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Archive for July 2013

Archive for July, 2013

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Things That Make You Go Hmmm: The Candyman

 

Who can take tomorrow
Dip it in a dream
Separate the sorrow
And collect up all the cream?
The candyman, the candyman can
The candyman can ’cause he mixes it with love
And makes the world taste good.
And the world tastes good ’cause the candyman thinks it should.

 –   “The Candyman”, Willy Wonka and the Chocolate Factory

In 1964, Roald Dahl penned what is arguably his most famous book. It tells the story of a poor boy who, thanks to the discovery of a golden ticket concealed in a bar of chocolate, wins his way into a magical factory run by a mysterious oddball named Willy Wonka.

The book, Charlie and the Chocolate Factory, was a smash hit; and inevitably the book was turned into a screenplay, which spawned a 1971 movie in which the word Charlie was replaced in the title with the name of the character the movie’s producers felt was far more important to the narrative: Willy Wonka. And so it was that one of cinema’s great transformations from written page to silver screen took place, and in the process one of its finest characters was born.

Gene Wilder’s Willy Wonka is the only portrayal officially recognised and endorsed by Things That Make You Go Hmmm…. Accept no imitations.

As much respect and admiration as I have for the extraordinary talents of Johnny Depp, just … no, sorry. There is only one Willy Wonka, and it’s Gene Wilder.

Now that I’ve clarified my position on that particular issue, let’s proceed.

I am sure that, somehow, there may be readers who haven’t either read the book OR seen the movie; and so for them I include a short synopsis of the story. Please be apprised that it contains spoilers that, well, give away the entire plot and the ending, to be honest. If you have read the book or seen the movie, it may be worth reacquainting yourself with the plot before we dive in any deeper:

Mr. Willy Wonka, the eccentric owner of the greatest chocolate factory in the world, has decided to open the doors of his factory to five lucky children and their parents. In order to choose who will enter the factory, Mr. Wonka devises a plan to hide five golden tickets beneath the wrappers of his famous chocolate bars. The search for the five golden tickets is fast and furious….

Charlie Bucket, the unsuspecting hero of the book, defies all odds in claiming the fifth and final ticket. A poor but virtuous boy, Charlie lives in a tiny house with his parents, Mr. and Mrs. Bucket, and all four of his grandparents.

In the factory, Charlie and Grandpa Joe marvel at the unbelievable sights, sounds, and especially smells of the factory. Whereas they are grateful toward and respectful of Mr. Wonka and his factory, the other four children succumb to their own character flaws. Accordingly, they are ejected from the factory in mysterious and painful fashions.

During each child’s fiasco, Mr. Wonka alienates the parents with his nonchalant reaction to the child’s seeming demise. He remains steadfast in his belief that everything will work out in the end….

After each child’s trial, the Oompa-Loompas beat drums and sing a moralizing song about the downfalls of greedy, spoiled children. When only Charlie remains, Willy Wonka turns to him and congratulates him for winning. The entire day has been another contest, the prize for which is the entire chocolate factory, which Charlie has just won. Charlie, Grandpa Joe, and Mr. Wonka enter a great glass elevator, which explodes through the roof of the factory. (Source: iSL Collective)

In the movie’s first act, Bill, the owner of the sweetshop, sings a song written by Anthony Newly and Leslie Bricusse, called “The Candyman”, which praises the wonderful world created by Wonka and espouses the pure joy of living in a place where everything is deliciously sweet; miracles, dreams, and rainbows are ubiquitous; and any sorrow is separated and discarded in favour (yes, there’s a u in favour — deal with it!) of cream … pure cream.

As Bill hands out free candy to a group of wide-eyed kids, you can see in their eyes the pure joy that only comes of living in a world where everything is wonderful and nothing bad ever happens.

Ladies and gentlemen, I give you … the S&P 500.

Source: Bloomberg

Yes, the US equity markets have bought firmly into the idea that everything is right in the world and that nothing will ever be allowed to go wrong. A prime example of this attitude emerged last Thursday, when we were greeted with two irreconcilable headlines on the same day:

Detroit declares bankruptcy, becoming largest city in U.S. history to go belly up

That was courtesy of the New York Post, and the opening paragraph — in true New York Post style — went straight to the meat of the story:

(NY Post): Detroit on Thursday became the largest city in U.S. history to file for bankruptcy, as the state-appointed emergency manager filed for Chapter 9 protection.

In paragraph 10 of the article, the Post went on to disclose the size of the hole on Detroit’s balance sheet:

Detroit’s budget deficit is believed to be more than $380 million. [State-appointed bankruptcy expert Kevin] Orr has said long-term debt was more than $14 billion and could be between $17 billion and $20 billion.

Wait … what?

“… more than $14 billion and could be between $17 billion and $20 billion.”

Sadly, this is the world we live in — where a state-appointed bankruptcy expert talks about a possible discrepancy of $6 billion in a city’s accounts and the figure is relegated to paragraph 10. Unicorns and rainbows. (Jefferson County, AL, the biggest previous municipal bankruptcy, totaled only $4 billion.)

Meanwhile, gracing Reuters on the same day was this little beauty:

Dow, S&P 500 end at all-time highs on earnings, Bernanke

The first paragraph of that story read as follows:

(Reuters): The Dow and the S&P 500 closed at record highs on Thursday after Morgan Stanley and others reported better-than-expected earnings and Federal Reserve Chairman Ben Bernanke’s comments further reassured markets.

A little higher up in the story than the Detroit balance sheet shortfall in the New York Post piece (in paragraph 6, for those of you keeping score at home) was this expansion on the headline:

(Reuters): Bernanke, speaking before the Senate banking committee, reiterated comments he made on Wednesday to the House Financial Services Committee. He stressed that the timeline for winding down the Fed’s stimulus program was not set in stone.

“We got no negative surprises from the Fed chairman today, so the market liked that,” said Bucky Hellwig, senior vice president of BB&T Wealth Management in Birmingham, Alabama.

Ladies and gentlemen, I give you Ben Bernanke — the Candyman. (Or perhaps that should be the Bendyman? Quite suitable, given the extent of his flexibility, don’t you think?)

As Bucky Hellwig points out, the market likes it when there are no negative surprises from the Fed chairman — the corollary of which is that the market HATES it when the Candyman threatens to stop with the sugar — last month’s Taper Tantrum being the obvious and most recent example.

But in its adherence to whatever is being handed out by Bernanke, the market is failing to pay attention to signals that would ordinarily call for caution. That is the danger of getting kids hooked on candy: rationality tends to fall by the wayside and behaviour becomes harder and harder to understand until, ultimately, a sugar crash occurs….


To continue reading this article from Things That Make You Go Hmmm… – a free weekly newsletter by Grant Williams, a highly respected financial expert and current portfolio and strategy advisor at Vulpes Investment Management in Singapore – please click here.

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Outside the Box: The Blip

 

This week’s Outside the Box does not make me feel good, but author Benjamin Wallace-Wells does explain Robert Gordon’s views better than anyone I have seen. (And of course the whole point of Outside the Box is to yank us out of our comfort zones from time to time.)

Dr. Robert Gordon is a professor of economics who has held a named chair at Northwestern University for decades; but as the author of this piece says, “[T]he scope of his bleakness has given him, over the past year, a newfound public profile.” Gordon offers us two key predictions, both discomfiting. The first pertains to the near future, when, he says, our economy will grow at less than half its average rate over the last century because of a whole raft of structural headwinds.

His second prediction is even more unsettling. He thinks the forces that drove the second industrial revolution (beginning in 1870 and created largely in the US) were so powerful and so unique that they cannot be repeated.

(A corollary view of Gordon’s, mentioned only indirectly in this article, is that computers and the internet and robotics and nanotech and biotech are no great shakes, compared to the electric grid and internal combustion engine, as forces for economic change. Which is where he and I part company.)

He thinks, in short, that we do not understood how lucky we have been, nor do we comprehend how desperately difficult our future is going to be. If nothing else, Gordon has provoked some serious reaction from leading figures who are not quite ready to throw in the towel. “Very impressive,” former Treasury Secretary (and leading Fed Chairman candidate) Larry Summers texted Gordon last August, the day after he published a working paper titled “Is U.S. Economic Growth Over?” Ben Bernanke delivered a commencement address this spring considering the paper’s implications. And of course the techno-optimists have been buzzing around Gordon like angry hornets. (An interesting TED-talk anecdote along these lines is related herein.)

Gordon makes me very uncomfortable, too, but he’s got me thinking not only about how we find growth but also about how we do a better job of managing our affairs, nationally and globally. I think Gordon’s totally bleak view misses more than half the story, but it’s up to all of us who still believe in the future of this country and this planet (and its increasingly dominant if not altogether wise species) to reject naysaying attitudes and stand right up on our hind legs and envision and create that future.

And it is quite possible that we will find ourselves with two very different parallel futures for the world. In one, the haves may see their lives get dramatically better, while in the other those less fortunate may suffer an even greater economic and political disparity. That is not a formula for a workable future.

I’m in New York City this afternoon, working on too many projects. But I am going to take off in a few hours and make my way down to Bobby Van’s at the close of the markets to meet with the Friends of Fermentation and my great friend Art Cashin. I wanted to see him yesterday, but he had a doctor’s appointment. Then this morning I read in his daily letter:

Missing Mauldin – My good friend John Mauldin is on one of his New York “drive-bys” on his way to the annual fishing visit to Leen’s Lodge in Maine with another friend, David Kotok, and an economic brain trust.  Since he was in town, he thought he might drop in on the Friends of Fermentation nightly conclave, as our mutual friend Dennis Gartman had done so notably last week.

Unfortunately, I had a late day doctor’s appointment that would most likely mean I might miss the FoF seminar myself.  So, I gave John the wave-off until another time.

