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Archive for April 2014

Archive for April, 2014

Outside the Box: Why Are So Many Boomers Working Longer?

 

There has been quite a lot of controversy in recent years around the idea that older workers – whose numbers are growing – have been taking jobs away from younger ones. Their numbers have certainly increased dramatically: the percentage of the labor force that is 55 or older grew from 29.4% in 1993 to 40.3% in 2013. And the unemployment rates of those 55 and older have dropped much faster than for younger cohorts; in fact we have seen those who are older than 55 take “market share” from the youngest. These are trends I’ve written about over the past year.

But did that increase and those trends cut into the employment prospects of young people? That is the central issue examined in today’s Outside the Box, which is an article by James J. Green that recently appeared on the ThinkAdvisor site. Green also does a nice job of laying out the reasons why Boomers are staying on the job. I have to admit that I was surprised by a few of the items he brought to my attention, and I think they’re worth thinking about.

But a lot of new ideas have come to my attention of late. Since I’m leaving for Europe in a few hours, I’ve been trying to call all of the speakers who will be on stage with me at the Strategic Investment Conference in just a few weeks, going over some of the logistics but mostly trying to probe a little bit to get an idea of the topics they will be covering. The theme of the conference is “Investing in an Age of Transformation,” and my hope is that the attendees and those who listen to the audio CDs will come away with a deeper and more complete sense of the powerful trends that are at play in the world today – and what to do about them now. How do you position your portfolios – not just to both protect yourself from the changes but also to take advantage of them?

I can honestly say I’m more excited about this conference than I was prior to any of the past ten. We kick off the conference with the always fascinating and prescient David Rosenberg. Last year at our conference he announced his transition to bond bear and full-on market bull and gave a strong presentation as to his reasons why. After David speaks, Rich Yamarone (chief economist at Bloomberg) and David Zervos (chief economist at Jefferies) will engage in a bull and bear debate but also share their usual thoughtful presentations on the investment climate. Jeff Gundlach of DoubleLine, whom Barron’s has dubbed the King of Bonds, will then take us behind the scenes in the world of fixed-income investing. You simply do not want to miss his PowerPoint presentation and powerful delivery.

My good friend Pat Cox of Transformation Technology Alert (a Mauldin Economics publication, I might add!) will talk about the amazing changes that are bubbling up in the technology space, with a focus on biotech and aging. Kyle Bass follows after lunch with what I can guarantee will be one of the most thought-provoking presentations at the conference. He has a smooth, confident delivery that is backed up by impeccable research. Then Gary Shilling will give us a lightning-fast presentation touching on the major facets of the world scene (he does seem to get to everything in 45 minutes – fasten your seatbelts), before my co-author Jonathan Tepper and Grant  Williams, the inimitable author of Things That Make You Go Hmmm…, double-team us with a joint presentation focusing on the view from London and Singapore and how international markets will fare in the near future. That night at dinner, three-star admiral Robert Harward, a Navy Seal and commander of the Seals prior to his very recent retirement, will tell us what it’s like to sit in the catbird seat, leading the best of our young men and women. I’m sure he will be talking about a few special nights in the recent past. (Think Osama bin Laden.) And that’s just day one.

Dylan Grice leads off the next day, and I don’t want to tip off his speech, but you want to be there. Somehow or other I’m supposed to follow his performance. I’ve been working on my speech for quite some time, as I want to develop a new theme. Without exception, the speakers who come to my conference always bring their “A games” to the podium, and so I have to try to elevate my own presentation just to keep up.

I made sure I wouldn’t follow Newt Gingrich, who will come up on the stage after me. He will be followed by Neil Howe (author of The Fourth Turning), who is probably the best demographer and analyst of generational trends in the world today. Two summers ago I had the pleasure of spending several long evenings with Newt and Neil as they made the history of the world come alive for hours on end. I live for experiences like that and am always looking for more of them. Listening to those two makes me realize just how much more there is to learn and think about. If Pat Cox and some of his friends can show me how to get an extra 40 to 50 years, I will need them just to catch up with Neil and Newt.

Paul McCulley will regale us at lunch the second day, in the slow Southern drawl delivery he learned at the knee of his Southern Baptist daddy. I sometimes feel like we should pass the collection plate after he’s finished his sermon. Then we’ll go to the other extreme as Dr. Lacy Hunt presents his latest research, which will not be as optimistic with regard to central banks as Paul will have been. Lacy is simply an intellectual force of nature. If you attend the conference, make sure you figure out how to spend a few moments in his space. He is very approachable, as are most of the speakers. Following a panel of some of the speakers, we’ll hear from George Gilder (Wall Street Journal contributing editor) and Stephen Moore (conservative thought leader) as they talk about the need for a new economics and a new politics. That night there is a poolside dinner where you can mingle with fellow attendees and the speakers.

And then we come to the third morning. Dear gods, you will need to fasten your seatbelt for this one. We start with geopolitical expert Ian Bremmer, who will lead us on a deep dive into the global situation and delight us with his inside stories of personal interactions with the global leaders who shape the nightly news. Anatole Kaletsky, the best-known economic journalist in Europe (and on whose cell phone are the direct-dial numbers of the biggest investors and global leaders in Europe), is going to reflect on where the global opportunities are; and then the one and only, the indomitable Niall Ferguson will share his incisive – possibly even incendiary! –thoughts about the problems and opportunities that China poses for the rest of the world. Finally, I will get Ian, Anatole, and Niall back up on stage for a panel discussion to close the conference.

That, my friends, is how to put together a conference that will expand our horizons as it deepens our understanding of the world. I design a conference that I want to attend, and then I invite all my friends to come. There are still some spots available, so maybe you should think about attending – there is simply nothing like being there, given all the opportunities for conversation and interaction; but if you can’t, then go ahead and purchase your audio CDs now for a discount off the post-conference price. You can register here or purchase CDs here. I hope to see you in San Diego May 13-16!

The driver will be here in less than two hours, so I really need to begin to think about packing and getting ready. I go to bed tonight somewhere over New York and wake up in London, then hop a quick plane to Amsterdam, where I will do some speeches for VBA Beleggingsprofessionals and then take a few days to see the area, spending a night in Delft and then slowly driving through the countryside to Brussels. I will spend the following few days with Geert Wellens of Econopolis in Brussels and then Geneva.

Last night the Dallas Mavericks lost a heartbreaker in the final few minutes to San Antonio, tying the series but requiring us, however improbably, to win two more games from the world champions. We came back from 20 points down to go ahead with not all that much time left, but we just couldn’t finish it. That’s the difference a few years makes. Four years ago this team closes it big-time. But it’s not over till it’s over, and every game has been back and forth. You really do like to see “your” team win in the end. I know that in reality it’s just one set of highly paid professionals vs. another, but it’s that human dynamic of our tribe versus their tribe, just without the swords and clubs. A lot more civilized and played by modern warriors doing things on the court that we mere mortals can only watch in awe. (But it would help if the referees weren’t so clearly in the tank for San Antonio and Tim Duncan. Just saying…)

I will be writing this weekend’s letter from Amsterdam, and my intention is to write about the thought process I went through in getting my mortgage and the terms I was offered, and how I am (finally!) hedging my mortgage in yen (and at what cost). I will also offer some comments on housing and Japan. It should make for an interesting letter and give you a glimpse at how I take my real-world economic analysis and turn it into actual investment decisions and trades. Until the weekend,

Your not quite ready for how expensive Europe will be analyst,

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

 

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Why Are So Many Boomers Working Longer?

By James J. Green
ThinkAdviser, April 17, 2014

Market watchers — or at least those pundits who are required to provide a reason for why the markets go up or down on a given day — love to speculate beforehand on the monthly employment figures, and then react quickly when the Department of Labor releases them. Those pundits, and their audiences, might be better served by looking at longer ranges of data on employment, such as the recently released Labor-force Participation Rates of the Population Ages 55 and Older, 2013, by the Employee Benefit Research Institute.

That report was written by EBRI’s Craig Copeland and considers data from the Census Bureau and the Bureau of Labor Statistics, along with EBRI’s own Retirement Confidence Survey. It concludes that labor force participation rates have increased for older Americans from the 1990s to the present, while the participation rate has fallen for younger Americans. That raises the question of why older Americans are working longer, and whether, as has been surmised, older Americans are “taking” jobs from younger Americans. As Copeland writes, “it appears either that older workers filled the void left by younger workers’ lower participation, or that higher older-worker participation limited the opportunities for younger workers or discouraged them from participating in the labor force.”

Before getting into that issue, some definitions are in order. First, the “labor force participation rate” measures those individuals in a specific age group who are “working or actively pursuing work,” which Copeland points out “is different from the share of those actually working who fall into a specific category.”

Second, let’s define the scope of the issue. Copeland says that the percentage of civilian, noninstitutionalized Americans near or at retirement age (age 55 or older) in the labor force increased from 29.4% in 1993 to 40.3% in 2013. In the report’s summary, Copeland writes:

  • For those ages 55–64, the upward trend was driven almost exclusively by the increased labor-force participation of women, whereas the male participation rate was flat to declining. However, among those ages 65 or older, the rate increased for both males and females over that period.
     
  • This upward trend in labor-force participation by older workers is likely related to workers’ current need for continued access to employment-based health insurance and for more years of earnings to accumulate savings in defined contribution (401(k)-type) plans and/or to pay down debt.
     
  • Many Americans also want to work longer, especially those with more education for whom more meaningful jobs are available that can be performed into older ages.

To return to the question of whether older people are “crowding out” younger people from jobs, it’s beyond the scope of the EBRI research to answer, but it turns out it has already been definitively addressed by researchers at Boston College’s Center for Retirement Research. The answer is no.

A 2012 paper by Alicia Munnell and April Yanyuan Wu, Are Aging Baby Boomers Squeezing Young Workers Out of Jobs?, is a serious academic work, discussing the “lump of labor” theory (the original “crowding out” theory from the mid-19th century), reviewing and analyzing the data, testing the theory, including a separate test “for the Great Recession” and exploring the “causal relationship between the labor force activity of the old and the young.” The conclusion?

“This horse has been beaten to death. An exhaustive search found no evidence to support the lump of labor theory in the United States. In fact, the evidence suggests that greater employment of older persons leads to better outcomes for the young — reduced unemployement, increased employment and a higher wage.” Moreover, these “patterns are consistent” for both men and women and for groups with different education levels, and were no different during the financial crisis, or Great Recession if you prefer.

So why should you care, as an advisor and/or as a member of this society? First, American workers are “undergoing a significant period of aging that appears likely to continue,” the EBRI paper points out. As evidence, Copeland cites EBRI’s most recent Retirement Confidence Survey (RCS), which found that “a growing percentage of workers expect to retire at later ages both because of the reasons described above [for health insurance, to pay down debt and to save longer for retirement] and/or because of an increased desire to continue to work.”

Older people want to work longer, at least those who enjoy their work, which in turn is directly correlated to how much education a worker has. “Overall, as workers’ educational attainment increased, their labor-force participation rate also increased,” Copeland reports. For example, in 2012, “60.7% of individuals with a graduate or professional degree were in the labor force, compared with 23.9% of those without a high school diploma.”

So that’s the entire labor force. What about older people and education? How did the financial crisis affect these workers?

“The recent economic downturn did not alter the trend of older workers in the labor force,” writes Copeland, “rather, it appears that this remained the trend, as more opportunities for older workers exist that correspond to their increased educational attainment. In fact, the increase in the percentage of those 55 or older in the labor force increased with the higher incidence of more highly educated people in this age group.” 

So baby boomers, who are more highly educated than previous generations, are working longer. Millennials – those age 25 to 32 – are the most highly educated generation in American history: 34% have at least a bachelor’s degree.

Let’s compare boomers with millennials. A Feb. 2014 survey by Pew Research found  that way back in 1979, “when the first wave of baby boomers were the same age that millennials are today,” the typical high school graduate earned about three-quarters (77%) of what a college graduate made. “Today, millennials with only a high school diploma earn 62% of what the typical college graduate earns.” That same study compared educational levels of prior generations at the same age as millennials: only 13% of 25- to 32-year-olds in 1965 had a college degree; of the “early” boomers who were age 25 to 32 in 1979, 24% held college degrees.

However, actual worker earnings have stayed nearly flat for each cohort of 25- to 32-year-olds since 1965: from $30,892 in 1965 to  $35,000 in 2012 (in 2012 dollars).

So here’s where we stand. The boomer clients you have now are more likely to work longer, for a number of reasons but buttressed by the fact that they like to work (sound familiar, advisors?), which is positively correlated to being better educated.

The generations that follow the boomers will be even better educated, and so are more likely to work even longer and for the same reasons. One big caveat: the Affordable Care Act may make it less necessary for older workers to be employed merely for the health insurance they want and need. So we’ll have to see how that will play out.

But maybe Social Security is a little healthier than we thought. If you continue to work into older age, you’ll still be paying your Social Security taxes (as will your employer, of course); and you’ll be paying income tax if you take Social Security benefits while you’re still working, depending on your total income.

Yes, not everyone is able to work due to health issues as they age, but higher longevity added to more educated people working longer will be a net benefit to the Social Security system and to society. And remember, old people are not keeping young people down, at least when it comes to jobs.

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World Money Analyst: Europe: Cliff Ahead?

 

Europe: Cliff Ahead?

By Dirk Steinhoff

(This article originally appeared in World Money Analyst)

When Kevin Brekke, managing editor [of World Money Analyst], contacted me last week, I knew it was time again to survey the investment landscape. This month, I will focus on Europe and its decoupled financial and real-economy markets.

Globally, the last two years were marked by booming stock exchanges of developed markets, disappointing bond markets, and devastation across the precious metals markets.

Since June 2012, the EURO STOXX 50 Index, Europe’s leading blue-chip index for the Eurozone, has advanced by approximately 50% and outperformed even the S&P 500 and the MSCI World indices.

Over the last six months, European stock exchanges have seen a surprising change of leadership: The major stock market indices of the “weaker” countries, like Portugal, Spain, and Italy, have outperformed those considered stronger, like Germany. One of the top performers was a country that was and still remains in “bankruptcy” mode: Greece.

The question at this point is: Can these outstanding European stock market performances continue?

In our search for an answer, let’s start with a closer look at the economic conditions within the European Union (EU), where approximately 2/3 of total “exports” (internal and external) of the EU-28 are traded. And then let’s have a look at the economic setting of some major trading partners, such as the US and BRIC countries, which account for roughly 17% and 21%, respectively, of the external exports of the EU-28.

Although the EURO STOXX 50 Index has soared since June 2012, certain key measures of the underlying real economies paint a different picture.

To start, the GDP of the EU-28 is not really growing. In 2012, it contracted by 0.4% and grew by the smallest fraction of 0.1% in 2013. The GDP growth numbers for the countries in the euro area are even worse: -0.7% in 2012 and -0.4% in 2013. Whereas Germany’s GDP was up in 2013 by 0.5%, economic growth was down in Spain, Italy, and Greece by -1.2%, -1.8%, and -3.6%, respectively.

Real GDP Growth Rates 2002-2012

 

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

EU

1.3

1.5

2.6

2.2

3.4

3.2

0.4

-4.5

2.0

1.6

-0.4

Germany

0.0

-0.4

1.2

0.7

3.7

3.3

1.1

-5.1

4.0

3.3

0.7

Spain

2.7

3.1

3.3

3.6

4.1

3.5

0.9

-3.8

-0.2

0.1

-1.6

France

0.9

0.9

2.5

1.8

2.5

2.3

-0.1

-3.1

1.7

2.0

0.0

Italy

0.5

0.0

1.7

0.9

2.2

1.7

-1.2

-5.5

1.7

0.5

-2.5

Portugal

0.8

-0.9

1.6

0.8

1.4

2.4

0.0

-2.9

1.9

-1.3

-3.2

 

 

The EU unemployment rate stood at 10.2% at the beginning of 2012 and stands at 12.1% today. That the European Union is anything but a homogenous body that moves in unison can be seen in the following chart:

Where Germany has a current unemployment rate of 5.2% and a youth (under 25) unemployment rate of 7.5%, the numbers for other countries are worrisome: Current unemployment in Spain is 26.7%, and 12.7% in Italy, with youth unemployment in Spain at an incredible 57.7%, and 41.6% in Italy. And don’t forget Greece, which is mired in a historically unparalleled economic depression where unemployment is 28% and youth unemployment is a shocking 61.4%. Keep in mind that all of these numbers are those officially released by bureaucratic agencies. The real numbers, as we know, would likely be even worse.

Recent EU industrial production numbers have shown some slight improvement. Nevertheless, industrial production has only managed to recover to its 2004 level, and remains way below its 2007 heights (see next graph).

Source: Eurostat

So let’s see: a shrinking GDP, high and rising unemployment, and stagnant production significantly below 2007 levels. Those are not the rosy ingredients of a booming economy (as indicated by the stock exchanges) but of one that is struggling.

Europe is not in growth mode.

This verdict is further supported by the export numbers for trade between EU countries, known as internal trade. In 2001, internal trade accounted for 67.9% of EU exports. Today, this share is down to 62.7%. In an attempt to compensate for sluggish European growth, EU companies had to develop other export markets, such as the US or the emerging markets.

Will these markets help rescue European companies?

Time to Taper Expectations

With regards to the US, two important developments are worth mentioning. The first key development, which will have severe consequences for the global economy, was brought to my attention by my friend Felix Zulauf, an internationally well-known investor and regular member of the Barron’s Roundtable for more than 20 years. Running ever-increasing deficits in its trade and current accounts for almost 30 years, the US thus provided an enormous amount of stimulus for foreign exporters. Since 2006, however, the US trade deficit has shrunk, with deteriorating trade data for many nations as a consequence.

The second key development is that the newly appointed head of the US Federal Reserve system, Janet Yellen, seems determined to continue the taper of its bond buying program. This fundamental shift in monetary policy could be questioned if the economic numbers for the US begin to show significant weakness. But in the meantime, the reduction of economic stimulus in the US should lead to a reduced appetite for European export goods.

The emerging markets had been seen, not too long ago, as the investment opportunity and alternative to the fiscal and debt crisis-stricken countries of the developed world. Today, on a nearly daily basis, you hear bad news about the situation and developments in the emerging countries: swaying stock markets, plunging currencies, company bankruptcies, corruption scandals, and even riots.

