“I don't write about what I know: I write to find out what I know.”
Every December, I write a Year in Reviewref 1–7 first posted on Chris Martenson’s website Peak Prosperityref 2 with a secondary posting at Zero Hedge.ref 3 What started as a brief introspective shared with a handful of e-quaintances has mutated into a detailed account that has accrued as many as 100,000 clicks. Each year I try to identify themes in events that evolve. As the title suggests, I have not seen a year in which so many risks—some truly existential—piled up so quickly. Each risk has its own, often unknown, probability of morphing into a destructive force. Groping for a metaphor—I love metaphors and similes—I feel like we’re in the final throes of a geopolitical Game of Tetris as financial and political authorities race to place the pieces correctly. But the acceleration is palpable. The proximate trigger for pain and ultimately a collapse can be small, as anyone who’s ever stepped barefoot on a Lego knows.
“If the world seems to be turning ’round faster than ever, you’re not alone. Grab hold of something, it shows no sign of abating.”
~Josh Brown, CEO of Ritholtz Wealth Management
My lack of credentials is absolute—the Paris Hilton of finance—but has not prevented me from being a poseur in the Wall Street Journalref 8 and The Guardianref 9 and on Russia Today,ref 10,11 and a host of podcasts.ref 1 On the heels of a threesome with Bob Lehman and Grant Williams on BTFD.tv following last year's review,ref 12 2014 started with a bang on BTFD.tv in a New Year’s Eve hexabox shared with a trader who cut his chops selling dime bags on street corners and a person who on close inspection appears to trade the trannies.ref 13 Subsequent interviews on Peak Prosperity,ref 14Wall Street for Main Street,ref 15Kunstlercast,ref 16Stansberry Radio,ref 17 and Red Pill Radioref 18 offered more opportunities to Milli Vanilli my way through finance and politics. I shared the podium with T. Boone Pickens and Alex Jones as an invited speaker at the Stansberry Investment Conference: “Boone. I agree with you. That first billion is being a bitch.”ref 19 (I took another swipe at the Roth IRA.) I almost made Rolling Stone, but Matt left me at the altar. (I still can't get that tune out of my head.) As this review is being uploaded to the web, I’m doing an interview with Erin Ade on Boom Bust (Russia Today), which will be posted on YouTube.ref 20
“Risk means more things can happen than will happen.”
~Elroy Dimsen, London Business School
Footnotes appear as superscripts, with the full reference for each provided in the Links section. The whole enchilada can be downloaded as a single PDF here or viewed in parts via the hot-linked contents as follows:
- Sources and the Fourth Estate
- On Conspiracy Theorizing
- The Economy
- Bending, Breaking, and Broken Markets
- Precious Metals
- Personal Debt, Savings, and Retirement
- States and Municipalities
- The Bond Caldera
- Argentina Versus the Bond Vultures
- Inflation Versus Deflation
- Wealth Disparity
- Banks and Bankers
- The Federal Reserve
- Barack Obama
- IRS Scandal Part Deux
- Bundy Ranch and Ferguson
- Militarization of Police
- Civil Forfeiture
- Civil Liberties
- Links Part 1 | Part 2
Each review begins with an account of my efforts to get to a financially secure retirement. I continue to cling doggedly to my belief in the Austrian business cycle theory and the need for a hard-asset-rich portfolio despite two consecutive years of decidedly lousy returns. The bulk of the review, however, describes thoughts and observations—just the year’s events told as a narrative. The links are copious, albeit not comprehensive. Some are flagged with enthusiasm (must see). I am a quote junkie: quotations capture people’s thoughts in their own voices, and they do the intellectual heavy lifting.
I try to avoid themes covered amply in previous reviews. Some topics seem to go into quiescence, whereas others move to center stage without warning. Precious metals are a personal favorite. Every year seems to pick up a theme, possibly reflecting the news cycle (although my sources are anything but mainstream). Geopolitics were huge this year. Sections titled Baptists and Bootleggers, Bankers, and the Federal Reserve cover the gamut of human folly. Owing largely to central banking largesse, the system seems to be wound tighter than a golf ball. The third and hopefully final leg of a secular bear market that began in 2000 may be visible—but record debt, bank interventions, low interest rates, and the onset of global currency wars may simply be bricks in the Wall of Worry. Naysayers relentlessly remind us how many terrible things have not happened. All year I kept thinking of a poignant declaration:
“Hey guys: It's a dud!”
~Lt. Red Winkle en route to becoming pink mist in Pearl Harbor
I finish with synopses of the books that shaped my thinking. You will not find any new releases from Geithner or Clinton: I am selective.
“There are people that don’t see the use in Twitter, and I get that. Who wants to mentally joust with the smartest, most relevant, and most connected people in the world?”
~Tony Greer, Buckingham Research Group
Before laying out a heap of content myself, a few comments about sources are warranted. Despite occasional bursts of glory and some serious journalism salted throughout the mainstream media, we have witnessed rot. The only commentary on TV worth expending ATP on is The Daily Show and its spawn. I do not need right- or left-wing propaganda. It is nauseating, especially given that so many reporters and academicians feigning impartiality are said to be on the payroll of political parties.ref 21 The former editor of one of Germany’s main dailiesref 22 admitted to being “bribed by [American] billionaires,” and a CIA operative referred to journalists as “cheaper than a good call girl.”ref 23 The once-illustrious CNBC ratings are now plummeting for a simple reason: it sucks. Simon Hobbs and Steve Sedgwick can put a sock in it. Mandy suggested that “over indebtedness comes from financial illiteracy.” Steve Liesman illustrated it by stating that “debt is the great bridge between working hard and playing hard in this country.” I can feel my IQ dropping. Wayne Rogers of Mash fame hammered a Fox host by noting, “You're a moron because you talk too much, and you don't think through it.”ref 24 Well said, Wayne.
@DavidBCollum Ask Fisher why a committee of bureaucrats sets the price of capital.
@steveliesman Because the alternative is the vagaries of the supply of gold.
My primary sources are an eclectic gaggle of bloggers—guys like Michael Kriegerref 25 and Charles Hugh Smithref 26—and select news consolidators. My actions speak to my enthusiasm for Peak Prosperity.ref 27 The 500-pound gorilla is Zero Hedge—edgy, ahead of the curve, and accurate enough. Newcomers this year include David Stockman's ContraCornerref 28 and a new Internet news network called RealVisionref 29 created by Grant Williams and Raoul Pal. Twitter may or may not be a good investment, but a good Twitter feed is a gateway to the world. You never know what you'll find:
“@zerohedge Ha ha, you are such a dickhead . . . it's wonderful.”
~David Andolfatto (@dandolfa), senior vice president, director of research, Federal Reserve Bank of St. Louis
“I still think we should buy them. He is on your schedule for Dec 15 or 16—we will need to sell him. I have a plan.”
~Anthony Noto (@anthonynoto), CFO of Twitter, struggling to keep tweets and direct messages separate
“I’m not going to censor myself to comfort your ignorance.”
These markets are making me a little schizophrenic—like Jerry (Mel Gibson) in Conspiracy Theory—so this blog is really a group effort. But I vehemently denounce those who claim there are no conspiracies and who try to protect their beliefs by labeling the rest of us conspiracy theorists. I could cite famous folks who share my views, but on this one I stand alone: Men and women of wealth and power conspire. Period/full stop. If a market can be rigged, it is being rigged. If numbers can be cooked to advance an agenda they probably are being cooked. It is usually the glib intellectuals—guys like Cass Sunsteinref 30—who denounce conspiracy theories as intellectually childish and those who consider them as diseased. You are trying to shut me up with a pejorative label. I will let one of the iconic educators of our time respond:
“You have to decide whether to look like an idiot before the crash or an idiot after it.”
~John Hussman, Founder of Hussman Funds
I have changed little in my portfolio since last year. The only consequential change is that I resumed purchasing physical gold after a decade-long hiatus, increasing the total tonnage by approximately 20%. Owing to life's events, I have a dramatically enhanced cash position and a relatively small standard equity index. I am in no rush to alter the cash position. Rebalancing continues to occur primarily through market forces and by splitting my retirement contributions into equal portions cash and energy equities.
