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Archive for December 2014

Archive for December, 2014

The 5 Phases of Bitcoin Adoption

 

The 5 Phases of Bitcoin Adoption

What will it take for Bitcoin to gain broad adoption and become the foundation of a new global financial system?

Worth Wray sat down with Barry Silbert, founder of the Bitcoin Investment Trust, to discuss. As one the most active venture capitalists in the industry (with investments in over 30 Bitcoin-related portfolio companies through the Bitcoin Opportunity Corp.), Barry has gone all-in on Bitcoin and Bitcoin-related businesses.

He believes the rise of Bitcoin from 2009 to 2014 is just the beginning… and the virtual payment system may be approaching a big inflection point as Wall Street takes the baton from Silicon Valley.

Silbert thinks about Bitcoin adoption in five general phases.

(1) Experimentation Phase. (2009–2010)

  • No real value associated with Bitcoin. Hackers and developers playing around with the source code. Experimenting with Bitcoin as a medium of exchange.

(2) Early Adopters Phase. (2011–2013)

  • Interest from investors and entrepreneurs started to grow with substantial press coverage in the wake of the Silk Road bust. First generation of Bitcoin-related companies (exchanges, merchant processors, wallet providers, etc.) started. Potential began to shine through poor management.

(3) Venture Capital Phase. (2013–Present)

  • World-class VCs started investing in Bitcoin companies and rapid ramp-up is already outpacing the early days of the Internet. VCs poured more than $90 million into Bitcoin-related businesses in 2013 and more than $300 million in 2014 (compared to $250 million invested in Internet-related businesses in 1995).

(4) Wall Street Phase. (2015?)

  • Institutional investors, banks, and broker-dealers begin moving money into Bitcoin. Rising price and volume (in addition to development of derivatives) become the catalyst for mass adoption as retail investment follows.

(5) Global Consumer Adoption Phase. (?)

  • Only happens if (i) companies continue to innovate and make it easier for consumers to buy, hold, and spend Bitcoin, (ii) volume expands dramatically so that large merchants can start accepting payment in Bitcoin, and (iii) Bitcoin awareness continues to rise with these developments.

If Barry is right, the rise of Bitcoin could be as transformative for finance as the Internet has been for commerce and communications… and it could happen FAST.

To learn more about Bitcoin and hear more from Barry and other world-class thinkers, check out Mauldin Economics’ latest documentary, Why Bitcoin Matters.

The article The 5 Phases of Bitcoin Adoption was originally published at mauldineconomics.com.

Outside the Box: The Burning Questions For 2015

 

Louis Gave is one of my favorite investment and economic thinkers, besides being a good friend and an all-around fun guy. When he and his father Charles and the well-known European journalist Anatole Kaletsky decided to form Gavekal some 15 years ago, Louis moved to Hong Kong, as they felt that Asia and especially China would be a part of the world they would have to understand. Since then Gavekal has expanded its research offices all over the world. The Gavekal team’s various research arms produce an astounding amount of work on an incredibly wide range of topics, but somehow Louis always seems to be on top of all of it.

Longtime readers know that I often republish a piece by someone in their firm (typically Charles or Louis). I have to be somewhat judicious, as their research is actually quite expensive, but they kindly give me permission to share it from time to time.

This week, for your Outside the Box reading, I bring you one of the more thought-provoking pieces I’ve read from Louis in some time. In Thoughts from the Frontline I have been looking at world problems we need to focus on as we enter 2015. Today, Louis also gives us a piece along these lines, called “The Burning Questions for 2015,” in which he thinks about a “Chinese Marshall Plan” (and what a stronger US dollar might do to China), Abenomics as a “sideshow,” US capital misallocation, and whether or not we should even care about Europe. I think you will find the piece well worth your time.

Think about this part of his conclusion as you read:

Most investors go about their job trying to identify ‘winners’. But more often than not, investing is about avoiding losers. Like successful gamblers at the racing track, an investor’s starting point should be to eliminate the assets that do not stand a chance, and then spread the rest of one’s capital amongst the remainder.

Wise words indeed.

A Yellow Card from Barry

What you don’t often get to see is the lively debate that happens among my friends about my writing, even as I comment on theirs. Barry Ritholtz of The Big Picture pulled a yellow card on me over a piece of data he contended I had cherry-picked from Zero Hedge. He has a point. I should have either not copied that sentence (the rest of the quote was OK) or noted the issue date. Quoting Barry:

Did you cherry pick this a little much? 

“… because since December 2007, or roughly the start of the global depression, shale oil states have added 1.36 million jobs while non-shale states have lost 424,000 jobs.”

I must point out how intellectually disingenuous this start date is, heading right into the crisis – why not use December 2010? Or 5 or 10 years? This is misleading in other ways:

It is geared to start before the crisis & recovery, so that it forces the 10 million jobs lost in the crisis to be offset by the 10 million new jobs added since the recovery began. That creates a very misleading picture of where growth comes from.

We have created 10 million new jobs since June 2009. Has Texas really created 4 million new jobs? The answer is no.

According to [the St. Louis Fed] FRED [database]:

PAYEMS – or NFP – has gone from 130,944 to 140,045, a gain of 9,101 over that period.
TXNA – Total Nonfarm in Texas – has gone from 10,284 to 11,708, for a gain of 1,424.

That gain represents 15.6% of the 9.1MM total.

Well yes, Barry, but because of oil and other things (like a business-friendly climate), Texas did not lose as many jobs in the recession as the rest of the nation did, which is where you can get skewed data, depending on when you start the count and what you are trying to illustrate.

My main point is that energy production has been a huge upside producer of jobs, and that source of new jobs is going away. And yes, Josh, the net benefit for at least the first six months until the job non-production shows up (if it does) is a positive for the economy and the consumer. But I was trying to highlight a potential problem that could hurt US growth. Oil is likely to go to $40 before settling in the $50 range for a while. Will it eventually go back up? Yes. But it’s anybody’s guess as to when.

By the way, a former major hedge fund manager who closed his fund a number of years ago casually mentioned at a party the other night that he hopes oil goes to $35 and that we see a true shakeout in the oil patch. He grew up in a West Texas oil family and truly understands the cycles in the industry, especially for the smaller producers. From his point of view, a substantial shakeout creates massive upside opportunities in lots of places. “Almost enough,” he said, “to tempt me to open a new fund.”

On a different note, everyone is Christmas shopping and trying to find the right gift. Two recommendations. First, the Panasonic wet/dry electric razor (with five blades). I just bought a new set of blades and covers for mine after two years (you do have to replace them every now and then); and the new, improved shave reminded me how much I was in love with it when I bought it. Best shaver ever.

Second, and I know this is a little odd, but for a number of years I’ve been recommending a face cream that contains skin stem cells, which I and quite a number of my readers have noticed really helps rejuvenate our older skin. (I came across the product while researching stem-cell companies with Patrick Cox.) It clearly makes a difference for some people. I get ladies coming up all the time and thanking me for the recommendation, and guys too sometimes shyly admit they use it regularly. (It turns out that just as many men buy the product as women.) The company is Lifeline Skin Care, and they have discounted the product for my readers. If you can get past the fact that this is a financial analyst recommending a skin cream for a Christmas gift, then click on this link.

It is time to hit the send button. I trust you are having a good week. Now settle in and grab a cup of coffee or some wine (depending on the time of day and your mood), and let’s see what Louis has to say.

Your trying to catch up analyst,

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

 

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The Burning Questions For 2015

By Louis-Vincent Gave, GavekalDragonomics

With two reports a day, and often more, readers sometimes complain that keeping tabs on the thoughts of the various Gavekal analysts can be a challenge. So as the year draws to a close, it may be helpful if we recap the main questions confronting investors and the themes we strongly believe in, region by region.

1. A Chinese Marshall Plan?

When we have conversations with clients about China – which typically we do between two and four times a day – the talk invariably revolves around how much Chinese growth is slowing (a good bit, and quite quickly); how undercapitalized Chinese banks are (a good bit, but fat net interest margins and preferred share issues are solving the problem over time); how much overcapacity there is in real estate (a good bit, but – like youth – this is a problem that time will fix); how much overcapacity there is in steel, shipping, university graduates and corrupt officials; how disruptive China’s adoption of assembly line robots will be etc.

All of these questions are urgent, and the problems that prompted them undeniably real, which means that China’s policymakers certainly have their plates full. But this is where things get interesting: in all our conversations with Western investors, their conclusion seems to be that Beijing will have little choice but to print money aggressively, devalue the renminbi, fiscally stimulate the economy, and basically follow the path trail-blazed (with such success?) by Western policymakers since 2008. However, we would argue that this conclusion represents a failure both to think outside the Western box and to read Beijing’s signal flags.

In numerous reports (and in Chapters 11 to 14 of Too Different For Comfort) we have argued that the internationalization of the renminbi has been one of the most significant macro events of recent years. This internationalization is continuing apace: from next to nothing in 2008, almost a quarter of Chinese trade will settle in renminbi in 2014:

This is an important development which could have a very positive impact on a number of emerging markets. Indeed, a typical, non-oil exporting emerging market policymaker (whether in Turkey, the Philippines, Vietnam, South Korea, Argentina or India) usually has to worry about two things that are completely out of his control:

1)   A spike in the US dollar. Whenever the US currency shoots up, it presents a hurdle for growth in most emerging markets. The first reason is that most trade takes place in US dollars, so a stronger US dollar means companies having to set aside more money for working capital needs. The second is that most emerging market investors tend to think in two currencies: their own and the US dollar. Catch a cab in Bangkok, Cairo, Cape Town or Jakarta and ask for that day’s US dollar exchange rate and chances are that the driver will know it to within a decimal point. This sensitivity to exchange rates is important because it means that when the US dollar rises, local wealth tends to flow out of local currencies as investors sell domestic assets and into US dollar assets, typically treasuries (when the US dollar falls, the reverse is true).

2)   A rapid rise in oil or food prices. Violent spikes in oil and food prices can be highly destabilizing for developing countries, where the median family spends so much more of their income on basic necessities than the typical Western family. Sudden spikes in the price of food or energy can quickly create social and political tensions. And that’s not all; for oil-importing countries, a spike in oil prices can lead to a rapid deterioration in trade balances. These tend to scare foreign investors away, so pushing the local currency lower and domestic interest rates higher, which in turn leads to weaker growth etc…

Looking at these two concerns, it is hard to escape the conclusion that, as things stand, China is helping to mitigate both:

  • China’s policy of renminbi internationalization means that emerging markets are able gradually to reduce their dependence on the US dollar. As they do, spikes in the value of the US currency (such as we have seen in 2014) are becoming less painful.
     
  • The slowdown in Chinese oil demand, as well as China’s ability to capitalize on Putin’s difficulties to transform itself from a price-taker to a price-setter, means that the impact of oil and commodities on trade balances is much more contained.

Beyond providing stability to emerging markets, the gradual acceptance of the renminbi as a secondary trading and reserve currency for emerging markets has further implications. The late French economist Jacques Rueff showed convincingly how, when global trade moved from a gold-based settlement system to a US dollar-based system, purchasing power was duplicated. As the authors of a recent Wall Street Journal article citing Reuff’s work explained: “If the Banque de France counts among its reserves dollar claims (and not just gold and French francs) – for example a Banque de France deposit in a New York bank – this increases the money supply in France but without reducing the money supply of the US. So both countries can use these dollar assets to grant credit.” Replace Banque de France with Bank Indonesia, and US dollar with renminbi and the same causes will lead to the same effects.

Consider British Columbia’s recently issued AAA-rated two year renminbi dim sum bond. Yielding 2.85%, this bond was actively subscribed to by foreign central banks, which ended up receiving more than 50% of the initial allocation (ten times as much as in the first British Columbia dim sum issue two years ago). After the issue British Columbia takes the proceeds and deposits them in a Chinese bank, thereby capturing a nice spread. In turn, the Chinese bank can multiply this money five times over (so goes money creation in China). Meanwhile, the Indonesian, Korean or Kazakh central banks that bought the bonds now have an asset on their balance sheet which they can use to back an expansion of trade with China…

Of course, for trade to flourish, countries need to be able to specialize in their respective comparative advantages, hence the importance of the kind of free trade deals discussed at the recent APEC meeting. But free trade deals are not enough; countries also need trade infrastructure (ports, airports, telecoms, trade finance banks etc…). This brings us to China’s ‘new silk road’ strategy and the recent announcement by Beijing of a US$40bn fund to help finance road and rail infrastructure in the various ‘stans’ on its western borders in a development that promises to cut the travel time from China to Europe from the current 30 days by sea to ten days or less overland.

Needless to say, such a dramatic reduction in transportation time could help prompt some heavy industry to relocate from Europe to Asia.

That’s not all. At July’s BRICS summit in Brazil, leaders of the five member nations signed a treaty launching the US$50bn New Development Bank, which Beijing hopes will be modeled on China Development Bank, and is likely to compete with the World Bank. This will be followed by the establishment of a China-dominated BRICS contingency fund (challenging the International Monetary Fund). Also on the cards is an Asian Infrastructure Investment Bank to rival the Asian Development Bank.

So what looks likely to take shape over the next few years is a network of railroads and motorways linking China’s main production centers to Bangkok, Singapore, Karachi, Almaty, Moscow, Yangon, Kolkata. We will see pipelines, dams, and power plants built in Siberia, Central Asia, Pakistan and Myanmar; as well as airports, hotels, business centers… and all of this financed with China’s excess savings, and leverage. Given that China today has excess production capacity in all of these sectors, one does not need a fistful of university diplomas to figure out whose companies will get the pick of the construction contracts.

