The Greatest Financial Train Wreck the World Has Ever Seen

Guest Post by Bill Bonner

BALTIMORE, MARYLAND – Last week, stocks finished at an all-time high. But guess what? In terms of real money – gold-linked, pre-1971 dollars – stocks have been losing ground since the start of the millennium.

We are looking at one of the most remarkable episodes in financial history. Investors think they are making money… when they’re actually getting poorer.

Donald J. Trump tells the international Deep Staters at Davos that the U.S. economy is “spectacular,” but most of its counties have never recovered from the crisis of ’08-’09.

What a jolly time to be alive… to be conscious… with a few dollars saved up and a sense of humor. And coming up… a financial Demolition Derby on a global scale…

Financial Train Wreck

Yes, we’ve seen plenty of little sh*thole countries go broke. They spend too much. They steal too much. And then, what do they do to cover the corruption and waste? They print money.

But we’ve never seen a country with the world’s reserve currency and a $20 trillion economy do it. So this will be fun to watch.

And on this TV you can’t touch that dial. You can’t turn it off.

Doesn’t matter how smart our Federal Reserve governors are. Doesn’t matter what stable genius is in the White House. Doesn’t matter what any of us think or do.

You don’t even need a “bad guy” or a monetary monster. Milton Friedman is practically a saint in some circles; but it was he who invented the new money in 1971… and he will be largely to blame for the destruction ahead.

Yes, Dear Reader, even good people do bad things… and even smart people make such jackass mistakes as to cause the gods to chuckle, and the dead to laugh out loud.

They’ve seen this before. They know how it turns out.

So let’s look more closely at why it is inevitable, even as they do everything “right”…

Do the Right Thing

The Fed clearly made the right choice when it chose to pump up the repo market with hundreds of billions in new money. Otherwise, the world economy, the stock market… the whole shebang would have gone to Hell.

It will surely do the right thing next week and the week after, too. The feds have $6 trillion of short term loans to “roll” in the next six months. That’s the cost of over-spending – wars, boondoggles, giveaways, waste – by the U.S. government.

Oh… and it’s not going away. No candidate – Democrat or Republican – is proposing to cut U.S. spending. And no president could survive in office if the Deep State connivers completely turned against him.

That’s why they will all do the “right” thing.

And who could blame Obama and then-Fed chief Bernanke for pushing the panic button in ’08? They did the right thing, adding $10 trillion in deficits and $3.6 trillion in Fed quantitative easing (QE).

Bernanke had the “courage to act” and saved the nation from a dreadful recession; he said so himself.

And didn’t Mr. Trump do the right thing when he cut taxes… and increased spending… too? Isn’t that why the Dow is at 29,000… unemployment is below 5%… and he can brag at Davos? He thinks so.

Mr. Obama had allowed for a modest decline in military spending as the wars in the Mideast wound down. Then, not only did the “conservative” Trump increase military spending, he boosted domestic entitlements, too.

Domestic, social spending rose 3.2% annually under Obama. Under Trump, it is going up at a 5.4% annual rate. Overall, spending is increasing more than twice as fast as it did during the Obama years.

And who doesn’t like it? Who doesn’t want more money? Widows? Veterans? Cronies? Lobbyists? The Swamp? Everybody is in favor. At least, at the beginning.

Hyperinflation Legend

Our old friend, Doug Casey, had the once-in-a-lifetime opportunity to meet a real central bank legend. It was Gideon Gono, who – as the governor of Zimbabwe’s central bank – had printed trillion-Zimbabwe dollar notes by the gazillion… and destroyed the country’s economy.

But Doug reported that Gono seemed like a nice, intelligent guy. He actually wrote a report to his boss, “Comrade Mugabe” (that’s what Zimbabwe’s head man liked to be called), in which he proposed a gold-backed dollar. And he only resorted to the printing press, he said, because he needed a way to pay the army.

