 12 a New York Fed statement said its trading desk would increase its repo operations around year end “to ensure that the supply of reserves remains ample and to mitigate the risk of money market pressures.”

Notice at the link how the NY Fed describes its plans. The desk will offer “at least” $150 billion here and “at least” $75 billion there. That’s not how debt normally works.

Lenders give borrowers a credit limit, not a credit guarantee plus an implied promise of more. The US doesn’t (yet) have negative rates, but the Fed is giving banks negative credit limits. In a very precise violation of Bagehot’s Dictum.

We have also just finished a decade of the loosest monetary policy in American history, the partial tightening cycle notwithstanding. Something is very wrong if banks still don’t have enough reserves to keep markets liquid.

Part of it may be that regulations outside the Fed’s control prevent banks from using their reserves as needed. But that doesn’t explain why it suddenly became a problem in September, necessitating radical action that continues today.

Here’s the official line, from the  minutes of the unscheduled Oct. 4 meeting at which the FOMC approved the operation.

Staff analysis and market commentary suggested that many factors contributed to the funding stresses that emerged in mid-September. In particular, financial institutions’ internal risk limits and balance sheet costs may have slowed the distribution of liquidity across the system at a time when reserves had dropped sharply and Treasury issuance was elevated.

So the Fed blames “internal risk limits and balance sheet costs” at banks. What are these risks and costs it was unwilling to accept, and why?

We still don’t know. There are lots of theories. Some even make sense.

QE4 Has Begun

Whatever the reason, it was severe enough to make the committee agree to both repo operations and the purchase of $20 billion a month in Treasury securities and another $20 billion in agencies.

It insists the latter isn’t QE, but it sure walks and quacks like a QE duck. So, I and many others call it QE4.

As we learned with previous QE rounds, exiting is hard. Remember that 2013 “Taper Tantrum?” Ben Bernanke’s mild hint that asset purchases might not continue forever infuriated a liquidity-addicted Wall Street.

The Fed needed a couple more years to start draining the pool and then did so in the stupidest possible way by both raising rates and selling assets at the same time.

Having said that, I have to note the Fed has few good choices. As mistakes compound over time, it must pick the least-bad alternative. But with each such decision, the future options grow even worse. So eventually instead of picking the least-bad, they will have to pick the least-disastrous one. That point is drawing closer.


The Great Reset: The Collapse of the Biggest Bubble in History

New York Times best seller and renowned financial expert John Mauldin predicts an unprecedented financial crisis that could be triggered in the next five years. Most investors seem completely unaware of the relentless pressure that’s building right now. Learn more here.

Patrick Watson: Where Is The World Going & How We Got Here

We all want to know the future. Unfortunately, the future isn’t talking. It’s just coming, like it or not.

We can, however, make educated forecasts. I think John Mauldin is broadly correct: the future is bright, but we’ll go through darkness first.

In fact, many of us are already in pretty dark situations, “left behind” in a supposedly thriving economy. We’re told there is no inflation even as the real cost of living rises ever higher.

Where is it leading us? To answer that, we have to think about how we got here.

America Alone

In his recent “Inflationary Angst” letter, John Mauldin shared an inflation chart, broken down into spending categories.

The cost of things average people must buy—healthcare, education, housing—tends to have risen more than wages did over the last two decades.

But aggregate inflation measures, like the Consumer Price Index, don’t show this. Falling prices elsewhere held them down. Those tend to be “luxury” goods… which is why inflation is no problem unless you’re poor.

My friend Bruce Mehlman had a different reaction on Twitter.

He’s right; the fastest-rising spending categories are things you can’t easily import from other countries. If you suddenly need surgery, you’re going to the nearest hospital pronto.

On the other hand, US hospitals and colleges do import certain components and personnel. That’s why we have foreign-born nurses and professors. It doesn’t seem to have reduced their costs, though.

Bruce’s latest slide deck is about global trends re-shaping the world. He distilled his outlook into a two-factor equation: globalization vs. regionalization, US-centric vs China-centric.

I realized long ago that globalization was on its last legs. I also think trade conflict will continue and even intensify. So Pax Americana or Pax Sinica (the top two quadrants) aren’t very likely.

The bottom left scenario—what Mehlman calls a “Free World United”—would be a partial end to trade wars, with the US and its allies uniting against China. That might happen but not without a leadership change in Washington. And maybe not even then.

So the “America Alone” scenario within an otherwise China-centered world seems the most likely. For Americans, this will probably mean even greater economic difficulties than we face now.

How people who are already struggling will deal with it is unclear. But it probably won’t go well.

Small Winners

Recently, I shared a report by Gavekal Research co-founder Louis-Vincent Gave called “The Knowledge Revolution and Its Consequences”.

Louis has a great way of systematically thinking through a situation to see where it leads. He thinks technology and political trends are aligning against mega-powers like the US and China. His key points:

  • Modern Western economies have become knowledge based. This means Marx’s three factors of production (land, labor, capital) now have a fourth.
  • Neither physical strength nor access to capital are sufficient for economic success. Power now resides with those best able to organize knowledge.
  • The internet has eliminated “middlemen” in most industries. In a representative democracy, politicians are basically middlemen.
  • Hence, the knowledge revolution should bring a shift to direct democracy, but those who benefit from the current structure are fighting this transition.
  • This is the source of much angst around the world, including the current wave of popular protests.
  • Smaller political entities should find the evolution toward direct democracy easier to achieve than big, sprawling governments.
  • Today’s great powers have little choice but to spend their way to political stability, which is unsustainable, and/or try to control knowledge, which is difficult.

The conclusion is that future growth potential should be highest in smaller countries with stronger, more flexible political institutions. The US, China, and most of Europe don’t qualify. Places like New Zealand and Switzerland have better odds.

That brought to mind one of my favorite Enlightenment philosophers, who happens to have been Swiss.

Subhead

Eighteenth-century thinker Jean-Jacques Rousseau wrestled with how to preserve individual freedom when we also have to depend on each other for survival.

Rousseau saw politics as a social contract between a sovereign and citizens. What we call “government” is the interface between them.

The sovereigns of Rousseau’s time were mostly kings, but he envisioned a democracy in which the people collectively were sovereign. But then he ran into a math problem.

In a tiny democracy of, say, a thousand citizens, each possesses one-thousandth of the sovereignty… small, but enough to have a meaningful influence.

Each individual’s share of sovereignty, and therefore their freedom, diminishes as the social contract includes more people. So, other things being equal, Rousseau thought smaller countries would be freer and more democratic than larger ones.

How do we reconcile that with democracy in a US composed of 330 million citizens? I’m not sure we can. It worked pretty well for a long time but maybe, as population grows, the math is catching up to us.

If so, the options are a non-democratic US or a smaller US. Or maybe no US at all.

This land we now inhabit wasn’t always the United States. Nothing requires it to remain so. At some point, it will develop into something else.

When and how that will happen, we don’t know yet. But we know it will.

After 20-Years Of Trading: You Learn You Know Nothing

You ever notice—

That some memories tend to be stronger than others?

What sort of things do you remember?

You remember events in your life that had a lot of feelings associated with them.

You remember the death of your pet like it was yesterday. All the nights spent sitting on the couch watching Wheel Of Fortune—it’s just a blur.

Researchers have studied this in rats. They found that rats remembered things better if they experienced a rush of adrenaline.

In those moments with strong memories, it feels like time slows down. Time doesn’t actually slow down—time is linear. But human beings experience time as flexible. Time also speeds up when things are boring.

I’m fond of saying that all of finance, or at least the interesting part, is about human behavior. I find the daily fluctuations of stocks and credit spreads less interesting the older I get. And I think finance is more depraved the older I get. But the human behavior part fascinates me.

Miller’s Planet

The fact that time stretches and compresses isn’t news to anyone who’s traded options.

In the world of options, time and volatility work in opposite directions. As time passes, options decay. As volatility increases, options increase in value. All stuff you learned in class.

But if you think about it, volatility increasing is another way of saying that there’s a lot of s— going on. Things are crazy. Options increase in value—which is really like saying that time is slowing down.

Which is exactly how we experience it. Of all my days trading on Wall Street, what are the times that I remember most? The financial crisis, naturally. There was a lot of adrenaline associated with that.

We all have strong memories of it. And while we experienced it, it seemed like time was slowing down—which was reflected in options prices. They were the highest in recorded history.

Finance is simply human behavior.

If I think back over the last 10 years, what do I remember?

  • The European crisis
  • The US debt downgrade
  • The Ebola scare
  • The yuan devaluation
  • The vol-splosion

All the crazy times. Nobody remembers the stuff in between. Old-timers like me remember all the way back to 1997 and 1998, with the Asian Financial Crisis and LTCM and the Russian debt default. It’s the accidents that help us mark our time in the markets.

Perspective

We all perceive things differently. As I just demonstrated, we all perceive time differently.

We also might perceive color differently—we just don’t know. There is no way to know that the red I see is the red you see.

We all have different perspectives, especially when it comes to financial markets. I might find a stock attractive that you find unattractive. Happens all the time.

A lot of financial analysis is searching for some objective truth in the markets. This is what the value people try to do. They try to identify the correct value of a security and then buy it if it’s underpriced.

But there really is no objective truth in finance—just a set of ever-changing perspectives. Some examples:

Target is up over 90%, year to date:

Is Target’s business 90% better? Is it earning 90% more revenue? Of course not—more people find the stock attractive and fewer find it unattractive.

Pharmaceutical giant Bristol-Myers is up 48% in the last couple of months:

Again, is their business 50% better? No.

People have created several models to explain stock market behavior. Keynes’s beauty pageant is at the top of the list. I will always catch a beauty pageant if it’s on TV. The goal isn’t picking the most attractive contestant. It’s picking the contestant that the judges will find most attractive. It’s a great exercise.

But I don’t think that’s the right model.

I came up with my own model and gave it to the world on the Bloomberg Opinion page. You can read about it here. But I feel like it’s incomplete, too.

Sentiment also plays a role—big turning points are always at sentiment extremes.

I’m not sure what the answer is—or if there even is an answer. I think about it all the time.  People smarter than me spend even more time thinking about it.

Maybe there is no Grand Unified Theory—maybe there are regimes in the financial markets, and sometimes some things work and sometimes other things work.

Maybe the rules change all the time and there is nothing we can do about it.

I am not even sure buy-and-hold and dollar-cost averaging will work going forward.

And that’s what you learn when you have 20 years of experience—that you actually know nothing.

That said, one thing I do know is that the adrenaline rush reckless traders get throwing money at “hot stocks” is not something to aspire to. It’s much better to even out your odds with a diversified, balanced portfolio and a long-term view.

The Real Investment Guide For The Next Decade

Written by Lance Roberts, Michael Lebowitz, CFA and John Coumarianos, M.S. of Real Investment Advice

As we head into the next decade, this complete set of articles delves into the fallacies of always owning stocks for the long run (aka “buy and hold” and passive strategies). Given that market’s cycle over time, it is important to understand how markets, and investing actually work, the impact on your wealth, and what you can do about it.

This series of articles will cover the following key points:

  • “Buy and Hold,” and other passive strategies are fine, just not all of the time
  • Markets go through long periods where investors are losing money or simply getting back to even
  • The sequence of returns is far more important than the average of returns
  • “Time horizons” are vastly under-appreciated.
  • Portfolio duration, investor duration, and risk tolerance should be aligned.
  • The “value of compounding” only works when large losses are not incurred.
  • There are periods when risk-free Treasury bonds offer expected returns on par, or better than equities with significantly less risk.
  • Investor psychology plays an enormous role in investors’ returns
  • Solving the puzzle: Solutions to achieving long-term returns and the achievement of financial goals.
  • Spot what’s missing: A compendium of investing wisdom from the world’s greatest investors.












Why Every Investor Should Go On An Information Diet

I spend a lot of time thinking about the information that I consume. Do you?

We all consume exabytes of information. Have you ever noticed that people spend way more time thinking about the food they consume than the information they consume?

I have family members who are health nuts—watching every bite they eat and augmenting it with supplements—but think nothing of spending 10 minutes cruising around The Drudge Report, which will make you feel like the world is coming to an end pretty much any time you load the page.  Some people have read Drudge for twenty years. Imagine how that would make you feel.

I gave up Drudge about six or seven years ago. I keep track of politics on Twitter—but I don’t follow people who are toxic waste. I don’t watch cable news. Before I started the radio show, I watched NBC Nightly News, but I’m glad to be rid of that. I’ve Marie Kondo-ed my information intake, getting rid of anything that doesn’t bring me joy.

Monitoring your information intake is crucial to your mental health. It is also crucial to your investment decision-making.

The Bulls and the Bears

If you want to read bearish information, there are places to do that. If you want to read bullish information, there are places to do that.

Funny—most people spend all their time either reading just the bearish or bullish information. They don’t get both sides of the story.

People like to point out that if you consumed nothing but bearish information since 2009, you would have missed out on a historic stock market rally and you would have drastically underperformed. This is true.