The emerging markets are dealing with the unintended consequences of the Quantitative Easing (including liquidity easing and credit easing) programs in the West. The increased liquidity spilled over into the emerging markets in the hunt for yield. This flow of capital into the emerging markets lowered capital costs, inflated asset prices like stocks and real estate, and boosted commodity prices. All that, and more, sparked the emerging markets boom.

Now, this process has reversed. The natural conclusion to exaggerated credit-driven growth, the tapering of QE programs, the shrinking US trade deficit, and lower commodity prices has been an outflow of capital from emerging markets, triggering lower asset prices and exchange rates. The attempt of some countries to defend their currencies by raising interest rates will only exert further pressure on their economies.

With weaker emerging market economies and currencies, there will be no big added demand for European exports. Revenues and profits for EU companies (measured in euros) will fall.

When Trends Collide

So, over the last two years we had opposing trends—booming European stock markets and weak underlying real economies. This conflicting mix was mainly fostered by easy money that drove down interest rates to historic low levels. Plowing money into stocks, despite the poor fundamentals, was the only solution for most investors.

At their current elevated levels European stock markets appear vulnerable, and it seems reasonable to doubt that we will see a continuation of booming stock markets. Of course, such a decoupling can continue for some time, but the longer it continues, the closer we will get to a correction of this anomaly. Either the real economy catches up to meet runaway stock prices, or stock prices come down to meet the poor economic reality. Or some combination of the two.

Because of the economic facts that I discussed above, in my view, we may be seeing just the beginning of a stronger correction in stock prices.

Dirk Steinhoff is chief investment officer of portfolio management (international clients) at the BFI Capital Group. Prior to joining BFI in 2007, Mr Steinhoff acted as an independent asset manager for over 15 years. He successfully founded and built two companies in the realm of infrastructure and real estate management. Mr Steinhoff holds a bachelor’s and master’s degree in civil engineering and business administration, magna cum laude, from the University of Technology in Berlin, Germany. Contact: advisors@bfiwealth.com.


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The article World Money Analyst: Europe: Cliff Ahead? was originally published at mauldineconomics.com.

Things That Make You Go Hmmm: Gyver & Guffin

 

This week’s TTMYGH revolves around “Macs.” The first is a man-turned-verb who was capable of extricating himself from seemingly hopeless situations, armed with an array of tools seemingly singularly unsuited to the purpose; and the second is an ingenious, though ultimately futile, plot device which has been used by everyone from Welles to Hitchcock to Tarantino.

I%20Heart%20Japan.psd

Though at first blush it’s hard to see a link between the two, in today’s world there are Angus MacGyvers everywhere, beetling away with duct tape and Swiss army knives, trying to extricate themselves from completely hopeless situations; and if they are to succeed before the credits roll, they must rely upon one very important thing: the suspension of disbelief by their audience.

That’s where the other “Mac” comes in.

Man first.

Angus MacGyver was a troubleshooter. He worked for the fictional Phoenix Foundation as a secret agent and also for the US government in the (also fictional) Department of External Services.

Macguyver.psd

Educated as a scientist and possessing an encyclopedic knowledge of the physical sciences, MacGyver had been a bomb disposal technician during the Vietnam War and possessed a distinctly pacifist outlook on life — he hated guns.

Also, his luck could scarcely be described as merely “good.”

Somehow, over the course of seven seasons, MacGyver managed to get himself into some 139 impossible-to-get-out-of situations — each of which he managed to navigate successfully by using conventional items in a distinctly unconventional way.

By way of illustration, in the pilot episode alone, MacGyver managed to do the following:

Rig a machine gun with a cord, string, stick, and matches so that when the string burned through, the machine gun fell and was triggered by the stick and began firing (while still being held by the cord).

Plug a sulfuric acid leak with chocolate. MacGyver stated that chocolate contains sucrose and glucose. The acid reacted with the sugars to form elemental carbon and a thick gummy residue. (NB this was subsequently proven to work, as demonstrated on the show Mythbusters.)

Make a “rocket thruster” by hitting a flare gun with a rock, launching MacGyver and a man he rescued off of a mountain, whereupon he opened a parachute and made a clean getaway.

Create a bomb to open a door using a gelatin cold capsule containing sodium metal, which he placed in a glass jar filled with water. When the gelatin dissolved, the sodium reacted violently with the water and caused an explosion which blew a hole in the wall.

Impressive stuff. It’s no wonder he ended up becoming a verb. But to witness perhaps his greatest-ever escape, afford yourself two minutes to watch THIS little stunt to see how MacGyver escaped from his own coffin.

Coffin.psd

 

I couldn’t help but think of MacGyver this past week as I sat chatting with a colleague about the situation Japan now finds itself in.

I won’t recap the details of the straitjacket into which the Japanese have been strapped for the past two decades — enough ink has been spilled on that subject already, including in a recent Things That Make You Go Hmmm… entitled Avenomics — but my conversation this week stemmed from the following statement, made by me to myself, as I leaned back in my chair after reading an article about proposed changes to the GPIF (Government Pension Investment Fund), Japan’s public pension fund:

“Japan really is totally f*****.”

What led me to that well-thought-out and eruditely expressed conclusion? Read on.

In case you are not familiar with the GPIF, it is the largest pool of government-controlled investment capital on the planet — outstripping even the infamous Arab sovereign wealth funds.

The GPIF controls ¥128.6 trillion, or $1.25 trillion, and to say the organization is somewhat risk-averse is akin to calling the Kardashian family somewhat shameless.

The GPIF holds almost 70% of its assets in bonds — and the vast majority of them are of the local variety. The reason for this? Well that would be because the GPIF is (and has always been) run by bureaucrats from the Ministry of Health, Labour & Welfare, as opposed to, say, investment professionals.

But that’s probably no bad thing, because no investment professional worth his salt would have bought so many JGBs; so if GPIF didn’t buy them, THAT would be a big problem for the Japanese government AND the BoJ.

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Source: GPIF

How did that allocation to domestic bonds do last year? Well, as it turns out, not so great:

 

Q1 2013

Q2 2013

Q3 2013

Q4 2013

Total 2013

Domestic Bonds

-1.48

1.18

0.18

-

-0.14

Domestic Stocks

9.70

6.07

9.19

-

27.05

Int’l Bonds

4.01

1.64

8.16

-

14.34

Int’l Stocks

6.14

7.13

16.23

-

32.17

Source: GPIF

Fortunately, over the last twelve years the GPIF has managed to meet its targets — by growing at an annualized rate of 1.54%.

Thankfully for the GPIF, despite their largest allocation throwing off negative returns, the BoJ’s actions in weakening the yen boosted the Nikkei, and the central-bank-inspired strength in equities and bonds elsewhere in the world helped GPIF’s performance to pass the smell test for 2013.

Now, when it comes to bureaucracy, Japan is in a league all of its own. My first up-close experience of this came in 1989 when I went to get a driver’s license after moving to Tokyo. Anybody who has attempted to complete that fairly straightforward objective in Japan knows that it requires the best part of a day traipsing upstairs and down between several counters, getting the same piece of paper stamped by numerous people in a very specific order. Several visits are required to the same person — but only in the correct order.

Jap%20Drivers%20License%20small.jpg

Maybe this process has changed 25 years on, maybe it hasn’t. I’m willing to bet on the latter.

Anyway, amongst themselves, foreigners in Japan have a saying which strikes at the very heart of this little bureaucratic problem:

“Everything makes sense once you realize Japan is a communist country.”

Aki Wakabayashi’s book Komuin no Ijona Sekai (The Bizarre World Of The Public Servant) sprang from her 10 years working at a Labour Ministry research institute and lifted the lid on some of the peccadilloes of Japan’s civil service.

The facts unearthed by Wakabayashi are remarkable:

(Japan Times): The national average annual income of a local government employee was ¥7 million in 2006, compared to the ¥4.35 million national average for all company employees and the ¥6.16 million averaged by workers at large companies. Their generosity to even their lowest-level employees may explain why so many local governments are effectively insolvent: Drivers for the Kobe municipal bus system are paid an average of almost ¥9 million (taxi drivers, by comparison, earn about ¥3.9 million).

Click here 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.

Thoughts from the Frontline: The Cost of Code Red

 

(It is especially important to read the opening quotes this week. They set up the theme in the proper context.)

 “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

– Ludwig von Mises

“No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempt to remedy a present ill by sowing the seeds of a much greater ill for the future.”

– Ludwig von Mises

“[Central banks are at] serious risk of exhausting the policy room for manoeuver over time.”

– Jaime Caruana, General Manager of the Bank for International Settlements

“The gap between the models in the world of monetary policymaking is now wider than at any time since the 1930s.”

– Benjamin Friedman, William Joseph Maier Professor of Political Economy, Harvard

To listen to most of the heads of the world’s central banks, things are going along swimmingly. The dogmatic majority exude a great deal of confidence in their ability to manage their economies through whatever crisis may present itself. (Raghuram Rajan, the sober-minded head of the Reserve Bank of India, is a notable exception.)

However, there is reason to believe that there have been major policy mistakes made by central banks – and will be more of them – that will lead to dislocations in the markets – all types of markets. And it’s not just the usual anti-central bank curmudgeon types (among whose number I have been counted, quite justifiably) who are worried. Sources within the central bank community are worried, too, which should give thoughtful observers of the market cause for concern.

Too often we as investors (and economists) are like the generals who are always fighting the last war. We look at bank balance sheets (except those of Europe and China), corporate balance sheets, sovereign bond spreads and yields, and say it isn’t likely that we will repeat this mistakes which led to 2008. And I smile and say, “You are absolutely right; we are not going to repeat those mistakes. We learned our lessons. Now we are going to make entirely new mistakes.” And while the root cause of the problems, then and now, may be the same – central bank policy – the outcome will be somewhat different. But a crisis by any other name will still be uncomfortable.

If you look at some of the recent statements from the Bank for International Settlements, you should come away with a view much more cautious than the optimistic one that is bandied about in the media today. In fact, to listen to the former chief economist of the BIS, we should all be quite worried.

I am of course referring to Bill White, who is one of my personal intellectual heroes. I hope to get to meet him someday. We have discussed some of his other papers, written in conjunction with the Dallas Federal Reserve, in past letters. He was clearly warning about imbalances and potential bubbles in 2007 and has generally been one of the most prescient observers of the global economy. The prestigious Swiss business newspaper Finanz und Wirtschaft did a far-reaching interview with him a few weeks ago, and I’ve taken the liberty to excerpt pieces that I think are very important. The excerpts run a few pages, but this is really essential reading. (The article is by Mehr zum Thema, and you can read the full piece here.)

Speculative Bubbles

The headline for the interview is “I see speculative bubbles like in 2007.” As the interviewer rolls out the key questions, White warns of grave adverse effects of ultra-loose monetary policy:

William White is worried. The former chief economist of the Bank for International Settlements is highly skeptical of the ultra-loose monetary policy that most central banks are still pursuing. “It all feels like 2007, with equity markets overvalued and spreads in the bond markets extremely thin,” he warns.

Mr. White, all the major central banks have been running expansive monetary policies for more than five years now. Have you ever experienced anything like this?

The honest truth is no one has ever seen anything like this. Not even during the Great Depression in the Thirties has monetary policy been this loose. And if you look at the details of what these central banks are doing, it’s all very experimental. They are making it up as they go along. I am very worried about any kind of policies that have that nature.

But didn’t the extreme circumstances after the collapse of Lehman Brothers warrant these extreme measures?

Yes, absolutely. After Lehman, many markets just seized up. Central bankers rightly tried to maintain the basic functioning of the system. That was good crisis management. But in my career I have always distinguished between crisis prevention, crisis management, and crisis resolution. Today, the Fed still acts as if it was in crisis management. But we’re six years past that. They are essentially doing more than what they did right in the beginning. There is something fundamentally wrong with that. Plus, the Fed has moved to a completely different motivation. From the attempt to get the markets going again, they suddenly and explicitly started to inflate asset prices again. The aim is to make people feel richer, make them spend more, and have it all trickle down to get the economy going again. Frankly, I don’t think it works, and I think this is extremely dangerous.

So, the first quantitative easing in November 2008 was warranted?

Absolutely.

But they should have stopped these kinds of policies long ago?

Yes. But here’s the problem. When you talk about crisis resolution, it’s about attacking the fundamental problems that got you into the trouble in the first place. And the fundamental problem we are still facing is excessive debt. Not excessive public debt, mind you, but excessive debt in the private and public sectors. To resolve that, you need restructurings and write-offs. That’s government policy, not central bank policy. Central banks can’t rescue insolvent institutions. All around the western world, and I include Japan, governments have resolutely failed to see that they bear the responsibility to deal with the underlying problems. With the ultraloose monetary policy, governments have no incentive to act. But if we don’t deal with this now, we will be in worse shape than before.

But wouldn’t large-scale debt write-offs hurt the banking sector again?

Absolutely. But you see, we have a lot of zombie companies and banks out there. That’s a particular worry in Europe, where the banking sector is just a continuous story of denial, denial and denial. With interest rates so low, banks just keep ever-greening everything, pretending all the money is still there. But the more you do that, the more you keep the zombies alive, they pull down the healthy parts of the economy. When you have made bad investments, and the money is gone, it’s much better to write it off and get fifty percent than to pretend it’s still there and end up getting nothing. So yes, we need more debt reduction and more recapitalization of the banking system. This is called facing up to reality.

Where do you see the most acute negative effects of this monetary policy?

The first thing I would worry about are asset prices. Every asset price you could think of is in very odd territory. Equity prices are extremely high if you at valuation measures such as Tobin’s Q or a Shiller-type normalized P/E. Risk-free bond rates are at enormously low levels, spreads are very low, you have all these funny things like covenant-lite loans again. It all looks and feels like 2007. And frankly, I think it’s worse than 2007, because then it was a problem of the developed economies. But in the past five years, all the emerging economies have imported our ultra-low policy rates and have seen their debt levels rise. The emerging economies have morphed from being a part of the solution to being a part of the problem.

Do you see outright bubbles in financial markets?

Yes, I do. Investors try to attribute the rising stock markets to good fundamentals. But I don’t buy that. People are caught up in the momentum of all the liquidity that is provided by the central banks. This is a liquidity-driven thing, not based on fundamentals.

So are we mostly seeing what the Fed has been doing since 1987 – provide liquidity and pump markets up again?

Absolutely. We just saw the last chapter of that long history. This is the last of a whole series of bubbles that have been blown. In the past, monetary policy has always succeeded in pulling up the economy. But each time, the Fed had to act more vigorously to achieve its results. So, logically, at a certain point, it won’t work anymore. Then we’ll be in big trouble. And we will have wasted many years in which we could have been following better policies that would have maintained growth in much more sustainable ways. Now, to make you feel better, I said the same in 1998, and I was way too early.

What about the moral hazard of all this?

The fact of the matter is that if you have had 25 years of central bank and government bailout whenever there was a problem, and the bankers come to appreciate that fact, then we are back in a world where the banks get all the profits, while the government socializes all the losses. Then it just gets worse and worse. So, in terms of curbing the financial system, my own sense is that all of the stuff that has been done until now, while very useful, Basel III and all that, is not going to be sufficient to deal with the moral hazard problem. I would have liked to see a return to limited banking, a return to private ownership, a return to people going to prison when they do bad things. Moral hazard is a real issue.

Do you have any indication that the Yellen Fed will be different than the Greenspan and Bernanke Fed?

Not really. The one person in the FOMC that was kicking up a real fuss about asset bubbles was Governor Jeremy Stein. Unfortunately, he has gone back to Harvard.

The markets seem to assume that the tapering will run very smoothly, though. Volatility, as measured by the Vix index, is low.

Don’t forget that the Vix was at [a] record low in 2007. All that liquidity raises the asset prices and lowers the cost of insurance. I see at least three possible scenarios how this will all work out. One is: Maybe all this monetary stuff will work perfectly. I don’t think this is likely, but I could be wrong. I have been wrong so many times before. So if it works, the long bond rates can go up slowly and smoothly, and the financial system will adapt nicely. But even against the backdrop of strengthening growth, we could still see a disorderly reaction in financial markets, which would then feed back to destroy the economic recovery.

How?

We are such a long way away from normal long-term interest rates. Normal would be perhaps around four percent. Markets have a tendency to rush to the end point immediately. They overshoot. Keynes said in late Thirties that the long bond market could fluctuate at the wrong levels for decades. If fears of inflation suddenly re-appear, this can move interest rates quickly. Plus, there are other possible accidents. What about the fact that maybe most of the collateral you need for normal trading is all tied up now? What about the fact that the big investment dealers have got inventories that are 20 percent of what they were in 2007? When things start to move, the inventory for the market makers might not be there. That’s a particular worry in fields like corporate bonds, which can be quite illiquid to begin with. I’ve met so many people who are in the markets, thinking they are absolutely brilliantly smart, thinking they can get out in the right time. The problem is, they all think that. And when everyone races for the exit at the same time, we will have big problems. I’m not saying all of this will happen, but reasonable people should think about what could go wrong, even against a backdrop of faster growth.

And what is the third scenario?

The strengthening growth might be a mirage. And if it does not materialize, all those elevated prices will be way out of line of fundamentals.

Which of the major central banks runs the highest risk of something going seriously wrong?

At the moment what I am most worried about is Japan. I know there is an expression that the Japanese bond market is called the widowmaker. People have bet against it and lost money. The reason I worry now is that they are much further down the line even than the Americans. What is Abenomics really? As far as I see it, they print the money and tell people that there will be high inflation. But I don’t think it will work. The Japanese consumer will say prices are going up, but my wages won’t. Because they haven’t for years. So I am confronted with a real wage loss, and I have to hunker down. At the same time, financial markets might suddenly not want to hold Japanese Government Bonds anymore with a perspective of 2 percent inflation. This will end up being a double whammy, and Japan will just drop back into deflation. And now happens what Professor Peter Bernholz wrote in his latest book. Now we have a stagnating Japanese economy, tax revenues dropping like a stone, the deficit already at eight percent of GDP, debt at more than 200 percent and counting. I have no difficulty in seeing this thing tipping overnight into hyperinflation. If you go back into history, a lot of hyperinflations started with deflation.

Many people have warned of inflation in the past five years, but nothing has materialized. Isn’t the fear of inflation simply overblown?

One reason we don’t see inflation is because monetary policy is not working. The signals are not getting through. Consumers and corporates are not responding to the signals. We still have a disinflationary gap. There has been a huge increase in base money, but it has not translated into an increase in broader aggregates. And in Europe, the money supply is still shrinking. My worry is that at some point, people will look at this situation and lose confidence that stability will be maintained. If they do and they do start to fear inflation, that change in expectations can have very rapid effects.

