STORMS OVER MANHATTAN

Traditionally, stocks were valued at about ten times earnings. With high margin trading, earnings on shares, only one or two percent, were far less than the eight to ten percent interest on loans used to buy them. This meant that any profits were in capital gains alone. Thus, Radio Corporation of America, which had never paid a dividend at all, went from 85 to 410 points in 1928. By 1929, some stocks were selling at 50 times earnings. - The Great Depression, John Kenneth Galbraith

It was the end of November, where I found myself looking out from my hotel located on the Hudson River in Jersey City at the expanse of what was Downtown Manhattan. Only six weeks earlier I was staying in Hell's Kitchen itself where I remember being captivated by the congestion, the overpriced and by no means oversized hotel rooms; garbage piled up on the sidewalks, displays of public urination in Washington square, rats frolicking in the iconic Central Park and the sheer size of what was a truly larger than life city. Standing on the shore of the Hudson river looking back presented a far rosier picture than what was the reality of NYC. While Jersey City would have long ago been developed as prime real estate in Australia as a quiet, peaceful and picturesque place within a stone's throw from the world's economic centre, from what I could glean by asking the locals, many American's considered Jersey as the Big Apple's poor neighbour.

Like most Australian's I couldn't imagine much better than living in the quiet, and peaceful Jersey City and trekking back and forth to-and-from NYC each day for what would presumably be some gloriously respectable high-end job, but countless Americans seemed to opt for living in the midst of the chaos that was The City of Dreams. As I considered the perplexing reality of the relative underdevelopment of Jersey City, I came to realise that many Americans are fundamentally different to Australians in that they have ingrained into them the culture of the bull.

Ostentation entwined with limitless novelty form the distractions that define the Manhattan landscape that seeks to meet the covetous yet ambitious have-not-yets with the flamboyant haves, which, without a doubt was a driving factor that propelled the city in the early 20th century to the top of financial prominence and the reality is that as individuals only get to the top of their respective dominance hierarchies, their games, by fighting for it, cities and nations also only get to the top by outcompeting all others.

The core characteristic that makes NYC the centre of the financial world is the fact that the people living there are hungry, bullish, brave and willing to tackle risk for the promise of gains and through the invisible hand of the new digitised financial economy, decisions made in NYC by a relative few have come to shape the lives of a lot.

In 2008 the aggregated financial sins of the bulls in this glorious city unravelled the world's economy. The sheer destructive forces unleashed on the unsuspecting world have left the global economically largely crippled ever since. However, in a way, it wasn’t the fault of the bulls themselves. Cattle are gloriously simple creatures so much so that the only things less cognitively blessed than an individual cow, is 1. A herd of cattle, 2. Any number of sheep and 3. The combined intelligence of just about all politicians. Cattle will go anywhere so long as there are presumably greener pastures, and cattle will believe that they are safe so long as they are part of a herd. Politicians will, on the other hand, believe that they are safe so long as they are hidden behind a vain smile and a pithy statement while sheep will believe they are safe so long as they are following other sheep.

The GFC was caused by the sheepish 'many', following their neighbours on the dream to better housing combined while certain bulls charged after obscene returns. But, ultimately the fault rested on those who controlled the gates and the pens and the access to the pastures, the politicians.

Through the breakdown of the ever-precious risk-return relationship that usually causes any decent investor that has skin in the game to take pause, the bulls were left to charge off in all the wrong directions ultimately tearing the farm apart. The policies of these all so wise politicians rested on the belief that more houses = better… whatever the cost. The removal of Glass-Stegall under Clinton, combined with Bush’s seemingly virtuous affordable housing plans that drove up subprime lending, partially fuelled by Fannie Mae and Freddie Mac, meant that the landscape was set for the most brutal economic blood bath since 1929.

