“To the intelligent man or woman, life appears infinitely mysterious, but the stupid have an answer for everything.”
I am penning my seventh “Year in Review.” These summaries began exclusively for myself, evolved into a sort of holiday cheer for a couple hundred e-quaintances with whom I had been affiliating since my earliest days as a market bear in the late ’90s, and metastasized into the Tower of Babble - longer than a Ken Burns miniseries -summarizing the human follies that capture my attention each year Jim Rickards kindly called it “a perfect combination of Mel Brooks, Erwin Schrodinger & Howard Beale.” I wade through the year’s most extreme lunacies as well as a few special topics while trying to find the overarching themes. I love conspiracy theories and detest detractors who belittle those trying to sort out fact from fiction in a propaganda-rich world. My sources are eclectic, but I give a huge hat tip to sites like Peak Prosperity and Zerohedge. If half of what they say is right, the world is a very weird place.
“Ninety percent of everything you read or hear is crap.”
“The amount of time you waste online doubles every 18 months.”
In an e-mail in early April, I told a friend and Master of the Universe that I wasn’t grasping the year’s theme. He assured me the year was young, but I had a deeper angst. I eventually realized that I had ascended Mount Stupid (Figure 1) and may be heading down The Far Side. Whether we are talking Greece, the Middle East, monetary policy, bonds, domestic politics, or sex changes, I am baffled by it all. Maybe life in the third millennium is like a sci-fi movie: it doesn’t have to make any sense. So my qualifications to comment on geopolitics are not in dispute: I am an organic chemist, a clueless academic one at that. Nothing should inspire you to read on. But—a big Kim Kardashian butt—I have somehow managed to capture a readership.
Figure 1. Mount Stupid
Occasionally I get a few selfies with prominent players, airtime on Russia Today, and some ink in The Guardian and Wall Street Journal.1 All help keep the ruse going. As this review is being uploaded to Peak Prosperity and soon thereafter to Zerohedge (hopefully). I offer just a little more elevator résumé disguised as a survey of personal events. My favorite interview this year was with a colleague-and sponsored by Cornell.8 I did podcasts with the likes of James Kunstler,9 Chris Martenson,10 Ed Rankin,11 and Jason Burack.12 Four BTFD.tv episodes chaperoned by Bob Lehman included a solo shot,13 two with Eric Hunsader of Nanex,14,15 and the last as a threesome with Eric and Joe Saluzzi,16 founder of Themis Trading and author of Broken Markets. A gig at the Stansberry Investment Conference in Vegas landed me some free meals and a shared stage with some actual famous guys. (Porter Stansberry is a self-proclaimed huckster and, in my opinion, brilliant.) The title of my talk was “College Life: The Good, the Bad, and the Ugly.” It came out a week before Yale and Mizzou went batshit and mercifully hid behind a paywall while outrageously uneventful ideas triggered mayhem across college campuses. I even found my nose stuck in the tail end of the Tim Hunt scandal, which I talk about herein. Last, I'm taking a bow for using a single Tweet to nip some corporate misbehavior in the bud.17 Ya gotta tweet ‘em right.
I draw inspiration from a Bloomberg headline:18
And with that, I am obliged to offer the following:
We face an epidemic of wusses, which is sanitized for “pussies,” which some believe finds its origins at pusillanimous. This document is laced with childish tripe, microaggressions, horsemeat, rat hairs, human DNA, central bankers, and presidential candidates. If I’ve already offended you, I apologize. (Just kidding. It only gets worse.) But you need not read on.
Presenting such a review poses a multitude of challenges. There are important topics from past years that remain important but will not be repeated. How many times can one rail on underfunded pension plans, unfunded liabilities, or a quadrillion-dollar derivatives market? These matters are important, but the plot line doesn’t change much year to year. I’m skipping right over Japan; it’s a basket case, but not enough has changed to spill some ink. Despite reams of accrued notes and links, I am light on the Middle East because nobody understands it (or eats parsley.) It’s that Mount Stupid descent again. I leave topics like global warming, mass shootings, and Israel versus Palestine to those who like to shout a lot. Other ideas manage to stay at center stage year after year. Compartmentalizing the topics can seem artificial. How does one separate broken markets from the Federal Reserve? Sovereign debt levels from bond markets? Government from civil liberties? It is also laced with blogger porn (quotes). Somehow 450 pages of notes, quotes, and anecdotes describing a web of interconnected concepts must be distilled into the “Year in Review,” all in a few short weeks. So let’s head to the choppers.
- The Economy and the Next Recession
- Broken Markets
- Share Buybacks and Balance Sheet Rot
- Gold and Silver
- Personal Debt
- State and Municipal Debt
- Inflation versus Deflation
- ZIRP and NIRP
- The War on Cash
- References Part 1 | Part 2
- Banks and Bankers
- The Federal Reserve
- The Middle East
- South America
- Random Human Tricks
- Patsies and Scapegoats
- Election 2016
- The Clintons
- Civil Liberties
- Campus Life: the Good, the Bad, and the Ugly
- References Part 1 | Part 2
Precious little of my portfolio changes most years. I began 2015 with the distribution shown below. Owing to downward adjustments in energy and metals prices and upward adjustments of putting savings back into those asset classes, my percent allocations remain about the same.
Precious metals etc.: 21%
Cash equiv (short term): 60%
Standard equities: 9%
The total change in my net wealth over the year was -5%. This results from downdrafts in physical gold (-11%), gold equities (-19%), and energy (-21%). The standard equities moved little (-1%). The huge short-term fixed income and cash attenuate even the most abrupt upward and downward movements. A net savings of 24% of my gross income elevated the total wealth accumulation by 1%.
My 16-year return beginning 01/01/00—a wild period to say the least—is an annually compounded 7%. Although this handily beats most investors, the huge commodity rout starting last year and precious metal rout beginning in 2011, which contrasts sharply with a 170% run in the S&P since 2009, has eroded what was once a huge lead. For a little perspective to the braggadocious chortlers, however, gold is up approximately 300% and the XLE up 128% over the 16-year period compared with only 46% by the S&P (ex-dividends). I am expecting to see many of the extreme moves over the last few years reversed, but only time will tell. In the infinite loop we loosely call markets, there is a relentless debate:
Market winners: “See. I told you so!”
Market losers: “Just you wait!”
I have been on both sides of that debate (preferring the former). I believe we are still in a secular bear market despite the evidence accrued over the last six years. For almost 20 years I have subscribed to a “three legs down” model of secular bears that translates as follows:
Phase 1 (2000–03): a flesh wound
Phase 2 (2008–09): damaging pain
Phase 3 (20??–??): deracination of hearts, minds, and souls
It’s the third leg down that causes generational changes in attitudes. Let me be clear, however. I have an exit strategy—a strategy to repot myself—from my bearish conundrum (assuming, of course, that I am not neuroplasticly too damaged to react.) I was deeply moved by A Random Walk Down Wall Street (see Books). Author Burton Malkiel convinced me that under most circumstances average blokes cannot beat the markets through active management. My premise is that the next recession will be a barn-burner—a category 5 shitstorm—that ushers in Phase 3. If the Fed fails to juice the markets (unlike in ’09), the markets will finally overcorrect and drop well below fair value. (The Fed snuffed this overcorrection in ’09.) When the next recession is in full bloom—when it is so obvious that even economists are writing about it—I will once again try to enter the markets. I will be taking my cue from Tobin’s Q (discussed later in Broken Markets). I started buying at fair value in ’09, figuring I would average down, but the markets jumped away from me too quickly. I will again start buying at fair value, be seriously buying at well below fair value, and wishing I had saved my ammo at rock bottom. Hopefully, at this point of maximum remorse, I will have reconstructed a long position from the spolia and asset carrion.
“There are segments of the perma-bear community that literally live their lives on the lunatic fringe.”
~David Rosenberg, chief economist at Gluskin Sheff
What will I buy? Probably a global index fund, but I have a few specialized ideas. Russia interests me as a scratch-and-dent opportunity. I recently began buying token quantities of closed-end Russian mutual funds (RBL, RSX, and TRF)—0.2% of my total assets—simply to put them on my radar. TRF will be liquidated as of December 18, 2015, which has a bottom feel to it. Commodity funds were locking their doors on me 15 years ago. Iran and parts of Persia look interesting, although it is legally difficult to invest there right now. How about Africa? Not a chance. Hernando de Soto (The Mystery of Capital) convinced me that Africa’s problems are deeply structural.
“I think there is more of a risk of a depression than a recession.”
~Ray Dalio, Bridgewater Associates
“I think we could have five or 10 years without a recession.”
