Mauldin Economics

Outside the Box
Howard Marks on Expert Opinion
John Mauldin | Jan 11, 2017
In a week when I have once more gone out on the old limb, in last weekend’s Thoughts from the Frontline, to bring you my forecast for the new year, and when I’m also sharing with readers of my Over My Shoulder service the tea-leaf skryings of some of the boldest and brightest among my fellow economic prognosticators, I’m feeling a need to use today’s Outside the Box to redress the balance a bit.
Thus, I have for you today a piece by legendary investor Howard Marks, co-chairman of Oaktree Capital, in which Howard says not one word about how 2017 may play out, but rather makes a rather convincing case that expert opinion ain’t worth a hill of beans.
(Or perhaps we should say that it ain’t no better than a hill of beans onto which additional beans are being randomly dropped, until we get a bean avalanche, large or small. Longtime readers will have instantly recognized a favorite theme of mine, which we first explored in my letter titled “Fingers of Instability: Ubiquity, Complexity Theory, and Sandpiles,” way back in April, 2006.)
Howard has a beautiful example of the deep worthlessness of expert opinion (especially when that opinion sallies forth into the future); and I got such a kick out of it that I just have to share it up front with you.
Howard shares with us some telling statistics from a full season of the New York Post’s “NFL Bettor’s Guide,” in which each week during football season, the Post’s 11 experts advise its readers as to which teams to bet on. Here’s how these geniuses did over the full 17-week season, covering 256 games:
  • The best picker was right 55.1% of the time.
  • The worst picker was right 48.8% of the time.
  • On average the pickers were right 51.6% of the time.
But wait, it gets even better. The experts also tipped readers off on their “best bets” each week.  Here’s how they did with their surest picks:
  • The best picker was right 62.7% of the time.
  • The worst picker was right 43.1% of the time.
  • On average the pickers were right 54.0% of the time.
Howard drolly notes that, with the results compactly distributed around 50/50 – Coin Toss City – and since it costs about 5% per week on average to bet with the bookies, none of the 11 experts’ overall picks added value “after fees.”
Whew! OK, then.
And speaking of experts, I would like to extend a hearty welcome to Paul Krugman as he joins us here in the camp of those who are concerned about high deficits and debt. Paul’s January 9 column in the New York Times is entitled (I do kid you not) “Deficits Matter Again.”
I can only assume it was a kind of Saul-of-Tarsus, road-to-Damascus experience that lead Brother Paul to his new faith – after he had persecuted those of us who have resolutely believed that deficits and debt do matter these last eight years, calling us debt-phobes and worse. Having been singled out as such I will readily admit that it has been hard to turn the other cheek. But still, glad to have ya with us, Paul, even if you’re a bit late to the party.
And yes, with conservative Republicans riding into town, ready to grasp the fiscal nettle with both hands, the federal debt and deficit are definitely more important than they have been for a while. But put me decidedly in the camp of Newt Gingrich and Bill Clinton, who together figured out how to control the deficit and actually reduce the debt over time.
Now, a less warm-hearted and understanding person than I might side with the National Review or the many bloggers who have hastened to note that it was only 78 days ago that Mr. Krugman was going on again about deficit scolds and debt-phobes. We must pardon them for concluding that deficits only matter in the World According to Paul Krugman when Republicans control the Congress and presidency. Some of these critics have uncharitably called Paul a has-been economist who has turned to political hacking. Please guys, no name-calling. He has sincerely stated that he wants to join us in the holy war against the demons Debt and Deficit. His conversion must be acclaimed – even though the latter-day Paul may have in common with his biblical namesake that he was once the chief of sinners. (For those who may not have ventured into the New Testament lately, that’s 1 Timothy 1:15.)
Then again, Paul may be suffering from a dire syndrome that I have recently seen to be spreading among the many liberal and progressive commentators in the media. I call it PTESD: Post-Trump Election Stress Disorder. The tell-tale symptoms include emotional outbursts of varying hues and stripes, the need for safe places to cry and mourn, and extreme difficulty in coming to grips with the fact that the world might actually change. Kind of like it did in 2000, 1992, 1980, 1976, 1968, 1960 – well, you get the idea.
And it is very possible that in the year 2021 our Paul may once again revert to his old-time religion under a new Democratic president. So perhaps his critics are right to be dismissive. I have to agree that in his Monday opinion piece, Paul’s economic arguments are just as weak as they were before his conversion; and so the fact that he seems to have arrived at a diametrically different conclusion 78 days on, when the only data point that has changed is that there is now a Trump presidency, is admittedly suspect.
Those suffering from PTESD seem to believe that the US presidency is imbued with all sorts of powers, some bordering on the miraculous and heretofore unseen, and that President Trump is liable to change everything overnight. The problem with that viewpoint – and this should give the sufferers considerable comfort – is that there is this pesky thing called Congress that has its own ideas as how the magic wand should be waved, and in whose direction. I somehow think it’s going to take more than a little bit of fairy dust to actually drain Foggy Bottom.
Sorry for the digression, but I find this whole business quite humorous. I will be in Washington DC next week for the inaugural, and I’m hoping to be able to interview on camera a number of Washington decision makers, to try to get at some of the real economic questions that will affect our businesses and portfolios this year and in years to come. I want to thank my good friend Monty Bennett, CEO of the Ashford Group of Companies, who moved heaven and earth to find my production team some rooms closer in than 40 miles.
You have a great week. This weekend, for better or worse, we’ll be checking out what some of my daring friends are forecasting for 2017. And hopefully I’ll get the letter to you a little earlier this week.
Your worried that I’m having too much fun analyst,
(I mean, seriously, I am working my tail off but having so much fun that I have to resist looking over my shoulder to see if anything is catching up!)

John Mauldin, Editor
Outside the Box
Federal Repression System
By John Mauldin | Oct 09, 2016
The Federal Open Market Committee, to almost no one’s surprise, did absolutely nothing at its last meeting other than say that maybe, if the data allow, they will raise rates in December. My cynical view on their dithering will be detailed below. And of course, the Bank of Japan met and decided that maybe they had gone a bridge too far; and rather than lowering already negative rates when the yield curve was flat out to 40 years, they decided to see if they could create a fulcrum around the 10-year Japanese bond at zero. So far, the move has not been a rousing success.
This is partially because their banks are bleeding cash and screaming at them, and they have got to figure out some way to walk back what is becoming a very destructive program. When you look at what low rates have done to the Japanese economy and Japanese retirees, Kuroda-san’s coming to Jackson Hole and declaring that negative rates have been a success demonstrated a fair amount of chutzpah. But then he supplied only a small helping of the staggering amount of hubris displayed at Jackson Hole by central bankers from all over the world, who were celebrating the success of the most repressive monetary policy conditions in the history of mankind. The IMF, the BIS, and the World Bank are all revising their global growth predictions downward at a rapid clip. You get the feeling these guys could spin Napoleon’s invasion of Russia into a positive story and one they could take credit for.
In today’s letter we are going to look at the FOMC’s decision-making process for monetary policy and survey the unpalatable future that our leaders are cooking up for us. But we won’t be living in the fantasy world they have created for themselves; we are going to have to live in the real world instead, where investment portfolios make a difference to our lifestyle and retirement, not only for ourselves but for our families and clients.
I must confess, the more I think about where the “monetary policy community” of academic elites has brought us, the angrier I get. It has been a long time since I have been this passionately upset about something. And not merely because the policies are stupid. If I got passionately upset about every stupid idea I come into contact with, I would soon require serious blood pressure medication. Having been intimately involved in the political process for almost 25 years in a prior life, I daily came into contact with stupid ideas and thought myself somewhat immune.
No, what the Fed has done is to destroy the retirement hopes and dreams of multiple tens of millions of my fellow US Boomers, and when we include the effects of the destructive policies of the rest of the world’s central banks, the number becomes hundreds of millions. The secure and protected world our central bankers live in is far removed from that of the American or European middle class retiree. The purity of their theory and the clarity of their economic thought is evidently far more important to them than people’s wellbeing is.
However, numerous thoughtful scholars and those in the business community are mounting a serious pushback. They may be considering the wisdom of Winston Churchill’s remark, “However beautiful the strategy, you should occasionally look at the results.
Central bankers of the world look around them and see nothing but confirmation of their brilliance. Mostly they see it reflected from the stock markets, but some of us are beginning to think they are going blind.
This week I want to expand on my recent Federal Reserve criticism. I’ve talked about the mistakes I think they will make in the next recession (whenever it starts). We need to think about that future in the light of the Fed’s mistakes in the wake of the last recession. That is really where our disagreement with them began. The Fed believes its policies worked. I say those policies did not work, and the dismal recovery we have suffered through occurred in spite of the Fed, not because of it. Federal Reserve policy has actually thwarted the normal recovery process.
The Fed’s Fruitless Follies
If the Fed had really believed their own post-recession forecasts, they would have been normalizing interest rates by 2012. Instead, they went on devising, deploying, and now winding down various shotgun stimulus tools. Maybe they honestly believe they hit the target, but the rest of us aren’t convinced.
Almost everything the Fed did to us since 2008 falls into two broad categories: interest rate repression and quantitative easing.
Here is the federal funds rate from 2007 to 2016. The shaded area is what we now call the Great Recession.
The Federal Open Market Committee entered 2007 with the rate target at 5.25%. They starting lowering it in August of that year – months before the economy went into recession. Why was that? Recession or not, many folks weren’t doing well. Even then there was talk of banks having difficulty, though the worst was yet to come.
Look how fast rates fell. In July 2007 savers could buy Treasury bills, certificates of deposit, or other principal-protected savings instruments and enjoy a 5% or better risk-free yield. Longer-term fixed-income products actually offered even higher yields. A year and a half later, the fed funds rate was bumping the zero bound, and savers could make nothing without taking on market risk, which few wanted to do at the time, because iconic brands were blowing up everywhere.
Here is the great irony and possibly the most iniquitous part of the Fed’s monetary policy initiative. They wanted investors to move out on the risk curve. But did they bother to look at the demographics of this country? We have a huge bulge of Boomers – retirees and near-retirees who do not need to be moving out the risk curve at this time in their lives. They need Steady-Eddie returns, and they need to be reducing their risk, not increasing it.
A sober look at the current economic environment reveals overvalued, overbought, and illiquid markets everywhere. The global central bank community’s ultra-low and negative interest rates have created an environment of risk that is looking more and more like a bubble in search of a pin. If and when it bursts, it will take the retirement dreams of millions of Americans with it.
From the Fed’s perspective, super-low interest rates were economic stimulus. With borrowing costs so low, we were all supposed to race out and buy stuff. Companies should have expanded and hired more workers. Homebuilders should have been incentivized to build more McMansions in the suburbs, knowing qualified buyers would appear like magic.
What was supposed to happen was a normal recovery. What we got was the weakest recovery on record. The Federal Reserve will offer the counterfactual that if they had not given us their stimulus, the recovery would have been even weaker. That, of course, is something that neither they nor we can prove, one way or the other. We can go back and look at a far worse recession in the early 1920s, when the government did nothing and the resulting recovery gave us the Roaring ’20s. Very few people remember what was calledthe Depression of 1920–21. Unemployment was close to 12%, and there was extreme deflation – the largest one-year percentage price decline in 140 years of data. Christina Romer estimates it was a 14.8% decline. Put that in your CPI pipe and smoke it. Industrial production dropped by 30%. And there was a horrendous bear market.
By the time President Harding and his Commerce Secretary, Herbert Hoover, got around to calling for a conference and organizing committees, the economy was already recovering. Notably, the administration did cut income taxes, which helped reinforce the Roaring ’20s.
A large part of the problem in the late ’10s was that the Fed was raising rates into the recession in an effort to protect the dollar and fight what they considered to be inflation. Central bankers of that era had a gold and hard-dollar fetish that led to massive policy errors. When they actually began to normalize their monetary policy, the economy took off. A normalized interest rate policy, what a concept…
In our own generation, we got stimulus for Wall Street in the form of QE, and it led to an inflation of asset prices. No one really minds if the value of their stocks, real estate, and other assets go up; and there was the assumption that a rise in the stock market and real estate would trickle down to Main Street. Clearly, it has not.
Speaking of asset price inflation, Peter Boockvar writes this week:
The inflation/deflation debate we know goes both ways for consumer prices. Where there should be NO debate is the asset price inflation we’ve seen over the past 5+ years. We also know that the asset price inflation was more than just in stocks and bonds. It also spilled over into high-end apartments, antique cars, and paintings. It also spread into other ‘hard assets.’ In 2014, the Action Comics #1 comic book that introduced Superman sold for $3.2mm up from $2.2mm three years earlier for another copy of the same comic in similar condition. That was a record high price. A few days ago a T206 Honus Wagner sold at auction for $3.2mm, also a record high price for the same exact card that sold for ‘just’ $2.1mm three years ago earlier. In case you missed it yesterday, the WSJ quantified the returns on Mickey Mantle baseball cards over the past 10 years. For the ultimate Mantle card, his Topps rookie year of 1952, the percentag e increase has been 674% for a high-grade card. The average return for his 16 Topps cards was 544%. These returns compare with 85% for gold, 40% for home prices, and 59% for the S&P 500 over the same 10-year time frame. The Fed, though, has no reason to be fearful on inflation for as long as they don’t include asset prices in the CPI or PCE so we magically won’t have any inflation much above 2%.
(Okay, how many Boomers just like me are kicking themselves for not keeping their shoeboxes full of baseball cards? I had those Mickey Mantle and Willie Mays cards, and all the others. And because my dad had played semipro, I collected a lot of the older cards of several previous generations that he told me about. The Ty Cobb and Cy Young cards were the anchors of my portfolio. Ahh, but I dream…)
Back to the real world. What did happen was the opposite of stimulus, at least for those who were not the direct beneficiaries of quantitative easing. That would be the people who actually wanted to be prudent and save and put money in fixed-income and certificates of deposits. Remember when you could invest in a CD at 5% to 6%? What a quaint notion.
 By reducing the incomes of retirees and terrifying near-retirees, the Fed successfully reduced economic activity. Hopefully, that was not their intent, but that is what happened. They claim they managed to save the banking system from collapse, and I would agree that QE1 was necessary and beneficial to the system. I guess that’s something to their credit, but it came at tremendous cost. They put much of the cost of rescuing the banks on the shoulders of completely innocent people. The cost was borne by savers and small investors.
In the Middle of a Massive Monetary Policy Error
I would argue that the Great Recession was a result of a massive monetary policy error: keeping rates too low for too long, which, when coupled with lax or no regulation in the mortgage markets, resulted in a housing bubble and a crash, which bled over to global markets. This outcome should not have been a surprise to anyone. A number of us were writing as early as 2004–05 about the problems that were the primary triggers for the Great Recession.
As noted above, it was central bank errors in 1919 and 1920 that caused the 1920-21 depression. And pretty much everyone agrees that the Federal Reserve had a big hand in causing the Great Depression. Certainly, the wrong monetary policies resulted in the recessions of ’80 and ’82. Note: it was not the policies of Paul Volcker that caused the back-to-back recessions but those of his immediate predecessors who allowed inflation to get out of control. Volcker’s hand was forced, and he had to act aggressively. I lived through that time as a businessman, and I vividly remember borrowing at 18%. It was not fun.
I believe we are again suffering the effects of a massive monetary policy error. The error has already been committed, but we have just begun to endure the consequences. We are still living in a dream, but we’re nervous, much like we were in 2006. The Federal Reserve has repeated the mistakes of the last cycle. They have kept rates too low for too long, but this time they have outdone themselves, clinging desperately to the zero bound. In doing so they have financialized the economy and made it hypersensitive to interest rate moves.
Ben Bernanke made a big mistake by opting for QE 3. Arguably, if he had begun to normalize rates rather than to create a “third mandate” for the Federal Reserve to support stock market prices during and after QE 3, we would not be in the situation we are in today, where the very hint of normalizing rates sends the markets into a frenzy.
Bernanke should have looked the stock market straight in the eye during the Taper Tantrum, summoned his inner Paul Volcker, and told the market, “I am not responsible for stock market prices.” The markets probably would have suffered a rather quick, sharp correction and moved on. And it might not even have been much of a correction. Markets often correct, as they did in 1987 or 1998, without becoming lasting bear markets if there is not a recession.
Admittedly, a normalized short-term interest rate today would likely still have a “2 handle” or even lower. Short-term rates, at least in normal times, have tended to be in the vicinity of inflation. The 10-year Treasury bond rate has had a close relationship with nominal economic growth.
I would prefer to allow a market mechanism (rather than a committee of 12 people who are prone to enormous biases) to determine short-term rates. A committee that prioritizes the interests of the stock market above the interests of savers and retirees and pension funds is a dangerous committee.
If the FOMC had begun to normalize rates in 2012 rather than looking at the stock market as a primary indicator of the health of the economy, the economy and the stock market would be doing much better today, and savers would at least be getting some return on their money. And perhaps, if rates were normalized, the governments of the world would be motivated to control their deficits. (I know, that last statement proves I’m a dreamer.)
Greenspan had monstrous confidence in the wealth effect and how it would trickle down. The data is now in; the papers have been written; and the nearly overwhelming conclusion is that the wealth effect is, at best, inconsequential. What we have is another instance of the Federal Reserve ignoring Winston Churchill’s maxim: “However beautiful the strategy, you should occasionally look at the results.”
Yet, the policy geniuses at the Fed appear certain that the wealth effect is going to trickle down to Main Street any day now.
How Do You Mess Up the Easiest Prediction in the World?
A few weeks ago we got the new dot plots showing where FOMC members expect interest rates to be in the future. If you were to look at this predictive path in isolation, you would make the rational assumption that interest rates are going to rise by 2% or more in the next two years. The chart below shows their expected rate increases four months ago: In June, by a margin of two to one, FOMC members were expecting at least two rate increases, if not more, this year.
Has the economy changed much since then? Not really, but somehow, afraid of their own shadow, FOMC members are now projecting by a three to one margin that there will be only one rate increase this year, of 25 basis points or less. Here is the plot from theSeptember meeting:
This constant rethink is not just a recent phenomenon. We have seen it ever since the FOMC began to give us their forecasts for interest rate hikes. Less than two years ago they were expecting rates to be around 3% today and to reach 4% by the end of 2018! Each subsequent quarterly plot is revised downward, but the pattern always remains the same. Rates are going to “normalize” in a time frame that is always just around the corner but never seems to arrive. The chart below, from Business Insider, shows the paths of their rate predictions, and the dotted line down at the bottom shows what has actually happened.
This reveals an interesting dichotomy. The Fed determines what interest rates will be. So what they are doing is predicting what their own decisions will be. And while Federal Reserve economists have basically gone “0-fer” with all their predictions for the growth of the economy – a predictive task that is orders of magnitude more difficult than predicting what they will decide on interest rates – they have also gone 0 for 11 quarters with their predictions for their own monetary policy!
While I have been known to change my mind now and then, the FOMC members have been thinking seriously about interest rates every quarter for as long as there has been an FOMC. They know they have to make forecasts. They meet regularly, and I am sure they have phone calls and private dinner meetings and conferences, just like any other board of directors would. The easiest prediction in the world should be to tell me what they are going to do with policy rates.
The dot plot tells us what they think should happen, but between the time their forecasts are made and the time they actually have to make a decision, something always happens to keep them from pulling the trigger. I think that something is Yellen and her inside crowd of ultra-doves in the leadership of the Fed.
Dr. Stanley Fischer, vice chairman of the Fed, when asked his views on negative rates, said:
Well, clearly there are different responses to negative rates. If you’re a saver, they’re very difficult to deal with and to accept, although typically they go along with quite decent equity prices. But we consider all that, and we have to make trade-offs in economics all the time, and the idea is, the lower the interest rate the better it is for investors.
Stanley Fischer is the intellectual leader of today’s Federal Reserve. He is one of the most respected members of the “policy community.” During the last crisis, when he was head of the Bank of Israel, in pursuing his quantitative easing he bought literally anything in Israel that was not nailed down. So when he says that he must put the interests of investors in the stock market ahead of the interests of savers and retirees because he thinks that is best for the overall economy, you have to realize that this is the dogma being whispered into the ears of every FOMC member.
And while there is a growing drumbeat from banks and serious members of the “policy community” in Europe and Japan that negative interest rates are damaging the system, you are not hearing that from Stanley Fischer and Janet Yellen and the other leaders of this Federal Reserve. Yves Mersch of the ECB talked about the problems banks are having and said, “The longer [rates] remain low, the more pronounced the side effects will be.” Deutsche Bank and other major European bank economists are starting to sound semi-apocalyptic as they bemoan the policies of the ECB. Here at Mauldin Economics, we are doing some in-depth research based on a few small reports about how desperate the European insurance community is. Understand that European insurance funds are several multiples the size of their banking community.
Low interest rates have traumatized US pension funds and basically made it impossible for funds to meet their investment targets. And the consultants to whom the funds pay large fees are still showing them models (based on gods know what assumptions) that say it is okay to project 7% to 7.5% compound returns for the future.
So here we are, in a weak recovery that grows longer in the tooth with each passing month. I have discussed the assorted potential crises that could set off the next recession. You know the list: China, Japan, Italy, Germany (99% of investors do not understand how vulnerable Germany is), our own elections here in the US, or just a gradual slowdown as consumers lose the will or ability to spend. Something will happen to set off another shock, and it will probably happen in the next year or two. Then what?
This brings us to perhaps the biggest danger of all: People are losing faith in the Federal Reserve. Not without reason, either. Ben Hunt says the Fed is “losing the narrative.” By that he means that most Americans are skeptical of the Fed’s happy talk and no longer believe that Fed policies will result in the economic growth projected.
Sadly, that group of “most Americans” does not include Federal Reserve governors and bank presidents. All evidence suggests they believe their policies are working out swell. Unemployment is down, so Janet Yellen is happy. Stocks are up, so Stanley Fischer is happy. They invited all their friends to Jackson Hole to plan the next party, in which they will spin the bottle on negative rates and try to get Congress to eliminate $100 bills. They think it will be fun. Many in the economics profession want to party with them.
We will have another financial crisis and/or recession, probably soon, and we can’t trust the Fed to respond correctly. We’ll be lucky if whatever comes out of their Frankenstein lab is only ineffective. There’s a very real risk they will make the situation far worse. The masses of unprotected people are in no mood to swallow more monetary policy medicine, much less any additional remedies that globalist plutocrats may try to shove down their throats.
In an ideal world we might be glad to see the Fed stand aside and let markets adjust themselves. The problem is that said adjustment will now be extremely painful for a large part of the population. So the Fed may be damned if it does and damned if it doesn’t.
I have no idea how the election will turn out. It seems to me that Donald Trump now needs a very good debate Sunday night. But win or lose, Trump is a huge canary in the political coal mine, and the political and monetary-policy elite should listen up. Brexit was a warning, and Austria and Italy and Germany – indeed all of Europe – are sending a similar warning. The Unprotected are beginning to push back, and not just at the edges. The center is not holding. A new center is going to be created, one that the elites may not appreciate.
The Protected elites of both major US political parties may genuinely think they are acting in the best interests of the country. But middle- and lower-class Americans are learning that politics and economics as usual mean diminished lifestyles and futures, not only for them but for their children.
The best-laid schemes o' Mice an' Men
Gang aft agley…
Winter is coming. You need to have a plan. Over the next few months I will be talking about how I intend to get through the coming economic winter. If my plan does not work for you, then you need to come up with your own. Hope is not a strategy, my fellow Baby Boomers.
Dallas, Planning, and Writing
I will be speaking at the MoneyShow Dallas, which will take place October 19–21. I will be speaking three times on Thursday, October 20. The first presentation will be a midmorning panel with Steve Moore and Mark Skousen on how the presidential election will affect your portfolio. The second one will take place shortly thereafter: I will share my thoughts on how the Federal Reserve will react in the macroeconomic environment that is unfolding. Then that afternoon I will make my first presentation to the public on how I think portfolios should actually be structured to meet the upcoming challenges, and I will be going into some detail. Click on the link above and register. You can see the rest of the speakers and the agenda there, too. There are some very good speakers at this conference (including friends Steve Forbes and Jeff Saut), and I am looking forward to interacting with as many of them as I can. Attendance is free, and I will actually have a booth in the exhibit hall where I will spend time meeting and talking with attendees.
I am speaking for my friends at the Commerce Street Bank at their annual Investment Conference on Thursday, October 27, at the George W. Bush Library here in Dallas.
Longtime readers have probably noticed that there is not a lot of travel in my upcoming schedule. That is on purpose. I feel like I have been planning the Normandy Invasion. I have developed a rather straightforward new approach to constructing a core portfolio for what I think is likely to be our economic future. But the logistics of making that approach a reality I can share with you – of attending to the regulatory complexities in a world where every i must be dotted and t must be crossed, and helping a score of new players get to know each other and learn to work together – is somewhat daunting. That said, I feel like I have rounded the final turn and can see the finish line in front of me. We will be announcing the new Mauldin Solutions Smart Core Portfolios in the not-too-distant future.
Not to mention that I am still working on my book about what the next 20 years will look like. I have rough drafts of eight chapters (out of a planned 25 or so); and as soon as we have finished the groundwork for Mauldin Solutions, I will pivot the bulk of my writing time to finishing the book. I will be glad to get both projects done. When that happens, I have promised Shane that we can take off for a few weeks on a real vacation. We can go anywhere she wants as long as there is wi-fi, a real gym, and a reasonable variety of foods to eat. But I must admit that I am not booking hotel rooms yet.
Some 25 years ago (where does the time go?) I took daughter Tiffani to a Dallas Mavericks basketball game (I have been a season ticket holder for some 34 years, although back then my tickets were up in nosebleed territory). Afterwards we took the elevator to the top of “the Ball” (Reunion Tower), which is still a Dallas skyline highlight. She had a virgin daiquiri and saw all of Dallas at night. It evidently made an impression on her, because tonight she wants to relive that experience and take her almost 7-year-old daughter, Lively, along to sit in the ball and watch Dallas go by as it revolves, while I think about how fast 25 years goes by. And realize that in 25 years from now it might be a great granddaughter. (It’s hard to get your head around that.)
You have a great week. I am hoping to finish a number of projects that are all so very close to being done, so that the real work can get started.
Your reading too many legal agreements analyst,
John Mauldin


The BIS Warns on China
John Mauldin | September 21, 2016
I’ve been saying for the past couple years that the next recession here in the US will probably be triggered by an external macro event or cascade of events, coming out of Europe or China. Today’s Outside the Box sharpens our focus on China, which had already got quite a lot sharper with Michael Pettis’s piece in Outside the Box on Sept. 2.
Today’s post comes from Ambrose Evans-Pritchard of the London Telegraph. He is commenting on the recently released quarterly report of the Bank for International Settlements (“the central banks’ bank”), in which the BIS repeats Pettis’s warning that China faces escalating risk of a major debt and banking crisis.
The BIS is also rightly concerned about spillover from China to the global economy. After noting that outstanding loans in China have reached $28 trillion – as much as the commercial banking loan books of the US and Japan combined – Ambrose adds, “The scale is enough to threaten a worldwide shock if China ever loses control. Corporate debt alone has reached 171pc of GDP, and it is this that is keeping global regulators awake at night.”
Total Chinese debt reached 255% of GDP at the end of 2015, a jump of 107% in the past eight years – and still rising fast. Every year, China’s leadership promises to rein in debt growth, and every year the growth just keeps accelerating. That is because China’s GDP growth is fueled by debt, and that debt is becoming increasingly inefficient in producing GDP.
Does China still have the resources to deal with this issue? The answer is a qualified yes – but then there may not be the resources to deal with the other little items on China’s shopping list. The New Silk Road that China seems to be actually in the process of building is estimated to cost $1 trillion, and that’s without cost overruns. Plus, the Chinese leadership has promised massive spending on the interior part of the country to bring up the quality of people’s lives there.
One trillion here and one trillion there, and pretty soon you have run through your reserves and are getting into monetization problems; and then you have all sorts of currency and related issues, not to mention potential inflation, unemployment, the slowing of the economy, the associated public unrest, and so on.
No, I do not think China is going to massively implode, but the world is really not ready for a China that is only growing at 2% or 3% a year. (Even though 2–3% growth would sound pretty good if it was happening in the US.) That will feel a lot like a hard landing as far as world growth is concerned. All happening when there are unsettled political agendas in a number of countries (starting with this one) with regard to globalization and trade treaties.
I am back in Dallas after spending the past few days with Shane in Denver. I got to catch up with David Rosenberg and Mark Yusko and have lunch with George Will. George, who is normally upbeat as he looks to the future, spoke after lunch at the conference and delivered one of the most depressing speeches I have heard in a long time. He was just not in a good mood. I should have tried to engage him on baseball, and the afternoon might have been more enjoyable.
Have a great week and savor the last few days of official summer.
Your seeing global risk everywhere he looks analyst,

John Mauldin, Editor
Outside the Box


Renzi’s Great Gamble


There is an extremely important election coming up, and I am not talking about the US presidential election. The upcoming referendum in either October or November in Italy may have as much or even more macroeconomic impact on the world as the US election, but hardly anyone outside of Italy is paying much attention to it – yet.

I have been saying for some time in interviews around the country that I think the referendum in Italy has even more potential impact than the Brexit vote did in the United Kingdom. And just like the Brexit vote, it is rife with emotion and political turmoil, making the outcome too close to call.

If you are a voter in Italy, your frustration (or maybe even anger) is entirely understandable. The current prime minister, Matteo Renzi, has basically bet his career on this referendum, which would allow him to enact what most of us would see as much-needed reforms – in fact they’re the very Italian reforms that I have written about in my letters over the last five years and that I talked about in my previous two books. Italy has about as sclerotic a governmental process as any country in Europe, and that is saying something. There is no end of corruption and crony politics, with each faction wanting to keep the status quo and not have to give up any of its perks but wanting everybody else to give up all of theirs. Not unlike a country close to where I reside (I say with a smile and a sigh). Seriously, friends, this needs to go on your economic radar screen. If the “no” vote wins, Renzi has promised to resign, which will throw Italy into a political crisis. Then there will be a real potential to elect parties that would call for a plebiscite on whether to stay in the European Union – Italexit – and is not at all clear today what the Italians would decide to do. Know this: the European Monetary Union really does not work very well, if at all, without Italy, and a “no” vote would be the death knell of the euro, at least as we know it today.
October 9, 2015

The 10th Man: Being the 10th Man

By Jared Dillian

I was going to give you this big macro rundown of what happened since the payroll number, but I changed my mind. Anybody can give you the play-by-play. Let’s talk about it in the context of true contrarian investing.
Being contrarian doesn’t just mean doing the opposite of what everyone else is doing. It means doing what is really unpopular and may make you subject to ridicule.
If you went on CNBC before the payroll number and said that you were a raging emerging markets bull, they would have put the clown nose on you and given you the hook.
And yet…
This may not seem like a big deal to you. If you are an individual investor, you can have the iShares MSCI Emerging Markets Index ETF (EEM) in your portfolio and lose money on it, and the only one who cares is you.
But if you run a mutual fund or a hedge fund, you have to file a 13F and then everyone can see EEM in your portfolio, and you have to explain to your investors why you have this dumb EEM position that everyone hates and that’s obviously going down—and if you lose money on indefensible things, it becomes difficult to defend your continued employment.
For example, if Nike (NKE) were to miss earnings and gap lower 15%, nobody would get fired, because everyone owns it.
But if you go down with the emerging markets ship, you are definitely getting fired.
So being a contrarian is hard if you’re a professional, because if you are wrong, you are wrong publicly, and you experience shame, and as we said before, shame is the most powerful motivator.
I did not pick up my moniker The 10th Man by accident. Do you know where it came from? It came from the zombie movie World War Z.
Spoiler alert: In the movie, Israel survived the zombie invasion because they employed a 10th man whose job it was to disagree when everyone else agree
d. Israeli intelligence intercepted emails from India saying that they were being attacked by “undead,” literally, zombies.
Everyone in Israeli intelligence figured that the Indian government was using the word “zombies” to refer to something else.
The 10th man said, “What if they are actually talking about zombies?”
Leading up to the payroll number, we got a lot of ultra-bearish articles hitting the tape, but the Big Kahuna was the slickly produced Carl Icahn video, Danger Ahead, whose release perfectly coincided with the low tick in stocks.
His argument was compelling, as it always is. But the bearish argument is always most compelling on the lows.
It’s tough to take the other side of Carl Icahn. His market timing is almost as legendary as his activist investing.
Here’s the point: If Carl Icahn comes out with this video on the highs, he gets the clown nose and the hook. If he comes out with it on the lows, he sounds like a freaking oracle.
It takes a lot of guts to publicly call Carl Icahn a loser. That’s what I did in my professional publication, The Daily Dirtnap. There is often blowback when you do things like that.
I do not care. I have never cared what people think of me, which is my greatest asset.
If people want to think I’m crazy, fine by me.
I may only be right about half the time, but I seem to be right when everyone else is wrong, which keeps me out of a lot of trouble.

Consensus Thinking

Somehow, over the course of the last month or so, this idea developed that a rate hike would be good because it removes uncertainty.
So people were cheering for a rate hike.
Rate hikes are always, always bad for asset prices. Removing liquidity is always bad (in the short term). More liquidity is always good.
When the payroll number turned out to be very weak, it pretty much ruled out a rate hike for 2015 (and longer).
Two-year notes rallied the most in years, with yields dropping a full 20 basis points.
And stocks…
It wasn’t hard to identify the consensus thinking. As usual, it was wrong.

Operant Conditioning

The Bank of Japan is likely to quantitatively ease again, now that the Fed is not hiking. Now the Bank of England might not raise rates until 2017. Suddenly, we are once again in a world awash with liquidity. Gold is up quite a bit, and silver up even more (disclosure: I am long both gold and silver in a variety of forms, including GLD and SLV).
Wouldn’t it be interesting if we got a big precious metals rally? That would blow apart consensus thinking.
The dominant investment thesis is that a stronger dollar will murder emerging markets. What if that turns out not to be true? What if the dollar doesn’t strengthen, or all currencies weaken equally (relative to hard assets)?
This short EM trade is so old and so tired that people will stubbornly cling to it for the next six months, even in the face of overwhelming evidence to the contrary.
We’re not altogether different from the pigeons in B.F. Skinner’s box. If you could make money by pushing a button, how many times would you push the button?
Or: if you stopped making money by pushing the button, how long would you continue to sit there and push the button like an imbecile?
Inquiring minds want to know.
Jared Dillian
Jared Dillian
If you enjoyed Jared's article, you can sign up for The 10th Man, a free weekly letter, at Follow Jared on Twitter @dailydirtnap
The article The 10th Man: Being the 10th Man was originally published at

Outside the Box: A Worrying Set Of Signals

By John Mauldin

There is presently a bull market in complacency. There are very few alarm bells going off anywhere; and frankly, in reaction to my own personal complacency, I have my antenna up for whatever it is I might be missing that would indicate an approaching recession.
It was very easy to call the last two recessions well in advance because we had inverted yield curves. In the US at least, that phenomenon has a perfect track record of predicting recessions. The problem now is that, with the Federal Reserve holding the short end of the curve at the zero bound, there is no way we can get an inverted yield curve, come hell or high water. For the record, inverted yield curves do not cause recessions, they simply indicate that something is seriously out of whack with the economy. Typically, a recession shows up three to four quarters later.
I know from my correspondence and conversations that I am not the only one who is concerned with the general complacency in the markets. But then, we’ve had this “bull market in complacency” for two years and things have generally improved, albeit at a slower pace in the current quarter.
With that background in mind, the generally bullish team at GaveKal has published two short essays with a rather negative, if not ominous, tone. Given that we are entering the month of October, known for market turbulence, I thought I would make these essays this week’s Outside the Box. One is from Pierre Gave, and the other is from Charles Gave. It is not terribly surprising to me that Charles can get bearish, but Pierre is usually a rather optimistic person, as is the rest of the team.
I was in Toronto for two back-to-back speeches before rushing back home this morning. I hope you’re having a great week. So now, remove sharp objects from your vicinity and peruse this week’s Outside the Box.
Your enjoying the cooler weather analyst,
John Mauldin, Editor
Outside the Box

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A Worrying Set Of Signals

By Pierre Gave
Sept. 28, 2015
Regular readers will know that we keep a battery of indicators to gauge, among other things, economic activity, inflationary pressure, risk appetite and asset valuations. Most of the time this dashboard offers mixed messages, which is not hugely helpful to the investment process. Yet from time to time, the data pack points unambiguously in a single direction and experience tells us that such confluences are worth watching. We are today at such a point, and the worry is that each indicator is flashing red.
Growth: The three main indices of global growth have fallen into negative territory: (i) the Q-indicator (a diffusion index of leading indicators), (ii) our diffusion index of OECD leading indicators, and (iii) our index of economically-sensitive market prices. Also Charles’s US recession indicator is sitting right on a key threshold (see charts for all these indicators in the web version).
Inflation: Our main P-indicator is at a maximum negative with the diffusion index of US CPI components seemingly in the process of rolling-over; this puts it in negative territory for the first time this year.
Risk appetite: The Gavekal velocity indicator is negative which is not surprising given weak market sentiment in recent weeks. What worries us more is the widening of interest rate spreads—at the long-end of the curve, the spread between US corporate bonds rated Baa and treasuries is at its widest since 2009; at the short-end, the TED spread is back at levels seen at the height of the eurozone crisis in 2012, while the Libor-OIS spread is at a post-2008 high. Moreover, all momentum indicators for the main equity markets are at maximum negative, which has not been seen since the 2013 “taper tantrum”.
These weak readings are especially concerning, as in recent years, it has been the second half of the year when both the market and growth has picked up. We see three main explanations for these ill tidings:
1) Bottoming out: If our indicators are all near a maximum negative, surely the bottom must be in view? The contrarian in us wants to believe that a sentiment shift is around the corner. After all, most risk-assets are oversold and markets would be cheered by confirmation that the US economy remains on track, China is not hitting the wall and the renminbi devaluation was a one-off move. If this occurs, then a strong counter-trend rally should ramp up in time for Christmas.
2) Traditional indicators becoming irrelevant: Perhaps we should no longer pay much attention to fundamental indicators. After all, most are geared towards an industrial economy rather than the modern service sector, which has become the main growth driver. In the US, industrial production represents less than 10% of output, while in China, the investment slowdown is structural in nature. The funny thing is that employment numbers everywhere seem to be coming in better than expected. In this view of things, either major economies are experiencing a huge drop in labor productivity, or our indicators need a major refresh (see Long Live US Productivity!).
3) Central banks out of ammunition: The most worrying explanation for the simultaneous decline in our indicators is that air is gushing out of the monetary balloon. After more than six years of near zero interest rates, asset prices have seen huge rises, but investment in productive assets remains scarce. Instead, leverage has run up across the globe. According to the Bank for International Settlements’ recently released quarterly review, developed economies have seen total debt (state and private) rise to 265% of GDP, compared to 229% in 2007. In emerging economies, that ratio is 167% of GDP, compared to 117% in 2007 (over the period China’s debt has risen from 153 to 235% of GDP). The problem with such big debt piles is that it is hard to raise interest rates without derailing growth. Perhaps it is not surprising that in recent weeks the Federal Reserve has backed away from hiking rates, the European Central Bank has recommitted itself to easing and central banks in both Norway and Taiwan made surprise rate cuts. But if rates cannot be raised after six-years of rising asset prices and normalizing growth, when is a good time? And if central banks are prevented from reloading their ammunition, what will they deploy the next time the world economy hits the skids?
Hence we have two benign interpretations and one depressing one. Being optimists at heart, we want to believe that a combination of the first two options will play out. If so, then investors should be positioned for a counter-trend rally, at least in the short-term. Yet we are unsettled by the market’s muted response to the Fed’s dovish message. That would indicate that investors are leaning towards the third option. Hence, we prefer to stay protected and for now are not making a bold grab for falling knifes. At the very least, we seek more confirmation on the direction of travel.

Positioning For A US Recession

By Charles Gave
September 29, 2015
Since the end of last year I have been worried about an “unexpected” slowdown, or even recession, in the world’s developed economies (see Towards An OECD Recession In 2015). In order to monitor the situation on a daily basis, I built a new indicator of US economic activity which contains 17 components ranging from lumber prices and high-yield bond spreads to the inventory-to-sales ratio. It was necessary to construct such an indicator because six years of extreme monetary policy in the US (and other developed markets) has stripped “traditional” cyclical economic data of any real meaning (see Gauging The Chances Of A US Recession).
Understanding this diffusion index is straightforward. When the reading is positive, investors have little to worry about and should treat “dips” as a buying opportunity. When the reading is negative a US recession is a possibility. Should the reading fall below – 5 then it is time to get worried – on each occasion since 1981 that the indicator recorded such a level a US recession followed in fairly short order. At this point, my advice would generally be to buy the defensive team with a focus on long-dated US bonds as a hedge. This is certainly not a time to buy equities on dips.
Today my indicator reads – 5 which points to a contraction in the US, and more generally the OECD. Such an outcome contrasts sharply with official US GDP data, which remains fairly strong. Pierre explored this discrepancy in yesterday’s Daily (see A Worrying Set Of Signals), so my point today is to offer specific portfolio construction advice in the event of a developed market contraction. My assumption in this note is simply that the US economy continues to slow. Hence, the aim is to outline an “anti-fragile” portfolio which will resist whatever brickbats are hurled at it.
During periods when the US economy has slowed, especially if it was “unexpected” by official economists, then equities have usually taken a beating while bonds have done well. For this reason, the chart below shows the S&P 500 divided by the price of a 30-year zero-coupon treasury.
A few results are immediately clear:
  • Equities should be owned when the indicator is positive.
  • Bonds should be held when the indicator is negative.
  • The ratio of equities to bonds (blue line) has since 1981 bottomed at about 50 on at least six occasions. Hence, even in periods when fundamentals were not favorable to equities (2003 and 2012) the indicator identified stock market investment as a decent bet. 
Today the ratio between the S&P 500 and long-dated US zeros stands at 75. This suggests that shares will become a buy in the coming months if they underperform bonds by a chunky 33%. The condition could also be met if US equities remain unchanged, but 30-year treasury yields decline from their current 3% to about 2%. Alternatively, shares could fall sharply, or some combination in between. 
Notwithstanding the continued relative strength of headline US economic data, I would note that the OECD leading indicator for the US is negative on a YoY basis, while regional indicators continue to crater. The key investment conclusion from my recession indicator is that equity positions, which face risks from worsening economic fundamentals, should be hedged using bonds or upping the cash component.
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The article Outside the Box: A Worrying Set Of Signals was originally published at
August 11, 2015

The 10th Man: A Correction Fireside Chat

By Jared Dillian

I don’t really enjoy these things like I used to. Keep in mind, I’ve traded through a lot of blowups, going back to 1997.
They all kind of feel the same after a while.
Nobody wins from corrections except for the traders, which today mostly means computers. I forget who said this: “In bear markets, bulls lose money and bears lose money. Everyone loses money. The purpose of a bear market is to destroy capital.”
And that’s what is going on today.
For starters, long-term investors inevitably get sucked into the media MARKET TURMOIL spin cycle and puke their well-researched, treasured positions at the worst possible time.
But I’m not trying to minimize the significance of a correction, because some corrections turn into bona fide bear markets. And if you are in a bear market, you should get out. If it is only a correction, you probably want to add to your holdings.
How can you tell the difference?

My Opinion: This Is a Correction

So what were the two big bear markets in the last 20 years? The dot-com bust, and the global financial crisis. Two generational bear markets in a 10-year span. Hopefully something we’ll never see again. In one case, we had the biggest stock market bubble ever and in the other, the biggest housing/debt crisis ever. Both good reasons for a bear market.
What are we selling off for again? Something wrong with China?
Again, not to minimize what is going on in China, because it is now the world’s second-largest economy. Forget the GDP statistics. After a decade of ridiculous overinvestment, it is possible that they’re on the cusp of a very serious recession, whether they admit it or not.
But the good news is that the yuan is strong and can weaken a lot, and interest rates are high and can come down a lot. China has a lot of policy tools it can use (unlike the United States).
Let’s think about these “minor” corrections over the last 20 years:
1997: Asian Financial Crisis
1998: Russia/Long-Term Capital Management (LTCM)
2001: 9/11
2011: Greece
All of these were VIX 40+ events.
In retrospect, these “crises” look kind of silly, even junior varsity.
The Thai baht broke—big deal.
Russia’s debt default was only a problem because it was a surprise. And the amount of money LTCM was down—about $7 billion—is peanuts by today’s standards.
After 9/11, stocks were down 20% in a week. The ultimate buying opportunity.
And in hindsight, we can see that the market greatly underestimated the ECB’s commitment to the euro.
So what are we going to say when we look back at this correction in 10-20 years? What will we name it? Will we call it the China crisis? I mean, if it’s a VIX 40 event, it needs a name.
I try to have what I call forward hindsight. Like, I pretend it’s the future and I’m looking back at the present as if it were the past.
My guess is that we will think this was pretty stupid.

What to Buy

I saw a sell-side research note yesterday suggesting that this crisis is marking the capitulation bottom in emerging markets. I haven’t fully evaluated that statement, but I have a hunch that it is correct.
China is cheap, by the way. But if China is too scary, they are just giving away India. I literally cannot buy enough. And I have a hunch that Brazil’s president, Dilma Rousseff, is going to be impeached and the situation in Brazil is going to improve relatively soon.
Think about it. The most contrarian trade on the board. Long the big, old, bloated, corrupt, ugly, bear market BRICs.
Also the scariest trade. But the scary trades are often the good trades.
There’s more. If you think we’re in the midst of a generational health care/biotech bull market, prices are a lot more attractive today than they were a few weeks ago.
I also like gold here because central banks are no longer omnipotent.
That reminds me—there was something I wanted to say on China. The reason everyone hates China isn’t because of the economic situation. It’s because they made complete fools of themselves trying to prop up the stock market. So virtually overnight, we went from “China can do anything” to “China is full of incompetent idiots.” Zero confidence in the authorities.
You want to know when this crisis is going to end? When China manages to restore confidence.
When they have that “whatever it takes” moment, like Draghi.
If they keep easing monetary policy, sooner or later there will be an effect.

I Am Bored

I used to get all revved up about this stuff. That’s when I made my living timing tops and bottoms. I don’t do that anymore. I do fundamental work, and I go to the gym and play racquetball. The mark-to-market is a nuisance.
Also, if you can’t get excited about a VIX 50 event, you have probably been trading for too long.
There is a silver lining. The disaster scenario, where the credit markets collapse due to lack of liquidity, isn’t happening. Everyone is hiding and too scared to trade.
Honestly, high-grade credit isn’t acting all that bad. And it shouldn’t. I don’t see any big changes in the default rate.
Anyway, if you want to go be a hero and bid with both hands, be my guest. It’s best to be careful and average into stuff. These prices will look pretty good a couple of months from now, I think.
Jared Dillian
Jared Dillian
If you enjoyed Jared's article, you can sign up for The 10th Man, a free weekly letter, at Follow Jared on Twitter @dailydirtnap
The article The 10th Man: A Correction Fireside Chat was originally published at
August 11, 2015

Connecting the Dots: Xiaomi: the Apple iPhone Killer?

By Tony Sagami

If you own Apple stock, you better pay attention.
A Chinese company named Xiaomi is eating Apple’s lunch in China, and its popularity is slowly spreading across the globe.
Don’t feel bad if you have never heard of it, because very few Americans have. However, Xiaomi is a household name in Asia and may soon become one in the US too.
Xiaomi—pronounced SHOW-em—is a smartphone maker, and it happens to make the #1 bestselling smartphone in China. Yup, Xiaomi is even more popular than the Apple iPhone.
The most recent market share numbers show that Xiaomi grabbed 15.9% of the mobile phone market in China during the second quarter of this year. In 2014, Xiaomi sold 420 million smartphones and pulled in $12 billion in revenues.
The Xiaomi phone that is generating those big sales is the Mi Note. Its screen is considerably larger than the iPhone’s. It is thinner, weighs nearly half an ounce less, has longer battery life and a higher-resolution camera that takes beautiful photos, and is compatible with all the Android apps on Google Play.
Best of all, it costs only $370 without a contract!

