Buy the Dip? Hell No.....Sell the Rip Instead

By Tony Sagami

Are you worried about the stock market? You should be; at least according to your local Starbucks barista.
Starbucks CEO Howard Schultz told his 190,000 employees in his daily “Message from Howard” email communication: “Today’s financial market volatility, combined with great political uncertainty both at home and abroad, will undoubtedly have an effect on consumer confidence and … our customers are likely to experience an increased level of anxiety and concern. Let’s be very sensitive to the pressures our customers may be feeling.”

You can’t make this stuff up!

Hey, maybe I shouldn’t be too harsh on Mr. Schultz, because the stock market is in a lot of trouble… and not for the reasons the mass media and Wall Street experts are telling you. The know it alls on CNBC are pointing their fingers at the Chinese stock market meltdown as the reason for our stock market turmoil, but that is just the catalyst… not the root problem.

The source of the meltdown is deeper, more problematic, and more painful. What I’m talking about is that the Federal Reserve—from Greenspan to Bernanke, to Yellen—thought they possessed Wizard of Oz powers to fix whatever ails the economy with their menu of monetary tools.

In 2000, the Fed thought it could solve the bursting of the dot-com bubble with massive interest rate cuts and repeated that playbook again for the 2008-09 Financial Crisis. And when they ran out of room by cutting interest rates to zero, they trotted out Operation Twist and QE 1, 2, and 3.

Those three rounds of QE added about $3.7 trillion to the Federal Reserve’s balance sheet since 2008, which now totals a mind boggling $4.5 trillion. The problem is not China; the problem is Janet Yellen and her Federal Reserve buddies.

The Fed—beginning with the original monetary Mr. Magoo of Alan Greenspan—created a bubble, then rolled out more of the same to deal with the bursting of the bubble, and like the shampoo bottle says: Rinse, Lather, Repeat. Zero interest rates plus QE1, QE2, and QE3 created a massive misallocation of capital that has affected everything from home supply, ocean-going freighters, the US dollar, and wages, and pushed stock prices to a bigger than ever bubble.

The recent weakness is the painful process of deflating that bubble, but the Federal Reserve refuses to learn from its mistakes. It won’t be long until we hear about QE4 and/or a delay to the overpromised interest rate liftoff. Former US Treasury Secretary Larry Summers had this to say yesterday: “A reasonable assessment of current conditions suggests that raising rates in the near future would be a serious error that would threaten all three of the Fed’s major objectives; price stability, full employment and financial stability.”

Honestly, I don’t know what the Federal Reserve will do next. Heck, I bet they don’t know what to do either… but they will do something. Central bankers are arrogant know-it-alls who think they can fix the world’s financial problems with a couple of pulls of a monetary lever.

So pull they will.

And so the stock market damage will continue, albeit with some powerful up moves along the way.
Bulls, whether in a Spanish bull-fighting arena or roaming the floor of the NYSE, are a tough animal to kill. They won’t surrender until they make a few more desperate attempts to push the market higher.
Look at what happened last Tuesday after the 588-point Monday meltdown. The Dow Jones Industrial Average shot up by as much as 441 points before ending the day with a 204-point loss.

My point is that you’re going to see a lot of powerful up moves in the coming months… but I’m telling you, these are nothing more than bear market traps to lure you into buying at the wrong time. The stock market is falling into a bear market, and that means big swings both up and down, similar to 2000–2003.

The Federal Reserve, along with the rest of the world’s central bankers, has puffed stock valuations into an epic bubble, and the stock market has a long, long ways yet to fall…..just not in a straight line. That’s heart attack material for both buy-hold-and-pray and buy the dip investors, but it is a goldmine if you adapt your strategy.

Instead of buying the dip, the right strategy going forward is SELL THE RIP.

When the stock market gives you a big rally, the right move will be to sell into strength.

And if you have some risk capital, that will be the time to load up on inverse ETFs and put options, like my Rational Bear subscribers did in July.

The biggest short-selling opportunity of our lifetimes is knocking on your door.

Tony Sagami

30 year market expert Tony Sagami leads the Yield Shark and Rational Bear advisories at Mauldin Economics. To learn more about Yield Shark and how it helps you maximize dividend income, click here.

To learn more about Rational Bear and how you can use it to benefit from falling stocks and sectors, click here.

The article Connecting the Dots: Buy the Dip? Hell No! Sell the Rip Instead was originally published at mauldineconomics.com.

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How to Invest in a Difficult Market

By Casey Research

Many experts hold dim views of the current state of the US economy—but what’s a prudent investor to do to make a profit? Find out what the blue-ribbon faculty of economists and investment pros at the recently concluded Casey Research Fall Summit thought.

Lacy Hunt, senior executive VP of Hoisington Investment Management Company and former chief economist at the Dallas Fed, says the main reason that the global economy continues to falter is that all countries borrow too much and save too little.

“275% total debt to GDP is the critical threshold. Every world economy of importance is above that level and moving higher.” He finds today’s monetary policy “impotent.” The Fed, Bank of England, and Bank of Japan are trying to solve the problem of too much debt by borrowing more, which has short-term benefits, but will be disastrous long term.

Too much borrowing, says Hunt, guarantees that we’ll get more asset bubbles. Because the United States is the least indebted of the three countries, it will continue to outperform Japan and Europe. He predicts that the dollar will rise against other major currencies and that inflation, as well as interest rates, will remain low.

Christian Menegatti, managing director of economic research at Roubini Global Economics, is convinced that we’re at the end of a supercycle and won’t see a normalization of monetary policy for quite some time.
Like Lacy Hunt, Menegatti predicts that global interest rates will stay low. On the positive side, he doesn’t believe that we will see secular stagnation; in other words, a full “Japanification” of the US is unlikely.

The current economic recovery in the US is weaker than that in the 1930s, claims Worth Wray, chief strategist at Mauldin Economics. He says while nominal interest rates are the lowest they've ever been, real rates could go lower.

When the Fed’s QE3 is over, he predicts that growth will weaken and rates will fall further. “Without another dose of stimulus, the US will likely slide into recession.”

Taking a global view, he thinks that China’s slowdown could cause the Australian housing bubble to pop, and that commodity prices will drop over the next few years, which will hurt resource rich countries like Australia, Norway, and Canada.

He recommends to buy U.S. Treasuries and to diversify across asset classes that thrive in different economic environments to strengthen your portfolio against a possible crisis.

Diversification is also the number one tip from the expert panel on “Building a Crisis Proof Portfolio” at the Casey Summit, consisting of Worth Wray and Casey editors Alex Daley, Terry Coxon, Dan Steinhart, and Dennis Miller.

They say a crisis can take one of two forms:

1. A “standard” crisis, where stocks crash but the financial system remains intact. In that scenario, you want to own US government bonds because they’ll retain their safe-haven properties.

2. A “reset,” meaning a complete implosion of the global financial system. Government bonds won’t save you from that type of crisis. Instead, you’d want to own real, non-financial assets, such as physical gold and silver, as well as farmland and other real estate.

For “Future Tech You Can Profit from Now,” Alex Daley, chief technology investment strategist at Casey Research, suggests to look for companies that offer game changing benefits or savings and that focus on “where businesses and people spend their time and money,” like OpenTable or Zillow.

Daley recommends three companies with great upside from his Casey Extraordinary Technology portfolio.
He says there’s no need to worry about the broader market if you can find great companies with consistent growth. “Look for 40% revenue growth over the same quarter last year; that’s the magic number.”

To get all of Alex Daley’s stock picks (and those of the other speakers), as well as every single presentation of the Summit, order your 26+-hour Summit Audio Collection now. It’s available in CD and/or MP3 format. Learn more here.

The article How to Invest in a Difficult Market was originally published at casey research

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Europe Takes the QE Baton

By John Mauldin

If the wide, wide world of investing doesn’t seem a little strange to you these days, it can only be because you’re not paying attention. If you’re paying attention, strange really isn’t the word you’re probably using in your day-to-day investing conversations; it may be more like weird or bizarre. It increasingly feels like we’re living in the world dreamed up by the creators of DC Comics back in the 1960s, called Bizarro World. In popular culture "Bizarro World" has come to mean a situation or setting that is weirdly inverted or opposite from expectations.