~Paul McCulley, May 2015 Strategic Investment Conference
Thousands of economists see low unemployment, but 100 million people (41% of working-age adults) not in the workforce disagree. On January I got into a minor Twitter disagreement—a Twiff?—with a confident young economist, which led to a gentlemen’s bet:
George Pearkes: We will not see a recession starting before 2017, in my opinion. I could well be wrong of course.
Me: OK. I'll take now.
My cockiness stems from a 1991 survey described in John Mauldin’s Code Red in which a poll of 53 economists put the probability of a recession that year at 3%, ignoring the 15% probability for recession in any year. The final arbiter of recessions—the NBER—eventually showed that the poll had been taken five months into a recession. Economists use the tools of science, but they are still tools. (How ambiguous.) The bet got edgier in April when Barry Ritholtz asked me which indicator I was using. I suggested it was many indicators, which promptly ended the discussion. I wasn’t alone, however. Many pundits not endorsed by the mainstream were reporting negative first derivatives. Even Bank of America seemed to lack optimism—but then predicted no recession for 10 years.19 That’s just stupid.
“This drop in oil prices, this drop in industrial metal prices, this is not good. It’s a canary in the coal mine that something is not right in the global economy.”
~Stephen Schork, The Schork Report
As I reminded Barry, a number of indicators were heading south. Wholesale inventories began surging at the end of 2014 (Figure 2), reaching an all-time high by the second quarter.20 Energy and energy sector jobs were getting annihilated. Commodities (not just energy) were getting crushed. Commodity routs often precede recessions. The Baltic Dry Index had turned down (Figure 3), indicating a global slowdown. The Chicago PMI crashed to 45.8 verses expectations of 58.7, reaching the lowest level since June 2009.21 U.S. labor participation was still dropping, undermining all claims of strong employment. Exports and U.S. factory orders were headed south (Figures 4 and 5.) Vehicle sales dropped in January. Q1 GDP “missed economists GDP targets” by fivefold to the downside.22 (Note to economists: your predictions miss the facts, not vice versa.) Credit was noticeably tightening by May. Consumer spending dropped as steeply in late spring as in the 2008 financial crisis.23 By April, Goldman was claiming four months of contraction.24 A survey of Wall Street forecasters blamed the slowdown in the first quarter on winter weather and the West Coast port slowdown.25 Of course, we have winter weather every winter, and the port slowdown might be a consequence rather than a cause. In a bit of journalistic genius, one headline noted “plant closings could make jobless claims jumpy.” The often-overlooked story is that Caterpillar sales had been quietly contracting for almost three years.26 This undoubtedly reflects emerging market problems, but it’s also our problem.
Figure 2. Wholesale inventories (shading are recessions)
Figure 3. Global economic activity
Figure 4. U.S. exports (shading are recessions)
Figure 5. U.S. factory orders (shading are recessions)
“This goes down as the sixth longest expansion since the Civil War.”
~David Rosenberg, chief economist at Gluskin Sheff
“Business cycles don’t typically die of old age. They are usually killed off by higher interest rates, a financial crisis, or some other shock…”
~Greg Ip, Wall Street Journal
That is some crisply worded gibberish. Yes, Greg, and people die of coronary heart disease, strokes, and organ failure rather than old age. Maybe we missed a recession by the technical definition and Pearkes was right, but there is a suspicious odor emanating from the basement. The yield curve can’t fully invert with rates at zero, but it sure flattened (Figure 6).27 The economy seems sick; capital expenditures—capitalism’s seed corn—have been largely sacrificed to buy back shares (vide infra). Pensions are being left underfunded to maximize profits per share. How underfunded will they be at the next downturn? Overstock.com’s CEO Jonathan Johnson has gone TEOTWAWKI and stockpiled $10 million in small-denomination gold coins to meet payroll and three months of food for his employees.28 I’m not that bearish.
Figure 6. Two years of yield curve flattening
“These markets are all rigged, and I don’t say that critically. I just say that factually.”
~Ed Yardeni, president of Yardeni Research, Inc.
“Whether it’s QE in the West or China’s recent regulatory intervention in the aftermath of the bursting of its equity bubble, market manipulation has become global in scope.”
~Stephen Roach, Yale University and former executive director of Morgan Stanley
The markets began breaking way back when Alan Greenspan went narcissistic and accepted the dual mandate to (1) preclude equity price discovery, and (2) subvert the business cycle. Let’s look at the bomb we’ve strapped on by first considering valuation. Goldman put price–earnings (P/E) ratios in the 98th percentile. Not a problem. The Fed model asserts that equity prices should correlate inversely with interest rates, which are at ridiculous multi-century lows. As the Fed jams rates to zero in the limit, the composite P/E ratios should go to infinity, right? (Hey: I didn't invent the model.) Now let’s drop some acid and ponder Fed chair Janet Yellen’s recent warning:
“Potentially anything—including negative interest rates—would be on the table. But we would have to study carefully how they would work here in the U.S.”
What does the Fed model predict now? Cliff Asness nicely explains why we should fight the Fed model.29 Common sense says fight the Fed model. David Einhorn says negative interest rates are like taking the square root of minus one.
“Nobody ever talks about the incentives to lie about the earnings.”
~Benjamin Friedman, Harvard University
Apparently Harvard doesn’t have Internet yet. In any event, guys with market experience have alternative back-tested metrics for market valuations with historical comps. Warren Buffett’s favorite, the market cap-to-GDP ratio (Figure 7), began the year at all-time highs. The understated Mr. Buffett noted, “if we get back to normal interest rates, stocks at these prices will look high.” A regression to the mean would require a >40% equity haircut. Regression through the mean? Priceless. Lest we forget, folks, mathematically you must spend half your statistically weighted time on each side of the mean.
Figure 7. Buffett’s valuation model 1950-2015
The always popular CAPE--Robert Shiller's cyclically adjusted P/E ratio smooths earnings over 10 years and began the year looking for a 40% correction to reach the historical mean. These nosebleed levels were surpassed only by the blackout levels in the tech bubbles of 1929 and 2000. Societe Generale has a proprietary guesstimate that predicts a “30% correction if all goes well and 60% if China hits a snag.” What are the odds of that? Mark Spitznagel likes Tobin’s Q (Figure 8), which is essentially the price-to-book ratio, and he assured me “it is the cleanest metric.” It’s not at a record level but is massively above the norm. Tobin’s Q reached fair value in 2009 and bounced like a golf ball off a cart path. After the ’09 crisis, Jeremy Grantham lamented the remarkably brief stay at fair value with deeply discounted bargains rare and fleeting at best. Even more interesting, check out Tobin’s Q in 1938—the year the Fed sinned by tightening monetary policy. Supposedly this little faux pas—French for “f*** up” (asterisk speak for “fuck up”)—elicited a belated apology from Ben Bernanke to Milton Friedman. I didn’t realize Ben did it or that Milton tried to stop him. In any event, Tobin’s Q had soared: the Fed had blown yet another frothy equity splooge with raging pinkeye. Maybe it had to act. Maybe, just maybe, the modern Fed is deathly afraid of being forced to act again.
Figure 8. Tobin’s Q 1900-2015
These plot-rich approaches to looking at valuations with those fancy schmancy, small-fonted x- and y-axes and hard data may be too confusing. Let’s just get the sage advice of grizzled gurus:
“On balance there’s no margin of safety.”
~Mario “The Bull” Gabelli, founder of Gamco Investors Inc.
“We're in the middle of a disastrous market mania . . . historically, these kinds of gaps get closed in one of three ways: by revolution, higher taxes, or wars. None are on my bucket list.”
~Paul Tudor Jones, Tudor Investment Management
“The good times are over.”
~Bill Gross, Janus Funds
“The median New York Stock Exchange stock is currently at a postwar record high P/E multiple, a record high relative to cash flow, and near a record high relative to book value!”
~Jim Paulsen, Wells Capital’s perennial bull
“[G]lobal financial markets are more distorted than ever before.”
~Felix Zulauf, Zulauf Asset Management and Barrons Round Table
“Sadly, I don’t think anybody’s capable of telling you precisely how and when the whole thing will come unstuck. Nevertheless, you know that at some point, it has to.”
~William White, Bank of International Settlements
“Markets will discover that they have been pushing asset prices to an excessively high level, and there will be a major downward shock to asset prices.”