“Mi” Fans

Chinese consumers are crazy about Xiaomi. Really crazy!
They call themselves “Mi-fans.” They have fan clubs and a “Mi-Fan Day” on April 6, when tens of thousands of Chinese travel all across China to attend new product launches. The crowds are so large—as many as 170,000—that security is required for crowd control.
At the recent 2015 Xiaomi festival, the company sold over 2 million smartphones and pulled in 2.08 billion yuan (US$335 million) in just 12 hours.
Part of the euphoria comes from charismatic founder Lei Jun, who inspires loyalty in his customers in much the same way the late Steve Jobs did for Apple. Lei even wears jeans and a black turtleneck like Jobs.
Charisma can create excitement, but a company needs to deliver a great product too. Xiaomi is known for delivering high-quality products at very affordable prices and has built a dedicated consumer base that absolutely loves its products.
Heck, Apple isn’t even #2 in China; a Taiwanese company called Huawei was a close second with a 15.7% market share. Xiaomi and Huawei together now control one-third of the smartphone sales in China.
The iPhone has fallen to third place with 10.9% of the market, closely followed by Samsung.
Third place is bad enough, but China, which was supposed to power Apple’s growth going forward, is now a drag for Apple: China sales plunged by 21% in the second quarter from Q1.
By comparison, Huawei’s sales surged 48% over the prior quarter.
What’s an investor to do?
I’m not suggesting that you buy Xiaomi stock.
Why not?
Because you can’t!
Xiaomi is one of the world’s largest smartphone makers, but it is privately held and estimated to be worth $46 billion, which makes it the second-highest valued private tech company in the world (behind Uber).
On April 28, 2015, I wrote this about Apple: “My expectation is that we’ll have a chance to buy it at a much cheaper price later this year.”
Apple closed at $130.02 that day, just a couple bucks off its 52-week high of $134.54, but is now substantially cheaper, as I predicted.
What I’m suggesting is that Apple’s best days are behind it, and I don’t say that just because Xiaomi and Huawei are kicking its ass in China:
  • Apple missed expectations on shipments for all its major products. In particular, investors were expecting a monster iPhone quarter, but Apple sold only 47.5 million iPhones instead of nearly 49 million as predicted.
  • Microsoft’s Windows 10 will provide more competition to the iPad and Mac.
  • Apple hasn’t revealed specific sales figures for the Apple Watch, but analytics firm Slice Intelligence says that sales have dropped from an average of 35,000 a day in April to 5,000 a day in July.
  • The smartphone market is maturing. Global mobile phone shipments grew a paltry 2%, from 428 million units in Q2 2014 to 434.6 million units in Q2 2015.
Look, the iPhone accounts for 70% of Apple’s total revenues, and the Chinese weakness is trouble because China passed the US as Apple’s biggest iPhone market in the first quarter of this year. Today, China is the world’s largest smartphone market, and Apple isn’t doing well there.
Heck, even CEO Tim Cook has acknowledged that China is creating “speed bumps” for Apple.
I’m not telling you to sell your Apple stock tomorrow morning. But I am telling you that you need some type of exit strategy to protect yourself because Apple’s stock is headed lower.
Let the hate mail begin!
Forget Apple… To find some great value stocks with good upside and an average yield of 4.75% (in our current portfolio), take advantage of our 90-day money-back guarantee and give Yield Shark a risk-free try.
Tony Sagami
Tony Sagami
30-year market expert Tony Sagami leads the Yield Shark and Rational Bear advisories at Mauldin Economics. To learn more about Yield Shark and how it helps you maximize dividend income, click here. To learn more about Rational Bear and how you can use it to benefit from falling stocks and sectors, click here.
July 21, 2015

Thoughts from the Frontline: Productivity and Modern-Day Horse Manure

By John Mauldin

“They just use your mind and they never give you credit. It’s enough to drive you crazy if you let it.”
– Dolly Parton, “Working 9 to 5”
Almost everyone wants to be more productive. I include myself in that group – there are lots of ways I could be more productive. When I have conversations with people I think are very productive, they almost always tell me they wish they were more productive. What more could anyone expect from them?
In most cases, they aren’t responding to external demands. No one is cracking a whip over them; they have personal reasons for wanting to produce more. They want their children and grandchildren to produce more, too. It’s almost a cliché in American culture: when the kids become “productive citizens,” a parent can finally feel that he or she succeeded. Multiply this by millions of families, and the result is economic growth.
What exactly do we mean by this “productivity” word? I’ve given this a good deal of thought lately, and I plan to explore it in my newsletters over the next few months. As you will see, productivity growth has both a positive side and a very negative side.
But before we go any further, I want to mention that the presentations and select videos from the 2015 Strategic Investment Conference are finally now available! Featured are videos of two of our most popular speakers, Jeffrey Gundlach and David Rosenberg, plus a number of other high-profile speakers like George Friedman and Louis Gave, plus all the expert panels. If you are a Mauldin Circle member, you can access the videos by going to to log in to your “members only” area of the Altegris website (getting there takes a little navigation). Upon login, click on the “SIC 2015” link in the upper-left corner to view the videos and more. If you have forgotten your login information, simply click “Forgot Login?” and your credentials will be sent to you.
If you are not already a Mauldin Circle member, the good news is that this program is completely free. In order to join, you must, however, be an accredited investor. Please register here to be qualified by my partners at Altegris and added to the subscriber roster. Once you register, an Altegris representative will call you to provide access to the videos and presentations by selected speakers at our 2015 conference.
Productivity & Growth
Productivity is a critical part of the economic growth equation. We track the productivity of entire nations by means of gross domestic product (GDP), the sum total of all the goods and services their people produce. I have some issues with the way we calculate GDP, but it’s the best statistic we have for now. (I wrote an overview last year called “GDP: A Brief But Affectionate History,” which you can read here.)
There are two – and only two – ways you can grow your economy. You can either increase your population or increase your productivity. That’s it.
The Greek letter delta is the symbol for change. So if you want to change your GDP, you write that as
Δ GDP = Δ Population + Δ Productivity
That is, the change (delta) in GDP is equal to the change in population plus the change in productivity.
If you are a country facing a population decline (like Japan), then to keep GDP growing you have to increase productivity even more. That is why I have written so much about demographics over the years. Population growth (or the lack thereof) is very important. Russia is facing a very serious problem over the next 20 years that will require either a significant increase in productivity or a high level of immigration to stave off a collapsing economy. Russia’s population has declined by almost 7 million in the last 19 years, to 142 million. UN estimates are that it may shrink by about a third in the next 40 years. But that’s another story for another letter.
One last economic sidebar. You cannot grow your debt faster than your nominal GDP forever. At some point, the market begins to think that you will not be able to pay your debt back. Think Greece. This is no different from the fact that a family cannot grow its debt faster than its ability to bring in income to pay that debt back. At some point, you run out of the ability to borrow more money, as lenders “just say no.”
As a family’s or a country’s debts grow, the carrying cost or interest expense rises, consuming an ever-larger portion of the budget until a breaking point is eventually reached. While the exact point is a matter for serious debate (and conjecture), there is a level at which debt actually limits the potential growth of an economy. Paraphrasing Clint Eastwood, a country has to know its limitations.
We are going to hear a lot about growth in the coming presidential election. A lot of people are going to offer formulas, but you can check how realistic they are because GDP growth has just three variables. If you want to increase growth, you have to increase:
  • the number of workers, and/or
  • the number of hours they work, and/or
  • the amount they can produce in an hour.
If you want GDP to grow, you have to make at least one of these factors go up without an offsetting decline in the others. Look at any story of economic progress or collapse anywhere in history, and these three variables will explain it.
Here in the United States, for instance, growth took off in the postwar 1950s but really soared in the ’60s and ’70s as newly “liberated” women entered the workforce, raising our total number of workers. In China over the last two decades, people moved from rural subsistence farming to urban industrial jobs. The number of workers in the overall economy didn’t change overnight, but productivity skyrocketed.
Going back further, inventions like the automobile and electricity unlocked tremendous growth by increasing hourly output. Untold thousands of workers went from shoveling horse manure to more advanced occupations.
Shoveling horse manure was honorable work back then. Those workers produced something necessary (clean streets – at least until the next horse came along), but they were capable of doing so much more. We don’t think much about it today, but the average horse produces 9 tons of manure every year. That is about 35 pounds of manure daily, plus 6 to 10 gallons of urine, all of which had to be disposed of. Not to mention the amount of labor it took to feed those horses. One-quarter of agricultural output in 1900 went simply to feed horses.
I was thinking about that last week while I was in lower Manhattan. Some of the streets I walked were still paved in part by the original, uneven cobblestones. What a pain it would have been to keep them clean. Forget sanitation.
 Henry Ford (and a few others) “killed” all those jobs dealing with horses, freed a lot of our agricultural output to be sold all over the world, and thereby opened the door to better times, economically. But a lot of people had to find new employment.
“Better” for those workers was better for everyone. Affordable transportation sped up everything. The result was an economic boom that lasted through the Roaring ’20s. Millions of people left farms, moved to cities, and found high-paying factory jobs.
Do we have a 21st century breakthrough equivalent to the Model T? You bet we do. When autonomous vehicles are ready for prime time in a few years, millions of taxi and truck drivers will lose their jobs. Instead of one person driving one vehicle, we will have human car wranglers managing entire fleets as they roam through the streets. That human’s hourly productivity will be orders of magnitude higher than that of today’s drivers.
So what will the ex-drivers do for work? We don’t know yet. I’m very confident the economy will find ways to keep them productive, but I can’t say how. But their jobs will go away, just as those who shoveled horse manure lost theirs 100 years ago.
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
July 1, 2015

Thoughts from the Frontline: The People’s Republic of Debt

By John Mauldin

It wasn’t that many centuries ago that China was the absolute economic center of the world. That center gravitated to Europe and then towards North America and has now begun moving back to China. My colleague Jawad Mian provided this chart showing the evolution of Earth’s economic center of gravity from 2000 years ago to a few years and into the future:

Most investors are well aware of the enormous impact China has had on the modern world. Thirty-five years ago China’s was primarily an agrarian society, with much of the nation trapped in medieval technologies and living standards. Today 500 million people have moved from the country to the cities; and China’s urban infrastructure is, if not the best in the world, close to that standard.
The economic miracle that is China is unprecedented in human history. There has simply been nothing like it. Deng Xiaoping took control of the nation in the late ’70s and propelled it into the 21st century. But now the story is changing. Those who think that all progression is linear are in for a rude awakening if they are betting on China to unfold in the future as it has in the past.
Among the most important questions for all investors and businessmen is, how will China manage its future and the problems it faces? There are many problems, some of them monumental – and at the same time there is an amazing amount of opportunity and potential. Understanding the challenges and deciphering the likely outcomes is itself an immense challenge.
A Brand-New Book Available Online
My colleague Worth Wray and I have been investigating and writing about China for some time now. Today I’m announcing a book that we have written and edited in collaboration with 17 well-known experts on China. The book is called A Great Leap Forward? Making Sense of China’s Cooling Credit Boom, Technological Transformation, High Stakes Rebalancing, Geopolitical Rise, & Reserve Currency Dream, and we think it will help you to a solid understanding of both China’s problems and its opportunities. I know, the subtitle is a tad long, but the book does really cover all those aspects of today’s China.
Notice that there is a “?” after the title “A Great Leap Forward.” The first Great Leap Forward, initiated by Mao Tse-tung in the early ’60s, was an utter disaster. It devastated the nation, bankrupted the economy, and caused the deaths of tens of millions of people. Let’s review a little history from the introduction to the book:
When Chairman Mao decided in 1958 to transform China’s largely agrarian economy into a socialist paradise through rapid industrialization, collectivization, and a complete subjugation of the market to Chinese Communist Party (CCP) central planners, the widespread misallocation of resources led to the worst famine in recorded history and the outright collapse of China’s economy.
With very little capital at China’s disposal after its long civil war and even longer subjugation to foreign colonialists in the nineteenth and early twentieth centuries, Mao decided the best way to fund the country’s rapid industrialization was for his government to monopolize agricultural production, use the nation’s bounty to support industrializing urban populations, and finance fixed-asset investments with crop exports.

1959 –– “Prosperity brought by the dragon & the phoenix”
Seeing grain and steel production as the essential elements of China’s rapid development, Mao boasted in 1958 that China would produce more steel than the United Kingdom within fifteen years.

1959 –– “Smelt a lot of good steel and accelerate socialist construction.”
Mao had very limited knowledge of agriculture or industrial production, yet he ruled China with an iron fist and silenced even well-intentioned opposition. China’s rural peasants were forced into collectives; households were torn apart; and private property rights were completely abolished. Mao ordered agricultural collectives to produce more grain while forcing farmers to employ less productive methods; he mobilized farmers to kill off “pests” like mosquitos, rats, flies, and sparrows (a campaign that upset the ecological balance in China’s farmlands); and insisted on a doubling of steel production to be achieved by diverting farmers with no industrial skill into operating poorly supplied backyard furnaces (which could not burn hot enough to produce high-quality steel).

1959 – Unskilled workers smelt steel in China’s backyard furnaces.
Steel production surged, and the economy appeared to boom… but at least half of that new production was unusable. A proliferation of crop-eating locusts (after the sparrows had been killed off) and the diversion of farm workers to industrial and public works projects led to a collapse in crop yields. Still, local officials all over China falsified their production figures in an effort to win favor with Beijing (and to spare themselves Mao’s wrath), which led to larger and larger grain shipments to China’s cities… and smaller and smaller rations for those living in its agricultural collectives.
Instead of taking a Great Leap Forward to a harmonious industrial society…

1959 –– “The commune is like a gigantic dragon, production is noticeably awe-inspiring.”
Mao’s command-and-control system dismantled the Chinese economy, ruined millions of lives, and left an enormous share of China’s population disillusioned.
Industrialization failed. From 1958 to 1961, millions died of starvation and exhaustion across China’s countryside (independent estimates range from 30 million to 70 million, while the CCP still insists the death toll was only 17 million), and the People’s Republic remained a net exporter of grain. As Harvard economist Dwight Perkins remembers it, “Enormous amounts of investment produced only modest increases in production or none at all.... In short, the Great Leap was a very expensive disaster.
As production and productivity collapsed along with the CCP’s social contract, Mao struggled to retain power as a number of influential officials sought to implement more market-oriented policies in response to the Great Famine. Fearing that growing opposition could lead the Party to reject its Marxist spirit (as the Soviet Union had done under Nikita Khrushchev a decade earlier), in 1966 Mao and his Red Guards launched the Cultural Revolution – a decade-long series of purges intended to root out enemies of Communist thought lurking within the Party, cleanse Chinese society of many of its traditional values, eliminate elitist urban social structures, and renew the spirit of China’s Communist revolution.

1967 – “Scatter the old world, build a new world.”
Under Mao’s leadership, the Party destroyed cultural artifacts, banned the vast majority of books, dismantled the educational system, and silenced millions for thought crimes against the Party. In a devastating blow to China’s human capital, Mao ordered children of privileged urban families – including current President Xi Jinping, when his father, Xi Zhongxun, was purged – to relocate far away from their families to be re-educated through manual labor in China’s countryside. What may have been the most promising youth of that “Lost Generation” were deprived of their educations and forced into hardship.

1972 –– President Xi Jinping during the Cultural Revolution
Considering the legacy of the Great Leap Forward, the Great Chinese Famine, and the Cultural Revolution, it is an understatement to say that Mao’s hardline policies devastated the economy and left deep scars at all levels of Chinese society. After Mao’s death in 1976, it didn’t take long for the pragmatic Deng Xiaoping to win control of the Party and take China in a new economic direction –– though with essentially the same repressive political system.
And now young XI Jinping has come from experiencing the Cultural Revolution, getting ready to embark upon what we believe is something as equally as revolutionary as the first Great Leap Forward. The question mark is whether it will be another disaster or a decisive leap into a new future, perhaps even a new world order.
My friend Woody Brock reminds us in his latest PROFILE that the theory of growth in emerging markets dates from 1960, with the publication of Walt Whitman Rostow’s book The Stages of Economic Growth. Rostow gave us a description of five different stages that “mark the transformation of traditional, agricultural societies and modern, mass-consumption societies.”
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
June 27, 2015

The 10th Man: When a Bond Is Not a Bond

By Jared Dillian

I don’t know anything about Greece. I actually make it a point not to.
What I’ve found over the course of my career is that the closer people get to an issue, the worse their predictive power is. The forest-for-the-trees phenomenon. Like all the economists who do nothing but watch the Fed, every piece of data, every speech. Their track record in predicting interest rate moves is worse than everyone else’s!
I deliberately try to be dumb about things.
Some of my friends and clients know a lot about the Greek negotiations. There is a lot to know. I try to keep it simple:
  1. The Greeks are communists
  2. Everyone is incentivized to get a deal done, unless
  3. The Greeks overplay their hand
There. Now I know everything there is to know about Greece. At the time of this writing, there was no deal in place, but it was starting to look promising.

Promising Isn’t the Word

People are starting to figure out that Greece is probably better off just defaulting and going back to the drachma. Painful, yes, but better than this perpetual bailout purgatory where everyone loses. Greece doesn’t make the necessary reforms, and Europe just keeps throwing good money after bad.
Which leads me to the point of this essay—if Europe bails out Greece once again, will they ever realistically pay it back?
Of course not. Everyone knows this.
Then it’s not really debt, right? It’s just aid. It’s a gift.
I think it’s time that people start being honest about what is going on here. This isn’t a rescue package, with covenants. It’s an aid package. If Europe wants to pay for Greece to pay all its civil servants (and its surprisingly large military), then fine. As we are starting to see, they’re less willing to do so when Varoufakis acts like a punk.
What does the profession of economics say about aid?
I’m not sure, actually. Though it seems that (in my experience) giving aid to countries stunts their growth. Five years of free trade is doing more for Africa than 50 years of aid ever did. I have some theories about charity in general, mainly that most of it has real externalities. So if you keep giving money to Greece, it’s only going to become dependent on… you get the picture. I am starting to sound like George Will.
What we do know is that if the Greek government issues more 10-year bonds—it will never pay them off. And it can’t refinance. So who would buy such a bond? It will default eventually, right?
That is the interesting question.
You see, as long as Europe (Germany) is willing to shovel cash into the money pit and call it debt, not aid, they will keep Greece afloat, and Greece never defaults, and nobody ever has to realize losses on Greek bonds, on which the recovery rate will surely be zero.
They are putting the pretend in “extend and pretend.” You pretend that Greece can pay it back, so if you’re a bank, you can keep the bonds marked at par on your balance sheet. So the accounting value (par) is different from the market value (60 or whatever), which is different from the economic value (zero).
Everything finds economic value eventually.
In my career, I’ve never seen anything like this. Sure, I’ve seen companies refinance that shouldn’t have been able to refinance, but that pales in comparison to this. It’s not debt. It’s aid.
My guess is there are geopolitical concerns at play here too. I saw a headline the other day about Washington being concerned that Greece was going to end up in Moscow’s orbit. Too late! They are communists.
I will go a step further and say that in 10 years’ time, Greece will be a less pleasant place to visit. I am beating around the bush. I think it will be a very unfree place.

Please Help

Saw an article on Quartz recently about peer-to-peer lending. Apparently people have done some quant magic on it and determined that the actual words in the loan application can determine whether you default or not. Seriously.
So these words…
Payday loan
Give me a chance
Please help
I promise
Will not
Will allow
… indicate that you’re a deadbeat.
And these words…
Excellent credit
Lower interest
Student Loan
… indicate that you’re good for the money.
Pretty cool, huh? Someone is going to make a lot of money on this. We’re talking about hundreds of basis points of edge.
So, back to Greece.
Which words are they using?
“Marxism” wasn’t mentioned in the article, but I’d wager it belongs in list number one.
Jared Dillian
Jared Dillian
The article The 10th Man: When a Bond Is Not a Bond was originally published at

June 16, 2015

The 10th Man: A Guidebook to Investing in Gold

By Jared Dillian

“A gold mine is a hole in the ground with a bunch of liars standing next to it.”
I started investing in gold in 2005. Not a bad time, right?
Here’s why I started: I was the ETF trader at Lehman Brothers at the time. A couple of guys came by to talk about this crazy idea they had about a gold ETF. I think one was from the World Gold Council and the other was from State Street. The WGC guy brought along a 10-ounce bar of gold. At the time, it was worth almost $6,000.
The ETF was SPDR Gold Shares (GLD).(* Please see disclosure below)
I ended up buying GLD, because I’m a trader. Trading stocks is what I do, so it’s easy for me to buy something with a ticker. I didn’t even know you could buy physical gold. It was 2005 or 2006, so I’m not even sure if the online bullion dealers were up and running yet. If you wanted to buy gold, you’d have to be in the know, go to some hole-in-the-wall coin dealer, get your face ripped off.
I have owned GLD since. And along the way, I learned a lot about investing in physical gold, and I bought that, too.
But that’s not the interesting part.

I Loathe Gold Culture

One of the things I figured out as I was starting to invest in precious metals is that a lot of the other guys investing in gold and silver were… not the kind of guys I really wanted to hang out with. Neckbeard McGoldbug. You know the type.
I’m talking about the ridiculous conspiracy theories, the bizarre politics that are so far right, they’re left. The hatred toward banks. I still don’t understand it. These are supposedly right-wing guys who found themselves on the same side of most issues as Matt Taibbi and Elizabeth Warren. The apocalyptic outlook, the relentlessly bearish views, the outright refusal to participate in one of the biggest (and most obvious) stock market rallies ever.
I am allegedly a right-wing guy—and I’ll own it—but I am not that.
The other thing I discovered about these guys is that it’s useless to try to sell newsletters to them. They don’t believe in intellectual property.
So part of my gold investing career has been figuring out what I am and what I’m not. I guess you could call me a classical liberal and monetarist who takes a keen interest in gold.

Freeze It, Personalize It, Polarize It

As the gold rally crested and rolled over, the mainstream financial media really started to go after the gold bugs. They were super annoying on the way up, and the (mostly liberal, Keynesian) pundits were crushing them on the way down. It’s gotten to the point where the only people left buying gold are… Neckbeard McGoldbug, and they’ve been thoroughly maligned for it.
If you recall, the whole idea was that quantitative easing (printing money) was going to create a lot of inflation. Plus, the budget deficit was about $1.8 trillion at the time, so we would have to monetize the debt. It was a pretty good argument. And it worked for years.
Then it stopped working.
The inflation the gold bugs predicted never happened. It was the biggest hoax perpetuated on investors, ever. So the beatdown from the Keynesians continues to this day, on Twitter, on blogs, in the news.
But maybe the gold bugs weren’t wrong—just super early.

I’m Not an Economist, But…

I do remember this from a class I had: the quantity theory of money.
I’m sure this looks familiar to many of you.
So M, the supply of money, has gone way up:
But V, money velocity, has gone way down:
Given constant Q (quantity of goods), P (price) remains pretty much unchanged.
So we will eventually get our inflation—if money velocity turns around and heads higher.
There aren’t any good theories as to why money velocity continues to plummet. At least, I haven’t read any. I think we will have a similar inability to predict when it rises.
This is overly simplistic, but I’m a simple guy.

Gold Is/Is Not for the Long Run

There are people who say gold should be x percent of your portfolio in all weather. I get it. It tends to be negatively correlated with other stuff, so it reduces the volatility of a portfolio.
And as long as central banks are doing what they’re doing, the long-term case for gold is pretty much intact, recent price action notwithstanding.
But let me tell you this. If central banks ever got religion and pulled a Volcker and hiked rates to the moon, it would be a remarkably bad time to hold gold.
On the other hand, throughout history, there have been times where people were very sad that they didn’t own gold. I talk about one of them here.
It’s very real, and the history of fiat currencies is also quite sad.
I am the furthest thing from an alarmist. I don’t think the dollar, or the euro, or any other currency is going to collapse, at least not imminently.
But I also think the Fed doesn’t want to raise interest rates, possibly ever.
The ECB is printing, and you have the prospect of direct monetization.
Japan is just insane.
Even Sweden is printing money.
And I can see a scenario where Canada, Australia, and Norway are all doing it too.
So: if the whole world is printing money, I’m okay with being long gold.
But in 2015, you really shouldn’t care about what people think.
*Disclosure: at the time of this writing, Jared Dillian was long GLD, SLV, and physical gold and silver.
Jared Dillian
Jared Dillian

May 27, 2015

Connecting the Dots: Memorial Day, Yohei Sagami, and the Price of Freedom

By Tony Sagami

Memorial Day is a very nostalgic, solemn day for me.
America is a nation of immigrants, and most of us can trace our roots to some place other than the US. For many Americans, this means European ancestry.
I can’t claim any lineage to any passengers on the Mayflower, nor did any of my ancestors cross the vast prairies of the Midwest in covered wagons. Like yours, however, my ancestors came to America in search of a better life.
My grandfather, Fusakichi Sagami, was from Hiroshima, Japan. He traveled across the Pacific Ocean in 1893 as a kitchen helper on an American sail-powered freighter. He continued to work in galleys on any ship that would hire him, including a short stint on the naval schooner USS Augusta.
He married Mitsu, a picture bride, in 1906, started a small vegetable farm in western Washington, and produced 10 children—including my father, Ken.
Fusakichi, Mitsu, and their 10 children were among the 110,000 American citizens of Japanese ancestry held in the World War II internment camps, and despite being unjustly imprisoned and stripped of his land, Fusakichi believed so strongly in America that he ordered all his sons to volunteer for the US Army.
“You may very well die, but you MUST do this to prove that we are loyal to America,” he told his eight sons from behind the barbed wired walls of the Minidoka War Relocation Center in Idaho.
Six of the eight Sagami boys volunteered and joined the US Army, and all of them fought in the highly decorated 442nd Infantry Regiment. One of them, my Uncle Yohei, died in France and was posthumously awarded a Silver Star and Bronze Star.
Family friends tell me that my grandmother was never the same after Yohei died. She wore his dog tags around her neck and rubbed the metal completely smooth over the next 50 years of her life. It was almost like she was self-medicating the hole that was in her heart.
“And they who for their country die shall fill an honored grave, for glory lights the soldier’s tomb, and beauty weeps the brave.”
Joseph Drake

Stand for Uncle Sam

My father ferociously worshiped four things: Jesus, my mother, hard work, and the United States of America. He was so fiercely patriotic, my grandfather and I believe the biggest disappointment I ever caused him was my failure to serve our country.
I turned 18 during the tail end of the Vietnam War, and my father pushed me to go the ROTC route for college. I reluctantly signed up for Navy ROTC and received an appointment, but I dropped out of the program eight days before the start of my freshman year… succumbing to the tears of a long-gone high school girlfriend.
My quitting ROTC disappointed him so badly that he didn’t talk to me until Christmas of that year. Of course he loved me, but I’m not sure he ever fully forgave me.
So what’s this got to do with investing?
My father died in 2009 at 93 years old, but I know he would be disgusted at the government for snooping into our phone calls and e-mails, IRS abuse of power, and other intrusions on the freedoms that the Sagami boys fought for in World War II.
Strong feelings translate into opportunities for businesses. Some companies are now looking at ways to help those of us who don’t want the government sticking its nose into our lives (especially, our electronic lives).
Remember, people won’t use technology they don’t trust. Companies like Google (GOOG), Facebook (FB), Apple (AAPL), Yahoo! (YHOO) and Twitter (TWTR) have already admitted giving the government access to our personal information, and that taints my view of them.
Here are five companies that make it their business to protect private information from prying eyes:
Barracuda Networks, Inc. (CUDA)
Fortinet Inc. (FTNT)
Check Point Software Technologies Ltd. (CHKP)
Palo Alto Networks, Inc. (PANW)
CyberArk Software, Ltd. (CYBR)
Currently all five provide Internet security solutions to corporations, instead of individuals, but they are experiencing very rapid growth.
One private company Wickr should go public in the near future with fantastic potential. Wickr uses military-grade encryption technology to send texts, photos, and videos between users. Plus, Wickr, itself, has zero access to any messages, so it can’t give the government access—even if ordered to do so.
Of course, timing is everything, so you should wait for my buy signal before you jump into any stock… but personal privacy and online security are going to be one of the biggest, most profitable businesses going forward, and you should look for ways to get them in your portfolio.
Memorial Day was originally known as “Decoration Day” and was created in 1868 to commemorate the Union and Confederate soldiers who died during the Civil War.
Today, it honors all the American servicemen and servicewomen who sacrificed their lives for our country, but sadly, the true meaning of Memorial Day has gradually been lost to many.
For many, Memorial Day has become an extra day off from work that includes barbecue hamburgers and baseball, instead of a solemn day to reflect and remember the brave men and women who gave their lives for America’s values and freedom.
“Freedom is never more than one generation away from extinction. We didn’t pass it on to our children in the bloodstream. The only way they can inherit the freedom we have known is if we fight for it, protect it, defend it and then hand it to them with the well thought lessons of how they in their lifetime must do the same.”
Ronald Reagan
Freedoms, including the right to privacy, are what my Uncle Yohei and thousands of other American soldiers fought for, and I hope that all of us take a moment to remember those fallen veterans.
Tony Sagami
Tony Sagami
30-year market expert Tony Sagami leads the Yield Shark and Rational Bear advisories at Mauldin Economics. To learn more about Yield Shark and how it helps you maximize dividend income, click here. To learn more about Rational Bear and how you can use it to benefit from falling stocks and sectors, click here.

May 20, 2015

The 10th Man: Double Black Diamond

By Jared Dillian

I was a halfway decent skier when I was a kid. Good enough that I could navigate every trail on the mountain except for one or two. Good enough that I could do the double black diamonds.
My grandfather built a cabin on the access road to Sugarbush, Vermont, in the ‘80s and sold it in the ‘90s. Makes me weep when I think what that thing would be worth now. I wasn’t kidding when I said I come from a financially unsophisticated family.
I’m about to make a really corny analogy, but you know what’s as steep as a double black diamond ski trail?
The yield curve.
At least, it’s getting steeper at an alarming rate.
That’s not supposed to happen. Supposedly, the Fed is tightening monetary policy, or soon will. They are threatening to. And they have been threatening to for a while.
So if the Fed raises rates, short-term rates will go higher and long-term rates will go lower, or stay put. In the chart above, you see the spread between the yield on the 2-year note and the 10-year note.
The 2-year note yield is basically just a function of fed funds expectations, but the 10-year note yield is a function of many things—three things in particular I’d like to highlight:
  1. Inflation expectations
  2. Supply and demand for loanable funds
  3. Supply and demand for securities at that maturity
If you own a 10- or 30-year piece of paper, you really care about inflation. Even a small amount of inflation, over time, will erode the value of that security. Think about it. If you own a 30-year bond at a 2.5% yield, there isn’t a lot of margin for error. If inflation rises even a little, your real yield could be negative.
So when the back end sells off and the curve starts steepening, it’s usually because people start to worry about inflation. There is evidence for this. First of all, copper, steel, and iron ore are coming back—
—and the yield spread most sensitive to inflation expectations, the spread between 10- and 30-year yields, is ripping higher.
Gold isn’t doing anything yet, but hope springs eternal.
What the market is telling us is that the Fed waited too long to hike rates. Now inflation expectations are becoming unmoored. The consequences could be dire. If mortgage rates go up to 5%, people are going to notice. It would be bad for me because I’m trying to sell my old house (in an area where pretty much everyone depends on financing).
There is another way to look at this. I actually talk about the forces that determine interest rates in the class I teach. You can draw a supply/demand diagram for interest rates, just like anything else. Interest rates are a function of the supply and demand for loanable funds.
If you think about it, we are literally choking on loanable funds. The banks are sitting on tons of cash and not lending it out, which you can see in this chart of excess reserves—
Little wonder that interest rates have been so low for so long! But now, perhaps, we’ll be seeing the first sign of demand for loanable funds. People borrow for 10 years or 30 years to fund long-term capital projects, like to build a house or maybe a factory. If after six years of what we’ve called a recovery, we are really having a recovery—maybe companies will rely a little less on buybacks and financial engineering and more on capital projects.
And finally, there has been near-limitless demand for 30-year paper from pension funds and insurance companies. Maybe something has changed?

What a Bond Bear Market Looks Like

Actually, we don’t really know what it looks like, because it’s been 30 years since we had one. A few things to think about—
Liquidity in treasury bonds is terrible. Which is amazing, right? Treasury bonds are supposed to be the most liquid instruments in the world. But Dodd-Frank came down hard on the credit default swap market, and that also had a huge effect on plain vanilla interest rate swaps, which have been around for ages and never posed a threat to anyone.
So people were driven out of the swaps market and into the futures market, which is imperfect, for technical reasons. Liquidity disappeared. It’s terrible. And in a post-Dodd-Frank world, you can’t go to a bank and ask for a bid on $100 million of bonds. Nobody will do it. Nobody will commit capital—too risky, too expensive.
So if we really are in a bond bear market, it’s going to be very disorderly. Remember the bond flash crash last October? That was just a taste. If there’s an asset on the board I would own, it would be interest rate volatility. Long gamma heaven!

The Risk Lives Somewhere

If the world’s biggest, most important asset class is going down for the dirtnap, who is going to get hurt? After all, the risk lives somewhere.
Answer: Baby Boomers.
They got wiped out in 2000-2002 and got killed again in 2008, at which point they said, “Screw it, stocks are impossible, we’re going all in on bonds.”
How do you think the PIMCO Total Return Fund (PTTRX) got so big? And more recently, the Vanguard Total Bond Market Index Fund (VBTLX)? I remember the days when the stock funds were the biggest!
One last thing to scare the pants off you, then I’m going to go. There is a concept known as duration that people use to measure interest rate sensitivity. The duration of the on-the-run 30-year bond is about 20 years.
So here’s the thumb rule: For every 1% change in interest rates, the price of the bond will decline by (approximately) its duration, in percent.
So if you own a mutual fund full of 30 year bonds, if interest rates go up one percent, your investment will lose 20% in value. If rates go up two percent, I mean…
I’d bet that two-thirds of bond mutual fund shareholders don’t even know the relationship between bond prices and interest rates.
Boy, this is going to be fun.
Jared Dillian
Jared Dillian
The article The 10th Man: Double Black Diamond was originally published at

May 12, 2015

Connecting the Dots: Investing in the American Dream

By Tony Sagami

Education is a Way of Life

My mother and I journeyed to the United States from Japan in 1957.
Our long, two-month trip on a slow naval transport ship must have been frightening to my then 20-year-old mother. But she was eager to start a new life in America… a place where anyone who studied hard and worked hard could be successful.
I was less than two years old when my parents divorced in 1957. My 20-year-old Japanese mother suddenly found herself living in a strange country with no family, friends, money, food or place to live.
Yet instead of returning to Japan where her family and friends were, she scratched, rummaged and scavenged enough to make a new life for us in the US. Why?
My mother knew that a half-Japanese, half-American child had limited opportunities in Japan. It wasn’t like it is today; the wounds from World War II were too fresh. I would have never gone to a top university or landed a top job.
Even though my mother barely spoke English and seldom had more than two nickels to rub together, she fiercely held to the idea of the American dream. “In America, anybody can get rich if they work hard,” she told me.
And she was determined to have me prove her right.

Putting the “Earn" in “Learn"

My mother ordered me to sit in the front row directly in front of the teacher’s desk. She gave me almost daily lectures on the importance of education and punished me severely if I brought home anything less than an A. My mother was a big believer in corporal punishment, and I got the spankings of my life for anything less than straight A's.
Those lectures and demands for academic excellence from my mother paid off for my siblings, my children and me.
My brother is a high-level executive at Nordstrom, my sister is one of the top physical therapists in the country, and my children have always done well in school. My oldest son, Ryan, is about to graduate with a Ph.D. in biology from Texas A&M; my daughter, Keiko, was valedictorian of her high school class and earned a near perfect 4.0 GPA at the University of Montana.
I am sad to say that my mother died years ago from cancer, but her dreams have become a reality for Asian-American families all over the United States.
Those same lectures about education are given every day all over Asia, especially in China, because academic success is a top cultural priority despite the effects of the global economic slowdown.
Most Chinese students don’t finish school until 6 p.m., watch little television, and play few video games. They're prohibited from working before the age of 16, so they can concentrate on school. Plus, most students attend tutoring classes after school and on Saturdays.
“Very rarely do children in other countries receive academic training as intensive as our children do. So if the test is on math and science, there’s no doubt Chinese students will win the competition,” said Sun Baohong of the Shanghai Academy of Social Sciences.
Plain and simple, the education sector is an all-weather, recession-resistant, steady growth winner and there is a way to profit—HANDSOMELY—from the Asian obsession with education and academic success.

Six Chinese Education Stocks for US Investors

Did you know that there are 10 Chinese education stocks listed on the NYSE and Nasdaq? Yup… and here are six of them:
  • ATA Inc. (ATAI) provides computer-based training courses to pass professional certification exams such as banking, insurance, and accounting.
  • China Distance Education Holdings Limited (DL) offers online education and test preparation courses in accounting, law, healthcare, construction, engineering, and information technology.
  • China Education Alliance (CEAI.PK) sells online “education resources” (a fancy name for a huge database of informative practice exams).
  • New Oriental Education & Tech. Group Inc. (EDU) is the largest English and college entrance exam preparation school in China.
Chinese students lined up to register for English classes at New Oriental Education office in Beijing.
  • TAL Education Group (XRS) is the largest private educational tutoring company in China.
  • Xueda Education Group (XUE) is also a private tutoring company but differs from TAL Education in that it tutors university students, as well as, high school students.
As you can see, there are several ways to profit from the Chinese obsession with academic excellence, but that doesn’t mean you should rush out and buy any of the above-mentioned stocks tomorrow morning. As always, timing is everything so I suggest that you wait for my buy signal.
Nonetheless, education is big business in Asia, and there are some big profits to be made by investing in it.
Tony Sagami
Tony Sagami
30-year market expert Tony Sagami leads the Yield Shark and Rational Bear advisories at Mauldin Economics. To learn more about Yield Shark and how it helps you maximize dividend income, click here. To learn more about Rational Bear and how you can use it to benefit from falling stocks and sectors, click here.
May 8, 2015

The 10th Man: Übermensch

By Jared Dillian

Elon Musk just unveiled something called the “Tesla Powerwall,” a means to store solar-created electricity in people’s homes… with the potential to put the entire utility industry out of business.
As you probably know, Musk also has these electric cars that people seem to like to drive… with the potential to put all the major car manufacturers out of business. Oh, and the dealerships too.
Musk also has a spaceship company. It is his stated goal to leave Earth and set up shop on Mars. He has already put the US government out of business when it comes to space.
How did he manage to do all this stuff? He made $34 million selling a software company when he was 24, which he freerolled into PayPal, which he made $165 million selling in 2002. He then freerolled that into SpaceX and Tesla.
Oh, and another thing. Musk thinks the state of California is incompetent to build a choo-choo train going from San Francisco to Los Angeles, so he drew up plans for a “Hyperloop,” basically a giant pneumatic tube that can get you there in 35 minutes for $20.
He said he didn’t have time to build it, so he gave the plans to the state for free. (Jerry Brown is going ahead with the snail rail. Unions need to get paid, you know.)

Feel Terrible About Yourself Yet?

I’m not done. He is chairman of a company called SolarCity, which is the second-biggest residential solar panel maker in the country. They will come to your house and install solar panels, so you don’t have to buy electricity from the grid.
Now—if you watch the video of Musk’s Powerwall speech, you’ll start to see the genius of his plan.
You have these giant batteries you keep in your house (which take up little space and hang flat on the wall).
You have solar panels on your roof to generate electricity.
You store the electricity in the battery when the sun goes down.
You charge your car off the battery.
Everything—every house, every car, every business--is now powered by what Elon Musk calls a “giant nuclear fusion reactor in the sky, which runs all the time.” Not oil or gas or coal.
I wouldn’t consider myself a big environmentalist, but still, this excites me. Have you ever heard of something called “Moore’s Law” where computing power grows at an exponential rate? It applies to solar panels too. It won’t be long before solar power is cheaper than conventional energy sources.
The politics of it are a little tricky. I don’t like subsidizing solar, and SolarCity’s entire business model is based on solar tax credits. But soon, it won’t matter—the technology will exist for solar power to compete directly with fossil fuels. And the higher oil prices go, the better solar will look.

Growing Eyes in the Back of Your Head

Elon Musk is a pretty inspirational character, but he seems to have made a lot of enemies along the way. Democrats don’t like him because he’s a creature of business and finance. Republicans don’t like him because he lives off subsidies. Not bad for a guy who calls himself half-Democrat, half-Republican.
The car companies sure don’t like him. If oil gets back above $100, they will like him even less. The history of the auto industry is full of all kinds of backstabbing and intrigue (see Preston Tucker).
If everyone starts driving electric cars, the oil companies aren’t going to like him very much, either.
And the utilities are really going to have it out for him. But they suck. Of all the terrible businesses out there, including the tobacco companies, I despise the utilities the most—even if it isn’t really their fault.
The utilities generate and distribute electricity pretty much the same way they have for the last 100 years. No innovation at all. Why not? Well, because we decided they were utilities! If you put a cap on the rate of return someone can earn, there isn’t a lot left over for innovation. So be very careful what you start calling a public utility.
SolarCity gives us the promise of distributed generation, where electricity is generated at the home or business, and if it’s generated in excess, it’s sold back to the grid. This already happens in dribs and drabs, and is starting to have an impact on the power trading business.
If enough people generate their own electricity, you don’t really need utilities anymore.
It’s not hard to see where this is going. The utility companies are going to fight back, hard. But not in the free market—on Capitol Hill.
If Musk is permitted to succeed—which is a big if—there’ll be no more carbon emissions and a cheap, endless power source.

Yes, We Can

This is save-the-world type stuff. Pretty ambitious. But will it work?
I can’t say this cynically enough: A lot of it depends on Musk managing the politics… not the engineering.
I owned both Tesla (TSLA) and (SolarCity) SCTY for a time. I traded them pretty well, which doesn’t happen often. I don’t currently own them.
One thing I love to say: Whenever you have a disruptive innovation, it’s a lot easier to bet against the losers than on the winners. And the utilities are clearly the losers.
It’s a long-term thesis, maybe 20 years, but this is like betting against BlackBerry (RIMM) in 2008—one of those trades that will seem really obvious seven years from now.
Then again, utilities have never been a growth business. It’s all about the dividends. And stupid dividend investors will hang on to a trade far longer than economic sense dictates. See tobacco.
I have a hunch that 20 years from now, we won’t be burning coal for electricity. But not because of any government decree, but because the free market will have done what the politicians couldn’t do for themselves: make renewable energy sources cheaper.
Jared Dillian
Jared Dillian
The article The 10th Man: Übermensch was originally published at

April 13, 2015

Outside the Box: Germany’s Trade Surplus Is a Problem

By John Mauldin

In Code Red I wrote a great deal about trade imbalances among the various European countries, which were at the heart of the European sovereign debt problem. As the peripheral countries have tried to rebalance their trade deficits with Northern Europe and especially with Germany, they have seen their relative wages fall and deflation become a problem. Greece is the poster child.
The north-south imbalance in the Eurozone is still a problem today. In this week’s Outside the Box, I highlight a recent blog on that topic from none other than former Fed Chairman Ben Bernanke. He first published his blog on March 30, and it appears he is going to post to three times a week. It’s a very thoughtful commentary, and I will admit to having subscribed. He is going back to his “professor” style and communicates very clearly.
I find it useful to get a handle on what the economic elite are thinking and discussing, and Bernanke’s blog is going to be one of the ways I can keep up. His ongoing debate with Larry Summers over secular stagnation is fascinating, although I think they both miss the point on structural growth. Monetary policy and fiscal policy lag behind other drivers of growth in terms of importance.
That fact was brought home to me at lunch today, when Woody Brock met me over at Ocean Prime for some fish and wisdom. Woody is simply one of the smartest economists on the planet and knows the gamut of the literature as well as anyone. “It’s the incentive structure that is the driver,” he told me; “that’s what I was trying to explain in my recent debate with Larry Summers.” There are times when I wish I could just be a fly on the wall, and that would have been one of them.
Everyone responds to incentives, no matter what the country or type of government. Setting incentives to maximize entrepreneurial activity will produce the most growth and jobs. Of course, it is always a balancing act.
It is my day for friends coming to Dallas. Tonight Steve Moore (WSJ and now with the Heritage Foundation) is in town for a speech, and he is hanging around to go to the Dallas Mavericks game with me. We’ll talk productivity and politics over steaks at Nick and Sam’s before we head to the game and again after the game at his hotel, where, randomly, my doctor, Mike Roizen (chief wellness officer at the Cleveland Clinic) is also staying the night for a speech. So a little health and politics late at night. What a great day.
You have a great week as well, and think through what Bernanke is saying. Do you really think Germany will follow through on his suggestions, as reasonable as they are? Me neither. Europe is well and truly hosed. They have just not figured out yet that they need to hit the reset button. Not just on monetary or fiscal policy (which are secondary), but on the entire incentives (regulations and labor-reform) environment.
Your incentivized to give you the best I can analyst,
John Mauldin, Editor
Outside the Box

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Germany's Trade Surplus Is a Problem

By Ben S. Bernanke
April 3, 2015
In a few weeks, the International Monetary Fund and other international groups, such as the G20, will meet in Washington. When I attended such international meetings as Fed chairman, delegates discussed at length the issue of “global imbalances”—the fact that some countries had large trade surpluses (exports much greater than imports) and others (the United States in particular) had large trade deficits. (My recent post discusses the implications of global imbalances from a savings and investment perspective.) China, which kept its exchange rate undervalued to promote exports, came in for particular criticism for its large and persistent trade surpluses.
However, in recent years China has been working to reduce its dependence on exports and its trade surplus has declined accordingly. The distinction of having the largest trade surplus, both in absolute terms and relative to GDP, is shifting to Germany. In 2014, Germany’s trade surplus was about $250 billion (in dollar terms), or almost 7 percent of the country’s GDP. That continues an upward trend that’s been going on at least since 2000 (see below).
Why is Germany’s trade surplus so large? Undoubtedly, Germany makes good products that foreigners want to buy. For that reason, many point to the trade surplus as a sign of economic success. But other countries make good products without running such large surpluses. There are two more important reasons for Germany’s trade surplus.
First, although the euro—the currency that Germany shares with 18 other countries—may (or may not) be at the right level for all 19 euro-zone countries as a group, it is too weak (given German wages and production costs) to be consistent with balanced German trade. In July 2014, the IMF estimated that Germany’s inflation-adjusted exchange rate was undervalued by 5-15 percent (see IMF, p. 20). Since then, the euro has fallen by an additional 20 percent relative to the dollar. The comparatively weak euro is an underappreciated benefit to Germany of its participation in the currency union. If Germany were still using the deutschemark, presumably the DM would be much stronger than the euro is today, reducing the cost advantage of German exports substantially.
Second, the German trade surplus is further increased by policies (tight fiscal policies, for example) that suppress the country’s domestic spending, including spending on imports.
In a slow-growing world that is short aggregate demand, Germany’s trade surplus is a problem. Several other members of the euro zone are in deep recession, with high unemployment and with no “fiscal space” (meaning that their fiscal situations don’t allow them to raise spending or cut taxes as a way of stimulating domestic demand). Despite signs of recovery in the United States, growth is also generally slow outside the euro zone. The fact that Germany is selling so much more than it is buying redirects demand from its neighbors (as well as from other countries around the world), reducing output and employment outside Germany at a time at which monetary policy in many countries is reaching its limits.
Persistent imbalances within the euro zone are also unhealthy, as they lead to financial imbalances as well as to unbalanced growth. Ideally, declines in wages in other euro-zone countries, relative to German wages, would reduce relative production costs and increase competitiveness. And progress has been made on that front. But with euro-zone inflation well under the European Central Bank’s target of “below but close to 2 percent,” achieving the necessary reduction in relative costs would probably require sustained deflation in nominal wages outside Germany—likely a long and painful process involving extended high unemployment.
Systems of fixed exchange rates, like the euro union or the gold standard, have historically suffered from the fact that countries with balance of payments deficits come under severe pressure to adjust, while countries with surpluses face no corresponding pressure. The gold standard of the 1920s was brought down by the failure of surplus countries to participate equally in the adjustment process. As the IMF also recommended in its July 2014 report, Germany could help shorten the period of adjustment in the euro zone and support economic recovery by taking steps to reduce its trade surplus, even as other euro-area countries continue to reduce their deficits.
Germany has little control over the value of the common currency, but it has several policy tools at its disposal to reduce its surplus—tools that, rather than involving sacrifice, would make most Germans better off. Here are three examples.
  1. Investment in public infrastructure. Studies show that the quality of Germany’s infrastructure—roads, bridges, airports—is declining, and that investment in improving the infrastructure would increase Germany’s growth potential. Meanwhile, Germany can borrow for ten years at less than one-fifth of one percentage point, which, inflation-adjusted, corresponds to a negative real rate of interest. Infrastructure investment would reduce Germany’s surplus by increasing domestic income and spending, while also raising employment and wages.
  2. Raising the wages of German workers. German workers deserve a substantial raise, and the cooperation of the government, employers, and unions could give them one. Higher German wages would both speed the adjustment of relative production costs and increase domestic income and consumption. Both would tend to reduce the trade surplus.
  3. Germany could increase domestic spending through targeted reforms, including for example increased tax incentives for private domestic investment; the removal of barriers to new housing construction; reforms in the retail and services sectors; and a review of financial regulations that may bias German banks to invest abroad rather than at home.
Seeking a better balance of trade should not prevent Germany from supporting the European Central Bank’s efforts to hit its inflation target, for example, through its recently begun quantitative easing program. It’s true that easier monetary policy will weaken the euro, which by itself would tend to increase rather than reduce Germany’s trade surplus. But more accommodative monetary policy has two offsetting advantages: First, higher inflation throughout the euro zone makes the adjustment in relative wages needed to restore competitiveness easier to achieve, since the adjustment can occur through slower growth rather than actual declines in nominal wages; and, second, supportive monetary policies should increase economic activity throughout the euro zone, including in Germany.
I hope participants in the Washington meetings this spring will recognize that global imbalances are not only a Chinese and American issue.
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April 4, 2015

Connecting the Dots: Macau: Six Times Bigger than Vegas, with Six Times the Opportunity

By Tony Sagami

58 years old. Yes, I’m the right age, but I’ve never considered myself to be a yuppie.
I’ve never owned a foreign sports car, I wear a Timex instead of a Rolex, I’d rather drink a Coors Light than a glass of Pinot Noir, I don’t golf, I’ve never been to Paris, I drink Folgers coffee like my father did, I’ve been married only once, and my idea of a good time is watching my boys play baseball or hiking in Glacier National Park.
I will forever be the son of a hardworking, simple vegetable farmer.
Yuppies, however, have been a powerful consumer bloc and have had a great impact on both the economy and the stock market. Investors who bought stock in companies that catered to yuppies have done well.
As powerful as the yuppie phenomenon has been, though, it is just a mosquito bite compared to the monumental shopping spree currently being undertaken by Chinese yuppies, which I call “Chuppies.”
The Chuppies are the rapidly growing, new middle class being created by the booming Chinese economy. Chuppies are well educated, ambitious, have money burning a hole in their pockets, and are more label-conscious than the worst gold diggers in Los Angeles.
Just like with American yuppies, you can make a lot of money by identifying how they are spending their money and investing in the companies that cater to them.
The clothes Chuppies wear. When it comes to apparel, the Chinese crave designer labels. Sure, Chinese teenagers wear clothes from The Gap (GPS), V.F. Corp.’s (VFC’s) Lee Jeans, and Abercrombie & Fitch (ANF), but the successful professionals are big buyers of Prada (PRDSY), Richemont (CFRUY), and Ralph Lauren (RL).
The food Chuppies eat. There are not many things more American than the hamburger, but I seldom see long lines at McDonald’s and Burger King stores in China. Why not? Asians much prefer chicken to beef, which is why Yum! Brands’ (YUM’s) KFC stores are almost always jam-packed with customers, and why more than 50% of Yum Brands’ revenues come from outside the US. Lastly, the Chuppies often finish their meals with a sweet donuts from Krispy Kreme (KKD) or a latte from Starbucks (SBUX).
The status symbols Chuppies flaunt. Successful Chuppies are very eager to show their success and are very conspicuous consumers, which is why Tiffany (TIF), Coach (COH), and Louis Vuitton (LVMUY) stores are doing gangbuster business and why I see more Bentley, Rolls Royce, BMW, and Porsche cars in Shanghai than I do in Seattle.
The way Chuppies spend their vacations. One of the most popular things that Chuppies are doing with their money is spending it on travel, especially within China. It wasn’t that long ago, when the communist rule was stricter, that travel wasn’t practical and was often prohibited. But now, thanks to aggressive infrastructure spending on railroads, airports, roads, and bridges, the Chuppies are making up for lost time.
Hotel chains like Homeinns (HMIN) and Intercontinental Hotels Group (IHG) are almost always close to fully booked; airlines like Cathay Pacific (CPCAY) and China Eastern (CEA) are filled to the rafters; and online travel agent (CTRP) pulled in US$1.2 billion in sales in the last 12 months.
I have traveled all over Asia and there is one place that is benefiting from the Chuppie spending boom more than anywhere else.
I’m not talking about the Great Wall of China, the Bund in Shanghai, or Nathan Road in Hong Kong, but about the Las Vegas of Asia: Macau.
Macau is the only location in China where gambling is permitted. And boy, do Asians love to gamble. Get this: more money is gambled in Macau than in Las Vegas.
Not just a little more…a LOT more. In fact, 600% more!
If you saw the high stakes being bet in Macau, you’d understand exactly what I’m talking about. The Chuppies—plus gamblers from Japan, Taiwan, South Korea, Singapore, and other countries—flock to Macau to try their luck.
Every time I go to Macau, I am shocked at how drastically the skyline has changed. Dozens of previously empty lots are now filled with steel girders stretching to the sky, filling the bulging demand for residential and office space. Macau real estate is appreciating so rapidly that many of the service workers—dealers, waitresses, cab drivers, maids, and cooks—are moving to a neighboring city called Zhuhai.
Here’s what should matter to you as an investor. All those glamorous casinos in Las Vegas were NOT built with the money from winners. So if Macau is out-gambling Las Vegas, that should tell you volumes about how profitable the casinos there are, and that Macau casino stocks are worth your consideration.
There are four public gaming stocks that are doing business in Macau: Las Vegas Sands (NYSE:LVS), Wynn Resorts (Nasdaq:WYNN), MGM Resorts (NYSE:MGM), and Melco Crown Entertainment (Nasdaq:MPEL).
All four of the above stocks are traded on the NYSE or Nasdaq, so they are as easy to buy as Boeing or Apple.
Bottom line: I’ve traveled all over Asia and no place is as vibrant, growing, and packed with opportunity as Macau is.
Warning: The above list is not a buy list. One of those four is an absolute dog, one is insanely overvalued, and one is okay—but one of them is an absolute steal that I think is an easy double by 2017.
In a future edition, I’ll tell you more about the one gaming stock I think could double.
Tony Sagami
Tony Sagami
30-year market expert Tony Sagami leads the Yield Shark and Rational Bear advisories at Mauldin Economics. To learn more about Yield Shark and how it helps you maximize dividend income, click here. To learn more about Rational Bear and how you can use it to benefit from falling stocks and sectors, click here.
March 29, 2015

Connecting the Dots: The Stock Market Hot Potato: Volatility, the VIX, and You!

