Calling out mal-investment or worse

Exposing Government Favoritism

This is the new frontier that cries out for further analysis & disclosure:

“Tax abatements are a common tool used by governments to stimulate economic development, but the taxpayer costs of such agreements are often hidden. This is a problem, because the cost of such corporate handouts from state and local governments is estimated to be as high as $70 billion per year.”

An obvious inequity: a company that has been a lifelong resident of a state can see a competitor be granted an immediate & huge tax subsidy.  Equitable? Equal treatment under the law? Not likely.

Worse, tax abatements provide a formal market for rent seeking and political corruption.  Chicago or Connecticut come to mind. We need more data on & analysis of this broad phenomena for the benefit of taxpayers and the economy.



Massive unfunded pension liabilities: political malfeasance?

The absolute fraud of pension accounting of unimaginable scale. Citizens and businesses need to understand this is a massive generational transfer of liabilities. Current benefits have neither been adequately funded nor accounted for. They have been essentially hidden... and abused. Willful political malfeasance?

“Despite the introduction of new accounting standards, the vast majority of state and local governments continue to understate their pension costs and liabilities by relying on investment return assumptions of 7-8 percent per year. This report applies market valuation to pension liabilities for 649 state and local pension funds. Considering only already-earned benefits and treating those liabilities as the guaranteed government debt that they are, I find that as of FY 2015 accrued unfunded liabilities of U.S. state and local pension systems are at least $3.846 trillion, or 2.8 times more than the value reflected in government disclosures. Furthermore, while total government employer contributions to pension systems were $111 billion in 2015, or 4.9 percent of state and local government own revenue, the true annual cost of keeping pension liabilities from rising would be approximately $289 billion or 12.7 percent of revenue. Applying the principles of financial economics reveals that states have large hidden unfunded liabilities and continue to run substantial hidden deficits by means of their pension systems.” 

Here's just one of the many analyses in the article: we suggest you check out your state, county, and city. The status may very well determine the future solvency of your state or municipality... or your future tax bill.



On the fiduciary rule

WWB strongly supports this position.

Regulations that facilitate conflicts and transacting under an overly complex body of regulation combined with poor but legalesed disclosure are what caused the problem. Together they enable, effectively, a regulatory safe harbor for operating under false color.  Its not complex... but gets so when regulatory capture holds the day. And that's where we are. 

"I do not believe a broker can act as a fiduciary to an investor seeking advice for his personal investments for one simple reason – he can’t serve two masters. A broker already owes a fiduciary duty to his client. It’s just that his client is not the public that buys his wares; his client is the issuer of securities, companies, municipalities, mutual fund companies and other investment product manufacturers. And frankly, Wall Street is already failing at fulfilling this duty. Any IPO that has a large pop on the first day of trading is a failure of the brokerage underwriter to meet his fiduciary duty to his client. What is needed is more education, not a blurring of the lines between advisers and brokers."

The Fiduciary Rule Educates The Public


An update on active vs passive management


The first graph from Indexes Beat Stock Pickers Even Over 15 Years explains the second.




Source: https://www.ici.org/pdf/2016_factbook.pdf


Active managers have had a tough go of it lately, moreso for their customers. No doubt more money will continue to be withdrawn from many underperforming active managers of public and private funds in favor of passive indexing, and the trend will continue and likely accelerate.

We are intrigued by how long it has taken this notion to get traction, particularly in the fiduciary realm of pensions & endowments, but that is perhaps a topic for another day or right of private action.

Active investors do provide a valuable role in price discovery and governance. For a market to function we need investors to sell poorly performing companies (lower the price & kill the pig), buy well performing companies (to increase the price), and play an active role in governance (remove poor or corrupt management).

We do think there is some merit to the argument that index funds are to some extent ‘free riders in the market or function of price discovery. Actively managed domestic equity mutual funds incurred outflows for 10 consecutive years, and one suspects that as more of the market gets indexed, the less efficient price discovery will become. Yin needs yang.

We don’t think active investing is dead or beyond resurrection. Passive indexed investing now comprises about a third of US mutual fund $ assets. If you believe in arbitrage one might hypothesize an equilibrium at 50%. And no doubt this will create an opportunity for those hedge fund managers, at least those who can survive. Reaching equilibrium will take time.

These things are cyclical.




LPL Financial No Longer Claiming to Be ‘Conflict Free’

Investors take note. This is a big deal. We've always encouraged investors to read & understand the fine print of advisory & brokerage agreements, particularly disclosure of conflicts. Of course, many have been written in legalese so as to obscure, if not misrepresent, the substance. The fog of advertizing under false color is slowly receding and with significant consequences for conflicted business models. And more will follow.  This from today’s WSJ LPL Financial No Longer Claiming to Be ‘Conflict Free’ .

LPL Financial Holdings, the Boston-based independent brokerage, is moving to prevent its affiliated financial advisers from claiming they are “conflict free.”

On Monday LPL removed those words from its web site following a story in The Wall Street Journal showing that some advisory firms claim to be “conflict free” on their public websites even though they also list numerous potential conflicts in their disclosures to government regulators.

LPL also asked its advisers to review their websites “for any use of that language and address the concerns that have been raised,” said a spokeswoman for the firm...

LPL’s regulatory filings disclose several conflicts, yet a Journal analysis found that the websites of approximately 70 LPL advisers asserted they were conflict free. As of last week LPL’s own website said the firm’s “objective research” enabled advisers to “provide conflict-free advice and guidance.”

Now one wonders if any of LPL's or its advisors' prior disclosures were misleading? What changed from an operational or policy perspective? One suspects nothing but sunshine. No doubt litigators will sort that one out.



Q1 2017 Review & Outlook: first, the rear view mirror



It is difficult to convey the magnitude of the quarterly performance of the equity sectors, perhaps less so for the fixed income markets. Below are the total returns of exchange traded funds that we use to represent the total US stock market [VTI], all non-US equities [VEU], emerging markets [VWO], the aggregate US bond market [BND] and the short term investment grade sector of the US bond market [VCSH].



Not to be dramatic, but if we annualize the nominal quarterly returns to an annual compound basis we see some supra-normal returns:

Total US equity market:                        22.9%
Non- US equity markets:                       39.4%
Emerging markets:                               49.7%
US aggregate bond market:                    3.5%
Short term US investment grade bonds:   1.7%

Do these returns look like anything in the real economy? We think not, and not just on the basis of the rearview mirror. We’ll get into that a bit later. Runs like this are dramatic, but we caution investors in current circumstances. While we’ve enjoyed the ride of QE and the pricing of the expectations of political reform, we are concerned about a disconnect between current market valuations and a sober view of economic expectations for growth and earnings in the near to intermediate future. Here’s why.

Let’s cheat by selecting a biased timeframe of analysis. From Feb 27, 2009, to March 31, 2017, SPY, an S&P 500 ETF, had a total return of 278% or 17.9% on an annual compound basis. So if you were in the market, stayed there and reinvested the dividends, you almost tripled your money and earned about 18% on it every year. Welcome to QE and a low entry point.

Do you recall hearing about how great the economy was in 2009? Or since? We do not. The Obama recovery is the weakest in the post World War II era. Note the 2.1% average annual growth in GDP since the U.S. recovery began in mid-2009.

Source: http://blogs.wsj.com/economics/2016/07/29/seven-years-later-recovery-remains-the-weakest-of-the-post-world-war-ii-era/

The recovery has been the weakest, and yet remarkably is one of the longer recoveries. How long will it persist?

Source: http://blogs.wsj.com/economics/2016/07/29/seven-years-later-recovery-remains-the-weakest-of-the-post-world-war-ii-era/


More importantly, did the economy in crisis and ‘recovery’ eliminate the structural constraints and market imbalances such that a robust recover could eventuate? Or do they still remain in some form? Are we on the verge of an American Renaissance or do we continue to suffer from too much regulatory excess, malinvestment, regulatory capture, excessive leverage, and corruption? Have we placed insurmountable and unmovable burdens on the productive machinery that will take years to repair?

We tend to share the view of Jeffery P Snider of Alhambra Investment Partners:

economic indications beyond payrolls continue to suggest only sustained weakness. There is improvement in most accounts beyond the labor market, to be sure, but like the labor market data nothing that is close to convincing that a positive inflection is even realistic let alone close at hand. Source: http://www.alhambrapartners.com/2017/04/07/who-carries-the-burden-of-proof/



The equity markets seem fully priced for robust and increasing future growth, and seemingly have been for some years. Pick your metric: equities are not cheap. Whether the growth materializes to sustain current levels remains to be seen. We think it’s a long shot.


Rem: above on 12 month trailing PE, as reported basis


Rem: above rolling 10 year average, inflation adjusted PE

Source: http://www.multpl.com/


There are many other metrics of valuation, and we present only two, but our point is simple: we think the market is vulnerable to multiple compression. And that could be induced by any number of factors... declining productivity, delays in regulatory & tax reform, geopolitical shocks, or political crisis.

Corporate profits seem strong (data thru Oct 2016 below) and the resurgence in Q4 is evident.



That seems to be continuing as the S&P 500 anticipates near double-digit earnings growth for Q1:

Source: https://insight.factset.com/earningsinsight_04.07.17

 Some credible analysts suggest the expansion of the business cycle has another two years to run absent a premature death by rate hikes from the Fed. That longevity may very well be a reasonable interpretation. 