Precious metals etc: 21%
Cash equiv (short term): 60%
Standard equities: 9%
My net change in wealth at the time of this writing (12/15/14) of -1.2% is poor when compared to the S&P 500 (+8%) and Berkshire Hathaway (23%) for the third year in a row. Also for the third year in a row, the return on the S&P gains arose largely from p/e expansion fueled by gargantuan leveraged stock buybacks (see below). Those crazy enough to challenge the investor flash mob by shorting this market have absorbent Pampers slapped on what used to be their faces. Corrections elicited phrases like “levels not seen in two weeks.”
Despite a very large cash and physical gold (+1%) positions, a small but strong standard equity position, and some added savings keeping me near even for the year, the carnage inflicted by vicious selloffs in the commodities smarted. At the time of this writing, my year-to-date results were influenced by gold (1%), silver (-12%), the XAU (-18%), the XLE (-16%) as a proxy for the energy sector, and the XNG as a proxy for the natural gas sector (-15%). Metal investors were bludgeoned by a late season sell-off and self-doubts and were berated by pretty much everybody on the planet, prompting CNBC to underscore the “vomiting camel” chart pattern (Figure 1). As social indicators go, that one could have called the gold market bottom.
Figure 1. Emetic dromedary pattern.
In a longer-term view, the total gain in personal wealth (including savings but excluding a large, positive one-time item) of 335% since January 1, 2000—the very challenging 15 years that followed the good times—compares favorably to the S&P (40%; ex-dividends) and Berkshire (329%, which includes accrued savings). It is going to take a crushing market event to regain a large lead I had on Buffett at one point. I remain a believer in the secular precious metal bull (albeit with white knuckles and self-loathing) for a rather simple reason: I think central bankers will destroy us. I see a secular equity low in our future, and the only way to exploit it is to park on cash and wait and wait and wait some more. In fact, that's one of the great advantages amateurs have over the temporally sensitive pros. I can stay irrational longer than the markets can stay liquid. I hope someday to exploit the hell out of opportunities in the energy sector that are being offered to us on a platter by the Saudis and the Obama administration. Until then, the Saudis can keep crushing the domestic energy markets (see below), and I will continue to white-knuckle my way through this mess.
King Arthur: Look, you stupid bastard, you've got no arms left!
Black Knight: Yes I have.
King Arthur: Look!
Black Knight: It's just a flesh wound.
~Monty Python and the Holy Grail
“By 2011, it was clear—at least to me—that the Great Recession was no longer an accurate moniker. It was time to begin calling this episode the Lesser Depression.”
~Bard Delong, economist at UC Berkeley, channeling James Rickards
“I am delighted to join you at a time when, despite the effects of the severe winter weather, the economy is on the firmest footing it has been on since the recovery began.”
~Charles Plosser, Federal Reserve Bank of Philadelphia, channeling David Lereah
We have the best economy money can buy. Fed governor John Williams suggested that “we are actually getting closer to getting at a normal economy.” How would we know with you Fed plonkers in the way? According to David Stockman, total revenue has grown by just 31% since 2009 while profits have skyrocketed by 253%.ref 31 We either did some serious regression to the mean from '09 to the present or will be doing so going forward. World-record profit marginsref 32 suggest regression to the mean is in our future. I did a quick survey of the Forbes 100 and estimate that 17% are explicitly in finance. Others are called “diversified.” I've gotta wonder if the economic gains are from various unconstructive economic pursuits (cf. Japan in the 1980s). Caveat aequitas emptor: if left unchecked, business cycles die of old age, and we are in the sixth longest (of 34) since 1854.ref 33 If you want some serious doom porn, check out a few of Michael Snyder's Listicles of Horror (my moniker) posted at The Economic Collapse Blog and secondarily at Zero Hedge.ref 34,35,36 The guy sees dead people.
As always, the difficulty is culling fact from fiction. In May, the ISM manufacturing indicators dropped precipitously and unexpectedly. A few hours after starching some more socks, ISM announced “my bad” and said that recalculations show that the economy is accelerating.ref 37 Nonetheless, economic indicators began missing estimates by wide margins.
Maxim: Facts miss pundit estimates rather than vice versa.
Mavens in the US blamed bad weather for their complete inability to hit the dartboard. Oddly, German pundits blamed their joblessness on good weather,ref 38 whereas Goldman suggested that the Germans actually have strong growth . . . because of the weather.ref 39 Fed governor Plosser says the economy is great “despite the effects of severe weather.”ref 40 The CEO of Walmart doubts the weather argument altogether, instead suggesting that everybody is unemployed and broke.ref 41Charles Dudley Warner insightfully noted, “Everybody complains about the weather, but nobody does anything about it.” I suspect the vital signs of the economy are stable, albeit with help from a high-capacity monetary respirator.
The weather is whacking California. One of our breadbaskets is going bone dry owing to a multiyear, high-sigma (500-year) drought. Analogies to the Dust Bowl are inescapable.ref 42 Some towns are shipping in all water by truck.ref 43 California will soon run out of Nevada and Oregon's water. One orange grower bulldozed 400 acres of trees (why?), suggesting that “if this persists in the next year, the devastation . . . will be biblical.”ref 44 California halted fracking because it may be contaminating aquifers.ref 45 (I must confess that of all the risks of fracking, destroying a big aquifer tops the list.)
Of course, housing is considered central to our economy. Maybe I have Assburger's syndrome or 80HD, but I go nuts trying to figure out whether housing is strong or weak. Choose an indicator and make any case you want. Owens Corning reported a weakness in roofing materials: the corporate numbers don't lie.ref 46 (Just kidding. Sure they do.) Some plots show existing home sales rising; others show existing home purchases rising. Dudes: they're the same numbers—a kind of housing velocity that may offer evidence that the market is loosening finally. That said, 20 million homeowners are still underwater,ref 47 rendering them professionally immobile. A nice list of the riskiest real estate markets in country shows Hartford, Connecticut, leading the pack with a potential downside of 35%.ref 48 (Canada and England now make us look like pikers, however, given that their busts remain prospective.)ref 49,50 And remember that iconic plot of mortgage resets foreshadowing (to those paying attention) the '08–'09 crisis?ref 51 Well the resets are back—$200 billion worth of resetting home equity lines of credit (HELOCs).ref 52 When the Fed finally normalizes rates, price discovery is gonna be a real bitch. The Fed never had an exit strategy.
Some argue that labor numbers are cooked like every other stat. That gets you labeled a conspiracy theorist (and got me labeled “pathetic”). John Crudele cites a Bureau of Labor Statistics whistle-blower claiming “I wouldn’t trust any data from the Census Bureau.”ref 53 Who knows, but they seem contrived. Government indicators of employment aside, the labor participation rate continues to plummet (Figure 2). We appear to be unwinding the gains from the feminist revolution, except it's men hitting the sofa with pork rinds and a remote in hand.ref 54 It was claimed and broadly disseminated that 11 states had more people on welfare than employed (despite rising numbers staffing welfare offices), but it might not be that simple.ref 55 The rallying cry of the boomers—”I'll work till I drop”—needs to include “or until I lose my job.” That said, the aging boomers are Hoovering up most of the new jobs (Figure 3).ref 56 Gotta wonder whose couch the millennials will crash on when their parents go to the light with unpaid mortgages. The dichotomy of part-time versus full-time jobs continues to distort perception. By example, the 800K part-time jobs gained in June were offset by 500K full-time jobs lost.ref 57 Total hours worked in this instance is crudely a wash (which is evidence of stagnation), but the lost benefits are definitely bad, and it has been disastrous long term (Figure 4). Walmart just cut health insurance for some 30,000 part-time employees,ref 58 causing serious angst among those who hate Walmart out of principle. At least we have Obamacare.
Figure 2. Labor participation rate.
Figure 3. Joblessness by age.
Figure 4. Total hours worked.
Attempts to wrap my brain around the economy sometimes reveals moments of hilarity and absurdity. A “highly regarded study” found that children entering the job market today have the same chance of climbing the income ladder as children born in the 1970s.ref 59 There is nothing quite like a decades-out extrapolation unguided by actual data. Prominent economist Justin Wolfers posted very cool plots showing that happiness correlates with earning power.ref 60 OK. Money makes me happier too, but I am surprised that earning $500K gives you a 100% chance of being happy. As Einhorn said to Bernanke, “ How do you get to 100 percent certainty about anything?”ref 61 Graphically slick charts like Wolfer's can seem very compelling and still be dubious (Figure 5).ref 62 A Pew Foundation study concluded that teen pregnancies are good for the economy and wealth creation.ref 63 They hedge their euphoria by noting that “it's obviously unrealistic to hope that the U.S. can return to the teenage birth rate of the Baby Boom.” One can only hope. As the cops often say, “spread 'em.”