~Mervyn King, former governor of the Bank of England
Here we are: ridiculous valuations for the third time in two decades, and you’ve been warned. You’ve been warned by Jim friggin’ Paulsen. The requisite leverage was provided by central banks worldwide. What makes this all so absurd is that there isn’t even a good narrative bias. The 1995–2000 mania was based on a very cool, world-changing tech revolution not unlike the tech revolution of the 1920s. Being duped by the narrative bias was forgivable. The current global equity run, by contrast, is based on the assumption that a bunch of second-rate economists (but first-rate bureaucrats) running monetary policy using third-rate Gaussian models have our backs covered. And get this: they are going to help us with controlled demolition of our currencies because . . . wait for it . . . inflation is good, and they know exactly how much is optimal because they are omnipotent.
You’ve all seen some variant of the plot of margin debt versus equity prices in Figure 9, unless of course you’ve been hanging out in the basement of the Eccles Building with Governor Boo Radley. It is collective debt accrued within the entire system, however, that fuels bubbles (Figure 10). In this grand game of Texas Hold‘em, the Big Money is all-in, waiting to distribute the equities to retail investors. But this ain’t gonna play out like a typical blow-off top: the retail investor is broke and broken. As the 75-month-old expansion stretches 30 months past the historical mean, the Big Money is the dumb money. I actually heard a bull say, “I am smart enough to get out early.” Ding. Ding. Ding. All those smart guys will be exiting through a keyhole if history is a guide. In the meantime, keep listening to the sell-side analysts: they have called every equity rally since the beginning of markets.
“At particular times a great many stupid people have a great deal of stupid money.”
~Walter Bagehot, clueless geezer
Figure 9. Margin debt and S&P 500 price 1990-2015
Figure 10. Debt showing the near fatal blip
Doom porn aside, the markets seemed rather typical. Ken Griffin of Citadel brought in $1.3 billion owing to high-frequency earnings.30 The Swiss National Bank (SNB) picked up the slack in equity markets by increasing its exposure to U.S. equities by 40%.31 The SNB is ahead of the crowd by buying the dip before it appears. Very sneaky. With timing like a Swiss watch, they even bought pre-dip Valeant, the pharma that largely went bust on corporate shenanigans.32 A fake leveraged buyout (LBO) offer triggered a 22% short squeeze on Avon Products and was good for a few laughs.33 The dollar flash crashed 4%. Gilead did a 10% flash crash for a few minutes.34 Commodity trader Glencore was said to be doing a Lehman, but that was to be expected in a commodity rout.35
Meanwhile, bargains were to be had for those with a discerning eye. In San Francisco, shacks that, if they weren’t so run down, would normally be sold in the parking lot of a Home Depot are selling for $1.2 million (Figure 11).36 Closets under stairwells in London are renting for $700 per month.37 The pinnacle of value investing, however, appeared in the art market (Figure 11) when Geriatric Patriot was scooped up for a mere $1.5 million38 and Big Fat German Chick on Sofa was wrestled down by an eager investor for $58 million ($100K per pound).39 You want classy art, you gotta pay up. And if those gems are unappealing, you could have dipped your toe into an IPO of a company searching for Sasquatch.39a
Figure 11. $1.2 million (left), $1.5 million (center), and $58 million (right).
The good times seemed to be long in the tooth as fears of a Fed rate hike began to exact their toll. Stresses in the global economy (see The Economy and the Next Recession) finally registered on radars; equity markets began to shudder. The economic and asset price cycles had been diverging for some time (Figure 12). Companies like Intel and Coke started assuming lower tax rates (and buying back shares) to juice their per-share earnings.40 The markets were narrowing: Amazon, Google, Apple, Facebook, Gilead, and Disney accounted for more than 100% of the gains in the S&P.41 Deterioration in leverage and credit conditions by midsummer foreshadowed trouble. We started to see oddities like Apple flash crashes that could only be stemmed by phone calls from CEO Tim Cook to market maven Jim Cramer.42
Figure 12. Earnings driving equity prices?
Something was fundamentally wrong, however, and markets began seizing up. Sites like Charles Schwab went dark.43 On July 8, 2015, the NYSE froze three times for four hours,44 Zerohedge and the Wall Street Journal went dark,45 and United Airlines grounded its fleet.46 (United grounded its fleet three times.47) Seems like cyber problems to me. I suspected the Russians when nobody blamed them. By August, the markets were fishtailing wildly. Despite little net change in direction, triple-digit intra-day swings became the norm. Zerohedge estimated that in a single day the triple-digit upward and downward moves of the Dow spanned 4,500 points (Figure 13).48 The concern was not how far the market moved but how much it was moving to go nowhere.
Figure 13. Single-day swings in the Dow
“It ain’t the meat, it’s the motion.”
Southside Johnny & the Asbury Jukes
“Stock buybacks and LBOs are the bastard offspring of the IRS and Federal Reserve.”
~David Stockman, Director of Management and Budget under Reagan
Corporate debt is a hot topic this year. Before the 2008–09 calamity, U.S. nonfinancial corporate debt teetered at $2.6 trillion dollars. It is now $5.8 trillion (Figure 14).49 The reported $2 trillion of corporate “cash on the balance sheet” constitutes only 30–35% of the corporate debt. So much for that meme. The high-yield debt placed in peril by the collapse of commodities is putting serious pressure on the high-yield (junk) bond indices (Figure 15). GM and Chrysler are way out on the subprime yield curve50; a recession would be poorly timed, which is precisely why it will arrive soon. Auto loans are pushed out 67 months.49 Liquidity in the market is faltering—a sell-off could get ugly.
Figure 14. Share buybacks and corporate debt 1990-2015
Figure 15. High-yield (junk) bond index since April
So what’s all this debt being used to fund? Share buybacks, of course. More is spent on share buybacks than on capital expenditures (Capex).51 Companies are making corn dogs from their seed corn. The record buying spree is twice that of the early months of 2014.52 Cisco Systems, toting a market cap of $150 billion, will have spent $90 billion on stock buybacks by the end of 2015.53 GE announced a bold 3-year, $50 billion share buyback program to “offset lower earnings” by GE Capital.54 How buybacks offset bad earnings is beyond my imagination. GE Capital subsequently wrote off over $16 billion of those “lower earnings.”55 And it’s gone. GE Capital is now for sale, presumably to “unlock shareholder value.” Wall Street loves obfuscating euphemisms.
Citi analysts noted that “if leverage is going up today because it’s funding tomorrow’s growth that might not be a bad thing. Unfortunately, that’s not what’s going on.” Companies reaching for returns on their cash have found another overpriced investment on which to squander their shareholders’ value—other companies’ bonds.56 The sellers of these corporate bonds are reputed to be using the proceeds to . . . wait for it . . . buy back shares of their companies! This is financial engineering that would make Escher proud.
In 2007, S&P 500 firms allocated more than one-third of their cash to buybacks just before the S&P 500 plunged by 56%.57 Dumb money buys the tops. The new-era corporate dip tip buyers fund their purchases in a variety of ways. Hewlett-Packard announced almost 100,000 layoffs to foot the bill (whatever “foot the bill” means). The S&P has collectively let pension funds slip to approximately 80% funded.58 If only it was that simple. The S&P is “returning” 104% of earnings as dividends and share buybacks.59 To achieve this relativistic miracle, companies are using credit—lots of credit. GM announced a $5 billion share buyback to keep an activist investor away from the board,60 and, ignoring the fact that the company has $45 billion in debt, boldly promised that all cash over $20 billion would be used to reward shareholders.51 Qualcomm borrowed $10 billion to “return some of its $29.5 billion cash stockpile to shareholders.”62 What does that even mean? As you can see, the financial engineers should work on their timing (Figure 16). Looks like the dumb money to me.
Figure 16. Share buybacks
It was Peter Lynch who spawned this zombie apocalypse. (BTW-Tie the dearly departed’s shoelaces together.) Decades ago he declared that companies buying back shares know their shares are undervalued. When insiders are buying, you should be buying! Well that’s a quaint notion that metastasized into financial engineering, allowing top execs to jack up their stock options by driving up the share prices. How about dividends? Come again? They decrease the value of stock options, so they are not so popular among options-entitled executives.
There are many layers to this magical onion. If Eugene Fama was correct, an efficient market would reduce the P/E ratios to account for the rotting imbalance sheet; leveraged share buybacks should be a zero-sum game (like stock splits). With almost a third of the “buying pressure” in the S&P coming from share buybacks, however, markets are not very efficient. Let’s take this notion to the limit. Imagine you borrow enough to buy up almost all the shares. The last share represents ownership in a company whose assets are entirely offset by debt. The P/E ratio of that share will head to zero in the limit. So who owns the company? The creditors! Yes indeedy, leveraged share buybacks constitute a sale of the company to creditors. It’s an LBO. Long before the LBO is complete, however, corporate debts that soared with century-low interest rates will lead to an 80-car pileup. Shale companies are being forced to re-issue shares—the reverse of a share buyback—at fire sale prices to cover their debt payments. A bond crisis will force an analogous deleveraging across the broader equity markets. The flawed TINA—There Is No Alternative—equity model will morph into TINWA—There Is No Worse Alternative. But until then, you just keep buying shares because insiders are buying, and they know what’s best.
