The Fed’s Alice In Wonderland Economy - What Happens Next?

By Nick Giambruno

After the president of the United States, the most powerful person on the planet is the chairman of the Federal Reserve. Ask almost anyone on the street for the name of the U.S. president, and you’ll get a quick answer. But if you ask the same person what the Federal Reserve is, you’ll likely get a blank stare. They don’t know - partly due to the institution’s deliberately obscure name - that the Fed is really the third iteration of the country’s central bank. Or that the Fed manipulates the nation’s economic destiny by controlling the money supply.

And that’s just how the Fed likes it. They’d prefer Boobus americanus not understand the king like power they wield. By simply choosing to utter the right words, the chairman of the Fed can create or extinguish trillions of dollars of wealth both in and outside of the U.S. He holds the economic fate of billions of people in his hands. So it’s no shocker that investors carefully parse everything he says. They have to, if they want to be successful. Some even go as far as to analyze the almighty chairman’s body language. Of course, the mainstream financial media revere the Fed.

You may recall the unhealthy spectacle that occurred in 1996. That’s when Alan Greenspan, the Fed chairman at the time, spoke the now famous phrase “irrational exuberance” in what should have otherwise been a dull and forgettable speech. Investors heard Greenspan’s phrase to mean that the Fed would soon raise interest rates to slow the global economy. It’s worth mentioning that Greenspan didn’t actually say the Fed would raise rates. Nor did he intend to signal that.

Nonetheless, the reaction was swift and panicky. U.S. markets were closed at the time, but stocks in Japan and Hong Kong dropped 3%. The German stock market fell 4%. When trading started in the U.S. market the next day, the market opened down 2%. Billions of dollars of wealth vanished in a period of 16 hours. That’s the absurd power over the global economy that the Federal Reserve gives to one human being. The words of the chairman can make or break the fortunes of anyone with a brokerage account.

The Fed’s Alice in Wonderland Economy

I almost fell out of my chair when I heard it….. A journalist recently asked Janet Yellen, the current chair of the Federal Reserve, if the central bank would keep interest rates at 0% forever. Her response: “I can’t completely rule it out.” I was stunned. The deferential financial media hurried to ignore the significance of that statement. Instead, it acted the way big city police might act after making a messy arrest on a busy sidewalk. “Move along folks, nothing to see here!”

Clearly, there was something to see. Something very important. Yellen’s words came amidst one of the most anticipated economic pronouncements in a generation… whether the Fed would finally raise interest rates for the first time in nine years. Short term rates have been at zero since the 2008 financial crisis. Interest rates are simply the price of borrowing money. Setting them at an artificial level is nothing other than price fixing. Not surprisingly, it has led to enormous amounts of malinvestment and other distortions in the economy.

Malinvestment is the result of faulty decision-making. Any investor or business can make a mistake, but central bank manipulation of interest rates subsidizes bad, wasteful decisions. Cheap borrowing costs trick companies. It causes them to plow money into plants, equipment, and other assets that appear profitable because borrowing costs are low. Only later, when the profits don’t show up, do they discover that the capital was wasted.

Seven years of quantitative easing (QE) and Fed engineered zero interest rates have drawn the U.S. and much of the world into an unsustainable "Alice in Wonderland" bubble economy riddled with malinvestment. The pundits had expected that, at this recent meeting, the Fed would move to raise rates just a little and give the global economy a tiny taste of sobriety. Not even that nudge materialized.

Instead, the Fed sat on its hands. It kept interest rates at zero. And Janet Yellen couldn’t even rule out that rates would stay at zero forever. If she can’t even do that, how is she going to start a sustained series of rate hikes, as many of those same pundits now expect her to do a few months down the road?

The truth is, seven years of 0% yields and successive rounds of money printing has so distorted the U.S. economy that it can’t handle even the tiniest increase in interest rates. It would be the pin that pricks the biggest stock and bond market bubble in all of human history. The Fed cannot let that happen.

What Happens Next

It’s clear that the Fed can’t raise interest rates in any meaningful way. It would trigger a financial meltdown that would quickly force them to reverse course. The Fed might be able to get away with a token increase, but that’s all. In other words, the Fed has trapped itself. Former Fed chairman Ben Bernanke admitted as much recently when he said he didn’t expect rates to normalize in his lifetime.

And then, we have the current chair Janet Yellen saying that rates might stay at zero forever!