The role of governments in markets, according to the classical liberal perspective, should primarily be based around protecting both the buyers and sellers against fraud, predatory behaviour, and ultimately market failures. The policies that shaped the financial world from Clinton to Bush worked in the opposite meaning that fraud, predatory lending, and financial shamanism flourished around these seemingly altruistic goals of ensuring homeownership which ironically forced many ‘sheep’ towards foreclosure on their mortgages and encouraged many bulls to get 'creative' as to how they handled their personal risk and exposure.

While the bulls would always be bulls and while the sheep would always be sheep, the responsibility for the failures that resulted in the GFC in this overused farming metaphor, shouldn’t fall on Wall Street, on the City of Dreams as we all know that the dog-eat-dog world of NYC would force the bulls to chase whatever profits the rules would allow them to pursue, but rather the responsibility should have fallen on those entrusted with the responsibility of the farm residing 227 miles south-west of the Big Apple. Washington’s stupidity and corruption lead to New York’s sins, which further corrupted and always will corrupt Washington where the main failure of any capitalistic system is, and always will be, its propensity to become less capitalistic overtime.

The Rain will come…

From late 2016 through to 2019 much of Australia, and especially an area known as New South Wales, experienced one of its most severe droughts in recorded history. The region where I live, was appropriately named “The New England”, largely because of the reminiscent rolling green hills and distinct four seasons iconic of the ‘old’ England. But, between 2016 to 2019, this name became highly inappropriate as the once rolling green hills were replaced with dust. Trees everywhere of every size died, lawns disappeared, and entire cities were on the verge of running out of drinking water.

The enormous cost on regional communities could not have been overstated, however, inarguably the worst hit, were the farmers. Farmers who didn’t sell off their stock early into the drought faced the prospects of either selling the stock late at an immense loss or trying to ride out the drought which all the talking heads, all the so-called ‘experts’ were saying could have gone on-and-on.

The problem, of course, is that when a farmer chose to ‘ride-out-the-drought’, the increasing amounts of debt that they accumulated would start to compound. Every day that they chose not to sell up, meant one more day that they would have to outperform in the future… too often it was a process of digging down at an increasingly fast rate in the hope that one day they would be able to finally dig up. This, of course, continues until the banks say no more and farms that may have been owned by families for generations would be sold off.

Globally Governments have been digging down since 2008

When the GFC struck the world’s financial system, one thing became evident, the returns that were promised to financial systems globally would never be fulfilled as the promised greener pastures turned out to be built on a housing bubble fuelled by bad Wall Street financial instruments enabled by bad Washington policies. But when the promises of future returns aren’t fulfilled, someone somewhere must assume the loss. Just as the farmers ended up sacrificing the family farm when the rain doesn’t come, so the investment banks and insurance agencies who were quickly running their balance sheets into the red, faced the prospect of liquidation. However, unlike the Australian farmer, the underlying value of the investment banks books during the GFC was, initial-asset-value to initial-asset-value, worth less than the typical Auzzie farm that held some promise of future rain, and also unlike the small family farmer, the banks were simply too big for the government to allow to fail.

The repercussions of this financial mismanagement that was fuelled by the political and economic mismanagement was that the bill came due and the only ones left to pick up the tab were those who didn’t participate in the gamble in the first place namely-the savers and the tax-paying middle class - the same middle class who ultimately bears the majority of the burden for all taxes - government programs, bailouts, and social welfare programs.

One of the problems with the US mortgage-backed securities was that they were considered a safe asset class at the peak of the housing market leading up to 2007 and as a result, they worked their way around the entire world into just about every portfolio imaginable in one form or another. When the recognised value of this asset class started to fall, it took with it personal and bank portfolios, mortgage funds, super funds, while the sudden deterioration of the asset class forced many players into a firesale as investors and banks alike tried to stem the flow of red ink and limit their exposure which further deteriorated the market value for the securities.