More from the BIS

The Bank for International Settlements is known as the “central bankers’ central bank.” It hosts a meeting once a month for all the major central bankers to get together for an extravagant dinner and candid conversation. Surprisingly, there has been no tell-all book about these meetings by some retiring central banker. They take the code of “omertà” (embed) seriously.

Jaime Caruana, the General Manager of the BIS, recently stated that monetary institutions (central banks) are at “serious risk of exhausting the policy room for manoeuver over time.” He followed that statement with a very serious speech at the Harvard Kennedy School two weeks ago. Here is the abstract of the speech (emphasis mine):

This speech contrasts two explanatory views of what he characterizes as “the sluggish and uneven recovery from the global financial crisis of 2008-09.” One view points to a persistent shortfall of demand and the other to the specificities of a financial cycle-induced recession – the “shortfall of demand” vs. the “balance sheet” view. The speech summarizes each diagnosis [and]… then reviews evidence bearing on the two views and contrasts the policy prescriptions to be inferred from each view. The speech concludes that the balance sheet view provides a better overarching explanation of events. In terms of policy, the implication is that there has been too much emphasis since the crisis on stimulating demand and not enough on balance sheet repair and structural reforms to boost productivity. Looking forward, policy frameworks need to ensure that policies are more symmetrical over the financial cycle, so as to avoid the risks of entrenching instability and eventually running out of policy ammunition.

Coming from the head of the BIS, the statement I have highlighted is quite remarkable. He is basically saying (along with his predecessor, William White) that quantitative easing as it is currently practiced is highly problematical. We wasted the past five years by avoiding balance sheet repair and trying to stimulate demand. His analysis perfectly mirrors the one Jonathan Tepper and I laid out in our book Code Red.

How Does the Economy Adjust to Asset Purchases?

In 2011 the Bank of England gave us a paper outlining what they expected to be the consequences of quantitative easing. Note that in the chart below they predict exactly what we have seen. Real (inflation-adjusted) asset prices rise in the initial phase. Nominal demand rises slowly, and there is a lagging effect on real GDP. But note what happens when a central bank begins to flatten out its asset purchases or what is called “broad money” in the graph: real asset prices begin to fall rather precipitously, and consumer price levels rise. I must confess that I look at the graph and scratch my head and go, “I can understand why you might want the first phase, but what in the name of the wide, wide world of sports are you going to do for policy adjustment in the second phase?” Clearly the central bankers thought this QE thing was a good idea, but from my seat in the back of the plane it seems like they are expecting a rather bumpy ride at some point in the future.

Let’s go to the quote in the BoE paper that explains this graph (emphasis mine):

The overall effect of asset purchases on the macroeconomy can be broken down into two stages: an initial ‘impact’ phase and an ‘adjustment’ phase, during which the stimulus from asset purchases works through the economy, as illustrated in Chart 1. As discussed above, in the impact phase, asset purchases change the composition of the portfolios held by the private sector, increasing holdings of broad money and decreasing those of medium and long-term gilts. But because gilts [gilts is the English term for bonds] and money are imperfect substitutes, this creates an initial imbalance. As asset portfolios are rebalanced, asset prices are bid up until equilibrium in money and asset markets is restored. This is reinforced by the signalling channel and the other effects of asset purchases already discussed, which may also act to raise asset prices. Through lower borrowing costs and higher wealth, asset prices then raise demand, which acts to push up the consumer price level.

[Quick note: I think Lacy Hunt thoroughly devastated the notion that there is a wealth effect and that rising asset prices affect demand in last week’s Outside the Box. Lacy gives us the results of numerous studies which show the theory to be wrong. Nevertheless, many economists and central bankers cling to the wealth effect like shipwrecked sailors to a piece of wood on a stormy sea. Now back to the BoE.]

In the adjustment phase, rising consumer and asset prices raise the demand for money balances and the supply of long-term assets. So the initial imbalance in money and asset markets shrinks, and real asset prices begin to fall back. The boost to demand therefore diminishes and the price level continues to increase but by smaller amounts. The whole process continues until the price level has risen sufficiently to restore real money balances, real asset prices and real output to their equilibrium levels. Thus, from a position of deficient demand, asset purchases should accelerate the return of the economy to equilibrium.

This is the theory under which central banks of the world are operating. Look at this rather cool chart prepared by my team (and specifically Worth Wray). The Fed (with a few notable exceptions on the FOMC) has been openly concerned about deflationary trends. They are purposely trying to induce a higher target inflation. The problem is, the inflation is only showing up in stock prices – and not just in large-cap equity markets but in all assets around the world that price off of the supposedly “risk-free” rate of return.

I hope you get the main idea, because understanding this dynamic is absolutely critical for navigating what the Chairman of the South African Reserve Bank, Gill Marcus, is calling the next phase of the global financial crisis. Every asset price (yes, even and especially in emerging markets) that has been driven higher by unnaturally low interest rates, quantitative easing, and forward guidance must eventually fall back to earth as real interest rates eventually normalize.

Trickle-Down Monetary Policy

For all intents and purposes we have adopted a trickle-down monetary policy, one which manifestly does not work and has served only to enrich financial institutions and the already wealthy. Now I admit that I benefit from that, but it’s a false type of enrichment, since it has come at the expense of the general economy, which is where true wealth is created. I would rather have my business and investments based on something more stably productive, thank you very much.

Monetary policies implemented by central banks around the world are beginning to diverge in a major way. And don’t look now, but that sort of divergence almost always spells disaster for all or part of the global economy. Which is why Indian Central Bank Governor Rajan is pounding the table for more coordinated policies. He can see what is going to happen to cross-border capital flows and doesn’t appreciate being caught in the middle of the field of fire with hardly more than a small pistol to defend himself. And the central banks even smaller than his are bringing only a knife to the gunfight.

The Fed & BoE Are Heading for the Exits…

In the United States, Federal Reserve Chairwoman Janet Yellen is clearly signaling her interest – if not outright intent – to turn the Fed’s steady $10 billion “tapering” of its $55 billion/month quantitative easing program into a more formal exit strategy. The Fed is still actively expanding its balance sheet, but by a smaller amount after every FOMC meeting (so far)… and global markets are already nervously anticipating any move to sell QE-era assets or explicitly raise rates. Just like China’s slowdown (which we have written about extensively), the Fed’s eventual exit will be a global event with major implications for the rest of the world. And US rate normalization could drastically disrupt cross-border real interest rate differentials and trigger the strongest wave of emerging-market balance of payments crises since the 1930s.

In the United Kingdom, Bank of England Governor Mark Carney is carefully broadcasting his intent to hike rates before selling QE-era assets. According to his view, financial markets tend to respond rather mechanically to rate hikes, but unwinding the BoE’s bloated balance sheet could trigger a series of unintended and potentially destructive consequences. Delaying those asset sales indefinitely and leaning on rate targeting once more allows him to guide the BoE toward tightening without giving up the ability to rapidly reverse course if financial markets freeze. Then again, Carney may be making a massive, credibility-cracking mistake.

While the BoJ & ECB Are Just Getting Started

In Japan, Bank of Japan Governor Haruhiko Kuroda is resisting the equity market’s call for additional asset purchases as the Abe administration implements its national sales tax increase – precisely the same mistake that triggered Japan’s 1997 recession. As I have written repeatedly, Japan is the most leveraged government in the world, with a government debt-to-GDP ratio of more than 240%. Against the backdrop of a roughly $6 trillion economy, Japan needs to inflate away something like 150% to 200% of its current debt-to-GDP… that’s roughly $9 trillion to $12 trillion in today’s dollars.

Think about that for a moment. At some point I need to do a whole letter on this, but I seriously believe the Bank of Japan will print something on the order of $8 trillion (give or take) over the next six to ten years. In relative terms, this is the equivalent of the US Federal Reserve printing $32 trillion. To think this will have no impact on the world is simply to ignore how capital flows work. Japan is a seriously large economy with a seriously powerful central bank. This is not Greece or Argentina. This is going to do some damage.

I have no idea whether Japan’s BANG! moment is just around the corner or still several years off, but rest assured that Governor Kuroda and his colleagues at the Bank of Japan will respond to economic weakness with more… and more… and more easing over the coming years.

In the euro area, European Central Bank Chairman Mario Draghi – with unexpected support from his two voting colleagues from the German Bundesbank – is finally signaling that more quantitative easing may be on the way to lower painfully high exchange rates that constrain competitiveness and to raise worryingly low inflation rates that can precipitate a debt crisis by steepening debt-growth trajectories. This QE will be disguised under the rubric of fighting inflation, and all sorts of other euphemisms will be applied to it, but at the end of the day, Europe will have joined in an outright global currency war.

I don’t expect the Japanese and Europeans to engage in modest quantitative easing. Both central banks are getting ready to hit the panic button in response to too-low inflation, steepening debt trajectories, and inconveniently strong exchange rates.

While the Federal Reserve, European Central Bank, Swiss National Bank, Bank of England, and Bank of Japan have collectively grown their balance sheets to roughly $9 trillion today, the next wave of asset purchases could more than double that balance in relatively quick order.

This is what I mean by Code Red: frantic pounding on the central bank panic button that invites tit-for-tat retaliation around the world and especially by emerging-market central banks, leading to a DOUBLING of the assets shown in the chart below and a race to the bottom, as the “guardians” of the world’s primary currencies become their executioners.

The opportunity for a significant policy mistake from a major central bank is higher today than ever. I share Bill White’s concern about Japan. I worry about China and seriously hope they can keep their deleveraging and rebalancing under control, although I doubt that many parts of the world are ready for a China that only grows at 3 to 4% for the next five years. That will cause a serious adjustment in many business and government models.

It is time to hit the send button, but let me close with the point that was made graphically in the Bank of England’s chart back in the middle of the letter. Once central bank asset purchases cease, the BoE expects real asset prices to fall… a lot. You will notice that there is no scale on the vertical axis and no timeline along the bottom of the chart. No one really knows the timing. My friend Doug Kass has an interview (subscribers only) in Barron’s this week, talking about how to handle what he sees as a bubble.

“Sell in May and go away” might be a very good adage to remember.

Amsterdam, Brussels, Geneva, San Diego, Rome, and Tuscany

I leave Tuesday night for Amsterdam to speak on Thursday afternoon for VBA Beleggingsprofessionals. There will be a debate-style format around the theme of “Are there any safe havens left in this volatile world?” I plan to write my letter from Amsterdam on Friday and then play tourist on Saturday in that delightful city full of wonderful museums. Then, if all goes well, I will rent a car and take a leisurely drive to Brussels through the countryside, something I have always wanted to do. I may try to get lost, at least for a few hours. Who knows what you might stumble on?

I will be speaking Monday night in Brussels for my good friend Geert Wellens of Econopolis Wealth Management before we fly to Geneva for another speech with his firm, and of course there will be the usual meetings with clients and friends. I find Geneva the most irrationally expensive city I travel to, and the current exchange rates don’t suggest I will find anything different this time.

I come back for a few days before heading to San Diego and my Strategic Investment Conference, cosponsored with Altegris. I have spent time with each of the speakers over the last few weeks, going over their topics, and I have to tell you, I am like a kid in a candy store, about as excited as I can get. This is going to be one incredible conference. You really want to make an effort to get there, but if you can’t, be sure to listen to the audio CDs.  You can get a discounted rate by purchasing prior to the conference.

The Dallas weather may be an analogy for the current economic environment. To look out my window is to see nothing but blue sky with puffy little clouds, and the temperature is perfect. My good friend and business partner Darrell Cain will be arriving in a little bit for a late lunch. We’ll go somewhere and sit outside and then move on to an early Dallas Mavericks game against the San Antonio Spurs. Contrary to expectations, the Mavs actually trounced the Spurs down in San Antonio last week. Of course the local fans would like to see that trend continue, but I would not encourage my readers to place any bets on the Mavericks’ winning the current playoff series.

I live only a few blocks from American Airlines Center, and so normally on such a beautiful day we would leisurely walk to the game. But the local weather aficionados are warning us that while we are at the game tornadoes and hail may appear, along with the attendant severe thunderstorms. That kind of thing can happen in Texas. Then again, it could all blow south of here. That sort of thing also happens.

So when I warn people of an impending potential central bank policy mistake, which would be the economic equivalent of tornadoes and hail storms, I also have to acknowledge that the whole thing could blow away and miss us entirely. I think someone once said that the role of economists is to make weathermen look good. Recently, 67 out of 67 economists said they expect interest rates to rise this year. We’ll review that prediction at the end of the year.

I’ve been interrupted while trying to finish this letter by daughter Tiffani, who is frantically trying to figure out how to buy tickets to get us to Italy (Tuscany) for the first part of June for a little vacation (along with a few friends who will be visiting). I am going to take advantage of being in Rome at the end of that trip, in order to spend a few days with my friend Christian Menegatti, the managing director of research for Roubini Global Economics. We will spend June 16-17  visiting with local businessmen, economists, central bankers, and politicians. Or that’s the plan. If you’d like to be part of that visit, drop me a note.

Finally I should note that my Canadian partners, Nicola Wealth Management, are opening a new office in Toronto. They will be having a special event there on May 8. If you’re in the area, you may want to check it out.

Have a great week, and make sure you take a little time to enjoy life. Avoid tornadoes.

Your hoping for a major upset analyst,

John Mauldin, Editor
subscribers@mauldineconomics.com

 

 

Thoughts from the Frontline: The Cost of Code Red

 

(It is especially important to read the opening quotes this week. They set up the theme in the proper context.)

 “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

– Ludwig von Mises

“No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempt to remedy a present ill by sowing the seeds of a much greater ill for the future.”

– Ludwig von Mises

“[Central banks are at] serious risk of exhausting the policy room for manoeuver over time.”

– Jaime Caruana, General Manager of the Bank for International Settlements

“The gap between the models in the world of monetary policymaking is now wider than at any time since the 1930s.”

– Benjamin Friedman, William Joseph Maier Professor of Political Economy, Harvard

To listen to most of the heads of the world’s central banks, things are going along swimmingly. The dogmatic majority exude a great deal of confidence in their ability to manage their economies through whatever crisis may present itself. (Raghuram Rajan, the sober-minded head of the Reserve Bank of India, is a notable exception.)

However, there is reason to believe that there have been major policy mistakes made by central banks – and will be more of them – that will lead to dislocations in the markets – all types of markets. And it’s not just the usual anti-central bank curmudgeon types (among whose number I have been counted, quite justifiably) who are worried. Sources within the central bank community are worried, too, which should give thoughtful observers of the market cause for concern.

Too often we as investors (and economists) are like the generals who are always fighting the last war. We look at bank balance sheets (except those of Europe and China), corporate balance sheets, sovereign bond spreads and yields, and say it isn’t likely that we will repeat this mistakes which led to 2008. And I smile and say, “You are absolutely right; we are not going to repeat those mistakes. We learned our lessons. Now we are going to make entirely new mistakes.” And while the root cause of the problems, then and now, may be the same – central bank policy – the outcome will be somewhat different. But a crisis by any other name will still be uncomfortable.

If you look at some of the recent statements from the Bank for International Settlements, you should come away with a view much more cautious than the optimistic one that is bandied about in the media today. In fact, to listen to the former chief economist of the BIS, we should all be quite worried.

I am of course referring to Bill White, who is one of my personal intellectual heroes. I hope to get to meet him someday. We have discussed some of his other papers, written in conjunction with the Dallas Federal Reserve, in past letters. He was clearly warning about imbalances and potential bubbles in 2007 and has generally been one of the most prescient observers of the global economy. The prestigious Swiss business newspaper Finanz und Wirtschaft did a far-reaching interview with him a few weeks ago, and I’ve taken the liberty to excerpt pieces that I think are very important. The excerpts run a few pages, but this is really essential reading. (The article is by Mehr zum Thema, and you can read the full piece here.)

Speculative Bubbles

The headline for the interview is “I see speculative bubbles like in 2007.” As the interviewer rolls out the key questions, White warns of grave adverse effects of ultra-loose monetary policy:

William White is worried. The former chief economist of the Bank for International Settlements is highly skeptical of the ultra-loose monetary policy that most central banks are still pursuing. “It all feels like 2007, with equity markets overvalued and spreads in the bond markets extremely thin,” he warns.

Mr. White, all the major central banks have been running expansive monetary policies for more than five years now. Have you ever experienced anything like this?

The honest truth is no one has ever seen anything like this. Not even during the Great Depression in the Thirties has monetary policy been this loose. And if you look at the details of what these central banks are doing, it’s all very experimental. They are making it up as they go along. I am very worried about any kind of policies that have that nature.

But didn’t the extreme circumstances after the collapse of Lehman Brothers warrant these extreme measures?

Yes, absolutely. After Lehman, many markets just seized up. Central bankers rightly tried to maintain the basic functioning of the system. That was good crisis management. But in my career I have always distinguished between crisis prevention, crisis management, and crisis resolution. Today, the Fed still acts as if it was in crisis management. But we’re six years past that. They are essentially doing more than what they did right in the beginning. There is something fundamentally wrong with that. Plus, the Fed has moved to a completely different motivation. From the attempt to get the markets going again, they suddenly and explicitly started to inflate asset prices again. The aim is to make people feel richer, make them spend more, and have it all trickle down to get the economy going again. Frankly, I don’t think it works, and I think this is extremely dangerous.

So, the first quantitative easing in November 2008 was warranted?

Absolutely.

But they should have stopped these kinds of policies long ago?

Yes. But here’s the problem. When you talk about crisis resolution, it’s about attacking the fundamental problems that got you into the trouble in the first place. And the fundamental problem we are still facing is excessive debt. Not excessive public debt, mind you, but excessive debt in the private and public sectors. To resolve that, you need restructurings and write-offs. That’s government policy, not central bank policy. Central banks can’t rescue insolvent institutions. All around the western world, and I include Japan, governments have resolutely failed to see that they bear the responsibility to deal with the underlying problems. With the ultraloose monetary policy, governments have no incentive to act. But if we don’t deal with this now, we will be in worse shape than before.

But wouldn’t large-scale debt write-offs hurt the banking sector again?