That’s when the roof fell in.  You would have thought I had canceled Christmas.  On learning of the wave-off, the FoF offered me sackcloth and ashes.  How could I dare cancel a rare opportunity to have John join the session?  Even Bob Pisani was not happy.

Ironically, the doctor’s office was empty and the test results were all good.  (Obviously, none had to with my mental state or acuity.)

When I slinked into the FoF at mid-session, I was the proverbial skunk at the picnic.  Since I had deprived them of access to John’s wit and wisdom (leaving them with only me), I was told the bill was on me.  I left with a much thinner wallet amid barely suppressed hissing.  I’ll never wave-off Mauldin again, even if there are riots in the streets.  Next time, John!

Next time indeed. I can’t leave a friend out in the cold.

Have a great week! My son Trey joins me tomorrow, and then we fly on to Maine Thursday morning. This is one of those weeks that I look forward to all year. So many friends. I think this may be the 7 th or 8th year Trey has gone. He has grown up with these guys, and it is a special bonding time for both of us. And who knows, maybe this year I’ll finally catch more fish than he does! All bear markets have to end someday, don’t they?

You’re getting ready to slow down analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com


The Blip

By Benjamin Wallace-Wells

New York magazine, July 21, 2013

What if everything we’ve come to think of as American is predicated on a freak coincidence of economic history? And what if that coincidence has run its course?

Picture this, arranged along a time line.

For all of measurable human history up until the year 1750, nothing happened that mattered. This isn’t to say history was stagnant, or that life was only grim and blank, but the well-being of average people did not perceptibly improve. All of the wars, literature, love affairs, and religious schisms, the schemes for empire-making and ocean-crossing and simple profit and freedom, the entire human theater of ambition and deceit and redemption took place on a scale too small to register, too minor to much improve the lot of ordinary human beings. In England before the middle of the eighteenth century, where industrialization first began, the pace of progress was so slow that it took 350 years for a family to double its standard of living. In Sweden, during a similar 200-year period, there was essentially no improvement at all. By the middle of the eighteenth century, the state of technology and the luxury and quality of life afforded the average individual were little better than they had been two millennia earlier, in ancient Rome.

Then two things happened that did matter, and they were so grand that they dwarfed everything that had come before and encompassed most everything that has come since: the first industrial revolution, beginning in 1750 or so in the north of England, and the second industrial revolution, beginning around 1870 and created mostly in this country. That the second industrial revolution happened just as the first had begun to dissipate was an incredible stroke of good luck. It meant that during the whole modern era from 1750 onward – which contains, not coincidentally, the full life span of the United States – human well-being accelerated at a rate that could barely have been contemplated before. Instead of permanent stagnation, growth became so rapid and so seemingly automatic that by the fifties and sixties the average American would roughly double his or her parents’ standard of living. In the space of a single generation, for most everybody, life was getting twice as good.

At some point in the late sixties or early seventies, this great acceleration began to taper off. The shift was modest at first, and it was concealed in the hectic up-and-down of yearly data. But if you examine the growth data since the early seventies, and if you are mathematically astute enough to fit a curve to it, you can see a clear trend: The rate at which life is improving here, on the frontier of human well-being, has slowed.

If you are like most economists – until a couple of years ago, it was virtually all economists – you are not greatly troubled by this story, which is, with some variation, the consensus long-arc view of economic history. The machinery of innovation, after all, is now more organized and sophisticated than it has ever been, human intelligence is more efficiently marshaled by spreading education and expanding global connectedness, and the examples of the Internet, and perhaps artificial intelligence, suggest that progress continues to be rapid.

But if you are prone to a more radical sense of what is possible, you might begin to follow a different line of thought. If nothing like the first and second industrial revolutions had ever happened before, what is to say that anything similar will happen again? Then, perhaps, the global economic slump that we have endured since 2008 might not merely be the consequence of the burst housing bubble, or financial entanglement and overreach, or the coming generational trauma of the retiring baby boomers, but instead a glimpse at a far broader change, the slow expiration of a historically singular event. Perhaps our fitful post-crisis recovery is no aberration. This line of thinking would make you an acolyte of a 72-year-old economist at Northwestern named Robert Gordon, and you would probably share his view that it would be crazy to expect something on the scale of the second industrial revolution to ever take place again.

“Some things,” Gordon says, and he says it often enough that it has become both a battle cry and a mantra, “can happen only once.”

Gordon assumed his present public identity – as a declinist and an accidental social theorist, as a roving publicist of depressing PowerPoints – last August, when he presented his theory in a working paper titled “Is U.S. Economic Growth Over?” He has held a named chair at Northwestern for decades and is one of the eminent macroeconomists of his generation, but the scope of his bleakness has given him, over the past year, a newfound public profile. It has been a good time to be bleak, and Gordon, bleaker than everyone else, commands attention. “Very impressive,” the former Treasury secretary Larry Summers wrote Gordon from his iPad the day after the paper appeared. Ben Bernanke, the Federal Reserve chairman, delivered a commencement address this spring considering the paper’s implications, and the financial press has weighed in vociferously for and against.

Gordon has two predictions to offer, the first of which is about the near future. For at least the next fifteen years or so, Gordon argues, our economy will grow at less than half the rate it has averaged since the late-nineteenth century because of a set of structural headwinds that Gordon believes will be even more severe than most other economists do: the aging of the American population; the stagnation in educational achievement; the fiscal tightening to fix our public and private debt; the costs of health care and energy; the pressures of globalization and growing inequality. Over the past year, some other economists who once agreed with Gordon – most prominently Tyler Cowen of George Mason University – have taken note of the recent discoveries of abundant natural-gas reserves in the United States, and of the tentative deflation of health-care costs, and softened their pessimism. But to Gordon these are small corrections that leave the basic story unchanged. He believes we can no longer expect to double our standard of living in one generation; it will now take at least two. The common expectations that your children will attend college even if you haven’t, in other words, or will have twice as rich a life, in this view no longer look realistic. Some of these hopes are already outdated: The generation of Americans now in their twenties is the first to not be significantly better educated than their parents. If Gordon is right, then for all but the wealthiest one percent of Americans, the rate of improvement in the standard of living – year over year, and generation after generation – will be no faster than it was during the dark ages.

Gordon’s second prediction is almost literary in its scope. The forces of the second industrial revolution, he believes, were so powerful and so unique that they will not be repeated. The consequences of that breakthrough took a century to be fully realized, and as the internal combustion engine gave rise to the car and eventually the airplane, and electricity to radio and the telephone and then mass media, they came to rearrange social forces and transform everyday lives. Mechanized farm equipment permitted people to stay in school longer and to leave rural areas and move to cities. Electrical appliances allowed women of all social classes to leave behind housework for more fulfilling and productive jobs. Air-conditioning moved work indoors. The introduction of public sewers and sanitation reduced illness and infant mortality, improving health and extending lives. The car, mass media, and commercial aircraft led to a liberation from the narrow confines of geography and an introduction to a far broader and richer world. Education beyond high school was made accessible, in the aftermath of World War II, to the middle and working classes. These are all consequences of the second industrial revolution, and it is hard to imagine how those improvements might be extended: Women cannot be liberated from housework to join the labor force again, travel is not getting faster, cities are unlikely to get much more dense, and educational attainment has plateaued. The classic example of the scale of these transformations is Paul Krugman’s description of his kitchen: The modern kitchen, absent a few surface improvements, is the same one that existed half a century ago. But go back half a century before that, and you are talking about no refrigeration, just huge blocks of ice in a box, and no gas-fired stove, just piles of wood. If you take this perspective, it is no wonder that the productivity gains have diminished since the early seventies. The social transformations brought by computers and the Internet cannot match any of this.

But even if they could, that would not be enough. “The growth rate is a heavy taskmaster,” Gordon says. The math is punishing. The American population is far larger than it was in 1870, and far wealthier to begin with, which means that the innovations will need to be more transformative to have the same economic effect. “I like to think of it this way,” he says. “We need innovations that are eight times as important as those we had before.”

There are many ways in which you can interpret this economic model, but the most lasting – the reason, perhaps, for the public notoriety it has brought its author – has little to do with economics at all. It is the suggestion that we have not understood how lucky we have been. The whole of American cultural memory, the period since World War II, has taken place within the greatest expansion of opportunity in the history of human civilization. Perhaps it isn’t that our success is a product of the way we structured our society. The shape of our society may be far more conditional, a consequence of our success. Embedded in Gordon’s data is an inquiry into entitlement: How much do we owe, culturally and politically, to this singular experience of economic growth, and what will happen if it goes away?

There are some people, scattered around this planet, for whom the question of economic growth many years hence is urgently important, for whom it seems to blot out all other matters. Economists, and think-tankers, and environmentalists concerned with climate change, and the dreamier kind of CNBC host, yes. But also ordinary people – liberals alarmed about their children’s student debt or conservatives outraged about the national deficit – who are not convinced that we will grow rich enough to pay these bills in the future, who hold ambient anxieties that things are getting not better but worse.

Among growth-worriers, there is a science-fiction streak. To be possessed by nightmares about the future requires that one be dreaming about the future in the first place. I don’t think I have had a single conversation about long-term economic growth that did not involve a detour into the matter of robots. Not robotization, but robots: how their minds worked, their strategies when engaged in a game of chess.

Very strong and well-defended opinions about the driverless car are held. People in this camp are open to the possibility that the future could be very different from the present, and so robots, evocative of a wholly transformed world – perhaps for good, perhaps not – are of special interest. One leading theorist in the Gordon camp urged me to read a Carter-era text called The Zero Sum Society, which suggests a grim dystopia that emerges once economic growth hits zero point zero, at which moment to gain anything requires that you take it from somebody else. “Once you start to think about growth,” the Nobel laureate Robert Lucas has said, “it is hard to think about anything else.”