But if you’re consuming nothing but bullish information, about how index funds are king and stocks for the long run and dollar cost averaging, you’ll probably get fricasseed when the bear market begins. We will get one eventually.

Polarization

Political polarization has happened for a lot of reasons, but chief among them is the advent of social media. Go look at charts of polarization—it didn’t really start happening until Facebook and Twitter came on the scene.

It is not particularly difficult to see why. Ever spend 5-10 minutes on Facebook and feel… unsettled?

People spend a lot of time on Facebook. I spend some time on Facebook. It’s pretty rare that Facebook makes me feel good.

There is a lot of crap, memes and such. But there are also people’s terrible political opinions. Funny thing about political opinions on Facebook. I don’t really care to read any of them, even the ones that I agree with. Facebook is full of user-generated content, and the problem with the user-generated content is that it is uninformed, hysterical garbage.

I hide opinionated people on Facebook, but not because the opinions bother me. It is really for my emotional health. I don’t want to log on and feel worse. I have been curating my feed for years, and I finally have it where I want it. As for me, I basically post pictures of my cats, which always make people feel good.

You may find this hard to believe, but there are lots of people out there whose purpose in life seems to be arguing on the internet. I blundered into communist Twitter the other day—not fun.

There are armies of trolls out there. The internet facilitates polarization because we are not dealing with each other face to face. It’s easy to dehumanize “the other side” online. If we were all sitting in the same room, we’d probably just have a normal conversation.

I hope that someday we get bored of arguing on the internet. But it seems to be getting worse, not better.

Politics < Ethics < Philosophy

It is easy to drown in the noise. Politics is noise. Above politics is ethics, and above ethics is philosophy.

If you’ve been following all the tit-for-tat and the drama of the impeachment hearings, if the names McGahn and Strzok mean anything to you, if you can actually recite the timeline of all the China trade negotiations, then you are spending time in politics, in the noise.

Imagine what you could have done with your time instead of learning about this nonsense. If you think this helps you have an opinion on the direction of the stock market, all I have to say to that is LMAO.

If you eat Big Macs and fries and fast food and other junk, you will get fat and feel terrible. I know this from experience. If you read toxic, opinionated trash, you will go crazy, and feel terrible.

And you will think all kinds of things, like, the stock market will crash, or the stock market will go up forever.

As it is with everything in life, the truth is somewhere in between.

Mauldin: The Dirty Secret Behind America’s “Full Employment”

Should just being “employed” make people/workers happy?

On one level, any job is better than no job. But we also derive much of our identities and self-esteem from our work.

If you aren’t happy with it, you’re probably not happy generally.

Unhappy people can still vote and are often easy marks for shameless politicians to manipulate. Their spending patterns change, too.

So it ends up affecting everyone and everything.

Unhappy Employment

There’s this plight of people who, while not necessarily poor, aren’t where they think they should be—and perhaps once were.

This disappointment isn’t just in their minds; the economy really has changed. Yes, you can probably get a job if you are physically able, but the odds it will support you and a family, if you have one, are lower than they once were.

The US Private Sector Job Quality Index aims to give data on this… distinguishing between low-wage, often part-time service jobs and higher-wage career positions.

What they have found so far isn’t encouraging.

Looking at “Production & Non-Supervisory” positions (essentially middle-class jobs), the inflation-adjusted wage gap between low-wage/low-hours jobs and high-wage/high-hours jobs widened almost fourfold between 1990 and 2018.

Worse, the good jobs are shrinking in number. In 1990, almost half (47%) were in the “high-wage” category. In 2018, it was only 37%.

Work More, Earn Less

Much of the wage gap came not from the hourly rates, but from the number of hours worked.

The labor market has basically split in two categories with little in between.

There are low-wage service jobs in which you get paid only when the employer really needs you, and higher-wage jobs that pay steady wages.

The number of young people working in the so-called gig economy, working multiple part-time jobs, is growing. And part-time jobs generally are not high-paying jobs.

This also helps explain why so many relatively well-off people feel like they are always working and ahave no free time. They aren’t imagining it. Their employers really do keep them busy.

So we really have two generally unhappy groups: people who want to work more and raise their income, and people who want to work less but keep their income.

What’s the answer? We need to find one, and to do so we must talk about it. And that is possibly an even bigger problem.

Broken Politics

The national anxiety level got where it is for many different reasons. Some are largely outside our control, like the technological advances that have replaced some human jobs.

Hence political decisions need to be made.

The problem is that the ideological gap between the median Democrat and the median Republican has widened into a huge chasm in this century.

What as recently as 2004 was a mountain-shaped distribution with a small dip in between now looks more like a volcanic crater.

The simple fact is that the “center” is shrinking. It is hard to consider compromises when positions are so hardened that no compromise is allowable.

Whatever the reason for this (which is another debate), it prevents our political system from addressing important issues. This leaves an anxious population to feel either completely abandoned, or thinking it must align with one side or the other just to survive.


The Great Reset: The Collapse of the Biggest Bubble in History

New York Times best seller and renowned financial expert John Mauldin predicts an unprecedented financial crisis that could be triggered in the next five years. Most investors seem completely unaware of the relentless pressure that’s building right now. Learn more here.

Why Every Investor Should Be Politically Flexible

Things used to be so simple.

You buy a stock, the government cuts taxes, the stock goes up.

Actually, things still are that simple.

And yet vastly more complex. We cut taxes in 2017, but future tax increases—large ones—are likely.

The Federal Reserve is lowering interest rates because it is told to by the president.

There are tariffs, things we haven’t seen in a while. Deficits are rising with zero collective will to contain them.

And we’ve seen a sharp rise in authoritarian behavior from elected leaders of all stripes, globally, which is a source of consternation.

There have been many articles written about how you should not mix your politics with your investing. Many. Except… occasionally, you should.

From 2009 to 2011, it paid to be a far-right gold bug. The liberals were left in the dust.

Since 2011, it has paid to be a liberal growth stock indexer.

Maybe going forward, it will pay to be an MMT-er. Who knows.

My point here is that the stock market goes through political regimes, much like it goes through volatility regimes.

It took me years to understand this. My early investing years were spent thinking that center-right policies were good for the stock market. In general, that is true.

And it is always and everywhere true that cutting taxes, especially corporate taxes and investment taxes, results in higher stock prices.

Aside from that, things get a little hazy. Tariffs are supposed to be bad for stocks, but on a long-term basis, they haven’t been.

As for deficits, the record is a bit mixed. Stocks have gone up when debt is both rising and falling.

Now that the debt issue is becoming a bit hard to handle, you might think that stocks would begin to care. Clearly, they don’t.

Crazy Town

You can’t say anything for certain anymore.

There are some folks out there—like Leon Cooperman—who say the stock market might not even open if Elizabeth Warren is elected president.

I tend to agree. But maybe not!

Maybe Elizabeth Warren gets elected—and stocks go up!

Sometimes stock markets go up when bad things are happening. This was true in Weimar Germany, Zimbabwe, and Venezuela.

There isn’t a person alive who can say with 100% certainty what stocks are going to do. After all, the conventional wisdom was wrong about Trump. The only thing you can say with 100% certainty is that it is going to be a surprise.

I try not to make normative statements about the stock market anymore.

I try not to say what the stock market should do.

I try to predict what the stock market will do.

One of the things I have been writing about is that supply and demand ultimately drives stock prices, and right now stock supply is down because of all the buybacks.

I’m not saying the market can’t go down, I’m saying it’s hard for it to go down.

Basically, nothing would surprise me about 2020. Nothing at all.

Political Investing

One of the hardest things about investing is to be intellectually malleable. To think one thing one day, and then think another thing the next.

Even harder is to be politically malleable. To have one political belief one day, and the opposite belief the next. Impossible.

I do not know one person who got it right from 2009 to 2011 and also got it right from 2011 to today. People take sides, they put on a jersey, and they play for that team. Which means you get to be right every so often, but not all the time.

I can sort of switch sides, but not really.

If it isn’t obvious by now, I am a libertarian-slash-classical liberal. Which means I have missed out on the stock market rally from about 2015 onwards.

I have run into a few people in my career who have actually told me that they would rather lose money than buy a stock like Alphabet. Or whatever. That gets into a central thesis of mine—the vast majority of people would rather be right than make money.

Ideally, you get to do both. But that is pretty rare. I remember buying fluffy tech stocks in 2013. It felt terrible, but I did it because it was the right trade. The trade worked. I was never comfortable with it. It was an unnatural act.

If you want to be right, put it on your tombstone. In this life, we make money.

Mauldin: We Are On The Brink Of The Second “Great Depression.”

You really need to watch this video of a recent conversation between Ray Dalio and Paul Tudor Jones. Their part is about the first 40 minutes.

In this video, Ray highlights some problematic similarities between our times and the 1930s. Both feature:

  1. a large wealth gap
  1. the absence of effective monetary policy
  1. a change in the world order, in this case the rise of China and the potential for trade wars/technology wars/capital wars.

He threw in a few quick comments as their time was running out, alluding to the potential for the end of the world reserve system and the collapse of fiat monetary regimes.

Maybe it was in his rush to finish as their time is drawing to a close, but it certainly sounded a more challenging tone than I have seen in his writings.

Currency Wars

It brought to mind an essay I read last week from my favorite central banker, former BIS Chief Economist William White.

He was warning about potential currency wars, aiming particularly at the US Treasury’s seeming desire for a weaker dollar. Ditto for other governments around the world. He believes this is a prescription for disaster.

One possibility is that it might lead to a disorderly end to the current dollar based regime, which is already under strain for a variety of both economic and geopolitical reasons. To destroy an old, admittedly suboptimal, regime without having prepared a replacement could prove very costly to trade and economic growth.

Perhaps even worse, conducting a currency war implies directing monetary policy to something other than domestic price stability. There ceases to be a domestic anchor to constrain the expansion of central bank balance sheets.

Should this lead to growing suspicion of all fiat currencies, especially those issued by governments with large sovereign debts, a sharp increase in inflationary expectations and interest rates might follow. How this might interact with the record high debt ratios, both public and private, that we see in the world today, is not hard to imagine.

I called Bill to ask if he thought this was going to happen. Basically, he said no, but it shouldn’t even be considered. It was his gentlemanly way of issuing a warning.

Currency devaluations against gold were part of the root cause of the Great Depression. Coupled with protectionism and tariffs, they devastated global economic growth and trade.

The Repeat of the 1930s?

Do I think it will happen in any significant way in the next few years?

It is not my highest probability scenario. But imagine a recession that brings the US deficit to $2 trillion, possibly followed by a governmental change that raises taxes and spending.

This could bring about a second “echo” recession with even higher deficits. This would force the Federal Reserve to monetize debt in order to keep interest rates from skyrocketing, thereby weakening the dollar.

Couple this with a concurrent crisis in Europe, potentially even a eurozone breakup, resulting in countries all over the world trying to weaken their currencies with the potential for higher inflation in many places.

In such a scenario, is it hard to imagine a desperate president and Congress, toward the latter part of the next decade, regardless of which party is in control, instructing the US Treasury to use its tools to weaken the dollar?

Can you say beggar thy neighbor? Can you see other countries following that path? All as debt is increasing with no realistic exit strategy except to monetize it?


The Great Reset: The Collapse of the Biggest Bubble in History

New York Times best seller and renowned financial expert John Mauldin predicts an unprecedented financial crisis that could be triggered in the next five years. Most investors seem completely unaware of the relentless pressure that’s building right now. Learn more here.

Mauldin: The Calm Before The Economic Storm

The global economy is slowing.

Germany, for instance, may already be in recession. GDP there dropped 0.1% in this year’s second quarter, with little reason to expect better from Q3 which we will learn soon.

Whatever you call it, Germany is certainly not in a good spot. It is highly dependent on exports which, for various reasons, are weakening, particularly in their auto industry.

Meanwhile, Brexit (depending on how it ends) could greatly reduce UK purchases of German goods.

On top of that, uncertainties induced by President Trump’s trade war are deterring businesses in Europe (as well as here) from investing in future growth projects.

And overarching all of it is the technology-driven decline in globalized manufacturing.

If Germany’s “technical recession” morphs into a real recession, the rest of Europe will certainly follow. And recession in Europe—and the measures its central banks will take to fight it—won’t leave the US economy unscathed.

The Rest of the World Is Not Well

Not coincidentally, commodity-producing emerging markets are also experiencing difficulty. Ditto for some more advanced commodity exporters like Australia and Canada.

Their problem springs from lower commodity prices, but more specifically from China. My friend Sam Rines (Director and Chief Economist at Avalon Advisors) explored this in a recent note.

Much of the commodity price pressure can be blamed on slowing Chinese growth, but that is not the entire story. China is roughly 20% of global GDP on a PPP basis, and constitutes much of the incremental growth in the global economy. When China’s growth slows, the ripples are felt in many places.

