No Risk Of Recession?

Authored by Lance Roberts via RealInvestmentAdvice.com,

Review

I have been traveling a lot the last couple of weeks, so a big “Thank You” goes to Michael Lebowitz for “pinch hitting” for me. This week, I just want to review a couple of things as we begin to wrap up 2017.

Earlier this week, I wrote a piece called “This Is Nuts.”   If you haven’t got a chance to read it, I suggest you do. It outlines my view on the current market extension in the short-term and the potential for a mean-reverting correction at some point in the future. To wit:

“More importantly, a decline of such magnitude will threaten to trigger ‘margin calls’ which, as discussed previously, is the ‘time bomb’ waiting to happen.

 

Here is the point. The ‘excuses’ driving the rally are just that. The election of President Trump has had no material effect on the market outside of the liquidity injections which have exceeded $2 Trillion.

 

Importantly, on a weekly basis, the market has pushed into the highest level of overbought conditions on record since 2005. I have marked on the chart below each previous peak above 80 which has correlated to a subsequent decline in the near future.”

As I noted, the problem for investors is not being able to tell whether the next correction will be just a “correction” within an ongoing bull market advance, or something materially worse. Unfortunately, by the time most investors figure it out – it is generally far too late to do anything meaningful about it. 

“As shown below, price deviations from the 50-week moving average has been important markers for the sustainability of an advance historically. Prices can only deviate so far from their underlying moving average before a reversion will eventually occur. (You can’t have an ‘average’ unless price trades above and below the average during a given time frame.)”

“Notice that price deviations became much more augmented heading into 2000 as electronic trading came online and Wall Street turned the markets into a ‘casino’ for Main Street. At each major deviation of price from the 50-week moving average, there has either been a significant correction, or something materially worse.”

However, in the short-term, the market trends are CLEARLY bullish, very overbought, but nonetheless bullish.

As such, our portfolios remain “long” on the equity side of the ledger…for now. 

I am still somewhat suspicious of the markets going into 2018. As I laid out over the last couple of weeks, I believe the risk of “tax-related” selling is a strong possibility at the beginning of the year as portfolios lock in gains without having to pay taxes until 2019. While the risk to the overall market trend remains small, a correction of 3-5% is possible. I am still looking for the right “setup” by the end of the month to add a small “short S&P 500” position to portfolios and increase longer-duration bond exposure to hedge off some of the potential risks. I will keep you apprised.

Importantly, while the short-term backdrop is clearly bullish, and as noted above, the longer-term overbought condition remains worrisome. The monthly chart below shows the current market extension is at levels rarely seen in market history. With the market trading into 3-standard deviations above the 3-year moving average, RSI pushing well above 70, and the MACD line hitting the highest level since 2000, the risk of a market reversion has risen.

While there is plenty of discussion of the support of Central Banks keeping markets afloat indefinitely into the future, it should be remembered that at the peak of every major market throughout history, it was always believed to be “different this time.”

But in the end, it wasn’t, and this time is unlikely to be different as well.

No Risk Of A Recession?

I have discussed, along with Doug Kass, several different “meme’s” running around as of late trying to justify the current market extension. To wit:

“The advance has had two main storylines to support the bullish narrative.

• It’s an earnings recovery story, and;


• It’s all about tax cuts.”

We can add to that list “economic growth” given the strength of the rebound over the last two-quarters which followed two quarters of exceptionally weak growth in Q4 of 2016 and Q1 of 2017. While the growth has certainly gotten everyone excited as of late, it is quite possible we have seen the peak of the “restocking cycle” for now.

Under the guise of these “meme’s” it is currently believed that a “recession” is nowhere to be found and therefore it should be “clear sailing” for investors as we head into 2018 and beyond.

But, is that necessarily the case?

A Funny Thing Happened On The Way To The Recession

The majority of the analysis of economic data is short-term focused with prognostications based on single data points. For example, let’s take a look at the data below of real economic growth rates:

• January 1980:        1.43%


• July 1981:                 4.39%


• July 1990:                1.73%


• March 2001:           2.30%


• December 2007:    1.87%

Each of the dates above shows the growth rate of the economy immediately prior to the onset of a recession.

You will remember that during the entirety of 2007, the majority of the media, analyst, and economic community were proclaiming continued economic growth into the foreseeable future as there was “no sign of recession.”

I myself was rather brutally chastised in December of 2007 when I wrote that:

“We are now either in, or about to be in, the worst recession since the ‘Great Depression.’”

Of course, a full year later, after the annual data revisions had been released by the Bureau of Economic Analysis was the recession officially revealed. Unfortunately, by then it was far too late to matter.

However, it is here the mainstream media should have learned their lesson.

The chart below shows the S&P 500 index with recessions and when the National Bureau of Economic Research dated the start of the recession.

There are three lessons that should be learned from this:

1. The economic “number” reported today will not be the same when it is revised in the future.


2. The trend and deviation of the data are far more important than the number itself.


3. “Record” highs and lows are records for a reason as they denote historical turning points in the data.

For example, the level of jobless claims is one data series currently being touted as a clear example of why there is “no recession” in sight. As shown below, there is little argument that the data currently appears extremely “bullish” for the economy.

However, if we step back to a longer picture we find that such levels of jobless claims have historically noted the peak of economic growth and warned of a pending recession.

This makes complete sense as “jobless claims” fall to low levels when companies “hoard existing labor” to meet current levels of demand. In other words, companies reach a point of efficiency where they are no longer terminating individuals to align production to aggregate demand. Therefore, jobless claims naturally fall. 

But there is more to this story.

Less Than Meets The Eye

The last two-quarters of economic growth have stronger than the last two, but not breaking any records by any measure. However, these two stronger quarters of growth come at a time when oil prices are recovering modestly from their crash boosting activity and earnings. 

Furthermore, this widely touted economic and earnings “recovery,” as witnessed by surging asset prices, should have certainly been met by stronger activity from the majority of Americans, right?

What’s going on here?

Economic cycles are only sustainable for as long as excesses are being built. The natural law of reversions, while they can be suspended by artificial interventions, cannot be repealed. 

More importantly, while there is currently “no sign of recession,” what is going on with the main driver of economic growth – the consumer?

The chart below shows the real problem. Since the financial crisis, the average American has not seen much of a recovery. Wages have remained stagnant, real employment has been subdued and the actual cost of living (when accounting for insurance, college, and taxes) has risen rather sharply. The net effect has been a struggle to maintain the current standard of living which can be seen by the surge in credit as a percentage of the economy. 

To put this into perspective, we can look back throughout history and see that substantial increases in consumer debt to GDP have occurred coincident with recessionary drags in the economy. No sign of recession? Are you sure about that?

There has been a shift caused by the financial crisis, aging demographics, massive monetary interventions and the structural change in employment which has skewed the seasonal-adjustments in economic data. This makes every report from employment, retail sales, and manufacturing appear more robust than they would be otherwise. This is a problem mainstream analysis continues to overlook but will be used as an excuse when it reverses.

Here is my point. While the call of a “recession” may seem far-fetched based on today’s economic data points, no one was calling for a recession in early 2000 or 2007 either. By the time the data is adjusted, and the eventual recession is revealed, it won’t matter as the damage will have already been done.

As Howard Marks once quipped:

“Being right, but early in the call, is the same as being wrong.” 

While being optimistic about the economy and the markets currently is far more entertaining than doom and gloom, it is the honest assessment of the data and the underlying trends that are useful in protecting one’s wealth longer term.

Is there a recession currently? No.

Will there be a recession in the not so distant future? Absolutely.

Whether it is a mild, or “massive,” recession will make little difference to individuals as the net destruction of personal wealth will be just as damaging. Such is the nature of recessions on the financial markets.

Of course, I am sure to be chastised for penning such thoughts just as I was in 2000 and again in 2007. That is the cost of heresy against the financial establishment, unexperienced investors consumed by complacent optimism and emotionally-driven willful blindness. I am okay with that, it is a price I will gladly pay to keep my clients, and loyal readers, from being burned at the stake, not if, but when the next recession begins.

Market Goes "Full Bitcoin"

Authored by Lance Roberts via RealInvestmentAdvice.com,

Market Review

What the “heck” was that?

This past week seemed to be the story of Christmas coming early. Earlier this week the markets surged higher on hopes that “Ole’ St. Tax Cuts” would soon be here. But that dream seemed to be short-lived on Friday, at least at the open, as General Mike Flynn seems to embody the “Grinch” trying to steal Christmas.