By Tony Sagami

“When did Noah build the Ark, Gladys? Before the rain, before the rain.”
—Nathan Muir (Robert Redford), in Spygame
If you’ve ever walked a dog, you know about the zigzag path that dogs take down a sidewalk. After all, there are great odors to sniff on both sides of the sidewalk so your dog will veer far to the left, take a few deep sniffs before veering off to the right to see what olfactory surprises the other side holds.
About the only thing that’s certain is that once your dog reaches the far end of his leash, it will swing back to the middle of the sidewalk before taking off for another trip to the extreme ends of the leash.
Human psychology, when it comes to investing, isn’t so different. Investor sentiment swings from extreme readings of euphoria and anxiety and extremes of fear and greed.
Like our friendly dogs on a walk, we investors swing from the far left to the far right of the Wall Street sidewalk.
There is a way to profit from the human emotions: the VIX, or CBOE Volatility Index.
Some of you already know plenty—probably more than me—about the VIX, but for those that don’t, here is a quickie tutorial.
The VIX, often referred to as the “fear index,” is calculated by the Chicago Board Options Exchange (CBOE) and measures market expectations of short-term volatility.
The VIX is derived from prices investors are paying for options on the S&P 500 Index and measures the market’s expectation for stock market volatility over the next 30-day period.
NOTE: There are three volatility indices: the VIX, which tracks the S&P 500; the VXN, which tracks the Nasdaq 100; and the VXD, which tracks the Dow Jones Industrial Average.
The VIX was created in 1993 and investors have been using it to hedge against severe market movements ever since; it’s one of the most closely watched indicators in the market.
The VIX has been very useful in helping spot major stock market turning points. As the above chart shows, the VIX has historically spiked after major investment calamities, such as the 2008 financial crisis and the dot-com bubble.
Conversely, the VIX has plunged to extreme low readings (in the “teens” as measured by the VIX) at stock market tops. When the stock market is rocking and rolling, investors lose all their fear and dogpile into the stock market.
As the above chart shows, whenever the VIX falls into the teens, it’s one of the most dangerous times to be in the market and one of the most rewarding to invest in the VIX.
Where is the VIX today? The VIX is well below the levels seen at the time of the 2008 crash, when the index jumped as high as 80, and is now in the 15 range.
How can you invest in the VIX? There are three ways: futures, options, and specialty ETFs.
There are eight different ETFs that track the VIX, but the most liquid—and one that I use—is iPath S&P 500 VIX Short-Term Futures ETN (VXX).
In fact, since starting my short-only service, Rational Bear, I have recommended VXX on five different occasions. And—knock on wood—it has been a profitable recommendation 100% of the time.
Above are the trade-by-trade results of my VXX recommendations. If you had invested $100,000 into those, all of my VXX trades, you would now be sitting on almost $135,000.
Yup, a 35% gain in three months!
Of course, past results don’t guarantee future returns and more importantly, timing is everything when it comes to investing, so I suggest that you wait for my new VIX buy signal before jumping in.
However, with the VIX index now in the teens, it’s in the sweet spot of producing the biggest rewards AND it’s an excellent way to protect your portfolio from the next bear market.
Tony Sagami
Tony Sagami
30-year market expert Tony Sagami leads the Yield Shark and Rational Bear advisories at Mauldin Economics. To learn more about Yield Shark and how it helps you maximize dividend income, click here. To learn more about Rational Bear and how you can use it to benefit from falling stocks and sectors, click here.
March 25, 2015

Outside the Box: US Dollar: American Phoenix

By John Mauldin

 “Just a little patience, yeah…”
– Guns N’ Roses
Lastweek the FOMC essentially removed forward guidance and placed all options back on the table, and at the end of the day they’ve opened the door for further tightening. As Yellen recently explained in advance, the removal of the word patience from the Fed’s guidance amounts to fair warning to the rest of the world’s central banks: an interest rate hike is on the horizon. Govern your actions accordingly. (My personal guess, for those interested, is September, with the Fed proceeding exceedingly slowly and cautiously thereafter.)
The bigger story here is the sustained strength of the US dollar, which has traded wildly in the FOMC’s wake. A correction to the one-way trading prior to the meeting was well overdue and could last some time, but then the dollar strength will resume. (Euro) Parity or Bust! My young colleague Worth Wray and I have been writing for some time about the risks this trend poses, to emerging markets in particular, and now it seems that nightmare could  happen sooner rather than later.
We’re already seeing profound FX pressures on countries like Russia, Brazil, Turkey, and South Africa, among many others; but, while clearly exacerbated by the strong dollar and/or weak commodity prices, recent stress in various emerging markets appears to have more to do with internal troubles than external shocks. Nevertheless, the dollar’s strength has not been fully absorbed by EM economies, so a BIG, broad-based, dollar-driven adjustment may be yet to come.
Until this Wednesday’s FOMC press conference with Janet Yellen, the growing consensus was that an eventual interest rate hike would lead to an even stronger USD. Now it seems most observers, including our own Jared Dillian, are doubting that a rate hike will come this summer… or anytime soon.
Worth and I have a different view. We believe that Federal Reserve Vice Chair Stanley Fischer has carefully laid out a framework for interpreting the FOMC’s opaque communications as the committee moves closer to a rate hike. In a speech last October, Fischer made it clear that the Fed would “recognize the effect of (its) actions abroad and … minimize the negative spillovers (those actions will likely have) on the global economy” by clearly communicating its policy intentions in advance. If you read between the lines, the only way the Fed can give foreign central banks the opportunity to prepare for the likely FX shock that would follow a rate hike is to send the message in a way that the market does not immediately understand as overtly hawkish. This week’s announcement makes perfect sense when looked at through that lens.
Translation: while the FOMC’s decision to hike interest rates remains data-dependent, the Fed has opened the door for further tightening as soon as June 2015. That could be terrible news for a number of emerging markets, but none of those countries can credibly complain that the Fed is responsible as capital flees their economies in search of safety and more-attractive risk-adjusted rates. Emerging markets are not a homogenous group, but even the best positioned countries like the Philippines are at risk in the event of a broad-based contagion. We’ve seen that dynamic play out repeatedly in the 1980s, the 1990s, and the 2000s. It may be time for another hurricane.
With our expectations on the table, Worth and I still have to ask… what if we’re wrong? What if the dollar doesn’t strengthen? We’ll consider that scenario in today’s OTB.
It’s a real pleasure for me to introduce today’s author, because this OTB is also the perfect opportunity for an announcement I’ve been wanting to make for some time: Jawad Mian has brought his excellent research service, Stray Reflections, to Mauldin Economics. You can learn more about his service here. His “transparent hedge fund” approach to investment research is unique, well-reasoned, and decidedly non-consensus. And his prose is unrivaled.
Today’s OTB is taken from Jawad’s top 10 investment themes. These are the themes around which he builds his portfolio. I agree with many of his ideas, but I offer up this particular piece as an example of one where I remain unconvinced, if not in outright disagreement. Yet… Jawad makes such a strong argument for the dollar’s weakening. We have exchanged emails and dueling notes of late (but in a very collegial fashion).
I have to admit, I am NEVER comfortable when this much of the crowd agrees with my view, as they seem to now. A serious correction of the recent trend in dollar strength is clearly due, but what if – as Jawad argues – we are seeing a major shift to an entirely new macro regime?
It’s worth noting that Jawad made this weaker dollar call several months ago. HSBC analysts and others are beginning to agree with him. The US dollar is the single most important factor in global macroeconomics; so do your homework, consider the antithesis to your closely held beliefs, and ignore Jawad’s thoughtful analysis at your own risk.
I was in Switzerland for the last week, meeting clients and speaking in Zürich. I kept asking the question, “Where is Draghi going to get €60 trillion in European bonds, month after month?” He is reportedly already behind the curve for this month’s purchases. I get no satisfactory (to me) answer. Maybe he does, but he wants to buy more than governments are issuing, and no pension company or insurance company is going to be able to sell him their bonds if they have a positive yield. Maybe he gets creative in what he buys. I will write more about this over the next weekend, but we are in the Twilight Zone for bonds. French yields are negative out to five years, and to get 1.5% you have to buy a 50-year French bond? Can anyone do that and seriously be considered a prudent fiduciary? Have you looked at France’s balance sheet and total commitments, not to mention the country’s politics? And don’t even get me started on the rest of Europe. Half of Northern Europe’s debt has negative yields.
I had the very real privilege of having dinner with William White, former chief economist of the Bank of International Settlements and currently consultant to seemingly everyone. He will be at my conference this year as the final speaker, and it will be a very impactful speech. On several occasions during dinner, I got him to agree to say in public what he said in private Tuesday night. I have long been a fan of his candor and style, and that evening I felt like a student. He is now my favorite (ex) central banker.
I want to thank so many of you who wrote to me expressing your condolences about my Mother. It meant a lot. Truly.
My sister flew in from Victoria Island, where she lives with her sons. I cornered her the first night she was there and told her that her other brother wanted us to sing at the graveside the lullabies that mother sang to us as children when she put us to bed (and which we all vividly remember). I tried to convey the clear impression that I thought it was a bad idea, but I was amazed that she agreed with him. “I think it is a marvelous idea, and mother would agree. You will do it.” How can you tell your little sister no when she looks at you that way? So, there I was, singing in the rain, or trying to. I don’t think I actually made it to the end of “Tura Lura Lural.” In the moment it was much more than an old Irish lullaby.
Your doing a lot of pondering analyst,
John Mauldin, Editor
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US Dollar: American Phoenix

By Jawad Mian

A New Religion

Divergent monetary policy, interest rate differentials, and growth trajectories favor the US over Europe and Japan. This has become the key investment theme for global investors. Foreign flows into US financial assets hit a record last year while traders’ speculative long positions in the dollar reached a new all-time high. It is believed the US dollar has begun a multi-year mega-uptrend. The faith in broad-based dollar strength is supported by (1) decent US growth, (2) higher yields than those of its main trading partners, (3) external balances that are in good shape, (4) cheap currency valuation on a real effective exchange- rate basis, and (5) deliberate devaluations in the rest of the world. Based on AKSIA’s Hedge Fund Manager Survey, 86% of the 187 managers polled expect the US dollar to be the top performing currency in 2015. So today, the dollar index is up 23% from its 2011 low, which, ironically enough, coincided with the S&P rating downgrade of US credit. But can this strength endure, as it did in the 1980s and 1990s?
Those two late-20th century upward moves in the dollar came in times of robust US growth and relatively tight monetary policy. The rally was further bolstered by risk aversion flows given periodic waves of uncertainty around the world.

We are skeptical of the consensus mindset and don’t think that the US dollar can appreciate significantly over the next five years. We view the dollar’s recent strong run-up as a cyclical phenomenon—not a secular upturn—and suspect it offers a great opportunity for investors to diversify outside of the dollar. While we believe that the US economy can withstand short-term rates above zero at this point, the anomalous divergence between payrolls growth and inflation expectations complicates the way forward. The global macro environment today is beset with deflationary tendencies. Based on our best judgment, monetary policy is unlikely to tighten at the pace it did during the previous cyclical dollar bull markets of the early 1980s and late 1990s. Measures of long-run inflation expectations based on the CPI swaps market have fallen below levels that preceded QE2, QE3, and Operation Twist. If deflation expectations accelerate, or in the event of any negative growth surprises, we believe the Fed will be forced to adopt a more relaxed attitude toward policy normalization than is currently anticipated.
Investors have also greatly overestimated the resilience of the US recovery, especially when we consider the prospect that we may have seen “peak payrolls” in November. Over the coming year, we think the labor market will be demonstrably weaker than indicated by the unemployment rate, as the pace of job growth stalls. It certainly looks like US GDP peaked in Q3 2014 on a sequential basis. According to BCA Research, the biggest boost from the most cyclical parts of the economy—housing and consumer durables—is already behind us. The labor market usually peaks 7 months in advance of a recession. Based on the Fed’s models, a large appreciation of the dollar is estimated to cut GDP growth by around 0.5% over the following year. We think the Fed’s priority of containing any unwarranted rise in bond yields may be displaced by its monitoring the rise of the dollar. We also observe that a positive co- movement has developed between the trade- weighted dollar and US stocks, which suggests that the dollar may not be the usual safe haven if equity markets slide.

American Hustle

One of the less-cited factors for dollar strength is the improvement in the US current account. The chief benefit of QE was the cheapening of the dollar to its lowest level in the postwar era. It was among several factors that led to a decline in the current account deficit from a peak of 6% of GDP in 2006 to about 2% of GDP in 2014. It was partly the reduction in the current account deficit that led to fewer US dollars being available in the global market, thus swelling the dollar’s value. The “short squeeze” on two-thirds of the $11 trillion cross-border loans that are denominated in dollars reversed institutional investment flows back into the US, according to Morgan Stanley. The last time the US had a current account surplus was in 1991, when the trade-weighted dollar was nearly 40% stronger than it is today. So the fact that even with the dollar’s major undervaluation since 2011, the US has been unable to return to a surplus suggests that the current account deficit is really structural in nature. We think the dollar is now vulnerable to a rewidening of the current account deficit on the back of stronger household consumption.
The temporary fillip to the current account from the shale oil boom, weak import demand, and lower interest rates should reverse in the next five years. The US trade deficit is already back to the record lows seen before the financial crisis in 2008, if we exclude oil. Even with the drop in oil prices, US terms of trade will benefit less, due to much lower sensitivity relative to history. It is for this reason that we believe the US will struggle to attract the same amount of external capital as it has in the past.

The Most Important Chart

By reviewing past tightening cycles, we observe that exchange rates can follow many paths that do not always correspond to the predictions from monetary policy actions. For instance, the Fed’s last tightening cycle began in mid-2004, when the unemployment rate had fallen to 5.5% and other labor market metrics were significantly stronger than they are now. The US dollar fell in the following six months, and by the time of the last rate hike during the summer of 2006, the dollar was at about the same level as when the liftoff began. Over an extended period of time, rising US interest rates are not necessarily accompanied by a rising foreign exchange value of the US dollar. Fed rate hiking since the early 1970s has actually been, on average, consistent with the dollar getting weaker, not stronger.

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March 15, 2015

Connecting the Dots: Oil, Divorce, and Bear Markets

By Tony Sagami

Everybody loves a parade. I sure did when I was a child, but I’m paying attention to a very different type of parade today.
The parade that I’m talking about is the long, long parade of businesses in the oil industry that are cutting jobs, laying off staff, and digging deep into economic survival mode.
The list of companies chopping staff is long, but two more major players in the oil industry joined the parade last week.
Pink Slip #1: Houston-based Dresser-Rand isn’t a household name, but it is a very important part of the energy food chain. Dresser-Rand makes diesel engines and gas turbines that are used to drill for oil.
Dresser-Rand announced that it's laying off 8% of its 8,100 global workers. Many Wall Street experts were quick to point the blame at German industrial giant Siemens, which is in the process of buying Dresser-Rand for $7.6 billion.
Fat chance! Dresser-Rand was crystal clear that the cutbacks are in response to oil market conditions and not because of the merger with Siemens. The reason Dresser-Rand cited for the workforce reduction was not only lower oil prices but also the strength of the US dollar.
If you’re a regular reader of this column, you know that I believe the strengthening US dollar is the most important economic (and profit-killing) trend of 2015.
Pink Slip #2: Oil exploration company Apache Corporation reported its Q4 results last week, and they were awful. Apache lost a whopping $4.8 billion in the last 90 days of 2014.
No matter how you cut it, losing $4.8 billion in just three months is a monumental feat.
Of course, the “dramatic and almost unprecedented” drop in oil prices was responsible for the gigantic loss, but what really matters is the outlook going forward.
CEO John Christmann, to his credit, is taking tough steps to stem the financial bleeding, and that means:
  • Shutting down 70% of the company's drilling rigs.
  • Slashing it's 2015 capital budget to between $3.6 and $5.0 billion, down from $8.5 billion in 2014.
Those aren’t the actions of an industry insider who expects things to get better anytime soon.
I don’t mean to bag on Dresser-Rand and Apache, because they’re far from alone. Schlumberger, Baker Hughes, Halliburton, Weatherford International, and ConocoPhillips have also announced major layoffs.
And don’t make the mistake of thinking that the only people getting laid off are blue-collar roughnecks. These layoffs affect everyone from secretaries to roughnecks to IT professionals.
In fact, according to staffing expert Swift Worldwide Resources, the number of energy jobs lost this year has climbed to well above 100,000 around the world.

From Global to Local

Sometimes it helps to put a local, personal perspective to the big-picture national news.
In my home state of northwest Montana, a huge number of men moved to North Dakota to work in the Bakken gas fields. Montana is a big state; it takes about 14 hours to drive from my corner of northwest Montana to the North Dakota oil fields, so that means those gas workers don’t make it back to their western Montana homes for months.
Moreover, the work was six, sometimes seven days a week and 12 hours a day, so once there, they couldn’t drive back home even if they wanted to. This meant long absences… and a good friend of mine who is a marriage counselor told me that the local divorce rate was spiking because of them.
Now the northwest Montana workers are returning home because the once-lucrative oil/gas jobs are disappearing. That news won’t make the New York Times, but it’s as real as it gets on Main Street USA.

From Local to National

Of course, the oil industry's woes aren’t a carefully guarded Wall Street secret. However, I do think that Wall Street—and perhaps even you—are underestimating the impact that low oil prices are going to have on economic growth and GDP numbers going forward.
Let me explain.
Industrial production for the month of January, which measures the output of US manufacturers, miners, and utilities, came in at a “seasonally adjusted" 0.2%.
A 0.2% gain isn’t much to shout about, but the real key was the impact the mining component (which includes oil/gas producers) had on the industrial-production calculation.
The mining industry is the second-largest component of industrial production, and its output fell by 1.0% in January. It was the biggest drag on the overall index.
However, the Federal Reserve Bank said, “The decline [was] more than accounted for by a substantial drop in the index for oil and gas well drilling and related support activities.”
How much did it account for? The oil and gas component fell by 10.0% in January.
Yup, a double-digit drop in output in just one month. Moreover, it was the fourth monthly decline in a row.
Last week’s weak GDP caught Wall Street off guard, but there are a lot more GDP disappointments to come as the energy industry layoffs percolate through the economy. Here’s how my Rational Bear readers are getting ready for GDP and corporate-earnings disappointments that are sure to rattle the markets.
Can your portfolio, as currently composed, handle a slowing economy and falling corporate profits? For most investors, the answer is “no.” Click above to find out how to protect yourself.
Tony Sagami
Tony Sagami
30-year market expert Tony Sagami leads the Yield Shark and Rational Bear advisories at Mauldin Economics. To learn more about Yield Shark and how it helps you maximize dividend income, click here. To learn more about Rational Bear and how you can use it to benefit from falling stocks and sectors, click here.
February 12, 2015

Outside the Box: Hoisington Quarterly Review and Outlook: Fourth Quarter 2014

By John Mauldin

Forecasting is a singularly difficult task and is more often than not fraught with failure. The Federal Reserve has some of the smartest economists in the world, and yet their forecasts are so wrong so often (as in, they almost never get it right) that some have pointed out that it’s almost statistically impossible to be as bad as the Fed. Yet they continue to issue such forecasts and to base economic and monetary policy on them. Go figure.
Their forecasts, like most economic predictions, are based on past performance. Intricate economic models look at history to try to determine the future relationships among economic determinants. I really shouldn’t pick on the Fed so much as point out that almost all of us in the forecasting business have dismal track records. The world has grown so complex that it is singularly difficult to understand the interrelationships of the million-odd factors that determine the outcome of an economy.
This is especially true during those periods when we see economic regime change. Not only is using past performance and relationships difficult, it can actually be misleading, as what is going to happen in a uniquely turbulent future has not been modeled in the past. I have been suggesting for some time that we are coming to the end of a long cycle and entering a period where past relationships will no longer hold. I have likened this to what happens when one approaches the boundary of a black hole in space. All known physical relationships are turned on their heads, and the math that works in the rest of the universe no longer applies.
For me, the massive amount of debt we have accumulated in our own planetary confines is the ecoomic equivalent of a black hole, and we are approaching the point at which that debt will implode if it is not resolved. As with Greece, the ability of players large and small to pay debt off in a global deflationary environment has been greatly compromised. I’m not certain how this will end. Maybe everyone will sit down and hammer out something like a Plaza Accord to resolve the debt, by which I mean dilute it, destroy it, make it go away, restructure it – whatever it takes. Of course, history suggests that we will do such a thing only in the middle of or immediately following a crisis.
Today’s Outside the Box is from our old friend Dr. Lacy Hunt of Hoisington Asset Management. He muses on the effects of debt and takes us back to the ’20s and ’30s, when there were similar problems with debt in countries that had engaged in currency wars for over a decade.
Clearly the policies of yesteryear and the present are forms of “beggar-my-neighbor” policies, which the MIT Dictionary of Modern Economics explains as follows: “Economic measures taken by one country to improve its domestic economic conditions … have adverse effects on other economies. A country may increase domestic employment by increasing exports or reducing imports by … devaluing its currency or applying tariffs, quotas, or export subsidies. The benefit which it attains is at the expense of some other country which experiences lower exports or increased imports.… Such a country may then be forced to retaliate by a similar type of measure.”
The existence of over-indebtedness, and its resulting restraint on growth and inflation, has forced governments today, as in the past, to attempt to escape these poor economic conditions by spurring their exports or taking market share from other economies. As shown above, it is a fruitless exercise with harmful side effects.
This is an important OTB, and it behooves us to pay attention, because Lacy has been one of the most accurate forecasters of interest rates for the last 20 to 30 years. He will also be at our conference in San Diego, where he is always one of the most highly rated speakers. And I want to express my appreciation to Lacy for once again letting us reproduce his work.
I send this Outside the Box to you from Little Cayman Island, where I am visiting my friend Raoul Pal at his beach house, which he just finished building. It is at the “far end” of a ten-mile-long by one-mile-wide island that is a libertarian paradise in that there is no government. Just some hundred-odd neighbors taking care of what needs to be done. With 10 MB broadband. Little Cayman is a bit of an island oddity, in that it is the tippy-top ridge of a very tall undersea mountain; just off the beaches, the Cayman Trench plunges to a depth of 25,000 feet, the deepest water in the Caribbean and one of the deeper trenches in the world. It is a scuba diver’s paradise, which pretty much drives the economy of the island.
While I was working, my companion went snorkeling some 20 feet off the beach from Raoul’s home. After she raved about the beauty and all the fish, I donned a little gear and for the first time in my life went snorkeling. I need to work on my snorkeling technique, but if Raoul invites us back, I will be better prepared. It was indeed a beautiful experience.
Raoul will also be presenting, along with his partner Grant Williams (of Things That Make You Go Hmmm… fame) at my conference, and he outlined what he thinks their presentation will cover. As is typical with Raoul and Grant, their approach to this talk is very fresh and different, focused on where global growth will go in the next few decades. Not exactly were you might expect it to go. I will be in the front row.
Raoul and Grant are the founders of RealVision TV, where they present in-depth interviews with famous investors. One of their concepts is to create a chain letter of sorts, by having a person who is interviewed find another fascinating person to interview. The interviewee then becomes the interviewer in the next round, and one great mind leads to another. Raoul led off by engaging Kyle Bass in a long-form interview that is fascinating. You can see it for free right here. There is also a special introductory price for Mauldin Economics readers to subscribe to RealVision.
Finally, I know there are many people who wonder about the lives of those of us who write about macroeconomics and investments for a living. Here is a picture of two of us (Raoul would be the handsome one) in typical working attire. It’s a hard-knock life.
As it turns out, I am actually hitting the send button from Grand Cayman Island, as we were summoned and rushed to the “airport” on Little Cayman to take a helicopter flight over to a nearby island where larger planes could land, because the small plane that usually services Little Cayman had broken down. Not a big deal, and as a bonus we had a helicopter tour of Little Cayman. I speak at the iCIO gathering this afternoon (hosted by Mark Yusko) and then speak at the Cayman Alternative Investment Summit tomorrow morning, where my good friend Nouriel Roubini and I will trade ideas in front of 650 attendees. It should prove to be fun. Then we’ll have a few days of R&R (hopefully) and then head back to Dallas on Sunday. You have a great week.
Your wondering why I don’t work from a beach sometimes analyst,
John Mauldin, Editor
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Hoisington Quarterly Review and Outlook – Fourth Quarter 2014


“No stock-market crash announced bad times. The depression rather made its presence felt with the serial crashes of dozens of commodity markets. To the affected producers and consumers, the declines were immediate and newsworthy, but they failed to seize the national attention. Certainly, they made no deep impression at the Federal Reserve.” Thus wrote author James Grant in his latest thoroughly researched and well-penned book, The Forgotten Depression (1921: The Crash That Cured Itself).
Commodity price declines were the symptom of sharply deteriorating economic conditions prior to the 1920-21 depression. To be sure, today’s economic environment is different. The world economies are not emerging from a destructive war, nor are we on the gold standard, and U.S. employment is no longer centered in agriculture and factories (over 50% in the U.S. in 1920). The fact remains, however, that global commodity prices are in noticeable retreat. Since the commodity index peak in 2011, prices have plummeted. The Reuters/Jefferies/CRB Future Price Index has dropped 39%. The GSCI Nearby Commodity Index is down 48% (Chart 1), with energy (-56%), metals (-36%), copper (-40%), cotton (-73%), WTI crude (-57%), rubber (-72%), and the list goes on. In some cases this broad-based retreat reflects increased supply, but more clearly it indicates weakening global demand.
The proximate cause for the current economic maladies and continuing downshift of economic activity has been the over- accumulation of debt. In many cases debt funded the purchase of consumable and non- productive assets, which failed to create a future stream of revenue to repay the debt. This circumstance means that existing and future income has to cover, not only current outlays, but also past expenditures in the form of interest and repayment of debt. Efforts to spur spending through relaxed credit standards, i.e. lower interest rates, minimal down payments, etc., to boost current consumption, merely adds to the total indebtedness. According to Deleveraging? What Deleveraging? (Geneva Report on the World Economy, Report 16) total debt to GDP ratios are 35% higher today than at the initiation of the 2008 crisis. The increase since 2008 has been primarily in emerging economies. Since debt is the acceleration of current spending in lieu of future spending, the falling commodity prices (similar to 1920) may be the key leading indicator of more difficult economic times ahead for world economic growth as the current overspending is reversed.

Currency Manipulation

Recognizing the economic malaise, various economies, including that of the U.S., have instituted policies to take an increasing “market share” from the world’s competitive, slow growing marketplace. The U.S. fired an early shot in this economic war instituting the Federal Reserve’s policy of quantitative easing. The Fed’s balance sheet expansion placed downward pressure on the dollar thereby improving the terms of trade the U.S. had with its international partners (Chart 2).
Subsequently, however, Japan and Europe joined the competitive currency devaluation race and have managed to devalue their currencies by 61% and 21%, respectively, relative to the dollar. Last year the dollar appreciated against all 31 of the next largest economies. Since 2011 the dollar has advanced 19%, 15% and 62%, respectively, against the Mexican Peso, the Canadian Dollar and the Brazilian Real. Latin America’s third largest economy, Argentina, and the 15th largest nation in the world, Russia, have depreciated by 115% and 85%, respectively, since 2011.
The competitive export advantages gained by these and other countries will have adverse repercussions for the U.S. economy in 2015 and beyond. Historical experience in the period from 1926 to the start of World War II (WWII) indicates this process of competitive devaluations impairs global activity, spurs disinflationary or deflationary trends and engenders instability in world financial markets. As a reminder of the pernicious impact of unilateral currency manipulation on global growth, a brief review of the last episode is enlightening.

The Currency Wars of the 1920s and 1930s

The return of the French franc to the gold standard at a considerably depreciated level in 1926 was a seminal event in the process of actual and de facto currency devaluations, which lasted from that time until World War II. Legally, the franc’s value was not set until 1928, but effectively the franc was stabilized in 1926.
France had never been able to resolve the debt overhang accumulated during World War I and, as a result, had been beset by a series of serious economic problems. The devalued franc allowed economic conditions in France to improve as a result of a rising trade surplus. This resulted in a considerable gold inflow from other countries into France. Moreover, the French central bank did not allow the gold to boost the money supply, contrary to the rules of the game of the old gold standard. A debate has ensued as to whether this policy was accidental or intentional, but it misses the point. France wanted and needed the trade account to continue to boost its domestic economy, and this served to adversely affect economic growth in the UK and Germany. The world was lenient to a degree toward the French, whose economic problems were well known at the time.
In the aftermath of the French devaluation, between late 1927 and mid-1929, economic conditions began to deteriorate in other countries. Australia, which had become extremely indebted during the 1920s, exhibited increasingly serious economic problems by late 1927. Similar signs of economic distress shortly appeared in the Dutch East Indies (now Indonesia), Finland, Brazil, Poland, Canada and Argentina. By the fall of 1929, economic conditions had begun to erode in the United States, and the stock market crashed in late October.
Additionally, in 1929 Uruguay, Argentina and Brazil devalued their currencies and left the gold standard. Australia, New Zealand and Venezuela followed in 1930. Throughout the turmoil of the late 1920s and early 1930s, the U.S. stayed on the gold standard. As a result, the dollar’s value was rising, and the trade account was serving to depress economic activity and transmit deflationary forces from the global economy into the United States.
By 1930 the pain in the U.S. had become so great that a de facto devaluation of the dollar occurred in the form of the Smoot-Hawley Tariff of 1930, even as the United States remained on the gold standard. By shrinking imports to the U.S., this tariff had the same effect as the earlier currency devaluations. Over this period, other countries raised tariffs and/or imposed import quotas. This is effectively equivalent to currency depreciation. These events had consequences.
In 1931, 17 countries left the gold standard and/or substantially devalued their currencies. The most important of these was the United Kingdom (September 19, 1931). Germany did not devalue, but they did default on their debt and they imposed severe currency controls, both of which served to contract imports while impairing the finances of other countries. The German action was undeniably more harmful than if they had devalued significantly. In 1932 and early 1933, eleven more countries followed. From April 1933 to January 1934, the U.S. finally devalued the dollar by 59%. This, along with a reversal of the inventory cycle, led to a recovery of the U.S. economy but at the expense of trade losses and less economic growth for others.
One of the first casualties of this action was China. China, on a silver standard, was forced to exit that link in September 1934, which resulted in a sharp depreciation of the Yuan. Then in March 1935, Belgium, a member of the gold bloc countries, devalued. In 1936, France, due to massive trade deficits and a large gold outflow, was forced to once again devalue the franc. This was a tough blow for the French because of the draconian anti-growth measures they had taken to support their currency. Later that year, Italy, another gold bloc member, devalued the gold content of the lira by the identical amount of the U.S. devaluation. Benito Mussolini’s long forgotten finance minister said that the U.S. devaluation was economic warfare. This was a highly accurate statement. By late 1936, Holland and Switzerland, also members of the gold bloc, had devalued. Those were just as bitter since the Dutch and Swiss used strong anti- growth measures to try to reverse trade deficits and the resultant gold outflow. The process came to an end, when Germany invaded Poland in September 1939, as WWII began.
It is interesting to ponder the ultimate outcome of this process, which ended with World Ware II. The extreme over-indebtedness, which precipitated the process, had not been reversed. Thus, without WWII, this so-called “race to the bottom” could have continued on for years.
In the United States, the war permitted the debt overhang of the 1920s to be corrected. Unlike the 1930s, the U.S. could now export whatever it was able to produce to its war torn allies. The income gains from these huge net trade surpluses were not spent as a result of mandatory rationing, which the public tolerated because of almost universal support for the war effort. The personal saving rate rose as high as 28%, and by the end of the war U.S. households and businesses had a clean balance sheet that propelled the postwar economic boom.
The U.S., in turn, served as the engine of growth for the global economy and gradually countries began to recover from the effects of the Great Depression and World War II. During the late 1950s and 1960s, recessions did occur but they were of the simple garden-variety kind, mainly inventory corrections, and they did not sidetrack a steady advance of global standards of living.


As noted above, economic conditions, framework and circumstances are different today. The gold standard in place in the 1920s has been replaced by the fiat currency regime of today. Additionally, imbalances from World War I that were present in the 1920s are not present today, and the composition of the economy is different.
Unfortunately, there are parallels to that earlier period. First, there is a global problem with debt and slow growth, and no country is immune. Second, the economic problems now, like then, are more serious and are more apparent outside the United States. However, due to negative income and price effects on our trade balance, foreign problems are transmitting into the U.S. and interacting with underlying structural problems. Third, over- indebtedness is rampant today as it was in the 1920s and 1930s. Fourth, competitive currency devaluations are taking place today as they did in the earlier period. These are a combination of monetary and/or fiscal policy actions and also, with floating exchange rates, a consequence of shifting assessments of private participants in the markets.
Clearly the policies of yesteryear and the present are forms of “beggar-my-neighbor” policies, which The MIT Dictionary of Modern Economics explains as follows: “Economic measures taken by one country to improve its domestic economic conditions ... have adverse effects on other economies. A country may increase domestic employment by increasing exports or reducing imports by ... devaluing its currency or applying tariffs, quotas, or export subsidies. The benefit which it attains is at the expense of some other country which experiences lower exports or increased imports ... Such a country may then be forced to retaliate by a similar type of measure.”
The existence of over-indebtedness, and its resulting restraint on growth and inflation, has forced governments today, as in the past, to attempt to escape these poor economic conditions by spurring their exports or taking market share from other economies. As shown above, it is a fruitless exercise with harmful side effects.

Interest Rates

The downward pressure on global economic growth rates will remain in place in 2015. Therefore record low inflation and interest rates will continue to be made around the world in the new year, as governments utilize policies to spur growth at the expense of other regions. The U.S. will not escape these forces of deflationary commodity prices, a worsening trade balance and other foreign government actions.
U.S. nominal GDP in this economic expansion since 2008 has experienced the longest period of slow growth of any recovery since WWII (Chart 3). Typical of the disappointing expansion, the fourth quarter to fourth quarter growth rate slowed from 4.6% in 2013 to 3.8% in 2014. A further slowing of nominal economic growth to around 3% will occur over the four quarters of 2015. The CPI will subside from the 0.8% level for the period December 2013 to December 2014 (Chart 4), registering only a minimal positive change for 2015. Conditions will be sufficiently lackluster that the Federal Reserve will have little choice in their overused bag of tricks but to stand pat and watch their previous mistakes filter through to worsening economic conditions. Interest rates will of course be volatile during the year as expectations shift, yet the low inflationary environment will bring about new lows in yields in 2015 in the intermediate- and long-term maturities of U.S. Treasury securities.
Van R. Hoisington
Lacy H. Hunt, Ph.D.
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February 8, 2015

The 10th Man: Mean Reversion Monkeys

By Jared Dillian

The buzz has been building on this trade for weeks. Clients, friends, people on Twitter, everyone I know has been waiting for a chance to pick the bottom in oil.
I’ve heard all this chatter on which triple-leveraged oil ETFs to use (I make a point of not knowing such things). They’ve been waiting for this opportunity since oil was at 80 bucks.
Interestingly, they could have shorted it when it was at 80.
Actually, they could have shorted it at 110.
Or 100.
Or 90.
Or 80.
Or 70.
Or 60.
Or 50. They could have shorted it at 50 and still made money.
But they waited this entire time, watching passively as oil plummeted over 60%, to play a 10-point bounce over the course of a couple of days.
Well, the mean reversion monkeys, as I call them, will tell you that they just made 20% in three days. Annualize that!
Problem is, it doesn’t work that way, because you can’t flawlessly pick every bottom. I was a mean reversion monkey once, and for every time I made 20% in three days, there were three other times I almost got carried out—like that time in 2008 when I tried top-ticking the Canadian dollar. That one was painful.
Have you ever heard of a CTA? CTA stands for Commodities Trading Advisor. It’s basically like a hedge fund that trades futures, but these guys are notorious trend followers. This is how John Henry, owner of the Boston Red Sox, made his money. They trade futures, they trade with leverage, and when stuff starts moving, they follow the trend. They don’t care what it is, or which way it’s going. The trend is your friend. There weren’t that many people who made money on falling oil, but the CTAs absolutely killed it.
Ever notice there’s no such thing as a CMRA? A Commodities Mean Reversion Advisor? That’s because they wouldn’t make any money.
The vast majority of traders and investors are mean reversion monkeys. I would place the number at well over 90%. Maybe 95%. You can make money as a mean reversion monkey, but not much. Basically, you are relying on your ability to scalp in and out of things continuously to make money.
And you wonder why average hedge funds only make 5-6% a year if they’re lucky. They cut short their losers, but they cut short their winners, too.
At the end of 2007, when I was still trading proprietarily at Lehman, I did an interesting exercise. I went back and looked at the P&L of every trade I did over the course of the year. I had one or two big winners, with small ups and downs everywhere else that all canceled each other out. If it weren’t for the one or two big winners, where I happened to bet big and let the profits run, I would have basically been flat for the year.
In fact, I think if you analyzed anyone’s portfolio, it would look pretty much the same. In a portfolio that’s up 10%, you’re going to have one or two huge winners, and everything else will be chopped salad.
The reality is that most people are only good for one or two good ideas a year. Maybe less.
So wouldn’t it make sense to put as much money in those ideas as possible?

Market Wizards

If you go back and read your Jack Schwager Market Wizards books, and read about all the stud traders, you won’t find one of them who would be buying triple-leveraged oil ETFs for a 10% bounce in oil. No. Those guys would have had the dominant trend right. They don’t care about the countertrend, because that’s not where the money is.
Trading with the trend is the only way to make meaningful amounts of money. All of Wall Street right now is doing a smug victory lap for their scalp in oil, but the funny thing about scalps is that people get greedy and, as trends often do, oil will make lower lows and people will find themselves sitting on losses instead of profits. Catching the falling knife requires so many things to go right simultaneously to work.
Have you ever met someone who has money all out of proportion to his intelligence? Someone who just goes around with a horseshoe up his ass? The guy that bought Apple at $50 and sold it at $700.
“So,” you ask this dude, “why did you buy Apple?”
“It was going up.”
It was going up. This is not someone who you think is particularly smart. But maybe he made $500,000 on this trade. And now he is long the iShares biotech ETF (IBB). How does he do it? How can someone so intellectually lazy be so rich? I mean, you spend hours staring at charts and watching oil tick for tick, and you timed the bottom perfectly, and you make… 10%.

The Magic of Compounding

Research has shown that owning equities with the dividends reinvested is about the closest you’re going to get to a sure thing in the markets. And your holding period needs to be long (like Buffett’s) so earnings/cash flows have a chance to compound.
I’m sure you’ve done that exercise where you were earning 3% interest in the bank and you want to see how it compounds over time, so you stick it in an Excel spreadsheet and do the math. Same thing. If you don’t give something a chance to compound, the odds of making a meaningful amount of money are very small.
Have you ever noticed that anyone who gained notoriety for being a day trader did so 15 years ago? There was no other time in history where you could literally make a living by cutting your winners short.
As for being intellectually lazy, well, there’s a difference between being smart and having a psychological need to prove you’re smart, or different. What’s wrong with holding IBB if you are making money? Seems easier than buying something that hasn’t had an uptick in months.
Like most sell-side guys, I was a mean reversion monkey back in the day. I’ve spent the last several years unlearning everything I had learned. Yes, investing is one of the hardest things in the world.
But shockingly, it doesn’t have to be.
Position: At the time of writing, Jared Dillian was short CAD
Jared Dillian
Jared Dillian
The article The 10th Man: Mean Reversion Monkeys was originally published at


January 27, 2015

Thoughts from the Frontline: How Global Interest Rates Deceive Markets

By John Mauldin

“You keep on using that word. I do not think it means what you think it means.”
– Inigo Montoya, The Princess Bride
“In the economic sphere an act, a habit, an institution, a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them.
“There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.
“Yet this difference is tremendous; for it almost always happens that when the immediate consequence is favorable, the later consequences are disastrous, and vice versa. Whence it follows that the bad economist pursues a small present good that will be followed by a great evil to come, while the good economist pursues a great good to come, at the risk of a small present evil.”
– From an 1850 essay by Frédéric Bastiat, “That Which Is Seen and That Which Is Unseen”
All right class, it’s time for an open book test. I’m going to give you a list of yields on various 10-year bonds, and I want to you to tell me what it means.
United States: 1.80%
Germany: 0.36%
France: 0.54%
Italy: 1.56%
UK: 1.48%
Canada: 1.365%
Australia: 2.63%
Japan: 0.22%
I see that hand up in the back. Yes, the list does appear to tell us what interest rates the market is willing to take in order to hold money in a particular country’s currency for 10 years. It may or may not tell us about the creditworthiness of the country, but it does tell us something about the expectations that investors have about potential returns on other possible investments. The more astute among you will notice that French bonds have dropped from 2.38% exactly one year ago to today’s rather astonishing low of 0.54%. Likewise, Germany has seen its 10-year Bund rates drop from 1.66% to a shockingly low 0.36%. What does it mean that European interest rates simply fell out of bed this week? Has the opportunity set in Europe diminished? Are the French really that much better a credit risk than the United States is? If not, what is that number, 0.54%, telling us? What in the wide, wide world of fixed-income investing is going on?
Quick segue – but hopefully a little fun. One of the pleasures of having children is that you get to watch the classic movie The Princess Bride over and over. (If you haven’t appreciated it, go borrow a few kids for the weekend and watch it.) There is a classic line in the movie that is indelibly imprinted on my mind.
In the middle of the film, a villainous but supposedly genius Sicilian named Vizzini keeps using the word “inconceivable” to describe certain events. A mysterious ship is following the group at sea? “Inconceivable!” The ship’s captain starts climbing the bad guys’ rope up the Cliffs of Insanity and even starts to gain on them? “Inconceivable!” The villain doesn’t fall from said cliff after Vizzini cuts the rope that all of them were climbing? “Inconceivable!” Finally, master swordsman – and my favorite character in the movie – Inigo, famous for this and other awesome catchphrases, comments on Vizzini’s use of this word inconceivable:
“You keep on using that word. I do not think it means what you think it means.”
(You can see all the uses of Vizzini’s use of the word inconceivable and hear Inigo’s classic retort here.)
When it comes to interpreting what current interest rates are telling us about the markets in various countries, I have to say that I do not think they mean what the market seems to think they mean. In fact, buried in that list of bond yields is “false information” – information so distorted and yet so readily misunderstood that it leads to wrong conclusions and decisions – and to bad investments. In today’s letter we are going to look at what interest rates actually mean in the modern-day context of currency wars and interest-rate manipulation by central banks. I think you will come to agree with me that an interest rate may not mean what the market thinks it means.
Let me begin by briefly summarizing what I want to demonstrate in this letter. First, I think Japanese interest rates not only contain no information but also that markets are misreading this non-information as meaningful because they are interpreting the data as if it were normal market information in a familiar market environment, when the truth is that we sailed beyond the boundaries of the known economic world some time ago. The old maps are no longer reliable. Secondly, Europe is making the decision to go down the same path as the Japanese have done; and contrary to the expectations of European central bankers, the potential to end up with the same results as Japan is rather high.
The false information paradox is highlighted by the recent Swiss National Bank decision. Couple that with the surprise decisions by Canada and Denmark to cut rates, the complete retracement of the euro against the yen over the past few weeks, and Bank of Japan Governor Kuroda’s telling the World Economic Forum in Davos that he is prepared to do more (shades of “whatever it takes”) to create inflation, and you have the opening salvos of the next skirmish in the ongoing currency wars I predicted a few years ago in Code Red. All of this means that capital is going to be misallocated and that the current efforts to create jobs and growth and inflation are insufficient. Indeed, I think those efforts might very well produce a net negative effect.
But before we go any farther, a quick note. We will start taking registrations for the 12th annual Strategic Investment Conference next week. There will be an early-bird rate for those of you who go ahead to register quickly. The conference will run from April 29 through May 2 at the Manchester Grand Hyatt in San Diego. For those of you familiar with the conference, there will be the “usual” lineup of brilliant speakers and thought leaders trying to help us understand investing in a world of divergence. For those not familiar, this conference is unlike the vast majority of other investment conferences, in that speakers representing various sponsors do not pay to address the audience. Instead, we bring in only “A-list” speakers from around the world, people you really want to meet and talk with. This year we’re going to have a particularly large and diverse group of presenters, and we structure the conference so that attendees can mingle with the speakers and with each other.
I am often told by attendees that this is the best economic and investment conference they attend in any given year. I think it is a measure of the quality of the conference that many of the speakers seek us out. Not only do they want to speak, they want to attend the conference to hear and interact with the other speakers and conference guests. This conference is full of speakers that other speakers (especially including myself) want to hear. And you will, too. Save the date and look for registration and other information shortly in your mail.
Now let’s consider what today’s interest rates do and do not mean as we navigate uncharted waters.
Are We All Turning Japanese?
Japan is an interesting case study. It’s a highly developed nation with a very sophisticated culture, increasingly productive in dollar terms (although in yen terms nominal GDP has not moved all that much), and carrying an unbelievable 250% debt-to-GDP burden, but with a 10-year bond rate of 0.22%, which in theory could eventually mean that the total interest expenses of Japan would be less than those of the US on 5-6 times the amount of debt. Japan has an aging population and a savings rate that has plunged in recent years. The country has been saddled with either low inflation or deflation for most of the past 25 years. At the same time, it is an export power, with some of the world’s most competitive companies in automobiles, electronics, robotics, automation, machine tools, etc. The Japanese have a large national balance sheet from decades of running trade surpluses. If nothing else, they have given the world sushi, for which I will always hold them in high regard.
We talk about Japan’s “lost decades” during which growth has been muted at best. They are just coming out of a triple-dip recession after a disastrous downturn during the Great Recession. And through it all, for decades, there is been a widening government deficit. The chart below shows the yawning gap between Japanese government expenditures and revenues.