Yellen’s belief that she has the power to suppress interest rates until the end of time is a frightening sign. As powerful as the Fed is, it isn’t stronger than the markets. A crisis in the markets could force rates higher even if the Fed doesn’t want them to go there. And the longer the Fed tries to sustain abnormalities like QE and 0% interest rates, the more likely it is that the whole business will end with the markets crushing the Fed.

And that’s not even considering a collapse of the petrodollar system or China pushing the establishment of a New Silk Road in Eurasia…two catalysts that would likely force interest rates higher. So I’ll go ahead and disagree with Yellen and rule out the possibility that rates might stay at zero forever. They won’t, because they can’t.

At the next sign of a market swoon or of a weakening economy, or with the next episode of deflationary jitters, the Fed will again ramp up the easy money. It could be another round of QE. Or the Fed could push interest rates into negative territory. If that fails, the Fed could go for the nuclear option and drop freshly printed money out of helicopters as Bernanke once infamously suggested – or, more likely, into everyone’s bank account. They’ll do whatever it takes, no matter what the eventual damage to the dollar’s value.
Whatever the details, one thing should be clear. This politburo of unaccountable central planners is the greatest risk to your financial wellbeing today.

What You Can Do About It

It’s a terrifying thought that the actions of a few people at the Fed so endanger your financial security.
But the facts are worse than that. There’s more to worry about than just the financial effects. The social and political implications of the Fed’s actions are even more dangerous. An economic depression and currency inflation (perhaps hyperinflation) are very much in the cards. These things rarely lead to anything but bigger government, less freedom, and shrinking prosperity. Sometimes they lead to much worse.

Fortunately, your destiny doesn’t need to be hostage to what’s coming. We’ve published a groundbreaking step by step manual that sets out the three essential measures all Americans should take right now to protect themselves and their families. These measures are easy and straightforward to implement. You just need to understand what they are and how they keep you safe. New York Times best selling author Doug Casey and his team describe how you can do it all from home. And there’s still time to get it done without any extraordinary cost or effort.

Normally, this "get it done" manual retails for $99. But I believe it’s so important for you to act now to protect yourself and your family that I’ve arranged for anyone who is a resident of the U.S. to get a free copy.

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The article was originally published at internationalman.com.

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Income Inequality? American Savers Treated Like Dogs

By Tony Sagami

One of the hot political topics these days is income inequality, but one of the groups of Americans that’s the most mistreated by Washington DC is the millions of Americans who have responsibly saved for their retirement.

When I entered the investment business as a stock broker at Merrill Lynch in the 1980s, savers could routinely get 7-9% on their money with riskless CDs and short term Treasury bonds.

In fact, I sold multimillions of dollars’ worth of 16 year zero coupon Treasury bonds at the time. Zero coupon bonds are debt instruments that don’t pay interest (a coupon) but are instead traded at a deep discount, rendering profit at maturity when the bond is redeemed for its full face value.

At the time, long term interest rates were at 8%, so the zero coupon Treasury bonds that I sold cost $250 each but matured at $1,000 in 16 years. A government-guaranteed quadruple!

Ah, those were the good old days for savers, largely thanks to the inflation fighting tenacity of Paul Volcker, chairman of the Federal Reserve under Presidents Jimmy Carter and Ronald Reagan from August 1979 to August 1987.

Monetary policies couldn’t be more different under Alan “Mr. Magoo” Greenspan, “Helicopter” Ben Bernanke, and Janet Yellen. This trio of hear see speak no evil bureaucrats have never met an interest rate cut that they didn’t like and have pushed interest rates to zero.

The yield on the 30 year Treasury bond hit an all time record low last week at 2.45%. Yup, an all time low that our country hasn’t seen in more than 300 years!

These low yields have made it increasingly difficult to earn a decent level of income from traditional fixed-income vehicles like money markets, CDs, and bonds.

Unless you’re content with near-zero return on your savings, you’ve got to adapt to the new era of ZIRP (zero interest rate policy). However, you cannot just dive into the income arena and buy the highest paying investments you can find. Most are fraught with hidden risks and dangers.

So to fully understand how to truly and dramatically boost your investment income, you absolutely must look at your investments in a new light, fully understanding the new risks as well as the new opportunities. There are really two challenges that all of us will face as we transition from employment to retirement: longer life expectancies; and lower investment yields.

