Monthly Archives: June 2017

Holding-your-nose, or bidding-your-time. Pick your poison.

How long can this last...  After all, valuations are hugely stretched by any measure you can think of; there’s no disputing that. Not even the most steadfast bull could make a case that today’s market is cheap in some way. But does that matter? …

And that’s the thing; fundamentally, I think our market is absurdly priced. There are bubbles everywhere, … (but) extreme valuations can persist for a long time before something finally spooks investors into heading for the exits. And I’m not disputing that this is likely to happen at some point but I am saying that shorting the market or sitting in cash for years to wait for it is imprudent. …

Indeed, at this point, I’m not entirely sure what would actually bring about a sell-off and that is why, despite my bearishness on the fundamentals, I’m still in the hold-your-nose-and-buy camp.

Josh Arnold. Seeking Alpha (Emphasis mine)


“I’m having a hard time with this market because I can see what a powerfully stable social equilibrium is being established around this transformation of capital markets into a political utility. I’m having a hard time with it because, like any powerfully stable social equilibrium, to be truly successful in that world you must give yourself over to that world. You must embrace that world in your heart of hearts. …

I can’t do it. I can’t embrace the machines and the vol selling and the ETF parade and the central bankers’ “communication policy”. So I’m NOT happy. I’m 20+ pounds overweight. I don’t sleep well. I DON’T trust the Fed, much less love them, and I never will. …

So here’s my question. How do you survive, both physically and metaphysically, in a market you don’t trust but where you must act as if you do? How do you pass? How do you reconcile the actions and beliefs necessary to be successful in this market with the experiences and training of a lifetime that tell you NOT to act this way and believe in all this?

Accommodation to the Hollow Market is a miserable experience for discretionary stock pickers (and the same is true for any security selectors, whether it’s bonds or commodities or currencies or whatever), and the higher your fee structure the more miserable it is, which is why hedge funds have been particularly hard hit. Why is accommodation so difficult? Because the point of discretionary stock picking is taking independent, idiosyncratic risk. …

For the past eight years, whenever you’ve stuck your neck out with idiosyncratic risk sufficient to differentiate yourself and move the needle, more often than not you’ve been slapped around brutally for your trouble. So you stop doing that. … you effectively lock in your underperformance and pray for the Old Gods to return and unleash their mighty wrath on global equity markets. Of course, you’ll be down 50% of the market in The Storm, just like you were in 2008, but hey … at least that would give you a reason to come into the office. Anything but this. …

Ben Hunt. Epsilon Theory (Emphasis mine)

Don’t we all (particularly us males) love to think we are smarter than the rest of the pack? We elaborate sophisticated reasonings for the most pressing issues at hand. And we do well at that. If we had to judge market players’ expertise according to their capacity to construct and replace narratives as needed, then the EMH would be indeed viable. Sadly though, players’ capacity for narrative cannot be inferred and transferred to data or conceptual analysis’ efficacy.

We need more profound and unbiased analysis, less narrative, and an effort to keep things simple. Sometimes they are. Like today. Three decades of easy credit, easy money, and permanent ultra low to hard negative real interest rates have generated something really ugly. Now dubbed the “everything bubble”, it is also known as the mother of all bubbles (Saddam-speak), the big fat ugly bubble (The Donald), a permanently high plateau for stock prices (I. Fischer), or … you name it. The result is, in plain wording, a scary, extremely dangerous price environment for investable assets.

And we asset managers have to live with that. Unfortunately for us, this extreme environment begs some very tough heads-or-tails decisions of the kind I really hate. In such a bubbly environment, only four relevant asset allocation decisions matter. That is of course if he/she can afford to decide because passive managers cannot. And most active managers can’t either because of that frequently forgotten concept called career risk.

But if you can decide, you have to take a stance on these four issues. Very much like Josh Arnold and Ben Hunt, all of us active independent asset managers have to pick our poison. The good, safe options dissipated in a central bank deceptive nebulous long ago (not to be confused by the technological cloud where things are supposed to be safely kept). Continue reading

The post-Keynesian paradise (hell): few viable options left.

