Showing posts with label Mauldin Economics. Show all posts
Showing posts with label Mauldin Economics. Show all posts

Sunday, January 3, 2016

A Half Dozen 2016 Stock Market Poisons

By Tony Sagami

Most of the “adults” on Wall Street are on vacation this week, and trading volume shrivels up to a trickle. That low volume is exactly the environment that the momentum crowd uses to paint the tape green. I call it the financial version of Reindeer Games.

However, once the “adults” return, the stock market will need to pay attention to the actual economic fundamentals and deal with facts—like, 2015 being the first year since 2009 when S&P 500 profits declined for the year.


I expect that 2016 is going to be a very difficult year for the stock market. Why do I say that? For any number of reasons, such as:

Poison #1: The Strong US Dollar

The greenback has been red hot. The US dollar index is up 9% in 2015 after gaining 13% in 2014.
A strong dollar can have a dramatic (negative) impact on the earnings of companies that do a significant amount of business outside of the US—for example, Johnson & Johnson, Ford, Yum Brands, Tiffany’s, Procter & Gamble, and hundreds more.


Poison #2: Depressed Energy Prices

I don’t have to tell you that oil prices have fallen like a rock. That’s a blessing when you stop at a gas station, but the impact on the finances of petro dependent economies, including certain US states, has been devastating. Plunging energy prices are going to clobber everything from emerging markets to energy stocks, to states like North Dakota and Texas.


Poison #3: Junk Bond Implosion

You may not have noticed because the decline has been orderly, but the junk bond market is on the verge of a total meltdown.


Third Avenue Management unexpectedly halted redemption of its high-yield (junk) Focused Credit Fund. Investors who want their money… tough luck. The investors who placed $789 million in this junk bond fund are now “beneficiaries of the liquidating trust” without any idea of how much they will get back and or even when that money will be returned. Third Avenue admitted that it may take “up to a year” for investors to get their money back. Ouch!

The problem is that the bids of the junkiest part of the junk bond market have collapsed. For example, the bonds of iHeartCommunications and Claire’s Stores have dropped 54% and 55%, respectively, since June!
What the junk bond market is experiencing is a liquidity crunch, the financial equivalent of everybody trying to stampede through a fire exit at the same time. In fact, the International Monetary Fund (IMF) warned that blocking redemptions could lead to an increase in redemption requests at similar funds.


Poison #4: Rising Interest Rates

As expected, the Federal Reserve hiked interest rates at its last meeting. The reaction (so far) hasn’t been too negative; however, we may have several more interest rate hikes coming our way.


Every single one of the 17 Federal Reserve members expects the fed funds rate to increase by at least 50 bps before the end of 2016, and 10 of the 17 expect rates to rise at least 100 bps higher in the next 12 months. I doubt our already struggling economy could handle those increases.


Poison #5: Government Interference

Sure, 2016 is an election year, which brings uncertainty and possibly turmoil. But the Obama administration could shove several changes down America’s throat via executive action—such as higher minimum wage, limits on drug pricing, gun control, trade sanctions including tariffs, immigration, climate change, and increased business regulation.


I don’t give the Republican led Congress a free pass either, as I have no faith that it will put the best interests of the US ahead of its desire to fight Obama.


Poison #6: China Contagion

We do indeed live in a small, interconnected world, and it’s quite possible that something outside of the US could send our stock market tumbling. Middle East challenges notwithstanding, the one external shock I worry the most about is one coming from China. The sudden devaluation of the yuan and the significant easing of monetary policy by the People’s Bank of China are signs that trouble is brewing.


However, I think the biggest danger is an explosion of non-performing loans in China. Debt levels in China, both public and private, have exploded, and I continue to hear anecdotal evidence that default and non-performing loans are on the rise.


Conclusion

To be truthful, I have no idea which of the above or maybe even something completely out of left field will poison the stock market in 2016, but I am convinced that trouble is coming. Call me a pessimist, a bear, or an idiot… but my personal portfolio and that of my Rational Bear subscribers are prepared to profit from falling stock prices.
Tony Sagami
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.



Get out latest FREE eBooK "Understanding Options"....Just Click Here

Wednesday, December 2, 2015

How Big the Gig Economy Really Is

By John Mauldin

There is growing awareness of what is being called the “gig economy.” It’s not just Uber driving or Airbnb. There are literally scores of websites and apps where you can advertise your services, get temporary or part time work, and do so from anywhere you happen to be.

Some “gigs” actually pay pretty good money, but they are for people with specialized skills who prefer to live a somewhat different lifestyle than the typical 9 to 5’er does. My hedge fund friend Murat Köprülü has been busy researching and documenting this phenomenon and regularly regales me with what he finds.

He goes and spends evenings and weekends with young gig workers, trying to figure out what it is they really do and how they make ends meet in New York City. It turns out they need a lot less to support their lifestyle than you might imagine, and they prefer working intermittent gigs, being able to do what they want, and having no boss.

A close look at the data indicates that the gig economy is indeed big and growing. But there is a great deal of debate among economists about how big it really is.

It’s Much Bigger Than the Employment Data Suggests

Gig workers don’t seem to show up clearly in the BLS employment data. Typically, we would expect those working in the gig economy to appear in the self employed category, but that category is actually drifting downward in numbers—relatively speaking.

But Harvard economist Larry Katz and Princeton’s Alan Krueger, who are working on research to document the rise of the gig economy in America, says that our current measures ignore the bulk of the gig economy.

 From a story at fusion.net:
Katz said two pieces of evidence suggest current measures of self-employment and multiple-job holding are “missing a large part of the gig economy.” The first is that the share of the employed (and of the adult population) filing a 1099 form, the tax document “gig economy” workers must file, increased in the 2000s, even as standard measures of self-employment declined in the 2000s. Other groups have confirmed this: Zen Payroll, a site that tracks the sharing economy, found increases in the share of 1099 workers across many major U.S. metros.

Mauldin-Economics-Gig-Economy
Source: Zen Payroll via Small Business Labs

And data from research group EconomicModeling.com show the share of traditional, 9-to-5 workers in the labor force has declined…..

Mauldin-Economics-Gig-Economy
Source: Fusion, data via EconomicModeling.com

… while those who categorize themselves as “miscellaneous proprietors” is climbing.

Mauldin-Economics-Gig-Economy
Source: Fusion, data via EconomicModeling.com

A recent survey found 60 percent of such workers get at least 25 percent of their income from gig economy work.

The problem with the BLS estimates is that they overlook a sizable chunk of the true gig economy.
And this report absolutely squares with what my friend Murat’s research is showing: that gig economy is not shrinking. On the contrary, it’s on the rise, and a quite rapid rise.

Subscribe to Thoughts from the Frontline

Follow Mauldin as he uncovers the truth behind, and beyond, the financial headlines in his free publication, Thoughts from the Frontline. The publication explores developments overlooked by mainstream news to help you understand what’s happening in the economy and navigate the markets with confidence.

The article was excerpted from John F. Mauldin’s Thoughts from the Frontline. Follow John Mauldin on Twitter. The article How Big the Gig Economy Really Is was originally published at mauldineconomics.com.


Get our latest FREE eBook "Understanding Options"....Just Click Here!

Friday, November 13, 2015

Investing Inspiration from the World of Sports

By John Mauldin 

One of the most successful investors in the world is Howard Marks of Oaktree Capital Management. One of the things I look forward to every quarter is the letter he writes to his clients – it goes right to the top of my reading list. Not only is it always full of generally brilliant investment counsel, Howard is also a really great writer. He has an easy style that pulls you through his letter effortlessly.

I have never sent his letter to you as an Outside the Box, as the copies I get are clearly watermarked and copyrighted. So I was surprised and delighted to learn that the letter is free when I listened to a speech by Howard in which he encouraged everyone to get it. Unlike another hundred billion dollar hedge fund company that shall go unnamed, Oaktree evidently thinks that brilliance should be shared.

I am especially pleased to be able to pass on this latest issue, in which Howard returns to a theme he has used in the past, which is the parallels between investing and sports. He recounts the career of Yogi Berra, who sadly passed away in September. Yogi was always a fan favorite, and he was certainly one of mine; but it was his consistency, both on offense and defense, that made him great.

Marks goes on to defend the seemingly indefensible: in last year’s Super Bowl, Pete Carroll, coach of the Seattle Seahawks, called for a passing play on the one yard line as time was running out, which as anyone who watched that game would remember, was one of the most spectacularly unsuccessful decisions of all time. But Howard asks us, “His decision was unsuccessful, but was it wrong?”

Can we judge a career on one play? I am grateful that my investment and writing careers are not judged solely by my many mistakes.

This past weekend at the T3 Conference in Miami was enlightening. Todd Harrison put together a great lineup of speakers who represented a wide range of investment styles and strategies. Perhaps because I have been looking at alternative income strategies in a world of low interest rates, I was particularly intrigued by how investors are finding reasonable yield income. I wrote seven years ago that I thought private credit would become a very large part of the investment spectrum in the future, and it is certainly turning out that way. The whole burgeoning world of “shadow banks” has been an unintended consequence of Dodd-Frank.

That overreaching regulation, coupled with enhanced liquidity requirements, has severely limited the ability of small banks to lend. Private credit funds are being set up to go where banks can’t or won’t, and frankly they have a natural advantage. Their cost of money is lower than banks’, and their overhead is even less. They typically don’t leverage as much as banks do, but they can still produce returns that any bank would be happy with. There is more and more interest in making these investment vehicles more accessible to the public, and I applaud anyone who tries.