Earlier this year, Gordon flew out to Long Beach to give a TED talk detailing his theory and its implications. TED’s audience is so primed for optimism about the future that Gordon, a rebuker of futurists, knew before he began that he’d lost the room – not in a Seth MacFarlane–at–the–Academy Awards way, but in a Bill O’Reilly–at–Al Sharpton’s–political–group kind of way, as a matter of tribal identity. TED had invited MIT’s Erik Brynjolfsson, an expert in the economics of technology and a known optimist about future breakthroughs, to give the counterpoint address. Gordon (short, round, and earnest) projects a donnish air; Brynjolfsson (tall, redheaded, bearded), the kind of cocky casualness that in Silicon Valley scans as cool. Gordon gave his account; introduced his graph; emphasized the abject poverty of life at the turn of the twentieth century; demonstrated how each American deficiency in education, inequality, demographics limited how much our economy might grow – and then, sensing that the crowd was not all that much moved, sat back to watch Brynjolfsson make the case against.

Brynjolfsson let a long beat elapse. “Growth is not dead,” he said casually, and then he grinned a little bit, and the audience laughed, and the tension that had lingered after Gordon’s pessimism dissipated. Brynjolfsson had the aspirational TED inflection down cold: “Technology is not destiny,” he said. “We shape our destiny.”

The second industrial revolution itself, he said, proved the point. After factories were electrified, Brynjolfsson explained, “the amazing thing is productivity didn’t increase in those factories for 30 years – 30 years!” It sometimes take a while for humans to figure out how to use innovations, he said, and perhaps we are just now beginning to comprehend the full possibilities of computerization. In Brynjolfsson’s view, we are now in the beginnings of the new machine age, an extended moment of revolution in artificial intelligence. “A child’s PlayStation,” he said, is more powerful than a military supercomputer from 1996; a chess program contained on a cell phone can defeat every grandmaster. Brynjolfsson pointed out that Watson, the IBM AI project, having successfully amassed enough everyday knowledge to defeat the grand champions on Jeopardy!, was “now applying for jobs at call centers, and getting them. In finance, and in law, and getting them.”

Economists often note that even experts are very bad at predicting the world to come and constantly underestimate it. Optimists like Brynjolfsson say that though productivity gains from computer technologies have declined since 2004, that’s no reason to expect the decline to continue. They see prospects. A recent McKinsey report detailing economic sectors that might grow found, for instance, great possibilities in intelligent machines: trillions of dollars in the so-called Internet of Things, for instance, and 3-D printing.

I called Brynjolfsson at his office at MIT to try to get a better sense of what a roboticized society might look like. It turns out the optimist’s case is darker than I expected. “The problem is jobs,” he said. Sixty-five percent of American workers, Brynjolfsson explained, occupy jobs whose basic tasks can be classified as information processing. If you are trying to find a competitive advantage for people over machines, this does not bode well: “The human mind did not evolve to multiply triple-digit numbers,” he told me. The robot mind has. In other words, the long history of Marx-inflected pleas, from “Bartleby” through to Fight Club, that office work was dehumanizing may have been onto something. Those jobs were never really designed for the human mind. They were designed for robots. The existing robots just weren’t good enough to take them. At first.

At opposite ends of the pay scale, there are jobs that seem safe from the robot menace, Brynjolfsson said – high-paying creative and managerial work, and non-routine physical work, like gardening. (The smartest machines still struggle to recognize an ordinary kitchen fork if it is rotated by 30 degrees.) As for the 65 percent of us who are employed in “information processing” jobs, Brynjolfsson said, the challenge is to integrate human skills with machine capacities – his phrase is “racing with machines.” He mentioned a biotech company that relied on human workers to refine the physical shapes of synthetic proteins, jobs at which the most sophisticated algorithms remain hopeless. I expressed some doubts about how many jobs there might be in endeavors like this. “The grand challenge is: Can we scale them up?” Brynjolfsson said. “We haven’t seen that yet. Otherwise, employment would be going up rather than down.”

Even among the most committed stagnation theorists, there is little doubt that innovation will continue – that our economy will continue to be buttressed by new ideas and products. But the great question at the center of the growth argument is how transformative those breakthroughs will be, and whether they will have the might to improve human experience as profoundly as the innovations of a century ago. One way to think about economic growth is as a product of human capital and technology: At moments like this, when human capital is not growing much (when the labor force is unlikely to grow, when it is not becoming more educated), all of the pressure rests on technology. For this reason, some economists who think Gordon greatly understates the potential of computers still agree that it will be hard for technology to sustain the growth rates we’ve become accustomed to. “We’re not going to get to 2.25 percent GDP growth – that’s way out on the tail,” Dale Jorgenson of Harvard told me. “There’s going to be a slowdown. It’s not a secular stagnation. It’s a change in demography. And this is a watershed event.”

Provoked by Gordon’s paper, Daniel Sichel of Wellesley and a team of collaborators have worked out a model by which future U.S. growth might match the rates it has historically achieved. It was not a science-fiction scenario, Sichel explained to me; it required a faster rate of improvements in microprocessor technology, and new computer technologies to be adopted quickly by sectors (education, health care) that have tended to move more slowly. But this is Sichel’s optimistic model; his median projection – his sense of what is most likely to happen – isn’t much more hopeful than Gordon’s. That we might continue to experience the kind of growth we’ve enjoyed for the past several decades remains a defensible possibility. But so does Gordon’s idea, that something great is gone.

In 2007, Mexicans stopped emigrating to the United States. The change was not very big at first, and so for a few years it seemed like it might be a blip. But it wasn’t. In 2000, 770,000 Mexicans had come across the Rio Grande, but by 2007 less than 300,000 did, and by 2010, even though violence in Mexico seemed ceaseless, there were fewer than 150,000 migrants. Some think that more Mexicans are now leaving the United States than are coming to it. “We’re never going to get back to the numbers we had in the late nineties,” says Wayne Cornelius, a political scientist at UC–San Diego who has spent the past 40 years studying this cross- border movement. A small part of this story is the increase in border protection, but the dominant engine has been the economic shifts on both sides of the border – it has become easier for poor Mexicans to improve their quality of life in Mexico and harder to do so in the United States. Because migrants from a particular Mexican village often settle in the same American place, they provide a fast conduit of economic information back home: There are no jobs in construction or housing. Don’t come. The Pew Hispanic Center has traced the migration patterns to economic performance in real time: a spike of migration during 1999 and 2000, at the height of the boom; a brief downturn in border crossing after the 2001 stock-market crash followed by a plateau; then the dramatic emptying out after the housing industry gave way in 2006. We think of the desire to be American as a form of idealism, and sometimes it is. But it also has something to do with economic growth. We are a nation of immigrants to the extent that we can make immigrants rich.

These hingelike mechanisms, in which social changes depend upon the promise of rapidly escalating well-being, are studded throughout the aftermath of the second industrial revolution. The United States did not really become a melting pot until the 1880s, when the economy was beginning to draw on the breakthroughs of electricity and the engine and attract migrants from Southern and Eastern Europe. The labors that housework required in the nineteenth century were so consuming that housewives in North Carolina walked 148 miles a year carrying 35 tons of water for nonautomated chores. It took until the fifties for household appliances to decline so much in price that they were ubiquitous; the next decade was the one of women’s liberation. The prospects for African-American employment increased most dramatically during World War II and in the period just after: 16.4 percent of black men held middle-class jobs in 1950; by 1960 it was 24 percent; by 1970, 35 percent. Progressives will often describe the history of social liberation by quoting Martin Luther King Jr.’s line that the arc of the moral universe bends toward justice; the implication is that metaphysics are somehow involved. But this history has also taken place during unique economic times, and perhaps that is not coincidence.

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Outside the Box and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA, SIPC, through which securities may be offered . MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.

Note: Joining The Mauldin Circle is not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for investors who have registered with Millennium Wave Investments and its partners at http://www.MauldinCircle.com (formerly AccreditedInvestor.ws) or directly related websites. The Mauldin Circle may send out material that is provided on a confidential basis, and subscribers to the Mauldin Circle are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private and non-private investment offerings with other independent firms such as Altegris Investments; Capital Management Group; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Investment offerings recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop.

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130726_TFTF_sm

Thoughts from the Frontline: A Lost Generation

 

It is pretty well established that a tax increase, especially an income tax increase, will have an immediate negative effect on the economy, with a multiplier of between 1 and 3 depending upon whose research you accept. As far as I am aware, no peer-reviewed study exists that concludes there will be no negative effects. The US economy is soft; employment growth is weak – and yet we are about to see a significant middle-class tax increase, albeit a stealth one, passed by the current administration. I will acknowledge that dealing a blow to the economy was not the actual plan, but that is what is happening in the real world where you and I live. This week we will briefly look at why weak consumer spending is going to become an even greater problem in the coming years, and we will continue to look at some disturbing trends in employment.

Last week, I noted at the beginning of the letter that an unintended consequence of Obamacare is a rather dramatic rise in the number of temporary versus full-time jobs. This trend results from employers having to pay for the health insurance of employees who work more than 29 hours a week.

I quoted Mort Zuckerman, who wrote in the Wall Street Journal:

The jobless nature of the recovery is particularly unsettling. In June, the government’s Household Survey reported that since the start of the year, the number of people with jobs increased by 753,000 – but there are jobs and then there are “jobs.” No fewer than 557,000 of these positions were only part-time. The June survey reported that in June full-time jobs declined by 240,000, while part-time jobs soared 360,000 and have now reached an all-time high of 28,059,000 – three million more part-time positions than when the recession began at the end of 2007.

That’s just for starters. The survey includes part-time workers who want full-time work but can’t get it, as well as those who want to work but have stopped looking. That puts the real unemployment rate for June at 14.3%, up from 13.8% in May.

As it turns out, the unintended consequences of Obamacare are not the only problem. Charles Gave wrote a withering indictment of quantitative easing this week (which we will look at in a few pages) and included the following chart, which caught my eye. Note that the relative increase in part-time jobs began prior to Obama’s even assuming office. The redefinition of part-time as less than 29 hours a week and the new costs associated with full-time employment due to Obamacare simply accelerated a trend already set into motion.

