Yeah! Crazy I very well might be, or at least I will admit to looking like it -to conventional thinkers. Fighting the tape has not been the best therapy to preserve my sanity, and that is what I’ve been doing for a long time. Constant procrastination by our economic and monetary authorities has, more frequently than not, driven me mad. It upsets me deeply to observe how, time and again, we avoid the decisions that are desperately needed to reroute us to a viable and peaceful future. Looking back, I still can’t believe what we have done to ourselves as a species.
Crazy or not, decidedly, I stand for the species assuming full responsibility for our leaders’ mischief. We have the leaders we deserve. It is, unquestionably, a depressing reality. To make things worse, it is hard not to be reminded daily, of the dismal quality of our dominant macho-alpha representatives. All the way from Hollande, Zapatero, Corbyn, or Putin to prospects like Le Pen or Donald and Hillary, across the Atlantic, you can recreate the same story. Honest and wise people never progress. Only populist procrastinators, dumb, ruthless, or radical politicians get to lead the pack. And that has been going on for a long time now. Think as far back as Jimmy Carter. Democracy is a disaster when the mob’s educational level is not above the minimum requirements for a wise vote. Take a hard look at our elected macho-alphas. Recently John Mauldin wrote an article considering the chance that we have reached the apex of stupidity as investors. That goes for voters as well. If we are not there, we are indeed close enough.
Decades after permanent procrastination by a series of appalling leaders, the situation is an unmitigated disaster. A couple of points to make sure I am able to transmit the landmarks of the spot we find ourselves in.
- Politically, the right or left wing extremes, or dumb populist proposals are the increasingly likely winners. Whatever social or economic policies they try to implement, I am not optimistic about their results. Syriza in Greece is the paradigmatic example. The Trump GOP or a Corbyn Labour victory would be a disaster. The balance of power increasingly tilts in favor of suspect parties.
- Socially speaking, humankind is broken beyond orderly repair. We will need a long healing period if we are to cure the wounds inflicted by unfairness and inequality. Geopolitical stability will not be easy or fast to achieve. Piecemeal wars are set to continue for a while at best. If not of the global kind.
- Economically we have run out of palatable options. Either we print and spend forever until hyperinflation finally appears, or we try to straighten things out and go through a massive debt write-down process that is unlikely to be peaceful. We are bankrupt, and there is no easy way out of that. More monetary stimulus is what we keep on doing.
- If we look at the ecological balance, not only climate change threatens us seriously. Our marine ecosystems are being devastated by overfishing. Land desertification continues at a rapid pace. And we are close to the limits of our friendly planet when it comes to some types of mineral or organic extraction. Not to forget the recycling issue that is becoming of growing significance. Some meaningful new costs are awaiting our future supply side (Gail Tverberg)
- As a species, we are growing older and we are inverting the population pyramid with no relevant provision for the consequences of this inversion. Sooner or later we will be confronted with a terrible reality. We did not save the money we need in order to sustain retirees’ living standards. ZIRP and NIRP make underfunding a lot worse. Decisions on this issue are unlikely to satisfy all parts involved (future workers and retirees).
- Ethics and education have been degraded substantially. Money and immediate satisfaction are now the drivers of our behavior. Dignity, loyalty, and generosity are out. Relativity is the new rule of the game when it comes to ethics. Groupthink pervasively excludes individual thinking outside socially accepted parameters. Educational levels have cratered. Personal effort is despised in some countries (like Spain).
That’s the way things are now, whether we like it or not. There will be a better time for us, but not before enduring some terrible misfortunes over the next couple of years. So we have to make the best of what we’ve got. And, right now, we have two things left, time, and money (hopefully).
Time is being lent to us by our beloved central bankers. We have to thank them for it. Had it not been for them, it would be a different world after the 2008 GFC. So we have been able to perpetuate the old system for a couple of extra years. At a serious cost (no free lunches Larry)! Our debt pile has increased by 57 trillion USD (McKinsey), and our global monetary base has multiplied by a factor of three (Goldman Chart). Monetary debasement has been huge.
