“Education is what survives when what has been learned has been forgotten”
Language is great. When used properly, you can sometimes come up with some easy to read, compressed wisdom. And making reading easy and short is not an unwanted or unnecessary outcome. It is paramount in our present “low intellectual effort” social environment. In that sense, I get lots of complaints about my posts. Not that they induce the remotest doubt that I should adapt to the easy-reading, no-substance, dominant posts of today. Private banking weekly “résumés” are guaranteed to make you laugh -or sob, in a heavyhearted remembering of what the “homo sapiens” once was like. No new ideas to share, and a compendium of financial press statements and reasoning of the lowest level. Yet it is exactly what their clients and readers want.
People talk monetary policy like it was soccer. As a Spanish politician, now defunct, once said: if everybody only spoke of what he knew about, there would be a planetary silence that we could all take advantage of in order to read and learn. Twain also cleverly phrased the problem. It ain’t what you don’t know, but what you think you know and you don’t, that will get you into trouble. Most investors think they know what they are doing because Fed chairs have eliminated downside risks for what seems an eternity. They don’t. They are in serious trouble today.
Brainless, memory-worn investors, humbled now to a degree, are getting what their educational level has entitled them to. Only education might have prevented investment patterns that enabled the last financial boom (and the previous ones). Greed always follows fear in the investment cycle, and only strict educational levels can help us humans remain disciplined at all times. Particularly if CB’s are playing cheerleaders and conducting the herd to economic suicide (with the inestimable support of the sell side segment of the securities industry). Investors followed the pied piper of Hamelin in droves, because once they had forgotten 2008, those memories gone, there was nothing else left to prevent them from doing so. And it sure helped that Ben played his Hamelin pied piper role magnificently. I hope history will be able to assign responsibilities for all the grief and misgivings his conduct has produced. More than a few Central Bankers ought to be jailed by the time this financial clean up is over. Highly unlikely though -save for isolated cases like Iceland.
Following up on compressed, easy to read wisdom, but somewhat bloodier, the adage about bulls and bears making money -while pigs get slaughtered-, is also a universal truth. A truth that had been deep frozen by the “easy money” and the “put for all” idiotic Fed policy. Greed has been relentlessly rewarded by CB’s -generating a pervasive moral hazard environment for the masses. We ran out of examples of risk materializing in heavy losses for imprudent investors. Investors were bailed out time and again at no cost. CB’s sponsored the party and ensured an “all you can drink” punch bowl use. I have felt like a priest recommending sexual constraint in a permanent non-stop sexual orgy, assuaged with lots of alcohol and drugs in order to make it last.
But, if something could not go on forever, it was certain to stop at some point. Yellen and Fisher finally understood the printing orgy had gone too far, for too long. Bubble pricing in financial assets, excessive risk undertaking by investors, and notorious malinvestment were all too evident. All their fed-talk about the strength of the US economy is bullsh.. to cover their backs. And they know it. Anyway, even if they try to hide the reasons for tightening us out of the easy money mess, we have to credit them for being brave enough to try to put an end to the party. Regrettably, their decision will induce gargantuan consequences that were baked in the cake by then. If global money magnitudes remain more or less stable, the traditional investment rules and adages will be applicable again. And even if that is undoubtedly good news for the long run, we will likely be unable to get to that point -while remaining financially alive.
Investors will be massacred. Yes, I understand many will hate me for suggesting people in Sodom and Gomorrah did need a punishment, particularly if they are being crushed right now. Nevertheless, I can’t help thinking it is good for the human species, and what’s left of the “homo sapiens”, that most financial pigs get slaughtered again. Unless education plays its role, we only learn the hard way. Be it so. But, once this financial collapse is over, let’s not forget that education is the only way to preclude new pied piper of Hamelin induced bubbles. And the subsequent blood in the streets.
