2018 Year in Review: The year everything changed (Part 1)

Guest post by Dave Collum

Introduction

Every December, I write a Year in Review^{ref 1} that’s first posted on Chris Martenson & Adam Taggart’s website Peak Prosperity^{ref 2} and later at ZeroHedge.^{ref 3} This is my tenth, although informal versions go back further. It always presents a host of challenging questions like, “Why the hell do I do this?” Is it because I am deeply conflicted for being a misogynist with sexual contempt—both products of the systemic normalization of toxic masculinity perpetuated by an oppressively patriarchal societal structure? No. That’s just crazy talk. More likely, narcissism and need for e-permanence deeply buried in my lizard brain demands surges of dopamine, the neurotransmitter that drives kings to conquer new lands, Jeff Bezos to make even more money, and Harvey Weinstein to do whatever that perv does. The readership has held up so far. Larry Summers said he “finished the first half.” Even as a fib that’s a dopamine cha-ching.

“If you think you are too small to make an impact, try spending the night in a room with a mosquito.”

~African proverb

A non-pejorative justification for writing this beast is that life, with the aid of the digital world, hurls information at us so fast we cannot process it. Who could forget when Knight Capital Group launched an algorithm that sent them into bankruptcy within 45 minutes? What ever came of the Vegas shootings? Will David Hogg’s 10 minutes of fame as a world-class douche be forgotten? (If not, please euthanize me.) It seems a shame to simply let these fragments of life drift into the void without trying to find an underlying meaning to the human folly. I mostly ponder broken markets and the antics of bankers looking for signs of unintelligent life. The markets have been well over the historical fair value marks for 15 years. I have been a bear long enough to earn my permabear merit badge. The always-chipper Mark Dow called me a “bunker monkey.” John Hussman referred to some of my ideas as “bloodthirsty,” although I prefer the term “ghoulish.” The odds that I understand what has already happened are vanishingly small. I don’t know if markets are going up or down, only that they will move from left to right. None of what I say should be taken as investment advice; channel George Costanza and do the opposite.

“I would have written a shorter letter, but I did not have the time.”

~Blaise Pascal, French mathematician, 1656

What’s with the trite “matrix” metaphor? (I swear I will not refer to naked swimmers, rhyming history, or kicking cans.) I’m not even sure the puzzle pieces are real, fake, or as Ben Hunt calls them, “counterfeit.” It is deeper than that. I have like-minded friends sharing seemingly common interests who look at events—think Brett Kavanaugh, for example—and extract from them unrecognizably different messages because our perspectives are not similar; they are profoundly different. If you shuffle a deck of cards, the odds that the resulting order has ever before been created is zero (52! = 8 × 10⁶⁷). What are the odds all of us share common websites, read the same articles or blogs, or have the same Twitter feed? Zero. It is preposterous to think that we are looking at the same world through similar lenses. The viral audio in which some hear “Yanny” and others hear “Laurel” is metaphorical.^{ref 4} This document is what I saw and heard described as fact-based hyperbole. It is the Year According to Dave.

“I want to thank everybody who made this day necessary.”

~Yogi Berra

Background: The Author

When reading Dave’s Year In Review
You’ll note one conclusion rings true
His odd observations
And strange contemplations
Have proven he’s missing a screw

@TheLimerickKing

By way of introduction—despite a knowledge and understanding of economics, finance, and politics that one would expect from a lifetime of studying organic chemistry—I am 1/1,024th economist. There is absolutely no substitute for a genuine lack of preparation. I’ve managed to get cameos in the most improbable of venues including the Wall Street Journal, Russia Today (RT), the Guardian, and even Rolling Stone (but not “on the cover”). With some regularity and little forethought, I routinely manage to risk career and what’s left of my tattered reputation by getting embroiled in international incidents, which included brawling publicly with the American Federation of Teachers in 2017^{ref 5} and locking arms with Nassim Taleb in defense of Nobel Prize winner Tim Hunt in 2015.^{ref 6} This year was no exception. I risked an international incident by being the only chemist in the world calling bullshit on the Sergei and Yulia Skripal Novichok poisoning story. That gets its own section.

Aristotle noted that an educated man can entertain an idea without endorsing it. I also have a penchant for entertaining any idea until it dies of SIDS or gets legs, and I have to chase it down. I am, in short, a conspiracy theorist. We all should be conspiracy theorists because men and women of wealth and power conspire. If some ideas make you uneasy, just shut up. Pejoratively denouncing the rest of us as “conspiracy theorists” is intentionally shutting down uncomfortable discussions. If you do this in the current political climate, I get to smack you to get you to agree with me. If you wish to discuss dicey topics, quit apologizing by saying, “I am not a conspiracy theorist but . . .” because you are one.

Figure 1. Jeff Macke (@JeffMacke) original. CNBC’s Fast Money and chartist-artist extraordinaire.

I can’t control what topics go on and off my radar; they just do it. Hardly a shot was fired this year in the War on Cash. Some issues are huge but change on geologic timescales. We’re all doomed to burn in eternal hell, but I can only say that so many years in a row before it starts getting old. I got the most email complaints for not discussing the opioid crisis. I still haven’t gone there, but I’m about to read Beth Macy’s Dopesick. Energy has been a hot topic and had moments of hilarity this year, but my bandwidth limitations and lack of investment exposure left me bored.

There is a tractor beam that pulls economic blogs into the political realm. I have saved more notes and links and destroyed more gray matter than I thought possible trying to understand Russian collusion, the politics of Trump and Trump haters, and criminal behavior inside the FBI and CIA. I could write a book, but I just can’t do these topics justice in this forum. I’m letting them go for now, concluding that we desperately need a wall . . . around the Beltway.

If I have offended you already—I guarantee that at least a few readers are—it’s time to stop reading. Although no puppies were killed writing this blog, trust me: I am just warming up.

Sources

I sit in front of a computer 16 hours a day gerrymandering my brain, at least three of which are dedicated to non-chemistry pursuits. I’m a huge fan of Adam Taggart and Chris Martenson (Peak Prosperity), Tony Greer (TG Macro), Doug Noland (Credit Bubble Bulletin), The Automatic Earth, Grant Williams (Real Vision and Things That Make You Go Hmmm), Raoul Pal (Real Vision), Bill Fleckenstein (Fleckenstein Capital), Mike Krieger (Liberty Blitzkrieg), Demetri Kofinas (Hidden Forces), James Grant (Grant’s Interest Rate Observer), Campus Reform, and any nonsense spewed by Twitter legend @RudyHavenstein. There are so many others, many of whom I consider friends that I am simply waiting to meet. ZeroHedge is by far my preferred consolidator of news; it’s an acquired taste and requires a filter, but I think those rogues are great. Twitter is a window to the world if managed correctly—especially for a chemist attempting to connect with the finance world. Warning: the Holy Grail of maximizing follower counts is an illusion; it produces a counterproductive hyperconnectivity that makes extracting signal from noise difficult. So much flow, so little time.

Contents

Footnotes appear as superscripts with hyperlinks in the Links section. The whole beast can be downloaded as a single PDF Here or viewed in parts via the hot-linked contents as follows:

Part 1

• Introduction
• Background: The Author
• Sources
• Contents
• My Personal Year
• Investing
• The Economy
• Valuations
• Broken Markets
• The FAANGs
• Gold
• Bitcoin: Tales from the Crypt
• Real Estate
• Pensions
• Debt
• Corporate Debt
• Personal Debt
• Sovereign Debt
• Inflation versus Deflation
• Banks
• The Fed
• Links in Part 1

Part 2

• Human Achievement
• Nature
• Middle East
• Syria
• Nerve Gas Poisoning
• Kavanaugh versus Blasey Ford
• Political Correctness–Adult Division
• Political Correctness–Collegiate Division
• Political Correctness–Youth Division
• Conclusion
• Acknowledgments
• Books
• Links in Part 2

My Personal Year

My emergent role as a Roosky apologist (pronounced “Roo-ski”) brought in a wave of interviews including two each with British provocateur George Galloway, RT,^{ref 7,8,9} Lee Stranahan and Garland Nixon on Fault Lines,^{ref 10} and Scott Horton.^{ref 12} Other interviews focusing on economics, markets, and the absurdity we call “college” included Crush the Street,^{ref 11} Jason Burack (Wall St. for Main Street),^{ref 13} Chris Martenson (Peak Prosperity),^{ref 14} several with Lance Roberts,^{ref 15,16} and several on local radio.^{ref 17} Last year’s write-up on pensions was reproduced verbatim in the Solari Report on pensions.^{ref 18}

A three-hour dinner with Jonah Goldberg. I’ll remember vividly. I also played a role in coaxing one of my favorite economists, Stephen Roach, and one of my readers and friend, Tony Deden, to do RealVision interviews purely out of self-interest: I wanted to hear what they had to say. This much heralded two-part Deden interview was his first interview ever.^{ref 19} In return, I got to spend 10 hours sitting on my deck chatting with Tony about the meaning of everything. Y’all are now free to eat your hearts out.

On the chemistry front. Somebody recorded a chemistry lecture I gave in Portugal in which you can hear my Yankee-dog jokes bomb.^{ref 20} Halfway through dinner that night, I remembered that one of my three compatriots had won the Nobel Prize in chemistry six months earlier. Another was six months shy of winning this year’s prize. (Congrats, Frances) In 2017 I had two NIH grants hit the same study section. Any academic will tell you that was guaranteed to be a “Sophie’s choice” moment at best. I only needed a few stitches—I got one of them funded—and it looks like the other is coming back in the spring. (Phew!)

Investing

My investing acumen has been pretty lucky, with one notable bad streak. From 1980 to 1987, I was all long-dated bonds. Those suffering acute equityphilia may not realize that bonds were great. The ’87 dip prompted me to switch to equities, which I held until mid-1999. Here’s a dark secret that I’ve never told anybody: I had tech stocks on leverage. Ding! Ding! Ding! They ring bells at the top! I woke up in time, sold everything, and held only cash, gold, and a token short position from late 1999 forward, dumping the short position during the ’02–’03 recession. From around 2003 through 2010 it was gold, cash, and energy-based equities with a pinch of tobacco. That was my best decade, relatively speaking, cranking out >10% annually compounded returns like a boss in an otherwise brutal environment. Yahtzee! Then we get to 2010 through the present, and Mr. Smarty Pants got a ’tude adjustment. Energy, gold, and cash hoisted me by my own petard and put me headfirst through a wood chipper. As explained last year, my employer booted me out of my entire (15%) energy position after the beatings. Thanks. I’ve been sitting on gold and cash witnessing an epic equity ’roid rage accumulating skid marks in my boxers.

Precious metals, etc.: 28%
Energy: 0%
Cash equivalent (short term): 63%
Standard equities: 9%

For me, however, investing is all about valuations. The section on “Valuations” will explain why I didn’t buy equities when they were dirt cheap—hint: they were never dirt cheap—and where I think it all goes from here. I have one overarching goal: don’t fuck up. If I hit this goal, I will retire in comfort. The one variable I have no control over, however, is time, and that is why the chronostrictesis of sitting on the sidelines for nearly a decade caused me to start cutting myself again. Let me show you a foreshadowing chart that should give you pause (Figure 2):

Figure 2. Peak-to-peak or trough-to-trough (full cycle) inflation-adjusted capital gains of 1.8–2.2% per annum since 1870.

If you negate timing—if you measure peak-to-peak or trough-to-trough—your inflation-adjusted capital gains will average about 2%. If you get caught holding your life savings in equities at the wrong time, you will not recover in your lifetime. Hold that thought until “Valuations.”

“But there is one course of action – one classic mistake – that I most strongly feel is wrong: reaching for return.”

– Howard Marks, founder of Oaktree Capital

How’d I do in 2018? Large physical gold and much smaller silver investments went moderately down (–5% and –15%, respectively). Fixed income finally offered returns without a zero preceding the decimal point, but they’re still pyrrhic gains at best. My TIAA retirement account returns 3.6% per year guaranteed (unless the zombie apocalypse arrives). I am also laddering 2-year treasuries and CDs; reaching any further for yield makes sense only if you’re a diehard deflationist because the yield curve is dangerously flat. To my joy, my former energy position would have cost me another –10% loss had it not been liquidated by my employer. I will get it back when I’m ready—when the next recession is making headlines. All this compares with a –10% return on an S&P index fund.

Here is my maxim: Save to retire, and invest to combat inflation. I have prided myself on saving 20–30% of my gross salary per year, but for the first time ever (including the college tuition years!), my spending exceeded earnings. Adult children are expensive as hell, especially when the youngest spawn is trying to be a non-starving musician and starting a new venture—buying and selling violins.^{ref 21} (You wanna buy a violin?) You could call the money loans, but that means you’ve never loaned money to your children. Also, being married to a grandmother of three who is armed to the teeth with credit cards and digitally linked to point-and-click purchases of toys and kid’s clothing (Amazon) is quite the experience. I bought her a Jacuzzi for our deck overlooking Cayuga Lake (Figure 3) knowing that she can’t order toys and clothes while while in the tub. I plunged into the antique furniture bear market after a multi-decade hiatus by buying some nice pieces at seriously low prices; those in Figure 4 are emblematic. They will be in my estate, but I’m still hoping they don’t get seriously cheaper. Did I mention the dental implant, which seems almost metaphorical? To top it all off, I got an altogether unexpected 30% hit on annual gross income, which appears to be a one-off event. I see a return to profitability in Q1 2019—the ol’ first-half recovery story.

Figure 3. Hot tub city, and I am the mayor.

 

Figure 4. (a) Mid-19th century tiger maple drop-leaf dining room table; (b) Circa 1770 century Boston highboy.

The Economy

“In our current framework the economy is singularly brittle.”

~Larry Summers (@LHSummers), former secretary of the Treasury

“Absolute blowout number for ISM Manufacturing Index in August. 61.3 is a 14-year high. While many keep pointing to threats, this economy is Kevlar.”

~Brian Wesbury (@wesbury), chief economist, First Trust Portfolios

“I am not playing this down at all. I think we have a very serious global synchronized downturn.”

~Lakshman Achuthan (@businesscycle), Economic Cycle Research Institute (ECRI)

It is instructive to ponder the meaning of wealth creation. It’s about making our collective lives better. The U.S. built an empire founded on strong property rights, a growing populace with a gritty work ethic, a resource-rich continent with seemingly limitless room for expansion, and global European competitors hobbled by relentless tribal fighting. How many of these factors are still intact? The first industrial revolution was about converting enthalpy (heat) obtained from fossil fuels into negative entropy (order we call civilization). I keep wondering what will drive the gains over the next 100 years. We are told FAANGs are replacing the smokestack industrial juggernauts. We’ll see.

Heady questions aside, how about this year? This time last year I was writing about downturns in housing and autos, and now I’m hearing about downturns in housing,^{ref 22} autos,^{ref 23} lumber,^{ref 24} retail,^{ref 25} trucking,^{ref 26} energy,^{ref 27} and semiconductors (chips ’n’ dips).^{ref 28} Did we have a boom I missed? Yes and no. Assuming inflation corrections using “substitution” and “hedonic improvements” are accurate—I don’t—and assuming GDP corrections using these inflation numbers are accurate—I don’t—then the GDP grew a paltry 2% off the ’09 bottom, quite literally tracking the Great Depression from 1931 to 1939.^{ref 29} BLS employment numbers are generated by a trend-cycle statistical model^{ref 30} (read: making shit up). Nonetheless, even Helen Keller could’ve seen the help wanted signs on the lowest economic rung (retail). Personal consumption expenditures (PCEs) are said to be soaring relative to GDP despite stagnant wages and no personal savings.^{ref 31}

“It doesn’t take even 10 minutes’ worth of investigation to show that the BLS tightness gauge—the U-3 unemployment rate—is not worth the paper it’s printed on.”

~David Stockman (@DA_Stockman), former Reagan economic advisor and former Blackstone group partner

In 2018 we somehow witnessed a couple quarters of 3–4% GDP growth. I am so dark that I wonder whether the numbers have been jiggered explicitly to provide cover for the Fed to raise rates. Even so, more balanced individuals than I wonder whether we are creating real wealth or witnessing economic activity stimulated by yet another credit bubble. Luke Gromen (FFTT, LLC) notes that the 4% GDP print was suspicious in light of a 6.5% year-over-year drop in tax receipts and a 1.8% drop in gasoline demand.^{ref 32} (Fuel consumption and economic activity go together like Starsky and Hutch.) Something is amiss. David Stockman says that “these goal-seeked numbers are notoriously unreliable at cyclical turning points like late 2007 and early 2018.” He also notes that S&P profits haven’t grown for over three years.^{ref 33} In a really engaging interview,^{ref 34} economist Mariana Mazzucato seems to contradict Stockman, noting that “this is the sharpest post-recession rise in reported EPS in history.” She goes on to say that the “sharp increase in earnings did not come from revenue.” Stephen Roach, former executive director at Morgan Stanley asks, “Are the fundamentals really that sound? For a U.S. economy that has a razor-thin cushion of saving, nothing could be further from the truth.”^{ref 35} He notes the anemic personal savings rate of 2.4%—the lowest in a dozen years and one-fourth of the historical norm—cannot support a strong economy. The scholarly market historian and market maven Lacy Hunt calls the economy “very weak.” Let us not forget the obvious: The views are always the best from the summit.

“Today’s economic boom is driven not by any great burst of innovation or growth in productivity. . . . The global economy is now awash in debt.”

~Steven Pearlstein, Washington Post

“If it’s debt financed, you cannot increase GDP. You can only increase components of GDP.”

~Lacy Hunt, economist

The main problem is that growth, whether tepid or strong, was driven largely by a doubling of global debt over the decade,^{ref 36} which I am tempted to call 7% annualized inflation. The debt-to-GDP ratio in the third world—called “emerging markets” on Wall Street and “shitholes” inside the Oval Office—created a mania of mergers and share buybacks while the real economy sputtered. Debt is consumption pulled forward. The bill for that hamburger you eat today is coming due on Tuesday, Wimpy.

Pre-pubescent Paul Volcker: “Why can’t we have a boat like those people?”

Momma Volcker: “They have mortgages; we don’t.”

Figure 5. Popular plot asserting that federal debt is losing its stimulatory effect.

The real story of the 2018 economy appears to be that it was juiced by several large, one-time stimuli. Hurricane repairs holding over from the 2017 carnage lifted GDP while creating no additional net wealth.^{ref 37} (One could argue trashing the old and replacing with new brings minor benefits.) The 14% Trump tax cuts and massive one-time tax repatriation of overseas earnings—one time since the last one in 2004^{ref 38}—is said to have contributed significantly to the economy. The bulk was preordained to go to share buybacks despite blathering by corporate chieftains. Even so, that is said to represent a new slug of coin pulsing through the economy somewhere—but maybe not. That money wasn’t just parked in a vault in Zurich; it was in the multinational banking system already juicing economies worldwide.

“For now, we estimate that the U.S. economy has peaked—the powerful expansionary cocktail of unfinanced tax cuts, repatriation of capital, and fiscal spending ramped up growth in the U.S., but these one-off effects will peter out as the year ends.”