Wasn’t that the right choice? Had he not paid the army, the soldiers might have gone on the rampage… or taken over the government.

And what about Rudolf von Havenstein? It was he who presided over one of the most notorious episodes in hyperinflation history, in Germany in the early 1920s.

Wasn’t he in almost the same situation as America’s current Fed chief, Jerome Powell? And didn’t he do the “right” thing, too? Liaquat Ahamed explains, in Lords of Finance:

Von Havenstein faced a real dilemma. Were he to refuse to print the money necessary to finance the deficit, he risked causing a sharp rise in interest rates as the government scrambled to borrow from every source. The mass unemployment that would ensue, he believed, would bring on a domestic economic & political crisis.

Was von Havenstein stupid? Evil? No more than the rest of us. Perhaps he made the right choice. But the results were disastrous.

Printing new money cheats people who have worked, saved, and trusted the old money. Stefan Zweig wrote that the money-printers had…

Cheated the mothers who had sacrificed their children, cheated the soldiers who came home as beggars, cheated those who had subscribed patriotically to war loans, cheated all who had placed any faith in any promise of the state, cheated those of us who had dreamed of a new and better ordered world and who perceived that the same old gamblers were turning the same old trick in which our existence, our happiness, our time, our fortunes were at stake.

One of those who felt cheated was a young, Austrian house painter named Adolf. He made plans to get even…

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SlickWilly
SlickWilly

Banking mantra ‘All humans are equal but some are more so’.

gatsby1219
gatsby1219

Trump lives rent free in Bill’s head.

John Galt
John Galt

Wow. That last sentence stands out like a mountain over a mole hill if you are brave enough to read real history and understand economic history as well….as you remember the victors always write history…..

Austrian Peter

So true, Bill, thank you. But it is unlikely to end in hyperinflation this time around because to have this happen you need another currency in circulation. Quote: “In economics, hyperinflation is very high and typically accelerating inflation. It quickly erodes the real value of the local currency, as the prices of all goods increase. This causes people to minimize their holdings in that currency as they usually switch to more stable foreign currencies, often the US Dollar.” https://www.investopedia.com/terms/h/hyperinflation.asp

And the USA has no alternative currency to use. My friend Gerry Brady at: http://boomfinanceandeconomics.com/#/ makes this clear in several posts of the past, and Wolf Richter has this to say: https://wolfstreet.com/2020/01/02/us-dollar-as-global-reserve-currency-chinese-renminbi/

As you say, we have never in history had a global reserve currency to be so mismanaged – it is anyone’s guess how this will end up. Maybe the US$ will collapse, or we get a credit crisis and interest rates take off causing mass defaults. I am favouring a deflationary depression as the most likely outcome when the world economy slows down and the BBBs go to junk with the institutions unloading as they must do?

Prof. Mandelbrot
Prof. Mandelbrot

“I think there are gonna be history books written about this period that rational people will read at some point, [and] they are gonna ask this question of economic historians with complete bewilderment in their voice:

‘Professor, did investors REALLY invest in bonds, of basically bankrupt countries, that printed money to make interest payments and [buy back] bonds they just issued in failing currencies? … Were investors really that stupid?'”

Prof. Mandelbrot
Prof. Mandelbrot

A saved article everyone here should understand…
Having previously exposed the greatest trick the market has pulled on Biotech investors in the past – What Is The PE Of The iShares Biotech ETF? It Depends On Whether You Read The Fine Print – it appears investors need another lesson in reality versus perception.

As Horizon Kinetics puts it so eloquently – It’s One Thing to Not Know, It’s Another to Be Told What Isn’t So

“So, in reality one knows that an unprofitable company makes an investment more expensive, while in the world of indexation, such as in the QQQ, unprofitable companies are eliminated, making the P/E lower.”
Unpacking a Mainstream Index, the NASDAQ 100
First, the Label
The essential value of an index is that it is a passive form of investing, the opposite of active management. The active manager’s results are dependent upon security selection; in contrast, indexation’s foundational intent is that the results will derive from broad exposure to a vast array of securities; that no individual security will dramatically impact the result – the entire idea is to avoid company?specific risk.