Not all pigs will be slaughtered though. Some pigs will outlive this event. But, at the very least, if an investor wants to be a surviving “pig” (an investor with inordinate amounts of risk in his portfolio), he has to be very smart and well educated (with excellent emotional control). Like Stan Druckenmiller. He can be a pig (in his own words) and live a long, financially successful life. But that is the exception that all but confirms the rule. Pigs don’t have that many ultra-smart, well-educated, individuals. You can take Stan’s advice on nearly everything -except being greedy in the markets. Not everybody can be a pig and survive.
The rest of us mortals desperately need to allocate more hours to reading and learning, and less to greedy, as you go, risk ignorant, trivial, no-homework investing. Just as there is no gain without pain, all risk taking investments are subject to mean reversion. Free rides or lunches are inviable -no matter how much Larry Summers (another relevant pied piper) can voice them to be in existence. At the end of the day (or decade or century), it is only the quality of investment per unit of risk that determines the long term successful investor. And when it ain’t so for a long period, it is not a symptom of a “great moderation”, but rather a dire warning that something is going terribly wrong (and has become a true menace for the survival of what’s left of the homo not so sapiens).
We need a nondisruptive monetary policy, with stable amounts of money and natural interest rate levels, for those principles to re-establish themselves. Once we get it (keep your spirits up: it will happen sometime in the future), market investment will be again subject to mathematical and probability rules. And, I really can’t wait to see, when the tide ebbs, who was swimming naked. My hunch is that the herd as a whole was mostly swimming naked while singing to the lively tune, “in our Central Bankers we trust”, played by the pied pipers next to them. They will be massacred. This is only the beginning.
The bad think about being an Austrian outsider is that you are distanced from society, and they inevitably tag you as a perma-bear -if not, in nastier terms, as a spoilsport. Non-conventional thinking, when outside the politically deemed correct parameters, is severely punished socially. The good thing about it is that you think for yourself -and mainstream or sociological biases do not dent your thinking. Einstein used to say that you have to look for different approaches if you are to come up with some relevant scientific axiom. More of the same doesn’t help you prosper (and where it does take you is near insanity).
I have been thinking apart and using an entirely different methodology. Hence, I can state that, regardless of the faster and faster stream of events, and the ensuing carnage, I have no changes to apply to the economic thinking outlined in this blog. I continue to sustain what I think is an alternative coherent and comprehensive economic theory bloc, in the terms I have been laying out in my posts. In fact, I incorporate only minor adjustments over time unless reality proves me wrong. And yes, despite the last sentences suggesting I am tooting my own horn, I remain aware that I have to keep humble enough to change my narrative when the time comes to be wrong. And it is sure to come, inevitably everybody is wrong at some point. But, regarding economic policy, it is not my turn now, but that of mainstream economists.
As I have said many times before, I do not change my views often, so it is important to emphasize any changes in the narrative. One of them is the introduction of inflation (in the traditional consumer goods and services pricing) as a concern. I did so in my last post. It is a very relevant change for my investments because it means that I have shifted from seeing the outcome with a deflationary risk bias, to seeing the risks between deflation and inflation as “balanced”. Short term we must still think deflationary, but in a couple of months -particularly if the CB’s engage in one last print to save the bubble price statu quo in financial markets, inflation -and even hyperinflation- could become the comeback kid.
My long term thesis, ever since the GFC started, is that inflation was nowhere to be found -and certainly, CB’s were right when they said that printing would not exacerbate inflationary pressures. Aggregate demand was just not there (it still isn’t), and a demand-pull reflationary process was to be deemed unlikely. Slack was everywhere, so costs were headed down (“prices paid” have shown this to be correct). By now I have changed my mind. I still think demand-pull inflation should be out of our radar screen of economic concerns. Nonetheless, from now on I think we have to be aware both of cost-push inflation risks, together with a possible, melt-down induced, last round of massive money-printing inflation risk.
