Deutsche: "We Are Almost At The Point Beyond Which There Will Be No More Bubbles"

Whereas many Wall Street strategists enjoy simplifying their stream of consciousness when conveying their thoughts to their increasingly ADHD-afflicted audience, the same can not be said for Deutsche Bank"s Aleksandar Kocic, who has a troubling habit of requiring a background and competency in grad level post-modernist literature as a prerequisite for his articles among the handful of readers who don"t already speak exclusively in binary. Here is an example of Kocic"s "unique" narrative style:

Volatility is a consequence of speed and speed is the result of fear. Acceleration of movement is a defensive maneuver, a tool of retreat -- high speed and high volatility represent sophistication of flight (flight to quality is an example of the speed event). However, absence of volatility is not necessarily synonymous with absence of fear. Volatility is low not only when things become predictable, but also if the distribution of risks causes paralysis, when the state of no change, regardless how uncomfortable it might be, becomes the least undesirable of all alternatives.

While a passage like that is far more likely to have been taken from a book by Lacan, Derrida, Deleuze and Guattari, Foucault or any other prominent POMO-ists, in this case it comes from Kocic" year end outlook which encapsulates many of the themes we have covered recently, most notably his recent take on the interplay between volatility and leverage, a topic which anyone who has read Minsky is quite familiar with, yet which Kocic decided to give it his unique post-modernist spin with the following "spiraling leverage" chart from one month ago...

... which he described as follows: "spiraling leverage cannot continue indefinitely. At some point, the bubble becomes too big and cannot be subsumed by a bigger bubble – the damage of its burst would become irreparable. Therefore, when that moment comes -- and we believe that moment is now – the market is facing a following dilemma."

• Permanent state of exception: We continue to operate in a regulated environment. Leverage is limited, but care is taken not to overconfine the system so we avoid the Japanese scenario. While this appears as a prudent approach to reality, it implies giving up all the ideas of unlimited growth, something that made US economy look better than the rest of the world. Compared to what we have seen before, this means settling for much less than this country is used to aspiring. Although a reasonable proposition, it is emotionally a difficult choice that is and will remain subject to substantial political manipulation. It is unlikely that populist narrative will not continue to challenge this choice [ZH: hey, one can just blame the Russians, right?]


• Flirting with high tail risk : Deregulation and deficit spending could result exactly due to abandoning the first path, as its direct challenge, under political pressure that American economy can restore its old status and resume its pace of the previous decades. This is a serious tail risk as it is playing against the backdrop of considerable overhang of the post-2008 one-side positioning. Central banks are massively short convexity in this scenario. Any inflationary maneuver, or anything that would be a bear steepener of the curve, could force disorderly unwind of the bond trade and reinforce the trend thus creating another crisis from which there could be no way out.


• Forced deleveraging: An overly hawkish Fed forces rates higher and triggers a disorderly unwind of the bond trade, thus forcing the system to deleverage. This is the policy mistake.

The Deutsche Banker"s conclusion was stark and certainly dramatic:

"The tension created by these three choices is in the center of both economic and political discourse. It will shape the market dynamics in the future, beyond the near term. Taper tantrum and the US presidential elections were the two most recent episodes that have highlighted the risk distribution opened by these choices. Policy mistake appears less likely at this point. The financial conditions are as loose as they have ever been. Fed hikes are only going to tone this down, but it is very difficult to see how they can create overly tight financial conditions and cause economic slowdown. Nevertheless, negative convexity of the central banks in the bear steepening or generally high rates scenarios are making risk of volatile deleveraging alive."

Of course, Kocic could (far simply) have said that it takes more and more debt to kick the can, and keep the world"s biggest asset bubble ever created - with the explicit backing of central banks - from bursting. This is precisely what Bank of America"s Barnaby Martin did in far less words one month ago:

"the irony in today"s world is that central banks are maintaining loose monetary policies to generate inflation…in order to ease the pain of a debt "supercycle"…that itself was partly a result of too easy (and predictable) monetary policies in prior times."

* * *

In any case, fast forward one month later when Kocic picks up where he left off on his favorite "spiraling leverage" diagram, and decides to once again paraphrase Minsky"s conclusion that "stability is destabilizing" using just a few hundred extra words than is necessary, although since he does so in a "cool", Pomoist way, here is the paraphrase:

Persistent low volatility is like a sirens’ song. Low uncertainty engenders high leverage which leads to compression of risk premia and further buildup of risk, which, in the long run, destabilizes the system causing ultimately volatile deleveraging. This is generally harmful for the economy and requires stimulus injection in order to create an economic turnaround leading to subsequent decline in volatility and gradual releveraging as the system recovers. When described in terms of leverage and volatility, economic trajectories exhibit quasi-periodic pattern. These dynamic are shown in the Figure as trajectories in the vol-leverage plain across several “cycles”.

 

Starting with the internet bubble in 1999, we reach the 2001 recession and subsequent recovery on the back of the real estate boom (2003-2007). The figure suggests that after each volatile deleveraging (e.g. 2000 and 2007), subsequent sweep leads to a bigger bubble. After each sweep, amplitudes grow bigger and the damage more substantial, requiring a heavier hand in terms of policy response as crises they create become deeper and recoveries longer and more difficult.

Kocic then reuses the same chart he showed back in November to indicate the four distinct endgames should the leverage cycle be pushed into one of four final states of "instability."

Where the narrative differs from last month, however, is in the slight but perceptible shift to Kocic" conclusion: he now appears resigned that the current twist of the vol spiral is also the last one, beyond which the current financial and monetary system will no longer exist, something his just as gloomy colleague Jim Reid concluded not too long ago and which we described in "This Is Where The Next Financial Crisis Will Come From."

Here is Kocic explaining why we may be approaching the end of financial history (at least as we know it):

It is clear that the spiraling trajectory cannot continue indefinitely; it has to stop at some point beyond which there will be no more bubbles. In many ways, it looks like the post-2008 represents the last lapse. A new game has to be reinvented for the old future to materialize, or a different paradigm altogether has to take over.

As to what happens next, after the two sweeps of the spiral, both of which culminated with crashes, Kocic reverts back to his forecasting self and writes that "we arrived at the juncture point (2017) from which four possible trajectories emerge, none of them are looking very attractive at this point." For those who may have forgotten the November report, here they are again:

• Throughout the post-crisis period, policy response has been designed around an attempt to avoid the lower left corner of low volatility and low leverage. It is safe to say that we have been able to stay clear of this outcome.


• At this point, with regulated financial sector and restricted leverage, we have found what appears to be a “reasonable” base case trajectory – a middle ground between Japanese style liquidity trap and repeat of the same mistake of the previous lapse -- with regulated markets, lower leverage, and subaverage growth (a.k.a. Permanent state of exception).


• Alternatives represent risk scenarios and correspond to volatile outcomes. The lower right corner is the policy mistake territory of forced deleveraging (without inflation) triggered possibly by overly aggressive Fed.