Plus, it was just good to see so many friends, then sit by the pool for an afternoon after the conference was over. It was supposed to rain, but we got lucky and caught some sunshine in Florida.

Now I’m back in Dallas and working away on the new book. I am told we have all the volunteer research assistants we need, so if you haven’t contacted us yet, my staff has asked me to suggest that we are full up.
Have a great week, and go to your favorite spot to read and think as you enjoy Howard Marks’ latest memo.

Your glad to be back home analyst,
John Mauldin, Editor
Outside the Box

Stay Ahead of the Latest Tech News and Investing Trends...
Each day, you get the three tech news stories with the biggest potential impact.

Memo to: Oaktree Clients
From: Howard Marks
Re: Inspiration from the World of Sports


I’m constantly intrigued by the parallels between investing and sports. They’re illuminating as well as fun, and thus they’ve prompted two past memos: “How the Game Should Be Played” (May 1995) and “What’s Your Game Plan?” (September 2003). In the latter memo, I listed five ways in which investing is like sports:
  • It’s competitive – some succeed and some fail, and the distinction is clear.
     
  • It’s quantitative – you can see the results in black and white.
     
  • It’s a meritocracy – in the long term, the better returns go to the superior investors.
     
  • It’s team-oriented – an effective group can accomplish more than one person.
     
  • It’s satisfying and enjoyable – but much more so when you win. 

Another angle on the investing/sports analogy has since occurred to me: an investment career can feel like a basketball or football game with an unlimited number of quarters. We may be nearing December 31 with a substantial year-to-date return or a big lead over our benchmarks or competitors, but when January 1 rolls around, we have to tackle another year. Our record isn’t finalized until we leave the playing field for good. Or as Yogi Berra put it, “It ain’t over till it’s over.” It was Yogi’s passing in late September that inspired this memo. [Since most of the references in this memo are to American sports, with their peculiarities and unique terminology, this is a good time for an apology to anyone who’s unfamiliar with them.]

Yogi Berra, Baseball Player 

Lawrence “Yogi” Berra was a catcher on New York Yankees baseball teams for eighteen years, from 1946 to 1963. Although he was rarely number one in any offensive category, he often ranked among the top ten players in runs batted in, home runs, extra base hits (doubles, triples and home runs), total bases gained and slugging percentage (total bases gained per at bat). He excelled even more on defense: in the 1950s he was regularly among the top three or four catchers in terms of putouts, assists, double plays turned, stolen bases allowed and base stealers thrown out.

Yogi was selected to play in the All-Star Game every year from 1948 through 1962. He was among the top three vote-getters for American League Most Valuable Player every year from 1950 through 1956, and he was chosen as MVP in three of those years. The Yankee teams on which he played won the American League pennant and thus represented the league in the World Series fourteen times, and they won the World Series ten times. He was an important part of one of the greatest dynasties in the history of sports. To me, the thing that stands out most is Yogi’s consistency. Not only did he perform well in so many different categories, but also:
  • He led the American League in number of games played at the grueling catcher position eight years in a row.
     
  • He was regularly among the catchers with the fewest passed balls and errors committed.
     
  • He had around 450-650 at bats most years, but over his entire career he averaged only 24 strikeouts per year, and there was never one in which he struck out more than 38 times. (In 1950 he did so only 12 times in nearly 600 at bats.) Thus, ten times between 1948 and 1959 he was among the ten players with the fewest strikeouts per plate appearance. 
In short, Yogi rarely messed up.

Consistency and minimization of error are two of the attributes that characterized Yogi’s career, and they can also be key assets for superior investors. They aren’t the only ways for investors to excel: some great ones strike out a lot but hit home runs in bunches the way Reggie Jackson did. Reggie – nicknamed “Mr. October” because of his frequent heroics in the World Series – was one of the top home run hitters of all time. But he also holds the record for the most career strikeouts, and his ratio of strikeouts to home runs was four times Yogi’s: 4.61 versus 1.16. Consistency and minimization of error have always ranked high among my priorities and Oaktree’s, and they still do. 


Yogi Berra, Philosopher 

Although Yogi was one of the all time greats, his baseball achievements may be little-remembered by the current generation of fans, and few non-sports lovers are aware of them. He’s probably far better known for the things he said:
  • It’s like déjà vu all over again.
     
  • When you come to a fork in the road, take it.
     
  • You can observe a lot by just watching.
     
  • Always go to other people’s funerals, otherwise they won’t come to yours.
     
  • I knew the record would stand until it was broken.
     
  • The future ain’t what it used to be.
     
  • You wouldn’t have won if we’d beaten you.
     
  • I never said most of the things I said. 
I’ve cited Yogi’s statements in previous memos, and I borrowed the Yogi-ism at the top of the list above for the title of one in 2012. “Out of the mouths of babes,” they say, comes great wisdom. The same was true for this uneducated baseball player, and many of Yogi’s seeming illogicalities turn out to be profound upon more thorough examination.

“Baseball is ninety percent mental and the other half is physical.” That was another of Yogi’s dicta, and I think it’s highly useful when thinking about investing. Ninety percent of the effort to outperform may consist of financial analysis, but you need to put another fifty percent into understanding human behavior. The market is made up of people, and to beat it you have to know them as well as you do the thing you’re considering investing in. 

I sometimes give a presentation called, “The Human Side of Investing.” Its main message surrounds just that: while investing draws on knowledge of accounting, economics and finance, it also requires insight into psychology. Why? Because investors’ objectivity and rationality rarely prevail as much as investment theory assumes, and emotion and “human nature” often take over instead. That’s why my presentation is subtitled, “In theory there’s no difference between theory and practice. In practice there is.” Yogi said that, too, and I think it’s absolutely wonderful.

Things often fail to work the way investment theory says they should. Markets are supposed to be efficient, with no underpricings to find or overpricings to avoid, making it impossible to outperform. But exceptions arise all the time, and they’re usually attributable more to human failings than to math mistakes or overlooked data.

And that leads me to one of the most thought-provoking Yogi-isms, concerning his choice of restaurant: “Nobody goes there anymore because it’s too crowded.” What could be more nonsensical? If nobody goes there, how can it be crowded? And if it’s crowded, how can you say nobody goes there?

But as I wrote last month in “It’s Not Easy,” a lot of accepted investment wisdom makes similarly little sense. And perhaps the greatest – and most injurious – of all is the near unanimous enthusiasm that’s behind most bubbles.

“Everyone knows it’s a great buy,” they say. That, too, makes no sense. If everyone believes it’s a bargain, how can it not have been bought up by the crowd and had its price lifted to non bargain status as a result? You and I know the things all investors find desirable are unlikely to represent good investment opportunities. But aren’t most bubbles driven by the belief that they do?
  • In 1968, everyone knew the Nifty Fifty stocks of the best companies in America represented compelling value, even after their p/e ratios had reached 80 or 90. That belief kept them there . . . for a while.
     
  • In 2000, everyone thought tech investing was infallible and tech stocks could only rise. And they were sure the Internet would change the world and the stocks of Internet companies were good buys at any price. That’s what took the TMT boom to its zenith.
     
  • And here in 2015, everyone knows social media companies will own the future. But will their valuations turn out to be warranted? 
Logically speaking, the bargains that everyone has come to believe in can’t still be bargains . . . but that doesn’t stop people from falling in love with them nevertheless. Yogi was right in indirectly highlighting the illogicality of “common knowledge.” As long as people’s reactions to things fail to be reasonable and measured, the spoils will go to those who are able to recognize this contradiction. 


Looking for Lance Dunbar 

There may be a few folks in America who, like the rest of the world’s population, are unaware of the growing popularity of daily fantasy football. In this on-line game, contestants assemble imaginary football teams staffed by real professional players. When that week’s actual football games are played, the participants receive “fantasy points” based on their players’ real world accomplishments, and the participants with the most points win cash prizes. (Why is it okay to engage in interstate betting on fantasy football but not on football itself?

Because proponents were able to convince the authorities that the act of picking a team for fantasy football qualifies it as a game of skill, not chance. But last week, Nevada became the sixth state to ban daily fantasy sports, concluding that it’s really nothing but gambling.) The commercials for fantasy football say things like, “Sign up, make your picks, and collect your winnings.” That sounds awfully easy . . . and not that different from discount brokers’ ads during bull markets. 

In daily fantasy football, the challenge comes from the fact that the participants have a limited amount of money to spend and want to acquire the best possible team for it. If all players were priced the same regardless of their ability (a completely inefficient market), the prize would go to the participant who’s most able to identify talented players. And if all players were priced precisely in line with their ability (a completely efficient market), it would be impossible to acquire a more talented team for the same budget, so winning would hinge on random developments.

The market for players in fantasy football appears to be less than completely efficient. Thus participants have the possibility of finding mispricings. A star may be overpriced, so that he produces few fantasy points per dollar spent on him. And a journeyman might be underpriced, able to produce more rushing (i.e., running) yards, catches, tackles or touchdowns than are reflected by his price. That’s where the parallel to investing comes in.

Smart fantasy football participants understand that the goal isn’t to acquire the best players, or players with the lowest absolute price tags, but players whose “salaries” understate their merit – those who are underpriced relative to their potential and might amass more points in the next game than the cost to draft them reflects. Likewise, smart investors know the goal isn’t to find the best companies, or stocks with the lowest absolute dollar prices or p/e ratios, but the ones whose potential isn’t fully reflected in their price. In both of these competitive arenas, the prize goes to those who see value others miss.

