Every year, friend-of-the-site David Collum writes a detailed "Year in Review" synopsis full of keen perspective and plenty of wit. This year's is no exception. Moreover, he has graciously selected PeakProsperity.com as the site where it will be published in full. It's quite longer than our usual posts, but worth the time to read in full. A downloadable pdf of the full article is available at the bottom of the post — cheers, Adam
“Dear Cornell students, don’t learn economics from your chemistry professor.”
~ Matt Yglesias, Salon
Every December, I write a Year in Review or, as my wife calls it, my Urine Review.1,2,3,4 It has found a home at Chris Martenson’s website PeakProsperity.com5 with a secondary posting at Zerohedge,6 whose rabid followers crashed the server last year by clicking the crap out of it. What started years ago as a simple summary intended for a couple dozen wingnuts morphed over time into a much more detailed account that accrued upward of 100,000 clicks last year.
Owing to a complete lack of street cred, I’ve got to throw my elevator resume at you right here, right now. I’ve been quoted in the Wall Street Journal on the Flash Crash (no knowledge needed)7 and been interviewed by Lauren Lyster on Capital Accounts (Russia Today),8 Chris Martenson (Peak Prosperity),9,10 and James Howard Kunstler (Kunstlercast).11 I found my way into the Guardian this year commenting on the 2016 presidential race12 and The Macro Tourist Hour on BTFDtv.com just to rant.13 (I’m still waiting for Cosmopolitan to ask for comments about beauty products.) As this review is being uploaded, I am scheduled to do an interview with Erin Ade on Boom Bust (Russia Today), which should be uploaded concurrently on YouTube.14 This fall a bunch of Cornell undergraduates invited me to be a “distinguished lecturer” on economics not chemistry. Apparently, they don’t follow Matt Yglesias on Twitter. With that said, a gallant defense of my honor came by e-mail:
“I can think of no one better than you, Dave, to fill the void of an increasingly undistinguished profession of economists. They have excellent judgment at Cornell.”
~ Stephen Roach, Yale and former executive director at Morgan Stanley
Why would anybody give a damn what an organic chemist thinks about investing, economics, and politics?15 I’m baffled. As a half-hearted defense, in over 34 years of investing with a decidedly lopsided portfolio, I have had only two years in which my total wealth decreased in nominal dollars. My 14-year return since 01/01/00 is 9% compounded with no leverage and no glass eye. (We all made money in the 90’s so I don’t even go there.)
Each review begins with a highly personalized account of my efforts to get through another year of investing, which is followed by an overview of 34 years of investing. I thought maybe I would drop the former, but I couldn’t because one of my two losing years was this year. Come again? You lost money this year? Yep, I’m the guy—an urban legend in the flesh. You cannot teach this kind of prowess. It was a very expensive year to be in the Church of Austrian Economics and Hard Assets. Thus, I must continue with the personal overview as a form of a trip to the confessional. The investing section may be instructive for those interested in my approach and for gold bulls on suicide watch. The bulk of the review, however, describes thoughts and observations—the year’s events told as a narrative. The links are copious, albeit not comprehensive. Some are flagged as highly recommended.
I try to avoid themes covered amply in my previous reviews. I won’t pick on the Roth IRA anymore (although I was right),16 and I’ve left resource depletion alone (it’s still a problem). Nonetheless, some gifts just keep on giving. Debt permeates all levels of society, demanding comment every year. Precious metals are a personal favorite. This year seems to be more about politics and less about economics. Sections entitled Baptists, Bankers, the Federal Reserve, and Bootleggers describe the players involved in the biggest battle since Frodo melted down the ring for beer money. Society is juiced on easy money, leaving some of us breathless. I finish with a book list that shaped my thinking.
Every year I have declared with an increasingly shrill voice now inaudible even to dogs that civil liberties must be protected at all costs and that we all should avoid using “conspiracy” as a pejorative term. Oh…my…God! Just as smartphones have put to rest the existence of Yeti, aliens, and the Loch Ness Monster, 2013 put to rest any claim that conspiracies do not exist. If you denounce conspiracy theories and conspiracy theorists to me, I will remind you of the quote from a 20th century philosopher:
“Everybody has a plan until they get punched in the face.”
~ Mike Tyson
Footnotes appear as superscripts throughout this review; associated hyperlinks can be found here. The contents are as follows:
- The Bear Case
- The Economy
- Broken Markets
- Debt and Retirement
- Municipal Debt
- Student Debt
- Bonds and Sovereign Debt
- Housing the Mortgage Markets
- Rest of the World
- The Fourth Estate
- CNBC–Rise Above
- Bankers and Finance
- Federal Reserve
- Paul Krugman
- Government Gone Wild
- Mr. Obama Goes to Washington
- Civil Liberties Part 1
- Civil Liberties Part 2: Edward Snowden versus the NSA
“People only want to be contrarians when it’s popular.”
~ Rick Rule
I have changed almost nothing consequentially in my portfolio year over year. I still split my retirement contributions into cash and energy equities. Rebalancing was achieved primarily by the brutality of market forces:
Precious metals et al.: 52% 41%
Energy: 15% 21%
Cash equiv (short-term): 30% 34%
Other: 3% 4%
My portfolio was dragged underwater in January by the continuing bear market in precious metals and is now swimming with bottom feeders. In a relatively rare instance, but for the second year in a row, an overall return on investment of -17% was beat by the S&P 500 (22%) and Berkshire Hathaway (28%) in what was not a photo finish. (Stevie Cohen had a better year.) As a reminder, however, for the second year in a row, the majority of the return on the S&P was p/e expansion, and according to Forbes, “More than 100% of equity market gains since January 2009 have taken place during the weeks the Fed purchased Treasury bonds and mortgages.” We’ll return to this risk later.
My precious metals are distributed in approximately three equal portions to the gold-silver holding company Central Fund of Canada (CEF), Fidelity’s precious metal fund (FSAGX), and physical metals. The carnage is amply illustrated with a plot of GLD versus the S&P 500 (Figure 1). Unlike last year when significant metal gains offset losses in the equities, this year they all just tanked with negative returns in gold (–25%), silver (–33%) and precious metal-based equities (–50%). The metal-equity bear market continued unabated, baffling the hard-asset crowd. Did I overstay my welcome in the sector? It’s hard to say with my crystal ball in the shop, but the precious metal market was fascinating this year, and I remain a believer in the secular bull (albeit with white knuckles and wobbly knees; vide infra).
Figure 1. Precious metal-based indices GLD versus S&P.
A basket of Fidelity-based energy and materials funds afforded 14–24%. They are represented emblematically by the XLE spider (19%) and XNG Amex natural gas index (21%) in Figure 2. I am wildly bullish on natural gas for reasons discussed in detail three years ago.3 Not only have the equities become rather perky, but Fidelity finally fired a profoundly underperforming manager in its natural gas fund (FSNGX). I keep adding to an already chunky position. America’s fleet of trucks is starting to transition aggressively to natural gas; that’s illustrative of what may be a global shift toward natural gas that should reward patient investors.
Figure 2. XLE (green) and XNG (red) versus S&P 500 (blue).
Cash was in a U.S. Treasury-backed money-market bunker returning the repressive rate of 0%. To say I am pissed off at the Fed for rendering my hard-earned and diligently saved capital worthless in the open markets because they are providing capital in unlimited quantities would be a grotesque understatement. I don’t have enough venom to heap on the Fed. I could care less what risky horsemeat Bernanke wishes I would buy, more people have been killed reaching for yield than at the point of a gun. Bonds will eventually become the story. Those who are pair trading—long bonds/short brains—will be carried away on boards.
I care deeply at a personal and moral level about my family’s savings rate. It was difficult to assess this year because I went longer real estate with the purchase of a new house (Figure 3) further confounded by some one-off gains. (I’ve invited everybody on Twitter to party on the lake this spring.) If we back out the “items”, even with the last full calendar year of college tuition—spike ball, end zone dance—we were on track to save approximately 22% of my gross income, which compares with a troubling 11% in 2012 and 20–30% in typical years.
Figure 3. View from the new digs.
To understand my lifetime returns, you must understand two unusual premises that have dominated my thoughts and actions. First, you’ve got to be a true believer to resist being shaken out of good investments or suckered into bad ones. You can sell good investments too soon. There are no guarantees out there (for retail investors). My second premise is that you have to get it right only about once a decade. Only time will tell if I over stayed my welcome in the precious metals and missed the beginnings of a secular bull in the S&P 500.
My variant of such a sequential trek via imbalanced portfolios changed in decadal rhythms as follows:
1980–88: exclusively bonds (100%)
1988–99: classic 60:40 equities:bonds
1999–2001: cash, precious metals, shorts (minor)
2001–2013: cash, precious metals, energy, tobacco (minor)
My total wealth accumulated through a combination of savings and investment as shown in Figure 4 (redacted dollar amounts.) The years 2008 and 2013 were the only two down years. Berkshire has dropped five years since 1991. A 9% compounded annual wealth accrual beginning 01/01/00 compares favorably to an annualized return on the S&P of 1.4% (ex-dividends) and on Berkshire of 8%.
Figure 4. Total wealth accumulated (ex-housing) versus year of employment. Absolute dollar values have been omitted.
To clarify the origins of a 14-year return of 9% per year I offer Figure 5. By plunging into the precious metal and energy sector early and avoiding all other forms of investments (S&P in particular), I was able to capture the entire hard-asset bull market as well as an ensuing cyclical (or secular) bear.