Absolutely. But you see, we have a lot of zombie companies and banks out there. That’s a particular worry in Europe, where the banking sector is just a continuous story of denial, denial and denial. With interest rates so low, banks just keep ever-greening everything, pretending all the money is still there. But the more you do that, the more you keep the zombies alive, they pull down the healthy parts of the economy. When you have made bad investments, and the money is gone, it’s much better to write it off and get fifty percent than to pretend it’s still there and end up getting nothing. So yes, we need more debt reduction and more recapitalization of the banking system. This is called facing up to reality.

Where do you see the most acute negative effects of this monetary policy?

The first thing I would worry about are asset prices. Every asset price you could think of is in very odd territory. Equity prices are extremely high if you at valuation measures such as Tobin’s Q or a Shiller-type normalized P/E. Risk-free bond rates are at enormously low levels, spreads are very low, you have all these funny things like covenant-lite loans again. It all looks and feels like 2007. And frankly, I think it’s worse than 2007, because then it was a problem of the developed economies. But in the past five years, all the emerging economies have imported our ultra-low policy rates and have seen their debt levels rise. The emerging economies have morphed from being a part of the solution to being a part of the problem.

Do you see outright bubbles in financial markets?

Yes, I do. Investors try to attribute the rising stock markets to good fundamentals. But I don’t buy that. People are caught up in the momentum of all the liquidity that is provided by the central banks. This is a liquidity-driven thing, not based on fundamentals.

So are we mostly seeing what the Fed has been doing since 1987 – provide liquidity and pump markets up again?

Absolutely. We just saw the last chapter of that long history. This is the last of a whole series of bubbles that have been blown. In the past, monetary policy has always succeeded in pulling up the economy. But each time, the Fed had to act more vigorously to achieve its results. So, logically, at a certain point, it won’t work anymore. Then we’ll be in big trouble. And we will have wasted many years in which we could have been following better policies that would have maintained growth in much more sustainable ways. Now, to make you feel better, I said the same in 1998, and I was way too early.

What about the moral hazard of all this?

The fact of the matter is that if you have had 25 years of central bank and government bailout whenever there was a problem, and the bankers come to appreciate that fact, then we are back in a world where the banks get all the profits, while the government socializes all the losses. Then it just gets worse and worse. So, in terms of curbing the financial system, my own sense is that all of the stuff that has been done until now, while very useful, Basel III and all that, is not going to be sufficient to deal with the moral hazard problem. I would have liked to see a return to limited banking, a return to private ownership, a return to people going to prison when they do bad things. Moral hazard is a real issue.

Do you have any indication that the Yellen Fed will be different than the Greenspan and Bernanke Fed?

Not really. The one person in the FOMC that was kicking up a real fuss about asset bubbles was Governor Jeremy Stein. Unfortunately, he has gone back to Harvard.

The markets seem to assume that the tapering will run very smoothly, though. Volatility, as measured by the Vix index, is low.

Don’t forget that the Vix was at [a] record low in 2007. All that liquidity raises the asset prices and lowers the cost of insurance. I see at least three possible scenarios how this will all work out. One is: Maybe all this monetary stuff will work perfectly. I don’t think this is likely, but I could be wrong. I have been wrong so many times before. So if it works, the long bond rates can go up slowly and smoothly, and the financial system will adapt nicely. But even against the backdrop of strengthening growth, we could still see a disorderly reaction in financial markets, which would then feed back to destroy the economic recovery.

How?

We are such a long way away from normal long-term interest rates. Normal would be perhaps around four percent. Markets have a tendency to rush to the end point immediately. They overshoot. Keynes said in late Thirties that the long bond market could fluctuate at the wrong levels for decades. If fears of inflation suddenly re-appear, this can move interest rates quickly. Plus, there are other possible accidents. What about the fact that maybe most of the collateral you need for normal trading is all tied up now? What about the fact that the big investment dealers have got inventories that are 20 percent of what they were in 2007? When things start to move, the inventory for the market makers might not be there. That’s a particular worry in fields like corporate bonds, which can be quite illiquid to begin with. I’ve met so many people who are in the markets, thinking they are absolutely brilliantly smart, thinking they can get out in the right time. The problem is, they all think that. And when everyone races for the exit at the same time, we will have big problems. I’m not saying all of this will happen, but reasonable people should think about what could go wrong, even against a backdrop of faster growth.

And what is the third scenario?

The strengthening growth might be a mirage. And if it does not materialize, all those elevated prices will be way out of line of fundamentals.

Which of the major central banks runs the highest risk of something going seriously wrong?

At the moment what I am most worried about is Japan. I know there is an expression that the Japanese bond market is called the widowmaker. People have bet against it and lost money. The reason I worry now is that they are much further down the line even than the Americans. What is Abenomics really? As far as I see it, they print the money and tell people that there will be high inflation. But I don’t think it will work. The Japanese consumer will say prices are going up, but my wages won’t. Because they haven’t for years. So I am confronted with a real wage loss, and I have to hunker down. At the same time, financial markets might suddenly not want to hold Japanese Government Bonds anymore with a perspective of 2 percent inflation. This will end up being a double whammy, and Japan will just drop back into deflation. And now happens what Professor Peter Bernholz wrote in his latest book. Now we have a stagnating Japanese economy, tax revenues dropping like a stone, the deficit already at eight percent of GDP, debt at more than 200 percent and counting. I have no difficulty in seeing this thing tipping overnight into hyperinflation. If you go back into history, a lot of hyperinflations started with deflation.

Many people have warned of inflation in the past five years, but nothing has materialized. Isn’t the fear of inflation simply overblown?

One reason we don’t see inflation is because monetary policy is not working. The signals are not getting through. Consumers and corporates are not responding to the signals. We still have a disinflationary gap. There has been a huge increase in base money, but it has not translated into an increase in broader aggregates. And in Europe, the money supply is still shrinking. My worry is that at some point, people will look at this situation and lose confidence that stability will be maintained. If they do and they do start to fear inflation, that change in expectations can have very rapid effects.

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.

Outside the Box: Hoisington Investment Management Quarterly Review and Outlook, First Quarter 2014

 

In today’s Outside the Box, Lacy Hunt and Van Hoisington of Hoisington Investment have the temerity to point out that since the Great Recession officially ended in 2009, the Federal Open Market Committee (FOMC) has been consistently overoptimistic in its projections of US growth. They simply expected QE to be more stimulative than it has been, to the tune of about 6% over the past four years – a total of about $1 trillion that never materialized.

Given that dismal track record, our authors ask why we should believe the Fed’s prediction of 2.9% real GDP growth for 2014 and 3.4% for 2015 – particularly with QE being tapered into nonexistence.

A big part of the reason the Fed has been so steadily wrong, say Lacy and Van, is its overreliance on the so-called “wealth effect,” which posits that an increase in consumer wealth – through higher stock prices or home values, for instance – will lead to increased consumer spending.

The wealth effect has been both a justification for quantitative easing and a root cause of consistent overly optimistic growth expectations by the FOMC. The research cited below suggests that the concept of a wealth effect is in fact deeply flawed. It is unfortunate that the FOMC has relied on this flawed concept to experiment with over $3 trillion in asset purchases and continues to use it as the basis for what we believe are overly optimistic growth expectations.

The effect isn’t completely absent, say the authors, but their research suggests that it may five to ten times weaker than the Fed assumes. Go figure.

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).

It is been a busy day for me here in Dallas. Besides nonstop meetings and conversations and my usual reading, I had the privilege of going to the Dallas branch of the Federal Reserve and watching President Richard Fisher make loans to a group of budding entrepreneurs to build lemonade stands. It is part of a fabulous organization called Lemonade Day. The basic concept is to enable young children to learn about entrepreneurship and capitalism by helping them launch a lemonade stand. Youth who register are taught 14 lessons from their entrepreneurial workbook, with either a parent, teacher, youth organization leader, or other adult mentor supervising. At the conclusions of the lessons, they are prepared to open their first business… a lemonade stand. Local businesses and banks volunteer to empower these kids by making them a $50 loan and helping them set up their business. By the time they come to talk with the “banker,” they have a business plan and a set of goals as to what they will do with them profits they make. Watching these kids respond to adults asking them about their plans brings joy to your heart.

On May 4, in some 35 cities across the country, 200,000 young people will be building lemonade stands and trying to turn a profit. If you drive by a lemonade stand, stop and support America’s future entrepreneurs. If you are in one of those 35 cities (click here to find out), make a point to find a few lemonade stands and support America’s future. And if you don’t have a lemonade stand in your city, consider following in the footsteps of local heroes (and my good friends) Reid Walker and Robert Alpert, who decided to launch Lemonade Day here in Dallas. This should be a spring ritual in every city in the country.

Buoyed by the kids and their enthusiasm, I then went to dinner with Richard Fisher and Woody Brock and a few other associates of Ray Hunt, who hosted us for a fabulous and thought-provoking session, talking economics, geopolitics, and even a little politics. There was an interesting mix of pessimism and optimism in the room about the future of our country, but there was not a person who was not concerned with the direction in which we are headed. Gerald Turner, the president of SMU, talked to us about how fiscally conservative and socially liberal his students are. That kind of mirrors my own children. The world is changing faster, both technologically and demographically, than many of us in the Boomer generation are comfortable with. But we’d better get used to it.

It’s been a tumultuous last few days, and tomorrow morning I have to leave early for San Francisco to do a video shoot with my partners at Altegris, before going right back to the airport and flying home to speak to a local group of investment advisers and brokers brought together by Peak Capital Management. It is late and time to hit the send button, because the alarm clock will go off early. Have a great week

Your wondering where all the time goes analyst,

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

 

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Hoisington Investment Management – Quarterly Review and Outlook, First Quarter 2014

Optimism at the FOMC

The Federal Open Market Committee (FOMC) has continuously been overly optimistic regarding its expectations for economic growth in the United States since the last recession ended in 2009. If their annual forecasts had been realized over the past four years, then at the end of 2013 the U.S. economy should have been approximately $1 trillion, or 6%, larger. The preponderance of research suggests that the FOMC has been incorrect in its presumption of the effectiveness of quantitative easing (QE) on boosting economic growth. This faulty track record calls into question their latest prediction of 2.9% real GDP growth for 2014 and 3.4% for 2015.

A major reason for the FOMC’s overly optimistic forecast for economic growth and its incorrect view of the effectiveness of quantitative easing is the reliance on the so-called “wealth effect”, described as a change in consumer wealth which results in a change in consumer spending. In an opinion column for The Washington Post on November 5, 2010, then FOMC chairman Ben Bernanke wrote, “…higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.” Former FOMC chairman Alan Greenspan in a CNBC interview on Feb. 15, 2013 said, “The stock market is the key player in the game of economic growth.” This year, in the January 20 issue of Time Magazine, the current FOMC chair, Janet Yellen said, “And part of the [economic stimulus] comes through higher house and stock prices, which causes people with homes and stocks to spend more, which causes jobs to be created throughout the economy and income to go up throughout the economy.”

FOMC leaders may feel justified in taking such a position based upon the FRB/US, a large- scale econometric model. In part of this model, employed by the FOMC in their decision making, household consumption behavior is expressed as a function of total wealth as well as other variables. The model predicts that an increase in wealth of one dollar will boost consumer spending by five to ten cents (see page 8-9 “Housing Wealth and Consumption” by Matteo Iacoviello, International Finance Discussion Papers, #1027, Board of Governors of the Federal Reserve System, August 2011). Even at the lower end of their model’s range this wealth effect, if it were valid, would be a powerful factor in spurring economic growth.

After examining much of the latest scholarly research, and conducting in house research on the link between household wealth and spending, we found the wealth effect to be much weaker than the FOMC presumes. In fact, it is difficult to document any consistent impact with most of the research pointing to a spending increase of only one cent per one dollar rise in wealth at best. Some studies even indicate that the wealth effect is only an interesting theory and cannot be observed in practice.

The wealth effect has been both a justification for quantitative easing and a root cause of consistent overly optimistic growth expectations by the FOMC. The research cited below suggests that the concept of a wealth effect is in fact deeply flawed. It is unfortunate that the FOMC has relied on this flawed concept to experiment with over $3 trillion in asset purchases and continues to use it as the basis for what we believe are overly optimistic growth expectations.

Consumer Wealth and Consumer Spending

Many episodes of rising and falling financial and housing asset wealth have occurred throughout history. The question is whether these periods of wealth changes are associated in a consistent and reliable way with changes in consumer spending. We examined, separately, percent changes in real consumption expenditures per capita against percent changes in the real S&P 500 index (financial wealth) and against percent changes in Robert Shiller’s real home price index (housing wealth). If economic relationships are valid they should work for all time periods, regardless of highly different idiosyncratic conditions, as opposed to an isolated subset of historical experience. As such, we conducted our analysis from 1930 through 2013, the entire time period for which all variables were available.

Financial Wealth. Chart 1 is a scatter diagram of current percent changes in both real per capita personal consumption expenditures (PCE), the preferred measure of spending, and the real S&P 500 stock price index. It is made up of 84 dots, which constitutes a robust sample. Over our sample period, as with most extremely long periods, time will tend to link economic variables to each other; population is a key factor that can cause such an association. By expressing consumption in per capita terms, trending has been reduced, and in turn, an artificially overstated degree of correlation has been avoided.

If financial wealth drives consumer spending, an unambiguous positively sloped line should be evident on this scatter diagram. Larger gains in the S&P 500 would be associated with faster increases in spending; conversely, declines in the S&P 500 would be tied to lower spending. If there was a strong positive correlation, the large gains in stock prices would be associated with strong gains in spending, and they would fall in the upper right quadrant of the graph. In addition, sizeable declines in the S&P would be associated with large decreases in consumer spending, and the dots would fall in the lower left quadrant, resulting in an upward sloping line. For the relationship to be stable and dependable the dots should be packed in an around the trend line. This is clearly not the case. The trend line through the dots is positive, but the observations in the upper left quadrant of the graph and those in the lower right exhibit a negative rather than positive correlation. Furthermore, the dots are not clustered close to the trend line. The goodness of fit (coefficient of determination) of 0.27 is statistically significant; however, the slope of the line is minimally positive. This suggests that an approximate one dollar increase in wealth will boost real per capita PCE by less than one cent, far less than even the lower band of the effect in the Fed’s model.

Theoretically, lagged changes are preferred because when current or coincidental changes in economic variables are correlated the coefficients may be biased due to some other factor not covered by the empirical estimation. Also, lags give households time to adjust to their change in wealth. As such, we correlated the current percent change in real per capita PCE against current changes as well as one- and two-year lagged changes (expressed as a three-year moving average) in the S&P 500. The lags did not improve the goodness of fit as the coefficient of determination fell to 0.21. An increased dollar of wealth, however, still resulted in a one cent increase in consumption. We then correlated current percent change in real per capita PCE with only lagged changes in the real S&P 500 for the two prior years (expressed as a two-year moving average), and the relationship completely fell apart as the goodness of fit fell to a statistically insignificant 0.06.

Housing Wealth. Chart 2 is a second scatter diagram, relating current percent changes in real home prices to current percent changes in real per capita PCE. Once again, the trend line does have a small positive slope, but there are so many observations in the upper left quadrant that the coefficient of determination does not meet robust tests for statistical significance. The dots are even more dispersed from the trend line than in the prior scatter diagram.

As with the analysis on financial wealth, when current changes in consumption were correlated against the lagged changes in home prices (both the three-year moving average and the two-year moving average), the goodness of fit deteriorated significantly and was not statistically significant in either case.

Correlations, or the lack thereof, indicated by these scatter diagrams do not prove causation. Nevertheless, economic theory offers an explanation for the poor correlation. If a person has an appreciated asset and wishes to increase spending, one option is to sell the asset, capture the gain and buy something else. However, the funds to make the new purchase comes from the buyer of the asset. Thus, when financial assets are sold, money balances increase for the seller but fall for the buyer. The person with an appreciated asset could choose to borrow against that asset. Since new debt is current spending in lieu of future spending, the debt option may only provide a temporary boost to economic activity. To avoid an accentuated business cycle, debt must generate an income stream to repay principal and interest. Otherwise any increase in debt to convert wealth gains into consumer spending may merely add to cyclical volatility without producing any lasting benefit.

Scholarly Research

Scholarly research has debated the impact of financial and housing wealth on consumer spending as well. The academic research on financial wealth is relatively consistent; it has very little impact on consumption. In “Financial Wealth Effect: Evidence from Threshold Estimation” (Applied Economic Letters, 2011), Sherif Khalifa, Ousmane Seck and Elwin Tobing found “a threshold income level of almost $130,000, below which the financial wealth effect is insignificant, and above which the effect is 0.004.” This means a one dollar rise in wealth would, in time, boost consumption by less than one-half of a penny. Similarly, in “Wealth Effects Revisited 1975- 2012,” Karl E. Case, John M. Quigley and Robert J. Shiller (Cowles Foundation Discussion Paper #1884, December 2012) write, “The numerical results vary somewhat with different econometric specifications, and so any numerical conclusion must be tentative. We find at best weak evidence of a link between stock market wealth and consumption.” This team looked at quarterly observations during the 17-year period from 1982 through 1999 and the 37-year period from 1975 through the spring quarter of 2012.

The research on housing wealth is more divided. In the same paper referenced above, Karl E. Case, John M. Quigley and Robert J. Shiller write, “In contrast, we do find strong evidence that variations in housing market wealth have important effects upon consumption.” These findings differ from the findings of various other economists. In “The (Mythical?) Housing Wealth Effect” (NBER Working Paper #15075, June 2009), Charles Calomiris, Stanley D. Longhofer and William Miles write, “Models used to guide policy, as well as some empirical studies, suggest that the effect of housing wealth on consumption is large and greater than the wealth effect on consumption from stock holdings. Recent theoretical work, in contrast, argues that changes in housing wealth are offset by changes in housing consumption, meaning that unexpected shocks in housing wealth should have little effect on non- housing consumption.”

Furthermore, R. Glenn Hubbard and Anthony Patrick O’Brien (Macroneconomics, Fourth edition, 2013, page 381) provide a highly cogent summary of the aforementioned research by Charles Calomiris, Stanley D. Longhofer and William Miles. They argue that consumers “own houses primarily so they can consume the housing services a home provides. Only consumers who intend to sell their current house and buy a smaller one – for example, ‘empty nesters’ whose children have left home – will benefit from an increase in housing prices. But taking the population as a whole, the number of empty nesters may be smaller than the number of first time home buyers plus the number of homeowners who want to buy larger houses. These two groups are hurt by rising home prices.”