As my Dad would say, “The whole situation seems about a half-bubble off dead center” (dating myself to a time when people used levels that actually had bubbles in them). But I suppose that now, were he with us, he might use the expression to refer to the little bubbles that are effervescing everywhere. In a Bizarro French version of very bubbly champagne (I can hardly believe I’m reporting this), the yield on French short term bonds went negative this week. If you bought a short-term French bill, you actually paid for the privilege of holding it. I can almost understand German and Swiss yields being negative, but French?

And then Friday, as if to compound the hilarity, Irish short term bond yields went negative. Specifically, roughly three years ago Irish two year bonds yielded 23.5%. Today they yield -0.004%! In non-related un-news from Bizarro World, the Spanish sold 50-year bonds at 4% this week. Neither of these statistics yielded up by Bloomberg makes any sense at all. I mean, I understand how they can technically happen and why some institutions might even want 50-year Spanish bonds. But what rational person would pay for the privilege of owning an Irish bond? And does anyone really think that 4% covers the risk of holding Spanish debt for 50 years? What is the over-under bet spread on the euro’s even existing in Spain in 50 years? Or 10, for that matter?

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We might be able to lay the immediate, proximate cause of the bizarreness at the feet of ECB President Mario Draghi, who once again went all in last Monday for his fellow teammates in euroland. He gave them another round of rate cuts and the promise of more monetary easing, thus allowing them to once again dodge the responsibility of managing their own economies. The realist in me scratches my already well scratched head and wonders exactly what sort of business is going to get all exuberant now that the main European Central Bank lending rate has dropped to 0.05% from an already negligible 0.15%. Wow, that should make a lot of deals look better on paper.

We should note that lowering an already ridiculously low lending rate was not actually Signor Draghi’s goal. This week we’ll look at what is happening across the pond in Europe, where the above-mentioned negative rates are only one ingredient in a big pot of Bizarro soup. And we’ll think about what it means for the U.S. Federal Reserve to be so close to the end of its quantitative easing, even as the ECB takes the baton to add €1 trillion to the world’s liquidity. And meanwhile, Japan just keeps plugging away. (Note: this letter will print longer than usual as there are a significant number of graphs. Word count is actually down, for which some readers may be grateful.)

But first, I’m glad that I can finally announce that my longtime friend Tony Sagami has officially come to work for us at Mauldin Economics. Tony has been writing our Yield Shark advisory since the very beginning, but for contractual reasons we could not publicize his name. I will say more at the end of the letter, but for those of you interested in figuring out how to increase the yield of your investments, Tony could be a godsend.

The Age of Deleveraging

Extremely low and even negative interest rates, slow growth, unusual moves by monetary and fiscal authorities, and the generally unseemly nature of the economic world actually all have a rational context and a comprehensible explanation. My co-author Jonathan Tepper and I laid out in some detail in our book End Game what the ending of the debt supercycle would look like. We followed up in our book Code Red with a discussion of one of the main side effects, which is a continual currency war (though of course it will not be called a currency war in public). Both books stand up well to the events that have followed them. They are still great handbooks to understand the current environment.

Such deleveraging periods are inherently deflationary and precipitate low rates. Yes, central banks have taken rates to extremes, but the low rate regime we are in is a natural manifestation of that deleveraging environment. I’ve been doing a little personal research on what I was writing some 15 years ago (just curious), and I came across a prediction from almost exactly 15 years ago in which I boldly and confidently (note sarcasm) projected that the 10-year bond would go below 4% within a few years. That was a little edgy back then, as Ed Yardeni was suggesting it might go below 5% by the end of the following year. That all seems rather quaint right now. The Great Recession would send the 10-year yield below 2%.

Sidebar: The yield curve was also negative at the time, and I was calling for recession the next year. With central banks holding short-term rates at the zero bound, we no longer have traditional yield curve data to signal a recession. What’s a forecaster to do?

I was not the only one talking about deflation and deleveraging back then. Drs. Gary Shilling and Lacy Hunt (among others) had been writing about them for years. The debt supercycle was also a favorite topic of my friend Martin Barnes (and prior to him Tony Boeckh) at Bank Credit Analyst.

Ever-increasing leverage clearly spurs an economy and growth. That leverage can be sustained indefinitely if it is productive leverage capable of creating the cash flow to pay for itself. Even government leverage, if it is used for productive infrastructure investments, can be self sustaining. But ever increasing leverage for consumption has a limit. It’s called a debt supercycle because that limit takes a long time to come about. Typically it takes about 60 or 70 years. Then something has to be done with the debt and leverage. Generally there is a restructuring through a very painful deflationary bursting of the debt bubble – unless governments print money and create an inflationary bubble. Either way, the debt gets dealt with, and generally not in a pleasant manner.

We are living through an age of deleveraging, which began in 2008. Gary Shilling summarized it this week in his monthly letter:

We continue to believe that slow worldwide growth is the result of the global financial deleveraging that followed the massive expansion of debt in the 1980s and 1990s and the 2008 financial crisis that inevitably followed, as detailed in our 2010 book, The Age of Deleveraging: Investment strategies for a decade of slow growth and deflation. We forecast back then that the result in the U.S. would be persistent 2% real GDP growth until the normal decade of deleveraging is completed. Since the process is now six years old, history suggests another four years or so to go.

We’ve also persistently noted that this deleveraging is so powerful that it has largely offset massive fiscal stimuli in the form of tax cuts and rebates as well as huge increases in federal spending that resulted in earlier trillion dollar deficits. It has also swamped the cuts in major central bank interest rates to essentially zero that were followed by gigantic central bank security purchases and loans that skyrocketed their balance sheets.  Without this deleveraging, all the financial and monetary stimuli would surely have pushed real GDP growth well above the robust 1982–2000 3.7% average instead of leaving it at a meager 2.2% since the recovery began in mid-2009.

The problems the developed world faces today are the result of decisions made to accumulate large amounts of debt over the past 60 years. These problems cannot be solved simply by the application of easy-money policies. The solution will require significant reforms, especially labor reforms in Europe and Japan, and a restructuring of government obligations.

Mohammed El-Erian called it the New Normal. But it is not something that happens for just a short period of time and then we go back to normal. Gary Shilling cites research which suggests that such periods typically last 10 years – but that’s if adjustments are allowed to happen. Central banks are fighting the usual adjustment process by providing easy money, which will prolong the period before the adjustments are made and we can indeed return to a “normal” market.

How Bizarre Is It?

We are going to quickly run through a number of charts, as telling the story visually will be better than spilling several times 1000 words (and easier on you). Note that many of these charts display processes unfolding over time. We try to go back prior to the Great Recession in many of these charts so that you can see the process. We are going to focus on Europe, since that is where the really significant anomalies have been occurring.

First, let’s look at what Mario Draghi is faced with. He finds himself in an environment of low inflation, and expectations for inflation going forward are even lower. This chart depicts inflation in the two main European economies, Germany and France.



Note too that inflation expectations for the entire euro area are well below 1% for the next two years – notwithstanding the commitment of the European Central Bank to bring back inflation.



But as I noted at the beginning, ECB policy has already reached the zero bound. In fact the overnight rate is negative, making cash truly trash if it is deposited with the ECB.



With inflation so low and a desperate scramble for yield going on in Europe, rates for 10-year sovereign debt have plummeted. It is not that Italy or Spain or Greece or Ireland or France is that much less risky than it was five years ago.

Note that banks can get deposits for essentially nothing. They can lever those deposits up (30 or 40 times), and the regulators make them reserve no capital against investments made in sovereign debt. Even after their experience with Greek debt, they essentially claim that there is no risk in sovereign debt. If your bank’s profits are being squeezed and it’s hard to find places to put money to work in the business sector, then the only game in town is to buy sovereign debt, which is what banks are doing. Which of course pushes down rates. Low interest rates in Europe are as much a result of regulatory policy as of monetary policy.