The happy fact is that we are still here, seven years later, and counting. We should all make sure we make the best of whatever time might be left. Sail, play golf, and enjoy ourselves as much as we can, while we are still (nominally) rich. Some of us will not be able to pay our green fees after the debt write-down. If we want to improve our handicap it is now or never.
Money is also still in our pockets (or bank accounts). Most of that money is an illusion because it has been printed by central banks, or written by the fractional reserve banking system against assets that are worthless, or at best worth a fraction of their book value. If I was aged twenty -five, I would spend it -because it’s prospective buying power is seriously suspect. But I’m fifty-seven and am sure to need it in a couple of years (if I am still alive). So I have to try to protect it.
Wealth protection has become a very tough job. We all have to protect our buying power. Yes, it sounds like gloom and doom just for the sake of it. But it’s not. The buying power of our savings is really at stake. It can happen through write-downs, destroying the corresponding nominal wealth, as our credit rights are weeded out of our balance sheets. Or we can lose it through hyperinflation, somewhere down the route of our heavy “nirping” and “printing” journey.
And, to make things difficult, we do not know the exact route to impoverishment. It would be a lot easier if we knew what to protect ourselves against, hyperinflation …, or massive defaults. Maybe, we will even get a combination of both (not unlikely), at different times, in separate areas (developed markets or Emerging markets). It is difficult to simultaneously fight both fires (reflation and nominal debt dilution), and ice (deflation and defaults). Dreaded stagflation is also a real possibility.
Yes, I was considering inflation! As of late, everybody is mentally playing with the hypothesis that easy money can go on forever, in view of the meager inflationary (or even disinflationary) readings we are registering in most countries. I am not so sure anymore. Inflation is down, but not out. And yes, It bears remembering that not so long ago, I repeatedly disregarded inflation as a threat to the continuum of Keynesian-inspired, ultra-easy monetary policy (see most of my previous posts). But things change fast in this crazy “run for your financial life” environment.
I am beginning to see the white in the eyes of cost inflation, at least in labor costs. No question the army of unemployed is impressive in developed markets. But most of them are becoming “unemployable unemployed”. When you look for the right candidates for a job with some qualification, you realize that slack is ebbing. A relevant portion of our unemployed is rapidly becoming obsolete. Adequate candidates are capturing some bargaining power -if you look at jobs above the “waiter” level.
And workers have to gain some bargaining power because inflation of some relevant parts of what they need is soaring. Education, healthcare and shelter costs are going ballistic in the US. Higher costs of living inevitably translate into higher labor costs. Easy money and regulatory costs feed the process surreptitiously.
The cost of capital will also rise. Post debt defaults, the amount of real capital left will be small, and real rates are also sure to go up. There is not that much real capital available. Most of the world’s savings are invested in dubious assets. Once we clean balance sheets, netting out fictitious assets, there is not that much real capital left. Equilibrium real rates are very low today -and will continue to be low in this environment. But they will probably be on the high side after a massive global default. Financial costs will surge for the leveraged survivors (and I am not sure those last two words are compatible). ERP’s (equity risk premiums) will correspondingly go up. The perception of risk will come back with a vengeance. Once this madness is over, real equilibrium rates can only move in one direction (not an unlikely event if you see the chart underneath).
Finally, I have repeated ad nauseam that fiscal policy will have to switch from taxing individuals and workers, to taxing companies for their use of aggregate demand (sales tax). So that will also be a cost increase for the supply side. Large caps and multinationals cannot see it coming, but I think a huge increase in their effective tax costs for doing business is a done deal. Somebody will have to pay for essential entitlements, and they are the obvious candidate for a variety of reasons. Taxation is not strictly a cost, but it influences pricing.
Yes, inflation is certainly nowhere near now. But it is not dead. Demand-pull inflation is finished, but cost-push inflation is right there, waiting to bite. The minute the deflationary process is finished, we can easily switch to hyperinflation -considering the abovementioned factors, in the context of a worldwide inflated monetary base (see the previous chart).