~Steen Jakobsen (@Steen_Jacobsen), chief economist and CIO at Saxo Bank

Meanwhile, corporate debt grew way faster than GDP.^{ref 39} Of course, some debt for pump ’n’ dump schemes (share buybacks) was offset by cash waiting for repatriation, but debt is the lifeblood of a leveraged system (Ponzi finance), and it grew. The IMF suggests that the benefits of the one-time boluses should wear off soon, leaving a 2.5% growth rate by 2019.^{ref 40} (I’m looking for contraction, but that’s just me.) Before moving to the last one-off stimulus, let me add that these routine overseas tax repatriations rot the system by giving advantage to slow-growing multinationals while providing no benefit to rapidly growing smaller companies. Look at it this way: If you can make money overseas and then get a tax jubilee every decade or so to “make America great,” where will you build your plants? Where will wily corporate bean counters declare all their earnings? Of course, the share buybacks don’t stimulate the economy at all because these monetary ’roids never left the system, so they can’t return to it. Shares and money just change hands. The real point is that since taxpayers will have to fill the void left by the tax jubilee, then what we just witnessed were taxpayer-funded corporate share buybacks.

The third one-time bolus for the economy this year was the looming trade war with China. Scrrrrratch! Come again? Are you nuts? Stay with me here as I digressively peel back a few layers of this onion. First, some claim that there has been a trade war on slow burn for decades and that the U.S. is finally starting to fight back. Obama fired the first shot with a tariff on rolled steel in 2014^{ref 41} to garner union support while, according to Roach (personal communication), it merely shifted business to higher cost producers. Trump then took the tariff debate to 11 on the dial. (He had been talking about doing this years before the election.)^{ref 42} One can squeal that this is a tariffying repeat of the Smoot–Hawley tariffs. The Smoot–Hawley Tariff Act was a political football for Roosevelt during the 1928 election, causing the putative damage from the bugger-thy-neighbor tariffs to be overplayed in the history books. The tariffs also conveniently take the blame off central bankers for creating a ginormous credit bubble in the ’20s as promulgated by the 500+ economists on the Fed’s payroll. Hoover’s failure to get authority to change the tariffs without Congressional approval may have left a destructive rigidity—an unresponsiveness—in the Smoot–Hawley Act (see “Books”). Through the auspices of the “United States Fair and Reciprocal Tariff Act”—yes, the U.S. FART Act—Trump requested the same authority.^{ref 43} Somehow giving the Donald discretionary power to do anything important makes people nervous. He is rumored to be a little volatile.

Do you have a point here, Onion Boy? Sure, but drop the ’tude, ya punk. Tariffs were GDP positive in 2018 as industry scrambled to make hay while the pre-tariff sun was still shining. The Atlanta Fed claimed that up to 60% of U.S. economic growth stemmed directly or indirectly from industry front-running the tariffs by stockpiling and accelerating exports.^{ref 44} Of course, billions of dollars of subsidies are already budgeted to offset the negative effects on farmers with presumably more to come.^{ref 45} The savvy reader will notice that the consumer will pay more for imported goods and higher taxes for the subsidies—a one-two punch to the groin. In the short run, the tariffs generated a little wiggle in the economy this year and may even be a powerful bargaining chip to get concessions during a period of Chinese vulnerability, but they will be a problem if they linger.

“What does it say about productivity when the retail sector reportedly hires 50k in the same month when sales dip 0.1%. Or maybe the payroll number was completely bogus.”

~David “Rosie” Rosenberg (@EconguyRosie), chief economist and strategist at Gluskin Sheff

We hear how employment is tight^{ref 46}—said by Alan Greenspan to be the tightest labor market ever—while 100 million working-age Americans are not working and while inflation-adjusted wages have been stagnant since the 1980s. The law of supply and demand says there’s something wrong with this picture. Indeed, we have a system in which 100 million are incented not to work even if jobs are aplenty. The other problem is that rising wages (oh thank the Lord. Finally!) will create what economists call “negative externalities” or, as the rest of us say, “shit happens.” What comes next is predictable. First, the wage pressures will cut into corporate profits—real wage growth conflicts with bubble-level corporate profit margins—driving equity valuations skyward or equity prices earthward. Second, the rising wages will be labeled “inflation,” which will cause the bean counters to correct for it declaring, “inflation-adjusted wages are stagnant.” Third, the Fed will get their thongs in knots and slay the inflation dragon by stepping on the economy. Just as consumers are trying to pull themselves up from the precipice, our Fed overlords will be stepping on their fingers.

“We have abolished the idea of failure—nature’s cleansing mechanism. As a consequence, we’ve lost real economic vitality. We’ve substituted finance for industry as the locomotive of economic growth. In GDP terms, it looks terrific. But it is neither enduring nor real.”

~Tony Deden, founder of Edelweiss Holdings

That’s a great segue into a chat about wealth inequality, a topic that is causing even the gazillionaires living in modern-era Versailles palaces to get nervous. I submit that a healthy economy naturally distributes wealth with a Machiavellian fairness. As you grow an economy that is firmly founded on wealth creation—making and moving goods and services—it is not a zero-sum game; all boats rise, albeit to different levels. (It will never be fair; get over it.) The natural tension between the cost of labor and the cost of labor-saving technology is dealt with by the supply–demand curve. When you have to redistribute wealth at a wholesale level to keep the mobs from charging the Bastille, however, something got out of whack. As you financialize the economy—as the GDP becomes a measure of how much money is being moved around or what economists call “rent seeking”—it is a reverse Robin Hood wealth distribution. The rich accumulate wealth at the expense of the poor because nobody is actually creating wealth. It becomes a zero-sum game with winners and losers. Rockefeller, Carnegie, and Vanderbilt got fabulously wealthy building an empire. I remain unconvinced that Zuckerberg, Bezos, and What’s His Name at Apple will be able to make such claims. David Tepper, Ray Dalio, Stevie Cohen, and Warren Buffett create none of the Wealth of Nations. They are wealth aggregators, much to the joy of their adherents.

“The greatest economic recovery the top 0.1% has ever seen.”

~@RudyHavenstein, legend

One more point. Economic models assume dislocated workers will just move, but they don’t. The impacts of “rolling industry recessions” is to leave workers behind and instill social instability owing to epidemic levels of cognitive dysphoria slathered with some serious hysteresis (lingering negative externalities!). The gutting of the middle class is setting up to be emblematic of the gutting of the American empire. What role did the Fed play? Their fake-it-till-you-make-it monetary policies financialized the economy. What do you think?

Valuations

“We’re probably only 10 years into another 50-year bull-market cycle.”

~Andy Sieg, head of Merrill Lynch Wealth Management

Jeepers. How long was Andy floating in the harbor when they found him? I recall sitting in a room with friends when the Nasdaq had just crept over 5,000 for the first time and proclaiming it would be back to triple digits. They laughed. I missed by <200 points. Benjamin Graham, the most legendary investor of the twentieth century and mentor of Warren Buffett, lost 70% in the ’29–’33 bear market. Failing to exit the highway before hitting the traffic jam taught him about risk. Every year I talk about valuations, but I will lay it out in detail so that, in the end, I can sleep knowing that you’ve been warned.

Let’s first illustrate the consequences of buying at secular highs. Many analyses show how long it has taken those fully invested at tops to break even. Of course, you must inflation-adjust to even approximate capital gains and losses. I have taken a slightly different tack by asking how long it takes to go from a secular high to that same value for the last time (Figure 6).

Figure 6: Inflation-adjusted S&P capital gains. Blue arrows show time required to return to the peak valuation for the last time (hopefully).

“So imagine valuations never see their norms, or 2009 levels again, and this cycle completes at 2002 levels—the highest level of valuations ever seen at a cycle low. That would still be more than enough to wipe out every bit of S&P 500 total return above T-bills since 2000.”

~John Hussman (@hussmanjp), Hussman Funds

The blue arrows illustrate four instances in which investors caught holding equities at the peaks paid profoundly. In each case, the big dip is followed by a recovery—the break-even point—followed by an extension of the rally that eventually fails. As though pulled by a tractor beam, the price revisits the original peak for the third and final time. Those arrows representing zero capital gains—treading water during the biblical flooding before finding terra firma from which to launch new gains—are 40–75 years! Let me repeat: on four separate occasions over the last 140 years, investors obtained zero inflation-adjusted capital gains for periods spanning half to three quarters of a century. The entire gains during those periods came from dividends eroded by a host of taxes and fees (see below). You will, however, get participation trophies too.

Don’t be deceived by analyses in which you start investing at the peak and invest throughout the ebbs and flows. These are calming words valid for millennials and Gen Zers. If you are a boomer with >80% of your lifetime savings already banked, however, there is little cost averaging in your future. Full return analyses in which dividends are included are less scary (Figure 7) but almost never account for the massive erosional costs discussed below.

Figure 7. Inflation-adjusted total return with dividend reinvestment by Mike Lebowitz uncorrected for fees and taxes.

“First law of finance: In the long run, returns must revert to the average.”

~Jason Zweig (@jasonzweigwsj), columnist at the Wall Street Journal, in 1997

You can keep your support lines and technical indicators. You can keep your crash fears too; they are rare technical events. All I care about are valuations. It has been said that “record-high equity valuations don’t mean poor returns are imminent, only inevitable.” The big risk is buying poor assets during good times. Although 2007–09 was painful, the 2007 market wasn’t even an equity bubble but rather a real estate and credit bubble caused by the Fed keeping rates too low for too long. The Mullahs of Macro’s response to the collapse was to keep rates way lower for way longer. Paradoxically, it seems both moronic and, for now, effective, but is it? Or are we in another bubble? Before answering these questions, let’s take a quick peek at what one can expect out of equities ignoring valuations.

“Anyone who says stocks are guaranteed to outperform bonds or cash is an ignoramus.”

~Benjamin Graham, mentor of Warren Buffett and author of The Intelligent Investor

Last year, I obsessed over why stocks persistently return several percent more than U.S. treasuries and concluded it must be the awesome power of the State—rules forcing government debt into portfolios of compliant victims. My back-of-the-envelope calculations suggested that equities would sustainably provide 4–5% inflation-adjusted returns—not 7–8%—over many cycles spanning many decades. Headline-grabbing nominal returns must be corrected for fees, taxes on real and inflated gains, disasters (full-cycle, not partial-cycle, analysis), survivorship bias within indices, and demographics (1.4% growth in pie sharers). With that bug still buzzing, the Baader–Meinhof phenomenon^{ref 47}—the tendency to notice things only after the initial awakening—ushered in some new confirmation bias.

A stupendous paper by retired economist Edward McQuarrie shows how claims of 6.6% inflation-adjusted returns over the long term—100–200 years—are profoundly deceptive because they hide nasty periods of many decades in which returns are disastrous.^{ref 48} McQuarrie does not account for taxes, fees, and demographics, all of which will conspire to bring that 6.6% much lower; others have attempted such corrections.^{ref 49} Mark Spitznagle takes 2% more off reported headline indices because of highly “non-ergodic” compounding.^{ref 50} In an article from 1999, Marty Zweig noted that “funds charge annual expenses of 1 percent or so; then it costs them another 1.5 percent to 2 percent to buy and sell their stocks each year.”^{ref 51} I assumed 1% total. He also said the oft-stated 9–11% compounded returns is “guano” and that small caps sustainably beating large caps is “a crock.” Rob Arnott, eight-time Graham and Dodd Award winner managing over $200 billion and said by Howard Marks to be “one of the real thinkers in our field,” calculates a sustainable 3.1% annual inflation-, tax-, and fee-adjusted return.^{ref 52} Graham-Buffett-Zweig, in the latest Intelligent Investor (see “Books”), put the long-term gains at 4% before taxes and fees. It would appear, therefore, that folks claiming much higher returns have carried out incomplete analyses or are serving up the surf ’n’ turf combo platter (fishy analysis slathered with bullshit).

“I love equities, I’m not a weirdo, and I don’t live in a bomb shelter. But in a very real sense, the compounding of stock returns over long periods is a fraud. It really is. No one has ever gotten those returns.”

~Ted Aronson, January 1999, Aronson and Partners

You may have noticed that none of these analyses assume corrections for valuations. Changes in valuations can offer up an additional +4% compounded gains above the norm, providing a tailwind pushing investors up the Wall of Worry to the valuation summit during a secular bull market. Shrinking valuations can hit investors with  gale-force –4% compounded losses, representing a headwind as investors take the express elevator to the gates of hell pistol whipping themselves the whole way during the secular bear market. Thus, valuations matter a lot. According to Buffett’s iconic 1999 must-read article,^{ref 53} multi-decade periods of collapsing valuations correlate with secular rises in interest rates, whereas the coveted valuation expansions are fueled by secular drops in interest rates. Thus, interest rates matter a lot too. Once rates have plumbed the lows or highs, you are at a turning point. Market extremes occur when it becomes “too expensive in the short-term to play the long-term.” Cliff Asness seems to contest this model by noting that falling rates do not justify high valuations,^{ref 54} but he notes that “to pay higher prices as a result of lower interest rates to avoid a very painful outcome requires that interest rates remain low indefinitely.” I infer that Asness and Buffett agree.

“Exponentially rapidly rising or falling markets usually go farther than you think, but they do not correct by going sideways.”

~Bob Farrell, former Merrill Lynch legend

Let’s ponder what some of the contenders for the Wall Street Fat Bear Championship have to say. Many focus on the awkward evidence suggesting the ’roid rage of ’09–present was largely a growth in valuations and profit margins. The market über-bears all use essentially the same assumptions: (1) normal growth in GDP and no catastrophic events (no world wars), (2) regression to the mean, a force of nature, will do its thing while largely ignoring the inevitable regression of valuations through the mean, and (3) investors will hold for 7 or 10 years. They include corrections for inflation, but none include corrections for taxes and fees. Note that using longer durations (up to 20 years) allows assumed 3% GDP growth to cosmetically mask the bad optics of negative compounding while investors consume 50% of the approximately 40-year investing life expectancy.

• Rob Arnott’s estimated +3.1% return does not include valuation changes. Regression from current valuation to historic norms predicts –3% compounded losses over a decade.^{ref 55}
• Jeremy Grantham sees a precipitous drop of –48% or, if spread over 7 years with standard GDP growth, a drop of –5% compounded losses over the next 7 years (a 30% correction with positive GDP growth overlaid).^{ref 56} His most sanitized version points to small positive annualized returns over the next 20 years.
• John Hussman sees a –57% loss in the Nasdaq, which is somewhat less than his expected losses in the S&P 500 (–64%), Russell 2000 (-68%), and Dow (–69%) over this cycle.^{ref 57} He also sees dead people.
• Robert Shiller cautions that he is not predicting major calamity for the market but rather a much lower level of returns, in the 2.6% annual range over the next 10 years.^{ref 58} But this estimate appears uncorrected for anything except mean-regressing valuations. Any correction would be “probably not as bad as 1929, but it could be disruptive.”
• Goldman’s “bear market indicator” suggests –3% per annum prospective total returns for 5 years, placing it in the optimistic camp.^{ref 59}
• Mike Lebowitz of 720Global projects a drag of –7% per annum on capital gains over the next 10 years, leaving GDP growth and dividends to mitigate the damage.^{ref 60}

“According to the Buffett yardstick, stocks are currently priced to deliver an annualized return of –3% over the next decade including dividends. Compare this to the 3% yield on the 10-year Treasury note and you’re looking at a –6% differential.”

~Jesse Felder (@jessefelder), former hedge fund manager and author of The Felder Report

“I expect the S&P 500 to lose approximately two-thirds of its value over the completion of this market cycle.”

~John Hussman

There are a gazillion valuation metrics. On the optimistic end you have peak idiocy and fibbing when price-to-earnings (P/E) ratios are quoted using non-GAAP forward earnings. Since markets are forward looking, why not five-year forward earnings? Why not ten? These are just Wall Streeters and corporate chieftains looking for bonuses. Let’s look at the ones that make the bears so fearful. What you’ll notice is that all metrics are normalized by dividing something (usually price) by something else (a metric of value) to give you a number that, unless you have good reason to think otherwise, should flop around some historic mean without trending up or down. Many will show that the last time we touched the historic mean was in ’09, and it stayed marginally below it for about 15 minutes. The last time we emerged from a protracted stay below the historic mean—we should reside below the mean half the time if my sixth grade math hasn’t failed me—was many years earlier (the early 90s). Bear in mind the latest edition of The Intelligent Investor confirmed that stocks were still overvalued after the 2000–2003 bear market, suggesting they had more correcting to do. As we shall see, the 2009 low was, by historical standards, near the historical mean, and the run from ’09 to ’18 was largely about elevating valuations. Regression through the means will take you into the dark mind of John Hussman. As I bang through some graphical measures of valuation, don’t lose sight of the fact that a 2× overvaluation requires a 50% correction to the mean and a 100% gain to recover. A 75% correction requires a 300% rally to recover. If you keep this arithmetic straight, it starts to get a bit ugly.

“The price of the market is ‘highly dubious’ right now . . . the next recession will be frightening.”

~Paul Tudor Jones, former hedge fund legend

The most deceptive and quite viral plot of the year (below) makes it look like you should never sell. Stocks almost always go up and a lot more than down. This little artifact derives from the non-linearity of the downside—100% down means you’re broke and need infinite returns to get even. The more conventional subsequent plot shows problems, but the normalization to the mean is obscured just like McQuarrie discusses (see above).

“We are at the top of the valuation range by any measure except for interest rates.”

~Stan Druckenmiller, former chairman and president of Duquesne Capital, compounding 30% returns over 34 years

The Shiller P/E with 10-year smoothing of earnings and analogous Crestmont P/E show >2× overvaluation relative to historic norms. Some say these will get tame looking as ’08–’09 earnings roll off the back end. Others did the math^{ref 61} and say the effect will be marginal because 10 years is a decent sample size. . . .

“If the Fed keeps on tightening, or if inflation breaks out and bondholders take fright, this latest and perhaps greatest of bubbles will also come to burst.”

~Edward Chancellor, author of Devil Take the Hindmost^{ref 62}

Doug Short’s composite valuation metric is parked at >100% overvaluation…

“It is a source of some concern that asset valuations are so high.”

~Janet Yellen, former chair of the FOMC, as the door is hitting her in the ass

Tobin’s Q, essentially a measure of price-to-book value, is approximately 2× the mean, sitting at a level commensurate with only the highest peaks and exceeded only by the 2000 bubble. The market cap-to-GDP (Buffett) indicator for the Wilshire 5000 is in the 99th percentile and sets a new world record. . . .

“Equities are currently more overpriced on dependable valuation measures, such as total market value to GDP and on a replacement cost basis (Tobin’s Q), than at any time save for the 2000 dot-com bubble. American corporations have also been borrowing like there is no tomorrow.”

~Edward Chancellor

Price-to-revenues and price-to-sales reached all-time highs. . . .

“A 40% crash looks justifiable . . . effectively a retracement to prior technical support levels, the S&P 500 highs of 2007 and 2000.”

~Scott Minerd (@ScottMinerd), CIO at Guggenheim Partners

Price-to-PEG and price-to-EBITDA (earnings with all bad stuff excluded) have exceeded the 2000 high-water marks. . . .

“Equity exposure today on U.S. personal balance sheets has only been exceeded once before and that was in the late-1990s tech craze. I just don’t get it. But if you’re still long U.S. equities, please have a different reason than this drivel about this being a hated and under-owned asset class.”

~David “Rosie” Rosenberg

Corporate profit margins are soaring and said to be notoriously mean regressing. Hussman’s valuation model is a profit-margin-adjusted CAPE. Crudely speaking, if mean reversion occurs for both the profit margins and the CAPE, we are looking at a >60% correction. . . .

“Every market cycle in history has taken the most reliable valuation measures we identify (those best correlated with actual subsequent S&P 500 market returns) to less than half of current levels.”