This next chart, from a Societe Generale report, seems to show that the Japanese are financing 40% of their budget. I say “seems” because there is a quirk in the way the Japanese do their fiscal accounting. Pay attention, class. This is important to understand. If you do not grasp this, you will not understand Japanese budgets and how they deal with their debt.
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.
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January 13, 2015

Thoughts from the Frontline: A Five-Year Global Financial Forecast: Tsunami Warning

By John Mauldin

It is the time of the year for forecasts; but rather than do an annual forecast, which is as much a guessing game as anything else (and I am bad at guessing games), I’m going to do a five-year forecast to take us to the end of the decade, which I think may be useful for longer-term investors. We will focus on events and trends that I think have a high probability, and I’ll state what I think the probabilities are for my forecasts to actually happen. While I could provide several dozen items, I think there are seven major trends that are going to sweep over the globe and that as an investor you need to have on your radar screen. You will need to approach these trends with caution, but they will also provide significant opportunities.
There is a book in here somewhere, but I do not intend to write one today. In fact, my New Year’s resolution is to write shorter letters in 2015. Over the last decade and a half, the letter has tended to get longer. A little more here, a little more there, and pretty soon it just gets to be a bit too much to read in one sitting. That means I need to either be more concise, break up my topics into two sessions or, if further writing is necessary, post the additional work on the website for those interested.
So I’m writing today’s letter in that spirit. Each of the major topics we’ll be covering will show up in other letters over the next few months. I would appreciate your feedback and any links to articles and/or data points that you think I should know about regarding these topics.
But first, this is generally the most downloaded letter of the year. I want to invite new readers to become one of my 1 million closest friends by simply entering your email address here. You can follow my work throughout the year, absolutely free (and see how my prognostications are turning out). And if you’re a regular reader, why not send this to a few of your friends and suggest they join you? At the very least, Thoughts from the Frontline should make for some interesting conversations this year. Thanks. Now let’s get on with the forecasting.
Seven Significant Changes for the Next Five Years
Let’s look at what I think are six inexorable trends or waves that will each have a major impact in its own right but that when taken together will amount to a tsunami of change for the global economy.
1. Japan will continue its experiment with the most radical quantitative easing attempted by a major country in the history of the world… and the experiment is getting dangerous. The Bank of Japan is effectively exporting the island nation’s deflation to its trade competitors like Germany, China, and South Korea and inviting a currency war that could shake the world. I’ve been saying this for years now, but the story took a nasty turn on Halloween Day, when the Bank of Japan announced it was greatly expanding and changing the mix of its asset purchases. The results have been downright scary, and a major slide in the JPY/USD exchange rate is almost certain over the next five years. I give it a 90% probability. All this while the population of Japan shrinks before our very eyes.
2. Europe is headed for a crisis at least as severe as the Grexit scare was in 2012 – and for the resulting run-up in interest rates and a sovereign debt scare in the peripheral countries. After all these years of struggle, the structural flaws in the EMU’s design remain; and now major economies like Italy and France are headed for trouble. In the very near future we will finally know the answer to the question, “Is the euro a currency or an experiment?” The changes required to answer that question will be wrenching and horrifically expensive. There are no good answers, only difficult choices about who pays how much and to whom. Again, I see the deepening of the Eurozone crisis as a 90% probability.
3. China is approaching its day of reckoning as it tries to reduce its dependency on debt in its bid for growth, while creating a consumer society. The world is simply not prepared for China to experience an outright “hard landing” or recession, but I think there is a 70% probability that it will do so within the next five years. And the probability that China will suffer either a hard landing OR a long period of Japanese-style stagnation (in the event that the Chinese government is forced to absorb nonperforming loans to prevent a debt crisis) is over 95%. To be sure, it is still quite possible that the Chinese economy will be significantly larger in 2025 (ten years from now) than it is today, but realizing that potential largely depends on President Xi Jinping’s ability to accomplish an extremely difficult task: deleveraging the debt overhang that threatens the country’s MASSIVE financial system while rebalancing the national economy to a more sustainable growth model (either through either a vast expansion of China’s export market or the rapid development of “new economy” sectors like technology, services, and consumption; or both). This will not be the end of China, which I’m quite bullish on over the very long term, but such transitions are never easy. Even given this rather stark forecast, it is still likely (in my opinion) that the Chinese economy will be 20 to 25% bigger as 2020 opens than it is today; and every other major economy in the world (including the US) would be thrilled to have such growth. At the very least, though, China’s slowdown and rebalancing is going to put pressure on commodity exporters, which are generally emerging markets plus Australia, Canada, and Norway.
4. All of the above will tend to be bullish for the dollar, which will make dollar-denominated debt in emerging-market countries more difficult to pay back. And given the amount of debt that has been created in the last few years, it is likely that we’ll see a series of crises in emerging-market countries, along with an uncomfortably high level of risk of setting off an LTCM-style global financial shock. My colleague Worth Wray spoke about this new era of volatile FX flows and growing risk of capital flight from emerging markets at my Strategic Investor Conference last May, and he has continued to remind us of those risks in recent months (“A Scary Story for Emerging Markets” and “Why the World Needs the US Economy to Struggle”). Now that Russia has tumbled into a full-fledged currency crisis with serious signs of contagion, Worth’s prediction is already playing out, and I would assign an 80 to 90% probability that it will continue to do so, as a function of (1) the rising US dollar and a reversal in cross-border capital flows, (2) falling commodity prices, or (3) both. This massive wave is going to create a lot of opportunities for courageous investors who are ready to surf when countries are cheap.
5. I do not believe that the secular bear market in the United States that I began to describe in 1999 has ended. Secular bull markets simply do not begin from valuations like those we have today. Either we began a secular bull market in 2009, or we have one more major correction in front of us. Obviously, I think it is the latter. It has been some time since I’ve discussed the difference between secular bull and bear markets and cyclical bull and bear markets, and I will briefly touch on the topic today and go into much more detail in later letters. For US-focused investors, this is of major importance. The secular bear is not something to be scared of but simply something to be played. It also offers a great deal of opportunity. If I am right, then the next major leg down will bring on the end of the secular bear and the beginning of a very long-term secular bull. We will all get to be geniuses in the 2020s and perhaps even before the last half of this decade runs out. Won’t that be fun? Let’s call the end of the secular bear a 90% probability in five years and move on.
6. Finally, the voters of the United States are going to have to make a decision about the direction they want to take the country. We can either opt for growth, which will mean a new tax and regulatory regime, or we can double down on the current direction and become Europe and Japan. I’ve traveled to both Europe and Japan, and they’re both pleasant-enough places to live, but I wouldn’t want to be a citizen of either Japan or the Eurozone for the rest of this decade. (I particularly love Italy, but it is beginning to resemble a basket case, with last year’s optimistic drive for reforms seemingly stalled.)
However, I would rather live and work and invest in a high-growth country, with opportunities all around me, a country where we reduce income inequality by increasing wealth and opportunities at the lower end of the income scale instead of trying to legislate parity by increasing taxes and imposing government-mandated wealth redistribution, which slows growth and squelches opportunity for everyone.
A restructuring of the US tax and regulatory regime does not mean a capitulation to the wealthy, big banks, or big business. Properly conceived and constructed, it will allow the renewal of the middle class and result in higher income for all. Sadly, it is not clear to me that either the Republican or Democratic parties are up to the task of making the difficult political decisions necessary. They each have constituencies that tend to opt for the status quo. But I see hope on both sides of the political spectrum that change is possible. The course they set will give us an idea where we will want to focus our portfolios in the decade of the ’20s. It is a 100% probability that we will have to make a decision. It is less than 50% that we will make the right one – or at least the one that I think is the right one.
7.  We have entered the Age of Transformation. We’re going to see the development of new technologies that will simply astound us – from increasingly capable robots and other applications of AI to huge breakthroughs in biotechnology. The winners are going to be those who identified the truly transformational technologies early on in their development and invested wisely. While riskier (potentially far riskier) than most of your investments should be, a basket of new-technology stocks should be considered for the growth part of your portfolio. I see the Age of Transformation as a 100% probability.
Just for the record, I also see a continuation of the global deflationary environment and a slowing of the velocity of money until we have some type of resolution concerning sovereign debt. Central banks will continue to try to solve the “crises” I mentioned above with monetary policy, but monetary policy will simply not be enough to stem the tide. Central banks can paddle as hard as they like into the waves of change, but they cannot reverse their powerful flow.
Now, let’s look further at each of the waves that are forming into a potential tsunami.

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

January 5, 2015

Connecting the Dots: Q3 GDP Jumps 5%; Ha! The Crap Behind the Numbers

By Tony Sagami

I was raised on a farm and I’ve shoveled more than my share of manure. I didn’t like manure back then, and I like the brand of manure that comes out of Washington, DC, and Wall Street even less.
A stinky pile of economic manure came out of Washington, DC, last week and instead of the economic nirvana that it was touted to be, it was a smokescreen of half-truths and financial prestidigitation.

According to the newest version of the Bureau of Economic Analysis (BEA), the US economy is smoking hot. The BEA reported that GDP grew at an astonishing 5.0% annualized rate in the third quarter.
5% is BIG number.
The New York Times couldn’t gush enough, given a rare chance to give President Obama an economic pat on the back. “The American economy grew last quarter at its fastest rate in over a decade, providing the strongest evidence to date that the recovery is finally gaining sustained power more than five years after it began.”

Moreover, this is the second revision to the third quarter GDP—1.1 percentage points higher than the first revision—and the strongest rate since the third quarter of 2003.

However, that 5% growth rate isn’t as impressive if you peek below the headline number.
Fun with Numbers #1: The biggest improvement was in the Net Exports category, which increased by 112 basis points. How did they manage that?  There was a downturn in Imports.
Fun with Numbers #2: Of the 5% GDP growth, 0.80% was from government spending, most of which was on national defense. I’m a big believer in a strong national defense, but building bombs, tanks, and jet fighters is not as productive to our economy as bridges, roads, and schools.
Fun with Numbers #3: Almost half of the gain came from Personal Consumption Expenditures (PCE) and deserves extra scrutiny. Of that 221 bps of PCE spending:
  • Services spending accounts for 115 bps. Of that 115, 15 bps was from nonprofits such as religious groups and charities. The other 100 bps was for household spending on “services.”
  • Of that 100 bps, the two largest categories were Healthcare spending (52 bps) and Financial Services/Insurance (35 bps).
The end result is that 85% of the contribution to GDP from Household Spending on Services came from healthcare and insurance! In short… those are code words for Obamacare!
While the experts on Pennsylvania Avenue and Wall Street were overjoyed, I see just another pile of white-collar manure and nothing to shout about.
Fun with Numbers #4: Lastly, the spending on Goods—the backbone of a health, growing economy—declined by 27 bps.
In a related news, the November durable goods report showed a -0.7% drop in spending, quite the opposite of the positive number that Wall Street was expecting.
Of course, Wall Street doesn’t want little things like facts to get in the way of their year-end bonus. As we close out 2014, the stock market marched higher and ignored things like:
  • The reaction of the bond market to the 5% number. Bonds should have softened in the face of such strong economic numbers, but the “adults” (the bond traders) on Wall Street saw the same manure that I did.
  • If the economy was as healthy as the BEA wants us to believe, the “patience” and “considerable time” promise of the FOMC should soon be broken… right?
I spend most of the year in Asia, including China, and I am seeing the same level of numbers massaging by our government as China’s. In China, the government leaders establish statistical goals and the government bean counters find creative ways to tweak the data to achieve those goals.
Zero interest rates.
24/7 central bank printing.
See-no-evil analysts.
Financial smoke and mirrors.
That’s the financially dangerous world we live in, and I hope that you have some type of strategy in place to deal with the bursting of what’s becoming a very big, debt-fueled bubble.
Tony Sagami
Tony Sagami
30-year market expert Tony Sagami leads the Yield Shark and Rational Bear advisories at Mauldin Economics. To learn more about Yield Shark and how it helps you maximize dividend income, click here. To learn more about Rational Bear and how you can use it to benefit from falling stocks and sectors, click here.


December 21, 2014

Thoughts from the Frontline: Oil, Employment, and Growth

By John Mauldin

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


December 3, 2014

Connecting the Dots: The Healthy Bull Market: Bah, Humbug!

By Tony Sagami

Are you a long-term investor? Convinced that all you have to do is wait long enough to be guaranteed huge stock market profits?
Take a look at the chart below of rolling 30-year returns of the S&P 500 and tell me if it affects your enthusiasm.
The reality is that stock market results vary widely depending on what your starting point is. For example, any investor who put $100,000 into the stock market 1954 was rewarded with roughly the same $100,000 30 years later in 1984.
Yup… 30 years in, and not a penny of profits.

With the stock market at all-time highs, you may find it hard to be pessimistic, but the stock market is doing as well as it’s ever done, with a rolling 30-year return of better than 400%.
How would you feel about earning 0% on your money for 30 years?
Could the stock market go even higher? Yes, it could—but the odds aren’t favorable after the QE-fueled rally has pushed stocks to historically high valuations.
High valuations? Despite what the mass media and the Wall Street crowd try to tell you, valuations are quite high.
The most popular myth spouted on financial TV these days is the notion that the S&P 500 is trading at 19 times earnings. Baloney!
First, that 19 P/E is based on “forward” earnings, not trailing earnings. As unreliable as economists and self-serving analysts are, I’m surprised that anyone—especially you—believes anything they say.
Second, that forward-looking earnings forecast is based on those 500 companies increasing their earnings by an average of 23% over the next 12 months. Yup… a 23% increase!
That’s extremely optimistic, but I think especially misplaced now that the steroid of quantitative easing is behind us. Consider this: everybody agrees that stocks responded extremely positively to quantitative easing, so doesn’t it make sense to be concerned now that the monetary punch bowl has been yanked away?
The first place to look for signs of waning enthusiasm are small-cap stocks. While the Dow Jones Industrial Average and the S&P 500 were setting all-time highs, the Russell 2000 wasn’t able to punch through its March, July, and September peaks.

This quadruple top looks like a formidable resistance level for small stocks and clear evidence that investors are reducing risk by rotating out of small-cap stocks and into big-cap stocks.

Additionally, financial stocks are showing signs of exhaustion too. Healthy bull markets are often led by financial stocks, but the financials are lagging the major indexes now.
That’s why I think last week’s 3.9% GDP print smelled fishy; some weak economic numbers are spelling trouble.
Durable Goods Orders Not So Good: The headline number for October durable goods orders was strong with a +0.4% increase, but if you back out the volatile transportation sales, the picture is a lot uglier. If you exclude transportation—because just a few $100 million jet orders can skew the numbers—the 0.4% gain turns into a 0.9% decrease.
By the way, orders for defense aircraft were up 45.3%, but orders for non-defense aircraft orders were down 0.1% in October. If not for some big government orders, the results would be absolutely horrible!
Unemployment Claims Rise Despite Holiday Hiring: The job picture, which had been improving, showed some deterioration last week despite going into the busy holiday hiring season. Initial jobless claims jumped to 313,000, a 7.2% increase from last week as well as much higher than the 286,000 forecast. It also broke a 10-week streak of claims below 300,000.
Before You Cheer Cheap Oil: After OPEC agreed to keep production levels unchanged, the price of oil plunged by 7% on Friday to less than $68 a barrel. That’s good news for drivers, but oil’s falling prices (as well as those of other commodities) are a very bad sign for economic growth. Moreover, the energy industry has been one of the few industries producing good, high-paying jobs. Thus, low oil prices could turn that smile into a frown in no time.

The Bond Conundrum: The yield on 10-year Treasury bonds was as high as 3% earlier this year but dropped to 2.31 last Friday. If our economy were rocking as well as the 3.9% GDP rate suggests, interest rates should be rising… not falling like a rock.
The stock market may not fall out of bed tomorrow morning, but the holiday season for stock market investors looks like it may be more Scrooge than Santa Claus.
30-year market expert Tony Sagami leads the Yield Shark and Rational Bear advisories at Mauldin Economics. To learn more about Yield Shark and how it helps you maximize dividend income, click here. To learn more about Rational Bear and how you can use it to benefit from falling stocks and sectors, click here.
November 29, 2014

Outside the Box: Stray Reflections

By John Mauldin

Today’s Outside the Box is special, because I’m about to give you a preview of things to come at Mauldin Economics. For months now I have been saying to my partners that we need to develop a service for the professionals who read me – the financial advisors, portfolio managers, family offices… you know who you are. And I’m excited to tell you that we are very close to making this service a reality. It will be called Mauldin Pro, and it will feature global macro and geopolitical research and analysis, portfolio recommendations, monthly interviews with some of the best talent in the business, and quarterly seminars to help you improve your game.
It will also feature a global macro analysis and investment letter that has created quite a buzz in the industry. Stray Reflections is written by Jawad Mian, a former portfolio manager who lives in the UAE. Born in Pakistan and educated in Canada, Jawad managed $250 million in proprietary funds before turning his attention to his real passion: writing about the macro themes that should be on every investor’s mind, and constructing a theme-based global macro investment portfolio. His audience includes some of the most-respected portfolio managers in the world.
He’ll bring his fantastic letter to Mauldin Pro in the coming weeks. If you are interested in learning more and you are a professional market participant, give us your email address, and we’ll contact you when the service is ready to go.
Regardless of who you are or how you make your living, you’ll enjoy this piece from Jawad, taken from the November edition of his Stray Reflections. It deals with his view on oil, which has been the focus of the market lately. Can we say Peak Demand?
I will be braving the crowds at Central Market in a few hours, stocking up for Thanksgiving. I am normally not much of a grocery shopper and try to relegate the task to someone with more patience and time. But today, I look forward to spending the time, selecting each ingredient that I will be using with care, choosing fresh spices, chatting with the other shoppers, and just getting into the whole cooking thing, always on the lookout for something new and different.
I will be cooking banana nut cake this evening, as that was my mother’s specialty, and it just isn’t Thanksgiving without banana nut cake, at least for my family. And maybe a carrot cake if I get ambitious. Starting the soups to cook overnight, making the thick glaze for the prime, getting up very early to start the prime, as it takes almost 6 hours (and sometimes more!) to cook, since I cook on very low heat. That really helps the meat stay moist and tender. And the fried turkeys and the mushrooms!
Have a great week with your family and friends. Remember to take some time to catalog the probably long list of things you should be thankful for. High on my list will be you, whose gracious allocation of time and attention, two of the most valuable commodities in the world, makes my world even possible. I am truly grateful.
I finish this note after a long workout, trying to get ready for the Thursday marathon (although I have been told on good authority that calories do not count on Thanksgiving Day). The Beast has changed up the workout routine from lighter weights and many repetitions to “maxing out” the last few days. To my utter surprise, at the end of the workout I bench-pressed 205 pounds, 10 more than my previous max (which was 10 years ago). Who knew that 65 was such a good age for working out?
Your deep into the creativity of the kitchen analyst,
John Mauldin, Editor
Outside the Box

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Stray Reflections (November 2014)

By Jawad Mian

Investment Observations

The precipitous decline in the price of oil is perhaps one of the most bearish macro developments this year. We believe we are entering a “new oil normal,” where oil prices stay lower for longer. While we highlighted the risk of a near-term decline in the oil price in our July newsletter, we failed to adjust our portfolio sufficiently to reflect such a scenario. This month we identify the major implications of our revised energy thesis.
The reason oil prices started sliding in June can be explained by record growth in US production, sputtering demand from Europe and China, and an unwind of the Middle East geopolitical risk premium. The world oil market, which consumes 92 million barrels a day, currently has one million barrels more than it needs. US pumped 8.97 million barrels a day by the end of October (the highest since 1985) thanks partly to increases in shale-oil output which accounts for 5 million barrels per day. Libya’s production has recovered from 200,000 barrels a day in April to 900,000 barrels a day, while war hasn’t stopped production in Iraq and output there has risen to an all-time high level of 3.3 million barrels per day. The IMF, meanwhile, has cut its projection for global growth in 2014 for the third time this year to 3.3%. Next year, it still expects growth to pick up again, but only slightly.
Everyone believes that the oil-price decline is temporary. It is assumed that once oil prices plummet, the process is much more likely to be self-stabilizing than destabilizing. As the theory goes, once demand drops, price follows, and leveraged high-cost producers shut production. Eventually, supply falls to match demand and price stabilizes. When demand recovers, so does price, and marginal production returns to meet rising demand. Prices then stabilize at a higher level as supply and demand become more balanced. It has been well-said that: “In theory, there is no difference between theory and practice. But, in practice, there is.” For the classic model to hold true in oil’s case, the market must correctly anticipate the equilibrating role of price in the presence of supply/demand imbalances.
By 2020, we see oil demand realistically rising to no more than 96 million barrels a day. North American oil consumption has been in a structural decline, whereas the European economy is expected to remain lacklustre. Risks to the Chinese economy are tilted to the downside and we find no reason to anticipate a positive growth surprise. This limits the potential for growth in oil demand and leads us to believe global oil prices will struggle to rebound to their previous levels. The International Energy Agency says we could soon hit “peak oil demand”, due to cheaper fuel alternatives, environmental concerns, and improving oil efficiency.
The oil market will remain well supplied, even at lower prices. We believe incremental oil demand through 2020 can be met with rising output in Libya, Iraq and Iran. We expect production in Libya to return to the level prior to the civil war, adding at least 600,000 barrels a day to world supply. Big investments in Iraq’s oil industry should pay-off too with production rising an extra 1.5-2 million barrels a day over the next five years. We also believe the American-Iranian détente is serious, and that sooner or later both parties will agree to terms and reach a definitive agreement. This will eventually lead to more oil supply coming to the market from Iran, further depressing prices in the “new oil normal”. Iranian oil production has fallen from 4 million barrels a day in 2008 to 2.8 million today, which we would expect to fully recover once international relations normalize. In sum, we see the potential for supply to increase by nearly 4 million barrels a day at the lowest marginal cost, which should be enough to offset output cuts from marginal players in a sluggish world economy.
Our analysis leads us to conclude that the price of oil is unlikely to average $100 again for the remaining decade. We will use an oil rebound to gradually adjust our portfolio to reflect this new reality.
From 1976 to 2000, oil consolidated in a wide price range between $12 and $40. We think the next five years will see a similar trading range develop in oil with prices oscillating between $55 and $85. If the US dollar embarks on a mega uptrend (not our central view), then we can even see oil sustain a drop below $60 eventually.

Source: Bloomberg
Normally, falling oil prices would be expected to boost global growth. Ed Morse of Citigroup estimates lower oil prices provide a stimulus of as much as $1.1 trillion to global economies by lowering the cost of fuels and other commodities. Per-capita oil consumption in the US is among the highest in the world so the fall in energy prices raises purchasing power compared to most other major economies. The US consumer stands to benefit from cheaper heating oil and materially lower gasoline prices. It is estimated that the average household consumes 1,200 gallons of gasoline a year, which translates to annual savings of $120 for every 10-cent drop in the price of gasoline. According to Ethan Harris of Bank of America Merrill Lynch: “Consumers will likely respond quickly to the saving in energy costs. Many families live “hand to mouth”, spending whatever income is available. The Survey of Consumer Finances found that 47% of families had no savings in 2013, up from 44% in the more healthy 2004 economy. Over time, energy costs have become a much bigger part of budgets for low income families. In 2012, families with income below $50,000 spent an average of 21.4% of their income on energy. This is almost double the share in 2001, and it is almost triple the share for families with income above $50,000.” The “new oil normal” will see a wealth transfer from Middle East sovereigns (savers) to leveraged US consumers (spenders).
The consumer windfall from lower oil prices is more than offset by the loss to oil producers in our view. Even though the price of oil has plummeted, the cost of finding it has certainly not. The oil industry has moved into a higher-cost paradigm and continues to spend significantly more money every year without any meaningful growth in total production. Global crude-only output seems to have plateaud in the mid-70 million barrels a day range. The production capacity of 75% of the world’s oilfields is declining by around 6% per year, so the industry requires up to 4 million barrels per day of new capacity just to hold production steady. This has proven to be very difficult. Analysts at consulting firm EY estimate that out of the 163 upstream megaprojects currently being bankrolled (worth a combined $1.1 trillion), a majority are over budget and behind schedule.
Large energy companies are sitting on a great deal of cash which cushions the blow from a weak pricing environment in the short-term. It is still important to keep in mind, however, that most big oil projects have been planned around the notion that oil would stay above $100, which no longer seems likely. The Economist reports that: “The industry is cutting back on some megaprojects, particularly those in the Arctic region, deepwater prospects and others that present technical challenges. Shell recently said it would again delay its Alaska exploration project, thanks to a combination of regulatory hurdles and technological challenges. The $10 billion Rosebank project in Britain’s North Sea, a joint venture between Chevron of the United States and OMV of Austria, is on hold and set to stay that way unless prices recover. And BP says it is “reviewing” its plans for Mad Dog Phase 2, a deepwater exploration project in the Gulf of Mexico.  Statoil’s vast Johan Castberg project in the Barents Sea is in limbo as the Norwegian firm and its partners try to rein in spiralling costs; Statoil is expected to cut up to 1,500 jobs this year. And then there is Kazakhstan’s giant Kashagan project, which thanks to huge cost overruns, lengthy delays and weak oil prices may not be viable for years. Even before the latest fall in oil prices, Shell said its capital spending would be about 20% lower this year than last; Hess will spend about 15% less; and Exxon Mobil and Chevron are making cuts of 5-6%.”
About 1/3rd of the S&P500 capex is done by the energy sector. Based on analysis by Steven Kopits of Douglas-Westwood: “The vast majority of public oil and gas companies require oil prices of over $100 to achieve positive free cash flow under current capex and dividend programs. Nearly half of the industry needs more than $120. The 4th quartile, where most US E&Ps cluster, needs $130 or more.”
As energy companies have gotten used to Brent averaging $110 for the last three years, we believe management teams will be very slow to adjust to the “new oil normal”. They will start by cutting capital spending (the quickest and easiest decision to take), then divesting non-core assets (as access to cheap financing becomes more difficult), and eventually, be forced to take write-downs on assets and projects that are no longer feasible. The whole adjustment process could take two years or longer, and will accelerate only once CEOs stop thinking the price of oil is going to go back up. A similar phenomenon happened in North America’s natural gas market a couple of years ago.
This has vast implications for America’s shale industry. The past five years have seen the budding energy renaissance attract billions of dollars in fixed investment and generate tens of thousands of high-paying jobs. The success of shale has been a major tailwind for the US economy, and its output has been a significant contributor to the improvement in the trade deficit. We believe a sustained drop in the price of oil will slow US shale investment and production growth rates. As much as 50% of shale oil is uneconomic at current prices, and the big unknown factor is the amount of debt that has been incurred by cashflow negative companies to develop resources which will soon become unprofitable at much lower prices (or once their hedges run out). Energy bonds make up nearly 16% of the $1.3 trillion junk bond market and the total debt of the US independent E&P sector is estimated at over $200 billion.
Robert McNally, a White House adviser to former President George W. Bush and president of the Rapidan Group energy consultancy, told Reuters that Saudi Arabia "will accept a price decline necessary to sweat whatever supply cuts are needed to balance the market out of the US shale oil sector.” Even legendary oil man T. Boone Pickens believes Saudi Arabia is in a stand-off with US drillers and frackers to “see how the shale boys are going to stand up to a cheaper price.” This has happened once before. By the mid-1980’s, as oil output from Alaska’s North Slope and the North Sea came on line (combined production of around 5-6 million barrels a day), OPEC set off a price war to compete for market share. As a result, the price of oil sank from around $40 to just under $10 a barrel by 1986.
In the current cycle, though, prices will have to decline much further from current levels to curb new investment and discourage US production of shale oil. Most of the growth in shale is in lower-cost plays (Eagle Ford, Permian and the Bakken) and the breakeven point has been falling as productivity per well is improving and companies have refined their fracking techniques. The median North American shale development needs an oil price of $57 to breakeven today, compared to $70 last year according to research firm IHS

Source: WoodMackenzie, Barclays Research
While we don’t believe Saudi Arabia engineered the latest swoon in oil prices, it would be foolish not to expect them to take advantage of the new market reality. If we are entering a “new oil normal” where the oil price range may move structurally lower in the coming years, wouldn’t you want to maximise your profits today, when prices are still elevated? If, at the same time, you can drive out fringe production sources from the market, and tip the balance in MENA geopolitics (by hurting Russia and Iran), wouldn’t it be worth it? The Kingdom has a long history of using oil to meet political and economic ends.
We don’t see any signs of meaningful OPEC restraint at the group’s 166th meeting on November 27th in Vienna. The cartel has agreed to cut crude production only a handful of times in the past decade, with December 2008 being the most recent instance. Based on our assessment, the only members with enough flexibility to reduce oil output voluntarily are the United Arab Emirates, Kuwait and Saudi Arabia. OPEC countries have constructed their domestic policy based on the assumption that oil prices will remain perpetually high and most members are not in a strong enough financial position to take production offline. Once all the costs of subsidies and social programs are factored-in, most OPEC countries require oil above $100 to balance their budgets. This raises longer-run issues on the sustainability of the fiscal stance in a low-oil price environment. On the one hand, you have rising domestic oil consumption because there is no price discipline, which leaves less oil for the lucrative export market, and on the other hand, you require more money now than ever before to support generous budgetary spending.
How will this be resolved?
And with a much slower rate of petrodollar accumulation, what will be the implication for global financial markets, given the non-negligible retraction in liquidity?
The current oil decline has potentially cost OPEC $250 billion of its recent earnings of $1 trillion. Thus, it is not surprising to see OPEC production – relative to its 30 million barrels a day quota – rising from virtual compliance to one where the cartel is producing above its agreed production allocation. Output rose to 30.974 million barrels per day in October, a 14-month high led by gains in Iraq, Saudi Arabia and Libya. So, it can be grasped that the lower the price of oil falls, the greater the need to compensate for lower revenues with higher production, which paradoxically pushes oil prices even lower.
We believe the “new oil normal” will alter relative economic and political fortunes of most countries, with income redistributing from oil exporters (GCC, Russia) to oil importers (India, Turkey). We therefore exited our long position in the WisdomTree Middle East Dividend Fund (GULF) at a 14.4% gain.
Those nations with abundant oil tend to suffer from the “resource curse”. With no other ready sources of income, the non-oil economy atrophies due to the extraordinary wealth produced by the oil sector. OPEC countries are some of the least diversified economies in the world.
In an article titled “When The Petrodollars Run Out”, economist Daniel Altman wrote for the Foreign Policy magazine as follows: “Twenty countries depend on petroleum for at least half of their government revenue, and another 10 are between half and a quarter. These countries are clearly vulnerable to big changes in the price and quantity of oil and gas that they might sell…So what can these countries do to bolster themselves for the future? For one thing, they might try to use their petroleum revenues to diversify their economies. Yet there's little precedent for that actually happening. In the three decades from 1983 to 2012, no country that ever got 20 percent of its GDP from oil and gas – according to the World Bank's figures – substantially reduced those resources' share of its economy. The shares typically rose and fell with prices; there were no long-term reductions.”

Source: Foreign Policy
Saudi Arabia appears to be comfortable with much lower oil prices for an extended period of time. The House of Saud is equipped with sufficient government assets to easily withstand three years at the current oil price by dipping into their $750 billion of net foreign assets. Saudi Arabia bolstered output by 100,000 barrels a day recently to 9.75 million, and cut its prices for Asian delivery for November – the fourth month in a row that it has cut official selling prices to shore up its global market share. With American imports from OPEC almost cut by half and given weak European demand, most oil-producing countries are now engaged in a price war in Asia. The Kingdom generates over 80% of its total revenue from oil sales so it may not remain immune in the “new oil normal” for long. According to HSBC research, Saudi Arabia would face a budget shortfall approaching 10% of GDP at $70 oil and at $50, the deficit could exceed 15% of GDP.
Russia and Saudi Arabia have opposing agendas in the Middle East. We believe Russia would like to see Middle East burn. This would shore up the cost of oil and keep America from geopolitically deleveraging from the region, thus allowing more room for Putin to outmaneuver his opponents in Europe. It was reported last year that the Saudis offered Russia a deal to carve up global oil and gas markets, but only if Russia stopped support of Syria’s Assad regime. No agreement was reached. It now seems the Saudis are turning to the oil market to affect an outcome.
With global energy prices at multi-year lows, Russia is facing a persistent low growth environment and an endemic outflow of capital. The $30 drop in the Brent price translates into an annual loss in crude oil revenues of over $100 billion. According to Lubomir Mitov, Russia’s financing gap has reached 3% of GDP, and they have to repay $150 billion in principal to foreign creditors over the next 12 months. Even with $400 billion in foreign currency reserves and the Russian central bank raising its official interest rate by 150 basis points to 9.5% last month, the ruble is down 38% from its June high making foreign liabilities a lot more onerous. As per Faisal Islam, political editor of Sky News, “financial markets have punished Russia far quicker than Western governments.”
“It took two years for crumbling oil prices to bring the Soviet Union to its knees in the mid-1980s, and another two years of stagnation to break the Bolshevik empire altogether…” writes Ambrose Evans-Pritchard in The Daily Telegraph. “…Russian ex-premier Yegor Gaidar famously dated the moment to September 1985, when Saudi Arabia stopped trying to defend the crude market, cranking up output instead.” It is estimated the Soviet Union lost $20 billion per year, money without which the country simply could not survive.
Could we see a repeat of events?
In the past, higher resource prices increased the occasions for military conflicts as nations would scramble to secure necessary supplies. Going forward, however, we firmly believe lower oil prices pose a greater risk of escalating current geopolitical challenges.
Putin is a determined and ambitious leader who wants to expand Russia’s power and influence. Since he rose to dominance in 1999, he advocated development of Russia’s resource sector to resurrect Russian wealth. In his doctoral thesis, he equated economic strength with geopolitical influence. Today, Russia needs an oil price in excess of $100 a barrel to support the state and preserve its national security. Consequently, there is no question Putin will try to resist lower oil prices either through outright warfare or more covert economic sabotage.
Russia is the world’s 8th-largest economy, but its military spending trails only the US and China. Putin increased the military budget 31% from 2008 to 2013, overtaking UK and Saudi Arabia, as reported by the International Institute of Strategic Studies. Russia also has plans to become the world’s largest arms exporter by more than tripling military exports by 2020 to $50 billion annually. We are convinced Putin would like to see a bull-market in international tensions. This is the biggest threat to our “new oil normal” theme.

Source: Cagle Cartoons
Turkey is a big beneficiary of lower oil prices, which provides much needed relief to the large current account deficit. As external imbalances correct and the inflation outlook gradually improves, we expect a significant shift in sentiment towards the country. Turkish stocks should do reasonably well going forward and we aim to buy the iShares MSCI Turkey ETF (TUR) on additional weakness. In our opinion, India will also continue to outperform many of its emerging market peers. Medium-term growth prospects have strenghtened due to credibility of policymakers and external windfalls from lower oil and gold prices. We will initiate a position in Indian equities once the election exuberance dissipates. The market is up 23% since Modi’s win.
Solar stocks have fallen 18% since oil peaked in June. It is assumed the fall in oil spells terrible news for the development of alternative energy sources, especially solar. We don’t agree with this conclusion as we see the world moving toward a more sustainable economy. We expect solar to gradually become more mainstream and less sensitive to fluctuations in the oil price. According to a Deutsche Bank research report, solar electricity may be as cheap or cheaper than average electricity-bill prices in 47 US states by 2016. Even if the tax credit drops to 10% (if Congress allows the federal tax credit for rooftop solar systems to expire at the end of 2016), solar will soon reach price parity with conventional electricity in well over half the nation. Solar has already reached grid parity in 10 states which are responsible for 90% of US solar electricity production. We own the Guggenheim Solar ETF (TAN) as a strategic long-term holding.
According to Nordea Research, markets are pricing in a 40% chance for an interest rate cut at the Norges Bank meeting in December. This has pushed the Norwegian kroner (NOK) nearly 7% weaker than the Norges Bank’s forecast for June of next year. We think markets have gone too far with an overreaction in NOK because of the Brent decline. The oil-sensitive Norwegian economy remains relatively more competitive with an average cash cost of $43 a barrel across the whole industry. We sold our NOK/SEK position for a 6.9% profit earlier and plan on re-buying the pair from lower levels. The cross-rate is the cheapest in two decades on a PPP basis and Sweden’s Riksbank cut its key interest rate to zero in October as it battles deflation.
In terms of other opportunities, we are also long the Mexican peso (MXN) versus the Colombian peso (COP). Mexico’s oil exports as a percent of GDP are 4% versus 8.5% in the case of Colombia. Our position is up 4.7% so far.
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The article Outside the Box: Stray Reflections was originally published at
November 21, 2014

The 10th Man: I Had My Cake, Until I Ate It

By Jared Dillian

After 30 years of declining interest rates, bond investors are beginning to worry that rates will go higher—especially after the events of May 2013.
Back then, 10-year yields went from 2% to 3% on a frozen rope. Things got very dicey in fixed income. Some holders of corporate bonds (like the new Apple bond) were suddenly down 10% just on interest rates alone.
So worrying about rising rates is not unreasonable. People learned very quickly how duration works, after having forgotten for decades. If you’ve never taken a bond math class, all you need to know about duration is this:
  1. It is the weighted average time to maturity of all coupon and principal payments.
  2. It is an approximate measure of interest rate risk.
With regard to 2), if the duration of a 10-year Treasury note is 8.5 years, for every 1% change in interest rates, the price of the bond will change by approximately 8.5%.
A 1% change in interest rates doesn’t sound like a lot, but an 8.5% hit to your capital if you’re a bond investor sounds terrible.
After 2013, people were looking for ways to mitigate interest rate risk and yet hang on to their bond portfolios. That is hard to achieve, because, well… bonds have interest rate risk!

Unconstrained Bond Funds

So this is the Holy Grail of bond investing: how to create a durationless portfolio that still has a return. People are doing it, with mixed success.
A few years back, people started investing in what were known as “unconstrained bond funds.” As the name implies, an unconstrained bond fund isn’t restricted to a sector or strategy or even a country. Unconstrained bond funds can invest in corporate credit, sovereign credit, currencies, high yield, emerging markets, any and all derivatives, and of course, Treasuries. They can invest in just about anything in any allocation.
Unconstrained bond funds have been known to move very quickly in and out of certain credits, even holding over 50% cash at times. The manager has broad discretion to change his asset allocation to maximize returns and more important, to dodge rising rates.
Unconstrained funds have become very popular. Unsurprisingly, money moved out of core bond funds in 2013 (after people got whacked on rates) and into unconstrained funds, which theoretically shield you from higher rates. Maybe.
That depends largely on the manager. In the old days of bond investing, you would pick a bond fund with a narrowly defined mandate, like “medium-term corporates,” and the bond manager would spend his life trying to outperform the stated benchmark.
For a core bond fund, the typical benchmark is the Barclays (formerly Lehman) Aggregate Index. This index is very heavy on government bonds and mortgages, and in a world of potentially rising rates, nobody wants to be tied to the “Agg,” as it is known.
In an unconstrained bond fund, the manager can hedge interest rate risk with futures, options, or swaps, or even short Treasury bonds or notes, and make up the loss in yield by overweighting credit. In fact, this is what many of them do. Of course, this all comes at a time when credit is very overpriced and there are even more concerns about the valuation (and liquidity) of corporate bonds.
There’s also the idea that the whole point of investing in a bond fund is to diversify away equity risk—bond funds usually do well when stock funds are doing poorly. But high yield actually has equity-like characteristics, so if you’re immunizing the duration and loading up on credit, you are doubling down on your risk profile.

Market-Timing Your Way to Victory

I think it’s kind of interesting that investors are giving so much latitude to the managers of unconstrained bond funds. What they are doing, in essence, is market-timing, something that is generally frowned upon when done by amateurs.
Some people will do it well, but most people will do it poorly. It is very hard to evaluate one unconstrained bond fund against another because you can’t even look at the portfolio on a static basis and judge it on its investment merits. You’re betting purely on the skill of the manager. It’s like betting on jai-alai. The players probably have a better idea of who’s going to win than you do.
In general, the unconstrained bond funds haven’t been doing all that great. If they’ve outperformed core funds, it hasn’t been by much. But they haven’t yet been tested by a rising rate environment. These guys might find that their hedges don’t work in the way that they planned or, at worst, give the portfolio return characteristics that mimic equity funds and other asset classes.
It’s no fun when everything you own goes down at the same time.
You occasionally see these situations in finance, where people want to have their cake and eat it, too. There are dozens of examples, but the classic one is portfolio insurance, where people want to cut risk without cutting the actual portfolio—pretty similar to what’s going on here with bonds.
There probably aren’t any systemic consequences to the proliferation of unconstrained bond funds, except a continuation of the credit bubble and maybe a lot of unhappy investors. If you reduce risk over here, you’re going to end up adding it over there—at least, if you want to achieve the same or greater return. There is no way around it.
At least it’s fun for the managers. I’d much rather be swinging it around with FX and derivatives than trying to beat the medium-term corporate bond index by a couple of basis points.
Plus, the fees are higher.
Corrections/Amplifications: Last week in our discussion about gold, I implied that Barry Ritholtz, CIO of Ritholtz Wealth Management, was permanently bearish on gold. That is actually untrue: Barry was long gold for an extended period of time, starting in 2005, which I was not aware of. His objection to gold has less to do with gold itself and more to do with people’s lack of discipline and risk management with regard to the asset class. My apologies to Mr. Ritholtz.
Jared Dillian
Jared Dillian
The article The 10th Man: I Had My Cake, Until I Ate It was originally published at
November 5, 2014

Thoughts from the Frontline: Rhyme and Reason

By John Mauldin

“The significant problems that we have created cannot be solved at the level of thinking we were at when we created them.”
– Albert Einstein
“Generals are notorious for their tendency to ‘fight the last war’ – by using the strategies and tactics of the past to achieve victory in the present. Indeed, we all do this to some extent. Life's lessons are hard won, and we like to apply them – even when they don't apply. Sadly enough, fighting the last war is often a losing proposition. Conditions change. Objectives change. Strategies change. And you must change. If you don't, you lose.”
Dr. G. Terry Madonna and Dr. Michael Young
“Markets are perpetuating a serious error by acting on the belief that central bankers actually know what they are doing. They do not. Not because they are ill-intentioned but because they are human and subject to the limitations that apply to all human endeavors. If you want proof of their fallibility, simply look at their economic forecasts. Despite their efforts to do so, central banks can’t repeal the business cycle (though they can distort it). While the 2008 financial crisis should have taught them that lesson, it appears to have led them to precisely the opposite conclusion.
“There are limits to knowledge in every field, including the hard sciences, and economics is not a hard science; it is a social science whose knowledge is imprecise, and practitioners’ ability to predict the future is extremely limited. Fed officials are attempting to guide an extremely complex economy with tools of questionable utility, and markets are ignoring their warnings that their ability to manage a positive outcome is highly uncertain. Markets are confusing what they want to happen with what is likely to happen, a common psychological phenomenon. Investors who prosper in the long run will be those who acknowledge the severe limits of economic knowledge and the compelling evidence that trillions of dollars of QE and years of zero interest rates may have saved the system from immediate collapse five years ago but failed to produce sustained economic growth or long-term price stability.”
– Michael Lewitt, The Credit Strategist, Nov. 1, 2014
As I predicted months ago in this letter and last year in Code Red, the Japanese have launched another missile in their ongoing currency war, somewhat fittingly on Halloween. Rather than being spooked, the markets saw it as just another round of feel-good quantitative easing and climbed to all-time highs on the Dow and S&P 500. The Nikkei soared even more (for good reason). As we will see later in this letter, this is not your father’s quantitative easing. The Japanese, for reasons of their own, will intervene not only in their own equity markets but in foreign equity markets as well, and do so in a size and manner that will be significant. This gambit is going to have ramifications far beyond merely weakening the yen. In this week’s letter we are going to take an in-depth look at what the Japanese have done.
It is something of a cliché to quote Mark Twain’s “History doesn’t repeat itself, but it does rhyme.” But it is an appropriate way to kick things off, since we are going to look at the “ancient” history of Mark Twain’s era, and specifically the Panic of 1873. That October saw the beginning of 65 months of recession (certainly longer than our generation’s own Great Recession), which inflicted massive pain on the country. The initial cause was government monetary intervention, but the crisis was deepened by soaring debt and deflation.
As we seek to understand what happened 141 years ago, we’ll revisit the phenomenon of October as a month of negative market surprises. It actually has its roots in the interplay between farming and banking.
The Panic of 1873
Shortly after the Civil War, which saw the enactment of federal fiat money (the “greenback” of that era, issued to finance the war), there was a federal law passed that required rural and agricultural banks to keep 25% of their deposits with certain certified national banks, which were based mainly in New York. The national banks were required to pay interest on those deposits, so they had to put the money out for loans. But because those deposits were “callable” at any time, there was a limit to the types of loans they could do, as long-term loans mismatched assets and liabilities.
The brokers of the New York Stock Exchange were considered an excellent target for such loans. They could use the proceeds of the loans as margin to buy stocks, either for their own trading or on behalf of their clients. As long as the stocks went up – or at the very least as long as the ultimate clients were liquid – there wasn’t a problem for the national banks. Money could be repatriated; or, if necessary, margins could be called in a day. But this was before the era of a central bank, so actual physical dollars (and other physical instruments) were involved as reserves, as was gold. Greenbacks could be used to buy gold, but at a rate that floated. The price of gold could fluctuate significantly from year to year, depending upon the availability of gold and the supply of greenbacks (and of course, market sentiment – which certainly rhymes with our own time).
The driver for October volatility was an annual cycle, an ebb and flow of dollars to and from these rural banks. In the fall when the harvest was ready, the country banks would recall their margin loans in order to pay farmers or loan to merchants to buy crops from farmers and ship them via the railroads. Money would then become tight on Wall Street as the national banks called their loans back in.
This cycle often caused extra volatility, depending on the shortness of loan capital. Margin rates could rise to as much as 1% per day! Of course, this would force speculators to sell their stocks or cover their shorts, but in general it could drive down prices and make margin calls more likely. This monetary tightening often sent stocks into a downward spiral – not unlike the downward pressure that present-day Fed tightening actions have exerted, but in a compressed period of time.
If there was enough leverage in the system, a cascade could result, with stocks dropping 20% very quickly. Since much of Wall Street was involved in railroads, and railroads were nothing if not leveraged loans and capital, falling asset prices would reduce the ability of investors in railroads to find the necessary capital for expansion and maintenance of operations.
This historical pattern no longer explains the present-day vulnerability of markets in October. Perhaps the phenomenon persists simply due to market lore and investor psychology. Like an amputee feeling a twinge in his lost limb, do we still sense the ghosts of crashes past?
(And once more with Mark Twain: “October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February.”)
It was in this fall environment that a young Jay Gould decided to manipulate the gold market in the autumn of 1873, creating a further squeeze on the dollar. Not only would he profit off a play in gold, but he thought the move would help him in his quest to take control of the Erie Railroad. Historian Charles R. Morris explains, in a fascinating book called The Tycoons:
Gould’s mind ran in labyrinthine channels, and he turned to the gold markets as part of a strategy to improve Erie’s freights. Grain was America’s largest export in 1869. Merchants purchased grain from farmers on credit, shipped it overseas, and paid off the farmers when they received their remittances from abroad. Their debt to the farmers was in greenbacks, but their receipts from abroad came in gold, for the greenback was not legal tender overseas. It could take weeks, or even months, to complete a transaction, so the merchant was exposed to changes in the gold/greenback exchange rate during that time. If gold fell (or the greenback rose), the merchant’s gold proceeds might not cover his greenback debts.
The New York Gold Exchange was created to help merchants protect against that risk. Using the Exchange, a merchant could borrow gold when he made his contract, convert it to greenbacks, and pay off his suppliers right away. Then he would pay off the gold loan when his gold payment came in some weeks later; since it was gold for gold, exchange rates didn’t matter. To protect against default, the Exchange required full cash collateral to borrow gold. But that was an opening for speculations by clever traders like Gould. If a trader bought gold and then immediately lent it, he could finance his purchase with the cash collateral and thereby acquire large positions while using very little of his own cash.
[Note from JM: In the fall there was plenty of demand for gold and a shortage of greenbacks. It was the perfect time if you wanted to create a “corner” on gold.]
Gould reasoned that if he could force up the price of gold, he might improve the Erie’s freight revenues. If gold bought more greenbacks, greenback-priced wheat would look cheaper to overseas buyers, so exports, and freights, would rise. And because of the fledgling status of the new Gold Exchange, gold prices looked eminently manipulable, since only about $20 million in gold was usually available in New York. [Some of his partners in the conspiracy were skeptical because…] The Grant administration, which had just taken office in March, was sitting on $100 million in gold reserves. If gold started suddenly rising, it would hurt merchant importers, who could be expected to clamor for government gold sales.
So Gould went to President Grant’s brother-in-law, Abel Corbin, who liked to brag about his family influence. He set up a meeting with President Grant, at which Gould learned that Grant was cautious about any significant movements in either the gold or the greenback, noting the “fictitiousness about the prosperity of the country and that the bubble might be tapped in one way as well as another.” That was discouraging: popping a bubble meant tighter money and lower gold.
But Gould plunged ahead with his gold buying, including rather sizable amounts for Corbin’s wife (Grant’s wife’s sister), such that each one-dollar rise in gold would generate $11,000 in profits. Corbin arranged further meetings with Grant and discouraged him from selling gold all throughout September.
Gould and his partners initiated a “corner” in the gold market. This was actually legal at the time, and the NY gold market was relatively small compared to the amount of capital it was possible for a large, well-organized cabal to command. True corners were devastating to bears, as they generally borrowed shares or gold to sell short, betting on the fall in price. Just as today, if the price falls too much, then the short seller can buy the stock back and take his losses. But if there is no stock to buy back, if someone has cornered the market, then losses can be severe. Which of course is what today we call a short squeeze.
The short position grew to some $200 million, most of it owed to Gould and his friends. But there was only $20 million worth of gold available to cover the short sales. That gold stock had been borrowed and borrowed and borrowed again. The price of gold rose as Gould’s cabal kept pressing their bet.
But Grant got wind of the move. His wife wrote her sister, demanding to know if the rumor of their involvement was true. Corbin panicked and told Gould he wanted out, with his $100,000+ of profits, of course. Gould promised him his profits if he would just keep quiet.
Then Gould began to unload all his gold positions, even as some of his partners kept right on buying. You have to keep up pretenses, of course. Gould was telling his partners to push the price up to 160, while he was selling through another set of partners.
It is a small irony that Gould also had a contact in the government in Washington (a Mr. Butterfield) who assured him that there was no move to sell gold from DC, even as that contact was personally selling all his gold as fast as he could. Whatever bad you could say about Gould (and there were lots of bad things you could say), his trading instincts were good. He sensed his contact was lying and doubled down on getting out of the trade. In the end, Gould didn’t make any money to speak of and in fact damaged his intention of getting control of the Erie Railroad that fall.
The attempted gold corner didn’t do much harm to the country in and of itself. But when President Grant decided to step in and sell gold, there was massive buying, which sucked a significant quantity of physical dollars out of the market and into the US Treasury at a time when dollars were short. This move was a clumsy precursor to the open-market operations of the Federal Reserve of today, except that those dollars were needed as margin collateral by brokerage companies. No less than 14 New York Stock Exchange brokerages went bankrupt within a few days, not including brokerages that dealt just in gold.
All this happened in the fall, when there were fewer physical dollars to be had.
The price of gold collapsed. Cornelius Vanderbilt, who was often at odds with Jay Gould, had to step into the market (literally – that is, physically, which was rare for him) in order to quell the panic and provide capital, a precursor to J.P. Morgan’s doing the same during the Panic of 1907.
While many today believe the Fed should never have been created, we have not lived through those periods of panics and crashes. And while I think the Fed now acts in ways that are inappropriate (how can 12 FOMC board members purport to fine-tune an economic cycle, let alone solve employment problems?), the one true and proper role of the Fed is to provide liquidity in time of a crisis.
People Who Live Too Much on Credit”
At the end of the day, it was too much debt that was the problem in 1873. Cornelius Vanderbilt was quoted in the epic book The First Tycoon as saying (emphasis mine):
I’ll tell you what’s the matter – people undertake to do about four times as much business as they can legitimately undertake.… There are a great many worthless railroads started in this country without any means to carry them through. Respectable banking houses in New York, so called, make themselves agents for sale of the bonds of the railroads in question and give a kind of moral guarantee of their genuineness. The bonds soon reach Europe, and the markets of their commercial centres, from the character of the endorsers, are soon flooded with them.… When I have some money I buy railroad stock or something else, but I don’t buy on credit. I pay for what I get. People who live too much on credit generally get brought up with a round turn in the long run. The Wall Street averages ruin many a man there, and is like faro.
In the wake of Gould’s shenanigans, President Grant came to New York to assess the damage; and eventually his Secretary of the Treasury decided to buy $30 million of bonds in a less-clumsy precursor to Federal Reserve open-market operations, trying to inject some liquidity back into the markets. This was done largely as a consequence of a conversation with Vanderbilt, who offered to put up $10 million of his own, a vast sum at the time.
But the damage was done. The problem of liquidity was created by too much debt, as Vanderbilt noted. That debt inflated assets, and when those assets fell in price, so did the net worth of the borrowers. Far too much debt had to be worked off, and the asset price crash precipitated a rather deep depression, leaving in its wake far greater devastation than the recent Great Recession did. It took many years for the deleveraging process to work out. Sound familiar?
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

October 27, 2014

Thoughts from the Frontline: A Scary Story for Emerging Markets

By John Mauldin

The consequences of the coming bull market in the US dollar, which I’ve been predicting for a number of years, go far beyond suppression of commodity prices (which in general is a good thing for consumers – but could at some point threaten the US shale-oil boom). The all-too-predictable effects of a rising dollar on emerging markets that have been propped up by hot inflows and the dollar carry trade will spread far beyond the emerging markets themselves. This is another key aspect of the not-so-coincidental consequences that we will be exploring in our series on what I feel is a sea change in the global economic environment.
I’ve been wrapped up constantly in conferences and symposia the last four days and knew I would want to concentrate on the people and topics I would be exposed to, so I asked my able associate Worth Wray to write this week’s letter on a topic he is very passionate about: the potential train wreck in emerging markets. I’ll have a few comments at the end, but let’s jump right into Worth’s essay.
A Scary Story for Emerging Markets
By Worth Wray
“The experience of the [1990s] attests that international investors have considerable resources at their command in the search for high returns. While they are willing to commit capital to any national market in large volume, they are also capable of withdrawing that capital quickly.”
– Carmen & Vincent Reinhart
“Capital flows can turn on a dime, and when they do, they can bring the entire financial infrastructure [of a recipient country] crashing down.”
– Barry Eichengreen
“The spreading financial crisis and devaluation in July 1997 confirmed that even economies with high rates of growth and consistent and open economic policies could be jolted by the sudden withdrawal of foreign investment. Capital inflows could … be too much of a good thing.”
– Miles Kahler
In the autumn of 2009, Kyle Bass told me a scary story that I did not understand until the first “taper tantrum” in May 2013.
He said that – in additon to a likely string of sovereign defaults in Europe and an outright currency collapse in Japan – the global debt drama would end with an epic US dollar rally, a dramatic reversal in capital flows, and an absolute bloodbath for emerging markets.
Extending that outlook, my friends Mark Hart and Raoul Pal warned that China – seen then by many as the world’s rising power and the most resilient economy in the wake of the global crisis – would face an outright economic collapse, an epic currency crisis, or both.
All that seemed almost counterintuitive five years ago when the United States appeared to be the biggest basket case among the major economies and emerging markets seemed far more resilient than their “submerging” advanced-economy peers. But Kyle Bass, Mark Hart, and Raoul Pal are not your typical “macro tourists” who pile into common-knowledge trades and react with the herd. They are exceptionally talented macroeconomic thinkers with an eye for developing trends and the second- and third-order consequences of major policy shifts. On top of their wildly successful bets against the US subprime debacle and the European sovereign debt crisis, it’s now clear that they saw an even bigger macro trend that the whole world (and most of the macro community) missed until very recently: policy divergence.
Their shared macro vision looks not only likely, not only probable, but IMMINENT today as the widening gap in economic activity among the United States, Europe, and Japan is beginning to force a dangerous divergence in monetary policy.
In a CNBC interview earlier this week from his Barefoot Economic Summit (“Fed Tapers to Zero Next Week”), Kyle Bass explained that this divergence is set to accelerate in the next couple of weeks, as the Fed will likely taper its QE3 purchases to zero. Two days later, Kyle notes, the odds are high that the Bank of Japan will make a Halloween Day announcement that it is expanding its own asset purchases. Such moves only increase the pressure on Mario Draghi and the ECB to pursue “overt QE” of their own.
Such a tectonic shift, if it continues, is capable of fueling a 1990s-style US dollar rally with very scary results for emerging markets and dangerous implications for our highly levered, highly integrated global financial system.
As Raoul Pal points out in his latest issue of The Global Macro Investor,The [US] dollar has now broken out of the massive inverse head-and-shoulders low created over the last ten years, and is about to test the trendline of the world’s biggest wedge pattern.”
One “Flight to Safety” Away from an Earth-Shaking Rally?
(US Dollar Index, 1967 – 2014)

For readers who are unfamiliar with techical analysis, breaking out from a wedge pattern often signals a complete reversal in the trend encompassed within the wedge. As you can see in the chart above, the US Dollar Index has been stuck in a falling wedge pattern for nearly 30 years, with all of its fluctuations contained between a sharply falling upward resistance line and a much flatter lower resistance line.
Any break-out beyond the upward resistance shown above is an incredibly bullish sign for the US dollar and an incredibly bearish sign for carry trades around the world that have been funded in US dollars. It’s a clear sign that we may be on the verge of the next wave of the global financial crisis, where financial repression finally backfires and forces all the QE-induced easy money sloshing around the world to come rushing back into safe havens.
Let me explain…
The EM Borrowing Bonanza
As John Mauldin described in his recent letter “Sea Change,” the state of the global economy has radically evolved in the wake of the Great Recession.
Against the backdrop of extremely accommodative central bank policy in the United States, the United Kingdom, and Japan and the ECB’s “whatever it takes” commitment to keep short-term interest rates low across the Eurozone, global debt-to-GDP has continued its upward explosion in the years since 2008… even as slowing growth and persistent disinflation (both logical side-effects of rising debt) detract from the ability of major economies to service those debts in the future.
Global Debt-to-GDP Is Exploding Once Again
(% of global GDP, excluding financials)

*Data based on OECD, IMF, and national accounts data.
Source: Buttiglione, Lane, Reichlin, & Reinhart. “Deleveraging, What Deleveraging?” 16th Geneva Report on the Global Economy, September 29, 2014.