Risk #1: Improved health care and nutrition have dramatically boosted life expectancies for both men and women. We will all enjoy a longer, healthier life, which means more time to enjoy retirement and spend with friends/family, but it also means that whatever money we’ve accumulated will have to work harder as well as longer.

Today, a 65 year-old man can expect to live until age 82, almost four years longer than 25 years ago; the life expectancy for a 65 year old woman is also up—from 82 years in the early 1980s to 85 today.

The steady increase in life expectancy is definitely something to celebrate, but it also means we’ll need even bigger nest eggs.

Risk #2: Don’t forget about inflation. Prices for daily necessities are higher than they were just a few years ago and constantly erode the purchasing power of your savings.

The way I see it, your comfort in retirement has never been more threatened than it is today, and it doesn’t matter if you’re 20 or 70.

The rules are different, and you only have two choices:

#1. spend your retirement as a Walmart greeter (if you’re lucky enough to get a job!); or

#2. adapt to the new rules of income investing.

Today, the new rules of successful income investing consist of putting together a collection of income focused assets, such as dividend paying stocks, bonds, ETFs, and real estate, that generate the highest possible annual income at the lowest possible risk.

Even in an environment of near zero interest rates and global uncertainty, there are many ways an investor can generate a healthy income while remaining in control. Income stocks should form the core of your income portfolio.

Income stocks are usually found in solid industries with established companies that generate reliable cash flow. Such companies have little need to reinvest their profits to help grow the business or fund research and development of new products, and are therefore able to pay sizeable dividends back to their investors.
What do I look for when evaluating income stocks?

• Macro picture. While it’s a subjective call, we want to invest in companies that have the big-picture macroeconomic wind at their backs and have long-term sustainable business models that can thrive in the current economic environment.

• Competitive advantage. Does the company have a competitive advantage within its own industry? Investing in industry leaders is generally more productive than investing in the laggards.

• Management. The company’s management should have a track record of returning value to shareholders.

• Growth strategy. What’s the company’s growth strategy? Is it a viable growth strategy given our forward view of the economy and markets?

• A dividend payout ratio of 80% or less, with the rest going back into the company’s business for future growth. If a business pays out too much of its profit, it can hurt the firm’s competitive position.

• A dividend yield of at least 3%. That means if a company has a $10 stock price, it pays annual cash dividends of at least $0.30 a year per share.

• The company should have generated positive cash flow in at least the last year. Income investing is about protecting your money, not hitting the ball out of the park with risky stock picks.

• A high return on equity, or ROE. A company that earns high returns on equity is usually a better-than-average business, which means that the dividend checks will keep flowing into our mailboxes.

This doesn’t mean that you should rush out and buy a bunch of dividend-paying stocks tomorrow morning. As always, timing is everything, and many—if not most—dividend stocks are vulnerably overpriced.

But make no mistake; interest rates aren’t rising anytime soon, and the solid, all weather income stocks (like the ones in my Yield Shark service) will help you build and enjoy a prosperous retirement. In fact, you can click here to see the details on one of the strongest income stocks I’ve profiled in Yield Shark in months.


Tony Sagami

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

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

The article Connecting the Dots: Income Inequality? American Savers Treated Like Dogs was originally published at mauldineconomics.com.

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Yellen’s Wand Is Running Low on Magic

By Doug French, Contributing Editor

How important is housing to the American economy?

If a 2011 SMU paper entitled "Housing's Contribution to Gross Domestic Product (GDP) quot; is right, nothing moves the economic needle like housing. It accounts for 17% to 18% of GDP. And don't forget that home buyers fill their homes with all manner of stuff—and that homeowners have more skin in insurance on what's likely to be their family's most important asset. All claims to the contrary, the disappointing first quarter housing numbers expose the Federal Reserve as impotent at influencing GDP's most important component.

The Fed: Housing's Best Friend

 

No wonder every modern Fed chairman has lowered rates to try to crank up housing activity, rationalizing that low rates make mortgage payments more affordable. Back when he was chair, Ben Bernanke wrote in the Washington Post, "Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance."

In her first public speech, new Fed Chair Janet Yellen said one of the benefits to keeping interest rates low is to "make homes more affordable and revive the housing market."