Commodity prices and China’s growth rate are understandably intertwined, and that may be a difficult correlation to break down. Why? It is difficult to pinpoint the next major tailwind. And—even when speculating on the next tailwind—timing is a further difficult hurdle to overcome.

But why not try. Of the three major headwinds to commodity pricing in the post-dual stimuli world (end of China’s building spree, US dollar following QE, and slower overall global growth), the US dollar is the most likely to abate as a headwind in the near-term. Global growth is dependent largely on US and China trade policy, but there could be a marginal shift higher in growth (the worst might be over). Replacing the rapid growth of China is not easy to see. India is gaining share of global GDP. But it is not easy to see the path to a full replacement of the China commodity cycle.

We may soon see the other side of China’s growth story. Just as it had an outsized effect on global GDP on the way up, it will likely be a major drag on the way down.

Note, when my young friend Sam says “the worst may be over,” he is talking in particular about the downturn from slower Chinese growth. If you read his daily missives, as I do, he is far from predicting a US recession.

Slower growth? Yes. It sounds like he thinks we are in a slower muddle-through world for the next few quarters at least. And maybe through the next elections…

The Signs of Looming Recession

While more goods are delivered electronically and supply chains are shrinking, the movement of physical goods is still the economy’s circulatory system.

The Cass Freight Index is the most comprehensive, high-frequency indicator of this. It tends to lead the economy by a few quarters but has signaled almost every economic turning point.

So the fact its year-over-year change has been negative every single month since December 2018 is more than a little concerning.

As you can see from the chart below, there have been periods of negative growth without a recession, but the latest drop’s sheer magnitude and rapidity is eye-opening.

Freight traffic is falling, and it looks even worse when Cass digs into the specifics.

Going deeper, Cass notes that “dry van” truck volume is a fairly reliable predictor for retail sales and is still relatively healthy.

That fits what we see elsewhere about consumer spending sustaining growth. But they also note that seasonally, dry van volume should be even stronger than it is. That suggests caution as the year winds down.

Other transport modes—rail, flatbed trucks, chemical tankers—indicate real problems in the industrial economy. Manufacturers seem to have little faith consumers will keep buying at the rates they are.

And, given how much consumer spending is debt-financed, they’re probably right to be cautious. Strong retail spending is not necessarily positive. Consider this Comscore holiday spending report from November 2007.

The Friday after Thanksgiving is known for heavy spending in retail stores, but it’s clear that consumers are increasingly turning to the Internet to make their holiday purchases,” said Comscore Chairman Gian Fulgoni. “Online spending on Black Friday has historically represented an early indicator of how the rest of the season will shake out. That the 22-percent growth rate versus last year is outpacing the overall growth rate for the first three weeks of the season should be seen as a sign of positive momentum.

The Great Recession began one month after this “sign of positive momentum.” A strong holiday shopping season won’t mean we are out of the woods and could mean we are just entering them.


The Great Reset: The Collapse of the Biggest Bubble in History

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Mauldin: China’s Grand Plan To Take Over The World

When the US and ultimately the rest of the Western world began to engage China, resulting in China finally being allowed into the World Trade Organization in the early 2000s, no one really expected the outcomes we see today.

There is no simple disengagement path, given the scope of economic and legal entanglements. This isn’t a “trade” we can simply walk away from.

But it is also one that, if allowed to continue in its current form, could lead to a loss of personal freedom for Western civilization. It really is that much of an existential question.

Doing nothing isn’t an especially good option because, like it or not, the world is becoming something quite different than we expected just a few years ago—not just technologically, but geopolitically and socially.

China and the West

Let’s begin with how we got here.

My generation came of age during the Cold War. China was a huge, impoverished odd duck in those years. In the late 1970s, China began slowly opening to the West. Change unfolded gradually but by the 1990s, serious people wanted to bring China into the modern world, and China wanted to join it.

Understand that China’s total GDP in 1980 was under $90 billion in current dollars. Today, it is over $12 trillion. The world has never seen such enormous economic growth in such a short time.

Meanwhile, the Soviet Union collapsed and the internet was born. The US, as sole superpower, saw opportunities everywhere. American businesses shifted production to lower-cost countries. Thus came the incredible extension of globalization.

We in the Western world thought (somewhat arrogantly, in hindsight) everyone else wanted to be like us. It made sense. Our ideas, freedom, and technology had won both World War II and the Cold War that followed it. Obviously, our ways were best.

But that wasn’t obvious to people elsewhere, most notably China. Leaders in Beijing may have admired our accomplishments, but not enough to abandon Communism.

They merely adapted and rebranded it. We perceived a bigger change than there actually was. Today’s Chinese communists are nowhere near Mao’s kind of communism. Xi calls it “Socialism with a Chinese character.” It appears to be a dynamic capitalistic market, but is also a totalitarian, top-down structure with rigid rules and social restrictions.

So here we are, our economy now hardwired with an autocratic regime that has no interest in becoming like us.

China’s Hundred-Year Marathon

In The Hundred-Year Marathon, Michael Pillsbury marshals a lot of evidence showing the Chinese government has a detailed strategy to overtake the US as the world’s dominant power.

They want to do this by 2049, the centennial of China’s Communist revolution.

The strategy has been well documented in Chinese literature, published and sanctioned by organizations of the People’s Liberation Army, for well over 50 years.

And just as we have hawks and moderates on China within the US, there are hawks and moderates within China about how to engage the West. Unfortunately, the hawks are ascendant, embodied most clearly in Xi Jinping.

Xi’s vision of the Chinese Communist Party controlling the state and eventually influencing and even controlling the rest of the world is clear. These are not merely words for the consumption of the masses. They are instructions to party members.

Grand dreams of world domination are part and parcel of communist ideologies, going all the way back to Karl Marx. For the Chinese, this blends with the country’s own long history.

It isn’t always clear to Western minds whether they actually believe the rhetoric or simply use it to keep the peasantry in line. Pillsbury says Xi Jinping really sees this as China’s destiny, and himself as the leader who will deliver it.

To that end, according to Pillsbury, the Chinese manipulated Western politicians and business leaders into thinking China was evolving toward democracy and capitalism. In fact, the intent was to acquire our capital, technology, and other resources for use in China’s own modernization.

It worked, too.

Over the last 20–30 years, we have equipped the Chinese with almost everything they need to match us, technologically and otherwise. Hundreds of billions of Western dollars have been spent developing China and its state-owned businesses.

Sometimes this happened voluntarily, as companies gave away trade secrets in the (often futile) hope it would let them access China’s huge market. Other times it was outright theft. In either case, this was no accident but part of a long-term plan.

Pillsbury (who, by the way, advises the White House including the president himself) thinks the clash is intensifying because President Trump’s China skepticism is disrupting the Chinese plan. They see his talk of restoring America’s greatness as an affront to their own dreams.

In any case, we have reached a crossroads. What do we do about China now?

Targeted Response

In crafting a response, the first step is to define the problem correctly and specifically. We hear a lot about China cheating on trade deals and taking jobs from Americans. That’s not entirely wrong, but it’s also not the main challenge.

I believe in free trade. I think David Ricardo was right about comparative advantage: Every nation is better off if all specialize in whatever they do best.

However, free trade doesn’t mean nations need to arm their potential adversaries. Nowadays, military superiority is less about factories and shipyards than high-tech weapons and cyberwarfare. Much of our “peaceful” technology is easily weaponized.

This means our response has to be narrowly targeted at specific companies and products. Broad-based tariffs are the opposite of what we should be doing. Ditto for capital controls.

They are blunt instruments that may feel good to swing, but they hurt the wrong people and may not accomplish what we want.

We should not be using the blunt tool of tariffs to fight a trade deficit that is actually necessary.  The Chinese are not paying our tariffs; US consumers are.

Importing t-shirts and sneakers from China doesn’t threaten our national security. Let that kind of trade continue unmolested and work instead on protecting our advantages in quantum computing, artificial intelligence, autonomous drones, and so on.

The Trump administration appears to (finally) be getting this. They are clearly seeking ways to pull back the various tariffs and ramping up other efforts.


The Great Reset: The Collapse of the Biggest Bubble in History

New York Times best seller and renowned financial expert John Mauldin predicts an unprecedented financial crisis that could be triggered in the next five years. Most investors seem completely unaware of the relentless pressure that’s building right now. Learn more here.

Seth Levine: Why Are We So Scared

I always find this time of year to be self-reflective. Year-end provides a natural point for critiquing past performance and fitting it into a broader investing context. These holidays in particular have a way of foisting this perspective upon me, and with deep meaning. As a parent of two young kids, my holidays now kick off with Halloween. Perhaps stuck in this spirit, I find myself wondering: Why are we so scared?

I can’t seem to shake this sense that we live in a culture that’s scared. I see a number of signs across the economic, political, and investment landscapes that seem support this observation. To be sure, this is not universally true on an individual level. However, as a culture we seem to have lost our mojo, our swagger, and the confidence that fuels significant economic advancements.

Why Scared

Scared is psychological state. It connotes being afraid or frightened. Scared feelings typically arise when one feels helpless in a situation or believes he/she is unable to improve it via action. Thus, it’s closely associated with victimhood. Scared is not a feeling that accompanies independence, confidence, and capability.

By all accounts this is the best time in human history to be alive. It’s never been easier to access information, collaborators, and different perspectives, nor in such abundance. These conditions should enable self-reliance and wealth creation. They are a perfect crucible for unbounded development and prosperity.

Yet, economic independence doesn’t seem as valued today as it once was. The cultural impetus shies away from proximal challenges and looks to others for solutions—and in particular, for political solutions. This doesn’t square with the times.

In my view, this shift is a matter of confidence and self-esteem. It’s not the shirking of responsibility that’s telling; it’s the unwillingness to engage with the issues. Confident individuals face challenges head-on. Scared ones look to others. Problem solving often requires creativity, not reverting to staid and ineffective ideas. The former is a strength of the market; the latter is a politician’s. To be sure, there’s a time and place for politicians and bureaucrats to assist. However, economics is not the place and these are not the times. The obsession with finding political fixes for economic underperformance suggests to me that we lack the self-confidence to tackle it ourselves. We seem scared.

Central Bank Dependence

The clearest example of this in the investment markets is the neurotic obsession with central banks. I commonly hear people critique their ignorance and ineffectiveness only to follow with—the same people, mind you—what central bankers ought to do next. I thought central bankers were ineffective?

It’s time we stop looking to central banks for solutions. They don’t have them. In fact, I see no need for them at all. In theory, central banks were created to oversee the money supply. Dual mandates were afterthoughts. Since the money supply merely reflects economic activity, this should be a fairly mundane task and one that decentralized private banking centers performed quite well (despite the popular narrative).

Today, however, our opinions of central bankers are quite different. They are viewed as omniscient, economic alchemists. We look to central bankers to manipulate business cycles, control inflation, and prescribe prosperous economic conditions. Where did this come from and when did it become so prevalent? Central banks can’t create money let alone produce these other conditions. They fall under the purview of the productive economy and thus are products of our actions alone. The perception of central bank dependence is false and marginalizes our own economic efficacies.

Political Dependence

The central bank obsession is, in my view, part of the more general, cultural shift towards increased political dependence. This can be observed by the rise of populism writ large. From Trump’s presidency in the U.S., to Brexit, to the Five Star Party in Italy, to the yellow-vest movement in France, there’s a clamor for retrenchment within national borders. The U.S.-China trade war is just another iteration of this, justified rationalized or not.

via GIPHY

To me, there’s a common theme to these movements. They are indicative of a reversion to tribalism, the cutting of global ties that underpin modern day prosperity, and represent a fear of “the other” mentality common in all primitive and destructive cultures.

Why is it important where the human who produced your steel resides? Seriously, why does it matter to you? If that person’s so evil the solution is simple: deal with someone else. I promise you there is no greater commercial influence than that. Just put yourself in the shoes of a business owner to see (go ahead, close your eyes and imagine).

Why are we suddenly seeking politicians to protect us from the ever-changing world? Economic issues are those of voluntary exchange and they are dynamic. Very few problems require political fixes. Seeking them indicates that one is too scared to trust his/her actions. It’s a skepticism over the power one commands in the marketplace. It’s cowardly.

The Monetary Policy—Fiscal Policy False Dichotomy

It’s often helpful to compare and contrast ideas against extreme conditions. Doing so can surface the essential issues for easier analysis. This is especially true for complex concepts such as those found in economics. Oftentimes, impacts are not obvious and secondary and tertiary effects must be considered.

In the investment markets we often hear about fiscal or monetary policy initiatives. Whenever the economy needs a boost, commentators opine that more accommodative monetary policy might be needed (such as lower interest rates). Or perhaps this particular instance requires a fiscal policy response (like lower taxes and/or greater government spending). Whatever the case may be, prescriptions are framed as being a matter of monetary policy or fiscal policy initiatives.