But to finance all of this, and to transform herself into a capital exporter, China needs stable capital markets and a strong, convertible currency. This explains why, despite Hong Kong’s pro-democracy demonstrations, Beijing is pressing ahead with the internationalization of the renminbi using the former British colony as its proving ground (witness the Shanghai-HK stock connect scheme and the removal of renminbi restrictions on Hong Kong residents). And it is why renminbi bonds have delivered better risk-adjusted returns over the past five years than almost any other fixed income market.

Of course, China’s strategy of internationalizing the renminbi, and integrating its neighbors into its own economy might fall flat on its face. Some neighbors bitterly resent China’s increasing assertiveness. Nonetheless, the big story in China today is not ‘ghost cities’ (how long has that one been around?) or undercapitalized banks. The major story is China’s reluctance to continue funneling its excess savings into US treasuries yielding less than 2%, and its willingness to use that capital instead to integrate its neighbors’ economies with its own; using its own currency and its low funding costs as an ‘appeal product’ (and having its own companies pick up the contracts as a bonus). In essence, is this so different from what the US did in Europe in the 1940s and 1950s with the Marshall Plan?

2. Japan: Is Abenomics just a sideshow?

With Japan in the middle of a triple dip recession, and Japanese households suffering a significant contraction in real disposable income, it might seem that Prime Minister Shinzo Abe has chosen an odd time to call a snap election. Three big factors explain his decision:

1)   The Japanese opposition is in complete disarray. So Abe’s decision may primarily have been opportunistic.

2)   We must remember that Abe is the most nationalist prime minister Japan has produced in a generation. The expansion of China’s economic presence across Central and South East Asia will have left him feeling at least as uncomfortable as anyone who witnessed his Apec handshake with Xi Jinping three weeks ago. It is not hard to imagine that Abe returned from Beijing convinced that he needs to step up Japan’s military development; a policy that requires him to command a greater parliamentary majority than he holds now.

3)   The final factor explaining Abe’s decision to call an election may be that in Japan the government’s performance in opinion polls seems to mirror the performance of the local stock market (wouldn’t Barack Obama like to see such a correlation in the US?). With the Nikkei breaking out to new highs, Abe may feel that now is the best time to try and cement his party’s dominant position in the Diet.

As he gets ready to face the voters, how should Abe attempt to portray himself? In our view, he could do worse than present himself as Japan Inc’s biggest salesman. Since the start of his second mandate, Abe has visited 49 countries in 21 months, and taken hundreds of different Japanese CEOs along with him for the ride. The message these CEOs have been spreading is simple: Japan is a very different place from 20 years ago. Companies are doing different things, and investment patterns have changed. Many companies have morphed into completely different animals, and are delivering handsome returns as a result. The relative year to date outperformances of Toyo Tire (+117%), Minebea (+95%), Mabuchi (+57%), Renesas (+43%), Fuji Film (+33%), NGK Insulators (+33%) and Nachi-Fujikoshi (+19%) have been enormous. Or take Panasonic as an example: the old television maker has transformed itself into a car parts firm, piggy-backing on the growth of Tesla’s model S.

Yet even as these changes have occurred, most foreign investors have stopped visiting Japan, and most sell-side firms have stopped funding genuine and original research. For the alert investor this is good news. As the number of Japanese firms at the heart of the disruptions reshaping our global economy – robotics, electric and self-driving cars, alternative energy, healthcare, care for the elderly – continues to expand, and as the number of investors looking at these same firms continues to shrink, those investors willing to sift the gravel of corporate Japan should be able to find real gems.

Which brings us to the real question confronting investors today: the ‘Kuroda put’ has placed Japanese equities back on investor’s maps. But is this just a short term phenomenon? After all, no nation has ever prospered by devaluing its currency. If Japan is set to attract, and retain, foreign investor flows, it will have to come up with a more compelling story than ‘we print money faster than anyone else’.

In our recent research, we have argued that this is exactly what is happening. In fact, we believe so much in the opportunity that we have launched a dedicated Japan corporate research service (GK Plus Alpha) whose principals (Alicia Walker and Neil Newman) are burning shoe leather to identify the disruptive companies that will trigger Japan’s next wave of growth.

3. Should we worry about capital misallocation in the US?

The US has now ‘enjoyed’ a free cost of money for some six years. The logic behind the zero-interest rate policy was simple enough: after the trauma of 2008, the animal spirits of entrepreneurs needed to be prodded back to life. Unfortunately, the last few years have reminded everyone that the average entrepreneur or investor typically borrows for one of two reasons:

  • Capital spending: Business is expanding, so our entrepreneur borrows to open a new plant, or hire more people, etc.
     
  • Financial engineering: The entrepreneur or investor borrows in order to purchase an existing cash flow, or stream of income. In this case, our borrower calculates the present value of a given income stream, and if this present value is higher than the cost of the debt required to own it, then the transaction makes sense.

Unfortunately, the second type of borrowing does not lead to an increase in the stock of capital. It simply leads to a change in the ownership of capital at higher and higher prices, with the ownership of an asset often moving away from entrepreneurs and towards financial middlemen or institutions. So instead of an increase in an economy’s capital stock (as we would get with increased borrowing for capital spending), with financial engineering all we see is a net increase in the total amount of debt and a greater concentration of asset ownership. And the higher the debt levels and ownership concentration, the greater the system’s fragility and its inability to weather shocks.

We are not arguing that financial engineering has reached its natural limits in the US. Who knows where those limits stand in a zero interest rate world? However, we would highlight that the recent new highs in US equities have not been accompanied by new lows in corporate spreads. Instead, the spread between 5-year BBB bonds and 5-year US treasuries has widened by more than 30 basis points since this summer.

Behind these wider spreads lies a simple reality: corporate bonds issued by energy sector companies have lately been taken to the woodshed. In fact, the spread between the bonds of energy companies, and those of other US corporates are back at highs not seen since the recession of 2001-2002, when the oil price was at US$30 a barrel.

The market’s behavior raises the question whether the energy industry has been the black hole of capital misallocation in the era of quantitative easing. As our friend Josh Ayers of Paradarch Advisors (Josh publishes a weekly entitled The Right Tale, which is a fount of interesting ideas. He can be reached at josh@paradarchadvisors.com) put it in a recent note: “After surviving the resource nadir of the late 1980s and 1990s, oil and gas firms started pumping up capex as the new millennium began. However, it wasn’t until the purported end of the global financial crisis in 2009 that capital expenditure in the oil patch went into hyperdrive, at which point capex from the S&P 500’s oil and gas subcomponents jumped from roughly 7% of total US fixed investment to over 10% today.”

“It’s no secret that a decade’s worth of higher global oil prices justified much of the early ramp-up in capex, but a more thoughtful look at the underlying data suggests we’re now deep in the malinvestment phase of the oil and gas business cycle. The second chart (above) displays both the total annual capex and the return on that capex (net income/capex) for the ten largest holdings in the Energy Select Sector SPDR (XLE). The most troublesome aspect of this chart is that, since 2010, returns have been declining as capex outlays are increasing. Furthermore, this divergence is occurring despite WTI crude prices averaging nearly $96 per barrel during that period,” Josh noted.

The energy sector may not be the only place where capital has been misallocated on a grand scale. The other industry with a fairly large target on its back is the financial sector. For a start, policymakers around the world have basically decided that, for all intents and purposes, whenever a ‘decision maker’ in the financial industry makes a decision, someone else should be looking over the decision maker’s shoulder to ensure that the decision is appropriate. Take HSBC’s latest results: HSBC added 1400 compliance staff in one quarter, and plans to add another 1000 over the next quarter. From this, we can draw one of two conclusions:

1)   The financial firms that will win are the large firms, as they can afford the compliance costs.

2)   The winners will be the firms that say: “Fine, let’s get rid of the decision maker. Then we won’t need to hire the compliance guy either”.

This brings us to a theme first explored by our friend Paul Jeffery, who back in September wrote: “In 1994 Bill Gates observed: ‘Banking is necessary, banks are not’. The primary function of a bank is to bring savers and users of capital together in order to facilitate an exchange. In return for their role as [trusted] intermediaries banks charge a generous net spread. To date, this hefty added cost has been accepted by the public due to the lack of a credible alternative, as well as the general oligopolistic structure of the banking industry. What Lending Club and other P2P lenders do is provide an online market-place that connects borrowers and lenders directly; think the eBay of loans and you have the right conceptual grasp. Moreover, the business model of online market-place lending breaks with a banking tradition, dating back to 14th century Florence, of operating on a “fractional reserve” basis. In the case of P2P intermediation, lending can be thought of as being “fully reserved” and entails no balance sheet risk on the part of the service facilitator. Instead, the intermediary receives a fee- based revenue stream rather than a spread-based income.”

There is another way we can look at it: finance today is an abnormal industry in two important ways:

1)   The more the sector spends on information and communications technology, the bigger a proportion of the economic pie the industry captures. This is a complete anomaly. In all other industries (retail, energy, telecoms…), spending on ICT has delivered savings for the consumers. In finance, investment in ICT (think shaving seconds of trading times in order to front run customer orders legally) has not delivered savings for consumers, nor even bigger dividends for shareholders, but fatter bonuses and profits for bankers.

2)   The second way finance is an abnormal industry (perhaps unsurprisingly given the first factor) lies in the banks’ inability to pass on anything of value to their customers, at least as far as customer’s perceptions are concerned. Indeed, in ‘brand surveys’ and ‘consumer satisfaction reports’, banks regularly bring up the rear. Who today loves their bank in a way that some people ‘love’ Walmart, Costco, IKEA, Amazon, Apple, Google, Uber, etc?

Most importantly, and as Paul highlights above, if the whole point of the internet is to:

a) measure more efficiently what each individual needs, and

b) eliminate unnecessary intermediaries,

then we should expect a lot of the financial industry’s safe and steady margins to come under heavy pressure. This has already started in the broking and in the money management industries (where mediocre money managers and other closet indexers are being replaced by ETFs). But why shouldn’t we start to see banks’ high return consumer loan, SME loan and credit card loan businesses replaced, at a faster and faster pace, by peer-to-peer lending? Why should consumers continue to pay high fees for bank transfers, or credit cards when increasingly such services are offered at much lower costs by firms such as TransferWise, services like Alipay and Apple Pay, or simply by new currencies such as Bitcoin? On this point, we should note that in the 17 days that followed the launch of Apple Pay on the iPhone 6, almost 1% of Wholefoods’ transactions were processed using the new payment system. The likes of Apple, Google, Facebook and Amazon have grown into behemoths by upending the media, advertising retail and entertainment industries. Such a rapid take- up rate for Apple Pay is a powerful indicator which sector is likely to be next in line. How else can these tech giants keep growing and avoid the fate that befell Sony, Microsoft and Nokia? On their past record, the technology companies will find margins, and growth, in upending our countries’ financial infrastructure. As they do, a lot of capital (both human and monetary) deployed in the current infrastructure will find itself obsolete.

This possibility raises a number of questions – not least for Gavekal’s own investment process, which relies heavily on changes in the velocity of money and in the willingness and ability of commercial banks to multiply money, to judge whether it makes sense to increase portfolio risk. What happens to a world that moves ‘ex-bank’ and where most new loans are extended peer-to-peer? In such a world, the banking multiplier disappears along with fractional reserve banking (and consequently the need for regulators? Dare to dream…). As bankers stop lending their clients umbrellas when it is sunny, and taking them away when it rains, will our economic cycles become much tamer? As central banks everywhere print money aggressively, could the market be in the process of creating currencies no longer based on the borders of nation states, but instead on the cross-border networks of large corporations (Alipay, Apple Pay…), or even on voluntary communities (Bitcoin). Does this mean we are approaching the Austrian dream of a world with many, non government-supported, currencies?

4. Should we care about Europe?

In our September Quarterly Strategy Chartbook, we debated whether the eurozone was set for a revival (the point expounded by François) or a continued period stuck in the doldrums (Charles’s view), or whether we should even care (my point). At the crux of this divergence in views is the question whether euroland is broadly following the Japanese deflationary bust path. Pointing to this possibility are the facts that 11 out of 15 eurozone countries are now registering annual year-on-year declines in CPI, that policy responses have so far been late, unclear and haphazard (as they were in Japan), and that the solutions mooted (e.g. European Commission president Jean-Claude Juncker’s €315bn infrastructure spending plan) recall the solutions adopted in Japan (remember all those bridges to nowhere?). And that’s before going into the structural parallels: ageing populations; dysfunctional, undercapitalized and overcrowded banking systems; influential segments of the population eager to maintain the status quo etc…

With the same causes at work, should we expect the same consequences? Does the continued underperformance of eurozone stocks simply reflect that managing companies in a deflationary environment is a very challenging task? If euroland has really entered a Japanese-style deflationary bust likely to extend years into the future, the conclusion almost draws itself.

The main lesson investors have learned from the Japanese experience of 1990-2013 is that the only time to buy stocks in an economy undergoing a deflationary bust is:

a)   when stocks are massively undervalued relative both to their peers and to their own history, and

b)   when a significant policy change is on the way.

This was the situation in Japan in 1999 (the first round of QE under PM Keizo Obuchi), 2005 (PM Junichiro Koizumi’s bank recapitalization program) and of course in 2013-14 (Abenomics). Otherwise, in a deflationary environment with no or low growth, there is no real reason to pile into equities. One does much better in debt. So, if the Japan-Europe parallel runs true, it only makes sense to look at eurozone equities when they are both massively undervalued relative to their own histories and there are expectations of a big policy change. This was the case in the spring of 2012 when valuations were at extremes, and Mario Draghi replaced Jean-Claude Trichet as ECB president. In the absence of these two conditions, the marginal dollar looking for equity risk will head for sunnier climes.