• The most acute risk is associated with the path leading to the upper right corner where possible deregulation and reckless fiscal spending could trigger rise in inflation leading to stagflationary outcome with potential currency decline and forced unwind of the bond trade. Both of these trajectories represent high risk alternatives to be avoided.

Unfortunately, as recent social events have demonstrated, the current "reasonable base case" of a "permanent state of exception" is becoming increasingly improbable because the forced surreal financial relationships are starting to tear apart the social fabric itself. Not only that, but the fact that the "stability" has only been bought thanks to some $15 trillion in central bank liquidity is lost on only the biggest fools, and socialists, pardon - MMTers - in finance. Here again is Kocic:

As much as the base case trajectory appears as “reasonable” and a worry-free choice, its biggest problem is its legitimation. Easy money provided by central banks to restore growth was easy for capital, but not for labor. Policy response to crisis added further to inequality by blowing up the financial sector and inviting speculative rather than productive investment. The Keynesian bond which ties profits of the rich to the wages of the poor seems to have been severed, cutting the fate of the elites loose from that of the masses and the well-being of the economy. 

Confused? You can thank Bernanke and Yellen for president Trump. Anyway, Kocic continues:

 With subaverage growth and highly skewed wealth distribution, the economy is converging towards what for a growing majority increasingly resembles a zero sum game. To the vast majority, that is saying that the best days are behind us. This is the most difficult aspect of the base case scenario: There has been no political system in modern history -- inclusive, exclusive, democratic or oppressive, all the same – that has promised anything but better future to its constituents. For any ideology the gradient between the present and the future has always had to be positive. It is difficult, if not impossible, to conceptualize any political narrative capable of making the reverse acceptable. And in a context where economic growth is a universal metric of progress, problems  with the base case become even more acute. The legitimation of the base case will continue to define the populist narrative as a voice of change. Politics will be shaped along the lines of looking to disrupt the status quo with quick short-term fixes, which could emerge as outright triggers of stagflationary trajectory.

Well, considering that years and decades of endless political lies that "the future is brighter" is the reason why the world finds itself on the edge of a social, political and financial catastrophe, and which has made a handful of people richer than their wildest dreams while pushing the vast majority of the population into considering that socialism - and even communism - may be a wise alternative to capitalism, perhaps it is not so bad that for once the truth will be told and someone will have the temerity to admit that no, the future will not be better, especially when one admits that after the next crash - and the wars that follows - the future, or as it will be known then, the present, will be the worst since the world wars.

And finally, for those who lament the disruptions to the status quo by populist elements promising "short-term fixes", well just look where said status quo got you: a world where the markets have to close their eyes and pretend they can exist forever in the artificial, central-bank created "permanent state of exception."

Which, thankfully, is impossible.

"People Ask, Where"s The Leverage This Time?" - Eric Peters Answers

One of the Fed"s recurring arguments meant to explain why the financial system is more stable now than it was 10 years ago, and is therefore less prone to a Lehman or "Black monday"-type event, (which in turn is meant to justify the Fed"s blowing of a 31x Shiller PE bubble) is that there is generally less leverage in the system, and as a result a sudden, explosive leverage unwind is far less likely... or at least that"s what the Fed"s recently departed vice Chair, and top macroprudential regulator, Stanley Fischer has claimed.

But is Fischer right? Is systemic leverage truly lower? The answer is "of course not" as anyone who has observed the trends not only among vol trading products, where vega has never been higher, but also among corporate leverage, sovereign debt, and the record duration exposure can confirm. It"s just not where the Fed usually would look...

Which is why in the excerpt below, taken from the latest One River asset management weekend notes, CIO Eric Peters explains to US central bankers - and everyone else - not only why the Fed is yet again so precariously wrong, but also where all the record leverage is to be found this time around.

This Time, by Eric Peters

“People ask, ‘Where’s the leverage this time?’” said the investor. Last cycle it was housing, banks.

 

“People ask, ‘Where will we get a loss in value severe enough to sustain an asset price decline?’” he continued. Banks deleveraged, the economy is reasonably healthy.

 

“People say, ‘What’s good for the economy is good for the stock market,’” he said.

 

“People say, ‘I can see that there may be real market liquidity problems, but that’s a short-lived price shock, not a value shock,’” he explained.

 

“You see, people generally look for things they’ve seen before.”

 

“There’s less concentrated leverage in the economy than in 2008, but more leverage spread broadly across the economy this time,” said the same investor.

 

“The leverage is in risk parity strategies. There is greater duration and structural leverage.”

 

As volatility declines and Sharpe ratios rise, investors can expand leverage without the appearance of increasing risk.

 

“People move from senior-secured debt to unsecured. They buy 10yr Italian telecom debt instead of 5yr. This time, the rise in system-wide risk is not explicit leverage, it is implicit leverage.”

 

“Companies are leveraging themselves this cycle,” explained the same investor, marveling at the scale of bond issuance to fund stock buybacks.

 

“When people buy the stock of a company that is highly geared, they have more risk.” It is inescapable.

 

“It is not so much that a few sectors are insanely overvalued or explicitly overleveraged this time, it is that everything is overvalued and implicitly overleveraged,” he said.

 

“And what people struggle to see is that this time it will be a financial accident with economic consequences, not the other way around.”

Saudi Wealth Fund Aims To Double AUM To $400 Billion By 2020 - Discovers Leverage Boosts Returns

Saudi Arabia’s sovereign wealth fund, a key engine of the kingdom’s plan to diversify the economy, on Wednesday laid out new targets for growth, saying it aims to nearly double the value of assets it manages to around $400 billion by 2020. That sum includes the expected proceeds from the planned initial public offering of up to 5% of state-owned oil giant Saudi Aramco. The listing, slated for next year, could raise as much as $100 billion, Saudi officials have said. The Saudi fund, called the Public Investment Fund or PIF, held assets worth roughly $224 billion as of September, it said in a document released on Wednesday. It had previously struggled to calculate the value of its holdings, estimating them to be between $200 billion and $300 billion. The PIF has made a series of high-profile investments and announcements since Saudi Arabia unveiled its long-term plan for economic overhaul last year. It has invested $3.5 billion in Uber Technologies Inc., and committed $45 billion to a technology fund led by SoftBank Group Corp.

The PIF’s announcement highlighted its aim of raising the fund’s annual returns.

“The Program also encompasses efforts to maximize value in PIF’s existing assets, which make up the majority of the Fund’s holdings, and a new target to increase PIF’s Total Shareholder Returns (TSR) up from 3 percent to between 4 to 5 percent.”

While our calculation suggests that they’ll need at least 5% to reach $400bn by 2020, Reuters reports that the PIF is even more optimistic about the “long-term”, aiming for 6.5-9.0% - all-time highs in equities and all-time lows in bond yields notwithstanding.

How will it do this?

As Reuters reported from the Future Investment Initiative in Riyadh, it will invest in almost every asset class (apart from gold and cryptos it seems) and – this might be important - add leverage to juice its performance.