In order to combat the rapidly deteriorating and catastrophic impacts, the Federal Reserve Bank bought trillions of dollars’ worth of these assets at an earlier market rate with cash that previously didn’t exist through a process known as ‘Quantitative Easing’, effectively bailing out the bulls, and bailing out the markets from a disaster that was caused by Washington. The primary problem with this outcome is that governments and central banks cannot borrow their way into growth nor can they print their way into growth they can only direct and delay the burden created by the initial missmanagement. When a business takes a loan to invest in new capital, human expertise, or technology, productivity growth can follow. When governments borrow huge amounts to prop up a failing economy, they may just be propping up the very broken businesses and practices that the Darwinistic-invisible hand of capitalism tried to eradicate in the first place. And, when central banks make interest rates effectively zero for extended periods of time to help sustain the gross overspending of these governments, companies tend to stop investing in capital, expertise, and R&D both due to profitability being easier to attain through the flow-on effects of expansionary monetary policies and through the impacts of expansionary fiscal policy 'crowding out' private investment. In other words, as the demand for capital goods falls, demand for skilled labour falls. This means that the inflationary effects, that would naturally come from the pursuit of wealth, are undermined by the very actions that the government used to stop the crash in the first place. More than that, the flow of cheap cash ever since 2008 has meant that financialization, has exploded and businesses are more in debt now than they've ever been.

US corporate bonds held by mutual funds 2001-2019:

As I've noted in earlier blogs, wealth cannot be printed. Real wealth is ultimately measured in available 'utility' or 'opportunities'. For example, a 'billionaire' in the inflation riddled Zimbabwe typically has less opportunity in terms of schooling, real estate, and healthcare than a middle-class American. Hence when governments make currency out of nothing, they don't create wealth, they simply change the distribution of opportunity between buyers and sellers in that given economy and when the economic system as a whole carries a relatively high degree of leverage when compared to production, governments will, historically, act to redistribute the burden of that leverage from the borrower back onto the saver effectively taking the savers' 'money' and giving it to the borrower whether this is through bankruptcy protection laws or through money printing. And, while the efforts under the Bush, Obama, and Trump administrations have, arguably, worked to maintain the solvency of the corrupted 'bull' organisations, the government itself has built a portfolio of debt that will never be repaid. Easy monetary policy, huge bailouts and the excessive government borrowing has driven the United States into the greatest public and private debt bubble in the history of the country.

The graph below shows the total federal debt in nominal figures.

The first problem with the graph above is that it is so underwhelming to most individuals. While most people can grapple with the concept of a few thousand dollars, the concept of the 'trillion' is simply beyond the comprehension of almost all but the most adept of mathematicians and hence it needs to be given some context. For example, if you were to earn one dollar every second, it would take you only 12 days before you became a millionaire, but to become a billionaire, it would take you 32 years. However, to have a trillion dollars, it would take you over 32,000 years. If an individual who was earning $1 every second attempted to pay off his Federal debt in the above graph as the debt currently stands, not factoring in interest or the fact that this debt will continue to grow at an increasingly fast rate, it would take that individual 800,000 years.

The second problem with this graph is that it's just plain wrong, it's wrong so much so that the US government is really closer to $200 trillion dollars in debt than $20 trillion. The old saying goes that there are 3 types of lies being: lies, damn lies, and statistics, really need to be amended to "lies, damn lies, statistics, and accounting". If a debt is simply defined as "money that is owed to someone"1, then you can't count the US debt without factoring in both state, local, and federal unfunded and underfunded liabilities. Through accounting smoke and mirrors, huge portions of the US government's liabilities, usually in the form of government pensions and healthcare obligations, aren't funded at the time of undertaking the obligations. Through this creative accounting, governments have found their convenient way of buying votes on the promise that future administrations will have to pay for their promises. The estimates of how large the US unfunded and underfunded obligations range from stupid to insane and they represent the failure of democratic institutions as we know it as this intergenerational theft has become common accounting practice amongst governments globally. Using our previous example of an individual earning $1 every second, or $12 million dollars every 12 days, it would take an individual 6.4 million years to pay off this amount of money.