As quick as they are to lower rates and increase prices, Fed chairs are notoriously slow at spotting their own bubble creation. In 2002, Alan Greenspan viewed the comparison of rising home prices to a stock market bubble as "imperfect." The Maestro concluded, "Even if a bubble were to develop in a local market, it would not necessarily have implications for the nation as a whole."

Three years later—in 2005—Ben Bernanke was asked about housing prices being out of control. "Well, I guess I don't buy your premise," he said. "It's a pretty unlikely possibility. We've never had a decline in home prices on a nationwide basis." With never a bubble in sight, the Fed constantly supports housing while analysts and economists count on the housing stimulus trick to work.

2014 GDP Depends on Housing

 

"There's more expansion ahead for the housing market in 2014, with starts and new-home sales continuing to rise at double-digit rates, thanks to tight inventory," writes Gillian B. White for Kiplinger. The "Timely, Trusted Personal Finance Advice and Business Forecast(er)" says GDP will bounce back. Fannie Mae Chief Economist Doug Duncan says, "Our full-year 2014 economic forecast accounts for three key growth drivers: an acceleration in spending activity from private-sector forces, waning fiscal drag from the federal government, and continued improvement in the housing market."
We'll see about that last one.

Greatest Housing Subsidy of All Time Running Out of Gas

 

With the central bank flooding the markets with liquidity, holding short rates low, and buying long term debt, mortgage rates have been consistently below 5% since the start of 2009. For all of 2012, the 30 year fixed mortgage rate stayed below 4%. In the post gold standard era (after 1971), rates have never been this low for this long. The Fed's unprecedented mortgage subsidy has helped the market make a dead cat bounce since the crash of 2008. After peaking in July 2006 at 206.52, the Case-Shiller 20 City composite index bottomed in February 2012 at 134.06. It had recovered to 165.50 as of January. However, while low rates have propped up prices, sales of existing homes have fallen in seven of the last eight months. In March resales were down 7.5% from a year earlier. That's the fifth month in a row in which sales fell below the year earlier level.

David Stockman writes, "March sales volume remained the slowest since July 2012." He listed 13 major metro areas whose sales declined from a year ago, led by San Jose, down 18%. The three worst performers and 6 of the bottom 11 were California cities. Las Vegas and Phoenix were also in the bottom 10, with sales down double digits from a year ago. This after housing guru Ivy Zelman told CNBC in February, "California is back to where it was in nirvana." Considering the entire nation, she said, "I think nirvana is not far around the corner… I think that I have to tell you, I'm probably the most bullish I've ever been fundamentally, and I'm dating myself, been around for over 20 years, so I've seen a lot of ups and downs."

Housing Headwinds

 

Housing is contributing less to overall growth than during both the days of 20% mortgage rates in the 1980s and the S&L crisis of the early 1990s. In Phoenix, where home prices have bounced back and Wall Street money has vacuumed up thousands of distressed properties, the market has gone flat. In Belfiore Real Estates' April market report, Jim Belfiore wrote, "The bad news for home builders is they have created a glut of supply in previously hot market areas… Potential buyers, as might be expected, feel no sense of urgency to buy because they believe this glut is going to exist indefinitely."

Nick Timiraos points out in the Wall Street Journal that with a 4.5% mortgage rate and prices 20% below their peak, "… homes are still more affordable than in most periods between 1990 and 2008." So why is demand for new homes so tepid? And why have refinancings fallen 58% year over year in the first quarter?
"Housing's rocky recovery could signal weakness more broadly in the economy," writes Timiraos, "reflecting the lingering damage from the bust that has left millions of households unable to participate in any housing recovery. Many still have properties worth less than the amount borrowers owe on their mortgages, while others have high levels of debt, low levels of savings, and patchy incomes."

More specifically, "So far we have experienced 7 million foreclosures," David Stockman, former director of the Office of Management and Budget, writes. "Beyond that there are still nine million homeowners seriously underwater on their mortgages, and there are millions more who are stranded in place because they don't have enough positive equity to cover transactions costs and more stringent down payment requirements." Young people used to drive real estate growth, but not anymore. The percentage of young home buyers has been declining for years. Between 1980 and 2000, the percentage of homeowners among people in their late twenties fell from 43% to 38%. And after the crash, the downtrend continued. The percentage of young people who obtained mortgages between 2009 and 2011 was just half what it was ten years ago.