Figure 5. Obviously strong causal relationship between Miss America and deadly hot vapors.ref 62
“Looking at Wall Street stock and bond trader screens, the world looks like a model of stability.”
“Given how sensitive markets are to headlines at the moment, there are no charts to send today.”
~Citi technical analysts
IPOs are always great entertainment because 80% of these nuggets of speculative bliss don't have earnings.ref 64 Alibaba (BABA), the Amazon of China, opened at the monumental 20× sales and puttered around for a while until it caught a late-year ramp. The shares, however, are a derivative—they offer no direct claim to ownership or a stream of revenue—suggesting that any measure of valuation is meaningless.ref 65 Twitter opened with a lot of fanfare, sloshed around, and finished the year marginally up. Peter Thiel noted that Twitter is a “horribly mismanaged company—probably a lot of pot-smoking going on there. But it’s such a solid franchise it may even work with all that.”ref 66 Put in tight stops, Peter. The IPO of Vascular Biogenics opened, tanked, and was unwound—they took a mulligan.ref 67 Presumably the wrong people got hurt. Soon after their IPO, the founders of GoPro cameras, circumvented the lockout period by placing shares in a family trust and selling them.ref 68 Irritated investors sold the news but soon forgave them. Pre-IPO Snapchat looks like a real gem with no business model, no revenue, no profits, and a $10 billion valuation.ref 69
“Sorry if you missed your IPO window. Don’t worry, we’ll blow up another one of these bad boys soon enough.”
~Josh Brown (@reformedbroker), CEO of Ritholtz Wealth Management
Stock buybacks have dominated the market. According to the most recent Capital IQ data, the single biggest buyers of stocks in the first quarter were none other than the companies of the S&P 500 itself—$600 billion this year alone—simultaneously driving equity prices up and capital expenditures (Capex) down.ref 70 How ironic. Years ago Peter Lynch used share buybacks as evidence insiders knew their shares were underpriced. Those were quaint times. Now they are used to boost share price by eroding balance sheets; investors profess to understand p/e ratios but are oblivious to balance sheet rot. Some estimate that, accounting for leverage, all earnings of the S&P are being plowed back into repurchase programs.
IBM is the poster child, buying back almost $40 billion while nuking its balance sheet with debt.ref 71 Apple completely gutted its huge cash hoard buying back shares,ref 72 which should stress holders of 30-year Apple debt issued when the balance sheet was strong.ref 73 Oracle missed earnings and revenues but borrowed $10 billion to buy back shares.ref 74 Oracle “returned” $21 billion of borrowed money in two years via buybacks and spent only $1.2 billion on Capex,ref 75 making it essentially the largest royalty trust in the universe. Ford has $90 billion in net debt (debt minus cash) and is buying back shares—the functional equivalent of a leverage buyout . . . by the owners.ref 76 Jonathan Glionna of Barclays explains: “There are a couple of reasons why companies do buybacks. One is that it seems to work; it makes stocks go up.”ref 77 Yes, Jonathan, and so did stock splits in the late '90s. This consequence of ultra-loose credit will unwind someday and inflict medieval pain on investors. One Zero Hedge poster suggested the FASB should allow buybacks to be categorized as Capex. Pure genius.
“Few are ready to curb financial booms that make everyone feel illusively richer. . . . The temptation to go for shortcuts is simply too strong, even if these shortcuts lead nowhere in the end.”
~Bank of International Settlements, June 2014
CYNK was the epitome of nuts. Only Zero Hedge was on this story at the outset.ref 78 CYNK is a small media company—one employee, no business model, no revenue, possibly a post office box—that ran up 100-fold in months to a market cap of over $1 billion. Traders were monitoring its price relative to the four-second moving average. During the manic phase I tweeted that CYNK could “drop 50% in microseconds.” Ten minutes later it dropped 30% in 30 minutes. Not a bad call for being off by three orders of magnitude. This one got embarrassing to the regulators, so they shut it down, trapping some traders.ref 79 One poor fool—a seriously poor fool—had all his retirement savings in it. Two weeks later CYNK reopened at a humbling 86% lower price.ref 80 It seems to have found strong support at $0.10. It's now a contrarian value play. The major risk is that the employee might quit.
The markets were interrupted daily by mini flash crashes—”meltups” or "meltdowns" owing to algos on 'roids. One of the biggest was the October 15th treasury meltup in which the yield on the 10 year dropped 0.4% in a few minutes—a testament to the stunning illiquidity of a once-bottomless market that finds its roots in Fed and central bank intervention (see below).ref 81
Concerns about valuation started to gurgle into the public consciousness. Buffet's favorite indicator—stock capitalization-to-GDP ratio—is now second only to that accompanying the 2000 bubble (Figure 6).ref 82 Serious debates began as the Case-Shiller p/e ratio (CAPE) began to soar with the eagles—40% above the mean—prompting Robert Shiller to exclaim with his legendary histrionic flare “the US stock market looks very expensive right now.”ref 83 Henry Blodget, despite his reputation from the past, has become decidedly bearish—Hussman bearish—noting that he is “still nervous about stock prices” and suggesting that “stocks are likely to deliver lousy returns over the next seven to 10 years.”ref 84 James Montier says the market is 50–70% overvalued.ref 85 John Hussman continues to hunker down for horrible prospective returns.ref 86 He evaluates stocks like a state function—a path-independent analysis of where we are now and where we ought to be in 10 years, assuming mean regression. Because everybody is planning to sell at the top, Hussman astutely notes that somebody must own these assets on the way back down. For them it will be a mean regression indeed.
Figure 6. Stock capitalization-to-GDP ratio.
Of course, as valuations get high, the metrics soon come into question. Recall the eyeball and click-count alternatives? Articles began questioning the merits of CAPE.ref 87 Alas, Lance Roberts, an analyst of considerable insight, noted that in his experience, the end is near when valuation metrics come under question. The Russell 2000 is sporting a p/e of 80. Michael Sincere's article “Why the Market Will Never Go Down” was satire at its finest,ref 88 eliciting scathing reviews from those who didn't get it.
“Negative earnings are excluded, extraordinary items are excluded, and P/E ratios over 60 are set to 60.”
~Disclaimer in a biotech exchange-traded fund that reports a p/e of 41
Many watch for absurd signs of a top—magazine covers, Dennis Gartman going bullish, etc.—and they were there if you looked. Facebook bought WhatsApp for $19 billion, paying the equivalent of four years of user fees that are charged after a free trial year.ref 89 It makes me wonder WhatsUp. Articles recommending using HELOCs to buy equities appeared,ref 90 which is more evidence of a zombie apocalypse or the last days of disco than a market top. As a dog returneth to its vomit, pro forma earnings are being embraced again (sigh). The S&P 500 price has increased five times faster than GDP.ref 90
As of mid-September, 47% of S&P equities were in a bear market.ref 91 With indices reaching new highs, this looks like the “market narrowing” observed in 2000 and again in 2007. There are planet-wide stretched carry trades—imbalances overtly engineered to generate profits for a select group. I detest the whole notion of carry trades. They are the root cause of many problems. The system is now so leveraged that abrupt moves in any direction by any market are high risk. Recall that a Russian bond default was the flapping butterfly triggering the market's fall to its knees in 1998 (mixed metaphorically speaking).ref 92
“It is hard to avoid the sense of a puzzling disconnect between the markets’ buoyancy and underlying economic developments globally.”
~84th Annual Report of the Bank of International Settlements
“Please make sure you have made the right decision.”
~Warning on a 110-volt electric bath toy sold on Alibaba
Michael Lewis's interest in the Aleynikov witch trialref 93 morphed into a story about high-frequency trading (HFT) that became the bestseller Flashboys (see Books). This story is not new: Joe Saluzzi and Sal Arnuk detailed it in Broken Markets in 2012, but Lewis's gravitas and the cute subplots gave it legs. Soon it was fight night. Insider Haim Bodek took on HFTer Manoj Narang.ref 94 Saluzzi took on an exceedingly annoying Irene Aldridge.ref 95 The Katsuyama–O’Brien brawl on CNBC was the Thrilla in Manila, with Katsuyama landing the haymaker: “I believe the markets are rigged, and I also think you are a part of the rigging.”ref 96 Boom! O’Brien counterpunched, and CNBC bloviated for the remainder of the day that the markets are not rigged (as though they would know). O’Brien's counters were retracted under pressure from the authorities the next day.ref 97 CNBC bloviation continues to this day.