This might seem self?evident. But, of course, we write this for a reason. Those who subscribe to and practice indexation – which is increasingly becoming everyone – might wish to take an actual look at the NASDAQ 100. This is a mainstream index, intended to be the 100 largest firms of the NASDAQ Composite Index, which now contains over 3,000 firms. It is available via the popular PowerShares NASDAQ 100 ETF (ticker QQQ), which has almost $50 billion of assets, making it one of the country’s 10 largest.

Just the top five holdingsin the NASDAQ 100, which are Apple, Google, Microsoft, Amazon and Facebook, total 41% of the value of the entire index. If an active manager presented that level of exposure, it would be daring, to say the least. In some jurisdictions, it would violate regulations.

For example, in the European Community, what are known as UCITS1 funds cannot have more than 40% exposure from position sizes of 5% or greater. To do so is considered reckless. Yet, the NASDAQ 100 is available via the iShares NASDAQ 100 UCITS ETF. It has over $1.1 billion in assets under management in the UK alone. In other words, concentration risk that isforbidden to an active manager is considered reasonable and permissible if it happensto be an index.

Clearly, this index is the opposite of diversified – its results depend powerfully on individual securities.

Second, Valuation: When is A P/E Not a P/E ?, or How To Turn 90 into 22 in Three Easy Steps
According to the PowerShares QQQ fact sheet, the P/E ratio of the NASDAQ 100 is 22.19x, calculated on a trailing basis, and that is roughly comparable to the P/E of the S&P 500. No doubt, the P/E – the price, in essence – is an important fact for investors who are considering whether to own it or not.

But is it really a fact, as we think of facts? Because the QQQ P/E is not the simple mathematical average of the P/E ratios of all of the companies in the index, as one might naturally expect.

First, it is calculated by excluding all firms with negative earnings. It also effectively excludes companies with excessively high P/E ratios. Would you do that? Does it make sense?

Let’s reason through the easy one first, the idea of excluding companies with negative earnings. For the simplicity of round numbers, say an investor in private businesses made a $1 million investment in each of 3 small companies, flower shops, convenience stores, what have you, for a total of $3 million. One business earns $100,000 per year, so it has a price?to?earnings ratio of 10x; the second earns $50,000, for a P/E ratio of 20, and the third earns only $20,000 and so has a P/E of 50. This last one is probably situated on a high?growth street corner. Averaging the three P/E ratios of 10, 20 and 50 means that the average P/E of the 3?company portfolio is 26.7x. So far, so good.

But what if business number two loses $50,000 a year instead of making $50,000? One can see that averaging the three P/E ratios would be misrepresentative, because then the average P/E ratio would be 13.3x (+10, ?20 and +50, divided by 3), which is one?half as expensive asthe original P/E of 26.7x. Obviously, the portfolio with a loss?generating company is not cheaper than the all?profitable one. In a sense, the ETF organizers are staying within the logic of averaging individual P/E ratios by eliminating the company with the negative P/E ratio from the calculation as a statistical aberration or outlier. Asi f it does not exist or have an impact. The resultant P/E, however, does not represent reality.

To try representing reality better, how do we imagine the private investor would look at his or her investments? I think we all know they’d look at actual dollars. Perhaps they would add up all the earnings of the three businesses, which in the first instance was $170,000 ($100,000 + $50,000 + $20,000), and compare that with the $3 million of total investment: that’s 17.1x earnings. In the second instance, including the business that loses $50,000, the three together earn $70,000 a year, not $170,000. Earnings of $70,000 is not a lot for $3,000,000 of investment; that’s 42.9x earnings or, in income yield terms, 2.03%. That’s reality.