Figure 5. 14-year return on S&P (blue), gold/silver (CEF; green), and energy (XLE; red).
Thinking About Capitalism: The Great Deformation
Given 2013’s special role for me as the only grinding bear market I’ve ever experienced, I will take it right to the hoop by presenting my case for an ongoing secular bear market in equities, bonds, and many other investments that may go on for a decade or more. I will present the case for a secular bull market in gold a bit later. Before doing so, let me do just a little more soul searching.
I suspect that previous readers of my annual reviews may notice a distinct change in tone this year; I certainly do. Despite my best efforts to compartmentalize the issues that are central to defining 2013, the lines seem to be blurring. Are Broken Markets the result of The Federal Reserve? Is Government Corruption eroding Civil Liberties?
I am witnessing what David Stockman calls The Great Deformation, but are these distortions in the global capital markets inflicted by seemingly horrendous monetary policies or in my perceptions? I’ve pondered this question for years, but I don’t have a definitive answer. I believe that readers who finish the review will develop a sense of foreboding—the sense that something is lurking below the placid surface. I didn’t plan to “penetrate deeper and deeper into the Heart of Darkness”, but it happened nonetheless.
“I feel sorry for [the bears] because they are simply living in the dark ages of monetary policy theory. They are stuck thinking like witch doctors rather than modern medical doctors.”
~ David Zervos, Jefferies economist
“By 2030, our calculations suggest that the real value of equities will be about 20% higher than in 2010….We do see it as something of a headwind…”
~ San Francisco Federal Reserve
As the equity markets were juiced higher and the equity bears became the walking dead, it is obvious why I don’t short stocks. But why am I still a secular bear? Of course, there are always things that go bump in the night. Some may prove inconsequential bricks in the wall of worry. I will do plenty of bricklaying throughout this document. However, some really big concerns—the monsters under my bed—keep me up at night.
Bonds and Buffett
In 1977, Buffett noted that “It is no longer a secret that stocks, like bonds, do poorly in an inflationary environment.” The quibbling over whether inflation is here continues, but there is little doubt that the hooligans at the Fed are determined to trigger some. The 32-year-old bond bull is long in the tooth, fully priced for an inflation-free world. We have central bankers on a bond buying spree that has the surreal effect of keeping interest rates low by printing money. Of course, these shenanigans will end, and price discovery in bonds will be accompanied by investors’ self-discovery. Optimists bray that rising rates are bullish, a sign that the world economy is recovering. In 1999, however, Buffett wrote a compelling article in Fortune attributing secular equity moves to one and only one parameter—the direction of long-term interest rates. Secular equity bull markets occur when long-term rates are dropping—not low but dropping—and secular bears occur when rates are rising.17 He didn’t equivocate. I could imagine him uttering some platitudinous gibberish like, “rising rates sink all boats.” When experts say that low rates are bullish they are either doofuses or Buffett has lost it. Buffett is a mafia don walking around in a bathrobe trying to look harmless, but I doubt he has lost it.
So are rates really that low? In a word, yes. I talk about that in the Bonds section. The salad days of the bond market are in our rear-view mirror. The rate bottom and subsequent rise will be global. Rising rates will spread into the markets and economy at large, causing concurrent stagnation, dropping price earnings ratios (from nosebleed Case–Shiller estimates of 24), collapse of credit-fueled/capex-lite corporate profit margins, and crush under-funded pensions and municipalities rendering them less funded. If rates have nowhere to go but up, what direction are they headed? Thought so. That is the generic monster under my bed.
Demographics and Unfunded Liabilities
The really nasty monster is a Frankenstein-like beast constituted by combining demographics and unfunded liabilities. We can watch demographics play out in living color in Japan. Japan’s 24-year-old lost decade is often attributed to inadequate intervention by central bankers and policy makers insufficiently armed with untested theories of academic economists mired in state capitalism. The Japanese have also been getting old. My Cornell colleague Rich Marin, former CEO of Bear Stearns Asset Management and author of the newly released Global Pension Crisis,18 estimates that Japan will demographically bottom out with one worker for every three retirees. You can fiddle with dollars, cents, yen, GDP, JGBs and savings estimates all you want, but the demonetized reality is that Japan will have one worker providing all the goods and services for four people. Kyle Bass is right: the Japanese economy is rotting from within.19,20
Well that’s gonna suck, but why do I care? That’s simple: we’re a decade or two behind Japan but making up ground fast. We’ve promised boomers a
butt boat load (spouse edit) of benefits in their old age. Kotlikoff, Burns, and Smetters,21 in cahoots with Secretary of the Treasury Paul O’Neill, set out to wrap their brains around the unfunded liabilities—promises made which, after subtracting reasonable estimates of revenue streams, we haven’t a clue how we will cover. Kotlikoff now estimates that they total $205 trillion.22
Some readers have heard this number, but precious few can grasp it. $205 trillion? Let me do another demonetization. Assuming that there are 100 million taxpayers to pick up this tab and that the average taxpayer contributes 50% of their $50,000 per year salary—a preposterous payment schedule—how long will it take to pay off these liabilities? The answer is…wait for it…80 years…80 friggin’ years…8 decades…four score…8.0×101 birthdays…a lifetime. Maybe Kotlikoff had an Excel fail; there’s been a lot of that lately. I think he’s great, but he is an economist. I’ve seen estimates as low as $70 trillion. That cuts the burden on taxpayers living on half-salary to a mere 25 years. As Marin said in a recent seminar focusing only on the pension component of the problem, “I am trying desperately not to be apocalyptic.” Good luck with that one Cheech. Now would be a good time to panic.
1%: “Our economy is doing very well.”
99%: “We’re very happy for you.”
Nothing is more difficult than teasing economic facts from the fiction being marketed daily. Dow watchers would claim we are at all time highs and, because markets are “forward looking,” we must be doing well. Others would call that a total crock. Even the most optimistic must admit that those down the food chain are less enamored with our current recovery. This section will necessarily have a left-wing, Elizabeth Warren feel to it. I don’t think she is a wealth redistributor, and I know that I am not because I (still) have some to distribute. However, a healthy economy probably distributes wealth in a rational (possibly even predictable) fashion, and I very much doubt we are observing that now. History shows that dismissiveness directed at expanding impoverished masses can have dire consequences. The 1% who suggest that the 99% “eat cake” are likely to eat it metaphorically. I don’t recommend we redistribute wealth, but we should be deeply concerned about how it is distributing as a possible symptom of a failing state. Some of the symptoms are mentioned in this section. Debt gets its own sections.
To start with some good news, corporate balance sheets are said to be in unbelievable shape. I find this perplexing given that my arithmetic shows the Dow 30 is $500 billion in the hole (cash minus debt). Maybe I am missing other financial assets, but I wonder whether the balance sheets are filled with borrowed money. We are also told with considerable glee that corporate profit margins are breaking all-time records (Figure 6), possibly up to 70% above the historical averages.23 This, unfortunately, is very bad news because profit margins are notoriously mean regressing. Picture a 70% mean regression. Now picture the inevitable and mandated overshoot (or it wouldn’t be the mean). Profit margins are propped up by cheap capital courtesy of the Fed, lower numbers of employed workers (euphemistically called increased efficiency), savings from increasing numbers of benefit-free, part-time workers, and a total lack of wage pressure by those fully employed. Corporate capital expenditure (capex) is near zero,24 supposedly to fund dividend payments (although fungibility of money makes that connection dubious). Regardless of motivation, cutting back on capex is eating your seed corn. At some point the pipeline of innovation runs dry. I was struck by the news that Merck faces pressure from generic drug companies. Their response? Buy back shares.25 My head hurts. Corporate profit margins will naturally shrink. If workers begin to enforce some wage inflation into the equation, the regression of profit margins through the mean could be dramatic. The margins will collapse like a dream sequence in Inception as the fruits of research and development will not exist.
Figure 6. Corporate profit margins
“Facts do not cease to exist because they are ignored.”
~ Aldous Huxley
Few stats are more cooked than the employment numbers from Bureau of Labor Statistics (BLS). The former head of the BLS estimates that the reported unemployment numbers are about 3% higher than the reported estimates.26 This year they got really creative by “forgetting” to include California’s numbers five months in a row.27 Some estimates exceed 20%.28 The departure of workers from the workforce, whether voluntarily or by discouragement, often greatly exceeds the number of new jobs; the participation rate is not a pretty picture (Figure 7),29 but it may be more instructive with which to view unemployment. As a reminder, each percentage point on the y axis in Figure 7 represents approximately 2 million workers no longer employed or seeking work. The labor participation rate is deceptive in that it suggests we were here pre-1980, and our world continued to rotate on its axis (albeit with serious stagflation). However, any further drop begins to dig into the gains made by women entering the workforce in droves. That distant era only worked well because men were paid enough to raise a family on a single income, most had full-time rather than part-time employment, and college grads weren’t doing jobs requiring name tags. Figure 7 also does not include the boomers exiting the work force en masse; that is just beginning this year. Of course, we are assured they will work till they drop (or are released in a corporate downsizing to increase productivity).
Figure 7. Long-term labor participation rate.