An Ugly Secular Trend in Part-Time Work

Look closely at this graph. It turns out the trend toward part-time employment started in the recession of the early 2000s, paused only briefly, and then really took off in the recent Great Recession. This is clearly a secular trend that was in place well before 2008.

This development is very troubling, especially because it primarily affects young people and those with fewer skills. As I documented in letters last year, workers 55 and older are actually taking “market share” from younger workers. I went back tonight to see if that trend is still in place. The first graph below (the next few graphs are from the St. Louis Fed’s FRED database) is one we are familiar with: the actual employment level over the last ten years. We are still two million jobs down since the onset of the last recession, some six years later. The only reason the unemployment rate has fallen at all is that several million people have simply left the labor force for one reason or another.

The next graph is the number of employed 25-54-year-olds. What you will notice is that the above graph shows about 7 million new jobs since the very bottom of the employment cycle, yet employment in the 25-54 age cohort has barely risen. Who got all the jobs?

That mystery is solved courtesy of the next chart, which shows the number of employed in the 55+ age group. Even acknowledging that there is a growing Boomer population does not account for the rather spectacular increase in employment in the 55+ age group. Can you find the recession in this chart? If the St. Louis Fed hadn’t shaded the recession in gray, you certainly couldn’t find it in the data. Not only did Boomers see a rise in employment, they took jobs from younger groups. If you dig down deeper, you find that the younger you are, the higher the unemployment level of your age-mates. I will spare you that exercise, as this is already depressing enough, unless you are 55+.

Note that I am not arguing that those of us over 55 should be put out to pasture. Many can’t afford to quit working (especially when their kids are living with them!). I am just reporting on the facts. The only way to solve this is to grow our way out of it, yet whatever we are doing is not working.


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Thoughts From the Frontline and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President and registered representative of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA and SIPC, through which securities may be offered. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.

Note: Joining The Mauldin Circle is not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for investors who have registered with Millennium Wave Investments and its partners at http://www.MauldinCircle.com (formerly AccreditedInvestor.ws) or directly related websites. The Mauldin Circle may send out material that is provided on a confidential basis, and subscribers to the Mauldin Circle are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private and non-private investment offerings with other independent firms such as Altegris Investments; Capital Management Group; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Investment offerings recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments.

All material presented herein is believed to be reliable but we cannot attest to its accuracy. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs may or may not have investments in any funds cited above as well as economic interest. John Mauldin can be reached at 800-829-7273.

falling gold

How Gold Lost Its Luster, How the All-Weather Fund Got Wet, and Other Just-So Stories

By: John Mauldin

We have not revisited the topic of gold in Outside the Box recently, mostly due to the fact that nearly everything I read on the subject is derivative of what I have been reading for years. There hasn’t been much that would cause me to think about gold in a different way, and that is the purpose of Outside the Box: to present new perspectives and make us think.

I have recently started to read the work of Ben Hunt at Epsilon Theory. His ideas are interesting in that he examines markets from a behavioral economics perspective, with ample doses of game theory and history, a combination that few people can bring to the table. (In a random but pleasant development, I will get to have lunch with him next week in Dallas when he visits my town. I look forward to it.)

I have read this piece twice and expect to look at it a few more times. He leads off with some interesting thoughts on the role and significance of sweeping social narratives, and in particular the “Narrative of Gold,” but there is more than thinking on gold in today’s Outside the Box. Pure gold bugs will be annoyed, but since I am neither gold bug nor pure, I find this a very useful essay. A small taste –

The source of gold’s meaning, whether you are a market participant in 1895 or 2013, comes from the Common Knowledge regarding gold. J.P. Morgan said that gold is money, and he was right, but only because at the time he said it everyone believed that everyone believed that gold is money. Today that same statement is wrong, but only because no one believes that everyone believes that gold is money….

To market participants in 2013 gold means lack of confidence in money, and their behavior in buying and selling gold similarly reflects this meaning. Buying gold today is a statement that you believe that global economic events may spiral out of the control of Central Bankers. It is insurance against some sort of massive monetary policy mistake that cannot be fixed without re-conceptualizing the global economic regime – hyperinflation in a developed nation, the collapse of the Euro, something like that – not an expression of a commonly shared belief in some inherent value of gold.

Thus the Narrative of Gold is still significant, but mostly in contrast to the narrative that has assumed primacy today: the Narrative of Central Banker Omnipotence. Like all effective narratives, says Ben, this one is simple: central bank policy will determine market outcomes.

Then Ben makes a crucial point:

You may privately believe that J.P. Morgan is still right, that gold has meaning as a store of value. But if you participate in the market on the basis of that belief, then you will buy and sell gold in an incredibly inefficient manner. You would be a smart gold investor in 1895, but a poor gold investor today.

This is some of the best, most fundamental thinking about gold that I have seen. But Ben’s thesis is larger than that. He wants to understand the manner in which historical correlations and correlation-based investment strategies come under tremendous stress in markets undergoing structural change. “I get VERY nervous,” he says,

when I am told that … a socially constructed behavior such as the assignment of value to highly symbolic securities is “timeless and universal”, particularly when the composition and preference functions of major market participants are clearly shifting, particularly when monetary policy is both massively sized and highly experimental, particularly when political fragmentation is rampant within and between every nation on earth.

I am back in Dallas after a long and very tiring trip. I think I overreached in terms of what I tried to do on the trip, and on my return I find myself as exhausted as I have ever been, on top of which I seem to have picked up a nasty virus somewhere along the way. Not that I did not enjoy every moment. Cyprus , Croatia, Switzerland, even France were all fascinating, with so many good times and meetings. I think I need to try and cram less into the schedule. That might mean a personality change is in order, as trying to do too much is one of my real weaknesses. So much opportunity, so little time. A little zen focus might be in order.

And now, I suggest you read Ben Hunt’s essay and appreciate his take on narrative. Have a great week, and for my US readers, enjoy the Fourth of July. I am off to the optometrist now to find out why I’m having such trouble focusing my eyes. I had laser surgery some 15 years ago, and they said it would last about 10 years, so my “sell-by” date is long past. The problem has slowly been getting worse and now demands to be dealt with.

Your thinking about multiple points of focus analyst,

John Mauldin, Editor
Outside the Box

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How Gold Lost Its Luster, How the All-Weather Fund Got Wet, and Other Just-So Stories

By Ben Hunt

“Gold is money. Everything else is credit.”
John Pierpont Morgan

“The relationships of asset performance to growth and inflation are reliable – indeed, timeless and universal – and knowable, rooted in the durations and sources of variability of the assets’ cash flows.”
Bob Prince, Co-Chief Investment Officer, Bridgewater Associates

Like every middle-aged white guy I know, I am a big fan of Rudyard Kipling. I grew up on his Just-So Stories and as an adult found that his novels and poems spoke to me, as they did to my father and his father before that. Kipling writes simply, directly, and evocatively. Whether it’s a poem, a short story, or a novel, the man knows how to tell a story. He was the youngest winner of the Nobel Prize in Literature (as well as the first English-language recipient), and after a too-long period of disfavor in the academy he now enjoys a well-deserved renaissance of interest and acclaim.

But there is also no doubt that what Kipling wrote was used by political and economic entities of his day to support their own self-interests. As George Orwell said, with wildly popular poems like “The White Man’s Burden” he was the “prophet of British imperialism.” Was he a simplistic rah-rah tout for the rewards of Empire? Not in the least. There is tension, nuance, and respect for the human condition in everything Kipling wrote, at least that I’m aware of. And this is exactly why he was such an effective prophet, such an effective Narrator for mainstream British policy in the first three decades of the 20th century. Kipling’s skill as an author allowed British citizens to feel good about themselves and to support their government’s policies without requiring them to check their brains or their scruples at the door.

These are the hallmarks of effective Narratives – they have an intrinsic ring of truth (“truthiness”, to use Stephen Colbert’s wonderful phrase) that speaks to us on an intellectual and emotional level AND they coincide with the goals and preferences of powerful political and economic entities. Neither of these qualities is inherently a bad thing, whatever “bad” means. Nor is the content of a Narrative necessarily less truthful because it helps serve broader interests, whatever “truthful” means. Questions of truth and falsehood, good and bad, are impossible to assess from the informational content of the Narrative itself and are only meaningful in the broader context of human society at some given point in time. Kipling’s work gave a voice to the orthodoxy of foreign policy Common Knowledge in 1905 and the anti-orthodoxy of foreign policy Common Knowledge in 1965, even though Kipling’s words themselves never changed. In both eras, the Narrative of Imperialism – pro in 1905, anti in 1965 – was highly relevant to political and economic entities, which gave the world a public lens to interpret Kipling’s work. Today no one cares about the Narrative of Imperialism. It is a dead Narrative, like Manifest Destiny or Cultural Revolution. What Kipling wrote 100 years ago is largely irrelevant for the Narratives that shape our world today, which is probably what allows his work to be better appreciated for how it moves us on a personal level.

The Narrative of Gold was relevant 100 years ago and, unlike the Narrative of Imperialism, it remains relevant today. But like the Imperialism Narrative in 1965, it has morphed from a centerpiece of Common Knowledge orthodoxy into the foil or antithesis for a more modern, ascendant Narrative. Just as the Narrative of Imperialism was supplanted by the Narrative of Self-Determination, so has the Narrative of Gold been supplanted by the Narrative of Central Banker Omnipotence.

So long as the Narrative of Self-Determination was useful to powerful political and economic entities, the Narrative of Imperialism was relevant as well. It’s much easier to make an argument for something when you have something to argue against. But when the Narrative of Self-Determination lost its usefulness (not coincidentally with the end of the Cold War), so did the Narrative of Imperialism fade away. Today the Narrative of Central Banker Omnipotence is extremely useful to powerful political and economic entities, which means that the Narrative of Gold is important, too. Gold is just not important in the same way that it was important 100 years ago, and that shift in meaning makes all the difference in understanding the price of gold.