Gold and Silver
“Growing numbers of investing experts have been declaring that gold is a bubble: an insanely overvalued asset whose price is bound to burst. There is no basis for that opinion . . . [gold miners] seem cheap—based not on subjective forecasts of continuing fiscal apocalypse, but on objective measures of stock-market valuation.”
~Jason Zweig, Wall Street Journal, 2011
“Let’s Be Honest About Gold: It’s a Pet Rock”
~Jason Zweig, Wall Street Journal Moneybeat, 2015
Jason Zweig is no idiot, but he may be a world-class contrary indicator. The goofiest gold bug award goes to a guy who tried to gold-plate his testicles—pelotas de oro. He was unsuccessful if surviving was his goal.63
“If you don't own gold . . . there is no sensible reason other than you don’t know history or you don’t know the economics of it.”
~Ray Dalio, Bridgewater Associates
Ray Dalio runs the biggest hedge fund in the world. I sense he is a reluctant gold enthusiast, as am I. What are us VAXers hedging? Calamities such as inflation and other forms of mayhem. Of course, the detractors note that any idiot can see there is no inflation, and gold doesn’t hedge it; equities do. I would disagree in part. By example, shovels and bulldozers both move dirt, but it would be a mistake to confuse the two. Similarly, both equities and gold hedge inflation, but it would be a mistake to confuse them as well. Gold hedges calamity, which is considered very rare unless, of course, you live in most countries around the world now or are a student of history. Gold is a bet against inept bureaucrats who happen to have the monetary nuclear launch codes and seem to be fumbling furiously at their keyboards. It is a bet that excessive debt and faltering economies will result in both foreseeable and unforeseeable problems. It is a bet that the War on Cash (vide infra) will soon become a hot war against the peasants (us) via absconding with civil liberties and wealth. Gold is a bet that the current system is at considerable risk. Risk is not about what happens but about what could happen and what the consequences could be. Russian roulette is statistically a 5:1 winner . . . until you lose.
“Buying gold is just buying a put against the idiocy of the political cycle. It’s that simple.”
~Kyle Bass, Hayman Capital Management
The coyote-like plummet in gold starting in 2011 has slowed to trickle, which has prompted me to spend approximately 20% of my gross salary on physical gold this year (my first purchases since my 1999–2005 binge.) Of course, the gold miners are priced like pillows at a thrift store, and investors are plastered across milk cartons. Maybe this is a bottom, but the inability of management to make money is epic. Harmony Gold is trading at 16% book value, but such numbers are often the costs of assets purchased in haste that have not yet been written down. Rumors of corporate insider buying in the industry in a profoundly beaten-down sector is arguably bullish, but I am leaving the gold equity “buying opportunity of a lifetime” (Figure 17) to others; my shrunken stash of equities is it for now. Maybe I just called the bottom.
Figure 17. Gold-to–gold equities ratio, 1996–2015.
Juicy stories always keep the bulls and bears shouting at each other. There appears to be a scrum by sovereign states to get their gold away from one another. Venezuela started the whole repatriation mania in 2011 by retrieving their sovereign gold,64 only to be squeezed into a forced liquidation by hyperinflation,65 which is the ultimate insult. Germany is said to have gotten from the U.S. 120 tons of the 700 tons demanded in 2014.66 (The German gold repatriation social movement actually started with one crazy German.67) It appears that the U.S. was too busy providing the Dutch with 122 tons covertly.68 (Shhh! It’s an Internet secret.) China finally announced its newest gold tallies at only 1,600 tons.69 I don’t believe the numbers, but that tonnage would be bullish if true because it means the country has a long way to go to achieve the estimated >8,000 tons needed to make it a Forex superpower.
India is a little schizo, putting barriers (tariffs) to block gold importation and then removing them.70 I asked Shashi Tharoor, former deputy director of the UN, about it, and he gave me the party line: they want investment not gold hoarding. India attempted to use gold as collateral for loans; it’s either a tacit gold standard or a fractional reserve Ponzi scheme.71 In a Monty Python “bring out your gold” solicitation, India rounded up a grand total of one kilogram in the first month.72 That’s the take of a good Indian wedding.
Austria repatriated 110 tons of their gold from the Bank of England.73 Zerohedge accused Spain of “repatriating” gold from Catalonia right before a Catalonian secession vote in what seemed like an outlier even for Zerohedge.74 The story was validated when officials denied it.75 Rick Perry took Kyle Bass’s advice and took possession of a billion dollars worth of gold for the Great State of Texas.76 Texas also put in an anti-seizure law just in case the paranoid wingnuts are right.77 Retail investors tried unsuccessfully to repatriate their gold from gold supplier Tulving to no avail; court proceedings are scheduled.78 Let us not forget that allocated ingots—ingots owned by investors—stored by MF Global clients got repatriated by JPM.79 Counterparty risk includes both insolvency and criminality.
“The price of gold is largely determined by what people who do not have trust in [the] fiat money system want to use for an escape out of any currency.”
~Fed minutes, 1993
Where is the gold coming from? Evidence suggests a combination of sovereigns, global mining operations, and possibly GLD (reputedly losing 48% of the stash since 2012).80 I have doubts GLD actually has gold and, even if it does, I have argued that liquidation of shares for physical gold by the global megabank cartel (bullion banks) is bullish not bearish.7 We must remind ourselves that somebody is selling as well, but that argument falters when the seller is the Perth Mint and its head says business is unprecedented.81 Reported gold shortages at the London exchanges82 coincided with shrinking supplies at the Comex (Figure 18).83 The Comex got down to several hundred kilograms—27 bricks—of available gold,84 which was followed by a rumored midnight JPM bailout.85 The stories about the Comex shortages are provocative, but they could be natural ebbs and flows. Similarly, a tenfold increase in JPM’s gold derivatives book (and Citi’s silver derivatives book) is very provocative and very difficult to grasp.86
Figure 18. COMEX gold inventories, 2000–2015.
“Therefore, at any price, at any cost, the central banks had to quell the gold price, manage it.”
~Sir Eddie George, Bank of England, September 1999
If one subscribes to a model that the gold market is rigged—actually, all markets are rigged—one can easily find confirmation (bias). Sell-offs often begin with derogatory press releases, and they ramped up this summer. Gold was suggested to be a “pet rock” and gold enthusiasts to have “rocks in their heads.”87 There were ludicrous claims that Indian dealers were offering discounts per ounce to offload their inventory88 and because it was raining a lot.89 (No kidding.) Sixteen analysts—16 of them—said gold would drop below $1,000,90 Deutsche Bank said it would reach “fair value” at $750 (whatever fair value means),91 and “a study” suggested $350 was dead ahead.92 On queue, Jeff Christiansen denounced shortage theories.93 The gold story was said to be based on conspiracy theories that were “patently untrue.” There is no hyperinflation, so gold bulls are brain-dead idiots. Yes, we are.
“The sudden debunking of gold in the financial press is circumstantial evidence that a full-scale attack on gold’s function as a systemic warning signal is under way.”
We’ve seen this plot line before. After the bad press, which provides cover to convince the regulators all is fair and square, the smackdowns are close behind. On July 7, somebody purged $1 billion of gold and silver in one futuristic wad.94 Some thought it was tied to the Citi and JPM precious metal derivatives positions. During the evening of July 19, while the western world slept, $2.7 billion of paper gold selling struck in one second.95 That was followed by another hard sell, effectively crushing the bid stack. After market seizures and dust settling, gold was $50 cheaper. A $26 flash crash of gold derived from “a huge dump of bullion, equivalent to one-fifth of a whole day’s trade in a normal session” in China occurred within two minutes.96 ANZ Bank analyst Victor Thianpiriya noted “the nature, size, and timing of the heavy selling” suggests someone “was taking advantage of low liquidity.”96 Five tons sold on the Shanghai Gold Exchange (SGE) in two minutes; the market only averages 25 tons a day. Meanwhile, on the other side of the globe, the Comex witnessed 7,600 contracts traded in the very same two-minute window.96 What are the odds, eh? Michael Krieger calls such behavior brazen market manipulation and “peak condescension.”97 The ultimate smash came in the wee hours of the morning on the Friday after Thanksgiving—Black Friday—when everything goes on a deep discount. A couple of billion dollars of gold derivatives drove the price of gold down in four distinct plunges (Figure 19) during peak market illiquidity.98 That’s classic bear raid stuff.