Time always provides the final judgment on an issue. To quote Cameron Crowe, it is always “time” that puts things in proper perspective. It took humanity an unspecified amount of time to know the Mona Lisa was superb. In just a few decades we learned that María Callas was as close to unique as you can get in real life. But, regrettably, it took almost a century for most economists to realize that Keynesianism (monetary and fiscal policy) was not the solution. It was the core problem, to begin with.

A debt overhang was not going to be solved with more debt, however profusely lubricated with monetary aggregate largesse. Even back in 2008, it was crystal clear that it would only make things worse. It sure did. We bought ourselves some time (one decade), but at what cost? Much like in the perfect storm we find ourselves in the wrong place at the wrong time. Never mind the extraordinary debt pile. While postponing the day of reckoning we have synchronized a couple of worldwide social and economic trends that seriously endanger a peaceful future for our species.

Well-known facts first. A huge and relentless money and credit boom that began when Nixon closed the Gold window has taken our credit and monetary aggregates to unthinkable dimensions. Despite the CB engineered delay, we face the inevitable bust of the cycle -according to Mises. Okay, I know not few think that the Mises outcome can be avoided, but even the optimists concede some difficulty when trying to achieve just that. I will give you a couple of charts to illustrate the point. The first one is courtesy of the McKinsey Global Institute -the figures are largely worse two years later, particularly in China. Global Nominal GDP is 78 trillion for 2017. Do you really think we can we dilute this debt pile with no bust?

The second chart shows the monetary base growth implemented by the three main CBs since 2008. Staggering. BOJ and ECB are increasing their balance sheet in 2017 by a further two trillion! We are monetizing more than 7% of European GDP per year yet we are delighted to find out that we are achieving 1.5 to 2% growth at best. Does that sound like remotely sustainable to you?

Are you missing the PBOC’s assets in the previous chart? It is not relevant to include the PBOC in global monetary base growth. The PBOC has resorted primarily to credit growth instead of base money growth because they control the banking sector. Sex is taking place behind not fully closed doors, in the Total Social Financing variable. Quarterly figures are breathtaking (chart: Zerohedge).Nevertheless, you pay a price for everything, even in China. Liquidity constraints at financial institutions have become serious by now, and the need to handle them is one of the reasons to “de facto” suppress free market pricing for the USDCNH. They need their USD reserves to provide some credible backing to the amount of renminbi they have to print to keep their financial system alive.

The next chart (hat tip: Kevin Muir) shows that monetary base growth keeps accelerating, demonstrating that this is not a stable macroeconomic model. We need incremental amounts of new money to remain afloat.

Let’s not become too fixated on debt. Sadly, the obvious debt overhang is no longer our sole relevant concern. Things have deteriorated sharply in the last decade. Social trends and CB policies have bought time at the cost of fostering major impediments to growth, the traditional recipe in order to dilute excess debt creation. It is difficult to grow yourself out of debt past a certain point. It is impossible to do so after ten years of disastrous neglect of the supply side -favoring instead financial market speculation. The reflationary trade is dead in the water and I have been saying so for months. I am betting the farm on that. Growth will not put a blanket over our accumulated credit excesses this time around. Why? We have messed up our supply side. Growth is a simple matter. It depends on the number of hours worked, and productivity increases. The number of hours worked depends on the working-age population growth. Productivity has two drivers: education and CAPEX.

A multiplicity of reasons suggests population growth is a non-starter in the developed countries. And we do not want to take on some people from the underdeveloped world to fill the void. It won’t be easy to change that because we need more than the addition of new souls to the production process. We need “educated souls”, and it would help if they were spiritually educated as well. I don’t care the underlying religion or lack of it, provided the ethic code shows some consistency. No way we can achieve those educational standards soon enough.

Productivity will not fare much better in the short term. The CB orchestrated money flood, and financial repression has lured savers to play the “everything bubble” -destroying CAPEX expenditure and, consequentially, productivity growth.

Money has been diverted from the real economy to fuel credit and financial market excess. Zero rates have grossly added to discounted cash flow values simultaneously providing “faux” valuation support (the Fed model is a sophism), and animal spirit backing for all the speculative activity taking place. In the meantime, our supply side barely invests to cover depreciation of our current capital infrastructure. With insufficient CAPEX, and decreasing standards of education, productivity is a mess, and it will also take a long time to fix that. US figures are unnerving. It’s just as bad, or even worse, elsewhere.