What “Jupiter” Morgan said about the primacy of gold above all other stores of value rang true to almost everyone when he said it. Did his public statements in support of the gold standard also serve his own self-interest? Absolutely. The US Treasury bought 3.5 million ounces of gold in 1895 from the House of Rothschild and … J.P. Morgan, using funds from a massive (for the time) 30-year bond issue syndicated by … J.P. Morgan. In a highly unusual (i.e. unconstitutional) move, this bond issue was carried out by the White House without any Congressional approval, under the authority of a forgotten Civil War era statute that was identified by … J.P. Morgan.

But while there’s no question that the bond sale and subsequent gold purchase lined Morgan’s pockets and served the interests of the rich and powerful considerably, there is also no question that these moves effectively ended the Panic of 1893. Why? Because everyone knew that everyone knew that gold was money. And now the US Treasury had lots of it. Huzzah! Confidence is restored as the Republic is saved by Grover Cleveland and Jupiter Morgan.

To be sure, the Narrative of Gold as told by J.P. Morgan was not accepted at the time by everyone as good or wise policy, any more than the Narrative of Imperialism as told by Kipling was accepted by everyone as good or wise policy at the time. Political oratory being what it was back then, in fact, William Jennings Bryan famously compared the imposition of the gold standard as the equivalent of “crucifying mankind on a cross of gold” at the Democratic national convention of 1896 and was nominated by acclamation as his party’s Presidential candidate. This despite Bryan being only 36 years old (the youngest Presidential candidate in American history) and despite Grover Cleveland, the outgoing President who bought the gold from Morgan and Rothschild, being a Democrat and the standard-bearer of the party. Clearly that must have been one hell of a speech!

  

But Bryan and his Free Silver Democrats weren’t opposed to the gold standard because they disagreed with the notion that gold was money; they just thought that silver should be money, too. Whatever you thought about the policy implications, the Common Knowledge about the meaning of gold in 1895 was clear: it was money, and the behavior of market participants in buying and selling gold reflected this meaning.

Now imagine if the current head of the House of Morgan, Jamie Dimon, made the same statement as Jupiter Morgan did, equating gold with money. People would think it was a joke. Everyone knows that everyone knows that gold does not mean the same thing to Jamie Dimon that it did to J.P. Morgan.

To market participants in 2013 gold means lack of confidence in money, and their behavior in buying and selling gold similarly reflects this meaning. Buying gold today is a statement that you believe that global economic events may spiral out of the control of Central Bankers. It is insurance against some sort of massive monetary policy mistake that cannot be fixed without re-conceptualizing the global economic regime – hyperinflation in a developed nation, the collapse of the Euro, something like that – not an expression of a commonly shared belief in some inherent value of gold.

The source of gold’s meaning, whether you are a market participant in 1895 or 2013, comes from the Common Knowledge regarding gold. J.P. Morgan said that gold is money, and he was right, but only because at the time he said it everyone believed that everyone believed that gold is money. Today that same statement is wrong, but only because no one believes that everyone believes that gold is money.

You may privately believe that J.P. Morgan is still right, that gold has meaning as a store of value. But if you participate in the market on the basis of that belief, then you will buy and sell gold in an incredibly inefficient manner. You would be a smart gold investor in 1895, but a poor gold investor today. Or let’s say that you privately believe gold to be a “barbarous relic” and that it’s ridiculous for gold to have any ascribed value at all other than what jewelry demand would bring. You, too, will buy and sell gold in an incredibly inefficient manner. In fact, you would be a poor gold investor in both 1895 and today.

In some periods of history gold is money. In other periods of history gold is not. But gold is always something, and that something is defined by the Common Knowledge of the day. To be an efficient gold investor in any period, I believe it’s crucial to identify and measure the relevant Narrative that is driving the Common Knowledge regarding gold. Only then can one construct an informational surface that predicts how the equilibrium price of gold will respond to new information (see “Through the Looking Glass” for a description of this game theoretic methodology).

There is no stand-alone Narrative regarding gold today, as there was in 1895. Today gold is understood from a Common Knowledge perspective only as a shadow or reflection of a powerful stand-alone Narrative regarding central banks, particularly the Fed … what I will call the Narrative of Central Banker Omnipotence. Like all effective Narratives it’s simple: central bank policy WILL determine market outcomes. There is no political or fundamental economic issue impacting markets that cannot be addressed by central banks. Not only are central banks the ultimate back-stop for market stability (although that is an entirely separate Narrative), but also they are the immediate arbiters of market outcomes. Whether the market goes up or down depends on whether central bank policy is positive or negative for markets. The Narrative of Central Banker Omnipotence does NOT imply that the market will always go up or that central bank policy will always support the market. It connotes that whatever the central bank policy might be, it will drive a market outcome; whatever the market outcome, it was driven by a central bank policy.

Like all effective Narratives it has a great deal of “truthiness” … it rings true to our intellect even as it appeals to our emotions. How comforting to believe that there is a reason why markets go up and go down, and that this reason is clearly identifiable and attributable to the decisions of a few Wise Men and Women, as opposed to the much scarier notion that the world (and markets) are adrift on a sea of chaotic events and hidden currents. And like all effective Narratives it serves the interests of the world’s most powerful political and economic entities … not that there’s anything wrong with that.

The strength of the Narrative of Central Banker Omnipotence has nothing to do with whether people believe that central bank policy is wise or foolish, good or bad. To predict market behavior it really doesn’t matter if QE is the balm of Gilead or the work of the Devil, any more than it mattered in 1895 whether the gold standard saved the Republic or crucified mankind. The only thing that matters from an Epsilon Theory perspective is whether everyone believes that everyone believes that central bank policy determines market outcomes.

The stronger the Narrative of Central Banker Omnipotence, the more likely it is that the price of gold goes down. The weaker the Narrative – the less established the Common Knowledge that central bank policy determines market outcomes – the more likely it is that the price of gold will go up. In other words, it’s not central bank policy per se that makes the price of gold go up or down, it’s Common Knowledge regarding the ability of central banks to control economic outcomes that makes the price of gold go up or down.

Look below at the price chart for gold over the past year. Gold peaked in late September and early October 2012, immediately after the Fed announced its open-ended QE program (red line). From the perspective of traditional macroeconomics, this makes no sense at all. The Fed had just announced its most aggressive monetary easing policy in history. Not only were they announcing yet another balance sheet expansion, but this time they were telling you that they weren’t going to stop at any pre-determined level, but were going to keep going for as long as it took to satisfy their full employment mandate. This is an inflation engine, pure and simple, and gold should go up, up, and away in price if the standard macroeconomic correlation between the price of gold and monetary easing held true.


London Gold Market Fixing Price, June 30, 2012 – June 30, 2013 (Source: Bloomberg L.P.)

But what was more relevant for the price of gold was the strengthening of the Narrative of Central Banker Omnipotence after the open-ended QE announcement. When you examine the public statements in major media outlets in the weeks following this announcement through a Common Knowledge methodology – both direct statements from Fed governors and “analysis” statements from prominent journalists, investors, and politicians – there was remarkably little opinion-leading or Narrative effort devoted to the direct economic or market implications of the new QE program. There was a one-day spike in inflation expectations and a few public comments to quell the “Oh my God, this means rampant inflation” crowd in the first day or so, but very little else. Instead, the focus of the mainstream Narrative effort moved almost entirely towards what open-ended QE signaled for the Fed’s ability and resolve to create a self-sustaining economic recovery in the US. And it won’t surprise you to learn that this Narrative effort was overwhelmingly supportive of the notion that the Fed could and would succeed in this effort, that the Fed’s policies had proven their effectiveness at lifting the stock market and would now prove their effectiveness at repairing the labor market. Huzzah for the Fed!

Within a week or so, however, opinion-leading voices from other prominent journalists, investors, and politicians joined the fray to say that this congratulatory viewpoint of the Fed’s new policy was entirely misplaced. There was absolutely no evidence showing that further expansion of the Fed’s balance sheet would have any impact whatsoever on US labor conditions, and that to claim otherwise was simply magical thinking. Moreover, according to this counter-argument, there was clearly a declining economic utility to more and more QE, so this latest program was a bridge too far.

But here’s the crucial point … whether these opinion-leaders and Narrative creators thought open-ended QE was a wonderful thing or a terrible thing, they ALL agreed that Fed policy had been responsible for the current stock market level. It was J.P. Morgan and William Jennings Bryan all over again, just arguing the merits of more QE versus less QE instead of the merits of the gold standard versus the gold + silver standard. But just as the debate over Free Silver only intensified the Common Knowledge that gold was money in 1896, so did this debate over the merits of open-ended QE only intensify the Common Knowledge that Fed policy was responsible for market outcomes in 2012. This was a positive informational inflection point in the Narrative of Central Banker Omnipotence, and as a result the price of gold has not had a good day since.

Gold is the most pronounced example of an asset with a mutable behavioral foundation because for all practical purposes there is no practical use for gold. It’s pretty and shiny and relatively rare, but so are a lot of things. For gold, at least, there is no “timeless and universal” relationship between it and economic constructs like inflation and growth, or monetary policy constructs like easing and tightening. There is a relationship, to be sure, but the nature of that relationship changes over time as the Common Knowledge regarding the meaning of gold changes.

The same is true of every other symbolized asset, which is to say every cash flow or fractional ownership interest or thing that is securitized and traded.