~John Hussman

The number of stocks trading above 10× revenues for both the S&P and the Russell 2000 are at extremes. These are the same levels that Sun Microsystem CEO, Scott McNealy, was prompted to say about his investors, “What were they thinking?”

“The biggest market disasters happen when both leverage and securitization get mixed up with the same clever scheme.”

~Ben Hunt (@EpsilonTheory), former hedge fund manager and founder of Epsilon Theory

Price-to-corporate profits-GDP ratio (analogous to Hussman) suggests that Hussman is an optimist. The ratio of financial assets to real assets indicates a pronounced financialization of the indices. . . .

“The S&P 500 is trading at about a 93% premium to the long-run median. Falling to median therefore involves a 48% fall.”

~Jeremy Grantham, founder of Grantham, Mayo, van Otterloo & Co. (GMO) asset managers

Household equity ownership versus disposable personal income seems like good news until it mean reverts. Hours of work needed to purchase the S&P is also extreme. . . .

“Assuming you have the requisite capital and nerve, the big and relatively easy money in investing is made when prices are low, pessimism is widespread, and investors are fleeing from risk . . . this is not such a time.”

~Howard Marks, Oaktree Capital Management

Financial sector assets as a percent of GDP and margin debt versus GDP illustrate the financialization of the economy and the role of margin debt to achieve it. . . .

“There are two bubbles. We have a stock market bubble and a bond market bubble. At the end of the day, the bond bubble will be the big issue.”

~Alan Greenspan, former chair of the FOMC, January 2018

Some of these graphics come from the Big Brokerages who make tons of money marketing stocks and pension accounts. Figure 8 shows a table that nicely summarizes valuation metrics. They look awfully tame—so much so that you should just keep buying the dips.

Figure 8. Sanford Bernstein’s valuation models.

“And although I read recently that bull markets don’t die of old age or collapse of their own weight, I think sometimes they do.”

~Howard Marks

David Rosenberg estimates that >13 million worker bees have entered the finance industry since the ’09 bottom.^{ref 63} They have never actually been through a “bear market” cycle. The boomers have; the next will be their third. They could get pretty skittish. For now, they are all-in for the ride.

Bloomberg’s Alix Steel: “Is there a magic-hedge that would help you if you owned the S&P 500?”

Mark Spitznagel: “Own less of it.”

On the off chance there are young ’uns reading this, I have altogether different advice. Save your asses off. Pick an asset allocation that smells right: I would think 60:40 or even 70:30 equities-to-fixed income sounds good. Allocate at that level. At the end of each year, don’t try to rebalance your portfolio immediately: Selling winners and buying losers is psychologically too hard. Simply change your allocation to bring it back to your set proportion. If bonds outperform, allocate to stocks. Make allocation changes once a year. The boomers’ risks are not your risks.

“The lapse of time during which a given event has not happened is . . . alleged as a reason why the event should never happen, even when the lapse of time is precisely the added condition which makes the event imminent.”

~George Eliot in Silas Marner

Broken Markets

JP Morgan’s top quant warns next crisis to have flash crashes and social unrest not seen in 50 years

~Headline, CNBC

“Stocks could surge 19% this year because investors are the right kind of cautious.”

~Bank of America Merrill Lynch

“When reward is at its pinnacle, risk is near at hand.”

~John Bogle, Vanguard and creator of index funds

“We are in the throes of a burgeoning financial bubble. If I had a choice between holding a U.S. Treasury bond or a hot burning coal in my hand, I would choose the coal.”

~Paul Tudor Jones, founder of Tudor Investment Management

Central banks dumped $20 trillion of backstop into the markets over the last decade; what do you expect to happen? I honestly can’t say because nothing like this has ever happened before. Unlike the mortgage crisis, which many of us saw coming from years back, I don’t know anybody who knows anybody who saw this level of central bank intervention—the Bernanke Put—adopted by every central bank. It is instructive to simply look at what did happen.

“The recent divergence in the performance of U.S. equities versus the rest of the world is unprecedented in history. . . . This has never happened before . . . this is a market condition that will not persist.”

~Marko Kolanovic, JPM

Not even King Canute will be able to hold back the next bear when it’s time. Somebody calls in a bomb scare, panic starts, cashless (cushionless) exchange-traded funds (ETFs) sell immediately, and leveraged speculators are right behind. The markets are narrowing, with many domestic equities and most global markets considerably off their highs. As I am typing, tremors are undeniable. When they start shooting the generals—selling the increasingly rare market leaders—which they did in the early spring and again starting in September, it’s time to get nervous. We are also in a rate-hiking cycle, and history shows that the Fed will continue pulling on that trigger until they blow somebody’s head off.

@StockCats: How do they get these trendlines so perfect?
@RampCapitalLLC: Because we all draw the same ones.

Frothy Markets. The markets have been riding bareback—condom-free—for a decade now, and bull markets do die of old age—platitudes and an interesting and oddly Bayesian analysis by Larry Summers aside.^{ref 64} We went a decade off the ’09 lows without a single 20% correction. How could investors not buy into the euphoria? The fact that this run has been supported by an annualized 2% GDP growth doesn’t matter when shares are rising. Hedge funds shorting and snorting trying to time the top—good luck with that one—keep getting squeezed (like in May). When legends like David Einhorn lose for several years in a row and massively this year (–28% year to date), what is the message? Are these former geniuses now garden-variety idiots for doubting one of the greatest runs in history? They should have watched this hilarious and must-see commercial for “Hindsight Capital.”^{ref 65}

“The market is cyclical, and given the extreme anomaly, reversion to the mean should happen sooner rather than later; we just can’t say when.”

~David Einhorn, founder of Greenlight Capital

“It has been one giant short-squeeze market.”

~Jim Chanos (@WallStCynic), Kynikos Associates (short seller)

The euphoria creates the fear of missing out (FOMO), causing a wave of articles explaining what a dumbass you are for not jumping on board. History shows the big gamblers during the bull—the twenty-somethings—get hurt the most at the inevitable conclusion, but these guys have never read the dusty archives so cannot fathom the chapter about to be written about them. Some random top-calling headlines:

“Stock Market Bears Are the Dumbest Thing on Wall Street”

~TheStreet.com

“Value’s for chumps as market puts momentum ETFs into overdrive”

~Bloomberg

“Are you missing out on the great market melt-up?”

~Bloomberg

“The stock market never goes down anymore”

~Bloomberg

“Market trends: bull run could last 20 years, optimists say”

~USA Today

“Stop freaking out about the Dow”

~@CNBC

What about all those corporate profits? Only the old guys remember the 1960s when 71% of IPOs paid a dividend. (Those senile old coots probably don’t either.) Some profits reported this year may be legit, albeit floated on huge mean-regressing profit margins and from tech companies that tend to have higher profit margins (for now, at least.) Margins are also riding the wave of cheap capital and stagnant wages. Regression of margins to historic means could stem from rising rates (check) and wage inflation (check). The huge profit repatriations from offshore are also blurring our beer goggles.

“We have intentionally constructed Berkshire in a manner that will allow it to comfortably withstand economic discontinuities, including such extremes as extended market closures.”

~Warren Buffett, 2017 annual report

What is stalling this day of reckoning besides recency bias observed at all market tops? Passive investing keeps a wall of money bidding up—not flowing into—markets. (Money doesn’t “flow,” contrary to what 99% of pundits say.) The Swiss National Bank keeps putting bids under shares with freshly printed Swiss francs, which is insanely anathema to the concept of free markets.^{ref 66} The numbers don’t seem that large, but share prices are determined at the margins and every little bid helps. The storyline behind this particular bull run—central banks and their gargantuan interventions have our backs covered in perpetuity—is the most pathetic and insane bubble narrative in history, but it is now deeply ingrained in the market’s psyche. The late-cycle tax cuts and repatriations from abroad have probably stalled Armageddon (although to argue this money was sitting dormant, not influencing asset prices, is putty-headed). At the end of November, Jerome Powell blinked. The Powell Put was born when our new Fed chair kowtowed to nervous markets (or Trump).

“Interest rates are already doing damage; people just haven’t noticed. Leverage in the U.S. is grotesque for this stage of the cycle. At the moment, you’ve got peak leverage at peak prices. It’s not like you have to dig deep to find a problem.”

~Andrew Lapthorne, head quant at Société Générale (SocGen)

Buybacks. Share buybacks are hailed as a tax-friendly way to return profits to investors. They broke records this year and were often used to goose share prices the way announced stock splits did in the late 90s. Some say that the share buybacks are hoarding capital from the economy.^{ref 67} In defense of buybacks, Cliff Asness cogently notes that this argument is nuts.^{ref 68} It’s not like the money was sitting dormant. However, the claims that repatriation of overseas profits this year would boost the economy by facilitating construction of factories and jobs in the US are equally nuts. They already had access to capital and weren’t doing that. Some would like to get those repatriated profits as worker compensation. Indeed, that, too, was already possible and not happening. You won’t be getting ponies for Christmas either.

“Market sell-off is about 80 percent over and will be reversed by share buybacks.”

~JPM analyst, October 17, 2018

Buybacks are like stock splits: What they giveth in share reduction, they taketh back in shrunken balance sheets. Efficient markets would recognize the trade-off. The companies are merely pair-trading their diversified investment portfolio for their own shares. This is not irrational, but it certainly depends on which is a better value. They may be making the mistake that employees make by keeping their 401Ks bloated with shares of their employers. Robert Shiller recently called share buybacks “smoke and mirrors.” There is even a legislative push to ban them again. (They were legalized in 1982.)^{ref 69}

Here are my gripes about the buybacks.

• The huge tax breaks that facilitated buybacks mean that taxpayers—whether present or future—funded the share buybacks.
• The notion that buybacks “return profits to investors” is a ruse. It’s not like you can reinvest them in better opportunities like beer, hookers, and shares of Netflix.
• The executives are conflicted; they win if share buybacks support option prices and lose if money escapes their containment field as dividends.
• Comparing share counts before and after the buybacks often show a shocking lack of share count reductions because they are being used to offset options issuance to executives. That’s not exactly returning capital to investors.^{ref 70}
• Share buybacks maximize at market tops (Figure 9), suggesting that the conflict is causing the buybacks to be dumb money (buying high). Oracle, for example, spent $15 billion buying back shares at $18 per share that they had allocated as options at $3 per share. Steve Eisman says Oracle will be issuing equity in 2019 (sell low).^{ref 71} In 2017, Deutsch Bank authorized buybacks and is now insolvent.

“Do these idiots ever do buybacks during the panic bottoms, when it actually makes more sense? Of course not.”

~Mr. Skin, anonymous market kingpin posting at Fleckenstein Capital

Figure 9. Share buybacks.

And here is the Big Unknown. Even if all share buybacks used only real cash flow and actually reduced share counts, the gains in price owing to share count reduction should be predictable with recourse to 5th-grade math: they should be zero. Yeah. That’s right: zero. It is impossible, however, to know what effects a perpetual bid under corporate shares will have on price, particularly given non-linear amplifications in market-cap-weighted ETFs. When a truck driver in Peoria pays one cent more for a share of Apple than the previous bid, the market cap just rose $50 million. Price is determined at the margins. Years ago, Kodak jumped $2 on a 200-share trade—the last trade of the day—prompting the SEC to pretend to care. What is Apple’s buyback program doing? You cannot say, but it is surely price positive and could be massively so.

“Whenever we have forced selling to take place, the buyers disappear and the sellers have to sell no matter what. And corporate buybacks are not going to be enough.”

~Matt Maley, Miller Tabak & Co.

How about that wave of debt-based buybacks—not the debt that was incurred waiting for the Great Repatriation, but real debt (leverage)? Analysts at SocGen showed that all net debt issuance in the twenty-first century has been used to pay for stock buybacks.^{ref 72} That’s just fraud—a covert leveraged buyout by the creditor. But, as Jesse Felder notes, “When you have captive buyers [passive investors] who are entirely price insensitive, there is really nothing to stop you from leveraging your balance sheet.” How do I wrestle with the fact that Warren Buffett says he might buy back shares? As I’ve said on many occasions, watch what he does; The Orifice of Omaha is a hoser of a higher order.

“The fact that something is able to be sold legally, or the fact that there’s a market for it, can be very different from the fact that it can always be sold at a price that’s intrinsically fair or close to the last price at which it sold.”

~Howard Marks

“The S&P 500 is the only major market to have defied gravity, lifted by the financialization of America’s economy, whereby artificially cheap interest rates fueled stock buybacks, and desperate pensions turbocharged a leveraged private equity boom. With the Fed now reversing course, will we not have a chance to buy stocks materially cheaper?”

~Kevin Peters, CIO of One River Asset Management

Let’s look at some of the silly, idiosyncratic events that happen when investors lose their minds:

• As noted below (see “Bitcoin”), companies doubled their market caps by adding blockchain to their name or issuing a cryptocurrency.^{ref 73}
• An 18-year-old launched a hedge fund from his bedroom in suburban New Jersey.^{ref 74}
• Equities ran 300+% off the lows while the GDP tracked the Great Depression, compounding at 2% per year.
• Value investing strategies have performed in the bottom 1 percentile since 1990.^{ref 75}
• The S&P ran 14 months in a row without a monthly loss.^{ref 76}
• Boeing rose 250% in two years.
• Blue Apron IPOed at $10 a little over a year ago; it’s now at $1.23 and nobody has been indicted.
• Tilray, a cannabis company reporting $28 million in sales, doubled in value in three trading days and rose tenfold in 2 months to a market cap of $20 billion before cutting in half.^{ref 77} As Scott McNealy would say, “What were they smoking?”
• Solid Biosciences has no revenues and disclosed that one of its clinical trials was put on hold before its IPO in January.^{ref 78} The company sported a $1 billion market cap.
• Domino’s Pizza added 35% to a 20-fold, 10-year run aided by a debt-funded buyback program.^{ref 79}
• Yulong Eco-Materials, a tiny Chinese manufacturer of eco-friendly building products, rallied 950% in one day after the company acquired a gemstone for $50 million.^{ref 80} The company claims the 17.9 kilogram Millennium Sapphire is worth up to $500 million, although the price suggests it’s worth . . . $50 million.
• World Wrestling Entertainment (WWE) tripled in the first 9 months of 2018, sporting a trailing P/E of >100.^{ref 81}
• 60% of corporate debt issued by companies in the Russell 2000 is rated as “junk.”^{ref 82}
• GM pays its investors a dividend yield of 4.1% with a negative cash flow.^{ref 83}
• Uber has never turned a profit, but it’s about to go public at $120 billion.^{ref 84}

Nike. Let’s take a peek at Nike. What’s not to like? It’s chart is totally parabolic, rising 20-fold in as many years. It got there, in part, aided by massive share buybacks. It’s sitting at a lofty trailing P/E of 100 on increased competition and faltering sales; regress that to 20 and you get an 80% loss. That would sting. Its edgy ads—Colin Kaepernick in particular—got elevated to meme status and prompted one sheriff to make all perps where Nike shirts for their mug shots.^{ref 85} Most disturbing, Nike is part of the “footwear index”—yes, there is a footwear index —which has risen >1300% in <20 years (Figure 10). Did we just discover the merits of shoes in the third millennium? Of course, after the company pioneered the Air Mercury line (Figure 11), the share price never looked back.

Figure 10. Shoe index.

Figure 11. A 2000-year-old Nike Air Mercury dug out of a Roman excavation.

“The market value of Elon Musk’s firm overtook BMW’s even though the profitable Bavarian luxury carmaker produced 30 times as many cars last year as the loss-making Tesla. . . . With so much dumb money about, one of Silicon Valley’s new mantras is ‘spray and pray’.”

~Edward Chancellor

Tesla. The newest entry to the automotive industry has a market cap larger than Honda’s and is headed by Elon Musk, the modern era’s Leonardo da Vinci or Thomas Edison. Why not jump on this can’t-fail opportunity? Again, there are niggling little details. Tesla’s shares took off in 2013 when the company announced the Model S. Musk is burning cash in the billions, except for the most recent and highly suspect quarter when earnings appeared just as new funding was needed (Figure 12).^{ref 86} Tesla began hemorrhaging senior executives right before the suspect earnings report.^{ref 87} The cash burn prompted Tesla to ask suppliers to give back some of their money,^{ref 88} rendering customer security deposits a little less secure. Tesla is supposedly making state-of-the-art cars in the desert in what are tents,^{ref 89} affording them an analyst-pleasing high sales-to-tent ratio. (I hasten to add that P. T. Barnum made some serious coin in tents.) Tesla had a fire at one of its factories.^{ref 90} What? No flame retardant on the tents? The Tesla Model 3 had a first-pass yield—the percent of cars requiring no additional work—of 14% during the last week of June compared with an industry norm of 80%. The tent-constructed cars, after making it through a rigorous inspection, began to spontaneously lose bumpers,^{ref 91} lock owners out of their cars,^{ref 92} and, on bad days, blow up.^{ref 93} Tesla owners are rumored to be fabricating unavailable parts to fix their own cars.^{ref 94} Note to Elon: hire those guys. Musk seems to have cut a few corners, like terminating “brake tests.”^{ref 95} The company also forgot to tell investors that the DEA (not the SEC) was investigating alleged meth and cocaine sales running through its Nevada Gigafactory.^{ref 96}

“Tesla is the perfect metaphor for where the U.S. economy is at: a company stuffed with debt plus government subsidies, unable to deliver the wished-for miracle product—affordable electric cars—whirling around the drain into bankruptcy.”

~James Kunstler, Kunstlercast

Figure 12. Cash burn.

Musk showed evidence of brain cell burn along the way, causing some to suspect that he was popping too much Ambien, downing too many mushroom pizzas, or going heavy on the poppy seed bagels at the Nevada Gigafactory. Before-and-after videos^{ref 97} make the new-era Musk look more like Dave Chappelle’s homeless character with the white stash. He started harassing analysts on conference calls for their “boring, boneheaded questions” about, oh, useless crap like “inventories.”^{ref 98} Harassment of the shorts included forcing an insider posting as “Montana Skeptic” (Lawrence Fosse) to shut down his Twitter feed by complaining to Fosse’s bosses.^{ref 99} Elon sent one of his detractors, David Einhorn, a pair of “shorts” to mock him. Late night (early morning) Tweets include gems like jokes about being bankrupt and insolvent,^{ref 100} which prompted fast response from the SEC (just kidding). He routinely taunted the SEC’s inability to reign him in.^{ref 101}

“Musk is at it again. He’s doubling down on his pedophile comment.”

~James Chanos, Kynikos Associates

“You don’t think it’s strange he hasn’t sued me?”

~Elon Musk tweet, prompting a lawsuit for the “pedophile” comment

“Despite intense efforts to raise money, including a last-ditch mass sale of Easter Eggs, we are sad to report that Tesla has gone completely and totally bankrupt. So bankrupt, you can’t believe it.”

~Elon Musk tweet

“When you’re massive negative free cash flow, your 7-year bonds are trading $86 bid, and you need debt capital markets financing . . . you don’t joke about bankruptcy.”

~David Tamberrino, Goldman Sachs, on his “sell” recommendation

The fateful moment came when Musk announced that he was considering taking Tesla private at $420 per share, well above the asking price, causing a gargantuan wad of money to change hands in the short squeeze:

“I think the Thomas Edison of our age has come off the rails. ‘Funding secured’ means he has the money lined up, or he’s guilty of market manipulation.”