But what does the Atlanta Fed think about future growth?



Maybe the folks in Atlanta have been looking at this: declining Commercial & Industrial Loan Growth.


Source: http://www.zerohedge.com/news/2017-03-29/why-loan-growth-collapsing-goldman-has-one-theor


Fixed Income

And what do the fixed income markets convey? On March 15, 2017, the Fed raised short term rates by .25% and stated their intentions of further increases. Immediately, yields on both the 2’s and 10’s declined, signaling a less robust view of the economy, one contradictory to the Fed and the equity markets.



Of greater valence is the spread between 10’s and 2’s below: since December of last year the spread has been declining. A flattening yield curve is typically indicative of a weaker economy (rem: data below thru 3/31).



Credit spreads seem to be declining or stable which indicates, more or less, equilibria. Seemingly no tightening in the credit markets, other than a recent pop in high yields.  No news is good news.



Inflation expectations impact fixed income and equity markets. It changes the valuations and impacts future expected returns of pretty much everything.

The spread between the 10 year TIPS and Treasury is right on the Fed’s target at 2%.


The 5 year, 5 year forward inflation expectation rate is slightly above the 2% target ( the 5/5 forward rate is a measure of the expected inflation over the 5 year period that begins five years from today) . Both current and forward indicators of inflation are stable and generally now in synch with Fed objectives. This in connection with stability of credit spreads, and the employment numbers is probably why they raised the funds rate.



The most important issue we see on the horizon is the likelihood of sustained lower future returns relative to recent history. This is systemic in nature and effects all investors and touches on issues such as retirement planning to pension solvency. Lower than expected returns can also impact risk tolerance, and consequently appropriate asset allocation. No one can duck this one (except politically controlled pensions which will go bankrupt because of it).

Rob Arnott, of Research Affiliates, lays out his thinking on prospective returns over the next decade in an email cited in The Unavoidable Pension Crisis:


“Quoting from his letter (in which he assumes the typical 60% equities/40% bonds ratio that most pension funds use), here’s the math:

40% Bonds. Yield is 2% for the US aggregate bond market.

60% Stocks. Our base case is 5.4% for US stocks, but we think valuations are too high, so we trim this to 3.3% for the coming decade.

...Add up the return from stocks and the return from bonds, and we get 2.8% to 4% from our balanced [60% equity/ 40% fixed income] portfolio.”

That’s not inconsistent with the range of ten year real expected returns of a 60/40 portfolio laid out by Vanguard in their 2017 economic and market outlook: Stabilization, not stagnation in which they characterize their outlook as the most guarded it has been in 10 years. Their analysis produced a median return 3.8% (ranging from 5th percentile -2.7% to 95th percentile of 10.4%).  For context the median real return on the same allocation from 1926 to 2016 was 5.5%.

There is a competent body of evidence that suggest that higher entry prices into the market are a predictor of future lower returns, and this seems to be echoed by those such as Vanguard and Arnott.  And what is the mantra, “Buy low, sell high...?”

Neither institutions nor retail investors should be planning of 7-8% long term returns for balanced portfolios.

Risk & volatility

The second most important issue we see is valuation risk to equities. We do not see modest incremental increases in the fed funds rate as necessarily harmful to equity returns in context of a firming economy. We do, however, see the risk of multiple (PE) contraction if growth is weak or negative. We are less concerned about interest rate risk simply because it is known and more easily managed.

We continue to expect spats of volatility which could be sizable. Trump’s reforms of large economic consequence (tax reform, immigration, and trade policy) may prove beneficial in an intermediate 3-7 year timeframe but one suspects getting through years 1-3 could get rough simply by virtue of the scale and complexities of the issues up for reform.

We also see a schism of expectations between the equity and fixed income markets. Both of them can’t be right and a reconciliation of their two outlooks seems increasingly likely. Something will likely get bumped... with direction and magnitude unknown. This goes to risk tolerance and asset allocation.

Derisking tilts

We were recently asked about adjustments one might make to de-risk a portfolio which stuck us as a timely question. Our view is that the only reason we invest in bonds is to mitigate equity risk. If we had no risk constraint (ie let Risk = 100%), we would not invest in bonds.

In a de-risking scenario one might reduce the equity allocation, say, from 40% to 35%  or 30%. One might consider as part of that process increasing the proportion of foreign equities relative to US within the overall equity allocation (given more favorable relative value, meaning foreign equities are cheaper than US).  So as a defensive/de-risking alternative they seem attractive relative to US stocks which seem fully valued. The discounts are non-trivial.

Relative Value for US and non-US equities (for VTI/VEU respectively, source Vanguard)



De-risking fixed income might typically shorten duration and lighten up on weaker credits. We continue to favor investment grade credits, but stipulate spread risk in that sector.  Ultimately the best course of action depends on future outcomes which are unknown. We do know the sources of risk & return in fixed income, and here's a simple menu of strategies:

•shorten duration (for example via BSV or VCSH)

•assume the market profile (i.e. the market portfolio qua market BND and BNDX or others)

•go long (BLV)

We’re not advocating any particular course of action here, which actions depend on the investor’s view, but simply point out that a de-risking tilt might incorporate some combination of the first two items. We would encourage modesty and humility in one’s confidence in making such tilts and note that none of the above are riskless, and all entail opportunity cost of one variety or another.

Given the uncertainty we believe it is imperative to remain diversified, and we encourage moderation in any portfolio tilts.


Many of the issues here are why we like the mechanics of rebalancing within the framework of an appropriate asset allocation as a risk disciplined, moderate manner of guiding clients through cycles. It seems to work. Over the long term it tends to produce the level of risk & return of the allocation one selects.


Lastly, we share a grimly morbid read on the state of the auto industry but it is good news for those looking to buy a used car in the near to intermediate future: The Next Subprime Crisis Is Here: 12 Signs That The US Auto Industry's Day Of Reckoning Has Arrived.




Q4 2016 Review & Outlook: An Early Take



Below we show the pre-tax year to date total returns (includes changes in price  & dividends) of three broad based index funds representing the total US market (VTI) , all foreign equities (VEU), and emerging markets (VWO). The total returns are impressive in the main. If we convert them to compound annual basis, they get bigger: 11.9% for US equities, 2.7% for foreign equities, and 14.2% for emerging markets stocks.  We note, although do not show it in the graph, Developed Foreign Markets are down -.2% on a total return basis for the same time period. We see a strong argument for diversification.


US Equities by Growth/Value and Large/Small Capitalization

Small cap stocks were up +16.4% leading all other sectors, followed by Value at +13.7% with Growth stocks in last place with +5.6%. Not bad numbers at all, far exceeding our expectations. Whether they are sustainable remains to be seen.


Fixed Income

Fixed income is of particular interest because this is where it all starts globally, where the linkages intersect the global markets instantaneously in terms of economic expectations, currencies, liquidity, credibility and confidence. Below we display Long Term Government Bonds, the Total Bond Market, Short Term Investment Grade Bonds, junk, and Emerging Markets bonds, and we see a significant point of inflection.

Reviewing the total returns year to date one is tempted to say, ‘well, not too bad,’ and indeed it is not. But there is something in the works. Look at the drawdowns, the declines from highs in the period for long bonds and emerging markets (green and red lines below, respectively). These are significant declines. A drawdown of ~11% in long bonds over a short time frame might make one question if the fixed income party is over. It certainly evidences the risk of duration, and much more to come, one suspects.



All this was driven by relative large moves across the curve with no formal action by the Fed. See the 10 and 30 year rates below. Seems to us a Fed move on short rates is a foregone conclusion but moot with regard to markets.


Probability of a rate hike & inflation expectations

Rate hikes and expectations are linked, and the Fed is following, not leading. Below we see courtesy of the Chicago Mercantile Exchange a translation of actual interest rate futures prices to the probability of a Fed hike. This is what the market thinks or rather what expectations market prices reflect.


We can also get a view of the longer term expectations by looking at the 5 year, 5 year forward inflation curve which reflects the market view of future inflation. More specifically, it is a measure of expected inflation (on average) over the five-year period that begins five years from today. And again, we see a significant trend.


Labor markets

Labor markets have reached what the Fed defines as full employment, that is unemployment at 5% or less. In their documented policy view, it’s game over, time to hike.


Of course, we do not agree with the metric of their primary benchmark, the Unemployment Rate, which ignores persons who are not looking for work (evidently people who could work but have stopped looking for work do not exist). So we included the Labor Participation Rate just to be contrary. It does raise a question: is there hidden slack in labor force? If so, it might be positive for economic growth in face of potential welfare reform. If not, we retain the same embedded costs and move on with the rate hike.

In any case the market expectations of higher nominal interest rates and higher inflation in connection with full employment seems to indicate higher rates are on the way. The questions, of course, are when and how much? Our view is that a .50% move by the Fed is a bit aggressive given their pattern of  passive/aggressive behavior, and a .25% hike... an action sufficient to have no impact... is much more likely. Nothing may be the best outcome. We’ll see. Only the Janet knows... which, in and of itself, seems to beg for reform of the Fed.