There’s another similarity. Sports media employ “experts” to cover this imaginary football league, and it’s their job to attract viewers and readers by offering advice on which players to draft. (What other talking heads does that remind you of?) My musings on fantasy football started in late September, when I heard a TV commentator urge that participants take a look at Lance Dunbar, a running back for the Dallas Cowboys, based on the belief that Dunbar’s price might understate his potential to earn fantasy points. The commentator’s thesis was that the Cowboys’ star quarterback was injured and, because of the replacement quarterback’s playing style, Dunbar might get more opportunities – and run up more yardage – than his price implied. Thus, Dunbar might represent an underappreciated investment opportunity.

Or not. Dunbar tore his anterior cruciate ligament in the next game, meaning he won’t produce any more points – real or virtual – this season. It just proves that even if your judgment is sound, randomness has a lot of influence on outcomes. You never know which way the ball will bounce.

“Sign up, make your picks, and collect your winnings.” If only everyone – fantasy football entrants and investors alike – understood it’s not that easy.


Are the Helpers Any Help?

In investing, there are a lot of people who’ll offer to enhance your results . . . for a fee. In an allegorical treatment in Berkshire Hathaway’s 2005 annual report, Warren Buffett called them “Helpers.” There are helpers in sports, too, especially where there’s betting. This memo gives me a chance to discuss an invaluable clipping on the subject that I collected nine months ago and have been looking for an occasion to mention.

The New York Post’s sports writers opine weekly as to which professional football games readers should bet on (real games, not fantasy). Each week, the Post reports on the results of the prognostications for the season to date. When they published the results last December 28, they might have thought they demonstrated the value of those helpers. But I think that tabulation – nearly at the end of the football season – showed something very different.

By the time December 28 had rolled around, the eleven forecasters had tried to predict the winner of each of the 237 games that had been played to date, as well as what they thought were their 47 or so “best bets.” By “the winner,” I assume they meant the team that would win net of the bookies’ “point spread.” (Without doing something to even the odds, it would be too easy for bettors to win by backing the favorites. To make betting more of a challenge, the bookies establish a spread for each game: the number of points by which the favored team has to beat the underdog in order to be deemed the winner for betting purposes.) How often were the Post’s picks correct? Here’s the answer:

Percentage correct Total picks (2,607 games) Best bets (522 games)
All forecasters 50.9% 49.4%
Median forecaster 50.6% 47.9%
Best forecaster 58.5% 56.2%
Worst forecaster 44.8% 39.6%

An incorrigible optimist – or perhaps the Post – might say these results show what a good job the forecasters did as a group, since some were right more often than they were wrong. But that’s not the important thing. For me, the key conclusions are these:
  • The average results certainly make it seem that picking football winners (net of the points spread) is just a 50/50 proposition. Evidently, the folks who establish the point spreads are pretty good at their job, so that it’s hard to know which team will win.
     
  • The symmetrical distribution of the results and the way they cluster around 50% tell me there isn’t much skill in predicting football winners (or, if it exists, these pickers don’t have it). The small deviations from 50% – both positive and negative – suggest that picking winning football teams for betting purposes may be little more than a matter of tossing a coin.
     
  • Even the best forecasters weren’t right much more than half the time. While I’m not a statistician, I doubt the fact that a few people were right on 56-58% of their picks rather than 50% proves it was skill rather than luck. Going back to the coin, if you flipped one 47 times (or even 237 times), you might occasionally get 58% heads.
     
  • Lastly, all eleven writers collectively – and seven of them individually – had worse results on the games they considered their “best bets” than on the rest of the games. So clearly they aren’t able to accurately assess the validity of their own forecasts. 
And remember, these forecasts weren’t made by members of the general populace, but rather by people who make their living following and writing about sports. 

My favorite quotation on the subject of forecasts comes from John Kenneth Galbraith: “We have two classes of forecasters: Those who don’t know – and those who don’t know they don’t know.” Clearly these forecasters don’t know. But do they know it? And do their readers?

The bottom line on picking football winners seems to be that the average forecaster is right half the time, with exceptions that are relatively few in number, insignificant in degree and possibly the result of luck. He might as well flip a coin. And that brings us back to investing, since I find this analogous to the observation that the average investor’s return equals the market average. He, too, might as well flip a coin . . . or invest in an index fund.

And by the way, the average participant’s average result – in both fields – is before transaction costs and fees. After costs, the average investor’s return is below that of the market. In that same vein, after costs the average football bettor doesn’t break even.

What costs? In sports betting, we’re not talking about management fees or brokerage commissions, but “vigorish” or “the vig.” Wikipedia says it’s “also known as juice, the cut or the take . . . the amount charged by a bookmaker . . . for taking a bet from a gambler.” This obscure term refers to the fact that to try to win $10 from a bookie, you have to put up $11. You’re paid $10 if you win, but you’re out $11 if you lose. N.b.: bookies and sports betting parlors aren’t in business to provide a public service.

If you bet against a friend and win half the time, you end up even. But if you bet against a bookie or a betting parlor and win half the time, on average you lose 10% of the amount wagered on every other bet. So at $10 per game, a bettor following the Post’s football helpers through December 28, 2014 would have won $13,280 on the 1,328 correct picks but lost $14,069 on the 1,279 losers. Overall, he would have lost $789 even though slightly more than half the picks were right. That’s what happens when you play in a game where the costs are high and the edge is insufficient or non-existent.


Another Look at Performance Assessment

This memo gives me an opportunity to touch on another recent sporting event: Super Bowl XLIX, which was played last February. I’m returning to a subject I covered at length in the “What’s Real?” section in “Pigweed” (February 2006), which was about the meltdown of a hedge fund called Amaranth. Among the ways I tried to parse the events surrounding Amaranth was through an analogy to the Rose Bowl game played at the end of the 2005 college football season to determine the national champion. In the game, the University of Texas beat the favored University of Southern California. While leading by five points with less than three minutes left to play, USC had a fourth down with two yards to go for a first down.

They lost largely because – in something other than the obvious choice – the coach elected to go for it rather than punt the ball away, and they were stopped a yard short. UT got the ball and went on to score the winning touchdown. Before the game, USC had widely been considered one of the greatest teams in college football history. Afterwards there was no more talk along those lines. Its loss hinged on that one very controversial play . . . controversial primarily because it was unsuccessful. (Had USC made the two yards and earned a first down, they would have retained the ball and been able to run out the clock, sealing a victory.)

Something very similar happened in this year’s Super Bowl. The Seattle Seahawks were trailing the New England Patriots by a few points. On second down, with just 26 seconds to go and one timeout remaining, the Seahawks had the ball on the Patriots’ one-yard line. Everyone was sure they would try a run by Marshawn Lynch (who in the regular season had ranked first in the league in rushing touchdowns and fourth in rushing yards), and that he would score the winning touchdown. But the Seahawks’ maverick coach, Pete Carroll – ironically, also the coach of USC’s losing Rose Bowl team – tried a pass play instead. The Patriots intercepted the pass, and the Seahawks’ dreams of a championship ended.

“What an idiot Carroll is,” the fans screamed. “Everyone knows that when you throw a pass, only three things can happen (it’s caught, it’s dropped or it’s intercepted) and two of them are bad.” The Seahawks lost a game they seemed to be on the verge of winning, and Carroll was vilified for being too bold and wrong . . . again. His decision was unsuccessful. But was it wrong?

With assistance from Warren Min in Oaktree’s Real Estate Department, I want to point out some of the considerations that Carrol may have taken into account in making his decision:
  • Up to that point in the season, more than 100 passes had been attempted from the one-yard line, and none of them had been intercepted. So Carroll undoubtedly expected that, at the very worst, the pass would be incomplete and the clock would stop (as it does after incomplete passes) with just a few seconds elapsed. That would have given the Seahawks time for one or two more plays.
     
  • With only 26 seconds remaining and the Seahawks down to their last timeout, if they ran and Lynch was stopped, the clock would have kept running (as it does after rushing plays). Seattle would then have been forced to either use their precious timeout or try a hurried play.
     
  • Malcolm Butler, the defender who intercepted Seattle’s pass, was a rookie playing in the biggest game of his life, and he was undersized relative to Ricardo Lockette, the wide receiver to whom the pass was thrown.
     
  • According to The Boston Globe, of Lynch’s 281 carries during the 2014 regular season, 20 had resulted in lost yardage and two more had yielded fumbles. In other words, the Seahawks had experienced a setback 7.8% of the time when Lynch carried the ball. Further, Lynch had been handed the ball at the one yard line five times in 2014, but he scored only once, for a success rate of 20%. Thus it was no sure thing that Lynch would be able to gain that needed yard against a defense expecting him to run. 
To the first level thinker, Carroll’s decision to pass looks like a clear mistake. Maybe that’s because great running backs seem so dependable, or because passing generally seems like an uncertain proposition. Or maybe it’s just because the pass was picked off and the game lost: outcomes strongly bias perceptions.

The second level thinker sees that the obvious call – to run – was far from sure to work, and that doing the less than obvious – passing – might put the element of surprise on the Seahawks’ side and represent better clock management. Carroll made his decision and it was unsuccessful. But that doesn’t prove he was wrong.