Nothing, in my view, illustrates cultural fear more than this false dichotomy of monetary policy—fiscal policy. They are conceptually similar and not appropriate book-ends of a conceptual dichotomy. Rather, monetary and fiscal policies are different flavors of central planning. Both seek government intervention in the economy, differing only by their preferred branch. Monetary policy utilizes central bank action while fiscal policy seeks legislative cures. They are not opposites.

The true opposite to central planning is economic liberty. Thus, the proper spectrum, in my view, has economic freedom on one side (deregulation and less controls) and central planning—i.e. fiscal and monetary policy, which are greater controls—on the other. One side reflects independence and confidence while the other forceful paternal shelter. Considering monetary or fiscal policy actions only rejects self-reliance as an option altogether. It’s a scared perspective.

Pacifying Investment Decisions

I also see the shift to passive investment strategies to fit into the fear of independence theme. To be sure, there are virtues of passive investing. Track records and fees relative to active management are compelling enough. But are these the sole motives?

Source: Morningstar

What if a fear of underperforming popular indices or standing out plays a part? Speculating on the future often yields wrong outcomes; it’s part and parcel with investing. As a colleague of mine is fond of saying, “we’re not bootstrapping treasuries.” By this he means that earning returns requires taking risks. Sometimes things don’t pan out as planned and losses occur. The trick, of course, is to minimize the losses; not neurotically seek to avoid them.

Are allocators more concerned with finding the comfort of consultants’ consensus rather than investing according to their own observations? Could career risk play a part in this trend? Are we too scared of being wrong to invest in themes that might play out over longer time horizons?

Share Buybacks Are Safest

What about share buybacks? Much has been made about the magnitude at which corporations have repurchased their shares. Why is this happening at such an unusually high level?

Source: 13D Research

To be sure, I take no issue with share repurchases and see them as a legitimate use of capital. However, even accretive buy-backs have short-lived impacts. They last only a year when year-over-year comparisons are made. Why aren’t businesses investing in projects that could yield multi-year benefits? Are executives simply playing it safe, too scared to commit capital to projects that might fail? Are the majority of shareholders really so shortsighted?

Scared As An Investment Theme

It’s easy to roll your eyes at this article and dismiss it as another meme. However, my intention is neither to seek scapegoats nor to emotionally vent. Rather, I’m interested in exploring whether this behavior is part of a larger cultural phenomenon of fear. If so, the next downturn could push us further from economic liberty and more towards political controls. This would surely have investment implications.

Of course, there is no such thing as “we.” We is just an aggregation of “I’s.” Thus the real question is: Why am I so scared? While an uncomfortable, if not antagonistic question to ask, it’s critical to understanding this emergent theme.

The world is in constant flux. No one should appreciate this more than investors. Change is the essence of our jobs—to profit from the movements in asset prices. Prices don’t move in stagnant conditions.

Yet, as a culture we seem terrified by change. I find this puzzling since we’ve never been better equipped to adapt and capitalize from it. Those investors who embrace change will survive and thrive. Those who don’t could perish from this business. What could be scarier than that?

Mauldin: Modern Central Banking Is More Vulnerable Than We Think

Banks are a place where you store your cash, right? Not exactly.

When you deposit money in a checking or savings account, you aren’t just letting the bank hold it on your behalf. You are lending the bank that money and the bank is borrowing it.

That’s why deposits show as a liability on the bank’s balance sheet.

We think of banks as lenders, and they are, but they’re also borrowers. They make money by lending at higher rates than they pay as borrowers, and by leveraging their deposits via fractional reserves.

Modern Central Banking

This is obvious if you think about it.

How can your bank simultaneously a) promise you can withdraw your cash on demand and b) lend that same cash to someone else?

That’s possible only because they know only a few people will want their cash back on any given day. And if cash requirements are more than expected, they can borrow from other banks or the Federal Reserve, as needed.

Modern central banking and regulatory practices have practically eliminated the old-fashioned bank run. It still happens occasionally, but the system can absorb it.

That’s because, while depositors can withdraw cash from a given bank, it is hard to withdraw from the banking system. Even if you buy gold, the gold dealer will probably deposit your cash in their bank, leaving the system exactly where it was before.

The System Is Vulnerable

Now, the system can be shaken up if too many people decide to hold physical paper money, or they transfer deposit money into other instruments banks can’t leverage as easily.

Central bank reserve requirements also play a role. The banking system is far more elaborate than the most complicated Swiss watch but it just keeps on ticking… until it stops.

Something weird happened in September, for reasons that remain a little murky. The repurchase agreement or “repo” market seized up.

I’ll spare you a plumbing lesson; all you need to know is that repos are really, really important for overnight funding.

Without them, it’s very hard for banks, brokers, funds, and other market participants to square their books. Modern banking simply wouldn’t function and the system would shut down.

Now, this wasn’t a catastrophe. The Fed injected some liquidity and everything seems okay for now. The important part is that it shouldn’t have happened and worse, apparently no one saw it coming.

Shades of 2007–2008

We had a string of similar hiccups in 2007–2008. All were manageable but eventually they added up to something much worse. So, this wasn’t a good sign for market stability.

That’s the problem with unconventional monetary policy. It may solve your immediate problem but create bigger ones later, as French economist Frédéric Bastiat said. We now know the Fed’s 2017–2018 rate hikes, concurrent with the balance sheet reductions or “QT” (quantitative tightening), were probably too aggressive, as even the Fed now tacitly admits. I said at the time they were running a two-factor experiment with unpredictable results. Could we now be seeing them? And if so, are they over?

No one knows, but the Fed looks rattled. And a rattled Fed isn’t what we need.


The Great Reset: The Collapse of the Biggest Bubble in History

New York Times best seller and renowned financial expert John Mauldin predicts an unprecedented financial crisis that could be triggered in the next five years. Most investors seem completely unaware of the relentless pressure that’s building right now. Learn more here.

Offense/Defense Index Looking Better

But technical analysts like ratios, too, and one of them is telling us that this bull market is not over yet.

Many years ago, a technical analyst named Boris Simonder, with whom I’ve lost touch, showed me his offense/defense index, which he created from a proprietary classification of stocks deemed part of the “offense,” such as technology, and stocks deemed part of the “defense,” such as consumer staples. I adapted it to use standard SPDR ETFs and have been following it ever since.

Here’s the formula:

( XLK * XLY ) / (XLP * XLV)

or, if you prefer:

XLK * XLY / XLP / XLV

That’s tech and consumer discretionary in the numerator and consumer staples and health care in the denominator.  And you may have noticed that it is an expansion on simpler XLY / XLP ratio many analysts now use.

We can argue on the specifics and you may think you want to substitute utilities for health care or some other tweak. Go ahead and float that boat but for this missive, I’ll stick with what’s been doing OK for me.

Anyway, take a look at this chart:

That’s a nice coiling pattern for my version of the offense/defense index. And you might think that we’re in a small decline within that pattern right now. I agree. But stochastics applied to the ratio shows a higher low on the last price swing lower. For regular stocks and indices, that suggests a bit of internal strength and there is no reason why it should not apply here.

Of course, we have to wait for the actual breakout to declare the bulls to be in charge but this is certainly a better picture than that of the traditional discretionary / staples ratio:

This also looks like resistance is at hand and it shows no encouragement in stochastics. Perhaps the lack of lower low in Sep/Oct is bullish but I’d like to see the index hold near the trendline and then make the breakout attempt.

Consider this one more, albeit small, bit of evidence that this bull market is not over yet.

Mauldin: How GE Screwed Over Its Retirees

Remember “defined benefit” pensions?

That is the kind of plan in which the employer guarantees the worker a set monthly benefit for life. They are increasingly scarce except for small closely held corporations.

The same rules apply for small closely held businesses as for large corporations.

These plans can be great tools for independent professionals and small business owners. But if you have thousands of employees, DB plans are expensive and risky.

The company is legally obligated to pay the benefits at whatever the cost turns out to be, which is hard to predict.

The advantage is you can use some hopeful accounting to set aside less cash now and deal with the benefit problems later. The problem is “later” comes faster than you would like, and procrastination can be a bitch.

That Brings Us to the Lesson for Today

On October 7, General Electric (GE) announced several changes to its defined benefit pension plans. Among them:

  • Some 20,000 current employees who still have a legacy-defined benefit plan will see their benefits frozen as of January 2021. After then, they will accrue no further benefits and make no more contributions. The company will instead offer them matching payments in its 401(k) plan.
  • About 100,000 former GE employees who earned benefits but haven’t yet started receiving them will be offered a one-time, lump sum payment instead. This presents employees with a very interesting proposition. Almost exactly like a Nash equilibrium. More below…

The first part of the announcement is growing standard. But the second part is more interesting, and that’s where I want to focus.

Suppose you are one of the ex-GE workers who earned benefits. As of now, GE has promised to give you some monthly payment when you retire. Say it’s $1,000 a month.

What is the present value of that promised income stream? It depends on your life expectancy, inflation, interest rates and other factors. You can calculate it, though. Say it is $200,000.

Is GE offering to write you a generous check for $200,000? No. We know this because GE’s press release says:

Company funds will not be used to make the lump sum distributions. All distributions will be made from existing pension plan assets in the GE Pension Trust. The company does not expect the plan’s funded status to decrease as a result of this offer. At year-end 2018, the plan’s funded ratio was 80 percent (GAAP).

So GE is not offering to give away its own money, or to take it from other workers. It is simply offering ex-employees their own benefits earlier than planned. But under what assumptions? And how much? The press release didn’t say.

If that’s you, should you take the offer? It’s not an easy call because you are making a bet on the viability of General Electric.

The choice GE pensioners face is one many of us will have to make in the coming years. GE isn’t the only company in this position.

Unrealistic Assumptions

When GE says its plan is 80% funded under GAAP, it necessarily makes an assumption about the plan’s future investment returns.

I dug around their 2018 annual report and found the “expected rate of return” was 8.50% as recently as 2009, when they dropped it to 8.00%, then 7.50% in 2014, to now 6.75%.

So over a decade they went from staggeringly unrealistic down to seriously unrealistic. They still assume that every dollar in their pension fund will grow to almost $4 in 20 years.

That means GE’s offered amounts will probably be too low, because they’ll base their offers on that expected return.

GE hires lots of engineers and other number-oriented people who will see this. Still, I doubt GE will offer more because doing so would compromise their entire corporate viability, as we’ll see in a minute.

Financial Engineering

GE has $92 billion in pension liabilities offset by roughly $70 billion in assets, plus the roughly $5 billion they’re going to “pre-fund.”

But that is based on 6.75% annual return. Which roughly assumes that in 20 years one dollar will almost quadruple.

What if you assume a 3.5% return? Then you are roughly looking at $2, which would mean the pension plan is underfunded by over $100 billion—and that’s being generous.

GE’s current market cap is less than $75 billion, meaning that technically the pension plan owns General Electric.

This is why GE and other corporations, not to mention state and local pension plans, can’t adopt realistic return assumptions. They would have to start considering bankruptcy.

If GE were to assume 3.5% to 4% future returns, which might still be aggressive in a zero-interest-rate world, they would have to immediately book pension debt that might be larger than their market cap.

GE chair and CEO Larry Culp only took over in October 2018.

We have mutual friends who have nothing but extraordinarily good things to say about him. He is clearly trying to both do the right thing for employees and clean up the balance sheet.

He was dealt a very ugly hand before he even got in the game.

GE needs an additional $5 billion per year minimum just to stave off the pension demon. That won’t make shareholders happy, but Culp is now in the business of survival, not happiness.

That is why GE wants to buy out its defined benefit plan beneficiaries. Right now, the company is on the wrong side of math.

It doesn’t have anything like Hussman’s 31X the benefits it is obligated to pay. Nor do many other plans, both public and private. Nor does Social Security.

Tough Choices

To be clear, I think GE will survive. Its businesses generate good revenue and it owns valuable assets. The company can muddle through by gradually bringing down the expected returns and buying out as many DB beneficiaries as possible. But it won’t be fun.

Pension promises are really debt by another name. The numbers are staggering even when you understate them. We never see honest accounting on this because it would make too many heads melt.

If I am a GE employee who is offered a buyout? I might seriously consider taking it because I could then define my own risk and, with my smaller amount, take advantage of investments unavailable to a $75 billion plan.


The Great Reset: The Collapse of the Biggest Bubble in History

New York Times best seller and renowned financial expert John Mauldin predicts an unprecedented financial crisis that could be triggered in the next five years. Most investors seem completely unaware of the relentless pressure that’s building right now. Learn more here.

Mauldin: Social Security Is Screwing Millennials

Social Security is a textbook illustration of how government programs go off the rails.

It had a noble goal: to help elderly and disabled Americans, who can’t work, maintain a minimal, dignified living standard.

Back then, most people either died before reaching that point or didn’t live long after it. Social Security was never intended to do what we now expect, i.e., be the primary income source for most Americans during a decade or more of retirement.

Life expectancy when Social Security began was around 56. The designers made 65 the full retirement age because it was well past normal life expectancy.