Credit spreads

Credit spreads are the premia that bond buyers pay over the US Treasury rate to compensate them for credit risk. Spreads indicate risk appetite of investors and represent a cost of credit that incorporates an acceptable return after expected losses. Spreads are a major component of the cost of money, and the trend for most of 2016 has been down. If rates go up, one might expect spreads to go up. It’s nature’s own way of tightening, and it can happen even absent explicit Fed actions. Spread widening based on an expectation of increasing demand for money to fund real, productive transactions can be a sign of economic growth and beneficial for equity markets. Alternatively, spread compression can also indicate a reduction of perceived credit risk. We’re not sure which phenomena we face.  We still retain a bias to investment grade product in favor of treasuries which in our view represent return free risk.


Yield curve offers some comfort

An upwardly sloping yield curve is generally a good thing, while a flat or negative curve can be a leading indicator of recession. The data below is the difference between the 2 and 10 year Treasury rates. Note the recovery of a more positive slope was mostly driven by a significant move in the 10 year rate. We view this as a positive indication. Adios, Mr. Obama.


The US$

The trade weighted US$ has strengthened to levels not seen since November, 2002. This will make US$ based exports more expensive to foreign buyers but imports less expensive for US$ based buyers. Most US based multinationals have a diversified portfolio of currencies, across both costs and revenues, so the impact will be negative, but manageable. It’s not like they haven’t seen a strengthening dollar for the last decade. Small to midsize companies face the same phenomena but typically have less international diversification.

Now is not a bad time to travel because your pommes frites avec vin rouge along with foreign stocks just got a lot cheaper.




We still face significant unknowns, but on balance the downside bleed of destructive policies of President Obama will soon cease. This alone is the basis for some optimism as the relief rally in equities has shown.

Where we go from here is the question that will be clarified. We do have concern about the aging bull markets in equities and fixed income. They are long in tooth and both fueled by money printing or “quantitative easing” in newspeak. Consider that from March of 2009 to date the total return of  the broad US market ( VTI )  was 290% (or 19.3% CAGR). That’s a very long & large run. See below:

Interest rates may well be a catalyst for correction... or geopolitical events or liquidity events abroad.  If the Fed does move, count on a retrenchment in stocks, but also realize that rising rates do not always mean a falling stock market, but there are many moving parts, including some that may be beneficial, some that may explode.


From a short term perspective domestic equities are at an all time high. Anticipate a correction. It may only take a little bad news, and we have so many opportunities to get it. Longer term we sense there significant upside as the move by the equity markets post election seems to validate, but we’re not sure the risk is diminished. We’re going to be moving some big, powerful things around, and we’re working pretty much without a net.

We anticipate rising rates but expect them to be modest. We do think we have reached a signal point of inflection for the bond market, that fixed income investors might wish to avoid an undiversified fixed income strategy that relies upon duration or junk spreads for yield. It could get a little chippy out there in fixed income.

Europe and Asia are not in good shape.  Europe has no choice but to monetize its debt by further devaluation, and that will spur capital inflows to the US Treasuries and equities.  Europe will essentially lower their standard of living and decapitalize their citizens by a long, slow bleed. Brexit fever may well spread to France and others. It could get a little more messy.

Mr. Trump

And all this brings us to Mr. Trump. We still face significant unknowns and will have to parse out the difference between what Mr. Trump says, what he means, what he wants to get done, and what he can get done.

We think much of the initial & ongoing hysteria was manufactured and overdone. Recall how all the hedge funds & talking heads were certain that if Trump won the equity market would instantly collapse? Wrong. Not only wrong in magnitude, but direction. Dead wrong, and remember that the next time you’re feeling frisky.

We think the manufactured hysteria about “he’ll do something crazy” is also overdone. We have this thing called the separation of powers, or at least before Obama we did. As a practical matter Trump will face severe opposition from incumbent Congressional Democrats. One suspects the Supreme and Federal courts will not accord him the same unlawful leeway accorded Obama, and we hope for sake of rule of law that they do not. Lastly, support by the Republican Congress, many of whom dislike the man for having disrupted their sandbox, should not be taken for granted. It will be necessary. Our sober view is that significant safety rails are built in.

As to policy matters, Mr. Trump’s  stated tax policy is a material improvement over our current (and imbecilic) tax regime and will likely generate higher levels of economic growth. His energy policy will create significant changes to domestic energy production and impact global petro$ flows. More petro$ will flow to US producers which in turn helps domestic capital formation & employment while simultaneously de-capitalizing many state sponsors of terror and other bad actors. Small changes in the long term expected cost of energy and the geopolitical risk associated with the energy supply chain can have a significant impact on the US and global economies, investment and employment... not to mention consumer spending. It might very well happen in the intermediate term.

Trade policy is our main concern. Wilbur Ross, David Malpass, Stephen Moore, and Peter Navarro are members of his Economic Advisory Council, and they have their work cut out for them on trade. But again, we suspect and hope Trump’s rhetoric may be a bit different than the results he may generate. We don’t need a trade war or another Smoot-Hawley.

From our perspective, though, and it may strike some as odd, education policy is the real touchstone.  Look at the waste of generations of human capital impaired by the serial failure & corruption of our public school systems and higher education. It spans generations and borders on gross neglect.

By that standard America may be seen as one of the underdeveloped countries in the world. It is not our resources that make our country great but our people, our human capital. The long term fix is to break the educational monopoly that has come to exist. Improve the schools, improve the quality of education, and greatly expand access to it by adding parental freedom of choice. If he can deliver educational freedom to the inner cities, to the entire country... look out. America just may be great again.  


we can all remind ourselves that the richness of this country was not born in the resources of the earth, though they be plentiful, but in the men that took its measure.” - And the Fair Land



2016 Q2 review & comment: nothing happened?

 Our outlook is not one we encourage anyone to bet on. We see continuing weakness in the US economy, and it strikes us that the economic damage or benefit to markets from the EU will largely be a function of political decisions yet to be made.

Brexit is a signal event in the battle between democracy & the wisdom of the crowds against the great Leviathan of the regulatory state and its central planners.  Think of the aggregate of markets, the collective & instantaneous grouping and expression of all known information and all  preferences. This we call “price”, and on which all free persons, everyone, vote every day. In the opposing camp are the endlessly elegant and constantly revised computations of the central planners, the ‘Let X= my summer vacation” types in Brussels and Washington whose pronouncements always seem to translate to some variation of less individual freedom, less choice, and no accountability.

“We have been tempted to believe that society has become too complex to be managed by self-rule, that government by an elite group is superior to government for, by, and of the people. But if no one among us is capable of governing himself, then who among us has the capacity to govern someone else?” - Ronald Reagan

For the UK we understand that of the entire body of law and regulation effecting the lives of our British brethren, some 60% is promulgated by EU officials who are neither seated nor removed by election. This may explain how they forgot that consent of the governed is a necessary condition that needs to be maintained by any representative or republican democracy. One may recall the magnitude of change forced upon the American people by ObamaCare and carried by a single vote, bought & paid for by pork.

As to the Brexit crisis if we look at the markets as of yesterday’s close... well, nothing of any magnitude really happened. Yes, a bit of volatility, some repricing of things European, but it seemed rather mild after a bit.  One can’t help but notice, or rather suspect, the aroma of the central bank plunge protection teams at work because something of magnitude did happen.


Nevertheless, the UK exit is significant… wait until Catalonia votes to leave Spain. There are a handful of these events around the corner.  It is quite possible that Escape from the EU has just begun.  And there is already market stress: major real estate funds have had to suspend redemptions. No bid is no exit. We might expect some further variations of this theme. 

Three big asset management firms have halted trading in real estate investment funds in the last 24 hours, the latest sign of turmoil since the U.K. voted to leave the European Union on June 23.

The funds are heavily exposed to offices and other prime commercial property that can't be unloaded quickly enough when nervous investors want their money back.

Standard Life halted trading in its fund on Monday because of "exceptional market circumstances." Aviva Investors followed Tuesday, suspending its fund due to a "lack of immediate liquidity." M&G Investments said it suspended trading in M&G Property Portfolio because "investor redemptions have risen markedly" since the Brexit vote.

source: Investors bail out of U.K. real estate on Brexit shock 7/5

 The real question for Brexit and the euro markets may be of duration rather than short term intensity. It is not the exit that determines the outcomes for markets, but rather how the EU reacts to it. A protectionist, regressive stance on the part of the EU would be a destructive response and could unleash longer term, powerful damaging forces. The converse holds as well, but one senses the capacity of the European Central Bank is slowly coming into question as is the feasibility of some of the peripheral and perhaps one of the major European banks.

And then, of course, we have the US election.... there are many marbles on the table.

US fixed income

Meanwhile domestically we are left with the perpetual softness of a low growth economy hampered by the continuing policy issues we previously and excessively discussed: the framework and causation of slow growth is unchanged. The problems compound.

Interest Rates

Below we see rates of 10 & 2 year Treasuries and the effective funds rate. Recall the Fed talking about raising rates in a ‘full employment’ economy? See the decline of 2’s and 10’s? The Fed has spent it’s last credibility. There is no sign of upward pressure, even pre Brexit. Do we have decreasing demand for money? Perhaps but it  is also hard to underestimate the flight money coming into the US$. Both?

More troubling is the continuing decline 10 - 2’s spread. Strengthening economies tend to generate yield curves that steepen rather than flatten. Negative yield curves tend to be fairly good leading indicators of recessions.