With this in mind, there are two possible arguments for an exposure to eurozone equities:

1)   The analogy of Japan is misleading as euroland will not experience a deflationary bust (or will soon emerge from deflation).

2)   We are reaching the point when our two conditions – attractive valuations, combined with policy shock and awe – are about to be met. Thus we could be reaching the point when euroland equities start to deliver outsized returns.

Proponents of the first argument will want to overweight euroland equities now, as this scenario should lead to a rebound in both the euro and European equities (so anyone underweight in their portfolios would struggle). However, it has to be said that the odds against this first outcome appear to get longer with almost every data release!

Proponents of the second scenario, however, can afford to sit back and wait, because it is likely any outperformance in eurozone equities would be accompanied by euro currency weakness. Hence, as a percentage of a total benchmark, European equities would not surge, because the rise in equities would be offset by the falling euro.

Alternatively, investors who are skeptical about either of these two propositions can – like us – continue to use euroland as a source of, rather than as a destination for, capital. And they can afford safely to ignore events unfolding in euroland as they seek rewarding investment opportunities in the US or Asia. In short, over the coming years investors may adopt the same view towards the eurozone that they took towards Japan for the last decade: ‘Neither loved, nor hated… simply ignored’.

Conclusion:

Most investors go about their job trying to identify ‘winners’. But more often than not, investing is about avoiding losers. Like successful gamblers at the racing track, an investor’s starting point should be to eliminate the assets that do not stand a chance, and then spread the rest of one’s capital amongst the remainder.

For example, if in 1981 an investor had decided to forego investing in commodities and simply to diversify his holdings across other asset classes, his decision would have been enough to earn himself a decade at the beach. If our investor had then returned to the office in 1990, and again made just one decision – to own nothing in Japan – he could once again have gone back to sipping margaritas for the next ten years. In 2000, the decision had to be not to own overvalued technology stocks. By 2006, our investor needed to start selling his holdings in financials around the world. And by 2008, the money-saving decision would have been to forego investing in euroland.

Of course hindsight is twenty-twenty, and any investor who managed to avoid all these potholes would have done extremely well. Nevertheless, the big question confronting investors today is how to avoid the potholes of tomorrow. To succeed, we believe that investors need to answer the following questions:

  • Will Japan engineer a revival through its lead in exciting new technologies (robotics, hi-tech help for the elderly, electric and driverless cars etc…), or will Abenomics prove to be the last hurrah of a society unable to adjust to the 21st century? Our research is following these questions closely through our new GK Plus Alpha venture.
     
  • Will China slowly sink under the weight of the past decade’s malinvestment and the accompanying rise in debt (the consensus view) or will it successfully establish itself as Asia’s new hegemon? Our Beijing based research team is very much on top of these questions, especially Tom Miller, who by next Christmas should have a book out charting the geopolitical impact of China’s rise.
     
  • Will Indian prime minister Narendra Modi succeed in plucking the low-hanging fruit so visible in India, building new infrastructure, deregulating services, cutting protectionism, etc? If so, will India start to pull its weight in the global economy and financial markets?
     
  • How will the world deal with a US economy that may no longer run current account deficits, and may no longer be keen to finance large armies? Does such a combination not almost guarantee the success of China’s strategy?
     
  • If the US dollar is entering a long term structural bull market, who are the winners and losers? The knee-jerk reaction has been to say ‘emerging markets will be the losers’ (simply because they were in the past. But the reality is that most emerging markets have large US dollar reserves and can withstand a strong US currency. Instead, will the big losers from the US dollar be the commodity producers?
     
  • Have we reached ‘peak demand’ for oil? If so, does this mean that we have years ahead of us in which markets and investors will have to digest the past five years of capital misallocation into commodities?
     
  • Talking of capital misallocation, does the continued trend of share buybacks render our financial system more fragile (through higher gearing) and so more likely to crack in the face of exogenous shocks? If it does, one key problem may be that although we may have made our banks safer through increased regulations (since banks are not allowed to take risks anymore), we may well have made our financial markets more volatile (since banks are no longer allowed to trade their balance sheets to benefit from spikes in volatility). This much appeared obvious from the behavior of US fixed income markets in the days following Bill Gross’s departure from PIMCO. In turn, if banks are not allowed to take risks at volatile times, then central banks will always be called upon to act, which guarantees more capital misallocation, share buybacks and further fragilization of the system (expect more debates along this theme between Charles, and Anatole).
     
  • Will the financial sector be next to undergo disintermediation by the internet (after advertising and the media). If so, what will the macro- consequences be? (Hint: not good for the pound or London property.)
     
  • Is euroland following the Japanese deflationary-bust roadmap?

The answers to these questions will drive performance for years to come. In the meantime, we continue to believe that a portfolio which avoids a) euroland, b) banks, and c) commodities, will do well – perhaps well enough to continue funding Mediterranean beach holidays – especially as these are likely to go on getting cheaper for anyone not earning euros!

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Important Disclosures

Things That Make You Go Hmmm: Signing Off

 

On Christmas Eve 1979, 27 days before I became a teenager, in a surburban street in Moseley in Britain’s West Midlands, a group of musicians put the finishing touches on their debut album.

The musicians — Brian Travers, Astro, James Brown (no, not that one), Earl Falconer, Norman Hassan, Mickey Virtue, and twins Ali and Robin Campbell — had a unique approach to the music business.

Eighteen months prior to completing their first album, Ali Campbell and Travers had plastered the streets of Birmingham with leaflets promoting the band, which had taken its name from the document issued to people claiming unemployment benefits from the UK government’s Department of Health and Social Security (DHSS). The name of the form — and thus the band — was UB40.

Having advertised themselves and with dreams of making a big splash on Britain’s reinvigorated music scene running wild in their heads, the band had just one remaining item on their to-do list — learn to play their instruments.

The members of UB40 made an agreement to spend the next year doing nothing other than learning their instruments and practising their songs until they felt they were good enough.

(I know, I know! This IS analagous to many modern-day Central Bank policy efforts, but that’s not where I’m going with this, so stop jumping ahead.)

Anyway, after about a year, the band felt competent enough to play in public; and they made their debut on the 9th of February, 1979, in an upstairs room at the Hare & Hounds, a small pub in King’s Heath. They had been “booked” by a friend to celebrate his birthday.

Following on the success of their first gig (apparently, the birthday boy was delighted), the band secured a series of similar shows, all in local pubs, at which they planned to unleash their blend of reggae and dub onto an unsuspecting public who, though they didn’t realise it, had been waiting for UB40 for years.

Remarkably, at one of these pub gigs, Chrissie Hynde just happened to be in attendance, no doubt supping a couple of pints of Throgmorton’s Dubious Explanation (a real ale so thick it’s served by the slice); and she liked what she saw so much, she offered the band a supporting slot on The Pretenders’ upcoming tour of the UK.

Simple.

Fast-forward to Christmas 1979, and the story of the recording of the band’s debut album burnishes the legend yet further:

(Wikipedia): The band approached local musician Bob Lamb as he was the only person they knew with any recording experience. Lamb had been the drummer with the Steve Gibbons Band for much of the 1970s and was a well-known figure within the Birmingham music scene…. However, as the band were unable to afford a proper recording studio, the album was recorded in Lamb’s own home at the time, a ground-floor flat in a house on Cambridge Road in Birmingham’s Moseley district….

Brian Travers recalled just how basic the recording facilities of the original Cambridge Road “studio” really were:

Because we couldn’t afford a studio and he was the only guy we knew who knew how to record music, we did the album in his bedsit. I remember he had his bed on stilts. So underneath the bed was a sofa and mixing desk. And so we recorded the album there on an eight-track machine, with the same 50p coin going through the electric meter continually because we’d booted the lock off it. And, with it being a bedsit and us being eight in the band, we’d record the saxophone in the kitchen — because there was a bit of resonance off the walls, a bit of reverb — before putting the machine effects on it. While the percussion — the tambourines, the congas, the drums — we’d do in the back yard. Which is why you can hear birds singing on some of the tracks! You know, because it was in the daytime we’d be shouting across the fences “Keep it DOWN! We’re RECORDING!”

Lamb remembered the process fondly:

Nothing was hard work about that album, it was a bit of a dream that sort of fell out of the sky… It was almost effortless to make in that they were so good at the time, and so happy at the time with the success that they got, there was no effort in it.

The title of the album, “Signing Off,” was inspired by the process of the band members ending their claim on UK unemployment benefits — and becoming pop stars.

The LP (Google it, Gen Y-ers), released on August 29, 1980, spent 71 weeks on the UK albums chart, peaking at number 2 and turning platinum (when doing such a thing used to mean something). It was greeted with rapture by Britain’s music press:

(Sounds): Five stars out of five. It is an (almost) perfect album…. It’s rare to find a debut album so detailed, so excellently played and so packed with bite — I sometimes think it hasn’t really happened since The Clash.

The album would go on to make Q Magazine’s “100 Greatest British Albums Ever” (#83, if you’re interested) and is featured in a book somewhat somberly titled 1001 Albums to Hear Before You Die.

I think it’s fair to say I played my part in the success of the band by spending the pocket money I had saved up on a copy of “Signing Off” (though the band have so far not publicly acknowledged my involvement).

Anyway, as I am now signing off from Mauldin Economics, I felt it would be appropriate to take stock of a few of the issues I have covered ad nauseum repeatedly during my two-plus years working with John and his team; and I thought I’d also take those of you unfamiliar with UB40’s debut album through a few of the tracks (and remind those of you who know the band just how spectacular that album was).

Track 2. King — 4:35

The “King” referred to in the second track on “Signing Off” was, of course, Martin Luther King, Jr. The song was short on lyrics but big on impact; however, the undoubted “King” in markets today is once again King Dollar, and the world’s reserve currency is making some serious waves right now, which threaten to cause chaos in world markets.

At this point I’ll throw things over to my friend and partner in Real Vision Television and author of The Global Macro Investor, Raoul Pal, who has been warning of the likelihood of a major move in the dollar for longer than just about anybody. In his most recent report, he explained the ramifications of a dollar bull market in the clearest, most concise way possible:

(Raoul Pal): Debt dynamics, deflation, positioning and technicals all suggest that a dollar bull market of some considerable velocity and length is underway.

When dollar bull markets occur, emerging markets get hit.

When dollar bull markets occur, carry trades get unwound.

When dollar bull markets occur, they tend to usher in disinflationary forces as commodities and goods get re-priced.

The preceding three factors lead to a self-reinforcing of the dollar bull market, creating more of the same in a cycle of liquidation and bad debts, creating more demand for US dollars.

As I said, clear and concise.

I watched Raoul present at the iCIO Summit this past week, and his presentation was compelling, to say the least. As he pointed out in a panel discussion with Mark Yusko, Dennis Gartman, David Rosenberg, and myself, “When currencies begin to trend, they can do so for decades.”

A sobering thought.

A look at the long-term charts of the DXY Index shows just how massive the potential reversal of this trend is; and based on Raoul’s roadmap, the sheer size of the reversal gives us a strong hint of the degree of carnage that will be wrought upon a world in which the dollar carry trade has reached somewhere between $5 trillion and $9 trillion.

Incidentally, one of those estimates is Raoul’s, and one belongs to the BIS, and I bet your first guess as to which is which would have been wrong.

A closer look at a shorter-term chart demonstrates the recent break clearly:

The BIS report to which I refer was published last week, and it was astounding in terms of the sheer size of the dollar carry trade it depicted.

According to the BIS, US dollar loans to China’s banks and companies have jumped to $1.1 trillion — that’s TRILLION — from virtually zero just five short years ago. The annual rate of increase of those loans is a mind-boggling 47%.

However, the fun doesn’t stop there.

Consider Brazil, for example, where cross-border dollar credit now stands at $461 billion, or roughly 20% of GDP. For Mexico those numbers are even more eye-watering. A country with a GDP of just $1.1 trillion has outstanding cross-border dollar credit of $381 billion — or roughly 30% of GDP. Frightening.

Meanwhile, in Russia the same metric has reached $751 billion. Why does this matter? Well, the charts below, which show the appreciation of the US dollar against those three currencies in the last five years, highlight the danger to countries that have been able to borrow seemingly endless amounts of (relatively) stable dollars to finance business operations and expansion.

Lastly — and perhaps most importantly — witness the change in direction of the Chinese renminbi which, after trending higher against the dollar for many years (and, in the process, moving virtually everybody to the same side of the boat in the belief that a stronger Chinese currency was a given), has suddenly started to look as if it may also succumb to the renewed strength of the dollar. The only difference here being that the Chinese may actively be looking now to devalue their currency in light of the ongoing attempt by the Japanese to devaluetheir way back to competitiveness. Few thought this a likely scenario until very recently; consequently, few are positioned accordingly; and when things like that happen in the macro world, you can get some REALLY funky moves.

When currency wars break out, they can get very nasty very quickly.

 

Under no circumstances should you take your eyes off the US dollar, folks. The sheer number of places where you will witness the knock-on effects of a soaring dollar — chief amongst them emerging markets and the commodity space — will be breathtaking.

I will write at greater length on the likely effects of the dollar’s move on gold in a few weeks, as it warrants a piece all its own; so stay tuned for that one.

