July 8, 2022

By Steve Blumenthal

“We’re now on a path to raise rates half a percent at a time until rates reach an arbitrarily determined, neutral level of around 2.5–3%. This gentle response is akin to trying to clear out your snow-covered driveway with an ice cream scooper.”

– David Einhorn, Founder and President, Greenlight Capital

Do you remember the movie The Big Short?  It was about a few traders who made billions shorting the sub-prime mortgage market in 2008–09. They saw what few were able to see at the time.

From Wikipedia:

In 2005, eccentric hedge fund manager Michael Burry discovers that the United States housing market, based on high-risk subprime loans, is extremely unstable. Anticipating the market’s collapse in the second quarter of 2007, as interest rates would rise from adjustable-rate  mortgages, he proposes to create a credit default swap, allowing him to bet against, or short, market-based mortgage-backed securities, for profit.

His long-term bet, exceeding $1 billion, is accepted by major investment and commercial banks but requires paying substantial monthly premiums. This sparks his main client, Lawrence Fields, to accuse him of “wasting” capital while many clients demand that he reverse and sell, but Burry refuses. Under pressure, he eventually restricts withdrawals, angering investors, and Fields sues Burry. Eventually, the market collapses and his fund’s value increases by 489% with an overall profit (even allowing for the massive premiums) of over $2.69 billion, with Fields receiving $489 million alone.

I was so angry after seeing the film. Greed, derivatives, swaps, and leverage took the financial system to near collapse. I won’t watch the movie again; Living it in real-time was enough. The height of the crisis was late 2008. The stock market bottomed on March 6, 2009. One wants to believe that senior executives are doing the right thing. Unfortunately, that is not always the case. It turns out that selling triple-A-rated pools of no-doc/no-money-down mortgages issued to unqualified home buyers really isn’t a good thing. In the end, it blew up and you and I and all our neighbors are on the hook for the subprime mess.

Henry Paulson, the former CEO of Goldman Sacs, was Secretary of the Treasury and stood in the center of the ring during it all.

• In April 2007, he said growth was healthy and the housing market was nearing a turnaround. “All the signs I look at [show] the housing market is at or near the bottom,” Paulson said, calling the U.S. economy “very healthy” and “robust.” Source
• In August 2007, Secretary Paulson explained that the U.S. subprime mortgage fallout remained largely contained due to the strongest global economy in decades.
• In May 2008, The Wall Street Journal wrote that Paulson said US financial markets are emerging from the credit crunch that many economists believe has pushed the country to the brink of recession. “I do believe that the worst is likely to be behind us,” Paulson told the newspaper in an interview.
• On July 20, 2008, after the failure of Indymac Bank, Paulson reassured the public by saying, “it’s a safe banking system, a sound banking system. Our regulators are on top of it. This is a very manageable situation.”
• On August 10, 2008, Secretary Paulson told NBC’s Meet the Press that he had no plans to inject any capital into Fannie Mae or Freddie Mac.
• On September 7, 2008, both Fannie Mae and Freddie Mac went into conservatorship.

On November 20, 2008, during remarks at the Ronald Reagan Presidential Library, Secretary Paulson said,

“We are working through a severe financial crisis caused by many factors, including government inaction and mistaken actions, outdated U.S. and global financial regulatory systems, and by the excessive risk-taking of financial institutions. This combination of factors led to a critical stage this fall when the entire U.S. financial system was at risk. This should never happen again. The United States must lead global financial reform efforts, and we must start by getting our own house in order.”

In the end, the government bailed out Fannie Mae, Freddie Mac, and the large banks. How didn’t the former head of one of the most important investment banks on the planet, with close relationships with other bank CEOs and business leaders, not see this coming?

Many say that nobody saw it coming. My friend Mark Finn saw it coming. Mark is one of the great investors in the business. In 1983, Mark became a member of the State of Virginia Retirement Plan’s Investment Advisory Committee and served as its chairman from 1990 through 1994. In the mid-1970s, Mark joined the predecessor to Vantage Consulting Group as a consultant and began serving as its chairman and Chief Executive Officer in 1986, a capacity in which he continues to serve today. Vantage clients are pensions, foundations, etc.

In mid-2007, I received a call from Mark. He was invested in a fund of hedge funds we managed and wanted to make sure we had no sub-prime mortgage exposure.  I could hear the concern in his voice.

“I’m pretty sure we don’t,” I responded.

“Make sure!” he demanded.

I knew something was up. When I called him back, I asked, “Mark, what do you see?” He laid out in detail what was going on.  A few weeks later, he redeemed his money and we closed the fund.

We saw it coming, wrote about it frequently, and in the end, the crisis turned out to be far worse than we imagined it could be.

When I watched David Einhorn’s recent presentation at the 2022 Sohn Investment Conference, it took me back to 2008. And it has me focused on the future. I share it with you below.