Here’s what my colleague Warren wrote me:
The media and “talking heads” completely buried the decision to throw because of one data point: the pass was intercepted and the Seahawks lost the game. But I don’t believe this was a bad decision. In fact, I think this was a very well informed decision that more people possessing all the data might have made given ample time to analyze the situation.

As you always say, you can’t judge the quality of a decision based on results. If we somehow were able to replay this game in alternative realities to test the results, I think the Seahawks’ decision wouldn’t look so bad. But they certainly lost, perhaps because of bad luck. Now, similar to the USC/Texas situation, the media has written some very significant storylines regarding legacies:
  • The Patriots secured “dynasty” status by winning four Super Bowls since 2001.
     
  • Tom Brady, the Patriots’ quarterback, is hailed as one of the greatest of all time.
     
  • The Seahawks’ defense, which was talked about as being “the greatest ever,” is 
lauded no more (despite the fact that it wasn’t defense that lost the game).
But should this one victory – which swung on a single play – really place the Patriots and Tom Brady among the greatest? And was Carroll actually wrong? All of this goes back to one of my favorite themes from Fooled by Randomness by Nassim Nicholas Taleb, for me the bible on how to understand performance in an uncertain world.

In his book, Taleb talks about “alternative histories,” which I describe as “the other things that reasonably could have happened but didn’t.” Sure, the Seahawks lost the game. But they could have won, and Carroll’s decision would have made the difference in that case, too, making him the hero instead of the goat. So rather than judge a decision solely on the basis of the outcome, you have to consider (a) the quality of the process that led to the decision, (b) the a priori probability that the decision would work (which is very different from the question of whether it did work), (c) the other decisions that could have been made, (d) all of the events that reasonably could have unfolded, and thus (e) which of the decisions had the highest probability of success.

Here’s the bottom line:
  • There are many subtle but logical reasons for arguing that Coach Carroll’s decision made sense.
     
  • The decision would have been considered a stroke of genius if it had been successful.
     
  • Especially because of the role of luck, the correctness of a decision cannot necessarily be judged 
from the outcome.
     
  • You clearly cannot assess someone’s competence on the basis of a single trial. 

What all the above really illustrates is the difference between superficial observation and deep, nuanced analysis. The fact that something worked doesn’t mean it was the result of a correct decision, and the fact that something failed doesn’t mean the decision was wrong. This is at least as true in investing as it is in sports. 


The Victor’s Mindset 

It often seems that just as I’m completing a memo, a final inspiration pops up. This past weekend, the Financial Times carried an interesting interview with Novak Djokovic, the number one tennis player in the world today. What caught my eye was what he said about the winner’s mental state:

I believe that half of any victory in a tennis match is in place before you step on the court. If you don’t have that self-belief, then fear takes over. And then it will get too much for you to handle. It’s a fine line. (Emphasis added) 

Djokovic’s statement reminded me of a conversation I had earlier this month, on a subject I’ve written about rarely if ever: self confidence. It ranks high among the attributes that must be present if one is to achieve superior results.

To be above average, an athlete has to separate from the pack. To win at high level tennis, a player has to hit “winners” – shots his opponents can’t return. They’re hit so hard, so close to the lines or so low over the net that they have the potential to end up as “unforced errors.” In the absence of skill, they’re unlikely to be executed successfully, meaning it’s unwise to try them. But people who possess the requisite skill are right in attempting them in order to “play the winner’s game” (see “What’s Your Game Plan”).

These may be analogous to investment actions that Yale’s David Swensen would describe as “uncomfortably idiosyncratic.” The truth is, most great investments begin in discomfort – or, perhaps better said, they involve doing things with which most people are uncomfortable. To achieve great performance you have to believe in value that isn’t apparent to everyone else (or else it would already be reflected in the price); buy things that others think are risky and uncertain; and buy them in amounts large enough that if they don’t work out they can lead to embarrassment. What are examples of actions that require self confidence?
  • Buying something at $50 and continuing to hold it – or maybe even buying more – when the price falls to $25 and “the market” is telling you you’re wrong.
     
  • After you’ve bought something at $50 (thinking it’s worth $200), refusing to “prudently take some chips off the table” when it gets to $100.
     
  • Going against conventional wisdom and daring to “catch a falling knife” when a company defaults and the price of its debt plummets.
     
  • Buying much more of something you like than it represents in the index you’re measured against, or entirely excluding an index component you dislike. 
In each of these cases, the first level thinker does that which is conventional and easy – and which doesn’t require much self confidence. The second level thinker views things differently and, as a consequence, is willing to take actions like those described above. But they’re unlikely to be done in the absence of conviction. The great investors I know are confident second level thinkers and entirely comfortable diverging from the herd.

It’s great for investors to have self confidence, and it’s great that it permits them to behave boldly, but only when that self confidence is warranted. This final qualification means that investors must engage in brutally candid self assessment. Hubris or over confidence is far more dangerous than a shortage of confidence and a resultant unwillingness to act boldly. That must be what Mark Twain had in mind when he said, “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” And it also has to be what Novak Djokovic meant when he said, “It’s a fine line.” 

So there you have some of the key lessons from sports:
  • For most participants, success is likely to lie more dependably in discipline, consistency and minimization of error, rather than in bold strokes – high batting average and an absence of strikeouts, not the occasional, sensational home run.
     
  • But in order to be superior, a player has to do something different from others and has to have an appropriate level of confidence that he can succeed at it. Without conviction he won’t be able to act boldly and survive bouts of uncertainty and the inevitable slump.
     
  • Because of the significant role played by randomness, a small sample of results is far from sure to be indicative of talent or decision making ability.
     
  • The goal for bettors is to see value in assets that others haven’t yet recognized and that isn’t reflected in prices.
     
  • At first glance it seems effort and “common sense” will lead to success, but these often prove to be unavailing.
     
  • In particular, it turns out that most people can’t see future outcomes much better than anyone else, but few are aware of this limitation.
     
  • Before a would be participant enters any game, he should assess his chances of winning and whether they justify the price to play.
These lessons can serve investors very well.

Like Outside the Box? Sign up today and get each new issue delivered free to your inbox.
It's your opportunity to get the news John Mauldin thinks matters most to your finances.




Get our latest FREE eBook "Understanding Options"....Just Click Here!

Friday, November 6, 2015

Jared Dillian is Pulling Out All the Stops

By Jared Dillian


When I was a teenager, I had a different sort of part-time job. I was a church organist. Actually, it was the best job ever because I was something of a piano prodigy as a child. Around age 12, my parents and I had to make a conscious decision about whether I was going to pursue a career in music. I decided not to, which has greatly reduced the amount of Ramen noodles I have eaten over the years.At age  13, I decided I wanted to play the organ. I took lessons from the organist in the big Catholic church downtown. What an incredible instrument!

Playing the organ is a lot harder than it looks. In case you hadn’t noticed, there is a whole keyboard at your feet—yes, you play with both your hands and your feet. And since you can’t possibly learn all the hymns, you have to be really good at sight-reading three lines of music at once. It takes a great deal of coordination. Plus, you have two or more “manuals” (keyboards) and dozens of stops, which activate the different sounds in the organ. This is where the phrase “pulling out all the stops” comes from.

So I got a job as the organist at the Unitarian church down the street. For the first and only time of my life, I was a member of a union—the American Guild of Organists. I received my union-protected minimum wage of $50 per service, which is a great deal of money if you’re 16 years old in 1990. $50 a week definitely put gas in my car. And there was a girl in the congregation that I dated a couple of times.

I felt sorry for my poor schlep classmates who were bagging groceries for $4/hour. They had to work 12 hours to make what I made in one. I felt pretty smug.  The high point was when I transcribed the theme from “A Clockwork Orange” and played it as the prelude for one of the church services. You can see where the subversive streak comes from.

I Got Skills

So why did I make more than 12 times what my high school classmates made? Because my skills were worth 12 times as much. Bagging groceries is kind of the definition of unskilled labor. Literally anyone can bag groceries. The supply of labor that has those skills is limitless.

Church organists are in slightly higher demand. But not by much! I think a church organist these days—if you are hired by the church to play every week, plus run all the choir and music programs, probably pays about $35,000 to $50,000 a year, depending on the church. So not a lot!

It’s a decent living if you like playing the organ, but you also have to deal with church politics. The wages of an organist not only depend on the supply of labor but the demand for labor as well. And church construction has gone way down in recent years. Not to mention the fact that the latest fad in religious services is “contemporary music.”


However, the fact that church organists make more money than grocery baggers does reflect the level of skill the occupation requires. Before I became a church organist, I had been playing either the piano or organ for six years. Six years of practicing 30 minutes to an hour a day, every day.

Nobody practices bagging groceries for 30 minutes a day, every day.

I don’t particularly like manual labor (though I have done it on occasion). That’s why I do my best to acquire skills that are rare and marketable so I don’t have to do things like chip paint. In this country (and others), we have this unhealthy obsession with manual labor. Politicians talk about “working Americans” all the time. We say things like “putting in a hard day’s work.” The most popular car is the Ford F-150. Who wants to put in a hard day’s work? Not me! Instead, I will put in a hard day’s thinking.

Hate and Discontent

A lot of people spend too much time thinking about what other people make. It’s unproductive. Everyone thinks Wall Street guys are overpaid, for example. Okay, so let’s take your average ETF option trader at a bank. Say he makes $500,000 a year (which might even be generous these days). Let’s examine one trade of many that he is confronted with on a daily basis. A sales trader stands up and yells to him, “20,000 XLE Jan 75 calls, how?”