So, in reality one knows that an unprofitable company makes an investment more expensive, while in the world of indexation, such as in the QQQ, unprofitable companies are eliminated, making the P/E lower.

Now for the more interesting technique of P/E reduction: neutralizing the impact of the excessively high P/E ratio. Companies with very high P/E ratios, say over 100, are effectively eliminated from the calculation of the QQQ valuation. For instance, in 2016, Amazon earned $4.90 per share. The trailing P/E for its current share price would be roughly 188.7x. Since Amazon is a 6.82% position in the NASDAQ 100 Index, its full inclusion would raise the index P/E by some appreciable and observable degree.

Similarly, by this convention, which we’ll explain shortly, there is no way of informing prospective NASDAQ 100 purchasers of the valuation impact of holdings other than Amazon, such as Netflix, Tesla, and JD.com. Their trailing P/E ratios are 191x, ?82x (yes, that’s negative), and ?117x, respectively. Such names effectively do not exist from a P/E risk measurement perspective, even though as weightings in the index they definitely affect the risk of any dollar invested in the index.

The manner in which this is done is as follows. On the PowerShares QQQ fact sheet (see accompanying excerpt), one will note the aforementioned P/E ratio of 22.19. A footnote to that figure indicates that the P/E is calculated using the Weighted Harmonic Mean.

Seems harmless enough. Wikipedia provides a definition: The harmonic mean can be expressed as the reciprocal of the arithmetic mean of the reciprocals of the given set of observations. Huh?

To translate that bewildering language into the 3?step recipe via which an egregiously high P/E ratio is cleansed into a harmless middling sort of group average, we’ll use a couple of examples. Observe the following hypothetical equal?weighted 4?stock portfolio consisting of a range of low, somewhat high and egregiously high?valuations, ranging from 10x to 300x. A simple average results in a portfolio P/E of 90x.

The first step in the P/E transformation process, from the definition of Harmonic Mean, is to calculate the reciprocals of each P/E ratio, so that, for example, 10 is turned into 1/10, or 0.10. This is done for each of the 4 companies, and those reciprocals will be added up.

This step is the critical part of the alchemy, because note how Stock D is treated. Its P/E ratio of 300, which is very large in relation to Stock A’s P/E of 10, is transformed, as 1/300, into 0.003. This is very small. So small, that when those four fractions are added together, Stock D accounts for only 1.61% of the sum of those fractions (.003 ÷ .1867), whereas it began as an equal one?quarter member of the four?stock portfolio. Now, it is virtually a rounding error.

Steps 2 and 3, as shown in the accompanying table, involve taking an average of the reciprocals just summed, in this case dividing by four, since it is a four?stock portfolio, and then taking the reciprocal of that number.

That completes the strange journey of transforming a fairly understandable, if alarming, P/E of 90x into the more comforting Harmonic Mean P/E ratio of only 21.5x.

A more representative and straightforward way of calculating the index P/E ratio would be to simply divide its total market capitalization by the total GAAP net profit that all those companies produce, as in the private investor example.

Done this way, the P/E is not 22.19, but 25.77x. Moreover, the lowest?P/E stock in the NASDAQ 100 is Ebay, at, oddly, only 4.8x. That’s because almost two?thirds of its $7.8 billion of reported earnings in 2016, was from a non?cash tax adjustment and a gain on the sale of a stock. Its real earnings were $2.3 billion, which is more than analysts expect it to earn this year, and the real P/E is 16.61x. If one is comfortable with this single adjustment, the NASDAQ 100 P/E is 26.33x, not 22.19.

However, comparing the total market value of the companies in the index to their total earnings is not the accepted procedure and, as a consequence, the NASDAQ 100 Index is not represented as a high?P/E, concentrated portfolio.