Credit spreads

Corporate spreads seem to have benefitted from the flight to quality of Brexit and the negative rates of many sovereign issuers in Asia and Europe. Some yield is better than negative yield, and US investment grade credits are arguably superior credits to many sovereigns, although opinions would vary on that, particularly those of certain European finance ministers. The decline of these spreads is good for investors that own them, perhaps less so for new buyers who get lower spreads. Is this an indirect indication of eroding credit quality of sovereign debt?

High yield spreads have also declined, driven mostly we suspect by the modest recovery in oil prices and the search for yield. Rising energy prices, even modestly so, will tend to increase both cash flow and recovery values in distressed energy assets.


 In the meantime where does money seeking a safe haven go? Well, notwithstanding Mrs. Clinton’s vaunted Reset with Russia, not to Mr.Putin’s Russian Ruble, nor to the  €uro which just blew up, and certainly not to Chinese Yuan. China has its own acute problems with capital flight. The safe haven money comes to US Treasuries, investment grade US debt, and US equities and in that order.

The bid for US fixed income, driven by higher rates and better credit quality, will strengthen. One suspects we will see the 10 year Treasury march lower over the course of this year regardless of what the Fed says or does. This in turn will pressure domestic fixed income investors, both institutions and retail investors, and threaten the viability of meeting longer term return objectives of fixed income portfolios.

Our  “data dependent” Fed seemingly has discovered that new data comes out everyday, and this provides a viable framework for continuous introspection. It’s a new dawn every day for Team Janet. They have lost whatever control they thought they had.

Some things that bother us:

We have 5 years of declining money velocity during what has been characterized as a “recovery”.


The labor force participation rate has been declining since about January of 2000. We show the last 5 years below. As to the unemployment rate, we are now well below the Fed’s measure of full employment. The labor market is now “over employed” by their own standard. Go figure data dependency on that one, my friends. They have something very wrong: it’s the central planner’s dilemma. They just don’t know the answer. Or consider the counterpoint made by a friend of the firm who is an active participant in the market, a former macro trader:

"I would argue the Fed does know the answer to labor force participation rate issue but;

  1. They are terrified of the structural changes (& accompanying short-term pain) it entails.  This reflects the fragility of the economy and political stasis more than anything.
  2. They are unwilling to acknowledge that their models, policies, and transmission mechanism are broken/ineffective. 
  3. Perhaps there's a bit of buck fever for people who have never taken real business/market risk in their lives. Markets need to clear. Bad trades need to be cut.  See Japan.  Absence of volatility prolongs the depression (slow, low growth) as it removes productive trauma / creative destruction from the market economy.  Smoothing out the natural business cycle never works.   Free market capitalism needs some volatility (read: price discovery)."

Strength of the US$

Looking back to 2014 both the GPB and the EUR have fallen about 20% relative to the US$. This puts pressure on US exporters and depresses reported earnings of non-$US revenues of US based multinationals. 


ECB capital and liquidity

Our sense is that the ECB is running out of both.

“In Europe’s highly supply constrained bond market, Mario Draghi would not only have to expand his central bank's collateral pool as it runs out of eligible bonds whose yields are below the ECB's deposit floor thus making them ineligible for ECB purchases, but may have to do even more QE in a vicious loop as frontrunning the ECB leads to ever lower yields, and thus even more deflation.

Well, in March the ECB indeed announced the monetization of corporate bonds, and moments ago, in a shocking admission, Mario Draghi admitted precisely what we had warned about:


... It also means that the ECB will have to further cut its -0.4% deposit rate going even deeper into NIRP, or do away with it entirely as a gating factor for future QE purchases. The reason for this is that as of this moment, more than half the German government bonds on the European Central Bank's shopping list are ineligible for its asset-purchase programme because they yield less than the deposit rate...

We give this 4-6 months before helicopter money is unveiled.”

Source: http://www.zerohedge.com/news/2016-06-30/euro-crashes-ecb-announces-moar-qe

The Italian banks are currently problematic with huge amounts of non-performing assets and may prove a testing ground for the new "bail in" regieme, wherein creditors are transformed into equity holders and depositors can be dragged along as well, if necessary. 

Other European banks are doing their own experiment, except instead of negative rates, they're trying out negative share prices.  Given the complexity and inter-connectedness of the system & the atypical volatility of late, that is concerning. Sometimes that kind of movement & pain takes a while to work through the system.  When large houses are down 20% in a day… and then down 20% the next day…  standard normal distribution-based risk management models tend to work… poorly.

Growing spread of negative interest rates

Look at the growth. In a broad sense this is a significant portion of the global fixed income portfolio. And who owns it?  Directly or indirectly pretty much everyone. Governments, central banks, private banks, insurance companies, pensions... In any event some of this is already here in the form of lower Treasury rates,  and one suspects more is coming our way, either directly or indirectly. Gold's performance is notable: normalize for volatility & you avoid this entire negative rates experiment, which is unsurprising for a haven commodity.

The takeaway

Below we present the ugly month of June in isolation, a look right through the heart of the Brexit beast. Here is the performance of  

  • US equity market,
  • developed non-US equities ,
  • emerging market equities,
  • the US bond market and
  • short term US investment grade bonds.

 We stipulate that a single day drop of about 6% in non-US equities and about 3% in US equities is unnerving, but there are two object lessons for professionals and lay investors alike: 

  • manage risk by diversification & an appropriate asset allocation
  • a panicked investor selling into a panicked market most often destroys value

 And the winner of this pig pile? Emerging markets. Who knew? And that is the point: you don' t know. 


“Look, I had a fascinating out of body experience meeting with one of the world's top central bankers in a private meeting about three years ago. And he said, "You know Kyle, quantitative easing only works when you're the only country doing it." He would never say that publicly....call it one of the four top central bankers in the world, it was a jarring experience for me, because when I look around the world  today, everyone's in the same boat. So we're all trying...we're attempting through our treasury and our Fed to get the rest of the world to not devalue against us, while we quietly attempt to devalue ourselves against them, and it's all this...it is the race to the bottom.... And I believe that there is no way out.” - Kyle Bass




On Negative Interest Rates: Whimpy Rules


An article in the Financial Times  was the catalyst for this overdue posting on negative rates. Veteran bond managers Jeffery Gundlach and Bill Gross, respectively as excerpted below, sum it up nicely:

negative interest rates “are the stupidest idea I have ever experienced”, and warned that “the next major event [for markets] will be the moment when central banks in Japan and in Europe give up and cancel the experiment”.

“Global yields lowest in 500 years of recorded history…. This is a supernova that will explode one day.”

Our thoughts on the general topic:

  • Negative rates are first and foremost a taking from savers & investors for the benefit of borrowers. One might note the most levered institutions in the world are fiscally irresponsible governments, most of which could not service their debt absent artificially low rates. Negative rates are a hidden tax designed to enable and cover up excessive government spending.

  • Negative rates do not address the causes of our economic problems: defective  tax, regulatory, labor, and fiscal policies which have caused massive distortion of all the markets & economic behavior they touch. And that’s a lot: the entire global economy.  Negative rates will only exacerbate the problems of excess debt, malinvestment, declining labor participation and productivity. We will see even slower growth and declining productivity.

  • Negative rates add (and have already done so) massive amounts of interest rate and systemic risk to global fixed income markets. This undermines the financial stability of every owner of fixed income assets globally.

  • Negative rates in theory requires massive behavioral changes of all players in the global economy. These changes will not occur without risk & disruption. They  are already being resisted & may fail or be extremely limited.

  • Negative rate theory values all consumption and at a premium to savings & investment. Such is not the case for the real economy.

And what is the scale of this phenomena? Negative yielding sovereign debt now exceeds $10 trillion dollars according to Fitch Ratings. And it spreads: according to the Financial Times  more than $36 billion of corporate bonds with a short-term maturity currently trade with a sub-zero yield. This because investors seek corporate paper with positive yields which in turn drives the yields down, ultimately now to yields that are less negative than the sovereign paper.

“If you want low risk investments you have to pay for them.” - Gene Fama


Imagine putting in the clutch and shifting it all in reverse. In a world with positive interest rates the borrower pays the lender for use of the money. In a world with negative rates the lender pays the borrower for using the money.  So we must reverse the entire global supply chain to Whimpy’s Rule: cash on Tuesday is worth more than that cash today.


And we see the institutional response already:

“Commerzbank announced that it was thinking of buying vaults to hold its excess deposits in bank notes. If rates go more deeply negative, the German bank could lower its own interest bill and offer more attractive (or less unattractive) rates to depositors.” https://next.ft.com/content/b4cbb6fc-2e56-11e6-bf8d-26294ad519fc

“According to Nikkei, and confirmed by Bloomberg, Japan's biggest bank, Bank of Tokyo-Mitsubishi UFJ, is preparing to quit its role as a primary dealer of Japanese government bonds as negative interest rates turn the instruments into larger risks, a fallout from massive monetary easing measures by the Bank of Japan. While the role of a Primary Dealer comes with solid perks such as meetings with the Finance Ministry over bond issuance and generally being privy to inside information and effectively free money under POMO, dealers also are required to bid on at least 4% of a planned JGB issuance, which as the Nikkei reports has become an increasingly heavy burden for BTMU.” http://www.zerohedge.com/news/2016-06-07/its-seismic-shift-japans-biggest-bank-quit-jgb-primary-dealer and http://asia.nikkei.com/Markets/Capital-Markets/BTMU-plans-to-quit-as-a-primary-dealer-of-Japanese-bonds

“German Munich Re which is roughly twice the size of Berkshire Hathaway Re, is boosting its gold reserves and buying gold in the face of the punishing negative interest rates from the European Central Bank, it announced...”