In the 1970's, Australia's then Prime Minister Gough Whitlam went through the process of creating significant changes to how superannuation and pensions would be funded for military and government personal where the obligation would only fall due when the employee retired meaning that instantly the government's present financial obligations were alleviated at the cost of future administrations and generations in what can only be called blatant intergenerational theft. No extra provisions would be made for these obligations until the Howard government in the mid-2000s.

Governments globally have been pulling this trick in racking up charges on the credit cards of future generations to such an extent that the only feasible political outcome will be that governments will have to destroy the burden of these obligations through quantitative easing. Governments will use unimaginable amounts of money printing to meet their future obligations as they already have been since 2008, that is except for the European states that don't have control over their own monetary policy. Ultimately, we have a situation when a political problem has created a mathematical problem that will create an economic problem that will further create bigger and bigger political and social problems. The fault for this economic time bomb is that of the politicians... and the voters who put them in power. The long-run repercussions for this financial mismanagement by governments globally will be a future that's defined by unfulfilled promises through the destruction of the value of fiat currencies. What this future will look like exactly, I don't know and I don't know if anyone else does, but I'm certain that the traditional investment doctrine of the 20th century won't be true for the early 21st century.

The Buffet Indicator and the Ugly Divorce 

A market boom based entirely on capital gains is merely a form of pyramid selling. - The Great Depression, John Kenneth Galbraith

One of the most interesting graphs that I think anyone in finance can ever come across would have to be the "Buffet Indicator". This simple graph plots the total market capitalisation of 3500 US stocks against the US GDP.

The US in the 1990s saw the rise of one of the wost bubbles since the Great Depression. Speculations abounded as the dot.com bubble grew and once again the hype inflated the nominal economy while the fundamentals, the underlying economic performance only crawled forward. What inevitability happened was that the fundamentals caught up and the Buffet indicator clearly showed that the marvel that was the internet, wasn't as much of a miracle as what was originally thought. The market corrected but not all the way as the Federal Reserve jumped in to save the failing economy with cheap money, which propped up and saved speculators from bearing the full brunt of their gamble. As Americans were burnt from the speculative stocks that failed them, attention then poured into the housing market and as we saw earlier, the poor regulatory policies combined with government policies that distorted the market, inflated the housing bubble to unimaginable proportions while once again, as with the dot.com bubble, the fundamentals struggled. When that bubble failed, the US entered a period of the easiest monetary policy in history and a decade on we aren't bubbling less now... the Buffet Indicator, PE ratios, and the inverted US government yield curves all converge on this point. But the question is: what bubble are we now in? Based on these indicators, stocks are high, real estate around the globe high, and both public and private debt for non-investment assets are obscenely high. This time the Storms are forming not only over Wall Street, this time they're everywhere.

Like we said earlier, 'sheep'/'voters', will go anywhere they believe to be greener pastures. Politicians have always promised more than they can deliver in terms of spending to buy the votes of the sheep and in a real way, the failure of the government's books, are the responsibility of those who have continued to vote them into power.

‘Well, we are right back at it: trying to stimulate growth through easy money. It hasn’t worked, but it’s the only tool the Fed’s got. Meanwhile, the Fed’s policies widen the wealth gap, which feeds political extremism, forcing gridlock in Washington. It seems the world is headed toward negative real interest rates on a global scale. This is toxic. Interest rates are used to price risk, and so in the current environment, the risk-pricing mechanism is broken. That is not healthy for an economy. We are building up terrific stresses in the system, and any fault lines there will certainly harm the outlook.’ – Michael Burry.

But, unfortunately, the distribution of this information seems to be asymmetric as "The wealthy investors who constitute Tiger 21, a group with more than 750 members worth in excess of $75 billion, raised their cash positions last year to 12% of their diversified portfolio, a level not seen since 2013."2. It seems like every top-performing investor and hedge fund are getting ready for the next correction while the 'dumb money' keeps pouring into this 30-year pyramid scheme. The next collapse isn't going to be like 2007-08, it's going to be far worse as the stakes are so much higher.