Figure 19. Black Friday massacre on gold.
Gold market manipulation was hung on a couple of patsies—Nassim Salim and Heet Khara—by the CME using Nanex data.99 Patsies are often foreigners ’cause xenophobia sells (see Patsies and Scapegoats). Mirus Trading was soon implicated in gold market rigging and fined a 1.0 Hillary ($200,000).100 The Department of Justice opened a case, which will sit dormant.
What is the bullish case for gold? For starters, it is claimed that the futures market—the so-called paper gold market—is currently leveraged over 200:1.101 Seems like a single bold hedge fund could leave 99.5% of customers holding worthless claims. Cash settlements are legal but may not be satisfying when the fur flies. I do not, however, buy into the notion that premiums and shortages of gold or silver coins constitute anything more than a coin shortage. Some claim they are seeing ingot shortages. Wake me when that is confirmed.
Gold bears often argue that rising rates will crush gold, an assertion that flies in the face of history. The most pronounced upward moves occurred while the Fed was tightening (1971–74, 1976–80, and 2001–07).102 Smart guys like Einhorn, Bass, Druckenmiller, and Grant have placed big bets that the fatal conceit—the belief that a complex system can be engineered rather than left to evolve—is circumnavigating the globe.
“Signs are emerging that the long Nikkei/short gold trade, which has done so much damage to gold’s price, is becoming problematic.”
~Paul Mylchreest, ADM Investor Services International
The gold community has serious confirmation bias—the tendency to disproportionately weight the data that supports a conviction. Confirmation bias, however, plays dichotomous roles: (1) it blinds you from the truth by confirming your hypothesis at any cost; and (2) it provides support while you white-knuckle an unpopular, but quite possibly brilliant, investment. When I entered gold in ’99 I would read anything that told me I wasn’t alone. Time will tell which category gold buggery falls into this time around. Gold enthusiasts will continue to draw inexplicable scorn for simply attempting to mitigate the risk of state-sponsored insanity. A little decorum please. We’re in this mess together.
“We keep thinking that lower energy prices are somehow good for the economy. That can’t be, because energy prices or commodity prices in general don’t drive economic growth. Economic growth drives commodity prices.”
“If oil prices stay below $90 per barrel for any length of time, we will witness massive fiscal squeezes and regime changes in one or more of the following countries: Iran, Bahrain, Ecuador, Venezuela, Algeria, Nigeria, Iraq, or Libya. It will be a movie we have seen before.”
~Steve Hanke, Johns Hopkins University and the Cato Institute, 2014
“I hope it does not go to $40, because then something is very, very wrong with the world, not just the economy. The geopolitical consequences could be—to put it bluntly—terrifying.”
~Jeff Gundlach, Doubleline Capital and New Bond King
Figure 20. Price of oil
Ouch. I asked Steve about oil under $40 and he noted that “the commodity price rout has created an unsustainable blood bath that won't last forever.Markets will see to that.” Also, Jeff: could you possibly rephrase that? Maybe a little sugarcoating—possibly some euphemisms? The energy sector began to collapse last year when the Saudis overtly jawboned the price of oil lower (Figure 20).103 Seemed obvious (to me) that they did it to hurt Putin while we agreed to deal with the emerging ISIS threat, which supposedly we now support . . . but I digress. The jabronis who hatched this plan—oddly referred to as the intelligence community—were not tasked with assessing the long-term consequences to the commodity sector at large, the U.S. energy industry, the global economy, or world peace. You guys grazed Putin—a flesh wound really—and at what cost?
Although I had expressed concerns that the energy sector was vulnerable to the credit markets,7 I was wildly bullish. (I still am but must admit to having to shift my timescales out a bit . . . OK, a lot.) I also did not grasp the role of the energy sector on the credit markets. I thought nobody did, but that’s not true. Todd Harrison discussed the risk of dropping oil prices in 2006.104 Probably others did too, and I just wasn’t listening. Everybody gets it now.
So what are these consequences? There were 100K oil industry layoffs worldwide by February and an estimated 250,000 by November.105 Alaska gets 90% of its revenue from oil taxes. Alaskans can see bankruptcy from their front porches. About two years ago, friends at University of Montana and Montana State were complaining that Montana legislators were refusing to spend the profits. The legislators were showing a little higher-order brain function after all, eh? The oil frackers hit the wall especially hard given that high prices are needed to break even. We owe the Fed for keeping the losers drilling unprofitably, leading to this mess. You can see the influence of the collapse on the XLE (Figure 21). I don’t think the energy equities have really corrected yet, however, presumably owing to the use of hedges rather than outright selling. Coal miners such as Alpha Natural Resources and Patriot Coal are going belly-up as well.
Figure 21. XLE, January 1 to December 4, 2015.
The world seems to have underestimated how structurally important collapsing crude prices are to global finance. High-yield energy debt (junk bonds) lost a whopping 16.1% between July and September alone.107 The yield reachers are feeling some pain. The most severe consequences are that oil-producing economies in developing countries are both losing their income streams and getting crushed, while the spiking dollar is obliterating dollar-denominated debt. There is a huge feedback loop: shortages of petrodollars are driving the dollar even higher. Kazakhstan let its currency drop 25% in one night.108 Petrobras and Brazil’s “century bonds” are going to hell fast.109 Whocouldanode? The Carlyle Group’s energy holdings in a flagship fund collapsed from $2 billion to $50 million.110 I imagine leverage was at play. Norway’s gargantuan $830 billion sovereign wealth fund is in forced liquidation.111 Commodity trading firm Glencore scrambled to convince markets that it’s liquid, which confirmed it was not. Glencore appears to have $100 billion of debt and is said to be the next Lehman.112 (Deutsche Bank detractors think it is the next Lehman, so the race to the bottom is on.) Some are calling this commodity rout “reverse QE” (reverse quantitative easing) or “quantitative tightening” because it is fighting central bank efforts to trigger the desired inflation. The quest for inflation by central banks is morally vile.
As they say, however, the secret to low prices is low prices. Rigs are being taken offline as expensive energy sources become a liability. Oil trading guru Andrew John thinks shale oil output will moderate this year as production peaks in 2016.113 So let’s wrap our brains around this mess: the U.S.’s goal to attain energy independence is going to be crushed by emerging market debt crises? That’s a bit twisted, wouldn’t ya say?
Some see a silver lining in the demise of the frackers. California frackers are consuming more than their share of fresh water during an epic drought. Water rationing excluded the frackers. Claims that fracking causes earthquakes don’t make sense to me at all—they would relieve extant stresses. During a discussion of oil fracking, Einhorn excluded natural gas fracking from his shitlist, noting that “natural gas frackers . . . are globally competitive low-cost energy producers with attractive economics.” Obsess over his recent (negative) returns at your own risk. The energy equities are giving me restless leg syndrome, but I am waiting for the next full-blown recession-induced sell-off.
“Central banks have sought to address ‘under-consumption’ . . . how many people do you know who voluntarily under-consume?”
~Paul Mylchreest, ADM Investor Services International
“The excess liquidity has manifested itself in surging levels of subprime auto loans, student debt, corporate share repurchases, rising levels of margin debt, and record levels of mergers and acquisitions.”
~Lance Roberts, Chief Strategist and Editor, Clarity Financial
“One-third of Americans have no financial plan.”
~Eddy Elfenbein, author of Crossing Wall Street blog
And the other two-thirds are planning to fund their retirements through state lottos, crowdsourcing, and “working till I drop.” On this final point, an estimated 80% of all retirements are out of the control of the retiree, coming in the form of health problems and layoffs.114 I have railed on personal debt and profoundly deficient retirement savings. The problem has been building for decades and will play out for decades. When the top-heavy markets correct, a serious update on the situation may be in order. For now, let’s just peek at a couple of 2015-specific stories.
“We also know you shouldn’t have taken out that large second mortgage during the housing boom to fix up your kitchen with granite countertops. You’ve been working very hard to pay off this debt and we admire your fortitude. But these shocks seem like a long time ago to us in a newsroom. Is that still what’s holding you back?”