The raw employment data are staggering. Grant Williams, for example, has noted that the heralded 236,000 job gain reported in one month included over 400,000 part-time jobs (without benefits).30 Although the headlines report job growth, we actually lost 276,000 full time jobs (with benefits). An estimated 77% of new jobs are part time.31 Only 47% of adults have full-time jobs. An estimated 100 million working-age people are not working—100 million.32 As we row this Roman galley of an economy through turbulent seas, only half the crew are pulling on the oars.
Median household income in the United States has fallen for four consecutive years. Over 50 percent of all American workers now make less than $30,000 a year.33 Forty percent of all workers in the United States make less than what a full-time minimum wage worker made back in 1968.34 A record and monumental 50 million people are on food stamps.34 Wal-Mart leaked a story of decaying fundamentals.35 (The Wal-Mart executive who leaked the info decided to spend time at the unemployment office.36) Watch the malls: many are using the Potemkin Village ploy—putting in unstaffed fake stores such as the “Garden Tractor Store”—for show.
“Money doesn’t make you happy. I now have $50 million, but I was just as happy when I had $48 million.”
~ Arnold Schwarzenegger
Wealth Disparity. Measures of wealth disparity are legion. The income growth at the top end of the earnings curve has soared by comparison, eliciting the 1%/99% nomenclature quoted at the opening.37 The net worth at the top has also soared whereas the “net worth” changes sign in the bottom deciles. Sales of high-end collectibles (such as impressionist paintings that I think are grotesquely overrated and certainly oversupplied) are busting records at Sotheby’s and Christies.38 Prices are not being driven by the builders of empires—Dell, Gates, Ellison—but by guys who move money for a living. This is what Kevin Phillips called “financialization” of an economy, the most prominent hallmark of empires about to exit through a non-revolving door.39
“Something is structurally amiss when so much financial activity is borderline.”
~ anonymous hedge fund manager
Guided in large part by the Austrian business cycle theory,40 I view serious risk residing in marginal activities—businesses that are only profitable in the most unhostile of environments. What happens when inflation rears it’s ugly head? Evidence suggests that it is already here. The levies could give way with little warning, leaving the Sorcerer’s Apprentice (the Fed) trying to mop up the liquidity. We have had a stay of execution owing to record low money velocity (Figure 8), but that will change. What happens when the free market asserts itself as it always does and rips control of interest rates away from central bankers? Marginally profitable businesses built on foundations of cheap credit will show the life expectancy of a soufflé in an earthquake. My dad once told me that the capital-intensiveness of his construction company protected him from capital-deficient goofballs entering the game and putting valid financial concerns out of business. Those protective walls don’t exist anymore. When the next recession comes—we are currently at about the median duration of an albeit feeble expansion41—it will hit an economy that is immunocompromised (Figure 9). Marginal businesses will be eviscerated as will some that should have survived.
Figure 8. Velocity of M2 money stock.
Figure 9. GDP over time.
This naturally brings me to a point that I’ve been meaning to make for years: Can you have too much creative destruction? Of course, replacing the dilapidated and inefficient old with new and improved variants—the epitome of creative destruction—is capitalism at its finest. Nobody will scream louder than buggy whip makers caught in the path of creative forces, but those screams should fall on deaf ears. There is a point, however, at which the hyperactive replacement cycle of durable goods becomes malinvestment—too many intermediate generations en route to the refined product. Disagree? Bulldoze your house every 10 years, and replace it with a better one. How would that work out? The replacement cycle may be cycling too fast. If so, I blame aggressive monetary policy fostering an economy that is flailing, owing to marginal activities.
“Every financial asset is artificially priced.”
~ Mohamed El-Erian, Pimco
“All risk asset prices are artificially high.”
~ Bill Gross, Pimco
I guess we know where Pimco stands. This year we celebrated efficient markets by giving the Nobel Memorial Prize in Economics to Eugene Fama, Robert Shiller, and some other guy. Fama made it big by building a model showing that markets are omniscient, including everything possible to get to the right price by definition. Shiller showed Fama’s theory was hooey. I guess this is the Cassius Clay–Sonny Liston model—somebody had to get knocked out to make history. The third guy probably did something arcane. Let’s look at how these efficient markets did this year.
Who’s to say that markets are under- or overpriced? The price is the price, right? Two New York Federal Reserve economists delivered a paper concluding that U.S. stocks were as cheap today as any time in history,42 which is a little odd given they were 60% cheaper in March 2009. Although the world equity markets rise, the GDP is looking a little green around the gills (Figure 10).43 You can graphically overlay anything on anything and say anything, but Figure 10 does seem to say something.
Figure 10. World GDP and equity prices.
Let’s focus on the U.S. forward-looking earnings, which are said to appear reasonable. Of course, these earnings do not exist except in the minds of optimistic analysts. By contrast, the Case–Shiller p/e using time-averaged earnings is in the scary 24 zone.44 John Hussman, a brilliant analyst who must be losing clients by the scores owing to his attempts to protect them, suggests bear market bottoms occur at a Case–Shiller p/e of about 8.45 The S&P 500 price/revenue ratio of 1.6 is twice its pre-bubble historical norm of about 0.8. (The 1987 peak occurred at a price/revenue ratio of less than 1.0.) The Russell 2000 is now sporting a p/e of 40 using 2014 fabricated earnings but a p/e of 60 times trailing earnings.46 Stockman says that by excluding charges—”ex-items”—companies fabricate an additional 30% to the earnings numbers. You can find distortions of comparable magnitude by using the forward earnings that are invariably waaaay too optimistic.47 As the forward earnings become discredited by reality, analysts quickly switch to forward earnings.
There are smart guys questioning whether price discovery is working (Fama aside). Jeremy Grantham, the wise old man with $150 billion under management, puts fair market value on the S&P 70% below the current levels,48 coincidentally the same percentile as the bloated profit margins. Cliff Asness, looking across all markets, concludes that “the 60–40 portfolio has been cheaper than it is now 98% of the time.”49 (Cliff wins no award for direct prose.) David Einhorn notes that “the S&P 500 index has advanced this year mostly through multiple expansion”50; the gains of 2012 were all multiple expansion as well.51 Are the distortions attributable to “ex-items” and “forward earnings” additive? I don't know, but Peter Boockvar summed it up nicely: “There is 0% chance this ends well.”52
We’ve created another equity bubble? It certainly tracks to the global central bankers massive monetary infusions—add Mentos to Coke and shake vigorously. Margin debt is soaring (Figure 11).53 I’ve had arguments about whether the tracking of margin debt with equity prices is causation or merely correlation. I actually don’t care. If both correlate with groundhogs popping their heads up, I’m keeping both eyes on the ground hogs. By the way, that previously mentioned wall of worry is unsupported by the technically relevant statistic that the number of equity bears just hit a greater than 25-year low (probably much greater than 25 years).54 When career risk forces managers to buy an asset class, it is time to sell that asset class.
Are we there yet? Jeremy Siegel thinks earnings are being underestimated—yes, you read that right—making the market only appear expensive. That, folks, was a groundhog sighting.
Figure 11. Margin debt (red) versus the S&P 500 (blue).
“Oh, my, gosh, that’s amazing, and so easy. I have to do this.”
~ 16-year-old day trader and soap opera actress
Einhorn suggests that “when ‘high short interest’ becomes a viable stock-picking strategy and conventional valuation methods no longer apply for many stocks, we can’t help but feel a sense of déjà vu.”55 Of course, he was probably thinking of Green Mountain Coffee (GMCR), which is an Einhorn short and is up 100% this year and 200% off its 2012 lows. Einhorn knows where the bodies are buried. This is a classic squeeze of traders who follow his lead but lack his patience. Other stocks that popped up like Uma Thurman include Tesla (320%), BestBuy (250%), and Fannie Mae (1000%). Those are year-to-date gains. Tesla’s market cap ($20 billion) and number of cars sold (35,000 per year) corresponds to >$500K per car. Netflix is now sporting a p/e of 200, causing value investors to wince and momentum traders to just keep on clicking. Amazon.com shares are up 60% since 2011 whereas their revenues have fallen 50% over that same time period.56 Shares in Tweeter, a bankrupt electronics retailer, briefly soared 1,800% on October 4th because some investors mistook its ticker symbol TWTRQ for TWTR, the shorthand chosen by Twitter ahead of the IPO. An NFL running back IPO’ed himself.57 Running backs have career expectancies of four years, which may put his IPO life cycle above average.
The stellar performer, however, was Bitcoin, everybody’s favorite virtual currency, starting the year at $13 per Bitcoin. And then it ran…and ran…and ran. A return of 100% in 15 minutes was upstaged by a 100-fold jump in the first 10 months of 2013, at which point “profit taking” looked like it would cause Bitcoin to hurtle back to Middle Earth (65-fold as of ten minutes ago). We are watching history being made or history being repeated. Although I endorse what Bitcoin represents—opposition to fiat currency—I am deeply skeptical of its success. I can, however, imagine a nickname if it tanks.
