May 30, 2014
By Steve Blumenthal
“Nassim Taleb’s Antifragile: just as a parent who overly cocoons a child prepares that offspring poorly to function in the wider world, so policy makers intent on cushioning the private sector from every shock in the economic cycle are doing the overall system a massive disservice. By preventing the build-up of immunity, or the ability to thrive in crises (i.e., anti-fragility), policy makers sow the seed for a greater crisis down the road (hence the repeated cycle of crises).” Louis-Vincent Gave
I believe the most important thing you can do is to create a portfolio that will make you money today and positions you to make even more money when the next crisis comes.
Within highly complex systems there is so much we do not know. What we can measure is the degree of risk and what we can do is position ourselves in a smart way to both hedge and profit from such risks.
A seminal moment in my financial life occurred several years ago. I was standing with skis in hand at 11,000 feet on a picture-perfect powder day. John Mauldin calls and shares his notes from the prior night’s dinner with house speaker Boehner and a few others. He was to join me for my 50th birthday dinner that night. Fortunately, for both of us, the power dinner in Texas trumped the powder snow in Snowbird, Utah.
To Boehner and his colleagues, Mauldin asked, “Ok boys, what’s your plan?” The answer came as a surprise. The plan was to print and to print and to keep on printing. Basically, they admitted to seeing this as the only viable way out of the mess. Damn the dollar. I thanked my friend for the great birthday gift.
Here we are three years later. There has been $4 trillion in Fed printing in the last five years and what is far less public is that the Fed has transacted tens of trillions of dollars more in swaps with the European Central Bank (we know this from Dodd-Frank disclosures). What is that money being used for? Who is participating and in which markets (dollar, currency, foreign, treasury bonds, stocks, gold) and from where – lead by who? We are living in a highly complex and, yes, highly manipulated system.
I believe risk is more elevated today than it was in 2008, though it didn’t feel much like risk back then either. As noted in the red circles on the following implied volatility chart showing then and now, the last time investors were this complacent, a 50% decline followed (gray arrow).
The goal today is to focus on the investment opportunity that crisis creates. It is not about fear; it is all about portfolio positioning. The good news is that you can profit today while positioning in a way that enables you even greater profit opportunities when the next crisis appears.
Let’s take a look at the following in this week’s On My Radar:
- James Rickards’ Video Interview
- Why Are Bond Yields So Low? By Louis-Vincent Gave
- Piketty’s Envy Problem
- Trade Signals – Bear Watch Report
James Rickards’ Video Interview
Some quick background. Link follows below.
Rickards graduated from The Johns Hopkins University in 1973 with a B.A. degree with honors and in 1974 from the Paul H. Nitze School of Advanced International Studies in Washington, D.C. with an M.A. in international economics. He received his Juris Doctor from the University of Pennsylvania Law School and an LL.M. in taxation from New York University School of Law.
In 1981, Rickards was involved in the Iran hostage crisis. He was the principal negotiator in the 1998 bailout of Long-Term Capital Management were he served as general counsel for the LTCM hedge fund. LTCM was bailed out by the Federal Reserve Bank of New York.
Rickards has worked on Wall Street for 35 years. In 2001, he began using his financial expertise to aid the U.S. national security community and the U.S. Department of Defense.
He is principal at Tangent Capital. The man has game.
I read Jim Rickards’ book, Currency Wars, shortly after my 2011 call with Mauldin. Much of what Jim wrote about has come to pass. He is smart, sharp and balanced.
Jim notes that the five biggest banks are bigger today, they have a larger percentage of the total banking assets and their derivatives book (where the real problem lies) is much bigger today. Everything about 2008 that was too big to fail is far larger today. Rickards believes that a continuation of the 2008 meltdown remains in front of us. I’m in that same camp.
As I watched, my best to remove that bias so I can focus was more on system complexity and structural risks. There was much I didn’t know. I thought Dennis Kneale did a good job leading the interview. Rickards is at his best. Hang on to your seat.
Jim sees the coming formation of a new global currency – perhaps IMF-led Special Drawing Rights or SDRs. He believes the Euro is the best positioned currency and the dollar will face significant challenges. He favors gold and alternative investments. He believes the IMF has the only remaining clean balance sheet and at 80:1 leverage, the Fed has maxed out their balance sheet. He, of course, adds much more. I’m not in agreement on all points but appreciate his information and how it gets me thinking. What do we think we know that we really don’t know?
Speaking of complexity and systemic risk, I found the next letter from Louis-Vincent Gave by way of John Mauldin on point.
Why Are Bond Yields So Low?