Next is a chart of 10 year bond yields. We’ve also included the US, Japan, and Switzerland. Note that Japan and Switzerland are in the 50-basis point range. (Japan is at 0.52%, and Switzerland is at 0.45%). Italy and Spain now have 10 year bond yields below that of the US.



The following chart is a screenshot of a table from Bloomberg, listing 10 year bond yields around Europe. Note that Greece is at 5.48%. Hold that thought while you look at the table.



This next chart requires a minute or two of analysis, and looking at it in black and white probably won’t work. Essentially, this is the spread of the yields of 10-year bonds of various European countries over German bunds. Note that only two years ago Greek debt paid 25% per year more than German debt did. Anyone who bought Greek debt when that country was busy defaulting has scored big. (While I probably take far too much risk in my portfolio, I will readily admit to not having enough nerve to do something like that.) The other thing to note, and it is a little bit more difficult to see on this chart, is that for all intents and purposes the market is treating European-wide EFSF debt as German debt. There are only 10 basis points of difference.



Now let’s take a little stroll through history and view a chart of the yield curve of French debt. The top dotted line is where the yield curve was on January 1, 2007. We took our first look at this chart last Tuesday in preparation for this letter, noting that short-term French debt was at the zero bound. It went negative on Thursday, and negative all the way out to two years! Note that a 50-year French note (which I’m not sure actually trades) yields a hypothetical 2.5%, only modestly more than a 30-year would yield. You might have to have the patience of Job, and I’m not sure quite how you would go about executing the trade, but that has to be one of the most loudly screaming shorts I’ve ever seen!



Here is the equivalent chart for the German yield curve going back to January 2007. Note that German debt has a negative yield out to three years!!!



While it should surprise no one, German long-term bond yields are at historic lows. I recall reading that Spanish bond yields are lower now than they have been at any other time in their history. I actually applaud the Spanish government for issuing 50-year bonds at 4%. I can almost guarantee you the day will come when Spain looks back at those 4% bonds with fondness. (I assume that the buyers are pension funds or insurance companies engaged in a desperate search for yield. I guess the extra 2% over a ten-year bond looks attractive … at least in the short term.)

And finally, let’s really widen our time horizon on German yields:



Time to Ramp up the Currency War

The yen hit a six-year low this week (over 105 to the dollar), creating even more of a problem for Germany and other European exporters to Asia. The chart below shows that Germany’s exports to the BRIICS except China are down significantly over the past few years, partially due to competition from Japan as the yen has dropped against the euro.

The yen-versus-euro problem (at least from Germany’s standpoint) is exacerbated by the remarkable appetite of Japanese investors for French bonds. This has been going on for over a year. In May and June of this year alone, Japanese investors bought $29.3 billion worth of French notes maturing at one year or more (presumably, this was before rates went negative). Note that even with minimal yields, the Japanese investors are up because of the currency play. (Interestingly, Japanese investors are dumping German bonds, again a yield play.)

Japanese analysts say that Japanese investors are hesitant to take the risks on the higher-yielding Italian and Spanish bonds, but for some reason they see almost no risk in French bonds. (Obviously not many Thoughts from the Frontline readers in Japan.) This behavior, of course, helps to drive down the price of the yen relative to the euro. (Source, Bloomberg)



Interesting side note: the third-largest country holding of US treasuries behind Japan and China is now Belgium. When you first read that, you have to do a double-take. Digging a little deeper, you find out there’s been a 41% surge in Belgian ownership of US bonds in just the first five months of this year. As it turns out, Euroclear Bank SA, a provider of security settlements for foreign lenders, is based in Belgium and is where countries can go to buy bonds they are not holding in their own treasuries. This buying surge is helping hold down US yields even as the Federal Reserve is reducing its QE program. Further, there is serious speculation, or rather speculation from serious sources, that Russian oligarchs are piling into US dollars by the tens of billions, again through Belgium.

Europe Takes the Baton

It is probably only a coincidence that just as the Fed ends QE, Europe will begin its own QE program. Note that the ECB has reduced its balance sheet by over $1 trillion in the past few years (to the chagrin of much of European leadership). There is now “room” for the ECB to work through various asset-buying programs to increase its balance sheet by at least another trillion over the next year or so, taking the place of the Federal Reserve. Draghi intends to do so.

Risk-takers should take note. European earnings per share are significantly lower than those of any other developed economy. Indeed, while much of the rest of the world has seen earnings rise since the market bottom in 2009, the euro area has been roughly flat.


Both the US and Japanese stock markets took off when their respective central banks began QE programs. Will the same happen in Europe? QE in Europe will have a little bit different flavor than the straight-out bond buying of Japan or the US, but they will still be pushing money into the system. With yields at all-time lows, European investors may start looking at their own stock markets. Just saying.

Draghi also knows there is really no way to escape his current conundrum without reigniting European growth. One of the textbook ways to achieve easy growth is through currency devaluation; and as we wrote in Code Red, the ECB will step up and do what it can to cheapen the euro in competition with Japan.
Just as the world is getting fewer dollars (in a world where global trade is done in dollars), Draghi is going to flood the world with euros.

Bank of Japan Governor Kuroda has steered the BOJ to where it now owns 20% of all outstanding Japanese government debt and is buying 70% of all newly issued Japanese bonds. The BOJ hoped that by driving down long-term rates it could encourage Japanese banks to invest and lend more, but bond-hungry regional Japanese banks are still snapping up long-term Japanese bonds, even at 50 basis points of yield. Given the current environment, the Bank of Japan cannot stop its QE program without creating a spike in yields that the government of Japan could not afford. Hence I think it’s unlikely that Japanese QE will end anytime soon, thus putting further pressure on the yen.

The BOJ is going to continue to buy massive quantities of bonds and erode the value of the yen over time in an effort to get 2% inflation.

In a world where populations in developed countries are growing older and are thus more interested in fixed-income securities, yields are going to be challenged for some time. Those planning retirement are going to generally need about twice what would have been suggested only 10 or 15 years ago in order to be able to achieve the same income. Welcome to the world of financial repression, brought to you by your friendly local central bank.

Introducing Tony Sagami

When we first launched Mauldin Economics some two years ago, my partners and I thought there was a need for a good fixed-income letter with a little different style and focus. My very first phone call was to my longtime friend Tony Sagami, to ask if he would write it. I have known Tony for almost 25 years. We have worked together, he has worked for me, and we have been competitors, but we’ve always been good friends.

Even though he now lives in Bangkok most of the year, we still visit regularly by email and Skype, and try to make a point of catching up in some part of the world at least twice a year. In addition to his talents as a writer, Tony brings a seasoned perspective and huge experience as a trader and investor. (Seasoned is a technical term for getting older, having made lots of instructive mistakes in your early years.) He has a way of taking my macro ideas and efficiently and effectively putting them to work. I know Yield Shark subscribers must be happy, because our renewal rates are very high by industry standards.

As I mentioned early in the letter, for contractual reasons we haven’t been able to name Tony as the editor of Yield Shark. I’m really pleased that we can do so now. Tony was recently in Dallas, and we did a short video together so that I could introduce him. You can watch the video and learn more about Tony here. You will soon be receiving information from my partners about a new newsletter that Tony will also be writing, which we are tentatively calling The Rational Bear.

San Antonio, Washington DC, Chicago, and Boston

My respite from travel will be over in a few weeks as I head to the Casey Research Summit in San Antonio, September 17-21. It actually takes place at a resort in the Hill Country north of San Antonio, which is a fun place to spend a weekend with friends. Then the end of the month will see me traveling to Washington DC for a few days.

I'll be back in Dallas in time for my 65^th birthday on October 4, and then I get to spend another two weeks at home before the travel schedule picks back up. I will make a quick trip to Chicago, then swing back to Athens, Texas, before I head on to Cambridge, Massachusetts, for conferences. There are a few other trips shaping up as well.