~Scott Galloway, author of The Four

“Funding secured” reached meme status, and the SEC did wake up this time. Elon and Tesla scrambled to find somebody to pretend like they were the ones tendering the offer (to no avail), eventually settling with the SEC for a $20 million fine and the requisite temporary demotion of Musk from CEO to CBW (Chief Bottle Washer).^{ref 102} Of course, that triggered another massive short squeeze,^{ref 103} yet again hurting those betting against Musk. Charlie Gasparino says Tesla could be bracing for “billions of dollars in potential liability from private lawsuits,” from both market longs, shorts, and, of course, cave-dwelling pedophiles. The street hasn’t yet figured out how to price Tesla’s shares (Figure 13). I think Tesla will eventually be auctioned off for parts on the courthouse steps. Of course, all this chaos has had a huge deleterious effect on its current share price (Figure 14).

“He claimed there is a specific source of funding, so that better be true. He also claimed that there is a specific amount available for funding, so that has to be true; otherwise even if it’s not manipulation it would be fraud.”

~Harvey Pitt, former SEC chairman

  

Figure 13. Chick fight over a few decimal points.

Figure 14. Tesla share price.

The VIX. I obsessed about the VIX—the so-called “volatility index”—last year.^{ref 104} It was important as both a reflection of and a cause of market frothiness. You could short the VIX at will—a one-decision trade—and make a lot of money, they said. Everybody extolled the virtues of shorting the VIX—“selling vol”—using vehicles like the XIV (clever anagram) or SVXY. There was historical precedence: Folks at LTCM loved shorting vol.^{ref 105}

“References to exceptionally high ‘risk-adjusted returns’ leave me wondering: How do you adjust for risk on the vol trade?”

David Collum, YIR 2017

“Should I kill myself?”

~Online investor after losing $4 million on XIV

“People say congratulations, you called the short-vol trade. No, nothing has happened yet. This is just the appetizer for the unwind that is about to come. I think this is what people should be really afraid of . . . it will be quite disorderly and ugly.”

~Chris Cole, getting credit for calling the vol implosion

There were an estimated $2 trillion vol shorts last year. Seemed like that game had to end, but when? On February 5th, 45 minutes after the markets closed on a 15% one-day loss, the VIX short trade collapsed (Figure 15). We are not talking “crushed” or a “crash ’n’ burn.” It went to zero in fifteen minutes. Credit Suisse “terminated” the XIV trading vehicle.^{ref 106} TradeStation clients were sent an email terminating “futures trading” and told that margin accounts were “subject to immediate liquidation.”^{ref 107} Nomura shut its trading down.^{ref 108} A number of funds blew up.^{ref 109} The speculation was that trading firms would collapse, but that did not materialize. Chris Cole had described in lurid detail how the VIX and $2 trillion of implicit and explicit vol bets could blow up about a week before it blew up.^{ref 110}

Figure 15. Collapse of the XIV, a VIX short ETF.

Who lost? Various pensions proved to be the vol sellers, including University of Hawaii and the Illinois pension funds.^{ref 111} Harvard got out in time. Are they lucky, connected, or just “wicked smaht”? Who won? That’s harder to say because not all wish to take credit. A small hedge fund made 8,600% on a wildly improbable bet the XIV would go to zero.^{ref 112} Discussions of serious market manipulations surfaced,^{ref 113} suggesting that VIX shorts got spread over the five boroughs like Fredo. And when the dust settled, there was Goldman, sitting like the fat bastard at Donner Pass, chewing a toothpick with a $200 million profit.^{ref 114} Goldman had predicted the problem, almost like they knew something. Oddly enough, soon after vol shorters became full-time gene pool cleaners, the SVXY vol shorting vehicle was resurrected and is attracting a new batch of suckers who can’t resist touching the stove too.

End of Cycle. The free market has caught up to a few hooligans. After 100 years, the iconic Sears is now a carcass being picked over by its creditors. Far more shocking, General Electric, the dominant industrial super power is –80% off its 2016 high and –88% off its 2000 all-time high (requiring an 700% gain to return), hitting levels not seen since 1994. It has been removed from the Dow and replaced with Walgreens,^{ref 115} which is sitting at its all-time high with the same market cap as GE. For those keeping score, GE bought back its own shares all the way down, which probably explains why its pension fund is the third largest holder of GE shares.^{ref 116} The $170 billion dollars of GE debt (depends on how you count) could be one of GE’s toaster ovens being tossed into the pool and may be what spooked Powell into backing away from an overtly hawkish stance—”the birth of the Powell Put^{ref 117}” (which, as of December 19th, is said to have died).

“General Electric is the most admired company for the sixth time in the past decade.”

~Forbes, 2006

For the most part, the markets have made conservative investors—what we call Cassandras, Chicken Littles, Grumpy Old Men, and Nouveau impoverished—look like fools. Has the top reared its ugly head this year with the entertainment just beginning? If not, when?

JPM’s Kolanovic says that the next meltdown in stock prices could cause the next financial crisis and has coined the name “Great Liquidity Crisis” to describe the phenomenon. Charles Hugh Smith suggests that 10 years of reckless behavior will “unleash a non-linear avalanche of reversions to the mean and rapid unwinding of extremes.” I think he’s saying it will be fast. Rates are rising, the cycle that was never fundamentally impressive (or even sound) in the first place is getting very long in the tooth, markets seem awfully jumpy, and the algo bus fueled by unprecedentedly easy monetary policy that drove us to the summit may have no brakes for the trip down.

“The bulls don’t seem to acknowledge the artificial nature of this bull market in risk assets in general—no other cycle had such interference from central bank incursions and support by their balance sheet expansion. . . . The tax cuts have helped buy the bulls a little bit of time, but history shows that monetary policy is far more powerful and exerts its influence with lags that are typically long, variable, and insidious.”

~David “Rosie” Rosenberg

They say that nobody rings a bell at the top or bottom, but some would argue that is untrue. If you believe that valuations are ridiculous, the journey could be fast and hair-raising. Please do not blame hiking rates for a rout. The Fed laid the ground work over decades. And, by the way, if you think that you can hide from a washout by staying in the lower deciles of valuation, dream on. Hussman showed that the pain will be severe in all 10 valuation deciles.^{ref 118} When valuations plumb the lows, half the equities will be valued even lower. How about emerging markets? They seem cheap. Yes, but they will get cheaper. On the bright side, maybe I’m just wrong.

“The complex world financial system has so detached itself from underlying economic reality that it simply cannot continue without a catastrophic discontinuity.”

~Tony Deden

FAANGs

“When wireless is perfectly applied the whole earth will be a huge brain. We shall be able to communicate with one another instantly, irrespective of distance.”

~Nikola Tesla, 1926

One couldn’t possibly miss the influence of the five FAANGs—Facebook, Apple, Amazon, Netflix, and Google—on collective global equity markets and, in turn, the perceived Wealth of Nations. The lowest interest rates since the Pharaohs walked the earth juiced world equity markets with hot money drawn to inflating assets. Non-linear gains owing to market-cap-dependent passive investing put the FAANGs on a tear (Figure 16). The euphoria has been palpable; the Bank of Montreal launched a triple-levered FANG ETF.^{ref 119} (Ding! Ding! Ding!) While the S&P rallied >200% off the 2009 lows, the FAANGs put up >600% gains, giving them a market cap greater than the UK’s FTSE index. At one point, Amazon alone accounted for >30% of the S&P 500’s gains for the year while putting 70% on its market cap in 165 trading days.^{ref 120} Market pundits breathlessly watched Apple and Amazon race to be the first company to reach a trillion-dollar market cap (willfully blind to PetroChina, which reached that high-water mark in ’07).^{ref 12} Somebody was bidding them up like they were signed copies of the Bible. A photo finish gave the win to Apple on September 2nd followed by Amazon two days later.^{ref 122} Am I the only one who finds this too coincidental? Does it seem odd that September 4th was also the high-water mark for Amazon?

Figure 16. FAANG index as of mid-2018.

Meanwhile, everything is not perfect in cyberspace. Insiders were locking in profits with record share sales.^{ref 123} I also question whether these five companies are equipped to drive economies of the twenty-first century. Can the FAANGs create wealth like Standard Oil, General Motors, U.S. Steel, and General Electric did in the twentieth century? Will the FAANGs create wealth tangible enough to provide the needs of pensioners, feed millions, and sustain the American Empire? Most have valuation and balance sheet issues that certainly would leave value investors wondering if their IQ tests came back negative.

“If the DOJ had not moved in on Microsoft in the late 90s and warned them to stop killing small firms such as Netscape in the crib, we would not have Google, we would have Bing.”

~Scott Galloway

Meanwhile, all but Netflix are facing political and regulatory pressures that could prove catastrophic. The selective censoring of social media users based on political biases is now epidemic proportions and undeniable. Twitter’s algorithms are so dumb that they censored their own CEO, Jack Dorsey (@jack) briefly.^{ref 124} I suspect that it won’t be long before First Amendment cases against Facebook, Google, or Twitter will be taken to the Supreme Court.^{ref 125}

“I think that this certain situation is so dire and has become so large that probably some well-crafted regulation is necessary.”

~Tim Cook, Apple CEO, on the Facebook scandals

“God only knows what it’s doing to our children’s brains.”

~Sean Parker, former president of Facebook on the influence of Facebook^{ref 126}

Facebook. Here we have a trailing P/E in the 20s and no debt, making Facebook seem reasonable. My own concern is that it has a trendiness like a teenage clothing chain. Scandals with Cambridge Analytica have given it a serious black eye,^{ref 127–129} starting an anti-Facebook movement endorsed by Jan Koum, billionaire founder of WhatsApp, when he announced, “It is time to #deletefacebook.”^{ref 130} Half of millennials are said to have removed the Facebook app from their phones.^{ref 131} Whether Facebook dropped the millennials’ phones from Facebook’s apps is an altogether different question. Its usage has been cut in half from its peak owing to censoring, mounting evidence that it is Deep-State personified, and its triggering of dopamine responses like crack cocaine.

Mark Zuckerberg is being drawn and quartered by those who want to be protected from fake news—news that is not in somebody’s political interest—and those who abhor censorship as a crackdown on free speech. Zuckerberg himself—that True Blood “Suckerberg” look—and his antics creepier than a Boston Dynamics robot. Facebook is now positioning to manage data for the healthcare^{ref 132} and banking industries.^{ref 133} If either is allowed, the term Orwellian will elevate to new levels. On the bright side, the Zuckerberg presidential run has returned to the netherworld from whence it came. Facebook looks like a long-term sell to me.

“Mark doesn’t care about publishers but is giving me a lot of leeway and concessions to make these changes. We will help you revitalize journalism . . . in a few years the reverse looks like I’ll be holding hands with your dying business like in a hospice.”

~Campbell Brown, head of news partnerships at Facebook

“They don’t need to identify suckers anymore; Facebook does it for them.”

~Analyst on Facebook’s program to assist fake product ads

Amazon. Of the five FAANGs, this is the 500-pound gorilla. Amazon has essentially no earnings (P/E > 200) and operating margins below 2%, but its business model appears to be (a) pay no taxes, and (b) buy or destroy all competitors.^{ref 134} Once brick-and-mortar competitors have taken the caravan to the light, don’t be surprised if Amazon brings back brick-and-mortar under new management.

Figure 17. Amazon revenue versus profit.

“I can’t explain the valuation of big tech companies. . . . [T]o justify the multiple that Amazon trades at today, the company would have to be worth 25% of the US economy five years from now.”

~Sam Zell, commercial real estate god

Some would call Sam’s quote a prediction, not a valuation warning. Amazon’s risk is regulatory and antitrust also. It is priced as a monopoly. Should sovereign states (possibly in Europe) decide Amazon is too ruthless and try to break it up, the company will be hobbled for years.^{ref 135} Amazon would become profitless pieces (and some profitable pieces) that do not enjoy monopolistic power. Who decides it is a monopoly? Some politically motivated judge looking over his shoulder at an angry mob that’s given up fighting Walmart and Occupying Wall Street.

“There is nothing conservative about big corporations; they are the backbone of the left.”

~Tucker Carlson, journalist

Amazon’s image got bruised by its deal with the U.S. Postal Service for shipping rates that put the USPS in the red.^{ref 136} Arguments are being made that government subsidies such as food stamps to underpaid employees in general (and Amazon’s employees in particular) are really just government subsidies to defer Amazon’s salary costs.^{ref 137} In an effort to mitigate a backlash about poor treatment of employees, Amazon offered raises and then, rather inexplicably, announced they would be paid for by removing bonuses.^{ref 138} Amazon hastily reintroduced a new cash bonus of $1,500–$3,000 for employment milestones of 5, 10, 15, and 20 years. If all 500,000 employees hit all benchmarks, it will cost Amazon a couple billion dollars in total. If higher pay starts shrinking that 2% profit margin, Bezos will automate even more. Of course, an employee may be at risk of being laid off in years 4, 9, 14, and 19.

We went full oligopoly when a triumvirate of three profound monopolists—Berkshire Hathaway, Amazon, and JPMorgan Chase—proposed to partner up to convert the healthcare system into “an independent company that is free from profit-making incentives and constraints.”^{ref 139} No offense, but if you buy that “free” part you’re an imbecile. The Nation didn’t and took them to task.^{ref 140} The article also did a nice job of beating Buffett with the ugly stick, which I have tried to do a few times myself.^{ref 141} Amazon is also deeply embroiled in the privacy battles, as their hot new product, Alexa, records conversations within your home and sends the key data to advertisers.^{ref 142} A camera that follows you around the house^{ref 143} is being called “the Eye of Sauron.”

Amazon announced two new corporate headquarters, one in Long Island City.^{ref 144} Whether the deal cut by Cuomo sold NY state’s souls to the devil remains to be determined. The placement right next to Cornell’s new tech campus gets my selfish juices flowing.

Apple. I love Apple products but am getting closer to bailing on them. Scott Galloway, author of The Four, says Apple is successfully branding itself as an elite product line like Cartier. Maybe so but only those who bought Apple shares at the bottom can afford the 20–25% price hikes.^{ref 145} Paying $1,000 for a phone, $1,500 for a basic MacBook Air, and $2,000 for a MacBook Pro or iMac seems egregious. The $400 Apple watch—the Cartier of the digital world—is competing with the $25 watch that I get at Target. Apple’s revenue growth rate has slowed to an average of less than 4% annually over the past 3 years.^{ref 146} Jesse Felder notes that Apple’s stock trades at its highest ever price-to-free cash flow ratio while the company’s 5-year average revenue growth is the lowest in its history.^ref

“So excited for the Apple Watch. For centuries, we’ve checked the time by looking at our phones. Having it on your wrist? Genius.”

~Ellen DeGeneres, talk show host

At least the company hasn’t saturated the marketplace with innovative new products. Bill Fleckenstein reminds us the iPhone 6, the latest product to dazzle the world, just had its sixth birthday! They grow up so fast. Tech analyst Fred Hickey calls Apple’s new iPhone rollout “disastrous”. Price cuts in Japan after only a month and collapsing sales in China are ominous. Buybacks are said to be keeping the shares afloat—or were until the swoon of >20% and moving faster than I can type. Apple is selling fewer phones than a few years back,^{ref 147} which is reflected in inventory numbers. What is the company’s response to drooping iPhone sales numbers? Stop reporting sales numbers!^{ref 148} Seems like those 20–25% price hikes on all products are working their magic on demand. Maybe Apple’s cloud presence will save it, but the cloud also offers arbitrage opportunities (narrowing profit margins). Apple seems like a money-printing machine now, but the law of large sizes alone puts it at risk of, at best, going nowhere. In a wonderful video, Steve Jobs explains how once you have a monopoly, new products don’t help you, only better marketing. Soon, marketing people are running the company and what made it great is gone.^{ref 149} Indeed, what made it great is gone. They miss you, Steve.

Netflix. A trailing P/E of >200, a price-to-revenue ratio of 10, a high cash burn rate for its new content,^{ref 150} a commitment of another $18 billion for more new content (some parked off balance sheet) earning the moniker “Debtflix (Figure 18),”^{ref 151} and a share price that reached 70% above its 200-day moving average put Netflix at risk. Disney is pulling its content from Netflix in 2019.^{ref 152} A Netflix spokesperson noted, “we expect to be free-cash-flow negative for several more years (Figure 18).”^{ref 153} Fixed income investors had auto-callable debt with a huge 20% yield, but the notes were recalled, leaving investors with a net loss owing to 2.7% in fees.^{ref 154} Well, the bankers did OK. Future debt issuance could get dicey.

Figure 18. Netflix cash flow and debt.

“Google and others are suppressing voices of Conservatives and hiding information and news that is good. They are controlling what we can & cannot see. This is a very serious situation-will be addressed!”

~Donald J. Trump, President of the United States

Google. The share price of Google is up a tame 600% from the ’08 lows. With control of 90% of the search market, further penetration will have to come from other sources. Scott Galloway sees antitrust activity ramping up, although it seems to me like a weaker case than the one against Amazon.^{ref 155} Google is accused of biasing search results toward advertisers that pay more, which may pose an optics problem but is also how capitalism works. Leaked emails showed that Google helped Hillary with biased search results,^{ref 156} although not enough apparently. Its participation in deep-state filtering including ham-fisted if not downright abusive attacks on right-wing YouTube sites could lead to fines (a sarcastic BFD) or antitrust activity (a real BFD). Strong ties with the NSA are consistent with the widely held belief that all social media companies offer back doors to the Deep State.^{ref 157} (If you are confused as to why I keep referring to the Deep State pejoratively, you’ve got some catching up to do.)^{ref 158} To get dominance in China, Google appears to be signing off on a platform that allows totalitarian-state-level censorship (code-named Dragonfly).^{ref 159} Squeals from within the Google employee echo chamber urged Google to drop its military-funded drone program. As a compromise, it dropped its 17-year-old guiding catch phrase, “Don’t Be Evil,”^{ref 160} replacing it with “Be Evil.” A $5 billion fine was a wrist slap.^{ref 161} Tangible constraints on them may be less benign.

Brand blemishing from firing James Damore last year got another smudge when a post-election video showed the high command at Google self-righteously spewing political views as truths and nothing but the truths.^{ref 162} The former head of public relations says that Google suffers from serious truth issues.^{ref 163}

“Give us a hundred years and us billionaires will show what wealth disparity looks like.”

~Sean Parker, former president of Facebook

As I type, the markets are having their way with the FAANGs—a “FAANG bang.” Maybe it’s just more jiggles en route to $2 trillion market caps for all…or maybe not.

Gold

“You very rarely, if ever, hear a serious discussion of the role of gold in the system going forward. I don’t see any appetite within that community to revisit that issue.”

~William White, formerly at the Bank for International Settlements

“The major gold-producing nations are tired of an international gold price that is determined in a synthetic trading environment having little to do with the physical gold market.”

~Sergey Shvetsov, deputy governor of the Bank of Russia

“If gold is a relic of history, why do central banks and the IMF still hold over $1T of gold? If it’s meaningless, why is everybody still holding it?”