“The 96-page program said PIF will structure its investments in six areas: Saudi equity holdings, sector development, real estate and infrastructure, mega projects, international strategic investments and a “diversified pool” across global asset classes….

 

Outside of Saudi Arabia, PIF’s investments will be in a number of assets such as fixed-income, public equity, private equity and debt, real estate, infrastructure and alternative investments such as hedge funds, the fund said…

 

It also outlined its four major sources of funding to include capital injections from the government, government asset transfers, loans and debt instruments as well as retained earnings from investments.

The PIF’s managing director, Yasir Al-Rumayyan, explained to Bloomberg how it discovered collateralized lending.

“If you look at investments we have today, it’s basically all equity -- we need to look at leverage,” Al-Rumayyan said at the event Tuesday.

 

“If we’re in one project, we can use the underlying project as the base for the leverage with no recourse to the rest of the portfolio.”

It"s not just about returns, however. The PIF’s press release estimated that its program will lead to the creation of nearly 300,000 new jobs.

The Public Investment Fund (PIF) Program (2018-2020) has today been launched as part of the Kingdom’s Vision 2030 Vision Realization Programs (VRP)…

 

The four key objectives underpinning the Program include growing and maximizing PIF assets; launching new sectors; localizing advanced technologies and knowledge; and building strategic economic partnerships…

 

The PIF Program, which is underpinned by 30 separate initiatives, will see the Fund’s AUM increase to SAR 1.5 trillion (over $400 billion) by 2020, creating 20,000 direct domestic jobs, more than half of which are high-skilled roles, and 256,000 construction jobs, which will increase PIF’s contribution to real GDP from 4.4 percent to 6.3 percent

For anyone who’s a tad skeptical about any of this, there were soothing words from “MBS” in the PIF’s press release. HRH Prince Mohammad bin Salman Al-Saud, said:

“The PIF Program represents a vital milestone as we work towards realizing Vision 2030. As well as being recognized for being well-capitalized, the Fund also wants to be known as being well-run, transparent and well-governed, and the PIF Program will ensure this ambition is delivered."

The Cost Of Market Crash Insurance Just Hit A Record High

With the VIX surging, and then quickly getting pummeled on two occasions in the past three weeks, dizzy traders could be forgiven to assume that any latent "risk off" threat, whether from North Korea or the US political front, has been taken off the table. However, a deeper look inside the vol surface reveals something very different: with increasingly more analysts and traders warning that volatility is set for a sharp return this fall, equities have already been adjusting to the increased probability of a "tail event." However, instead of buying VIX futures, call or ETPs, they have been doing so by bidding up the price of OTM equity put options, or equivalently, by steepening the S&P 500 put skew and.

As a reminder, a put skew shows how much more expensive it is to buy deep OTM puts vs puts that are in the money or in other words, a levered bet on (or hedge against) a market crash.

 And as the following chart from Bank of America shows, the S&P put skew is now at the highest level on record, making the relative price of tail hedges the highest in 13 years as traders are quietly bracing for a sharp market crash.

While not new, Bank of America again underscored the potential risk in the coming months to actively managed portfolios from a possible volatility flaring event, primarily impacting risk-parity portfolios. This is what the team of BofA Benjamin Bowler wrote in an overnight note:

Both equity and bond valuations are high. In a report from last week, our equity strategists pointed out that the S&P 500 forward P/E expanded in July and hit its loftiest level since the Tech Bubble. Even at these elevated levels, equities look attractive relative to bonds whose risk premium is more than 50% above its long-term average. This is clearly a concern for portfolios that invest in both classes (risk parity). A significant risk for multi-asset managers going forward is a breakdown in the diversification between stocks and bonds in which we see simultaneous declines in both asset classes similar to the ‘Taper Tantrum’ in May/Jun-13 or to a slightly lesser extent the risk-off event from Aug-15 two years ago. It may be surprising to an equity investor, but for a multi-asset manager these two declines were the largest since 2008 and equal to 50% of the drawdowns from the GFC. With multi-asset vol so low, for those managers who use leverage, the leverage levels may be high and therefore their portfolios may be more sensitive to a breakdown in correlation.

Bank of America then writes that with both rates and equity volatility at historically low levels, however with correlations between the two rising, going into the fall - even if equities and rates remain range-bound - an uptick in volatility could lead to outsized jumps in a cross-asset vol pair trade.

Interestingly, for most of this year an increase in equity volatility has tended to coincide with an increase of rates volatility. The payout is dependent on rates going higher and equities falling from current levels, so it is implicitly short equity/rates correlation. This correlation has had an increase over the past month and provides for an attractive entry point (Chart 11)."

Indeed, while many traders point out that intra-equity correlation has dropped to near all time lows, traditionally a welcome sign for active investors as it provides return dispersion and alpha creation abilities that are detached from broader macro conditions, looking at cross-asset vol shows a very different picture. As the following two charts show, correlation between rates and equity volatility, or MOVE and VIX, shows a sharp spike in recent weeks. In fact, as Chart 10 shows, the correlation is now the third highest on record. Confirming this troubling observation, Chart 11 shows that the correlation between the underlying asset classes has also soared in recent weeks, after plumbing near record lows just weeks ago.

To explain the surge in put skew, below we present several observations from BofA on why the recent period of record low volatility appears to be coming to an abrupt end.

1. The S&P recorded three moves of at least +/- 1% within a six days span, the first time this has occurred since September 2016. In fact, prior to the 1.48% loss on 10-Aug, SPX hasn’t moved morethan +/- 0.3% in a single day since 19-Jul.

"These larger one-day moves are evidence that the record-low vol we’ve seen throughout the summer may be starting to come to an end. As we’ve noted recently, seasonal trends and a fall which encompasses numerous catalysts (including the debt ceiling deadline, the September FOMC meeting, and political reform negotiations) suggest that the extreme quiet may not last much longer."

2. Last week, the VIX recorded +30% spikes twice in a six day period (10-Aug, when the VIX jumped 44.37% and 17-Aug, when the VIX jumped 32.45%). This is only the third time ever that we’ve seen two such drastic moves occur in that short a period of time.

"Notably, the only other two times this has occurred were early August 2011, immediately following S&P’s downgrade of US government debt, and August 2015, when markets were rattled over fear of slowing growth in China. The seasonally low vol environment typically seen during late summer may be a contributing factor to these occurrences as each has happened during August."

3. On 8-Aug-17, the total number of VIX call options (including all strikes and all expiration dates) was 1,994,418, an all-time high, as investors piled into long call options amid the rising tensions with North Korea. The amount of options traded surpassed other notable highs on 3-Feb-2014 and 13-July-2015, when 1.85mn and 1.93mn call options were traded, respectively. "The former period saw investors buying VIX calls due to a global selloff sparked by concerns over Asia and EM, and the latter period saw purchases on the back of Grexit fears."