Let’s turn the page, and take a look at the opposite risk -deflation and defaults. When it comes to considering the chances of losing buying power because of our debtors not honoring their debts, the issue is neither down nor out. Look at the prices of high yield, and consider the number of rating downgrades taking place. HY ETF’s are being massacred. Unless we get a fresh round of USD money printing, things will not get any better.
In any event, some serious defaults are unavoidable (See chart for debt at the corporate level). You don’t even want to look at autos o education related credit levels -an accident waiting to happen. Particularly if you combine them with record auto inventories for sale.
If we look at sovereign debt dynamics, it gets worse. Take a close look at the European periphery where things are said to be improving. Spanish and Italian ten-year bonds have a lower yield than the US equivalent treasury, how can they be considered a safe investment? Even if we hyperinflate most of our debts (debt dilution) out of our global non-consolidated balance sheet, I can’t emphasize enough the need to tighten our credit standards. What’s the use of picking up some yield if you get a serious haircut one or two years later?
Financial markets stink. Commodities are not done yet, further price cuts are still likely, even though one begins to consider there is a limit to everything. Surely resources will end up being worth more than zero (I hate zero). Bonds and equities look terrible. There is really nowhere to hide. Gold will not do. My point of view is that value will be associated with utility or usefulness in the immediate future. Marginal utility is the ultimate economic driver of price in economic theory, and we are going all the way back to economic fundamentals after this Keynesian epidemic is cleaned up. The marginal utility of accumulating gold is subject to the same diminishing law. Other considerations for value, like scarcity, or marginal cost of production, will be left behind in a financial survival oriented world. If you own something that is not useful, or better yet, essential to life, it’s price will stall (best case scenario) or drop like everything else (defaults and write-down scenario).
Expect more of what we have seen over the last two years with gold unless we hyperinflate. My Austrian colleagues will not be happy with this view, but then, I have never considered myself a hard-core Austrian school economist. A gold standard and free unregulated markets with no supervision will not help us out of this mess. At least we Austrian economists, light or hard-core, didn’t generate the problem.
Bonds and shares are priced beyond logic and suggest we are near the apex of stupidity for investors. It is obvious that retail investors are not thinking. To make things worse, most of our investors are HFT, index funds, corporates doing their buy-backs, or central banks investing freshly minted reserves. They are not even meant to think, they do passive investing. They just follow the mob. Nevertheless, even the apex of stupidity is not enough to sustain prices where they are. When you look at actual market prices, four possible combined drivers stand out.
- Economic actors are ignoring the obvious because they are working hard to avoid cognitive dissonance. They need to think that everything is alright, and everything will be alright -and remain the same (or similar). They believe what they need to believe. They want to be comforted by good news (see the last essay by Jeremy Grantham)
- Prices are held up because a substantial part of our nearly extinct savers need income. Deprived of interest rate income, they grab whatever speculative instrument is available to serve the same end. Risk is ignored because they need that money. They have no other option if they are to pay for their food and lodging.
- The market is rigged. CB’s are twisting and turning prices to their advantage using their POMO desks and others (Citadel?), but always in stealth mode. Price formation is only apparently market driven, in truth we are in a Soviet market pricing system.
- Central bank reserve investments and corporate buy-backs have been an impressive driver for this market. I think they are in the last stages, but a fresh round of printing would add new reserves to be invested in equities and long duration bonds. I love the SNB’s portfolio (particularly Valeant). Aren’t they smart investing our freshly printed money!
First of all, I think a short volatility type of portfolio is not the way to go. Buy and hold is very inappropriate today. It is a soothing way to manage assets because the stream of returns is nice and steady, you can avoid positions where you are inevitably betting the ranch, you feel safe because you think you are diversified (a goddam sell side lie!), and you do not have career risk.