Our supply side is hardly ready to take a leap forward. It shows some serious additional flaws. Zero and negative interest rates have endangered the stability of corporations in the US, taking the ratio of corporate debt to EBITDA to historic heights. Much less so in Europe and Japan, but China is another leveraged corporate monster. And our global supply side has maneuvered successfully to avoid taxation and convert competitive markets into oligopolistic structures. In most sectors, the winner takes it all, creating a spiral of increasingly oligopolistic global markets. The “FAAMGs” are the paradigmatic example. Nothing that can’t be fixed if we want to (the establishment does not), but this is not a supply side that can spring to efficient, widespread growth instantaneously.

At this point in history, we are fast running out of luck. There seems to be no limit to our woes. Robotics is endangering a meaningful percentage of our global workforce, adding to the problem of unemployment, and the increasingly inefficient distribution of wealth. It will be difficult to build a solid aggregate demand if we cannot put most people to work and pay them reasonable salaries. By raising the complexity of jobs that are left for humans (the rest will be taken over by robots or software), technology is compounding our educational problem. We not only need to recover previous educational levels. We have to increase them markedly, and steadily, over the next decade or more.

Lastly, the population is growing older as we combine falling natality with the extension of life expectancy. The population dependency ratio deteriorates as I write -and this is a secular trend. That does not bode well for entitlement pressures, never mind the undeliverable promises that have been sold by our politicians to the masses. Even if we had no accumulated debt, entitlement promises and pensions were a chimera. Add debt and life expectancy expenses (medical and pension costs) to the problem, and there are very few viable options left. A lot less than in 2008.

In fact, whatever growth we have been able to squeeze out of the system since 2008 has always been based on debt, money printing, or currency devaluation. Healthy, productivity-driven growth has only been found in a few small countries.

We have already shown the consequences of printing and growing debt aggregates. Devaluation of currencies is another traditional way to grow. But, globally speaking it is a zero sum game. You can devalue your currency against the rest, but not everybody can devalue at the same time. Some countries can opt for this, but it will never be a global solution to what has become a pervasive planetary problem: growth!

Think about it. We have simply been shifting growth around with currency market moves. A strong yen transferred growth abroad. A weaker yen took it back to Japan. Euro weakness last year stimulated the euro area and euro strength will sap growth if kept up.The Chinese would love to devalue if allowed to, Trump wants a weak dollar, Swiss and Swedes want weak currencies, the Bank of Canada allows bubbles to form when trying to keep rates low to protect the Loonie, New Zealand tries desperately to temper Kiwi appreciation. The minute the problem is global, currency devaluation is out of the question for most. We will not collectively devalue our way to growth either.

Sooner or later things will have to change … big! It is thus crucial to find out faster than the rest what road we are going to take -as these problems explode and provoke a new era for society and financial investments. It is not difficult to envisage the problems we are up against. It is near impossible to know what the CBs will do when pressured by future events, or the calendar of such events. Yet therein lies the reward in financial terms. We won’t get paid for outlining the problems. But we can make a killing if we are the first to guess what our establishment will do when confronted with reality. There is also great value in pinpointing the time more precisely. An unlikely feat unless luck helps.

What can CBs and governments possibly do? Well, let’s start by looking into what they are actually doing right now.

Muddle through: Austerity and Financial Repression.

From a macro-financial perspective, initially, I don’t care much if austerity is imposed reducing government expenses or increasing taxes. Of course, I have a view, but I think the relevant issue is to assume or not that millennials will accept to pay for our excess, either diminishing public services or allowing for a higher taxation that does not provide them with additional services.

In the long run, I am positive that the new generations will revolt against paying for our excesses. They don’t hold most of the financial assets endangered by a global reset. It is in their interest to bust the system and write off debt -and as a side effect they will devalue real estate prices and enable access to ownership of their homes. They cannot afford them now. Healthcare and educational costs are also pressuring them. At some stage, they are going to say enough is enough.