4. On 17-Aug SPX fell 1.5%, the second largest decline YTD since the 17-May 1.8% drop and similar to the 1.4% sell-off on 10- Aug. However, in one regard this sell-off was remarkably different.

"Specifically, markets this time around appeared to have made little distinction between different pockets of the market. For instance, the underperformance of cyclical sectors vs. defensives was less pronounced in the latest sell-off. Consequently, also the relative moves in volatility were not as significant as in the past two largest sell-offs YTD. This could signal the beginning of a new narrative whereby market participants are more skeptical about the prospective of a pro-business agenda being pushed forward in Washington; as such they stop differentiating between potential losers and winners from the aforementioned agenda."

BofA: "2018 Is When Bond Investors Again Get Very Concerned About Fundamentals"

One week ago, we closed the book on the long-running debate whether gross (and net) leverage is the highest on record, when we showed a chart from Goldman according to which net debt/EBITDA for all companies (with or without energy) is the highest on record, surpassing the previous credit bubble peak by nearly 0.3x turns. Furthermore, as Goldman said that the time, "given we are 8+ years into an economic expansion, we believe it’s prudent to also view this via a “normalized EBITDA” lens (i.e., median NTM 2007Q1-2017Q1). On this basis, aggregate leverage (ex- Energy) would move up to 2.1x, roughly 20% higher than current levels and 18% above the prior cycle peak."

Of course, none of the above matters right now; in fact if anything as Friday"s oversubscribed Tesla bond sale as well as yesterday"s massively oversubscribed sale of Amazon bonds confirmed, investors still can"t get enough of corporate debt.

But how much longer can this relentless re-leveraging continue before something snaps, or before someone finally pays attention? According to BofA"s chief credit strategist, Hans Mikkelsen, the answer is 2018.

We republish from our weekly the preliminary review of 2Q US high grade credit fundamentals. As highlighted in that piece gross leverage (ex. financials, commodities and utilities) jumped 0.11x to 2.38x, nearly matching the all-time high of 2.41x reached in 1Q 2002 during a recession.

Recall that the 2017 BofAML Corporate Risk Management Survey showed that roughly two-thirds of US companies do in fact plan to use some of the overseas cash to pay down debt. A lot of companies - but not as many - also have plans for each of the categories "Share repurchases", "M&A", "Capital expenditure", "Dividends", "Fund Pension" and "Other". But these are also the usual uses of proceeds for new issuance, suggesting that that overseas cash will be used over time in place of supply, thus further reducing gross leverage as existing bonds mature. However, even despite this corporate balance sheets overall will remain relatively stretched and we think that 2018 is when corporate bond investors again get very concerned about fundamentals... This as less uncertainty about US fiscal policy, and continued economic growth of just around 2%, incentivize companies once again to accelerate M&A and share repurchases.

Well, if this is what "less uncertainty about US fiscal policy" looks like just over a month before a debt ceiling debate which increasingly looks like it could result in a technical default by the US, we would hate to see what more uncertainty is. What is just as ironic, is that in the very same BofA report, however by a different author, we read that in the second quarter, borrowing by high grade corporations outpaced earnings, again.

We provide a preliminary read on market fundamentals for US non-financial high grade issuers as most 2Q results are out by now. The results show increasing leverage as companies continued to accumulate debt at rates faster than they grew earnings.

We estimate that median gross leverage increased to 2.38x from 2.27x in 1Q, while net leverage rose more modestly to 1.72x from 1.69x in 1Q. On a YtD basis gross and net leverage increased by similar 0.16x and 0.18x, respectively, from 2.22x and 1.54x in 4Q-2016 (Figure 4). Coverage also weakened to 10.69 in 2Q from 10.89 in 1Q (Figure 5).... YoY debt growth accelerated to 2.3% during the quarter after slowing down to 1.5% in 1Q. Margins and liquidity were both mixed in 2Q and capex growth rates remained little changed at low levels. While the pace of supply moderated in 2Q from the record pace in 1Q (Figure 6), the aggregate market debt rose 3.6% QoQ, outpacing the increase in LTM EBITDA by almost a percentage point, resulting in higher leverage. Most of the largest leverage increases were related to M&A funding. Companies also likely front-loaded issuance to take advantage of lower interest rates.

BofA"s attempts at spin aside, we agree that even in a case of "higher uncertainty", whatever it may look like, companies would probably issue even more debt, as they rush to take advantage of every last greater fool out there investing with other people"s money, before the rug is pulled out from a buyside community which appears to be staffed almost entirely with 20 year old "managers" who have never, in their professional lives, seen a debt crisis.

"Why Does Extraordinarily Low Volatility Matter" Baupost Explains...

With elites increasingly sounding the alarm about the state of the stock market, and various market participants fearing the complacency is masking the fragility of the market"s true character; it is no surprise that Baupost"s recently named President and Head of Public Investments, Jim Mooney, has joined the chorus.

While Mooney (and Klarman"s) warning regarding market volatility is not new, perhaps the most interesting nuance is the "difference this time".

Confirming JPMorgan"s Marko Kolanovic"s concern that "we may be very close to a tipping point" as he explained that "low volatility would not be a problem if not for strategies that increase leverage when volatility declines," Baupost"s Mooney explains that crucial market structure differences between current times and the 2008 market crash could lead to an exacerbation of any stock market price readjustment.

A Period of Subdued Volatility

"Stability leads to instability. The more stable things become and the longer things are stable, the more unstable they will be when the crisis hits." — Hyman Minsky

...Realized (actual) and implied (anticipated) volatilities hover near their lowest levels ever. The most commonly referenced measure of equity market implied volatility, the VIX has traded at an average of 11 since late April. To put this level in context, since 1990 when the VIX was first created, the index has closed below 10 on only 16 days; seven of those days have been since May 1, 2017. The average closing of the VIX between 1990 and 2016 was about 20 versus a 2017 year-to-date average of roughly 12. Similarly, realized SPX 500 volatility has fallen, with the one and six month levels both at seven. ON these measures, 2017 is the least volatile year since 1965.

Not surprisingly, there is a fair bit of commentary attempting to justify today"s historically low levels. The most prominent explanation is that the low realized volatility, which results when asset prices march steadily upward with very few interruptions, naturally causes quantitative models to predict a continuation of subdued volatility, i.e. low implied volatility. Some suggest that dampened market fluctuations result from the consistent bid for equities provided by capital flows into passively managed index finds. Many cite limited realized volatility in underlying U.S> and global economic measures such as economic growth and inflation and conclude we are in a new era of stability. Finally, there is the abiding view that central banks will reliably deploy accommodative monetary policy to arrest any downward market moves.

These explanations almost certainly contain elements of truth, but it is hard not to see a bit of sophistry as well. While there may be a mathematical answer for why volatility is low when nearly every financial asset trades at all-time highs, common sense might suggest the opposite conclusion.

Why does extraordinarily low volatility matter?