~Jon Hilsenrath, Wall Street Journal, gettin' down and talkin' trash
Hilsenrath wrote an open letter to consumers about their unwillingness to spend.115 It was pure tongue in cheek and seriously tone deaf. Many others could have pulled it off, but Jon is “the Fed's bitch”—its mouthpiece—and he got the blood eagle sans Valhalla. The ruction began. Comments totaled in the thousands, all negative. Bloggers had a field day. Hilsenrath tried to recover to no avail.116
Down to business. It is said that if you have $10 in your pocket and no debt, you are better off than 25% of adult Americans.117 Thirty million Americans tapped their retirement accounts prematurely this year.118 Why? Because 40% of all American households spend more money than they make each month. Fifty-one percent of American workers made less than $30,000 last year. That means that the middle class—more appropriately called the median class—is making $15 per hour. How do you have a financial plan making $15 per hour with a family? Auto loans are soaring, and they are subprime ugly. Ally Bank reports 20% delinquencies, and that bank certainly knows delinquencies, having done a few itself. Auto loans may be too small to be systemic to banks, but people losing their cars will experience systemic risk (Permageddon™). In short, consumers are broke, and they are going to stay broke. Any Gaussian-driven economist thinking the rational consumer is still resilient is clueless. Personal balance sheets have now corrected the real estate froth but have a very long way to go (Figure 22). That’s not one of those plots that is supposed to go lower left to upper right.
Figure 22. Sixty years of household debt
“High debt levels, whether in the public or private sector, have historically placed a drag on growth and raised the risk of financial crises that spark deep economic recessions.”
~The McKinsey Institute
“For all intents and purposes, we are out of money now.”
~Leslie Geissler Munger, Chicago comptroller
The muni debt problem is a combination of demographics and over-promising. This analysis is short because I have laid out the risk before, and the ice has not yet audibly cracked under our feet. But it will.
State-run pension funds are more than $1 trillion in the hole during strong markets.119 This is old news, but lifeguards in Orange County are “retiring at age 51 with over a $100K pensions plus health-care benefits.”120 That pays for a lot of sunscreen, Dude. CalPERS says that the state pension funds are underfunded by $80 billion assuming 7.5% returns going forward.120 Good luck getting those returns. The problem is not CalPERS but rather the promises made by various unions and then expected to be handled by CalPERS.
Illinois has a $33 billion state budget and pension funds that are underfunded by almost $100 billion (Figure 23).120
Figure 23. Illinoisan pension woes.
The Illinois Supreme Court ruled that scaling back government promises is unconstitutional.121 The protection was built into the state constitution. The problem is that there is no money. Put that in your constitution. I suspect, however, that the judge is not precluding a solution but rather telling them to pay up or go Chapter 9 bankruptcy. Seems logical to me. Judges elsewhere are starting to let pensions get pared back to ward off defaults. New Jersey, Pennsylvania, Illinois, and Arkansas have saved the least for the next rainy day.122 Chicago’s unfunded liabilities are 10 times its revenues.123 Thank God Rahm Emanuel is calling in favors from his friends to manage the money.124 States are turning to pension obligation bonds to cover pensions.125 That merely moves insolvency down the road. Kansas governor Sam Brownback proposes to withdraw pension contributions to an already-lagging state pension fund to pay for tax cuts.126 Tell us how that works out for ya. Illinois sent IOUs instead of checks to lottery winners.127 You didn’t think the odds of a payout could get even lower, did ya? In New Jersey, Camden is so broke and screwed up that its last supermarket closed.128 The USDA declared Camden a “food desert” (or can’t spell dessert).128 The city’s police force is being disbanded, which will solve that police brutality problem. There will necessarily be more Camdens in the country before this is resolved. The problem may not be “over” until the demographically overbearing baby boomers start dying off. Alas, that is the very last entry on the boomers’ bucket lists.
“Bonds have never been more expensive in human history, and yet their supply has never been higher.”
~Tim Price, PFP Group
“If you have the option to hold [bonds] to maturity, your risks are bounded and very small.”
~Brad DeLong, economist at University of California, Berkeley, ignoring inflation risks
“Anyone that complains of a bubble in government bonds is someone that should probably be investigated and perhaps prosecuted.”
~One of Brad DeLong’s Ph.D. groupies
Liz Ann Sonders noted, “I’m amazed at how often I find investors who don’t really even understand the basics of how yields and prices move in the opposite direction.” It’s not that hard, is it?
As rates plumb 700-year lows (Figure 24), bond prices are soaring to 700-year highs. Is there a maxim about buying high and selling low? Didn’t think so. I don’t want to be around when that trend finally reverses. According to Bloomberg, “Bond prices are now so high that yields on more than $4 trillion of the developed world’s sovereign debt have turned negative.” As the price goes to infinity, the rate goes to zero, right? I don’t really know how negative rates are achieved on a pre-existing bond—you probably can’t get there from here (to quote the recently departed Yogi)—but we will talk about it in the ZIRP and NIRP section below. Welcome to Mount Stupid.
Figure 24. 700 years of interest rates.
“We have a bond market bubble and when that decides to work its way off we are in trouble.”
~Alan Greenspan, Chair of the STFU Committee
I previously called the bond market the “bond caldera”—a bubble so large that you can see it only from space (or from Greenspan’s front porch). I believe that someday, we will all be hosed when the liquidity leaves the system. This is not a unique view, but many bond speculators believe that (1) central banks would never let rates rise uncontrollably; (2) they are smart enough to get out first; and (3) their counterparties will actually pay them when the time comes. Apparently, there’s a lot of omnipotence to spread around. Until the burst, I simply marvel at the metastability with awe.
Catastrophe bonds—securitized insurance products that pass the risk of catastrophic payouts onto unsuspecting suckers—will surely be deemed ironic before the Final Exit. This insight comes from former General David Petraeus in his new position as a bond expert at Kohlberg Kravis Roberts (KKR).129 (Bonds? I thought you said bombs!) Risk parity funds endorsed by Ray Dalio are premised on the idea that a 200–300% leveraged bond portfolio will bring the return and the risk of bonds to parity with equities.130 Be careful what you wish for, Ray. You may find that risk you are looking for and then some. Unwinding risk parity funds will add some serious fuel to the inferno. Bridgewater Associates will probably apply for bank status late some Sunday night. Bond Kings Bill Gross and Jeff Gundlach called the top of the German bond bund market (Figure 25).131,132 Gross called them “the short of a lifetime.” Actually, they probably didn’t call the top but rather caused it. Epilogue: the German bunds are rallying back already. Human folly knows no bounds.
Figure 25. German bund prices 11/14–5/15
“The risk is there could be a run on the bond funds, causing further downward price movement. . . . They’ve been searching for yield and throwing caution to the wind.”
~Jeff Gundlach, Doubleline Capital
Bond market liquidity is a topic of considerable concern of late. You would be forgiven (by me, at least) if you found this confusing. Contextually, liquidity can refer to the ability to exit an asset without seriously altering the price. In the bond market, it seems to refer to an availability of legally mandated collateral for the money markets. From the horses' mouths', Andy Huszar and Deron Green, had trouble buying $5–9 billion of qualifying bonds per day while running QE I (first quantitative easing). Fortunately, the Fed cared little about the quality; only quantity mattered. The Bank of Japan is said by an IMF paper to “need to reduce the pace of its bond purchases in a few years due to a shortage of sellers.”133 Ewald Nowotny of the European Central Bank Governing Council noted that “there are simply too few of these structured products out there.”133 According to Jim Reid of Deutsche Bank, “the combination of high money liquidity (ZIRP and QE) and low trading liquidity (regulation and bank capital constraints) creates air pockets.” He went on to say, “I can't help thinking that when the next downturn hits, the lack of liquidity in various markets is going to be chaotic. These increasingly regular liquidity issues we’re seeing might be a mild dress rehearsal.”134 I’m not sure which liquidity Jim is referring to in that statement. FINRA is worried about the liquidity of high-yield (junk) bond funds: “Investors might get locked out again.”135 This concern is certainly in reference to a buyer’s strike. FINRA also worries about “bond investors losing money when interest rates rise.” Yield reachers will also lose their shirts. Remember: rates up/prices down.
I think we’ve got big problems with sovereign debts reaching unsustainable levels. Debtors will default and creditors will get hosed. Central banks are struggling to guide this system back to safety like a shot-up World War II bomber. World debt is 40% higher than it was at its peak before The Crisis.136 Central banks are buying up (monetizing) 100% of newly issued debt in an effort to—how do they say it?—trigger inflation.137 It’s probably not going to play out fast (although it could). Collapsing energy prices are putting huge pressures on emerging markets relying on cash flows (petrodollars) to pay off dollar-denominated debt.138 Rumor has it that 2017 is the big year for emerging market debt rollovers. Put that on your calendars—your 2016 calendars. Noah built the ark before the rains.