Young people don't seem to view owning a home as the American dream, as was the case a generation ago. Plus, who has room to take on more debt when 7 in 10 students graduate college with an average $30k in student loan debt? "First time home buyers are typically an important source of incremental housing demand, so their smaller presence in the market affects house prices and construction quite broadly," Fed Chairman Ben Bernanke told homebuilders two years ago.

There's not much good news for housing these days. For a little while, the Fed's suppression of interest rates juiced housing enough to distract Americans from weak job creation and stagnant real wages. Don't have a job? No problem! Just borrow against the appreciation of your house to feed your family. But Yellen's interest rate wand looks to be out of magic. The government had a pipe dream of white picket fences for everyone. But Americans can't refinance their way to wealth. Especially in the Greater Depression.

Read more about the Fed’s back-breaking economic shenanigans and the ways to protect your assets in the Casey Daily Dispatch—your daily go-to guide for gold, silver, energy, technology, and crisis investing.

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The article Yellen’s Wand Is Running Low on Magic was originally published at Casey Research

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Every Central Bank for Itself

By John Mauldin

“Everybody has a plan until they get punched in the face.”

– Mike Tyson

For the last 25 days I’ve been traveling in Argentina and South Africa, two countries whose economies can only be described as fragile, though for very different reasons. Emerging market countries face a significantly different set of challenges than the developed world does. These challenges are compounded by the rather indifferent policies of developed world central banks, which are (even if somewhat understandably) entirely self centered. Argentina has brought its problems upon itself, but South Africa can somewhat justifiably express frustration at the developed world, which, as one emerging market central bank leader suggests, is engaged in a covert currency war, one where the casualties are the result of unintended consequences. But the effects are nonetheless real if you’re an emerging market country.

While I will write a little more about my experience in South Africa at the end of this letter, first I want to cover the entire emerging market landscape to give us some context. Full and fair disclosure requires that I give a great deal of credit to my rather brilliant young associate, Worth Wray, who’s helped me pull together a great deal of this letter while I am on the road in a very busy speaking tour here in South Africa for Glacier, a local platform intermediary. They have afforded me the opportunity to meet with a significant number of financial industry participants and local businessman, at all levels of society. It has been a very serious learning experience for me. But more on that later; let’s think now about the problems facing emerging markets in general.

Every Central Bank for Itself

Every general has a plan before going into battle, which immediately begins to change upon contact with the enemy. Everyone has a plan until they get hit… and emerging markets have already taken a couple of punches since May 2013, when Fed Chairman Ben Bernanke first signaled his intent to “taper” his quantitative easing program and thereby incrementally wean the markets off of their steady drip of easy money. It was not too long after that Ben also suggested that he was not responsible for the problems of emerging-market central banks – or any other central bank, for that matter.

As my friend Ben Hunt wrote back in late January, Chairman Bernanke turned a single data point into a line during his last months in office, when he decided to taper by exactly $10 billion per month. He established the trend, and now the markets are reacting as if the Fed's exit strategy has officially begun.

Whether the FOMC can actually turn the taper into a true exit strategy ultimately depends on how much longer households and businesses must deleverage and how sharply our old age dependency ratio rises, but markets seem to believe this is the beginning of the end. For now, that’s what matters most.

Under Fed Chair Janet Yellen’s leadership, the Fed continues to send a clear message to the rest of the world: Now it really is every central bank for itself. 

The QE-Induced Bubble Boom in Emerging Markets

By trying to shore up their rich-world economies with unconventional policies such as ultra low rate targets, outright balance sheet expansion, and aggressive forward guidance, major central banks have distorted international real interest rate differentials and forced savers to seek out higher (and far riskier) returns for more than five years.

This initiative has fueled enormous overinvestment and capital misallocation – and not just in advanced economies like the United States.

As it turns out, the biggest QE-induced imbalances may be in emerging markets, where, even in the face of deteriorating fundamentals, accumulated capital inflows (excluding China) have nearly DOUBLED, from roughly $5 trillion in 2009 to nearly $10 trillion today. After such a dramatic rise in developed world portfolio allocations and direct lending to emerging markets, developed world investors now hold roughly one third of all emerging market stocks by market capitalization and also about one third of all outstanding emerging market bonds.

The Fed might as well have aimed its big bazooka right at the emerging world. That’s where a lot of the easy money ran blindly in search of more attractive real interest rates, bolstered by a broadly accepted growth story.