“Munich Re is resorting to the equivalent of stuffing notes under the mattress as the reinsurer seeks to avoid paying banks to hold its cash under the European Central Bank’s negative interest rates. The German company will store at least 10 million euros ($11 million) in two currencies so it won’t have to pay for the right to access the money at short notice, Chief Executive Officer Nikolaus von Bomhard said at a press conference in Munich on Wednesday. “We will also observe what others are doing to avoid paying negative interest rates,” he said....” http://www.bloomberg.com/news/articles/2016-03-16/munich-re-rebels-against-ecb-with-plan-to-store-cash-in-vaults


Now if our masters can not force the desired behavior on institutional investors, how will it work for everyday Americans? Imagine the scale of behavior that must change and the learning curve that touches every aspect of our economy and entire supply chain... our mentality and habit of being.


So if we analyze these scenarios, a generalized rational strategy would be to borrow as much money as you can and stuff all the cash in your very large mattress. The mattress grows in relative value every day. This is what we call an arbitrage: money in the mattress vs cash invested. It will happen. The big guys are already doing it. Alternatively, one could borrow a bunch of money and buy the biggest leveraged asset you can. Roll the dice big: go large or go home. You can walk away and flip the keys to the bank. We call this leveraged finance.  

And one might ask, “What happened to my $5?”. Perhaps one might think of it as debt you did not borrow but have to repay.

The key points: negative rates

  • Subsidize borrowers at the expense of savers who are penalized

  • Are an attempt to induce specific behaviors over the entire system, both institutions and individuals. The goal is to force spending and investment that would not otherwise occur.

 It remains a valid question to ask why we need these behaviours after so long a period of zero interest rates? What will negative rates do that zero rates did not? Why were zero interest rates not effective, and what policies brought us to this point in the first place? Will negative rates actually address the cause of the problems we face. We think not.

We have already seen the first wave of institutional responses which are not the desired behavior. Now imagine if we extend this phenomena to the entire complex of the US economy, and note the institutional responses will generally be a variation of our simple examples above. Will this be a risk free experiment? Again, we think not. Any impact on investment, job creation, and real productivity? Evidently Larry Fink of BlackRock and many others agree:

"...Mr Fink said that low rates were preventing savers from getting the returns they needed to prepare for retirement, so they were increasingly being forced to divert money from current spending into savings.  There has been plenty of discussion about how the extended period of low interest rates has contributed to inflation in asset prices,” he wrote. “Not nearly enough attention has been paid to the toll these low rates — and now negative rates — are taking on the ability of investors to save and plan for the future.”  https://next.ft.com/content/5965b5e6-fd01-11e5-b5f5-070dca6d0a0d


“In the long run, however, classical economics would tell us that the pricing distortions created by the current global regimes of QE will lead to a suboptimal allocation of capital and investment, which will result in lower output and lower standards of living over time. In fact, although U.S. equity prices are setting record highs, real median household incomes are 9 percent lower than 1999 highs. The report from Bank of America Merrill Lynch plainly supports the conclusion that QE and the associated currency depreciation is not leading to higher global output.

The cost of QE is greater than the income lost to savers and investors. The long-term consequence of the new monetary orthodoxy is likely to permanently impair living standards for generations to come while creating a false illusion of reviving prosperity.” http://guggenheimpartners.com/perspectives/media/the-monetary-illusion


We reserve a special place for Swiss Re who have been on the vanguard of sounding the warning on malinvestment, the impact on the real economy, and systemic risk. This from their seminal analysis and commentary, Financial repression: The unintended consequences :


"US savers alone have lost a whopping USD 470 billion in interest rate income, net of lower debt costs. This is just one upshot of central banks' unconventional monetary policies initially enacted to manage the crisis....

“Capital markets' ability to function well also comes under threat. Artificially low yields crowd long-term investors out of the market, preventing them from pumping savings into the real economy to stimulate growth. This reduces the diversification of funding sources to the economy, representing a risk for financial stability at large."

And this:

“Long-term investors, like re/insurance companies and pension funds, are also faced with an "opaque tax" on their investment income – as seen in the decline in running yields over recent years. Re/insurers' current high allocation to fixed income assets translates into roughly USD 20-40 billion in additional income that could have been generated over the 2008-2013 period for both US and European insurers. This also results in lower risk capital available to be put to work in the real economy.”



An implicit goal of negative rates is to accelerate spending, any kind of spending, to stimulate economic activity.  We believe an erroneous assumption behind that thinking is that spending of any kind is an inherent good regardless of opportunity cost or outcome. Accelerated consumption is all that counts for old style Keynesians. And here is the problem: it’s like a distressed LBO (leveraged buyout) going on a spending binge it can’t afford and funding it with a zero coupon bond. It can live for a bit more, but the debt comes due. In the case of negative rates, the adverse outcome arrives when massive value is destroyed as artificial rates normalize.

"All debt must be repaid, if not by the borrower then by the lender. " Frédéric Bastiat

The Keynesian focus on consumption of kind at any cost is simply wrong. Consider:

“by simple analogy, if you borrow money and buy a bottle, well, let's make it a case, of Château Ausone St. Emilion 1998, and throw a kicking party, the next day all you have is a headache and the debt to pay back. You may have joie de vivre, but you are impoverished. On the other hand, if you borrow the same amount of money and buy productive assets, the next day and for all future you will have the economic production of those assets. You may be dour, but you are creating wealth, the extent of which is determined by the economic productivity of the asset in which you invested.

To modify this example for sovereign states, you simply need to make the dollars bigger (add zeros !?!) and the time frames longer. A simple, but essentially correct analogy.”http://www.wwbllc.com/commentary/2010/2/5/dynamite-in-the-hands-of-children.html

This is the kind of thinking that leads to bubbles, declining investment and productivity. Any consumption is inherently good and any investment becomes good as long as you borrow. Remember the billions of vacant buildings in China? Or the dot.com bubble? We are now in process of exporting duration, credit risk and systemic risk into global fixed income portfolio while depleting the interest income which they earn and re-invest. Some of this has spilled over into the equity markets as well. We note near record levels for the S&P and contrast it with the weakness of growth and GDP.  Negative rates are the opioids, the enabler that allows defective policy and malinvestment to compound.

The magnitude of change associated with negative rates is too great to digest. The underpinnings of our real economy are too weak to support the implementation of a risky and unproven hypothetical concept. Fixed income investors have been abused too long are now are at the point where their portfolios are stacked with Fed induced risk and returns so low that long term investment objectives are threatened.  

More pointedly, how does this impact individuals who have relatively modest  financial capacity to bear prudently significant equity risk, say a 50 year old planning for retirement? Buy bonds for a negative nominal and worse real return? Extend duration? Buy junk bonds and hope for the best? Or take on larger amounts of equity risk? Sophie’s choice.

Try to run an insurance company or annuity firm at negative rates. Try to fund your retirement or your children’s education with negative rates. Try to adequately capitalize the financial sector with negative rates.

And we’re there already with real (triangles), as opposed to nominal rates (dots) :


 Having exhausted my rant we now return to Mr. Fama’s comment, “if you want low risk assets you have to pay for them.”  He’s right. The current prices reflect current supply and demand; however, the Fed and other central banks have had their thumbs on the scale for some time.  People are buying these instruments because they are the best alternatives they see, which we take as prima facie evidence of the policy defects that brought us to this moment.

Hello, bitcoin, blockchain, and gold? Perhaps.

We recall the comment of a grizzly, seasoned crisis manager working through a distressed obligor. In the initial meeting with the bankers he opened with, “You’re not getting out. Nobody is getting out.” This, of course, turned out to be true. The only difference is that the bankers at the meeting voluntarily made the loans at inception to lend. Negative rates don’t give you a choice. Nobody is getting out of this game... unless we fix the fundamental policies.




Q1 2016 market review & outlook: what you already know

Equity markets

In the first quarter the US markets (VTI) were slightly negative on a total return basis at -1.4% to be surpassed by the Emerging Markets (VWO) at +1.5%, and foreign Developed Markets (VEA) went negative -4.2%. Note our quarterly data is as labeled, to March 28. 

We prefer a longer view, pictured below, and over the last 12 months all were negative. Before we start jumping out windows, let’s bear in mind that the total return of the US markets (VTI) over the last 36 months was 35.8%. 

Within the US market large caps were slightly positive, while small and mid cap sectors declined about -8.0% and -4.6% respectively, and growth vs value didn’t matter much.

Volatility has been largely stable, well, except for Fed/oil/China induced surprises. We expect more surprises, although not of the magnitude easily seen below in August. That we presume to be have been a mere “teachable moment” for the Fed. We do anticipate a growing probability of volatility through this year. There are any number of possible provocations including geopolitical issues, an unexpected weakening of the economy, disruption of global oil supplies, the unpredictability of the Fed, or simply domestic politics which seem to have an unlimited capacity for grim surprises.