“For the people who say there will be inflation, yes, when, please? Tell me: within what?"
~Mario Draghi, president of the European Central Bank
“We may be headed into a world where capital is abundant and deflationary pressures are substantial. Demand could be in short supply for some time.”
~Larry Summers on the Great Stagnation
“The next shoe to drop will be the realization that the U.S. recovery is stalling and outright deflation . . . is every bit as immediate as that in the Eurozone.”
~Albert Edwards, Societe Generale
“There’s a lack of faith in monetary policy—you’ve thrown the kitchen sink at it, you’ve cut rates to zero, you’re printing money—and still inflation is lower.”
~Lee Ferridge, State Street
“Believe me, our misery will increase. The scoundrel will get by. But the decent, solid businessman who doesn’t speculate will be utterly crushed; first the little fellow on the bottom, but in the end the big fellow on top too. But the scoundrel and the swindler will remain, top and bottom. The reason: because the state itself has become the biggest swindler and crook. A robbers’ state!”
~Adolf Hitler, cornerstone of Godwin’s Law
“Our kids can’t readily provide all goods and services; we outnumber them. I believe that unfunded liabilities, promises made that were not cashed in at the time, represent latent inflation pressures. The cashing in of these IOUs—large numbers of chits chasing limited goods and services—could trigger a virulent inflation. In this paygo system, we flourished while the boomers produced and were compensated with promises. Now we are about to hit the downslope.”
~Collum, 2013 “Year in Review”
I am a reformed inflationist. I had faith in the omnipotence of central bankers, and they seemed determined to destroy the currencies of the world while hoping We the People didn’t notice. Their omnipotence is in doubt, and their impotence is showing. First, let’s be clear that describing something so complex as the collective price levels of bazillions of commodities, healthcare, tuition, stocks, bonds, and labor in a binary language—inflation or deflation—is an absurdity of a higher order. It’s not that I think generalized price levels will drop—I don’t—but rather that we could face a deflationary liquidation of assets and debt (negative inflation to the euphemists.) That maximum-pain, Black Swan moment is gonna smart.
You can find evidence of both inflation and deflation depending on where you look. Both Europe and Japan reportedly slipped into deflation in October.139 There is an ongoing deflationary commodity rout. David Stockman notes that “iron ore is . . . the real measure of the violence of global deflation that is currently underway,” yet beef and veal are up 30% in two years.140 Rents have been soaring in the U.S.141 and are so high that in San Francisco, converted shipping containers are being leased for $1,000/month.142
I was asked recently about why I hold gold while facing deflationary risk. That’s easy: people of prominence and authority are still saying incredibly stupid things and making asinine decisions. Let’s look at a few:
“I do not hesitate to say that although the prices of many products of the farm have gone up . . . I am not satisfied. It is definitely a part of our policy to increase the rise and to extend it to those products that have as yet felt no benefit. If we cannot do this one way, we will do it another. But do it we will.”
~Mario Draghi, European Minister of Inflation and Debasement
“Inflation is hopefully giving little signs of moving up in the right direction.”
~Christine Lagarde, director, IMF
“When older cohorts have more influence on the redistributive policy, the economy has a relatively low steady-state level of capital and a relatively low steady-state rate of inflation.”
~James Bullard, president of the St. Louis Fed
"Even if we had some kind of shock that sent prices up for some reason, the Fed has the tools to stop inflation. That’s not very hard. . . . There is a whole generation of people who don’t remember inflation. They don’t know what it is, and so I think inflation is a non-existent threat."
~Alice Rivlin, former Fed governor, making my brain hurt
The award for the most moronic statement goes to . . . envelope please . . . Alice Rivlin! If we don’t know what inflation is, it can’t hurt us. Fabulous! As far back as the Neolithic era when division of labor first appeared, increased efficiency and productivity resulted in deflation naturally: goods improved and prices dropped as production methods evolved. In a highly inflationary world of fiat currency and central banking, however, you only get deflation when central bankers completely screw the pooch. They think central planning precludes deflation when it is the failures of central planning that cause a post-inflation, chaotic deflation. Every bust is preceded by excessive credit.
The authorities—the sharpest bulbs in the deck—fear deflation but are remarkably sanguine about inflation. Why? In the Fed’s version of Field of Dreams, voices say “print and it will come,” but got a big goose egg. Although housewives are hurting from rising prices, economists see a falling money velocity, and fret over assets that have been pumped and are now poised to dump.
“Deflation is clearly the boogeyman . . . and the only thing that will save the middle class.”
~Rick Santelli, CNBC
Let’s take a closer look at the dollar-centric money velocity (Figure 26). Isn’t it a truism that if you jam more money into a system than it can absorb, the velocity will plummet? Back in 2010 I called this a “monetary capacitor” waiting to discharge.3 Even Greenspan frets that the unseemly globs of money on the bank balance sheets are a latent inflation waiting to release (and he has nth stage something.)143 But so far the Fed's efforts to inflict inflationary carnage—debase your currency and your savings—have yet to work their magic: their grand monetary stimulation has been flaccid.
Figure 26. Money (dollar) velocity versus money stock, 1985–2015.
Where have we seen this precipitous drop in money velocity before? Oh. Right. Weimar Germany in the 1920s (Figure 27). In fact, the velocity plummeted twice before the infamous German hyperinflation kicked into gear, eventually hurtling the world into a second world war. If that happens again, we are gonna see some high-frequency quantitative tightening.
Figure 27. Weimar money velocity.
The authorities couldn’t give a hoot about Consumer Price Index inflation: they hide it. (I dealt with MIT’s Billion Prices Project last year;7 it has flaws with statistical weighting and transparency in my opinion.) The authorities also love asset inflation: they promote it. What they care about deeply is preventing asset deflation. There are, nonetheless, some big-brained guys worrying about inflation and its consequences:
“Asset inflation is roaring, but it is sectoral and skewed. Consumer inflation is understated, and thus growth is overstated. Employment data [are] misleading. This combination of factors means that ordinary citizens are not doing well, but the owners of high-end everything are doing just fine, with few concerns for the middle-class people who know things are not ‘all right,’ but cannot put their finger on why.”
~Paul Singer, Elliott Management Corporation
“The idea that when people see prices falling they will stop buying those cheaper goods or cheaper food does not make much sense. And aiming for 2 percent inflation every year means that after a decade prices are more than 25 percent higher, and the price level doubles every generation. That is not price stability, yet they call it price stability. I just do not understand central banks wanting a little inflation.”
~Paul Volcker, former Fed chairman
“In spite of all the paper issues, commercial activity grew more and more spasmodic. Enterprise was chilled and business became more and more stagnant.”
~Andrew Dickson White on the French inflation
“Thus the menace of inflationism . . . is not merely a product of the war, of which peace begins the cure. It is a continuing phenomenon of which the end is not yet in sight.”
~John Maynard Keynes
“If rates go negative, the U.S. Treasury Department’s Bureau of Engraving and Printing will likely be called upon to print a lot more currency as individuals and small businesses substitute cash for at least some of their bank balances.”
~New York Fed, 2012
“We are now in the terminal stages of QE, during which the practical limitations of this fatuous and discredited policy are being revealed.”
~Tim Price, PFP Group
“It goes without saying that deeply negative interest rates would be accompanied by a massively expanded QE4 in the US. The last seven years of exploding central bank balance sheets will seem like Bundesbank monetary austerity compared to what is to come.”
~Albert Edwards on a bull session with Bob Janjuah
“When zero interest rates don’t do the trick, we begin to imagine that maybe negative interest rates and penalties on saving might coerce people to spend now. Look around the world, and that same basic policy set is the hallmark of economic failure on every continent.”
~John Hussman, founder and head of Hussman Funds
As the world struggles back from the 2008–09 crisis, the central banks remain at DEFCON 1. Maybe they are lying—the world is not recovering. Maybe they are pusillanimous. Central bankers suffer Hayek’s Fatal Conceit, deluding themselves into believing they are more qualified than the market to set the price of capital—to set interest rates. I find it a breathtaking conceit. We often hear about what rates are telling us about the economy when in fact sovereign bonds reflect the central bankers perception of the economy . . . well, actually, their perception of what is good for the economy . . . or maybe the banking system . . . whatever. Supply and demand meet at price. What’s true for widgets is true for capital. Central bankers have decided they don’t like current prices, the price discovery mechanism, or even free markets. The result is the proliferation of zero interest rate policy (ZIRP) and, most amazing, negative interest rate policy (NIRP). Why zero? It’s a policy . . . try to keep up.