Amir Sufi, Professor of Finance at the University of Chicago, also indicates that the effect of housing wealth is much smaller than assumed in the policy models and earlier empirical research. Dr. Sufi calculates that an increase of one dollar of housing wealth may yield as little as one cent of extra spending (“Will Housing Save the U.S. Economy?”, April 2013, Chicago Booth Economic Outlook event). This is in line with a 2013 study by Sherif Khalifa, Ousmane Seck and Elwin Tobing (“Housing Wealth Effect: Evidence from Threshold Estimation”, The Journal of Housing Economics). These economists found that a threshold income level of $74,046 had a wealth coefficient that rounded to one cent. Income levels between $74,046 and $501,000 had a two cent coefficient, and incomes above $501,000 had a statistically insignificant coefficient.

In total, the majority of the research is seemingly unequivocal in its conclusion. The wealth effect (financial and housing) is barely operative. As such, it is interesting to note its actual impact in 2013.

Where Was the Wealth Effect in 2013?

If the wealth effect was as powerful as the FOMC believes, consumer spending should have turned in a stellar performance last year. In 2013 equities and housing posted strong gains. On a yearly average basis, the real S&P 500 stock market index increase was 17.7%, and the real Case Shiller Home Price Index increase was 9.1%. The combined gain of these wealth proxies was 26.8%, the eighth largest in the 84 years of data. The real per capital PCE gain of just 1.2% ranked 58th of 84. The difference between the two was the fifth largest in the 84 cases. Such a huge discrepancy in relative performance in 2013, occurring as it did in the fourth year of an economic expansion, raises serious doubts about the efficacy of the wealth effect (Chart 3).

In econometrics, theoretical propositions must be empirically verifiable. Researchers using numerous statistical procedures examining various sample periods should be able to identify at least some consistent patterns. This is not the case with the wealth effect. Regardless if examining a simple scatter diagram or something far more sophisticated, the wealth effect is weak and inconsistent. The powerful wealth coefficients imbedded in the FRB/US model have not been supported by independent research. To quote Chris Low, Chief Economist of FTN (FTN Financial, Economic Weekly, March 21, 2014), “There may not be a wealth effect at all. If there is a wealth effect, it is very difficult to pin down …” Since the FOMC began quantitative easing in 2009, its balance sheet has increased more than $3 trillion. This increase may have boosted wealth, but the U.S. economy received no meaningful benefit. Furthermore, the FOMC has no idea what the ultimate outcome of such an increase will be or what a return to a ‘normal’ balance sheet might entail. Given all of this, we do not see any evidence for economic growth as robust at the FOMC predicts.

Without a wealth effect, the stock market is not the “key player” in the economy, and no “virtuous circle” runs through the stock market. We reiterate our view that nominal GDP will rise just 3% this year, down from 3.4% in 2013. M2 growth in the latest twelve months was 5.8%, but velocity should decline by at least 3% and limit nominal GDP to 3% or less.

The Flatter Yield Curve: An Opportunity for Treasury Bond Investors

The Fed has indicated that the federal funds rate could begin to rise in the next couple of years, and the Treasury market has moderately anticipated this event. Similar to the 2004-2005 federal funds rate cycle, long before the federal funds rate increased short Treasury rates began their ascent (Chart 4). Interestingly, once the federal funds rate did begin to rise in 2004, long Treasury rates fell over the next two years. From May of 2004 until Feb. 2006 the federal funds rate increased by 350 basis point (bps) and the five-year note increased by 80 bps, yet the 30-year bond fell by 84 bps as inflation expectations fell. If the Fed follows through with its forecast and short rates rise, the dampening effect on inflation expectations should again cause long rates to fall. On the other hand, should economic activity continue to moderate then the downward pressure on inflation will continue. The prospect for lower Treasury yields appears favorable.

Van R. Hoisington
Lacy H. Hunt, Ph.D.


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Outside the Box: Dare to Be Great II

 

I can’t tell you how many thousands of hours I have spent, over the years, thinking about, reading about, and talking about how to be a consistently successful investor; but I can tell you this: I’m still working at it. And once in a while – less frequently as the years pass, it seems – I come across investment advice that strikes me as fundamentally strong, innovative, and worth assimilating.

I feel that way about today’s Outside the Box. It’s a client memo sent last week by Howard Marks, founder and chairman of Oaktree Capital Management. He calls it “Dare to Be Great II,” since it’s a follow-up to the famous memo by that name he wrote in 2006.

The first thing we need if we’re to become superior investors, says Howard, is an explicit investing creed. What do we believe in? What principles will underpin our process? He suggests that we ask ourselves questions like the following – and be willing and able to come to agreement on them with our colleagues.

  • Is the efficient market hypothesis relevant? Do efficient markets exist? Is it possible to “beat the market”? Which markets? To what extent?
  • Will you emphasize risk control or return maximization as the primary route to success (or do you think it’s possible to achieve both simultaneously)?
  • Will you put your faith in macro forecasts and adjust your portfolio based on what they say?
  • How do you think about risk? Is it volatility or the probability of permanent loss? Can it be predicted and quantified a priori? What’s the best way to manage it?
  • How reliably do you believe a disciplined process will produce the desired results? That is, how do you view the question of determinism versus randomness?
  • Most importantly for the purposes of this memo, how will you define success, and what risks will you take to achieve it? In short, in trying to be right, are you willing to bear the inescapable risk of being wrong?

Now that’s what I call a worthwhile list of questions.

If we’re going to dare to be great, Howard asserts, we have to dare to be different.

Speaking of which, one of my personal heroines is Ayaan Hirsi Ali. Her courage in confronting the oppression of women at the risk of her own life is inspiring. In person she is a quiet, reserved, formidable force of nature. This last week she suffered an unjust, cowardly affront to her courage and her work dedicated to helping those who can’t help themselves.

Brandeis University decided to offer Ayaan an honorary doctorate for her efforts on behalf of women in Muslim societies. When the decision was announced, a group of students, faculty members, and the usual politically correct pressure groups campaigned to have the university withdraw the honor. Brandeis president Frederick Lawrence quickly capitulated. Not even bothering to sign his own notice, he offered that Ayaan’s story is “compelling,” whatever that means. But, he added, “That said, we cannot overlook certain of her past statements that are inconsistent with Brandeis University’s core values. For all concerned, we regret that we were not aware of the statements earlier.”

That is simply Academic Bullshit. First of all, no one requested or forced Brandeis to offer the degree in the first place; it was their own clear choice. Secondly, after two best-selling books and hundreds of public appearances, Ayaan has made her views well-known. That she has criticized certain aspects of Islamic culture is no secret. For the Brandeis administration to say that they were unaware of her views stretches one’s sense of credulity beyond the limit. In Texas we would simply call it a lie.

I would be interested in the views of those who opposed her. Precisely which of the practices she condemns would they like to see maintained? Female genital mutilation, honor killings, forced marriage, or Sharia law? Perhaps treating women as property is deemed appropriate by some people.

The simple fact is, there is a portion of the academic community that is so politically correct that they are socially useless. In the name of being tolerant they tolerate acts so despicable as to be worthy of shunning. They have the discernment of a fruitfly. And that is probably an insult to fruitfly-kind.

Even more interesting is that just a few years ago Brandeis awarded an honorary degree to playwright Tony Kushner, who had been quoted as saying, “The biggest supporters of Israel are the most repulsive members of the Jewish community.” At the time the Brandeis president justified the award saying, “Just as Brandeis does not inquire into the political opinions and beliefs of faculty or staff before appointing them, or students before offering admission, so too the University does not select honorary degree recipients on the basis of their political beliefs or opinions.” So which is it, President Lawrence? Or is it just that women cannot hold strong beliefs?

If I were Brandeis graduate, I would be profoundly embarrassed. But a good way to voice your displeasure might be to write a check to Ayaan’s foundation at http://theahafoundation.org/, send a copy of it to President Lawrence, and say that until he personally apologizes for his cowardly behavior and ungentlemanly conduct in disparaging the character of a person so courageous as Ayaan Hirsi Ali, no more checks to Brandeis will be forthcoming. This whole distasteful event is especially galling when you realize that Brandeis was founded as a nonsectarian Jewish coeducational institution to counter oppression and a lack of tolerance.

The rest of my readers may also want to click on the link and make donations. There are tens of thousands of young girls around the world who face severe oppression that is justified in the name of culture and religion. Someone has to stand up and say no more. Ayaan does that, and perhaps we should stand with her. Think of your daughters and granddaughters and decide what kind of world you want them to grow up in.

I am back in Dallas and enjoying being home and next to my gym. I was not in the gym enough in South Africa, and I can feel it. I’m going to have to get better at scheduling workout time when I’m on the road. Have yourself a great week, and really sit and think through some of the questions that Howard Marks challenges us with. They are at the heart of the investing portion of our lives. Without clear answers to them, we are wandering aimlessly and can expect unsatisfying results.

Your back just in time to pay my higher-than-ever taxes analyst,

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

 

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Memo to:        Oaktree Clients

From:               Howard Marks

Re:                    Dare to Be Great II

In September 2006, I wrote a memo entitled Dare to Be Great, with suggestions on how institutional investors might approach the goal of achieving superior investment results. I’ve had some additional thoughts on the matter since then, meaning it’s time to return to it. Since fewer people were reading my memos in those days, I’m going to start off repeating a bit of its content and go on from there.

About a year ago, a sovereign wealth fund that’s an Oaktree client asked me to speak to their leadership group on the subject of what makes for a superior investing organization. I welcomed the opportunity. The first thing you have to do, I told them, is formulate an explicit investing creed. What do you believe in? What principles will underpin your process? The investing team and the people who review their performance have to be in agreement on questions like these:

  • Is the efficient market hypothesis relevant? Do efficient markets exist? Is it possible to “beat the market”? Which markets? To what extent?
  • Will you emphasize risk control or return maximization as the primary route to success (or do you think it’s possible to achieve both simultaneously)?
  • Will you put your faith in macro forecasts and adjust your portfolio based on what they say?
  • How do you think about risk? Is it volatility or the probability of permanent loss? Can it be predicted and quantified a priori? What’s the best way to manage it?
  • How reliably do you believe a disciplined process will produce the desired results? That is, how do you view the question of determinism versus randomness?
  • Most importantly for the purposes of this memo, how will you define success, and what risks will you take to achieve it? In short, in trying to be right, are you willing to bear the inescapable risk of being wrong?

Passive investors, benchmark huggers and herd followers have a high probability of achieving average performance and little risk of falling far short. But in exchange for safety from being much below average, they surrender their chance of being much above average. All investors have to decide whether that’s okay. And, if not, what they’ll do about it.

The more I think about it, the more angles I see in the title Dare to Be Great. Who wouldn’t dare to be great? No one. Everyone would love to have outstanding performance. The real question is whether you dare to do the things that are necessary in order to be great. Are you willing to be different, and are you willing to be wrong? In order to have a chance at great results, you have to be open to being both.

Dare to Be Different

Here’s a line from Dare to Be Great: “This just in: you can’t take the same actions as everyone else and expect to outperform.” Simple, but still appropriate.

For years I’ve posed the following riddle: Suppose I hire you as a portfolio manager and we agree you will get no compensation next year if your return is in the bottom nine deciles of the investor universe but $10 million if you’re in the top decile. What’s the first thing you have to do – the absolute prerequisite – in order to have a chance at the big money? No one has ever answered it right.

The answer may not be obvious, but it’s imperative: you have to assemble a portfolio that’s different from those held by most other investors. If your portfolio looks like everyone else’s, you may do well, or you may do poorly, but you can’t do different. And being different is absolutely essential if you want a chance at being superior. In order to get into the top of the performance distribution, you have to escape from the crowd. There are many ways to try. They include being active in unusual market niches; buying things others haven’t found, don’t like or consider too risky to touch; avoiding market darlings that the crowd thinks can’t lose; engaging in contrarian cycle timing; and concentrating heavily in a small number of things you think will deliver exceptional performance.

Dare to Be Great included the two-by-two matrix and paragraph below. Several people told me the matrix was helpful.

 

Conventional
Behavior

Unconventional
Behavior

Favorable Outcomes

Average good results

Above-average results

Unfavorable Outcomes

Average bad results

Below-average results

Of course it’s not that easy and clear-cut, but I think that’s the general situation. If your behavior and that of your managers is conventional, you’re likely to get conventional results – either good or bad. Only if your behavior is unconventional is your performance likely to be unconventional … and only if your judgments are superior is your performance likely to be above average.

For those who define investment success as being “average or better,” three of the four cells of the matrix represent satisfactory outcomes. But if you define success strictly as being superior, only one of the four will do, and it requires unconventional behavior. More from the 2006 memo:

The bottom line on striving for superior performance has a lot to do with daring to be great. Especially in terms of asset allocation, “can’t lose” usually goes hand-in-hand with “can’t win.” One of the investor’s or the committee’s first and most fundamental decisions has to be on the question of how far out the portfolio will venture. How much emphasis should be put on diversifying, avoiding risk and ensuring against below-pack performance, and how much on sacrificing these things in the hope of doing better?

In the memo I mentioned my favorite fortune cookie: “the cautious seldom err or write great poetry.” Like the title Dare to Be Great, I find the fortune cookie thought-provoking. It can be taken as urging caution, since it reduces the likelihood of en-or. Or it can be taken as saying you should avoid caution, since it can keep you from doing great things. Or both. No right or wrong answer, but a choice. . . and hopefully a conscious one.

It Isn’t Easy Being Different

In the 2006 memo, I borrowed two quotes from Pioneering Portfolio Management by David Swensen of Yale. They’re my absolute favorites on the subject of institutional behavior. Here’s the first:

Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom.

“Uncomfortably idiosyncratic” is a terrific phrase. There’s a great deal of wisdom in those two words. What’s idiosyncratic is rarely comfortable. . . and in order for something to be comfortable, it usually has to be conventional. The road to above average performance runs through unconventional, uncomfortable investing. Here’s how I put it in 2006:

Non-consensus ideas have to be lonely. By definition, non-consensus ideas that are popular, widely held or intuitively obvious are an oxymoron. Thus such ideas are uncomfortable; non-conformists don’t enjoy the warmth that comes with being at the center of the herd. Further, unconventional ideas often appear imprudent. The popular definition of “prudent” – especially in the investment world – is often twisted into “what everyone does.”

Most great investments begin in discomfort. The things most people feel good about – investments where the underlying premise is widely accepted, the recent performance has been positive and the outlook is rosy – are unlikely to be available at bargain prices. Rather, bargains are usually found among things that are controversial, that people are pessimistic about, and that have been performing badly of late.

But it isn’t easy to do things that entail discomfort. It’s no coincidence that distressed debt has been the source of many successful investments for Oaktree; there’s no such thing as a distressed company that everyone reveres. In 1988, when Bruce Karsh and I organized our first fund to invest in the debt of companies seemingly at death’s door, the very idea made it hard to raise money, and investing required conviction – on the clients’ part and our own – that our analysis and approach would mitigate the risk. The same discomfort, however, is what caused distressed debt to be priced cheaper than it should have been, and thus the returns to be consistently high.

Dare to Be Wrong

“You have to give yourself a chance to fail.” That’s what Kenny “The Jet” Smith said on TV the other night during the NCAA college basketball tournament, talking about a star player who started out cold and as a result attempted too few shots in a game his team lost. It’s a great way to make the point. Failure isn’t anyone’s goal, of course, but rather an inescapable potential consequence of trying to do really well.

Any attempt to compile superior investment results has to entail acceptance of the possibility of being wrong. The matrix on page two shows that since conventional behavior is sure to produce average performance, people who want to be above average can’t expect to get there by engaging in conventional behavior. Their behavior has to be different. And in the course of trying to be different and better, they have to bear the risk of being different and worse. That truth is simply unarguable. There is no way to strive for the former that doesn’t require bearing the risk of the latter.

The truth is, almost everything about superior investing is a two-edged sword:

  • If you invest, you will lose money if the market declines.
  • If you don’t invest, you will miss out on gains if the market rises.
     
  • Market timing will add value if it can be done right.
  • Buy-and-hold will produce better results if timing can’t be done right.
     
  • Aggressiveness will help when the market rises but hurt when it falls.
  • Defensiveness will help when the market falls but hurt when it rises.
     
  • If you concentrate your portfolio, your mistakes will kill you.
  • If you diversify, the payoff from your successes will be diminished.
     
  • If you employ leverage, your successes will be magnified.
  • If you employ leverage, your mistakes will be magnified.

Each of these pairings indicates symmetry. None of the tactics listed will add value if it’s right but not subtract if it’s wrong. Thus none of these tactics, in and of itself, can hold the secret to dependably above average investment performance.

There’s only one thing in the investment world that isn’t two-edged, and that’s “alpha”: superior insight or skill. Skill can help in both up markets and down markets. And by making it more likely that your decisions are right, superior skill can increase the expected benefit from concentration and leverage. But that kind of superior skill by definition is rare and elusive.

The goal in investing is asymmetry: to expose yourself to return in a way that doesn’t expose you commensurately to risk, and to participate in gains when the market rises to a greater extent than you participate in losses when it falls. But that doesn’t mean the avoidance of all losses is a reasonable objective. Take another look at the goal of asymmetry set out above: it talks about achieving a preponderance of gain over loss, not avoiding all chance of loss.

To succeed at any activity involving the pursuit of gain, we have to be able to withstand the possibility of loss. A goal of avoiding all losses can render success unachievable almost as readily as can the occurrence of too many losses. Here are three examples of “loss prevention strategies” that can lead to failure:

  • I play tennis. But if when I start a match I promise myself that I won’t commit a single double fault, I’ll never be able to put enough “mustard” on my second serve to keep it from being easy for my opponent to put away.
  • Likewise, coming out ahead at poker requires that I win a lot on my winning hands and lose less on my losers. But insisting that I’ll never play anything but “the nuts” – the hand that can’t possibly be beat – will keep me from playing lots of hands that have a good chance to win but aren’t sure things.
  • For a real-life example, Oaktree has always emphasized default avoidance as the route to outperformance in high yield bonds. Thus our default rate has consistently averaged just 1/3 of the universe default rate, and our risk-adjusted return has beaten the indices. But if we had insisted on – and designed compensation to demand – zero defaults, I’m sure we would have been too risk averse and our performance wouldn’t have been as good. As my partner Sheldon Stone puts it, “If you don’t have any defaults, you’re taking too little risk.”