But at the end of it all, not much actually changed. Well, except for the fact that volatility not only made an appearance as stock prices swung wildly in both directions, but also in Treasury rates. As expectations of tax reform grew, rates spiked higher but then sank just as quickly as fears of turmoil in the Administration sent money into the safety of bonds.

As shown above, despite all of the “sound of fury” the S&P advanced 1.53% for the week while rates, not surprisingly as money rotated from “safety” to “risk,” ticked up from 2.3% to 2.4%. However, while volatility finished week only up mildly, intra-week we saw volatility jump to nearly 15 before settling back at 11.

The sharp advance, as the market went all “bitcoin,” pushed well into 3-standard deviation territory above the longer-term moving average with overbought conditions pushing extremes. While the backdrop remains decidedly bullish, the sharp moved higher has all the earmarks of an exhaustion move which suggests some profit-taking cool things off over the next couple of weeks. 

While the market is extremely overbought, the bullish trends remain intact. Furthermore, the month of December tends to bullish for equities which keeps portfolios allocated towards equity risk currently.

With the tax bill now out of the Senate, the real work begins as the House bill and Senate bill will go to conference to work out the rather substantial differences between the two bills. With neither bill even remotely approaching a “fiscally conservative” that will actually lead to stronger economic or reduced debts and deficits, it is a huge windfall for corporations.

This, of course, raises the question as to how much of the “tax cuts” are already priced into the markets.

One thing to be cautious of is the possibility this could well be a “buy the rumor, sell the news” event as we move into the New Year. As I stated last week, I see two potential outcomes:

1. A tax bill clears Congress reducing taxes which leads to tax-related selling by money manager to lock in gains at a lower tax rate that will not have to be paid until 2019, or;


2. The tax bill fails, a still likely scenario, which leads to tax-related selling by money manager to lock in gains on which taxes will not have to be paid until 2019, 

Let me repeat from the last newsletter:

“As I see how December plays out, I will be seriously looking at adding a short-hedge to portfolios before year end. I will keep you apprised.”

This weekend, I am traveling to Florida to give a presentation on the markets and will be joined by some of my friends like Chris Martenson and Nomi Prins. It promises to be fun and I will fill you in on any great insights next week.

The Bitcoin Ramp – Is It Sustainable?

by Michael Lebowitz, CFA

The explosive rise of Bitcoin (BTC) has taken the investing world by storm, and for good reason. Over the past six months alone BTC has quadrupled in value. Since 2012, it has risen over 200,000%. To put that into context, had one invested 10k in 2012 they would be worth over $20 million today. The graph below shows the meteoric rise.

There are predominantly two camps with strong opinions on what the future holds for BTC. One generally believes it to be the currency of the future while the second camp thinks BTC is another financial bubble. Given BTC’s increasing popularity we thought it would be helpful to present these two competing perspectives and then offer our own assessment.

Believers

Believers in BTC claim it is quickly becoming a widely accepted global currency. To better understand their view let’s see how BTC meets the definition of a currency, both as a means of transacting (money) as well as a store of value.

Money: money is anything that two parties can agree is acceptable in exchange for goods and services. For example, if I pay you a case of beer to mow my lawn, the beer, in this instance, is money. However, for “money” to be widely accepted, the masses must ascribe similar value to it.  While there is an increasing number of vendors accepting BTC, it is nearly impossible to use BTC to meet your everyday needs. Further, the value, or price of money, needs to be relatively stable to be effective. If a dollar bill bought you a case of beer today, but only a single bottle tomorrow and a keg the following week, few consumer or vendors would trust the dollar’s value. BTC’s value can fluctuate 5-10% on an hourly basis

Store of value: a store of value is something that allows one to save money and retain its value. When we save money we want comfort in knowing the money we earned can buy us the same amount of goods and services tomorrow that it can buy today. Again, the extreme volatility of the price of BTC makes it difficult to project how much purchasing power a BTC will buy you in the future. All currencies fluctuate but typically nowhere near the degree we are witnessing in BTC.

If the extreme price movements of BTC subside it is possible that BTC can serve as a widely accepted currency and the believers could be correct.

Deniers

A second camp believes BTC is a financial bubble. The chart below compares BTC to other recent investment fads.

You will notice in all instances above the bubbles rise steadily in price before transitioning to an exponential increase prior to collapse. Often, in the so-called euphoric phase, prices go well beyond the point most investors think is reasonable. In this respect, BTC is following the path of prior bubbles.

Bubbles are not solely defined by price movements, but more importantly by a lack of supporting fundamental value. If you subscribe to the value of BTC as does the first camp, the rapid increase in price may well be justified. If you believe there is no value, BTC is showing the classic pattern of most bubbles.

Our Take

We believe BTC can rise even further from current levels. That said, we question whether it has any meaningful fundamental value. In the textbook on sound investing, Security Analysis, Benjamin Graham, and David Dodd define investing as follows:

“An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

Based on this very clear definition of terms, there is no way to classify BTC as anything other than speculation. Furthermore, while we agree with those in camp one that BTC might one day be universally accepted as money and a reliable store of value, we have one major problem with which to contend.

To help you grasp our issue, consider that an investor who bought Bitcoin a few years ago and sold it today would have accumulated a remarkable gain. Even better, unlike a capital gain on stocks, bonds, real estate and all other financial assets, that profit is tax-free.

Now ask yourself, how long will the government allow investors to avoid paying taxes on gains in BTC? Further, will the U.S. government, or any other government, cede control of its currency and ultimately the economy? We expand on this concept below from a primer we wrote on cryptocurrencies- Salt, Wampum, Benjamins – Is Bitcoin next?

The preamble to the U.S. Constitution states the purpose of the Federal government is to:

“…form a more perfect union, establish justice, insure domestic tranquility, provide for the common defense, promote the general welfare, and secure the blessings of liberty to ourselves and our posterity.”

In other words, the government’s role is to protect the freedoms and liberties of its citizens. If the government has no ability to fund itself and is unable to provide defense and law enforcement it cannot uphold the Constitution. More precisely – the sovereignty of any nation, regardless of its form of government, rests upon the strength and integrity of its currency.

Summary

There may still be gains ahead for BTC, but the volatility of its price and still low adoption as a means of transacting pose obvious problems. The bigger risk, however, is given government incentives to impose taxes on the public and manage economic activity, the speculative value currently being ascribed to BTC does not seem durable and is therefore unlikely to survive.

Here’s What Works For Me

by Doug Kass

“And I said to myself, ‘This is the business we have chosen."” –Hyman Roth, “The Godfather” 

To me, stock price deception is seen with more frequency today than in any time in modern investment history.

Our markets, influenced by massive central bank liquidity and dominated by passive strategies (ETFs, risk parity, and volatility trending), not only are inhibiting price discovery but also are artificially influencing price action — “buyers live higher and sellers live lower” — to both the upside and downside.

In some measure, this is reducing the authenticity and validity of stock prices and charts and is hurting the value of technical analysis, which may be basing its decisions, in part, on artificial patterns/prices/data. On the other hand, it benefits those who view the market without emotion and who are willing to buy extreme weakness and sell extreme strength.

Yesterday underscored the reasons why and how I look at stocks. I would emphasize, again, that I do not have a concession on the process and I recognize that others have different approaches that provide good investment returns.

But I have a logic in my approach and Wednesday’s bifurcated action and its selective and often extreme volatility underscores some of these principles that I have adopted over the last four decades and provides some additional lessons:

* Avoid Volatile and Unpredictable Stocks — It’s Gambling: In the last two days, Riot Blockchain Inc. (RIOT) has had a range from about $12 to $25. There has been no news to account for that volatility and random action.Other collateral bitcoin plays such as Social Reality Inc. (SRAX) and Xunlei Ltd. (XNET) have had similarly large trading ranges. No specific company news there, either. Given my risk profile, I never will trade in these stocks. Others believe differently and believe they successfully can skate on this thin ice, but I will stick to my risk appetite, and I believe all but a few professionals may be kidding themselves in rationalizing these stocks “tradeability.” This also explains my reluctance to trade bitcoin, which had a trading range yesterday of $9,290 to $11,377 — again, on no news.