Flash Crashes and Market Glitches
Last year we had some stellar market glitches; although Facebook got the press, the complete annihilation of BATS and Knight Trading brought comedic flare. This year was tame, but daily flash crashes and glitches documented by Eric Hunsader et al. at the research firm Nanex became truly voluminous.58 Hunsader’s documentary entitled, The Wall Street Code starring high frequency trader (HFT) Haim Bodek is worth a peek.59
The Nasdaq kept going dark for anywhere from a few seconds to a number of hours, inspiring Zerohedge to anoint it the Nasdark. Some blackouts seemed to be tied with trading in Apple shares.60 Goldman reported a slew of bad trades (defined as any trades that lost Goldman money), which were immediately followed by a big-time Nasdark.61 Not to worry: Goldman got the trades unwound. In some cases, envoy-class traders still managed to adjust their portfolios while everybody else was blocked out.62 That probably included Goldman. Fannie Mae did a 50% spike and return,63 all on low volume in 15 minutes. Industrial conglomerate Tyco did a sub-second 10% face plant.64 Natural gas flash crashed 8%.65 This is all in good fun. If you haven’t done so already, listen to Ben Lichtenstein giggling his way through the May 6, 2010 Flash Crash.66
This frothy market behavior emanates from the Federal Reserve’s perverse monetary policy in collaboration with algorithmic trading platforms (“algos”) guided by HFTs—Algos Gone Wild. Hunsader has been trying to alert the SEC but failing for a very simple reason: the SEC is worthless. For years now the algos have been illegally carpet bombing the markets with fake quotes designed to disrupt trading. Up to 4% of the quote volume can be caused by a single algorithm sending digital sonar signals.
Hunsader realized that the HFTs in Chicago were trading off news emanating from New York faster than the speed of light could transfer the news.67 He concluded that the traders were getting advance notice and hiding this edge by trading in the narrow window between the release in New York and the arrival of the news in Chicago seven milliseconds later.68 The story got national press, prompting Larry Kudlow to exclaim, “All I know is the speed of light is seven milliseconds.” I concur with Larry: that is all he knows, and its a preposterously foolish statement. Advance notice to the big traders of key economic statistics kept popping up and could have been a big scandal but, like all big scandals on Wall Street, it went away. If ever there was a market strategy poised to give up all advantage to arbitrage it would be algorithmic trading, and it seems to be happening. So what do they do now? HFT carnies started marketing algorithmic trading to the masses!69 This ought to kick start a few pension funds, eh? There is a movement afoot, however, to contain the algos. Italy put a nominal tax on each trade to make the high-volume fake trades unprofitable.70 Think about that one: Italy is ahead of the U.S. in combating organized crime.
Odd Chart Patterns and Rigged Markets
Charles Schwab, unlike Scott Trade, is a real person who exclaimed that “we are in a manipulated market.” Whereas Nanex focuses on microsecond time-scale patterns that would trigger a Peter Max-quality flashback, I find some of the lower frequency oddities interesting. A favorite is the ramp ‘n’ camp in which indices rise and park on a price (Figure 12). The mirror image to the downside is the drop ‘n’ flop. I’ve exchanged many a Tweet with Joe Saluzzi, author of the book Broken Markets and veteran trader, hooting about these common occurrences. I seem to be uniquely—as in all alone—enamored with the invisible hand of the market on the S&P (Figure 13). That thing moves with the natural grace of a marionette. The fingerprints of Adam Smith’s invisible hand are indicated with red asterisks. I guess it is pinging some trend line.
Figure 12. Ramp ‘n’ camp of the German DAX without an associated news event.
Figure 13. The S&P 500 for 2013. Asterisks indicate whatever.
Where’s all this coming from? Maybe it’s the flow of money into ETFs (Figure 14).71 Ignore the green mutual fund curve; that's normal behavior for a market in the midst of a five-year selloff, which didn’t occur. Put a straight edge up to that yellow ETF curve: Can you imagine the R-factor? Is the invisible hand guided by the President’s Working Group on Financial Markets?72
Figure 14. Flows in and out of mutual funds and ETFs.
This is all just conspiracy theory crap. The definitive word on odd market behaviors is provided by the SEC:
“Most rapid price spikes are caused by old-fashioned human mistakes, such as 'fat finger' errors, where a trader may accidentally add an extra zero to an order, or by portfolio managers accidentally requesting a large order be immediately executed rather than meted out in a managed flow. Contrary to public speculation, these types of events do not seem to be triggered by proprietary high-speed algorithms, by robots gone wild, or by excessive order cancellations.”
~ Greg Berman, associate director of the Office of Analytics and Research in the SEC’s Division of Trading and Markets
I stand corrected.
“Gold bugs are frequently jerks. This [drop] vindicates the economic ideas of the economic elites.”
~ Joe Weisenthal, Business Insider
“ The [gold] bull market is broken, the prior narrative has utterly failed, and is no longer taken seriously, except by yellow metal jihadists and other assorted suckers.”
~ Barry Ritholtz
“There’s a clique that enjoys pointing out the pain in gold as it goes down.”
~ Art Cashin
The gold bear that began in 2012 marches on, and the detractors were braying the whole way (sigh). It is the first bear market that I’ve personally ever witnessed from the inside… prostrate…under a bridge…stewing in my own vomit. Gold may be the story of 2013, but not for the reasons that many believe. Grant Williams posted an interesting graphic showing that gold’s dozen-year run turned south when Venezuela repatriated 100 tons (Figure 15; left vertical line). It turned downright fugly when Germany demanded gold be repatriated (Figure 15; right vertical line) from France immediately and from the United States, which the U.S. interpreted as within seven years (or whenever).
Figure 15. Gold price showing vertical lines corresponding to Venezuela and German gold repatriations (first created by Grant Williams).
The price of gold spent all of 2013 in a state of continuous carnage. Reporters breathlessly reported tonnage being liquidated from GLD, Comex, Brinks, JPM, and other gold depositories (Figure 16).73 (Comex disclaims their numbers as fictional.74) The Hong Kong Metals Exchange was liquidated and closed.75 ABN Amro and Rabobank defaulted,76 telling customers that their allocated gold had been rehypothecated (sold or leased out with no chance of getting it back), and payment would be in cash—shades of MF Global.
Figure 16. Liquidations care of Jesse’s Cafe Americain. (Jesse was one of the original market bears a dozen years ago.)
It got gruesome when India decided to mitigate their trade deficit and growing inflation problem by suppressing demand for gold in the land of the gold bugs. (Indians are to gold as teenagers are to cell phones.) Tariffs and taxes were explicitly implemented to shut down consumer demand.77 Indian authorities discussed setting up a GLD-like ETF to shunt consumer demand away from physical gold.78 Reread that last sentence. Proposed bans of gold coin sales were followed by the eventual shutdown of the Indian metals exchange.79 Premiums on physical gold soon soared as the Indian gold market became a classic black market with smuggling rising >300%80 (and a spike in the sales of body scanners and anal probes.) The authorities discussed selling sovereign gold into the open market to “strengthen the rupee”,81 but decided that such logic was completely backwards and moronic—a form of quantitative easing (QE) currency debasement Indian style. Indian commercial banks were directed to purchase gold from consumers.82 The authorities reserved their special place in Hell by threatening to confiscate the gold acquired over millennia by religious organizations.83
India wasn’t alone. France banned the sale of gold and silver by mail.84 Vietnamese authorities forced banks to charge for gold storage85 and appears to be heading for gold confiscation.86 Thailand, Pakistan, and Syria all jumped in to suppress the demand for gold from the retail markets.87
April was the global organ harvest for the gold bulls, yielding remarkable crop to the gold shorts wielding rusty butter knives. Snippets of bearish news just kept rolling in, but I couldn’t grasp what I was sensing. China imported record amounts of gold in March. Soon thereafter, Obama met with bankers (probably on Jekyll Island), and a few days later Goldman tells the world to “short gold.”88 When was the last time a major brokerage declared an all out short against any asset class? (Hint: Never.) After an odd two-day calm, gold got absolutely crushed. We are not talking skittish investors starting to move in concert but a real stampede. Thousands of futures contracts were sold in one second;89 billions of dollars worth of futures contracts in 15 minutes; tens of billions in one day.90 A single trade of 2 million ounces crashed the CME computers.91 An unprecedented collapse of the trading platform in the physical gold market place and the shutdown of Kitco’s pricing mechanism,92 brilliantly timed for Sell-off Friday, forced panicky gold bugs looking to hedge for the weekend into the options market, driving the prices even lower.93 The CME decided that was an excellent opportunity to raise margin requirements by 18.5%, which was guaranteed to force more selling.94 The Friday glitch-a-thon gave the brokerages ample time to line up their margin calls to ensure selling continued unabated the following Monday. It was pandemonium in the gold markets.
That, folks, was a textbook bear raid, brought to you by Goldman Sachs and heaven knows what other powerful forces. It left serious “technical damage”, which is a euphemism for “merciless beatings with baseball bats.” A number of summaries of the carnage have been penned, the best of them from Grant Williams.95,96
Throughout the remainder of the year gold sales showed odd patterns, such as high correlations with Japanese debt (JGBs; Figure 17)97 and trading in shares of Apple.98 Confiscation of Cypriot gold by EU banks—a microstash at best—caused more bone-crunching selling despite the lack of evidence that Cypriot gold would ever see the open market.99 The Boston Marathon bombing triggered selling. Yes indeed. It would appear that even terrorist bombings are now bearish for gold. Societe Generale (SocGen) wrote a report declaring “The End of the Gold Era.”100 It appears to be game over for gold, right?
Figure 17. Gold vs JGBs
Are you confused yet? I sure am. Although the sell-off had all the trappings of a panic, much of what I just recounted reflects a huge spike in demand for physical gold, squeezing supply from every nook, cranny, and orifice (quite literally).101 Authorities around the globe seemed to be apoplectic about containing this demand. Asians were panicking too in a different way. Asia witnessed lines around the block at gold dealers that were dominated by buyers, not sellers. The Perth mint was swamped with purchase offers.102 Even the U.S. Mint broke all-time selling records on the day that the price drop in gold broke records.103 The demand for physical gold went bonkers, yet the price just…kept…dropping.