What’s happening here is that a client is asking for a two-sided market on the January 75 call options in XLE, which is the Energy Select Sector SPDR ETF, 20,000 times, which means options on 2,000,000 shares, or about $140,000,000. It’s a big trade, definitely, but there are bigger ones. So let’s think of all the things the option trader needs to know. He needs to know what an option is, starting from scratch.

He needs to know what XLE is, that it’s an energy ETF, and he should have a good idea of what stocks are in the portfolio. He might have a cursory knowledge about factors affecting supply and demand for crude oil. In order to come up with a price for these options, he has to have an idea of what implied volatility should be and what realized volatility might be going forward.

This requires a knowledge of an option pricing model like Black-Scholes and many, many years of college mathematics, including probability theory and differential equations. He needs to know how he is going to hedge this option. Will he hedge the delta all in the stock? Will he hedge with other options? How will he dynamically hedge the trade until maturity? Will he lay off some of the risk in other strikes? Will he buy single stock options on some of the names in the index, like XOM, CVX, or COP, to effect a dispersion trade?

This means he has to know what a dispersion trade is. More math. He also needs to understand liquidity. What will be his execution impact by trying to sell 800,000 shares of XLE? This affects how wide he makes his market. And best of all, he needs to think about all of these things in a split-second, without hesitation. If he is off by even a penny—he loses money on the trade. I would characterize that as “skilled labor.” And we haven’t even talked about the emotional fortitude it takes to take that kind of risk. $500,000 a year seems low.

CEOs

People get the most upset about executive pay. Here you have some dillweed CEO who is the direct beneficiary of the agency problem. If company XYZ does well, he gets paid millions. If it does poorly, he gets fired and loses nothing, personally. We say that he has no skin in the game.

Well, do you have what it takes to run one of the 500 largest companies in the world?

Pretend we’re talking about McDonald’s. Many people think McDonald’s is doing a terrible job. There’s a lot of evidence that they are. They’re losing market share to Chipotle and lots of other “fast casual” restaurants.

But running a company is hard enough. You have 50,000 odd restaurants, you have to manage supply and distribution for this massive network, you have to do all the managerial science behind what is on the menu and how much it costs, you have to directly negotiate, and I mean meet with leaders of foreign governments, you need to go on CNBC from time to time and not be a mutant, and above all, you need to lead inspirationally.

Not many people can do all that. I can’t. Maybe I’m smart enough, but I don’t have the emotional maturity or even the desire for that kind of responsibility. Everyone wants to be the boss, but nobody really wants to be the boss. If you think you are underpaid—maybe you are. The labor market is not perfectly efficient. Anomalies can persist.

Take a look at people who you think are overpaid. What are they doing that you aren’t? Maybe you just aren’t willing to do those things (like kiss lots of ass). The responsibility is yours and yours alone. And that, my friends, is something nobody wants to hear.
Jared Dillian
Jared Dillian

If you enjoyed Jared's article, you can sign up for The 10th Man, a free weekly letter, at mauldineconomics.com

The article The 10th Man: Pulling Out All the Stops was originally published at mauldineconomics.com.


Get our latest FREE eBook "Understanding Options"....Just Click Here!

Friday, October 2, 2015

A Worrying Set Of Signals

By John Mauldin 

There is presently a bull market in complacency. There are very few alarm bells going off anywhere; and frankly, in reaction to my own personal complacency, I have my antenna up for whatever it is I might be missing that would indicate an approaching recession.

It was very easy to call the last two recessions well in advance because we had inverted yield curves. In the US at least, that phenomenon has a perfect track record of predicting recessions. The problem now is that, with the Federal Reserve holding the short end of the curve at the zero bound, there is no way we can get an inverted yield curve, come hell or high water. For the record, inverted yield curves do not cause recessions, they simply indicate that something is seriously out of whack with the economy. Typically, a recession shows up three to four quarters later.

I know from my correspondence and conversations that I am not the only one who is concerned with the general complacency in the markets. But then, we’ve had this “bull market in complacency” for two years and things have generally improved, albeit at a slower pace in the current quarter.

With that background in mind, the generally bullish team at GaveKal has published two short essays with a rather negative, if not ominous, tone. Given that we are entering the month of October, known for market turbulence, I thought I would make these essays this week’s Outside the Box. One is from Pierre Gave, and the other is from Charles Gave. It is not terribly surprising to me that Charles can get bearish, but Pierre is usually a rather optimistic person, as is the rest of the team.

I was in Toronto for two back-to-back speeches before rushing back home this morning. I hope you’re having a great week. So now, remove sharp objects from your vicinity and peruse this week’s Outside the Box.

Your enjoying the cooler weather analyst,
John Mauldin

Stay Ahead of the Latest Tech News and Investing Trends...

Each day, you get the three tech news stories with the biggest potential impact.

A Worrying Set Of Signals

By Pierre Gave
Regular readers will know that we keep a battery of indicators to gauge, among other things, economic activity, inflationary pressure, risk appetite and asset valuations. Most of the time this dashboard offers mixed messages, which is not hugely helpful to the investment process. Yet from time to time, the data pack points unambiguously in a single direction and experience tells us that such confluences are worth watching. We are today at such a point, and the worry is that each indicator is flashing red.

Growth: The three main indices of global growth have fallen into negative territory: (i) the Q-indicator (a diffusion index of leading indicators), (ii) our diffusion index of OECD leading indicators, and (iii) our index of economically-sensitive market prices. Also Charles’s US recession indicator is sitting right on a key threshold (see charts for all these indicators in the web version).

Inflation: Our main P-indicator is at a maximum negative with the diffusion index of US CPI components seemingly in the process of rolling over; this puts it in negative territory for the first time this year.

Risk appetite: The Gavekal velocity indicator is negative which is not surprising given weak market sentiment in recent weeks. What worries us more is the widening of interest rate spreads—at the long end of the curve, the spread between US corporate bonds rated Baa and treasuries is at its widest since 2009; at the short-end, the TED spread is back at levels seen at the height of the eurozone crisis in 2012, while the Libor-OIS spread is at a post-2008 high. Moreover, all momentum indicators for the main equity markets are at maximum negative, which has not been seen since the 2013 “taper tantrum”.

These weak readings are especially concerning, as in recent years, it has been the second half of the year when both the market and growth has picked up. We see three main explanations for these ill tidings:

1) Bottoming out: If our indicators are all near a maximum negative, surely the bottom must be in view? The contrarian in us wants to believe that a sentiment shift is around the corner. After all, most risk-assets are oversold and markets would be cheered by confirmation that the US economy remains on track, China is not hitting the wall and the renminbi devaluation was a one-off move. If this occurs, then a strong counter-trend rally should ramp up in time for Christmas.

2) Traditional indicators becoming irrelevant: Perhaps we should no longer pay much attention to fundamental indicators. After all, most are geared towards an industrial economy rather than the modern service sector, which has become the main growth driver. In the US, industrial production represents less than 10% of output, while in China, the investment slowdown is structural in nature. The funny thing is that employment numbers everywhere seem to be coming in better than expected. In this view of things, either major economies are experiencing a huge drop in labor productivity, or our indicators need a major refresh (see Long Live US Productivity!).

3) Central banks out of ammunition: The most worrying explanation for the simultaneous decline in our indicators is that air is gushing out of the monetary balloon. After more than six years of near zero interest rates, asset prices have seen huge rises, but investment in productive assets remains scarce.

Instead, leverage has run up across the globe. According to the Bank for International Settlements’ recently released quarterly review, developed economies have seen total debt (state and private) rise to 265% of GDP, compared to 229% in 2007. In emerging economies, that ratio is 167% of GDP, compared to 117% in 2007 (over the period China’s debt has risen from 153 to 235% of GDP). The problem with such big debt piles is that it is hard to raise interest rates without derailing growth.

Perhaps it is not surprising that in recent weeks the Federal Reserve has backed away from hiking rates, the European Central Bank has recommitted itself to easing and central banks in both Norway and Taiwan made surprise rate cuts. But if rates cannot be raised after six-years of rising asset prices and normalizing growth, when is a good time? And if central banks are prevented from reloading their ammunition, what will they deploy the next time the world economy hits the skids?

Hence we have two benign interpretations and one depressing one. Being optimists at heart, we want to believe that a combination of the first two options will play out. If so, then investors should be positioned for a counter-trend rally, at least in the short-term. Yet we are unsettled by the market’s muted response to the Fed’s dovish message. That would indicate that investors are leaning towards the third option. Hence, we prefer to stay protected and for now are not making a bold grab for falling knifes. At the very least, we seek more confirmation on the direction of travel.

Positioning For A US Recession

By Charles Gave
Since the end of last year I have been worried about an “unexpected” slowdown, or even recession, in the world’s developed economies (see Towards An OECD Recession In 2015). In order to monitor the situation on a daily basis, I built a new indicator of US economic activity which contains 17 components ranging from lumber prices and high-yield bond spreads to the inventory-to-sales ratio. It was necessary to construct such an indicator because six years of extreme monetary policy in the US (and other developed markets) has stripped “traditional” cyclical economic data of any real meaning (see Gauging The Chances Of A US Recession).