 

* No Matter What the Charts Say, I Prefer to View Every Trade/Investment Based on an Assessment of Reward vs. Risk — Seize Those Opportunities: The dynamic of an upside/downside calculation and determining discounts or premiums to intrinsic value form the basis for my trading and investment decisions. Recently, I successfully traded two retail stocks, Macy’s Inc. (M) and Dillard’s Inc. (DDS) , on this basis. Consider Twitter Inc. (TWTR) , which at $22 a share looked technically solid. Nevertheless, I sold off a large portion of my position between $22 and $22.50 recently based on an assessment of a less-favorable upside/downside ratio. Others bought based on an improving chart. Both I and they are likely comfortable with our decisions, but the purpose of this missive is to further explain my tenets and methodology.

 

* There Are Many Great Charts That Lie at the Bottom of the Sea: Though one or two days don’t make a market, the artificiality of the markets may be underscored by two stocks yesterday — Micron Technology Inc. (MU) and Square Inc. (SQ) . Both recently looked fantastic technically. Embraced by many a talking head in the business media, both have been schmeissed in recent sessions. Like the Nasdaq 100 ((QQQ) was down $3 yesterday), they all looked good on the charts until they didn’t, and all provided little indication to prepare traders for the reversals. At times like these, it is increasingly dangerous to buy stocks on breakouts. Buying calls on these stocks moves one further to the end of the risk curve. This strategy may work well for some time in a trending market, but a swift directional change can evaporate profits and eviscerate a portfolio. Again, such a strategy should be limited to professionals, and even that body of traders may suffer from a steady diet of options activity, as academic studies show.

 

* Do Not Underestimate the Impact of Price Momentum Strategies on Individual Stocks and Sectors: Over the last month, technology, especially of a FANG kind, has soared and other areas such as retail have collapsed. The possible artificiality of both moves was evident in the reversals this week and yesterday. Amazon.com Inc. (AMZN) , as an example, was down by more than $45 on no news yesterday. Retail stocks such as M and DDS rose by 10% on Wednesday and 20% in the last week, also on no news. This may underscore (1) the reduced value of analyzing stocks on price technically, and (2) that opportunities are provided for those who are emotionless and have a sense of intrinsic values and legitimate upside/downside calculations.

 

* A Diversified Portfolio Is a Preferable Course: Jim “El Capitan” Cramer detailed the value of this approach late yesterday in a well-thought-out column, “‘Am I Diversified?’ May Be Boring, but It Can Help Avoid the Pain.” Please reread it. As a matter of course, and as most are now aware, I keep my individual stock positions as a low percentage of my total overall portfolio and often have 40 to 50 portfolio names. I am always diversified in position size (typically at about 2% to 3% each) and in sector exposure (limited to 15% of the portfolio). Recognize that when a trader or investor is only buying “good” charts, that is not being diversified. Rather, it is part of a process that leads to a binary outcome that may end badly given the likely artificiality of prices.

Bottom Line

The artificiality of stock prices has accelerated in recent years with the domination of passive investment strategies.

I will not trade/invest in stocks solely on the basis that they “look good” on the charts in this sort of setting, which is dominated by influences that create an under-appreciated degree of price deception.

For these reasons and others I will not buy breakouts and sell breakdowns; this may be the wrong approach in the environment we are now in.

Rather, an approach to buying value and breakdowns and selling seemingly irrationally based prices and breakouts is my investment cup of tea based on the fundamental and dynamic assessment of intrinsic values relative to the current prices.

Others disagree and I respect their ability to navigate differently. I am not taking a shot at their approaches; rather, I am saying what serves me well and what may serve the majority of conservative risk-based investors and traders well.

This is how I am handling the markets these days, and, frankly, will forever.

And … buckle up.

Bond Bears & Why Rates Won"t Rise

Authored by Lance Roberts via RealInvestmentAdvice.com,

Here we go again…

Since June of 2013, I have been writing about the reasons why rates can’t rise much and why calls for the end of the “bond bull market” remain wrong.

Regardless, about every 3-months or so, there is a tick up in rates and you can almost bet that soon thereafter will be a litany of articles explaining why THIS time the “bond bull market” is really dead. For example, just from this past week:

• Great Ready For The Great Bond Bust Of 2020


• The Great Bond Bull Market May Be Coming To An End


• 700 Years Of Bond Data Forewarn Of Rapid Reversal From Low Interest Rates

What is the argument from low rates will rise?

It basically boils down to simply this – rates are so low they MUST go up.

The problem, however, is that interest rates are vastly different than equities. When people go to make a purchase on credit, borrow money for a house, or get a loan for a new car, they don’t ask what the level of the stock market is but rather “how much will this cost me?” The differentiator between making a purchase, or not, is based on the simple outcome of the interest rate effect on the loan payment. If interest rates rise too much, consumption stalls, and along with it economic growth, causing rates to go lower. If economic demand is robust, rates rise to meet the demand for credit.

The trend and level of interests are the singular best indicator of economic activity. As Doug Kass recently noted:

“The spread between the two- and ten-year U.S. notes has fallen to 68 basis points — that’s the lowest print in ten years and if history is a guide it is signaling a potential domestic economic slowdown.”

“The flattening in the yield curve is happening despite a likely continued Federal Reserve tightening and a rise back to December levels for overnight index swaps (OIS). It was back in 2004 — as the Fed started its tightening cycle (that concluded in Summer, 2006) — that both the curve flattened and the five year OIS rose. At the conclusion of the tightening in the middle of 2006, a deep recession followed by about fifteen to eighteen months later.”

In other words, “It’s the economy, stupid.”

Economic Growth Drives Rates

The chart below is a history of long-term interest rates going back to 1857. The dashed black line is the median interest rate during the entire period. I have compared it to the 5-year nominal GDP growth rate during the same period.

(Note: As shown, interest rates can remain low for a VERY long time.)

Interest rates are a function of strong, organic, economic growth that leads to a rising demand for capital over time.There have been two previous periods in history that have had the necessary ingredients to support rising interest rates. The first was during the turn of the previous century as the country became more accessible via railroads and automobiles, production ramped up for World War I and America began the shift from an agricultural to industrial economy.

The second period occurred post-World War II as America became the “last man standing” as France, England, Russia, Germany, Poland, Japan and others were left devastated. It was here that America found its strongest run of economic growth in its history as the “boys of war” returned home to start rebuilding the countries that they had just destroyed. But that was just the start of it.

Beginning in the late 50’s, America embarked upon its greatest quest in history as man took his first steps into space. The space race that lasted nearly twenty years led to leaps in innovation and technology that paved the wave for the future of America. Combined with the industrial and manufacturing backdrop, America experienced high levels of economic growth and increased savings rates which fostered the required backdrop for higher interest rates.

Currently, the U.S. is no longer the manufacturing powerhouse it once was and globalization has sent jobs to the cheapest sources of labor. Technological advances continue to reduce the need for human labor and suppress wages as productivity increases. Today, the number of workers between the ages of 16 and 54 is at the lowest level relative to that age group since the late 70’s. This is a structural and demographic problem that continues to drag on economic growth as nearly 1/4th of the American population is now dependent on some form of governmental assistance.

This structural employment problem remains the primary driver as to why “everybody” is still wrong in expecting rates to rise.

As you can see there is a very high correlation, not surprisingly, between the three major components (inflation, economic and wage growth) and the level of interest rates. Interest rates are not just a function of the investment market, but rather the level of “demand” for capital in the economy. When the economy is expanding organically, the demand for capital rises as businesses expand production to meet rising demand. Increased production leads to higher wages which in turn fosters more aggregate demand. As consumption increases, so does the ability for producers to charge higher prices (inflation) and for lenders to increase borrowing costs. (Currently, we do not have the type of inflation that leads to stronger economic growth, just inflation in the costs of living that saps consumer spending – Rent, Insurance, Health Care)

The chart above is a bit busy, but I wanted you to see the trends in the individual subcomponents of the composite index. The chart below shows only the composite index and the 10-year Treasury rate. Not surprisingly, the recent decline in the composite index also coincides with a decline in interest rates.

In the current economic environment, the need for capital remains low, outside of what is needed to absorb incremental demand increases caused by population growth, as demand remains weak. While employment has increased since the recessionary lows, much of that increase has been the absorption of increased population levels.

Many of those jobs remain centered in lower wage paying and temporary jobs which do not foster higher levels of consumption. To offset weaker organic consumption, artificially suppressed interest rates, though monetary policy, gives the appearance of economic growth by dragging forward future consumption which leaves a future “void” that has to be continually refilled.