As John Mauldin and Jonathan Tepper explained in their last book, Code Red, monetary policies have fueled overinvestment and capital misallocation in developed-world financial assets…
Developed World Financial Assets Still Growing
(Composition of financial assets, developed markets, US$ billion)

Data from the McKinsey Global Institute
Source: Buttiglione, Lane, Reichlin, & Reinhart. “Deleveraging, What Deleveraging?” 16th Geneva Report on the Global Economy, September 29, 2014.

… but the real explosion in debt and financial assets has played out across the emerging markets, where the unwarranted flow of easy money has fueled a borrowing bonanza on top of a massive USD-funded carry trade.
Emerging-Market Financial Assets Have Nearly DOUBLED Since 2008
(Composition of financial assets, emerging markets, US$ billion)

Data from the McKinsey Global Institute
Source: Buttiglione, Lane, Reichlin, & Reinhart. “Deleveraging, What Deleveraging?” 16th Geneva Report on the Global Economy, September 29, 2014.

These QE-induced capital flows have kept EM sovereign borrowing costs low…

… and enabled years of elevated emerging-market sovereign debt issuance…

… even as many those markets displayed profound signs of structural weakness.
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

October 11, 2014

Outside the Box: The world’s greatest stock picker? Bet you sold Apple and Google a long time ago.

By John Mauldin

My good friend Barry Ritholtz, famous for launching The Big Picture blog (and since graduating to being a regular Bloomberg columnist as well as writing a weekly column for the Washington Post), is well-known for being a contrarian. Barry is a regular dinner partner when I get to New York, and he also participates in the annual Maine fishing trip. We frequently trade information … and barbs. The word colorful affectionately comes to mind when I think of Barry (and maybe opinionated would work).
I can usually count on him to find at least a few things to disagree with me on at our dinners. No matter what devastating arguments I produce to demonstrate the errors in his thinking, he conjures up new facts to support his flawed positions. We have had a few of these episodes as members of a panel in front of a large public audience, much to the amusement of the spectators (and watching Barry can be an entertaining spectacle). My only real frustration with Barry is that he is mentally faster than I am and he seemingly remembers every obscure data point from the last thousand years. I consider it a triumph if I merely hold my ground.
But one thing we do agree on and are both passionate about is that we human beings were not designed for these modern times. As I so often say, we evolved on the African savanna dodging lions and chasing antelopes. We have converted those survival instincts into an unwieldy approach to dealing with financial markets, which is not the optimal way to approach investing. Both of us write a great deal about behavioral investing and the foibles of human nature.
I was struck by the insights of Barry’s latest Washington Post column. How difficult it is for us humans to hold on in the middle of dramatic volatility. Don’t you wish you had held Apple for the last 10 years? A 1000-bagger is not to be sneezed at. But dear gods, the volatility! And what about the stocks that once looked like a better bet than Apple that went to zero? How do you decide when to hold and when to fold? (Cue Kenny Rogers.)
This is a short Outside the Box, but it’s one that should make you think, which is the purpose of this letter.
And in a departure from my usual close, I want to offer two links. The first is to a fascinating web post at something called of 52 colorized historical photos. You  have seen most of these photos in black and white (or at least you have if you have reached my advanced age). Seeing them in color is quite another story.
Second, and not for the faint of heart, is a link to a rather heated exchange between Ben Affleck and Bill Maher over radical Islam and Islamaphobia. I generally find Maher annoying, sometimes in the extreme. But this “conversation” is instructive. It illustrates the tensions in the Western world around dealing with Islamic beliefs and the religion in general. The other guests chime in with fascinating anecdotes. You can decide for yourself who wins this argument, but it is one that is increasingly important in our world. And I am not sure anyone will be comfortable with the answers. This is courtesy of my friends over at Real Clear Politics.
I am still luxuriating in the aftermath of my birthday party on Saturday night. Friends flew in from all over the country (and from around the world) and surprised me. Too many to mention, but I was deeply honored and humbled. My staff and friends and family put the whole thing together (huge thanks to Shannon and Mary and Shane and my kids). My daughter Melissa put together a playlist on Spotify of all the songs she has heard me listening to over the years. Three and a half hours of one hit after another. We are working on making it available to those of you who are already on Spotify.
And just for the record, that morning I did 66 consecutive push-ups on my 65th birthday. I then went on to do a total of 360 push-ups (50×5+44) in less than two hours, with the help of an Avacor machine to cool me down between sets, in a workout that included a similar number of abs, lat pulldowns, arm exercises, etc. Knock on wood, I do not plan to go gently into that good night. As a geek, I am coming late in life to loving the gym. But better late…
It is time to hit the send button. I am off to the Great Investors’ Best Ideas Symposium here in Dallas. It is a who’s who of famous investors, all of whom agreed to speak and to give one investment tip to aid a great charity. Bill Ackman, David Einhorn, Paul Isaac, Bill Miller, Ray Nixon, Richard Perry, T. Boone Pickens, Michael Price, Tom Russo, and moderated by Gretchen Morgenson. Have a great week while thinking about how to get your human nature under control.
Your more human that I want to admit analyst,
John Mauldin, Editor
Outside the Box

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The world’s greatest stock picker? Bet you sold Apple and Google a long time ago.

By Barry Ritholtz
The Washington Post, Oct. 4, 2014
Let’s imagine for the moment that you are the World’s Greatest Stock Picker. You have an uncanny talent for ferreting out “the next Microsoft” – companies that are on the sharpest edge of what’s next, that are about to undergo tremendous growth. These firms will rule the world: They will be the most powerful, profitable and influential corporate entities known to man.
Even better, your superpower is that you can find these companies when they are tiny, before they have had their explosive growth, when hardly anyone has heard of them. You find and buy these stocks while their prices are still in the single digits. Companies like Apple, Google, Tesla, Netflix and Chipotle that will one day measure their growth in increments of thousands of a percent.
Can you imagine how much wealth you could create?
I have some bad news for you, kiddos: Even if you had that superpower, it would be worth surprisingly little to you. The odds are that it would not create much wealth, and it might even cost you money.
How could that be possible?
The short answer is your brain. The three-pound ball of gray matter sitting atop your spinal cord was never designed to make risk/reward decisions in capital markets. It took about 100,000 years to optimize for its intended purpose: Keeping you alive.
The occasional Darwin Award aside, it does an outstanding job of keeping you safe from all manner of predators on the savanna. That you now live in a condo and enjoy lattes is irrelevant to its functionality. Its job remains keeping you alive long enough for you to procreate, pass your genes along and perpetuate the species.
This dynamic, opportunistic, self-organizing system of systems occasionally runs into trouble when we try to force it to perform other, “off-label” uses. That includes buying and selling pieces of paper that represent tiny slices of companies. As we shall see, that big, under-utilized brain of yours is no help anytime it gets over-stimulated by your emotions.
Which is precisely why being the World’s Greatest Stock Picker is unlikely to be how any of you is going to get rich. Let’s use the shares of five companies as examples: Google, Tesla, Chipotle, Netflix and Apple.
The performance of each since its initial public stock offering has been nothing short of astounding. Since going public, each stock has generated returns of more than 1,000 percent. A $10,000 IPO allocation in any one is now worth at least $100,000.
To give you an idea of just how phenomenal these companies have done, Google is the laggard of the lot. Since its IPO in August 2004, it has gained a mere 1,282 percent. Tesla edged out the boys from Mountain View, Calif., with a gain of 1,352 percent. And they did it in less than four years – Tesla’s IPO was June 2010 – vs. the decade it took Google to gain 1,000 percent.
Those spectacular returns look downright paltry compared with the 2,865 percent gain Chipotle has had since going public in 2006. And Netflix beats that, rising 5,816 percent since 2002.
Then there is Apple. It is a beast unto itself, racking up a mind-boggling 22,288 percent in appreciation since its 1980 debut. It has become world’s biggest company by market capitalization.
Even if you bought large chunks of each of these firms at their IPOs, the odds are that nearly all of these giant gains would have eluded you. Why? As I shall show you, each of these companies would have sent you running for the exits – repeatedly – over the years, screaming as if your hair were on fire.
Don’t believe me? Consider the facts:
• Netflix has lost 25 percent of its value on four separate days. Not over four days; on separate occasions, it lost 25 percent in a single day. In one four-month stretch in 2011, it lost 80 percent of its value. On Netflix’s worst day, it fell 41 percent.
• Chipotle has lost 15 percent in a single day on four occasions. During the 2007-2009 crash, it lost 76 percent of its value – about 50 percent worse than the market overall.
• Tesla went up 400 percent in 6 months, then lost 40 percent over the next 10 weeks. In one month, it lost about 25 percent of its value.
• Google lost nearly 70 percent in the Great Recession. During its worst quarter, its stock price fell more than 36 percent.
• Apple has lost 25 percent or more six times in the past 10 years alone. That was after its meteoric rise. During its worst week, it was cut in half, falling 51 percent. It saw similar damage during its worst month and quarter as well – getting cut in half in each time   period.
How often have you invested in a stock, only to get scared out of it when things grew shaky? That’s fairly typical behavior for investors.
Now imagine how you would have behaved if you happened to have a significant part of your net worth tied up in that one holding.
Let’s say a decade ago, you put $15,000 into Apple. You bought 1,000 shares at $15 (with $13 cash) because you thought that newfangled iPod had some potential. Since then, it split two for one and then earlier this year, it split seven for one. You now are holding 14,000 shares of Apple. At the current price of about $100, it is worth $1.4 million dollars. For most people, this is a very high percentage of their net worth. How well do you sleep when 90 percent of your total net worth goes through giant swings?
Apple was worth about the same amount in September 2012 – just before it gave back almost half its value, falling 44 percent. Would you have held on? What about all of those prior 50 percent corrections?
This is not an academic theory. Consider how you have reacted to much more modest drops in your holdings. How often were you shaken out of a stock, only to see it rocket higher after you sold? And somebody was dumping stocks in March 2009; after all, selling climaxes (also known as capitulation) are how bottoms are made.
Some years ago, I recommended to the brokers I worked with to do just that regarding Apple. They bought millions of shares at an average price of $15. At $20 dollars, they were selling it, whooping it up and high-fiving one another. When I asked why they were selling it when my price target was higher ($30!), I was told: “It’s a 33 percent winner – time to ring the bell, Ritholtz!” That was even before any trouble had hit.
How many of you, dear readers, could hold onto a giant winner like these five for the duration? How do you know that any of these are not about to turn into a classic disaster stock? Think about once-giant winners that collapsed: Lehman Brothers, WorldCom, Lucent, JDS Uniphase.
All of these were one-time market heroes; all went bust in spectacular fashion. Your superpower gives you the ability to find the giant winners, but it does not give you the ability to hold onto them, nor does it give you the ability to distinguish between the superstars and the washouts.
As we have discussed previously, this is a feature, not a bug. The good news is your brain has kept you alive long enough to read this column. The bad news, it also made you sell Apple 10,000 percent ago.
The reality is, when it comes to risk/reward decisions, you are just not built for it.

Barry Ritholtz is Chairman and Chief Investment Officer at Ritholtz Wealth Management. His columns on personal finance can be found at the Washington Post. His daily musings on all things finance- & Wall Street-related can be found on Bloomberg View. Be sure to check out Masters in Business, his weekly interview series on Bloomberg Radio. Follow him on Twitter @Ritholtz.
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September 27, 2014

Outside the Box: Future Bull

By John Mauldin

In a conversation this morning, I remarked how rapidly things change. It was less than 20 years ago that cutting-edge tech for listening to music was the cassette tape. We blew right past CDs, and now we all consume music from the cloud on our phones. Boom. Almost overnight.
A lot has changed about the global economy and politics, too. Things that were unthinkable only 10 years ago now seem to be reality. What changes, I wonder, will we be writing about a few years from now that will seem obvious with the advantage of hindsight?
In today’s Outside the Box, my good friend David Hay of Evergreen Capital sends us a letter written from the perspective of a few years in the future. I find myself wishing that some of the more hopeful events he foresees will come true, and my optimistic self actually sees a way through to such an outcome. In that future, I will join David as a bull. But the path that he proposes to take to that more optimistic future is not one that most investors will enjoy, so on the whole it’s a very sobering letter and one that should make all of us think.
I’m back from San Antonio, where I spent four enjoyable days with my friends and participants at the Casey Research Summit. I tried to attend as many of the conference sessions as I could, and I intend to get the “tapes” for some of the ones I missed.
I did a lot of video interviews while in San Antonio, too. And finished up a major documentary. Mauldin Economics will be making all of these available very soon. It’s hard to recommend one interview over another, but Lacy Hunt is just so smart.
And with no further remarks let’s turn it over to David Hay and think about how the next few years will play out. Have a great week.
Your wishing his crystal ball was clearer analyst,
John Mauldin, Editor
Outside the Box

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Future Bull

By David Hay
Twitter: @EvergreenGK
“Money amplifies our tendency to overreact, to swing from exuberance when things are going well to deep depression when they go wrong.”
– Economist and historian Niall Ferguson
Future bull.  Let me admit up front that this EVA has been rolling around in my mind for quite awhile. Its genesis may be directly related to the fact that I’ve been desperately yearning to write a bullish EVA – besides on Canadian REITs or income securities that get trounced by the Fed’s utterances. In other words, I want to return to my normal posture of being bullish on the US stock market.
It wasn’t long ago, like in 2011, that clients were chastising me for believing in what I formerly referred to as “the coiled spring effect.” By this I meant that corporate earnings had been rising for over a decade, and yet, stock prices were much lower than they there were in 1999. Consequently, price/earnings ratios were compressed down to low levels, though certainly not to true bear market troughs. My belief was that stocks were poised for an upside explosion once the inhibiting factors, primarily extreme pessimism on the direction of the country, were removed. I even remember one long-time client dismissing my “Buy America” argument on the grounds that in my profession I had to be bullish (regular EVA readers know that is definitely not the case!).
Well, a funny thing happened to my “coiled spring effect” – namely, it became a reality. Additionally, the upward reaction was much stronger than I envisioned. But what really caught me by surprise was that it played out with virtually no improvement on the “extreme pessimism on the direction of the country” front. Perhaps I’m wrong, but I don’t think there has ever been a rally that has taken stocks to such high valuations (time for my usual qualifier – based on mid-cycle profit margins, not the Fed-inflated ones we have today) concurrent with such pervasive fears America is on the wrong track.
Undoubtedly, the pros among you who just read that last sentence are thinking: “That’s great news! All that pessimism will keep this market running. We’re not even close to the peak.” Not so fast, mon amis (and amies)! We’re not talking market pessimism here. As numerous EVAs have documented, US investors are as heavily exposed to stocks as they have ever been, other than during the late 1990s, when stocks bubbled up to valuations that made 1929 look restrained.
Further, please check out the chart below from still-bullish Ned Davis regarding investment advisor sentiment.  The bearish reading is the lowest since the fateful year of 1987, while bulled-up views are in the excessively optimistic zone.  (See Figure 1.)

It is my contention that there are currently millions of fully-invested skeptics. They aren’t bullish long-term – in fact, they believe the underlying fundamentals are alarming (with the usual perma-bull exceptions) – but they feel compelled by the lack of competitive alternatives to remain at their full equity allocation. Disturbingly, professional investors are increasingly doing so even with money belonging to retired investors who need both cash flow and stability.
Okay, with all that history out of the way, let’s go the other direction  – into the future, to a time several years from now, when conditions are nearly the polar opposite of where they are today.

The Evergreen Virtual Advisor (EVA)

November, 201???

At long last, reforms! Do you remember back in 2014 when the stock market was as hot as napalm? When it just never went down? When millions believed the Fed could control stock prices by whipping up a trillion here and a trillion there?
Looking back from the vantage of today, it all seems so obvious. We should have known better than to believe that the S&P 500 had years more of appreciation left in it after having already tripled by the fall of 2014 from the 2009 nadir. The warning signs were there. But, before we rehash what went wrong, let’s focus on the upside of what some are calling “The Great Unwind” – the hangover after years and years of the Fed recklessly driving asset prices to unsustainable heights.
First of all, let me start with what I think is the biggest positive of all:  the end of the central banks’ era of omnipotence. While that might sound like a major negative, you may have noticed that with the crutch of binge-printing taken away, our nation’s leaders are finally getting around to implementing reforms that should have been enacted years ago. The history of our country is that we are energized by crises, and the latest is no exception. Our most recent financial convulsions have galvanized a bipartisan coalition to attack an array of long-festering problems that have hobbled our country since the start of the millennium.
Arguably, the most important was the recently enacted tax reform legislation. Skeptics believed the US could never move toward the type of simple tax system that has long been used in countries like Singapore, Hong Kong, and even Estonia. It took the realization by both parties that lower tax rates with almost no deductions would actually produce more revenue. Moreover, the elimination of incalculable and massive “friction costs” for millions of businesses and individuals, trying to adhere to and/or game that beastly labyrinth known as the tax code, is quickly catalyzing real economic growth. This is in contrast to the 2010 to 2014 counterfeit version that rolled off the Fed’s printing press.
By 2014, the US was ranked a lowly 32nd out of 34 countries in terms of tax fairness and efficiency. Yet, now, thanks to last year’s drastic tax reform, US corporations are no longer fleeing in droves to other countries, using such tax dodges as inversions (buying out foreign companies and assuming their country of corporate citizenship to access lower tax rates). They have even begun to repatriate their trillion or so of offshore profits since the formerly onerous tax rate of 35%, the highest in the developed world, has been reduced. And, thanks to the eradication of the aforementioned legalized tax dodges, corporate tax receipts are actually beginning to rise sharply, despite the fact that our economy is in the early stages of recovering from the latest recession.
As we all know, the rationalization of our national business model involves much more than even the essential aspect of tax code simplification. At long last, meaningful tort reform has been enacted. No longer will the rule of lawyers be allowed to dominate the rule of law. The enormous, but insidiously hidden, costs of a subsector of the legal system whose chief mission is to squeeze unjustifiable sums from the private sector is finally being reined in.
Similarly, regulatory overkill is also being addressed by the very entity that created this monster in the first place: the government itself. Absurd, overlapping, and often conflicting directives that hobbled the most essential element of the private sector – small businesses – have been abolished, replaced by a much simpler and unified set of rules.
Even America’s dysfunctional and wasteful healthcare system is being revamped using rational economic solutions, rather than by piling on more incomprehensible rules, requirements, and panels. Consumers can now easily compare prices among service providers thanks to technology as instituted by for-profit providers. Along with significantly improved visibility, they also now have far greater control over how their healthcare dollars are spent.  Medical outlays are now in a decided downtrend.
Incredibly, Congress is actually beginning to behave like a representative of the people rather than an ATM dispensing taxpayer money to the most politically connected. The intense implosions of the multiple bubbles the Fed intentionally inflated triggered a backlash of voter ire toward its legislative enablers. Since then, we’ve seen a dramatic House – and Senate – cleaning. This new “coalition of the thinking” is now following the proven path to recovery that numerous countries – such as Germany, Sweden, and Canada – blazed when their economic and financial systems hit previous roadblocks. As in those nations, moving away from excessive socialism, while simultaneously supporting the business community, rather than vilifying and hindering it, is already beginning to elevate America out of its long stagnation.
Collectively, these sweeping reforms are as dramatic as those seen in the 1980s and promise to unleash a growth boom equally as powerful as the ones that followed those overhauls. Yet, despite these dramatic and highly promising changes, investors remain hunkered down in their bomb shelters.
Fool me once, fool me twice, fool me thrice!  After the third devastating bear market since 1999, investor hostility toward stocks has reached a level unseen since the 1970s. Far too many were lured in by the last up-leg of the great bull market that started in the depths of pessimism in March of 2009. As the market resolutely climbed higher and higher, even beyond the five-year length of most bull cycles, millions of investors succumbed to either greed or complacency.

Indicative of the feverish conditions prevailing then—despite the widely disseminated myth that it was the most hated bull market of all time—headlines like those shown below, and graphics such as the one above, began to dominate the financial press.

Remarkably, at least to me, investors once again ignored warnings from the savviest savants, almost all of whom had waxed cautious about the tech and housing manias: Bob Shiller, Jeremy Grantham, Rob Arnott, John Mauldin, Seth Klarman, and John Hussman. As the esteemed Mohamed El-Erian had prophetically written in June of 2014, “In their efforts to promote growth and jobs, central banks are trading the possibility of immediate economic gains for a growing risk of financial instability later.”
Conversely, Janet Yellen didn’t do her legacy any favors by uttering these words in July, 2014: “Because a resilient financial system can withstand unexpected developments, identification of bubbles is less critical.” At the time, I was pretty sure she would come to regret that statement as much as Ben Bernanke did his equally ill-advised assurances back in 2007 that the problems in sub-prime mortgages were contained. Based on how fragile the “resilient financial system” turned out to be, I’ll say no more.
It did surprise me that despite having called out those previous bubbles, as well as several others including the 2008 blow-offs in commodities and Chinese stocks, I received such intense resistance from other professionals and even clients. After awhile, I was getting so much push back I started to feel like the nose of a commercial airliner being readied for take-off.
Ignorance wasn’t bliss. Another aspect of the late stages of the last bull market was how many investment professionals – who should have known better – dismissed Robert Shiller’s namesake P/E. To clarify, Shiller believes (as did Warren Buffett’s mentor, Ben Graham) that the stock market needs to be valued based on normalized earnings, not bottom- or top-of-the cycle profits. Despite the unassailable logic of this approach, a legion of perma-bulls repeatedly sought to discredit Shiller and his valuation methodology. Some even went so far as to deride his process as “Shiller Snake Oil,” notwithstanding Dr. Shiller’s Nobel Prize and, more meaningfully in my view, the fact that he had forewarned of both the tech and housing bubbles – unlike almost all of those throwing stones at him back in 2014.
The main criticism from those who were “hatin’ on” Shiller in 2014 was that his P/E had produced only two buy signals over a 25-year period. This was a valid critique but it missed an essential point: Despite the reality that the stock market from 1990 to 2014 traded at valuations far higher than it had in any previous quarter-century timeframe, the Shiller P/E accurately predicted future returns. In other words, when the Shiller P/E was very elevated – like in the late 1990s, 2007, and 2014 (so far) – stocks went on to generate extremely disappointing future returns (it also did so in decades going all the way back to the 1920s but this was not the era that the Shiller debunkers were criticizing). The graphic on the next page vividly illustrates this fact, even though it was created before the most recent bear market further underscored the danger of ignoring high Shiller P/Es. (See Figure 2.)

It also shocked and dismayed me at the time how many contortions Wall Street strategists, and even money managers, performed in order to dismiss concerns about the extreme variability of earnings. Somehow charts like the one below from Capital Economics were blown-off despite (or, perhaps, because) it so clearly highlighted the tendency of corporate profits to return back down to the long-term trend-line of nominal GDP growth, with stocks closely following. As we all now know, this time wasn’t different. (See Figure 3.)

The legions of market cheerleaders also ignored the heavy reliance on profits from the financial sector, a notoriously unstable source of earnings. This proved to be a disaster in 2007 and, unsurprisingly, was again once the Fed’s “Great Levitation” fell victim to gravitational forces. (See Figure 4.)

Even David Rosenberg, one of the few economists who saw the housing debacle coming, but who briefly flirted with drinking the Fed-spiked bubble-aid in 2014, noted that 60% of earnings growth from 2010 through 2013 came from share buy-backs. He calculated that the market’s “organic” P/E, backing out the influence from share repurchases, was over 20, even prior to normalizing for peak profit margins. Additionally, the reality that corporations buy the most stock at high prices, and the least at low prices, was forgotten – another costly oversight. (See Figure 5, above.)
It was also overlooked during this era of Fed-induced euphoria, that low interest rates – so often cited by bulls as a justification for lofty P/Es – historically coincided with lower earnings multiples. (See Figure 6.)

As Japan and Europe have repeatedly shown over the last two decades, when low interest rates are a function of chronic economic stagnation, P/Es actually contract, not expand. The fact that the latest recession has reduced America’s anemic 1.8% annual growth rate since 2000 to even lower levels is a key reason why stocks have been thrashed over the last couple of years, despite interest rates on the 10-year treasury note falling to 1%.
Another massive mistake was to overlook the strident warning from Evergreen’s favorite valuation metric, the price-to-sales (P/S) ratio. By the summer of 2014, the median stock in the S&P 500 was trading at its highest P/S ratio on record. Sadly, this attracted little attention. (See Figure 7.)

But perhaps the most egregious oversight of all was to forget the theorem from the late, great economist Hyman Minsky who long ago warned that stability breeds instability. As was the case from 2002 through 2007, the exceptionally low volatility of the years leading up to the latest crisis numbed market participants to the steadily rising risks. Even professional investors convinced themselves they could get out in time once conditions became unstable, an arrogance that has been severely punished, as well it should. Alas, we’ve had to learn Dr. Minsky’s lesson the hard way, once again.
But let’s close this EVA by focusing on the stunning opportunity for investors created by the Fed’s latest misadventure…
Investors, start your engines! It is certainly understandable that US investors are thoroughly disenchanted with the stock market. The fact that the powers-that-be, or at least used-to-be, allowed securities trading to become so heavily dominated by computers was, like the tolerance of the Fed’s asset inflation, inexcusable. The influence of computerized, black box trading was unquestionably a huge factor in the speed-of-light-in-a-vacuum drop in stock prices. Also as feared, many ETFs poured kerosene on the fire as investors became terrified by the nearly overnight erosion in these prices, causing them to sell en masse. The plethora of ETFs holding illiquid underlying securities were particularly crushed, with many simply halting trading for long stretches. Now, instead of rapturous paeans about the wonders of ETF liquidity and low costs, the financial press is full of horror stories about their fundamental flaws (fortunately, higher quality and more liquid ETFs, performed as expected during the worst of the panic).
Further, based on the failure of the Fed’s desperate maneuver to stabilize stocks after their first big break, by launching another $1 trillion QE, this time directly buying US shares, investors have rationally lost faith in the Fed’s ability to make stocks dance to its tune. While QE 4 did cause a sharp counter-trend rally after it was initially launched, the supportive effects soon waned, as we all are now painfully aware. The resumption of the bear market after the Fed’s frantic triage effort was reminiscent of Dorothy, the Tinman, the Lion, and Toto discovering that behind the green curtain was a scared old man instead of The Wizard of Oz.
The extreme negativity by investors toward the stock market today is reflected in the high level of outflows being seen from equity mutual funds, including ETFs. Cash levels are high everywhere as institutional and retail investors, as well as corporations, have become excessively risk averse. This provides the rocket fuel for the next bull market which might just be much closer than almost everyone believes.
Rampant investor pessimism is also being manifested in the drop in the Shiller P/E to the mid-teens from 26 at the peak of the last bull romp.  As a direct result, future returns on stocks are now projected by the aforementioned Jeremy Grantham and John Hussman to be in the low double digits over the next seven to ten years.  Yet, no one seems interested. Even Warren Buffett’s ragingly bullish comments, which were considerably premature, are being attributed to the ramblings of a soon-to-be nonagenarian.
Naturally, I have considerable empathy for Mr. Buffett because, as usual, Evergreen was early to shift into bullish mode. We waited much longer than most people and actually did a fairly commendable job of cutting back into the Fed’s QE4 driven rally, after raising our equity exposure during the initial steep sell-off. But once stocks fell hard after that sugar-high wore off, we were guilty of our typical “premature accumulation syndrome.”
However, we did the same thing way back in October of 2008 when we published our client newsletter, “A Bull is Born” (and wrote a series of “buy the panic” EVAs), only to watch the market slide another 30%.  Yet, buying when almost the entire world was in liquidation mode, much of it forced, in the fall of 2008 proved to be extremely lucrative over the next two years. We are convinced the same will be true following this latest episode of market mayhem.
From a longer-term standpoint, a perspective most investors seem unwilling to take given their still-fresh pain and suffering, conditions look highly encouraging. In addition to the previously described remedies our policy makers are belatedly adopting, many of the key positive trends the bulls used to justify over-the-top valuations for stocks back in 2014 are still in place. Admittedly, the enthusiasm got ahead of reality but the energy renaissance continues apace in the US, despite the well-publicized fracking problems. Re-shoring of manufacturing, which has been slower than the uber-optimists forecast, appears to be now accelerating. Relatedly, robotic adoption is rapidly spreading through the US industrial base, supporting Evergreen’s belief that re-shoring is a reality, not a fantasy. Yet, there’s even more to like.
Nanotechnology and solar power innovators continue to provide breathtaking breakthroughs. Today, nanotech is becoming as ubiquitous as the microprocessor was a decade ago. Meanwhile, solar power, thanks to miniaturization advances similar to Moore’s Law, has achieved “grid parity,” or even lower, in over a dozen US states. Power is becoming increasingly cheap and abundant and that’s terrific news for humanity.
Finally, and perhaps most significantly, we are far closer to achieving that wondrous, if slightly scary, state known as “singularity.” As most us now know, this means that humans are becoming one with computers. The proliferation of wearables has essentially elevated the intelligence of anyone who can afford to spend $150 for an iWatch or Google Glass, to the level of a supercomputer. We now take for granted being able to whisper a few instructions into our watches, like Dick Tracy, and have all the information of the Cloud at our disposal. (It may soon be feasible to actually have a computer implanted into our brains, possibly even curing Alzheimer’s.) Clearly, the implications for productivity are nearly limitless. Already, we are beginning to see this in the data and we believe we are in the very early innings of a true revolution – with no apologies to gloomsters like Northwestern University’s Robert Gordon who believed, and still do, that the era of radical innovation ended long ago.
One of the biggest challenges a professional investor faces is the tyranny of current prices. When they are relentlessly rising, as they were back in 2013 and 2014, clients extrapolate those indefinitely, and, for a long time, they are right to do so. The same thing happens on the downside in periods such as we are in right now.  But rising markets always turn down and falling ones always turn up. Those are unquestionable facts. We are getting closer to the point where this bear goes back into its cave for a nice long nap while a powerful young bull is ready to bust out of the pen it’s been cooped up in for what seems like an eternity. Get out your checkbook – it’s time to bet on the bull!
Back to the here and now. A wise man once said that if you are going to predict that something will happen, don’t be so foolish as to say when it will happen. You may have noticed, I’ve followed that advice, perhaps to an irritating degree, mainly because I truly have no clue when our current bull market, already so long in the horns, will succumb.
It also goes without saying, but I will anyway, that the sequence and details of future financial events are almost certain to be dramatically different than what I’ve suggested in this EVA edition. However, I believe the broad outline is likely to be roughly along these lines, including my exceedingly optimistic long-term outlook for America.
It dawned on me as I wrote the section about tax, tort, healthcare, and regulatory reforms that many readers were probably thinking: “Not in my lifetime – and I’m only 50!” First, of all, let me say that I’m jealous you’re just 50. Second, it is highly unlikely stocks will remain in a long-term bull market, or even continue to hover at such generous valuations, unless our country makes some truly dramatic changes. It can’t remain business as usual, persistently avoiding essential reforms, relying almost totally on the Fed.
Believe me, I will be a bull again, and likely a very lonely one at that. But it’s going to take a combination of lower valuations and a serious makeover of how this country operates. We can do it and I’m convinced we will do it. Hopefully, I’ll be able to convince some of you the next time fear is on the rampage.

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September 19, 2014

Thoughts from the Frontline: What’s on Your Radar Screen?

By John Mauldin

Toward the end of every week I begin to ponder what I should write about in the next Thoughts from the Frontline. Much of my week is spent in front of my iPad or computer, consuming as much generally random information as time and the ebb and flow of life will allow. I cannot remember a time in my life after I realized you could read and learn new things that that particular addiction has not been my constant companion.
As I sit down to write each week, I generally turn to the events and themes that most impressed me that week. Reading from a wide variety of sources, I sometimes see patterns that I feel are worthy to call to your attention. I’ve come to see my role in your life as a filter, a connoisseur of ideas and information. I don’t sit down to write with the thought that I need to be particularly brilliant or insightful (which is almighty difficult even for brilliant and insightful people) but that I need to find brilliant and insightful, and hopefully useful, ideas among the hundreds of sources that surface each week. And if I can bring to your attention a pattern, an idea, or thought stream that that helps your investment process, then I’ve done my job.
What’s on Your Radar Screen?
Sometimes I feel like an air traffic controller at “rush hour” at a major international airport. My radar screen is just so full of blinking lights that it is hard to choose what to focus on. We each have our own personal radar screen, focused on things that could make a difference in our lives. The concerns of a real estate investor in California are different from those of a hedge fund trader in London. If you’re an entrepreneur, you’re focused on things that can grow your business; if you are a doctor, you need to keep up with the latest research that will heal your patients; and if you’re a money manager, you need to keep a step ahead of current trends. And while I have a personal radar screen off to the side, my primary, business screen is much larger than most people’s, which is both an advantage and a challenge with its own particular set of problems. (In a physical sense this is also true: I have two 26-inch screens in my office. Which typically stay packed with things I’m paying attention to.)
So let’s look at what’s on my radar screen today.
First up (but probably not the most important in the long term), I would have to say, is Scotland. What has not been widely discussed is that the voting age was changed in Scotland just a few years ago. For this election, anyone in Scotland over 16 years old is eligible. Think about that for a second. Have you ever asked 16-year-olds whether they would like to be more free and independent and gotten a “no” answer? They don’t think with their economic brains, or at least most of them don’t. If we can believe the polls, this is going to be a very close election. The winning margin may be determined by whether the “yes” vote can bring out the young generation (especially young males, who are running 90% yes) in greater numbers than the “no” vote can bring out the older folks. Right now it looks as though it will be all about voter turnout.
(I took some time to look through Scottish TV shows on the issue. Talk about your polarizing dilemma. This is clearly on the front burner for almost everyone in Scotland. That’s actually good, as it gets people involved in the political process.)
The “no” coalition is trying to talk logic about what is essentially an emotional issue for many in Scotland. If we’re talking pure economics, from my outside perch I think the choice to keep the union (as in the United Kingdom) intact is a clear, logical choice. But the “no” coalition is making it sound like Scotland could not make it on its own, that it desperately needs England. Not exactly the best way to appeal to national instincts and pride. There are numerous smaller countries that do quite well on their own. Small is not necessarily bad if you are efficient and well run.
However, Scotland would have to raise taxes in order to keep government services at the same level – or else cut government services, not something many people would want.
There is of course the strategy of reducing the corporate tax to match Ireland’s and then competing with Ireland for businesses that want English-speaking, educated workers at lower cost. If that were the only dynamic, Scotland could do quite well.
But that would mean the European Union would have to allow Scotland to join. How does that work when every member country has to approve? The approval process would probably be contingent upon Scotland’s not lowering its corporate tax rates all that much, especially to Irish levels, so that it couldn’t outcompete the rest of Europe. Maybe a compromise on that issue could be reached, or maybe not. But if Scotland were to join the European Union, it would be subject to European Union laws and Brussels regulators. Not an awfully pleasant prospect.
While I think that Scotland would initially have a difficult time making the transition, the Scots could figure it out. The problem is that Scottish independence also changes the dynamic in England, making it much more likely that England would vote to leave the European Union. Then, how would the banks in Scotland be regulated, and who would back them? Markets don’t like uncertainty.
And even if the “no” vote wins, the precedent for allowing a group of citizens in a country within the European Union to vote on whether they want to remain part of their particular country or leave has been set. The Czech Republic and Slovakia have turned out quite well, all things considered. But the independence pressures building in Italy and Spain are something altogether different.
I read where Nomura Securities has told its clients to get out of British pound-based investments until this is over. “Figures from the investment bank Société Générale showing an apparent flight of investors from the UK came as Japan’s biggest bank, Nomura, urged its clients to cut their financial exposure to the UK and warned of a possible collapse in the pound. It described such an outcome as a ‘cataclysmic shock’.” (Source: The London Independent) The good news is that it will be over next Thursday night. One uncertainty will be eliminated, though a “yes” vote would bring a whole new set of uncertainties, as the negotiations are likely to be quite contentious.
One significant snag is, how can Scottish members of the United Kingdom Parliament continue to vote in Parliament if they are leaving the union?
I admit to feeling conflicted about the whole thing, as in general I feel that people ought have a right of self-determination. In this particular case, I’m not quite certain of the logic for independence, though I can understand the emotion. But giving 16-year-olds the right to vote on this issue? Was that really the best way to go about things? Not my call, of course.
Emerging Markets Are Set Up for a Crisis
We could do a whole letter just on emerging markets. The strengthening dollar is creating a problem for many emerging markets, which have enough problems on their own. My radar screen is full of flashing red lights from various emerging markets. Brazil is getting ready to go through an election; their economy is in recession; and inflation is over 6%. There was a time when we would call that stagflation. Plus they lost the World Cup on their home turf to an efficient, well-oiled machine from Germany. The real (the Brazilian currency) is at risk. Will their central bank raise rates in spite of economic weakness if the US dollar rally continues? Obviously, the bank won’t take that action before the election, but if it does so later in the year, it could put a damper on not just Brazil but all of South America. Take a look at this chart of Brazilian consumer price inflation vs. GDP:

Turkey is beginning to soften, with the lira down 6% over the last few months. The South African rand is down 6% since May and down 25% since this time last year. I noted some of the problems with South Africa when I was there early this year. The situation has not improved. They have finally reached an agreement with the unions in the platinum mining industry, which cost workers something like $1 billion in unpaid wages, while the industry lost $2 billion. To add insult to injury, it now appears that a Chinese slowdown may put further pressure on commodity-exporting South Africa. And their trade deficit is just getting worse.
Who’s Competing with Whom?
We could also do a whole letter or two on global trade. The Boston Consulting Group has done a comprehensive study on the top 25 export economies. I admit to being a little surprised at a few of the data points. Let’s look at the chart and then a few comments.

First, notice that Mexico is now cheaper than China. That might explain why Mexico is booming, despite the negative impact of the drug wars going on down there. Further, there is now not that much difference in manufacturing costs between China and the US .
Why not bring that manufacturing home – which is what we are seeing? And especially anything plastic-related, because the shale-gas revolution is giving us an abundance of natural gas liquids such as ethane, propane, and butane, which are changing the cost factors for plastic manufacturers. There is a tidal wave of capital investment in new facilities close to natural gas fields or pipelines. This is also changing the dynamic in Asia, as Asian companies switch to cheaper natural gas for their feedstocks.
(What, you don’t get newsfeeds from the plastic industry? Realizing that I actually do makes me consider whether I need a 12-step program. “Hello, my name is John, and I’m an information addict.”)
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

September 10, 2014

Thoughts from the Frontline: Europe Takes the QE Baton

By John Mauldin

If the wide, wide world of investing doesn’t seem a little strange to you these days, it can only be because you’re not paying attention. If you’re paying attention, strange really isn’t the word you’re probably using in your day-to-day investing conversations; it may be more like weird or bizarre. It increasingly feels like we’re living in the world dreamed up by the creators of DC Comics back in the 1960s, called Bizarro World. In popular culture "Bizarro World" has come to mean a situation or setting that is weirdly inverted or opposite from expectations.
As my Dad would say, “The whole situation seems about a half-bubble off dead center” (dating myself to a time when people used levels that actually had bubbles in them). But I suppose that now, were he with us, he might use the expression to refer to the little bubbles that are effervescing everywhere. In a Bizarro French version of very bubbly champagne (I can hardly believe I’m reporting this), the yield on French short-term bonds went negative this week. If you bought a short-term French bill, you actually paid for the privilege of holding it. I can almost understand German and Swiss yields being negative, but French?
And then Friday, as if to compound the hilarity, Irish short-term bond yields went negative. Specifically, roughly three years ago Irish two-year bonds yielded 23.5%. Today they yield -0.004%! In non-related un-news from Bizarro World, the Spanish sold 50-year bonds at 4% this week. Neither of these statistics yielded up by Bloomberg makes any sense at all. I mean, I understand how they can technically happen and why some institutions might even want 50-year Spanish bonds. But what rational person would pay for the privilege of owning an Irish bond? And does anyone really think that 4% covers the risk of holding Spanish debt for 50 years? What is the over-under bet spread on the euro’s even existing in Spain in 50 years? Or 10, for that matter?
We might be able to lay the immediate, proximate cause of the bizarreness at the feet of ECB President Mario Draghi, who once again went all in last Monday for his fellow teammates in euroland. He gave them another round of rate cuts and the promise of more monetary easing, thus allowing them to once again dodge the responsibility of managing their own economies. The realist in me scratches my already well-scratched head and wonders exactly what sort of business is going to get all exuberant now that the main European Central Bank lending rate has dropped to 0.05% from an already negligible 0.15%. Wow, that should make a lot of deals look better on paper.
We should note that lowering an already ridiculously low lending rate was not actually Signor Draghi’s goal. This week we’ll look at what is happening across the pond in Europe, where the above-mentioned negative rates are only one ingredient in a big pot of Bizarro soup. And we’ll think about what it means for the US Federal Reserve to be so close to the end of its quantitative easing, even as the ECB takes the baton to add €1 trillion to the world’s liquidity. And meanwhile, Japan just keeps plugging away. (Note: this letter will print longer than usual as there are a significant number of graphs. Word count is actually down, for which some readers may be grateful.)
But first, I’m glad that I can finally announce that my longtime friend Tony Sagami has officially come to work for us at Mauldin Economics. Tony has been writing our Yield Shark advisory since the very beginning, but for contractual reasons we could not publicize his name. I will say more at the end of the letter, but for those of you interested in figuring out how to increase the yield of your investments, Tony could be a godsend.
The Age of Deleveraging
Extremely low and even negative interest rates, slow growth, unusual moves by monetary and fiscal authorities, and the generally unseemly nature of the economic world actually all have a rational context and a comprehensible explanation. My co-author Jonathan Tepper and I laid out in some detail in our book End Game what the ending of the debt supercycle would look like. We followed up in our book Code Red with a discussion of one of the main side effects, which is a continual currency war (though of course it will not be called a currency war in public). Both books stand up well to the events that have followed them. They are still great handbooks to understand the current environment.
Such deleveraging periods are inherently deflationary and precipitate low rates. Yes, central banks have taken rates to extremes, but the low-rate regime we are in is a natural manifestation of that deleveraging environment. I’ve been doing a little personal research on what I was writing some 15 years ago (just curious), and I came across a prediction from almost exactly 15 years ago in which I boldly and confidently (note sarcasm) projected that the 10-year bond would go below 4% within a few years. That was a little edgy back then, as Ed Yardeni was suggesting it might go below 5% by the end of the following year. That all seems rather quaint right now. The Great Recession would send the 10-year yield below 2%.
Sidebar: The yield curve was also negative at the time, and I was calling for recession the next year. With central banks holding short-term rates at the zero bound, we no longer have traditional yield-curve data to signal a recession. What’s a forecaster to do?
I was not the only one talking about deflation and deleveraging back then. Drs. Gary Shilling and Lacy Hunt (among others) had been writing about them for years. The debt supercycle was also a favorite topic of my friend Martin Barnes (and prior to him Tony Boeckh) at Bank Credit Analyst.
Ever-increasing leverage clearly spurs an economy and growth. That leverage can be sustained indefinitely if it is productive leverage capable of creating the cash flow to pay for itself. Even government leverage, if it is used for productive infrastructure investments, can be self-sustaining. But ever-increasing leverage for consumption has a limit. It’s called a debt supercycle because that limit takes a long time to come about. Typically it takes about 60 or 70 years. Then something has to be done with the debt and leverage. Generally there is a restructuring through a very painful deflationary bursting of the debt bubble – unless governments print money and create an inflationary bubble. Either way, the debt gets dealt with, and generally not in a pleasant manner.
We are living through an age of deleveraging, which began in 2008. Gary Shilling summarized it this week in his monthly letter:
We continue to believe that slow worldwide growth is the result of the global financial deleveraging that followed the massive expansion of debt in the 1980s and 1990s and the 2008 financial crisis that inevitably followed, as detailed in our 2010 book, The Age of Deleveraging: Investment strategies for a decade of slow growth and deflation. We forecast back then that the result in the U.S. would be persistent 2% real GDP growth until the normal decade of deleveraging is completed. Since the process is now six years old, history suggests another four years or so to go.
We’ve also persistently noted that this deleveraging is so powerful that it has largely offset massive fiscal stimuli in the form of tax cuts and rebates as well as huge increases in federal spending that resulted in earlier trillion-dollar deficits. It has also swamped the cuts in major central bank interest rates to essentially zero that were followed by gigantic central bank security purchases and loans that skyrocketed their balance sheets.  Without this deleveraging, all the financial and monetary stimuli would surely have pushed real GDP growth well above the robust 1982–2000 3.7% average instead of leaving it at a meager 2.2% since the recovery began in mid-2009.
The problems the developed world faces today are the result of decisions made to accumulate large amounts of debt over the past 60 years. These problems cannot be solved simply by the application of easy-money policies. The solution will require significant reforms, especially labor reforms in Europe and Japan, and a restructuring of government obligations.
Mohammed El-Erian called it the New Normal. But it is not something that happens for just a short period of time and then we go back to normal. Gary Shilling cites research which suggests that such periods typically last 10 years – but that’s if adjustments are allowed to happen. Central banks are fighting the usual adjustment process by providing easy money, which will prolong the period before the adjustments are made and we can indeed return to a “normal” market.
How Bizarre Is It?
We are going to quickly run through a number of charts, as telling the story visually will be better than spilling several times 1000 words (and easier on you). Note that many of these charts display processes unfolding over time. We try to go back prior to the Great Recession in many of these charts so that you can see the process. We are going to focus on Europe, since that is where the really significant anomalies have been occurring.
First, let’s look at what Mario Draghi is faced with. He finds himself in an environment of low inflation, and expectations for inflation going forward are even lower. This chart depicts inflation in the two main European economies, Germany and France.