Let’s look back at that plot of gold provided by Grant Williams in Figure 15 and reiterate a question he posed: Why would repatriation—demand for hundreds of tons of gold—cause gold to tank? Shouldn’t it cause gold to rise as authorities scramble to round it up?
I played a minor role in the headline-grabbing liquidation of GLD stockpiles that begins to shed light on what was happening. Tony Deden told me that he and a team of lawyers tried to pry $60 million dollars of physical gold from GLD; Tony was told to pound sand. I told Grant Williams, he wrote about it, and the blogosphere went nuts, declaring GLD gold unavailable. On further fact checking, I found that Deden’s tale of woe was public knowledge in 2007.104 The so-called bullion banks—the 20 Too Big to Fail (TBTF) global banks—have since GLD’s inception been the only organizations allowed to trade shares for gold. They appear to be using GLD as a fractional reserve gold bank,105 and this year GLD witnessed massive outflows. Let me restate that: The banks traded in vast reams of paper gold for physical gold. Hold that thought.
The horrifying gold sentiment within the investing community at large is captured in these quotes from the New York Times:
“There is simply nothing in the economic picture today to cause a rush into gold. The technical damage caused by the decline is enormous and it cannot be erased quickly. Avoid gold and gold stocks.”
~ New York Times
“Two years ago gold bugs ran wild as the price of gold rose nearly six times. But since cresting two years ago it has steadily declined, almost by half, putting the gold bugs in flight. The most recent advisory from a leading Wall Street firm suggests that the price will continue to drift downward, and may ultimately settle 40% below current levels.”
~ New York Times
“The fear that dominated two years ago has largely vanished, replaced by a recovery that has turned the gold speculators’ dreams into a nightmare.”
~ New York Times
Thousands of quotes like these appeared online all year. The above quotes, however, are from 1976.106 They were precipitated by a 50% drop in the spot price of gold ($200 to $100 per ounce. Ouch.) The headlines were followed by an epic eightfold gold run from $100 to $850 an ounce. It might have continued if Paul Volcker hadn't risked turning his name into a verb to gain control of global markets. You've got to wonder who was calling the shots at the Times.
For every seller there is a buyer, but who were the buyers? The jerks in China! (See Figure 18.)107 China even purchased the golden goose—the London Metals Exchange.108 India, Korea, Russia, Mongolia, Switzerland, and several dozen mostly Asian buyers joined the buying spree via their central banks (Figure 19). Even the People’s Republic of Texas did some serious repatriating, prompting Rick Perry to declare, “We don’t want just the certificates. We want our gold. And if you’re the state of Texas, you should be able to get your gold.”109 (He had a second point to make but forgot it.) CNBC, of course, accused Texans of “hoarding”, an odd pejorative term given that gold is stored in vaults.
Figure 18. China gold purchases
The gold is migrating from West to East. The West is busy selling paper and physical gold. The East only wants the real McCoy. I suspect we are witnessing the very beginning of a fundamental change in the global currency regime, and the sovereign state currently holding the world’s reserve—that would be the U.S. of A—may be in trouble. Are you sure U.S. authorities care? Take the time to read a declassified Volcker memo from 1974 describing how much the U.S. desperately wanted to demonetize gold.110
Figure 19. Central bank gold purchases
The debate continues about who actually has gold and whose gold has been rehypothecated (sold or leased out with no chance of getting it back). Some don’t seem to care as evidenced by this moment of clarity:
“[Gold] can be sold, leased out, used as collateral, employed to extinguish liabilities and counted as bank capital just the same whether it exists or not.”
~ John Carney, CNBC
Stay with that teleprompter, John. It’s your safe place. Also, take your meds. CNBC gets a special place in this review (vide infra).
Is gold manipulated now? Some very thoughtful market watchers think so whereas others do not. It certainly was manipulated back in 1974. Bloomberg recently suggested the daily London Gold Fix is, well, ripe for fixing.111 If 2013 taught us anything it was that wealthy and powerful men and women conspire. Much of the evidence of the motivation underlying gold market manipulation has trickled into the public forum as cryptic utterances over the years.
“To encourage and facilitate the eventual demonetization of gold, our position is to keep the present gold price, maintain the present Bretton Woods agreement ban against official gold purchases at above the official price and encourage the gradual disposition of monetary gold through sales in the private market.”
~ Paul Volcker, 1974
“Central banks stand ready to lease gold in increasing quantities should the price rise.”
~ Alan Greenspan, 1998
“We looked into the abyss if the gold price rose further. A further rise would have taken down one or several trading houses, which might have taken down all the rest in their wake. Therefore, at any price, at any cost, the central banks had to quell the gold price, manage it.”
~ Sir Eddie George, Bank of England, 1999
“Suppressing the price of gold is very beneficial for the U.S. in maintaining the U.S. dollar’s role as the international reserve currency.”
~ China’s National Foreign Exchanges Administration, 2013
We may be witnessing a monumental move on the global chessboard. Did China promise to keep buying our treasuries (against all logic) if we promised to drive gold into their coffers at high volume and steep discount? Other buyers may simply have realized that the Federal Reserve is staffed by a gaggle of boobs who think that printing gobs of money has no downside because of American exceptionalism. Figure 20 shows a frequently posted graphic illustrating the duration of reserve currencies. I suspect the next one will be gold-backed and may emerge sooner than many realize. This year has flushed the traders out of the market. I remain very long gold with very white knuckles.
Figure 20. Reserve currencies.
Although many seem dazed and confused about the importance of gold…
“Nobody really understands gold prices, and I don’t pretend to understand them either.”
~ Ben Bernanke, chair of the FOMC, 2013
“I don’t think anybody has a very good model for what makes gold prices go up or down.”
~ Janet Yellen, chair-elect of the FOMC, 2014
Others see reasons to be long the shiny coins and ingots…
“I never thought it wise to sell [gold], because for Central Banks this is a reserve of safety…it gives you good protection against fluctuations of the USD.”
~ Mario Draghi, President of the European Central Bank, 2013
“The Fed Will Destroy the World…we repeat our key forecasts of the S&P Composite to bottom around 450, accompanied by sub-1% U.S. 10y yields and gold above $10,000.”
~ Albert Edwards, Societe Generale
“The Fed…has embraced this dual mandate in a very harmful way…the sovereigns are under owned in gold.”
~ Paul Singer, Elliot Capital
I’ve totally ignored silver in this review having said so much about it in the past.2 I am still wildly bullish long term, but it is currently mirroring gold. Above-ground gold and silver bullion stashes are near parity (1–2 billion ounces), and silver is consumed voraciously by the digital world—the consumption clock is ticking. A case can be made that silver will someday decouple from gold to the upside in a substantial way.
Debt—consumption from the future pulled to the present or past
Austerity is not a policy; it is a consequence of bad policy
These definitions of saving and debt keep you from getting tangled up in dollars and cents. If you pull consumption forward, you'll eventually have to go without later. A baby born with absolutely nothing to its name is better off than 25% of adult Americans who are in net debt.112 That holds steady until young adulthood when student debt gets a grip on many. (Student debt gets its own section owing to it's complexity and importance.) The U.S. and arguably the rest of the developed world are in a boatload of trouble owing to what many call a debt supercycle—a global debt problem of monumental proportions. Can you really have a global debt problem? Yes. To the extent that you can neither stockpile goods and services, the entire world is on the pay-as-you-go (paygo) system. I don’t care who has what drawer full of chits claiming somebody owes them money, a global demographic problem is a global debt problem.
I have described a global debt problem as the misalignment of perception and reality and still find this approach most compelling.113 If everybody thinks they will live at a level that is above the production capacity, you have a global debt problem. In dollar currency terms, if you are aware of what has been promised to you yet unaware of what your costs will be to service promises to others, you have a debt problem. Everybody knows what’s in their pension, but does the average taxpayer realize that they owe $30,000 each to top off existing municipal pension funds? Does the average taxpayer realize that their share of the total unfunded liabilities is $2 million? They have a debt problem. If you are owed goods and services by folks who haven’t a clue how they will pay up—a form of counterparty risk—their debt problem is now your debt problem. We can’t live the American dream if we can’t crank out adequate goods and services to do so.
“America’s debt challenge is not a political problem. It’s an arithmetic problem.”
~ Simon Black, Sovereign Man blog
Let’s look at some specifics. I blur the lines between debt and lack of savings on the logic that both involve misaligned expectations and reality. I talked about the Five Percentile Guy last year: $154K annual salary with $1.2 million of accrued wealth who is also likely to be a boomer.1 According to the time-tested rule of 4% withdrawal in retirement to minimize risk of running out,14 this guy can pull out only $45K per year. A more recent estimate by Roach puts this guy’s financial assets at only $550K.115 There are many ways to suffer at this income level, even supplemented by Social Security. Recent studies have noted that financial repression inflicted on us by the Federal reserve dropping fixed income returns to precisely squat render 4% too aggressive.114 Even a 3% withdrawal rate is said to leave a 30% chance of running out of money before you take your last breath (which should come within about a month after running out of food). At 3% withdrawal and Roach’s estimates, Mr. Five Percentile Guy just slipped below the pay scale of the lowest paid commuter pilot (around $20K). But it’s worse than that. The putative well-off are already in trouble. We have increasing numbers of doctors declaring bankruptcy.116 As described in the truly marvelous book The Millionaire Next Door,117 doctors are the worst savers—but bankruptcy?