Currently, there are few economic tailwinds prevalent that could sustain a move higher in interest rates. The reason is that higher interest reduces the flow of capital within the economy. For an economy that remains dependent on the generosity of Central Bankers, rising rates are not the outcome that “stock market bulls” should NOT be rooting for.

The Implications Of A Bond Bust

If there is indeed a bond bubble, a burst would mean bonds decline rapidly in price pushing interest rates markedly higher. This is the worst thing that could possibly happen. 

1) The Federal Reserve has been buying bonds for the last 9- years in an attempt to push interest rates lower to support the economy. The recovery in economic growth is still dependent on massive levels of domestic and global interventions. Sharply rising rates will immediately curtail that growth as rising borrowing costs slows consumption.

2) The Federal Reserve currently runs the world’s largest hedge fund with over $4 Trillion in assets. Long Term Capital Mgmt. which managed only $100 billion at the time nearly brought the economy to its knees when rising interest rates caused it to collapse. The Fed is 45x that size.

3) Rising interest rates will immediately kill the housing market, not to mention the loss of the mortgage interest deduction if the GOP tax bill passes, taking that small contribution to the economy away. People buy payments, not houses, and rising rates mean higher payments.

4) An increase in interest rates means higher borrowing costs which lead to lower profit margins for corporations. This will negatively impact the stock market given that a bulk of the “share buybacks” have been completed through the issuance of debt.

5) One of the main arguments of stock bulls over the last 9-years has been the stocks are cheap based on low interest rates. When rates rise the market becomes overvalued very quickly.

6) The massive derivatives market will be negatively impacted leading to another potential credit crisis as interest rate spread derivatives go bust.

7) As rates increase so does the variable rate interest payments on credit cards.  With the consumer are being impacted by stagnant wages, higher credit card payments will lead to a rapid contraction in income and rising defaults. (Which are already happening as we speak)

8) Rising defaults on debt service will negatively impact banks which are still not adequately capitalized and still burdened by large levels of bad debts.

9) Commodities, which are very sensitive to the direction and strength of the global economy, will plunge in price as recession sets in.

10) The deficit/GDP ratio will begin to soar as borrowing costs rise sharply. The many forecasts for lower future deficits will crumble as new forecasts begin to propel higher.

I could go on but you get the idea.

The problem with most of the forecasts for the end of the bond bubble is the assumption that we are only talking about the isolated case of a shifting of asset classes between stocks and bonds. However, the issue of rising borrowing costs spreads through the entire financial ecosystem like a virus. The rise and fall of stock prices have very little to do with the average American and their participation in the domestic economy. Interest rates, however, are an entirely different matter.

I won’t argue there is much room left for interest rates to fall in the current environment, there is also not a tremendous amount of room for increases. Since interest rates affect “payments,” increases in rates quickly have negative impacts on consumption, housing, and investment. This idea suggests is that there is one other possibility that the majority of analysts and economists ignore which I call the “Japan Syndrome.”

Japan is has been fighting many of the same issues for the past two decades. The “Japan Syndrome” suggests that while interest rates are near lows it is more likely a reflection of the real levels of economic growth, inflation, and wages.

If that is true, then rates are most likely “fairly valued” which implies that the U.S. could remain trapped within the current trading range for years as the economy continues to “muddle” along.

The irrationality of market participants, combined with globally accommodative central bankers, continues to push asset values higher and concentrate investors into the ongoing “chase for yield.” There isn’t much guessing on how this will end, history tells us that such things rarely end well.

Mauldin: "Investors Ignore What May Be The Biggest Policy Error In History"

Submitted by John Mauldin

My good friend Peter Boockvar recently shared a chart with me. The University of Michigan’s Surveys of Consumers have been tracking consumers and their expectations about the direction of the stock market over the next year. We are now at an all-time high in the expectation that the stock market will go up.

The Market Ignores Monetary Uncertainty

It is simply mind-boggling to couple that chart with the chart of the VIX shorts (I wrote about the VIX craze in this this issue of Thoughts from the Frontline).

Peter writes:

Bullish stock market sentiment has gotten extreme again, according to Investors Intelligence. Bulls rose 2.9 pts to 60.4 after being below 50 one month ago. Bears sunk to just 15.1 from 17 last week. That’s the least amount since May 2015. The spread between the two is the most since March, and II said, “The bull count reenters the ‘danger zone’ at 60% and higher. That calls for defensive measures.” What we’ve seen this year the last few times bulls got to 60+ was a period of stall and consolidation. When the bull/bear spread last peaked in March, stocks chopped around for 2 months. Stocks then resumed its rally when bulls got back around 50. Expect another repeat.

Only a few weeks ago the CNN Fear & Greed Index topped out at 98. It has since retreated from such extreme greed levels to merely high measures of greed. Understand, the CNN index is not a sentiment index; it uses seven market indicators that show how investors are actually investing. I actually find it quite useful to look at every now and then.

The chart below, which Doug Kass found on Zero Hedge, pretty much says it all. Economic policy uncertainty is at an all-time high, yet uncertainty about the future of the markets is at an all-time low.

Why This Is Happening Now

At the end of his email blitz, which had loaded me up on data, Dougie sent me this summary:

• At the root of my concern is that the Bull Market in Complacency has been stimulated by:


• the excess liquidity provided by the world’s central bankers,


• serving up a virtuous cycle of fund inflows into ever more popular ETFs (passive investors) that buy not when stocks are cheap but when inflows are readily flowing,


• the dominance of risk parity and volatility trending, who worship at the altar of price momentum brought on by those ETFs (and are also agnostic to “value,” balance sheets,” income statements),


• the reduced role of active investors like hedge funds – the slack is picked up by ETFs and Quant strategies,


• creating an almost systemic "buy the dip" mentality and conditioning.


• when coupled with precarious positioning by speculators and market participants:


• who have profited from shorting volatility and have gotten so one-sided (by shorting VIX and VXX futures) that any quick market sell off will likely be exacerbated, much like portfolio insurance’s role in a previous large drawdown,


• which in turn will force leveraged risk parity portfolios to de-risk (and reducing the chance of fast turn back up in the markets),


• and could lead to an end of the virtuous cycle – if ETFs start to sell, who is left to buy?

On the Brink of the Largest Policy Error

The chart above, which shows the growing uncertainty over the future direction of monetary policy, is both terrifying and enlightening. The Federal Reserve, and indeed the ECB and the Bank of Japan, went to great lengths to assure us that the massive amounts of QE that they pushed into the market would help turn the markets and the economy around.

Now they are telling us that as they take that money back off the table, they will have no effect on the markets. And all the data that I just presented above tells us that investors are simply shrugging their shoulders at what is roughly called “quantitative tightening,” or QT.

I simply don"t buy the notion that QE could have had such an effect on the markets and housing prices while QT will have no impact at all.

In the 1930s, the Federal Reserve grew its balance sheet significantly. Then they simply left it alone, the economy grew, and the balance sheet became a nonfactor in the following decades. I don’t know why today’s Fed couldn’t do the same thing.

There really is no inflation to speak of, except asset price inflation, and nobody really worries about that. We all want our stocks and home prices to go up, so there’s no real reason for the central bank to lean against inflationary fears; and raising rates and doing QT at the same time seems to me to be taking a little more risk than necessary.

And they’re doing it in the midst of the greatest bull market in complacency to emerge in my lifetime.

Do they think that taking literally trillions of dollars off their balance sheet over the next few years is not going to have a reverse effect on asset prices? Or at least some effect? Is it really worth the risk? Remember the TV show Hill Street Blues? Sergeant Phil Esterhaus would end his daily briefing, as he sent the policemen out on their patrols, with the words, “Let’s be careful out there.”

* * *

Sharp macroeconomic analysis, big market calls, and shrewd predictions are all in a week’s work for visionary thinker and acclaimed financial expert John Mauldin. Since 2001, investors have turned to his Thoughts from the Frontline to be informed about what’s really going on in the economy. Join hundreds of thousands of readers, and get it free in your inbox every week.

Kass: "Investors Seemingly Learned Nothing From History"

Authored by Doug Kass via RealInvestmentAdvice.com,

“‘A bull market is like sex. It feels best just before it ends."” – Warren Buffett

Excuse me for being redundant, but the following Jim Rogers quote that I posted yesterday underscores Mark Twain’s famous quote that “history doesn’t repeat itself, but it often rhymes”:

“When things are going right, we all need a 26-year-old. There’s nothing better than a 26-year-old in a great bull market especially in a bubble. They’re fearless. They don’t know. It will never end. They will tell you why it will never end. They know that it cannot end and will never end. So in the bull market, you’ve got to have a 26-year-old. But when they end you don’t want the 26-year-old around… they make a lot of money. They don’t know why they made money. So they don’t know why they lose money. They don’t know what happened.“ -Jim Rogers on Realvision

Back in 1997 I wrote this editorial in the Other Voices section of Barron’s that echoed Rogers’ recent quote.