When I first went to work at Citibank in 1968, they had a slogan that “scared money never wins.” It’s important to play judiciously, to have more successes than failures, and to make more on your successes than you lose on your failures. But it’s crippling to have to avoid all failures, and insisting on doing so can’t be a winning strategy. It may guarantee you against losses, but it’s likely to guarantee you against gains as well. Here’s some helpful wisdom on the subject from Wayne Gretzky, considered by many to be the greatest hockey player who ever lived: “You miss 100% of the shots you don’t take.”

There is no formulaic approach to investing that can be depended on to produce superior risk-adjusted returns. There can’t be. In a relatively fair or “efficient” market – and the concerted efforts of investors to find underpriced assets tend to make most markets quite fair – asymmetry is reduced, and a formula that everyone can access can’t possibly work.

As John Kenneth Galbraith said, “There is nothing reliable to be learned about makingmoney. If there were, study would be intense and everyone with a positive IQ would be rich.” If merely applying a formula that’s available to everyone could be counted on to provide easy profits, where would those profits come from? Who would be the losers in those transactions? Why wouldn’t those people study and apply the formula also?

Or as Charlie Munger told me, “It’s not supposed to be easy. Anyone who finds it easy is stupid.” In other words, anyone who thinks it can be easy to succeed at investing is being simplistic and superficial, and ignoring investing’s complex and competitive nature.

Why should superior profits be available to the novice, the untutored or the lazy? Why should people be able to make above average returns without hard work and above average skill, and without knowing something most others don’t know? And yet many individuals invest based on the belief that they can. (If they didn’t believe that, wouldn’t they index or, at a minimum, turn over the task to others?)

No, the solution can’t lie in rigid tactics, publicly available formulas or loss-eliminating rules . . . or on complete risk avoidance. Superior investment results can only stem from a better-than-average ability to figure out when risk-taking will lead to gain and when it will end in loss. There is no alternative.

Dare to Look Wrong

This is really the bottom-line: not whether you dare to be different or to be wrong, but whether you dare to look wrong.

Most people understand and accept that in their effort to make correct investment decisions, they have to accept the risk of making mistakes. Few people expect to find a lot of sure things or achieve a perfect batting average.

While they accept the intellectual proposition that attempting to be a superior investor has to entail the risk of loss, many institutional investors – and especially those operating in a political or public arena – can find it unacceptable to look significantly wrong. Compensation cuts and even job loss can befall the institutional employee who’s associated with too many mistakes.

As Pensions & Investments said on March 17 regarding a big West Coast bond manager currently in the news, whom I’ll leave nameless:

. . . asset owners are concerned that doing business with the firm could bring unwanted attention, possibly creating headline risk and/or job risk for them. . . .

One [executive] at a large public pension fund said his fund recently allocated $100 million for emerging markets, its first allocation to the firm. He said he wouldn’t do that today, given the current situation, because it could lead to second-guessing by his board and the local press.

“If it doesn’t work out, it looks like you don’t know what you are doing,” he said.

As an aside, let me say I find it perfectly logical that people should feel this way. Most “agents” – those who invest the money of others – will benefit little from bold decisions that work but will suffer greatly from bold decisions that fail. The possibility of receiving an “attaboy” for a few winners can’t balance out the risk of being fired after a string of losers. Only someone who’s irrational would conclude that the incentives favor boldness under these circumstances. Similarly, members of a non-profit organization’s investment committee can reasonably conclude that bearing the risk of embarrassment in front of their peers that accompanies bold but unsuccessful decisions is unwarranted given their volunteer positions.

I’m convinced that for many institutional investment organizations the operative rule – intentional or unconscious – is this: “We would never buy so much of something that if it doesn’t work, we’ll look bad.” For many agents and their organizations, the realities of life mandate such a rule. But people who follow this rule must understand that by definition it will keep them from buying enough of something that works for it to make much of a  difference for the better.

In 1936, the economist John Maynard Keynes wrote in The General Theory of Employment, Interest and Money, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally” [italics added]. For people who measure success in terms of dollars and cents, risk taking can pay off when gains on winners are netted out against losses on losers. But if reputation or job retention is what counts, losers may be all that matter, since winners may be incapable of outweighing them. In that case, success may hinge entirely on the avoidance of unconventional behavior that’s unsuccessful.

Often the best way to choose between alternative courses of action is by figuring out which has the highest “expected value”: the total value arrived at by multiplying each possible outcome by its probability of occurring and summing the results. As I learned from my first textbook at Wharton fifty years ago (Decisions Under Uncertainty by C. Jackson Grayson, Jr.), if one act has a higher expected value than another and “. . . if the decision maker is willing to regard the consequences of each act-event in purely monetary terms, then this would be the logical act to choose. Keeping in mind, however, that only one event and its consequence will occur (not the weighted average consequence),” agents may not be able to choose on the basis of expected value or the weighted average of all possible consequences. If a given action has potential bad consequences that are absolutely unacceptable, the expected value of all of its consequences – both good and bad – can be irrelevant.

Given the typical agent’s asymmetrical payoff table, the rule for institutional investors underlined above is far from nonsensical. But if it is adopted, this should be done with awareness of the likely result: over-diversification. This goes all the way back to the beginning of this memo, and each organization’s need to establish its creed. In this case, the following questions must be answered:

  • In trying to achieve superior investment results, to what extent will we concentrate on investments, strategies and managers we think are outstanding? Will we do this despite the potential of our decisions to be wrong and bring embarrassment?
  • Or will fear of error, embarrassment, criticism and unpleasant headlines make us diversify highly, emulate the benchmark portfolio and trade boldness for safety? Will we opt for low-cost, low-aspiration passive strategies?

In the course of the presentation described at the beginning of this memo, I pointed out to the sovereign wealth fund’s managers that they had allocated close to a billion dollars to Oaktree’s management over the preceding 15 years. Although that sounds like a lot of money, it actually amounts to only a few tenths of a percent of what the world guesses their assets to be. And given our funds’ cycle of investing and divesting, that means they didn’t have even a few tenths of a percent of their capital with us at any one time. Thus, despite our good performance, I think it’s safe to say Oaktree couldn’t have had a meaningful impact on the fund’s overall results. Certainly one would associate this behavior with an extreme lack of risk tolerance and a high aversion to headline risk. I urged them to consider whether this reflects their real preference.

Lou Brock of the St. Louis Cardinals was one of baseball’s best base stealers between 1966 and 1974. He’s the source of a great quote: “Show me a guy who’s afraid to look bad, and I’ll show you a guy you can beat every time.” What he meant (with apologies to readers who don’t understand baseball) is that in order to prevent a great runner from stealing a base, a pitcher may have to throw over to the bag ten times in a row to hold him close, rather than pitch to the batter. But after a few such throws, a pitcher can look like a scaredy-cat and be booed. Pitchers who were afraid of those things were easy pickings for Lou Brock. Fear of looking bad ensured their failure.

Looking Right Can Be Harder Than Being Right

Fear of looking bad can be particularly debilitating to an investor, client or manager. This is because of how hard it is to consistently make correct investment decisions. Some of this comes from my last memo, on the role of luck.

  • First, it’s hard to consistently make decisions that correctly factor in all of the relevant facts and considerations (i.e., it’s hard to be right).
  • Second, it’s far from certain that even “right” decisions will be successful, since every decision requires assumptions about what the future will look like, and even reasonable assumptions can be thwarted by the world’s randomness. Thus many correct decisions will result in failure (i.e., it’s hard to look right).
  • Third, even well-founded decisions that eventually turn out to be right are unlikely to do so promptly. This is because not only are future events uncertain, their timing is particularly variable (i.e., it’s impossible to look right on time).

This brings me to one of my three favorite adages: “Being too far ahead of your time is indistinguishable from being wrong.” The fact that something’s cheap doesn’t mean it’s going to appreciate tomorrow; it can languish in the bargain basement. And the fact that something’s overpriced certainly doesn’t mean it’ll fall right away; bull markets can go on for years. As Lord Keynes observed, “the market can remain irrational longer than you can remain solvent.”

Alan Greenspan warned of “irrational exuberance” in December 1996, but the stock market continued upward for more than three years. A brilliant manager I know who turned bearish around the same time had to wait until 2000 to be proved correct. . . during which time his investors withdrew much of their capital. He wasn’t “wrong,” just early. But that didn’t make his experience any less painful.

Likewise, John Paulson made the most profitable trade in history by shorting mortgage securities in 2006. Many others entered into the same transactions, but too early. When the bets failed to work at first, the appearance of being on the wrong track ate into the investors’ ability to stick with their decision, and they were forced to close out positions that would have been extremely profitable.

In order to be a superior investor, you need the strength to diverge from the herd, stand by your convictions, and maintain positions until events prove them right. Investors operating under harsh scrutiny and unstable working conditions can have a harder time doing this than others.

That brings me to the second quote I promised from Yale’s David Swensen:

. . . active management strategies demand uninstitutional behavior from institutions, creating a paradox that few can unravel.

Charlie Munger was right about it not being easy. I’m convinced that everything that’s important in investing is counterintuitive, and everything that’s obvious is wrong. Staying with counterintuitive, idiosyncratic positions can be extremely difficult for anyone, especially if they look wrong at first. So-called “institutional considerations” can make it doubly hard.

Investors who aspire to superior performance have to live with this reality. Unconventional behavior is the only road to superior investment results, but it isn’t for everyone. In addition to superior skill, successful investing requires the ability to look wrong for a while and survive some mistakes. Thus each person has to assess whether he’s temperamentally equipped to do these things and whether his circumstances – in terms of employers, clients and the impact of other people’s opinions – will allow it … when the chips are down and the early going makes him look wrong, as it invariably will. Not everyone can answer these questions in the affirmative. It’s those who believe they can that should take a chance on being great.

April 8, 2014

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The article Outside the Box: Dare to Be Great II was originally published at mauldineconomics.com.

Thoughts from the Frontline: Every Central Bank for Itself

 

“Everybody has a plan until they get punched in the face.”

– Mike Tyson

For the last 25 days I’ve been traveling in Argentina and South Africa, two countries whose economies can only be described as fragile, though for very different reasons. Emerging-market countries face a significantly different set of challenges than the developed world does. These challenges are compounded by the rather indifferent policies of developed-world central banks, which are (even if somewhat understandably) entirely self-centered. Argentina has brought its problems upon itself, but South Africa can somewhat justifiably express frustration at the developed world, which, as one emerging-market central bank leader suggests, is engaged in a covert currency war, one where the casualties are the result of unintended consequences. But the effects are nonetheless real if you’re an emerging-market country.

While I will write a little more about my experience in South Africa at the end of this letter, first I want to cover the entire emerging-market landscape to give us some context. Full and fair disclosure requires that I give a great deal of credit to my rather brilliant young associate, Worth Wray, who’s helped me pull together a great deal of this letter while I am on the road in a very busy speaking tour here in South Africa for Glacier, a local platform intermediary. They have afforded me the opportunity to meet with a significant number of financial industry participants and local businessman, at all levels of society. It has been a very serious learning experience for me. But more on that later; let’s think now about the problems facing emerging markets in general.

Every Central Bank for Itself

Every general has a plan before going into battle, which immediately begins to change upon contact with the enemy. Everyone has a plan until they get hit… and emerging markets have already taken a couple of punches since May 2013, when Fed Chairman Ben Bernanke first signaled his intent to “taper” his quantitative easing program and thereby incrementally wean the markets off of their steady drip of easy money. It was not too long after that Ben also suggested that he was not responsible for the problems of emerging-market central banks – or any other central bank, for that matter.

As my friend Ben Hunt wrote back in late January, Chairman Bernanke turned a single data point into a line during his last months in office, when he decided to taper by exactly $10 billion per month. He established the trend, and now the markets are reacting as if the Fed’s exit strategy has officially begun.

Whether the FOMC can actually turn the taper into a true exit strategy ultimately depends on how much longer households and businesses must deleverage and how sharply our old-age dependency ratio rises, but markets seem to believe this is the beginning of the end. For now, that’s what matters most.

Under Fed Chair Janet Yellen’s leadership, the Fed continues to send a clear message to the rest of the world: Now it really is every central bank for itself.

The QE-Induced Bubble Boom in Emerging Markets

By trying to shore up their rich-world economies with unconventional policies such as ultra-low rate targets, outright balance sheet expansion, and aggressive forward guidance, major central banks have distorted international real interest rate differentials and forced savers to seek out higher (and far riskier) returns for more than five years.

This initiative has fueled enormous overinvestment and capital misallocation – and not just in advanced economies like the United States.

As it turns out, the biggest QE-induced imbalances may be in emerging markets, where, even in the face of deteriorating fundamentals, accumulated capital inflows (excluding China) have nearly DOUBLED, from roughly $5 trillion in 2009 to nearly $10 trillion today. After such a dramatic rise in developed-world portfolio allocations and direct lending to emerging markets, developed-world investors now hold roughly one-third of all emerging-market stocks by market capitalization and also about one-third of all outstanding emerging-market bonds.

The Fed might as well have aimed its big bazooka right at the emerging world. That’s where a lot of the easy money ran blindly in search of more attractive real interest rates, bolstered by a broadly accepted growth story.

The conventional wisdom – a particularly powerful narrative that became commonplace in the media – suggested that emerging markets were, for the first time in a long time, less risky than developed markets, despite their having displayed much higher volatility throughout the past several decades.

As a general rule, people believed emerging markets had much lower levels of government debt, much stronger prospects for consumption-led growth, and far more favorable demographics. (They overlooked the fact that crises in the 1980s and 1990s still limited EM borrowing limits until 2009 and ignored the fact that EM consumption is a derivative of demand and investment from the developed world.)

Instead of holding traditional safe-haven bonds like US treasuries or German bunds, some strategists (who shall not be named) even suggested that emerging-market government bonds could be the new safe haven in the event of major sovereign debt crises in the developed world. And better yet, it was suggested that denominating these investments in local currencies would provide extra returns over time as EM currencies appreciated against their developed-market peers.

Sadly, the conventional wisdom about emerging markets and their currencies was dead wrong. Herd money (typically momentum-based, yield-chasing investors) usually chases growth that has already happened and almost always overstays its welcome. This is the same disappointing boom/bust dynamic that happened in Latin America in the early 1980s and Southeast Asia in the mid-1990s. And this time, it seems the spillover from extreme monetary accommodation in advanced countries has allowed public and private borrowers to leverage well past their natural carrying capacity.

Anatomy of a “Balance of Payments” Crisis

The lesson is always the same, and it is hard to avoid. Economic miracles are almost always too good to be true. Whether we’re talking about the Italian miracle of the ’50s, the Latin American miracle of the ’80s, the Asian Tiger miracles of the ’90s, or the housing boom in the developed world (the US, Ireland, Spain, et al.) in the ’00s, they all have two things in common: construction (building booms, etc.) and excessive leverage. As a quick aside, does that remind you of anything happening in China these days? Just saying…

Broad-based, debt-fueled overinvestment may appear to kick economic growth into overdrive for a while; but eventually disappointing returns and consequent selling lead to investment losses, defaults, and banking panics. And in cases where foreign capital seeking strong growth in already highly valued assets drives the investment boom, the miracle often ends with capital flight and currency collapse.

Economists call that dynamic of inflow-induced booms followed by outflow-induced currency crises a “balance of payments cycle,” and it tends to occur in three distinct phases.

In the first phase, an economic boom attracts foreign capital, which generally flows toward productive uses and reaps attractive returns from an appreciating currency and rising asset prices. In turn, those profits fuel a self-reinforcing cycle of foreign capital inflows, rising asset prices, and a strengthening currency.

In the second phase, the allure of promising recent returns morphs into a growth story and attracts ever-stronger capital inflows – even as the boom begins to fade and the strong currency starts to drag on competitiveness. Capital piles into unproductive uses and fuels overinvestment, overconsumption, or both; so that ever more inefficient economic growth increasingly depends on foreign capital inflows. Eventually, the system becomes so unstable that anything from signs of weak earnings growth to an unanticipated rate hike somewhere else in the world can trigger a shift in sentiment and precipitous capital flight.

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.

Things That Make You Go Hmmm: What’s the Frequency Zenith?

 

WARNING: This week’s Things That Make You Go Hmmm… is going to run a little longer than usual, I’m afraid, so if you have some time to kill, strap yourself in for the ride.

Yes. I have read it.

For the last couple of weeks those have been the five words I have used the most — by a country mile.

The second most-used five-word combination during that time has been “I know, what a tool.”

The subject to which the first group of words pertains is, of course, Michael Lewis’s new book, Flash Boys; and the second phrase refers to a certain president of a certain exchange, who made a complete fool of himself during the fierce media debate that has surrounded the book since it burst upon the public consciousness in the space of what ironically felt like a few nanoseconds. (The particular piece to which I refer has to be seen to be believed; but if you somehow missed it, you’ll have your chance. Stick around.)

Now, before we get started, let’s get a few things straight right off the BAT(s).

Firstly, I am an enormous fan of Michael Lewis’s work. I think he is an incredible storyteller with a gift for narrative worthy of a place alongside many modern greats. I have read each of his books and enjoyed them all tremendously. Michael has an ability to weave complex subject matter into a tapestry that can be understood and enjoyed by many who might otherwise find such material utterly incomprehensible.

Secondly, I am no expert in high-frequency trading, but I have had some experience of it in recent years; and I have spent some considerable time analyzing it from a business perspective, which has given me a reasonable understanding of its mechanics.

Thirdly, whilst I have limited direct experience of HFT, I DO have almost thirty years’ hands-on experience of equity, bond, and commodity markets in the US, UK, Singapore, Hong Kong, Australia, and Japan, as well as in another dozen or so countries across Asia Pacific; and having watched markets of all types move in strange ways for seemingly no reason until, a few moments later, the cause of the move revealed itself, I feel I have developed enough of an understanding about how the markets work and, perhaps more importantly, about the people who MAKE them work, to venture an opinion or two about the subjects raised by Michael Lewis inFlash Boys.

But before we get to the book that is on everybody’s Kindle, we’re going to turn to sport for a little lesson. Let’s go back in time to Game 6 of the American League Championship Series between the Boston Red Sox and the New York Yankees in 2004, and recall the actions of another “Flash Boy,” Alex Rodriguez, the Yankees’ star third baseman.

Now, at this point, I’m sure the thousands of non-baseball fans amongst you are tuning out in your droves; but in order to try to keep you engaged, let me also tell you a parallel story from the football (or “soccer,” if you must) 2002 World Cup in South Korea, a tale that features one of its brightest stars of that era, the Brazilian midfielder Rivaldo … and some decidedly unsavory antics.