Note too that inflation expectations for the entire euro area are well below 1% for the next two years – notwithstanding the commitment of the European Central Bank to bring back inflation.

But as I noted at the beginning, ECB policy has already reached the zero bound. In fact the overnight rate is negative, making cash truly trash if it is deposited with the ECB.
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

August 21, 2014

Outside the Box: AI, Robotics, and the Future of Jobs

By John Mauldin

This past week several reports came across my desk highlighting both the good news and the bad news about the future of automation and robotics. There are those who think that automation and robotics are going to be a massive destroyer of jobs and others who think that in general humans respond to shifts in employment opportunities by creating new opportunities.
As I’ve noted more than once, in the 1970s (as it seemed that our jobs were disappearing, never to return), the correct answer to the question, “Where will the jobs come from?” was “I don’t know, but they will.” That was more a faith-based statement than a fact-based one, but whole new categories of jobs did in fact get created in the ’80s and ’90s.
However, a new Wall Street Journal poll finds that three out of four Americans think the next generation will be worse off than this generation.
Barack Obama’s former chief economist Larry Summers began this chant of “secular stagnation.” It’s a pessimistic message, and it’s now being echoed by Federal Reserve Vice-Chair Stanley Fischer. He agrees with Summers that slow growth in “labor supply, capital investment, and productivity” is the new normal that’s “holding down growth.” Summers also believes that negative real interest rates aren’t negative enough. If Fischer and Fed chair Janet Yellen agree, central bank policy rates will never normalize in our lifetime. (National Review Online)
As the above-cited article asserts (and I agree), the term secular stagnation is a cover-up for the failure of Keynesian policies which, as my friends Larry Kudlow and Stephen Moore note, began in the Bush years and were doubled down on by the current administration.
Kareem Abdul-Jabbar, who is pursuing a career as a social commentator after dominating the NBA boards for so many years, tells us that Ferguson (which is on all the news channels all the time) is not just about systemic racism; it’s about class warfare and how America’s poor are held back.
Jared Dillian over at the Daily Dirtnap notes that the militarization of the nation’s police forces has been an issue for a number of people for a long time. Exactly why does some small community in Connecticut need grenade launchers? Seriously? But he does make a point about the news cycle and trading:
The key here is the press. Journalism is such a powerful force, a force for good or bad (often bad), but if you look at Radley Balko, here was a journalist who had a pet issue (which really made him a polemicist) and he kept writing about this issue over and over again, but nobody really cared. He had a small, but loyal following. Now he has a very large following, because this issue just blew up on national TV, and now everyone is interested in it, like, why does my police department have a tank? And so on. So it went from being a non-issue to a big issue – overnight.
So this is what happens: now that it is at the forefront of the consciousness of the press, any time they hear about an incident like this, they will report on it. And it will seem like police militarization is everywhere. Before it seemed like it was nowhere. The only difference is that now, people will be reporting on it! It’s not like this wasn’t an issue before Ferguson. It was a huge issue before Ferguson. But now, everyone is talking about it. People are interested in hearing about it. And journalists will report on things that people like to hear about.
But here is the great part. Our friend Radley Balko, the expert on police militarization, the guy who has studied it his whole adult life, wrote a book on it, is the leading authority, does he get to be the leading voice on police militarization? No. There are plenty of other opportunists around who just latch on to whatever is the new new thing and position themselves as the expert on it. I guess what I am trying to say is that the guy who is short the whole way up and is finally right at the top is actually worse off than the guy who is just right at the top. Think about the financial crisis. The cemeteries are full of the bodies of money managers who were smart and early and short all the way up. It really is about being in the right place at the right time.” (The Daily Dirtnap)
I think having a national conversation about the militarization of police is probably a good thing. We all support the police, but more than a few of us are becoming a little uncomfortable with the number of SWAT teams in our communities. A little balance here and there might be a useful thing.
But to bring us back to robotics and automation, Kareem and others do point out that the social fabric of this country (and of the entire developed world) is more fragile than we would like it to be. And while the country had 50-70+ years to adapt to increasing automation on farms from the 1870s onward, and survived that transition, the radical restructuring of what we think of as work that is going to happen in the next 20 years is going to be far more difficult. Especially when everything is on the news.
The report that is today’s OTB is from Pew Research and Elon University and runs to 67 pages. I have excerpted about six of those pages, which highlight some of the key takeaways from thought leaders among the 1,896 experts the authors consulted with, some of whom think robotics will be a huge plus and others who are deeply concerned about our social future.. (You can find the whole study at plus links in the first few pages of the report to other fascinating subjects on the future. Wonks take note.)
The vast majority of respondents to the 2014 Future of the Internet canvassing anticipate that robotics and artificial intelligence will permeate wide segments of daily life by 2025, with huge implications for a range of industries such as health care, transport and logistics, customer service, and home maintenance. But even as they are largely consistent in their predictions for the evolution of technology itself, they are deeply divided on how advances in AI and robotics will impact the economic and employment picture over the next decade.
The countries that are winners in the coming technological revolution will be those that help their citizens organize themselves to take advantage of the new technologies. Countries that try to “protect” jobs or certain groups will find themselves falling behind. This report highlights some of the areas where not just the US but other countries are failing. Especially in education, where we still use an 18th-century education model developed to produce factory workers for the British industrialists, putting students into rows and columns and expecting them to learn facts that will somehow help them cope with a technological revolution.
Finally, I note that our views on the future impact of robotics and automation have a tendency to take on a religious tone. While everyone can marshall their “facts,” the facts mostly get used to conjure up speculations about the future. This is not unlike some of the arguments I heard in seminary. Are you post-millennial or pre-millennial? Do you see a William Gibson post-apocalyptic world coming, or a bright Ian Banks future where technology is our servant and has freed us of the mundane drudgery of needing to work to survive ?
The transition we are engaged in is likely to be volatile, no matter what your religious (I mean scientific) opinion of it is. But one of the joys of my life – and I hope of yours –is that I get to live through it. This week’s Outside the Box is my hopefully helpful way of getting you think about these important issues.
This weekend was only partially aided by automation. We went out to my friend Monty Bennett’s ranch in East Texas, where he runs a wildlife game reserve. He has animals from all over the world. I think I saw more gemsbok at his ranch than I did when I was last on a South African safari. And to my great delight I saw a red Indian deer that had one of the most magnificent racks of antlers I’ve ever seen on any animal anywhere. And if the local redneck hunters knew about the size of the racks on his whitetail deer, he would have trouble keeping said two-leggeds from climbing the 8-foot fence that surrounds the property. (Please note, I grew up not far from Monty’s neck of the woods, where redneck was not a pejorative term.)
Have a great week, and remember that robots need jobs too.
Your wanting more automation in his life analyst,
John Mauldin, Editor
Outside the Box

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AI, Robotics, and the Future of Jobs

By Aaron Smith and Janna Anderson

Key Findings

The vast majority of respondents to the 2014 Future of the Internet canvassing anticipate that robotics and artificial intelligence will permeate wide segments of daily life by 2025, with huge implications for a range of industries such as health care, transport and logistics, customer service, and home maintenance. But even as they are largely consistent in their predictions for the evolution of technology itself, they are deeply divided on how advances in AI and robotics will impact the economic and employment picture over the next decade.

Key themes: reasons to be hopeful:

1) Advances in technology may displace certain types of work, but historically they have been a net creator of jobs.
2) We will adapt to these changes by inventing entirely new types of work, and by taking advantage of uniquely human capabilities.
3) Technology will free us from day-to-day drudgery, and allow us to define our relationship with “work” in a more positive and socially beneficial way.
4) Ultimately, we as a society control our own destiny through the choices we make.

Key themes: reasons to be concerned:

1) Impacts from automation have thus far impacted mostly blue-collar employment; the coming wave of innovation threatens to upend white-collar work as well.
2) Certain highly-skilled workers will succeed wildly in this new environment—but far more may be displaced into lower paying service industry jobs at best, or permanent unemployment at worst.
3) Our educational system is not adequately preparing us for work of the future, and our political and economic institutions are poorly equipped to handle these hard choices.
Some 1,896 experts responded to the following question:
The economic impact of robotic advances and AI—Self-driving cars, intelligent digital agents that can act for you, and robots are advancing rapidly. Will networked, automated, artificial intelligence (AI) applications and robotic devices have displaced more jobs than they have created by 2025?
Half of these experts (48%) envision a future in which robots and digital agents have displaced significant numbers of both blue- and white-collar workers—with many expressing concern that this will lead to vast increases in income inequality, masses of people who are effectively unemployable, and breakdowns in the social order.
The other half of the experts who responded to this survey (52%) expect that technology will not displace more jobs than it creates by 2025. To be sure, this group anticipates that many jobs currently performed by humans will be substantially taken over by robots or digital agents by 2025. But they have faith that human ingenuity will create new jobs, industries, and ways to make a living, just as it has been doing since the dawn of the Industrial Revolution.
These two groups also share certain hopes and concerns about the impact of technology on employment. For instance, many are concerned that our existing social structures—and especially our educational institutions—are not adequately preparing people for the skills that will be needed in the job market of the future. Conversely, others have hope that the coming changes will be an opportunity to reassess our society’s relationship to employment itself—by returning to a focus on small-scale or artisanal modes of production, or by giving people more time to spend on leisure, self-improvement, or time with loved ones.
A number of themes ran through the responses to this question: those that are unique to either group, and those that were mentioned by members of both groups.

The view from those who expect AI and robotics to have a positive or neutral impact on jobs by 2025

JP Rangaswami, chief scientist for, offered a number of reasons for his belief that automation will not be a net displacer of jobs in the next decade: “The effects will be different in different economies (which themselves may look different from today's political boundaries). Driven by revolutions in education and in technology, the very nature of work will have changed radically—but only in economies that have chosen to invest in education, technology, and related infrastructure. Some classes of jobs will be handed over to the ‘immigrants’ of AI and Robotics, but more will have been generated in creative and curating activities as demand for their services grows exponentially while barriers to entry continue to fall. For many classes of jobs, robots will continue to be poor labor substitutes.”
Rangaswami’s prediction incorporates a number of arguments made by those in this canvassing who took his side of this question.

Argument #1: Throughout history, technology has been a job creator—not a job destroyer

Vint Cerf, vice president and chief Internet evangelist for Google, said, “Historically, technology has created more jobs than it destroys and there is no reason to think otherwise in this case. Someone has to make and service all these advanced devices.”
Jonathan Grudin, principal researcher for Microsoft, concurred: “Technology will continue to disrupt jobs, but more jobs seem likely to be created. When the world population was a few hundred million people there were hundreds of millions of jobs. Although there have always been unemployed people, when we reached a few billion people there were billions of jobs. There is no shortage of things that need to be done and that will not change.”
Michael Kende, the economist for a major Internet-oriented nonprofit organization, wrote, “In general, every wave of automation and computerization has increased productivity without depressing employment, and there is no reason to think the same will not be true this time. In particular, the new wave is likely to increase our personal or professional productivity (e.g. self-driving car) but not necessarily directly displace a job (e.g. chauffeur). While robots may displace some manual jobs, the impact should not be different than previous waves of automation in factories and elsewhere. On the other hand, someone will have to code and build the new tools, which will also likely lead to a new wave of innovations and jobs.”
Fred Baker, Internet pioneer, longtime leader in the IETF and Cisco Systems Fellow, responded, “My observation of advances in automation has been that they change jobs, but they don't reduce them. A car that can guide itself on a striped street has more difficulty with an unstriped street, for example, and any automated system can handle events that it is designed for, but not events (such as a child chasing a ball into a street) for which it is not designed. Yes, I expect a lot of change. I don't think the human race can retire en masse by 2025.”

Argument #2: Advances in technology create new jobs and industries even as they displace some of the older ones

Ben Shneiderman, professor of computer science at the University of Maryland, wrote, “Robots and AI make compelling stories for journalists, but they are a false vision of the major economic changes. Journalists lost their jobs because of changes to advertising, professors are threatened by MOOCs, and store salespeople are losing jobs to Internet sales people. Improved user interfaces, electronic delivery (videos, music, etc.), and more self-reliant customers reduce job needs. At the same time someone is building new websites, managing corporate social media plans, creating new products, etc. Improved user interfaces, novel services, and fresh ideas will create more jobs.”
Amy Webb, CEO of strategy firm Webbmedia Group, wrote, “There is a general concern that the robots are taking over. I disagree that our emerging technologies will permanently displace most of the workforce, though I'd argue that jobs will shift into other sectors. Now more than ever, an army of talented coders is needed to help our technology advance. But we will still need folks to do packaging, assembly, sales, and outreach. The collar of the future is a hoodie.”
John Markoff, senior writer for the Science section of the New York Times, responded, “You didn't allow the answer that I feel strongly is accurate—too hard to predict. There will be a vast displacement of labor over the next decade. That is true. But, if we had gone back 15 years who would have thought that ‘search engine optimization’ would be a significant job category?”
Marjory Blumenthal, a science and technology policy analyst, wrote, “In a given context, automated devices like robots may displace more than they create. But they also generate new categories of work, giving rise to second- and third-order effects. Also, there is likely to be more human-robot collaboration—a change in the kind of work opportunities available. The wider impacts are the hardest to predict; they may not be strictly attributable to the uses of automation but they are related…what the middle of the 20th century shows us is how dramatic major economic changes are—like the 1970s OPEC-driven increases of the price of oil—and how those changes can dwarf the effects of technology.”

Argument #3: There are certain jobs that only humans have the capacity to do

A number of respondents argued that many jobs require uniquely human characteristics such as empathy, creativity, judgment, or critical thinking—and that jobs of this nature will never succumb to widespread automation.
David Hughes, a retired U.S. Army Colonel who, from 1972, was a pioneer in individual to/from digital telecommunications, responded, “For all the automation and AI, I think the 'human hand' will have to be involved on a large scale. Just as aircraft have to have pilots and copilots, I don't think all 'self-driving' cars will be totally unmanned. The human's ability to detect unexpected circumstances, and take action overriding automatic driving will be needed as long and individually owned 'cars' are on the road.”
Pamela Rutledge, PhD and director of the Media Psychology Research Center, responded, “There will be many things that machines can't do, such as services that require thinking, creativity, synthesizing, problem-solving, and innovating…Advances in AI and robotics allow people to cognitively offload repetitive tasks and invest their attention and energy in things where humans can make a difference. We already have cars that talk to us, a phone we can talk to, robots that lift the elderly out of bed, and apps that remind us to call Mom. An app can dial Mom's number and even send flowers, but an app can't do that most human of all things: emotionally connect with her.”
Michael Glassman, associate professor at the Ohio State University, wrote, “I think AI will do a few more things, but people are going to be surprised how limited it is. There will be greater differentiation between what AI does and what humans do, but also much more realization that AI will not be able to engage the critical tasks that humans do.”

Argument #4: The technology will not advance enough in the next decade to substantially impact the job market

Another group of experts feels that the impact on employment is likely to be minimal for the simple reason that 10 years is too short a timeframe for automation to move substantially beyond the factory floor. David Clark, a senior research scientist at MIT’s Computer Science and Artificial Intelligence Laboratory, noted, “The larger trend to consider is the penetration of automation into service jobs. This trend will require new skills for the service industry, which may challenge some of the lower-tier workers, but in 12 years I do not think autonomous devices will be truly autonomous. I think they will allow us to deliver a higher level of service with the same level of human involvement.”
Jari Arkko, Internet expert for Ericsson and chair of the Internet Engineering Task Force, wrote, “There is no doubt that these technologies affect the types of jobs that need to be done. But there are only 12 years to 2025, some of these technologies will take a long time to deploy in significant scale…We've been living a relatively slow but certain progress in these fields from the 1960s.”
Christopher Wilkinson, a retired European Union official, board member for, and Internet Society leader said, “The vast majority of the population will be untouched by these technologies for the foreseeable future. AI and robotics will be a niche, with a few leading applications such as banking, retailing, and transport. The risks of error and the imputation of liability remain major constraints to the application of these technologies to the ordinary landscape.”

Argument #5: Our social, legal, and regulatory structures will minimize the impact on employment

A final group suspects that economic, political, and social concerns will prevent the widespread displacement of jobs. Glenn Edens, a director of research in networking, security, and distributed systems within the Computer Science Laboratory at PARC, a Xerox Company, wrote, “There are significant technical and policy issues yet to resolve, however there is a relentless march on the part of commercial interests (businesses) to increase productivity so if the technical advances are reliable and have a positive ROI then there is a risk that workers will be displaced. Ultimately we need a broad and large base of employed population, otherwise there will be no one to pay for all of this new world.”
Andrew Rens, chief council at the Shuttleworth Foundation, wrote, “A fundamental insight of economics is that an entrepreneur will only supply goods or services if there is a demand, and those who demand the good can pay. Therefore any country that wants a competitive economy will ensure that most of its citizens are employed so that in turn they can pay for goods and services. If a country doesn't ensure employment driven demand it will become increasingly less competitive.”
Geoff Livingston, author and president of Tenacity5 Media, wrote, “I see the movement towards AI and robotics as evolutionary, in large part because it is such a sociological leap. The technology may be ready, but we are not—at least, not yet.”

The view from those who expect AI and robotics to displace more jobs than they create by 2025

An equally large group of experts takes a diametrically opposed view of technology’s impact on employment. In their reading of history, job displacement as a result of technological advancement is clearly in evidence today, and can only be expected to get worse as automation comes to the white-collar world.

Argument #1: Displacement of workers from automation is already happening—and about to get much worse

Jerry Michalski, founder of REX, the Relationship Economy eXpedition, sees the logic of the slow and unrelenting movement in the direction of more automation: “Automation is Voldemort: the terrifying force nobody is willing to name. Oh sure, we talk about it now and then, but usually in passing. We hardly dwell on the fact that someone trying to pick a career path that is not likely to be automated will have a very hard time making that choice. X-ray technician? Outsourced already, and automation in progress. The race between automation and human work is won by automation, and as long as we need fiat currency to pay the rent/mortgage, humans will fall out of the system in droves as this shift takes place…The safe zones are services that require local human effort (gardening, painting, babysitting), distant human effort (editing, coaching, coordinating), and high-level thinking/relationship building. Everything else falls in the target-rich environment of automation.”
Mike Roberts, Internet pioneer and Hall of Fame member and longtime leader with ICANN and the Internet Society, shares this view: “Electronic human avatars with substantial work capability are years, not decades away. The situation is exacerbated by total failure of the economics community to address to any serious degree sustainability issues that are destroying the modern ‘consumerist’ model and undermining the early 20th century notion of ‘a fair day's pay for a fair day's work.’ There is great pain down the road for everyone as new realities are addressed. The only question is how soon.”
Robert Cannon, Internet law and policy expert, predicts, “Everything that can be automated will be automated. Non-skilled jobs lacking in ‘human contribution’ will be replaced by automation when the economics are favorable. At the hardware store, the guy who used to cut keys has been replaced by a robot. In the law office, the clerks who used to prepare discovery have been replaced by software. IBM Watson is replacing researchers by reading every report ever written anywhere. This begs the question: What can the human contribute? The short answer is that if the job is one where that question cannot be answered positively, that job is not likely to exist.”
Tom Standage, digital editor for The Economist, makes the point that the next wave of technology is likely to have a more profound impact than those that came before it: “Previous technological revolutions happened much more slowly, so people had longer to retrain, and [also] moved people from one kind of unskilled work to another. Robots and AI threaten to make even some kinds of skilled work obsolete (e.g., legal clerks). This will displace people into service roles, and the income gap between skilled workers whose jobs cannot be automated and everyone else will widen. This is a recipe for instability.”
Mark Nall, a program manager for NASA, noted, “Unlike previous disruptions such as when farming machinery displaced farm workers but created factory jobs making the machines, robotics and AI are different. Due to their versatility and growing capabilities, not just a few economic sectors will be affected, but whole swaths will be. This is already being seen now in areas from robocalls to lights-out manufacturing. Economic efficiency will be the driver. The social consequence is that good-paying jobs will be increasingly scarce.”

Argument #2: The consequences for income inequality will be profound

For those who expect AI and robotics to significantly displace human employment, these displacements seem certain to lead to an increase in income inequality, a continued hollowing out of the middle class, and even riots, social unrest, and/or the creation of a permanent, unemployable “underclass”.
Justin Reich, a fellow at Harvard University's Berkman Center for Internet & Society, said, “Robots and AI will increasingly replace routine kinds of work—even the complex routines performed by artisans, factory workers, lawyers, and accountants. There will be a labor market in the service sector for non-routine tasks that can be performed interchangeably by just about anyone—and these will not pay a living wage—and there will be some new opportunities created for complex non-routine work, but the gains at this top of the labor market will not be offset by losses in the middle and gains of terrible jobs at the bottom. I'm not sure that jobs will disappear altogether, though that seems possible, but the jobs that are left will be lower paying and less secure than those that exist now. The middle is moving to the bottom.”
Stowe Boyd, lead researcher at GigaOM Research, said, “As just one aspect of the rise of robots and AI, widespread use of autonomous cars and trucks will be the immediate end of taxi drivers and truck drivers; truck driver is the number-one occupation for men in the U.S.. Just as importantly, autonomous cars will radically decrease car ownership, which will impact the automotive industry. Perhaps 70% of cars in urban areas would go away. Autonomous robots and systems could impact up to 50% of jobs, according to recent analysis by Frey and Osborne at Oxford, leaving only jobs that require the 'application of heuristics' or creativity…An increasing proportion of the world's population will be outside of the world of work—either living on the dole, or benefiting from the dramatically decreased costs of goods to eke out a subsistence lifestyle. The central question of 2025 will be: What are people for in a world that does not need their labor, and where only a minority are needed to guide the 'bot-based economy?”
Nilofer Merchant, author of a book on new forms of advantage, wrote, “Just today, the guy who drives the service car I take to go to the airport [said that he] does this job because his last blue-collar job disappeared from automation. Driverless cars displace him. Where does he go? What does he do for society? The gaps between the haves and have-nots will grow larger. I'm reminded of the line from Henry Ford, who understood he does no good to his business if his own people can't afford to buy the car.”
Alex Howard, a writer and editor based in Washington, D.C., said, “I expect that automation and AI will have had a substantial impact on white-collar jobs, particularly back-office functions in clinics, in law firms, like medical secretaries, transcriptionists, or paralegals. Governments will have to collaborate effectively with technology companies and academic institutions to provide massive retraining efforts over the next decade to prevent massive social disruption from these changes.”

Point of agreement: the educational system is doing a poor job of preparing the next generation of workers

A consistent theme among both groups is that our existing social institutions—especially the educational system—are not up to the challenge of preparing workers for the technology- and robotics-centric nature of employment in the future.
Howard Rheingold, a pioneering Internet sociologist and self-employed writer, consultant, and educator, noted, “The jobs that the robots will leave for humans will be those that require thought and knowledge. In other words, only the best-educated humans will compete with machines. And education systems in the U.S. and much of the rest of the world are still sitting students in rows and columns, teaching them to keep quiet and memorize what is told to them, preparing them for life in a 20th century factory.”
Bryan Alexander, technology consultant, futurist, and senior fellow at the National Institute for Technology in Liberal Education, wrote, “The education system is not well positioned to transform itself to help shape graduates who can ‘race against the machines.’ Not in time, and not at scale. Autodidacts will do well, as they always have done, but the broad masses of people are being prepared for the wrong economy.”

Point of agreement: the concept of “work” may change significantly in the coming decade

On a more hopeful note, a number of experts expressed a belief that the coming changes will allow us to renegotiate the existing social compact around work and employment.

Possibility #1: We will experience less drudgery and more leisure time

Hal Varian, chief economist for Google, envisions a future with fewer ‘jobs’ but a more equitable distribution of labor and leisure time: “If ‘displace more jobs’ means ‘eliminate dull, repetitive, and unpleasant work,’ the answer would be yes. How unhappy are you that your dishwasher has replaced washing dishes by hand, your washing machine has displaced washing clothes by hand, or your vacuum cleaner has replaced hand cleaning? My guess is this ‘job displacement’ has been very welcome, as will the ‘job displacement’ that will occur over the next 10 years. The work week has fallen from 70 hours a week to about 37 hours now, and I expect that it will continue to fall. This is a good thing. Everyone wants more jobs and less work. Robots of various forms will result in less work, but the conventional work week will decrease, so there will be the same number of jobs (adjusted for demographics, of course). This is what has been going on for the last 300 years so I see no reason that it will stop in the decade.”
Tiffany Shlain, filmmaker, host of the AOL series The Future Starts Here, and founder of The Webby Awards, responded, “Robots that collaborate with humans over the cloud will be in full realization by 2025. Robots will assist humans in tasks thus allowing humans to use their intelligence in new ways, freeing us up from menial tasks.”
Francois-Dominique Armingaud, retired computer software engineer from IBM and now giving security courses to major engineering schools, responded, “The main purpose of progress now is to allow people to spend more life with their loved ones instead of spoiling it with overtime while others are struggling in order to access work.”

Possibility #2: It will free us from the industrial age notion of what a “job” is

A notable number of experts take it for granted that many of tomorrow’s jobs will be held by robots or digital agents—and express hope that this will inspire us as a society to completely redefine our notions of work and employment.
Peter and Trudy Johnson-Lenz, founders of the online community Awakening Technology, based in Portland, Oregon, wrote, “Many things need to be done to care for, teach, feed, and heal others that are difficult to monetize. If technologies replace people in some jobs and roles, what kinds of social support or safety nets will make it possible for them to contribute to the common good through other means? Think outside the job.”
Bob Frankston, an Internet pioneer and technology innovator whose work helped allow people to have control of the networking (internet) within their homes, wrote, “We'll need to evolve the concept of a job as a means of wealth distribution as we did in response to the invention of the sewing machine displacing seamstressing as welfare.”
Jim Hendler, an architect of the evolution of the World Wide Web and professor of computer science at Rensselaer Polytechnic Institute, wrote, “The notion of work as a necessity for life cannot be sustained if the great bulk of manufacturing and such moves to machines—but humans will adapt by finding new models of payment as they did in the industrial revolution (after much upheaval).”
Tim Bray, an active participant in the IETF and technology industry veteran, wrote, “It seems inevitable to me that the proportion of the population that needs to engage in traditional full-time employment, in order to keep us fed, supplied, healthy, and safe, will decrease. I hope this leads to a humane restructuring of the general social contract around employment.”

Possibility #3: We will see a return to uniquely “human” forms of production

Another group of experts anticipates that pushback against expanding automation will lead to a revolution in small-scale, artisanal, and handmade modes of production.
Kevin Carson, a senior fellow at the Center for a Stateless Society and contributor to the P2P Foundation blog, wrote, “I believe the concept of ‘jobs’ and ‘employment’ will be far less meaningful, because the main direction of technological advance is toward cheap production tools (e.g., desktop information processing tools or open-source CNC garage machine tools) that undermine the material basis of the wage system. The real change will not be the stereotypical model of ‘technological unemployment,’ with robots displacing workers in the factories, but increased employment in small shops, increased project-based work on the construction industry model, and increased provisioning in the informal and household economies and production for gift, sharing, and barter.”
Tony Siesfeld, director of the Monitor Institute, wrote, “I anticipate that there will be a backlash and we'll see a continued growth of artisanal products and small-scale [efforts], done myself or with a small group of others, that reject robotics and digital technology.”
A network scientist for BBN Technologies wrote, “To some degree, this is already happening. In terms of the large-scale, mass-produced economy, the utility of low-skill human workers is rapidly diminishing, as many blue-collar jobs (e.g., in manufacturing) and white-collar jobs (e.g., processing insurance paperwork) can be handled much more cheaply by automated systems. And we can already see some hints of reaction to this trend in the current economy: entrepreneurially-minded unemployed and underemployed people are taking advantages of sites like Etsy and TaskRabbit to market quintessentially human skills. And in response, there is increasing demand for ‘artisanal’ or ‘hand-crafted’ products that were made by a human. In the long run this trend will actually push toward the re-localization and re-humanization of the economy, with the 19th- and 20th-century economies of scale exploited where they make sense (cheap, identical, disposable goods), and human-oriented techniques (both older and newer) increasingly accounting for goods and services that are valuable, customized, or long-lasting.”
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August 15, 2014

Outside the Box: Low and Expanding Risk Premiums Are the Root of Abrupt Market Losses

By John Mauldin

Risk premiums. I don’t know anyone who seriously maintains that risk premiums are anywhere close to normal. They more closely resemble what we see just before a major bear market kicks in. Which doesn’t mean that they can’t become further compressed. My good friend John Hussman certainly wouldn’t argue for such a state of affairs, and this week for our Outside the Box we let John talk about risk premiums.
Hussman is the founder and manager of the eponymous Hussman Funds, at Let me offer a few cautionary paragraphs from his letter as a way to set the stage. I particularly want to highlight a quote from Raghuram Rajan, who impressed me with his work and his insights when we spent three days speaking together in Scandinavia a few years ago. At the time he was a professor at the University of Chicago, before he moved on to see if he could help ignite a fire in India.
Raghuram Rajan, the governor of the Reserve Bank of India and among the few economists who foresaw the last financial crisis, warned last week that “some of our macroeconomists are not recognizing the overall build-up of risks. We are taking a greater chance of having another crash at a time when the world is less capable of bearing the cost. Investors say ‘we will stay with the trade because central banks are willing to provide easy money and I can see that easy money continuing into the foreseeable future.’ It’s the same old story. They add ‘I will get out before everyone else gets out.’ They put the trades on even though they know what will happen as everyone attempts to exit positions at the same time.”
As a market cycle completes and a bull market gives way to a bear market, you’ll notice an increasing tendency for negative day-to-day news stories to be associated with market “reactions” that seem completely out of proportion. The key to understanding these reactions, as I observed at the 2007 peak, is to recognize that abrupt market weakness is generally the result of low risk premiums being pressed higher. Low and expanding risk premiums are at the root of nearly every abrupt market loss. Day-to-day news stories are merely opportunities for depressed risk premiums to shift up toward more normal levels, but the normalization itself is inevitable, and the spike in risk premiums (decline in prices) need not be proportional or “justifiable” by the news at all. Remember this, because when investors see the market plunging on news items that seem like “nothing,” they’re often tempted to buy into what clearly seems to be an overreaction. We saw this throughout the 2000-2002 plunge as well as the 2007-2009 plunge.
Yesterday evening, another astute market observer in the form of my good friend Steve Cucchiaro, founder of Windhaven, joined a few other friends for an entertaining steak dinner; and then we talked long into the night about life and markets. It is difficult to be “running money” at a time like this. The market is clearly getting stretched, but there is also a serious risk that it will run away for another 10 or 15%. If you are a manager, you need to be gut-checking your discipline and risk strategies. If you’re a client, you need to be asking your manager what his or her risk strategy is. It’s not a matter of risk or no risk but how you handle it. What is your discipline? What non-emotional strategy instructs you to enter markets and to exit markets? Is it all or nothing, or is it by sector? Are you global? If so, do you have appropriate and different risk premiums embedded in your strategies? Just asking… John’s piece today should at least get you thinking. That’s what Outside the Box is supposed to do.
It’s an interesting week around the Mauldin house. All the kids were over Sunday, and we grilled steaks and later ended up in the pool, shouting and horsing around, all of us knowing that three of the seven would be off to different parts of the country the next day. I know that’s what adult children do, and as responsible parents we all want our children to be independent, but the occasion did offer a few moments for reflection. Sunday night we just told stories of days past and laughed and tried not to think too much about the future.
A friend of mine just came back from California and Oregon complaining about the heat. Dallas has been rather cool, at least for August. If this weather pattern somehow keeps up (and it won’t), I can see lots of tax refugees streaming into Texas from California.
Tomorrow (Thursday) my mother turns 97, and we will have an ambulance bring her to the apartment, where she wants to have her birthday party. She is bedridden but is absolutely insisting on this party, so my brother and I decided to let her have her way. Which isn’t any different from the way it’s always been. Have a great week.
You’re rich in family and friends analyst,
John Mauldin, Editor
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Low and Expanding Risk Premiums Are the Root of Abrupt Market Losses

By John P. Hussman, Ph.D.
Through the recurrent bubbles and collapses of recent decades, I’ve often discussed what I call the Iron Law of Finance: Every long-term security is nothing more than a claim on some expected future stream of cash that will be delivered into the hands of investors over time. For a given stream of expected future cash payments, the higher the price investors pay today for that stream of cash, the lower the long-term return they will achieve on their investment over time.
The past several years of quantitative easing and zero interest rate policy have not bent that Iron Law at all. As prices have advanced, prospective future returns have declined, and the “risk premiums” priced into risky securities have become compressed. Based on the valuation measures most strongly correlated with actual subsequent total returns (and those correlations are near or above 90%), we continue to estimate that the S&P 500 will achieve zero or negative nominal total returns over horizons of 8 years or less, and only about 2% annually over the coming decade. See Ockham’s Razor and The Market Cycle to review some of these measures and the associated arithmetic.
What quantitative easing has done is to exploit the discomfort that investors have with earning nothing on safe investments, making them feel forced to extend their risk profile in search of positive expected returns. The problem is that there is little arithmetic involved in that decision. For example, if a “normal” level of short-term interest rates is 4% and investors expect 3-4 more years of zero interest rate policy, it’s reasonable for stock prices to be valued today at levels that are about 12-16% above historically normal valuations (3-4 years x 4%). The higher prices would in turn be associated with equity returns also being about 4% lower than “normal” over that 3-4 year period. This would be a justified response. One can demonstrate the arithmetic quite simply using any discounted cash flow approach, and it holds for stocks, bonds, and other long-term securities. [Geek's Note: The Dornbusch exchange rate model reflects the same considerations.]
However, if investors are so uncomfortable with zero interest rates on safe investments that they drive security prices far higher than 12-16% above historical valuation norms (and at present, stocks are more than double those norms on the most reliable measures), they’re doing something beyond what’s justified by interest rates. Instead, what happens is that the risk premium – the compensation for bearing uncertainty, volatility, and risk of extreme loss – also becomes compressed. We can quantify the impact that zero interest rates should have on stock valuations, and it would take decades of zero interest rate policy to justify current stock valuations on the basis of low interest rates. What we’re seeing here – make no mistake about it – is not a rational, justified, quantifiable response to lower interest rates, but rather a historic compression of risk premiums across every risky asset class, particularly equities, leveraged loans, and junk bonds.
My impression is that today’s near-absence of risk premiums is both unintentional and poorly appreciated. That is, investors have pushed up prices, but they still expect future returns on risky assets to be positive. Indeed, because all of this yield seeking has driven a persistent uptrend in speculative assets in recent years, investors seem to believe that “QE just makes prices go up” in a way that ensures a permanent future of diagonally escalating prices. Meanwhile, though QE has fostered an enormous speculative misallocation of capital, a recent Fed survey finds that the majority of Americans feel no better off compared with 5 years ago.
We increasingly see carry being confused with expected return. Carry is the difference between the annual yield of a security and money market interest rates. For example, in a world where short-term interest rates are zero, Wall Street acts as if a 2% dividend yield on equities, or a 5% junk bond yield is enough to make these securities appropriate even for investors with short horizons, not factoring in any compensation for risk or likely capital losses. This is the same thinking that contributed to the housing bubble and subsequent collapse. Banks, hedge funds, and other financial players borrowed massively to accumulate subprime mortgage-backed securities, attempting to “leverage the spread” between the higher yielding and increasingly risky mortgage debt and the lower yield that they paid to depositors and other funding sources.
We shudder at how much risk is being delivered – knowingly or not – to investors who plan to retire even a year from now. Barron’s published an article on target-term funds last month with this gem (italics mine): “JPMorgan's 2015 target-term fund has a 42% equity allocation, below that of its peers. Its fund holds emerging-market equity and debt, junk bonds, and commodities.”
On the subject of junk debt, in the first two quarters of 2014, European high yield bond issuance outstripped U.S. issuance for the first time in history, with 77% of the total represented by Greece, Ireland, Italy, Portugal, and Spain. This issuance has been enabled by the “reach for yield” provoked by zero interest rate policy. The discomfort of investors with zero interest rates allows weak borrowers – in the words of the Financial Times – “to harness strong investor demand.” Meanwhile, Bloomberg reports that pension funds, squeezed for sources of safe return, have been abandoning their investment grade policies to invest in higher yielding junk bonds. Rather than thinking in terms of valuation and risk, they are focused on the carry they hope to earn because the default environment seems "benign" at the moment. This is just the housing bubble replicated in a different class of securities. It will end badly.

Raghuram Rajan, the governor of the Reserve Bank of India and among the few economists who foresaw the last financial crisis, warned last week that "some of our macroeconomists are not recognizing the overall build-up of risks. We are taking a greater chance of having another crash at a time when the world is less capable of bearing the cost. Investors say 'we will stay with the trade because central banks are willing to provide easy money and I can see that easy money continuing into the foreseeable future.' It's the same old story. They add 'I will get out before everyone else gets out.' They put the trades on even though they know what will happen as everyone attempts to exit positions at the same time."
While we’re already observing cracks in market internals in the form of breakdowns in small cap stocks, high yield bond prices, market breadth, and other areas, it’s not clear yet whether the risk preferences of investors have shifted durably. As we saw in multiple early selloffs and recoveries near the 2007, 2000, and 1929 bull market peaks (the only peaks that rival the present one), the “buy the dip” mentality can introduce periodic recovery attempts even in markets that are quite precarious from a full cycle perspective. Still, it's helpful to be aware of how compressed risk premiums unwind. They rarely do so in one fell swoop, but they also rarely do so gradually and diagonally. Compressed risk premiums normalize in spikes.
As a market cycle completes and a bull market gives way to a bear market, you’ll notice an increasing tendency for negative day-to-day news stories to be associated with market “reactions” that seem completely out of proportion. The key to understanding these reactions, as I observed at the 2007 peak, is to recognize that abrupt market weakness is generally the result of low risk premiums being pressed higher. Low and expanding risk premiums are at the root of nearly every abrupt market loss. Day-to-day news stories are merely opportunities for depressed risk premiums to shift up toward more normal levels, but the normalization itself is inevitable, and the spike in risk premiums (decline in prices) need not be proportional or “justifiable” by the news at all. Remember this because when investors see the market plunging on news items that seem like “nothing,” they’re often tempted to buy into what clearly seems to be an overreaction. We saw this throughout the 2000-2002 plunge as well as the 2007-2009 plunge.
As I’ve frequently observed, the strongest expected market return/risk profile is associated with a material retreat in valuations that is then joined by an early improvement across a wide range of market internals. These opportunities occur in every market cycle, and we have no doubt that we will observe them over the completion of the present cycle and in those that follow. In contrast, when risk premiums are historically compressed and showing early signs of normalizing even moderately, a great deal of downside damage is likely to follow. Some of it will be on virtually no news at all, because that normalization is baked in the cake, and is independent of interest rates. All that’s required is for investors to begin to remember that risky securities actually involve risk. In that environment, selling begets selling.
Remember: this outcome is baked in the cake because prices are already elevated and risk premiums are already compressed. Every episode of compressed risk premiums in history has been followed by a series of spikes that restore them to normal levels. It may be possible for monetary policy to drag the process out by helping to punctuate the selloffs with renewed speculation, but there’s no way to defer this process permanently. Nor would the effort be constructive, because the only thing that compressed risk premiums do is to misallocate scarce savings to unproductive uses, allowing weak borrowers to harness strong demand. We don’t believe that risk has been permanently removed from risky assets. The belief that it has is itself the greatest risk that investors face here.
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August 6, 2014

Outside the Box: Money: How the Destruction of the Dollar Threatens the Global Economy

By John Mauldin

Forbes Editor-in-Chief and longtime friend Steve Forbes leads off this week’s Outside the Box with a sweeping historical summary – and damning indictment – of the “cheap money” policies of the US executive branch and Federal Reserve. Four decades of fiat money (since Richard Nixon and his Treasury Secretary, John Connally, axed the gold standard in 1971) and six years of Fed funny business have led us, in Steve’s words, to an era of “declining mobility, great inequality, and the destruction of personal wealth.”
And of course the damage has not been limited to the US; it is global. Steve reminds us that “The bursting of the subprime bubble put in motion a collapse of dominoes that started with the U.S. financial sector and European banks and led to the sovereign debt crisis in Europe, the Greek bankruptcy crisis, and the banking disasters in Iceland and Cyprus.” To make matters worse, the fundamentally weak dollar (and fiat currencies worldwide) have contributed a great deal to record-high food and energy prices that are spurring serious social instability.
As I showed in Code Red and as Steve notes here, we now face the looming specter of a global currency war. Steve reminds us that the real bottom line is that
Money is simply a tool that measures value, like a ruler measures length and a clock measures time. Just as changing the number of inches in a foot will not increase the building of houses or anything else, lowering the value of money will not create more wealth. The only way we will ever get a real recovery is through a return to trustworthy, sound money.  And the best way to achieve that is with a gold standard:  a dollar linked to gold.
Today’s Outside the Box is from Steve’s latest book, which is simply called Money.
I think it’s Steve’s best book in years. Get it for your summer reading. While there is more than one solution to reining in the current abuses by the major global central banks, Steve highlights the problems as well as anyone. This situation really has the potential to end badly. Just this morning the Wall Street Journal noted that “Reserve Bank of India Governor Raghuram Rajan warned Wednesday that the global economy bears an increasing resemblance to its condition in the 1930s, with advanced economies trying to pull out of the Great Recession at each other’s expense.” Rajan is one of the more highly respected economists in the world.
I am back in Dallas for an extended period of time (at least extended by my standards), where my new apartment is paying off in a less hectic lifestyle – people seem to be coming to me for the next few weeks. Tomorrow my good friend Bill Dunkelberg, the Chief Economist of the National Federation of Independent Business, will drop by for a day. We’re going to talk about the future of work, what kind of jobs will be there for our kids (and increasingly our fellow Boomers), what policies should be developed to encourage more jobs, and a host of other issues.
I’m still trying to absorb what I learned in Maine. We enjoyed the most beautiful weather we’ve had in the last eight years, and the conversations seemed to take it up a notch. I fished more than usual, too, which gave me more time to think. On Sunday, however, my thought process was not disturbed by so much as a nibble on my hook. That was after the previous two days, when the fish were practically jumping into the boat.
We had a discussion on complexity theory and why complexity actually had a hand in bringing down more than 20 civilizations. I understand the argument but think there is more to it than that. Something can be complex but continue to work smoothly if information is allowed to run “noise-free.” I began to ponder whether our government has become so complex that it has begun to stifle the flow of information. Dodd–Frank. The Affordable Care Act. Energy policy. The list goes on and on and on. Are we taking all of the profit out of the system in order to comply with complex rules and regulations? Not for large companies, necessarily, but for small ones? When we are losing companies faster than new ones are being created, that should be a huge warning flag that something is wrong in the system. The data in this chart ends in 2011, but the pictures is not getting better.

It will be good to see my old friend Dunk, and perhaps he can shed some light on my continually confused state. Enjoy your August.
John Mauldin, Editor
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The following book excerpt is adapted from Chapter One of Money: How The Destruction of the Dollar Threatens The Global Economy – and What We Can Do About It, by Steve Forbes and Elizabeth Ames
The failure to understand money is shared by all nations and transcends politics and parties. The destructive monetary expansion undertaken during the Democratic administration of Barack Obama by then Federal Reserve chairman Ben Bernanke began in a Republican administration under Bernanke’s predecessor, Alan Greenspan. Republican Richard Nixon’s historic ending of the gold standard was a response to forces set in motion by the weak dollar policy of Democrat Lyndon Johnson.
For more than 40 years, one policy mistake has followed the next.  Each one has made things worse. The most glaring recent example is the early 2000s, when the Fed’s loose money policies led to the momentous worldwide panic and global recession that began in 2008. The remedy for that disaster? Quantitative easing—the large monetary expansion in history.
One of the reasons that QE has been such a failure was a distortionary bond-buying strategy that was part of QE known as “Operation Twist.” The Fed traditionally expands the monetary base by buying short-term Treasuries from financial institutions.  Banks then turn around and make short-term loans to those businesses that are the economy’s main job creators. But QE’s Operation Twist focused on buying long-term Treasuries and mortgage-backed securities. This meant that instead of going to the entrepreneurial job creators, loans went primarily to large corporations and to the government itself.
Supporters insisted that Operation Twist’s lowering of long-term rates would stimulate the economy by encouraging people to buy homes and make business investments. In reality this credit allocating is cronyism, an all-too-frequent consequence of fiat money.  Fed-created inflation results in underserved windfalls to some while others struggle.
Unstable Money:  Odorless and Colorless
Unstable money is a little bit like carbon monoxide:  it’s odorless and colorless.  Most people don’t realize the damage it’s doing until it’s very nearly too late.  A fundamental principle is that when money is weakened, people seek to preserve their wealth by investing in commodities and hard assets. Prices of things like housing, food, and fuel start to rise, and we are often slow to realize what’s happening. For example, few connected the housing bubble of the mid-2000s with the Fed’s weak dollar.  All they knew was that loans were cheap. Many rushed to buy homes in a housing market in which it seemed prices could only go up. When the Fed finally raised rates, the market collapsed.
The weak dollar was not the only factor, but there would have been no bubble without the Fed’s flooding of the subprime mortgage market with cheap dollars.  Yet to this day the housing meltdown and the events that followed are misconstrued as the products of regulatory failure and of greed. Or they are blamed on affordable housing laws and the role of government-created mortgage enterprises Fannie Mae and Freddie Mac. The latter two factors definitely played a role.  Yet the push for affordable housing existed in the 1990s, and we didn’t get such a housing mania. Why did it happen in the 2000s and not in the previous decade?
The answer is that the 1990s was not a period of loose money. The housing bubble inflated after Alan Greenspan lowered interest rates to stimulate the economy after the 2001 – 2002 recession. Greenspan kept rates too low for too long. The bursting of the subprime bubble put in motion a collapse of dominoes that started with the U.S. financial sector and European banks and led to the sovereign debt crisis in Europe, the Greek bankruptcy crisis, and the banking disasters in Iceland and Cyprus.
Other Problems Caused by the Weak Dollar
Many may not realize it, but the weakening of the dollar is at the heart of many other problems today:
High Food and Fuel Prices
As with the subprime bubble, the oil price rises of the mid-2000s (as well as the 1970s) were widely blamed on greed.  Yet here, too, no one bothers to ask why oil companies suddenly became greedier starting in the 2000s.  Oil prices averaged a little over $21 a barrel from the mid-1980s until the early part of the last decade when there was a stronger dollar, compared with around $95 a barrel these days.  Rising commodity prices spurred by the declining dollar have also driven up the cost of food. Many shoppers have noticed that the prices of beef and chicken have reached record highs. This is especially devastating to developing countries where food takes up a greater portion of people’s incomes.  Since the Fed and other central banks began their monetary expansion in the mid-2000s, high food prices wrongly blamed on climate shocks and rising demand have caused riots in countries from Haiti to Bangladesh to Egypt.
Declining Mobility, Great Inequality, and the Destruction of Personal Wealth
The destruction of the dollar is a key reason that two incomes are now necessary for a middle-class family that lived on one income in the 1950s and 1960s. To see why, one need only look at the numbers from the U.S. Bureau of Labor Statistics. What a dollar could buy in 1971 costs $5.78 in 2014.  In other words, you need almost six times more money today than you did 40 years ago to buy the equivalent goods and services. Say you had a 2014 dollar and traveled back in time to 1971. That dollar would be worth, according to the CPI calculator, a mere 17 cents. What has this meant for salaries?  According to statistics from the U.S. Census Bureau, a man in his thirties or forties who earned $54,163 in 1972 today earns around $45,224 in inflation adjusted dollars –a 17% cut in pay. Women have entered the workforce in much larger numbers since then, and women’s incomes have made up the difference for families. As Mark Gimein of points out, “The bottom line is that as two-income families have replaced single-earner ones, the median family has barely moved forward. And the single-earner family has fallen behind.”
Increased Volatility and Currency Crises
The 2014 currency turmoil in emerging countries is just the latest in a succession of needless crises that have occurred over the past several decades as a consequence of unstable money. Today’s huge and often-violent global markets, in which a nation’s currency can come under attack, did not exist before the dollar was taken off the gold standard. They are a direct response to the risks created by floating exchange rates. The crises for most of the Bretton Woods era were mild and infrequent. It was the refusal of the United States to abide by the restrictions of the system that brought it down.
The weak dollar has also been the cause of banking crises that have been blamed on the U.S. system of fractional reserve banking. Traditionally, banks have made their money by lending out deposits while keeping reserves to cover normal withdrawals and loan losses.  The rule of thumb is that banks have $1 of reserves for every $10 of deposits.  In the past, fractional reserve banking has been criticized for making these institutions unnecessarily fragile and jeopardizing the entire economy. Indeed, history is replete with examples of banks that made bad loans and went bust.  Historically, the real problems have been bad banking regulations.  In the post-Bretton Woods era, however, the cause has most often been unstable money. Misdirected lending is characteristic of the asset bubbles that result when prices are distorted by inflation. This has been true of past booms in oil, housing, agriculture, and other traditional havens for weak money.
The Weak Recovery
This bears repeating:  the Federal Reserve’s quantitative easing, the biggest monetary stimulus ever, has produced the weakest recovery from a major downturn in American history.  QE’s Operation Twist has not been the only constraint on loans to small and new businesses.  Regulators have also compounded the problem by pressuring banks to reduce lending to riskier customers, which by definition are smaller enterprises.
In 2014 the Wall Street Journal reported that this credit drought had caused many small businesses, from restaurants to nail salons, to turn in desperation to nonbank lenders—from short-term capital firms to hedge funds—that provide loans at breathtakingly high rates of interest. Interest rates for short-term loans can exceed 50%.  Little wonder there are still so many empty storefronts during this period of supposed recovery.  Monetary instability encourages a vicious cycle of stagnation: the damage it causes is usually blamed on financial sector greed. The scapegoating and finger-pointing bring regulatory constraints that strangle growth and capital creation.  That has long been the case in countries with chronic monetary instability, such as Argentina.  Increased regulation is now hobbling capital creation in the United States as well as in Europe, where there is growing regulatory emphasis on preventing “systemic risk.”  Regulators, the Wall Street Journal noted, “are increasingly telling banks which lines of business they can operate in and cautioning them to steer clear of certain areas or face potential supervisory or enforcement action.”
In Europe, this disturbing trend toward “macroprudential regulation” is turning central banks into financial regulators with sweeping arbitrary powers. The problem is that entrepreneurial success stories like Apple, Google, and Home Depot—fast-growing companies that provide the lion’s share of growth and job creation—all began as “risky” investments. Not surprisingly, we’re now seeing growing public discomfort with this increasing control by central banks. A 2013 Rasmussen poll found that an astounding 74% of American adults are in favor of auditing the Federal Reserve, and a substantial number think the chairman of the Fed has too much power.
Slower Long-Term Growth and Higher Unemployment
Even taking into account the economic boom during the relatively stable money years of the mid-1980s to late 1990s, overall the U.S. economy has grown more slowly during the last 40 years than in previous decades. From the end of World War II to the late 1960s, when the U.S. dollar had a fixed standard of value, the economy grew at an average annual rate of nearly 4%.  Since that time it has grown at an average rate of around 3%. contributor Louis Woodhill explains that this 1% drop means a lot. Had the economy continued to grow at pre-1971 levels, gross domestic product (GDP) in the late 2000s would have been 56% higher than it actually was.  What does that mean?  Woodhill writes: “Our economy would have been more than three times as big as China’s, rather than just over twice as large. And, at the same level of spending, the federal government would have run a $0.5 trillion budget surplus, instead of a $1.3 trillion deficit.”  And what if the United States had never had a stable dollar? If America had grown for all of its history at the lowest post-Bretton Woods rate, its economy would be about one-quarter of the size of China’s.  The United States would have ended up much smaller, less affluent, and less powerful.
Unemployment has also been higher as a consequence of the declining dollar. During the World War II gold standard era, from 1947 to 1970, unemployment averaged less than 5%. Even with the economy’s ups and downs, it never rose above 7%.  Since Nixon gave us the fiat dollar it has averaged over 6%:  it averaged 8.5% in 1975, almost 10% in 1982, and around 8% since 2008. The rate would have been higher had millions not left the workforce. The rest of the world has also suffered from slower growth, in addition to higher inflation, since the end of the Bretton Woods system. After the 1970s, world economic growth has been a full percentage point lower; inflation, 1.5% higher.
Larger Government with Higher Debt
By enabling endless monetary expansion, the post-Bretton Woods system of fiat money has helped propel the unchecked growth of government. In 1971 the total U.S. federal debt stood at $436 billion.  Today it is more than $17 trillion. It’s no coincidence that the federal debt has doubled since 2008, the same year that the Fed started implementing QE.
The Keynesian and monetarist bureaucrats who today set the monetary policies of the Fed and other central banks are like pre-Copernican astronomers who subscribed to the notion that the sun revolved around the earth. They are convinced that government can successfully direct the economy by raising and lowering the value of money. Yet, over and over again, history, and recent events, has shown that they are wrong.
What they don’t understand is that money does not “create” economic activity. Money is simply a tool that measures value, like a ruler measures length and a clock measures time. Just as changing the number of inches in a foot will not increase the building of houses or anything else, lowering the value of money will not create more wealth. The only way we will ever get a real recovery is through a return to trustworthy, sound money.  And the best way to achieve that is with a gold standard:  a dollar linked to gold.
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August 5, 2014

Thoughts from the Frontline: Transformation or Bust

By John Mauldin

China continues to be front and center on my list of concerns, even moreso than the latest Federal Reserve press release or fluctuation in the Dow (although you should pay attention). I believe China is the single biggest risk to world economic equilibrium, even larger than Japan or Europe. This week my young associate Worth Wray provides us with a keenly insightful essay on what is currently happening in China. I will admit to not having written about China very much in the past five years, primarily because, prior to Worth’s coming to work with me I really had no secure understanding of what was happening there. I know some readers may be surprised, but I really don’t like to write about things I have no understanding of. Worth has helped me focus. (It helps that he studied Mandarin and lived in China for a while, and is obsessed with China.)
Worth has been working directly with me for over one year now. I have had the privilege of working with a number of impressive (lately mostly younger) people over the years, but Worth brings something extra to the table. He is one of the best young macroeconomic minds I have been with in years. He constantly challenges me to step up my game. And so without further ado, let me give you Worth’s thinking regarding our latest discussions on China.