Not to the same extent as gold … there’s a continuum to this perspective, with securities representing gold and other precious metals at one end, then securities representing foreign exchange, then securities representing industrial metals and other commodities, then securities representing publicly traded stocks and bonds, and finally securities representing privately traded equity and debt at the other end of the spectrum. Within each of these categories, the more symbolic the security the more fragile the correlation between it and real-world economic factors (so, for example, an aggregation of stock symbols via an ETF is more prone to game-playing than an individual stock.) Put slightly differently, the more clearly identifiable and directly attributable the cash flow foundation of an asset, the less the impact of the Common Knowledge game. Still, the assignment of value to any symbolized asset is inherently a social construction and will inevitably change over time, occasionally in sharp and traumatic fashion.

The notion that the preference function of market participants may change over time has been around for a long time, particularly in the study of commodity markets. Ben Inker at GMO recently wrote an excellent paper on this topic (“We Have Met the Enemy, and He Is Us“) that I highly recommend if you want to dig into the gory details, but here’s the basic idea:

Back in the 1930′s Keynes proposed an idea called “normal backwardation” to explain how commodity futures markets could support a profit for traders who specialized in those markets. In this theory, commodity producers like farmers were typically risk averse when it came to market risk, and so would be willing to accept a forward contract guaranteeing a lower future price for their crop than a straightforward projection of the current spot price would suggest. The difference between this agreed upon futures price and the projected futures price was the risk premium required by the specialized commodity trader to take the other side of the trade. As Keynes pointed out, the risk premium would have to be pretty high for the commodity trader to engage in this trade (and thus push the futures price down) because, obviously, the commodity trader’s entire livelihood was based on making a profit on these trades.

But now let’s fast-forward 80 years to a world where anyone can be a commodity trader, or rather, anyone can make commodity trades without being a specialized commodity trader. In fact, the notion of an entire market being made by specialists seems terribly quaint today. More importantly, the meaning of a commodity futures contract has changed since Keynes proposed his theory, in the same way that the meaning of gold has changed since J.P. Morgan smoked his last cigar. Pretend you’re a giant pension fund with several hundred billion dollars worth of current assets and future liabilities. Do you think about owning a commodity futures contract because you’re interested in making a small profit in the difference between a farmer’s hedge and a projected forward spot price? Are you agonizing over a few basis points like a specialized commodity trader? Of course not. The only reason you are interested in owning a commodity futures contract is because you’re worried about inflation within the context of your portfolio of assets and liabilities. It’s your preference function regarding inflation that will drive your behavior, not a preference function regarding the intricacies and competitive risk premium associated with this particular commodity.

Whatever historical correlations and patterns existed in this commodity market when it was limited to specialty traders have to be tossed out the window when the pension funds and other enormous asset managers get involved. It’s like playing poker at a table with five penny-pinching off-duty Vegas dealers, and then moving to a table with five rich doctors in town for the weekend. If you don’t change the way you play your cards, even if you’re dealt exactly the same cards from one table to another, then you’re a fool.

This transformation in the composition and goals of market participants is by no means limited to commodity markets. Over the past decade there has been a sea change in the structure of global debt and equity markets, as well. Multiple papers by Simon Emrich and Charles Crow at Morgan Stanley lay out the structural transformation in equity markets in fantastic detail, most recently “Trading Strategies for 2013 – Optimal Responses to Current Market Structure” (March 18, 2013), but here are the two most striking findings from a game theoretic perspective:

1) Over the past 10 years, institutional management of equity portfolios has increased from 54% to 81%.

2) Over the same period, the share of what Emrich and Crow call “real institutional trading” has declined from 47% of trading volume to 29%.

There are far fewer market participants today than just ten years ago, managing much larger portfolios across more asset classes, and using much less trading. In future letters I’ll lay out in detail how this structural shift has large and specific consequences for the nature of game-playing in markets, but for the balance of this letter I just want to make a simple, and I hope obvious, point: structural change in any social environment wreaks havoc on historically observed correlations and patterns within that environment.

Unfortunately this sort of structural change is effectively invisible to econometric modeling of portfolios, and as a result understates the risks inherent in portfolios that rely heavily on historical correlation patterns. In a market undergoing structural change, all of the “timeless and universal” relationships that form the backbone of Risk Parity funds like Bridgewater’s All-Weather Fund and similar offerings by Invesco and AQR are much less certain than their econometric justifications would suggest. The underperformance of these strategies in recent weeks and months (“Fashionable ‘Risk Parity’ Funds Hit Hard“, Wall Street Journal, June 27, 2013) takes on new meaning when seen in this light.

There’s nothing wrong with the math of the correlation exercises that underpin Risk Parity funds, any more than there was anything wrong with the math of the correlation exercises that ratings agencies like Moody’s and S&P used to grade Residential Mortgage-Backed Securities (RMBS). But in both cases there is an assumption about market behavior – the relationship of asset performance under varying conditions of growth and inflation for Risk Parity funds; the role of geographical diversity in mitigating the risk profile of mortgage portfolios for RMBS ratings – that is exogenous to the calculation of the projected returns. In both cases, the standard portfolio model of y = α + β + Ɛ, where Epsilon is treated as an error term and the preference functions of market participants are assumed, gives a very compelling result: Risk Parity funds demonstrate an excellent risk-adjusted return profile, and trillions of dollars worth of RMBS deserve a AAA rating. But if you are wrong in your exogenous assumptions – if, for example, there is a nation-wide decline in US home prices for the first time since the 1930′s and geographical diversity provides no protection for a mortgage portfolio – then all the Gaussian cupolas and other econometric legerdemain in the world won’t save your AAA-rated security.

Risk Parity funds are a more broadly conceived, less levered version of Long-Term Capital Management. I mean that as a compliment, because it was the narrow conception and over-use of leverage at LTCM that ruined a solid investment premise and made it impossible for that firm to survive even a small disruption in patterns of market participant preferences – in LTCM’s case, the strong historical preference of major sovereign nations not to default on their debt obligations and the strong historical preference of major bond investors not to pay non-economic prices for the safety of US sovereign debt. The investment premise of LTCM was to identify small arbitrage opportunities between securities on the basis of historical correlations and to lever up those opportunities to generate nice returns. If you can take that premise and improve it significantly by expanding the scope and depth of the arbitrage opportunities and by shrinking the leverage turns required for acceptable returns … well, that seems like a really great idea to me. And I have zero doubt that investment giants like Ray Dalio, Bob Prince, and Cliff Asness can design a complex levered bond portfolio that is both safer and more rewarding than a simple unlevered stock and bond portfolio under most conditions. But I get VERY nervous when I am told that the reason these complex levered bond portfolios work so well is that a socially constructed behavior such as the assignment of value to highly symbolic securities is “timeless and universal”, particularly when the composition and preference functions of major market participants are clearly shifting, particularly when monetary policy is both massively sized and highly experimental, particularly when political fragmentation is rampant within and between every nation on earth.

Timing is everything with levered bond arbitrage, just ask Jon Corzine. Five years ago, this is a guy for whom there was a plausible path to become President of the United States. This is why he left the US Senate to become Governor of New Jersey, so that he could more easily and more effectively run for President. Losing his re-election bid in 2009 to Chris Christie closed that door, but only temporarily, as F. Scott Fitzgerald’s line that “there are no second acts in American lives” was probably wrong when he wrote it and is clearly not applicable to American society today.

So MF Global came along after the gubernatorial defeat and gave him a place to hang his hat for a few years, maybe refill the personal coffers that had been depleted by his phenomenally expensive campaigns. Within a year of taking the MF Global reins in March 2010, Corzine transformed the firm from a poorly managed commodities brokerage plagued by rogue traders and seemingly constant regulatory fines into a significant capital markets and prop trading player under his direct control. The culmination of this transformation was MF Global’s approval by the New York Fed as a primary dealer in February 2011, allowing the firm to fund itself as cheaply as any major investment bank. From that moment on Corzine – who started his career at Goldman Sachs as a sovereign bond trader – began to build a levered position in distressed European peripheral sovereign debt. By levering MF Global’s capital to the hilt in order to borrow dollars at historically low rates and buy, say, Portuguese 5-year paper with a 10% current yield in April 2011, Corzine stood to make an absolute killing as soon as the Europeans got their act together. After all, this is the sovereign nation of Portugal we’re talking about here, a full-fledged member of the European Union with a currency backstopped by the ECB and Germany, and it’s trading like a distressed corporate bond? Time to back up the truck. In fact, why don’t we put a little bit of duration risk into the mix to juice the returns even more. What could possibly go wrong?

We all know the rest of the story. One day you’re at the pinnacle of business and politics, poised to make a billion or two on a killer trade; the next day you’re testifying before Congress about misuse of client funds and considering taking the Fifth; tomorrow there may be a perp walk. The irony, of course, is that if Corzine had put this trade on 6 to 9 months later, we would today be talking about the brilliance of Jon Corzine, Lion of Wall Street, and how he had created a new Goldman Sachs.

The lesson? Pride may goeth before a fall, but so does leverage, bad timing, and poorly examined assumptions. A dislocation in the price of gold may be the least of our worries in a market and world undergoing structural change.

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Outside the Box and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA, SIPC, through which securities may be offered . MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.

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Outside the Box: Hoisington Investment Management Quarterly Review and Outlook, Second Quarter 2013

 

Lacy Hunt and Van Hoisington kick off their second-quarter Review and Outlook with a contrarian view: “The secular low in bond yields has yet to be recorded.” And as usual, they have their reasons; but unlike most of the blabbermouth economic talking heads out there, they aren’t interested in endlessly parsing the fitful utterances of Ben Bernanke and friends. Rather, they zero in on the fundamental reasons why long-term Treasury yields have probably not hit their low. Those reasons fall, they say, into four categories: (a) diminished inflation pressures, (b) slowing GDP growth, (c) weakening consumer fundamentals, and (d) anti-growth monetary and fiscal policies.

Then Lacy and Van take us deep into the whys and wherefores of their thesis. Their reasoning and the evidence behind it make for compelling reading – but you may want to read twice.