Fixed Income & interest rates

Below is a graph of 30, 10, and 2 year constant maturity Treasury rates along with the Effective Fed Funds rate. It strikes us as odd behavior given the contemporaneous declarations by the Fed of impending interest rate hikes. Evidently, a substantial portion of the market didn’t quite get on board with the Fed.

The yield curve is probably more important than the absolute rates. The 10’s less 2’s spread as below reveals a curve flattening, again while the Fed threatens to raise rates. Robust economies tend to be associated with a curve widening, and an inverted curve is a leading indicator of recession. So we’re stable for now, but major forces are at work here and not necessarily in harmony. Do we have a Fed tightening into a weakening business cycle?

Credit spreads are the market’s own way of tightening, of adjusting the price of credit risk to reflect changing conditions. As perceived credit risk changes, the price of credit responds.Junk spreads have been widening, at peak almost doubling since last June with significant relief in February.

We see the same story with investment grade spreads (note the slight change of time frame). The market has been tightening since ~Sept 2014 with significant relief again in Feb.

Inquiring minds might ask what happened in February 2016?  Perhaps Obama won another Nobel Prize? Was the market pricing in a huge improvement in credit quality, perhaps driven by a positive and unexpected surge in economic conditions? Or was is something else? Maybe oil prices started to stabilize?

We retain our bias to short corporate investment grade product, but contemplate changing to incorporate slightly longer duration if and when we get clarity on the Fed’s strategy. Our bias is primarily a function of risk budget, not necessarily opportunity cost of forgone duration... simply put, we’re not inclined to go long in front of the Fed.

Money velocity: At any rate, now that we know the cost of money, let’s look at how fast it’s moving. We summarize: not much and slowing, either of which are bad news.

Labor markets

We see a decade’s trend of increasing numbers of Not in Labor Force and a declining labor force participation. We do note an upturn starting in Sept of 2015 and hope it continues. The big picture, however, is that we have a huge structural problem. Fewer people have skin in our economic game. While it is partially driven by aging demographics and emerging technologies, we believe the primary cause is slow growth in connection with a variety of failed social policies. We’ve run them through the mill before: education, tax, and punitive hidden marginal penalties on social benefits that preclude a transition from welfare to independent employment.  We need all citizens to have skin in the game.

But the official unemployment rate looks robust, and we note is and has been below the Fed’s target. In their world we are at full employment.

The US$ dollar strengthened dramatically for most of 2015 and will apply pressure to reported earnings of US based multinational companies, the full extent of which we’ll start to see shortly. The dollar has weakened ytd and any Fed tightening will bring back upward trend. The US$ remains a haven during times of geopolitical tumult. Trade weighted US$ below:

Commodities: still crushed and crying for mercy

Let’s see, it is ‘buy low, sell high’, right?


Our outlook from year end remains fundamentally unchanged. We do note, however, recent work at the St Louis Fed Revisiting GDP Growth Projections which we quote, “Based largely on predicted trends for labor force participation, GDP is projected to grow at an average annual rate of 2.2 percent over the next decade.” This is not their official projection, but rather utilizes a methodology assumes among other things that GDP per labor force participant continues to grow at the same rate as it did for the 2010-15 period. We wonder about that. Regardless, this seems to be a sensible outlook if one is optimistic. It in fact exceeds the annual growth projected by the Congressional Budget Office for potential GDP, which is expected to converge toward 2.0 percent over the next decade. We shall call this the sunny side of life, and one wonders how 2% growth for the next decade will sustain the standard of living of our country and the looming crisis of excessive debt and unfunded government liabilities?

We do just love stable hockey stick forecasts with no discernable downturns on the horizon for a decade, don’t you?


On the other hand GDP Now also a venture of the St Louis Fed paints a very different picture, at least for Q1 2016:

“The GDPNow model forecast for real GDP growth (seasonally adjusted annual rate) in the first quarter of 2016 is 0.6 percent on March 28.”


As our Gentle Readers contemplate the skew, bear in mind that Ms. Yellen’s Fed is and remains without qualification “data driven”.  The economic & market consequences of Fed actions sometimes create long term trends or behaviors that can be difficult to reverse.  So we shall look at one particularly stunning example of revisions that can happen to data from time to time? For example Personal Spending in January was revised:  

“from a 0.5% increase reported a month ago, it was now revised to a paltry 0.1%. In nominal dollar terms, this means that instead of US consumer spending a whopping $67.5 billion more in January, the increase was a paltry $14.7 billion, a delta of $52.8 billion!”

Source: One Third Of Q1 Economic Growth Was Just "Revised" Away



If we examine S&P 500 Forward 12 Mo. p/e’s over 5 or 10 years, (see p.23, courtesy of Factset) one senses the market is now fully valued. Projected earnings for Q1 2016 are weak: “For Q1 2016, S&P 500 companies are predicted to report year-over-year declines in both earnings (-8.7%) and revenues (-1.1%). Analysts currently do not expect earnings growth and revenue growth to return until Q3 2016. “

“Downward revisions to earnings estimates in aggregate for the first quarter to date have been well above recent averages. The percentage decline in the Q1 bottom-up EPS estimate (which is an aggregation of the earnings estimates for all 500 companies in the index and can be used as a proxy for the earnings for the index) since December 31 is -9.3% (to $26.42 from $29.13)... In fact, if -9.3% is the final number for the quarter, it will mark the largest percentage decline in the bottom-up EPS estimate for a quarter since Q1 2009 (-26.9%).”

The energy sector hurts the aggregate numbers significantly.  “If the Energy sector is excluded, the estimated revenue growth rate for the S&P 500 would jump to 1.8% from -1.1%. “ So the core may be doing just well enough to get by... or not.

We present a slide from Ed Yardini’s  S&P 500 Industry Briefing of 3/22/2016.


Bear in mind there are a variety of valuation metrics & methods, and this is just one. We don’t see a lot of upside these days, but we are of dour disposition.

For some time we have not seen much will change the basic the basic outlook: low and slow growth which batttles the growing dead weight of destructive, costly policy impediments.  Swiss Re has been kind enough to provide one example: The money tap continues to run, while the costs continue to increase

It is called mal-investment and is driven by wealth transfers of a whole variety of means. Consider their estimate of interest income forgone by US investors on account of ZIRP (zero interest rate policy) is expressed as a % of GDP, and it is staggering. So much for the social contract of save your money and work hard.

Nothing will change until the election. Beyond that no one has any visibility. In the meantime we will likely see some backwardation induced from the 4-4 paralysis of the Supreme Count. One might surmise further increases in regulatory burdens and a further drifting from rule of law as we have come to know it. The Fed will continue to do whatever & whenever the Fed does. And did we hear Rick Santelli speculate no hikes until after the election so as... and get this... the Fed might avoid politicizing matters?

What to do? We do anticipate more volatility as the market sorts out the earnings announcements, the state of the energy markets, and the Fed’s unfathomable clarity of so many dots & situational data dependency. Asset allocation determines most of your risk, so make sure you've got it right, and part of that  entails sufficient liquidity to manage through & recover from any downturn.  We would not abandon non-US investments as valuations seem to be more attractive than the domestic markets, but we concede the impact of the social & economic crisis that is now Europe & the EU needs time to be sorted out. No doubt costs will be incurred and budgets stressed by the security matters. Meanwhile we can witness the train wreck of Brazil (a must watch) and only dream of competent, ethical leadership and reform of rent seeking & other mis-behaviors, criminal or otherwise, within our political institutions. 

Lastly, we leave you with this little gem which will be the subject of our next posting and shortly so we hope.


“one-third of global government debt is trading at negative nominal yields” - Mohamed El-Erian




FINRA's problem: arbitration, settlements, expungement & credibility

Let's say you have a legitimate complaint against a broker who behaved unethically (e.g. sold unsuitable investments or misrepresented or ommitted material facts). You go to arbitration and a settlement is offered; however, a requirement of the settlement is a release for expungement, a statement that you will not oppose the broker's request for expungement of the FINRA record of the whole matter.
So you take your money and move on, leaving the perpetrator or the public with no record of the event... about 92% of them in 2014. All the while FINRA proudly proclaims the virtue of its Broker Check function in the name of transparency and accountability.
The best regulation money can buy, and did. More here: Deleted: FINRA Erases Many Broker Disciplinary Records

2015 Q4 Review and Outlook: What Every Flying Machine Man Thinks

Updated on Monday, January 4, 2016 at 02:11PM by Registered Commenterhb

Updated on Monday, January 4, 2016 at 02:13PM by Registered Commenterhb

Updated on Wednesday, January 13, 2016 at 07:33AM by Registered Commenterhb

Updated on Thursday, February 4, 2016 at 08:33AM by Registered Commenterhb

Updated on Thursday, February 4, 2016 at 08:33AM by Registered Commenterhb

“Monetary policy made itself ineffective with low interest rates, which were seen as a cure rather than a transitory painkiller.” - Nassim Taleb

Our economic view remains from last quarter’s. We anticipate a recession in the US with about a ~60-70% probability starting sometime in the next 6 to 24 months, assuming that we are not unknowingly in the front end of one now. Given the timing of the national elections, we do not anticipate any material reform of our wayward domestic policies. Political paralysis with essentially a sideways and weak GDP, say ~2%, seems our best case.

To the downside we see an increasing likelihood of a disruptive environment

Click to read more ...