My time at home has been well spent, as I’m catching up on all sorts of projects, spending more time in the gym, and just enjoying being home. Surprisingly, being at home has allowed me to see more friends than usual as they’ve come through town. Dennis Gartman was in yesterday, and we spent two pleasant hours catching up over lunch. He is one of the truly consummate gentlemen in our business and a bottomless reservoir of great stories. A perfect evening would be Dennis Gartman and Art Cashin holding court at the Friends of Fermentation after the market closes. You’d just sit there and scribble notes.

The other thing about being home is that it makes me want to get on a plane and go see even more friends! Yesterday I caught up with George and Meredith Friedman on the phone, and we realized it has been well over a year since we’ve seen each other, which is unusual for us. I really enjoy them, and they are their own source of endless stories. George and Meredith travel much more than I do, and all over the world at that, doing speeches and research and the like; but we agreed that sometime in October we will make a visit happen, whoever is doing the flying. I think one of the reasons that God made planes was so that friends could see each other more often.

A special hat tip goes to my associate Worth Wray for finding and creating most of the charts for this week. Plus helping me think through the letter. He has been a huge help this last year.
You have a great week and take a friend who tells great stories to lunch. It will do wonders for your outlook on life.

Your still can’t believe negative French interest rates analyst,

The article Thoughts from the Frontline: Europe Takes the QE Baton was originally published at mauldin economics.com.

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Listening to the Canary

By Terry Coxon, Senior Economist

During World War II, the British Royal Air Force (RAF) undertook a plan of misdirection to allow a squadron of bombers to approach an exceptionally valuable target in Europe undetected. The target was so heavily guarded that destroying it would require more than the usual degree of surprise.


Although the RAF was equipped to jam the electronic detection of aircraft along the route to the target (a primitive forebear of radar was then in use), they feared that the jamming itself would alert the defending forces. Their solution was to “train” the defending German personnel to believe something that wasn't true. The RAF had a great advantage in undertaking the training: The intended trainees were operating equipment that was novel and far from reliable; and those operators were trying to interpret signals without the help of direct observation, such as actually seeing what they were charged with detecting.

At sunrise on the first day, the RAF broadcast a jamming signal for just a fraction of minute. On the second day, it broadcast a jamming signal for a bit longer than a minute, also around sunrise. On each successive day, it sent the signal for a somewhat longer and longer time, but always starting just before sunrise.

The training continued for nearly three months, and the German radar personnel interpreted the signals their equipment gave them in just the way the British intended. They concluded that their equipment operates poorly in the atmospheric conditions present at sunrise and that the problem grows as the season progresses. That mistaken inference allowed an RAF squadron to fly unnoticed far enough into Europe to destroy the target.

People will get used to almost anything if it goes on for long enough. And the getting-used-to-it process doesn't take long at all if it's something that people don't understand well and that they can't experience directly. They hear about Quantitative Easing and money printing and government deficits, but they never see those things happening in plain view, unlike a car wreck or burnt toast, and they never feel it happening to themselves.

QE has become just a story, and it's been going on for so long that it has no scare value left. That's why so few investors notice that the present situation of the U.S. economy and world investment markets is beyond unusual. The situation is weird, and dangerously so. But we've all gotten used to it.

Here are the four main points of weirdness:

1. The Federal Reserve is still fleeing the ghost of the dot-com bubble. It was so worried that the collapse of the dot-com bubble (beginning in March 2000) would damage the economy that it stepped hard on the monetary accelerator. The growth rate of the M1 money supply jumped from near 0% to near 10%. This had the hoped for result of making the recession that began the following year brief and mild.

2. A nice result, if that had been all. But there was more. Injecting a big dose of money to inoculate the economy against recession set off a bubble in the housing market. Starting in 2003, the Fed began gradually lowering the growth rate of the money supply to cool the rise in housing prices. That, too, produced the intended result; in 2006, housing prices began drifting lower.
   
   But again, there was a further consequence—the financial collapse that began in 2008. This time, the Federal Reserve stomped on the monetary accelerator with both feet, and the growth of the money supply hit a year-over-year rate of 21%. It's still growing rapidly, at an annual rate of 9%.

3. The nonstop expansion of the money supply since 2008 has kept money market interest close to zero. Rates on longer-term debt aren't zero but are extraordinarily low. The ten-year Treasury bond currently yields just 2.7%; that's up from a low of 1.7%.
   
   The flow of new money has been irrigating all financial markets. In the U.S., stocks and bonds tremble at each hint the Fed is going to turn the faucet down just a little. And it's not just US markets that are affected. When credit in the US is ultra cheap, billions are borrowed here and invested elsewhere, all around the world, which pushes up investment prices almost everywhere.

4. US federal debt management is living on borrowed time. The deficit for 2013 was only $600 billion, down from trillion dollar plus levels of recent years. But this less terrible than before figure was achieved only by the grace of extraordinarily low interest rates, which limit the cost of servicing existing government debt. Should interest rates rise, less than terrible will seem like happy times.

Almost no one imagines that the current situation can continue indefinitely. But is there a way for it to end nicely? For most investors, the expectation (or perhaps just the hope) that things can gracefully return to normal rests on confidence that the people in charge, especially the Federal Reserve governors, are really, really smart and know what they're doing. The best minds are on the job.

If the best minds were in charge of designing a bridge, I would expect the bridge to hold up well even in a storm. If the best minds were in charge of designing an airplane, I would expect it to fly reliably. But if the best minds were in charge of something no one really knows how to do, I would be ready for a failure, albeit a failure with superb academic credentials.

Despite all the mathematics that has been spray-painted on it, economics isn't a modern science. It's a primitive science still weighted with cherished beliefs and unproven dogma. It's in about the same stage of development today that medicine was in the 17th century, when the best minds of science were arguing whether the blood circulates through the body or just sits in the veins. Today economists argue whether newly created cash will circulate through the economy or just sit in the hands of the recipients.

Let's look at the puzzle the best minds now face.

If the Federal Reserve were simply to continue on with the money printing that began in 2008, the economy would continue its slow recovery, with unemployment drifting lower and lower. Then the accumulated increase in the money supply would start pushing up the rate of price inflation, and it would push hard. Only a sharp and prolonged slowdown in monetary growth would rein in price inflation. But that would be reflected in much higher interest rates, which would push the federal deficit back above the trillion dollar mark and also push the economy back into recession.

So the Fed is trying something else. They’ve begun the so called taper, which is a slowing of the growth of the money supply. Their hope is that if they go about it with sufficient precision and delicacy, they can head off catastrophic price inflation without undoing the recovery. What is their chance of success?

My unhappy answer is "very low." The reason is that they aren't dealing with a linear system. It's not like trying to squeeze just the right amount of lemon juice into your iced tea. With that task, even if you don't get a perfect result, being a drop or two off the ideal won't produce a bad result. Tinkering with the money supply, on the other hand, is more like disarming a bomb—and going about it according to the current theory as to whether it's the blue wire or the red wire that needs to be cut means a small failure isn’t possible.

Adjusting the growth of the money supply sets off multiple reactions, some of which can come back to bite. Suppose, for example, that the taper proceeds with such a light touch that the U.S. economy doesn't tank. But that won't be the end of the story. Stock and bond markets in most countries have been living on the Fed's money printing. The touch that's light enough for the U.S. markets might pull the props out from under foreign markets—which would have consequences for foreign economies that would feed back into the U.S. through investment losses by U.S. investors, loan defaults against U.S. lenders, and damage to U.S. export markets. With that feedback, even the light touch could turn out not to have been light enough.

To see what the consequences of economic mismanagement can be, and how stealthily disaster can creep up on you, watch the 30 minute documentary, Meltdown America. Witness the harrowing tales of three ordinary people who lived through a crisis, and how their experiences warn of the turmoil that could soon reach the US. Click here to watch it now.