~Alan Greenspan, May 2018

Gold has been boring for years, lurking in what a friend calls “the Collum range . . . oh, about $1,200.” (Figure 19). It will be tested during the next downturn and consequent stimulus effort, but until then I’ve largely stopped reading articles about why gold will tank or soar. If it hedged against monetary idiocy, I would be living on my own Island in the Caribbean. Occasionally, however, I stumble across a nugget. Gold dropped linearly from April to August (Figure 20). Maybe that’s normal or maybe Bernie Madoff whistleblower Harry Markopolos is right: Linearity in finance is fraud. (A 21-day linear drop in silver was even more awesome.) Hedge funds went net short,^{ref 164} suggesting correlation if not causation, possibly fueling the brief dip below $1,200. Evidence of horseplay appeared in the form of 260,000 futures contracts—$34 billion notional value—monkey-hammering gold in 4 hours in June.^{ref 165} Nobody even blinks at these anymore, especially not the regulators. Of course, a couple of gold-rigging charges were made—one guy even admitted that it had been happening at the industrial scale for years—but they were disposable traders and got acquitted anyway.^{ref 166} Canada’s Scotiabank will pay $800,000 to settle charges of “spoofing” (fake bidding).^{ref 167} Wow. $800,000. HSBC has been caught four times rigging the price of gold, promising four times to never do it again.^{ref 168} For those interested in buying allocated gold, the Texas Bullion Exchange has opened its vaults.^{ref 169} You get the convenience of a debit card while still enjoying the projectile-vomit-inducing price fluctuations of gold. There are others such as the Tocqueville Bullion Reserve.^{ref 170}

Figure 18. Ten-year gold price.

Figure 19. Linear drops in gold.

“You can feel the dejection among hard core gold owners. They’re finally starting to ask themselves why there don’t seem to be any kind of market conditions in which gold *works* as an investment or hedge.”

~Mark Dow (@mark_dow), hedge fund manager and gold bear

The debate about the future of gold in the global monetary system rages on among the 10 people who care. Craig Hemke (TF Metals Report) was early to notice an apparent pegging of the yuan to gold (Figure 20).^{ref 171} Could be true or just goldbug pareidolia; regardless, it seemed to end this fall. Canada sold every last ounce of sovereign gold by 2016,^{ref 172} putting their holdings below those at the Bank of Dave. China, Russia, Poland, Hungary, Pakistan, Egypt, and Mongolia kept accruing the Bar-B-Qued relic.^{ref 173} Hungary cranked its inventories 10-fold with an affiliated repatriation from foreign vaults.^{ref 174} Turkey decided its gold was safer at the Istanbul Exchange than in JPM’s vaults in New York.^{ref 175} Rumors that Russia and China have outlined plans to create a 100% gold-backed currency system to replace the U.S. dollar as the world’s dominant currency are wild speculation and provocative (Figure 21).^{ref 176} They certainly trust gold more than the dollar-denominated global banking cartel.

Figure 20. Yuan-gold peg and gold in U.S. dollars.

Figure 21. Russian and Chinese gold acquisition.

You really can’t put a value on gold (or eat it), but there are technical indicators suggestive of future price movements. The so-called speculators—the dumb money, whatever that means—went net short for the first time since the 2001 bottom, while the banks—the smart money (?)—went net long for the first time in history. We are parked at an all-time high of >500 claims against each ounce of gold at the COMEX vaults,^{ref 177} which could leave some wondering who Madoff with their gold.

“In recent years, bullion inventories have fallen materially, and last summer Charlie and I concluded that a higher price would be needed to establish equilibrium between supply and demand.”

~Warren Buffett, on silver, 1997

“We have a very similar situation in gold . . . it appears that a higher price is needed to establish equilibrium between supply and demand. . . . This won’t matter till it matters. Whenever it does, it will likely be too late to do anything about it.”

~Jesse Felder

For the gold-is-real-money crowd, the market value of all above-ground gold as a percentage of U.S. financial assets currently stands at 3.4%, which is well below the historic peaks of approximately 16% and not too far from the historic lows of approximately 2%.^{ref 178} In the spirit of bear markets die of boredom, Vanguard Gold Fund dropped “gold” from its name at the 2001 bottom and dropped the fund altogether this year.

In the world of human interest that even non-goldbugs can appreciate, the Rooskies dropped 3 tons of gold all over the runway when taking off at the Yakutsk Airport.^{ref 179} “Risk” players know that nothing good happens in Yakutsk. An amphora containing hundreds of fifth-century gold coins was found in excavations in Italy, while a Spanish galleon containing an estimated $17 billion in gold may have been located.^{ref 180}

“Gold could be in a prolonged tailspin.”

~Barron’s headline

Silver got pummeled a bit but, fortunately, nobody owns any (except me). The industrial demand keeps my relatively small position intact. Solar now consumes about 10% of annual silver production,^{ref 181} and silver is found in non-recoverable form in every electronic device. The gold–silver ratio has soared from 16:1 by weight in the ground to 80:1 by price in the market.^{ref 182} The notion that it should somehow price in proportion to supply is hotly debated, although the consumption of silver but not gold would logically give silver the relative boost in my opinion. JPM is said to control over 50% of the COMEX silver inventories—new-era Bunker Hunts or simply their clients’ silver.^{ref 183} For now, I watch with bemusement.

“The question as to whether the Fed can engineer yet another cycle (as it was able to in 2009) or whether the coming crash will be the end of the Supercycle will determine whether gold (and the miners) go up a lot or whether they rise to a terrifying degree.”

~Daniel Oliver, founder and managing director of Myrmikan Capital

Bitcoin: Tales from the Crypt

“Don’t put any money into bitcoin that you can’t afford to lose. But I don’t think we should ban it—the green bills in your pocket don’t have an intrinsic value, either.”

~Sheila Bair, former chair of the U.S. Federal Deposit Insurance Corporation

“Cryptocurrencies do not fulfill any of the three purposes of money. They are neither a good means of payment, nor a good unit of account, nor are they suitable as a store of value. They fail dramatically on each of these counts.”

~Agustín Carstens, general manager of the Bank for International Settlements

In the battle of gold versus cryptos—the Bugs versus the Crypts—I am in the bug camp, but I am sympathetic and respectful of the cryptophiles. Against the current monetary regime, the enemy of my enemy is my friend.

”Millennials are afraid stocks are too risky, so they’re investing in bitcoin.”

~MarketWatch

The strongest case I can make for cryptos is karmic: I don’t own any. It’s still the Wild West, but that’s not to say this sector can’t make doubters look like boobs going forward. Some speculate that the loss in volatility—the onset of boredom—will be their demise, but I completely disagree. If they are to become currencies, they must calm the hell down. That plateau in the $6K zone in Figure 22, therefore, seemed “highly constructive”—until the bottom fell out. Shaking youthful day traders from the “space” is also constructive. Start with George . . .

Figure 22. Bitcoin price.

From Figure 22 we see that the cryptocurrencies got pegged this year as investors spit the bit. The trip from sublime to supine did not take long. After bitcoin was driven above $20,000 in late December 2017 (on its trek to $1,000,000, of course) it has now pulled back to about $3,200, which I believe is below the estimated $8,000 to mining it.^{ref 184} (It is said that crypto mining uses more energy per year than Ireland does.^{ref 185}) The founder of the cryptocurrency called Ripple became richer than Zuckerberg^{ref 186} before a little market inefficiency got cleaned up by handing Ripple a 90% drop in two days.^{ref 187} (Now if only we could get some market efficiency on FAANGs.)

  

Dogecoin, invented as a spoof four years ago,^{ref 188} hit a market cap of $2 billion in January, eventually pulling back 90%.^{ref 189} It seems indisputable that the vast majority of cryptos will find strong technical support at zero. KuCoin, with a market cap of <$50,000, can’t be long for this world. Obviously the beatings took some of the piss and vinegar from Cryptomania, but The Big Three—Bitcoin (BTC), Ethereum (ETH), and XRP—retain a combined market cap of $80 billion at the time of this writing, and there are more than 2,000 cryptos listed at CoinMarketCap.com.^{ref 190} Since its inception, the crypto space has taken beatings that would make Whitey Bulger blush (or die), yet they have shown remarkable anti-fragility.

“If authorities do not act preemptively, cryptocurrencies could become more interconnected with the main financial system and become a threat to financial stability. . . . Accordingly, authorities are edging closer and closer to clamping down to contain the risks related to cryptocurrencies. . . . Cryptocurrencies are, in a nutshell, a bubble, a Ponzi scheme, and an environmental disaster.”

~Agustín Carstens, BIS

There are, however, some serious problems that pose existential risks. The authorities—every developed sovereign state and central bank in the world—have oligopolies on creating money and taxing money flows. If they can’t assimilate the Crypto Collective into the Borg Collective, they will try to destroy it. Crypto “hodlers” (hang on for dear lifers) stand defiantly (Figure 23), but it would scare the bejesus out of me. My Texas Hold ’em all-in bet would be on the awesome power of the State.

Figure 23. Tommy Lee lowering his expectations, predicting a 250% rally in Bitcoin in the last two months of 2018.

The State will try to tame Bitcoin before just crushing the crypto bastards garishly. Given that ignoring the cryptos wasn’t working, we witnessed subtle efforts to mainstream them. First, the banks had to stop the use of credit card purchases of cryptos for obvious reasons: the crypto collapse would (and did) cause people to default on their credit cards.^{ref 191} Banks then began introducing new crypto products—crypto futures, brownies, and vapes. This set the stage for the Commodity Futures Trading Commission (CFTC) to ride into Dodge City to get control.^{ref 192} During the routs this year, there were some huge buyers stepping in to provide what appeared to be J.P. Morgan-esque support. We’re talking $500 million purchases.^{ref 193} However, a federal judge ruled that cryptocurrencies are “commodities”^{ref 194} and, unlike all other markets on the planet where manipulation runs unchecked, the authorities promised to mete out some jail sentences. The SEC is “probing investment advisers for potential misconduct involving cryptocurrencies, signaling a new direction in its oversight of this emerging market.”^{ref 195} Ominously, Google announced a ban on all crypto and initial coin offering (ICO) advertising. This is the power of the State using Google as a stalking horse. (I capitalize state to get you to say, “Oooooh” and shake with fear.)

The IRS declared the gazillions of crypto transactions are merely gazillions of taxable events creating gazillions of miles of red tape and gazillions of new criminals, tipping risk–reward calculations decidedly toward risk.^{ref 196} Can you imagine if every time you bought a product with dollars it became a line item on your tax return? (Of course not: the dollar purchasing power monotonically drops.) How about all those cool toys, houses, and Lamborghinis bought with liquidated Bitcoins? They’ve got the goods and huge capital gains tax bills.^{ref 197} Could be worse, as Saxo Bank has pointed out: Some particularly resilient consumers purchased the toys on credit, comforted by the cushion of Bitcoins priced at $2,000 apiece.^{ref 198} They’ve now got the toys, debts, and crypto cushions that are more like donuts.

Claims that hackers from Russia were interfering in the crypto markets means the crypto space is a national security concern.^{ref 199} The NSA is now tracking the cryptos—they always were, silly—which means the whole privacy thingie is hooey.^{ref 200} (Hooey is Russian slang for horseshit.) It is also the rallying cry for more State intervention.

What would a mania be without human folly, self-inflicted wounds, and some serious humor? North American Bitcoin Conference organizers in Miami stopped accepting bitcoin payments for conference tickets owing to network fees and congestion.^{ref 201} A long position in bitcoin futures in Hong Kong’s OKEx crypto exchange processed a $416 million trade.^{ref 202} The exchange was “unable to cover the trader’s shortfall as Bitcoin’s price slumped.” Rob Arnott says bitcoin futures are 10–20× leveraged,^{ref 203} which accounts for the big moves both ways. CNBC had a guest whose firm offered a 100× leveraged bitcoin product.^{ref 204} I’m guessing they are now untraceable in the blockchain (like Lawnmower Man). A company called Proof of Weak Hands Coin, referring to themselves as “a Ponzi scheme” on Twitter complete with a pyramid avatar, raised $800,000.^{ref 205} Hackers promptly drained its funds. Another Ponzi scheme was so bad that the Russians shut it down, but it has resurfaced and is thriving in the Heart of Darkness (Africa).^{ref 206} A video promo for BitConnect was produced Gangnam style—some serious sleaze on display.^{ref 207} BitConnect turned out to be a Ponzi scheme and, unlike the other Ponzi schemes offered by Wall Street, actually collapsed.^{ref 208} There is no BitConnect without Bitcon. The miracle of creative destruction is on full display as Uber scooped up the influx of new drivers.

Legitimate (albeit pathetic) companies added “blockchain” to their names, causing their market caps to soar.^{ref 209} Eastman Kodak announced a crypto coin, causing shares to take off in flash. “Long Island Iced Tea” became “Long Island Blockchain.” Smith Corona changed its name to Smith Coinola and did an ICO. (OK, I made that one up.) After a brief spike, the Kool-Aid swillers gave it all back, of course.^{ref 210} There are, however, emerging legitimate uses of blockchain. The LegalFling app, for example, records consensual sex agreements (blockchain keys to the chastity belts).^{ref 211} As Jim Rickards said, “Have fun, kids.” Here’s some funny satire.^{ref 212}

Real Estate

“There is a tsunami of supply comin’ down the road. If someone on this panel can tell me where the demand is gonna come from to meet that supply, then we got something to talk about.”

~Sam Zell

Seems like a truism to me that as rates drop, real estate prices will rise—and vice versa. It’s not shocking that big real estate bubbles occurred in the 1920s and 2000s during periods of loosening policies. And, of course, rates being too damned low for too damned long should goose prices too damned high, but I don’t sense that buyers and lenders have completely lost their minds this time. With mortgage rates at a 7-year high and rising (Figure 24), we will soon find out.

Figure 24. Thirty-year mortgage rates.

Some think we will have another crippling real estate bust. My canaries in the coal mine are the single-family rentals. As Joe and Jane Six-pack drove away from the burbs in ’09 watching their former abode shrink in the rearview mirror, the rest of you witnessed the absurdity of rising home prices in the face of falling occupancy (Figure 25). Nobody slipped you acid. The private equity guys jumped in to buy the houses at steep discounts and then drove the prices higher.^{ref 213} Mind you, single-family rentals are a terrible business that works only when the paper-thin capitalization rates (profit margins) are amplified by leverage—cheap money—relying on low interest rates. The obvious risks are, of course, rising interest rates. That risk didn’t stop Cerberus from increasing its portfolio with a $500 million expansion of FirstKey Homes.^{ref 214} I suspect, however, that the boom (and Cerberus) may die as rising interest rates and commensurate falling cap rates cause the private equity guys to decide the game is over and start liquidating their large shadow inventory to flood the real estate market. For now, however, we are witnessing more froth than fragility. For those interested, that image in Figure 25 in which two normally correlated prices diverge is called “alligator jaws.” There are a lot of 2018 charts from all over the financial universe that look like that. Alligator jaws are known to slam shut without much warning. It is not a subtle metaphor.

Figure 25. Home ownership rate versus price.

The enthusiasm for housing did get a bit manic, with a third of U.S. homebuyers (or should I say buyers of U.S. homes) bidding sight unseen.^{ref 215} A five-story Manhattan townhouse sold for a new record of $37.2 million—quadruple what the buyers had paid in 2012.^{ref 216} Credit unions are once again offering 0% down for mortgages up to $2.5 million.^{ref 217} I saw a show this morning describing how a divorced couple who had a house-flipping show during the last bubble have gotten past their hatred and contempt to restart the show. (Ding! Ding! Ding!) Real estate analyst Mark Hanson lays out city-by-city plots showing serious froth (Figure 26). These numbers are not inflation corrected.^{ref 218}

Figure 26. Mark Hanson analysis.

Despite surveys showing a willingness of the majority of California residents to at least consider leaving the state,^{ref 219} the California housing market is on fire! (OK, that was tasteless.) As we witness a net population exodus from The (shit-stained)^{ref 220} Streets of San Francisco for the first time ever,^{ref 221} the cost of a median single-family dwelling in San Francisco rose to $1.6 million (Figure 27).^{ref 222} An 804-square-foot house in nearby Palo Alto sold for $100K in 2003 and $5.3 million in 2018.^{ref 223} A 900-square-foot bungalow near downtown Palo Alto listed for $2.6 million,^{ref 224} below the median listing in Palo Alto of $3 million.^{ref 225}

Figure 27. San Francisco housing and their feces reports.

Evidence of housing market softening, however, is very real. Shares of homebuilders have been getting crushed (losses of 29–55%) in an economy said to be booming.^{ref 226} According to prominent economist Lakshman Achuthan, the national home price index was contracting by mid-year.^{ref 227} I—a friggin’ chemist—saw the subprime and banking crisis as far back as 2002. ^{ref 228} Bank and credit analyst Chris Whalen reminds us that the bust was clear by 2005.^{ref 229} He now says “nothing changed since 2008, but as in 2006, we have convinced ourselves that everything is just fine.” Total real estate sales in Manhattan fell 11% year over year.^{ref 230} Offers are coming in well below asking prices.^{ref 231} The drop was attributed to an acute oversupply of luxury units as foreign buyers sat on their hands, rising material costs of construction, and changes in tax deductibility of mortgage payments.^{ref 232} This latter point is important: If you can only deduct $10,000 per year of your state taxes on your Federal return, the prices of higher-end housing will necessarily adjust downward.

Canada never really experienced a bust when the U.S. did. It seems like they have rolling booms and busts as hot money moves from city to city. While the British Columbia median prices rose 9.2% year over year, the once-hot Vancouver housing market dropped over 40%.^{ref 233} The two biggest Canadian banks cranked up lending rates right before 50% of all Canadian mortgages were poised to reset.^{ref 234} Stay tuned. Toronto buyers were feeling their oats, as people were flipping their pre-sale houses—tripling the money on their down payments before the sale even closes.^{ref 235,236} The down payments were acting like levered options. That game may have ended. A 3,500-square-foot lot with a 650-square-foot house sold for only $1.1 million because it is too close to a highway.^{ref 237} The Carlyle Group is committing a $225 million senior secured loan to Canadian homebuilder Empire Communities.^{ref 239} Timing seems sketchy, eh? This turn-key, ready-for-occupancy gem in Vancouver is listed for $4 million:

Figure 28. Vancouver handy-man’s dream.

The price of a house in London has increased fourfold in 20 years.^{ref 240} It appears as though Brexit, political upheaval, and mounting consumer debt may finally be causing the formerly red-hot London market to drop precipitously.^{ref 241,242} Spain’s housing bubble seems to have burst too.^{ref 243} China’s cap rates are in the razor-thin 1–3% range. Down in the Woop Woop of Australia, the credit bubble and housing boom seems be a bit of a boomerang, leaving homeowners a bit crikey and stonkered. Australian house prices are down 14% from their peaks and may not even be halfway to the lows,^{ref ref 244} which would pose way more systemic challenges than 30–45% drops in equities.

Another housing bust will call for more government intervention. It will be as feckless as the last:

Pensions

“If you were going to look for what’s the possible real crack in the financial architecture for the next crisis, rather than looking in the rearview mirror, pension funds would be on our list.”

~David Hunt, CEO of $1.2 trillion asset manager PGIM

“But if you look at these state pension funds, they’re a mess. These bills have got to be paid. . . . [A] good rate of return today of 2.5% to 3.5% doesn’t do the job. A big fear to me is who the hell in their right frame of mind would be buying bonds now?”

~Ken Langone, former CEO of Home Depot, on quantitative easing (QE)

“U.S. pension fund collapse isn’t a distant prospect. It could come in 5 years”

~Bloomberg headline

“Why your pension is doomed”

~Wall Street Journal headline

“42% of Americans are at risk of retiring broke”

~CNBC headline

In ancient Rome, Augustus set up a military pension fund using the equivalent of $500 million of his own money and put ex-military trustees in charge. It got pilfered.^{ref 245} We have pilfered essentially every modern-day pension plan as well. Underfunded pensions are a form of leverage, and the pensioners are the creditors. Looming defaults will be devastating. Headlines focus on the risk posed by Social Security that, in conjunction with Medicare, is leveraged $50 trillion^{ref 246} backed by a tax base racking up >$1 trillion (6–7%) annual deficits. The state, municipal, and corporate pension plans and private retirement accounts (401Ks and IRAs) are where the real bodies are buried. More than 100 million working-age Americans who should be progressing toward a stable retirement have saved precisely zero.^{ref 247} As you read the anecdotes below, keep in mind that pension holes are based on aggressive assumptions of 7–8% returns. The only safe bet is that those rates of return are not safe bets. The targeted balances—the balances the pros say you will need to retire comfortably—in personally funded accounts are pathologically understated.^{ref 248} If we really are in the Mother of All Bubbles (MOAB), what happens if it bursts?