What about the average bloke? A typical worker near retirement has less than two years of replacement income saved, with median estimates of $70K retirement savings for 55-year-olds. Using the rickety 4% rule, $70K will spin off the princely sum of $2,800 per year.118 Estimates state that 41% of 65–74 year olds actually living in their own house still have mortgages, and the median balance within that group is $97,000 for pre-retirees and $70,000 for retirees.119 Moody’s says that a bunch of home equity lines of credit are about to reset to higher rates.120 How many retirees will be caught by that? More than 30% of 45–55 year olds have saved nothing for retirement.121 The median retirement account across all age brackets is estimated at $3000.122 The boomers aren’t such an aberration.
Any notion we will grow our way out of this problem is suspect in light of median wages, which have shrunk in the last five years123 and are said to have largely stagnated (inflation-adjusted) for production workers for several decades.124 Sixty percent of workers accumulated more debt than they contributed to retirement savings between 2010 and 2011. One fifth of 401K holders have a loan against it.125 Frontline’s "The Retirement Gamble" is worth a peek.126 Ted Benna, the father of the 401K, is horrified at his creation.127
This is a sad state of affairs. It seems unlikely that the spiking price of Netflix or a Twitter IPO will save us. Austerity is not a policy.
Three random bits of advice to the young:
- Save more and spend less. You will have more and need less.
- Stop buying cigarettes and lotto tickets at the convenience store.
- Read Millionaire Next Door in your early 20s.
One of my employees from China has been in the U.S. for a dozen years and just became a naturalized U.S. citizen. I know what she is paid. Her husband maintains an independent apartment working in Chicago. She has paid off a huge percentage of her house, maxed out her retirement account, and put a son through Cornell without taking on a penny of debt. She shames us all.
“I refuse to let Detroit go bankrupt.”
~ Barack Obama, 2012
Of course, the big news in the municipal bond market (munis) was the Chapter 9 filing by Detroit.128 After years of a non-revitalizing economy, the entire city simply fell into its own foundation. Videos with various “Detroit Ghetto” titles are a must see.129 (Watch the boats: they represent a bygone era of hopes and dreams.) I find one photo montage capturing Detroit's previous splendor in total ruin to be particularly disturbing.130 A judge tried to stop the bankruptcy,131 but no judicial fiat can change reality: they are out of cash and $20 billion in the hole. (Ironically, the presiding judge is an expert on Ponzi schemes.132) A Michigan bond deal went fully unsubscribed;133 you’ve got to imagine Detroit played a role in that.
I’m not sure Detroit’s plight was inevitable, but it was to be an uphill battle at best. The pension costs get a lot of credit, but they are only 5% of the budget.134 The fees paid to the financial system on the general obligation bonds used to top off the pensions, however, may have been oppressive.135 Some suggest that Detroit failed to adjust in real time, causing them to hit the bridge abutment at full throttle. Failure to curb waste and make mid-course corrections in any economy is bad (and it’s happening everywhere.) So what is Detroit planning as all seems lost? A toga party? No. Building a taxpayer-funded sports arena!136 (The economics of such projects have been discredited by multiple analyses.137) As a non-fan of government-sponsored programs, I would enthusiastically support Federal funds to pay local blue-collar workers to bulldoze dozens of square miles of abandoned buildings. I could imagine green sprouts emerging over time, but not from total wreckage.
The day that Beirut on the Lake went belly up the Dow hit all-time highs. The muni bond market, by contrast, got the bejeesus scared out of it with good cause.138 Illinois, for example, seems to have some serious problems with a pension fund that is only 40% funded—$53 billion in the hole and still digging.139 An Illinois public relations man fought back against Zero Hedge’s assertion that the pension is in big trouble. That was Baghdad Bob talking because their pension guru said that the “Illinois Teachers Retirement System cannot invest its way out of the funding hole we are in.” Illinois had a debt sale that went south and was promptly delayed, prompting Cate Long, a prolific writer on municipal debt, to note wryly that “something went very wrong.” Cook County is $140 million in the hole. Is that big? I don’t know. The state is $305 billion in the hole—$30,000 per taxpayer. That’s big. Meanwhile, 1 in 6 Illinoisans are on food stamps.140
Other states are not far behind. Only eight states have budget surpluses.141
California has state and local governments that are in the hole for over $1 trillion—$26,000 per capita.142 CalPERS is having trouble collecting pension payments from the municipalities.143 It’s not surprising given bankruptcies in Vallejo, San Bernardino, Mammoth Lakes, Stockton (probably “just to name a few”).144 The overall muni market showed serious stress by June of this year. Puerto Rico’s problems led to a 20% bond collapse in a single month,145 posing the question of how far our concerns should reach. Given that QE has been bailing out all of Europe, it seems that question has been answered.
Many of the wounds were self-inflicted with Wall Street supplying the weapon. A number of states are suffering because they sold bonds against their revenues from the tobacco settlement, only to watch the tobacco revenues tail off with abstinence.146 Stockton was guided into bankruptcy by some ill-conceived pension obligation bonds that went bad. Jefferson County won billions in a settlement (although certainly not enough) related to scams against it.147 Denver is spending over 60% of its school budget to unwind ill-advised derivatives trades.148 Miami–Dade County’s $91 million loan to build the Marlins a new stadium (another stadium!) cost them an additional $1.2 billion in fees.149 Maybe some of the Marlins players can IPO themselves to help pick up the tab. Watch out for forthcoming privatizations Chicago style.150 It all makes you wonder whether some of the mayors are smoking crack.
“Yes, I have smoked crack cocaine, probably in one of my drunken stupors.”
~ Rob Ford, mayor of Toronto
“The subprime mess is grave but largely contained”
~ Ben Bernanke, 2007
“The amount of U.S. student debt is large, but not particularly likely to cause macro-economic instability.”
~ Ben Bernanke, 2013
The student debt problem is often presented in simple terms: unlimited credit allows banks to saddle mentally impaired consumers (18-year-olds) with non-dischargeable loans at usurious rates to pay soaring tuition bills stemming from gold-plated amenities and overpaid faculty, all of which have come about because colleges can charge anything they want. There are shards of truth in there, but the story is a little more nuanced. Let’s first look at the problem, which is undeniable.
Student debt has soared to over $1 trillion, causing many to declare it the next bubble (Figure 21). Last year I argued that stringent legal protections of even the most usurious lenders would preclude the popping phase. Apparently, the students did not read my review: the bubble is popping (Figure 22). Seven million student loans are in default;151 50% of all loans are in forbearance or deferment.152 You cannot squeeze blood out of a stone. Parents who had the stones to cosign are another story.
Figure 21. Growth in student debt.
Student debt that at one time appeared to be a highly protected asset class is increasingly becoming subprime and defaulting.153 Sallie Mae was forced to cancel debt offerings.154 The popular Stafford loans are about to see their interest rates double (3.4% to 6.8%).155 That’s really gonna smart. I’m unsure how this is going to play out. Right now it's simply a monumental mess.
Figure 22. Delinquent student loans.
What really concerns me is that student debt is almost guaranteed to hobble a generation and our economy for years. I obsess over the diversion of what Bloomberg called “indentured students” who had the potential to change the world but, instead, will be forced to plant themselves in a cubical to get three square meals, a roof, and a monthly loan payment. Generation Hosed is justifiably irritated. Imagine watching brokerage ads touting ages 25–35 as critically formative saving years while sitting on a huge pile of student debt accruing penalties and sitting on your parents’ couch doubling as a bed. They were told to get a degree and a job. One out of two is bad.
“For those of you who may be unaware, [Michael] Boskin is the economist/weasel/fraud who helped to officially distort the CPI, making it more or less worthless as a measure of inflation. The Boskin Commission… was an act of cowardice. Rather than man up and say 'fix this, its broken, we can’t afford it….'”
~ Barry Ritholtz
“You can’t trust those American GDP numbers. They cook the books”
~ Chinese Finance Ministry
Are college costs really soaring above inflation and, if so why? The charts say they are (Figure 23). Although offering little consolation, I suggested in last year's review that tuition—the cost of running a small city—may be a better measure of the true inflation rate than is the politicized CPI. Figure 24 shows a CPI that is clearly too low to anybody who remembers prices in 1978. I lived in NYC on a $4400 annual stipend in 1978 and could get a full breakfast for under a dollar. The inflation measures coming out of ShadowStats.com and tuition hikes aren’t that far off. Nonetheless, the affordability of college is undeniably declining. As a case in point, costs to go to the University of Wisconsin have soared relative to 40 years ago when measured by hours needed to work your way through—summer plus 50 hours per week now versus summer plus 10 hours per week 40 then.156 Embedded in this benchmark, however, is the failure of low-paying jobs to keep up with the real costs of living.
Figure 23. College tuition versus medial costs and the cost of living (CPI).
Figure 24. Inflation according to the CPI (red) and ShadowStats.com (blue).