The article Listening to the Canary was originally published at Casey Research

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What’s the Frequency Zenith?

By Grant Williams

WARNING: This week’s Things That Make You Go Hmmm... is going to run a little longer than usual, I’m afraid, so if you have some time to kill, strap yourself in for the ride.

Yes. I have read it.


For the last couple of weeks those have been the five words I have used the most — by a country mile.

The second most used five word combination during that time has been “I know, what a tool.”

The subject to which the first group of words pertains is, of course, Michael Lewis’s new book, Flash Boys; and the second phrase refers to a certain president of a certain exchange, who made a complete fool of himself during the fierce media debate that has surrounded the book since it burst upon the public consciousness in the space of what ironically felt like a few nanoseconds. (The particular piece to which I refer has to be seen to be believed; but if you somehow missed it, you’ll have your chance. Stick around.)
Now, before we get started, let’s get a few things straight right off the BAT(s).

Firstly, I am an enormous fan of Michael Lewis’s work. I think he is an incredible storyteller with a gift for narrative worthy of a place alongside many modern greats. I have read each of his books and enjoyed them all tremendously. Michael has an ability to weave complex subject matter into a tapestry that can be understood and enjoyed by many who might otherwise find such material utterly incomprehensible.

Secondly, I am no expert in high-frequency trading, but I have had some experience of it in recent years; and I have spent some considerable time analyzing it from a business perspective, which has given me a reasonable understanding of its mechanics.

Thirdly, whilst I have limited direct experience of HFT, I DO have almost thirty years’ hands-on experience of equity, bond, and commodity markets in the US, UK, Singapore, Hong Kong, Australia, and Japan, as well as in another dozen or so countries across Asia Pacific; and having watched markets of all types move in strange ways for seemingly no reason until, a few moments later, the cause of the move revealed itself, I feel I have developed enough of an understanding about how the markets work and, perhaps more importantly, about the people who MAKE them work, to venture an opinion or two about the subjects raised by Michael Lewis in Flash Boys.

But before we get to the book that is on everybody’s Kindle, we’re going to turn to sport for a little lesson. Let’s go back in time to Game 6 of the American League Championship Series between the Boston Red Sox and the New York Yankees in 2004, and recall the actions of another “Flash Boy,” Alex Rodriguez, the Yankees’ star third baseman.

Now, at this point, I’m sure the thousands of non-baseball fans amongst you are tuning out in your droves; but in order to try to keep you engaged, let me also tell you a parallel story from the football (or “soccer,” if you must) 2002 World Cup in South Korea, a tale that features one of its brightest stars of that era, the Brazilian midfielder Rivaldo ... and some decidedly unsavory antics.

Let’s see how we get on with this whole parallel story thing, shall we? I know Michael Lewis would do a phenomenal job of weaving the two stories together. Me? I’m not so sure.....

Deep breath.

In 2002, Rivaldo Vitor Borba Ferreira was a footballer at the very top of the world game. He had helped Brazil reach the final of the 1998 World Cup (where they lost to France), and four years later he was one-third of the renowned “Three Rs,” alongside Ronaldo and Ronaldinho (sadly NOT referred to as “the Two Ronnies”), who spearheaded the dynamic Brazilian team that was rightly installed as the prohibitive favourite to win the trophy that year.

In Brazil’s opening game against Turkey on June 3rd, Rivaldo scored a goal in the 87th minute to give Brazil a 2-1 lead with only three minutes to play, and was on his way to earning the Man of the Match award (think “MVP,” baseball fans). With seconds of added time left, Brazil won a corner, which Rivaldo wandered across the pitch to take at a pace which could, at best, be described as “lacking a degree of urgency.” The ball was at the feet of Turkish defender Hakan Ünsal, who most certainly WAS in a hurry.....

(Cue Michael Lewis-like change of scene to increase the dramatic tension.)

Game 6 of the 2004 ALCS, played at Yankee Stadium on October 19, 2004, had urgency to spare, as the Boston Red Sox, having lost the first three games of the series to their hated rivals from New York, needed a win to tie the series at 3 games each and force a Game 7 decider, which would be played at The Stadium the following night. One more loss and their season was over. (No team had ever come from 3 games down to take a Championship Series.)

The Yankees were led by their talismanic third baseman, Alex Rodriguez, who had almost joined the Red Sox earlier that year after the team had suffered a heart-breaking Game 7 loss in the 2003 ALCS — to whom else but the Yankees — only to have the deal voided at the last minute by the players’ union, a move which opened the door for the Yankees to steal the highest-paid and, at the time, most prolific player in the game from under the noses of the seemingly cursed Red Sox. (You can see how that whole situation played out in the excellent ESPN short documentary The Deal).

Rodriguez had been on a tear in 2004 and would end the season with 36 home runs, 106 RBIs, 112 runs scored, and 28 stolen bases. (Soccer fans, I’d give you a comparison, but there isn’t one. Think: doing everything. Really well.) This made Rodriguez only the third player in the 100+ years of baseball history to compile at least 35 home runs, 100 RBIs, and 100 runs scored in seven consecutive seasons (joining two other players with names that even soccer fans would know [kinda]: Babe Ruth and Jimmie Foxx). (No, NOT the actor who won an Oscar for Ray, soccer fans.)

During the playoffs, Rodriguez had dominated the Minnesota Twins, batting .421 with a slugging percentage of .737. (Soccer fans, let’s face it, baseball owns statistics. You got nuthin’. Nuthin’. Take it from me, Rodriguez was Messi with a bat.) He had also equaled the single game post season record by scoring five runs in Game 3 as the Yankees seized a 3-0 lead.

But in Game 6, Messi with a bat was about to get messy with at-bats as his form deserted him and he found himself at the plate in the 8th inning, facing Red Sox relief pitcher Bronson Arroyo, in the game for starting pitcher Curt Schilling, who had battled heroically through seven innings with a torn tendon sheath in his right ankle.

With the Yankees down 4-2 and team captain Derek Jeter on first base, Rodriguez represented the tying run......

On that steamy night two years prior, in a purpose-built stadium in Korea, Rivaldo stood by the corner flag, hands on his knees, waiting oh so patiently for the clock to run down Ünsal to pass the ball to him. The fans whistled their derision at the Brazilian’s delaying tactics. Sadly, time wasting in such situations is commonplace in football, and though the referees are obliged to add additional seconds to negate these tactics, they seldom do so effectively.

Ünsal was no doubt frustrated at the Brazilian’s gamesmanship and kicked the ball towards him at some pace in an attempt to speed things up.

Rivaldo flinched and tried to turn away from the incoming ball, which struck him roughly two inches above his right knee.

With the linesman (baseball fans, think: third base umpire) standing no more than two or three feet from the Brazilian, Rivaldo collapsed to the ground, clutching hisface as if he had pole axed by the incoming projectile, and writhing around as if every bone in his face had been shattered by the evil Turk.

To the astonishment of everybody in the stands, commentators from over a hundred countries, hundreds of millions of fans around the world, and, above all, Ünsal himself, the Turkish player was shown a red card and sent off (baseball fans, think: ejected) for his “crime.”

Rivaldo, having made a miraculous recovery, took the resulting corner, and Brazil held on against the ten men of Turkey for the victory.

Back in the Bronx, with the count at 2-2 (soccer fans, that’s two balls and two strikes, which means... oh, to hell with it. Baseball is so much trickier to explain. From here on in, you’re on your own), Alex Rodriguez swung his bat, made contact with Arroyo’s pitch, and sent it bobbling down the first-base line. As soon as he hit it, Rodriguez set off in a furious foot race that he had absolutely no chance of winning as he tried to beat the ball to first base. He knew it. We knew it.

Sure enough, Arroyo, with a head start, got to the ball first and took the two or three steps necessary to tag the Yankee with the ball (before he reached first base, which would render him “out” and send him back to the dugout, bringing the Yankee inning closer to an end).