The conventional wisdom – a particularly powerful narrative that became commonplace in the media – suggested that emerging markets were, for the first time in a long time, less risky than developed markets, despite their having displayed much higher volatility throughout the past several decades.

As a general rule, people believed emerging markets had much lower levels of government debt, much stronger prospects for consumption led growth, and far more favorable demographics. (They overlooked the fact that crises in the 1980s and 1990s still limited EM borrowing limits until 2009 and ignored the fact that EM consumption is a derivative of demand and investment from the developed world.)

Instead of holding traditional safe haven bonds like US treasuries or German bunds, some strategists (who shall not be named) even suggested that emerging market government bonds could be the new safe haven in the event of major sovereign debt crises in the developed world. And better yet, it was suggested that denominating these investments in local currencies would provide extra returns over time as EM currencies appreciated against their developed market peers.

Sadly, the conventional wisdom about emerging markets and their currencies was dead wrong. Herd money (typically momentum based, yield chasing investors) usually chases growth that has already happened and almost always overstays its welcome. This is the same disappointing boom/bust dynamic that happened in Latin America in the early 1980s and Southeast Asia in the mid 1990s. And this time, it seems the spillover from extreme monetary accommodation in advanced countries has allowed public and private borrowers to leverage well past their natural carrying capacity.

Anatomy of a “Balance of Payments” Crisis

The lesson is always the same, and it is hard to avoid. Economic miracles are almost always too good to be true. Whether we’re talking about the Italian miracle of the ’50s, the Latin American miracle of the ’80s, the Asian Tiger miracles of the ’90s, or the housing boom in the developed world (the US, Ireland, Spain, et al.) in the ’00s, they all have two things in common: construction (building booms, etc.) and excessive leverage. As a quick aside, does that remind you of anything happening in China these days?

Just saying…...Broad based, debt fueled overinvestment may appear to kick economic growth into overdrive for a while; but eventually disappointing returns and consequent selling lead to investment losses, defaults, and banking panics. And in cases where foreign capital seeking strong growth in already highly valued assets drives the investment boom, the miracle often ends with capital flight and currency collapse.

Economists call that dynamic of inflow induced booms followed by outflow induced currency crises a “balance of payments cycle,” and it tends to occur in three distinct phases.

In the first phase, an economic boom attracts foreign capital, which generally flows toward productive uses and reaps attractive returns from an appreciating currency and rising asset prices. In turn, those profits fuel a self-reinforcing cycle of foreign capital inflows, rising asset prices, and a strengthening currency.

In the second phase, the allure of promising recent returns morphs into a growth story and attracts ever stronger capital inflows – even as the boom begins to fade and the strong currency starts to drag on competitiveness. Capital piles into unproductive uses and fuels overinvestment, overconsumption, or both; so that ever more inefficient economic growth increasingly depends on foreign capital inflows. Eventually, the system becomes so unstable that anything from signs of weak earnings growth to an unanticipated rate hike somewhere else in the world can trigger a shift in sentiment and precipitous capital flight.

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.

The article Thoughts from the Frontline: "Every Central Bank for Itself" was originally published at Mauldin Economics

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Forecast 2014: The Killer D’s

By John Mauldin

It seems I'm in a constant dialogue about the markets and the economy everywhere I go. Comes with the territory. Everyone wants to have some idea of what the future holds and how they can shape their own personal version of the future within the Big Picture. This weekly letter is a large part of that dialogue, and it's one that I get to share directly with you. Last week we started a conversation looking at what I think is the most positive and dynamic aspect of our collective future: The Human Transformation Revolution. By that term I mean the age of accelerating change in all manner of technologies and services that is unfolding before us. It is truly exhilarating to contemplate. Combine that revolution with the growing demand for a middle class lifestyle in the emerging world, and you get a powerful engine for growth. In a simpler world we could just focus on those positives and ignore the fumbling of governments and central banks. Alas, the world is too complex for that.

We'll continue our three part 2014 forecast series this week by looking at the significant economic macrotrends that have to be understood, as always, as the context for any short term forecast. These are the forces that are going to inexorably shift and shape our portfolios and businesses. Each of the nine macrotrends I'll mention deserves its own book (and I've written books about two of them and numerous letters on most of them), but we'll pause to gaze briefly at each as we scan the horizon.