No one foresaw the various medical and technological advances that let more people reach that age and a great deal more, or the giant baby boom that would occur after World War II, or the sharp drop in birth rates in the 1960s, thanks to artificial birth control.

Those factors produced a system that simply doesn’t work.

A few modest changes back then might have avoided today’s challenge. But now, we are left with a crazy system that rewards earlier generations at the expense of later ones.

Screwing Millennials

I am a perfect example.

I’ve long said I never intend to retire, if retirement means not working at all. I enjoy my work and (knock on wood) I’m physically able to do it.

Social Security let me delay collecting benefits until now, for which I will get a higher benefit—$3,588 monthly, in my case.

Now, that $3,588 I will be getting each month isn’t random. It comes from rules that consider my lifetime income and the amount of Social Security taxes I and my employers paid.

That amount comes to $402,000 of actual dollars, not inflation-adjusted dollars. (I also paid $572,000 in Medicare taxes. Again, actual dollars, not inflation-adjusted dollars.)

What did those taxes really buy me? In other words, what if I had been allowed to invest that same money in an annuity that yielded the same benefit? Did I make a good “investment” or not?

That is actually a very complicated question, one that necessarily involves a lot of assumptions and will vary a lot among individuals.

In my case, if I live to age 90 and benefits stay unchanged, the internal real rate of return on my Social Security “investment” will be 3.84%. If I only make it to 80, that real IRR drops to 0.75%.

While this may not sound like much, it actually is. Even 1% real return (i.e., above inflation) with no credit risk is pretty good and 3.84% is fantastic. If I live past 90 it will be even better.

But this is not due to my investment genius. Four things explain my high returns.

  • Double indexing of benefits in the early 1970s (thank you, Richard Nixon).
  • I delayed claiming benefits until age 70, which I could afford to do but isn’t an option for many people.
  • I will probably live longer than average, due to both genetic factors and maintaining good health (thank you, Shane!).

But maybe most of all because

  • The system is massively screwing the next generation. From a Social Security benefit standpoint, being an early Boomer is a pretty good deal.

Social Security structurally favors its earliest users. The big winners are not the Baby Boomers like me, but our parents.

They paid less and received more. But we Boomers are still getting a whale of a deal compared to our grandchildren.

Now, consider a male who is presently age 25, and who earns $50,000 every year from now until age 67, his full retirement age.

Such a person is not going to get anything like the benefits I do, especially with benefit cuts, which my friend Larry estimates will be as high as 24.5%.

So, if this person lives an average lifespan and gets only those reduced benefits, his real internal rate of return will be -0.23%.

I suspect very few in the Millennial generation know this and they’re going to be mad when they find out. I don’t blame them, either.

The Next Quadrillion

The reason Millennials won’t see anything like the benefits today’s retirees get is simple math. The money simply isn’t there.

The so-called trust fund (which is really an accounting fiction, but go with me here) exists because the payroll taxes coming into the system long exceeded the benefits going to retirees.

That is no longer the case.

Social Security is now “draining” the trust fund to pay benefits. This can only continue for so long. Projections show the surplus will disappear in 2034. A few tweaks might buy another year or two. Then what?

Well, the answer is pretty simple. If Congress stays paralyzed and does nothing, then under current law Social Security can only pay out the cash it receives via payroll taxes. That will be only 77% of present benefits—a 23% pay cut for millions of retirees.

And please understand, there is no trust fund. Congress already spent that money and must borrow more to make up the difference.

This IS going to happen. Math guarantees it.

Missing Opportunities

These problems would be less serious if more people saved for their own retirements and viewed Social Security as the supplement.

There are good reasons many haven’t done so. Worker incomes have stagnated while living costs keep rising.

But more important, telling people to invest their own money presumes they have investment opportunities and the ability to seize them. That may not be the case.

The prior generations to whom Social Security was so generous also had the advantage of 5% or better bond yields or bank certificates of deposits at very low risk.

That is unattainable now. And let’s not even talk about mass numbers of uninformed people buying stocks at today’s historically high valuations. That won’t end well.

So, if your solution is to put people in private accounts and have them invest their own retirement money, I’m sorry but it just won’t work.

It will have the same result as those benefit cuts we find so dreadful: millions of frustrated and angry retirees.

So, what is the answer if you are in retirement or approaching it? The easiest answer is to raise the retirement age. Yes, that’s really just a disguised way to cut benefits, but making it 70 or 75 would get the program a lot closer to its original intent.

Today’s 65-year-olds are in much better shape than people that age were in 1936 or even 1970.

(Note, I would still leave the option for people who are truly disabled to retire younger. I get that not everybody is a writer and/or an investment adviser who makes their living in front of the computer or on the phone. Some people wear out their bodies and really deserve to retire earlier.)


The Great Reset: The Collapse of the Biggest Bubble in History

New York Times best seller and renowned financial expert John Mauldin predicts an unprecedented financial crisis that could be triggered in the next five years. Most investors seem completely unaware of the relentless pressure that’s building right now. Learn more here.

Confidence Drives The Economy & Trump’s Trade War Is Killing It

Economic growth isn’t random.

It comes from individual decisions to buy, sell, or do nothing. We all make dozens every day.

Corporate CEOs and CFOs make bigger decisions, like whether thousands of people get hired or a factory gets built.

That means, the economy generally does better when business leaders see growth opportunities, and worse when they don’t.

Right now, the latter is happening. We know why, too: President Trump’s erratic trade policies make long-term planning difficult, to say the least.

If you spent decades building a transoceanic supply chain and are now unsure the US government will let you use it, then your best bet is to postpone investment decisions until you have clarity.

Allowing “clarity” isn’t in the Trump playbook. But without it, every path leads downhill.

Falling Confidence

Back in June, I reported the Business Roundtable’s CEO Economic Outlook Index had fallen for five consecutive quarters. Now it’s six.

The index, which combines hiring plans, capital spending plans, and sales expectations, declined enough to fall below its long-term average.

Two of the three components are below average, too. Hiring plans are still historically high, but capital investment and sales expectations are lagging.

(Curious disconnect here. Why are these CEOs hiring if they don’t expect higher sales and aren’t willing to make growth investments? I don’t know. One explanation is they are trading expensive workers for lower-paid ones, but that’s just a guess).

Still, for now, the survey doesn’t point to recession. It’s consistent with other surveys like the NFIB Small Business Optimism Index, which shows weakening but not collapse.

On the other hand… confidence can drop fast. CEOs were still relatively optimistic well into 2008—about like they are now. Then they suddenly weren’t.

A new Duke University survey of chief financial officers isn’t comforting, either.

Some 55% of finance chiefs became more pessimistic last quarter. They predict less than 1% capital spending growth over the next year. The CFOs say “economic uncertainty” is now their biggest concern.

From where does this uncertainty emanate? We don’t have to look far.

Stifled Demand         

One of Trump’s first trade moves was to “help” American steel producers with import tariffs.

That was last year. How are they doing now? Here’s a Sept. 18 Bloomberg headline:

“Trump Trade-War Boomerang Hits Steelmakers as Prices, Profit Sag”

That doesn’t sound like a win for the US. It’s certainly not a win for the steel industry. From the Bloomberg story:

Since the Trump administration announced tariffs last year, domestic steelmakers’ shares have slumped, partly on concern that trade tensions with China threatened global economic growth and demand for the commodity. Now, there’s evidence that those fears are being borne out, with U.S. Steel Corp., Nucor Corp. and Steel Dynamics Inc. all warning this week on third-quarter profit outlooks.

So look what happened. Tariffs “protected” American steel producers from foreign imports. But the tariffs also threatened global growth and steel demand. The tariffs hurt US companies more than they helped.

But it doesn’t stop with the steel industry. Bloomberg interviewed a trader who described the problem well.

“All of these trade battles that are going on are creating uncertainty for everyone at every level, all the way from the manufacturer down to the end consumer,” Randy Frederick, a vice president of trading and derivatives who helps oversee $3.7 trillion in assets at Charles Schwab in Austin, Texas, said in a telephone interview. “And uncertainty always breeds complacency, which ultimately is going to stifle demand for things like steel.”

This is what I keep saying. Tariffs aren’t the main problem. They’re not great, but businesses could adapt.

The real problem is no one knows what to expect next. This makes business planning impossible and, as that trader says, stifles demand.

Wide Latitude

In a rational world, the powers-that-be would see their strategy isn’t achieving the desired results and try something different. Unfortunately, it isn’t happening that way. More like the opposite.

The conservative billionaire Koch brothers—who support Trump on many other issues—have been using their political network to argue against the trade war. Last week, they admitted it isn’t working.

“The argument that, you know, the tariffs are adding a couple thousand dollars to the pickup truck that you’re buying is not persuasive,” a senior Koch official, who declined to be named, said during a briefing in New York. “It doesn’t penetrate with the people that are willing to go along with the argument that you have to punish China.” (CNBC)

That’s another way of saying the Trump base is all aboard. Other surveys show even suffering Midwest farmers often still support agricultural tariffs.

As I’ve said before, shared adversity tends to unify people, especially when they have a charismatic leader like Trump. So the base is rock-solid.

But you know who else will be rock-solid behind Trump’s 2020 campaign? The same Koch brothers who hate his tariffs.

Think about it. Are the Kochs or other conservative activists going to support a Democrat against Trump? No way.

Nor will most business leaders. They may dislike some Trump policies, but they have even more issues with any Democrat. As sometimes happens (tragically) with abused spouses, they will stay with Trump no matter how badly he hurts them.

This gives Trump wide latitude to do whatever he wants, and a trade war is clearly high on his list.

Eventually, this will push the US economy into recession, which probably won’t help Trump. But he’s ready for that, too. He will blame recession on Jerome Powell and the Federal Reserve.

Very little can stop this trade war, and it will probably get worse. That means business confidence will keep falling. Recession will follow.

Some folks know this and think they can handle it. We will know soon if they’re right.

Mauldin: Economics Is Like Quantum Physics

I often say a writer is nothing without readers. I am blessed to have some of the world’s greatest. Your feedback never fails to inspire and enlighten me.

My last week’s That Time Keynes Had a Point letter brought many more comments than usual. Apparently Keynes is still provocative 73 years after his death, no matter what you say about him.

But my real point was about the twisted economic thought that is having dangerous effects on us all. And we can’t blame it just on Keynes.

Today I want to share some of the feedback I received, add a few thoughts, and then show you some real-world consequences that are only getting worse. But first, let me wax philosophic for a minute.

Economic Dispute

This economic dispute is, at its core, a very old argument about how we understand reality. The ancient Greek philosopher Aristotle might agree with some of today’s economists. He taught deductive reasoning with the classic syllogism:

  • All men are mortal
  • Socrates is a man
  • Therefore, Socrates is mortal

In other words, Aristotle said to move from general principles to specific conclusions. That’s what the bulk of modern macroeconomics does, using their (much more elaborate) models to deduce the “best” policy choices.

Centuries later, Sir Francis Bacon turned Aristotle upside down when he advocated inductive reasoning.

Rather than start with broad principles and apply them everywhere, he said to presuppose nothing, observe events and move from specific to general as you gather more observations… what we now call the “scientific method.”

Today’s economists may think that’s what they are doing, but they often aren’t. They begin with models that purport to include all the important variables, then fit facts into the model. When the facts don’t fit, they look for new ones, never considering that the model itself may be flawed.

Furthermore, as I have shown time and time again, they assume away reality in order to construct models that are in “equilibrium” with themselves. This is supposed to give us insight into the reality that has been assumed away.

That process isn’t necessarily wrong, but it’s not science. It is the opposite of science. Bacon would be horrified to see this. He tried to show the world a better way and now, centuries later, some of our most learned professors still don’t get it.

This is sadly not just a philosophical argument. It has real consequences for real people, including you and me.

Uncertainty Principle

Speaking of science, I received this note from an actual scientist (i.e., not an economist).

“Dear John, having been an avid reader of your articles for many years now I wanted to write to say how much I tend to agree with your commentary, and in particular how much I enjoyed this week’s article. I’d like to make a couple of comments about this week’s material.

Firstly, reference was made to comparing economics with physics, and how economists suffer from “physics envy” (I should say that I have a PhD in physics from Oxford and subsequently worked as a physicist at the European Center for Nuclear Physics Research (CERN) in Geneva, Switzerland, although I left behind my career as a physicist a long time ago.)

Economies and financial markets are much more like the world of quantum mechanics than the world of classical physics. In classical physics there is complete independence between the observer and the system under observation. However, in the realms of quantum mechanics, the systems under observation are so small that the act of observation disturbs the system itself, described by Heisenberg’s Uncertainty Principle.

This situation is similar to that of financial markets, where the actions of market players is not separate from market outcomes; rather the actions of market players PRODUCE the market outcomes.