In the difficult business of piling up a fortune everyone has an infallible strategy and a set of assumptions, technical and./or fundamental, that leads them to investment nirvana.

But it is never easy. The rules change and so do the players.

From my perch I steadily have listened to the irrational being rationalized as the bulls declare, with straight-faced confidence, that valuations in the 95% decile should be ignored because a synchronized global expansion will “earn out” from these extended metrics.

This confidence is expressed despite a plethora of possible adverse outcomes, particularly in the interconnected world in which we live.

The positive outcome of steadily expanding global growth coupled with low inflation and equally low interest rates may yet prove to become reality. Geopolitical friction may subside. Political partisanship in Washington, D.C, may succumb to cooperation, leading to the initiation of tax and regulatory reform and the repatriation of overseas corporate cash. The Orange Swan may wake up and reject the extreme influences of the Republican right. Trump may stop threatening a war with North Korea in a ping-pong of outrageous and provocative tweets. The rate of growth in real GDP may expand to 3% and we may be in another new paradigm of uninterrupted growth. S&P profits will grow at a rate of 8% annually, ad infinitum. Natural disasters will be a thing of the past and global warming concerns are nonsensical. The North Korean Rocket Man may be all hat and no cattle. The proliferation of ETFs, which in number now exceed the number of listed equity securities, and the ever-present quant strategies that are ignorant of fundamentals may not yield a “flash crash,” easily accommodating any selling waves. Every dip will continue to be bought. And interest rates and inflation may be in a permanent stage of adolescence.

But, I am blinded by a sense of history, and the belief that few of the conditions in the last paragraph are likely to be met.

In our flat, interconnected and network world, the odds favor less stability over more stability.

To this observer the markets’ dominos are exhibiting signs of falling around all over — in consumer packaged goods, in (T)FANG, in retail and elsewhere. Yet the selective memory of the talking heads in the business media emphasize the narrowing field of outperforming stocks (e.g., Nvidia Corp. (NVDA) and Deere & Co. (DE) ) that have been working, failing to see those falling dominoes around them.

Fear and Doubt Have Left Wall Street

The ever-present risk to the contrarian is that, over the short term, the past literally is repetitive and the crowd typically outsmarts the remnant. Tuesdays always follow Mondays and Wednesdays follow Tuesdays. But as we extend time cycles, history seems to move from repeating itself to rhyming with the past.

History undoubtedly teaches lessons about investment, but it does not say which lesson to apply when. “Find value, always” is as good a precept as any, but value is subjective and its definition is liable to change. In highly speculative markets, value means, to most, “it is going up.”

Stay abreast because in bull markets there is rarely a clear demarcation between progress and fantasy. I remain of the strong belief that we are in a Bull Market in Complacency that likely ends poorly and that has reduced the upside and has expanded the potential market downside.

To the bullish cabal the market “feels” great now (for, as Warren Buffett says, it is because, like sex, if feels best at or near the end), but after an eight-year bull market it may be time to consider the investment contrary. As James Surowiecki wrote in “The Wisdom of Crowds”:

“Diversity and independence are important because the best collective decisions are the product of disagreement and contest, not consensus or compromise.”

Investment returns likely have been pulled forward by central bank liquidity, low interest rates and passive investing. However, over the next five years returns may be substandard at best, but more likely, negative. At worse, we face an incipient bear market.

As expressed in yesterday’s opener, the nature of and players in the investment business have changed. This helps to explain the Teflon nature of the S&P 500 Index.

But as Grandma Koufax used to say, “my matzah brei doesn’t grow to the sky,” and every day we move closer to a Minsky Moment.

The salutary environment perceived by many today may be transitory and weak in foundation.

The potential political, geopolitical, economic and market outcomes are many, and a clear and market-friendly path is not certain.

Bottom Line

The name of the game is money. It was Lord Keynes who first saw that the handling of it is a game. Most discussions of money and investing speak only of economics and statistics, but that’s only a part of the game. The other part is people, individually and together, the emotional investor and the irrational crowd.

And it again might be the market scene that is often (as it was in 2000 and 2007) seen only in kids’ eyes or in the eyes of older investors who behave like 26-year-olds at or near the end of every significant bull market cycle:

“‘See, see,’ said the Great Winfield. ‘The flow of the seasons ! Life begins again! It’s marvelous! It’s like having a son! My boys! My kids!"” -Adam Smith, “The Money Game”

Do some reading over the weekend as it appears that the only thing many investors have learned from history is that they haven’t learned from history.

iPhone X So Expensive In India "You Can Fly To Hong Kong, Buy It, Come Back And Save Money"

One day after the most anticipated Apple product launch in 10 years, several problems have emerged for the much hyped iPhone X, face-recognition demo flop notwithstanding: it will be substantially delayed confirming all earlier reports of supply-chain bottlenecks, and it will be expensive, perhaps prohibitively so. The introductory prices of the iPhone 8 and the iPhone 8 Plus have gone up compared to the prices of the iPhone 7 and the iPhone 7 Plus. The iPhone X, meanwhile, will price in the 4 digits well equipped. Addressing this issue, the WSJ has a front page article titled "Apple’s New iPhones Gamble on Allure of Premium Pricing."

In one place that gamble may prove insurmountable. As India Today writes, when it goes on sale in India on November 3, the iPhone X will cost Rs 89,000 for the 64GB version. The top-end variant with 256GB is going to cost Rs 102,000. "In other words, this is one expensive phone, although you can say that the iPhone has always been expensive."

To demonstrate just how expensive, on a purchase price parity basis, the iPhone X will be in India, India Today writes that "the other thing that you can say about the iPhone X is that it is cheaper in some other places. As it always happens, the market where the iPhone X is going to be the cheapest is probably Hong Kong." 

In fact, the iPhone X is so expensive in India, and so cheap in Hong Kong, that you can go Hong Kong, buy the phone, and come back and yet save some money. And this includes the cost of flight ticket to Hong Kong. Just see the math."

iPhone X (256GB) in India: Rs 102,000

iPhone X (256GB) in Hong Kong: Hong Kong Dollar 9,888. This means using the current exchange rate, in Indian currency the price is Rs 80,999.

What does this mean? It is cheaper to go to Hong Kong and buy the iPhone X 256Gb variant there.

The iPhone X will be available from November 3. Now, if you book your flight to Hong Kong today, the cheapest flight in the first week of November that you can book from Indian will cost around Rs 20,000. If you book a flight from Kolkata, you can get a return ticket to Hong Kong for little over rs 17,000. From Bangalore it is around Rs 19,000. From Delhi, around Rs 20,000. From Mumbai it is a little more expensive.

Flight ticket: Air Asia Rs 17,800

iPhone X 256GB: 80,999
Some other expenses: Around Rs 2000 to Rs 3000
Total: Around Rs 1 lakh
Money saved: Around Rs 2000

The report"s conclusion:

Now, we know the whole thing sounds like a joke. And in a way it is. No one is going to go specifically to Hong Kong from India to buy the iPhone. Also, it works best with the 256GB variant. But it does show the ridiculousness of the iPhone prices. and particularly the iPhone X prices, in India. Is it because Apple can"t price the iPhone any cheaper? Is it because Apple wants big profit margins? Is it because of Indian government taxes? Is it because Apple wants to keep the iPhone prices high so that it continues to a status symbol in India? We don"t know. Only Apple can answer these questions, if it wishes to answer them.

For now Apple is ignoring these, and various other pressing questions - including the whole animated poop emoji. Overnight Doug Kass released the following assessment of why this time Apple may have gone too far:

Apple continues to deliver an expensive smartphone relative to its peers, with many features that are already available from its competition and most of which were anticipated, including face recognition, a full-screen interface and no home button.

The only exception to reality versus anticipation was the later-than-expected availability, which is toward the end of the year (orders will be accepted on Oct. 27 and deliveries are slated for Nov. 3). As a result, analysts could take 3 million to 4 million iPhones out of their December quarter projections and reduce full-year 2018 estimates by about $0.40 a share.

However, the new Apple phone will provide an animated poop emoji so you can talk crap to your friends.