“Wall Street at its most socially useless.”
~The Atlantic on HFT
This form of digital Marco Polo enabled by the trade routing firms skims money, but I am unconvinced that the retail consumer is paying the rake. What has my undies in a bunch is the role of the “algos” in the legendary flash crash of May 6, 2010 and numerous micro flash crashes documented daily by Eric Hunsader and crew at Nanex. The mouth-breathing regulators completely ignored them, declaring “quote stuffing doesn't exist.” The HFTers claim to provide liquidity, but they are destabilizing the system. An 80-car pileup seems inevitable and will elicit endless ineffectual congressional investigations, a few fines, and no convictions. There is no better evidence that the risk–reward of HFT is tapering than Goldman's exit from the game as described in Flashboys.
“I've been pleased with the transparency of the investment banking industry in my lifetime”
~Senator Ron Johnson during a hearing on HFT
“If you’re capable of understanding the world, you have a moral obligation to become rational. And I don’t see how you become rational hoarding gold. Even if it works, you’re a jerk.”
~Charlie Munger, 2011
Andrew Ross Sorkin: Warren Buffet won't touch gold. Do you think he is wrong?
Ray Dalio: I think he is making a big mistake.
“There is no more important challenge facing us than this issue—the restoration of your freedom to secure gold in exchange for the fruits of your labors.”
As gold appeared to be headed south, I was asked by a prominent Keynesian and money manager, Mark Dow, what gold price would tell me I was wrong. Good question. The price action has made this an unpleasant ride for the last two of my 15 years of ownership, but it is not about price for me. I am a reluctant gold enthusiast and will remain so as long as political and monetary events dictate. In this section, I discuss a few that transpired this year. None has knocked me off my commitment to gold fostered by the folks at the Fed.
The market was not as savage (wildly sold) as it was in 2013, but there was no shortage of volatility. After a strong first-half start, I began to smell possible trouble when Goldman, Bank of America, and the World Gold Council began talking down gold in early summer. Of course, the former two are talking their books. The World Gold Council, despite its name, appears to bash the metal routinely. Soon thereafter, suspiciously large (billion-dollar) trades began appearing in the wee hours of the morning when poor liquidity leaves the market vulnerable.ref 98 Of course, all of this was accompanied by schadenfreude from those who regret missing the first 10 years of the gold bull market. You could write volumes on the tits for tats between bugs and bears. Many of us simply trying to mitigate the perceived currency risk imparted by central banks find the attacks a little tiring.
“The idea that the world is ending and the accompanying demand for guns, canned food, bottled water and gold is having difficulty attracting new adherents.”
~Barry Ritholtz in the “Rules of Goldbuggery”, The Big Picture blog
India was a bit schizophrenic. At first they took their foot off the throats of gold importers by removing 2013 import restrictions imposed ostensibly to control their balance of trade. I asked a prominent economist on the relative impact of importing gold and buying shares of Intel on the trade deficit; there is none. Alas, there were too many smugglers with too many body cavities to control. As the year progressed, however, restrictions reappeared, and smugglers got out the K-Y once again.
Gold repatriation continues to be a hot topic. In 2013 the Germans announced they would repatriate 700 tons of gold, but they retrieved only 5 tons from the US and 32 tons from France.ref 99 Lo and behold, the Germans decided that they didn't really want it (sour grapes), with a spokesman declaring, “There's no reason for mistrust.”ref 100 Subtle hints to the contrary came from Bundesbank President Jens Weidmann: “[The US] will not transfer gold to Germany because we doubt whether it is really there.”ref 101 Seems clear enough. In a surprise announcement, the Netherlands managed to quietly repatriate 122 tons from the US to safety behind the dikes.ref 102 France has expressed interest in repatriation now that Germany absconded with theirs.ref 103 Belgium is pondering a similar move.ref 104
“For central banks [gold] is a reserve of safety; it’s viewed by the country as such. In the case of non-dollar countries it gives them value protection against fluctuations with the dollar.”
~Mario Draghi, President of the European Central Bank
The Swiss peasants decided they wanted to take a crack at getting their gold back after the majority was sold off a decade ago under pressure from the IMF. (Pakistan, under similar pressure, told the IMF to ???? ??, which Google translates to “bite me.”) The overt 10% overnight putsch on the Swiss franc last year left a bad taste in their mouths. Thus, a Swiss referendum to mandate gold repatriation, maintain at least 20% of its reserves in gold, and never sell any of it (the latter being decidedly too rigid) loomed large. If passed, the Swiss would be repatriating at least 700 tons back to the Alps. “Not a problem,” said an analyst at Deutsche Bank who noted that the Swiss can use gold swaps to move paper gold on and off the balance sheet every month. I’m not sure that's what the Swiss peasants were yodeling about. Of course, the referendum was violently opposed by the Swiss National Bank because it has a currency to debase. The week before the vote, Willem Buiter of Citigroup penned a report describing gold as a ridiculous reserve asset (Figure 7).
Figure 7. Screenshot of a Citigroup report on gold days before the Swiss referendum.
Buiter has been critical of the Federal Reserve's reckless policies, so this one came out of the blue for many of us, prompting a brief email exchange ending with this:
Collum: “Your email box must be filled with detractors.”
Buiter: “It is indeed.”
On the last trading day preceding the referendum—November 28th (Black Friday, ironically)—gold got bonked by 2.5%, silver by 6.5%, and oil by 10%—the Thanksgiving Turkey Massacre. It was a classic “swan dive” chart pattern (Figure 8).
Figure 8. Routine example of price discovery in the gold market.
I topped my personal best that day for “flushing money down a rat hole.” Like the Scottish vote for independence, the Swiss referendum didn't pass. Whether the selloff was in anticipation of a negative vote, engineered to elicit a negative vote, or unrelated to the vote is unknowable. Generally, however, voting power away from the powerful will run into opposition. The first trading day after the failed referendum was wild. The night the vote failed, gold tanked almost 4% and silver dropped 10%. Apparently, all that price appreciation before the vote—there was none—was getting unwound. I also didn’t realize the Swiss rejected a silver referendum too. (Actually, Brevan Howard announced the closing of its commodity hedge fund that weekend too, possibly liquidating a large silver position.ref 105) Regardless of proximate cause, the shorts were putting on a full-court press. Gold investors were seeing nothing but bus axles.
Strange restoring forces were at work, however, causing gold bugs to get a strange feeling (like when climbing the ropes in gym class.) That same weekend—it was a busy weekend—India made a major policy reversal (again), removing mandated gold exports.ref 106 Also, the gold forward offered rate (GOFO), touted as an indicator of demand for physical gold, had gone markedly negative and was now diving,ref 107 evidencing short supplies of the metal. By the end of trading on Monday, gold and silver had massively reversed, closing with bold gains. Another sure bet bites the dust. By December 3, the grifters at the London Bullion Metals Exchange stopped reporting the GOFO.ref 108 I'm sure it was for some macroprudential reason.
China and Russia continue to suck up gold by the pallet. Russia was selling treasuries to buy gold (see below).ref 109 China is rumored to have imported 2,000 tonsref 110—the equivalent of 25% of the US's entire unaudited gold stash. The CPM group, another one of those gold-bashing gold organizations, suggested that the Chinese demand for gold is speculative hearsay,ref 111 but guys like Koos Jansen—a new breed of gold analysts who understand the Asian market—enthusiastically disagree.ref 112 Both China and South Korea are said to be building new vaults to hold this fictitious gold.ref 113,114 China's gold demand prompted a shocking article by Alan Greenspan—that Alan Greenspan—describing China's motives for buying gold and the merits of gold.ref 115 The man may have a marble or two left and is trying to disembarrass himself. This resurrected version of the much younger Greenspan is, once again, touting the virtues of gold as the only defense against central bankers like, well, Alan Greenspan:
“If, in the words of the British economist John Maynard Keynes, gold were a ‘barbarous relic,’ central banks around the world would not have so much of an asset whose rate of return, including storage costs, is negative.”