Hoisington Investment Management Company (www.Hoisingtonmgt.com) is a registered investment advisor specializing in fixed-income portfolios for large institutional clients. Located in Austin, Texas, the firm has over $5 billion under management and is the sub-adviser of the Wasatch-Hoisington US Treasury Fund (WHOSX).

I write this note from Newport, Rhode Island. There is a reason that the rich and powerful built their summer mansions here a century ago. It is disarmingly beautiful. The weather gods have arranged a perfect day and evening, the waters are calm, and the sailboats are out in force. All is right with the world. The Defense Department Office of Net Assessment futures planning group I am with uses the facilities of the Naval War College here. we enjoy a charming hotel on Goat Island, surrounded by boats and tourists, in the evenings and experience the rather drastic contrast of a military facility beset by the rigors of sequestration during the day. Air conditioning is one of the casualties of Congressional inaction, it seems.

I am enjoyably assaulted by new ideas and issues each day, and often find myself very far afield from my usual intellectual haunts. We are tasked with developing outside the box future scenarios. Economics is just a small part. It is good to stretch the mind.

Have a great week, and read what Lacy writes carefully. Everybody is rushing to the other side of the bond boat, trying to catch a stiff breeze that could just turn on the sailors. Be careful out there.

Your feeling woefully but happily inadequate analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com

Hoisington Investment Management – Quarterly Review and Outlook, Second Quarter 2013

By Lacy Hunt, PhD, and Van Hoisington

Lower Long Term Rates

The secular low in bond yields has yet to be recorded. This assessment for a continuing pattern of lower yields in the quarters ahead is clearly a minority view, as the recent selling of all types of bond products attest. The rise in long term yields over the last several months was accelerated by the recent Federal Reserve announcement that it would be “tapering” its purchases of Treasury and mortgage-backed securities. This has convinced many bond market participants that the low in long rates is in the past. The Treasury bond market’s short term fluctuations are a function of many factors, but its primary and most fundamental determinate is attitudes toward current and future inflation. From that perspective, the outlook for long term Treasury yields to fall is most favorable in light of: a) diminished inflation pressures; b) slowing GDP growth; c) weakening consumer fundamentals; and d) anti-growth monetary and fiscal policies.

Inflation

Sustained higher inflation is, and has always been, a prerequisite for sustained increases in long term interest rates. Inflation’s role in determining the level of long term rates was quantified by Irving Fisher 83 years ago (Theory of Interest, 1930) with the Fisher equation. It states that long term rates are the sum of inflation expectations and the real rate. This proposition has been reconfirmed in numerous sophisticated statistical studies and can also be empirically observed by comparing the Treasury bond yield to the inflation rate (Chart 1). On an annual basis, the Treasury bond yield and the inflation rate have moved in the same direction in 80% of the years since 1954.

Presently the inflation picture is most favorable to bond yields. The year-over-year change in the core personal consumption expenditures deflator, an indicator to which the Fed pays close attention, stands at a record low for the entire five plus decades of the series (Chart 2).

Additional factors restraining inflation are the appreciation of the dollar and the decline in commodity prices. The dollar is currently up 14% from its 2011 lows. A rise in the value of the dollar causes a “collapsing umbrella” effect on prices. A higher dollar leads to reduced prices of imports, which have been deflating at a 1% rate (ex-fuel) over the past year. When importers cut prices, domestic producers are forced to follow. Commodity prices have dropped more than 20% from their peak in 2011. This drop in commodity prices has also contributed to lower rates inflation.

Sustained higher inflation is not currently evident, and the forces that create inflation are absent. Thus, a period of sustained higher long term rates is improbable.

GDP

GDP growth, whether if measured in nominal or real terms, is the slowest of any expansion since 1948. From the first quarter of 2012 through the first quarter of 2013, nominal GDP grew at 3.3%. This is below the level of every entry point of economic contraction since 1948 (Chart 3). Real GDP shows a similar pattern. For the past four quarters real economic growth was just 1.6%, which was even less than the 1.8% growth rate in the 2000s and dramatically less than the 3.8% average growth rate in the past 223 years. These results demonstrate chronic long term economic underperformance.

Over the past year, the Treasury bond yield rose as the nominal growth in GDP slowed. The difference between the Treasury bond yield and the nominal GDP growth rate (Chart 4) is important in two respects. First, when the bond yield rises more rapidly than the GDP growth rate, monetary conditions are a restraint on economic growth. This condition occurred prior to all the recessions since the 1950s, as indicated in the chart. This condition also signaled the growth recessions in 1962 and 1966-67. Second, the nominal GDP growth rate represents the yield on the total economy, a return that embodies greater risk than a 30 year Treasury bond. Thus, the differential is a barometer of cyclical value for investors in Treasury bonds versus more risky assets.

On two occasions in the 1990s the Treasury bond/GDP differential rose sharply. Neither a quasi- nor outright recession ensued, but in both cases bonds turned in a stellar performance over the next year or longer. This economic indicator simultaneously casts doubt on the prevailing pessimism on Treasury bonds and the optimism over U.S. economic growth.

Consumer

Consumers have not yet healed from the great recession. Their income and employment situations have languished. Based on the standard of living, as measured by the real median household income, this entire recovery has bypassed the consumer sector. The standard of living has contracted regularly in recessions, but this is the first time deep into an expansion that it has continued to erode. The current standard of living is unchanged from 1995 (Chart 5).

In spite of job gains in the first half of 2013, the downward pressure on the standard of living actually intensified. Approximately three quarters of the increases in jobs were in four of the lowest paying industries – retail trade; the temporary help services component of professional and business services; hospitality and leisure; and the nursing and residential care facilities component of the medical category. These increases may reflect efforts of firms to minimize the increase in health care costs associated with full time employment under the Affordable Care Act. Part time jobs averaged increases of 93,000 per month in the first half of 2013, while full time jobs averaged increases of only 22,000 per month. Full time employment as a percentage of the adult population is currently 47%, which is near the lows of the last three decades.

Historically, when taxes are increased, the initial response of households results in a lower saving rate rather than an immediate reduction in spending. For some consumers, recognition of the tax changes in their income is a problem, particularly for those whose earnings are dependent on commissions, bonuses or seasonal work. This explains the sharp drop in the personal saving rate to 2.7% in the first five months of this year, a level at or below the entry points of all the economic contractions since 1929. The 2013 slump in the saving rate is a precursor of the painful adjustments that lie ahead, and an additional restraint on economic growth. (Note: In late July the Bureau of Economic Analysis is expected to release a benchmark revision to the National Income and Product Accounts. As a result of the revision the personal saving rate may be raised by up to 1.5%. This is due to the change in consumer ownership of defined benefit pension plans. This revision will not change the trend of the saving rate, nor will this higher figure indicate a source of funds for immediate spending since consumers will only receive such pension benefits when they retire.)

The drop in the saving rate in 2013 also serves to explain why the primary drain from higher taxes occurs with a lag after the taxes take effect. Based on various academic studies there is a two or three quarter lag in curtailed spending after the tax increase. Thus, the main drag on growth will fall in the third and fourth quarters of this year, with negative residual influences persisting through the end of 2015. Approximately $140 billion of the tax increase constitutes what might be termed a reduction in permanent income, or its equivalent life cycle income. In addition to working with a lag, over a three year period this portion will carry a negative multiplier of between two and three.

Monetary & Fiscal

Astronomical sums of money have been expended by both monetary and fiscal authorities since the crisis. With the benefit of hindsight it is clear their efforts have not aided economic growth, but rather the balance of their actions has been counter productive. The Fed has maintained the Fed Funds rate at near-zero levels, and it has tried to lower longer term rates through a series of quantitative easings. The effect of each of the quantitative easings was the opposite of the Fed’s intentions. During every period of balance sheet expansion long rates rose, yet when securities purchases were discontinued yields fell (Chart 6). The Fed cannot control long rates because long rates are affected by inflation expectations, not by supply and demand in the market place. This is extremely counter intuitive. With more buying, one would assume that prices would rise and thus yields would fall, but the opposite occurred. Why? When the Fed buys, it appears that the existing owners of Treasuries (now amounting to $9.5 trillion) decide that the Fed’s actions are inflationary and sell their holdings, raising interest rates. When the Fed stops this program, inflation expectations fall creating a demand for Treasuries, bringing rates back down. The Fed’s quantitative policies have been counter productive to growth as interest rates have risen during each period of quantitative easing. During QE1 and QE2, commodity prices rose, the dollar fell and inflation rose temporarily. Wages, however, did not respond. Thus, the higher interest rates during all QEs and the fall in the real wage income during QE 1 & 2 served to worsen the income and wealth divide. This means many more households were hurt, rather than helped, by the Fed’s efforts.

In terms of government spending, fiscal policy has not, and will not, have a major affect on economic growth. The increased spending immediately following the financial crisis did little to encourage the economy to grow faster. Likewise, the decrease in spending associated with the “sequester” will unlikely be a drag on growth after the initial and lagged effects are fully exhausted. The research on government spending multipliers suggests that the multiplier on spending is very close to zero.

The impact of tax changes is not nearly as harmless. It has been argued that an expired “temporary payroll tax cut” would not effect spending as the initial increase in income was not seen as permanent. The facts seem to counter this opinion. The average monthly year-over-year growth rate of real personal income less transfer payments for 2011 was 3.4%, and in 2012 it was 2.2%. This year, with the payroll tax change in effect, the average is 1.8% through May. The slower income has resulted in a slowdown in spending. Like income, real personal consumption expenditures has trended lower, with average monthly year-over-year growth rates of 2.5% for 2011, 1.9% for 2012 and 1.8% through May of this year. This trend is expected to continue for some time.

A Final Consideration Favoring Bonds

In the aftermath of the debt induced panic years of 1873 and 1929 in the U.S. and 1989 in Japan, the long term government bond yield dropped to 2% between 13 and 14 years after the panic. The U.S. Treasury bond yield is tracking those previous experiences (Chart 7). Thus, the historical record also suggests that the secular low in long term rates is in the future.