Betting on financial markets is different from betting on the outcome of an independent event, such as the outcome of a horse race or a football match. The latter are akin to classical physics where there is independence between observer and observed. Whilst actions in the betting market change the odds on which horse/team is favored to win, they don’t impact the outcome of the event, which is rather determined by the best horse/team on the day.” —Paul Shotton

Thank you, Paul, for pointing out this important distinction. I can’t pretend to understand quantum mechanics but your point about independent observation is profound.

Economists don’t just build models; they (and all of us) are parts of the model. We are the economy and the economy is us. While discussing it, we also affect it.

George Soros calls this the principle of reflexivity, the idea that a two-way feedback loop exists in which investors’ perceptions affect that environment, which in turn changes investor perceptions. (Here’s his essay explaining more.)

That means these macroeconomic models, which with their Greek letters and complex equations look very scientific to a layperson, are often at odds with the scientific method.

You can’t conduct independent observations and experiments on an entire economy. That doesn’t render the models completely useless, but greatly limits them.

Borrowing from Clint Eastwood, this might be fine if those who use these models would respect the limitations. All too often, they don’t. And this is where it gets a little complicated.

I confess that I use models. I build them and work with others who build even better ones. Models can help inform us of potential outcomes and better understand risk and reward.

But there are clearly inherent limitations on using historical or theoretical observations to predict future results.

(Dis) Equilibrium

Here are a couple more letters, taking issue with my comments on equilibrium.

“Just to clarify… Even if the economy can be modeled in some sense by a sand pile that will ultimately collapse, that does not mean that the economy is, at any point in time, not in equilibrium. In fact, it must be in equilibrium in order to form the sand pile! You could argue that the equilibrium is “unstable,” perhaps, but it is certainly a (possibly unstable) equilibrium.” —John Bruch

***

“John, I’ve been a reader for years and love your letter. But your comment today is over the top;

The entire premise of equilibrium economics is false. Efficient market hypothesis is over the top but the premise of equilibrium is perfectly modeled in your sand pile letter. Cycles have always existed and always will exist.

Natural market forces will always move markets towards equilibrium but government interference slows the process making the sand pile grow in size and magnitude. To say that the principle of equilibrium is false is just ignoring reality.

The economy is like our forests. When a fire starts in the forest you let it burn so that nature’s cycle can run its course. If you keep putting out the fire you build excess fuel and then at some point you have a catastrophic fire that no humans can control. Mother Nature eventually steps in and puts out the fire and puts life back into equilibrium.

I agree that we need to rethink economics. But the principle of equilibrium, however short lived that moment in time is, is a sure reality.” —Dennis Carver

John and Dennis raise an interesting question. The mere fact that the “sand pile” exists intact for some period of time means that equilibrium exists for that interval. Fair enough. The grains of sand do, in fact, line up so that they don’t collapse.

But we are constantly adding more sand and each additional grain changes the equilibrium. The previous equilibrium ends at that point, having been so brief as to be meaningless.

Eventually a grain of sand will create an unstable equilibrium, causing the pile to partially or completely collapse (and then be in equilibrium once again). So if no single state of equilibrium can exist for more than an instant, I would argue it’s not really “equilibrium” for any practical purpose. We can’t rely on it to continue. Every moment brings a new, unknown situation.

Let’s look at it another way. The sandpile model assumes there will be moments of instability. In economic terms, we are experiencing transitory equilibrium. The sandpile model is inherently unstable, a perfect example of Minsky’s Financial Instability Hypothesis: Stability leads to instability and the longer the period of stability, the greater the instability will be at the end.

(Nassim Taleb’s Antifragility Principle is important to understand when we think about equilibrium, or rather the lack of it. His book Antifragile is important and you should at least read the first half.)

My old friend and early economics mentor Dr. Gary North sees this idea of “equilibrium” as not just wrong, but downright evil.

In his 1963 textbook for upper division economics students, [Israel] Kirzner wrote about the assumptions of economists regarding the use of equilibrium as an explanatory model. They use it to describe the system of feedback that the price system provides the market place. “The state of equilibrium should be looked upon as an imaginary situation where there is a complete dovetailing of the decisions made by all the participating individuals.”

This means not only perfect knowledge of available economic opportunities, but also men’s universal willingness to cooperate with each other. In short, it conceives of men as angels in heaven, with fallen angels having conveniently departed for hell and its constant disequilibrium, where totalitarian central power is needed to co-ordinate their efforts. “A market that is not in equilibrium should be looked upon as reflecting a discordancy between the various decisions being made.”

The heart of free market economic analysis is the concept of monetary profits and losses as feedback devices that persuade people to cooperate with each other in order to increase their wealth. “But the theorist knows that the very fact of disequilibrium itself sets into motion forces that tend to bring about equilibrium (with respect to current market attitudes)” (Market Theory and the Price System, p. 23). Presumably, even devils cooperate on this basis. They, too, prefer profits to losses.

Biblically speaking, this theory of equilibrium is wrong. It is not just wrong; it is evil. It adopts the idea of man as God as its foremost conceptual tool to explain people’s economic behavior. It explains the market process as man’s move in the direction of divinity. Economists are not content to explain the price system as a useful arrangement that rewards people with accurate knowledge who voluntary cooperate with each other. They explain the economic progress of man and the improvement of man’s knowledge as a pathway to divinity, however hypothetical. The science of economics in its humanist framework rests on the divinization of man as a conceptual ideal.

Setting aside the theology, the point here is that economists assume human beings are perfectly rational and consistent, or at least wish to be. That’s what makes equilibrium possible.

But we know humans aren’t perfect or consistent. So how can we have equilibrium? We can’t, unless we assume markets are in equilibrium because they act in a manner we deem appropriate or ideal.

Insane Ideas

Again, this isn’t an academic argument. People who believe these ideas either hold seats of power or have influence on those who do. They truly think they can twist some knobs on their models and make everything better.

If we just had better monetary or fiscal policy, if the government could tax the right people and distribute the money correctly, everyone would be so much better off. And of course, their highly complex models and theories will conveniently lead to their desired political conclusions.

It is increasingly obvious that conventional monetary policy is useless now that rates have been so low for so long, and everyone believes they will remain low.

Nothing the central banks do incentivizes anyone to make immediate growth-generating decisions. If you need to borrow money, you likely did it long ago.

A new Deutsche Bank analysis says the major world economies now have government debt, on average, exceeding 70% of GDP, the highest peacetime level of the past 150 years.


Source: Financial Times

This is obviously unsustainable but the economics profession (and the bankers) desperately want to sustain it. With monetary tools no longer useful, they are turning to fiscal policy. Serious people are mapping strategies like helicopter money, debt monetization, MMT, and worse.

These all, in various ways, essentially say that government debt doesn’t matter, and in some cases we actually need more of it. Historically, the only way that can be right is if we are on the cusp of another WW2-like crisis.

This horrifying but well-researched Bloomberg article is chock full of links to insane ideas. Some look superficially attractive, especially to those unfamiliar with even basic economics. Many have familiar, heavyweight names attached to them. All have, to me at least, a whiff of desperation. They are frantic attempts to make the world stop spinning.

I don’t think these ideas will work. I think we are beyond the black hole’s event horizon. Bad things are going to happen, culminating in some kind of globally coordinated debt liquidation I have dubbed the Great Reset. I really see no other way out.

Every day brings more signs of the impending crisis. Duke University’s latest quarterly CFO survey found more than half of finance chiefs foresee a US recession before the 2020 election. Possibly worse, they project only a 1% increase in capital spending over the next 12 months.

An economy in which near-zero interest rates can’t spur more investment than that is an economy with serious problems. And I expect them to get worse, not better.

Furthermore, an increasing body of evidence says that increasing sovereign debt is a slow but inexorable drag on GDP. It is like the frog being boiled in water, but so slowly that we as citizens don’t really understand what is happening to us. We do sense something is wrong, though. Hence today’s worldwide populist movements.

The driver for 1930s populism was the Great Depression and unemployment. Now the impetus is rising debt and underemployment, with people unable to improve their lives as past generations did. Millions no longer expect to be better off economically than their parents. That frustration is sparking unproductive political partisanship and has the potential to bring political chaos as governments try to protect their own technology and businesses.

The world in general has clearly benefited from globalization and automation, but that is a hard argument to make as jobs disappear. And more jobs will disappear as technology increasingly lets businesses replace expensive humans with cheap robotics and algorithms. Sigh… I wish I had answers. Well, I do, but I don’t think they’ll going to get a great deal of traction.

This won’t be the end of the world. I really do think there are ways that you can properly position your portfolio and your personal life to not just survive but to thrive. We will get through it and be better on the other side. But it’s going to be a bumpy ride.


The Great Reset: The Collapse of the Biggest Bubble in History

New York Times best seller and renowned financial expert John Mauldin predicts an unprecedented financial crisis that could be triggered in the next five years. Most investors seem completely unaware of the relentless pressure that’s building right now. Learn more here.

A Somewhat Bullish Market Commentary

Let’s just put the lead where it should be. Stocks are resilient and short-term dip notwithstanding; they are likely to be higher before the end of the year.

Here’s the evidence in bullet form.

  • The NYSE advance/decline is hovering at all-time highs.
  • Three-month bill yields are dropping hard. The Fed will cut rates one more time this year.
  • Financials are holding tight near resistance thanks to the “uninverting” of the yield curve. You can argue with me on that point later.
  • Trade deals are getting done (Japan) so China will feel the heat. I do not buy the argument that the Chinese are waiting out the current administration (i.e. impeachment or failed reelection). They know better than that.
  • Sector rotation is a healthy sign. Chart below of value and growth.
  • Retail is not dead. Chart below.

Of course, it’s not all great. I’d like to see more stocks hitting new highs and small caps, which started to perk up nicely, have eased back.

Now let’s talk about those headlines.

  • Impeachment inquiry. This may or may not hurt the orange fella but it is likely to seal the deal for Elizabeth Warren on the blue side. Wall Street has already vocalized that it will crumble for President Warren.
  • Softening economic numbers. Nothing stays that good forever. The U.S. is still the best game in town. Why else is the U.S. dollar at a 2 ½ -year high? Yeah, we’ve got positive bond yields but we’ve also got a growing economy. By the way, the UUP bullish dollar ETF is at an 11-year high.
  • What the heck happened to gold? After a major, long-term upside breakout in June and a nice rally to resistance in August, it is now overstaying its welcome as a correcting market. That pesky dollar, right? Well, gold priced in euros has been flat for more than a month, too.
  • And while I’m using such foul language, what the heck happened to bitcoin? It was supposed to get a boost from all this economic turmoil. And when I say foul language, I mean bitcoin.

So, unless something big and bad happens, I’m still a stock market fan.

In the spirit of Warner Wolf, CMT, let’s go to the charts.

(Click on image to enlarge)

Important support for big cap indices.

(Click on image to enlarge)

Important support for the Transports (yes, this is a chart of DJTA, not what eSignal labeled it).

(Click on image to enlarge)

Rotation value from growth.

(Click on image to enlarge)

Retail ice age seems to be enjoying a little market climate change.

(Click on image to enlarge)

There you go. A new low.

Your move Chairman Powell.

J.M. Keynes: The Time He Had A Point

John Maynard Keynes once said:

“Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”

While true, it doesn’t go far enough. The problem isn’t simply defunct economists or “scribblers of a few years back.”

We are in the grip of economists who, far from being defunct, hold great power. Whether they hear voices in the air (or Twitter), I can’t say, but they are indeed madmen in authority.

Not all economists are in that category. Many provide valuable insight or are at worst harmless. They don’t pretend they can change human nature or prevent the inevitable.

Unfortunately, some economists do believe those things. Worse, they are in places from which they can wreak havoc, and they are.

Last weekend I received two emails referring me to articles about the economics profession that stirred my writing juices.

I don’t agree with everything in the articles. They are, however, important because they try, at least, to describe and possibly fix the problem Keynes identified.

We have to address them, not just economically but politically. We can’t just put our heads in the sand and think this will go away.

The whole debt bubble, the income and wealth inequality angst, a growing deficit which will get worse after the next recession, and lack of economic understanding among voters is all coming home to roost.

Better to think about that now, while we can still act and maybe even change things.

False Assumptions

The first item is a July 2019 TED talk by Nick Hanauer, a self-described Seattle “plutocrat” who founded and sold several companies.

He is now a venture capital investor. Hanauer is far to my left politically, but his thinking reminds me a bit of Ray Dalio, and as we will see, some of the proponents of neo-Keynesian “new economics.”

Hanauer’s latest TED talk is titled “The dirty secret of capitalism—and a new way forward.” He begins by describing the widening inequality problem we have discussed before, then quickly zeroes in on what he thinks is the problem: neoliberal economics.

Economics has been described as the dismal science, and for good reason, because as much as it is taught today, it isn’t a science at all, in spite of all of the dazzling mathematics. In fact, a growing number of academics and practitioners have concluded that neoliberal economic theory is dangerously wrong and that today’s growing crises of rising inequality and growing political instability are the direct result of decades of bad economic theory.