Let’s see how we get on with this whole parallel story thing, shall we? I know Michael Lewis would do a phenomenal job of weaving the two stories together. Me? I’m not so sure…

Deep breath.

In 2002, Rivaldo Vitor Borba Ferreira was a footballer at the very top of the world game. He had helped Brazil reach the final of the 1998 World Cup (where they lost to France), and four years later he was one-third of the renowned “Three Rs,” alongside Ronaldo and Ronaldinho (sadly NOT referred to as “the Two Ronnies”), who spearheaded the dynamic Brazilian team that was rightly installed as the prohibitive favourite to win the trophy that year.

In Brazil’s opening game against Turkey on June 3rd, Rivaldo scored a goal in the 87th minute to give Brazil a 2-1 lead with only three minutes to play, and was on his way to earning the Man of the Match award (think “MVP,” baseball fans). With seconds of added time left, Brazil won a corner, which Rivaldo wandered across the pitch to take at a pace which could, at best, be described as “lacking a degree of urgency.” The ball was at the feet of Turkish defender Hakan Ünsal, who most certainly WAS in a hurry…

(Cue Michael Lewis-like change of scene to increase the dramatic tension.)

Game 6 of the 2004 ALCS, played at Yankee Stadium on October 19, 2004, had urgency to spare, as the Boston Red Sox, having lost the first three games of the series to their hated rivals from New York, needed a win to tie the series at 3 games each and force a Game 7 decider, which would be played at The Stadium the following night. One more loss and their season was over. (No team had ever come from 3 games down to take a Championship Series.)

The Yankees were led by their talismanic third baseman, Alex Rodriguez, who had almost joined the Red Sox earlier that year after the team had suffered a heart-breaking Game 7 loss in the 2003 ALCS — to whom else but the Yankees — only to have the deal voided at the last minute by the players’ union, a move which opened the door for the Yankees to steal the highest-paid and, at the time, most prolific player in the game from under the noses of the seemingly cursed Red Sox. (You can see how that whole situation played out in the excellent ESPN short documentary The Deal).

Rodriguez had been on a tear in 2004 and would end the season with 36 home runs, 106 RBIs, 112 runs scored, and 28 stolen bases. (Soccer fans, I’d give you a comparison, but there isn’t one. Think: doing everything. Really well.) This made Rodriguez only the third player in the 100+ years of baseball history to compile at least 35 home runs, 100 RBIs, and 100 runs scored in seven consecutive seasons (joining two other players with names that even soccer fans would know [kinda]: Babe Ruth and Jimmie Foxx). (No, NOT the actor who won an Oscar for Ray, soccer fans.)

During the playoffs, Rodriguez had dominated the Minnesota Twins, batting .421 with a slugging percentage of .737. (Soccer fans, let’s face it, baseball owns statistics. You got nuthin’. Nuthin’. Take it from me, Rodriguez was Messi with a bat.) He had also equaled the single-game post-season record by scoring five runs in Game 3 as the Yankees seized a 3-0 lead.

But in Game 6, Messi with a bat was about to get messy with at-bats as his form deserted him and he found himself at the plate in the 8th inning, facing Red Sox relief pitcher Bronson Arroyo, in the game for starting pitcher Curt Schilling, who had battled heroically through seven innings with a torn tendon sheath in his right ankle.

With the Yankees down 4-2 and team captain Derek Jeter on first base, Rodriguez represented the tying run…

On that steamy night two years prior, in a purpose-built stadium in Korea, Rivaldo stood by the corner flag, hands on his knees, waiting oh so patiently for the clock to run down Ünsal to pass the ball to him. The fans whistled their derision at the Brazilian’s delaying tactics. Sadly, time wasting in such situations is commonplace in football, and though the referees are obliged to add additional seconds to negate these tactics, they seldom do so effectively.

Ünsal was no doubt frustrated at the Brazilian’s gamesmanship and kicked the ball towards him at some pace in an attempt to speed things up.

Rivaldo flinched and tried to turn away from the incoming ball, which struck him roughly two inches above his right knee.

With the linesman (baseball fans, think: third base umpire) standing no more than two or three feet from the Brazilian, Rivaldo collapsed to the ground, clutching hisface as if he had pole-axed by the incoming projectile, and writhing around as if every bone in his face had been shattered by the evil Turk.

To the astonishment of everybody in the stands, commentators from over a hundred countries, hundreds of millions of fans around the world, and, above all, Ünsal himself, the Turkish player was shown a red card and sent off (baseball fans, think: ejected) for his “crime.”

Rivaldo, having made a miraculous recovery, took the resulting corner, and Brazil held on against the ten men of Turkey for the victory.

Back in the Bronx, with the count at 2-2 (soccer fans, that’s two balls and two strikes, which means… oh, to hell with it. Baseball is so much trickier to explain. From here on in, you’re on your own), Alex Rodriguez swung his bat, made contact with Arroyo’s pitch, and sent it bobbling down the first-base line. As soon as he hit it, Rodriguez set off in a furious foot race that he had absolutely no chance of winning as he tried to beat the ball to first base. He knew it. We knew it.

Sure enough, Arroyo, with a head start, got to the ball first and took the two or three steps necessary to tag the Yankee with the ball (before he reached first base, which would render him “out” and send him back to the dugout, bringing the Yankee inning closer to an end).

However, as he reached out to tag Rodriguez, the ball spun loose from Arroyo’s glove and bobbled into right field, keeping the play alive and letting Jeter score from second and throw the Yankees a lifeline.

Rodriguez continued to second base, where he stopped, called time out, clapped his hands, and whooped.

Cue pandemonium.

Everybody in the stadium — except the first-base umpire … and presumably the millions at home — had seen Rodriguez intentionally slap the ball from Arroyo’s glove, a move which in baseball parlance is known as “cheating.” (Soccer fans, think: cheating.)

After a strong protest from Red Sox manager Terry Francona and a lengthy consultation among the various umpires, justice was done. Rodriguez was called “out,” Jeter was returned to second base, and the score remained 4-2.

The Red Sox would go on to win the game and, the following night, become the first team in baseball history to win a series after losing the first three games. They would go on to defeat the St. Louis Cardinals 4-0 in the 100th World Series (soccer fans, think: national championship with no “world” connotation whatsoever) and to vanquish a famous “curse” that had persisted for 86 years.

Now, armed with that background, watch these two defining moments HERE and HERE.

In the aftermath, both players were defiant. Rivaldo, amazingly, tried to paint himself as the victim:

(BBC): Rivaldo had admitted fooling the referee by clutching his face after Ünsal kicked the ball at his leg while he was waiting to take a corner in the closing moments of the Group C match.

But he shrugged off the fine and defended his faking as part and parcel of the game.

The 30-year-old said: “I’m calm about the punishment.

“I am not sorry about anything.

“I was both the victim and the person who got fined.

“Obviously the ball didn’t hit me in the face, but I was still the victim. I did not hit anyone in the face.”

… whilst Rodriguez was, for some reason, “perplexed”:

(NY Times): Alex Rodriguez was standing on second base when the umpires decided that he did not belong there. He folded his hands atop his helmet and screamed, “What?’’

He was, to use his word, perplexed.

After the game, Yankees Manager Joe Torre demonstrated that, when it comes to seeing important plays that go against your team, there is one thing common to both soccer AND baseball: the unreliability of a manager’s eyesight. These guys see EVERYTHING that goes against their team perfectly but somehow always seem to be curiously oblivious when the shoe is on the other foot:

(NY Times): “Randy Marsh was closer than anyone else, and it looked like there were bodies all over the place,’’ Torre said, referring to the fact that first baseman Doug Mientkiewicz was near the play. “There were a lot of bodies in front of me, so I can’t tell you what I saw. I was upset it turned out the way it did for a couple of reasons.”

Presumably neither of those reasons involved the fact that the call was right.

Anyway, the point of these two stories as they pertain to Flash Boys is this:

Both Rodriguez and Rivaldo knew there were dozens of TV cameras on them. They knew there were millions of pairs of eyes on them around the world, and they knew that they were being watched by officials charged with monitoring the games to ensure fairness and punish malfeasance — and yet, knowing all that to be true, they both instinctively cheated to try to gain an edge.

That is how they, as competitors, are wired. Whether it’s right or wrong is irrelevant. (It’s wrong, in case you were wondering.) They were both given a set of rules within which to play, and both chose to step outside those rules in the hope that they would get away with it.

Rivaldo did, Rodriguez didn’t.

It’s a fine line, but the reward for success — even if it does involve bending the rules — is considerable.

Lewis’s media blitz began on Sunday night with an appearance on 60 Minutes, and in answering a simple opening question with a typically florid response, he sparked a media storm the likes of which I haven’t seen in a long, long time.

Steve Kroft: What’s the headline here?

Michael Lewis: Stock market’s rigged. The United States stock market, the most iconic market in global capitalism, is rigged.

Those words sent financial anchors on CNBC and Bloomberg TV into a state of apoplexy at the mere suggestion that the playing field in financial markets is anything but scrupulously fair.

As I watched the circus unpack its tents, erect them, and send a parade of clowns careening into the ring, I was genuinely baffled at what I was seeing.

The first act was Bill O’Brien, the president of BATS (one of the exchanges which, according to Lewis’s book, offers an unfair advantage to high-frequency traders), going toe-to-toe on CNBC with the hero of the book, Brad Katsuyama, once of RBC and now the founder of IEX, an exchange dedicated to leveling the playing field for the average investor.

Until last Sunday, I had never heard of either man, nor had I ever seen them in action.

What followed was extraordinary.

If you haven’t seen the clip, you can (and should) watch it HERE, because excerpts from a transcript cannot do justice to either the defensiveness of O’Brien or the cool confidence of Katsuyama; but from the off, had it been a fight, it would have been stopped before one of the participants embarrassed himself any further:

(CNBC):O’Brien: I have been shaking my head a lot the last 36 hours. First thing I would say, Michael and Brad, shame on both of you for falsely accusing literally thousands of people and possibly scaring millions of investors in an effort to promote a business model.

Bob Pisani (to Katsuyama): You are very respected on the street. I have known you a little while. You are thought very highly of. Do you think the markets are rigged?

Katsuyama (calmly): I think it’s very hard to put a word on it…

O’Brien (animatedly): He said it in the book. You said it in the book. “That’s when I knew the markets were rigged.” It’s disgusting that you are trying to parse your words now. Okay?

Katsuyama (calmly): Let me walk you through an example…

O’Brien: It’s a yes or no question. Do you believe it or not?

Katsuyama (calmly): I believe the markets are rigged.

O’Brien (somewhat triumphantly): Okay. There you go.

Katsuyama (calmly): I also think that you are part of the rigging. If you want to do this, let’s do this.

From there, Katsuyama proceeded to ask O’Brien how his own exchange (the one he, O’Brien, is president of) prices trades:

O’Brien: We use the direct feeds and the SIP (Securities Information Processor) in combination.

Katsuyama: I asked a question. Not what you use to route. What do you use to price trades in your matching engine on Direct Edge?

O’Brien: We use direct feeds.

Katsuyama: No.

O’Brien: Yes, we do…

Katsuyama: You use the SIP.

O’Brien: That is not true.

From there, O’Brien made the most successful attempt to make himself look a fool that I think I have ever seen (and on CNBC, that’s saying something). It was, I thought, painfully embarrassing to watch.

In my head, all I could hear was Sir Winston Churchill’s booming voice:

“Never engage in a battle of wits with an unarmed man.”

Less than 24 hours later…

(Wall Street Journal): BATS Global Markets Inc., under pressure from the New York Attorney General’s office, corrected statements made by a senior executive during a televised interview this week about how its exchanges work.

BATS President William O’Brien, during a CNBC interview Tuesday, said BATS’s Direct Edge exchanges use high-speed data feeds to price stock trades. Thursday, the exchange operator said two of its exchanges, EDGA and EGX, use a slower feed, known as the Securities Information Processor, to price trades.

Viva El Presidente!

Anyway, the interesting thing to me, once I got past the sheer insanity of it all, was the level of amazement shown by the CNBC journalists that the market could possibly be “rigged” in any way, shape, or form.

That amazement was shared by the two anchors on Bloomberg’s Market Makers show, Stephanie Ruhle and Eric Schatzker, when their turn came to take a tilt at Lewis the following day:

Ruhle (bewildered): The market is rigged? That’s a big claim!

Lewis (even more bewildered): Well it IS rigged. If you read the book, I don’t think you’d put it down and say the market’s not rigged.

Then, after a pretty good casino analogy that was interrupted by the anchors a few times, Lewis got to the crux of the issue that had been bothering me as I watched:

Lewis: Why are you so invested in the idea this is fair? Why are you even arguing about this? It’s so clear… people are front-running the market. There’s plenty of evidence in the book.

Schatzker: Their orders are being “anticipated.”

Lewis (laughing at the escalating absurdity): Anticipated and run in front of…. [The HFTs] PAY to execute the orders. Tens of millions of dollars a year. Ask yourself THAT question. Why would ANYONE pay for the right to execute someone else’s stock market order?… It’s quite obvious. That order is an opportunity to exploit, because he has advance information about the pricing in the stock market. Is that “fair”?

Ruhle: Today, when I go to execute a stock, I feel like, man, how did that get jacked right in front of me, every time? I do feel that way. But fifteen years ago when I did a trade, I was paying significantly more to do it through a specialist because of what the fees were…. Is it a different situation than when specialists were on the floor?

Lewis (with a somewhat confused look on his face): I never said THAT.

Ruhle: So has the system ALWAYS been rigged?

Lewis: Yes.

Yes.

After watching these exchanges, I was so astounded that so many people could STILL live in a complete fantasy world under the illusion assumption that the markets couldn’t possibly be rigged that I turned to my friends in the Twittersphere:

That was the 2,567th tweet I have sent out and, in contrast to the nearly pathological indifference shown by the rest of the world to the previous 2,566, this one was retweeted 96 times. (Button it, Bieber! That’s an impressive number for me, OK?)

But who are these people who believe in unicorns and rainbows fair markets?

Click here 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.

Thoughts from the Frontline: Every Central Bank for Itself

 

“Everybody has a plan until they get punched in the face.”

– Mike Tyson

For the last 25 days I’ve been traveling in Argentina and South Africa, two countries whose economies can only be described as fragile, though for very different reasons. Emerging-market countries face a significantly different set of challenges than the developed world does. These challenges are compounded by the rather indifferent policies of developed-world central banks, which are (even if somewhat understandably) entirely self-centered. Argentina has brought its problems upon itself, but South Africa can somewhat justifiably express frustration at the developed world, which, as one emerging-market central bank leader suggests, is engaged in a covert currency war, one where the casualties are the result of unintended consequences. But the effects are nonetheless real if you’re an emerging-market country.

While I will write a little more about my experience in South Africa at the end of this letter, first I want to cover the entire emerging-market landscape to give us some context. Full and fair disclosure requires that I give a great deal of credit to my rather brilliant young associate, Worth Wray, who’s helped me pull together a great deal of this letter while I am on the road in a very busy speaking tour here in South Africa for Glacier, a local platform intermediary. They have afforded me the opportunity to meet with a significant number of financial industry participants and local businessman, at all levels of society. It has been a very serious learning experience for me. But more on that later; let’s think now about the problems facing emerging markets in general.

Every Central Bank for Itself

Every general has a plan before going into battle, which immediately begins to change upon contact with the enemy. Everyone has a plan until they get hit… and emerging markets have already taken a couple of punches since May 2013, when Fed Chairman Ben Bernanke first signaled his intent to “taper” his quantitative easing program and thereby incrementally wean the markets off of their steady drip of easy money. It was not too long after that Ben also suggested that he was not responsible for the problems of emerging-market central banks – or any other central bank, for that matter.

As my friend Ben Hunt wrote back in late January, Chairman Bernanke turned a single data point into a line during his last months in office, when he decided to taper by exactly $10 billion per month. He established the trend, and now the markets are reacting as if the Fed’s exit strategy has officially begun.

Whether the FOMC can actually turn the taper into a true exit strategy ultimately depends on how much longer households and businesses must deleverage and how sharply our old-age dependency ratio rises, but markets seem to believe this is the beginning of the end. For now, that’s what matters most.

Under Fed Chair Janet Yellen’s leadership, the Fed continues to send a clear message to the rest of the world: Now it really is every central bank for itself.

The QE-Induced Bubble Boom in Emerging Markets

By trying to shore up their rich-world economies with unconventional policies such as ultra-low rate targets, outright balance sheet expansion, and aggressive forward guidance, major central banks have distorted international real interest rate differentials and forced savers to seek out higher (and far riskier) returns for more than five years.

This initiative has fueled enormous overinvestment and capital misallocation – and not just in advanced economies like the United States.

As it turns out, the biggest QE-induced imbalances may be in emerging markets, where, even in the face of deteriorating fundamentals, accumulated capital inflows (excluding China) have nearly DOUBLED, from roughly $5 trillion in 2009 to nearly $10 trillion today. After such a dramatic rise in developed-world portfolio allocations and direct lending to emerging markets, developed-world investors now hold roughly one-third of all emerging-market stocks by market capitalization and also about one-third of all outstanding emerging-market bonds.

The Fed might as well have aimed its big bazooka right at the emerging world. That’s where a lot of the easy money ran blindly in search of more attractive real interest rates, bolstered by a broadly accepted growth story.

The conventional wisdom – a particularly powerful narrative that became commonplace in the media – suggested that emerging markets were, for the first time in a long time, less risky than developed markets, despite their having displayed much higher volatility throughout the past several decades.

As a general rule, people believed emerging markets had much lower levels of government debt, much stronger prospects for consumption-led growth, and far more favorable demographics. (They overlooked the fact that crises in the 1980s and 1990s still limited EM borrowing limits until 2009 and ignored the fact that EM consumption is a derivative of demand and investment from the developed world.)

Instead of holding traditional safe-haven bonds like US treasuries or German bunds, some strategists (who shall not be named) even suggested that emerging-market government bonds could be the new safe haven in the event of major sovereign debt crises in the developed world. And better yet, it was suggested that denominating these investments in local currencies would provide extra returns over time as EM currencies appreciated against their developed-market peers.

Sadly, the conventional wisdom about emerging markets and their currencies was dead wrong. Herd money (typically momentum-based, yield-chasing investors) usually chases growth that has already happened and almost always overstays its welcome. This is the same disappointing boom/bust dynamic that happened in Latin America in the early 1980s and Southeast Asia in the mid-1990s. And this time, it seems the spillover from extreme monetary accommodation in advanced countries has allowed public and private borrowers to leverage well past their natural carrying capacity.