~Alan Greenspan, Foreign Affairs
A lot of guys with suspiciously strong Chinese affiliations and bold resumes are also advocating for gold:
“China should now rapidly increase its gold reserves, without pushing up prices of the precious metal excessively.”
“Currently, there are more and more people recognizing that the ‘gold is useless’ story contains too many lies. Gold now suffers from a ‘smokescreen’ designed by the US . . . to maintain the US Dollar hegemony.”
~Sun Zhaoxue, Former President of the China Gold Association
“China should increase its gold reserves appropriately, and China must take every chance to buy, especially when gold prices fall.”
~Li Yining, a senior economist at Peking University and a member of the Chinese People's Political Consultative Committee
We continued to witness the drop in gold inventories in GLD.ref 116 Ignore those (of us) who think GLD is fractional reserve gold—rehypothecation at its finest—and ask a simple question: Why would GLD liquidate any gold in a sell off? If I owned a housing real estate investment trust, for example, a market selloff would reduce the price of the trust without a requisite liquidation of inventory. Provisions for arbitraging the price of GLD versus the price of physical gold in theory causes some adjustments in GLD around the margins,ref 117 but the directions of what should be razor-thin adjustments could be up or down. This is amply illustrated by SLV, the analogous silver trust, in which a vicious two-year selloff caused inflows of silver.ref 118 Given that only the multinational investment banks, the TBTF group, can trade GLD shares for physical gold—this is trueref 119—I've got two theories:
(1) The TBTF banks traded shares for the physical metal, presumably owing to demand for the clinky stuff in Asia.
(2) The collateral underlying the share price of GLD was vaporizing (going to China), causing the share price to drop. This idea is a little kinky but has been lurking on the Internet.ref 120
In a sense, the two theories are two sides of a push–pull argument. Either way, bullion rushing out of GLD and shipping off to Asia seems bullish for the future price of the metal. The volume of gold imports relative to the price of GLD shows a nice supply–demand relationship (Figure 9), but a correlation of demand going up with price—a Giffen goodref 121—wouldn't be nuts either.
Figure 9. Gold imports through Hong Kong versus gold price.
Those accusing JPM of market rigging got a hoot when the London Gold Fix—the group of bankers that sit around fixing the price of gold each morning (duh)—was shown to be fixing the price of gold.ref 122 They moved the rigging onto computers this year hoping that we could never imagine rigging a market with a computer.ref 123 Soon precious metal riggers were jumping ship (from the rigging). The Queen of Darkness, Blythe Masters, resigned from JPM to become a market regulator at the Commodity Futures Trading Commission.ref 124 No, really! She had claimed that “manipulating the metals market is not part of our business model. It would be wrong, and we don't do it,” but nobody believed that.ref 125 Going from rigger to regulator was way too much irony, causing her to reverse course within the week.ref 126 Soon the five banks overseeing the century-old rig-a-thon—Barclays, Deutsche Bank, Bank of Nova Scotia, HSBC, and Société Générale—were formally accused by authorities of participating in the con.ref 127 A Financial Times article on the scandal claiming the market was crooked as hell got yanked, but it had been saved. E-permanence is a bitch.ref 128 Barclays offered up a sacrificial lamb, accusing Daniel Plunkett of the early morning spankings designed to make Barclays' customers “puke up their positions.”ref 129 The cockroach model says that Plunkett did not work alone. We are told the silver fix was a fix also.ref 130
So where do we stand? Many claim gold and silver inventories are tight, as reflected by backwardation, a linguistic abortion describing greater demand for physical in the near term. Inventories at the Shanghai Metals Exchange have plummeted.ref 131 Our newest sovereign state, the Islamic State of Iraq and Syria (ISIS), is about to release a gold currency—the dinar.ref 132 Kiev (Ukraine) got IMF blood money (a loan) and bought gold with it,ref 133 but more recent rumors suggest it is gone (South Park style).ref 134 Ecuador pawned its gold to Goldman Sachs for a collateralized loan,ref 135 which will likely turn into a net purchase at default.
The barbequed relic may have some life left in it. I think we are at the beginning of a seismic change in the global currency system, and gold will move to center stage in the new Bretton Woods Whatever. With other asset classes priced for perfection—all gains pulled forward—there may be serious price risk in gold medium term, but the opportunity costs of owning gold seem modest.
“I did a lot of things at times with people on Wall Street, and I don’t trust them. . . . Gold is always going to have a value and there will always be something there.”
~Michael Franzese, former mafia boss (ba-da-bing)
“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
At the time of this writing, oil is hovering near $60 (Figure 10). The energy sector took a serious beating in the second half of 2014 owing to geopolitics, not geology. Goldman says the market is saturated (despite the rising price preceding the bloodbath),ref 136 but interpreting Goldman reports is very difficult because Goldman always has a book being talked up. The CEO of Marathon Oil says he had been seriously underestimating the company’s reserves.ref 137 The CEO of Continental Resources, Harold Hamm, says the notion that the market is in a glut is nuts.ref 138 He says it's all geopolitical. Others view it as a global economy in stress. Again, it seems likely (to me, at least) the global game of Tetris is accelerating to a finale.
Figure 10. Crude oil price.
Meet the Frackers. The massive (40%) plummet in global crude prices has inflicted carnage on the marginal producers. Most are riddled with junk debt—supposedly over 25% of the entire junk bond marketref 139—and likely to serially fail. Before the collapse, the seven major producers were already witnessing falling liquids production.ref 140 The good news is that once located in a big shale field, the frackers never hit dry wells. The bad news is that fracked wells have the life expectancies of gnats. The increasing output derives from an exponentially growing well count (Figure 11).ref 141
Figure 11 Output versus fracking well count.ref 141
I return to the geopolitics of oil in the section on Russia. I suspect, however, that the enthusiasm of the Saudis for low oil prices is temporary. Once they are done fracking my brokerage account, there could be an excellent entry into the energy sector as an investment. I am holding a large and growing position in energy and am tied to the mast. This time next year, I may be writing a lot more about the energy sector. At least we won't be suffering bogus announcements of strategic petroleum releases anytime soon.
“[Malls] are trying to change; they’re trying to get different kinds of anchors, discount stores. . . . What’s going on is the customers don’t have the fucking money. That’s it. This isn’t rocket science.”
~Howard Davidowitz, flamboyant retail analyst
Every year I write about the dire situation in personal savings and retirement. This is as painful as watching a Nicholas Cage movie. I will keep it short this year because nothing has changed, it's not gonna change, and I'm starting to sound like Crazy Eddie. We have a large group of people who will spend their twilight years marinating in a grinding poverty that is altogether unfamiliar. After years of not saving—regardless of why or whose fault it might be—they are heading down the Niagara River in a barrel: they are going over the falls. Let's reconsider a few numbers.
The median retirement savings is $2,000.ref 142 That is not a typo: 200 rolls of quarters. The assets in existing retirement accounts are broken down by age in Figure 12.ref 143 Charles Schwab's numbers are more dire.ref 144 One-third of the boomers over 65 still have mortgages.ref 145 Those with equity in their houses are being pushed into treacherous reverse mortgages.ref 146 Fidelity estimates that 48% of boomers report that they are not on track to cover the basics in retirement.ref 146 Most of the others suffer self-delusion. It is said the average retirement age is 62, which is way too low. You eat what you kill. Few have created enough wealth to live another 35 years on the fruits of their labor. Boomers looking to retire early from a good job intending to pick up money on the side should reconsider.
Figure 12. Balances of existing retirement accounts by age.ref 143
Let's take a deep breath and push forward. More than 30% of all new loans are subprime, which suggests that the debtors can't really afford the payments.ref 147 Credit cards issued to subprime borrowers rose 39% in the first quarter alone.ref 148 HELOCs are on the rise again.ref 149 An estimated 60% of working-age Americans have less than $25,000 saved.ref 150 One in six Americans depends on food stamps.ref 151
The self-deception has been institutionalized within the financial industry. Ya know those commercials that ask, “What's your number?” Well, the answer is a lot bigger than the numbers carried around in the commercial. Optimistic returns going forward—returns ignoring Hussman's dire analyses completely—suggest you can remove 4% of your retirement money without serious risk of running out. A million dollars spins out $40K per year. Now go look at what it takes to accrue a million dollars.ref 152 It's a scary scenario for most. A mathematically challenged pundit rhetorically asked us to “consider a [50-year-old] worker making $50,000 a year, and saving 5 percent of it, with accumulated savings of $500,000.”ref 153 Can somebody tell me where that $500,000 came from?