The answer lies in volatility influence on risk-taking and, by extension, leverage. In any elevated market, one very important thing to identify is where leverage exists in the system — both that which is obvious and more perniciously, that which is hidden. While leverage is not directly responsible for every financial disaster, it usually can be found near the scene of the crime. Structural leverage linked to low realized volatility may well prove destabilizing and the precipitant, or at least an accelerant, for the next financial crisis. Realized volatility is a critical reference point for a substantial amount of investment activity. For many investors, the level of market volatility determines the level of risk incurred both in their portfolios as well as in many investment products. The lower the volatility, the more risk investors are willing to or, in some cases, required to incur.

Specifically, realized volatility is the essential input for Value-at-Risk (VaR) calculations, and determines the degree of leverage incorporated in a variety of quantitative and structured investment strategies. For instance, the models used by both risk parity and volatility targeting funds, which use volatility levels to determine asset allocations, have been signalling "risk-on" for some time. This has resulted in steadily increased portfolio leverage as realized volatility has fallen across asset classes. Additionally, certain structured short-volatility ETFs have algorithm-based selling and buying programs that automatically lever up and, critically,d own based on realized volatility.

Over the last several years, one of the most reliable winning betes has been shorting volatility in just about any asset class. Investors have generated significant returns with high Sharpe ratios by capturing the spread between higher implied volatility and lower realized volatility. As realized volatility has remained low, profits have mounted and assets deployed in these volatility-targeting and short-volatility trades have grown tremendously. However, it is hard to ignore that this strategy becomes less and less attractive as the absolute level of volatility declines and the spread between implied and realized volatility falls. As the saying goes, "what a wise man does in the beginning, a fool does in the end "

Although it is impossible to calculate with precision, the volume of assets whose performance is, in some manner, linked to volatility likely runs into the hundreds of billions of dollars. As such, any spike in equity markets realized volatility, even to historical average levels, as the potential to drive a significant amount of equity selling (much of it automated). Such selling would, in turn, further incresae volatility which would call for more de-leveraging and yet more selling.

We cannot know whether a dramatic increase in volatility is imminent or even inevitable, nor can we be certain that a spike in volatility would have cataclysmic results...although it certainly could. One thing, however, is for sure: anyone who is directly or indirectly shorting volatility at the current lows is betting current benign environment will persist. Our experience would suggest that, "benign" and "persist" are not words normally associated with one another.

In addition to our areas of regular focus, we have exposure to hedges designed to help protect the portfolio from a sustained change in the volatility environment.

Mooney concludes, rather ominously...

"As has been the case for longer than we would have imagined, we remain in a market that is broadly expensive and largely indifferent to risk.

This continues to be a time for patience and, above all, caution. If there is anything to be taken from Hyman Minksy"s words, it is that no one should be lulled into a false sense of comfort by the illusion of stability which surrounds us... We most assurdely, are not"

And if one wants a picture of what that looks like, Morgan Stanley recently explained...A violent rise in volatility could be driven by just a 3% to 4% one-day S&P 500 selloff.  Right now the risk is greatest in the VIX complex, and demand for VIX futures from three main sources could result in 100,000 contracts ($100mm vega) to buy in a down 3.5% SPX move.  For context VIX futures ADV over the last year is 230,000 (although has risen to as high as 700,000 in big selloffs).

LTCM Is Back: One Hedge Fund Uses 25x Leverage To Beat The Market

Before we start, a little history lesson...

At the beginning of 1998, Long-Term Capital Managementhad equity of $4.72 billion and had borrowed over $124.5 billion with assets of around $129 billion, for a debt-to-equity ratio of over 25 to 1.

It was run by finance veterans, PhDs, professors, and two Nobel Prize winners. Everyone on Wall Street wanted a piece of their profits.

But by 1998, that firm was primed to expose America"s largest banks to more than $1 trillion in default risks. The demise of the firm, LTCM, was swift and sudden. In less than one year, LTCM had lost $4.4 billion of its $4.7 billion in capital.

The disaster had all the players - the Federal Reserve, which finally stepped in and organized a bailout, and all the major banks that did the heavy lifting: Bear Stearns, Salomon Smith Barney, Bankers Trust, J.P. Morgan, Lehman Brothers, Chase Manhattan, Merrill Lynch, Morgan Stanley, and Goldman Sachs.

In desperate need of a $4 billion bailout, the crumbling firm was at the mercy of the banks it had once snubbed and manipulated.

And so, given all that, we would imagine lessons were learned, "risks" were comprehended, and the fallacy of so-called experts (or as Taleb would call them Intellectual-Yet-Idiots) once and for all distinguished.

Which brings us to today... Meet Morten Mathiesen, 45, chief investment adviser at Copenhagen-based Moma Advisors A/S, whose Asgard Fixed Income Fund has delivered a 19 percent return in the past year.

As Bloomberg reports, the philosophy behind his success - the best returns are not in the riskiest stocks but in the least risky bonds. But you can’t get them without leverage.

“That’s the core of our strategy,”  said in a phone interview on Thursday. “The best risk-adjusted returns are actually the low vol trades.”

“We try not to speculate whether rates will go up or down,” he said. “We’re typically fully hedged.”

Bloomberg reports that Mathiesen uses a proprietary model to forecast and pick the best risk premiums in short-term, high-quality bond markets. Most of the fund’s bonds are AAA rated, such as Danish mortgage bonds.

“We’re long risk premiums in fixed income,” he said. “We have a strong bias toward the Nordics. We invest in anything that has a risk premium that doesn’t involve credit risk.”

The 600 million-euro ($670 million) fund bets on yield spreads, country spreads and money market spreads in the European fixed income markets.

The spread is usually small so the fund must borrow money to boost the return. Current leverage is about 11 times and has been as high as 25 times, according to Mathiesen. The volatility target is about 6 percent.

As Mathiesen concludes...

“We’ve been successful in providing alpha,” or excess returns, he said. “We’ve produced a higher risk-adjusted return than what the carry should justify in the positions we hold.”

By "alpha" we suspect Mathiesen means massively-levered beta, but still, performance has been stellar... The fund has delivered returns of 14 percent a year since its inception in 2003 and is beating key bond indexes. Bloomberg’s government bond index has returned 5 percent per year over the past decade.

However, looking back we are getting an ugly sense of deja vu all over again.

"Almost unbelievable track record" - check

"Sophisticated proprietary model" - check

"Betting on small spreads with borrowed money" - check

"25x leverage" - check

"we"re fully hedged" - check

What could possibly go wrong?

One Bank's Surprising Discovery: The Debt Party Is Finally Over

A recurring theme on this website has been to periodically highlight the tremendous build up in US corporate debt, most recently in April when we showed that "Corporate Debt To EBITDA Hits All Time High." The relentless debt build up is something which even the IMF recently noted, when in April it released a special report on financial stability, according to which 20% of US corporations were at risk of default should rates rise. It is also the topic of the latest piece by SocGen"s strategist Andrew Lapthorne who uses even more colorful adjectives to describe what has happened since the financial crisis, noting that "the debt build-up during this cycle has been incredible, particularly when compared to the stagnant progression of EBITDA."