James Grant on the Fed's hike

Simple, clear, easy to understand, and hugely important. Watch:



The duty of an advisor vs a broker operating under color of defective & misleading regulation

This is a huge issue, and most investors are unaware of it. It is driven by the best regulation that money can buy... and did.

"many financial professionals who hold themselves out as “trusted advisers” are legally allowed to recommend investments that pay the adviser more while exposing investors to higher costs, greater risks and poorer performance than available alternatives."

The Document You Should Ask Your Advisor to Sign


Q3 2015 Review & Comment: Keeping Frankenstein on the Table

Updated on Tuesday, October 6, 2015 at 02:06PM by Registered Commenterhb

“This is a monetary moment. I think we are looking at the beginning of the world’s reappraisal of the words and deeds of central bankers like Janet Yellen and Mario Draghi. What we’re waiting for is a sufficient recognition of the monetary disorder. You see monetary disorder manifested in super low interest rates, in the mispricing of credit broadly and you see it in the escalation of radical monetary nostrums that are floating out of the various central banks and established temples of thought...” - James Grant

Our economic view is not optimistic, but rather sanguine, and that in the archaic sense of  bloody. We anticipate a recession in the US with about a ~60-70% probability starting sometime in the next 9 to 24 months. One colleague hopes for timing before the election so as to clarify the outcomes created by policy over the last decade or so. I think “Democrats hanging from the lamp posts...” was the phrase he used. Well, perhaps he can scratch that ambassadorship...

Click to read more ...


Comments on recent market events

Perspective is important to maintaining a clear head in face of market turbulence.

Below is a picture of the last 6 months price performance of VTI (in green), Vanguard Total U.S. Stock Market, which represents approximately 95% of the tradable US equity market. We added BIL (orange) , SPDR 1-3 Month T-Bill ETF (0.2yr) which tracks short term Treasury bills, and VEU (blue), Vanguard FTSE All-World ex-US, a proxy for all non-US equities.

You can see the decline of VTI of about -5.6% over the last 6 months and -8.5% for VEU. Not a good or pleasant thing.

 But also consider the longer term perspective.

We’ve had a huge bull run from March 2009 to Aug 15, 2015. Take a look at the total returns below (which include price & reinvestment of dividends or interest).

But here’s the fine print that we always need to recall: you don’t get equity returns without equity risk.  

And you can see it in the absolute price movement, volatility (below as the annualized standard deviation of price) and Drawdown (represents the largest % decline from the maximum to minimum of daily prices over the same period).

We've seen a correction, it is unpleasant, and there may be a bit more to go depending on the next catalyst.

 In our last quarterly commentary we noted the disconnect between productivity and the equity prices and commented:

“We sense multiples may contract as 1) a natural response to the long bull run of the equity markets and currently fulsome valuations 2) in anticipation of rising interest rates in the US or 3) a response to particular events of geopolitical conflict.

We also noted our expectation of the Fed raising short rates by .25% “unless the economy completely stalls”. Europe, China and the emerging markets might now fit that description. There will be spillover to the US, and we now believe the Fed hike will likely be shelved... at least until commodity prices stabilize a bit or possibly until after the election.

Our expectation is that US corporate earnings will be ok this year but will become less robust over time. Exports are going to be hurt by the US$ strength. 

  • Earnings Scorecard - “ Of the 436 companies that have reported earnings to date for Q2 2015, 73% have reported earnings above the mean estimate and 51% have reported sales above the mean estimate.”
  • Earnings Growth - “the blended earnings decline is 1.0%. The last time the index reported a year-over-year decrease in earnings was Q3 2012 (-1.0%).”   FactSet Aug 6.

We look for 1-2% GDP this year. Some, but not us, expect a slight acceleration as high as 3.5% in the second half. That would be a good thing, but we’re not buying it.

The US consumer may get some relief in energy costs with oil now about $40/barrel, although, ObamaCare will eat away at that benefit which would otherwise be a huge stimulus to the entire economy... but he’s not interested in wealth creation, only its transfer.

The bond markets still have a positive yield curve with 10 year less 2 year spreads still relatively normal. Bear in mind we’ve never had a recession without some foretelling by a negative yield curve. So from our perspective this is about growth, multiple contraction, and perception of risk. The risk premium just got raised, Mr. President and Ms. Yellen.

Readers of our commentaries this year know we’re not going to engage in a lot of happy talk. This recent market is unpleasant, and it may not be over yet. The fact is no one knows. We do know that this is what extended bull markets do.

There is also a political element to the extant economic issues & risks we face. There is a genuine sense that some big things are wrong with our policies, our leadership, and their manner of comportment, but the apparent degree of support for populist, wrong headed remedies such as trade restraints, trade wars, US $ devaluations is making people, including us, very nervous.

The world is not ending, but rather repricing, and the market tends to reprice to value. Consider: XOM, perhaps the best managed company in the world, is now selling at a a P/E of 12.8 and yields 4.05%. Some would say its cheap, and many other good companies may join the crowd. At some point the markets start to buy. That is what rebalancing does.




Aggregate funded and unfunded liabilities of the states divided by the number of taxpayers


We came across The 2013 Financial State of the States and wanted to bring broader attention to it. The report addresses the scale of the problem of unfunded liabilities of state pensions & other retirement benefits. Recall these amounts are typically off balance sheet items, unseen & poorly understood by the public, and therefore a great source of financial & fiscal abuse by politicians. They are very real and large.

Below is an estimate of the scale of the aggregate problem: you can see that only $195 billion of the estimated $1.1 trillion of liabilities are actually reported on states’ balance sheets. So how is a citizen to know? Well, the intent was that citizens were not supposed to know and that’s the point of abuse. The deception has largely been successful:

source: Truth in Accounting research as in The 2013 Financial State of the States

Some of their definitions will be helpful before we get to the chart below. They’re pretty simple.

  • “Assets” are those reported on the state’s balance sheet, except Net Pension Assets
  • “Capital Assets” include infrastructure like buildings, roads, bridges and parks that realistically cannot be used to pay bills.
  • “Restricted Assets” are those assets that are restricted by law or contract. See the detailed definition in the Methodology section of the report.
  • “Assets Available to Pay Bills” is the remaining amount after subtracting Capital Assets and Restricted Assets from Assets.
  • “Bills” is the amount of accumulated debt and unfunded retirement promises the state has made  
  • “Money Needed to Pay Bills” is calculated by subtracting Bills from Assets Available to Pay Bills.
  • “Each Taxpayer’s Financial Burden” is the Money Needed to Pay Bills divided by the number of state taxpayers. The number of each state’s taxpayers is based on the number of federal filers who paid federal taxes.(Internal Revenue Service 2011) The last available data from the Internal Revenue Service is for 2011, so the number was increased by the percentage of increase in the estimated population accounting to the Census Department.(U.S. Census Bureau 2013)

So, as you look at the chart below, recall the Taxpayer Burden represents each taxpayer’s share of the deficit of funded and unfunded liabilities, net of the state’s assets available to pay them. Simply, it is your share of existing obligations, marked to market, that your state cannot today pay. These numbers do not include municipal liabilities which would add considerably to the burden.

There is only one way each state can meet those obligations: taxes. So, if the chart may be taken as a predictor of increasing taxes it may also be taken as an indicator of future migration of businesses and individuals, particularly those approaching retirement... that is to say capital flight by those who can. And if the people with money start leaving, and tax revenues are levered to higher brackets, well, might one anticipate declining tax revenues? So goes the death spiral.


The full list and summaries of individual states are in the report (starting at p.42 ff.) The report also contains vital policy recommendations to reform financial reporting standards of the states and municipalities. The sponsor of the study is State Data Lab. They also provide some tools for comparative analyses.

Kudos to them.

Our take: combine this data with the Tax Foundation's comparative tax study of the states and you've got a good start on your retirement plan. You know where you don't want to be at any rate.



WWB comments on DoL's Proposed Conflict of Interest Rule

Watson Wilkins & Brown, LLC, submitted formal comments to the Department of Labor on it's Proposed Conflict of Interest Rule.

Although the formal comment period is formally closed, we understand DoL is still accepting comments. We wanted to submit the comments by email, but after 5 phone calls to various offices in the Office of Regulations and Interpretations... well, we snail mailed it.

And that, my friends, is part of the problem.


Come play the backtest and overfit game!

 We've written before about the risks of excessive back testing in our posting The Effect was Never There... It Was Just a Random Pattern. But now thanks to the good folks at the Scientific Data Management Group at Lawrence Berkeley National Laboratory at UC, we have a nifty little gizmo that will take you for a test drive.

Give it a go on the link below: then open your own quant hedge fund!

Backtest Overfitting: An Interactive Example

If you want to actually read about the toy before you use it, well, you go here, Backtest Overfitting Demonstration Tool: An Online Interface, a paper in the Big Data & Innovative Financial Technologies Paper Series. If you do that, however, you are not qualified by disposition to run a quant fund.

One suspects this phenomena, which is rampant in the investment arena, is going to get some attention in the form of litigation or regulatory scrutiny. In the meantime caveat emptor. A different group is coming to the same conclusion:

"We argue that most claimed research findings in financial economics are likely false."

Remember, kids, actual results may vary!