The fact that inflation is back as a possibility, complicates our investment stance further. Long duration bonds are also risky from now on, and we cannot use duration to incorporate some sorely needed yield to our portfolio. That leaves term yield spreads out, together with credit spreads. Only currency risk is left, if we are to enhance our meager (or outright negative) coupon based fixed income returns.
Tough as it is, there is no way we can postpone protecting against inflationary risks.
- Qualified labor slack is small. Educational levels are not rising. And they should be rising big if we are to employ the unemployed and improve our productivity (the only way to improve the economy if labor and capital figures are roughly constant). Software developers are the paradigmatic example. They are hard to find without competing in price with their actual employers. If we don’t educate the population, there will be an abundance of entitlement seekers and a shortage of qualified workers.
- Regulatory costs continue to rise. There is a point that linear models cannot capture, in which the advantages of more regulation (protecting the population against abuse, physical or health risks), are outweighed by economic costs. Try and explain this concept to a dumb, demagogic politician.
- Entitlement related costs (healthcare, unemployment, pension funding, immigrant costs) are soaring and will have to be paid for. Most of these costs are inevitable, and they will pressure the cost of what is sold in the market. We can’t ignore longevity and the pension and healthcare costs associated with the new life expectancy. The same reasoning is applicable to environmental costs. Pricing will be pressured to allow for them both -in the production process.
- Interest rates will go back up after the debt write-down and generate capital costs that are nonexistent today. Money will not be for free for long -whatever Bernanke or Kuroda may think. The market will re-establish itself, and raise funding costs for businesses. Goods pricing will be pressured by financial costs as well.
- CB’s are likely to press the nuclear “print for your life” button if deleveraging, and price deflation, become a sustained and fast market dynamic. This last print -if and when it happens- is likely to lift the anchor in actual inflationary expectations. It is a very real risk. Confronted with a melt-down, the pressure on CB’s will be enormous.
We are not anywhere near the end yet. But I think the Fed decision to end easy money policies (the fact that they raised rates 25 bps is anecdotal) is the beginning of the end. They now have to prove that there is a way out of incrementally easy money for nearly two decades. I congratulate Yellen, and above all, Stanley Fisher, for having the nerve to engage in a transition back to normality. It takes courage to do what they have done. Unfortunately, I side with Kalecki and Mises on the impossibility of success in their quest. It is never too late to try and begin again, but the meltdown is inevitable if they do not revert to printing.
My portfolio suffers no relevant changes from what I related in detail, in my December post. A couple of comments on that.
1. Equity shorts have been vindicated as I write this. I think there is a lot more downside unless Yellen throws in the towel and prints again. I do not think backpedaling on their explicit schedule to raise rates four times this year (Fischer, Williams) will be enough to stop the carnage. I do not think a negative rate policy for the USD would support prices either. It has to be a fresh round of money printing, and even then…(see Buffet indicator -just to show one of them).
The Chinese Yuan and their equity market are in a genuinely precarious position. US equity overvaluation is a joke compared to Shanghai. But shorting the Chinese market from here is gambling because nothing is what it seems. You have to be there to see for yourself -their numbers for everything are totally unreliable.
Depending on your risk profile, and your expertise, I suggest shorting one or another equity market -more or less intensively. I see a compelling reason to short nearly all of them (of course VaR considerations prevent me from doing so).
The only thing that is beyond doubt, in my understanding, is the need to refrain from playing the long side -unless liquidity increases again. The downside remains huge, even when we get to ten or twenty percent below the top. Sell vicious bear market rallies if and when they come (they will be establishment supported and induced). We might have one soon. The market is massively oversold in the short run.
You always have to toss in a caveat for a trade. Or just call it seeing the other side of the trade. Do remain on the alert for printing or liquidity increases. They are the only game-changer policy left in their toolkit, and they hold back only because they know using it again would come at a heavy price. But they will become desperate to stop the price debacle.