Louis-Vincent Gave
“As long as men continue to age, they will probably complain that “things were better in their day” and that “the world is going to hell in a hand-basket”. Ignore for a moment that the proportion of undernourished people fell from 23% of the developing world in 1990-92 to under 15% in 2010-2012, that more than two billion people gained access to improved sources of drinking water in the past decade, and that never in history have so many people across the globe lived so comfortably—as far as financial markets are concerned, the ‘old-timers’ may have a point.
Indeed, anyone who started their financial career in the late 1990s has had to deal with the Asian Crisis, the Russian default and Long Term Capital Management failure, the Technology, Media, Telecom (TMT) bubble and collapse, the subprime bust and global financial crisis, the eurozone crisis and the past 12 months’ bond market taper tantrum and emerging market wobbles. In other words, there have been plenty of opportunities to catch the volatility on the wrong side. And these recurrent punches in the gut (combined with the recent violent rotation from growth stocks to value stocks or the fall in the renminbi), may explain why so many investors continue to seek the shelter of the long-dated treasuries, bunds and Japanese Government Bonds, despite these instruments’ apparent lack of value. Simply put, after almost two decades of repeated financial crises, investors today do not have their forebears’ tolerance for pain. And so the old timers may be right: today’s young people are wimps, for both theoretical and practical reasons:
- An inherent level of systemic risk? Most people intuitively feel Karl Popper’s observation that: “In an economic system, if the goal of the authorities is to reduce some particular risks, then the sum of all these suppressed risks will reappear one day through a massive increase in the systemic risk and this will happen because the future is unknowable”. In other words, suppress risk somewhere and it comes back with a vengeance to bite you on the derriere at some later date. Look at 2008 as an example: we cut up credit-issuing risk into tiny parcels and distributed it across the system through securitization, only to see the banks take on a lot more leverage and ultimately sink their balance sheets on instruments they failed to understand. Hyman Minsky summed up this inherent contradiction well when he stated that “stability breeds instability”. In other words, the more stable a thing is, the temptation rises to pile on leverage, which makes that “something” more unstable on the back end.
- The notion of Antifragile: the above brings us to the Nassim Taleb notion of “antifragile”: just as a parent who overly cocoons a child prepares that offspring poorly to function in the wider world, so policy makers intent on cushioning the private sector from every shock in the economic cycle are doing the overall system a massive disservice. By preventing the build-up of immunity, or the ability to thrive in crises (i.e., anti-fragility), policy makers sow the seed for a greater crisis down the road (hence the repeated cycle of crises).
- Lay the blame on zero interest-rate policy (ZIRP): following on the above, not only does ZIRP allow the survival of zombie companies (which drags down the returns for everyone) but it most certainly affects investors’ behavior. Firstly, by encouraging banks to play the yield curve and buy long bonds, rather than go out and lend. Secondly, because almost all investors hold part of their assets in equities and part in cash or fixed incomes. And in a world in which fixed income instruments yield close to nothing, the tolerance for pain in other asset classes probably diminishes all the more. Indeed, if an investor is guaranteed a 7% coupon on his fixed income portfolio, then a mild sell-off in equity markets can be easily dismissed. But drop the yield on the bond portfolio to 2.5% and all of a sudden, the slightest drop in equity markets risks pushing the overall returns of the total portfolio into the red… Unless, of course, one holds much more fixed income instruments than equities. Paradoxically, that growing population cohort which seeks a guaranteed level of annual income faces the perverse reality that low bond yields force an even greater allocation of their savings into bonds! And this quandary is further amplified by the last point.
- The changing structure of savings: a generation ago, employees of large corporations would typically be enrolled in that company’s “defined benefits” pension plan. This meant that most salary-men, at least in the US, could look forward to a fixed monthly sum upon retirement, regardless of a) how long they lived for and b) what the market did. At that time, the overall behavior of financial markets was the concern of the pension fund’s managers who, if they were wise, could average up in bear markets and take some gains off the table when markets got hot; in other words, stomach the volatility of financial markets (back-stopped by their companies’ long-term earning power) for the long-term benefit of their plan holders. But today, following the evolution of most pension plans away from “defined benefits” to “defined contribution”, the average pensioner’s relationship to his pension has been turned on its head. Today, the average saver receives a monthly statement explaining how much he has saved; and any dip in that amount triggers sentiments of panic and fears that a looming retirement may not be well provided for. Combine that fear with rises in healthcare and college costs (two costs that older folks have to worry about) that, over the past decade, have typically continued to outstrip inflation and any dip in the market is more likely to trigger a sentiment of panic, and rapid shift into bonds, than a willingness to ‘buy on the dip’.