The states’ unfunded pension liabilities have grown sixfold since 2003, and are now exceeding $1.4 trillion with the pedal to the metal. State pension costs are swallowing >25% of general revenues. The underfunding is estimated to eventually impose a surcharge to each household ranging from $30,000 for Tennessee to $180,000 for Alaska.^{ref 249} Kentucky has 16% of the funding needed, becoming the topic of a Frontline episode that made officials there look like a bunch of gullible hicks.^{ref 250} California’s CalPERS is funded to <70%, with every private citizen in California owing >$100,000.^{ref 251} Illinois owes >$100 billion to its pension funds—six times the annual state revenue—and the liabilities are on track to double every 6 years (11% compounded).^{ref 252} It is said that if the Illinois state government put 50% of state revenue toward debt, pensions, and retiree healthcare, it will reach full funding in 30 years.^{ref 253} The state could raise taxes, but the Fighting Illini (tax payers) are already ranked #1 in the nation. Go team! New Jersey has $80 billion socked away to pay for $280 billion of future liabilities.^{ref 254} (The funding ratio fell from 93% in 2003 to approximately 30% in a dozen years.) Michigan, Pennsylvania, Florida, Ohio, Oregon, Colorado, Kentucky, and Rhode Island are said to not have the biggest actuarial problems but are at risk of running out of cash first.^{ref 255} I’m not even sure what that means. For 28 states, accrued liabilities have grown by 50% since 2003, way faster than their statewide GDPs.

Figure 29. Six states with problematic pension–GDP gaps.

What are states to do? The California Supreme Court will decide whether pensions can be cut on government employees.^{ref 256} I’m gonna guess no. The Illinois Supreme Court blocked state pension reforms in 2015, consistent with the idea that you cannot selectively screw one class of creditor.^{ref 257} CalPERS voted to increase the amount cities must pay, leading cities to foreshadow Chapter 9 bankruptcies.^{ref 258} Governor Jerry Brown wanted to crank up gas taxes by 40%, which could move him markedly closer to retirement.^{ref 259} Illinois wants to borrow $100 billion to speculate on equities.^{ref 260} That ought to help its already junk-level credit rating. The League of California Cities urged CalPERS officials to think “out of the box” to improve on their already aggressive 7% presumed annualized returns.^{ref 261} Short the VIX, dudes! It’s a one-decision trade. The state will be “totally bankrupt by 2021–2022.”^{ref 262} Between 2006 and 2017, Kentucky’s bond portfolio has grown from <1% junk bonds to 53% junk.^{ref 263}

Reaching for yield is never a good idea, despite being forced at gunpoint by the Fed. Connecticut is broke: It may hock (sell) $2 billion worth of its buildings and lease them back at 7.5%.^{ref 264} Meanwhile the Fed has designed a bailout of the insolvent PBGC (Pension Benefit Guarantee Corporation)—a bailout mechanism in its own right—but one that does not cover state pensions.^{ref 265} My suspicion is that the Fed will loan the states money knowing full well it will never be paid back.

Figure 30. Total state pension deficits (dated data but trending).

The local (municipal) plans aren’t doing much better. New Orleans firefighters can expect 10 cents on the dollar based on their 10% funding level.^{ref 266} Wilkes Barre’s police and firemen’s pensions are <50% funded.^{ref 267} Courts ruled that they couldn’t stick the pensioners. Next up: Chapter 9 restructuring, which is the legally correct solution. Cops and firemen in the tiny burg of Central Falls, Rhode Island, agreed to forfeit >50% of their pensions to escape insolvency.^{ref 268} New York, Philly, LA, Houston, and Phoenix all have $20,000–$30,000 per-capita pension IOUs coming due.^{ref 269} The murder capital of the country, Chicago, has a pension funded to 30%.^{ref 270} While the equity markets tripled from 2009 to 2018, Chicago’s liabilities more than doubled. Each Chicagoan is on the hook for more than $50,000 in pension debts and >$100,000 in total debts—not to mention the bar tab from the state.^{ref 271} Chicago’s problems are a little vague because Chicago’s and Moody’s bean counters disagree by a factor of two owing to different actuarial assumptions. Rahm Emanuel is taking a lifeboat—retiring…on a good pension—to distance himself from the Titanic problems. Before leaving, however, he wanted to borrow $10 billion to dump into the equity markets, but that got put on hold.^{ref 272} Maybe Illinois will lend you the money, Rahm. Similar strategies sent Detroit, Stockton, and San Bernardino into insolvency.^{ref 273}

Figure 31. Municipal pension deficits versus tax revenue for 10 major cities.

There are countless reasons why we’re in this mess, but let’s just look at a bulleted list of waste that illustrates part of the problem, while retaining a comedic touch.

• The head of the Oregon Health & Science University retired on a $913,000 per year benefit, while the poor University of Oregon’s retired football coach of 15 years only gets only $560K per year.^{ref 274} There are 2,000 Oregonians who get more than $100,000 per year.^{ref 275}
• The pooper scoopers who are charged with cleaning up shit off the streets in San Francisco make $184,000 per year.^{ref 276}
• The mayor of Ithaca, Svante Myric, is proposing that the city provide “free” child care. (I know Svante: He is a young man who I think will run for president someday. His platform will likely include some freebies.)
• Illinois has been generous. The top 10 pensioners are each expected to pull an estimated $8–10 million from the state pension plan before they die (unless they visit Chicago). One gets over $400,000 per year as the superintendent of a school district with 1,200 kids.^{ref 277}
• Illinois taxpayers will be on the hook for more than 20,000 six-figure annual pensions for educators. Their pension benefits have compounded at 9% annually for nearly 30 years.^{ref 278}
• More than half the states have grown their pension promises at >5% annually since 2003.^{ref 279}

One could make the argument that some of that is odious debt—debt incurred by somebody else (usually sovereign leaders) that is so odious that you say, “Screw it: I’m not paying.”^{ref 280} I believe, however, that the courts are unlikely to consider odiousness at lower levels.

Self-directed retirement plans—so-called defined contribution plans—are in brutal shape. Data from the Saint Louis Fed (Figure 32) show that the median retiree has almost nothing ($1,100),^{ref 281} and the highly indebted boomers with little time left to correct the error in their ways are altogether unready for retirement. The rallying cry that 80 is the new 50 ignores the harsh reality that 50% of retirements are forced by personal circumstances to retire,^{ref 282} and folks who do seek post-retirement employment—that’s not retirement—take a 25% pay cut.^{ref 283} Most people have not been adequately trained to be their own human resource specialists.

Figure 32. Median retirement account and median boomer accounts.

On the bright side, the millennials are getting the memo early enough to act. The challenge is that the message seems to be either “Don’t worry; be happy” or “Don’t bother.” Surveys show that even those with retirement accounts seem to have saved little. Those same millennials, not known for letting reality encroach on their world, want to retire, on average, at 56 years old.^{ref 284} Time to cut back on the bottled water, pumpkin spice lattes, and, for that matter, any form of food. It’s time to stop being a bunch of dingleberries, put your phones down, and pay attention.

On that latter point, there is a new group called FIRE—“financial independence, retire early.”^{ref 285} Members of the group want to work hard, cut costs, and then retire in their 30s and 40s to travel the world:

“How to retire in your 30s with $1 million in the bank”

~New York Times headline

“Nothing was wrong with the job—it was a great company, good money, six figures. I was 26 and I said, ‘Why am I going to spend my 20s sitting at a desk?’”

~Mason, 29-year-old retiree

There are over 400,000 subscribers to FIRE on Reddit,^{ref 286,287} sharing tips like “how to survive a Minnesota winter without shoes, gloves, or coats.” Suze Orman blew out both ovaries noting, “I hate it. I hate it. I hate it. I hate it.”^{ref 288} This group will be positioned perfectly for the Great Attitude Adjustment (GAA).

Well at least we have the corporate pensions to fall back on, but they are underfunded as well (Figure 33). Corporations could always top off their pensions if they diverted funds from share buybacks and other forms of financial engineering. Ironically, that would cut into the multi-sigma profit margins, crush share prices, and, ironically, shrink everybody’s pensions plans. That’s swell. Pension coffers should be bloated with FAANG-based returns as we near the end of this investment cycle. They obviously are not.

Figure 33. Corporate pension shortfalls.

The aforementioned PBGC bailout plan does not cover the state-funded (or should we say state-unfunded) plans. There are discussions of using Puerto Rico as a beta test to introduce Chapter 9 legislation to allow for state bankruptcies, which are currently not allowed under the federal bankruptcy code.^{ref 289} Bankruptcy laws are designed for precisely when available assets are insufficient to cover liabilities. Private defined-contribution pensioners—the IRA/401K crowd—are gonna be investing doggie style and playing a lot of Dialing for Dollars.

Debt

“It is incumbent on every generation to pay its own debts as it goes. A principle which if acted on, would save one-half the wars of the world.”

~Thomas Jefferson

You have a debt problem when you have more debt than the capacity to pay it off. It arises from consumptive debt that is non-self-extinguishing. As far back as David Ricardo in the nineteenth century, we have known that debt-financed spending is not constructive to GDP. The debt problem goes global when the collective promises of sovereign states to their masses cannot be satisfied by future output. Not everybody can live the metaphorical American Dream no matter what global leaders have promised. There is a paradox in that you can save at the local level—personal, municipal, state, and even national—by having others outside your defined group owe you future goods and services (albeit accounted for using units of currency). You cannot, however, save globally. Because sovereign-level debt problems are PAYGO (pay-as-you-go) plans by definition, we’ve been trapped by compensation mechanisms that have increasingly relied on unfulfillable promises in the future rather than payment in the present. Now we find ourselves in a putative global asset boom—one that I find to be a sandcastle built by central bank largesse—while concurrently having debt problems. In the U.S., for example, average household net worth is soaring while the median family needs credit for basic needs and has squat for retirement savings.

“The great bond bull market began waaay back in 1982—36 years. And as governments were able to keep financing at lower and lower rates, they kept promising more and more.”

~Capitalist Exploits on the social justice movement

In the following sections I treat debt and savings as two sides of the same coin while somewhat arbitrarily separating corporate, personal, and sovereign debt problems from a looming global pension crisis and, for that matter, problems in the real estate market. I suspect that the Fed’s pathological aversion to letting the economy sink or swim on its own may stem from its PTSD-levels of fear of the next recession, which—I hasten to add—is as inevitable as death and taxes. The Wall Street Journal worries that we will burn a decade recovering from the next recession. I worry that they are optimists.

All this debt has accumulated with a tailwind of relentlessly falling interest rates from a 36-year secular bull market in bonds. The blowoff phase of the bond bull is a decade of rates wrestled to 5,000-year lows by central bankers. Now we are in a rising-rate environment. The gyrations across global markets are just the trailer. If the secular bear market in bonds goes wheels up—if rates begin a multi-decade upward march because of our modern-era guns-and-butter policy—many of us may not be around to see resolution.

Corporate Debt

“This time around, the big bubble is the extreme leverage on the corporate balance sheet, where the chart of debt-to-GDP looks a lot like the mortgage debt-to-GDP in 2007.”

~David “Rosie” Rosenberg

“Corporate debt has soared, but most of it has been used for financial engineering. . . . Who knows how many corporate zombies are out there because free money is keeping them alive?. . . Competition is a better tool than price control for protecting consumers. That applies to Amazon and the bond market.”

~Stan Druckenmiller

“It is clear that this is a very different corporate bond market, and history-based financial models will most likely be found wanting.”

~Louis Gave, cofounder of GaveKal

The corporate debt market is a complicated story because huge amounts of debt to financially engineer pump ’n’ dump schemes with share buybacks were waiting to be extinguished by repatriated savings (tax amnesty) from overseas. Assessing corporate leverage—debt net offsetting cash and other assets—is more important than usual. That said, from my perspective up in the nosebleed section, loose monetary policy managed to create a mountain of corporate debt, which is unsurprising to everybody but central bankers. Whocouldanode? The 54 AAA-rated companies in the S&P before the crisis have been reduced to only two because of leverage.^{ref 290} Many—myself included—believe that the corporate bond market will be Ground Zero of the next crisis. In case I haven’t said it enough times, we are in a rising rate environment: The fuse has been lit. Net leverage normalized to EBITDA (earnings before interest, taxes, depreciation, and amortization) has doubled in only a few years. Tighter banking regulations acted like Prohibition, opening the door to hooligans, hedge funds, and other non-bank grifters with their own leverage. There is a so-called shadow banking system^{ref 291} that is so enormous, complex, and hidden from the light of day for us Philistines. Here’s a trick question: Who do they borrow from? These corporate-focused lenders will scamper away in a heartbeat in a downturn. The retail investor will see bids for corporate paper (debt) buried in their portfolios disappear, and it could happen in a matter of days, hours, or minutes.

Mario Draghi’s European corporate-bond-buying binge sent some corporate bonds into negative interest rates—companies were being paid to borrow—and the Bank of Japan has now joined in.^{ref 292} The global bond binge caused the premium spreads—the extra interest paid for buying total garbage like commercial-mortgage-backed securities versus AAA bonds—to reach lows not seen since early 2007.^{ref 293} Those spreads are now widening. Companies are citing higher interest expenses chewing into earnings, which will amplify the credit spreads. Over $2.5 trillion—50% of the investment-grade corporate debt market—is rated just one notch above junk.^{ref 294} Exchange-traded notes (ETNs) based on corporate debt are unsecured, subordinated debt that trades daily. A day will come when they don’t trade. The volume of covenant-lite corporate bonds—bonds with lower levels of constraints than the stuff we call garbage^{ref 295}—has soared and poses a huge risk because of (not despite) the fuzzy name. U.S. firms sold $9.2 trillion in bonds since 2013, a non-trivial $3.5 trillion being used for share buybacks ($850 billion in 2018).

Is this really a systemic problem? I think so. As I am writing, GE and Deutsche Bank are gasping their last breaths—debt rattles—while doing laps around the drain. GE has $170 billion in debt owing to years of financial engineering.^{ref 296} Its productive assets will live on in the hands of new owners, but current holders of its debt and equities will be dealt with severely. Deutsche Bank is so huge that it seems likely to be nationalized. Rumors of a merger with Commerzbank just surfaced in what seems like one of those ’08-esque shotgun weddings.^{ref 297} Companies like GM and IBM are not far behind. These are Mothra-sized butterflies flapping their wings.

“The debt load for U.S. corporations has reached a record $6.3 trillion, according to S&P Global. The good news is U.S. companies also have a record $2.1 trillion in cash to service that debt.”

~CNBC headline

What CNBC seems to have missed is that borrowing money (the $2.1 trillion part) to pay the interest on the $6.3 trillion is a Ponzi scheme,^{ref 292} and I’m not speaking metaphorically or hyperbolically. Individual companies that don’t have the cash flow to make interest payments are called zombies, implying that they are dead but somehow still stumbling around the planet posing existential risks to the living. Of course, they are rare, right? Well, 20% of the Russell 2000 index and 14% of the S&P 500 are zombies.^{ref 299} Passive index investors own the shares of these gems and, if not, are financially linked to clowns called “counterparties” who own them. The problem is, as noted by the Bank for International Settlements (BIS), zombies do not come back to life.^{ref 300} Unlike real zombies in which all you need to do is tie the recently departed’s shoelaces together, these Walking Dead require the free market metes out shots to their heads.

The beginning of what looks like a serious bond bear is hammering risk-parity funds—bond funds that used leverage to seek the risk of equities.^{ref 301} Congrats, guys: You found it! And then there is the “leveraged loan market,” in which companies too weak to access the junk bond market go and borrow from a guy named Vinnie. These are the payday lenders for corporations. Retail investors with this crap in their retirement accounts will be toe-tagged and bagged.

“The selloff in GE is not an isolated event. More investment-grade credits to follow. The slide and collapse in investment grade debt has begun.”

~Scott Minerd, CIO at Guggenheim Partners

Let’s finish by taking a special look at GE’s debt. In 2002, I predicted that GE was headed for trouble in an email to a friend at Goldman.^{ref 302} Years of financial engineering finally worked their magic.^{ref 303} GE survived ’08–’09 with a lot of help from the authorities but appears to be on life support now. It is getting crushed by debt estimated at $40–$170 billion depending on who is doing the bean counting. The confusion is probably caused by off-balance-sheet debt . . . just like Enron. A bunch of GE debt is still investment grade, but it is “trading like junk,” which means we’re waiting for the rating agencies to read them last rites. To avoid bankruptcy, GE eliminated its quarterly dividend, causing double-notch bond rating downgrades.^{ref 304} The debt burden owing to a Hail Mary strategy of borrowing heavily for M&A (mergers and acquisitions) is probably now too high. GE is said to be “locked out of the commercial paper market,”^{ref 305} which means it’s time to call Vinnie. A default is said to be “unthinkable,” posing systemic risks as well as sentimental risks owing to a fall of an American Icon. On that note, Sebastian Mallaby gave us a “Crisis for Dummies” description of how cascading failures happen.^{ref 306}

Personal Debt

“How do you make poor people feel wealthy when wages are stagnant? You give them cheap loans.”

~Vincent Daniel in The Big Short

According to a Federal Reserve study, Americans have $1 trillion of credit-card debt, $1.5 trillion of student debt (Figure 34), $1.5 trillion of auto loans, and $13.5 trillion in mortgage debt.^{ref 307} So many zeroes: What the hell does that even mean? We can manage the mind warp by bringing it down to the family level. The average household has $140,000 in total debt.^{ref 308} This number does not included unfunded liabilities at the municipal, state, and federal levels. The student debt is disturbing in that 40% of it is held by senior citizens and who are defaulting with troubling frequency (37%),^{ref 309} and the boomers now owe more than the millennials: “Thanks, Mom and Dad. I’ll swing by on my way to Fort Lauderdale this spring.” There are 101 individuals with over $1 million of student debt, and one dentist owes >$2 million.^{ref 310} The $100,000 student debt club has 2.5 million members. Owed mortgage debt is almost 5× the yearly salaries of the owners.^{ref 311} Credit card debt has climbed back to its 2008 peak,^{ref 312} but the average interest rose 3% to a lofty average 15.5%. Consumers are paying $100 billion a year in interest payments with their disposable income. One could argue that if you have credit card debt, you have no disposable income.

Figure 34. Student debt or monetary policy?

Consumer debt is growing at 2× the rate of salaries (Figure 35) while 100 million Americans have no job to make such a comparison. The auto debt market continues to show stress fractures. Approximately 30% of trade-ins are in functional default (worth less than the loan balance.)^{ref 313} Trading in a beater for an improved newer model is a bad decision. An estimated $280 billion of subprime auto loans are defaulting, stressing the smaller subprime lenders.^{ref 314} A heavily cited stat this year was that 40% of Americans do not have enough money to cover an unexpected $400 expense without borrowing the money or selling something they own, and 60% can’t cover a $1,000 tab.^{ref 315} This is not a moral judgment, just the facts.