Lapthorne calculates that S&P1500 ex financial net debt has risen by almost $2 trillion in five years, a 150% increase, but this mild in comparison to the tripling of the debt pile in the Russell 2000 in six years. He also notes, as shown he previously, that as a result of this debt surge, interest payments cost the smallest 50% of stocks in the US fully 30% of their EBIT compared with just 10% of profits for the largest 10% and states that "clearly the sensitivity to higher interest rates is then going to be with this smallest 50%, while the dominance and financial strength of the largest 10% disguises this problem in the aggregate index measures."

Another key point that Lapthorne makes, as also highlighted here back in November 2015, is that the reason for this increase in debt is largely down to financial engineering – aka share buybacks (see charts below). However the most recent data points to a significant change in this trend – with not only debt issuance in decline, but also the quantity of share buybacks.

Clearly over the long-term, this is obviously good news; borrowing money to buy back your elevated shares is clearly nonsense. However that has been the case for a number of years now. Are US corporates really waking up to the foolishness of their actions or are they constrained by their balance sheets? Or they may simply be anticipating greater clarity on Trump’s policies? Who knows! But in the short term, this does significantly reduce the impact of the biggest net purchaser of US equities, according to the SocGen strategist.

In other words, Lapthorne has found something surprising: after years of constant growth "having boomed out of control", net debt growth is rapidly heading toward zero, and perhaps even a contraction, for the first time since the financial crisis!

Needless to say, for an economy in which debt growth - either public or private - has been a primary driver of overall economic expansion, this is a stunning development. So what is driving it.

Here, Lapthorne makes several nuanced observations which have significant implications not only on future debt levels but overall equity prices and broader risk-assets:

Firstly, while the headline S&P 500 continues to move ever higher, the dynamics within the US equity market are not so encouraging. The chart below breaks down the FT US non-financial universe into top and bottom quintiles based on balance sheet strength (as measured by Merton’s Distance to Default). What is abundantly clear is that while the strongest continue to do very well, ever since the Fed surprised the markets back in February with a US rate move, stocks with the weakest balance sheets have struggled.

This goes to an observation we made last month, namely that virtually half of the S&P return has been due to a handful of high growth tech, (i.e., no debt) companies. At the same time, the average stock as measured by the equal-weighted performance, has also gone nowhere.

And here is where SocGen may have found something few have considered so far: "many are associating the surge in FAANG performance as a ‘go-for-growth’ play, but in a reality it looks like investors are running scared into cash rich companies."

Lapthorne"s conclusion: "This is not a Trump policy play, this is balance sheet risk."

Lapthorne next highlights an odd discrepancy between equity and debt: the aversion to debt "may seem a little odd given that high yield bond yields are down at historical lows and the appetite for new issuance remains strong. What drives credit is typically a mixture of leverage levels, interest rates, asset prices and asset volatility. Corporate leverage ratios are currently high, despite near record asset prices, and while interest rates are gradually rising, credit spreads on high yield bonds have plummeted. Why? Well asset volatility is very low compared to historical levels, or to put it another way, asset price confidence is high. This, coupled with the continuous clamor for yield, is helping to compress corporate bond spreads. This overconfidence may be misplaced. If equity volatility were to move higher, lower quality bonds could struggle, as firms with poor balance sheets are already in the US equity market."

The chart below plots the relationship between long/short portfolios formed on balance sheet strength (again using Merton) and high yield bond yields. That they have a strong historical relationship is not surprising as both are measures of credit risk, but as such it is interesting when they diverge. For example there are only two instances in which we saw major divergences in the chart below. The first was the original Fed tapering bond sell-off in 2013. The second is today, with equity markets clearly balance sheet risk averse and credit markets seemingly incredibly complacent.

Going back to the core point made by the SocGen strategist, namely that investors are increasingly reluctant to lend to companies that already have a sizable debt load, Lapthorne points out, as one would expect, that where he has seen the greatest aversion to debt is within the smaller cap Russell 2000 index. A long/short balance sheet strength strategy is up 20% this year – the long leg is up 7% and the short leg is off 13%. To confirm this is not all about beta or cyclicality – a long portfolio formed on just price volatility is flat this year while the short leg is off 7%.

To summarise SocGen"s unexpected finding which started by looking at debt incurrence among various "quality" strata of companies and ended up with implications for risk appetite for stocks: the strength of tech stocks (lowest amount of debt) and the Russell 2000 weakness (most debt) this year has nothing to do with Trump and everything to do with interest rate rises and balance sheet concerns.

And one final point from SocGen: "the problem with highly leveraged companies experiencing falling market caps is that it makes things worse, i.e. implied leverage and price volatility both go up!"

We wonder if Janet Yellen and her central bank peers are aware of these findings which have dramatic consequences for the Fed"s treasured "wealth effect", as they set off to not only raise rates but also unwind record balance sheets, in the process exacerbating the divergence between a handful of no/low debt companies and the rest of the public market facing increasingly higher interest rates...

Paper Vs. Physical: The Amazing Amount Of Leverage In The Silver Market

Authored by Steve St.Angelo via SRSroccoReport.com,

While many precious metals investors realize the massive amount of paper trading leverage taking place in the gold market, they should see what is going on in the silver market.  In a previous article, I provided data showing that an amazing $9.8 trillion of notional gold paper trading took place on the world’s exchanges in 2016 versus $42 billion in actual physical gold investment.  This was a paper to physical ratio of 233 to 1.

However, the amount of paper trading leverage in the silver market is much higher than that.

But, before I get into the specifics of the paper silver market trading leverage, let’s take a look at the pathetic amount of physical silver investment versus Central Bank asset purchases.  According to the data in the recently released 2017 World Silver Survey, total physical silver investment for 2016 came in at a whopping $4.4 billion:

That’s correct.  When we add up all the global silver investment demand last year, it adds up to a measly $4.4 billion.  It was nearly ten times less than all physical gold investment in 2016.  The analysts who wrote 2017 World Silver Survey, arrived at the $4.4 billion figure by using the following data:

Global Silver Investment 2016 (in million oz – Moz):

Physical Bar Investment = 83.6 Moz

Official Coins & Medals = 123.2 Moz

ETP (ETF) Inventory Build = 47 Moz

Grand Total Silver Investment = 253.8 Moz

By adding up total Physical Bar investment of 83.6 Moz, Official Coins & Medals of 123.2 Moz and ETP (ETF) Inventory Build of 47 Moz and then multiplying it by the average silver spot price of $17.14, it totaled $4.4 billion.

Even when the silver price reached a high of $49 in 2011, total global silver investment was only $6.6 billion.  Looking over the market in the past six years, the total $32 billion of silver investment from 2011 to 2016 is nothing when we compare it to the staggering amount of Central Bank asset purchases.  According to a recent Zerohedge article, Why “Nothing Matters”: Central Banks Have Bought A Record $1 Trillion In Assets In 2017:

A quick, if familiar, observation to start the day courtesy of Bank of America which in the latest overnight note from Michael Hartnett notes that central banks (ECB & BoJ) have bought $1 trillion of financial assets just in the first four months of 2017, which amounts to $3.6 trillion annualized, “the largest CB buying on record.”