Incidentally, measuring the NASDAQ 100 valuation in a manner more aligned with accepted procedure, by calculating the simple average of the P/E ratios of the 91 profitable companies, results in a valuation of 43.6x earnings. Or, even closer to accepted practice, if one calculated the weighted average P/E ratios of the 91 profitable companies (giving proportionately greater weight to the larger companies), then the QQQ valuation is 41.04x. No active manager would be permitted to manage a concentrated, high?P/E portfolio for an institutional client. Only an index enjoys this privilege.

Without dwelling on the figures themselves, the industry sector concentration in the NASDAQ 100 is as extreme as its company?specific concentration. It is readily seen that it lacks many of the presumed characteristics of a bona fide diversified index, and that it is truly expensive if one includes in the valuation those of its components that are in fact remarkably expensive. Indeed, it has many of the characteristics that advocates of indexation claim, not without justification, typify active management, including no sense of risk control and no valuation discipline, yet all available in an index format at a reduced fee.

These issues of market saturation and valuation apply to substantially all of the major index?centric stocks that represent ‘the market’ as investors understand it, including the consumer branded products companies like McDonalds and Procter & Gamble. Indexation has unwittingly become the place to go for systemic risk. Whether the index constituents are designated as consumer discretionary or information technology, or as dividend aristocrats or REITs or Non?US Developed Nations, their practical capacity to provide differentiated outcomes has been largely drained away. The diversification exists primarily in name only.

The large?cap and mega?cap companies occupy the same multiplicity of ETFs and experience the same inflow of funds upon which they largely depend for their valuation. As they do upon artificially low interest rates. They have either substantially saturated their markets and cannot expand their sales, in which case they trade at P/E ratios traditionally reserved for growth companies, of 22x to 25x; or they manifest legitimately rapid growth, in which case their P/E ratios are so anomalously high that they are actually excluded from the index P/E calculations.

Under these circumstances, does the safety of the crowd, herd immunity, still pertain? If the primary risks are systemic, then perhaps one should be outside the system. No one requires you, many of us are driven to remind our teenage children, to stay at the party if you’re uncomfortable being there.

Prof. Mandelbrot
Prof. Mandelbrot

if you exclude the loss making companies from the p/e calculations of the index (trailing and forward estimate?) – why do you include loss making companies in the index at all?

seems to me that the way to analyze the index – aka, the market – is to sum all earnings/losses and divide by market cap.

of course, price to free cahs flow on a current and expected basis would be useful, as would accurate PE to accurate gorwith in accurate E.

if the index does not reflect the accurate characterisitcs of its components, valuation metrics such as PE are useless.And a few quick follow on questions to ask yourself….

Anonymous
Anonymous

No charismatic political animal with a forceful silver tongue will be rising up from the economic ashes of our once free republic .
The federal reserve banking system has destroyed all but the connected few I refer to as the circle jerk and their minions who are paid from its organized theft of wealth and value formerly earned honestly by average American citizens !
Industries that once paid wages and benefits to good honest working people were raped pillaged and plundered by that invisible “THEY”!
Yes the “THEY” of the circle jerk of Wall Street to K- Street to Capitol Street and the government minions armed and otherwise in their employ have barely felt a ripple of financial inconvenience while former industry working people either hang on by a thread or literally fall thru the cracks in our society . Creating homeless masses surviving in despair or working minimal paying part time hand to mouth jobs that were once for young people completing education or the mother of a couple kids now in their teens to help get a few extras for the family !
We are told it’s our fault that business could not afford to pay wages and benefits to working people anymore yet some how those in government employ do very well and retire with life left to live and the means to live it . If I forcibly take wealth from them I become a criminal but if the system organized to forcibly take wealth from me to redistribute to them without any consideration the damage to me that’s not just legal but good for me . Should I protest there is a whole army of agents ready to threaten with force to shut me up and take everything from me including my life !
Any wonder why citizens of America are constantly facing government schemes to disarm them . It’s because citizens are facing a government poised to do a multitude of things to them that will force free armed citizens to fight back !
FORGET ME NOT

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