Transformation or Bust, China Version
The People’s Republic of China is running up against its debt capacity; and its consumption-repressing, credit-fueled, investment-heavy growth model is nearly exhausted. History suggests that China’s “miracle” could dissipate into a long period of painfully slow growth or terminate abruptly with a banking crisis and sudden collapse. That said, China’s modern economic transformation has defied historical precedents for decades. However unlikely, China could surprise us again. Miracles will happen in the Age of Transformation.
What happens next depends largely on the economic wisdom and political resolve of China’s reformers, who must find a way to gradually deleverage overextended regional governments and investment-intensive sectors while simultaneously rebalancing the national economy toward a more sustainable consumption-driven, service-intensive model. The trouble is, their efforts may prove too little too late to slowly let the air out of a massive debt bubble. Even rapid productivity growth from “new economy” sectors may not be enough to overcome the debt equation.
At first blush, China’s ruling elite do not appear to be in denial about the severity of the debt problem, the urgent need for structural reforms, or the opposition from vested interests within the Communist Party; but the jury is still out on whether President Xi Jinping and his allies will maintain the political capital necessary to complete, or even continue, the task. With little margin for error, he will either lead the Middle Kingdom through the greatest transformation in world history... or he will preside over one of the most spectacular busts on record.
Before we dive into recent data and explore the transformation taking place across the People’s Republic, let’s step back and think intentionally about the conditions that often set “rich” developed economies apart from their “poor” developing peers.
I am going to quote extensively in the next two sections from a recent blog post by Peking University Professor Michael Pettis. Pettis provides a CRITICAL foundation for understanding the transformation taking place and the reforms required to keep it going, so please bear with me. We will have plenty of time to delve into the recent data in the second half of the letter. Unless otherwise noted, all quotes are excerpted from his brilliant post, "The Four Stages of Chinese Growth."
Becoming a Developed Economy
Becoming a truly developed country depends on far more than just accumulating an abundant capital stock or a highly capable workforce. Durable growth and sustainable development depend on “social capital” – or institutional structures including property rights, the legal code and the justice system, the financial system, corporate governance, political culture and practice, tax structures, etc. – which establish and/or maintain the right incentives for economic resources to be used efficiently, creatively, and ultimately, productively.
Pettis explains: “In a country with highly developed social capital, incentive structures are aligned and frictional costs reduced in such a way that agents are rewarded for innovation and productive activity. The higher the level of social capital, the more likely they are to act individually and creatively to exploit current economic conditions and infrastructure to generate productive growth.” Extending his argument, John and I would contend that high levels of social capital effectively incubate innovation and entrepreneurship so that, with disciplined savings and investment over time, the right incentives produce lasting wealth and ever-higher levels of development.
I think MIT Professor Robert Solow would agree with us on this front. Solow’s work on the US economy – which has become a textbook economics lesson – explains that innovation has accounted for more than 80% of the long-term growth in US per capita income, with capital investments accounting for only 20% of per capita income growth. In other words, the United States and the rest of the post-industrial, developed world owe their epic rise in living standards to the underlying “social capital” that properly incentivized innovation, entrepreneurship, and thus technological transformation over the last two centuries.
The lesson here is powerful. It is not enough just to mobilize resources and direct investments to the “right” sectors as China’s central planners have been doing for the last few decades. Once the basic building blocks of economic development are at hand, they still need to be used creatively, effectively, and productively.
Pettis elaborates, “In developed countries … abundant social capital encourages residents and businesses to use available conditions and infrastructure in the most productive ways possible. Undeveloped countries, on the other hand, are poor because they do not have the often-intangible qualities that allow citizens spontaneously, and without planning, to exploit their economic and infrastructure resources most efficiently and productively.”
Emphasizing the importance of incentive-aligning institutions, developing economies must not only strive to create (1) policies aimed at providing and improving the basic building blocks of production like adequate infrastructure, abundant capital stocks, and healthy, educated workforces but also (2) policies and institutions capable of streamlining the commercial incentives for using those resources as productively as possible with as little waste as possible.
Like the USSR in the Cold War era, the People’s Republic has been wildly successful in mobilizing resources; but failing to use those resources efficiently may be its downfall.
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.
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July 31, 2014

Outside the Box: Big Banks Shift to Lower Gear

By John Mauldin

For today’s Outside the Box, good friend Gary Shilling has sent along a very interesting analysis of the big banks. Gary knows a lot about what went down with the big banks during and after the Great Recession, and he tells the story well.
After the bailout of banks during the financial crisis, many wanted too-big-to-fail institutions to be broken up. Big banks resisted and pointed to their rebuilt capital, but regulators are responding with restraints that strip them of proprietary trading and other lucrative activities and push them towards spread lending and other traditional commercial banking businesses. The fiasco at Citigroup, JP Morgan's London Whale, and BNP Paribas's sanctions violations have spurred regulators as well.
Regulators are pressured to impose big fines and get guilty pleas for infractions. Meanwhile, big bank deleveraging proceeds. In this new climate, big banks are still profitable but at reduced levels and are moving toward utility and away from growth-stock status. The end of mortgage refinancing and weak security trading are also drags.
Banks are reacting by taking more risks, but regulators are concerned as long as depositors’ money is at risk. Still, regulators want to keep big banks financially sound and profitable enough to serve financial needs.
Gary’s analysis is extensive and thorough, but it’s only one part of his monthly Insight report. If you subscribe to Insight for $335 via email, you'll receive a free copy of Gary Shilling's full report on large banks, excerpted here, plus 13 monthly issues of Insight (for the price of 12), starting with their August 2014 report.
To subscribe, call them at 1-888-346-7444 or 973-467-0070 between 10 AM and 4 PM Eastern time or email Be sure to mention Outside the Box to get your free report on the big banks. (This offer is for new subscribers only.)
I am back from Whistler, British Columbia, where I spent the weekend at Louis Gave’s 40th birthday party. I went to Louis’s new home on the mountain, where you can ski down and take the gondola back up when you want to go home. Sunday afternoon Louis and I sat and talked for a few hours about the state of the world, interrupted now and again by the excitement of the children when a mother bear and cub walked through the yard. Later we saw another mother with two cubs.
The conversation drifted to the state of the investment industry in which we both work. It echoed similar conversations I have had over the world with other market participants. There is a growing feeling (admit it, you probably feel it too) that significant changes in the investment business are coming at us rather swiftly. Everywhere I go people are trying to figure out what those changes will entail. I’m not talking about just another bear market. In the same way, much of the music industry was sitting fat and happy in 2000 – they had little idea that Napster was just around the corner. And while Napster came and went, the way that people consume music today is significantly different than it was 10 or 15 years ago.
I have the feeling that the investment industry is getting ready to be hit by its equivalent of Napster. I’m not quite sure what that ultimately means, other than in 10 years (or maybe less) clients will be consuming their investment research and advice in a different manner. Old dogs are going to have to learn new tricks or be retired to the porch. And I am not ready to retire, so I will need to master a few new tricks, I guess. Of course, I would like to avoid Napster and go straight to Spotify. Then again, wouldn’t we all?
As Louis drove us back to the hotel – past more bears – he remarked that one does have to be careful around them. “Not really,” I said. “I have run with more than a few bears in my life and been OK.” He looked at me rather strangely, and I added. “Yeah, like Marc Faber, Gary Shilling, Rosie in his former life. Those were REAL bears. These are just cute animals.” He smiled and kept driving.
I will write my next note from Maine, where my son Trey and I will be going to fish for the 8th year in a row at what has become known as Camp Kotok. And though they tell me they are all around us there, the only bears I have seen are some of my fellow campers.
Your ready to lose the fishing contest again,
John Mauldin, Editor
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Big Banks Shift to Lower Gear

(Excerpted from the July 2014 edition of A. Gary Shilling's INSIGHT)
In February 2007, the subprime mortgage bubble broke (Chart 1). Big British bank HSBC was forced to take a $1.8 billion writedown on its U.S. Household subprime lending unit's bad loans, at the time an unprecedented amount, and subprime mortgage lender New Century reported disappointing fourth quarter results.

Quick Spreading

At the time, many housing bulls tried to convince us that the problem was limited to subprime loans that were made to people they, luckily, would never have to meet. But it spread to Wall Street. Bear Stearns was laden with subprime-related securities and when market lenders refused to finance the firm, the New York Fed provided $30 billion in short-term financing. On March 16, 2008, the firm merged with JP Morgan Chase bank in a stock swap worth $2 per share, only 7% of its value two days earlier and 1% of the $172 a share price for Bear Stearns in January 2007. Morgan bank paid $1 billion and the New York Fed was stuck with $29 billion.
Lehman Brothers was next. But this time, the Fed and the Bush Administration refused to bail out that firm and it filed for bankruptcy on September 15, 2008 when outside financing of its hugely leveraged portfolio disappeared and its net worth was a negative $129 billion.
With a meltdown of major Wall Street firms in prospect that probably would have spread worldwide, the Fed and the Administration twisted Congress’ arms into passing the Troubled Asset Relief Program. TARP originally authorized $700 billion to finance troubled assets but it soon morphed into a bailout fund for banks and other troubled financial institutions and took equity positions in 707 banks. The objective was to stabilize their balance sheets and encourage them to lend.
Some $475 billion of TARP money was disbursed and all but $40 billion has been repaid. That $40 billion went to automakers GM and Chrysler as well as insurer AIG – two of them non-banks. But that didn’t stop Washington from placing most of the blame for the financial crisis on the big banks and their CEOs. After all, when a lot of people lose a lot of money, there is a cosmic need for scapegoats, and the big banks have served themselves up for this role.

Too Big To Fail

Much of Wall Street is financed by very short-term loans, often only overnight. So if one firm gets in trouble, funding woes can spread quickly to other firms in the same business, regardless of their individual size, as lending dries up. This is the systemic risk problem. Nevertheless, Congress addressed the situation with such measures as “living wills,” plans prepared by banks to liquidate themselves quickly in the event of future troubles. But if a specific bank were in deep difficulty, would others remain untouched? Can you “keep your head when all about are losing theirs and blaming it on you?”
Then there is the Volcker Rule, proposed by former Fed Chairman Paul Volcker and part of the 2010 Dodd-Frank financial reform law. It strips banks of proprietary trading for their own accounts even though proprietary trading was not a problem for any troubled firms during the financial crisis.
Most significant is the Too-Big-To-Fail concept, the belief that big banks need to be broken up so they can fail individually without endangering the entire financial system. Proponents apparently dismiss the systemic risk reality and forget that bank runs took down many small banks in the early 1930s as well as large ones. We recall a story of people queued up to withdraw their money from a bank in a line that stretched past another bank. So they made a run on that second bank while waiting!
The too-big-to-fail concept originated
in the 1980s when Continental Illinois
had to be rescued. That bank wasn’t
involved in exotic financial activities but rather straightforward commercial banking, taking deposits and making loans. Unfortunately, it made too many bad loans, as have failed predecessors over the centuries.

Bank Concentration

The too-big-to-fail concept is also fueled by the increasing concentration of bank assets. Sure, the number of banks continues to fall (Chart 2), largely due to mergers. The FDIC now insures 6,730 institutions, down from an earlier peak of 18,000 in 1985. But most of the decline of 10,000 banks in the 1984-2011 years was among small banks with less than $100 million in assets due to mergers, consolidations and failures, with 17% of banks collapsing. Increasing costs of regulations since 2008 has also speeded the demise of small banks. At the same time, the number of banks with $100 million to $1 billion in assets has risen since 1985. More regulation in response to earlier collapse in the residential mortgage market, and economies of scale, are encouraging mergers of medium-sized banks into larger units.

Many observers believe banks with less than $1 billion in assets are too small to cope with increased regulation. Last year, in 204 bank mergers, the target bank had assets under that level, about the same as the 206 in 2012 but up hugely from 102 in 2009 before the pressure to merge was fully felt. Not only Dodd-Frank regulations, but also the new “qualified mortgage” rules by the Consumer Finance Protection Bureau that insures borrowers can afford mortgages, are very costly for small banks.
Also, the number of bank branches continues to drop, in part due to mobile and electronic banking. Last year, 2,563 branches disappeared and reduced the total to 96,339 in mid-2013 (Chart 3). This is a far cry from the situation in the early 1960s when I was working on my Ph.D at Stanford and a girlfriend from the Chicago area was visiting me in the summer. She had a letter of introduction from Continental Illinois so she could cash checks at Bank of America, then entirely located in California. While filling out the Bank of America forms in San Francisco, she was stymied by the blank that called for the branch of her bank. Illinois at the time had only unit banking, one location per bank. The Bank of America officer in turn couldn’t understand her problem because of that bank’s statewide branch network.

Big Banks Balloon

Nevertheless, the largest banks’ share of assets continues to leap. It was propelled in the 1990s by the progressive relaxation and final elimination in 1999 of the Depression- era Glass-Steagall law that kept commercial banks out of investment banking. Then with the 2008 financial crisis, stronger big banks bought weaker competitors – with government encouragement, we might add. JP Morgan Chase took over failed Washington Mutual as well as Bear Stearns, Bank of America acquired mortgage lender Countrywide and Merrill Lynch, and Wells Fargo purchased Wachovia. At the end of 2013, the five largest institutions controlled 44.2% of total bank assets, up from 38.4% in 2007. As of March 31, 2014, those 107 institutions with over $10 billion in assets were only 1.7% of the total number but held 80.8% of all bank assets (Chart 4).

In addition, critics of big banks note that buyers of bank debt are more lax in their due diligence of a bank that’s too big to fail because they anticipate a government bailout if needed. This allows the leaders of these banks to borrow cheaply and take bigger risks in a self-feeding cycle of more leverage and more risks.
A recent New York Fed study found that big banks pay 0.31 percentage points less than smaller banks when issuing high-quality bonds, and an even bigger advantage in comparison with nonfinancial corporations where the spread is 0.5 percentage points. Similarly, the IMF reports a borrowing advantage of 0.6 percentage points for too-big-to-fail banks in Japan and the U.K. and 0.9 in the eurozone.
Furthermore, bank CEO pay is much more linked to size than performance. A recent study revealed that the eight U.S. “Systemically Important Banks” – Wells Fargo, JP Morgan Chase, Goldman Sachs, State Street, Bank of New York Mellon, Morgan Stanley, Citigroup and Bank of America – had a median stockholder total return (stock appreciation plus dividends) of 38% since 2009 while the return for smaller banks like US Bancorp, PNC and Sun Trust exceeded 100%. But the median total pay, including cash and stock awards of the large banks between 2010 and 2013, was $57 million compared with $35 million for the second tier. Sure, larger firms are more complex and harder to manage but they can make bigger mistakes, as shown by JP Morgan’s $6.2 billion loss with the London Whale, as we’ll discuss later. No wonder big bank CEOs resist dismemberment and want to grow even bigger!

Break-Up Proponents

Among those now advocating the breaking up of big banks is Sanford Weill, who, ironically, earlier led the charge to end Glass-Steagall so he could merge insurer Travellers, which he headed, with Citigroup. In fact, the Gramm-Leach-Bliley Act that killed Glass-Steagall was dubbed the “Citigroup Authorization Act.” In announcing his reversal in opinion in July 2013, Weill said, “I think the earlier model was right for that time. I think the world changed with the collapse of the real estate market and the housing bubble and what that did because ofleverage ofcertain institutions. So I don’t think it’s right anymore.” He also said, “I am suggesting that they be broken up so that the taxpayer will never be at risk, the depositors won’t be at risk.” And he admitted, “Mistakes were made.”
Others advocating the break-up of big banks include Philip Purcell, the former CEO of Morgan Stanley, Sheila Bair, the former head of the FDIC, John Reed, who ran Citigroup before it was merged with Travellers, Thomas Hoenig, former Kansas City Fed President and Dallas Fed President Richard Fisher. A number in Congress are also on board including Sen. Ron Johnson from Wisconsin.
Like unscrambling an egg, it’s hard to envision how big banks with many, many activities could be split up. But, of course, one of the arguments for doing so is they’re too big and too complicated for one CEO to manage. Still, there is the example of the U.K., which plans to separate deposit-taking business from riskier investment banking activities – in effect, recreating Glass-Steagall.
In any event, among others, Phil Purcell believes that “from a shareholder point ofview, it’s crystal clear these enterprises are worth more broken up than they are together.” This argument is supported by the reality that Citigroup, Bank of America and Morgan Stanley stocks are all selling below their book value (Chart 5). In contrast, most regional banks sell well above book value.

Push Back

Not surprising, current leaders of major banks have pushed back against proposals to break them up. They maintain that at smaller sizes, they would not be able to provide needed financial services. Also, they state, that would put them at a competitive disadvantage to foreign banks that would move onto their turf.
The basic reality, however, is that the CEOs of big banks don’t want to manage commercial spread lenders that take deposits and make loans and also engage in other traditional banking activities like asset management. They want to run growth companies that use leverage as their route to success. Hence, their zeal for off-balance sheet vehicles, proprietary trading, derivative origination and trading, etc. That’s where the big 20% to 30% returns lie – compared to 10% to 15% for spread lending – but so too do the big risks.

Capital Restoration

The strategy of big bank CEOs seems to be to fight break- up proposals tooth and nail in the hope that as memories of the 2008-2009 bailouts fade, so too will interest in reducing their size. Furthermore, the vast majority of banks, big and small, have restored their capital. Most banks are comfortably above impending capital requirements. At the end of the first quarter, 98.2% of all FDIC-insured institutions representing 99.8% of industry assets (and therefore all the big banks) met or exceeded the requirements of the higher regulatory capital category.
Nevertheless, the FDIC and Federal Reserve are planning a new “leverage ratio” schedule that would require the eight largest “Systemically Important Banks” to maintain loss-absorbing capital equal to at least 5% of their assets and their FDIC-insured bank subdivisions would have to keep a minimum leverage ratio of 6%. This compares with 3% under the international Basel III schedule. Six of these eight largest banks would need to tie up more capital. Also, regulators may impose additional capital requirements for these “Systemically Important Banks” and more for banks involved in volatile markets for short-term borrowing and lending. The Fed also wants the stricter capital requirements to be met by 2017, two years earlier than the international agreement deadline.
The number of institutions on the FDIC’s “Problem List” fell to 411 and the assets of those banks dropped to $126.1 billion in the first quarter. Bank failure numbers have yet to return to pre-crisis levels, but have dropped considerably since the 157 peak in 2010 (Chart 6). Similarly, the percentage of institutions with quarterly losses continues to fall
while the percentage with quarterly earnings increases exceeds the pre-crisis
level (Chart 7).

More Regulation

Despite the improving financial status
of banks, especially larger institutions,
their push back against being dismembered has been met with more regulation. The unvoiced strategy in Washington seems to be, if the big banks
don’t agree to be broken up, they’ll be regulated to the point that they wish they
were, or at least to the degree that individual failures are much less likely
and far less damaging if they do occur.
Slowly but surely, they’re being busted back toward spread lending and other traditional commercial banking businesses and bereaved of many risky but highly-profitable activities – highly-profitable until adjusted for risks. Consider the higher Basel III capital requirements, the pressures to orient executive compensation toward long- run risk-adjusted profitability and away from short-run speculation, the divestiture of non-core bank assets, the Volcker Rule, the selling ofbranches and subsidiary banks, etc.
Late last year, the FDIC prepared a plan to unwind large banks on the edge of collapse without taxpayer bailouts. The FDIC would keep parts of the bank open, prioritize payments to creditors and recapitalize the firm. “Unsecured creditors and shareholders must bear the losses of the financial company without imposing a cost on U.S. taxpayers,” said FDIC Chairman Martin Greenberg.
All of these new regulation proposals strike us as fighting the last war. With all the Dodd-Frank and other regulations now in place and the losses, chastisements and embarrassments of bankers, mortgage lenders, homeowners, etc., it’s unlikely that a repeat of the 2008 financial crisis and the speculation that spawned it will occur any time soon. That doesn’t mean that financial bubbles are extinct, but that the next one will occur in a different area that is outside the scope of the regulatory reaction to the last crisis. Besides, all those super bright, million-dollar per year guys and gals on Wall Street can figure out how to beat most $100,000 regulators any day!

Fed Proposals

Meanwhile, the Fed and the Office of the Controller of the Currency, another bank regulator, in March 2013 told banks to avoid funding takeover deals that would leave companies with high debts. But since then, “judging from aggressive market data, it appears that many banks have not fully implemented standards set forth” in March 2013, said a senior Fed official recently. In March of this year, the OCC said there would be “no exceptions” to the guidance for newly-issued loans. These junk “leveraged” loans have seen a rapid reduction in investor-protecting covenants that moves them back to previous day’s levels that proved disastrous when the 2008 financial meltdown hit.
In a similar vein, the Fed’s point man on regulations, Gov. Daniel Tarullo, said recently that after reading accounts of the role that money market and other short-term markets played in the financial crisis, a “broadly applicable” minimum margin requirement makes sense. Fed Chairwoman Janet Yellen also backs new rules for short-term funding to mitigate risks to the financial system.
The final version of the Volcker Rule has been delayed by haggling over the difference between genuine hedging of customer assets and proprietary trading with bank assets. The Volcker Rule isn’t expected to be implemented until 2015 and promises to be very specific as to what is and what isn’t a hedge. Meanwhile, Wall Street houses such as Goldman Sachs have exited their in-house trading.

More Examiners

Regulators are adjusting their staffs to better understand and control financial institutions’ activities. The New York Fed roughly doubled its supervision staff since the crisis and has between 15 and 40 overseeing each of the largest bank holding companies. The OCC, which regulates banks with national branch networks like JP Morgan and Wells Fargo, has upped its staff examining large banks by 20% since 2007, with up to 60 at the largest institutions. These examiners have access to computer systems and can attend internal strategy meetings and readily meet with bank executives and board members.
At the same time, the heat is on banks to beef up their compliance. Regulators are concerned that banks don’t comprehend their own operations, including measuring risks and planning for future crises. The OCC recently said that only two of 19 banks have met the standards it laid out after the crisis. Among other things, it wants two independent directors on boards of national banks and independent officers to track and monitor all business lines.
Large banks are hyping their compliance staffs. JP Morgan plans to add over 13,000 people and the industrywide hiring effort is creating a war for talent with escalating pay levels. Similarly, bank risk officers are multiplying like fruit flies as the OCC warns that “credit risk is now building after a period of improving credit quality and problem loan cleanup.” At major banks, their numbers are rising over 15% annually.
Wells Fargo now has 2,300 in its risk management department, up from 1,700 two years ago and the department's budget has doubled to $500 million. In contrast, the bank's total workforce has remained flat. Goldman Sachs put its chief risk officer on the 34-person management committee for the first time in the firm's 145-year history. Senior risk officer pay is up as much as 40% from a few years ago and equal to the compensation of chief financial officers and general counsels. Earlier, they were paid a third less.
Large banks are being pushed by regulators to specify in writing which risks and how much they're willing to take to meet financial goals. Risk officers are being urged to examine big losses or big profits for signs of undue risks.
The efforts of regulators and risk officers may be having significant effects. At the end of 2013, the five largest banks had $793 billion in equity capital to protect against losses, up 19% from $667 billion in 2009. At the same time, their value at risk, in effect their exposure to losses on any given trading day, fell 64% from $1.05 billion to $381 million

Who’s The Toughest?

Then there is the war among regulators to be the toughest. They’re chastised in and out of Washington for leveling billion-dollar fines that are still just a cost of doing business for major banks, for letting them off with mere “we neither admit nor deny” statements and for not sending individual bankers to jail. The relatively new SEC Chairwoman Mary Jo White promises to be a lot tougher, but the results are yet to be seen. The OCC recently detailed risk management standards for banks with over $50 billion in assets, which puts the monkeys on the bank board members’ backs and requires banks to have independent audit and risk management offices that can take their concerns directly to the board.
Then there’s the game of one
regulator trying to deflect
pressure by saying that other
regulators are lax. The SEC
has criticized the Financial
Industry Regulatory Authority, which it oversees, for being
too lenient in its sanctions. In
the five years since the financial
crisis, FINRA did not
discipline any Wall Street
executives and imposed fines
of $1 million or more 55 times
compared with 259 times for
the SEC. FINRA regulated
4,100 brokerage firms and over 600,000 brokers and collected just $74.5 million in fines last year compared to $3.9 billion for the SEC. Note, however, that the SEC, not FINRA, takes the most serious fraud cases while FINRA concentrates on lesser infractions such as operations breakdowns where penalties are smaller.


Dodd-Frank has bereaved banks of much of their origination in trading in futures, options and other derivatives. Derivative trading is largely being transferred to exchanges that guarantee fulfillment of the contracts as opposed to the highly-profitable over-the-counter derivatives that banks trade but with which investors or speculators have to look to counterparties to be good for losses. This is the “counterparty risk” problem. Still, the seven largest banks still accounted for 98% of the $215 trillion notional value of derivative contracts as of March 31 (Chart 8), 85% of which were interest rate contracts (Chart 9).

Still, regulators are concerned with derivatives. Those from 10 European and North American countries recently released a report that said many large banks and their regulators are still not ready to deal with difficulties in the huge derivatives market. They lack the information to consistently and accurately know who their counterparties are. Officials estimate that banks are up to three years away from having the necessary systems in place.

Dark Pools And High-Speed Trading

Another area of concern to regulators is dark pools, private trading venues that don't disclose their activities publicly and account for 14% of all stock trading. Another 23% occurs in other off-exchange locales. The purpose of dark pools is to facilitate large institutional trading without exposure to high-frequency traders. Barclays bank runs Barclays LX, the country's second largest dark pool, which is marketed with the motto, “Protecting clients in the dark.” But the New York Attorney General has charged that Barclays offered access to Barclays LX to high-speed traders. The bank is also accused of using other trading venues that benefit Barclays rather than its customers.
Under pressure from their institutional investor clients, many large brokers are routing trades away from Barclays LX and other dark pools. The SEC is investigating dark pools to determine whether they accurately disclose how they operate and whether they treat all investors fairly. Chairwoman White said in June that the size of off-exchange trading “risks seriously undermining” the quality of the U.S. stock market. Goldman Sachs recently agreed to pay an $800,000 fine for mispricing 400,000 trades in dark pool Sigma X in 2011. The firm already reimbursed clients with $1.67 million.

Citigroup Charades

One big bank that remains squarely in regulators’ gun sights is Citigroup, and for good reason. The present firm resulted from the merger of Citicorp and Travellers in 1998. Vikram Pandit left Morgan Stanley in 2005 after being passed over for CEO and, with two colleagues, started a hedge fund, Old Line. It was sold to Citigroup in 2007, right at the top of the financial bubble, for $800 million. Even though that hedge fund was not very successful and eventually closed, Pandit rose to be CEO of the firm in December 2007.
On his watch, the company’s stock continued its collapse from what would have been $564 per
share in December 2006, except for the
10-to-1 reverse split in May 2011 to avoid the embarrassment of its selling at penny stock prices (Chart 10). The swoon to the trough in March 2009 was 98.2%.

Pandit’s relations with regulators were poor and he didn’t help matters by letting the bank consider completing the purchase of a private jet after receiving $45 billion in TARP bailout money. Despite his announcement to the Citigroup directors that all was well with regulators, the bank failed the Fed’s stress test in 2012. So it was not allowed to increase its quarterly dividend from one-cent per share to five cents and it requested but could not buy back up to $6.4 billion in stock. Shareholders were not amused and Pandit was shown the door in October.
Pandit told Congress in February 2009 that “my salary should be $1 per year with no bonus until we return to profitability.” After some improvement in the bank’s finances, he was awarded a $23.2 million retention package in 2011, close to the top of CEO compensation. Nevertheless, in April 2012, 55% of shareholders voted against increasing his pay to $15 million, the first nonbinding rejection of a compensation plan by a major bank.

History Repeats

In a repeat of history, last March the Fed again said Citigroup flunked its stress test, only the second bank along with Ally Financial to fail twice. So it can’t raise its quarterly dividend from one-cent to five cents per share.
It wasn’t the quantitative part of the test that tripped up Citigroup. Its Tier 1 capital ratio would only fall to 7% under very adverse conditions, still well above the fed’s 5% minimum. That adverse scenario, specified by the Fed, includes a deep recession with leaping unemployment, a steep decline in house prices and a 50% plummet in equity prices. Also, in the third annual stress test, the Fed made its own projection of the bank’s balance sheet, assuming the assets rise during tough times rather than fall as banks had assumed, so more bank capital would be necessary. In addition, the Fed forced eight big banks to assume the default of their largest counterparty.
The Fed this year flunked Citigroup on the quantitative side of the stress test. It cited deficiencies in Citi’s capital-planning process and risk assessments. The Fed had earlier warned the bank about these problems, but received an inadequate response. In effect, the Fed is questioning whether Citigroup is too big and too complex to manage without posing systemic risk.

The London Whale

In failing Citigroup in its stress test, the Fed has yet to bring up the bank’s risks controls in Mexico and the Banamex loss. But the Fed and other regulators have been clear over JP Morgan Chase’s lack of controls that led to the London Whale disaster in 2012.
Banks normally invest funds they’re not using for loans in Treasurys, but with low interest rates, JP Morgan became aggressive. As an example, at the end of 2006, it held $600 million in riskier corporate debt, or about 1% of total investments, but jumped those holdings to $10 billion, or 5% of all security holdings, two years later, and $62 billion, or 17% of the total, at the end of 2008 after the Fed initiated its zero interest rate policy. Similarly, non-U.S. residential mortgage security holdings jumped from $2 billion at the end of 2008 to $75 billion in early 2012. At the time, CEO Jamie Dimon disputed the idea that the bank was taking on more risk. “I wouldn’t call it more aggressive. I would call it better,” he said.
Meanwhile, the bank’s culture of risk-taking – and we believe the tone in any organization is set at the top – was rampant in London. A JP Morgan bank trader, Bruno Iksil, was making huge bets totaling $82 billion, with insurance-like derivatives called credit default swaps so big that he became known as the London Whale. That attracted hedge funds to take the other side of his trades, figuring he’d have to unwind them sooner or later. Meanwhile, his boss was urging him to put even higher values on his positions. When asked about this trading on April 13, 2012, Dimon said concerns were “a complete tempest in a teapot.”
Then came revelations of losses of at least $2 billion and Dimon began to realize the extent of the problem. “There’s blood in the water – hedge funds are going to come after us and make it worse,” he was told by a colleague. And they did, with the loss leaping to $6.2 billion by July. Dimon tried to get ahead of the bad public relations by stating that the trades were “flawed, poorly executed, poorly reviewed and badly monitored.”
The Chief Investment Office in which these trades took place was supposed to manage and hedge the firm’s fixed- income assets. But it has become clear that the CIO was taking directional bets and speculating in contradiction of the impending Volcker Rule. In 2011, risk-control caps that had required traders to exit positions when their losses exceeded $20 million were dropped. Subsequently, Dimon admitted as much, saying, “What this hedge morphed into violates our own principles.” Also, he was slow to fire Ina Drew, who was responsible for the CIO, and he dithered about clawing back the $14.7 million in stock awards she received.

Bones And Joints

Furthermore, Dimon, the bank and Wall Street faced huge fallout from this mess. He has led the charge against the Volcker Rule and other new bank regulations and had considerable credibility in Washington and on Wall Street because his bank largely avoided the near-financial meltdown.
Dimon was known as the smart, hands-on operator who says he knows all the “bones and the joints” of the bank. Is his being shocked! shocked! to discover the $6.2 billion loss proving what many regulators and legislators believe: that big banks are too complicated to manage and should be broken up? If they’re too big to fail, it’s ironic that when asked, in hindsight, what he should have paid more attention to, Dimon quipped, “Newspapers,” no doubt referring to the April 6, 2012 front page Wall Street Journal story about the London Whale.
Furthermore, the London Whale fiasco has not hindered Dimon’s compensation, although he suffered a pay cut at the time. In January 2014, the JP Morgan board raised his pay 74% to $20 million for 2013, a year in which the bank agreed to more than $20 billion in fines and other legal payouts and suffered its first quarterly loss in nine years. In making that award, which included $18.5 million in stock, the board cited “the regulatory issues the company has faced and the steps the company has taken to resolve those issues.”
Well, in contrast to Citigroup, JP Morgan’s stock fell “only” 70% during the financial crisis. Since then, it has rallied 260% to now exceed the May 2007 peak by 8%. And investors didn’t have lasting concerns over the 2012 London Whale losses and lack of controls. Regulators, however, may have the last word.


That lack of investor worry comes despite the huge fines and other penalties being paid by JP Morgan and other big banks over bad mortgages, manipulation of currency, interest rate and commodity markets, and illegally helping Americans to avoid taxes.
The CFTC and JP Morgan settled for $100 million in the London Whale case after the regulator charged the bank with reckless use of manipulative devices. The bank also acknowledged wrongdoing as part of the $970 million settlement with the SEC, OCC, the Fed and U.K. regulators in September 2013 in the same case.
The SEC got $200 million of that total and admissions by JP Morgan that it misstated its first quarter 2012 financial results, failed to properly oversee its traders and didn’t keep its board of directors informed about the trading problems. This is only the second time, after the settlement with hedge fund company SAC, that the SEC obtained admission of wrongdoing and it is in line with Chairwoman White’s promise to get tough and get more admissions. Earlier, U.S. District Court Judge Jed S. Rakoff rejected a $285 million settlement the SEC negotiated with Citigroup, in part because Citi did not admit liability.


Big foreign banks with U.S. operations are not beyond the reach of American regulators. France’s largest bank, BNP Paribas, has finally agreed to pay $9 billion in penalties and plead guilty to criminal charges over concealing about $30 billion in oil and other transactions with countries that are sanctioned by the U.S. including Iran, Cuba and Sudan. Also, as demanded by New York State regulators, 30 people will leave the bank. Starting in January, the bank will lose its permission to clear certain dollar transactions for a year. The alternative to accepting these harsh sanctions was being banned from done business in lucrative U.S. financial markets.
Since French banks dominate trade financing and these transactions between the Americas and Asia are carried out in U.S. dollars, this last penalty is especially meaningful for BNP, although the bank has six months to arrange a transition to other firms that will handle this business during BNP's absence. French President Francois Hollande called the demands by U.S. regulators “unfair and disproportionate,” but with classic French face-saving, Finance Minister Michel Sapin took credit for the limited scope of the dollar ban. “In line with the demands of the French authorities, this agreement sanctions the activities of the past and protects the future,” he said.
Prosecutors in the Justice Department and Manhattan District Attorney’s office were especially irked by BNP’s slow and incomplete response to their requests for documents and interviews in 2009 concerning transactions that took place between 2002 and 2009. U.S. authorities believe that BNP employees took deliberate steps over several years to hide their dollar transactions with U.S.-sanctioned countries. Transactions were run through intermediate banks to avoid detection, in schemes that resemble money-laundering. BNP apparently did not expect this big of a fine since it reserved only about $1.1 billion. It plans to maintain its dividend and its stock rose 3.6% on the news, although it had dropped 18% since February when the bank announced the provision for possible U.S. fines....
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Important Disclosures

July 29, 2014

Thoughts from the Frontline: Time to Put a New Economic Tool in the Box

By John Mauldin

[E]conomists are at this moment called upon to say how to extricate the free world from the serious threat of accelerating inflation which, it must be admitted, has been brought about by policies which the majority of economists recommended and even urged governments to pursue. We have indeed at the moment little cause for pride: as a profession we have made a mess of things.
It seems to me that this failure of the economists to guide policy more successfully is closely connected with their propensity to imitate as closely as possible the procedures of the brilliantly successful physical sciences – an attempt which in our field may lead to outright error. It is an approach which has come to be described as the “scientistic” attitude – an attitude which, as I defined it some thirty years ago, “is decidedly unscientific in the true sense of the word, since it involves a mechanical and uncritical application of habits of thought to fields different from those in which they have been formed.
– Friedrich Hayek, from the introduction to his Nobel Prize acceptance speech in 1974
Last week we took a deep dive into how the concept of GDP (gross domestic product) came about. We looked at some of the controversies surrounding GDP statistics that we use to measure the growth of the economy, and we noted that the GDP tool seems designed to reflect and serve an economic theory (Keynesianism) that prefers to focus on the demand side of economic activity. If your measurement of the growth of the economy is entirely defined by final consumption (that is, consumer spending) and government spending, then if you want to try to improve growth you are left with just two policy dials to adjust:
  1. How do we increase consumption?
  2. How much government spending should there be to stimulate growth when the economy is in a recession?
But what if there are other ways to measure the economy? Might those other measurement tools suggest a different set of policies and methods to help the economy grow? Indeed, I noted last week that the one thing – besides science fiction – that Paul Krugman and I agree on is that we need more growth. (There are actually some economists out there who don’t agree with that assessment. Go figure.)
As it happens, Mr. Krugman stumbled upon my post and wrote the following under the heading “The Horror, the Horror”:
I happened to click on this John Mauldin post, in which he informs us that GDP is a Keynesian plot, and that without it Hayek would of course have won the macroeconomic debate. Oh, kay – but that’s not the horror. It’s this:
“We have now made the Newt Gingrich and Niall Ferguson Strategic Investment Conference videos available. … This week, we are happy to provide even more material from this incredibly informative event. Newt Gingrich and Niall Ferguson were the two highest rated presenters at a conference packed with some of the finest economic and investment minds in the world.”
Oh, boy.
Well, we did feature two of Paul K’s least favorite people at the conference. (His debates with Niall are classic.) I don’t know why, but I started reading the comments to Paul’s piece from readers, some of which were quite thoughtful and showed that commenters had actually read my letter. To those who found me from that link, let me point out that we also had at the conference my good friend, über-Keynesian Paul McCulley, who, along with two or three of the other speakers, was more than capable of defending the Keynesian position. Paul has been a featured speaker at our conference for over 10 years, but I am quite sure there are many people who wonder why we would include him. As I have always maintained in this letter and in my Outside the Box letter, I think it is important to consider and try to appreciate all positions. In fact, I even featured Mr. Krugman himself in Outside the Box, back in 2009.
(At the end of this letter I offer a link to let you see our conference speeches and judge the various positions for yourself.)
All that being said, Mr. Krugman, I don’t think GDP as it is measured today is a Keynesian plot. GDP is a valuable measurement tool, if you understand what is being measured and all those asterisks with caveats that attend any such measure. But as we will see in this week’s letter, there are other ways to measure GDP that would suggest additional policy dials for spurring economic growth.
Say’s Law Makes a Comeback
Actually, the debate on what constitutes an economy goes back much further than Keynes and Hayek. The debate was well recounted in an essay by economist Steve Hanke, a professor of applied economics at Johns Hopkins University. Let’s quote a few paragraphs:
The Classical School of economics prevailed roughly from Adam Smith’s Wealth of Nations time (1776) to the mid-19th century. It focused on the supply side of the economy. Production was the wellspring of prosperity.
The French economist J.-B. Say (1767-1832) was a highly regarded member of the Classical School. To this day, he is best known for Say’s Law of markets. In the popular lexicon – courtesy of John Maynard Keynes – this law simply states that “supply creates its own demand.” But, according to Steven Kates, one of the world’s leading experts on Say, Keynes’ rendition of Say’s Law distorts its true meaning and leaves its main message on the cutting room floor.
Say’s message was clear: a demand failure could not cause an economic slump. This message was accepted by virtually every major economist, prior to the publication of Keynes’ General Theory in 1936. So, before the General Theory, even though most economists thought business cycles were in the cards, demand failure was not listed as one of the causes of an economic downturn.
All this was overturned by Keynes. Kates argues convincingly that Keynes had to set Say up as a sort of straw man so that he could remove Say’s ideas from the economists’ discourse and the public’s thinking. Keynes had to do this because his entire theory was based on the analysis of demand failure, and his prescription for putting life back into aggregate demand – namely, a fiscal stimulus [read: lower taxes and/or higher government spending].”
The BEA Introduces Gross Output
So what other tool than GDP might we use? Conveniently, on this very day, July 25, 2014, the Bureau of Economic Analysis begins to publish a quarterly statistic called “gross output.” A good part of the reasoning behind this new statistic and the impetus to produce it comes from a book published in 1990 by my friend of 30 years Dr. Mark Skousen. The book was titled The Structure of Production, and in it Skousen forcefully argued that production rather than demand should be the basis for analyzing the strength of an economy. No less an authority on productivity than Peter F. Drucker commented in a review at the time, “The next economics will have to be centered on supply and the factors of production rather than being functions of demand. I've read Mark Skousen’s book twice, and it comes the closest to achieving this goal.”
Gross output (GO) measures the total output of an economy, including investments made by businesses in order to produce their goods, such as capital outlays on new equipment, raw materials, or other business-to-business transactions. In Structure, Skousen makes the case that modern economists downplay the importance of the business sector in the economy and overstate the importance of consumer spending. He believes that the GDP should not be used as the sole measure of economic activity.
Let’s go to the lead editorial by Mark that was published in the Wall Street Journal just a few months ago:
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July 25, 2014

Outside the Box: Geopolitics and Markets

By John Mauldin

Growing geopolitical risk is on everyone’s mind right now, but in today’s Outside the Box, Michael Cembalest of J.P. Morgan Asset Management leads off with a helpful reminder: the only time since WWII that a violent conflict has had a medium-term negative effect on markets was in 1973, when the Israeli-Arab war led to a Saudi oil embargo against the US and a quadrupling of oil prices. And he backs up that assertion with an interesting table of facts labeled “War zone countries as a percentage of total world… [population, oil production, GDP, etc.].”
Having gotten that worry out of the way, he takes on the dire warnings that have recently been issued by the BIS, the IMF, and even the Fed, about a disconnect between market enthusiasm and the undertow of global economic developments. (He gives this section the cute title “Prophet warnings.”) Let’s look, he says, at actual measures of profits and how markets are valuing them; and then he goes on to give us a “glass half-full” take on prospects for the US economy for the remainder of the year. He throws in some caveats and cautions, but Cembalest thinks we could finally see another 3% growth quarter this year, which could create room for further profit increases.
There are good sections here on Europe and emerging markets here, too. Cembalest gives us a true Outside the Box, with a more optimistic view than some of our other recent guests have had. But that’s the point of OTB, is it not, to think about what might be on the other side of the walls of the box we find ourselves in? I have shared his work before and find it well thought out. He is one of the true bright lights in the major investment bank research world. That’s my take, at least.
I write this introduction from the air in “flyover country,” heading back home from rural Minnesota. I flew to Minneapolis to look at a private company that is actually well down the road to creating hearts and livers and kidneys and skin and other parts of the body that can be grown and then put into place. It will not be too many years before that rather sci-fi vision becomes reality, if what I saw is any indication. This group is focused and has what it takes in terms of management and science.
When you hold the beating, pumping scaffolding for a heart in your hand and know that it will soon be a true heart – albeit for a test animal at this point, though human trials are not that far off – then you can well and truly feel that we are entering a new era. I declined to pick up a rather huge liver, but the chief scientist handled it like it was just another auto part. Match these “parts” with young IPS cells, and we truly will have replacement organs ready for us when we need them, if we can wait another decade or so (or maybe half that time for some organs!). My friend and editor of Transformational Technology Alert, Patrick Cox, toured the place with me and will write about it in a few weeks. (You will be able to see his complete analysis of this company for free in his monthly letter on new technologies. You can subscribe here.)
Ukraine and Gaza are epic tragedies, but gods, what wonders we humans can create when we pursue life rather than death. It just makes you want to take some people by the back of the neck and shake some sense into them.
And now a brief but enlightening tale from … The Road. It’s about the Code of the Road Warrior. The Road can be a lonely place, soul-searing in its weariness, with only brief moments of pleasure. But you have to do it because that is what the job requires. And there are lots of us out there. You see the look, you recognize yourself in the other person. If you can help, you do. It’s the unwritten Code that we all come to realize you must live by. It has nothing to do with race, religion, sexual alignment, or political persuasion. You help fellow Road Warriors on the journey.
As do we all, you seek out your favorite airline club in airports (for me it’s the American Airlines Admirals Club) and know you are “home.” A comfortable chair for your back, a plug for your tools, a drink to quench your thirst, and peace for your soul. But then there are the times when you are in an airport where there is no home for you.
Over the years, I have invited dozens of fellow Road Warriors to be my “guest” in a club. No true cost to me, just a courtesy you give a fellow Roadie. Today, I arrived at the Minneapolis airport, and there Delta and United rule. My companion, Pat Cox, was traveling on Delta back to Florida, so I thought I would see if my platinum card would get us into the Delta lounge. Turns out it would, but only if I was on Delta. I was getting ready to limp away to seek some other place of solace for a few hours when a fellow Road Warrior behind me said, “He is my guest.”
The lady behind the counter said, “That’s fine, but you can only have one guest.” Then the next gentleman looked at Pat in his Hawaiian shirt and flip-flops and said, “He is my guest.” The lady at the counter smiled, knowing she was faced with the Code of the Road Warrior, and let us in.
You have to understand that Pat is nowhere close to being a Road Warrior. He agrees with cyberpunk sci-fi author William Gibson that “Travel is a meat thing.” He indulged me for this trip. I will admit to being meat. I like to meet meat face to face when I can.
So Pat was somewhat puzzled, and he turned to our two benefactors and asked, “Do you know him?” (referring to me). Pat assumed they had recognized me, which sometimes does happen in odd places. But no, they had no idea. I told him I would explain the Code of the Road Warrior to him when we sat down, and everyone grinned at Pat’s astonishment over a random act of kindness. So we said thank you to our Warrior friends, whom we will likely never meet again, and entered into the inner sanctum. With electrical outlets.
The Road can be lonely, but many of us share that space. If you are one of us, then make sure you obey the Code. Someday, it will bring help to you, too. And as I write this, my AA travel companion on the flight back, an exec who runs a large insurance company, who was trying to figure out what the heck today’s court ruling might do to the 70,000 subsidized policies they sold, noticed I did not have the right connection and dug through his bag and found the right plug for me. It’s a Code thing. I knew him only as Ken, and he knew me as John. We then both hunched over our computers and worked.
Have a great week. And maybe commit a random act of kindness, even if you are not on The Road.
Your smiling as he writes analyst,
John Mauldin, Editor
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Geopolitics and markets; red flags raised by the Fed and the BIS on risk-taking

Michael Cembalest, J.P. Morgan Asset Management
Eye on the Market, July 21, 2014
You can be forgiven for thinking that the world is a pretty terrible place right now: the downing of a Malaysian jetliner in eastern Ukraine and escalating sanctions against Russia, the Israeli invasion of Gaza, renewed fighting in Libya, civil wars in Syria, Afghanistan, Iraq and Somalia, Islamist insurgencies in Nigeria and Mali, ongoing post-election chaos in Kenya, violent conflicts in Pakistan, Sudan and Yemen, assorted mayhem in central Africa, and the situation in North Korea, described in a 2014 United Nations Human Rights report as having no parallel in the contemporary world. Only in Colombia does it look like a multi- decade conflict is finally staggering to its end. For investors, strange as it might seem, such conflicts are not affecting the world’s largest equity markets very much. Perhaps this reflects the small footprint of war zone countries within the global capital markets and global economy, other than through oil production.