Figure 35. Household debt normalized to disposable income.

It’s hard to know whether the consumers are feeling the stress. The millennials are certainly in a rush to retire with <$20K saved (see “Pensions”).^{ref 316} Another survey showed that 41% of them spent more money on coffee than on investing in retirement last year.^{ref 317} No problem: There is a Congressional bill that would allow students to pay student loans with future Social Security money.^{ref 318} You get just deserts only after you eat your seed corn. Whoever hatched that plan should take some of that bank lobby money they obviously accepted and get professional help.

For every debtor there is a creditor. A global debt problem is less about some crazy form of owing too much but rather counterparty risk—the risk that debtors can’t pay. Good news: Somebody owes you $500,000. Bad news: It’s your teenage son.

“Twenty years ago there was $40 trillion of debt in the world; today there is $250 trillion worth of debt in the world.”

~David Stockman, former Reagan economic advisor and Blackstone Group

“$20 trillion got to $21 trillion in 186 days: That is blistering. . . . Donald is pro-Warfare State, pro-welfare state and has just slashed Uncle Sam’s tax take to 16.6% of GDP—the lowest rate since 1950.”

~David Stockman

Sovereign Debt

“The only question is whether we are able to look reality in the eye and face what is coming in an orderly fashion, or whether it will be disorderly. Debt jubilees have been going on for 5,000 years, as far back as the Sumerians.”

~William White

The markets most important to the functioning of capitalism—the credit markets in which lenders and borrowers haggle to determine the cost of money—are damaged. Central banks have subverted price discovery, sending bizarre signals to market participants. I asked the Twittersphere what interest rate they would demand to buy a 30-year Treasury that they were required to hold for 30 years—no selling, trading, or hedging. The answer was telling:

Figure 36. Twitter poll about the term premium^{ref 319} that investors would require for 30-year treasuries.

It would appear that 30-year bonds are priced wrong because somebody will be holding these assets for 30 years. My personal answer is comfortably above 7%. The interest payments on U.S. debt rose by 14% over the last year owing to increased principal payments on inflation-protected securities (“just the TIPS”),^{ref 320} continued generalized debt growth motoring along at 6–7%,^{ref 321} and overall higher rates. We will add well over $1 trillion of debt before the year is over.^{ref 322} Stanley Druckenmiller submits that the next recession will usher in a $2 trillion deficit. Many say we should have issued century bonds—100-year treasuries—when interest rates were low. I disagree profoundly: Forcibly jamming rates low, eliciting fixed-income investors to do unnatural things with barnyard animals just to get income, and then stiffing your counterparties with such abominations would be bad karma. In any event, that ship may have sailed because sovereign holders of treasuries such as Japan, Russia, and China are now sellers.^{ref 323} We are on a path to our Minsky Moment at which debt overruns our capacity to make payments. We will just inflate it away, right? Maybe not. You create inflation by creating money, and you create money by creating debt. It makes me scratch my head.

“People who confidently think they know the consequences—none of whom predicted this—know what’s going to happen next? Again, witch doctors. How many in this room would have predicted negative interest rates in Europe?”

~Charlie Munger, Berkshire Hathaway

Global debt rose from 276% of global GDP in 2007, wallowed through the Great Recession, came out the other side topping 327% of global GDP, and continues to expand at >10% per annum.^{ref 324} Simon Black notes that while the economy grew 36%, the debt grew 123%.^{ref 325} The IMF blames the growth on a prolonged period of low interest rates—those foisted on us by central banks—for nearly a decade.^{ref 326} By early 2018, sovereign debt returning negative nominal interest rates—absurdities that should never exist in a functioning bond market—topped $10 trillion.

Figure 37. Negative interest rates on sovereign debt.

“If 2.60% is broken on the upside—if yields move higher than 2.60%—a secular bear bond market has begun.”

~Bill Gross, the former Bond King (2017) on the 10-year yield

“If we take out 3 percent . . . it’s bye-bye bond bull market. Rest in peace.”

~Jeff Gundlach, the new Bond King (2017) on the 10-year yield

Figure 38. Ten-year treasury yields.

Bank of America’s Michael Hartnett says, “the lowest interest rates in 5,000 years have guaranteed a melt-up trade in risk assets,” which explains the 600% wilding of the FAANGs off the ’09 lows. The rising-rate environment means that resolution and redemption—dead bodies—may start floating to the surface. JPM reported that the global bond yield curve inverted in June (Figure 39), which will trigger, sequentially, the following: (a) “yield curve deniers” will declare such inversions irrelevant, and (b) a potentially bone-crushing recession will arrive. There is also a big debt rollover coming in 2019–2028 (Figure 40). I’ve added the iconic plot of mortgage resets foreshadowing the ’08–’09 crisis just in case anybody else sees parallels.

Figure 39. Global bond yield curve turning negative.

Figure 40. Debt rollover, 2019–2028, versus mortgage resets, 2007–2012.

“Consider for a second that for the first time in 18 years (!), U.S. 10-year yields are trading at a premium (10 bps) to Australian comparables! The long bond at 3.21% is 6 bps above Italian 30-year yields. . . . America is an AAA credit, and Italy is BBB.”

~David “Rosie” Rosenberg

Europe seemed relatively quiet. Brexit looms, but I refuse to spend any more time reading about the carnage that will happen and patiently wait to see what does happen. The idiocy of central bankers is reflected by negative yields on Spanish sovereign debt, 10-year Swiss debt returning 0%, bonds maturing in 2055 returning 0.5%, emerging-market junk-bond yields that are now below U.S. junk-bond yields, and a Greek 10-year yield below that of the U.S. 10-year yield. Negative yields on Italian debt concurrent with the country’s budget imploding finally triggered a VIX-like response (Figure 41). Mario Andretti would be in awe of the acceleration on that price discovery. Meanwhile, the covenants underlying much of this sovereign debt are said to be weak.^{ref 327}

Figure 41. Italian bond massacre.

“China is rewriting the economic history books because they have embarked on a view that they can simply borrow twice the amount of output growth as the growth in GDP.”

~Jim Chanos, Kynikos (on Real Vision)

The out-of-body experiences are found in the emerging markets. Emerging-market debt tripled during the last 8 years.^{ref 328} China’s bond market is opaque but said by many to be a profound risk to global markets. According to S&P, China’s local governments have $5.8 trillion of off-balance-sheet debt, representing “an iceberg with Titanic credit risks.”^{ref 329} Jim Chanos, who is a galaxy-class short seller, says that the Chinese are building two to three times the number of apartments that demand can absorb. Outstanding loans are growing by >10% year over year.

“My thesis is that over the next decade we will endure increasingly damaging debt crises that culminate in a coordinated global default—“The Great Reset,” as I call it. There are limits in how much leverage the world can handle and I think we are already beyond them. And that is before we have a global recession. The only question now is how we will manage the collapse.”

~John Mauldin, founder of Mauldin Economics

Japan doesn’t even have a bond market; it was nationalized by the Bank of Japan to the point that there are days in which not a single bond trades.^{ref 330} A market with a single buyer is called a “monopsony” (brought to you by Snapple.) Japan already spends a quarter of its tax revenue just to service its debt even though rates are ridiculously low.^{ref 331} If interest rates in Japan rose to 1% (not exactly usury), the nation’s annual debt service would literally exceed all government tax revenue. When what few private bondholders left sell causing rates to flicker higher, the BOJ intervenes (three times in a single week), buying up all the bonds.

Argentina defaults on its debt every 15 years on average.^{ref 332} In 2017 the country issued 100-year bonds—century bonds or what I call “Beanie Bonds”—that were oversubscribed by some of the biggest names in U.S. finance: Fidelity, BlackRock, Lazard Asset Management, and who knows how many multinational banks (Figure 42).^{ref 333} Gillian Tett of the Financial Times noted that these bonds “may end up being the government bond market equivalent of the Pets.com IPO during the 2001 tech boom—the sign of a bubble peak.”^{ref 334}

Figure 42. Purchasers of Argentine century bonds.

It took less than 1 year for Argentina to functionally default.^{ref 335} Of course, its GoFundMe campaign secured $50 billion from the IMF to prevent global market turmoil by paying off its creditors.^{ref 336} Jim Rickards thinks the whole affair was a “backdoor way for China to lighten up on dollars. Yeah, it’s complicated.” That is outside my wheelhouse. What I do know is that it is never the country being bailed but rather the seemingly moronic creditors . . . which is not moronic if the creditors know bailouts are preordained. The IMF launders money from a number of countries to pay for such bailouts, but the primary sponsor is the United States—the U.S. taxpayer. Meanwhile, a 25% inflation rate and interest rates soaring to 40% are frying Argentina’s empanadas whether the country defaults or not.

“China reminded us that the tale of synchronized growth was false and that what we have been seeing in recent years has been synchronized growth of debt.”

~Daniel Lacalle, eighth-ranked “economic influencer” in the world!^{ref 337}

I suspect that when the cost of money resets—when price discovery rears its fugly head—many of these assets will cease to exist. What’s left will likely have new owners.

Inflation and Deflation

“I just don’t see much inflation pressure.”

~James Bullard, president of the St. Louis Federal Reserve

“If I had to bet my life on higher or lower inflation, I’d bet a lot higher.”

~Warren Buffett

“We know how to deal with inflation. We don’t know how to deal with deflation in this country.”

~Gary Cohn, former CIO of Goldman Sachs and former chief economic advisor to President Donald Trump

“My generation gave former tenured economics professors discretionary authority to fabricate money and to fix interest rates. We put the cart of asset prices before the horse of enterprise. We entertained the fantasy that high asset prices made for prosperity, rather than the other way around. We actually worked to foster inflation, which we called ‘price stability.’ . . . We seem to have miscalculated.”

~James Grant, talking to our future selves and grandchildren, 2014

The Fed claims that a small amount of inflation is good and then wavers as to how much is optimal. Never mind that luminaries like Paul Volcker have denounced such thinking as delusional. I asked financial Twitter for the best arguments supporting the Fed’s ideas and got a host of answers, all of which had chards of truth and none of which made complete sense. The debate drew in big fish and little fry.

Some claimed that inflation is needed to coerce people to invest as though profit motive isn’t enough. Others said consumers will retrench if they know products are going to get cheaper, contrary to data on tech gadgetry and common sense aside. William White, formerly of the BIS, previously noted that “the widely held assumption that consumers and corporate investors will extrapolate from past price declines and hold off on making purchases as a result of deflation has essentially no empirical support behind it.”^{ref 338} Other Tweeters pointed to the dreaded deflation that has been MIA for almost a century. Of course, the reason deflation is so dreaded is that for it to appear against the headwinds of our inherently inflationary banking system means that central bankers already did way too much—they screwed the pooch.

Governments embrace inflation because they like to squander money they don’t have to buy votes and, as Milton Friedman said, “Inflation is taxation without legislation.” They also like the covert tax of inflation, and love taxing nominal gains that are illusory.

“I hate the word deflation because it is only a symptom of the problem. It’s not the reason we have the problems we have today.”

~Richard Koo, chief economist at Nomura Research Institute, talking about Japan

Some chimed in that the psychological impacts of wage cuts are so devastating that they are better masked by positive nominal gains. Others believe paying somebody in debased money is better than laying them off; it is a sticky wage argument. The Wall Street Journal had made such an assertion:

“Higher inflation could have other benefits. It could help economies adjust after a downturn by lessening the need for outright wage cuts, because rising prices will erode wages anyway.”

~Wall Street Journal

The ultimate foolishness is that a Committee of Elders—the Fed—thinks it is better equipped than the Wisdom of Crowds—the free markets—at setting the price of capital. Its members appear to me to be just a bunch of fools making shit up based on hopelessly flawed Gaussian models claiming to be “data dependent.” It is odd that nobody in the mainstream seems to think that when deflationary pressures appear, maybe the markets are telling us that we need a dollop of deflation.

The article in the Wall Street Journal that enthusiastically endorsed inflation I found problematic and Tom McClellan found support for this monetary creationism inexcusable.^{ref 339} He attacked the Fed for trying to keep too many ligma balls in the air at one time:

The mystery of this most recent decade is that creating vast sums of new reserves in central banks—an estimated $20 trillion—did not generate high or even hyper-inflation (yet). I’m a goldbug; I thought inflation was coming. Ben Bernanke blamed the “savings glut” of our trading partners, which seems to be just looking for a scapegoat. Mervyn King (see “Books”), however, did a nice job of explaining that if our trading partners let trade imbalances chase financial assets rather than goods and services, you get a lousy economy and inflation in the financial assets. That’s exactly what we got. Of course, those who speculate in those financial assets love that kind of inflation until it unwinds (oftentimes violently).

“I’ve never bought into that.”

~William White, on the “savings glut” thesis

Just as deflation is demonized by the Fed, inflation is demonized by the blogosphere. Somebody called it the “the date rape drug of taxes.” Bloggers squealing about the dollar losing 97% of its purchasing since 1913, however, often forget that there are compensating mechanisms along the way in the form of nominal pay raises and nominal asset appreciations. David Andolfatto, vice president of the St. Louis Federal Reserve and who seems to function as an outreach coordinator for the Fed, addresses this in a thoughtful blog, noting that you are 97% poorer only if you took your 1913 dollars and stuffed them in a mattress.^{ref 340} Ironically, if they were in uncirculated condition, you would enjoy nominal gains of up to 200-fold in the numismatic marketplace. Andolfatto also makes the curious argument that high interest rates are anti-inflationary by stepping on the economy (check) but pro-inflationary by jamming gobs of interest into the system. Wait. What? That idea is new to me and creates a bit of a monetary paradox, but I keep thinking about it.

Michael Hartnett of Bank of America, noting 700 rate cuts and $14 trillion asset purchases by central banks since the Great Recession, sees parallels of 2018 and 1966.^{ref 341} Millennial chart monkeys will likely not appreciate that the years after 1966 witnessed virulent inflation, horrific real (inflation-adjusted) returns on financial assets, and an economic malaise that lasted until the early 1980s. The shift in preference from equities to hard assets and high-interest-rate bonds—notice I didn’t say “flow” into or out of anything, which is risible nonsense—caused severe turbulence. It was a terrible time to invest for most.

Official reports of inflation are starting to creep up, although by no means outside the Fed’s highly fluid comfort range. Anecdotal reports, however, are painting a more serious picture. The CEO of Sherwin-Williams said that “raw material inflation has been unrelenting and accelerating.”^{ref 342} Eric Cinnamond listens to hundreds of microcap investor conference calls each quarter and says that CEOs are all complaining of cost pressures.^{ref 343} Companies like Caterpillar report that price increases are not keeping up with rising production costs.^{ref 344} The CEO of Lincoln Electric claims that “We’re in a very rapidly increasing inflationary environment.”^{ref 345}

“J.B. Hunt says 10% raises are the antidote to the truck-driver shortage”

~Bloomberg headline

The tariffs discussed in the “Economy” section are causing companies to arbitrarily implement 15–25% price hikes anticipating raw material or finished goods costs emanating from China.^{ref 346} (I can’t help but wonder, admittedly with a low probability weighting, if the tariffs aren’t part of a covert bilateral agreement.) The wage pressures seem real. Teachers across America have been walking out of school classrooms to attend rallies in protest for higher salaries and improved classroom resources.^{ref 347} Jobs are going unfilled. Wage inflation scares macro bean counters. BIS economists suggest that a global shrinkage of the working-age population is causing inflation to trend up (more money chasing, fewer workers).^{ref 348} Paul Tudor Jones sees Fed chair Powell as George Custer, sandwiched between a mountain of debt on one side and inflationary pressures on the other.^{ref 349} He thinks Powell needs to hike rates pronto to curb margin debt in the markets and facilitate a more efficient allocation of capital.

“Volatility collapsed after the crisis because of central bank manipulation. That game’s over. With inflation pressures now building, we will look back on this low-volatility period as a five standard-deviation event that won’t be repeated.”

~Paul Tudor Jones

By now most have read about the distortions of substitution and hedonic adjustment foisted on us by the Boskin Commission^{ref 350} and unfoisted by John Williams.^{ref 351} I’ve already taken a bat to the MIT Billion Prices Project—I think there is an Achilles’ heel in it—and won’t return to it.^{ref 352} We also know that products that don’t last should be priced per unit function: They are not. Figure 43, showing the cost of various goods and services, blanketed the internet this year. Do you really think you can buy a TV for 4% of what you paid in 1990? Sure it’s a better TV (or at least a cooler TV), but you are not walking out of Best buy with an $8 TV even on Black Friday. Have prices of cars really not moved in 20 years? A Ford F150 cost $17,000 in 2007 and $40,000 in 2017. Yes, it now has a backup camera and anti-lock brakes, but it costs more than twice as much to move firewood, display our gun collections, and wield MAGA bumper stickers. Try Googling rents or single-family home prices: Are they really up only 61% since 1995? I am calling bullshit on this chart. It was undoubtedly created by hedonic-adjusting tools (economists).

“Americans are getting stronger. Twenty years ago it took two people to carry $10 worth of groceries; today a five-year-old could do it.”

~Henny Youngman, comedian

Figure 43. Hedonically adjusted prices.

I take a swipe at hidden inflation every year. The durable goods we buy have a programmed and accelerated senescence that borders on progeria. Your kids’ toys are cheaper, but do they last more than a few minutes? A toaster that cannot be repaired when it breaks is expensive, especially when it breaks fast. The quality reduction can be profound too. Processed food uses animal and vegetable parts that were previously fed to pigs. Food scientists have rendered them palatable through very clever tricks like adding buttloads of salt and sugar (or high-fructose corn syrup). The meat in Dinty Moore stew is disgusting. Cracker Jacks no longer are made from popcorn. Your appliances are shiny with lots of buttons that you never use, and they don’t last. Shrinkflation has been around for eons. Coke cut its 1.75-liter bottle to a 1.5-liter bottle and then raised the price. At some point, the company will offer a really large bottle (1.75 liters) for an even higher price. I still haven’t figured out how to account for laptops, iPads, iPhones, and internet service. For what you get, they are amazingly cheap. As a part of a family’s budget, however, they pose existential financial risk. How do you account for amazing technology that you must own—even the Mennonites own them—but that you cannot buy without a HELOC? Check out Figure 44. Try a little mental math on how much a paycheck could buy you in 1938.

  

Figure 44. Cost versus quality.

And here is a curious little anecdote:

1932 gold ounce = $20.67

1932 Yale University tuition, room, and board = $1,056 (51 ounces of gold)

2018 gold ounce = $1,225

2018 Yale University tuition, room, and board = $65,000 (53 ounces of gold)

Banks

“With mortgage applications declining, executives have a choice to make: Should underwriting standards be lowered? When volume becomes the defining metric for how loan officers and mortgage companies get paid, then loan quality deteriorates.”

~Chris Whalen, Whalen Global Advisors

“Your problem is that you are trying to understand it as an economic story. Once you think of it as a crime story, you’ll get it.”

~Insider to Matt Taibbi when writing about the subprime crisis

We’re told that the post-crisis banking rules were tightened to make the banks safe again, and now we are about to unwind these protections with the poorly named “Economic Growth, Regulatory Relief, and Consumer Protection Act” that would return the banks to their birthright as gigantic hedge funds.^{ref 353} A 1982 declassified memorandum included Jack Anderson, a journalist, discussing the upcoming collapse of the banking system and the CIA’s risk assessment.^{ref 354} There were crises of course; the late 80s savings and loan crisis may have been what was spooking the spooks. Do the bankers never learn? Are they doomed to loop around this infinite Mobius strip? In a sense, yes. This year’s winner of the Nobel Prize in economics, Paul Romer, and some famous guy named Akerlof, wrote a 1994 paper titled, “Looting: The Economic Underworld of Bankruptcy for Profit.”^{ref 355} They describe how the inefficiency of the boom–bust cycle is exploited by the banks during both phases. During the boom, the bankers make huge fees and pay themselves handsomely because, well, they are wonderful stewards of capitalism. During the bust, profits stem from looting the system, cloaked by the chaos and pandemonium of bailouts. The bankers then pay themselves handsomely because they are wonderful stewards of crony capitalism too.