I concede that tuition is rising above inflation, but where is the hemorrhage? When I arrived at Cornell in 1980 everything that had direct comparison with the present was supported at a higher level. The staffing levels—a huge percentage of the cost—were higher. The number of teaching assistants was larger. I have spoken with many in the university community, including 3 hours with colleague Ron Ehrenberg, an economist with a globally recognized expertise on university finance.157 There is no simple answer. I imagined that in a winner-take-all system, that the highest-paid faculty had elongated the pay scale. I can’t speak for the nation at large, but this is definitely not true in my department. Comparing salaries of the top three faculty with those of starting assistant professors reveals a proportionality that has not budged since 1980. Moreover, faculty salaries have slipped when compared with graduate student stipends.
I suspect—suspect—that the bloat has appeared in middle management and administrative staff. What is difficult to fathom by those outside the system, however, is the enormous complexity of running an institution that is tied in every respect to state and federal government. Compliance with financial and social responsibilities has grown, a form of unfunded mandates. Think about the changes that have occurred in the typical doctor’s office; that has happened at universities as well. I suspect universities could do better, but it is a battle.
How about the luxurious facilities? Indeed, they are constantly improving relative to the olden days. There is an arms race to get the best students. But our buildings and dorms are largely funded from private donations and government sources, not tuition. Recent construction at Cornell has been paid for by Seth Klarman, Sandy Weill, and Bill and Melinda Gates. Chuck Feeney (Duty-Free Shops fame) has donated almost $1 billion to Cornell, including the money to build the new dorms that supposedly drive up the cost of housing. Money flooding in from wealthy alumni goes to mitigate the costs of education. The real cost of running a university is much higher than the tuition dollars collected.
I do not have solutions to the existing problem, but I do have a few suggestions.
- Don’t go to an expensive college when a cheap one will suffice. Some of the state schools are spectacular, although they are getting more expensive.
- Help your kids think about their majors; some subjects should be minors.
- Start cheaply and transfer into the elite schools.
- Some kids should delay entering college or take time off after entering school to sharpen their focus. (Parents are often the biggest obstacles to such a plan.)
- Skip college if you are just going to screw around; it is an expensive way to learn keg-stand skills.
- We should develop payment systems based on percentage of income for a set number of years after graduation to protect students from impossible payment schemes and incentivize schools to produce a profitable educations.
- Don’t count on the massive open online courses—the MOOCs—to save us. I’ve gotten to know 18- to 22-year-olds pretty well, and the maturity required to excel without the cloistering of the campus life is rare. MOOCs could be part of the solution, but only part.
- Wealthy donors might consider supporting renovations of existing structures rather than new buildings. It's a much harder sell for administrators.
Everybody says we need more college graduates. That’s a total crock. We need a more skilled populace. For some, education provides the needed skills. Others should find the skills elsewhere.
“No, Mr. Bond, I expect you to die.”
Bonds and, by proxy, sovereign debt almost became the story of the year when the Fed threatened to taper QE. Interest rates rose sharply, and the Fed went completely spineless and did an Emily Litella “never mind.” This year foreshadowed what might happen when bonds finally sell off in earnest.
But if this is the one bubble that rules them all—and I believe it is—this bubble is a very strange one indeed because it is feared by all. Foreigners are selling bonds. Brokerages are hiding from them, issuing warnings to their customers to lighten up or at least shorten up the duration (to about 15 minutes.) The reach for yield is going other places. In February UBS warned its clients to lighten up158 with the same urgency that Jamie Dimon told the DOJ to lighten up. Bank of America (BofA) warned of a bond crash.159 HSBC warned of the “great liquidity drought.”160 Mohamed El Erian of Pimco asked rhetorically, “why is it that the Pimcos of this world are not disciplining a system that is becoming more and more artificial? Why do we allow the manipulation?”
Are we sure it’s a bubble? Yes, it is a bubble. Rwanda's 10-year debt dropped below 6%.161 Rwanda? The U.S. junk bond market has hit a record $2 trillion.162 Barclays says that “the U.S. high yield index fell to a record-low 4.97%, the first time it has ever fallen below 5%.”163
Apple, with its enormous cash balance—a real cash balance in excess of $100 billion—sold 30-year debt, turning itself into combination tech company and levered hedge fund.164 Let me wrap my brain around this: a tech company selling 30-year debt? Tech companies should avoid buying green bananas for their cafeteria. Oddly enough, Apple’s share price almost immediately started its downward slide, and the Apple bonds are already underwater, losing 9% of their principal in one week.165
So yes, it’s a bubble. Just look at the chart (Figure 25). Rates were this low in the post-WWII disinflationary period in which the U.S. was the only financial juggernaut in the world. That is no longer the case.
Figure 25. Interest rates on 10-year treasury, 1967–present.
The irony is that the low yields (high prices) are manifestations of inflation incited by the Feds (or what a Rabobank analyst called “The Great Flotation”.) The central banks can keep it up for awhile—maybe even a long while—but the day will come when the Fed will be forced to taper. What if they don’t taper? Doesn’t matter. Someday the bond market will roll over with a gigantic groan because this gigantic chunk of debt illustrated in Figure 26 normalized to GDP is top heavy. (The downturn in Figure 26 is largely mortgage defaults; the real deleveraging has not begun.) We will then discover that bonds have risk. Jim Rogers noted that a 1% rise on the 10-year bond shaves 9% off the principal. Jim Rickards is predicting that rising rates will cut bond portfolios in half. The 1987 crash was preceded by rising rates that went unheeded by risk seekers; equity investors are likely to find the risk they are always professing to seek. (See The Bear Case above.)
Figure 26. Debt normalized to GDP.
Low interest rates have been supporting marginally profitable enterprises. I’ve already noted that corporate profit margins supported by low borrowing costs are at record highs; they will regress to the mean and p/e ratios will follow. Many marginal enterprises will become unprofitable. We will have the epiphany to end all epiphanies: The Fed doesn’t have a clue what it's doing. It will get a lesson in malinvestment. The bubble may not burst instantaneously—maybe it will be in slow motion—but it will leave investors prostrate before the secular bear market is over. And it won’t be our children and grandchildren who pay—that meme trivializes the risk because we obviously don’t give a hoot about them. It will be us, and it will be a generational lesson.
But this year, we got only a belch from Vesuvius. The peasants of Pompei have returned to their homes confident that the Gods contained the risk.
“There were some so afraid of death that they prayed for death.”
~ Pliny the Younger, on the eruption of Vesuvius
“The last time the housing market was this hot in Phoenix and Las Vegas, the buyers pushing up prices were mostly small time. Nowadays, they are big time — Wall Street big.”
~ New York Times
You would be forgiven if you were confused by the housing markets. We are being told by waves of pundits that housing is in full recovery mode. How could this be? Didn’t we just build more houses than the system could possibly absorb? Didn’t Greenspan convince homeowners to withdraw equity from their houses, only to find out that they lived in the same house but owed twice as much? Are we generating yet another bubble? Yes and no. We have a huge credit bubble but not a new housing bubble, only the aftermath of a deflating old one. Figure 27 shows new housing starts, and the double-digit percentage growth in new housing starts said to be the “largest surge in home sales since 1980” is feeble at best. Can’t see it at the far right edge of Figure 27? Maybe zooming in or squinting will help. A trillion dollars per year of Fed stimulus bought us that?
Figure 27. Single family housing starts 1964–present.
There are indeed new buyers coming into the market, but many would-be new buyers are unemployed 20-somethings living in the basements of their parents houses—houses that have a 22% probability of being funded by an underwater mortgage.166 An estimated 11 million mortgages are underwater.
The plot thickens when you find that up to 60% of new buyers of single family homes (SFHs) are paying with cash.167 We really are rich! Well, not exactly. This wave of buyers are private equity firms, hedge funds, and big banks leveraging up using Fed largesse to buy billions of dollars worth of SFHs. It's not cash. They are securitizing the houses to market rent-backed bonds and rental REITs (real estate investment trusts).168 Maybe these are the first buyers—the vanguard—who appear at the bottom in any distressed market. I also believe that some renters, formerly unsuited homeowners, should remain renters. So maybe all is going according to plan.
Here’s where the plotline turns dark. SFH rentals are notoriously lousy businesses. Ask any homeowner. There are already reports of renters being unable to get in touch with the absentee landlords.169 Wall Street often places huge bets on lousy businesses; they are the new flippers. Recent entrants include JPM, Deutsche Bank, and Blackstone. New companies with catchy names like American Homes 4 Rent are announcing IPOs. You’ll be seeing a lot of post-IPO charts like that of Silver Bay Realty Trust Corp (SBY; Figure 28) and American Residential Properties (ARPI). Goldman traders supposedly referred to these two companies as “straight to Muppet dump.”170 It will be much like the mortgage craze of a decade ago except the appreciation part—the honeymoon period for investors—will be very short-lived. Shiller thinks this is a new mania in which the Wall Street is just chasing momentum, but what does he know?171 Regardless, a new wave of securities are coming to a pension fund near you. Cover your faces because they are about to get ripped off.
Figure 28. Silver Bay Royalty Trust Corp (SBY; rental REIT)
“Europe should let go of hopeless causes”
~ Financial Times
That, unfortunately, would be Europe. Europe has been tribal for millennia. It is the exceptional moment when a bar fight isn’t breaking out somewhere on the continent. Fighting stops when they run out of resources. Many factors for European conflict are squarely in place. Leader of the UK Independent Party, Nigel Farage, is betting on “violent revolution across Europe.” I’m sure others share his view if not his penchant for unmitigated prose. The U.S. has been attempting to hold Europe together. Unbeknownst to many, the top five recipients of QE II went to European banks.172 Really? Not the guys at the local VFW? Even with that help, the European banks have a boatload of bad loans. Europe’s debt-to-GDP ratio is soaring while building permits are dropping to zero.173 The European Union is a loosely affiliated group of basket cases. It is painfully instructive to look at them basket by basket.