The limited market impact of geopolitics is nothing new. This is a broad generalization, but since 1950, with the exception of the Israeli-Arab war of 1973 (which led to a Saudi oil embargo against the US and a quadrupling of oil prices), military confrontations did not have a lasting medium-term impact on US equity markets. In the charts below, we look at US equities before and after the inception of each conflict in three different eras since 1950. The business cycle has been an overwhelmingly more important factor for investors to follow than war, which is why we spend so much more time on the former (and which is covered in the latter half of this note).
As for the war-zone countries of today, one can only pray that things will eventually improve. Seventy years ago as the invasion of Normandy began, Europe was mired in the most lethal war in human history; the notion of a better day arising out of misery is not outside the realm of possibility.
Soviet invasions of Hungary and Czechoslovakia did not lead to a severe market reaction, nor did the outbreak of the Korean War or the Arab-Israeli Six-Day War.
We did not include the US-Vietnam war, since it’s hard to pinpoint when it began. One could argue that Vietnam-era deficit spending eventually led to rising inflation (from 3% in 1967 to 5% in 1970), a rise in the Fed Funds rate from 5% in 1968 to 9% in 1969, and a US equity market decline in 1969-1970 (this decline shows up at the tail end of the S&P series showing the impact of the Soviet invasion of Czechoslovakia).

The Arab-Israeli war of 1973 led to an oil embargo and an energy crisis in the US, all of which contributed to inflation, a severe recession and a sharp equity market decline. Pre-existing wage and price controls made the situation worse, but the war/embargo played a large role. Separately, markets were not adversely affected by the Falklands War, martial law in Poland, the Soviet war in Afghanistan, or US invasions of Grenada or Panama. The market decline in 1981 was more closely related to a double-dip US recession and the anti-inflation policies of the Volcker Fed.

Equity market reactions to US invasions of Kuwait and Iraq, and the Serbian invasion of Kosovo, were mild. There was a sharp market decline after the September 11th attacks, but it reversed within weeks. The subsequent market decline in 2002 was arguably more about the continued unraveling of the technology bust than about aftershocks from the Sept 11th attacks and Afghan War. As for North Korea, in a Nov 2010 EoTM we outlined how after North Korean missile launches, naval clashes and nuclear tests, South Korean equities typically recover within a few weeks.

Prophet warnings. So far, the year is turning out more or less as we expected in January: almost everything has risen in single digits (US, European and Emerging Markets stocks, fixed-rate and inflation linked government bonds, high grade and high yield corporate bonds, and commodities). What made last week notable: concerns from the Fed and the Bank for International Settlements (a global central banking organization) regarding market valuations. The BIS hit investors with a 2-by-4, stating that “it is hard to avoid the sense of a puzzling disconnect between the market’s buoyancy and underlying economic developments globally”. The Fed also weighed in, referring to “substantially stretched valuations” of biotech and internet stocks in its Monetary Policy Report submitted to Congress. What should one make of these prophet warnings?
Let’s put aside the irony of Central Banks expressing concern about whether their policies are contributing to aggressive risk-taking. They know they do, and relied on such an outcome when crafting monetary policy post-2008. Instead, let’s look at measures of profits and how markets are valuing them.           The first chart shows how P/E multiples have risen in recent months, including in the Emerging Markets. The second chart shows valuations on internet and biotech stocks referred to in the Fed’s Congressional submission. The third chart shows forward and median multiples, an important complement to traditional market-cap based multiples.

Are these valuations too high? Triangulating the various measures, US valuations are close to their peaks of prior mid-cycle periods (ignoring the collective lapse of judgment during the dot-com era). We see the same general pattern in small cap. On internet and biotech, valuations have begun to creep up again after February’s correction, and I would agree that investors are paying a LOT of money for the presumption that internet/biotech revenue growth is “secular” and less explicitly linked to overall economic growth.
As a result, we believe earnings growth is needed to drive equity markets higher from here. On this point, we see the glass half-full, at least in the US. After a poor Q1 and a partial rebound in Q2, US data are improving such that we expect to see the elusive 3% growth quarter this year (only 6 of 20 quarters since Q2 2009 have exceeded 3%). With new orders rising and inventories down, the stage is set for an improvement. Other confirming data: vehicle sales, broad-based employment gains, hours worked, manufacturing surveys, homebuilder surveys, a rise in consumer credit, capital spending, etc. If we get a growth rebound, the profits impact could be meaningful. The second chart shows base and incremental profit margins. Incremental margins measure the degree to which additional top-line sales contribute to profits. After mediocre profits growth of 5%-7% in 2012/2013, we could see faster profits growth later this year. With 83 companies reporting so far, Q2 S&P 500 earnings are up 9% vs. 2013.

Accelerated monetary tightening could derail interest-rate sensitive sectors of the economy, so we’re watching the Fed along with everybody else. Perhaps it’s a reflection of today's circumstances, but like Bernanke before her, Yellen appears to see the late 1930s as a huge policy fiasco: when premature monetary and fiscal tightening threw the US back into recession. That’s what Yellen's testimony last week brings to mind: she gave a cautious outlook, cited "mixed signals" and previous "false dawns", and downplayed the decline in unemployment and recent rise in inflation. In other words, she’s prepared to wait until the US expansion is indisputably in place before tightening.
An important sub-plot for the Fed: where are all the discouraged workers? For Fed policy to remain easy, as the economy improves, the pace of unemployment declines will have to slow and wage inflation will have to remain in check. The Fed believes discouraged workers will re-enter the labor force in large numbers, holding down wage inflation. Fed skeptics point out that so far, labor participation rates have not risen, creating the risk of inflation sooner than the Fed thinks. It’s all about the “others” in the chart, since disabled and retired persons rarely return to work. If “others” come back, it would show that there hasn’t been a structural decline in the pool of available workers. The Fed believes they will eventually return, and so do we.


Germany and France are slowing; not catastrophically, but by more than markets were expecting. This has contributed to a decline in European earnings expectations for the year. As shown on page 2, Europe was priced for a return to normalcy, and with inflation across most of the Eurozone converging to 1%, things are decidedly not that normal. Markets are not priced for any negative surprises, which is why an issue with a single Portuguese bank contributed to a sharp decline in banks stocks across the entire region.

Emerging Markets

The surprise of the year, if there is one, is how emerging markets equities have rebounded. As we wrote in March 2014, the history of EM equities shows that after substantial currency declines, industrial activity often stabilizes. Around that same time, we often see equity markets stabilize as well, even before visible improvements in growth, inflation and exports. This pattern appears to be playing itself again: the 4 EM Big Debtor countries (Brazil, India, Indonesia and Turkey) have experienced equity market rallies of 20%+ despite modest improvement in economic data (actually, things are still getting worse in Brazil and Turkey).

There’s also some good news on the EM policy front. In Mexico, it appears that the oil and natural gas sector is being opened up after a 25% decline in oil production since 2004. This would effectively end the 75-year monopoly that Pemex has over oil production. Other energy–related positives: Mexico has shifted the bulk of its electricity reliance from oil to cheaper natural gas over the last decade, giving it low electricity costs along with its competitive labor costs. Factoring in new energy investment, new telecommunications and media projects opened to foreign investment and support from both private and public credit, we can envision a 2% boost to Mexico’s GDP growth rate in the years ahead. This can not come soon enough for Mexico: casualties in its drug war rival some of the war zone countries on page 1.
Now for the challenges. Brazil has bigger problems right now than its mauling at the World Cup. With goods exports, manufacturing and industrial confidence slowing and wage/price inflation rising, Brazil is about to experience a modest bout of stagflation. Markets don’t appear to care (yet).

As for China, growth has stabilized (7%-8% in Q2) but we should be under no illusion as to why: credit growth is rising again. China ranks at the top of list of countries in terms of corporate debt/GDP. I don’t know what the breaking point is, but we’re a long way from pre-crisis China when GDP growth was organically driven and less reliant on expansion of household and corporate debt1. There’s some good news regarding the composition of growth: investment is slowing in manufacturing and real estate, and increasing in infrastructure; and while capital goods imports are flat, consumer goods imports are rising, suggesting a modest transition to more consumer-led growth. But for investors, the debt overhang of state-owned enterprises and its impact on the economy is the dominant story to watch. That explains why Chinese equity valuations are among the lowest of EM countries (only Russia is lower; for more on its re- militarization, economy and natural gas relations with Europe, see “Eye on the Russians”, April 29, 2014).

On a global basis, demand and inventory trends suggest a pick-up in economic activity in the second half of the year. If so, our high single digit forecast for 2014 equity market returns should be able to withstand the onset of (eventually) tighter monetary policy in the US. The ongoing M&A boom probably won’t hurt either.
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July 15, 2014

Outside the Box: Poverty Matters for Capitalists

By John Mauldin

Having taken Thomas Piketty to the cleaners a few weeks back (see “Gave & Gave … and Hay”), Charles Gave now redresses the balance with regard to the issue of economic inequality in today’s Outside the Box. He makes a forceful case that “poverty matters for capitalists”:
Every US recession that I can recall was preceded by a fall in long rates, and I doubt the next will be much different. As such, do not expect the next US downturn to arise from the Federal Reserve pushing rates higher, an overvalued dollar or even mal-investments. Expect it to result from a decline in the income of the working poor. Early warning signs are likely to show up in the shopping aisles of stores such as Walmart, average driving miles, and the price of houses at the cheaper end of the market. I suspect the lesson that will eventually be learnt is that in a modern industrialized economy there are few worse things a central bank can do than deliberately attack the spending power of the poor.
Charles is clearly tying the economic struggle of the working poor to Federal Reserve policy. As he says, “negative real rates amounts to the Fed imposing a regressive tax on the poor although it lacks the authority to collect taxes.”
Income decline among the least wealthy in US society is not just an economic issue, he asserts:
At a moral level, I would also question the validity of a system that no longer allows its weakest members to get by. This is why I contend that the post-2010 policy of ZIRP has had little to do with protecting the health of the capitalist system, but rather has been a ruse to protect the rich. The policy is not only failing to deliver growth, it is also immoral.
And that income decline has been drastic since 2000, and particularly since 2010. Charles has created what he calls a “Walmart CPI,” which tracks the prices of rent, food, and energy (the things the poor must spend nearly all their income on); and he uses it to demonstrate the effects of negative real rates on the poor. Since 2000 there has been more than a 15% increase in the ratio of the Walmart CPI to standard US CPI.
We can expect this deadly combination of rising prices for necessities and declining incomes to affect the stock market, too, says Charles:
Pretty much every equity bear market in the US over the last 30 years has occurred against the backdrop of the working poor experiencing a decline in living standards (the one exception was 1987 when the market was reacting to over valuation).
Strong stuff. But that’s Charles: never afraid to tell it like he sees it.
I am preparing to leave for Nantucket in a few hours, and I’m looking forward to the trip. I’ve never been there; and not only are my hosts providing very pleasant accommodations along the waterfront, they have also conveniently arranged for the weather to be nearly perfect. I have an iPad full of books that are all begging to be read, and of course a weekly letter will have to be teased out of my computer sometime in the next few days.
Wrapping up, two significant items hit my inbox this morning, including one from Andrew McCreath, who is a host for BNN in Canada. He uses data from my friend Bill Dunkelberg, Chief Economist of the National Federation of Independent Business (who will be visiting me in a few weeks here in Dallas), showing the correlation between certain aspects of the NFIB survey and wages. It will be good news for workers if wage hikes are in the offing, but that means that margins in businesses, which are sky-high right now, will come under pressure. This also plays well into Rosie’s (David Rosenberg’s) theme that we are going to see wage inflation soon, which he visualizes in interestingsa charts. Will this trend finally lead to some talk of interest rate increases? And yet I am told that Ben Bernanke, in his $250,000 speeches, is saying that we will not see much higher rates in his LIFETIME.

Maybe Ben (who is still young enough that “his lifetime” means a VERY long time) was reading David Kotok’s latest note this morning, as David worries a few trout in Wyoming:
Gasoline prices have reached levels that (1) will be sustained for a while in all likelihood and (2) that are, in real terms, equivalent to levels that previously led to economic slowdowns in the US. This development prompted our exit from [an overweight position in the Energy] sector.
In a compelling study, Ned Davis Research examined the real price of gasoline, adjusted for the inflation rate, and its economic impacts. The inflation-adjusted price of gasoline today has reached levels that have historically throttled growth. Furthermore, the Ned Davis study finds that a higher price for gasoline would be the equivalent of a major shock. The research suggests that under either circumstance – current gas prices or prices that surge even higher – the weight on the economy from that adjustment is onerous.
And I just can’t close without this brief, ironic comment. Readers may know that I have neighbors who question my Texas ancestry (which goes back to the Republic, thank you) because I don’t own any guns. I am perfectly content for my friends to have lots of them and feel gun ownership is one of those sacred rights, but I have just never been motivated to build a bunker with an arms locker, or even possess a small pistol. For whatever reason, I feel perfectly safe without one.
With that admission (which some will applaud and others see as a glaring lapse of character), I note that over the 4th of July weekend, there were 82 people shot, 14 fatally, in Chicago.
I read elsewhere that Houston had six shot and two dead over that same period. Chicago, the third-largest city in the US, has no places where you can legally buy a gun. Houston, the fourth-largest US city, has over 500 (including Walmarts, etc., which are not listed as gun stores per se but have rather extensive offerings). Not sure what that means, but you have to wonder.
Have a great week. And enjoy your summer! I know most farmers are, as the weather is perfect for growing all sorts of crops, which look to produce record yields in the US this year.
Your going to be reading about GDP this week analyst,
John Mauldin, Editor
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Poverty Matters for Capitalists

By Charles Gave
GaveKal Dragonomics
July 8, 2014
Inflation is a much misunderstood phenomenon. Most people assume that a CPI rate of 10% means that most prices are rising by a similar amount. In reality, some prices may be falling even while others soar. This matters because price variations affect socio-economic groups in very different ways. The rich tend not to be impacted unduly by price hikes for “necessities” such as food, rent and fuel, while the impact on the poor is to slash that portion of their income left over for discretionary spending.
A sharp rise in the price of staples imposes an effective tax on low earners, resulting in recession conditions for firms that sell to them. The broad picture in the US may be of low interest rates and rising real average incomes, but the poor have seen their real incomes slashed since 2008 and with scant subsequent improvement. The poor also own few assets. Aside from the inequity of such a situation, the macro concern is that the erosion of real incomes creeps up the earning scale so that middle earners eventually see an erosion of living standards. At some point, the decline in activity created by a fall in average incomes will lead to a recession.
I have tested this postulate by building a US inflation index comprised of price variations for oil, food and rent. This can be seen in the chart below where rent is weighted at 50%, food at 30% and energy at 20%. I term this price measure the Walmart Index since it is where most low earners tend to shop. The chart shows the relationship since 1934 between the US CPI and my adapted measure of the price index most relevant to the lives of the least well-off in America.

There is a clear relationship between periods of rising prices for essential items and negative real rates. Such a policy undermines the dollar as a store of value. As a result, investors seek alternatives such as gold, oil and agricultural land (see The High Cost Of Free Money). Boiled down, the impact for low earners is an abnormal rise of the Walmart CPI vs the US CPI. Put another way, negative real rates amounts to the Fed imposing a regressive tax on the poor although it lacks the authority to collect taxes.

The chart below shows the impact of this effective tax hike on household incomes. The actual income of the low income group varies more when measured against the price of necessities rather than the broad CPI.

Looking back, it is clear that America’s working poor did pretty well between 1982 and 2000, and had a bad time in the ensuing period, when real interest rates have, for the most part, been negative.

Next, consider the “acceleration phenomenon”, which we have often used to explain the non-linear dynamics of consumption. We have mostly used this tool to show spending in developing economies experiencing real income growth. Sadly, we now apply the method to the US under reversed conditions. The framework begins with the observation that the propensity to spend on certain goods does not rise smoothly with income, but moves in steps: households just above a certain income threshold are much more likely to buy say, a car, than households just below it; hence the notion of “acceleration”. Our thesis is that significant sections of the US population have stopped consuming certain bigger ticket items. For illustration, the chart below shows the likely impact of a 25% fall in average incomes.

The economic impact

The chart below shows a worrying relationship between the standard of living, as measured by the Walmart CPI, and US recessions.

Going back to 1970 each time the lower income group of Americans experienced a fall in their standard of living for two years or more, the period ended with a recession. This is the inevitable arithmetical outcome from pursuing policies which crimp the incomes of that population cohort most inclined to spend what they earn. At a moral level, I would also question the validity of a system that no longer allows its weakest members to get by. This is why I contend that the post-2010 policy of ZIRP has had little to do with protecting the health of the capitalist system, but rather has been a ruse to protect the rich. The policy is not only failing to deliver growth, it is also immoral.

The stock market impact

Pretty much every equity bear market in the US over the last 30 years has occurred against the backdrop of the working poor experiencing a decline in living standards (the one exception was 1987 when the market was reacting to over valuation).


Every US recession that I can recall was preceded by a fall in long rates and I doubt the next will be much different. As such, do not expect the next US downturn to arise from the Federal Reserve pushing rates higher, an overvalued dollar or even mal-investments. Expect it to result from a decline in the income of the working poor. Early warning signs are likely to show up in the shopping isles of stores such as Walmart, average driving miles, and the price of houses at the cheaper end of the market. I suspect the lesson that will eventually be learnt is that in a modern industrialized economy there are few worse things a central bank can do than deliberately attack the spending power of the poor.
Given the Fed’s asinine policy stance, at least since 2002, it seems likely that the prices of discretionary items bought by the least well off are likely to slip into a protracted decline. Hence, the deflationary tendencies that have been visible for some years are likely to explode during the process of a deflationary contraction. The fact that the price of oil, gas and rents has continued to rise only hardens my conviction in this view.
I make no claim on the timing of this outcome. But the end game for this cycle is surely for US long rates to decline and quality spreads to open massively. My advice would be to maintain a deflation hedge in all portfolios, improve liquidity and boost the quality of both bond and equity holdings.
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July 9, 2014

Thoughts from the Frontline: Central Bank Smackdown

By John Mauldin

Smackdown: smack·down, ˈsmakˌdoun/, noun, US informal
1.  a bitter contest or confrontation.
"the age-old man versus Nature smackdown"
2.  a decisive or humiliating defeat or setback.
The term “smackdown” was first used by professional wrestler Dwayne Johnson (AKA The Rock) in 1997. Ten years later its use had become so ubiquitous that Merriam-Webster felt compelled to add it to their lexicon. It may be Dwayne Johnson’s enduring contribution to Western civilization, notwithstanding and apart from his roles in The Fast and The Furious movie series. All that said, it is quite the useful word for talking about confrontations that are more for show than actual physical altercations.
And so it is that on a beautiful July 4 weekend we will amuse ourselves by contemplating the serious smackdown that central bankers are visiting upon each other. If the ramifications of their antics were not so serious, they would actually be quite amusing. This week’s shorter than usual letter will explore the implications of the contretemps among the world’s central bankers and take a little dive into yesterday’s generally positive employment report.
BIS: The Opening Riposte
The opening riposte came from the Bank for International Settlements, the “bank for central banks.” In their annual report, released this week, they talked about “euphoric” financial markets that have become detached from reality. They clearly – clearly in central banker-speak, that is – fingered the culprit as the ultralow monetary policies being pursued around the world. These are creating capital markets that are “extraordinarily buoyant.”
The report opens with this line: “A new policy compass is needed to help the global economy step out of the shadow of the Great Financial Crisis. This will involve adjustments to the current policy mix and to policy frameworks with the aim of restoring sustainable and balanced economic growth.”
The Financial Times weighed in with this summary: “Leading central banks should not fall into the trap of raising rates ‘too slowly and too late,’ the BIS said, calling for policy makers to halt the steady rise in debt burdens around the world and embark on reforms to boost productivity. In its annual report, the BIS also warned of the risks brewing in emerging markets, setting out early warning indicators of possible banking crises in a number of jurisdictions, including most notably China.”
“The risk of normalizing too late and too gradually should not be underestimated,” the BIS said in a follow-up statement on Sunday. “Particularly for countries in the late stages of financial booms, the trade-off is now between the risk of bringing forward the downward leg of the cycle and that of suffering a bigger bust later on,” the BIS report said.
The Financial Times noted that the BIS “has been a longstanding sceptic about the benefits of ultra-stimulative monetary and fiscal policies, and its latest intervention reflects mounting concern that the rebound in capital markets and real estate is built on fragile foundations.”
The New York Times delved further into the story:
There is a disappointing element of déjà vu in all this,” Claudio Borio, head of the monetary and economic department at the BIS, said in an interview ahead of Sunday’s release of the report. He described the report “as a call to action.”
The organization said governments should do more to improve the performance of their economies, such as reducing restrictions on hiring and firing. The report also urged banks to raise more capital as a cushion against risk and to speed efforts to deal with past problems. Countries that are growing quickly, like some emerging markets, must be alert to the danger of overheating, the group said.
The signs of financial imbalances are there,” Mr. Borio said. “That’s why we are emphasizing it is important to take further action while the time is still there.”
The B.I.S. report said debt levels in many emerging markets, as well as Switzerland, “are well above the threshold that indicates potential trouble.” (Source: New York Times)
Casual observers will be forgiven if they come away with the impression that the BIS document was seriously influenced by supply-siders and Austrian economists. Someone at the Bank for International Settlements seems to have channeled their inner Hayek. They pointed out that despite the easy monetary policies around the world, investment has remained weak and productivity growth has stagnated. There is even talk of secular (that is, chronic) stagnation. They talk about the need for further capitalization of many banks (which can be read, of European banks). They decry the rise of public and private debt.
Read this from their webpage introduction to the report:
To return to sustainable and balanced growth, policies need to go beyond their traditional focus on the business cycle and take a longer-term perspective – one in which the financial cycle takes centre stage. They need to address head-on the structural deficiencies and resource misallocations masked by strong financial booms and revealed only in the subsequent busts. The only source of lasting prosperity is a stronger supply side. It is essential to move away from debt as the main engine of growth.
“Good policy is less a question of seeking to pump up growth at all costs than of removing the obstacles that hold it back,” the BIS argued in the report, saying the recent upturn in the global economy offers a precious opportunity for reform and that policy needs to become more symmetrical in responding to both booms and busts.
Does “responding to both booms and busts” sound like any central bank in a country near you? No, I thought not. I will admit to being something of a hometown boy. I pull for the local teams and cheered on the US soccer team. But given the chance, based on this BIS document, I would replace my hometown team – the US Federal Reserve High Flyers – with the team from the Bank for International Settlements in Basel in a heartbeat. These guys (almost) restore my faith in the economics profession. It seems there is a bastion of understanding out there, beyond the halls of American academia. Just saying…
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

June 26, 2014

Outside the Box: The Four Horsemen of the Geopolitical Apocalypse

By John Mauldin

Ian Bremmer, NYU professor and head of the geopolitical consulting powerhouse Eurasia Group, consults at the highest levels with both governments and companies because he brings to the table robust geopolitical analysis and a compelling thesis: that we are witnessing “the creative destruction of the old geopolitical order.” We live, as his last book told us, in a “G-0” world. In today’s Outside the Box, Ian spells out what that creative destruction means in terms of events on the ground today. As Ian notes, the most prominent feature of the international landscape this year has been the expansion of geopolitical conflict. That expansion is gaining momentum, he says, creating larger-scale crises and sharpening market volatility.
Hold on to the reins now as Ian take us for a ride with the “Four Horsemen of the Geopolitical Apocalypse.” (For more information about the Eurasia Group or to contact Ian Bremmer, please email Kim Tran at
We’ll follow up Ian’s piece with an excellent short analysis of the Iraq situation from a Middle East expert at a large hedge fund I correspond with. Pretty straightforward take on the situation with regard to ISIS. This quagmire has real implications for the world oil supply. (It appears that the Sunni rebel forces are now in complete control of the key Baiji Refinery, which produces a third of Iraq’s output.)
Back in Dallas, it’s a little hard to focus on geopolitical events when seemingly all the news is about ongoing domestic crises. But the outrageous IRS loss of emails doesn’t really affect our portfolios all that much. What happens in Iraq or with China does. There’s just not the emotional impact.
One domestic humanitarian crisis that is brewing just south of me is the massive influx of very young children across the US-Mexican border. When this was first brought to my attention a few weeks ago, I must admit that I questioned the credibility of the source. We have had young children walking across the Texas border for decades but always in rather small numbers. The first source I read said that 40,000 had already come over this year. I just found that to be non-credible, but then with a little reasonable research it not only became believable but could be a bit low – it looks as many as 90,000 children will cross the border this year.
What in the name of the Wide Wide World of Sports is going on? First of all, how do you cover up something of this magnitude until it is a true crisis? When the administration and other authorities clearly knew about it last year? (The evidence is irrefutable. They knew.)
I am the father of five adopted children. In an earlier phase of my life, I was somewhat involved with Child Protective Services here in Texas. It was an emotionally difficult and heartrending experience. (One of my children came out of that system and three from outside of the United States). I have no idea how you care for 90,000 children who don’t speak the language and have no connection to their new locale. Forget the dollar cost, which could run into the tens of billions over time. These are children, and they are on our doorstep and our watch. You simply can’t ignore them and say, “They are not supposed to be here, so it’s not our responsibility.” They are children. Someone, and that means here in the US, is going to have to figure out how to take care of them, even if it is only to learn why they try to come and figure out where to send them back to. And frankly, trying to to send them back is going to be a logistical and legal nightmare, not to mention psychologically traumatic to the children.
Maybe someone thought that waiting until there was a crisis to let this information slip out (and we found out about it because of photos posted anonymously of children packed together in holding cells) would create momentum for immigration reform. And they may be right. But I’m not certain it’s going to result in the type of immigration reform they were hoping to get.
I have to admit that I’ve been rather tolerant of illegal immigrants over the course of my life. There are a dozen or so key issues that I think this country should focus on, but I’ve just never gotten that worked up about illegal immigration. The simple fact is that everyone here in the US is either an immigrant or descended from immigrants. It may be, too, that I’ve hired a few undocumented workers here and there in my life. As an economist, I know that we should be trying to figure out how to get more capable immigrants here, not less. What you want are educated young people who are motivated to create and work, not children as young as four or five years old who are going to need housing, education, adult supervision, healthcare, and most of all a loving environment where they can grow up.
It is one thing for undocumented workers to come across the border looking for jobs or for families to come across together. It is a completely different matter when tens of thousands of preteen children come across the border without parents or supervision. They didn’t get across 1500 miles of desert without significant support and a great deal of planning. This couldn’t be happening without the awareness of authorities in Mexico and the Central American countries from which these children come, and if this is truly a surprise to Homeland Security, then there is a significant failure somewhere in the system.
And if it was not a surprise? That begs a whole different series of questions.
This is a major humanitarian crisis, and it is not in the Middle East or Africa. It is on our border, and we need to figure out what to do about it NOW!
I don’t care whether you think we need to build a 20-foot-high wall across the southern border of the United States or give amnesty to anyone who wants to come in (or both), something has to be done with these children. It is a staggering problem of enormous logistical proportions, and we have a simple human responsibility to take care of those who cannot take care of themselves.
And on that note I will go ahead and hit the send button, and let’s focus on the critical geopolitical events happening around the globe. Iraq is a disaster. Ukraine is a crisis. What’s happening in the China Sea is troubling. It just seems to come at you from everywhere. Even on a beautiful summer day.
Your stunned by the magnitude of it all at analyst,
John Mauldin, Editor
Outside the Box

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(From Ian Bremmer)

dear john,
we're halfway through 2014, and the single most notable feature of the international landscape has been the expansion of geopolitical conflict. why should we care? what's the impact; what does it mean for the global economy? how should we think about geopolitics?
my thoughts on the topic, looking at the four key geopolitical pieces "in play"–in eurasia, the middle east, asia, and the transatlantic.


i've written for several years about the root causes of the geopolitical instability the world is presently experiencing. a new, g-zero world where the united states is less interested in providing global leadership and nobody else is willing or able to step into that role. that primary leadership vacuum is set against a context of competing foreign policy priorities from increasingly powerful emerging markets (with very different political and economic systems) and a germany-led europe; challenges to the international system from a revisionist russia in decline; and difficulties in coordination from a proliferation of relevant state and non-state actors even when interests are aligned. all of this has stirred tensions in the aftermath of the financial crisis: instability across the middle east after a stillborn arab spring; a three-year syrian civil war; a failed russia "reset"; rising conflict between china and japan; fraying american alliances with countries like brazil, germany, and saudi arabia.
and yet geopolitical concerns haven't particularly changed our views on global markets. each conflict has been small and self-contained (or the spillover wasn't perceived to matter much). geopolitics has been troubling on the margins but not worth more than a fret.
that's about to change. though perceived as discrete events, the rise of these geopolitical tensions are all directly linked to the creative destruction of the old geopolitical order. it's a process that's gaining momentum, creating in turn larger-scale crises and broader market volatility. we've now reached the point where near- to mid-term outcomes of several geopolitical conflicts could become major drivers of the global economy. that's true of russia/ukraine, iraq, the east and south china seas and us/europe. in each, the status quo is unsustainable (though for very different reasons). and so, as it were, the four horsemen of the geopolitical apocalypse.


the prospect of losing ukraine was the last straw for a russian government that has been steadily losing geopolitical influence since the collapse of the soviet union over two decades ago. moscow sees nato enlargement, expanded european economic integration, energy diversification and the energy revolution as direct security threats that need to be countered. ukraine is also an opportunity for the kremlin...for president putin to invigorate a flagging support base at home.
putin intends to raise the economic and military pressure on kiev until, at a minimum, southeast ukraine is effectively under russian control. the ukrainian government's latest effort in response, a unilateral week-long cease fire in the southeast, was greeted with lukewarm rhetoric by putin and rejected by russian separatists in the region, who escalated their attacks against the ukrainian military. meanwhile, thousands of russian troops recently pulled back from the ukrainian border have now been redeployed there, bolstered by putin ordering 65,000 russian troops on combat alert in the region.
the choices for kiev are thankless. if they press further, violence intensifies and russian support expands, either routing the ukrainian military, or taking serious losses and requiring direct "formal" intervention of russian troops. if they back off, they lose the southeast, which is critical for their internal legitimacy from the ukrainian population at large. all the while the ukrainian economy teeters with much of their industrial base off line, compounded by russian disruptions on customs, trade, and gas supply.
the growing conflict will lead to further deterioration of russia's relationship with the united states and europe: gas flow disruptions, expansion of defense spending and nato coordination with poland and the baltic states, turbulence around moldova and georgia given their european association agreements this week...and "level 3" sectoral sanctions against russia. that in turn means a serious economic downturn in russia itself...and knock-on economic implications for europe, which has far greater exposure to russia than the united states does.
for the last several years, the major market concern for europe was economic: the potential for collapse of the eurozone. that's no longer a worry. the primary risk to europe is now clearly geopolitical, that expanded russia/ukraine conflict hurts europe, in worst case pushing the continent back into recession.


like so much of the world's colonial legacy, many of the middle east's borders only "worked" because of the combination of secular authoritarian rule and international military and economic support. that was certainly true of iraq–most recently under decades of control by the baath party, beginning in 1963. saddam hussein's ouster forty years later by the united states and great britain, combined with the dismantling of nearly all of the military and political architecture that supported him (in dramatic contrast to, say, the ouster of egypt's hosni mubarak) undermined iraq's territorial integrity. since then, iraqi governance could still nominally function given significant american military presence and military and economic aid. once that was removed, there was little left to keep iraq functioning as a country.
sectarianism is the primary form of allegiance in iraq today, both limiting the reach of prime minister nouri al maliki's majority shia government and creating closer ties between iraq's sunni, shia and kurdish populations and their brethren outside iraq's borders. extremism within iraq has also grown dramatically as a consequence, particularly among the now disenfranchised sunni population--made worse by their heavy losses in the war against bashar assad across the largely undefended border with syria. the tipping point came with the broad attacks by the islamic state of iraq and syria (isis) over the past fortnight, speeding up a decade-long expansion of sectarian violence and ethnic cleansing between iraq's sunni and shia. the comparatively wealthy and politically stable kurds have done their best to steer clear of the troubles, seizing a long-sought opportunity for de facto independence.
the american response has been cautious. domestic support for military engagement in iraq diminished greatly as the war in iraq continued and the economic and human costs mounted. obama repeatedly promised an end to the occupation and considered full withdrawal a major achievement of his administration. there's little domestic upside for taking responsibility in the crisis. obama's position has accordingly been that any direct military involvement requires a change in governance from the iraqis--initially sounding like a unity government and increasingly evolving into the replacement of prime minister maliki. the pressure on maliki has gained momentum with shia grand ayatollah ali al-sistani calling on the iraqi prime minister to broaden the government to include more kurds and sunnis.
but maliki, having successfully fought constitutional crises and assassination attempts, to say nothing of decisively winning a democratic election, is unlikely to go. isis poses a threat to the unity of the iraqi state, but not to maliki's rule of iraq's majority shia population, which if anything now stands stronger than it did before the fighting. and maliki's key international sponsor, iran, has little interest in forcing maliki into compromise as long as there's no threat to baghdad: they see themselves in far better strategic standing with a maliki-led iraqi government where they exert overwhelming influence, than over a broader government where they're one of many competing international forces. further, even if maliki were prepared to truly share power with iraq's kurds and sunni (something made more likely by the informal "influence" of 300 us military advisors now arriving in baghdad), he's unlikely to see much enthusiasm responding to that offer. the kurds are better off sticking to nominal (and a clearer road to eventual formal) independence; and sunni leaders that publicly find common cause with maliki would better hope all their family members aren't anywhere isis can find them.
absent american (or anyone else's) significant military engagement, the iraqi government is unlikely to be able to remove isis from leadership and, accordingly, reassert control over the sunni and kurdish areas of the country. that will lead to a significant increase in extremist violence emanating from the islamic world, a trend that's already deteriorated significantly in recent years (and since obama administration officials announced that cyberattacks were the biggest national security threat to the united states--a claim president obama overturned during his west point speech last month). since 2010, the number of known jihadist fighters has more than doubled; attacks by al qaeda affiliates have tripled.
the combination of challenging economic conditions, sectarian leadership, and the communications revolution empowering individuals through narrowing political and ideological demographic lenses all make this much more likely to expand. that's a greater threat to stability in the poorer middle eastern markets, but also will morph back into a growing terrorist threat against western assets in the region and more broadly. that creates, in turn, demand for increased security spending and bigger concerns about fat tail terrorism in the developed world, particularly in southern and western europe (where large numbers of unintegrated and unemployed islamic populations will pose more of a direct threat).
the broader risk is that sunni/shia conflict metastasizes into a single broader war. isis declares an islamic state across sunni iraq and syria, becoming ground zero for terrorist funding and recruitment from across the region. the saudi government condemns the absence of international engagement in either conflict and directly opposes an increasingly heavy and public iranian hand in iraqi and syrian rule. the united states completes a comprehensive nuclear deal with iran and declares victory (but doesn't work meaningfully with teheran on iraq), steering clear of the growing divide between the middle east's two major powers. the gulf cooperation council starts to fragment as members see opportunity in economic engagements with iran. iranian "advisors" in iraq morph into armed forces; saudi arabia publicly opposes isis, but saudi money and weapons get into their hands and an abundance of informal links pop up. militarization grows between an emboldened iran and a more isolated, defensive saudi arabia. that's when the geopolitical premium around energy prices becomes serious.

east/south china sea

ukraine and iraq are the two major active geopolitical conflicts. but there are two more geopolitical points of tension involving major economies that are becoming significant.
in asia, it's the consequences of (and reactions to) an increasingly powerful and assertive china. the growth of china's influence remains the world's most important geopolitical story by a long margin. but, at least to date, china's growth is mostly an opportunity for the rest of the world. for the middle east, it's the principal new source of energy demand as the united states becomes more energy independent. for africa, it's the best opportunity to build out long-needed infrastructure across the continent. for europe and even the united states, it's a critical source of credit propping up currency, and a core producer of inexpensive goods. that's not to argue that there aren't significant caveats in each of these stories (or that those caveats aren't growing--they are), but rather that overall, china has been primarily perceived as an opportunity rather than a threat for all of these actors, and so it remains today.
for asia, a rising china has been seen more clearly as a double-edged sword. the greater comparative importance of the chinese economy has translated into more political influence (formal and informal) for beijing, at the expense of other governments in the region. meanwhile, china's dramatic military buildup has fundamentally changed the balance of power in asia; it's had negligible interest elsewhere.
china's military assertiveness has also grown in its backyard. in other regions, china continues to promote itself as a poor country that needs to focus on its own development and stability. in east and southeast asia china has core interests that it defends, and it is increasingly willing to challenge the status quo as its influence becomes asymmetrically greater.
that's been most clear with vietnam, where china first sent one oil rig to drill in contested waters directly off vietnam's shore--accompanied by several hundred chinese fishing vessels. they announced last week that they are repositioning four more. unsurprisingly, the vietnamese response has been sharp--anti-chinese demonstrations, violence, increased naval presence in the region, and coordination with the philippines.
none of that creates significant political risk on its own: vietnam isn't an ally of the united states and so engenders less support and response from washington than the philippines or japan...which is precisely why beijing has decided that's the best place to start changing the regional security balance.
but tokyo feels differently. the japanese government understands that a rising china is longer term a much more existential threat to its own security position in asia, and it isn't prepared to wait to raise concern until its position weakens further. so prime minister shinzo abe has declared his security support for vietnam. for america's part, obama has jettisoned the official "pivot" to asia. but the administration continues to believe that america's core national security interests, now and in the future, are in asia; and if china significantly escalates tensions in the east and south china seas, the united states is not likely to sit as idly by as they have on syria or ukraine.
the good news here is that--unlike with the countries driving the tensions in eurasia and the middle east--china has solid political stability and isn't looking for international trouble. but the realities of chinese growth, coupled with strong leadership from japan and (over time) india, along with the persistence of a strong american footprint are contributing to a much more troublesome geopolitical environment in the region.
the principle danger to the markets is what happens if the chinese government no longer holds that perspective. president xi jinping's commitment to transformational economic reform has been strong over the first year of his rule, and he has gotten surprisingly little pushback from the country's entrenched elites. but the uncertainty around china's near- to medium-term trajectory is radically greater than that of any of the world's other major economies. should significant instability emerge in china, very plausible indeed, china's willingness to take on a far more assertive (and risk-acceptant) security strategy in the region, promoting nationalism in the way putin has built his support base of late, would become far more likely. and then, the east and south china seas move to the top of our list.


finally, the transatlantic relationship. advanced industrial economies with consolidated institutions and political stability, there's none of the geopolitical conflict presently visible in the middle east, eurasia, or asia. geopolitical tensions have long been absent from the transatlantic relationship, the great success of the nato alliance. for all the occasional disagreement in europe on us military and security policy both during the cold war and since (the war in iraq, israel/palestine, counterterrorism and the like), european states never considered the need for broader security ties as a counterbalance for nato membership.
but the changing nature of geopolitics is creating a rift between the united states and europe. american global hegemony had security and economic components, and it was collective security that had been the core element holding together the transatlantic alliance. that's no longer the case--a consequence of changing priorities for the americans and europeans, and an evolving world order (russia/ukraine a major blip, but notwithstanding). the transatlantic relationship is much less closely aligned on economics.
it's not the conventional wisdom. most observers say that, after bush, american policy looks more european these days--less militarist, more multilateralist. but actually, us foreign policy isn't becoming more like europe, it's becoming more like china. it's less focused on the military, except on issues of core security concern (in which case the united states acts with little need to consult allies), while american economic policy tends to be unilateralist in supporting preferred american geopolitical outcomes--which is seen most directly in us sanctions behavior (over $15bn in fines now levied against more than 20 international banks--mostly european) and nsa surveillance policy (with no willingness of the us to cooperate in a germany requested "no spying" mutual agreement)
transatlantic economic dissonance is also in evidence in a number of more fundamental ways: america's "growth uber alles" approach to a downturn in the economy, compared to germany's fixation on fiscal accountability. europe's greater alignment between governments and corporations on industrial policy, as opposed to a more decentralized, private-sector led (and occasionally captured) american policy environment. a more economy-driven opportunistic european approach to china, russia and other developing markets; the us government looking focused more on us-led/"universalist" principles on industrial espionage, intellectual property, etc.
as the g-zero persists, we will see the united states looking to enforce more unilateral economic standards that the europeans resent and resist; while the europeans look to other countries more strategically as counterbalances to american economic hegemony (the german-china relationship is critical in this regard, but that's also true of europe's willingness to support american economic policies in russia and the middle east). all of this means a much less cooperative trans-atlantic relationship--less "universalism" (from the american perspective) and less "multilateralism" (from the european perspective). more zero-sumness in the transatlantic relationship is a big change in the geopolitical environment; a precursor to true multipolarity, but in the interim a more fragmented and much less efficient global marketplace.
* * *
so that's where i see geopolitics emerging as a key factor for the global markets--much more than at any time since the end of the cold war. there's some good news and bad news here.
the good news is none of these geopolitical risks are likely to have the sort of market implications that the macro economic risks did after the financial crisis. there are lots of reasons for that. a low interest rate environment and solid growth from the us and china--plus the eurozone out of recession--along with pent up demand for investment is leading to significant optimism that won't be easily cowed by geopolitics. the supply/demand energy story is largely bearish, so near-term geopolitical risks from the middle east won't create sustained high prices. and markets don't know how to price geopolitical risk well; they're not covered as clearly analytically, so investors don't pay as much attention (until/unless they have to).

the bad news...that very lack of pressure from the markets means political leaders won't feel as much need to address these crises even as they expand, particularly in the united states. this is another reason the world's geopolitical crises will persist beyond a level that a similar economic crisis would hit before serious measures start to be taken to mitigate them. these geopolitical factors are going to grow. now's the time to start paying attention to them.
* * *
every once in a while, it's good to take a step back and look at the big picture. hope you found that worthwhile. i'll surely get back in the weeds next monday.
meanwhile, it's looking like a decidedly lovely week in new york.
very best,

From intel sources:

Dislodging ISIS Will Be a Difficult Task

The ISIS advance toward Baghdad may be temporarily held off as the government rallies its remaining security forces and Shia militias organize for the upcoming Battle for Baghdad. There is a rather clear reason why the ISIS leader has renamed himself Abu Bakr al-Baghdadi, meaning the Caliph of Baghdad . ISIS will at a minimum be able to take control of some Sunni neighborhoods in Baghdad shortly and wreak havoc on the city with IEDs, ambushes, single suicide attacks, and suicide assaults that target civilians, the government, security forces, senior members of government, and foreign installations and embassies. Additionally, the brutal sectarian slaughter of Sunni and Shia alike that punctuated the violence in Baghdad from 2005 to 2007 is likely to return as Shia militias and ISIS fighters begin to assert control of neighborhoods and roam the streets.
Even if Iraqi forces are able to keep ISIS from fully taking Baghdad and areas south, it is unlikely the beleaguered military and police forces will be able to retake the areas under ISIS control in the north and west without significant external support, as well as the support of the Kurds.
ISIS and its allies are in a position today that closely resembles the position prior to the US surge back in early 2007. More than 130,000 US troops, partnered with the Sunni Awakening formations and Iraqi security forces numbering in the hundreds of thousands, were required to clear Anbar, Salahaddin, Diyala, Ninewa, Baghdad, and the "triangle of death." The concurrent operations took more than a year, and were supported by the US Air Force, US Army aviation brigades, and US special operations raids that targeted the jihadists’ command and control, training camps, and bases, as well as its IED and suicide bomb factories.
Today, the Iraqis have no US forces on the ground to support them, US air power is absent, the Awakening is scattered and disjointed, and the Iraqi military has been humiliated badly while surrendering or retreating in disarray during the lightning fast jihadists' campaign from Mosul to the outskirts of Baghdad. This campaign, by the way, has been remarkably and significantly faster than the U.S. armored campaign advance to Baghdad in 2003 . The US government has indicated that it will not deploy US soldiers in Iraq, either on the ground or at airbases to conduct air operations.  Meanwhile, significant amounts of US made advanced armaments, vehicles, ammunition, and diverse military equipment have fallen into ISIS jihadists’ hands .
ISIS is advancing boldly in the looming security vacuum left by the collapse of the Iraqi security forces and the West's refusal to recommit forces to stabilize Iraq. This has rendered the country vulnerable to further incursions by al Qaeda-linked jihadists as well as intervention by interested neighbors such as Iran. Overt Iranian intervention in Iraq would likely lead any Sunnis still loyal to the government to side with ISIS and its allies, and would ensure that Iraq would slide even closer to a full-blown civil war and de facto partition, and risk a wider war throughout the Middle East.
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Important Disclosures

June 25, 2014

Things That Make You Go Hmmm: The Slip ‘n’ Fail Mutts

By Grant Williams

Now the news has arrived
From the Valley of Vail
That a Chippendale Mupp has just bitten his tail
Which he does every night before shutting his eyes
Such nipping sounds silly. But, really, it's wise.

He has no alarm clock. So this is the way
He makes sure that he'll wake at the right time of day.
His tail is so long, he won't feel any pain
'Til the nip makes the trip and gets up to his brain.
In exactly eight hours, the Chippendale Mupp
Will, at last, feel the bite and yell "Ouch!" and wake up.
-Dr. Seuss

Theodore Seuss Geisel was a master of anapestic meter.
An anapest is a metrical foot used in poetry which comprises two short syllables, followed by a long one. More familiarly (particularly in the world created by Seuss), it consisted of two unstressed syllables followed by a stressed one:
"Twas the night before Christmas and all through the house..."
Description: euss%20Stamp.psd
Or, in keeping with this week's theme:
"The sun did not shine.
It was too wet to play.
So we sat in the house
All that cold, cold, wet day."
Simple, but at the same time extremely difficult to pull off effectively.
Geisel was an English major at Dartmouth who eventually became the editor-in-chief of the college humor magazine, the Dartmouth Jack O' Lantern; but after being forced by the dean to resign his post after being caught drinking gin in his dorm room, he rather cunningly adopted the nom de plume "Seuss" in order to continue to be able to write for the magazine.
Apparently, nobody at the Ivy League college figured out the identity of the mysterious "Seuss."
When banned from his post for a gin-drinking crime
The scribe picked a name and then bided his time.
In a different guise he remained on the loose
By pretending to be the mysterious "Seuss."
Geisel graduated from Dartmouth and left the USA to pursue a PhD in English literature at Lincoln College, Oxford; but, whilst there, he met a lady named Helen Palmer who persuaded him that he should give up his dream of becoming an English teacher and pursue a career as a cartoonist.
Returning home without a degree but with a fiancée (named Helen Palmer), Geisel found that his drawing ability allowed him to earn a rather handsome living as a cartoonist after he succeeded in getting his first cartoon published in theSaturday Evening Post on July 16, 1927.
Geisel took a job as a writer and illustrator at the humourous magazine Judge in October of 1927, married Palmer a month later, and five months after that, his first work was published and credited simply to "Dr. Seuss."
A successful career as an illustrator allowed Geisel and his wife to travel extensively. According to Geisel himself it was on the journey home from an ocean voyage to Europe that the rhythmic noise of the ship's engines inspired him to write his first book, the anapestically titled And to Think That I Saw It on Mulberry Street.
While at Oxford (in England) a lady supposed
To suggest he choose drawing instead of his prose.
When the young man relented his future unfurled
And he ended up famous all over the world.
And that, Dear Reader, is how Theodore Geisel became Dr. Seuss.
Thirty-five years after the publication of And to Think That I Saw It on Mulberry Street, Seuss wrote The Sleep Book, the brilliant story of a contagious yawn, started by a small bug called Van Vleck, that would lull even the most spirited toddler successfully off to sleep.
On page 32 of The Sleep Book, we are introduced to the Chippendale Mupp, a curious creature with an extraordinarily long tail. The Mupp bites the end of that tail when he goes to sleep every night, and its length ensures that the sensation of pain only reaches him eight hours later, causing him to wake up. It's a brilliant and flawless alarm clock.
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Of course, once the Mupp has bitten his tail, the end result — in this case, a rather nasty, sharp pain — though delayed for quite some time, is assured; and there is nothing he can do about it.
I was discussing the Chippendale Mupp with Steve Diggle recently as we pondered the actions of central banks in recent years and, more specifically, the great inflation/deflation debate that has raged constantly ever since the dawn of QE. As the ECB battles to stave off what looks like deflationary pressures, Japan continues to struggle to generate the promised 2% inflation, and the US continues to pretend to the world that the cost of living from sea to shining sea is rising at just 1.46% per annum, it's abundantly clear to me that the day QE was unleashed into the world was the very same day that the world's central bankers — the Slip 'n' Fail Mutts — bit their own tails.
The pain from that bite is now working its way towards the brain and will, at some point, manifest itself in an almighty "OUCH!" that will wake the entire world; BUT there is one X-factor at this point: none of us knows exactly how long the Slip 'n' Fail Mutts' tail actually is.
We will find out.
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Back in 2012 — July 26th to be precise — Mario Draghi, in a speech at the Global Investment Conference in London, uttered those famous words which put an end to the seismic volatility roiling European debt markets once and for all for the time being:
(Mario Draghi): ...the third point I want to make is in a sense more political.
When people talk about the fragility of the euro and the increasing fragility of the euro, and perhaps the crisis of the euro, very often non-euro area member states or leaders underestimate the amount of political capital that is being invested in the euro.
And so we view this, and I do not think we are unbiased observers, we think the euro is irreversible. And it’s not an empty word now, because I preceded saying exactly what actions have been made, are being made to make it irreversible.
But there is another message I want to tell you.
Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.
Almost instantaneously, the clouds seemed to part, the oceans calmed, and the storm abated — all based on an ephemeral promise from a man under immense pressure who, let's face it, if he was prepared to DO whatever it took, would most certainly SAY whatever it took.
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