Putting it all together, it seems hard to find one factor that explains the low level of yields. In our view, the ageing of our societies, ZIRP and the low level of rates, the shift from defined benefits to defined contributions, the activism of policy makers (who, by attempting to cushion the volatility of the economic cycle more often than not end up increasing the volatility of financial markets down the road)… have all had a hand in keeping interest rates low. And if that is the case, then it will probably take a marked change in some of the above factors to trigger a significant rise in bond yields. (Read the full piece here)
Piketty’s Envy Problem
“There can be little doubt that Thomas Piketty’s new book, Capital in the 21st Century, has struck a nerve globally. What is surprising, however, is that the absurd ideas contained in the book could captivate so many supposedly intelligent people.” Peter Schiff
Piketty’s book is about how radical wealth redistribution will create a better society. I wonder how many politicians (schooled in political science, loaded with law degrees and lacking any real practical business experience) might embrace such a belief. The developed world has over borrowed and over promised. Debt and pension promises are the global issue and we are near a crossroad. There are forward solutions – which path do we choose?
This from Peter, “All economists, regardless of their political orientation, acknowledge that improving productive capital is essential for economic growth. We are only as good as the tools we have. Food, clothing and shelter are so much more plentiful now than they were 200 years ago because modern capital equipment makes the processes of farming, manufacturing, and building so much more efficient and productive (despite government regulations and taxes that undermine those efficiencies). Piketty tries to show that he has moved past Marx by acknowledging the failures of state-planned economies.
But he believes that the state should place upper limits on the amount of wealth the capitalists are allowed to retain from the fruits of their efforts. To do this, he imagines income tax rates that would approach 80% on incomes over $500,000 or so, combined with an annual 10% tax on existing wealth (in all its forms: land, housing, art, intellectual property, etc.). To be effective, he argues that these confiscatory taxes should be imposed globally so that wealthy people could not shift assets around the world to avoid taxes. He admits that these transferences may not actually increase tax revenues, which could be used, supposedly, to help the lives of the poor. Instead he claims the point is simply to prevent rich people from staying that way or getting that way in the first place.
Since it would be naive to assume that the wealthy would continue to work and invest at their usual pace once they crossed over Piketty’s income and wealth thresholds, he clearly believes that the economy would not suffer from their disengagement. Given the effort it takes to earn money and the value everyone places on their limited leisure time, it is likely that many entrepreneurs will simply decide that 100% effort for a 20% return is no longer worth it. Does Piketty really believe that the economy would be helped if the Steve Jobses and Bill Gateses of the world simply decided to stop working once they earned a half a million dollars?”
Here is the link to Piketty’s Envy Problem.
And this from David Hay of Evergreen Virtual Advisor, May 16, 2014:
“As indicated by the runaway success of Mr. Piketty’s book, there is intense interest in the wealth tax issue among the intelligentsia. Those of a more practical bent, who realize the growth-killing impact of his proposed confiscatory tax rates, especially on income, might want to start offering alternatives. Devoid of a more pragmatic solution, the Pikettys of the world may capture the minds of the planet’s politicians and the hearts of their voters.”
We are healthy because we have the world’s broadest and deepest capital structure. It is a rich resource and expansive platform that might just provide the seed capital for your next great business idea. Would that capital have been available if not for another’s success? Tax it, take it and redistribute to whom? Who decides? The government?
Personally, I believe on the other side of this debt, pension and entitlement mess is a move from public sector to private sector dominance. Excessive debt and unmanageable entitlements lead to tax confiscation and expanded regulation. Perhaps Piketty is the cover story that signals the top of this overly dominant public sector cycle.
Trade Signals – Bear Watch Report
A look at the most recent investor sentiment and market trend charts. The cyclical trend remains bullish for both the equity and fixed income markets. Sentiment is back to extreme optimism.
Click here for a link to Wednesday’s Trade Signals.
Conclusion
The arrogance of a few men with great power is concerning and unfortunately (or fortunately depending on which side of the trade you are on) it is an all too familiar human trait. We are witnessing the grandest of all economic experiments, yet we have done little to reduce outstanding debt and allocate newly created currency towards productive use. I hope it works – I doubt it does. The snow beneath the surface is unstable. Be forewarned and be prepared.
What you can do is hedge your equity exposure and allocate to strategies not solely dependent on an up-trending market. Find those that have the opportunity to profit today and defend tomorrow. A better buying opportunity will present itself in the future. I want to have the ability to buy high yield funds and ETFs when yields move back to 12% or 15% and buy stocks at a 30% to 50% discount. This is not possible if I’m taken out by an avalanche of panic selling.
With warm regards,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Philadelphia – King of Prussia, PA
steve@cmgwealth.com
610-989-9090 Phone
610-989-9092 Fax
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