The reasoning for my shorts was explained over the last few posts. No changes in that reasoning. If any, I am more convinced that profits are headed down, both in absolute terms and as a percentage of GDP. I saw that trend coming more than a year ago. Currency exchange rates may move pricing power around. But listed companies’ profit expectations are to be held firmly down. In a context of decreasing liquidity and high corporate leverage, it is a potentially explosive situation.
Liquidity growth might be reignited, but the profit scare is going to last for a couple of years -and it will be a lot worse than a scare. Accounting gimmicks are being used more and more as well (see chart). Who wants to own equities in this environment?
2. I am increasingly confident that a recession is in the cards for the US and EM. Macro data has been supporting this suggested outcome -since I first introduced it in one of my summer posts. I thought a recession could be with us this first quarter, and I find myself early once again -but most likely right.
Tactically speaking, Europe is still doing well, and GDP growth should continue for a couple of months. You want to be careful about shorting the Euro until the continent catches up with the external global recession. For a while, it might look as if the Eurozone is the cleanest dirty shirt. It isn’t. I live in Europe. But make sure you adjust your timing to the cycle time lag between the US and Europe. Right now the EUR is pressured up, not down. It’s only a matter of time, but timing is critical to investment success.
Sovereign spread widening should precede structural weakness in the euro. It’s best to wait for that before you go all in.
3. Expect the Fed to try to slow or impede USD strength. But do not try to short the USD unless Yellen prints again. Return of your money comes first. It pays to be skittish on shorting any USD pair. Particularly the USDJPY pair. The yen is not a safe haven currency anymore! They are as bankrupt as the rest (yes they are a creditor country but what’s the use of that, if debtors don’t pay?).
4. Gold might move up in a panicky environment, but I still think moves will not be significant unless the Fed prints again. And in that event, a rising tide will lift all boats. All commodities would rebound strongly. Gold is kaputt as a safe haven. Some things are different this time. Yeah, I know that is a dangerous statement. Anyway, I am not suggesting shorting gold, and it is always easier to make up for lost opportunities than it is for lost money. No gold in my portfolio.
5. Credit risk spreads will continue to widen, both for sovereign and corporate bonds. Remain long credit spreads. I stick to my Bund-OAT/BTP spread widener in strength. I see lots of credit spreads with significant upside. Pick your trade, but always play the long side in credit spreads. I know Goldman is suggesting the opposite trade to mine: BTP’s reducing their spread to Bunds. They are, no doubt, a smart bunch. But I remain undeterred. BTP’s are only a third of my trade while the Bund OAT spread is two thirds. Italian banks, and slightly less so, French banks, are an accident waiting to happen. With dire consequences because of the size of their balance sheets (particularly French ones). I see core periphery spreads widening as an intermediate to long term trend in Europe -in the context of a global credit risk spread widening.
I would stand aside yield curve flatteners for a time. And I remain neutral on duration as a rule. We have to wait and see how things turn out. No need to pre-commit. Bonds will continue to be safe-haven bid for a time. But a fresh round of printing would turn the tide. So would a global melt-down with abundant defaults. I see higher long term rates after that.
To state it unambiguously, I think long term rates will continue their downward path, until we see fresh money printing or a massive global default. I think those are alternative events so, any case, a couple of months/years down the road, rates will back up viciously. Bid your time, it is hard to see the numerical difference between wrong and early. Bonds will provide a great shorting opportunity in due time. Market distortions will always allow us to make serious money, provided we get the timing right.
Enough is enough. Let’s see how this wave of financial panic unravels. CB’s are not to be underestimated. They will play their hand via their POMO desks, and verbal intervention. And they can affect the process significantly. But they won’t turn the tide unless the FED prints again. Whatever you do, do not average down your equity, commodity or HY portfolio holdings. Sweat it out if that’s your hunch, but do not add to your risk exposure!
I will be back sometime next month. Good luck with capital preservation. We are all going to need it after this weekend plus MLK day truce. Markets will be fully open Tuesday morning again. Monday could be a transition day, because markets are clearly oversold, but the trend is down. Beware false dawns -unless they print at the Fed.