My partner John Mauldin calls what is coming “The Great Reset,” which he loosely defines as a global sovereign debt and entitlement crisis. We will have to figure out how to reset, or”restructure” the system. We are in the early innings of The Great Reset. A restructuring of debt (which means defaults) and a restructuring of our entitlement programs. There will likely be a combination of defaults, reduced benefits, higher taxes, and, yes, more money printing. When will things really get going? We have no real idea. Our best guess is the latter half of this decade.

Inflation was not a problem post-2008. The money printed went directly to the banks and did not find its way into the system. The banks used the money to recapitalize their balance sheets and simply deposited much of the free cash with the Fed. A good gig if you can get it, and the banks got it.

What I want to highlight is that, in a few short months, Treasury Secretary Hank Paulson went from no plans to bail out Fanny and Freddie to bailing them out, and then the government bailed out the Wall Street investment banks. Low rates and QE continued, and then Covid opened up an even bigger government bailout window. Money was helicoptered directly into the system via individuals and businesses, and the Fed overstepped its mandate and began buying high-yield corporate bond ETFs. My point is that we are now dependent on the Government to backstop every crisis. We are digging ourselves a deeper and deeper hole. Inflation is the consequence.  I believe it will continue.

Who among us is going to vote for the leader who reduces our social security and Medicare benefits, and reduces our police, firefighter, and school teacher pensions? Who wants to vote for the person running on the platform to increase our taxes? We’ll most likely vote for the “give me free stuff” candidates. They’ll wave their fingers in the air and swear it will work. It won’t. Read Ray Dalio’s work on what happens at the end of long-term debt accumulation cycles. Five hundred years of history tells us free money printing does not work.

Your job and mine is to understand the tides of the water we are swimming in. As Warren Buffett said, “Only when the tide goes out do you discover who’s been swimming naked.” It’s up to us to do our best to safely swim from here to the other side, with our suits intact. Printing money provides short-term gain, but—as we’ve seen time and again,—inflation is the side effect, which is painful for all.

How safely can central bankers and legislators navigate the situation? It remains to be seen; however, we should take note when the most important financial person on the planet, Jerome Powell, says, “I think we now understand better how little we understand about inflation.” That should make the hair on the back of our necks stand up.

It is in this direction that I share with you David Einhorn’s recent presentation at the 2022 Sohn Investment Conference. Einhorn founded his hedge fund, Greenlight Capital, in May 1996 with $900,000 in start-up funds. In May 2002, he gave a speech at the Sohn Investment Research Conference, where he recommended shorting (betting an asset will decline in value) a mid-cap financial company called Allied Capital. Einhorn accused the company of defrauding the Small Business Administration, while Allied said that Einhorn was engaging in market manipulation. In June 2007, after a lengthy investigation, the SEC found that Allied broke securities laws relating to the accounting and valuation of illiquid securities it held. After the incident, Einhorn published a book, Fooling Some of the People All of the Time, regarding this five-year fight. He also famously shorted Lehman Brothers stock.  You’ll find my summary notes and a link to the full presentation next.

Grab that coffee and read on, but please do so from the perspective of optimism. Movement creates opportunity, and that means there is much to be optimistic about.

For discussion purposes only. Talk with your investment advisor. Not a recommendation to buy or sell any security. 

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An Investment Idea from David Einhorn

David Einhorn Sohn 2022 Notes

You’ll find my select bullet-point notes below.

David begins with a story about his grandfather, Ben. Ben was a gold bug who believed that eventually the government would debase its currency by printing too much money, and we would have inflation. Gold would be the play in inflation. When he was asked when that might happen, Ben answered, “Eventually.”

David argues that eventually is now, with the disclaimer that the idea he presents is an existing position in his portfolio, and he may change his position at any time.