Recall in ’09 when huge bonuses were defended to keep talent around long enough to save the world from the Apocalypse caused by all this talent. Banking is like Danegeld—payments to the Vikings to stop them from looting and spreading their DNA around the Isle of Britannia. Soon the Danes wanted more money and hot chicks. I suspect we have finished the boom half of the cycle again and are now looking for the raping and pillaging phase to commence. What will trigger the next crisis? Bank analyst Chris Whalen already sees lenders bracing for problems and reducing staff in their consumer and mortgage lending businesses.^{ref 356} Eyes are on the European banking sector getting its market caps deracinated. One of the popular risk measures—the Libor–OIS margin^{ref 457}—is vibrating like the puddle in Jurassic Park.

“The Senate just voted to increase the chances your money will be used to bail out big banks again.”

~Elizabeth Warren (@SenWarren), insert politically incorrect Indian joke here

Despite regulatory constraints, the banks have managed to insert leverage into every orifice imaginable while moving the risks away from themselves or so they say. Bank loans to non-bank financial firms have increased sixfold since 2010.^{ref 358} Big banks are not making lots of subprime auto loans but rather lending to subprime loan bundlers who have jammed a record $345 billion of subprime loans.^{ref 359} In a crisis, the autoloans default first, and then the bundlers hit a bridge abutment. Hmmm . . . who is on the hook now? Increasingly popular and dubious loans to unsuspecting, near destitute, and likely to be transitory homeowners are called “non-qualified mortgages.”^{ref 360} Truth in advertising. That particular form of high-risk lending doubled in a year and is said to be on track to double again next year.^{ref 361} The direct risks posed by notional derivatives, which have grown 50% to $1 quadrillion since ’07, are watched nervously.

“Getting a lot of calls about DB today. Where to begin? A hedge fund in drag that pretends to be a bank. . . . Earth [to] Merkel.”

~Chris Whalen

Bearing down on a few specifics, the systemically important financial institutions (SIFIs) are all wobbling in synch—precessing—while their credit default swaps (CDSs) have arisen from their slumber.^{ref 362} Deutsche Bank (DB), for example, is five times the size of the former Lehman when it brought the system to its knees. DB also has the largest derivatives book on the planet. Of special interest, it is trading like Lehman, having lost 94% off its ’07 high (Figure 45). An 80% drop in earnings in 1 year suggests that the bank is insolvent and headed for nationalization. DB fired 10,000 employees (10% of its workers), a drop in the bucket.^{ref 363} I think it’s time it changed its name to Deutsche Blockchain.

Figure 45. Deutsche Bank.

“The best thing that could happen to society is the bankruptcy of Goldman Sachs.”

~Nassim Taleb, author of bestsellers (see “Books”) and former Goldman trader

Banking is supposed to be boring, but there were a few humorous moments this year. Goldman got caught stealing billions from the 1 Malaysian Development Bank (1MDB),^{ref 364} but who cares about the impoverished Malaysians? That’s a rhetorical question: Other sovereign wealth fund managers seemed to care.^{ref 365} As Jimmy Carter said, “I guess you just can’t trust Goldman.” Danske Bank laundered over $200 billion according to whistleblowers.^{ref 366} That ought to generate a few fines and send a lot of business back to HSBC. Wells Fargo had a “glitch” that led to double dipping on some payments and even some accounts being emptied.^{ref 367} It got fined $2 billion for stealing from millions of customers. Since fines for committing felony on a gargantuan scale are considered a business expense, the bank will get a nice tax break.^{ref 368} It was downgraded by its bank brethren for having inadequate safeguards to prevent getting caught.^{ref 369} Once Wells emptied its coffers to pump shares with stock buybacks,^{ref 370} it had insufficient funds to keep 26,000 people on payroll.^{ref 371} On the bright side, the CEO got a 36% raise this year to ensure that he sticks around to clean up his mess.

Of course, Wells Fargo’s largest shareholder, Berkshire Hathaway, played activist and jumped in to bring some honor back to this once great institution. Yeah, right. Neither side of Warren Buffett’s mouth was available for comment, but the irrepressible Charlie Munger chimed in:

“Wells Fargo will end up better off for having made those mistakes. I think it’s time for regulators to let up on Wells Fargo. They’ve learned.”

~Charlie Munger

Yes, Charlie, we’ve all learned: Crime pays, and your bluntness is surpassed only by your ruthlessness. The miracle of modern medicine is that you can sleep at night. That Wells hasn’t been auctioned off for parts and its high command marched off to a gulag illustrates the efficacy of the Obama-era “No Banker Left Behind” (NBLB) program. Being owned by Berkshire is also a “protected class.” The most satisfaction customers will get comes in the form of checks to compensate them for their losses. I’ve gotten two such checks for settlements of class action suits. They both were <0.1% of my assets under management. You know what this means? I got screwed three times: (a) the brokerages slipped roofies to me Cosby-style and repeatedly jammed illegal hidden fees up my . . ., (b) the lawyers took half the settlement, and (c) the justice system settled for squat and didn’t hang any of the bankers with their genitalia stuffed in their mouths. Do I sound bitter?

Several academic papers concluded that Wall Street firms trade on inside information and that “changing the law to fix that may not even be feasible.”^{ref 372} (Academics actually get paid to come up with such epiphanies.) Bank of America (BofA) did not have a single day trading loss in the first quarter.^{ref 373} Seems like an improbable run in a straight game. BofA also got caught robbing safe deposit boxes again.^{ref 374} Recall that the state of California was emptying safe deposit boxes and selling the contents without even inventorying them first.^{ref 375} BofA has also been freezing the accounts of people suspected of being illegal aliens, no doubt out of a deeply moral conviction and support for Trump’s immigration policies.^{ref 376} One of Morgan Stanley’s highly compensated bankers has been driving for Uber in his free time.^{ref 377} Any bets on who gets the >$100 billion Uber IPO? Finally, Jeffrey Skilling of Enron fame got out of prison.^{ref 378} The bankers who helped set up all the off-balance sheet scams have not been released because, well, they never got arrested.

The party isn’t rockin’ until somebody calls the cops or puts an eye out. Until then, the social IQ of the partygoers just keeps dropping. Although nothing is happening yet—the KRE banking index is comfortably 200+% off the ’09 lows and only –20% off its 2018 highs.^{ref 379} There are, however, stresses building within the banking system. SocGen analysts list four triggers: trade wars, significant market repricing, European policy uncertainty, and a hard Chinese downturn.^{ref 380} The FDIC monitors “assets of problem banks” and reported a 200% increase during the third quarter of 2018.^{ref 381} The four largest U.S. retail banks are witnessing consumer stress in the form of credit card losses.^{ref 382} Scott Minerd suggests that small hikes in lending rates will blow out the zombies (see “Corporate Debt”), causing a wave of defaults that are long overdue.^{ref 383} Minerd notes, “There are a lot of companies that are zombie companies that survived the last cycle. As these companies have their debt repriced by the market with rates going up, it’s going to be harder and harder (for them) to stay alive.” The credit system is surely at risk if corporate paper starts defaulting. Jesse Felder suggests that “a cottage industry has developed to explain what is behind the dramatic move in Libor.”^{ref 384} Something is stirring below the placid surface. (Cue the Jaws sound effects.) Europe in general and Italy in particular pose serious risks, as does China. Whalen Global Advisors claims that net interest income for all U.S. banks will be declining by early 2019 and that, “the superficial narrative parroted by Wall Street pundits that rising interest rates are good for banks and other leveraged investors will be shown to be complete nonsense.”^{ref 385} Cheap funding is over. “Banks in the U.S. are about to get caught in an interest rate squeeze of gigantic proportions,” causing shrinking profits and—wait for it—a recession! There will be 11 Wells Fargo employees who couldn’t care less because they won a half billion dollars in California’s Powerball.^{ref 386}

“From the economy’s vantage point, instead of asking how the banks are to be saved ‘next time’, the question should be, how should we best let them go under.”

~Michael Hudson, Levy Economics Institute

The Fed

“You will never see another financial crisis in your lifetime.”

~Janet Yellen, spring 2018

“I do worry that we could have another financial crisis.″

~Janet Yellen, fall 2018

“The lower-for-longer approach promises, in effect, to allow the economy to boom. The FOMC needs to make a credible statement endorsing such an approach, ideally before the next downturn.”

~Janet Yellen

“We have undertaken to stabilize economic forces, to mitigate the effects of the crash and to shorten its destructive period. I believe, I can say with assurance that our joint undertaking has succeeded to a remarkable degree.”

~Herbert Hoover, 1930

“The Fed can change the way things look, but it cannot change what they are.”

~James Grant

“The last duty of a central banker is to tell the public the truth.”

~Alan Blinder, former U.S. Federal Reserve vice chairman

“For more than three decades, macroeconomics has gone backwards.”

~Paul Romer, winner of the 2018 Nobel Prize in economics

The Fed has been oversteering and overmedicating the economy since 1913. The Fed promptly spawned a credit bubble in the 1920s that led to the biggest crisis in our history and was, in my opinion, the primary cause of the Great Depression.^{ref 387} The emergence of Greenspan sent us through a series of micro-crises ultimately leading to the big one in 2008–09. (Actually, I think the Big One is coming, but that is conjecture.) Everybody agrees that Greenspan kept rates too low for too long, laying the groundwork for the crisis. In response, Bernanke and eventually all central bankers began coloring way outside the lines. What did he do? As Stan Druckenmiller puts it, “They tripled down on what caused the crisis, and [they] tripled down globally.”

“Data dependent Fed: average real GDP growth during QE was 2.2%. During no QE and the 5 rate hikes it’s averaged 2.1%.”

~@GreekFire23, smart guy—possibly in prison or Goldman (but certainly not both)

Now the central banking cartel has created what appears to be an epic bubble of equities, bonds, and pretty much anything denominated in dollars. Bernanke opened the tap; Yellen kept it open and went for a smoke. All central banks served up buckets of punch, and the global economy became a sloppy drunk. Jerome Powell was left with the job of getting everybody to the vomitorium and cleaning up the vomit. Some think he’ll blink and let the party resume, but don’t forget that in 2001, the Fed hiked rates 50 basis points—a monetary bitch slapping—with the Nasdaq already 40% off its 2000 highs. Let’s hope that as Jay moose-knuckles the rates higher he has a steady, consistent hand on the rudder:

“I think we are actually at a point of encouraging risk-taking, and that should give us pause. Investors really do understand now that we will be there to prevent serious losses . . . we look like we are blowing a fixed-income duration bubble right across the credit spectrum that will result in big losses when rates come up down the road. You can almost say that that is our strategy. I think there is a pretty good chance that you could have quite a dynamic response in the market.”

~Jerome Powell, chairman of the FOMC

“There’s no reason to think this cycle can’t continue for quite some time, effectively indefinitely.”
~Jerome Powell

“The US is on an unsustainable fiscal path; there’s no hiding from it.”

~Jerome Powell

“When it is time for us to sell [Fed assets], or even to stop buying, the response could be quite strong.”

~Jerome Powell, before becoming FOMC chair

As @GreekFire23 said—I can’t believe I just typed that—the average GDP growth during QE was only 2.2%. During the subsequent period witnessing multiple rate hikes GDP has averaged 2.1%. One might ask “What is it good for?” The answer could be “Absolutely nothing! Say it again!” Economists at the St. Louis Fed published a report card on the efficacy of QE and, shockingly, concluded that it was largely a bust.^{ref 388} The Fed made stone soup hoping that the free market would start bringing things to add substantial ingredients. While QE pushed up asset prices as intended, the economy limped along feebly. The Fed was trying to shove credit into a saturated credit market. This is how it plays out in my head:

Borrowers: “We would like to borrow some money.”

Savers: “OK. Here is what it will cost.” (Some haggling ensues.)

Savers: “We have a deal?”

Fed: “That price is too high. We know because we have PhDs! We’ll pound it lower.”

Borrowers: “Deal!”

Savers: “Dufuq?”

So how does QE actually work? In theory, banks can sell treasuries to get cash equivalents to be used as reserves for lending—treasuries are technically not considered reserves. Alas, that is a zero sum game because now cash is depleted elsewhere. When the Fed replaces long-maturity assets with short-maturity reserves via QE, no cash drains and the banks now have larger reserves against which they can lend more money with a 10- to 12-fold multiplier. Richard Koo noted that the 19-fold increase in reserves risked a 19-fold inflation and got . . . crickets.^{ref 389} Indeed, there was some lending, but arguably not lending conducive to economic growth (share buybacks, for example), and banks stored these reserves at the Fed in interest-bearing accounts more like an annuity to kick off a steady cash flow. The Fed economists who wrote the QE report seemed to question the practical consequences of QE and even the theoretical underpinnings:

“It is not clear that QE should have any effect and it might actually be detrimental to the efficiency of the financial system. . . . QE works much as conventional accommodative policy does—it lowers bond yields and increases spending, inflation, and aggregate output. But we should be skeptical of this interpretation.”

Frequent and willing sparring partner and vice president of the St. Louis Fed, David Andolfatto, often tells me that this cash-for-treasury swap is no big deal:

“I do not think QE facilitates credit creation. QE simply relabels the public debt as ‘interest-bearing reserves’ instead of ‘interest-bearing treasuries’.”

~David Andolfatto, vice President of St. Louis Federal Reserve

By the end of the ensuing debate, I find myself asking something like, “Then why did they do it?” I guess we will find out if it is no big deal in reverse, too, as they dehydrate the markets (drain liquidity) via quantitative tightening (QT). But I am ahead of myself.

Charles Gave notes, “purchasing government bonds from domestic banks, so flooding them with reserves, the Fed can engineer an increase in the U.S. monetary base.” OK, but as Andolfatto would say, “so what?” Based on efforts in the U.S. and in Japan, where QE was big, or in Canada, where no QE is undertaken, the skeptics in St. Louis wondered whether there was any evidence that QE increases inflation or, more important, real GDP: “Evaluating the effects of monetary policy is difficult, even in the case of conventional interest rate policy. With unconventional monetary policy, the difficulty is magnified . . . perhaps the private sector can do a better job than the central bank in turning long-maturity debt into short-maturity debt.” We also got a report out of Deutsche Bank claiming that, with respect to “unconventional” monetary policies such as QE and negative interest rates, “the impact on the economy was negative.”^{ref 390} Prominent economist Daniel Lacalle concurs: Monetary stimulus does not work.^{ref 391}

“In my view it failed, 100 percent. It caused the stock market to go up because people took all that liquidity and invested it in the stock market, but it did not cause the economy to grow even 10 basis points faster.”

~Steve Eisman on the effect of QE

One can only imagine what’s coming next and how we get out of this monetary lobster trap. Maybe QT will be a bust just like QE—no big deal. Oddly, Richard Koo claims he could find no papers whatsoever describing how to exit QE and submits that it might be quite a bitch—a Hotel California moment. Some say the Libor rate that determines corporate borrowing rates is already tightening ahead of the Fed. This is way above my pay grade, but the folks at BMO Capital Management seem seriously concerned.^{ref 392} They say a slow, methodical and putatively painless natural unwind by paying 2.5% on reserves will add $50 billion to our already bloated deficit every year. Why? Because it will deplete the cash flow from the Fed to the U.S. Treasury, which uses the cash flow to pay bills. Many don’t realize that the “FAST Act”, which authorized the U.S. government to plunder excess capital from the Federal Reserve, established a mechanism for the Fed to monetize Federal debt.^{ref 393}

“Fed officials will be under enormous pressure to accommodate swelling federal deficits—even if it means pretending that the central bank is a source of revenue to the Treasury. The operative model of political economy here is Argentina in the 1970s.”

~Chris Whalen

“One of the characteristics of a struggling republic is the inability to separate its central bank’s resources from the fiscal largesse of the federal government. Using central bank resources to avoid addressing funding of the government is a sure path to runaway inflation, economic decline, and periodic financial crisis.”

~David Kotok, co-founder of Cumberland Advisors

“Stop talking about ‘The Fed’. Talk about central banks. . . . Their balance sheets are the highest they’ve ever been.”

~Jim Bianco, founder of Bianco Research

Jim’s point is that everything you see the Fed doing is being done across the globe. The Bernanke QE model was implemented on industrial scales without even beta testing it. QT will be carried out with equal care and preparation.

“The success of our institution is really the result of the way all of us carry out our responsibilities. We approach every issue through a rigorous evaluation of the facts, theory, empirical analysis, and relevant research.”

~Janet Yellen

“Congress has taken away some of the tools that were crucial to us during the 2008 panic. It’s time to bring them back.”

~Bernanke, Paulson, Geithner

“Rubbish, they had all the tools necessary. They just never recognized beforehand that the economy was a massive credit bubble—just like it is now.”

~Albert Edwards, Societe General (SocGen), in response to the Bernank

Let’s finish with some quotes that give me pause and may give a few bloggers some quote porn.

“Although we work through financial markets, our goal is to help Main Street, not Wall Street.”

~Janet Yellen

“If the Fed can cause a 500-basis-point change in interest rates, it is absurd to wonder if monetary policy is important.”

~Paul Romer

“The Federal Reserve may have to press harder on the brakes at some point over the next few years. If that happens, the risk of a hard landing will increase.”

~Bill Dudley, former president of the New York Federal Reserve and former economist at Goldman Sachs

“Central bankers are like stupid magicians: They are as surprised as the audience when they pull a rabbit out of their hat that they just put there.”

~Sean Corrigan (@TrueSinews), Cantillon Consulting

“History suggests that if the Fed waits too long to remove accommodation at this stage in the economic cycle, excesses and imbalances begin to build, and the Fed ultimately has to play catch-up.”

~Robert Kaplan, president of the Dallas Federal Reserve

“I see roughly equal odds that the U.S. economy’s performance will be somewhat stronger or somewhat less strong than we currently project.”

– Janet “Yogi” Yellen

“We’ve become so complacent about central bank policies that we’ve quietly tolerated a rise in financial asset prices to the point where even a little inflation would devastate portfolio returns.”

~Eric Peters, CIO of One River Asset Management

“We have been suppressing rates. If rates rise it’s a ticking time bomb.”

~Richard Fisher, former President of the Dallas Fed, speaking in 2015

“Everything we see about the near-term outlook is quite strong.”

~Ben Bernanke, July 2018

“The Fed has acknowledged no failures. All the experiments have been successful, every one: no failures, no negative side-effects, no perverse consequences, only diminishing returns.”

~Peter Fisher, former official at the New York Federal Reserve

“Try to publish an article critical of the Fed with an editor who works for the Fed.”

~J. K. Galbraith, Harvard University and author of The Great Crash, 1929

“Even when things happen in the economy that would otherwise have triggered inflationary episodes, they don’t today because financial markets trust the Fed to do the right thing to keep inflation under control.”

~James Bullard

The yield curve will soon be inverted
As many have clearly asserted
When everything tanks
The fault? …central banks
Their policies? …clearly perverted

~@TheLimerickKing