In a series of conversations I’ve been fortunate to have had with some of the best macro traders in the world in recent months through Real Vision Television, there has been one overarching takeaway from every one of them: macro is back, and 2015 is shaping up to be an epic year for the guys who trade these fundamental shifts. To a man, after several years of little action in the macro world, they are positively licking their lips at the potential opportunities that are headed their way next year.

One person’s opportunity is another person’s crisis. You have been warned.

3. 12 Bar — 4:24

Track 3 was an instrumental number called “12 Bar,” a reggae reimagining of the 12-bar blues that highlighted Brian Travers’ remarkably good saxophony skills (given his lack of attention to learning to play the instrument before forming the band).

Obviously, during my time with Mauldin Economics, the “bars” which have preoccupied me have been those of the gold variety — and for the most part, their constant movement in an easterly direction.

I have written article after article and given presentation after presentation about the dichotomy between paper and physical gold and have regularly highlighted the magnitude of the flow of gold out of the West and into strong Eastern hands. In the previous edition of this publication (“How Could It Happen?”), I imagined a future in which this stunning relocation of physical gold had finally mattered; and between publishing that piece and penning this one, a couple of interesting things have happened. Firstly, my friend Barry Ritholtz took a big, fat shot at me in a Bloomberg column entitled “The Gold Fairy Tale Fails Again.” Barry’s article (which was entirely consistent with his very public and oft-stated thinking and was, as is always the case with Barry, very well-written) took apart what he sees as the various failed narratives in the gold markets. He began with gold’s link to QE:

(Barry Ritholtz): [T]he most popular gold narrative was that the Federal Reserve’s program of quantitative easing would lead to the collapse of the dollar and hyperinflation. “The problem with all of this was that even as the narrative was failing, the storytellers never changed their tale. The dollar hit three-year highs, despite QE. Inflation was nowhere to be found,” I wrote at the time…

… moved on to the recent SGI:

Switzerland was going to save gold based on a ballot proposal stipulating that the Swiss National Bank hold at least 20 percent of its 520-billion-franc ($538 billion) balance sheet in gold, repatriate overseas gold holdings and never sell bullion in the future. This was going to be the driver of the next leg up in gold. Except for the small fact that the “Save Our Swiss Gold” proposal was voted down, 77 percent to 23 percent, by the electorate….

… then hit upon the recent Indian import restrictions and reports of gold shortages, which Barry clearly feels are spurious, before eventually finding his way to yours truly:

Perhaps the most egregious narrative failure came from Grant Williams of Mauldin Economics. He imagined a conversation 30 years from now about China’s secret three-decade-long gold-buying spree, dating to November 2014. Well, we only need to wait 30 years to see if this prediction is correct.

Now, in response to the lighting up of my Twitter feed after Barry’s article was posted (and my thanks to all those who kindly pointed it out to me), I would say this: Barry is right on all counts.

For now.

I am delighted to be able to call Barry a friend and have absolutely no problem with his calling me out on what I said. Those of us who possess sufficient hubris to deem our thoughts worthy of distribution wider than the inside of our own heads are absolutely there to be taken to task should others disagree with us. We make ourselves fair game the second we hit the wires.

Sadly, none of us actually KNOW anything. How could we? We all take whatever inputs we find and then use them to reach our own conclusions based mostly on probability, and more often than not those conclusions are wrong.

HOWEVER… if your logic is sound and your thought processes rigorous, being wrong is often a temporary state — something that can also be said about being right, of course. In my humble opinion, the issue with gold today is not one of narrative, as Barry suggests, but rather that the extent of the current interference in markets by our friends at the various central banks around the world has meant that being wrong (no matter which part of the financial jigsaw puzzle you may be concerned with) has never been easier — even though being right has never, in my own mind at least, been more assured in the long term, certainly as far as gold is concerned.

As I slumped against the literary ropes, Barry threw one more punch when he suggested that the reader would “only need to wait 30 years to see if this prediction is correct,” but this is where I stop covering up and finally flick a jab or two of my own.

I think the chances of having to wait 30 years to see the gold conundrum resolve itself (in materially higher prices, I might add) lie close to those of Barry’s being invited to give the opening address at the next GATA conference. The evidence is crystal clear that significant quantities of physical gold have been pouring into Eastern vaults (due to both private- and public-sector activity); and gold is, after all, a finite resource. Not only that, but the “weakness” in gold (which remains roughly 500% above its turn-of-the-century low, despite the recent 30% correction) is confined to the paper market.

Whilst this distinction between paper and real gold hasn’t mattered up until now, there will come a day when it absolutely does — to everybody — and at that point, anyone not positioned correctly will be in a world of hurt.

(Charts above and below courtesy of Nick Laird at Sharelynx and Koos Jansen)

Tightness in the physical market has increased consistently as the likes of Russia continue to stockpile ever-increasing amounts of gold and as Chinese imports as well as withdrawals from the Shanghai Gold Exchange maintain a torrid pace. The only missing piece of the puzzle is the lack of any official acknowledgement that the Chinese have been doing the same thing to a far greater degree; and, as I wrote in “How Could It Happen?”, there is a curious demand for absolute proof from those who dispute official figures, whilst the principle of reasonable doubt continues to hold sway on the other side of the argument.

I suspect that imbalance will right itself — possibly very soon — and when it does there will be absolutely no putting the genie back into the bottle.

In the meantime, as Barry so confidently predicted, the Swiss Gold Initiative failed, but that was overshadowed (in my mind at least) by a couple of very interesting developments that were covered beautifully by two of my buddies, Willem Middelkoop (author of The Big Reset — a phenomenal read) and Koos Jansen.

Firstly, Koos reported on the increasing drive to allocate the gold held within the Eurosystem:

(Koos Jansen): [M]ost of the Eurosystem official gold reserves are allocated, and since January 2014 (which is as far as the more detailed data goes back) the unallocated gold reserves are declining, as we can see in the next chart.

Unfortunately we do not know what happened prior to 2014.

Note, allocated does not mean the gold is located on own soil, but it does mean the gold is assigned to specific gold holdings, including bar numbers, whether stored on own soil or stored abroad. Unallocated gold relates to gold held without a claim on specified bar numbers; often these unallocated accounts are used for easy trading… The fact the Eurosystem discloses the ratio between its allocated and unallocated gold and, more important, the fact that the portion of allocated gold is far greater and increasing, tells me the Eurosystem is allocating as much gold as they can.

Secondly, another repatriation request was unearthed — this time made by perhaps the least likely source imaginable:

(Koos Jansen): In Europe, so far, Germany has been repatriating gold since 2012 from the US and France, The Netherlands has repatriated 122.5 tonnes a few weeks ago from the US, soon after Marine Le Pen, leader of the Front National party of France, penned an open letter to Christian Noyer, governor of the Bank of France, requesting that the country’s gold holdings be repatriated back to France; and now Belgium is making a move. Who’s next? And why are all these countries seemingly so nervous to get their gold ASAP on own soil?

Funnily enough, the answer to Koos’ rhetorical question about who’s next was answered just a few days later:

(Bloomberg): The Austrian state audit court says central bank should address concentration risk of storing 80% of its gold reserves with the Bank of England, Standard reports, citing draft audit report. Court advises central bank to diversify storage locations, contract partners.

Austrian central bank reviewing gold storage concept, doesn’t rule out relocating some of its gold from London to Austria: Standard cites unidentified central bank officials. Austria has 280 tons gold reserves, according to 2013 annual report. Austrian Audit Court Will Review Nation’s Gold Reserves in U.K.

Say what you want about the gold price languishing below $1200 (or not, as the case may be, after this week), and say what you want about the technical picture or the “6,000-year bubble,” as Citi’s Willem Buiter recently termed it; but know this: gold is an insurance policy — not a trading vehicle — and the time to assess gold is when people have a sudden need for insurance. When that day comes — and believe me, it’s coming — the price will be the very last thing that matters. It will be purely and simply a matter of securing possession — bubble or not — and at any price.

That price will NOT be $1200.

A “run” on the gold “bank” (something I predicted would happen when I wrote about Hugo Chavez’s original repatriation request back in 2011) would undoubtedly lead to one of those Warren Buffett moments when a bunch of people are left standing naked on the shore.

It is also a phenomenon which will begin quietly before suddenly exploding into life.

If you listen very carefully, you can hear something happening…

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

The article Things That Make You Go Hmmm: Signing Off was originally published at mauldineconomics.com.

Thoughts from the Frontline: Oil, Employment, and Growth

 

Last week we started a series of letters on the topics I think we need to research in depth as we try to peer into the future and think about how 2015 will unfold. In forecasting US growth, I wrote that we really need to understand the relationships between the boom in energy production on the one hand and employment and overall growth in the US on the other. The old saw that falling oil prices are like a tax cut and are thus a net benefit to the US economy and consumers is not altogether clear to me. I certainly hope the net effect will be positive, but hope is not a realistic basis for a forecast. Let’s go back to two paragraphs I wrote last week:

Texas has been home to 40% of all new jobs created since June 2009. In 2013, the city of Houston had more housing starts than all of California. Much, though not all, of that growth is due directly to oil. Estimates are that 35–40% of total capital expenditure growth is related to energy. But it’s no secret that not only will energy-related capital expenditures not grow next year, they are likely to drop significantly. The news is full of stories about companies slashing their production budgets. This means lower employment, with all of the knock-on effects.

Lacy Hunt and I were talking yesterday about Texas and the oil industry. We have both lived through five periods of boom and bust, although I can only really remember three. This is a movie we’ve seen before, and we know how it ends. Texas Gov. Rick Perry has remarkable timing, slipping out the door to let new governor Greg Abbott to take over just in time to oversee rising unemployment in Texas. The good news for the rest of the country is that in prior Texas recessions the rest of the country has not been dragged down. But energy is not just a Texas and Louisiana story anymore. I will be looking for research as to how much energy development has contributed to growth and employment in the US.

Then the research began to trickle in, and over the last few days there has been a flood. As we will see, energy production has been the main driver of growth in the US economy for the last five years. But changing demographics suggest that we might not need the job-creation machine of energy production as much in the future to ensure overall employment growth.

When I sat down to begin writing this letter on Friday morning, I really intended to write about how falling commodity prices (nearly across the board) and the rise of the dollar are going to affect emerging markets. The risks of significant policy errors and an escalating currency war are very real and could be quite damaging to global growth. But we will get into that next week. Today we’re going to focus on some fascinating data on the interplay between energy and employment and the implications for growth of the US economy. (Note: this letter will print a little longer due to numerous charts, but the word count is actually shorter than usual.)

But first, a quick recommendation. I regularly interact with all the editors of our Mauldin Economics publications, but the subscription service I am most personally involved with is Over My Shoulder.

It is actually very popular (judging from the really high renewal rates), and I probably should mention it more often. Basically, I generally post somewhere between five and ten articles, reports, research pieces, essays, etc., each week to Over My Shoulder. They are sent directly to subscribers in PDF form, along with my comments on the pieces; and of course they’re posted to a subscribers-only section of our website. These articles are gleaned from the hundreds of items I read each week – they’re the ones I feel are most important for those of us who are trying to understand the economy. Often they are from private or subscription sources that I have permission to share occasionally with my readers.

This is not the typical linkfest where some blogger throws up 10 or 20 links every day from Bloomberg, the Wall Street Journal, newspapers, and a few research houses without really curating the material, hoping you will click to the webpage and make them a few pennies for their ads. I post only what I think is worth your time. Sometimes I go several days without any posts, and then there will be four or five in a few days. I don’t feel the need to post something every day if I’m not reading anything worth your time.

Over My Shoulder is like having me as your personal information assistant, finding you the articles that you should be reading – but I’m an assistant with access to hundreds of thousands of dollars of research and 30 years of training in sorting it all out. It’s like having an expert filter for the overwhelming flow of information that’s out there, helping you focus on what is most important.

Frankly, I think the quality of my research has improved over the last couple years precisely because I now have Worth Wray performing the same service for me as I do for Over My Shoulder subscribers. Having Worth on your team is many multiples more expensive than an Over My Shoulder subscription, but it is one of the best investments I’ve ever made. And our combined efforts and insights make Over My Shoulder a great bargain for you.

For the next three weeks, I’m going to change our Over My Shoulder process a bit. Both Worth and I are going to post the most relevant pieces we read as we put together our 2015 forecasts. This time of year there is an onslaught of forecasts and research, and we go through a ton of it. You will literally get to look “over my shoulder” at the research Worth and I will be thinking through as we develop our forecasts, and you will have a better basis for your own analysis of your portfolios and businesses for 2015.

And the best part of it is that Over My Shoulder is relatively cheap. My partners are wanting me to raise the price, and we may do that at some time, but for right now it will stay at $39 a quarter or $149 a year. If you are already a subscriber or if you subscribe in the next few days, I will hold that price for you for at least another three years. I just noticed on the order form (I should check these things more often) that my partners have included a 90-day, 100% money-back guarantee. I don’t remember making that offer when I launched the service, so this is my own version of Internet Monday.  

You can learn more and sign up for Over My Shoulder right here.

And now to our regularly scheduled program.

The Impact of Oil On US Growth

I had the pleasure recently of having lunch with longtime Maine fishing buddy Harvey Rosenblum, the long-serving but recently retired chief economist of the Dallas Federal Reserve. Like me, he has lived through multiple oil cycles here in Texas. He really understands the impact of oil on the Texas and US economies. He pointed me to two important sources of data.