However, as he reached out to tag Rodriguez, the ball spun loose from Arroyo’s glove and bobbled into right field, keeping the play alive and letting Jeter score from second and throw the Yankees a lifeline.

Rodriguez continued to second base, where he stopped, called time out, clapped his hands, and whooped.
Cue pandemonium.

Everybody in the stadium — except the first-base umpire ... and presumably the millions at home — had seen Rodriguez intentionally slap the ball from Arroyo’s glove, a move which in baseball parlance is known as “cheating.” (Soccer fans, think: cheating.)

After a strong protest from Red Sox manager Terry Francona and a lengthy consultation among the various umpires, justice was done. Rodriguez was called “out,” Jeter was returned to second base, and the score remained 4-2.

The Red Sox would go on to win the game and, the following night, become the first team in baseball history to win a series after losing the first three games. They would go on to defeat the St. Louis Cardinals 4-0 in the 100th World Series (soccer fans, think: national championship with no “world” connotation whatsoever) and to vanquish a famous “curse” that had persisted for 86 years.

Now, armed with that background, watch these two defining moments HERE and HERE.
In the aftermath, both players were defiant. Rivaldo, amazingly, tried to paint himself as the victim:

(BBC): Rivaldo had admitted fooling the referee by clutching his face after Ünsal kicked the ball at his leg while he was waiting to take a corner in the closing moments of the Group C match.

But he shrugged off the fine and defended his faking as part and parcel of the game.

The 30-year-old said: “I’m calm about the punishment.

“I am not sorry about anything.

“I was both the victim and the person who got fined.

“Obviously the ball didn’t hit me in the face, but I was still the victim. I did not hit anyone in the face.”

... whilst Rodriguez was, for some reason, “perplexed”:

(NY Times): Alex Rodriguez was standing on second base when the umpires decided that he did not belong there. He folded his hands atop his helmet and screamed, “What?’’

He was, to use his word, perplexed.

After the game, Yankees Manager Joe Torre demonstrated that, when it comes to seeing important plays that go against your team, there is one thing common to both soccer AND baseball: the unreliability of a manager’s eyesight. These guys see EVERYTHING that goes against their team perfectly but somehow always seem to be curiously oblivious when the shoe is on the other foot:

(NY Times): “Randy Marsh was closer than anyone else, and it looked like there were bodies all over the place,’’ Torre said, referring to the fact that first baseman Doug Mientkiewicz was near the play. “There were a lot of bodies in front of me, so I can’t tell you what I saw. I was upset it turned out the way it did for a couple of reasons.”

Presumably neither of those reasons involved the fact that the call was right.

Anyway, the point of these two stories as they pertain to Flash Boys is this:

Both Rodriguez and Rivaldo knew there were dozens of TV cameras on them. They knew there were millions of pairs of eyes on them around the world, and they knew that they were being watched by officials charged with monitoring the games to ensure fairness and punish malfeasance — and yet, knowing all that to be true, they both instinctively cheated to try to gain an edge.

That is how they, as competitors, are wired. Whether it’s right or wrong is irrelevant. (It’s wrong, in case you were wondering.) They were both given a set of rules within which to play, and both chose to step outside those rules in the hope that they would get away with it.

Rivaldo did, Rodriguez didn’t.

It’s a fine line, but the reward for success — even if it does involve bending the rules — is considerable.
Lewis’s media blitz began on Sunday night with an appearance on 60 Minutes, and in answering a simple opening question with a typically florid response, he sparked a media storm the likes of which I haven’t seen in a long, long time.

Steve Kroft: What’s the headline here?

Michael Lewis: Stock market’s rigged. The United States stock market, the most iconic market in global capitalism, is rigged.

Those words sent financial anchors on CNBC and Bloomberg TV into a state of apoplexy at the mere suggestion that the playing field in financial markets is anything but scrupulously fair.

As I watched the circus unpack its tents, erect them, and send a parade of clowns careening into the ring, I was genuinely baffled at what I was seeing.

The first act was Bill O’Brien, the president of BATS (one of the exchanges which, according to Lewis’s book, offers an unfair advantage to high-frequency traders), going toe-to-toe on CNBC with the hero of the book, Brad Katsuyama, once of RBC and now the founder of IEX, an exchange dedicated to leveling the playing field for the average investor.

Until last Sunday, I had never heard of either man, nor had I ever seen them in action.

What followed was extraordinary.

If you haven’t seen the clip, you can (and should) watch it HERE, because excerpts from a transcript cannot do justice to either the defensiveness of O’Brien or the cool confidence of Katsuyama; but from the off, had it been a fight, it would have been stopped before one of the participants embarrassed himself any further:

(CNBC):O’Brien: I have been shaking my head a lot the last 36 hours. First thing I would say, Michael and Brad, shame on both of you for falsely accusing literally thousands of people and possibly scaring millions of investors in an effort to promote a business model.

Bob Pisani (to Katsuyama): You are very respected on the street. I have known you a little while. You are thought very highly of. Do you think the markets are rigged?

Katsuyama (calmly): I think it’s very hard to put a word on it...

O’Brien (animatedly): He said it in the book. You said it in the book. “That’s when I knew the markets were rigged.” It’s disgusting that you are trying to parse your words now. Okay?

Katsuyama (calmly): Let me walk you through an example...

O’Brien: It’s a yes or no question. Do you believe it or not?

Katsuyama (calmly): I believe the markets are rigged.

O’Brien (somewhat triumphantly): Okay. There you go.

Katsuyama (calmly): I also think that you are part of the rigging. If you want to do this, let’s do this.

From there, Katsuyama proceeded to ask O’Brien how his own exchange (the one he, O’Brien, is president of) prices trades:

O’Brien: We use the direct feeds and the SIP (Securities Information Processor) in combination.

Katsuyama: I asked a question. Not what you use to route. What do you use to price trades in your matching engine on Direct Edge?

O’Brien: We use direct feeds.

Katsuyama: No.

O’Brien: Yes, we do...

Katsuyama: You use the SIP.

O’Brien: That is not true.

From there, O’Brien made the most successful attempt to make himself look a fool that I think I have ever seen (and on CNBC, that’s saying something). It was, I thought, painfully embarrassing to watch.
In my head, all I could hear was Sir Winston Churchill’s booming voice:

“Never engage in a battle of wits with an unarmed man.”

Less than 24 hours later...

(Wall Street Journal): BATS Global Markets Inc., under pressure from the New York Attorney General’s office, corrected statements made by a senior executive during a televised interview this week about how its exchanges work.

BATS President William O’Brien, during a CNBC interview Tuesday, said BATS’s Direct Edge exchanges use high-speed data feeds to price stock trades. Thursday, the exchange operator said two of its exchanges, EDGA and EGX, use a slower feed, known as the Securities Information Processor, to price trades.

Viva El Presidente!

Anyway, the interesting thing to me, once I got past the sheer insanity of it all, was the level of amazement shown by the CNBC journalists that the market could possibly be “rigged” in any way, shape, or form.
That amazement was shared by the two anchors on Bloomberg’s Market Makers show, Stephanie Ruhle and Eric Schatzker, when their turn came to take a tilt at Lewis the following day:

Ruhle (bewildered): The market is rigged? That’s a big claim!

Lewis (even more bewildered): Well it IS rigged. If you read the book, I don’t think you’d put it down and say the market’s not rigged.

Then, after a pretty good casino analogy that was interrupted by the anchors a few times, Lewis got to the crux of the issue that had been bothering me as I watched:

Lewis: Why are you so invested in the idea this is fair? Why are you even arguing about this? It’s so clear... people are front-running the market. There’s plenty of evidence in the book.

Schatzker: Their orders are being “anticipated.”

Lewis (laughing at the escalating absurdity): Anticipated and run in front of.... [The HFTs] PAY to execute the orders. Tens of millions of dollars a year. Ask yourself THAT question. Why would ANYONE pay for the right to execute someone else’s stock market order?... It’s quite obvious. That order is an opportunity to exploit, because he has advance information about the pricing in the stock market. Is that “fair”?