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Outside the Box and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA, SIPC, through which securities may be offered . MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.

Note: Joining The Mauldin Circle is not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for investors who have registered with Millennium Wave Investments and its partners at http://www.MauldinCircle.com (formerly AccreditedInvestor.ws) or directly related websites. The Mauldin Circle may send out material that is provided on a confidential basis, and subscribers to the Mauldin Circle are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private and non-private investment offerings with other independent firms such as Altegris Investments; Capital Management Group; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Investment offerings recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop.

All material presented herein is believed to be reliable but we cannot attest to its accuracy. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs may or may not have investments in any funds cited above as well as economic interest. John Mauldin can be reached at 800-829-7273.

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Thoughts from the Frontline: “This Country is Different”

By: John Mauldin

Panics do not destroy capital; they merely reveal the extent to which it has been destroyed by its betrayal into hopelessly unproductive works.

– John Mills, “On Credit Cycles and the Origin of Commercial Panics,” 1867

Hyman Minsky developed an economics of financial instability, of instability bred by stability itself…. Minsky’s approach, very different from Godley’s, is conceptual rather than statistical. A key virtue is that it puts finance at the center of economic analysis, analytically inseparable from what is sometimes called real economic activity, for the simple reason that capitalistic economies are run by banks.

To grasp what Minsky is about, it seems to me, is to go immediately beyond the coarse notion of the ‘Minsky moment,’ a concept which implies falsely that there are also non-Minsky moments. It is to recognize that the financial system is both necessary and dangerous, that strict financial regulation is both indispensable and imperfect.

– James Galbraith, 5th annual Dijon conference on post-Keynesian economics, Copenhagen, May 2011

I find myself finishing this letter on an island off the coast of Croatia, on the backside of the middle of nowhere. But it is the perfect place to contemplate my recent experience in Cyprus. Through the efforts of your fellow readers, I was able to meet a wide variety of people and have some in-depth discussions on the crisis that has enveloped Cyprus. And while the details are different, of course, there is a pattern to the weave, so to speak, that calls to mind various aspects of the crisis that began in 2008. And perhaps that pattern will give us a glimpse of what else may be coming our way.

You must first realize that Cyprus is a very small country, some 800,000 people. Among the leadership, everyone knows everyone. There is much to admire, as we will see. But Cyprus has had a gut-wrenching crisis, proportionately more dire than any in other European countries recently; and precedents are being established here for how future problems will be dealt with in the Eurozone and elsewhere.

To start a two-day marathon of meetings, I sat down Tuesday morning with two brothers, Symeon and Andreas Matsis. Symeon was until a few weeks ago a board member of the Bank of Cyprus, the largest bank on the island and now the focus of the financial crisis. He made his career in the governmental sector, where he was the general manager of the Planning Bureau of the Ministry of Finance. Andreas Matsis is a local businessman who until a few weeks ago sat on the board of the Central Bank of Cyprus. He is a successful entrepreneur who was also until recently the president of one of the local chambers of commerce. They are both in their early 70s, soft-spoken and totally engaging and forthcoming. Our one-hour meeting stretched to two hours.

Symeon carried a copy of This Time Is Different by Rogoff and Reinhart. It was dog-eared and full of notes. “I am reading it so I can try to understand what happened to us. The more I read the more I understand that they were describing Cyprus. And we did think that ‘This country is different.’ Which is why the crisis has been such a shock to our local culture.”

And such a shock. The next evening, I dined with a group of families, eating the local version of Greek cuisine, course after course after course. While they were all severely financially distressed, to a person they believed that Cyprus would come back, and they offered reasons why one should still do business is Cyprus. They were not sure what they would do, as their livelihoods were in danger, yet they faced the future with the strong resolve to figure it out. “Our parents lost everything in 1974 (when Turkey invaded the north portion of the island) and then came here and built a good new life. We can do this.”

One of the women at dinner was a charming lady who had retired in January after a career at the Bank of Cyprus. Note this was less than three months before the crisis in mid-March. She had her entire pension and life savings in the Bank of Cyprus, which she totally trusted. And now it looks like she will lose at least 60% of those savings. It could have been worse. She could have been at Laiki Bank. There the losses may be 100%.

The country has instituted capital controls, and she has access to only about 10% of her savings. At some point she will get all the remaining money but cannot move it out of the country until the capital controls are released.

“If you could get it today, would you leave it in the bank?” I asked.

She looked down and said quietly, “No, I would have to move it. I have children that will need that money for going to college abroad and then for help in buying homes. I can’t take the risk that the money will not be there.”

She pointed to one of the unique and positive features of Cyprus. Until recently, there was no university on the island. Everyone went abroad to college, typically then staying on in the country where they were educated and getting work experience before returning with skills and contacts. Cyprus is a country of accountants and lawyers, engineers, and other professionals.

The Bank of Cyprus made about 40% of the loans extended to businesses in Cyprus. It is now out of business itself. There are some solvent banks with available funds, but they can’t make loans, because if capital controls are lifted, it is likely that a significant number of Cypriots would, like the lady mentioned above, move their money. There’s no question that money will fly out of the country if trust is not first restored. But with no available bank financing, in addition to capital controls, businesses are closing up left and right. Unemployment, which was basically unknown before, now stands at 15% and is likely to go to 20%. If there is no functioning banking system for new loans, that makes doing business very difficult; and buying and selling property, outside of the cash market, is at a standstill.

But which will arrive first? Trust and a new beginning or capital flight and a long nightmare? It is a chicken and egg sort of problem with no easy answer, and one which I will attempt to bring some thought to later.

“This Country Is Different”

But to in order to delve further into this conversation about Cyprus, we are first going to return to France. Last week I wrote from France, where I suggested that France was on its way to becoming the next Greece. I got a very impassioned letter from a French citizen who made the case that France is not Greece. “As a Frenchman I am more than used to this mainstream French bashing, and I hoped from such an article to read about new facts or data.” And he made one point on which I need to allow him to correct me:

You say, “French President F. Hollande is worsening the situation by undoing what Sarkozy did well (putting back the retirement age from 62 to 60).” Not true. The legal age for retirement in France is still 62; FH did not change that. Had you looked a bit deeper into the details you would have understood that he only made a minor adjustment for the people who started working very early in life. The cost of this was nearly €200 million (1% of the 2020 estimated deficit of the pension system). And … the French government is currently working on a reform to balance the pension budget by 2020. The first pension reform by a socialist government ever…

He then went on to list the ways that France is not Greece. And if you take them at face value, there are indeed many ways that France is not Greece. And neither is France Spain; nor is it Italy, Ireland, Portugal, or … Cyprus. Yet all these Eurozone nations do share similar problems. What the writer basically maintains is that France is somehow different – that its circumstances are different and that the government is in some way more serious.

But serious about what? My friend Kiron Sarkar notes today:

The French auditor, the Cour des Comptes, states that France has only “a small chance” of meeting its revised budget target of 3.7% of GDP this year and will have to cut back on spending. Furthermore, they added that the extended deadline of 2015 to reduce debt to GDP to 3.0% would require France making a “big effort”. There is a chance that the French economy would contract this year, they reported. The current administration in France is not going to cut back. I just can’t see how France and/or the EZ deals with these issues. Today, French June consumer confidence came in at 78 M/M, lower than the 81 expected and the 79 in May.”

It is not the differences that are at issue, it is the similarities. And at the root of the Eurozone crisis is too much debt. Too much bank debt. Too much sovereign debt. Too much bad debt.

The quote from John Mills at the beginning of the letter returns to mind:

Panics do not destroy capital; they merely reveal the extent to which it has been destroyed by its betrayal into hopelessly unproductive works.

The most important book on the topic of the problems that have come to the fore in the last decade is clearly Rogoff’s and Reinhart’s brilliant tome, This Time Is Different, which examines 260+ financial crises over the last few centuries. While each is different in the particulars, they all have at their root too much debt and insolvent governments and/or banks. There is not some magic number that shouts, “Too much. This far and no further!” but the fundamental issue is clear.

The BANG! Moment comes, say R&R, when a wary bond market refuses to buy debt at a price that is financially sustainable for the debtor. In that moment, confidence and trust are lost. Can France pull back from that precipice? Surely. Nothing is hopeless, and my French correspondent is no less hopeful that his mother country, France, will avoid a crisis than I am hopeful about the US. Somehow, I must confess, I really do think that the US is different and will see the warning lights and pull back from the brink. At the same time, I squirrel away a little gold every month, just in case. I guess at the end of the day I truly don’t trust the bastards. (By the way, I am happy to see the gold price drop, because that means I get more pieces of gold for my pieces of paper. But then, I am not buying gold as an investment but as central bank insurance. I like it when my insurance premiums go down.)

So what can Cyprus teach us? Many things actually. First, as Symeon said, they truly believed that “This country is different.” And for good reasons.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

© 2013 Mauldin Economics. All Rights Reserved.

Thoughts from the Frontline is a free weekly economic e-letter by best-selling author and renowned financial expert, John Mauldin. You can learn more and get your free subscription by visiting www.MauldinEconomics.com.

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Thoughts From the Frontline and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President and registered representative of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA and SIPC, through which securities may be offered. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.

Note: Joining The Mauldin Circle is not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for investors who have registered with Millennium Wave Investments and its partners at http://www.MauldinCircle.com (formerly AccreditedInvestor.ws) or directly related websites. The Mauldin Circle may send out material that is provided on a confidential basis, and subscribers to the Mauldin Circle are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private and non-private investment offerings with other independent firms such as Altegris Investments; Capital Management Group; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Investment offerings recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments.

All material presented herein is believed to be reliable but we cannot attest to its accuracy. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs may or may not have investments in any funds cited above as well as economic interest. John Mauldin can be reached at 800-829-7273.