Now, if we look at the chart above, Central Banks purchased $7 trillion (that was made public, could be higher) from 2011 to 2016.  If the Central Banks purchased $1 trillion in just the first foru months of 2017 versus the $7 trillion from 2011-2016, something seriously wrong must be going on in the markets.

Regardless, $7 trillion is a lot of money when we compare it to the pathetic $32 billion invested in silver over the same period.  If we just took $100 billion of that $7 trillion and placed it in silver, it would have quadrupled the amount of global silver investment from $32 billion to $132 during that 2011-2016 time period.  A quadrupling of silver investment demand, would have pushed the price of silver, WAY ABOVE the peak $50 price.

By the Central Banks propping up the STOCK, BOND and REAL ESTATE markets, the value of silver (or gold) is being severely depressed.  And of course, to keep investors from finding out about SILVER’S HIGH QUALITY STORE OF VALUE, the price continues to be capped by the massive amount of paper trading leverage.

So, how much paper trading leverage is in the Silver Market?  Let’s look at the following chart:

Again, according to the data put out by the 2017 World Silver Survey, total paper trading silver volume on the world’s exchanges was 159,000 Moz, or 159 billion oz in 2016.    Thus, the exchanges traded 180 times more paper silver in 2016 than the global mine supply of 886 Moz.

If we look at the ratio of global notional paper silver traded last year compared to actual silver investment, it was more than double that of gold:

By multiplying the 159 billion ounces of paper silver traded in 2016 by the average spot price of $17.14, we arrive at a staggering $2.27 trillion of notional paper silver traded versus $4.4 billion actual silver investment.  Thus, the paper notional silver trading ratio to physical silver investment was a whopping 517 to 1… double the 233/1 for gold.

Now, this 517/1 notional paper trading ratio to physical silver investment in 2016 does not take into account any of the huge OTC market where a lot of silver is traded and there are no quantifiable statistics to the amount or degree.

Currently, the crypto-currencies are experiencing huge gains over the past several months.  It doesn’t matter if an individual agrees with owning Bitcoin or one of the many crypto-currencies, the important thing to understand is that the tremendous price increases in many crypto-currencies are likely due to concern to the massive amount of Central Bank $1 trillion in asset purchases in the first four months of the year.

Furthermore, crypto-currencies are a likely a GOOD INDICATOR of what will take place in the gold and silver market when investors realize most STOCKS, BONDS and REAL ESTATE values will continue to implode as the U.S. and Global Oil Industries disintegrate.

The gold and silver prices are being capped because paper contracts can be added as more funds move in.  However, crpyto-currencies do not have this problem because the amount of Bitcoins, as an example, are limited.

The Ag Paradox: Farm Incomes And Equipment Purchases Tank While John Deere's Stock Soars

Last week we wrote about the U.S Department of Agriculture"s latest biannual report of farm incomes which painted a very bleak picture for the American farmer.  In its first forecast for 2017, the USDA saw real farm cash receipts down 14% versus 2015 and 36% from the previous high set in 2012 as farm debt continued to soar and leverage surged to all-time highs.

Below is a summary of some of the key takeaways: 

Real farm incomes in 2017 are expected to sink below 2010 levels which represents a 36% decline from the recent peak and a 14% decline since 2015.

Meanwhile farm debt continues to rise at an astonishing rate...

While farmer leverage has spiked to the highest level since at least 1960.

And of course, lower incomes means less money to spend on shiny new John Deere tractors with equipment capex expected to decline 35% compared to 2015.

And finally, farmer returns have crashed to the lowest levels ever.  We"re not sure about you but a 2.1% ROIC seems a "little low" even in our current rigged interest rate environment. 

In summary, farmers are making no money but are managing to barely stay afloat by adding a massive amount of debt and slashing capital expenditures.

Moreover, the summary above was seemingly confirmed recently when ISI released their latest data on North American sales volumes for tractors and combines.  Not surprisingly, January volumes were down anywhere from 20% to nearly 50% YoY, as they were for most of 2015 and 2016. 

Which leads us to our final point, which is, what exactly are John Deere investors seeing that we"re not? 

While we certainly understand the concept of investing in cyclical stocks at the bottom of their earnings cycle, we"re somewhat less familiar with the strategy of completely pricing in a recovery multiple years in advance while continuing to buy those same cyclical stocks at all-time highs and peak multiples.

That said, we"re sure those multiples have room to get even "peak-ier" tomorrow when John Deere reports earnings...we can"t wait to see efficient markets at work.

Fed Warns: "Asset Valuation Pressures Have Increased", "Leverage Remains Elevated"

It is a long-running Fed tradition to quietly incorporate material warnings (deep within) about asset prices in the semi-annual Monetary Policy Report submitted as part of the Chair"s congressional testimony, and it did not disappoint this time either, when it made the following warning: "Nonfinancial corporate business leverage has remained elevated by historical standards even though outstanding riskier corporate debt declined slightly last year. In addition, valuation pressures in some asset classes increased, particularly late last year."

And elaborated:

Nonfinancial corporate business leverage has remained elevated by historical standards, and household borrowing has increased modestly, leaving the household debt-to-income ratio about unchanged. On balance, the ratio of aggregate nonfinancial credit to gross domestic product (GDP) has moved up a little in recent years to about its level in the mid-2000s but remains well below its recent peak. Valuation pressures in some asset classes have been rising, particularly late last year.

Asset valuation pressures have increased, on balance, since mid-2016, along with several indicators of investors’ risk appetite. Although yields on Treasury securities and term premiums increased as market expectations about future growth shifted higher in the fall, they both remain low. In addition, the spread of yields on corporate bonds over those on comparablematurity Treasury securities narrowed. Estimates of risk premiums in equity markets also declined. Outstanding riskier corporate debt edged down over the past year, but gross issuance of leveraged loans was strong and the share of bond issuance rated B or below remained in the fourth quarter at the high end of its range over the past few years.

Commercial real estate (CRE) valuations, which have been an area of growing concern over the past year, rose further, with property prices continuing to climb and capitalization rates decreasing to historically low levels. While CRE debt remains modest relative to the overall size of the economy and the tightening in bank lending standards for CRE loans in the second half of last year may reflect some reduction in the appetite for CRE lending, the heightening of valuation pressures may leave some smaller banks vulnerable to a sizable CRE price decline. Also, residential home prices continued to rise briskly through November.

Of course, considering that we are now nearly two years, and 300 points higher, after Yellen"s May 2015 warning that "I would highlight that equity market valuations at this point generally are quite high," adding that "there are potential dangers there", expect the market to fully ignore today"s warning too.