Understanding this diffusion index is straightforward. When the reading is positive, investors have little to worry about and should treat “dips” as a buying opportunity. When the reading is negative a US recession is a possibility. Should the reading fall below – 5 then it is time to get worried – on each occasion since 1981 that the indicator recorded such a level a US recession followed in fairly short order. At this point, my advice would generally be to buy the defensive team with a focus on long dated US bonds as a hedge. This is certainly not a time to buy equities on dips.

Today my indicator reads – 5 which points to a contraction in the US, and more generally the OECD. Such an outcome contrasts sharply with official US GDP data, which remains fairly strong. Pierre explored this discrepancy in yesterday’s Daily (see A Worrying Set Of Signals), so my point today is to offer specific portfolio construction advice in the event of a developed market contraction. My assumption in this note is simply that the US economy continues to slow. Hence, the aim is to outline an “anti-fragile” portfolio which will resist whatever brickbats are hurled at it.

During periods when the US economy has slowed, especially if it was “unexpected” by official economists, then equities have usually taken a beating while bonds have done well. For this reason, the chart below shows the S&P 500 divided by the price of a 30 year zero coupon treasury.

A few results are immediately clear:
  • Equities should be owned when the indicator is positive.
     
  • Bonds should be held when the indicator is negative.
     
  • The ratio of equities to bonds (blue line) has since 1981 bottomed at about 50 on at least six occasions. Hence, even in periods when fundamentals were not favorable to equities (2003 and 2012) the indicator identified stock market investment as a decent bet. 
Today the ratio between the S&P 500 and long dated US zeros stands at 75. 
This suggests that shares will become a buy in the coming months if they underperform bonds by a chunky 33%. The condition could also be met if US equities remain unchanged, but 30 year treasury yields decline from their current 3% to about 2%. Alternatively, shares could fall sharply, or some combination in between. 


Notwithstanding the continued relative strength of headline US economic data, I would note that the OECD leading indicator for the US is negative on a YoY basis, while regional indicators continue to crater. The key investment conclusion from my recession indicator is that equity positions, which face risks from worsening economic fundamentals, should be hedged using bonds or upping the cash component.
Like Outside the Box?

Sign up today and get each new issue delivered free to your inbox. It's your opportunity to get the news John Mauldin thinks matters most to your finances.


The article Outside the Box: A Worrying Set Of Signals was originally published at mauldineconomics.com.


Get our latest FREE eBook "Understanding Options"....Just Click Here!

Monday, September 28, 2015

Balloons in Search of Needles

By John Mauldin

I love waterfalls. I’ve seen some of the world’s best, and they always have an impact. The big ones leave me awestruck at nature’s power. It was about 20 years ago that I did a boat trip on the upper Zambezi, ending at Victoria Falls. Such a placid river, full of game and hippopotamuses (and the occasional croc); and then you begin to hear the roar of the falls from miles away.

Unbelievably majestic. From there the Zambezi River turns into a whitewater rafting dream, offering numerous class 5 thrills. Of course, you wouldn’t want to run them without a serious professional at the helm. When you’re looking at an 8 foot high wall of water in front of you that you are going to have to go up (because it’s in the way); well, let’s just say it’s a rush.

If there were rapids like this in the United States, it’s doubtful professional outfits could get enough liability insurance to make a business of running them. In Zimbabwe we just signed a piece of paper. Our guides swore nobody had ever been lost – well, except for a few people who disobeyed the rules and leaped in the water in the calm sections because it was 100° out. That’s where the crocs are.

They promised we wouldn’t run into any in the rapids, which was good. More than a few of us got dumped in the water trying to run the rapids, but they had teams of kayakers who got you out quickly. The canyon below the falls is unbelievable, and below that is the even more impressive Bakota Gorge.

And yes, you then had to walk to the top of the canyon up a switchback trail to get home. I would do it all over again in a heartbeat, but I would spend at least three months training for the hike out. That was most definitely not in the full-disclosure-of-risks one-page piece of paper.


It would be hard to miss an analogy to the stock market. Everything’s peaceful and calm, you’re drinking some fabulous wine, eating some fantastic fresh game and fish, looking at all the beautiful animals as you drift easily with the current. Anybody can steer the boat in a bull market. Until the rapids hit and the bottom falls out.

As an aside, while the large waterfalls are majestic and awe-inspiring, the smaller ones are more hypnotic. I love the sound of falling water. I could listen for hours. The one place I don’t like to see waterfalls is on stock charts. Those leave me awestruck at the market’s power. They do have the power to focus the mind, however, especially when we own the shares that just went over the falls.

The US stock market is having the most turbulent year we’ve seen in a while.  It’s not terrible by historical standards, but we have a full quarter to go. And next week it’ll be October, a month in which the stock market has run into trouble before. With all that in mind, this week I want to take a look at where stocks stand and maybe offer a thought or two about the events that could bring us to the next waterfall.

Not Niagara Falls Yet
Here is how the waterfall looks so far this year. Barely a 10% move peak to trough, and it lasted for just a few days. We see a lot of jostling, followed by the harrowing plunge in August, and then a partial (less than halfway) recovery. Where do we go from here?


Let’s start with the macro view. Back in July I showed you some research that I did with Ed Easterling of Crestmont Research. This was before the China sell-off accelerated into the headlines, so it is very interesting to read again in hindsight. (See “It’s Not Over Till the Fat Lady Goes on a P/E Diet”).

Our view is that we are still in a secular bear market, and have been since the 2000 Tech Wreck. You may find that view surprising, since the benchmarks have roughly tripled since the 2009 low. Our analysis looks at price/earnings ratios to identify when bull and bear markets begin or end. P/E multiples were close to 50 in year 2000. In order for that bear market to end, they needed to drop into the very low double digit or single-digit range, which has been the signal for the end of every long term secular bear cycle for over 100 years. That hasn’t happened during the intervening 15 years.

Can a secular bear market last 15 years? Yes. Some have lasted even longer, like 1966-1981 and 1901-1920. So this one isn’t unprecedented. And please note that the long-term secular cycles can have cyclical movements inside them. Again, we see secular cycles in terms of valuation and the shorter cyclical cycles in terms of price. (Unless this time is different) long-term secular bear market cycles will always end in a period of low valuations.

Currently, P/E ratios (or any other valuation metric you want to use) are not low enough to provide the boost that typically starts a new bull market. They were closer in 2009 than today, but have never dipped into the area that would mark the end of the bear market and the onset of the new bull. We’re still riding the same bear.


What’s taking so long? Our best guess is that stocks were so richly valued at the 2000 peak that it is taking the better part of a generation to work off that excess. In order for this bear to end – and the new bull cycle to begin – valuations need to tumble. That can happen only if prices drop considerably or earnings rise without pulling prices higher.

Obviously, there can be many trading opportunities within a secular bull or bear cycle, but Ed’s research says we have three long-term options from here.
  1. If P/E ratios decline toward 10 or below, we will be near the end of this secular bear. A new bull cycle should follow.
  2. If P/E ratios stay near where they are, we will be in what Ed calls “secular hibernation.” This would mean a lot of sideways price movement, with dividends having to deliver the lion’s share of stock market returns.
  3. If P/E/ ratios rise further, we will go back into the kind of “secular bubble” that created the Tech Wreck. I recall those years vividly, and I would rather not relive them.
Now, combine this market situation with what appears to be a global economic slowdown. China is a big factor, but not the only one. The entire developed world is in slow-growth mode. At some point it will likely dip into recession territory. Canada is already there. I don’t think they will be alone for long. Japan and Europe are weak.

I think the next true move to lower valuations will be a cyclical bear market combined with a recession. Can the stock market hold on to today’s valuations in a recession? Nothing is impossible, but I wouldn’t bet the farm on it, either. I can’t find an example of stock prices and valuations staying in place in the midst of a recession. Prices can fall slowly or they can fall fast, but I feel confident they will do one or the other.

Speaking of Bubbles
Our old friend Robert Shiller popped up last week in a Financial Times interview. Shiller is the father of CAPE, the cyclically adjusted price/earnings multiple, which looks back ten years to account for earnings cyclicality. He is also a Yale professor and a Nobel economics laureate.

Shiller’s CAPE has been saying for several years that stocks are seriously overvalued. In his FT interview, Shiller dropped the “B” word: It looks to me a bit like a bubble again, with essentially a tripling of stock prices since 2009 in just six years and at the same time people losing confidence in the valuation of the market.

When will the bubble burst? Shiller is less helpful there. He said the recent bout of volatility “shows that people are thinking something, worried thoughts. It suggests to me that many people are re-evaluating their exposure to the stock market. I’m not being very helpful about market timing, but I can easily see aftershocks coming.

Now, if you aren’t very confident about timing, it’s arguably better not to use words like bubble and aftershock. You can be sure the media and analysts will jump all over them, just as I’m doing right now.
In any case, Ed Easterling and Bob Shiller reach similar conclusions (though for different reasons). Neither sees a very bullish future, though both are unsure about timing. So when will we know the end is nigh? Sadly, we probably won’t, unless we begin to see signs that a recession is building in the United States.

Balloons in Search of Needles
As the old proverb goes, no one rings a bell at the top. The same applies at the bottom. Let’s imagine the stock market as a whole bunch of balloons. One or two can pop loudly and everyone will jump and then laugh it off. You now have deflated debris hanging from your string. Eventually, enough balloons will pop that the weight of the debris overwhelms the remaining balloons’ ability to keep the string aloft. Then your whole bunch falls down.