“I am pretty horrified by the global quantitative floodgates that have been opened since the 2008 Great Recession. Once an emergency measure of dubious effect, it is now a never-ending stream of confetti money being thrown around the world to inflate asset prices. QE has now become the policy variable of first resort. Personally I think this will all end very badly.”
Given that yields correlate inversely with price (although my math breaks down with negative rates), this is the largest bond bubble in history, which necessarily makes it the biggest bubble of any kind in history. As the highly flawed theory goes, zero rates can become insufficient such that they must lay siege on savers with NIRP. Just to be clear, in the World According to NIRP, borrowers are paid to borrow and creditors pay to lend. Hmmm . . . must be a theoretical construct, n’est-ce pas? Not exactly.
“Ideas that would have been considered crazy just a decade ago are now seen as much more likely.”
~Mike Bird, Business Insider
Switzerland became the first 10-year bond to go negative; Switzerland profits from borrowing money (Figure 28).144 Sources close to the SNB suggest “a rate of minus 1.5 percent is being considered.”145 Sweden’s Riksbank started its monetary bestiality, keeping its repo rate at minus 25 basis points and announcing that more bond purchases would be in order if the markets didn’t kowtow to the desire for inflation.146 Who doesn’t crave a good dose of inflation? Then the German five-year note went negative. Thirty percent of European sovereign debt is now trading at negative interest rates—2 trillion Euros (Figure 29). Seventy percent of all German bonds and 50% of French bonds are returning wealth-consuming negative rates.147 The Great Danes similarly have jumped the negative interest rate shark. Even the Spaniards pay to loan money to their insolvent state.147 It eventually leaked into the corporate sector with Nestlé enjoying the right to be paid 50 basis points to borrow money.148
“There is an inherent risk of future losses if we buy at negative yields.”
~Ewald Nowotny, European Central Bank Governing Council
Figure 28. Swiss yield curve.
Figure 29. Growth in negative yielding debt
“It is easy to neuter cash taken out of the bank as a way to defeat negative interest rates simply by removing the guarantee that the Bank of Japan will take that cash back at face value.”
~Miles Kimball, economist at the University of Michigan
Operational equivalents of negative yields can be inflicted on retail banking clients through fees that exceed interest rates. The Australians are pondering a tax on savings. The incentives are often oddly perverse. While some are charging fees, others are shunning large deposits. Deutsche Bank no longer wants checking accounts; in the QE world, deposits are no longer the foundation of its capital.
“I’m quite happy to pay a trusted creditor (a.k.a. the government) a moderate fee in the form of a negative interest rate for storing part of my wealth.”
~Morgan Stanley analyst on negative rates
So what’s the problem? Some enthusiasts think that when money is cheap, sovereigns should borrow their collective asses off. Worked well for home buyers in 2000–09. Others have noted that positive yields are available by shorting the debt.147 Very weird. Central banks obsess over expectations, and we are told the deflation mindset is deadly, but the evidence is unconvincing to me.
In the best-case scenario, the whole debt superstructure remains intact and bondholders make nothing on their investments. How will those endowments, defined-benefit pension plans, and 401Ks perform when 40% of their 60-40 portfolios return negative squat? Ya can’t even make it up on volume with risk-parity bond funds because they are all risk, no return. The consequences of this nonsense are legion. The pros will call it a “yield chaser’s market” and assure us they are the smart guys. The 7–8% projected returns required to achieve projected demographic needs don’t look too probable. The more likely scenario, however, is that bond prices and bond portfolios will tank. Unlike the 2008–09 crisis in which bonds cushioned the fall for equities, bonds and equities will drop in concert. Yield-starved investors in the developed world tried to escape NIRP and ZIRP with yield-chasing in emerging markets. That market is collapsing as I type. It could really get out of control.
“Cash is not a very convenient store of value.”
“The benefits of cash are significant—but they need not be offered for free.”
How Orwellian. With all this talk of ZIRP and NIRP, it is patently obvious that the return of zero percent on cash in your mattress exceeds the return on money in the bank in a NIRP world. Don’t go hollowing out your Sealy just yet, however. The War on Cash is already circumnavigating the globe and could get fugly.
The initial skirmishes are predictably authoritative jawboning. Folks of wealth and power have been preaching the evils of cash for some time. Willem Buiter penned a screed wailing on the limitations of cash148 (and the dastardly consequences of gold).149 He thinks taxing cash is no worse than inflation. Yes, Willem, and your point is what? Buiter, by the way, began spewing these ideas as early as 2009.150 Charles Goodhart, formerly hailing from the Bank of England, proposes abolishing high-denomination currency, which exists “to finance drug deals.”151 Maybe he’s Charlie McGruff the Crime Dog, but he tips his hand by noting that cash also makes it hard for bankers to “drive interest rates a little bit further down.” Harvard University economist Kenneth Rogoff wrote a paper favoring the exploration of “a more proactive strategy for phasing out the use of paper currency.”152 He too feigns crime-dog status but goes on to note that “central banks cannot cut interest rates nearly as much as they might like.” A German economist named Peter Bofinger claims that “coins and notes are in fact an anachronism.” The Financial Times, obviously doing a little whoring of its own, gives five specious arguments against cash,153 not the least telling of which is the suggestion that “the existence of cash—a bearer instrument with a zero interest rate—limits central banks’ ability to stimulate a depressed economy.” Andrew Haldane from the Bank of England notes154 that negative rates “encourage people to take their savings out of the bank and hoard them in cash. This could slow, rather than boost, the economy. It would be possible to get around the problem of hoarding by abolishing cash.”
“Faced with seeing their money slowly confiscated, people are more likely to spend it on goods and services. When this change in behaviour takes place across the country, the economy gets a significant fillip.”
~Jim Leaviss, M&G Investments
It’s not just talk: cash is getting pushed to the margins. A number of sovereign states including Italy, Switzerland, Russia, Spain, Uruguay, Mexico, and France have legal caps on cash transactions.155 The U.S. requires cash withdrawals above $10,000 or serial withdrawals exceeding $10,000 in aggregate to be reported to authorities.156 Are you willing to risk asset seizure? Not me. I accepted my loss of civil liberty and stopped withdrawing even 4-digit sums. Louisiana actually has a legal (albeit unconstitutional) restriction on cash transactions.156 Apparently, “all debts public and private” doesn't really mean all debts . . . only little ones . . . maybe no debts . . . and I’m not sure about the private part either.
JPM has been the most aggressive to squash cash. It threatened to charge certain customers a “balance sheet utilization fee.”157 That’s short for ‘stealing your God damned money. ’JPM also banned paper currency or coins in safe deposit boxes unless they are collectibles.158 I suspect American gold eagles are not deemed collectibles. And, by the way, how do they know what’s in your box? Lest we forget, the State of California did a massive smash-and-grab on safe deposit boxes159 until the courts finally stopped it. I trust JPM a lot less.
At least one Swiss bank has banned cash withdrawals. The CEO of MasterCard talks his book by noting, “We generally believe cash has a tremendous cost to society.” Thank God using your MasterCard is free (head slap). A German MasterCard subsidiary has banned cash withdrawals using the card. Given that it could simply bust chops with huge withdrawal fees, one wonders what the angle is. It’s not like we needed another reason to hate credit card companies and their affiliated banks.
Denmark seems to be taking the plunge into a cashless society. The wealth will be held not by a bank but by the government. Phew! So once those crazy Danes go cashless, what is to protect them from a 1% service fee? How about 4%? Maybe that’s too hyperbolic, but I’ve noticed that ATM cash withdrawal fees have gone up massively at both ends of the transaction. With ATMs within a hundred yards of us at all times, you would think the market would drive the cost per withdrawal down, not up.
Let’s summarize restrictions on cash: We can’t hoard it, withdraw it in big chunks, withdraw it in little chunks except with huge fees, or spend it in significant quantities. Now let me be really clear: Cash is a civil liberty that allows you to maintain arm’s reach from the strong arm of the government. I am willing to share it with the drug lords if need be. I also think those who wish to ban cash are, at best, clueless and misguided. Others are wretched people, fascists, quite possibly treasonous, and definitely worthy of a swift beating. If you douchebags in power force people to go to hard assets to avoid oppression, don’t be surprised if those hard assets include firearms. You are playing with fire.
“No State shall enter into any Treaty, Alliance, or Confederation; grant Letters of Marque and Reprisal; coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts; pass any Bill of Attainder, ex post facto Law, or Law impairing the Obligation of Contracts, or grant any Title of Nobility.”
~Section 10, U.S. Constitution
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