Those overwhelmed by debt may not have screwed up. Maybe it was odious debtref 154—debt incurred under conditions awful enough to provide a moral backstop to repudiation. Regardless, overwhelmed debtors have a binary choice that is gonna hurt either way: suck it up or default. The free market solution to default would cause the creditors to lose a lot of money. They will call for bailouts, which comes from savers and is most definitely not a market solution. I like the idea of branding bankers' foreheads with a $ (Inglorious Bastards) and dropping them in the middle of an ISIS stronghold. They would beheaded for trouble. Maybe that's too extreme.
“You have a 25% chance of living 'til 93 years old, and you're going to need like $3 million to live on. Totally go to Starbucks now, it's fine.”
~Josh Brown (@reformedbroker), CEO of Ritholtz Wealth Management
“If You Don't Need It, DON'T BUY IT”
~1943 War Rationing Card
“Detroit's industrial ruins are picturesque, like crumbling Rome in an 18th-century etching.”
~P. J. O'Rourke
States and municipalities are still deeply underfunded—the situation will necessarily rectify over the coming years—but there were not many fireworks this year. The underfunded pensions continue to make news, with Illinois always at center stage. The Chicago firemen's pension fund is a $50,000 liability per Chicago household—probably far higher for households that are net payers of taxes.ref 155 Illinois passed a reform bill to ease the state's burden,ref 156 but who picked up that bar tab? Some of it may have been put back on the pensioners. Kankakee, Illinois, is in dire straights with a pension plan that is only 18% funded.ref 157
Michigan's auto woes continue to fester. Flint's pension plan is estimated to consume 32 percent of the $55 million general fund.ref 158 The ultimate disaster zone—Fallujah on the Lake—is obviously Detroit. The cost to clear Detroit's blight using bulldozers (literally) is said to top $850 million.ref 159 Even as a small government guy, I could endorse such conversions of crack houses to green space. Montages of Detroit's blight are legion. One shows decay over merely the last half-dozen years.ref 160 Detroit was planning to shut off water to 150K mostly black residents owing to lack of bill payment.ref 161 This is a no-win situation. Detroit thought it might pawn its art for $3 billion (below market price),ref 162 although the legality of doing so while in bankruptcy proceedings is doubtful. I'm sure some wealthy Wall Street folks would gladly sign a rent-to-own agreement using profits from Detroit's debt restructurings. Detroit politicians—on the dole no doubt—tried to sign a crappy debt restructuring deal (again), and a judge said no.ref 163 People often forget, however, that the primary function of bankruptcy is to distribute assets in cases in which there is simply not enough to go around. Maybe in prospective years Illinois will attack Michigan, eliciting some serious Krugman-esque stimulation of their respective economies.
Defaults on pensioners seem likely to be the horror story of the next decade or two. A Kentucky ruling on whether bankruptcy can negate pensions could change contract law by determining whether pension funds can be elevated to most senior creditors.ref 164 A judge in the Stockton, California, bankruptcy will rule whether CalPERS is merely a servicing agency (moving it out of harm's way) and whether it can reduce payouts to the pensioners.ref 165 Precedent is being set while pensioners are possibly being set up.
Sixteen counties in Northern California want to secede from California.ref 166 Sounds like another brother-against-brother fight brewing. CalPERS is dumping its hedge funds, which made for great headlines.ref 167 The fine print, however, reveals that hedge funds and private equity moneys constitute only 1% of its portfolio.
“The Fed has somehow managed to take the income out of fixed income and the yield out of high yield. . . . There are no interest rates to observe.”
~Jim Grant, editor of Grant's Interest Rate Observer
“Successful financial repression requires a widespread belief that conventional government bonds are safe.”
~Peter Warburton, Director at Economic Perspectives Ltd and author of Debt and Delusion
I obsessed over the bond market all year long. It appears that central bankers have pumped up a bond bubble—a Bond CalderaTM—so hunormous that you can see it only from space. The global bond market is all trade, no investment. Try this exercise: Imagine buying bonds to clip the coupon for the duration of the bond—a real commitment to bonds as an investment. Would you park on treasuries returning 2.0% for 10 years? How about 2.9% for 30 years? Didn't think so. A lot can happen in 30 years.
Let's go way out over our skis: how about reaching for yield? That's always a brilliant idea endorsed by central banks the world over. With a little timing, you could have snarfed up the following portfolio:
Source Duration (yrs) Yield
Cyprus 5 4.8%
France 10 1.3%
Germany 10 0.8%
Greece 10 6.4%
Ireland 10 3.2%
Italy 10 2.3%
Kazakhstan 10 4.0%
Mexico 100 5.5%
Nigeria 1 11%
Portugal 10 3.0%
Puerto Rico 10 7.0%
Rwanda 10 6.0%
Spain 10 2.2%
Spain 50 4.0%
*Japanese JGBs at 0.4% for 10 yr were excluded because the market no longer exists; the Bank of Japan buys 100% of the new issue.
Do any of those look good? Most are basket cases. Others are decent credit risks but offer pathetic returns. All are results of unfettered central bank credit. The only high-yield bonds in the bunch—possibly even the most attractive—were email-marketed by Nigerian princes. As Mark Gilbert of Bloomberg says, “You might want to dance near the door.” Everyone is betting they can top-call this market and get out. I'd rather pick up nickels on the Autobahn. To reiterate Hussman's Truism: “somebody must own these assets” as trillions of dollars of risk morph into billions of dollars of detritus.
“Junk bonds have really gone to levels which under our analysis are pretty much the most overvalued in history.”
~Jeff Gundlach, The New Bond King
“In my 20 years of managing high-yield bond investments, I’ve never seen so many signals that scream caution.
~Steve Blumenthal in Forbes
“For too long, markets failed to raise funding costs for countries with unsustainable policies. “
~Mario Draghi, hours before Portugal defaulted on a bond
China and Russia both backed away from the US treasury market this year: who picked up the slack? The Belgians! Yes. Those crazy waffleheads supposedly committed half of their GDP to buy $141 billion of US treasuries, becoming the third largest holder.ref 168 If Belgium can bail out the US, then why doesn't Possum Trot, Kentucky bail out Detroit? Of course, somebody used Belgium as a proxy buyer because Belgium is also a basket case. I'm guessing the Fed was doing it; some say China. It could be any central bank, given that they are really one gigantic interconnected web of quantitative easing (QE).
2014 was the year of the taper—the Fed’s long-awaited exit (Fexit) from grotesque QE monetizations. The bond trade of the century was on: short US treasuries! Problem is that somebody forgot to tell the bond market: the taper ended (sort of), treasuries soared, and interest rates went even lower. Excuse me while I kiss the sky. Maybe the Belgians blew through the stops. Or, better yet, maybe it was those two Japanese guys caught carrying $134 billion in bonds over the Italian-Swiss border back in 2009.ref 169 This one wasn't a dud for those who front-ran the taper by shorting bonds. That'll teach them to bet on a sure thing.
“If I traded bonds, I'd have been bankrupt seven years in a row. I just don't geddit.”
~Mark Gilbert, Bloomberg
How is it possible to pull off the taper without event? I have a theory that is without support—a hunch of the highest order: The Fed was able to decouple temporally headline risk—the Fear Factor—from actual liquidity risk. It would require help from other central banks. Curiously, within hours of the US-centric QE coming to a close, Bank of Japan (BOJ) governor Kuroda surprised the markets (and other BOJ governorsref 170 apparently) by announcing a huge QE. Soon thereafter, Mario Draghi announced the Eurowanker variant.ref 171
Bill Gross stunned the world and the bond market when he moved from Pimco to the two-faced Janus.ref 172 (Nice truth-in-logo, guys.) Apparently, that sweet old man who wrote the folksy monthly reports was actually a bit demonic at the office, noting wryly to Mohamed El-Erian, “I have a 41-year track record of investing excellence. What do you have?”ref 173 Ouch. I wouldn't be shocked if Gross's divorce from Pimco was akin to Sam Zell marking the top of the real estate market almost to the minute by selling his $38 billion real estate empire. For a while, it looked like Pimco liquidations by Gross's groupies might eviscerate some bond indices, but price-insensitive central banks can buy up any slack.