Q2 2015 Commentary: the pruning knife vs two issues


Our market outlook is simple. Nothing will happen between now and November 8, 2016, that is, nothing particularly good. Anticipate no reform of policy or regulations...  tax, fiscal, monetary, environmental, energy, labor, or educational matters. We may see futile, symbolic, political gestures, and we will most certainly see Obama launch a last wave of initiatives, mostly by Presidential fiat, and some will likely be materially destructive. A cynic might argue Republicans have incentive to let them roll, to sit and watch the rubble in advance of the elections. But who among us would be a cynic?

Meanwhile the big economic picture remains the same. Our national problems remain unsolved, and so they compound, become more deeply embedded, more complex & costly to remedy.   There seems to be another broad phenomena, coincident or causal: everything seems more brittle. We have previously, some would say endlessly, pointed out our concerns about systemic risk, flawed regulations, flawed incentives, and structural concerns with our markets & economy ... but this notion of brittleness extends well beyond the markets. It seems to have extended deeply into our culture, our confidence in leadership, our social fabric, rule of law, civil discourse, race relations... you name it.  Brittle things break more easily.

There are such things as bad endings, and they have severe consequences: Detroit or Puerto Rico or Greece. Europe’s debt crisis is much broader than Greece, but less publicized as the fuse is longer.

“Italian total real economy debt (government, household and business) is about 259 per cent of gross domestic product, up 55 per cent since 2007. France’s equivalent debt is about 280 per cent of GDP, up 66 per cent since 2007. This ignores unfunded pension and healthcare obligations as well as contingent commitments to eurozone bailouts.

Italy is running a budget deficit of 2.9 per cent. Government debt is around €2.1tn, or 132 per cent of GDP. French public debt is just above €2tn, or 95 per cent of GDP. The current budget deficit is 4.2 per cent of GDP. France’s budget has not been balanced in any single year since 1974

Italy’s economy has shrunk about 10 per cent since 2007, as the country endured a triple-dip recession. Italy’s unemployment is more than 12 per cent, with youth unemployment about 44 per cent. French GDP growth is anaemic, with unemployment above 10 per cent and youth unemployment of more than 25 per cent.” Source: http://on.ft.com/1KbJ6at

And for all the sound and fury, nothing has been fixed in Greece. It will go on endlessly with further adjustments, additions and right sizings. Greece will devolve to a near Third World living standards.

We have our own growing federal debt & unfunded liability crisis, and we better pay attention.


The graph above is simply funded debt and does not include unfunded federal liabilities. The distinction is important. Funded debt is evidenced by a bond or note and is recorded as debt on the government’s balance sheet. Unfunded liabilities are ‘promises’ not evidenced by a note or bond and not recorded as debt on the balance sheet of the government. Unfunded liabilities such as pensions, Social Security, ObamaCare, other healthcare, or hidden, unfunded obligations, dwarf the actual and reported funded debt. This we know as the fraud of government accounting. These unfunded obligations are equally important in a social and economic context as the funded debt.

As Stanley Druckenmiller has noted, the ballooning costs of Social Security, Medicare and Medicaid (which with unfunded liabilities estimated as high as $211 trillion or about 12x the actual funded federal debt,) will bankrupt the nation's youth and pose a much greater danger than the debt currently being debated, much less understood, in Congress.

Recall Detroit, Chicago, Harrisburg, Stockton, Puerto Rico? Consider that pension expenses now consume some 18% of Chicago’s entire annual budget. They’re cooked, like Puerto Rico. Here’s one list of the body count and another of the next 20 to go.

We have low growth and falling productivity, and there is no short term fix. This is a structural problem created by misguided policy. Productivity is the most important metric of the economy. It is how we sustain and grow our standard of living.

“Productivity over the past six months fell by the most in more than two decades, leading to increases in U.S. labor costs that threaten corporate profits.The measure of employee output per hour decreased at a 1.9 percent annualized rate after a revised 2.1 percent drop in the prior three months, a Labor Department report showed Wednesday in Washington. The decline on average over the past two quarters was the biggest since the first six months of 1993.”  

Biggest U.S. Productivity Drop in Decades Sends Ugly Omen May 6, 2015

Real GDP growth remains weak and erratic, as do Final Sales to Domestic Purchasers, another indicator of economic activity.


Want to get really ugly? Look at Jim Paulsen’s chart from his June 19th commentary: see the solid line, left scale for productivity.


Note the trend of decreasing productivity and the negative correlation to stock prices. Perhaps a temporary and reversible consequence of fiscal excess & easy monetary policy? A colleague asked what detrended means. It’s a high level geek process to wash out autocorrelation & “memory” of data sets. Good luck.

We have a surging US$

The trade weighted US$ is up about 20% over a one year period. This makes it a tough for domestic companies to export, but very cheap to import. Other than that we’re not sure what impact this will have. Clearly it’s adversely impacted the USD$ value of unhedged foreign currency debt & operating cash flows. May we suggest this would be a good time to travel abroad? Perhaps to buy low: vin rouge, pommes frites or foreign stocks, anyone?  



We have record low labor participation rates: more people in the cart, fewer people pulling it. This is an extended trend with no improvement, no fix in sight.

“the labour force participation rate stands at its lowest since the 1970s, suggesting millions of people remain on the sidelines of the jobs market rather than seeking or holding work. The question is whether this decline in the active workforce is largely a structural one — related, for example, to an ageing population — or a cyclical one that could be countered with stimulative monetary policy.” http://www.ft.com/intl/cms/s/0/72759f3c-2a35-11e5-8613-e7aedbb7bdb7.html#ixzz3fxR4mroa

We think the answer is obvious. Demographic cycles can influence these numbers, but ‘stimulative monetary policy’ does not work when the stimulus is consumed (by wealth transfers) rather than productively invested. Our problem is structural, manufactured by policy, and subsidized to that form. We need productive labor and investment.

Our take going forward

We look for slow to low growth to continue with no particular change in trend. We anticipate the Fed, having boxed itself into a corner, will raise short term rates modestly in late Q3 unless the economy completely stalls, We do note the allegations of the Fed leaking material inside information which is a non-trivial distraction.

We expect a modest rise of .25% will be benign to equity markets. Given continuing chaos in Europe, weakness in Asia & the emerging markets, and the massive flight money coming into the US dollar, we don’t see the long end of the US$ interest rate curve moving too much. Longer rates could actually go down given weak domestic demand. We could be wrong, and we’re still averse, but less so, to extending duration right now. We still like short term investment grade product as a relatively safe harbor.

We anticipate lower or stable energy prices but the benefit of that reduction will be consumed again by tax and cost increases of ObamaCare, and the consumer will continue to be squeezed. It’s hard to imagine the magnitude of burden our new health care system is placing on citizens, but there it is: The Coming Shock in Health-Care Cost Increases, right in the WSJ. We don’t see how the consumer is going to be having a good time, and this will ultimately reduce corporate top lines and capital investment. It already has, and this too will continue.

So, it’s sideways, low, and slow to the election. The equity markets will be relying on the remarkable efficiency and resiliency of corporate America, well placed with good liquidity and strong balance sheets, to make adequate profits with 1-2% real economic growth. For sake of clarity, we’re not jumping out windows here.

Our major concern: life goes on after the election. The big problems are unresolved and in the main getting bigger, and it is imperative we get a timely, sober, and practical grip on them. We’re running out of rope, and it’s in the markets. We anticipate lower returns in equity and fixed income. It will take some time to wash out the sand in the gears.

“Many investments today using artificially cheap capital are not increasing productivity — they are being made because money is cheap and the profit motive is strong. Consider the evidence. This year likely will witness record US stock buybacks; the second biggest year for mergers and acquisitions; the highest percentage of non-investment grade borrowers among new issuers of corporate debt; and a record for covenant-light loan issuance.”  Source: http://www.ft.com/cms/s/0/8c860c72-23d7-11e5-bd83-71cb60e8f08c.html#ixzz3fxNSO6Fm

We all know we’re waiting for relief. We’re at the front end of a period change, the direction of which is unknown. In the meantime we have seemingly a national crisis of faith, suffer from poor leadership, and, we believe, destructive policies. Markets, healthy economies, and stable democracies require sensible policies with stability & predictability of rule of law. Rising standards of living require freedom and incentives to innovate. For now we seem to be losing them ... unless you can buy ‘em from politicians.

That’s the problem. The good news is that it is not too late. The bad news is that we can little afford to keep ignoring the problems. Greece happens.




"The pruning knife of taxation is a very important instrument. With it the workers’ state will be able to clip the young plant of capitalism, lest it thrive too luxuriously.” - Leon Trotsky

“As long as it is admitted that the law may be diverted from its true purpose — that it may violate property instead of protecting it — then everyone will want to participate in making the law, either to protect himself against plunder or to use it for plunder. Political questions will always be prejudicial, dominant, and all-absorbing. There will be fighting at the door of the Legislative Palace, and the struggle within will be no less furious. To know this, it is hardly necessary to examine what transpires in the French and English legislatures; merely to understand the issue is to know the answer.

Is there any need to offer proof that this odious perversion of the law is a perpetual source of hatred and discord; that it tends to destroy society itself? If such proof is needed, look at the United States [in 1850]. There is no country in the world where the law is kept more within its proper domain: the protection of every person's liberty and property. As a consequence of this, there appears to be no country in the world where the social order rests on a firmer foundation. But even in the United States, there are two issues — and only two — that have always endangered the public peace.” - Frederick Bastiat in The Law, Perverted Law Causes Conflict, 1850