The last balloon to pop wasn’t any bigger or smaller than the others; it just happened to be last. In like manner, some kind of catalyst sets off every market collapse. It is usually something that would be survivable by itself. The plunge occurs because of all the previous balloons that bit the dust, but pundits and the media always like to point the finger at the most recent event.

So, if Easterling and Shiller are right, balloons are popping and making investors nervous, but there’s not enough damage yet to drag down the whole bundle. What are some candidates for the last balloon? A Chinese “hard landing” is probably the biggest, most obvious balloon right now. And actually, China is big enough for multiple balloons. Their stock market downturn produced one pop already. Beijing’s currency adjustment may have been another one.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best selling author, and Chairman of Mauldin Economics – please click here.



Get our latest FREE eBook "Understanding Options"....Just Click Here!

Thursday, August 13, 2015

A Great Insight into Why Commodity Weakness Will Persist

By John Mauldin 

In today’s Outside the Box, good friend Gary Shilling gives us deeper insight into the global economic trends that have led to China’s headline making, market shaking devaluation of the renminbi. He reminds us that today’s currency moves and lagging growth are the (perhaps inevitable) outcome of China massive expansion of output for many products that started more than a decade ago. China was at the epicenter of a commodity bubble that got underway in 2002, soon after China joined the World Trade Organization.

As manufacturing shifted from North America and Europe to China –with China now consuming more than 40% of annual global output of copper, tin, lead, zinc and other nonferrous metal while stockpiling increased quantities of iron ore, petroleum and other commodities – many thought a permanent commodity boom was here.

Think again, Australia; not so fast, Brazil. Copper prices, for instance, have been cut nearly in half as world growth, and Chinese internal demand, have weakened. Coal is another commodity that is taking a huge hit: China’s imports of coking coal used in steel production are down almost 50% from a year ago, and of course coal is being hammered here in the US, too.

And the litany continues. Grain prices, sugar prices, and – the biggee – oil prices have all cratered in a world where the spectre of deflation has persistently loomed in the lingering shadow of the Great Recession. (They just released grain estimates for the US, and apparently we’re going to be inundated with corn and soybeans. The yield figures are almost staggeringly higher than the highest previous estimates. Very bearish for grain prices.)

Also, most major commodities are priced in dollars; and now, as the US dollar soars and the Fed prepares to turn off the spigot, says Gary, “raw materials are more expensive and therefore less desirable to overseas users as well as foreign investors.” As investors flee commodities in favor of the US dollar and treasuries, there is bound to be a profound shakeout among commodity producers and their markets.

See the conclusion of the article for a special offer to OTB readers for Gary Shilling’s INSIGHT. Gary’s letter really does provide exceptional value to his readers and clients. It’s packed with well-reasoned, outside-the-consensus analysis. He has consistently been one of the best investors and analysts out there.

There are times when you look at your travel schedule and realize that you just didn’t plan quite as well as you could have. On Monday morning I was in the Maine outback with my youngest son, Trey, and scheduled to return to Dallas and then leave the next morning to Vancouver and Whistler to spend a few days with Louis Gave. But I realized as Trey and I got on the plane that I no longer needed to hold his hand to escort him back from Maine. He’s a grown man now. I could’ve flown almost directly to Vancouver and cut out a lot of middlemen. By the time that became apparent, it was too late and too expensive to adjust.

Camp Kotok, as it has come to be called, was quite special this year. The fishing sucked, but the camaraderie was exceptional. I got to spend two hours one evening with former Philadelphia Fed president Charlie Plosser, as he went into full-on professor mode on one topic after another. I am in the midst of thinking about how my next book needs to be written and researched, and Charlie was interested in the topic, which is how the world will change in the next 20 years, what it means, and how to invest in it. Like a grad student proposing a thesis, I was forced by Charlie to apply outline and structure to what had been only rough thinking.

There may have been a dozen conversations like that one over the three days, some on the boat – momentarily interrupted by fish on the line – and some over dinner and well into the night. It is times like that when I realize my life is truly blessed. I get to talk with so many truly fascinating and brilliant people. And today I find myself with Louis Gave, one of the finest economic and investment thinkers in the world (as well as a first class gentleman and friend), whose research is sought after by institutions and traders everywhere. In addition to talking about family and other important stuff, we do drift into macroeconomic talk. Neither of us were surprised by the Chinese currency move and expect that this is the first of many
.
I did a few interviews while I was in Maine. Here is a short one from the Street.com. They wanted to talk about what I see happening in Europe. And below is a picture from the deck of Leen’s Lodge at sunset. Today I find myself in the splendor of the mountains of British Columbia. It’s been a good week and I hope you have a great one as well.


Oops, I’ve just been talked into going zip-trekking this afternoon with Louis and friends. Apparently they hang you on a rope and swing you over forests and canyons. Sounds interesting. Looks like we’ll do their latest and greatest, the Sasquatch. 2 km over a valley. Good gods.

Your keenly aware of what a blessing his life is analyst,
John Mauldin, Editor

Stay Ahead of the Latest Tech News and Investing Trends...

Each day, you get the three tech news stories with the biggest potential impact.

Commodity Weakness Persists

(Excerpted from the August 2015 edition of A. Gary Shilling’s INSIGHT)
The sluggish economic growth here and abroad has spawned three significant developments – falling commodity prices, looming deflation and near-universal currency devaluations against the dollar. With slowing to negative economic growth throughout the world, it’s no surprise that commodity prices have been falling since early 2011 (Chart 1). While demand growth for most commodities is muted, supply jumps as a result of a huge expansion of output for many products a decade ago. China was the focus of the commodity bubble that started in early 2002, soon after China joined the World Trade Organization at the end of 2001.


China, The Manufacturer


As manufacturing shifted from North America and Europe to China – with China now consuming more than 40% of annual global output of copper, tin, lead, zinc and other nonferrous metal while stockpiling increased quantities of iron ore, petroleum and other commodities – many thought a permanent commodity boom was here.

So much so that many commodity producers hyped their investments a decade ago to expand capacity that, in the case of minerals, often take five to 10 years to reach fruition. In classic commodity boom-bust fashion, these capacity expansions came on stream just as demand atrophied due to slowing growth in export-dependent China, driven by slow growth in developed country importers. Still, some miners maintain production because shutdowns and restarts are expensive, and debts incurred to expand still need to be serviced. Also, some mineral producers are increasing output since they believe their low costs will squeeze competitors out. Good luck, guys!

Copper, Our Favorite


Copper is our favorite industrial commodity because it's used in almost every manufactured product and because there are no cartels on the supply or demand side to offset basic economic forces. Also, copper is predominantly produced in developing economies that need the foreign exchange generated by copper exports to service their foreign debts. So the lower the price of copper, the more they must produce and export to get the same number of dollars to service their foreign debts. And the more they export, the more the downward pressure on copper prices, which forces them to produce and export even more in a self reinforcing downward spiral in copper prices. Copper prices have dropped 48% since their February 2011 peak, and recently hit a six year low as heavy inventories confront subdued demand (Chart 2).


Even in 2013, after two solid years of commodity price declines, major producers were in denial. That year, Glencore purchased Xtrata and Glencore CEO Ivan Glasenberg called it “a big play” on coal. “To really screw this up, the coal price has got to really tank,” he said at the time. Since then, it’s down 41%. But back in February 2012 when the merger was announced, coal was selling at around $100 per ton and Chinese coal demand was still robust.

Nevertheless, Chinese coal consumption fell in 2014 for the first time in 14 years and U.S. demand is down as power plants shift from coal to natural gas. Meanwhile, coal output is jumping in countries such as Australia, Colombia and Russia. China’s imports of coking coal used in steel production are down almost 50% from a year ago. Many coal miners lock in sales at fixed prices, but at current prices, over half of global coal is being mined at a loss. U.S. coal producers are also being hammered by environmentalists and natural gas producers who advocate renewable energy and natural gas vs. coal.

Losing Confidence?


Recently, major miners appear to be losing their confidence, or at least they seem to be facing reality. Anglo-American recently announced $4 billion in writedowns, largely on its Minas-Rio $8.8 billion iron ore project in Brazil, but also due to weakness in metallurgical coal prices. BHP took heavy writedowns on badly timed investments in U.S. shale gas assets. Rio Tinto’s $38 billion acquisition of aluminum producer Alcan right at the market top in 2007 has become the poster boy for problems with big writeoffs due to weak aluminum prices and cost overruns.

Glencore intends to spin off its 24% stake in Lonmin, the world’s third largest platinum producer. Iron ore-focused Vale is considering a separate entity in its base metals division to “unlock value.” Meanwhile, BHP is setting up a separate company, South 32, to house losing businesses including coal mines and aluminum refiners. That will halve its assets and number of continents in which it operates, leaving it oriented to iron ore, copper and oil.

Goldman Sachs coal mines suffered from falling prices and labor problems in Colombia. It is selling all its coal mines at a loss and has also unloaded power plants as well as aluminum warehouses. The firm’s commodity business revenues dropped from $3.4 billion in 2009 to $1.5 billion in 2013. JP Morgan Chase last year sold its physical commodity assets, including warehouses. Morgan Stanley has sold its oil shipping and pipeline businesses and wants to unload its oil trading and storage operations.