Corporations continued a record bond-issuing spree. Examples of unappealing offerings include Caterpillar (50 yrs at 4.8%), Hasbro (30 yrs at 5%), and Target (10 yrs at 3.5%). If these and other large-cap companies are such stellar credit risks, why did they need to borrow money? Stock buybacks—almost $1 trillion of stock buybacks!ref 174 This form of bond-denominated stock monetization (BDSM) is a modern day variant of a leveraged buyout. Clearly the equity buyers find per-share rises in earnings well worth rotting their balance sheets. Stock buybacks are the new stock splits.
Telltale signs that the bond market is unglued are legion. State tobacco bonds were used to pull tobacco settlements forward, but buyers failed to anticipate drops in cigarette sales.ref 175 An index reflecting Mexican corporate junk bonds dipped to a 5.2% annualized rate.ref 176 How do you pass on those? It appeared as though the junk bond market was about to crack open in the summer, but paroxysms gave way to renewed tranquility. US junk bond indices dropped below 5% yield. As my fingers prepare to release the keys, however, the junk bond market is being crushed by the energy sector. The Fed also wants more high-quality assets for stability in a crisis and has inexplicably excluded munis from that category.ref 177 Muni crisis in 3...2...1...
The big story receiving no attention is that the Fed is considering exit fees—penalties—for removing assets from bond funds and some money market funds during times of stress.ref 178 Nobody bought into those funds with that rule in place. You would think that such fees would cause the bond market to collapse. You pass that law, and it will be a time of stress. Restricted withdrawal on just one fund—akin to breaking the buck—could cause a global contagion.
I've run into seemingly savvy investors who swear off bond funds, instead buying the bonds. They defiantly declare that they can't lose principal because they won't sell them. This baffles me to no end: aren't they just failing to mark their portfolios to market, whereas the bond funds have no such luxury? If rates double, dudes, you've lost a lot of principle. You just aren't calculating it. Cliff Asness pointed me toward his comparable analysis.ref 179
Why do I think it's a bond bubble—a Bond Caldera? Because short-term interest rates (some now negative), quantitative easing, and mountains of affiliated carry trades necessarily inflated it. Normalization of first-world sovereign overnight rates to, say, 4%—not exactly a Volcker-esque nightmare scenario—would demand a stunning reduction in principal.
So how is this going to play out? Jack Bogle says, “The best estimate of returns of bonds going forward is today's interest rate . . . with a 0.91 correlation.”ref 180 Sounds easy enough, but this is the nominal return and, as noted above, 2% nominal return on treasuries won't cut it. We have pulled all imaginable returns forward. Is it good news if the bond market holds steady and we earn dismal nominal returns for eternity? If so, projected returns on 60:40 equity-bond portfolios will stink unless equities soar, and that is not going to happen with current nosebleed valuations (see Broken Markets). The best-case scenario for future bond buyers and the worst-case scenario for current bondholders is a bond rout—serious repricing and affiliated rising yields. In the event of a bond crisis, equities will not be very perky either. Thus, unlike in '08–'09, when soaring bond funds offset tanking stock funds, the market will experience simultaneous paroxysms. It's unclear whether cow blowing or jawboning by fluffers Draghi, Bullard, Yellen, or Kuroda will put Humpty back together again.
“The age of getting rich quickly is over as is (most likely) the age of getting rich slowly.”
~Bill Gross, former bond king, Janus
“We sympathize with traditional stock and bond investors, who are faced with extremely poor choices today.”
~Paul Singer, Elliot Capital Management
To silence those who will bleat that nobody saw an epic bond crisis coming, I leave you with a few more warnings from some of the old mossbacks of finance:
“Leveraged loans to private equity are not just flashing red but have a wailing siren.”
“A skeptic would have to be blind not to see bubbles inflating in junk bond issuance, credit quality, and yields”
~Seth Klarman, Baupost Group
“I can’t recommend buying any long-term bond as the yields stink relative to inflation.”
~Peter Boockvar, Lindsey Group
“This is a game we won’t even bother playing.”
~Tim Price, PFP Group, on the bond market
“Most government bondholders are unlikely to achieve a positive real return over the medium-to-long-term from this starting point.”
~Jim Reid, Deutsch Bank
“The Argentine Republic will meet its obligations, pay off its debts, and honor its commitments.”
~Axel Kicillof, economic minister of Argentina
“If I were the Argentine government, I would make all participants believe that I was willing to push everyone over the proverbial cliff at the end of July to improve my negotiating position.”
~Kyle Bass, Hayman Capital
There are always nuggets of folly in Argentina. The day the Argentine Central Bank's reserves accounting was questioned publicly, a massive fire destroyed a warehouse archiving documents from the entire banking system.ref 181 That's funny stuff. Alas, just like Obama's benefactor-turned-ambassador who has never even visited the place,ref 182 South America doesn't do it for me.
What caught my attention, however, was Paul Singer of Elliot Capital Management and a cadre of “vulture funds” raiding Argentina's debt markets like pox-riddled conquistadors.ref 183 The media excoriated Singer et al.ref 184,185 This battle would be the end of capitalism, they decried. How will we ever repeatedly bail out poor third-world countries (read: global banking cartel) ever again? The media was clueless and wrong.
The backstory: Argentina has been defaulting on debts since 1824.ref 186 Economist Steve Hanke estimates that it has been in default for 35% of its history.ref 187 A rolling loan gathers no loss. The default in question, however, occurred in 2002 on bonds issued in 2001. Whoever lent them that money has the intellectual firepower of an empanada. Singer and the Gouchos bought mucho cheap debt, waited for the banks to restructure it, and then told Argentina no way were they settling for a few pesos on the dollar. Argentina said, “Yes way!” but that didn't work. Normally, a collective action clause allows a majority of creditors—the banks—to force all creditors including the “holdouts” to accept the new terms. Argentina's bonds, however, did not include this clause. Oops. Specifically, the rights upon future offers (RUFO) or “pari passu” clause mandated that Argentina could not settle with the holdouts without paying all creditors off at the same rate.ref 188
So why not just cut the crap and default? It's not like it would tarnish their stellar Fico score. Of course, that's just crazy talk because the banks wouldn't get paid, and the banks bought a lot of politicians to get paid. US courts, however, ruled that any form of settlement would be in violation of RUFO. Apparently, the bankers should have budgeted more for the judges (an unforced error). Argentina protested that the court ruling “is merely a sophisticated way of trying to bring us down to our knees before global usurpers.”ref 189 And your point is?
Argentina went jurisdiction shopping. It considered having the investment banks pay Singer, but this was deemed RUFO forbidden.ref 190 Argentina tried to get the court to order payment so as to claim that such a mandate negated RUFO. The Bitcoin guys were champing at the Bit to offer their services. Alas, payments of any kind in any way would trigger RUFO. Singer bet that the global banking cartel would find a way to pay them: they bet on moral hazard.
Only Hanke seemed to get it right by accusing Argentina of serial defaults and giving a thumbs-up to a default.ref 191 The upside of a default is that everybody—Argentina, the banks, and Singer—would get schooled on risk. There was no solution, and on July 30th Argentina defaulted.ref 192 The high-yield bond market at large didn't really like it. The St. Louis Fed (@stlouisfed) tweeted “Why did the Argentine peso fall following Argentina’s default?” (They are actually paid to say stuff like this?) Meanwhile, the world continued rotating on its axis. Rumor has it that Singer has his sites on some hard assets.
Bottom line: If you lend to countries like Argentina in a free-market-driven credit system, you will quite justifiably lose your shirt. Because it's probably not actually your shirt, you should also lose your job, your freedom, and possibly your genitalia. Repeatedly lending to third-world countries aided and abetted by bribed third-world politicians destroys more lives than the collective efforts of serial killers. You should probably have your ass colocated with a prison cell.
“Argentina’s professed willingness to negotiate with its creditors has proven to be just another broken promise.”
~Jay Newman, spokesman for Elliot Capital Management
“Perhaps it is one secret of their power that, having studied the fluctuations of prices, the [bankers] know that history is inflationary.”