Ruhle: Today, when I go to execute a stock, I feel like, man, how did that get jacked right in front of me, every time? I do feel that way. But fifteen years ago when I did a trade, I was paying significantly more to do it through a specialist because of what the fees were.... Is it a different situation than when specialists were on the floor?

Lewis (with a somewhat confused look on his face): I never said THAT.

Ruhle: So has the system ALWAYS been rigged?

Lewis: Yes.

Yes.

After watching these exchanges, I was so astounded that so many people could STILL live in a complete fantasy world under the illusion assumption that the markets couldn’t possibly be rigged that I turned to my friends in the Twittersphere:

That was the 2,567th tweet I have sent out and, in contrast to the nearly pathological indifference shown by the rest of the world to the previous 2,566, this one was retweeted 96 times. (Button it, Bieber! That’s an impressive number for me, OK?)

But who are these people who believe in unicorns and rainbows fair markets?

Click here to continue reading this article from Things That Make You Go Hmmm… – a free weekly newsletter by Grant Williams, a highly respected financial expert and current portfolio and strategy advisor at Vulpes Investment Management in Singapore.

The article Things That Make You Go Hmmm: What’s the Frequency Zenith? was originally published at Mauldin Economics

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Why Gold Is Falling and a Gold Forecast You May Not Like

The bitter truth about what may happen to gold is not all that exciting and likely don’t want to know, but you need to understand what is unfolding as we speak…..

Long story short, the prices of bonds look as though they are about to rally once again. Mounting fears of a stock market correction has money flowing into bonds which in turn will drive interest yields lower yet gain.

But the BIG PICTURE of what he FED said the other week about how they plan to raise rates in 2015 and cut QE down to $55 billion per month hurts the long term outlook for gold.

This news may not sound that important, it actually is and undermines the price of miners, silver and gold in a big way. Find out why gold is falling and the threat that could trigger a much larger meltdown in the long run with my gold forecast video.



Chris Vermeulen
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Hedge Fund Trader Seth Klarman: QE Stimulus Bubble Will Burst

Major hedge fund trader says the QE stimulus bubble will burst.... at some point

In his letter to investors, Seth Klarman noted that “most” investors are downplaying risk and this “never turns out well,” noting that most people are not prepared for anything bad to happen. “No one can know what the future holds, but any year in which the S&P 500 jumps 32% and the NASDAQ Composite 40% while corporate earnings barely increase should be cause for concern, not further exuberance,” Seth Klarman’s investor letter said. “It might not look like it now, but markets don’t exist simply to enrich people.”

Noting that stock markets have risk and are not guaranteed investments may seem like an obvious notation, but against today’s backdrop of never before witnessed manipulated markets Seth Klarman sagely notes “Someday, financial markets will again decline. Someday, rising stock and bond markets will no longer be government policy. Someday, QE will end and money won’t be free. Someday, corporate failure will be permitted. Someday, the economy will turn down again, and someday, somewhere, somehow, investors will lose money and once again come to favor capital preservation over speculation. Someday, interest rates will be higher, bond prices lower, and the prospective return from owning fixed-income instruments will again be roughly commensurate with the risk.”

When will this happen? “Maybe not today or tomorrow, but someday,” he writes, then starts to consider what a collapse might look like. “When the markets reverse, everything investors thought they knew will be turned upside down and inside out. ‘Buy the dips’ will be replaced with ‘what was I thinking?’ Just when investors become convinced that it can’t get any worse, it will. They will be painfully reminded of why it’s always a good time to be risk-averse, and that the pain of investment loss is considerably more unpleasant than the pleasure from any gain. They will be reminded that it’s easier to buy than to sell, and that in bear markets, all to many investments turn into roach motels: ‘You can get in but you can’t get out.’ Correlations of otherwise uncorrelated investments will temporarily be extremely high. Investors in bear markets are always tested and retested. Anyone who is poorly positioned and ill prepared will find there’s a long way to fall. Few, if any, will escape unscathed.”

Seth Klarman’s focus on Fed

Seth Klarman then once again turned his sharp rhetorical knife to the academics that run the US Federal Reserve who seem to think that controlling free markets is a matter of communications policy.

“The Fed, in its ongoing attempt to tamp down market volatility as much as possible decided in 2013 that its real problem was communication,” Seth Klarman dryly wrote. “If only it could find a way to communicate to the financial markets the clarity and predictability of policy actions, it could be even more effective in its machinations. No longer would markets react abruptly to Fed pronouncements. Investors and markets would be tamed.” The Fed has been harshly criticized by professional traders for its lack of understanding of real world market mechanics.

This lack of understanding is a concern given that the Fed is taking the economy into uncharted territory with unprecedented stimulus. “As experienced traders who watch the markets and the Fed with considerable skepticism (and occasional amusement), we can assure you that the Fed’s itinerary is bound to be exceptional, each stop more exciting than the one before,” Seth Klarman wrote, sounding a common theme among professional market watchers. “Weather can suddenly turn foul, the navigation faulty, and the deckhands hard to understand. In short, the Fed captain and crew are proficient in theory but lack real world experience. This is an adventure into unexplored terrain, to parts unknown; the Fed has no map, because no one has ever been here before. Most such journeys end badly.”

While the mainstream media is loaded with flattering articles of the Fed’s brilliance in quantitative easing and its stimulus program, the real beneficiaries of such a policy are the largest banks. Here Seth Klarman notes they have placed the economy at great risk without achieving much reward. “Before 2009, the Fed had never bought a single mortgage bond in its nearly 100-year history,” Seth Klarman writes of the key component of the Fed’s policy that took risky assets off the bank’s balance sheets. “By 2013, the Fed was by far the largest holder of those bonds, holding over $4 trillion and counting. For that hefty sum, GDP was apparently raised as little as 25 basis points in the aggregate. In other words, the policy has been a near-total failure. Bernanke is left arguing that some action was better than none. QE in effect, had become Wall Street’s new ‘too big to fail’ policy.”

Seth Klarman: What do economists know?

There has been considerable discussion that the academic side of the economics profession has little clue how markets really work. Economic academics, who now make up the majority of the Fed governors, often look at the world from the standpoint of a game of chess, where one can explore different options and there is now a “right” or “wrong” approach to market manipulation.

“The 2013 Nobel Memorial Prize in economics was shared by three academics: two were proponents of the efficient market hypothesis and the third was a behavioral economist, who believes in market inefficiency,” Seth Klarman wrote. “We suppose that could be considered a hedged position for the awards committee, one that would never occur in the hard sciences such as physics and chemistry, where a prize shared among three with divergent views would be an embarrassing mistake or a bad joke. While a Nobel Prize might well be the culmination of a life’s work, shouldn’t the work accurately describe the real world?”

Another interesting insight on the topic was to come from David Rosenberg, Chief Economist and Strategist at GluskinSheff, who recently wondered “[A]m I the only one to find some humour, if not irony, in the fact that the three U.S. economists who won the Nobel Prize for Economics did so because they ‘laid the foundation for the current understanding of asset prices’ at the same time that these asset prices are being determined less today by market-determined forces but rather by the distorting effects of the unprecedented central bank manipulation?”

Seth Klarman: Fed Created Truman Show Style Faux Economy

Baupost Group, among the largest hedge funds in the world, returned $4 billion in assets to clients at the end of 2013 because it didn’t want to grow too quickly and dilute performance. Klarman’s fund, which in 2013 had a high of 50% of his portfolio in cash, up from 36% in 2012, posted 2013 returns in the mid-teens consistent with the fund’s nearly 22 year track record.

Seth Klarman on Baupost’s returns

Saying the fund “drew a line in the sand” when it decided to return roughly $4 billion to clients at year end, Seth Klarman reflected on the decision, saying he wanted to control the fund’s head count, noting “we could not allow the firm to grow without limit. We are wise enough to know a good thing when we see it, and cautious enough to want to cherish, protect and nurture it so that we might maintain its essential qualities for a very long time.” A 50% cash position for a hedge fund might be construed as an indication the fund has grown to the point it was having difficulty allocating all the capital in appropriate trades.