Jefferies, the investment bank piece of Leucadia National Corp., is selling its Bache commodities and financial derivatives business that it bought from Prudential Financial in 2011 for $430 million. But the buyer, Societe Generale, is only taking Bache’s top 300 clients by revenue while leaving thousands of small accounts, and paying only a nominal sum. Bache had operating losses for its four years under Jefferies ownership.

Grains and other agricultural products recently have gone through similar but shorter cycles than basic industrial commodities. Bad weather three years ago pushed up grain prices, which spawned supply increases as farmers increased plantings. Then followed, as the night the day, good weather, excess supply and price collapses. Pork and beef production and prices have similar but longer cycles due to the longer breeding cycles of animals.

Sugar prices have also nosedived in recent years (Chart 3). Cane sugar can be grown in a wide number of tropical and subtropical locations and supply can be expanded quickly. Like other Latin American countries, Brazil – the world's largest sugar producer – enjoyed the inflow of money generated from the Fed’s quantitative easing. But that ended last year and in combination with falling commodity prices, those countries’ currencies are plummeting (Chart 4). So Brazilian producers are pushing exports to make up for lower dollar revenues as prices fall, even though they receive more reals, the Brazilian currency that has fallen 33% vs. the buck in the last year since sugar is globally priced in dollars.


Oil Prices


Crude oil prices started to decline last summer, but most observers weren’t aware that petroleum and other commodity prices were falling until oil collapsed late in the year. With slow global economic growth and increasing conservation measures, energy demand growth has been weak. At the same time, output is climbing, especially due to U.S. hydraulic fracking and horizontal drilling. So the price of West Texas Intermediate crude was already down 31% from its peak, to $74 per barrel by late November.

Cartels are set up to keep prices above equilibrium. That encourages cheating as cartel members exceed their quotas and outsiders hype output. So the role of the cartel leader – in this case, the Saudis – is to accommodate the cheaters by cutting its own output to keep prices from falling. But the Saudis have seen their past cutbacks result in market share losses as other OPEC and non-OPEC producers increased their output. In the last decade, OPEC oil production has been essentially flat, with all the global growth going to non-OPEC producers, especially American frackers (Chart 5). As a result, OPEC now accounts for about a third of global production, down from 50% in 1979.


So the Saudis, backed by other Persian Gulf oil producers with sizable financial resources – Kuwait, Qatar and the United Arab Emirates – embarked on a game of chicken with the cheaters. On Nov. 27 of last year, while Americans were enjoying their Thanksgiving turkeys, OPEC announced that it would not cut output, and they have actually increased it since then. Oil prices went off the cliff and have dropped sharply before the rebound that appears to be temporary. On June 5, OPEC essentially reconfirmed its decision to let its members pump all the oil they like.

The Saudis figured they can stand low prices for longer than their financially-weaker competitors who will have to cut production first. That list includes non-friends of the Saudis such as Iran and Iraq, which they believe is controlled by Iran, as well as Russia, which opposes the Saudis in Syria. Low prices will also aid their friends, including Egypt and Pakistan, who can cut expensive domestic energy subsidies.

The Saudis and their Persian Gulf allies as well as Iraq also don’t plan to cut output if the West's agreement with Iran over its nuclear program lifts the embargo on Iranian oil. As much as another million barrels per day could then enter the market on top of the current excess supply of two million barrels a day.

The Chicken-Out Price


What is the price at which major producers chicken out and slash output? It isn’t the price needed to balance oil-producer budgets, which run from $47 per barrel in Kuwait to $215 per barrel in Libya (Chart 6). Furthermore, the chicken out price isn’t the “full cycle” or average cost of production, which for 80% of new U.S. shale oil production is around $69 per barrel.


Fracker EOG Resources believes that at $40 per barrel, it can still make a 10% profit in North Dakota as well as South and West Texas. Conoco Phillips estimates full cycle fracking costs at $40 per barrel. Long run costs in the Middle East are about $10 per barrel or less (Chart 7).


In a price war, the chicken out point is the marginal cost of production – the additional costs after the wells are drilled and the pipelines laid – it’s the price at which the cash flow for an additional barrel falls to zero. Wood Mackenzie’s survey of 2,222 oil fields globally found that at $40 per barrel, only 1.6% had negative cash flow. Saudi oil minister Ali al-Naimi said even $20 per barrel is “irrelevant.”

We understand the marginal cost for efficient U.S. shale oil producers is about $10 to $20 per barrel in the Permian Basin in Texas and about the same on average for oil produced in the Persian Gulf. Furthermore, financially troubled countries like Russia that desperately need the revenue from oil exports to service foreign debts and fund imports may well produce and export oil at prices below marginal costs – the same as we explained earlier for copper producers. And, as with copper, the lower the price, the more physical oil they need to produce and export to earn the same number of dollars.

Falling Costs


Elsewhere, oil output will no doubt rise in the next several years, adding to downward pressure on prices. U.S. crude oil output is estimated to rise over the next year from the current 9.6 million level. Sure, the drilling rig count fell until recently, but it’s the inefficient rigs – not the new horizontal rigs that are the backbone of fracking – that are being sidelined. Furthermore, the efficiency of drilling continues to leap. Texas Eagle Ford Shale now yields 719 barrels a day per well compared to 215 barrels daily in 2011. Also, Iraq’s recent deal with the Kurds means that 550,000 more barrels per day are entering the market. OPEC sees non-OPEC output rising by 3.4 million barrels a day by 2020.

Even if we’re wrong in predicting further big drops in oil prices, the upside potential is small. With all the leaping efficiency in fracking, the full-cycle cost of new wells continues to drop. Costs have already dropped 30% and are expected to fall another 20% in the next five years. Some new wells are being drilled but hydraulic fracturing is curtailed due to current prices. In effect, oil is being stored underground that can be recovered quickly later on if prices rise Closely regulated banks worry about sour energy loans, but private equity firms and other shadow banks are pouring money into energy development in hopes of higher prices later. Private equity outfits are likely to invest a record $21 billion in oil and gas start ups this year.

Earlier this year, many investors figured that the drop in oil prices to about $45 per barrel for West Texas Intermediate was the end of the selloff so they piled into new equity offerings (Chart 8), especially as oil prices rebounded to around $60. But with the subsequent price decline, the $15.87 billion investors paid for 47 follow-on offerings by U.S. and Canadian exploration and production companies this year were worth $1.41 billion less as of mid-July.


Dollar Effects


Commodity prices are dropping not only because of excess global supply but also because most major commodities are priced in dollars. So as the greenback leaps, raw materials are more expensive and therefore less desirable to overseas users as well as foreign investors. Investors worldwide rushed into commodities a decade ago as prices rose and many thought the Fed’s outpouring of QE and other money insured soaring inflation and leaping commodity prices as the classic hedge against it.

Many pension funds and other institutional investors came to view them as an investment class with prices destined to rise forever. In contrast, we continually said that commodities aren’t an investment class but a speculation, even though we continue to use them in the aggressive portfolios we manage.

We’ve written repeatedly that anyone who thinks that owning commodities is a great investment in the long run should study Chart 9, which traces the CRB broad commodity index in real terms since 1774. Notice that since the mid-1800s, it’s been steadily declining with temporary spikes caused by the Civil War, World Wars I and II and the 1970s oil crises that were soon retraced. The decline in the late 1800s is noteworthy in the face of huge commodity-consuming development then: In the U.S., the Industrial Revolution and railroad building were in full flower while forced industrialization was paramount in Japan.


At present, however, investors are fleeing commodities in favor of the dollar, Treasury bonds and other more profitable investments. Gold is among the shunned investments, and hedge funds are on balance negative on the yellow metal for the first time, according to records going back to 2006. Meanwhile, individual investors have yanked $3 billion out of precious metals funds.

Commodity Price Outlook

Commodity prices are under pressure from a number of forces that seem likely to persist for some time.

1. Sluggish global demand due to continuing slow economic growth.
2. Huge supplies of minerals and other commodities due to robust investment a decade ago.
3. Chicken games being played by major producers in the hope that pushing prices down with increasing supply will force weaker producers to scale back. This is true of the Saudis in oil and hard rock miners in iron ore.
4. Developing country commodity exporters’ needs for foreign exchange to service foreign debt. So the lower the prices, the more physical commodities they export to achieve the same dollars in revenue. This further depresses prices, leading to increased exports, etc. Copper is a prime example.
5. Increased production to offset the effects on revenues from lower prices, which further depresses prices, etc. This is the case with Brazilian sugar producers.
6. The robust dollar, which pushes up prices in foreign currency terms for the many commodities priced in dollar terms. That reduces demand, further depressing prices.

It’s obviously next to impossible to quantify the effects of all these negative effects on commodity prices. The aggregate CRB index is already down 57% from its July 2008 pinnacle and 45% since the more recent decline commenced in April 2011. To reach the February 1998 low of the last two decades, it would need to drop 43% from the late July level, but there’s nothing sacred about that 1998 number.

In any event, ongoing declines in global commodity prices will probably renew the deflation evidence and fears that were prevalent throughout the world early this year. And they might prove sufficient to deter the Fed from its plans to raise interest rates before the end of the year.

Like Outside the Box? Sign up here today and get each new issue delivered free to your inbox.
It's your opportunity to get the news John Mauldin thinks matters most to your finances.

The article Outside the Box: Commodity Weakness Persists was originally published at mauldineconomics.com.


Get our latest FREE eBook "Understanding Options"....Just Click Here!

Stock & ETF Trading Signals