I was positive a determined central banker could trigger inflation, and contemporary central bankers are a determined bunch. Austrian economists predicting rampant inflation were eviscerated this year, however, as the deflation drumbeat became deafening. Central bankers are wracked with apoplithorismosphobia (irrational fear of deflation). I am still very much afraid of inflation but began to wonder: Can you jam money into the system without triggering serious inflation? Can huge volumes of dormant money with low velocity be sopped up before it becomes high-velocity inflation?
Now for the confession: I don't understand the inflation–deflation debate at the most rudimentary level. How can you describe something so extraordinarily complex using binary language? Try describing the weather or the Great Barrier Reef using only two terms. Not easy, eh? Possibly for this reason, the inflation–deflation debate has elicited some of the most bizarre financial analyses I've ever read. Let's begin with a couple deflationary warnings from two very smart and respect-worthy guys:
“The new reality is that we currently stand face-to-face with the very deflation risk that just about everyone denied could ever happen.”
~Steen Jakobsen, Saxo Bank
“The Fed and the ECB have failed to prevent a dreaded replay of Japan’s deflationary template a decade earlier in the West. The Ice Age is once again about to exert its frosty embrace on markets as investors wake up to a new and colder reality.”
~Albert Edwards, Société Générale
Europe is said to be staring into the abyss occupied by Japan. US central bankers are developing nervous ticks. This all sounds so macroprudential (a content-free Yellen term). The dialog spans the gamut of pensive to inane. Let's begin with some of the Masters of the Universe—mostly central bankers—in their own words.
Bullard is “forecast[ing] rising inflation,” which is why he is “concerned about declining inflation expectations.” Mmm-kay. Whatever you say, Jim. Kocherlakota tells us we should be concerned about “below-target inflation” without clarifying from what dark place the Fed pulls its target. From recently released Fed minutes, we find that Bernanke thinks “low inflation is generally good” but that a “2% inflation target may be too low.” Fed governor Charles Evans declares “2% is not the right number.” I agree with Chuck, but I doubt we would agree on why 2% is not my number. With deflation risk in mind, a Fed report warned us that “consumers have decided to hoard money,” presumably in small banks called “hoardings and loans.” Krugman—a central banker in his dreams—warns that “the great danger facing advanced economies is that governments and central banks will do too little,” which is a complete 360 for him. He also noted that “inflation redistributes wealth down the scale of both wealth and age, while deflation does the reverse.” Poor folks love rising prices at Walmart. Adam Posen, president of the Petersen Institute, explains this odd consumer preference: “Food is one component of consumption. A rise in its cost is not inflation.”
Whether journalists are duplicitous or merely duped by macroeconomists is unclear, but they take in these nuggets of ambiguity from the authorities and spit out some seriously content-free content. Let's start with The Economist—the gateway to higher economic reasoning—by blowing right through an extraordinary flowing montage of quotes: “the biggest problem facing the rich world’s central banks today is that inflation is too low. . . . Politicians and central bankers are not providing the world with the inflation it needs. . . . The perversity of the low-inflation world is shown by the fact that the catalyst for the latest deflation scare is in itself a largely positive development. . . . The belief that goods bought tomorrow will be cheaper than goods bought today chokes consumption.” And then there was this little treasure: “You can have too much of a good thing, including low inflation. Very low inflation may benefit important segments of the population, notably net savers.” I respectfully suggest you guys step back and take a deep breath or change your name to one that better reflects your content.
Other media outlets had their 10 minutes of glory. The Financial Times warned that “it can be extremely difficult to increase the rate at which prices rise.” God forbid. Bloomberg noted that “an inflation rate approaching zero is bad for the economy because . . . companies’ inability to raise prices hurts profits.” So if profits need inflation, are they real? The Wall Street Journal worried that “the recent period of very low inflation could persist longer than first thought and may threaten the currency area's economic recovery.” It was a Yahoo Finance headline, however, that captured the weapons-grade stupidity of the discourse on deflation:
“Golden Years look dark as lower inflation eats into Social Security.”
Wait . . . what? Jeepers. It astonishes me that people actually penned these ideas. I know bats spewing shit less crazy than that. I personally don't need any inflation whatsoever. I like dropping prices, living large on less, boosting the GDP like an Italian (blow and hookers). Here's a simple sanity check: name one example of a good that fails to sell because it has gotten too cheap (besides equities, that is.) Raoul Paul Ilargi of Automatic Earth asserted that real deflation is not about dropping prices but about how much you have to spend. That's a keeper.
Let's bring a single member of the opposing team—the Sultan of Swat—off the bench:
“I remember sitting in class at Harvard being told by a fiscal policy expert that a little inflation was good for the economy. All I can remember after that was a word flashing in my brain like a yellow caution: bullshit. . . . This kind of stuff that you’re being taught at Princeton disturbs me.”
~Paul Volcker, former FOMC Chair
Some argue the definitive resolution to the inflation–deflation debate comes from the Billion Price Project (BPP) of Roberto Rigobon and big-brained economists at MIT.ref 193 By monitoring over a billion prices using NSA-quality robotic software, they amass a sample size on daily price fluctuations so enormous that no sane person could contest the final read on inflation. Not so fast, Bucko. How do they statistically weight the prices? How do you compare the price of toothpicks to college tuition? Soaring toothpick prices are never going to trouble me; I'll use my fingernail. A billion prices need a billion statistical weightings to reflect the magnitude of the prices, the percentage of one's income dedicated to the purchases, and the optionality of the purchases. That is where error and even chicanery could lurk. I asked Rigobon how they weight the prices, and he courteously told me that info is “proprietary,” which is a euphemism for ???? ??. In chemistry, a manuscript that describes a new method without providing any methodology gets rejected. The Billion Fudge Factor Project (BFFP) is a nonstarter without details.
Curiously, when I posted my concerns about the Billion Price Project online, somebody said the index went live, came in way too hot relative to the consumer price index (CPI), was brought back to the shop for a tune-up, and was re-released in the new CPI-friendly form. This, at present, is an unsubstantiated rumor, but back-testing to the CPI would be very tempting and would completely negate the basic premise. Also, I can name 50 items whose prices have profoundly influenced my lifetime of consumption; the other 999,999,950 are largely white noise. According to Daniel Kahneman (Thinking Fast and Slow), we must ignore the white noise.
Consumers deeply understand that which eludes central bankers and maybe even MIT economists: CPI inflation is very real. Prices are going up and package sizes are shrinking. John Williams of Shadowstats would argue that inflation is seriously underestimated.ref 194 I don't know if he's right, but his methodology is clean and simple. Oddly, even data from the Fed suggest high consumer inflation.ref 195 Paul Singer of Elliott Asset Management suggests that “the arithmetic of government statistics (jobs, growth, and inflation) is distorted and dishonest almost beyond measure.” Philippa Malmgren, former member of the President's Working Group on Financial Markets, refers to “a growing gap between what central banks are telling us about inflation versus what people are really experiencing.” The technical term for those who doubt government inflation numbers is “inflation truther,” which roughly translates to “ignorant peasant with a walnut-size brain.” Someone who uses “inflation truther” pejoratively is technically referred to as an “asshat.”
Lets call a spade a spade. Contemporary central bankers care deeply about CPI inflation because consumers must get less than expected somehow to exit this morasse of debt. What the bankers fear, however, is the deflation of assets on member banks' balance sheets. They fear the bad deflation—the kind that leads to defaults on loans rather than just cheaper goods—because of bank failures and because it shows that the central banks royally screwed the pooch. According to Austrian business cycle theory, the bigger the boom the bigger the bust. We are now at the end of a monumental bank-sponsored credit boom; brace for the Red Bull-sponsored bust. The inflationary credit boom is the disease; deflation is a symptom. We are being relentlessly waterboarded with liquidity by central bankers and fed propaganda with rectal feeding tubes. Charles Kindleberger, the world's expert on bubbles in his day, noted that bubbles arise when excess credit is jammed into a system with decaying fundamentals.ref 196 Decaying fundamentals? Sound familiar? If somehow all this money hoarded at the Fed escapes into the wild, take cover. Either way, proclamations that “it's a dud” seem premature. I highly recommend Banking and the Business Cycle (1937) for a compelling description of what happened the last time we hit this bridge abutment.
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Given the length of David's letter, we will publish part 2 tomorrow (along with a full PDF).