The starting price for the 64GB model of the iPhone X is $999 and $1,149 for the 256GB model. The Apple smartphone continues to be a high-priced aspirational product accompanied by a remarkably effective marketing effort that is stretching its status symbol appeal. However, I see little incremental to the latest product offerings, leaving room for disappointment relative to optimistic expectations. (It is why I initiated an Apple put position yesterday morning and added to that position when the stock was up $2 early in the afternoon).

The expectations of an Apple replacement super-cycle accompanied by higher unit volumes and much higher average selling prices, leading to expectations of a "hockey stick" of earnings growth in the coming fiscal year coupled with a general confidence in sustainable growth from there, have spurred a rise of more than 50% in Apple"s one-year forward price/earnings multiple in the last 1 1/2 years.

I clearly have underestimated the strength of and the confidence in the Apple franchise over the last year. Recognition of this has led me to maintain more of a trading-oriented short position, whereas years ago I had more of an investment short position, which proved successful. Nevertheless, I continue to believe that these aggressive "going forward" expectations for Apple and the company"s current valuation remain too ambitious.

But the biggest threat facing the iPhone and perhaps the entire Apple business model, is if its products are no longer perceived as the pinnacle of "coolness." And while it is too early to conclude either way, following yesterday"s disappointing and badly leaked release, many appear to be taking aim at Apple not as the source of brilliant Steve Jobsian innovation and "hipness", but as the target of mockery, scorn and humor. Indeed, as one readers suggested, "The bloom may be coming off the rose.  Even folks in the twittersphere piling on.  In the past there was such a halo around apple, nobody would make fun of them.  Now it seems the opposite."

Iis the idol worship coming to an end? According to these widely publicized reactions to the iPhone release, the answer appears to be yes.

Howard Marks Unveils The 6 Options For Investing In Today's "Low-Return World"

Via Seabreeze Partners" Doug Kass,

In late July, Oaktree Capital Management co-chairman Howard Marks issued several market warnings in "There They Go Again ... Again," which I extensively highlighted in my Diary.

"There is plenty more food for thought in this must-read 22 pages of observations. Howard closes his musings with this advice:

"If you refuse to fall into line in carefree markets like today"s, it"s likely that, for a while, you"ll (a) lag in terms of return and (b) look like an old fogey. But neither of those is much of a price to pay if it means keeping your head (and capital) when others eventually lose theirs. In my experience, times of laxness have always been followed eventually by corrections in which penalties are imposed.

It may not happen this time, but I"ll take that risk. In the meantime, Oaktree and its people will continue to apply the standards that have served us so well over the last [thirty] years."

From my perch, greed reigns today.

As Howard relates, investors make the most -- and safest -- money when they do things that other people don"t want to do. But when most investors are unworried and taking unusually high risks, asset prices are typically elevated, risk premiums are low and markets are risky.

It"s what happens when there is too much money and too little fear."

--Kass Diary, "There They Go Again ... Again," July 27, 2017

In that July memo Howard made these principal points in evaluating current conditions:

* The market uncertainties are unusual in terms of number, scale and insolubility.

* In the vast majority of asset sectors, prospective returns are about the lowest they have ever been.

* Asset prices are high and almost nothing can be purchased at a discount to intrinsic value. In general, the best we can do is find asset classes that are less overvalued than others.

* Pro-risk behavior is commonplace as most investors are embracing increased risk.

In the commentary Howard admitted he was likely issuing a premature warning because it is better to be cautious too early than to be too late in evaluating opportunities and conditions.

Howard is no stranger to cautionary memoranda. Back in 2005, in "There We Go Again," he shared some non-consensus concerns that were most prescient, as they would precede the worst economic contraction since The Great Depression. Reading that memo would have saved an investor a boatload of money.

I find most of Howard"s commentaries as extraordinarily important in understanding market conditions and reward versus risk. His body of work always makes me think and it is invariably logical in argument and characterized by a heavy dose of analytical dissection.

Fast forward to yesterday"s newest (and another value-added) memorandum from Howard Marks, "Yet Again?"

Howard starts his latest commentary with the following introduction:

"There They Go Again . . . Again" of July 26 has generated the most response in the 28 years I"ve been writing memos, with comments coming from Oaktree clients, other readers, the print media and TV. I also understand my comments regarding digital currencies have been the subject of extensive - and critical - comments on social media, but my primitiveness in this regard has kept me from seeing them.

The responses and the time that has elapsed have given me the opportunity to listen, learn and think. Thus I"ve decided to share some of those reflections here."

--Howard Marks, "Yet Again?"

The body of Howard"s memo deals with the media"s reaction to his July memo and a further discussion of his views on bitcoin (and other cryptocurrencies), FANG, the ramifications of passive investing, investing in a low-return world and, of course, evaluating the state of the capital markets.

The State of the Market

There has been a lot of discussion about how elevated I think the market is.  I’ve pushed back strongly against people who describe me as “super-bearish.”  In short, as I wrote in the memo, I believe the market is “not a nonsensical bubble – just high and therefore risky.” 

I wouldn’t use the word “bubble” to describe today’s general investment environment.  It happens that our last two experiences were bubble-crash (1998-2002) and bubble-crash (2005-09).  But that doesn’t mean every advance will become a bubble, or that by definition it will be followed by a crash.

Current psychology cannot be described as “euphoric” or “over-the-moon.”

Most people seem to be aware of the uncertainties that are present and of the fact that the good times won’t roll on forever.

Since there hasn’t been an economic boom in this recovery, there doesn’t have to be a major bust.

Leverage at the banks is a fraction of the levels reached in 2007, and it was those levels that gave rise to the meltdowns we witnessed.

Importantly, sub-prime mortgages and sub-prime-based mortgage backed securities were the key ingredient whose failure directly caused the Global Financial Crisis, and I see no analog to them today, either in magnitude or degree of dubiousness.

It’s time for caution, as I wrote in the memo, not a full-scale exodus.  There is absolutely no reason to expect a crash.  There may be a painful correction, or in theory the markets could simply drift down to more reasonable levels – or stay flat as earnings increase – over a long period (although most of the time, as my partner Sheldon Stone says, “the air goes out of the balloon much faster than it went in”).

Howard concludes his latest memo with the following:

"A lot of the questions I"ve gotten on the memo are one form or another of "So what should I do?" Thus I"ve realized the memo was diagnostic but not sufficiently prescriptive. I should have spent more time on the subject of what behavior is right for the environment I think we"re in.

In the low-return world I described in the memo, the options are limited:

1. Invest as you always have and expect your historic returns.

2. Invest as you always have and settle for today"s low returns.

3. Reduce risk to prepare for a correction and accept still-lower returns.

4. Go to cash at a near-zero return and wait for a better environment.

5. Increase risk in pursuit of higher returns.

6. Put more into special niches and special investment managers.

It would be sheer folly to expect to earn traditional returns today from investing like you"ve done traditionally (#1). With the risk-free rate of interest near zero and the returns on all other investments scaled based on that, I dare say few if any asset classes will return in the next few years what they"ve delivered historically.

Thus one of the sensible courses of action is to invest as you did in the past but accept that returns will be lower. Sensible, but not highly satisfactory. No one wants to make less than they used to, and the return needs of institutions such as pension funds and endowments are little changed. Thus #2 is difficult.

If you believe what I said in the memo about the presence of risk today, you might want to opt for #3. In the future people may demand higher prospective returns or increased prospective risk compensation, and the way investments would provide them would be through a correction that lowers their prices. If you think a correction is coming, reducing your risk makes sense. But what if it takes years for it to arrive? Since Treasurys currently offer 1-2% and high yield bonds offer 5-6%, for example, fleeing to the safety of Treasurys would cost you about 4% per year. What if it takes years to be proved right?

Going to cash (#4) is the extreme example of risk reduction. Are you willing to accept a return of zero as the price for being assured of avoiding a possible correction? Most investors can"t or won"t voluntarily sign on for zero returns.

All the above leads to #5: increasing risk as the way to earn high returns in a low-return world. But if the presence of elevated risk in the environment truly means a correction lies ahead at some point, risk should be increased only with care. As I said in the memo, every investment decision can be implemented in high-risk or low-risk ways, and in risk-conscious or risk-oblivious ways. High risk does not assure higher returns. It means accepting greater uncertainty with the goal of higher returns and the possibility of substantially lower (or negative) returns. I"m convinced that at this juncture it should be done with great care, if at all.