What we now know is that the economics that made me so rich isn’t just wrong, it’s backwards, because it turns out it isn’t capital that creates economic growth, it’s people; and it isn’t self-interest that promotes the public good, it’s reciprocity; and it isn’t competition that produces our prosperity, it’s cooperation.

What we can now see is that an economics that is neither just nor inclusive can never sustain the high levels of social cooperation necessary to enable a modern society to thrive.

I know, those are fighting words to most free-market defenders, but hear this out. Hanauer blames the sad state of modern economics on three false assumptions.

First, it isn’t true the market is an efficient equilibrium system. You may have read my “sandpile” article that is one of my most popular ever.

It describes how our astronomically complex modern economy is anything but an equilibrium. It is a growing sandpile whose collapse is certain. As Hyman Minsky wrote, stability breeds instability.

If, as too many economists believe, you think you can manage an economy toward equilibrium, you simply help the sandpile grow bigger so its eventual collapse is even more violent. That’s how we get crises like 2008, and the one we will have again in due course.

The second false assumption is that price always equals value. That’s the heart of the efficient market hypothesis, that stock prices always reflect all available information. Clearly, they don’t, since we have all seen both overvalued and undervalued markets.

In fact, we have economist-run institutions like the Federal Reserve working to make sure prices don’t equal value.

They intentionally distort prices, starting with the most important one: the price of money, what we call “interest rates,” with all kinds of harmful effects (and often benefits to those who already own assets).

The third false assumption is that humans are rational, utility-maximizing machines who look out for our own interests first. It’s just not true.

Humans are social animals, and we will, in the right conditions, sacrifice our own interests for others. Soldiers don’t heroically jump on grenades because they’re selfish. Parents and friends often sacrifice for their children and their friends.

People accept lower returns to invest in ways they think improve the world, or pursue behaviors they feel are in the common and general interest but not their own individual interests. Happens all the time.

If we were all so naturally self-maximizing, there would be no such thing as love, which is a choice to place someone else’s good ahead of your own. If you have some hidden selfish motive, it’s not really love, is it? Not in the way any religion I know describes it.

Yet many economists persist in believing we are all competitive, all the time, and this somehow leads to equilibrium and prosperity.

That is false and if it is your base assumption, all your other answers are going to be wrong. This is not an embrace of human nature, but a denial of it.

Meanwhile, another Seattle billionaire had some words on the same subject recently. Bill Gates didn’t say exactly “economists know nothing,” but that’s clearly what he meant in this Quartz interview.

“Too bad economists don’t actually understand macroeconomics,” the Microsoft co-founder said. Asked what he meant by that, Gates continued:

“It’s not like physics where you take certain inputs and you predict certain outputs. Will interest rates ever return to normal, and why aren’t they returning to normal? You won’t get a consensus between economists quite the way that if you dropped a ball out your window and called up physicists and asked, ‘What the hell happened?’ There’s so many factors including what [economist John Maynard] Keynes called ‘animal spirits’ in the economic equation that we don’t have predictability.

Even today, people are still arguing about what happened in 2008. So it’s even harder to look forward. [Look at] the role of the bond rating agencies in 2008, which is completely unreformed. Why would that be? Well, there must be a lack of consensus.”

Both Hanauer and Gates make a point. Economists began assuming equilibrium must exist early in the 20th century. General equilibrium was wonderful because it let them model the economy on paper (and later, computers).

Economists have physics envy. In essence, they assume away whatever doesn’t fit the model. Unsurprisingly, the models don’t work when put to the test, because the assumptions are not anchored in reality.

The entire premise of equilibrium economics is false. The world is a complex system. To model it requires complexity mathematics and theory. Sadly, but not unsurprisingly, we are decades away (if ever) from actually being able to model the economy as long as one continues to assume equilibrium at some point.

Of course we can make observations and theories and propose policies. But we shouldn’t do so under the illusion that some mathematical model allows us to know what we’re doing. “Lies, damn lies and models” should have been the quote. So when Gates and Hanauer and others, including me, say that economists don’t understand economics, our real point is that they rely on incorrect models and assumptions.

It gets worse when the politicians get economists to create models for them. These economists are every bit as trained as any circus animal and they don’t even need a whip.

The economists’ assumptions inevitably lead to the conclusions the politician wants. Of course, they all have “neutral data and facts.” What would a model be without facts and data?

Necessary Debate

The second article came to me from a person who thought it ridiculous. He sent it along with a lengthy preface warning about its (in his view, false) claims.

I appreciated the thought but I am also trying very hard to break out of the tribal box. I now often say that I’m neither Republican nor Democrat, but American.

I don’t automatically reject ideas simply because of their origin. If I reject them, it’s because I have studied them and concluded they are wrong.

That said, this one has a lot of problems but is still worth reading. The author is Jared Bernstein, an economist who once advised Vice President Joe Biden. In this piece he describes what he calls a “new economics” that will create a more “just” America.

Like Dalio and Hanauer, I think Bernstein correctly identifies many of our problems. It is not the case that everything would be peachy if government just got out of the way; we have deeper issues. I completely endorse Bernstein’s first sentence: “The American economy has some serious, structural problems—and the economists are partly to blame.” He goes on:

It is not a coincidence that the new economics is in ascendency at this moment. Though by some measures, inequality has not grown much in recent years, it remains at levels as high as the late 1920s, which, for the record, didn’t end well. In one of the most disturbing developments emerging from recent research, the inequality of income and wealth is increasingly associated with the inequality of life expectancy.

The assumption that self-interested firms would self-regulate gave rise to repeated rounds of deregulation that gave us what I call the “shampoo economy”: bubble, bust, repeat. The old economics wrongly claimed we couldn’t have persistently low unemployment without spiraling inflation, yet that’s precisely what we’ve enjoyed in recent years.

In other words, the new economics isn’t arising just because we want “better” outcomes from our markets. It’s also arising because a lot of the old stuff has turned out to be just plain wrong.

That is mostly true but I think it’s because deregulation hasn’t gone far enough. Large companies use political influence to have government protect them from competition.

The result is a bunch of “zombies” engaged in counterproductive activities that market discipline would quickly send to the graveyard, were it allowed to work.

The solution, in my opinion, is not for government to further regulate private business, but for it to stop picking winners and losers. Consumers could then decide what works.

Of course, there’s room for reasonable regulation; we all want safe vehicles, clean food, etc. But regulations should promote competition, not suppress it.

I think many of Bernstein’s policy ideas won’t have the desired results, and some would be disastrous, but these are debates we need to have. We will achieve better results if we engage in them civilly and sincerely. That is hard in today’s polarized environment… but avoiding it will be even harder.

Keynesian Sense?

That brings us back to Lord Keynes. Many now regard him as one of the “defunct economists” he himself blamed for the problems of his time.

In certain quarters, “Keynesianism” is as unpalatable as socialism. In fact, while Keynes was a leftist by today’s standards, he wasn’t against capitalism.

Recently I ran across a 2009 article by Bruce Bartlett with the provocative headline, Keynes Was Really a Conservative. That overstates it, but Keynes was more conservative than you might think. Here’s Bartlett.

Keynes completely understood the central role of profit in the capitalist system. This is one reason why he was so strongly opposed to deflation and why, at the end of the day, his cure for unemployment was to restore profits to employers. He also appreciated the importance of entrepreneurship: “If the animal spirits are dimmed and the spontaneous optimism falters… enterprise will fade and die.” And he knew that the general business environment was critical for growth; hence business confidence was an important economic factor. As Keynes acknowledged, “Economic prosperity is… dependent on a political and social atmosphere which is congenial to the average businessman.”

Indeed, the whole point of The General Theory was about preserving what was good and necessary in capitalism, as well as protecting it against authoritarian attacks, by separating microeconomics, the economics of prices and the firm, from macroeconomics, the economics of the economy as a whole. In order to preserve economic freedom in the former, which Keynes thought was critical for efficiency, increased government intervention in the latter was unavoidable [at least to him]. While pure free marketers lament this development, the alternative, as Keynes saw it, was the complete destruction of capitalism and its replacement by some form of socialism.

“It is certain,” Keynes wrote, “that the world will not much longer tolerate the unemployment which… is associated—and, in my opinion, inevitably associated—with present-day capitalistic individualism. But it may be possible by a right analysis of the problem to cure the disease whilst preserving efficiency and freedom.”

In Keynes’ view, it was sufficient for government intervention to be limited to the macroeconomy—that is, to use monetary and fiscal policy to maintain total spending (effective demand), which would both sustain growth and eliminate political pressure for radical actions to reduce unemployment. “It is not the ownership of the instruments of production which is important for the State to assume,” Keynes wrote. “If the State is able to determine the aggregate amount of resources devoted to augmenting the instruments and the basic rate of reward to those who own them, it will have accomplished all that is necessary.”

One of Keynes’ students, Arthur Plumptre, explained Keynes’ philosophy this way. In his view, Hayek’s “road to serfdom” could as easily come from a lack of government as from too much. If high unemployment was allowed to continue for too long, Keynes thought the inevitable result would be socialism—total government control—and the destruction of political freedom. This highly undesirable result had to be resisted and could only be held at bay if rigid adherence to laissez-faire gave way, but not too much. As Plumptre put it, Keynes “tried to devise the minimum government controls that would allow free enterprise to work.”

There’s actually a lot to like here. A government that focuses on keeping the “macro” playing field level while letting producers and consumers control the “micro” economy would be a vast improvement over what we have now.

That last quote from Plumptre is well said. Keynes wanted “the minimum government controls that would allow free enterprise to work.” He sought a balance between central planning and anarchy. He saw a lot of room between the extremes.

Likewise, by establishing conditions in which market forces could work, Keynes sought to prevent the kind of radical policies some of his modern followers want.

The crazy ideas we now fear—negative rates, MMT and the rest—didn’t appear spontaneously. Their proponents see them as solutions to real problems. These ideas would go nowhere if the economy functioned better.

Today we’re still seeking the balance Keynes wanted. We need an economics profession with clear thinkers. They’re out there. We have to amplify their voices.


The Great Reset: The Collapse of the Biggest Bubble in History

New York Times best seller and renowned financial expert John Mauldin predicts an unprecedented financial crisis that could be triggered in the next five years. Most investors seem completely unaware of the relentless pressure that’s building right now. Learn more here.

The 60/40 Portfolio Is Riskier Than Ever

As investors we have to make assumptions about the future. We know they will likely prove wrong, but something has to guide our asset allocation decisions.

Many long-term investors assume stocks will give them 6–8% real annual returns if they simply buy and hold long enough.

Pension fund trustees hire consultants to reassure them of this “fact,” along with similar interest rate and bond forecasts, and then make investment and benefit decisions.

Those reassurances are increasingly hollow, thanks to both low rates and inflated stock valuations, yet people running massive piles of money behave as if they are unquestionably correct.

Realistic Forecasts

You can, however, find more realistic forecasts from reliable, conflict-free sources.

One of my favorites is Grantham Mayo Van Otterloo, or GMO. Here are their latest 7-year asset class forecasts, as of July 31, 2019.

These are bleak numbers if you hope to earn any positive return at all, much less 6% or more.

If GMO is right, the only answer is a large allocation to emerging markets which, because they are emerging, are also riskier.

The more typical 60/40 domestic stock/bond portfolio is a certain loss, according to GMO. (Note these are all “real” returns, which means the amount by which they exceed the inflation rate.)

Others like my friends at Research Affiliates (Rob Arnott), Crestmont Research (Ed Easterling), or John Hussman (Hussman Funds) have similar forecasts. They differ in their methodologies but the basic direction is the same.

The point is that returns in the next 7 or 10 years will not look anything like the past.

If you think these are reasonable forecasts (I do), then one reaction is to keep most of your assets in cash for at least a fractionally positive, low-risk return. That’s simple to do. But it probably won’t get you to your financial goals.

The 60/40 Fallacy

Many financial advisors, apparently unaware the event horizon is near, continue to recommend old solutions like the “60/40” portfolio.

That strategy does have a compelling history. Those who adopted and actually stuck with it (which is very hard) had several good decades. That doesn’t guarantee them several more, though. I believe times have changed.

But those decades basically started in the late ‘40s and went up until 2000. After 2000, the stock market (the S&P 500) has basically doubled, mostly in the last few years, which is less than a 4% return.

When (not if) we have a recession and the stock market drops 40% or more, index investors will have spent 20 years with a less than 1% compound annual return. A 50% drop, which could certainly happen in a recession, would wipe out all their gains, even without inflation.

And yes, there have been historical periods where stock market returns have been negative for 20 years. 1930s anyone? Yes, it is an uncomfortable parallel.

The “logic” of 60/40 is that it gives you diversification. The bonds should perform well when the stocks run into difficulty, and vice versa. You might even get lucky and have both components rise together. But you can also be unlucky and see them both fall, an outcome I think increasingly likely.

Louis Gave wrote about this last week.