Anatomy of a “Balance of Payments” Crisis

The lesson is always the same, and it is hard to avoid. Economic miracles are almost always too good to be true. Whether we’re talking about the Italian miracle of the ’50s, the Latin American miracle of the ’80s, the Asian Tiger miracles of the ’90s, or the housing boom in the developed world (the US, Ireland, Spain, et al.) in the ’00s, they all have two things in common: construction (building booms, etc.) and excessive leverage. As a quick aside, does that remind you of anything happening in China these days? Just saying…

Broad-based, debt-fueled overinvestment may appear to kick economic growth into overdrive for a while; but eventually disappointing returns and consequent selling lead to investment losses, defaults, and banking panics. And in cases where foreign capital seeking strong growth in already highly valued assets drives the investment boom, the miracle often ends with capital flight and currency collapse.

Economists call that dynamic of inflow-induced booms followed by outflow-induced currency crises a “balance of payments cycle,” and it tends to occur in three distinct phases.

In the first phase, an economic boom attracts foreign capital, which generally flows toward productive uses and reaps attractive returns from an appreciating currency and rising asset prices. In turn, those profits fuel a self-reinforcing cycle of foreign capital inflows, rising asset prices, and a strengthening currency.

In the second phase, the allure of promising recent returns morphs into a growth story and attracts ever-stronger capital inflows – even as the boom begins to fade and the strong currency starts to drag on competitiveness. Capital piles into unproductive uses and fuels overinvestment, overconsumption, or both; so that ever more inefficient economic growth increasingly depends on foreign capital inflows. Eventually, the system becomes so unstable that anything from signs of weak earnings growth to an unanticipated rate hike somewhere else in the world can trigger a shift in sentiment and precipitous capital flight.

In the third and final phase, capital flight drives a self-reinforcing cycle of falling asset prices, deteriorating fundamentals, and currency depreciation… which invites more even more capital flight. If this stage is allowed to play out naturally, the currency can fall well below the level required to regain competitiveness, sparking run-away inflation and wrecking the economy as asset prices crash.

(To those of you who’ve been reading me for a while, this may sound suspiciously similar to the Minsky cycle we often use to describe the leverage process. If you caught that, you get extra credit.)

In order to avoid that worst-case scenario, central bankers often choose to spend their FX reserves or to substantially raise domestic interest rates to defend the currency. Although it comes at great cost to domestic growth, this kind of intervention often helps to stem the outflows… but it cannot correct the core imbalances. The same destructive cycle of capital flight, falling asset prices, falling growth, and currency depreciation can restart without warning and trigger – even years after a close call – an outright currency collapse if the central bank runs out of policy tools.

The Taper Reveals What QE Was Hiding

That worst case is the looming risk for many emerging markets today, particularly in the externally leveraged “Fragile Five”: Brazil, India, Turkey, Indonesia, and South Africa (where I am as I finish this letter). Together they account for more than $3.3 trillion of the total $10 trillion of developed-country assets currently invested in emerging markets. Not only have those countries amassed a disproportionate share of total inflows to emerging markets, each has its own insidious combination of structural and political obstacles to long-term growth. And their own central banks are seriously constrained in the run-up to national elections between now and October 2014.

After a brief reprieve from taper-induced capital flight, the most externally leveraged emerging economies have had some time to breathe easy; but the crisis is far from over. This one, as all such booms and busts do, will end in tears.

Although countries like India and Indonesia have taken positive steps toward reducing their external imbalances, real reforms take time; and balance-of-payments episodes will recur until the core imbalances have been resolved.

A sudden rise in real interest rates abroad – which could arise purely from a miscue in FOMC forward guidance – could slam a long list of emerging markets simply by reducing the real risk premium over “safe” assets. Even a 200-basis-point move in US rates could create a strong incentive for less productive capital in compromised or overvalued markets to rush for the exits in headlong capital flight.

It may sound like an extreme case, but even a moderate rise in real interest rates abroad would be enough to trigger disorderly and destructive currency adjustments across the emerging world.

Rajan Shows His Cards

A little over two months ago, I argued that Reserve Bank of India Governor Raghuram Rajan was stepping forward as the unofficial spokesman for an entire group of emerging-market central bankers struggling to manage what he calls “capital-flow-induced fragility.” 

(I spent several days on a speaking tour with Rajan, and he is a very serious academic and critical thinker. As a central banker, he will be a force to be reckoned with. I wonder how often that marvelously sly sense of humor that I saw will be allowed to come out during the crisis that is brewing in India. I haven’t seen much of it in his last interviews and speeches. This is a man who understands the seriousness of his situation.)

Developed-market observers like to criticize emerging-market policymakers first for complaining about excessive capital inflows into their economies and then for throwing a “tantrum” when supposedly unwanted flows slow or start to reverse… but Rajan took that tendency to task in a January 30, 2014, interview with Bloomberg’s Vivek Law. (You can watch Governor Rajan’s January appeal to rich-world investors here. Even if you have already seen it several times, I encourage you to watch it again… and this time play close attention to his body language.)

In the real world, Rajan explained, FX volatility can be downright traumatic for emerging markets.

We complain when it goes out for the same reason when it goes in. It distorts our economies. And the money coming in made it more difficult for us to do the adjustment which would lead to sustainable growth and prepare for the money going out.

You see, the nostrum amongst economists here is “Let the prices adjust and things will be fine. Let the exchange rate move; let the money flow out; and you will figure it out. That is often a reasonable prescription for an economy that has its fundamentals, as well as its institutions, well-anchored. But when those aren’t anchored, what happens is the volatility feeds on itself. Exchange rates fall. Stop loss limits are hit. More selling takes place. Then some firms get into difficulty because they have unhedged exposures. Government budgets get hit because they’re not hedged against currency fluctuations. There are also second- and third-round effects which happen in a country which is not as advanced or industrialized.

This week Governor Rajan upped the ante by presenting an explosive and controversial paper at the Brookings Institution – literally right in front of former Fed Chairman Ben Bernanke – entitled, “Competitive Monetary Easing: Is it yesterday once more?” (Please note that this is the same Ben Bernanke who basically told emerging-market central banks that the US was not responsible for their problems, not all that long ago when he was chairman of the Fed. This was the central banker’s equivalent of saying, “Go pound sand!”)

In his paper and oral presentation, Rajan worries openly about the consequences for the rest of the world as advanced-economy interest rates start to normalize. His comments offer us critical insights into the coming climax and resolution of the global debt drama (emphasis mine).

Ultra accommodative monetary policy [in advanced economies] created enormously powerful incentive distortions whose consequences are typically understood only after the fact. The consequences of exit, however, are not just to be felt domestically, they could be experienced internationally.

Perhaps most vulnerable to the increased risk-taking in this integrated world are countries across the border. When monetary policy in large countries is unconventionally accommodative, capital flows into recipient countries tend to increase local leverage; this is not just due to the direct effect of cross-border banking flows, but also the indirect effect, as the appreciating exchange rate and rising asset prices, especially in real estate, make it seem that borrowers have more equity than they really have…

Recipient countries should adjust, of course, but credit and flows mask the magnitude and timing of needed adjustment. For instance, higher collections from property taxes on new houses, sales taxes on new sales, capital gains taxes on financial asset sales, and income taxes on a more prosperous financial sector may all suggest that a country’s fiscal house is in order, even while low risk premia on sovereign debt add to the sense of calm. At the same time, an appreciating nominal exchange rate may also keep down inflation. The difficulty of distinguishing the cyclical from the structural is exacerbated in some emerging markets where policy commitment is weaker, and the willingness to succumb to the siren calls of populist policy greater…

Ideally, recipient countries would wish for stable capital inflows, and not flows pushed in by unconventional policy…. But when source countries move to exit unconventional policies, some recipient countries are leveraged, imbalanced, and vulnerable to capital outflows.

Given that investment managers anticipate the consequences of the future policy path, even a measured pace of exit may cause severe market turbulence and collateral damage. Indeed the more transparent and well-communicated the exit is, the more certain the foreign investment managers may be of changed conditions, and the more rapid their exit from risky positions.

So, Rajan is clearly lining out a framework for understanding the QE-induced bubble boom and the balance of payments crises that could follow in overexposed countries.

Unconventional monetary policy pushes far more capital into emerging markets than would naturally flow there in a normalized rate environment, and the easy money tends to lull elected officials into inaction.

Following the classic balance-of-payments boom/bust cycle, capital overflows appear to boost growth for a while as leverage grows and policymakers have an increasingly difficult time distinguishing between cyclical and structural forces in the economic data – making it virtually impossible to intervene at the appropriate time. The bubble builds up until the “source country” decides to exit its unconventional policies, wrecking asset prices globally and damaging overexposed “recipient countries.”

The problem for emerging markets is that there are no conventional tools for blocking this kind of knock-out punch… except for much-reviled exchange rate interventions and capital controls.

Considering the available options, it is very clear that Rajan intends to do whatever it takes to defend the Indian rupee; but he would obviously like to avoid trade sanctions in the process. That’s why he argues so forcefully that emerging markets find themselves pushed up against a new kind of constraint equivalent to the zero bound.

Emerging economies have to work to reduce vulnerabilities in their economies, to get to the point where, like Australia, they can allow exchange rate flexibility to do much of the adjustment for them to capital inflows. But the needed institutions take time to develop. In the meantime, the difficulty for emerging markets in absorbing large amounts of capital quickly and in a stable way should be seen as a constraint, much like the zero lower bound, rather than something that can be altered quickly.

Expanding on that argument, Governor Rajan argues that there are essentially two kind of unconventional policy: “policies that hold rates at near zero for long” and “balance sheet policies such as quantitative easing or exchange intervention, that involve altering central bank balance sheets in order to affect certain market prices.”

In other words, Rajan is arguing that quantitative easing, which aims to lower real rates at the zero bound, is essentially identical to exchange-rate intervention, which aims to explicitly target an exchange rate to maintain or regain competiveness. And that “our attitudes towards [either approach] should be conditioned by the size of their spillover effects rather than by any innate legitimacy of either form of intervention.”

For better or worse, Governor Rajan is clearly broadcasting his intent to employ explicit exchange-rate intervention (probably some form of currency peg) or outright capital controls to protect the Indian rupee.

I think a lot of emerging-market central banks will follow suit, and harder currency pegs will follow. Otherwise, as Rajan says,

The lesson some emerging markets will take away from the recent episode of turmoil is (1) don’t expand domestic demand and run large deficits, (2) maintain a competitive exchange rate, and (3) build up large reserves, because when trouble comes, you are on your own.

Notice in the chart below that the currency exchange-rate regimes for countries change all the time. I would expect that volatility to increase in the next few years as emerging markets respond to what is in effect a developed-market currency war, currently led by Japan, though I expect it to heat up everywhere within a few years.

What’s a Country to Do?

One of the significant differences I’ve noticed this time in South Africa is just how remarkably cheap (for the traveler) everything seems to be that has no, or very little, international component in its makeup – things like food and wine. The rand has depreciated significantly since I was last here; and while that is good for tourists, it is hard on the locals. I had more than a few South African financial industry participants tell me they wished they could come to our conference in San Diego but that the rand had fallen too much to make it affordable. I joked about how I feel the same about travel in Europe, but that was hollow consolation.

I spoke some eight times in four days here, plus media interviews, and at each of the venues there was a considerable question-and-answer period. The most difficult questions centered around how South Africa should respond to the actions of the developed-world central banks and especially the US Federal Reserve and what South Africa should do to improve its own current situation? These difficulties are compounded by the fact that a general election will be held here in less than a month. The ruling party, the African National Congress, is beset by serious charges of corruption and an economy that is clearly not hitting on all cylinders, yet it appears the ANC will still get at least 60% of the vote.

South Africans are quite passionate about their country and their desire to see it do better. They genuinely wanted to hear some answers from me, but that didn’t make coming up with them any easier.

The problem is that there is not much South Africa can do about the policies of central banks other than their own. As I described above, it truly is every central bank for itself. But the South African central bank has local problems that compound its problems. Unemployment is roughly where it was 4-5 years ago, at 24%. Inflation is high and seemingly rising, and the rand is weakening (see chart below).

The South African inflation rate has been relatively stable the last few years at around 6%, after rising to almost 11% in late 2008 and dropping to well below 4% in late 2010.

Treasury bill yields are somewhat lower than the current inflation rate, just as they are in much of the world. But clearly the central bank felt it needed to raise rates in a world where the rand was suffering.

From my friends at moneyweb.com, based here in South Africa:

Record low interest rates in the U.S., Europe, and Japan, along with the U.S. Federal Reserve’s multi-trillion dollar quantitative easing programs, caused $4 trillion of speculative “hot money” to flow into emerging market investments over the last several years. A global carry trade arose in which investors borrowed cheaply from the U.S. and Japan, invested the funds in high-yielding emerging market assets, and earned the interest rate differential or spread. Soaring demand for emerging market investments led to a bond bubble and ultra-low borrowing costs, which resulted in government-driven infrastructure booms, dangerously rapid credit growth, and property bubbles in countless developing nations across the globe.

The emerging markets bond bubble helped to push South Africa’s 10-year government bond yield down to a record low of 5.77 percent after the global financial crisis:

South Africa’s external debt now totals $136.6 billion or 38.2 percent of the country’s GDP – the highest level since the mid-1980s – due in large part to the emerging markets bond bubble that boosted foreign demand for the country’s bonds. South Africa’s external debt-to-GDP ratio was 25.1 percent just five years ago. $60.6 billion of South Africa’s external debt is denominated in foreign currencies, which exposes borrowers to the risk of rising debt burdens if the South African rand currency depreciates significantly, such as the currency’s 15 percent decline against the U.S. dollar in the past year. To make matters worse, over 150 percent worth of South Africa’s foreign exchange reserves are required to roll over its external debt that matures in 2014.

Unsecured loans, or consumer and small business loans that are not backed by assets, are the fastest growing segment of South Africa’s credit market and are essentially the country’s own version of subprime loans. Unsecured loans have grown at a 30 percent annual compounded rate since their introduction in 2007, when the National Credit Act was signed into law. Unsecured lending has become popular with banks because they are able to charge up to 31 annual interest rates, making these riskier loans far more profitable than mortgage and car loans in the low interest rate environment of the past half-decade. The unsecured credit bubble is estimated to have boosted South Africa’s GDP by 219 billion rand or U.S. $20.45 billion from 2009 to mid-2013.

Like U.S. subprime lenders from 2002 to 2006, South Africa’s unsecured lenders target working class borrowers who have limited financial literacy, which has contributed to the country’s growing household and personal debt problem.  A 2012/2013 report from the National Credit Regulator showed that South Africa’s 20 million citizens carried an alarming 1.44 trillion rand or U.S. $140 billion worth of personal debt – equivalent to 36.4 percent of the GDP. In addition, household debt now accounts for three-quarters of South Africans’ disposable incomes.

What’s a central bank to do when faced with such a situation? There is very little else it can do other than try to mitigate the damage if there are significant currency outflows. The rest – the heavy lifting – will have to be done by the government. Which is somewhat problematical, given that the government under current president Zuma has essentially done very little for the last five years.

Seven years ago I wrote a very optimistic piece about South Africa called Out Of Africa. Many of the reasons for that optimism remain, including the basic spirit and willingness of South Africans to work and the significant financial-community expertise that is available.

But the similarities between then and now end there. Now the South African equity markets are rather fully valued. And the government, which I had hoped would cut through the red tape hindering business, has in fact added to it. Admittedly, there have been some positive changes, and an encouraging document outlining a decade-long economic plan has been developed, but there has been no implementation whatsoever.

The policy recommendations I outlined to Zuma in our meetings a number of years ago remain the same. The country must be structured for higher exports and the production that makes them possible. This will require significant labor reform or at least the introduction of commercial business loans with labor-law terms that will allow foreign direct investment to feel comfortable in coming to South Africa.

South Africa must realize that it’s competing with every other country in the world when it seeks foreign direct investment. And with regard to manufacturing for the African continent, while the scope of the competition might narrow to other countries in Africa, the competitive principle remains the same.

One of the remarkable things I notice as I travel around the world is the business acumen of the South African diaspora. South African expatriates always seem to be running businesses and conducting entrepreneurial activities. Their skills are highly sought after.

Those same entrepreneurial skills and desires are found in abundance in South Africa, and that, not gold or platinum or diamonds, is the greatest resource of this country. A restructuring of the rules surrounding the formation of businesses would unleash a South African renaissance in less time than you might think, given the predatory activities of major central bankers fighting currency wars.

Free-trade zones, a completely revamped education system that is freely available and teaches skills based upon needs of the future rather than upon academic training suited to the past, and a thorough cleansing of the climate of corruption in the country would also help. This last real problem requires the creation of institutions free from the manipulation of the ruling government that can tackle the problems of corruption. The rule of law must be upheld. Political corruption and crony capitalism must both be done away with, root and branch. (And that goes double for the United States!)

On a personal note, South Africa remains one of my very favorite countries to visit. I find the people friendly and engaging; the scenery varies from exotic to breathtakingly beautiful (Cape Town gets my vote for most beautiful city in the world); and the culture is most pleasant. I have high hopes for the country and hope to be invited back often. Perhaps after this upcoming election the leadership will find the courage to take on the entrenched powers and move the country forward.

Amsterdam, Brussels, Geneva, and San Diego

I will be flying back to Dallas via London in a few hours. It is a long trip, and I must admit that after 25 days on the road I will be glad to be home. I will try to limit travel for a little over two weeks before heading to Europe on another speaking tour. I will be in Amsterdam, then Brussels, and on to Geneva. Then I am back home for a few days before hopping over to San Diego for my Strategic Investment Conference, where you really should join me! And at some point in the next few weeks, I have to begin making plans to return to Italy for the first few weeks of June.

I think that rather than making my normal personal comments, I will just go ahead and hit the send button, as I need to shower and check out of the hotel and make my way to the airport. In addition to trying to work through my once-again massive backlog of emails, I think I will take the opportunity on this flight to round up a little science fiction on my iPad. After the last few weeks I need a little break. Have a great week. I look forward to your comments and thank you for taking the time to make me part of your life.

Your ready to relax and enjoy the plane ride analyst,

John Mauldin, Editor
subscribers@mauldineconomics.com

 

© 2013 Mauldin Economics. All Rights Reserved.

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