“We are continuing to see the EU crumbling before our eyes.”
~ Benn Steil, Council on Foreign Relations
Put a fork in it. Unemployment exceeds 25%, and youth unemployment exceeds 50%.174 Recall that violent behavior usually comes from unemployed youth; they are incapable of waxing philosophically like their ancestors. Several large Greek banks have collapsed, and there weren’t that many to start with. Branches are closing at the rate of two or three per day.175 Authorities placed restrictions on withdrawals to stem the flow of capital. Indeed, it worked. Hardly a euro will ever flow into the Greek banking system—Hotel California in reverse. The IMF is said to have manhandled Greece, turning their economy into a pile of rubble owing to their austerity policy. Austerity is not a policy; it is a consequence of bad policy. Nobody should ever lend to the Greeks; they are the perennial world default champions. Greece continues to create ruins.
Good news. Spanish debt is registering some pretty low interest rates. The bad news is that those rates reflect a monumental global credit bubble fueled by monetary interventionists of a higher order. Spain has over a trillion dollars of debt and has been through a half dozen bailouts in short order.176 Debt service is sucking up 30% of its tax revenues. Spain was forced to “borrow” from its social security reserve to fund pension payments.177 New Jersey did this too,178 which puts Spain in bad company. Spain also has a monstrous property bubble with over 800,000 unfilled homes.179 Rumors of a 47-story office building in which the contractors had forgotten to install elevators180 is probably a spoof turned internet legend, but how would you know? One intrepid Canadian debt analyst asked, “Do I really want to blow my brains out in Spain again?”181 I’m guessing he’s not loading up on Spanish debt in his personal account. Heads up: Once Spain's creditors have retrieved as much as possible from bailouts, they will be replaced with bail-ins. Film at 11:00.
S&P just downgraded France's debt, so the French are looking a little fried. The French finance minister Michel Sapin said that “there is a state but it is a totally bankrupt state,” and he goes on to note that “a flight of capital has already left the country amid concerns that France’s Socialist leader intends to soak the rich and businesses.” The president of France, Francois Hollande has things under control: “We can’t let the Euro fluctuate as the market sees fit”. Socialism is likely to live up to expectations. France also happens to have the second biggest pension deficit—a colossal one at that.182
“We all know what to do; we just don’t know how to get reelected after we’ve done it.”
~ Jean-Claude Juncker, prime minister of Luxemborg
Well, at least there's Germany. They must be doing well, right? First off, I would not be the first casual observer of history to notice certain geopolitical trends that keep appearing when Germany gets strong. More to the point, however, Germany has its problems. The DAX has rocked, doubling in only four years, while economic growth dropped from 4% to 0.7% over this same period.183 Trend-following hedge funds don’t care, but the rest of us probably should. Germany also has the largest pension deficit in all of Europe. Their pensions are less funded than Detroit's’. Reunification came at a cost.18
Sweden had four days of riots. Riots in Sweden? Ireland held the G8 meeting and created fake store fronts—a Potemkin Village—for the visitors. A governor of the Bank of England suggested that “there is momentum behind the recovery that’s coming” (like the momentum the car in my garage has).184 Britain has a huge housing bubble.185 Portugal is broke, unemployed, Spain’s Mini Me. I can’t keep this up….(projectile vomit)…(burp). This is nauseating; let’s move on.
What? No Cyprus? Cyprus is more than just a country imploding. Cyprus is a beta test for some very bad things and gets its very own basket.
“There is really no more stupid an idea even to consider a suggestion for a haircut on bank deposits”
~ Michael Sarris, finance minister of Cyprus
Cyprus may eventually become part of a huge story. Cyprus’s banking system passed the sham we call bank stress tests and was subsequently found to be insolvent, in no small part owing to pressure on Cypriot banks to buy Greek debt to bail out the Greeks.186 Enter the “bail-in”, a euphemism that describes a bailout of a bank using taxpayers's deposits to avoid burdening taxpayers.187 (Huh?) The haircut to depositors throughout the island kingdom was said to be 10%, a decimation in the purest sense. It might also be referred to as an “eisphora”, an emergency tax invented in fifth century BC Greece. The banking system was in complete lockdown. Emergency parliamentary sessions were scheduled and cancelled. The peasants were unhappy. This was bewildering for the head of the central bank named Panicos. No nickname needed there.
Substantial penalty for late withdrawals
~ Sign in Cyprus bank window
Soon stories began to leak out that the master plan was to clip $60 billion from Russian oligarchs using the shady Cypriot banking system for nefarious purposes.188 (The Cypriot banking system is actually quite transparent—literally so now that the banks have been vacated, leaving ”see-through” buildings.) We discovered, however, that the Russian oligarchs had gotten wind of the bail-in the previous week and emptied their accounts.189 Those that did not were able to do so at their leisure through the London offices of Cypriot banks, which were conveniently kept open.190 The president of Cyprus and his friends also exited; can you blame them?191 Soon the reported bail-in rose to 20%, 50%, and then urban legend levels of 90%.192 That is an expensive and indiscriminate haircut, especially for depositors in some banks that were not insolvent. The details probably don’t matter to non-Cypriots. Once the dust settled, Cyprus imposed capital controls to stem the flow out of the country by “slamming the bank door.”
“We cannot serve you right now due to upgrade.”
~ Quote from Cyprus ATM
Why would Cypriot politicians let the country get looted? Well, politicians are fungible, and the going price for any politician never exceeds six digits, whereas the looting was on an 11-digit scale. Probes into the carnage began but then terminated owing to “insufficient data”.193
“Only Europe and the U.S. can stop the world from falling apart.”
~ Wolfgang Schäuble, German finance minister
What you mean US Kemosabe? Asia is clearly of profound importance going forward. I can imagine writing volumes in some future Year in Review, but it feels like Asia is in a holding pattern with troubles in the queue waiting to make headlines. A China/Japan or North Korea/South Korea military conflict could bring on the fireworks. The Fukushima nuke story continues to smolder.
China watchers I respect are both wildly bullish (Stephen Roach) and wildly bearish (Jim Chanos). I suspect both bulls and bears are right at some level. Credit and real estate bubbles (ghost cities) portend a crisis, and the authorities are terrified of the response by the citizenry. If you recognized the China growth story 15 years ago and dumped your money into the Fidelity China Region fund—I did at one point, but only briefly—you would have beat the S&P, but your annual compounded return would have only been 5%. This is disappointing for a miraculous growth story, especially if the downside risk is large. A hoard of investors are focusing specifically on Mongolia, but their economy is in its infancy (baby steppes), and it doesn’t interest me yet. I will, however, put in two cents on Japan.
“Japan appears to be turning the economic corner.’“
~ Jack Lew, secretary of the Treasury, 2013
“Japan has turned the corner”
~ Stefan Green, Goldman Sachs, 2007
“Japan has turned the corner”
~ John Taylor, undersecretary of the Treasury, 2003
It’s little wonder they make good cars. They will also likely be the market leader in "cluster trucks." Japan has truly massive demographic problems. As noted earlier but worthy of reiteration, estimates are that in 20 years Japan will have one worker providing all the goods and services for four people. Neither Abenomics nor the Yakuza are gonna change that butt-ugly picture. Kyle Bass is always giving must-see talks on Japan’s mathematically impossible recovery.19 Even the major brokerages follow this plotline. It seems to have attained truism status for at least some pundits that rising interest rates in the JGBs will destroy Japan's currency, markets, and economy, and interest rates will rise someday. The BOJ, like central banks around the globe, is determined to print around, over, or through this problem. (Am I the only one who thinks BOJ sounds pornographic?) Last time Japan tried to inflate its way out of debt was the 1930s. It led to hyperinflation, assassination of the prime minister, and World War II. The most direct solution to demography was provided by Japanese finance minister Taro Aso who suggested that the elderly should “hurry up and die” rather than drain the resources of the government.194 They had better hurry up, because the Japanese government is currently borrowing half of its federal budget every year.
My dark horse winner for the 21st century is Russia: they have land and resources. All they have to do is straighten out their political system. Moscow is said to have the largest number of billionaires of any city in the world, but every one of them stole their wealth, which suggests finance and banking will be growth industries.
I have little to say about or interest in South America. Brazil is the lead off batter for the BRICs but recently started fanning strikes.195 Argentina, once viewed as the Western Hemisphere’s rising superpower, is now what Henry Kissinger referred to as a “dagger aimed at the heart of Antarctica.”
And then there’s Africa. I hear rumblings that Sub-Saharan Africa is a future growth region. This is garbage analysis. Read Hernando DeSoto’s The Mystery of Capital.196 Africa has no ports, no inland waterways, no property laws, weak educational systems, more AIDS than any region of the World, a large machete-toting populace, and numerous oppressive dictators. Although one of my very bright colleagues is actually creating a bank in Ghana, I don’t think any quantity of Bill Gates’ help will dent Africa’s problems. I will not be investing in a Fidelity Africa Fund anytime soon.
Given its length, we've had to break this report in half so as not to crash your browser. Click here to read Part 2 of David Collum's 2013 Year in Review, available free to all readers.