The first is a research report published earlier this year by the Manhattan Institute, entitled “The Power and Growth Initiative Report.” Let me highlight a few of the key findings:

1. In recent years, America’s oil & gas boom has added $300–$400 billion annually to the economy – without this contribution, GDP growth would have been negative and the nation would have continued to be in recession.

2. America’s hydrocarbon revolution and its associated job creation are almost entirely the result of drilling & production by more than 20,000 small and midsize businesses, not a handful of “Big Oil” companies. In fact, the typical firm in the oil & gas industry employs fewer than 15 people. [We typically don’t think of the oil business as the place where small businesses are created, but for those of us who have been around the oil patch, we all know that it is. That tendency is becoming even more pronounced as the drilling process becomes more complicated and the need for specialists keeps rising. – John]

3. The shale oil & gas revolution has been the nation’s biggest single creator of solid, middle-class jobs – throughout the economy, from construction to services to information technology.

4. Overall, nearly 1 million Americans work directly in the oil & gas industry, and a total of 10 million jobs are associated with that industry.

Oil & gas jobs are widely geographically dispersed and have already had a significant impact in more than a dozen states: 16 states have more than 150,000 jobs directly in the oil & gas sector and hundreds of thousands more jobs due to growth in that sector.

Author Mark Mills highlighted the importance of oil in employment growth:

The important takeaway is that, without new energy production, post-recession US growth would have looked more like Europe’s – tepid, to say the least. Job growth would have barely budged over the last five years.

Further, it is not just a Texas and North Dakota play. The benefits have been widespread throughout the country. “For every person working directly in the oil and gas ecosystem, three are employed in related businesses,” says the report. (I should note that the Manhattan Institute is a conservative think tank, so the report is pro-energy-production; but for our purposes, the important thing is the impact of energy production on recent US economic growth.)

The next chart Harvey directed me to was one that’s on the Dallas Federal Reserve website, and it’s fascinating. It shows total payroll employment in each of the 12 Federal Reserve districts. No surprise, Texas (the Dallas Fed district) shows the largest growth (there are around 1.8 million oil-related jobs in Texas, according to the Manhattan Institute). Next largest is the Minneapolis Fed district, which includes North Dakota and the Bakken oil play. Note in the chart below that four districts have not gotten back to where they were in 2007, and another four have seen very little growth even after eight years. “It is no wonder,” said Harvey, “that so many people feel like we’re still in a recession; for where they live, it still is.”

To get the total picture, let’s go to the St. Louis Federal Reserve FRED database and look at the same employment numbers – but for the whole country. Notice that we’re up fewer than two million jobs since the beginning of the Great Recession. That’s a growth of fewer than two million jobs in eight years when the population was growing at multiples of that amount.

To put an exclamation point on that, Zero Hedge offers this thought:

Houston, we have a problem. With a third of S&P 500 capital expenditure due from the imploding energy sector (and with over 20% of the high-yield market dominated by these names), paying attention to any inflection point in the US oil-producers is critical as they have been gung-ho “unequivocally good” expanders even as oil prices began to fall. So, when Reuters reports a drop of almost 40 percent in new well permits issued across the United States in November, even the Fed’s Stan Fischer might start to question [whether] his [belief that] lower oil prices are “a phenomenon that’s making everybody better off” may warrant a rethink.

Consider: lower oil prices unequivocally “make everyone better off.” Right? Wrong. First: new oil well permits collapse 40% in November; why is this an issue? Because since December 2007, or roughly the start of the global depression, shale oil states have added 1.36 million jobs while non-shale states have lost 424,000 jobs.

The writer of this Zero Hedge piece, whoever it is (please understand there is no such person as Tyler Durden; the name is simply a pseudonym for several anonymous writers), concludes with a poignant question:

So, is [Fed Vice-Chairman] Stan Fischer’s “not very worried” remark about to become the new Ben “subprime contained” Bernanke of the last crisis?

Did the Fed Cause the Shale Bubble?

Next let’s turn to David Stockman (who I think writes even more than I do). He took aim at the Federal Reserve, which he accuses of creating the recent “shale bubble” just as it did the housing bubble, by keeping interest rates too low and forcing investors to reach for yield. There may be a little truth to that. The reality is that the recent energy boom was financed by $500 billion of credit extended to mostly “subprime” oil companies, who issued what are politely termed high-yield bonds – to the point that 20% of the high-yield market is now energy-production-related.

Sidebar: this is not quite the same problem as subprime loans were, for two reasons: first, the subprime loans were many times larger in total, and many of them were fraudulently misrepresented. Second, many of those loans were what one could characterize as “covenant light,” which means the borrowers can extend the loan, pay back in kind, or change the terms if they run into financial difficulty. So this energy-related high-yield problem is going to take a lot more time than the subprime crisis did to actually manifest, and there will not be immediate foreclosures. But it already clear that the problem is going to continue to negatively (and perhaps severely) impact the high-yield bond market. Once the problems in energy loans to many small companies become evident, prospective borrowers might start looking at the terms that the rest of the junk-bond market gets, which are just as egregious, so they might not like what they see. We clearly did not learn any lessons in 2005 to 2007 and have repeated the same mistakes in the junk-bond market today. If you lose your money this time, you probably deserve to lose it.

The high-yield shake-out, by the way, is going to make it far more difficult to raise money for energy production in the future, when the price of oil will inevitably rise again. The Saudis know exactly what they’re doing. But the current contretemps in the energy world is going to have implications for the rest of the leveraged markets. “Our biggest worry is the end of the liquidity cycle. The Fed is done. The reach for yield that we have seen since 2009 is going into reverse,” says Bank of America (source: The Telegraph).

Contained within Stockman’s analysis is some very interesting work on the nature of employment in the post-recession US economy. First, in the nonfarm business sector, the total hours of all persons working is still below that of 2007, even though we nominally have almost two million more jobs. Then David gives us two charts that illustrate the nature of the jobs we are creating (a topic I’ve discussed more than once in this letter). It’s nice to have somebody do the actual work for you.

The first chart shows what he calls “breadwinner jobs,” which are those in manufacturing, information technology, and other white-collar work that have an average pay rate of about $45,000 a year. Note that this chart encompasses two economic cycles covering both the Greenspan and Bernanke eras.

So where did the increase in jobs come from? From what Stockman calls the “part-time economy.” If I read this chart right and compare it to our earlier chart from the Federal Reserve, it basically demonstrates (and this conclusion is also borne out by the research I’ve presented in the past) that the increase in the number of jobs is almost entirely due to the creation of part-time and low-wage positions – bartenders, waiters, bellhops, maids, cobblers, retail clerks, fast food workers, and temp help. Although there are some professional bartenders and waiters who do in fact make good money, they are the exception rather than the rule.

It’s no wonder we are working fewer hours even as we have more jobs.

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.

Important Disclosures

Outside the Box: How the Rising Dollar Could Trigger the Next Global Financial Crisis

 

This week’s Outside the Box continues with a theme that I and my colleague Worth Wray have been hammering on for some time: the very real potential for a rising dollar to trigger the next global financial crisis.

We are concerned about the consequences of multi-speed economic growth around the world and the growing divergence between major central banks. In our opinion, if these trends persist, they likely mean (1) a major US dollar rally, (2) a rapid unwind of QE-induced capital flows to emerging markets, (3) a hard slide in fragile emerging-market and commodity-exporter currencies, and (4) financial shocks capable of ushering in a new global financial crisis.

Alongside true macro legends like Kyle Bass, Raoul Pal, Luigi Buttiglione, and Raghuram Rajan, Worth and I have written about this theme extensively in 2014 (“Central Banker Throwdown,” “Every Central Bank for Itself,” “The Cost of Code Red,” “Sea Change,” “A Scary Story for Emerging Markets”). Now it’s quickly becoming a mainstream macro theme on almost everyone’s radar. Virtually every economist and investment strategist on Wall Street has a view on the US dollar and the QE-induced carry trade into emerging markets… and anyone who doesn’t should start looking for a different job.

Policy divergence is really the only macro theme that matters right now. And on that note, the Bank for International Settlements just released its predictably must-read quarterly review, with an urgent warning:

The appreciation of the dollar against the backdrop of divergent monetary policies may, if persistent, have a profound impact on EMEs [emerging-market economies]. For example, it may expose financial vulnerabilities as many firms in emerging markets have large US dollar-denominated liabilities. A continued depreciation of the domestic currency against the dollar could reduce the credit worthiness of many firms, potentially inducing a tightening of financial conditions.

Echoing those comments on Twitter, the “bank for central banks” reiterated how this trend affects all of us (feel free to follow us at @JohnFMauldin and @WorthWray):

@BIS_org: US dollar as global unit of account in debt contracts means a stronger dollar constitutes tightening of global financial conditions.

This is in spite of continued efforts by central banks to ease monetary conditions. Calling attention to that very risk in our Halloween edition of Thoughts from the Frontline, Worth explained that the catalysts are already in position to spark a collapse in a number of fragile emerging markets if the dollar moves even modestly higher (into the low 90s on the DXY Index); but we have struggled to quantify the actual size of the nebulous USD-backed carry trade that could now come unwound at any moment.

Reasonable estimates range from $2 trillion to $5 trillion. The true number could be even larger if more speculative money has slipped through the cracks than has been officially reported in places like China; or it could be smaller if a significant portion of recent inflows represents a more permanent deepening of emerging-market financial systems rather than an attempt to escape financial repression in the developed world. It’s hard to know for sure, and that’s why this week’s Outside the Box is so important.

In a recent presentation at the Brookings Institution, BIS Head of Research and Princeton University Professor Hyun Song Shin shared his research revealing that dollar-denominated credit to non-bank offshore borrowers is now more than $9 TRILLION and at serious risk in the event of continued policy divergence.

I’d encourage you to listen to or download an audio recording of Dr. Shin’s presentation, and take some time to flip through his slides; but David Wessel’s cogent summary, which follows in today’s Outside the Box, will give you an idea of what may happen as the US dollar rallies. It’s short, sweet, and REQUIRED READING for anyone who wants to understand where the global financial system is heading in the coming quarters.

Then we wrap up with an essay on the same theme by my friend Mohamed El-Erian, who is typically not as strident in his wording; but for those of us who know Mohamed, this is the equivalent of him pounding the table:

Avoiding the disruptive potential of divergence is not a question of policy design; there is already broad, albeit not universal, agreement among economists about the measures that are needed at the national, regional, and global levels. Rather, it a question of implementation – and getting that right requires significant and sustained political will.

The pressure on policymakers to address the risks of divergence will increase next year. The consequences of inaction will extend well beyond 2015.

For readers interested in this theme, let me also offer a link to some on-the-record remarks from Claudio Borio, the head of the Monetary and Economic Department at the BIS, and Dr. Shin, preceding the release of the BIS quarterly report. For a representative of such a staid and sober organization, Mr. Borio uses a lot of rather disconcerting terms. He is clearly very concerned. Again, you can read the full BIS quarterly review here.

I’ve spent some time this week working with Jack Rivkin and our respective teams at Altegris and Mauldin Economics, putting together the lineup for our 2015 Strategic Investment Conference. I think it will be our best conference ever. You should definitely save the dates April 29 through May 2, as this will be a can’t-miss conference. We will get you more details soon.

I trust your week is going well. We are planning for the holidays and looking forward to some great family time. We’ll see if a new grandchild shows up in time for Christmas or decides to become a New Year’s baby.

Your thinking about 2015 analyst,

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

 

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How the Rising Dollar Could Trigger the Next Global Financial Crisis

By David Wessel
Wall Street Journal, Dec. 7, 2014


A slide from Hyun Song Shin’s presentation to the Brookings Institution on financial stability risks shows the Bank for International Settlement’s analysis of dollar lending to non-banks outside of the United States.
Bank for International Settlements

Hyun Song Shin, who is on leave from Princeton while chief economist at the Bank for International Settlements in Basel, spends a lot of time wondering what could cause the next financial crisis. He suspects it will be something different from the leveraged bets on housing that were at the root of the last crisis.

So, what might it be? Perhaps the steady rise of the U.S. dollar on global currency markets.

In recent presentations at the Brookings Institution, Mr. Shin documented the growing use of the U.S. dollar by borrowers and lenders outside of this country. U.S. banks and bond investors have lent $2.3 trillion outside the U.S. Foreign banks and foreign bond investors have lent much more: $6.5 trillion.

(Mr. Shin and colleagues at the Bank for International Settlements elaborated on his latest analysis in the bank’s new Quarterly Review posted Sunday.)

Here’s how Mr. Shin sees the world: A manufacturer in an emerging market borrows in dollars, perhaps because it sells a lot of goods in dollars and sees borrowing in dollars as a hedge. A local bank lends the dollars, borrowing from some big global bank. When the emerging-market currency is strong and the dollar is weak, that manufacturer’s balance sheet looks sturdier–and the local bank sees that and lends more readily. Thus a weak dollar can lead to a global credit boom.

When the dollar rises, though, all this runs in reverse, effectively tightening global financial conditions, particularly in emerging markets. The emerging-market currency falls. The manufacturer has trouble making payments on its dollar loans;  so do its peers. Banks lend less readily. Capital investment stalls.  Global money managers–the ones with lots of short-term wholesale deposits that search the world for the best yields–see a falling local currency and a weakening economy and pull  money from the emerging-market banks.

Then, global asset managers who had been lured by a high-growth story see that it is now over and do the same thing, selling emerging-market corporate bonds. That pushes up interest rates that businesses in emerging markets have to pay, and weakens them further in a vicious cycle.