Even if you are doing a macro management style portfolio you want to be careful about ending up in a short volatility type of portfolio. Macros have been killed this year in just two or three events (EUR USD 3% move in two days was the last episode). You sit on your euro shorts, become overconfident, and voilà, a Draghi volatility spike wipes you out.
You do have to be flat to short the euro, but no need to overstay, or oversize. Particularly when bartenders and office clerks are also going short the euro. Crowded trades are becoming as dangerous as crowded places. If you have a reasonably sized euro short, you can take in the last move with a grain of salt -and remain there. That is exactly what I have done. I was short the EURUSD for a residual 50% of the underlying portfolio and I still am. I only gave back November gains. Not happy, but still alive and in deeply in the money for that trade.
Once you have understood that this is not the environment in which to rely on contained volatility, you have to be really careful about what you are betting the ranch on. And you have to accept that if you play volatility on the long side, your returns will have to be bumpy, but, hopefully, satisfactory in the long run. I am betting the ranch on two ideas.
1. I have been shorting the S&P 500 for more than a year now (ever since I wrote “timing the top“). But I have been tiptoeing around until this last summer (see “the top is in save 4 QE4“). Since then I hold a well sized to XL short. To be sure, I’ve been playing around with my position’s size (I was stopped out of 50% of my position in the October rally). But always short for 50% or more of my portfolio (Index wise I consider 50% a large trade, whilst in currency plays I think 50% is reasonably small).
I still think the top is in, save for new USD printing (an unlikely event in the short run). Yes, I still think the trade offers an excellent risk-reward ratio. And I stand by the assertion that you always have to be flexible when shorting an equity market -stop losses are healthy even if they are painful as well. No news here.
It is always difficult to add new arguments to what is being written about the US equity market. Breadth is a disaster, and HY divergence is a tell-tale I always follow swiftly. Valuations do not drive markets in the short run, but this Ned Davis chart is good. It gives you the median stock valuation. ¿Still want to mess around with a long only portfolio?
And profit margins are still awesome. The chart is already dated (they are down somewhat), but it offers a very good historical perspective, in a context of earnings growth going south. You just have to be short a market like this (charts via zero hedge).
2. Currency-wise, may I further insist that USD shorts are a serious mistake (unless they print again at the Fed), and EUR shorts are a must do. CNY (or the offshore CNH) is a massive short. Playing USD and EUR, you want to be flexible picking your pairs and your timing -and carefully considering size. Being flat is not a waste of time. You want to play the market’s volatility increases, not the opposite way. If you can find and easy way to short CNY you can go all in on that trade.
I have been involved in a EURSEK short (long SEK vs the EUR) since January. Why? Same reasoning as with the CHF until January this year. In fact, I just switched from CHF longs to SEK longs. Beating the Riksbank is a matter of time. You want to use forwards and swaps for this trade, because holding SEK in your accounts is going to be a nuisance. I hate to leave cash balances at the bank, and holding SEK compels you to do so. I am 120% long SEK versus euro. And I will ride out all Riksbank interventions (like the one this last week). I am old and can be patient.
I won’t be writing again before year end. I wish you all, the best Christmas. Next year will only be happy if we learn to enjoy more with less. It’s not that difficult if you try. And let me hope we are lucky enough for the next couple of years. We are going to need it. See you in 2016!
Post datum. I published this post on Saturday morning (UTC time). It is now the afternoon and I literally forgot to mention my third relevant trade. As I said in the post before last, I initiated a long credit spreads trade. As a rule, I think credit spreads will widen, and term spreads will flatten. You can implement this short selling HY, and simultaneously buying the investment grade equivalent bond. My choice has been playing sovereign spreads. I am long bunds and short the same amount in OAT and BTP. Mispricing of credit risk is particularly relevant in the European periphery. For a reason of course -Mario Draghi and co. That reason cannot and will not last forever. I see little downside here, so the risk reward looks good to me. I will wait patiently for the near sure reward one day or another. It is anything but a crowded trade nowadays. I love to play contrarian.