Historically, the optimized portfolio of choice, and the one beloved of quant analysts everywhere, has been a balanced portfolio comprising 60% growth stocks and 40% long-dated bonds. Yet recently, this has come to look less and less like an optimized portfolio, and more and more like a “dumbbell portfolio,” in which investors hedge overvalued growth stocks with overvalued bonds.

At current valuations, such a portfolio no longer offers diversification. Instead, it is a portfolio betting outright on continued central bank intervention and ever-lower interest rates. Given some of the rhetoric coming from central bankers recently, this is a bet which could now be getting increasingly dangerous.

For the moment, I still think long-term yields will keep falling, helping the bond side of a 60/40 portfolio. Meanwhile, negative or nearly negative yields will push more money into stocks, driving up that side of the ledger.

So 60/40 could keep firing on all cylinders for a while. But it won’t do so forever, and the ending will probably be sudden and spectacular.

Which brings us to my final point.

Friends don’t let friends buy and hold

The primary investment goal as we approach the recession should be “Hold on to what you have.” Or, in other words, capital preservation.

But you may not realize that capital preservation can be better than growth, if the growth comes with too much risk. Here’s the math.

  • Recovering from a 20% loss requires a 25% gain
  • Recovering from a 30% loss requires a 43% gain
  • Recovering from a 40% loss requires a 67% gain
  • Recovering from a 50% loss requires a 100% gain
  • Recovering from a 60% loss requires a 150% gain

If you fall in one of these deep holes you will spend valuable time just getting out of it before you can even start booking any gains. Once you start to fall, the black hole won’t let go. Far better not to get too close.

I can’t say that strongly enough: Friends don’t let friends buy and hold.

You must have a well thought out hedging strategy if you’re going to be long the stock market.

If your investment advisor simply has you in a 60/40 portfolio and tells you that, “We are invested for the long term and the market will come back,” pick up your capital and walk away.

I can’t be any more blunt than that.

Past performance does not predict future results. That has never been more true than for the coming decade.

The 2020s will be more volatile and difficult for the typical buy-and-hold index fund investor than anything we have seen in my lifetime.

Active investment management is not popular right now because passive strategies have outperformed. But I think that is getting ready to change.

You should start, if you’re not already, investigating active management and more proactive investment styles. You will be much happier if you do.

Relying on past performance as the tectonic plates shift underneath us, as the central bank policies suck historical performance into their maws, we must look forward rather than backwards to design our portfolios.


The Great Reset: The Collapse of the Biggest Bubble in History

New York Times best seller and renowned financial expert John Mauldin predicts an unprecedented financial crisis that could be triggered in the next five years. Most investors seem completely unaware of the relentless pressure that’s building right now. Learn more here.

Negative Rates Are Destructive But Profitable

“Remember that Time is Money.”

Benjamin Franklin, Advice to a Young Tradesman

It’s unfortunate that such genius identifications as the above have long been forgotten by the economic community. First penned in 1748, Benjamin Franklin makes the connection between human effort—or rather the application of human effort towards productive work—and the effect/product, i.e. wealth. We measure this increase in prosperity, of course, in terms of money. Thus, “Time is Money” (or rather, time is potential money). They are one in the same since time is the one truly scarce resource with which all living creatures have to work.

However, you’d never know this by a look at today’s markets. Negative interest rates are now common place and widely accepted as a policy tool. In fact, a tradition of thought is being established as a means of “normalizing” them. Pushing deeper into negative territory seems all but a foregone conclusion. No longer is the absurdity and devastation of such policies discussed. No longer discussed is that negative interest rates negative human life.

Negative Interest Rates Negate Human Life

“Negative interest rates negative human life” is a bold statement, I know, but I stand by it. I suspect “Big Ben” would too. We both understand what economics is all about. It has nothing to do with fine tuning commercial activities for some nebulous greater good. Rather, economics is about individual, human happiness. It’s about making the most of our time on this planet; to use our time, effort, and brainpower to maximize the human experience while it lasts. The better use of time we make—via productivity—the more wealth can be created, the more comfortable and fulfilling our lives, and the better the existence we can enjoy. Hence, time is money in a pure, genuine, and profound way.

This is why negative interest rate policies (NIRP) are so pernicious and beyond absurd, irrespective of whether or not they saved the collapsing financial system in 2008. NIRP implies contractions on such fundamental scales that they cannot be beneficial. Specifically, that either: 1) your time and efforts are valueless (or worse, destructive), or; 2) your currency is valueless. In other words, action is detrimental to survival; time is not money, and; one’s currency choice is not important. None could be more obviously false.

Time and Effort Are Valuable

Your time and effort are valuable. Fundamentally, these are your survival tools. If time and effort were not valuable then there would be no need to ever take any action of any sort. You’d be better served to lay curled up in the fetal position than to attempt to work. This is clearly false. Human survival (and thriving beyond this basic need) requires one to produce and trade for values. This requires action; hence time and effort are valuable.

Time is Money

If time were not money then no one would work, full stop. Why toil if the fruits of one’s labor did not exceed the effort and time spent while working? Humans work for the purpose of survival; however we’re lucky that civilization has sufficiently advanced such that immediate survival is no longer of primary concern for much of the developed world.

Instead of concerning ourselves with food and shelter, human effort can be diverted towards life enhancements. Today, engineers make software, artists make films, ride-sharing drivers transport us, and financiers fund dreams. Without people working on such projects there would be none of the results. There’d be no Ubers and iPhones and movies and biotechnology and office buildings without men and women applying their time towards these endeavors.

If time were not money why on earth would anyone work? Surely there would be better ways to spend one’s only truly scare resource of time. Simply doing nothing and conserving energy would be an evolutionary advantage. Why work if there are no values to gain?

Working to lose would favor not working or acting at all. This is the absurdity of negative interest rates. To apply capital only to lose it—i.e. NIRP—would favor not applying capital in the first place. Thus, NIRP’s existence implies a contrived construct to exist, not one grounded in natural law.

Sound Money Is Universally Desired

Another possibility of NIRP is that it says something negative about the currency and not necessarily output. The currency is depreciating over time. But this too is nonsensical. Why would anyone use a depreciating currency given the choice? In fact, no one ever chooses such inferior currency, looking at history. These circumstances typically arise with a healthy dose of force. Poor currencies are typically foisted upon an unwilling population and they typically don’t last; no one wants to lose value in a transaction. If a currency cannot serve as a reliable unit of account, the populace will eventually find something that can—officially or unofficially sanctioned.

Thus, people will flock to the best currency option available so long as they are not forced to choose otherwise by regulation and statute. This in part explains the U.S. Dollar’s dominance in international financial transactions. True it’s the “reserve currency” but it’s the reserve currency for a reason and the dominance of the U.S. Navy is not one. Rather, the respect for the rule of law, deep capital pools, and established and incentivized institutions are what likely preserves the U.S. Dollar’s reserve status. Don’t kid yourself; an IMF mandate for settling trade in renminbi would yield no (material) results. Economic actors will act according to their best interests, factoring in the price of non-compliance. Thus, the “bag-holders” are always those compelled to hold depreciating currency.

Sweet Siren’s Song

The challenge with negative and low rates is just how profitable they can be to trade. Hence, they should not be ignored, in my view. I introduced the chart below nearly a year ago. It illustrates how much return potential is embedded in the 10 year U.S. Treasury bond (USTs) expressed as a function of its current yield (see here for a more detailed description). As yields have fallen, the appreciation/depreciation potential has dramatically increased. No longer are USTs boring, yield providing investment vehicles. In the environments of NIRP and ZIRP (zero interest rate policy) they are now total-rate-of-return vehicles ripe for speculation and outperformance.

Today’s Bizarre State of the World

These dynamics gave us the current state of the world. Investors cheer the stupidity of NIRP because they yield profits. The more ZIRP, NIRP, and QE (quantitative easing) the more capital gains can be reaped despite no detectable economic benefits produced. Hence, investors cheer the nonsensical which policymakers mistake as as endorsements. A self-reflective loop is established.

Many claim that NIRP, ZIRP, and QE saved the failing financial system. This, however, is mere conjecture. We simply don’t know what would have arisen from the ashes, better or worse. Counter-factual claims cannot be empirically debated.

Thus to claim that NIRP is beneficial displays one’s bias and, in my view, is grounds for mistrust on non-objectivity. This is particularly true since we can see how truly absurd the theoretical construct for NIRP is. Time is money and freely exchanging citizens desire sound currency, these we know as fact. Arguing to the contrary in papers or by inciting tradition can’t negate these.

So long as the academic and political will favors the incumbent policies they will likely be entrenched. The IMF recently published their playbook for the next economic slowdown and NIRP plays prominently. Economics (true economics) illustrate why these next rounds will also fail to stoke economic activity.

There’s no breaking the link between time and money and the desirability for sound currency. These are universal truths. That said, bond math illustrates that trading “rates” in such an absurd environment can be lucrative, at least for the time being. Thus, I find it useful to know both: the absurd and the trading potential. Profitably trading won’t negate the deleterious effects of NIRP, but it can help preserve one’s capital for better, more intellectually sound times.

War Gaming The Trade War

People respond to incentives. So do national governments. This is foundational to both economics and geopolitics.

Carefully examining each side’s incentives can illuminate how a conflict will end. No one has infinite choices. They choose from limited options.

That applies to the US-China trade war, which is right now one of our top economic issues. So let’s think through what the players really want, and what each can actually do.

Outrageous or Flexible?

To begin, let’s note that the US and China really have two disputes.

One is about trade, the other is a struggle for military and technological dominance. These overlap. So knowing which drives any particular decision is hard. But for now, I’ll talk mostly about trade.

The first problem is that Donald Trump leads the US side. Understanding what he really wants from China is, well, difficult.

Often, he makes outrageous demands China could never accept. Possibly this is a negotiating tactic. Asking for the moon lets the other side think itself lucky to give anything less than the moon. And if that’s all you need, then you win.

But other times, US demands seem more flexible. We just want China to play fair, respect the rules, and open the Chinese market to US companies, just as the US is open to Chinese imports.

Underlying this is the fact Trump is a politician who wants to get re-elected. To do that, he needs to keep his base support. The base wants him to look tough against China. This limits his negotiating options.

Yet he also needs to keep the economy stable or growing. An extended trade standoff doesn’t help.

The one thing Trump can’t do is let China win. He needs Beijing to give him at least the appearance of significant concessions.

Excess Capacity

Xi Jinping doesn’t have to run for re-election, but he has a billion+ mouths to feed. He needs a growing domestic economy.

To date, much of that growth has come from building infrastructure and industrial production capacity. Someone has to buy what China produces with all that capacity—if not Westerners, then people in China.

Opening China to foreign competitors, as Trump demands, is inconsistent with Xi’s requirements. George Friedman of Geopolitical Futures explained in a recent analysis:

The Trump administration has used tariffs to try to force the Chinese to open their markets to U.S. competition. The problem is that the Chinese economy is in no position to accept such competition. The financial crisis severely affected China’s export industry as the global recession reduced the appetite for Chinese goods. This hurt the Chinese economy greatly, throwing it off balance in a crisis that still reverberates in China today.

China’s main solution to this problem has been to increase domestic consumption – a task that has proved difficult because of the distribution of wealth in China, the inability of financial markets to massively increase consumer credit, and the positioning of Chinese industry to target foreign, rather than domestic, consumers. Selling iPads to Chinese peasants isn’t easy.

Allowing the U.S. to access the Chinese market would have been painful if not disastrous. The Chinese domestic market was the only landing pad China had, and U.S. demands for greater access to it were impossible to meet.

If George is right, then we have the proverbial irresistible force meeting an immoveable object. Trump can’t reduce his demands. Xi can’t accept them.

Also, China’s government is communist. It allows some competition and other capitalist activities, but the kind of open markets that exist in the US are incompatible with China’s objectives.

That makes stalemate the likeliest near-term result… which is what we’ve seen.

This may explain why the US-China trade “negotiations” keep breaking down. They aren’t real negotiations. Agreement is impossible, but it serves both sides to look like they’re making progress.

Presenting that appearance is critical because the US and Chinese governments aren’t the only players here. Others are in the game, too.

Rational Choices

Business leaders are also part of this. What are their incentives?

They want to generate profits. That means making wise investments in new products and markets.

If, for instance, you lead a US manufacturer, the amount you invest in developing a new product depends on the number of potential buyers. That number is bigger if you can include China.

Likewise, your production costs depend on the availability and price of Chinese components.

When both those conditions are in doubt—as they are right now—then you have less incentive to invest in that new product.

You might use the cash that would have gone toward hiring workers and building new facilities to, say, repurchase your own stock. At least you’ll make shareholders happy.

That’s a perfectly rational choice, given the circumstances. But it has consequences.

The longer this drags on, the less confident businesses become, and the more reluctant they are to make growth investments. Eventually, it adds up to recession.

That is the outcome even if everyone involved—CEOs, Trump, and Xi—keeps doing what is reasonable to them, given their incentives and limitations.

Conclusion: This trade war has no off-ramp, so it will likely get worse, not better.