“Even if you have long-term investors and you don’t have [leveraged investors], if events in the financial markets translate into events in the real economy, you can get a feedback loop,” Mr. Shin says. And this, he adds, is a very different mechanism than the insolvency of highly leveraged financial institutions that was at the heart of the recent global financial crisis.

All this is a timely reminder that all the important steps taken to strengthen the foundations of the world’s banks in response to the last crisis aren’t a cause for complacency.

David Wessel is director of the Brookings Institution’s Hutchins Center on Fiscal & Monetary Policy and a contributing correspondent to The Wall Street Journal. He is on Twitter: @davidmwessel.

A Year of Divergence

By Mohamed El-Erian
Project Syndicate, Dec. 11, 2014

LAGUNA BEACH – In the coming year, “divergence” will be a major global economic theme, applying to economic trends, policies, and performance. As the year progresses, these divergences will become increasingly difficult to reconcile, leaving policymakers with a choice: overcome the obstacles that have so far impeded effective action, or risk allowing their economies to be destabilized.

The multi-speed global economy will be dominated by four groups of countries. The first, led by the United States, will experience continued improvement in economic performance. Their labor markets will become stronger, with job creation accompanied by wage recovery. The benefits of economic growth will be less unequally distributed than in the past few years, though they will still accrue disproportionately to those who are already better off.

The second group, led by China, will stabilize at lower growth rates than recent historical averages, while continuing to mature structurally. They will gradually reorient their growth models to make them more sustainable – an effort that occasional bouts of global financial-market instability will shake, but not derail. And they will work to deepen their internal markets, improve regulatory frameworks, empower the private sector, and expand the scope of market-based economic management.

The third group, led by Europe, will struggle, as continued economic stagnation fuels social and political disenchantment in some countries and complicates regional policy decisions. Anemic growth, deflationary forces, and pockets of excessive indebtedness will hamper investment, tilting the balance of risk to the downside. In the most challenged economies, unemployment, particularly among young people, will remain alarmingly high and persistent.

The final group comprises the “wild card” countries, whose size and connectivity have important systemic implications. The most notable example is Russia. Faced with a deepening economic recession, a collapsing currency, capital flight, and shortages caused by contracting imports, President Vladimir Putin will need to decide whether to change his approach to Ukraine, re-engage with the West to allow for the lifting of sanctions, and build a more sustainable, diversified economy.

The alternative would be to attempt to divert popular discontent at home by expanding Russia’s intervention in Ukraine. This approach would most likely result in a new round of sanctions and counter-sanctions, tipping Russia into an even deeper recession – and perhaps even triggering political instability or more foreign-policy risk-taking – while exacerbating Europe’s economic malaise.

Brazil is the other notable wild card. President Dilma Rousseff, chastened by her near loss in the recent presidential election, has signaled a willingness to improve macroeconomic management, including by resisting a relapse into statism, the potential benefits of which now pale in comparison to its collateral damage and unintended consequences. If she delivers, Brazil would join Mexico in anchoring a more stable Latin America in 2015, helping the region to overcome the disruptive effects of a Venezuelan economy roiled by lower oil prices.

This multi-speed economic performance will contribute to multi-track central banking, as pressure for divergent monetary policies intensifies, particularly in the systemically important advanced economies. The US Federal Reserve, having already stopped its large-scale purchases of long-term assets, is likely to begin hiking interest rates in the third quarter of 2015. By contrast, the European Central Bank will pursue its own version of quantitative easing, introducing in the first quarter of the year a set of new measures to expand its balance sheet. The Bank of Japan will maintain its pedal-to-the-metal approach to monetary stimulus.

Of course, there is no theoretical limit on divergence. The problem is that exchange-rate shifts now represent the only mechanism for reconciliation, and the divide between certain market valuations and their fundamentals has become so large that prices are vulnerable to bouts of volatility.

For the US, the combination of a stronger economy and less accommodative monetary policy will put additional upward pressure on the dollar’s exchange rate – which has already appreciated significantly – against both the euro and the yen. With few other countries willing to allow their currencies to strengthen, the dollar’s tendency toward appreciation will remain strong and broad-based, potentially triggering domestic political opposition.

Moreover, as it becomes increasingly difficult for currency markets to perform the role of orderly reconcilers, friction may arise among countries. This could disturb the unusual calm that lately has been comforting equity markets.

Fortunately, there are ways to ensure that 2015’s divergences do not lead to economic and financial disruptions. Indeed, most governments – particularly in Europe, Japan, and the US – have the tools they need to defuse the rising tensions and, in the process, unleash their economies’ productive potential.

Avoiding the disruptive potential of divergence is not a question of policy design; there is already broad, albeit not universal, agreement among economists about the measures that are needed at the national, regional, and global levels. Rather, it a question of implementation – and getting that right requires significant and sustained political will.

The pressure on policymakers to address the risks of divergence will increase next year. The consequences of inaction will extend well beyond 2015.

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Important Disclosures

Outside the Box: The World’s Dumbest Idea

 

In today’s Outside the Box the redoubtable James Montier of GMO lifts his lance to prick the underbelly of the Mighty SVM. (That’s Shareholder Value Maximization, for you newbies.) “The world’s dumbest idea” (among many candidates in the world of finance), says James, citing none other than “Neutron Jack” Welch in support.

After noting that taking on SVM “is a little like criticizing motherhood and apple pie,” James sets right to work, tracing the monster’s birth to an editorial by Milton Friedman in 1970, in which Saint Milton wrote, “There is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits…”

Our intrepid author then explains how in the 1970s the Gospel According to Milton translated into the challenge of how to get corporate executives to focus on maximizing the wealth of shareholders. The solution: pay them a s***load of money (but not just cash – stock and options now constitute about two-thirds of total CEO compensation).

But, alas, there is pretty good research to suggest that larger incentives actually translate to lower performance, for reasons that James runs down for us. To make matters worse, both the average tenure of a corporate CEO and the average lifetime of an S&P 500 company have plummeted since the 1970s.

Bottom line: SVM has pretty well laid the kingdom to waste. James focuses on three areas of damage: (1) declining and low rates of business investment, (2) rising inequality, and (3) a low labor share of GDP. James takes these outcomes on one at a time, in his usual convincing manner. (Other work by James and some of the brightest minds around can be found at www.gmo.com.)

Last night there was a small dinner/reception/fundraiser at Harland and Amy Korenvaes’ home for the foundation of Ayaan Hirsi Ali. Ayaan wrote the books Infidel and Nomad, detailing her journey from Somalia, where as a young girl she actually joined the Muslim Brotherhood. (That’s what her family and all her friends did. When she started asking questions, it became a problem. She was told that girls simply did as they were told.) She ended up fleeing to Europe and went on to become a member of the Dutch parliament (one of the great political twists of all time) and an outspoken advocate of Islamic women’s rights. For those not familiar, she was integral (as in, provided the outline and ideas) for Theo van Gogh’s movie outlining the problems that some Islamic young women have in the parts of Muslim society that considers them property.

This past November was the 10th anniversary of the murder of van Gogh on the streets of Amsterdam by an Islamic radical, who considered the movie an affront to his religion, a transgression that called for the death of anyone involved. Ayaan has lived with death threats for over 20 years now. She is accompanied by serious security everywhere she goes. I’ve actually gotten to know some of her security detail over time. Talk with Ayaan and her husband, Niall Ferguson, about the constraints imposed upon them by the constant worry that at any moment she could be attacked, and you are introduced to another world.

Niall, too, is outspoken. But thankfully, being a forceful critic of neo-Keynesianism merely gets you vilified by Paul Krugman. I didn’t even need security when I went to Japan a few years ago and told them their debt problem was going to create a significant crisis and the yen was toast. (The yen was close to its all-time high at that point.)

The majority of the people around the dinner table last night were women, and the evening was designed to stimulate free-flowing conversation, so it was interesting to observe the kinds of questions people asked of Ayaan. While everyone in the room (other than your humble analyst) would’ve been in the upper reaches of the 1%, they came from varied backgrounds. Yet there was clearly somewhat of a struggle to understand the depth of oppression and desperation in the world Ayaan came from.

If you are a young girl in a very closed culture and are told certain facts by your parents and your religious authorities and all your neighbors, then what can you do if you see that those facts don’t square with actions? How can Islam be a religion of peace with ISIS and Boko Haram beheading people simply because they believe differently? Why would you, as a girl, not be allowed the same rights as your brothers? What is the true line between belief and practice?

There is a part of the world where honor killings, genital mutilation, beatings, forced marriages of girls under 15, and so on are common practice. That world was so far removed from our Dallas table, and yet Ayaan’s story moved everyone in the room.

As you consider your Christmas giving, why not take some time to read Ayaan’s books, get to know her through her work, and then consider a donation to help her help other girls growing up as she did. You can make a donation at her foundation’s website, http://theahafoundation.org/. I can think of nothing that is more in the spirit of the season than helping those who can’t help themselves.

Before I close, I want to mention that Jack Rivkin (CIO of Altregris) and I are going to be interviewing Ian Bremmer next Tuesday. We’ll be talking about the geopolitical situation all over the world and how it will affect our investments. I hope to steer the conversation to what is happening in Russia and the Middle East, with of course a nod to China; but we’ll see what Jack and Ian want to talk about. My goal is for listeners to walk away with greater clarity about the changing geopolitical landscape and an actionable perspective on global markets and the potential for diversifying investment alternatives in 2015. If you are a member of the Mauldin Circle, you should have already received an invitation. Otherwise, if you would like information on how to gain access, see below.

Have a great week.

Your thinking the Christmas tree goes up this week analyst,

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

 

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If you are an accredited investor or a FINRA-licensed advisor, please join me for an exclusive Mauldin Circle webinar on Tuesday, December 9, at 12:30 p.m. EST/9:30 a.m. PST. This highly anticipated webinar, “Navigating a Changing Global Landscape: What Investors Need to Know for 2015,” will provide a timely perspective for investors making 2015 portfolio decisions. I’ve invited my friend Ian Bremmer, President of Eurasia Group, and Altegris CIO Jack Rivkin to join me. These two leading minds will provide a terrific mix of economic and investment viewpoints, with a bent towards examining the impact of global events on investment decisions.

If you are a Mauldin Circle member, a webinar invitation will be sent directly to you by email. A replay will also be available to qualified registrants. If you are unable to listen in to the live discussion, be sure to register so that you can receive the replay information. If you are not a member of the Mauldin Circle and are an accredited investor or a FINRA-licensed advisor, please join today. The Mauldin Circle program provides exclusive access to alternative investment managers and other thought leaders. In addition, members receive access to special events and conferences. Upon qualification by my partners at Altegris, you will receive an email invitation. I apologize for limiting this discussion to accredited investors and investment advisors, but we must follow the rules and regulations. I look forward to having you at this special Mauldin Circle event. (In this regard, I am president and a registered representative of Millennium Wave Securities, LLC, member FINRA.)

 

The World’s Dumbest Idea

By James Montier
GMO White Paper, Dec. 2104

When it comes to bad ideas, finance certainly offers up an embarrassment of riches – CAPM, Efficient Market Hypothesis, Beta, VaR, portfolio insurance, tail risk hedging, smart beta, leverage, structured finance products, benchmarks, hedge funds, risk premia, and risk parity to name but a few. Whilst I have expressed my ire at these concepts and poured scorn upon many of these ideas over the years, they aren’t the topic of this paper.

Rather in this essay I want to explore the problems that surround the concept of shareholder value and its maximization. I’m aware that expressing skepticism over this topic is a little like criticizing motherhood and apple pie. I grew up in the U.K. watching a wonderful comedian named Kenny Everett. Amongst his many comic creations was a U.S. Army general whose solution to those who “didn’t like Apple Pie on Sundays, and didn’t love their mothers” was “to round them up, put them in a field, and bomb the bastards,” so it is with no small amount of trepidation that I embark on this critique.

Before you dismiss me as a raving “red under the bed,” you might be surprised to know that I am not alone in questioning the mantra of shareholder value maximization. Indeed the title of this essay is taken from a direct quotation from none other than that stalwart of the capitalist system, Jack Welch. In an interview in the Financial Times from March 2009, Welch said “Shareholder value is the dumbest idea in the world.”

A Brief History of a Bad Idea

Before we turn to exploring the evidence that shareholder value maximization (SVM) has been an unmitigated failure and contributed to some very undesirable economic outcomes, let’s spend a few minutes tracing the intellectual heritage of this bad idea.

From a theoretical perspective, SVM may well have its roots in the work of Arrow-Debreu (in the late 1950s/early 1960s). These authors demonstrated that in the presence of ubiquitous perfect competition and fully complete markets (neither of which assumption bears any resemblance to the real world, of course – break these assumptions and you break the link between SVM and social welfare; but trivial details like the critical realism of assumptions never seem to bother the average economist) a Pareto optimal outcome will result from situations where producers and all other economic actors pursue their own interests. Adam Smith’s invisible hand in mathematically obtuse fashion.

However, more often the SVM movement is traced to an editorial by Milton Friedman in 1970. Given Friedman’s loathing of all things Keynesian, there is a certain delicious irony that the corporate world is so perfectly illustrating Keynes’ warning of being a slave of a defunct economist! In the article Friedman argues that “There is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits…”

(It is quite staggering just how many bad ideas in economics appear to stem from Milton Friedman. Not only is he culpable in the development of SVM, but also for the promotion of that most facile theory of inflation known as the quantity theory of money. Most egregiously of all, he is the father of the doctrine of the “instrumentalist” view of economics, which includes the belief that a model should not be judged by its assumptions but by its predictions.)