• Peter Peterson wrote a book about our demographic and fiscal situation in 1993. Back then, our long-term problems were visible, but long He said the rubber would meet the road when the baby boomers retired. Politicians used to take this seriously. We made some progress along the way. And we got to a balanced budget in 1999.
• In 2002, the Graham Rudman Hollins Balanced Budget Act of 1985 expired and since then, fiscal incontinence has been a bipartisan effort.
• In response to the great financial crisis of 2008, we socialized a lot of the private sector losses and transferred the problem to the sovereign.
• Then COVID came in, and any remaining fiscal discipline went out the proverbial window. First came the $2.2 trillion Cares Act in March of 2020. Given the crisis, this seemed completely understandable. In October 2020, Powell confidently asserted that when it came to Congress spending more, the risks of overdoing it seemed, at the time, to be smaller. Implicitly, he promised to print whatever was needed.
• Nancy Pelosi stood proud and said Chairman Powell’s warning could not be more clear: robust action is immediately needed.
• This led to an enormous second $900 billion rescue stimulus in December 2020.
• In May 2021, Janet Yellen said, and I’m paraphrasing, historically low-interest rates mean the government can spend now; debt concern should not keep the government from spending. Even though the peak of the crisis has long since passed, we got the $1.9 trillion American rescue plan in March 2021.
• And with unemployment nearly back to pre-COVID levels, the $1.2 Trillion Infrastructure Investment and Jobs Act followed in November 2021.
• Some people called this spending modern monetary theory; others just called it helicopter money.
• In any case, the Treasury borrowed and the Fed supported the purchases—some would call that money printing.
• The impact of all this is that the US debt-to-GDP has exploded. When Paul Volcker raised interest rates to 19% in 1981, the US debt-to-GDP was just 30%. Heading into the global financial crisis, it was about 60%. It is twice that much today, and much of this new national debt has been purchased by the Fed and sits on its balance sheet.
• The Fed currently owns over 19% of all outstanding Treasury securities. The 3.3 trillion increase in Treasuries on the Fed’s balance sheet fully funded the entire deficit, and then some.
• Generally, the deficit tracks the economy. When we have full employment, the deficit is usually around zero, as taxes are high and social safety net benefits are low. Despite the top–of-the-cycle conditions today, which historically created a balanced budget, or even a surplus, we still have a projected deficit of over 4% of the GDP this year.
• Meanwhile, the US demographic situation is getting more precarious by the day: literally every day in the US, 10,000 people turn 65 and the Social Security Trust Funds are projected to be used up in just 12 years. Already the trust funds have become sellers of Treasury securities.
• The Congressional Budget Office projects a 2022 deficit of over a trillion dollars. Demographics will cause this to more than double in a decade. And these projections don’t assume a recession, rapidly rising inflation index benefits such as Social Security, or high interest rates on the national debt.
• As everyone knows, we have an inflation problem.

Einhorn continues and I encourage you to listen to his full presentation.  Following are some conclusions:

• Long-term gold is a buy; he doesn’t think the Fed has the tools it says it has to fight inflation.
• “All the work to curtail inflation will have to come from the demand side. As a result, prices will have to go much higher to dissuade substantial consumption. As such, inflation is likely to be much more persistent.”
• “We’re now on a path to raise rates half a percent at a time until rates reach an arbitrarily determined, neutral level of around 2.5–3%. This gentle response is akin to trying to clear out your snow-covered driveway with an ice cream scooper.”
• He points to US economic history to show that the real interest rates cannot be negative to successfully combat inflation.
• But, “The Fed is limited in raising rates… every 1% increase in the rates adds $70 billion to the deficit…and that’s just the first year.”
• A new world order is imminent—Especially with the freezing of Russian-held USDs
• This destroys some credibility of the US as a reserve currency—countries shift to gold as another reserve currency when they cannot trust foreign countries’ bonds.
• “In other words, the current deficit, combined with the Fed’s quantitative tightening plans, combined with the possible selling and run off of US treasuries by foreign central banks, who are worried their reserves could be frozen, could create a supply-demand imbalance in the treasury market.”
• He noted: “The Fed is bluffing.”
• Inflation won’t go away so fast.

Here is the link to the Sohn Investment Conference Video replay:

Not a recommendation to buy or sell any securities.  See important disclosures below.

Trade Signals: Avoiding Recessions

July 7, 2022

Market Commentary 

Notable this week:

Avoiding Recessions

Everything cycles and recessions are an important part of the business/economic cycle. Excesses are cleared out, the healthy survive, and a new cycle begins.  Recessions are normal and frankly, they are a healthy part of free-market systems. The problem for investors is the drop in equity market prices that occur during recessions. The average decline is greater than -30%. In the last two recessions, the S&P 500 Index declined by more than 50%. The NASDAQ even more. Avoiding the losses that come during recessions is important. Many years ago, I wrote a paper titled, The Merciless Mathematics of Loss. The important message is summarized in this next chart which shows how much of a return is needed to overcome the loss. For example, if your 401k is down 20%, you will need a 25% subsequent gain to get back to even.  That is doable and the recovery time to get back to even is typically not hard to painful to endure.  If it is down 40%, you need 67% to get back to even. Down 50%, you need 100% to get back to even. It took 15 years, from 2000 to 2015, for the NASDAQ and popular stocks like Microsoft to get back to even.

The bad stuff happens in recessions and the bad stuff gets worse when leverage is involved. The good news is leverage is coming down and with the popular indices down meaningfully and some popular stocks down more than 50%, if you’ve been playing more defense than offense, the storm is passing and the sky is starting to clear.