And that leaves #6. "Special niches and special people," if they can be identified, can deliver higher returns without proportionally more risk. That"s what "special" means to me, and it seems like the ideal solution. But it"s not easy. Pursuing this tack has to be based on the belief that (a) there are inefficient markets and (b) you or your managers have the exceptional skill needed to exploit them. Simply put, this can"t be done without risk, as one"s choice of market or manager can easily backfire.

As I mentioned above, none of these possibilities is attractive or a sure thing. But there are no others. What would I do? For me the answer lies in a combination of numbers 2, 3 and 6.

Expecting normal returns from normal activities (#1) is out in my book, as are settling for zero in cash (#4) and amping up risk in the hope of draws from the favorable part of the probability distribution (#5) (our current position in the elevated part of the cycle decreases the likelihood that outcomes will be favorable).

Thus I would mostly do the things I always have done and accept that returns will be lower than they traditionally have been (#2). While doing the usual, I would increase the caution with which I do it (#3), even at the cost of a reduction in expected return. And I would emphasize "alpha markets" where hard work and skill might add to returns (#6), since there are no "beta markets" that offer generous returns today.

These things are all embodied in our implementation of the mantra that has guided Oaktree in recent years: "move forward, but with caution."" 

*  *  *

Run, don"t walk, to read Howard Marks" newest commentary.

Move forward, but with caution.

SkyNet is Sentient and Will Destroy Your Investments and Pension

SkyNet is Sentient and Will Destroy Your Investments and Pension

By

Cognitive Dissonance

https://www.patreon.com/CognitiveDissonance

http://twoicefloes.com/

Do you really want to know about how SkyNet controls your investments and pension via the various financial markets? I ask with all sincerity because the subject is not pleasant and may even be frightening to those who have followed a strict diet of financial ignorance.

Once you know, it is nearly impossible to un-know. And just as there is never only one weed in the garden, knowing this inevitably leads to a critical juncture where one must then decide if they wish to know more or simply curl up in the fetal position on the bathroom floor.  

You see, when “We the Mindless Minions” (desperately) wish to avoid responsibility for knowing, while the specific tactics used may vary greatly, the theme remains pretty consistent. I call it the Sgt. Schultz defense.

“I know nothing, I see nothing and I was never here.”

A variation of the theme, usually employed when among others, thus we cannot claim total ignorance about the uncomfortable subject presently being discussed, is brilliant in its ability to disavow responsibility while passing the buck to someone (anyone) at a higher pay grade.

“They would never let that happen/do that,” or the always reassuring “I’m sure someone’s looking into that as we speak.” Now how about those (fill in this blank with any sport, celebrity, politician, TV show or viral cat video).

Disavowing knowledge or responsibility, passing the buck and then changing the subject is the time tested way to live in blissful ignorance. Or as I have grown fond of saying, unconscious incompetence with a heaping side order of willful ignorance. 

By the way, if you have never come across that phrase, let me give you the crib notes with a little Donald Rumsfeld thrown in for good measure. There is unconscious incompetence. I do not know that I do not know. There is conscious incompetence. I know I do not know and I’m trying like hell to get up to speed and improve.

Then there is conscious competence, where I have fully embodied my incompetence and have turned it around by mindfulness and constant personal work. Finally there is unconscious competence, where I have reached a point where it all just comes naturally, with little thought given to actually doing what by now is simply a natural part of my self.

It should be noted with great emphasis these four steps are speaking to spiritual growth and evolution, not scientific, political or mathematical knowledge. Though it should also be noted those of us firmly enmeshed within the Imperial culture dwell strictly at the first level of unconscious incompetence. Any accidental glimpse of our actual ‘self’ is quickly suppressed and forgotten. Beware, for there be dragons.

Viral cat videos, conversing with your lover next to you in bed via text and narcissistic selfies are just a few examples of unconscious incompetence. Let your imagination be your guide while compiling your own personal list.

So, with this information firmly in hand, do you really wish to know how SkyNet is controlling your investments and pension?

Below this piece are links to two articles written by Doug Kass, a financial professional MANY pay grades above me. He explains in reasonably plain English what this potential problem is about.

Just in case your ADHD has suddenly flared up, or your hands are shaking at  the thought of reading his (shorter than mine) missives, let me give you the down and dirty. While the financial mainstream media likes to promote the illusion actual humans are in charge as they control the financial markets, helped along with images of human traders shouting into phones or scribbling on a pad of paper, reality is quite different.

These days over 60% of actual ‘trading’, meaning buying and selling of stocks, bonds and derivatives, is executed by (thinking) machines aka computers. And no, I’m not talking about that sleek looking desktop box or fancy laptop you bought from Dell last year.

This means less than 40% of all trading is actually done by thinking humans using real world judgment and expertise. And that percentage is rapidly diminishing on a daily basis. I suspect in a few years it will be down to less than 20%.

The thing about computers is they are fast and efficient. And the ultimate in unconscious incompetence, since they have (at least for now) no spiritual presence, let alone common sense or fear of high places from which they could fall. Such as an extremely overbought stock and bond market at all time highs; markets which have completely divorced themselves from fundamental financial logic and reason.

Greed runs riot in the towers of Wall Street. Or to be more accurate, in mainframe computers tucked away in nondescript industrial parks in New Jersey, Chicago, Texas or wherever.

But the computers are not the problem here, or at least not the primary problem. That’s because computers are essentially expensive boat anchors unless instructed on what and how to do something. This requires an operating system and software, similar to the operating system and programs on your Windows, Linux or Apple computer.

Ok, somewhat similar. Maybe! Well, actually not. But we’re getting to that.

Software is (usually) dumb as a rock and entirely dependent upon the genius of the creator(s) of that software. While a computer may be millions of times faster than a human, it is only as smart as the human who programs it.

Unless………

It"s not just a science fiction movie anymore.

Popular media introduced us to the concept of Artificial Intelligence (AI) decades ago via science fiction in book and movie form. Everyone over a certain age remembers HAL from 2001: A Space Odyssey, where HAL the AI computer begins making ‘mistakes’ and decisions that are at times contrary to the wellbeing of the humans on board the spaceship. The Terminator series of movies is another example of AI run riot; in this case the AI was a group of networked computers called SkyNet.

While the concept was/is always quickly dismissed as highly improbable, if not outright impossible, it no longer is impossible, at least when it comes to trading the financial markets.

In an effort to increase the efficiency of trading computers (read that as make them more PROFITABLE) computer scientists and programmers have infused the computers with increasingly sophisticated AI software. Meaning these computers can now learn very quickly on their own.

Most people are not aware that professional human traders using extremely sophisticated trading strategies and tools (aka financial derivatives) can make a boat load of money regardless of whether the market is going up or down. While you are encouraged to stay in the market regardless of what’s happening, the professionals are leveraging your passive position into money in their bank. So be it. That is the confidence game the markets have always been.

Now here’s the kicker.

The individuals and institutions with financial dogs in this fight, along with a (very LARGE) paycheck to maintain, will assure all who ask if these trading programs are safe. “Yup, no problem, we can turn HAL off anytime we want. See, here is the panic button right here. And if all else fails, here are some grenades and a flame thrower.”

However, frank discussions with actual computer scientists who create AI software for a living reveal a slightly (ok, very) different assurance.

Popular myth informs us ALL computers are simply fast humans. Whatever a human can do, a computer can do much faster. And that may be the case for 99.9999% of the computers out there. But this is NOT the case with AI computers.

Once the AI computer is turned on and the software begins to ‘learn’, no one knows exactly what it is doing or why. And the longer it learns, the more it can and will deviate from its own original programming.

Anyone who says otherwise is either lying directly to your face or demonstrating their glaringly obvious unconscious incompetent.

Or both.

The AI trading software has one prime directive. Make money, lots of money. Or as my lovely bride likes to say, a crap ton of money. It does this mostly by making tiny (profitable) trades tens of thousands of times per second.

That is not a typo. I said per ‘second’.

All the financial markets are currently awash in oceans of liquidity. Meaning nearly free money is handed by the Federal Reserve (and other central banks) to all those warm and cuddly too-big-to-fail banks and their partner institutions and companies to do with as they please. They in turn got their friends in Congress to OK rigging the market with their AI computers so they can’t lose.

There are banks and trading institutions out there that have not had a single losing day trading the market in years.

Y E A R S!