"Something For Nothing" All-Weather Funds Disappoint In Post-Election Era

Variously marketed as "all-weather", "all-season", or "bulletproof", the so-called "risk-parity" strategies of some of the world"s largest hedge funds have been anything but "stable" since the election as the combination of leverage and bond losses have crushed the gains from an exuberant equity market.

Promise people something for nothing and you are going to attract a lot of attention. Stumble in the process and the critics will be quick to pounce.

As The Wall Street Journal reports, the weeks since the election have been rough for one of the most polarizing investment strategies out there: risk parity.

The strategy - which simply put, involves using diversification - and sometimes borrowed money (leverage) - to find an (historically-optimized) balance between risk and return.

Bridgewater’s variant of this strategy, for example, has historically used borrowed money to invest about $1.50 for each dollar in assets, often putting the leverage in historically less-volatile bonds. The goal is stocklike returns with less volatility.

Problems occur when histroical relationships between asset-classes break down... just as they did during this year (when the historical norm of inversely correlated bond and stock prices reversed completely)...

The post-election rally in stocks and selloff in bonds hit these portfolios, embolding critics of the approach...

Bonds have been in a bull market for 35 years, so adding leverage would have produced strong returns for a modest increase in volatility, says Ben Inker of fund management firm GMO. He also argues that “volatility and risk are not the same.”

As WSJ concludes, the strategy has sharply underperformed both stocks and a traditional 60% stock 40% bond index fund offered by Vanguard since 1993.

Without the benefit of leverage, lower volatility equals lower returns. Even with it, though, there are occasional bumps in the road. For investors whose moods are as fickle as the weather, risk parity may involve more risk than reward.

A Lion in Fiji: Berukoff touts buried gold, out of country

 
A Lion in Fiji: Berukoff touts buried gold, out of country

 
Despite recent pullbacks, junior miners, like Lion One Metals, have made big gains this year. Many provide surprising diversification characteristics and upside leverage to metal prices.
 
November 7, 2016
 
Walter Berukoff, CEO of Lion One Metals, illustrates in two sentences his fondness for precious metals. “My grandparents came here from Eastern Europe,” he explains. “What they brought with them was their gold.”
 
Berukoff’s grandparents weren’t alone. Decedents of slews of political and economic refugees relate similar experiences.
 
They explain in part Berukoff’s penchant for international opportunities, the latest of which is the Tuvatu gold play in the South Pacific Fiji island chain.
 
Despite recent pullbacks, junior mining stocks, like Lion One Metals, - which is up nearly 300% since January - have made big gains this year. Many provide surprising diversification characteristics and excellent upside leverage to price increases in the underlying metals.
 
Lion One Metals stock price. (LIO:CN)
 
“The value of paper money is disappearing and I own physical bullion.” says Berukoff. “I don’t keep it in a vulnerable place where governments can take control. That gold in the ground (Tuvatu) is my (money) in the bank.”
 
A Lion in Fiji: buried gold
Berukoff’s parallel between an undeveloped gold resource like Tuvatu, and metaphorical “buried gold,” is a useful one.
 
That’s particularly true for precious metals investors, for whom the collective memory of FDR’s seizure of Americans’ gold during the Great Depression – the country’s last period of “secular stagnation” -  is forcing them to be increasingly creative in their hedging strategies.
 
Junior mining stocks, - despite recent pullbacks, - are thus emerging as increasingly popular diversification options.
 
GDXJ as at November 4th, 2016
 
Big opportunities: but not for everyone
Yet while junior mining stocks have excellent qualities, they are not for everyone. Fiji, for example, where Lion One Metals’ Tuvatu play is located, underwent a coup as recently as 2006. The situation has stabilized somewhat. Elections held in 2014 were reported by a multinational observer group to have been conducted fairly.  
 
Yet while international investors fled the country in the wake of the coup, Berukoff headed straight there.
 
“I got the deposit for pennies on the dollar,” said Berukoff, who has done business in areas ranging from developed economies to trouble spots like Russia, Sudan, East Africa and Cuba. “Fiji has a long history as a British colony and a rule of law tradition. There is political risk anywhere you go. But I had a good feeling.”
 
Berukoff’s patience looks to be paying off.
 
During recent months Lion One Metals officials claim to have significantly de-risked Tuvatu, which is located adjacent to the Vatukoula gold mine, one of the oldest and best producing mines in the South Pacific.
 
In August Lion One Metals inked a memorandum of understanding with Ansteel-CapitalAsia, which would see the China-based player finance 80% of the capital expenditures needed to get the project up and running. In September Lion One Metals announced a $38 million private placement, by several large institutional investors, to help fund the rest.
 
Upside leverage to gold price increases
That said, starting up a gold mine, even a fully permitted one like Lion One Metals’ Tuvatu project, which is next door to a long-term producer, and thus can benefit from considerable existing road and other infrastructures, is no easy task. Input costs can go up, gold prices could fall, and even a minor official, who is slow to stamp the most mundane piece of paperwork, could prohibitively derail the process.
 
Experts thus say that when you buy stock in a junior mining firm, what you are really buying is not the asset itself, but the management team.
 
CEOs like Berukoff, who owns nearly 20% of Lion One Metals, and thus has “skin in the game,” are particularly prized, because – unlike the bonus-bumped “hired help” that runs the majors - they ride in the same car as shareholders. 
 
Berukoff also has another asset prized by investors: strong hands-on experience in the sector. He was an early investor in a slew of projects and companies ranging from La Mancha, to Northern Orion and Miramar. “I do everything,” says Berukoff. “I put together my management team, talk to local officials, make sure we get power (electricity access is a major issue in much of the developing world) … I even go underground.”
 
In fact, even Berukoff’s most public challenge – his ill-fated investment in Leisure Canada, which sought to develop hotels and other properties in Cuba, - isn’t necessarily the setback it may appear to be. In fact one of the best predictors of entrepreneurial success… is a previous failure.
 
The good news, is that once first pouring approaches, juniors, - particularly those like Lion One Metals that don’t sell their production streams away – generally have strong upside leverage should the price of gold increase.
 
For example Lion One Metals officials project that the Tuvatu play will produce an internal rate of return of 52% if gold trades at USD $1,200 per ounce. However at USD $1,300 – an 8% increase – the company’s projected IRR rises to 62% - a 20% increase.
 
As if that was not enough, that upside leverage doesn’t include exploration opportunities on adjacent properties, which in the case of Lion One Metals, Berukoff believes are substantial.
 
Few good deposits being discovered
Whether Berukoff can keep the Tuvatu project moving forward remains to be seen. If he does, early investors, particularly those who participated in the company’s private placements and will thus generate increased upside from the warrants they were issued, will benefit big time.
 
Brent Cook, editor of Exploration Insights summarizes the stakes. “Very few deposits that are identified are eventually developed, due to costs, complexities and political hurdles,” says Cook. “That means you need access to a good independent assessment of the geology of a formation before you decide to invest. However there are few good deposits being discovered so the upside can be substantial.”

 
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