He noted the 2013 performance occurred “despite the drag of large, zero yielding cash balances throughout the year.” Klarman, author of Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor, said the performance resulted from “considerable progress in event driven and private situations, and at least some uplift from the strong equity rally. Distressed debt, public equities, structured products, and real estate led the gains.” Tail risk hedges, the only material area of loss in the portfolio, cost approximately 0.2% as the fund reduced exposure to distressed debt, structured products, and private investments while public equity exposure increased modestly.

Market bifurcation {the basis for being bullish on equities}

In 2013 Seth Klarman noted the market bifurcation, which he describes as “a momentum environment of market haves (which we avoid spending time on) and have-nots (which receive our undivided attention) – coupled with our energetic sourcing efforts and valued long-term relationships,” and he expressed optimism for the fund in 2014 amidst what might be a stock market subject to individual interpretation. “In the face of mixed economic data and at a critical inflection point in Federal Reserve policy, the stock market, heading into 2014, resembles a Rorschach test,” he wrote. “What investors see in the inkblots says considerably more about them than it does about the market.”

Seth Klarman noted that those “born bullish,” those who “never met a stock market they didn’t like” and those with “a consistently short memory,” might look to the positives and ignore the negatives. “Price-earnings ratios, while elevated, are not in the stratosphere,” he wrote, stating the bull case. “Deficits are shrinking at the federal and state levels. The consumer balance sheet is on the mend. U.S. housing is recovering, and in some markets, prices have surpassed the prior peak. The nation is on the road to energy independence. With bonds yielding so little, equities appear to be the only game in town. The Fed will continue to hold interest rates extremely low, leaving investors no choice but to buy stocks it doesn’t matter that the S&P has almost tripled from its spring 2009 lows, or that the Fed has begun to taper purchases and interest rates have spiked. Indeed, the stock rally on December’s taper announcement is, for this contingent, confirmation of the strength of this bull market. The picture is unmistakably favorable. QE has worked. If the economy or markets should backslide, the Fed undoubtedly stands ready to once again ride to the rescue. The Bernanke/Yellen put is intact. For now, there are no bubbles, either in sight or over the horizon.

Seth Klarman’s market analysis

Like many of the best market analysts, Seth Klarman looks at both sides of the issue, the bull and bear case, in depth. “If you’re more focused on downside than upside, if you’re more interested in return of capital than return on capital, if you have any sense of market history, then there’s more than enough to be concerned about,” he wrote. Citing a policy of near-zero short-term interest rates that continues to distort reality and will have long term consequences, he ominously noted “we can draw no legitimate conclusions about the Fed’s ability to end QE without severe consequences,” a thought pervasive among many top fund managers. “Fiscal stimulus, in the form of sizable deficits, has propped up the consumer, thereby inflating corporate revenues and earnings. But what is the right multiple to pay on juiced corporate earnings?”

As he outlined the bear case, he started to divulge his own analysis that “on almost any metric, the U.S. equity market is historically quite expensive. A skeptic would have to be blind not to see bubbles inflating in junk bond issuance, credit quality, and yields, not to mention the nosebleed stock market valuations of fashionable companies like Netflix, Inc. and Tesla Motors Inc.

As it turns out he was just warming up. “There is a growing gap between the financial markets and the real economy,” Seth Klarman wrote, noting that even as the Fed promised that interest rates would stay low, they did get out of control to some degree across the yield curve in 2013. “Medium and long­term bond funds got hammered in 2013. Meanwhile, corporate earnings sputtered to a mid-single digit gain last year even as stocks drove relentlessly higher, without even a 10% correction in the last two and a half years,” a concern among many professional traders.

When it comes to stock market speculation and jumping on the bull market happy talk, Seth Klarman notes it’s never hard to build a “coalition of willing” who are willing to climb on the bandwagon. “A flash mob of day traders, momentum investors, and the usual hot money crowd drove one of the best years in decades for U.S., Japanese, and European equities,” he wrote. “Even with the ranks of the unemployed and underemployed still bloated and the economy barely improved from a year ago, the S&P 500 , Dow Jones Industrial Average 2 Minute, and Russell 2000 regularly posted new record highs.”

Seth Klarman noted that whether you see today’s investment glass as half full or half empty depends on your age and personality type, as well as your “lifetime” of experiences. “Our assessment is that the Fed’s continuing stimulus and suppression of volatility has triggered a resurgence of speculative froth,” while citing numerous examples of overvalued internet stocks that defied value investing logic.

“In an ominous sign, a recent survey of U.S. investment newsletters by Investors Intelligence found the lowest proportion of bears since the ill-fated year of 1987,” he wrote. “A paucity of bears is one of the most reliable reverse indicators of market psychology. In the financial world, things are hunky dory; in the real world, not so much. Is the feel-good upward march of people’s 401(k)s, mutual fund balances, CNBC hype, and hedge fund bonuses eroding the objectivity of their assessments of the real world? We can say with some conviction that it almost always does. Frankly, wouldn’t it be easier if the Fed would just announce the proper level for the S&P, and spare us all the policy announcements and market gyrations?” he said in a somewhat hilarious moment that bears a degree of truth.

Seth Klarman on Europe

Seth Klarman still isn’t much of a bull in Europe, as we noted in a previous ValueWalk. “Europe isn’t fixed either, but you wouldn’t be able to tell that from investor sentiment,” he noted. “One sell-side analyst recently declared that ‘the recovery is here,’ a sharp reversal from his view in July 2012 that Greece had a 90% chance of leaving the Euro by the end of 2013. Greek government bond prices have nearly quintupled in price from the mid-2012 lows. Yet, despite six years of painful structural adjustments, Greece’s government debt-to-GDP ratio currently stands at 157%, up from 105% in 2008,” he said, noting a growing concern among fund managers regarding the government debt crisis getting out of hand.

Seth Klarman noted that Germany’s own government debt-to-GDP ratio stands at 81%, up from 65% in 2008, and said “That doesn’t look fixed to us.” The EU credit rating was recently reduced by S&P, he noted, while European unemployment remains stubbornly above 12%. “Not fixed,” he said. “Various other risks lurk on the periphery: bank deposits remain frozen in Cyprus, Catalonia seems to be forging ahead with an independence referendum in 2014, and social unrest continues to escalate in Ukraine and Turkey. And all this in a region that remains saddled with deep structural imbalances. As Angela Merkel recently noted, Europe has 7% of the world’s population, 25% of its output, and 50% of its social spending.” While he notes the problems in Europe, Seth Klarman did not rule out that opportunity might be found in the region.

Seth Klarman on Bitcoin

Seth Klarman also weighed in on Bitcoin, noting that “Only in a bull market could an online ‘currency’ dubbed bitcoin surge 100-fold in one year, as it did in 2013. Now most sell-side firms are rushing to provide research on this latest fad,” he also noted that while “bitcoin funds” are being formed, the fund is “happy to let pass us by, the thinking behind cryptocurrencies may contain a kernel of rationality. If paper currencies – dollars and yen – can be printed in essentially unlimited volumes, and just as with all currencies are only worth what recipients on any given day will exchange in goods or services, then what makes them any better than the “crypto” kind of money?”

Comparing the economy and the Federal Reserve’s management of it to the movie The Truman Show, where the lead character lived in a false, highly-orchestrated environment, Seth Klarman notes with insight, “Every Truman under Bernanke’s dome knows the environment is phony. But the zeitgeist is so damn pleasant, the days so resplendent, the mood so euphoric, the returns so irresistible, that no one wants it to end, and no one wants to exit the dome until they’re sure everyone else won’t stay on forever.” Then he quotes Jim Grant who recently noted on CNBC, the problem is that “the Fed can change how things look, it cannot change what things are.”

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The article Outside the Box: Seth Klarman: Investors Downplaying Risk “Never Turns Out Well” was originally published at Mauldin Economics.

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