If you never lose money when trading the markets, obviously the markets are rigged in your favor. But it’s all ‘legal’ so what’s the problem. Heads they win, tails you lose. It just doesn’t get any better than this.

The easiest way for the machines to make money is to push the market up. But when the tide turns, and it always eventually turns, the machines will shift to making money on the way down with the same speed and zeal they apply to the ‘up’ market.

Only ‘down’ markets tend to breed panic in the humans. When selling really ramps up, market conditions move very rapidly and markets can drop many percentage points in seconds, especially when you have machines making tens of thousands of trades a second and you have thousands of machines all doing this at the same time.

Can you say “Express elevator to the basement?”

The somewhat uncomfortable euphemism coined for this phenomenon by market participants down in the pits and up in the peanut gallery is “Flash Crash”. You may even remember the 2010 Flash Crash, where markets dropped like a rock (“collapsed” is the technical term) then quickly rebounded to regain most (but not all) of the loss, all in under 40 minutes.  

While this hiccup was eventually blamed on one individual, a so-called rogue trader, we must fully understand the markets are a con game, a Ponzi scheme. And the only way they can continue to bleed the suckers dry is to maintain confidence in the game. Thus those who ‘regulate’ the game will not destroy confidence in the game by telling the truth.

It simply won’t happen!

Supposedly this ‘problem’ was fixed shortly after the crash and all was right in the world again. But over the ensuing years mini flash crashes have been showing up first in small illiquid stocks, then larger blue chip stocks and recently in the US Treasury market, the largest, most liquid and stable market in the world.

And while the people who own these (rip off) machines claim all is well, those who appear to being channeling a bit of their conscious incompetence (meaning they are breaking from their Imperial conditioning) are sounding the alarm bells.

Loudly, as in air horns at 2 paces.

My mother imbued in me some wisdom, life lessons I eventually embraced after resisting them for as long as I could. The really good ones were always short and sweet.  Just because everyone else is doing something doesn’t mean you should. And if something is good, more is not always gooder…or better as the case may be. In fact it rarely is.

These were tough pills to swallow for an impatient young boy with a severely underdeveloped impulse control. But it’s one thing for a seven year old to become violently sick from excessive indulgence in candy bars (10 to be exact) and another for a relatively few men and women to set loose ‘thinking machines’ they do not actually control upon markets that are already long overdue for a correction and therefore extremely fragile.

But alas, we are dutifully assured by various financial high priests and powerful fiat wizards that capital markets are efficient and highly regulated. Worst case scenario, we can mosey on over to Mabel the thinking machine and pull her plug. Problem solved.

Lies. Damn lies in fact.

Unfortunately. No, let me try that again. UNFORTUNATELY the problem is even worse than outlined, if that’s even possible. IF the world’s governments weren’t spending money like drunken sailors and IF the world’s central banks weren’t printing money out of thin air like mad hatters and IF personal, corporate and governmental debt wasn’t well past the point of ever being paid back and IF public and private pensions weren’t severely underfunded despite an all time high bond and stock market and IF student loan debt default rates weren’t at 30% and rising and IF the US wasn’t going full police state and IF….well, you get the picture.

IF all these (and more) detrimental socioeconomic conditions weren’t present, then MAYBE SkyNet becoming sentient MIGHT be a recoverable event.

The ONLY reason you accept these pieces of paper in exchange for your labor (work) is because you have faith and belief they will be accepted by the business down the street in exchange for their goods and services.

What happens when one of you no longer believes that? What would it take for you to no longer believe that?

That which is unsustainable cannot and will not be sustained. Something has to give. The longer the unsustainable is forced to sustain, the greater the damage when it all comes crashing back down to terra firma.

If you are a student of history, eventually you come to realize events large and small tend to cycle in and out on a reasonably predictable time frame. Huge financial catastrophes appear to occur in 80 to 90 year cycles, though this timing isn’t hard and fast. And it is often regional rather than global, such as northern or southern hemisphere, eastern or western cultures etc.

What is evident to me is these huge socioeconomic disasters follow the life cycle of humans, meaning the insanity ramps up precisely when the generation affected by the last collapse has just about died off from the face of the Earth.

The last socioeconomic implosion, the Great Depression followed closely by World War Two, has now essentially completely disappeared from living human and institutional memory. All that remains are chapters in history books and the following generation (that’s me) who vaguely remembers grandma and pa talking about those terrible times.

In the minds of we mere mortals, distance and time tend to greatly diminish the concept of risk. When those parameters extend beyond our living memory, we can easily convince ourselves and others we have progressed mightily since those ancient times and the warnings from the grave are meaningless and not applicable.

This is precisely what the high priests, financial wizards and every conflicted soul who benefits from the financial insanity are telling us today. Ignore that man behind the curtain (or in the grave) for I am the mighty and powerful Wizard of Oz.

One final thought. The financial crash in 2000-2001 was a loss of confidence in individual companies and/or a sector of companies. That market crash is most remembered as the tech wreck, where technology companies got way over their skies and needed to be rescued or allowed to fail. The banks did the heavy work in bringing the confidence game back from the grave.

But in 2008-2009, the banks themselves got in way over their heads. And this time the Federal Reserve and the US Government, along with every other major global central bank and government, came to the rescue, bailing OUT the too-big-to-fail banks at the expense of the taxpayer. This abomination was later extended to savage the savers with interest rates pegged at near zero in order to guarantee the banks a solid profit.

After all, the bank executives, traders and upper level management must be fairly compensated for all the financial death and destruction they have wrought. It’s hard work destroying hearth and home for crying out loud. To expect anything different would be un-American.

When the next financial crisis hits, it will be the central banks and governments who will suffer a crisis of confidence. Because this time it will be a currency crisis once everyone realizes the money is backed by nothing more than thin air. And they’ve been printing a LOT of thin air over the last ten years.

So exactly who will come to the rescue of the various global governments? Yup, you and me, that’s who. And we won’t be given any choice in the matter. Suddenly the rapid expansion of the police state makes more sense when seen from this perspective.

We will witness our (large) bank deposits, along with stocks, bonds and other ‘securities’ vaporize as “We the Morons” are bailed IN, not out. Our money will be confiscated and swapped for bank equity, government bonds or some new type of fake fiat in order to protect us from the disaster they created. Sounds like the perfect mafia protection scam to me.

The rules, regulations and laws enabling all of this to happen have already been passed in all the first and second world countries, including the USA.

What’s that? You never read about this in the newspaper or saw anything about this on the boob tube ‘news’ shows?

I wonder why that is?

So when do the fireworks start? To be perfectly frank I haven’t the foggiest idea. There’s an old saying on Wall Street. The markets can remain irrational far longer than you can remain solvent. The farce could continue for the next six weeks, six months or six years. And it might even last longer.

But remember this. All confidence games are pretty solid right up until confidence is lost. When that happens, the rush of escaping air reaches hurricane force in an instant and all exit doors suddenly slam shut. We peons will be the last to know when the jig is up; therefore there will be no exit for us.

The markets will be shut, the banks closed and all trading ceased before the public is told there is a serious problem. Usually this occurs over the weekend and these institutions simply don’t reopen on Monday. Your money will be frozen in place and completely inaccessible. Sure, the relative small dollar amounts in checking and savings accounts might remain available. But the big chunks will be locked away under ‘capital control’ decrees.

Suddenly it will be a brave new world, one completely alien to us. Righteous indignation will quickly follow shock and awe. Then the panic begins. It’s happened before and it will happen again. Most people don’t know the USA has defaulted on its financial obligations several times in its past. So has every other old world country. It’s not a matter of if, but when.

All fiat currencies fail simply because there is nothing backing a fiat currency but pure faith and belief, since anything of substance was long ago looted. It eventually becomes a pure confidence game once the collusion between the elites, the financial interests and the government escalates to the point where there’s no turning back.

We are well past that point at this time.

The choice is simple. Either be a victim (whocouldanode) or break from the herd and prepare for the inevitable.

The articles linked below explain the AI issue much better than I can, though I have added a great deal of background and opinion in this piece for clarity. Or hilarity is you so wish. I urge you to read both of them.

Go ahead. What do you have to lose, except possibly your investments and pension?

06-18-2017

Cognitive Dissonance

Like Something Out of "The Twilight Zone," This Market Is About the Machines

Doug Kass: Not Even The Algo Creators Know What Is Going On

Our old way of life, of excess consumption, is ending. What cannot be sustained will not be sustained. We have two choices. Have change thrust upon us or change on our own terms in advance of the wave.