Austerity comes together with financial repression. We have done this in the past, in the aftermath of WW II. Investors help dilute debt if CBs impose negative or barely positive real rates on debt. It takes a long time but it can dilute debt significantly if maintained. It also helps public perception of the sustainability of a high debt load.

It is morally repugnant. Money is transferred from prudent savers to people and institutions that overspent or overindebted themselves. Old people are affected most because it impacts the return on the accumulated savings of a lifetime. Sublime unfairness!

But it works, at least for some time. The main problem is not just the moral underpinnings of such strategy,  but the significant side effects we explained in previous paragraphs. Zero rates destroy propensity to save, generate asset bubbles, bankrupt insurance companies, and pension funds if kept for too long, decrease CAPEX feeding bubbly speculation instead, augment wealth concentration, stimulate further leverage etc etc. Low rates are unsustainable in the long run, particularly in economies that need substantial CAPEX investments due to the complexity of the installed productive capacity on the supply side. If kept low for too long, productivity stalls, creative destruction subsides (no cleaning up of economic zombies) and growth languishes.

The key issue is: can you perpetuate austerity and financial repression? The answer could very well be yes. Acknowledged, you can’t be sure of anything nowadays, regardless of the fact that even CBs themselves see obvious stability risks (ECB chart released last month shows it clearly). Yet my own view is that, before long, the have-nots will denounce austerity. Even if that doesn’t happen, over time, financial repression will stymie our residual growth potential, taking the global economy to a standstill and a global recession. It’ll be curtains for markets after that. When that happens, if it happens, is anybody’s call.

The nuclear option: Debt defaults.

A plain global default of the unserviceable levels of debt is the free market’s choice. Most active independent Asset Managers are desperate to get there. Put me on that list. No matter how painful, we need to move ahead, and the sooner the better for the new generations. Defaulting is not something to look forward to, but the alternative options are even less palatable. Governments should print only what’s needed to protect bank deposits “strictu sensu”. All other financial assets should teach their holders the true meaning of risk and fake valuations. We ought to leave moral hazard behind before we engage in a new economic model that precludes credit and monetary induced growth.

Understandably, CB’s try to prevent this outcome. It was a long time ago that central banking was an honest profession. Bernanke is still arguing that he did the right things in spite of assuring in 2008 that subprime risks were “contained”. Amazingly he kept the job for another seven long years.

The Zimbabwean way. Currency debasement using inflation.

This is the traditional method to destroy debt. You can still opt to inflate away your debts. But you have to generate inflation in the real economy for that end. And go ask Mario, Janet, or Kuroda-san, it ain’t easy. Somehow the money is always finding its way into physical or financial assets. Even if you succeed at stoking inflation, you have a new problem: keeping long-term rates low (you can anchor short-term rates, but to anchor long-term rates as inflation grows, you need some kind of permanent QE).

If inflation becomes the preferred option and it takes hold, you want to convert your money to equities and physical assets fast enough. An inflationary environment is the only way to prevent a stock market bust. All shorts would be exterminated.

The existence of this option is what makes things so difficult for a fund manager. Equities are grossly overpriced but would be the asset of choice in an inflationary scare. We just had one. And you never know what CBs might do. It CBs fail to generate inflation, intentionally or not, debt defaults are forthcoming and prices could be cut in half. If they succeed, equities will soar as the asset that best protects you in that environment. An extreme binary option between both tails of the normal distribution. Buying index puts and calls makes a lot of sense, particularly with current levels of implied volatility. Only the difficulty of the timing puts me off.

Tough times ahead -but you have to believe in humanity.

We have painted ourselves into a corner with no easy way out. However, the choices that will be made greatly condition the optimal investment strategy. Impossible to know well in advance. I will do my best, but can’t help a feeling of despair when I think about what we are up to. Preserving wealth in this context is a vast undertaking. When faced with something we don’t know, and can’t possibly know for certain, you have to remember Mark Twain’s prescient advice. It ain’t what you know, but what you think you know, but don’t, that will get you into trouble.

Remaining humble and adaptable is key to surviving this future, Mauldin denominated, “Global Reset”. While we wait we can lift our spirits remembering some of the highlights of the human species. If Donizetti and Pavarotti could write and sing this piece, there is at some point a bright future for us. I always run out of tears when listening to it.