The best leading economic indicators I know and the sequence of the signals are this: 1) The High Yield Bond Market is an excellent leading indicator of the stock market. Simply, high yield junk bond investors, probably because of the high level of risk in such bonds seem quicker to derisk their portfolios, 2) the Stock Market is an excellent leading indicator of the economy, and 3) the economy is last to signal. This is because the government statistics that measure the economy, like gross domestic product (GDP) lag in their reporting to be given to us. We only know a recession occurred after the fact.

If a recession is avoided in 2022, the worst of the market decline is likely behind us. My belief is that we are in a recession right now.  The Atlanta Fed attempts to forecast GDP and puts out something they call GDPNow and updates it each week. It will update again on July 8, 2022.  Note the sharp decline since May 2022.  A recession is defined as two negative quarters in a row of GDP.  Q1 2022 was negative. Q2 is likely to be negative.

With the S&P 500 index down 20%, the NASDAQ down more than 30%, and many stocks down more than 50%, you get the picture. The government will report GDP on September 29th, 2022. By the time a recession is officially logged in the books as a recession, it will be too late for investors. The bulk of the losses will have occurred and it will be time to put your offense back on the field. Don’t listen to pundits who justify equity prices by saying, “the economy is fine.” First, look at the trend in the high yield market, then the trend in the stock market, and that will be your best way to avoid recession. Smart investors consider leading indicators and not lagging indicators.

I believe our number one objective as investors is to avoid the really big mistakes.  We can easily recover from a -20% decline. Minus 50% declines are tougher especially if you are pre-retired or retired and dependent on your nest egg. The really big mistakes come in recession. Thus, “Avoiding Recessions” should be our primary focus. Taking advantage of the opportunities recessions create should be focus number two. Our indicators are signaling recession and if I’m right the S&P 500 Index has another 20% to go on the downside. Keep your defense on the field and tell your quarterback to start warming up. I’d be thrilled to see the S&P 500 drop to the 3,000 level. That level is near the 58-year median fair value level of the market. Essentially, a point in which the market is fairly priced. At that level, 10% annualized returns are probable. It will take a recession to get us there. The opportunity will present quickly and investors will be in a state of fear.

The Dashboard of Indicators follows next.  The intermediate-term equity signals remain bearish for U.S. equities. The bond market is getting interesting. Notable this week is the inversion of the 2-year vs. 10-year Treasury yields (the shorter-term 2-year yield is now higher than the 10-year yield). This is another warning sign the economy has a severe fever. I wrote last week, “The Trade Signals are signaling recession. First, the high yield market signaled an economic warning, Dr. Copper followed, and the ‘Economy Based on the Stock Market’ indicator signaled ten weeks ago. The economy is slowing. The recession is either here or very near. From a buy and holder’s perspective, it’s been a painful year for bond investors. From a trader’s perspective, the opportunities have been good. And a long Treasury bond trade appears to be set up.” That trade did signal this week. You’ll see below two new green buy signal arrows for bonds. That is after approximately 4 1/2 months in sell signals. Inflation is taking its toll on the economy as are the Fed’s restrictive policies. Gold remains in a sell signal.

Not a recommendation for you to buy or sell any security.  For information purposes only.  Please talk with your advisor about needs, goals, time horizon, and risk tolerances.

Personal Note –  Dallas, Oil and Natural Gas

Dallas was hot. Very hot. While I’ve visited frequently, I’ve been successful at avoiding the summertime.  On my trip this week, every day felt like stepping into a 115-degree sauna; maybe 100 degrees at 10 pm.

I was there on business to review a potential investment opportunity. Mauldin and I joined the team from Skyway Capital to meet with and do due diligence on an oil and gas drilling company. I’m in favor of nuclear energy and all things green energy, but we just don’t yet have the grid built to deliver green energy to end-users efficiently and cost-effectively. Few people want a nuclear plant in their backyard. But nuclear is here to stay and part of the clean energy solution. Therefore, I’m bullish on Uranium. I believe we’ll reach a point where solar roof shingles will capture the sun’s energy and feed it to battery storage units that will power our homes. I’m hoping Elon Musk can make that happen. My fundamental view is that we still need oil and natural gas until we get there. We have the natural resources in this country and I hope we use them. The bet is the price of oil stays above $50. Risks are reduced due to large IRS tax benefits. The investment time frame is less than five years. There are a number of things we like about the play, yet there is more work to be done.

We’ll keep looking for unique, niche, investment opportunities. And you should too. Frankly, it is what makes the investment business so exciting.

It is fun traveling again. The airports were packed, as were the planes. Some masks, but not many. All in all, the world is back and moving again. A special hat tip to Mike, Adin, and Pete for a fun afternoon on the golf course. We played Maridoe Golf Club. The greens were outstanding. And it was really nice to visit my sister Amy and her family.

I have yet to see the new Top Gun movie and I was told the new Elvis movie is a must. I’m going to ask my beautiful Susan for a date.

Wishing you a great week!

Steve

Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.

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