Friedman argues that corporates are not “persons,” but the law would disagree: firms may not be people but they are “persons” in as much as they have a separate legal status (a point made forcefully by Lynn Stout in her book, The Shareholder Value Myth). He also assumes that shareholders want to maximize profits, and considers any act of corporate social responsibility an act of taxation without representation – these assumptions may or may not be true, but Friedman simply asserts them, and comes dangerously close to making his argument tautological.

Following on from Friedman’s efforts, along came Jensen and Meckling in 1976. They argued that the key challenge when it came to corporate governance was one of agency theory – effectively how to get executives (agents) to focus on maximizing the wealth of the shareholders (principals). This idea can be traced all the way back to Adam Smith in The Wealth of Nations (1776) where he wrote:

The directors of such [joint stock] companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master’s honour, and very easily give them a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.

Under an “efficient” market, the current share price is the best estimate of the expected future cash flows (intrinsic worth) of a company, so combining EMH with Jensen and Meckling led to the idea that agents could be considered to be maximizing the principals’ wealth if they maximized the stock price.

This eventually led to the idea that in order to align managers with shareholders they need to be paid in a similar fashion. As Jensen and Murphy (1990) wrote, “On average, corporate America pays its most important leaders like bureaucrats.” They argued that “Monetary compensation and stock ownership remain the most effective tools for aligning executive and shareholder interests. Until directors recognize the importance of incentives and adopt compensation systems that truly link pay and performance, large companies and their shareholders will continue to suffer from poor performance.”

Widespread Adoption of the Bad Idea

So far we have traced only the rise of SVM amongst academics and, frankly, who cares what a bunch of academics think? Of considerably more concern is the evidence that the tenet of SVM has become conventional wisdom (an oxymoron if ever there was one) amongst those who inhabit the real world. For instance, take a look at the statements issued by the Business Roundtable (an association of CEOs of leading U.S. companies). In 1981 they stated, “Corporations have a responsibility, first of all, to make available to the public quality goods and services at fair prices, thereby earning a profit that attracts investment…provide jobs, and build the economy.”

By 1997, this concern for the role of the corporation at large had transmuted into a single-minded focus on SVM as represented by the following edict: “The principal objective of a business…is to generate economic returns to its owners…if the CEO and the directors are not focused on shareholder value, it may be less likely the corporation will realize that value.”

In many ways that bluest of blue chips, IBM, represents a perfect microcosm of the general pattern of obsession with SVM. Cast your eyes over Exhibit 1. It charts the total returns to an investor in IBM since 1973. In those early days, IBM’s mission statement was outlined by Tony Watson (the son of the founder) and was based on three principles (in descending order of importance): 1) respect for individual employees; 2) a commitment to customer service; and 3) achieving excellence.

By the early 1990s, IBM had pretty much been flat in total nominal return terms since the 1970s. Lou Gerstner arrived as CEO and stated, “Our primary measures of success are customer satisfaction and shareholder value.” In their Roadmap 2010, under Samuel Palmisano, the goal shifted to the primary aim of doubling earnings per share over the next five years!

One might be tempted to conclude that the evidence offered by IBM strongly supports the power of SVM. After all, after languishing for a prolonged period, when Gerstner and his focus on SVM arrived on the scene IBM enjoyed a significant revival. However, before you conclude I’ve shot myself in the foot by showing this example, take a look at Exhibit 2, which compares the SVM champion IBM with a company with an altogether different perspective, Johnson & Johnson.

In contrast to IBM’s transient objectives, Johnson & Johnson has stuck with a mission statement written by its founder (Robert Wood Johnson) as part of its IPO documentation in 1943, which reads as follows: “We believe our first responsibility is to the doctors, nurses and patients, to mothers and fathers and all others who use our products…We are responsible to our employees…We are responsible to the communities in which we live and to the world community as well…Our final responsibility is to our stockholders…When we operate according to these principles, the stockholders should realize a fair return.”

The contrast between the two firms couldn’t be much greater. Whilst IBM targeted SVM, Johnson & Johnson thought shareholders should get a “fair return.” Yet, Johnson & Johnson has delivered considerably more return to shareholders than IBM has managed over the same time period.

Prima Facie Case Against SVM

To move from the micro to the macro, we can contrast the returns achieved by shareholders in the era of managerialism (defined here as 1940-90, although the results are robust to the exact sample chosen) with those achieved in the era of SVM (1990-2014). Exhibit 3 shows the results of this comparison in two different ways. The first pair of bars shows the total real returns (p.a.) in the two periods. They are virtually identical (the era of managerialism actually produced slightly higher real returns). So much for the horror that was visited upon investors by this experience.

The second set of bars adjusts the total real return data to account for shifts in valuation, which effectively have nothing to do with the underlying return generation of companies, but rather reflect the price that the market is willing to put upon those returns. As you can see, the adjustment barely impacts the returns achieved during the era of managerialism. However, a significant proportion of the returns achieved in the era of SVM actually came from the price investors were willing to pay. If we remove this element, then the underlying return generation of companies has fallen significantly under SVM.

What Went Wrong?

Given this data, the natural follow-on question is, of course, what went wrong? I think one of the most obvious candidates concerns the pay of CEOs. When one casts even a cursory glance over Exhibit 4 (CEO median pay) the increasing dominance of stock-related pay becomes obvious. During the era of managerialsim, the vast majority (i.e., over 90%) of the total compensation for CEOs came through salary and bonus. In the last two decades one can see the increasing dominance of stock-related pay. In the last decade some two-thirds of total CEO compensation has come through stock and options.

This has certainly aligned managers and shareholders à la Jensen and Murphy, but doesn’t seem to have generated the kind of impact that one might have expected. At least two reasons for this stand out. Firstly, as is now well known, options aren’t the same thing as stock. They give executives all of the upside and none of the downside of equity ownership. Effectively they create a heads I win, tails you lose situation. (The asymmetry of options and their excessive use in CEO remuneration have been pet peeves of mine (and many others for a long time). I recently came across a note I wrote in 2002 moaning about exactly this.)

In addition, incentives don’t always work in the way that one might expect (yet more evidence of the law of unintended consequences). Economists tend to have complete faith in the concept of incentives, driven by their obsession with a very specific definition of rationality. However, the evidence on the way incentives work may surprise you (and recently raises questions for many economists).

In 2005, Dan Ariely and coauthors set up some intriguing experiments to test the power of incentives. They journeyed to rural India to conduct their experiments because in this setting they could offer the participants meaningfully large incentives, in a way that just isn’t possible on tight research budgets when applied to first world countries. (In case you are wondering about the relevance of rural Indians to CEOs, Ariely et al. also tested their findings on the more orthodox cash-strapped U.S. student, and found similar patterns of behaviour.)

Participants were asked to play six games and were told that their pay would relate to their performance on the various tasks. In the low incentive version, participants received 4 rupees if they reached the “very good” level in a game, under the medium incentive version they got 40 rupees for reaching the same level, and under the high incentive version they received 400 rupees for attaining the “very good” level.

Now 400 rupees was close to the all-India average monthly per capita consumption. Thus, if players in the high incentive condition reached the “very good” standard in all six games they stood to win the equivalent of half a year’s consumption – not an insignificant amount.

Exhibit 5 shows the percentage of the maximum available earnings that were achieved by each of the groups. Those who faced the lowest incentives captured around 35% of the maximum possible. Under the medium incentive version, 37% of the maximum was attained. But under the high incentive only 19.5% of the maximum possible was reached.

From the collected evidence on the psychology of incentives, it appears that when incentives get too high people tend to obsess about them directly, rather than on the task in hand that leads to the payout. Effectively, high incentives divert attention away from where it should be.

One of the other features that stands out as having changed significantly between the era of managerialism and the era of SVM is the lifespan of a company and the tenure of the CEO. Both have shortened significantly.

In the 1970s, the average lifespan of a company in the S&P 500 was 27 years (already down massively from the 75 years seen in the 1920s!). In the latter half of the last decade, the lifespan of a corporate in the S&P 500 had declined still further to a paltry 15 years.

In parallel to this trend, the average tenure of a CEO has fallen sharply as well. In the 1970s, the average CEO held his position for almost 12 years. More recently this has almost halved to an average tenure of just six years. It is little wonder that CEOs may be incentivized to extract maximum rent in the minimum time possible given the shrinkage of their time horizons (not independent of the shrinkage in time horizons for investors perhaps).

SVM and the Damage Done*
*With apologies to Neil Young.

Let’s now turn to the broader implications and damage done by the single-minded focus on SVM. In many ways the essence of the economic backdrop we find ourselves facing today can be characterized by three stylized facts: 1) declining and low rates of business investment; 2) rising inequality; and 3) a low labour share of GDP (evidenced by Exhibits 7 through 9).

I’m going to argue that SVM has played a role in each of these characteristics. That isn’t to say that SVM alone is responsible, rather it is part of broader set of policies that have magnified these effects, but these are beyond the scope of this paper.

(In my opinion, SVM is part of the quartet of neoliberal policies that have led to the current economic situation. The others include the abandonment of full employment and its replacement with inflation targeting, globalization, and drive towards so-called flexible labour markets. I intend to return to these other policies in future notes. It is important to realize that all of these are policy choices; in as much as they are behind what has been called “secular stagnation” I’d argue that the outcome is itself a policy choice.)

Let me now turn to describing how SVM has played a significant part in generating these stylized facts. We will start with low and declining rates of business investment.

Given the shortening lifespan of a corporate and the decreasing tenure of the CEO, the finding that many managers are willing to sacrifice long-term value for short-term gain probably shouldn’t be a surprise. Nonetheless, an insightful survey of chief financial officers (CFOs) was conducted by John Graham et al. in 2005. They asked CFOs the following question: “Your company’s cost of capital is 12%. Near the end of the quarter, a new opportunity arises that offers a 16% internal rate of return and the same risk as the firm. The analyst consensus EPS estimate is $1.90. What is the probability that your company will pursue this project in each of the following scenarios?” The scenarios were based on how far short of expectations taking the project would leave quarterly EPS. Exhibit 10 shows the results.

If they take the project and exceed the earnings estimate, 80% would willingly invest (which obviously leaves you wondering about the other 20%!) However, a miss of even 10c reduced this from 80% to 59%. By the time the miss was at 60c short of expectations, only approximately half of the CFOs would invest in the project.

More evidence of the pernicious impact of SVM can be found in a recent study conducted by Asker et al. (2013). They compared the investment rates of public (listed) and private (unlisted) companies. Asker et al. uncovered the startling fact that when one compares the two groups (controlling for size and stage of the life cycle) “the average investment rate among private firms is nearly twice as high as among public firms, at 6.8% versus 3.7% of total assets per year.”

This preference for low investment tragically “makes sense” given the “alignment” of executives and shareholders. We should expect SVM to lead to increased payouts as both the shareholders have increased power (inherent within SVM) and the managers will acquiesce as they are paid in a similar fashion. As Lazonick and Sullivan note, this led to a switch in modus operandi from “retain and reinvest” during the era of managerialism to “downsize and distribute” under SVM.

Evidence of the rising payout amongst nonfinancial firms can be found in Exhibit 12. As one would expect under SVM, we have witnessed a marked increase in payouts over time. In the era of managerialism, somewhere between 10% and 20% of cash flow was regularly returned to shareholders. Under the rule of SVM this has risen significantly, reaching 50% of cash flows just prior to the Global Financial Crisis.

This diversion of cash flows to shareholders has played a role in reducing investment. A little known fact is that almost all investment carried out by firms is financed by internal sources (i.e., retained earnings). Exhibit 13 shows the breakdown of the financing of gross investment by source in five-year blocks since the 1960s. The dominance of internal financing is clear to see (a fact first noted by Corbett and Jenkinson in 1997).

From the mid 1980s onwards, equity issuance has been net negative as firms have bought back an enormous amount of their own equity (and geared themselves by issuing debt – a massive debt for equity swap). One of the most common raison d’êtres for stock markets that gets offered up is that they are providing vital capital to the corporate sector – the evidence suggests that this is nothing more than a fairy tale. Far from providing capital to the corporate sector,8 shareholders have been extracting it from corporates.

Now, if one were feeling charitable, one might choose to suggest that there just weren’t many new investment opportunities, and thus this return of capital was a perfectly reasonable thing to do. If this were the case, one might hope that the buybacks were done at prices that were below intrinsic value (since this would have genuinely improved the lot of shareholders). However, as Exhibit 14 shows, this hasn’t been the case. When market valuations were high (prior to the financial crisis) a record number of buybacks were conducted. Conversely, at the market lows, firms were hardly doing any buybacks at all. As Warren Buffett said in his letter to shareholders back in 1999, “Buying dollar bills for $1.10 is not a good business for those who stick around.”

The obsession with returning cash to shareholders under the rubric of SVM has led to a squeeze on investment (and hence lower growth), and a potentially dangerous leveraging of the corporate sector.

To see how this is related to the rising inequality that we have seen it is only necessary to understand who benefits from a rising stock market (i.e., who gets the “benefits” of SVM and its buyback frenzy). The identity of this group is revealed in Exhibit 15. The top 1% own nearly 40% of the stock market, and the top 10% own 80% of the stock market. These are the beneficiaries of SVM.

Another reflection of the role of SVM in creating inequality can be seen by examining the ratio of CEO-to-worker compensation. Before you look at the evidence, ask yourself what you think that ratio is today and what you think is “fair.” A recent study by Kiatpongsan and Norton (2014) asked these exact questions. The average American thought the ratio was around 30x, and that “fair” would be around 7x.

The actual ratio is shown in Exhibit 16. It turns out the average American was off by an order to magnitude! If we measure CEO compensation including salary, bonus, restricted stock grants, options exercised, and long-term incentive payouts then the ratio has increased from 20x in 1965 to a peak of 383x in 2000, and today sits somewhere just short of 300x!

We can see this has been a driving force behind the rise of the 1% thanks to a study by Bakija, Cole, and Heim (2012). The rise in incomes of the top 1% has been driven largely by executives and those in finance. In fact, executives and those in finance accounted for some 58% of the expansion of the income for the top 1%, and 67% of the increase in incomes for the top 0.1% between 1979 and 2005. Thus, there can be little doubt that SVM has played a major role in the increased inequality that we have witnessed.

This makes the decline in the labour share even more dramatic for those outside of the top 1%. Exhibit 9 includes the top 1%, so if we were to exclude them the share of GDP going to the rest of labour would be even lower. In fact, if we look at the bottom 90% we would see their labour share of GDP going from around 42% in the late 1940s to approximately 27% today.

If one looks at the income gains during expansions as Pavlina Tcherneva (2014) has done, one will find that during the last two expansions the income gains have gone entirely (and most recently more than entirely) to the top 10%.

The problem with this (apart from being an affront to any sense of fairness) is that the 90% have a much higher propensity to consume than the top 10%. Thus as income (and wealth) is concentrated in the hands of fewer and fewer, growth is likely to slow significantly. A new study by Saez and Zucman (2014) provides us with the final exhibit in this essay. It shows that 90% have a savings rate of effectively 0%, whilst the top 1% have a savings rate of 40%.

The role of SVM in declining labour share should be obvious, because it is the flip-side of the profit share of GDP. If firms are trying to maximize profits, they will be squeezing labour at every turn (ultimately creating a fallacy of composition where they are undermining demand for their own products by destroying income).

Conclusions

So what is one to conclude from this tirade? Three things stand out to me, each addressing a different constituency:

Shareholder’s Lesson

Firstly, SVM has failed its namesakes: it has not delivered increased returns to shareholders in any meaningful way, and may actually have led to poorer corporate performance!

Corporate’s Lesson

Secondly, it suggests that management guru Peter Drucker was right back in 1973 when he suggested “The only valid purpose of a firm is to create a customer.” Only by focusing on being a good business are you likely to end up delivering decent returns to shareholders. Focusing on the latter as an objective can easily undermine the former. Concentrate on the former, and the latter will take care of itself. As Keynes once put it, “Achieve immortality by accident, if at all.”

Everyone’s Lesson

Thirdly, we need to think about the broader impact of policies like SVM on the economy overall. Shareholders are but one very narrow group of our broader economic landscape. Yet by allowing companies to focus on them alone, we have potentially unleashed a number of ills upon ourselves. A broader perspective is called for. Customers, employees, and taxpayers should all be considered. Raising any one group to the exclusion of others is likely a path to disaster. Anyone for stakeholder capitalism?

Mr. Montier is a member of GMO’s Asset Allocation team. Prior to joining GMO in 2009, he was co-head of Global Strategy at Société Générale. Mr. Montier is the author of several books including “Behavioural Investing: A Practitioner’s Guide to Applying Behavioural Finance; Value Investing: Tools and Techniques for Intelligent Investment”; and “The Little Book of Behavioural Investing.” Mr. Montier is a visiting fellow at the University of Durham and a fellow of the Royal Society of Arts. He holds a B.A. in Economics from Portsmouth University and an M.Sc. in Economics from Warwick University.

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The article Outside the Box: The World’s Dumbest Idea was originally published at mauldineconomics.com.

Thoughts from the Frontline: Is Bitcoin the Future?

 

Bitcoin is a topic of discussion almost everywhere I go. My introduction to Bitcoin came when I was speaking at a gold conference in Palm Springs and three bright-eyed, bushy-tailed college students approached me with a video camera and asked for my thoughts on Bitcoin. Noting my confusion, they began to evangelistically espouse the virtues of Bitcoin and tell me how it would save us from the evils of the Federal Reserve. I kept from rolling my eyes (you do want to encourage passion in the young) and mentioned a meeting that I had to go to – at that very moment as it turned out.

Since that time Worth Wray and I and our entire team at Mauldin Economics have done a great deal of research on Bitcoin.  We will soon release a video documentary that is one of the best productions I’ve ever been involved with and that does a good job of explaining both the controversy around Bitcoin and its considerable promise. We talked with skeptics, enthusiasts, and people willing to put up tens of millions of dollars betting on the future of Bitcoin.

Worth Wray has written this week’s letter as a summary of what we know about Bitcoin. Delving into its history and bringing us up to date, he also offers a glimpse of the future. At the end of the letter I offer a few of my own thoughts on the relationships among gold, fiat money, Bitcoin, and financial transactions.

If nothing else, Bitcoin offers a provocative way to think of the future of money. Now let me turn it over to Worth.

Is Bitcoin the Future?

By Worth Wray

“Growth demands a temporary surrender of security.”

– Gail Sheehy

“When people write the history of this thing, of bitcoin, they are not going to write the story of 6 million to a billion. What is truly remarkable is the story of zero to 6 million. It has already happened! And we’re not paying attention! That’s incredible. That’s what had one chance in a million, and it already happened.”

– Wences Casares, Founder & CEO of Xapo

“[Virtual currencies] may hold long-term promise, particularly if the innovations promote a faster, more secure and more efficient payment system.”

– Ben Bernanke, Chairman of the Federal Reserve, USA

Yusko’s Rule

Before I teamed up with John Mauldin in July 2013, I worked as the portfolio strategist for an $18-billion money manager in Houston that, among its other businesses, co-managed (with an elite team of investors from the university endowment world) one of the largest registered funds of funds in the United States.

I had a front-row seat for every investment decision in a multi-billion-dollar portfolio for almost five years, and for a bright-eyed kid from South Louisiana it was a life-changing experience that no graduate school in the world could have offered… an opportunity to learn from some of the most experienced minds in finance and hone the skills I would need to identify disruptive macro trends and build more balanced portfolios with those forces in mind.

That opportunity to learn, not just about investments but also how to think about emerging trends, continues to inform everything I do today; and Morgan Creek Capital Management’s Mark Yusko – a man who has built his career on incorporating investment talent and macro themes into highly diversified portfolios – continues to be one of my most important teachers.

In the course of his daily business (which involves bouncing around the world searching for new ideas and world-class talent), Yusko has evolved a rule for vetting new ideas:

If I hear something once, I remember it. If I hear it twice, I write it down. If I hear it three times, I do something about it.

It sounds simple, as the most valuable investment insights usually are; but Mark is not just talking about “new” ideas that appear on the front page of the New York Times or the opening segment of CNBC’s Squawk Box. He’s saying that in the course of tapping into a large pool of truly world-class thinkers – who range from hedge fund legends like Julian Robertson and Stanley Druckenmiller to venture capitalists like David Hornik and Marc Andreesson – it pays to pay attention.

Innovative ideas can grow into consensus views and missed investment opportunities before our very eyes in a world awash with information. With constant access to the web through our computers, tablets, and smart phones, it’s easy for investors to filter out valuable information in an effort to cut through all the noise; but even still, it’s possible to catch emerging trends early enough in their life cycles by holding to a homework rule: When an idea comes up over and over again – especially when it’s validated by experienced investors who command and influence vast sums of capital – it’s not necessarily time to buy, but it’s time to do your homework.

And when it comes to Bitcoin, I should have done my homework earlier.

Thank goodness it’s still early…

What is Bitcoin, Anyway?

Bitcoin is a peer-to-peer digital currency that trades on public exchanges and can be instantly transferred between any two people anywhere in the world with the speed of an email… and at FAR lower cost than for transactions processed through the traditional financial system.

While a lot of people have experimented with digital currencies in the internet age, Bitcoin’s mysterious creator, “Satoshi Nakamoto,” was the first person to solve the issue of “double spending” in a completely decentralized network, meaning that all transactions are made directly between parties, with no middlemen, yet in a way that is verifiable across the entire network and virtually impossible to counterfeit.

Much like the internet itself, the Bitcoin hive is essentially a distributed network of computers and people that are relying on a common technological process – the Bitcoin protocol – to confirm and validate every transaction made, using a unit of account called a “bitcoin” that can be broken down into fractions, thereby enabling previously impossible micro-transactions.

The genius behind the Bitcoin protocol is an element of the system called the “blockchain” – essentially a giant, globally shared ledger of every bitcoin and every transaction in the history of the network. Whenever two people follow through with a transaction, it is broadcast throughout the entire network, and the blockchain expands as that exchange is automatically lumped together with other transactions in a new “block.”

While it requires a MASSIVE amount of computing power to verify, confirm, and record every transaction that occurs within the network, it’s basically a self-funding system.

Bitcoins are created through a process called “mining,” which happens to be the same mathematical process that seals blocks of new transactions onto the blockchain by verifying that every exchange is valid and using real bitcoins. By rewarding “miners” with new bitcoin for devoting their time and computing power to maintenance of the blockchain, the Bitcoin protocol provides the incentive for the network to continue running in a completely decentralized manner.

In the early days, the mining process could be competitively and profitably run from a series of graphics cards linked to a home computer, but in recent years bitcoin mining has become a BIG business. Today, a lot of the mining is done on massive server farms in places like Iceland, where temperatures are cool and power is cheap.

There is an upper limit of 21 million bitcoins that can ever be minted, and the protocol is designed to release a “reward” of a new bitcoin every 10 minutes until every unit of the digital currency has been created. As of today, roughly 13.5 million bitcoins have been mined, with roughly 7.5 million to go.


Source: Coinbase

On paper, Bitcoin is an elegant and efficient way to streamline a global payments system; but in practice, the web of businesses and support structures around the Bitcoin protocol must pass a wide range of tests, from storage security and compliance to the creation of tradable derivatives and merchant adoption, before any kind of digital revolution can begin.

That said, Bitcoin – or something like it – has the potential to do for finance what the internet has done for communications and commerce… and we’re already six years into the process.

Bit by Bit

When I heard about Bitcoin for the first time, I dismissed it almost immediately. It seemed like a half-baked scheme cooked up by a bunch of technically skilled but financially naïve computer nerds to disrupt a global financial system that none of them really understood.

Early adopters espoused ideas about freeing the individual from the tyranny of a government-controlled money supply; but in order to pull off their grand vision, Bitcoin’s programming forefathers had to convince enough people to put their trust in the system – without governments shutting them down in the process. It seemed unlikely.

In the early days – 2009 and 2010 – a single bitcoin traded for pennies… – but its value was basically unknowable. The digital currency had virtually no daily trading volume; its price swung around wildly (volatility that only became more pronounced over time); and aside from experimental transactions within a small online community, it was virtually useless as a reliable unit of account or medium of exchange.

Internet legend has it that the first real-world Bitcoin transaction was a long-distance arrangement made on May 18, 2010, between an American programmer named Laszlo Hanyecz and a fellow enthusiast he met on the Bitcoin Talk forum. Apparently, Hanyecz offered to pay 10,000 bitcoins to anyone willing to buy him pizza, and an Englishman took him up on the offer… making an international phone call to a Papa John’s in Jacksonville, Florida, in exchange for roughly $25 in bitcoins at the then-current exchange rate.

I can’t help but wonder if that Englishman turned around and spent his 10,000 bitcoins or saved them for a rainy day. At today’s US dollar exchange rate, they would be worth nearly $3.8 million.

The second time I heard about Bitcoin (about a year later), it sounded a lot more interesting as a medium of exchange; but it seemed imminently doomed by regulation. The virtual currency had risen from a price around of $0.0025 the day of Laszlo Hanyecz’s pizza purchase to nearly $30 in early 2011 as Bitcoin became the basis for real-world transactions within the Bitcoin community… and the preferred medium of exchange for nefarious activities on the web.

Following the embarrassing release of US diplomatic cables to the general public in late 2010, the US government organized a financial blockade against the hacker/whistleblower Julian Assange and his nonprofit firm WikiLeaks. When Bank of America, Visa, Mastercard, PayPal, and Western Union refused to transmit donations to WikiLeaks, the nonprofit started accepting donations in Bitcoin.

As the price of Bitcoin began to rise, it saw another big uptick in volume when an online black market named Silk Road launched in early 2011, enabling the sale of illicit drugs and forged IDs exclusively in exchange for Bitcoin.

Business boomed, and the Bitcoin community expanded from computer nerds to mischievous hackers and anonymous drug dealers who wished to skirt the financial system and/or the eyes of the law. And for the libertarians and anarchists who embraced Bitcoin as an anti-QE investment at this stage, it essentially became an enlightened bet against corrupt governments.

Teething Issues

Within a few months the price of Bitcoin surged to nearly $30… and then Mt. Gox, the most popular Bitcoin exchange, was hacked and trading suspended for several days in June 2011.

In the following months the price collapsed by roughly 90% to less than $3, but that was not the end of Bitcoin.

“Naturally there were teething issues,” my friend Grant Williams explained in his April 2013 letter, “Bit Happens,” “exchanges were hacked and wallets full of bitcoins stolen after being left unprotected on users’ computers; and [there was] much bad press… but slowly and steadily the marketplace weathered the growing pains and, as more and more merchants began accepting payment in bitcoins, the community broadened into something more than just a weird underground movement.”

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.

Important Disclosures