The Killer D's
The first five of our nine macro-forces can be called the Killer D's: Demographics, Deficit, Debt, Deleveraging, and Deflation. And while I will talk about them separately, I am really talking threads that are part of a tapestry. At times it will be difficult to say where one thread ends and the others begin.

Demographics – An Upside Down World
One of the most basic human drives is the desire to live longer. And there is a school of economics that points out that increased human lifespans is one of the most basic and positive outcomes of economic growth. I occasionally get into an intense conversation in which someone decries the costs of the older generation refusing to shuffle off this mortal coil. Typically, this discussion ensues after I have commented that we are all going to live much longer lives than we once expected due to the biotechnological revolution. Their protests sometimes make me smile and suggest that if they are really worried about the situation, they can volunteer to die early. So far I haven't had any takers.

Most people would agree that growth of the economy is good. It is the driver of our financial returns. But older people spend less money and produce far less than younger, more active generations do. Until recently this dynamic has not been a problem, because there were far more young people in the world than there were old. But the balance has been shifting for the last few decades, especially in Japan and Europe.

An aging population is almost by definition deflationary. We can see the results in Japan. An aging, conservative population spends less. An interesting story in the European Wall Street Journal this week discusses the significant amount of cash that aging Japanese horde. In Japan there is almost three times as much cash in circulation, per person, as there is in the US. Though Japan is a country where you can buy a soft drink by swiping your cell phone over a vending machine data pad, the amount of cash in circulation is rising every year, and there are actually proposals to tax cash so as to force it back into circulation.

A skeptic might note that 38% of Japanese transactions are in cash and as such might be difficult to tax. But I'm sure that Japanese businesses report all of their cash income and pay their full share of taxes, unlike their American and European counterparts.

Sidebar: It is sometimes difficult for those of us in the West to understand Japanese culture. This was made glaringly obvious to me recently when I watched the movie 47 Ronin. In the West we may think of Sparta or the Alamo when we think of legends involving heroic sacrifice. The Japanese think of the 47 Ronin. From Wikipedia:

The revenge of the Forty-seven Ronin (Shi-jū-shichi-shi, forty-seven samurai) took place in Japan at the start of the 18th century. One noted Japanese scholar described the tale, the most famous example of the samurai code of honor, bushidō, as the country's "national legend."

The story tells of a group of samurai who were left leaderless (becoming ronin) after their daimyo (feudal lord) Asano Naganori was compelled to commit seppuku (ritual suicide) for assaulting a court official named Kira Yoshinaka, whose title was Kōzuke no suke. The ronin avenged their master's honor by killing Kira, after waiting and planning for almost two years. In turn, the ronin were themselves obliged to commit seppuku for committing the crime of murder. With much embellishment, this true story was popularized in Japanese culture as emblematic of the loyalty, sacrifice, persistence, and honor that people should preserve in their daily lives. The popularity of the tale grew during the Meiji era of Japanese history, in which Japan underwent rapid modernization, and the legend became subsumed within discourses of national heritage and identity.

The point of my sidebar (aside from talking about cool guys with swords) is that, while Japan may be tottering, the strong social fabric of the country, woven from qualities like loyalty, sacrifice, and diligence, should keep us from being too quick to write Japan off.

"Old Europe" is not far behind Japan when it comes to demographic challenges, and the United States sees its population growing only because of immigration. Russia's population figures do not bode well for a country that wants to view itself as a superpower. Even Iran is no longer producing children at replacement rates. At 1.2 children per woman, Korea's birth rates are even lower than Japan's. Indeed, they are the lowest in the World Bank database.

A basic equation says that growth of GDP is equal to the rate of productivity growth times the rate of population growth. When you break it down, it is really the working-age population that matters. If one part of the equation, the size of the working-age population, is flat or falling, productivity must rise even faster to offset it. Frankly, developed nations are simply not seeing the rise in productivity that is needed.
As a practical matter, when you are evaluating a business as a potential investment, you need to understand whether its success is tied to the growth rate of the economy and the population it serves.

In our book Endgame Jonathan Tepper and I went to great lengths to describe the coming crisis in sovereign debt, especially in Europe, which shortly began to play itself out. In the most simple terms, there can come a point when a sovereign government runs up against its ability to borrow money at reasonable rates. That point is different for every country. When a country reaches the Bang! moment, the market simply starts demanding higher rates, which sooner or later become unsustainable. Right up until the fateful moment, everyone says there is no problem and that the government in question will be able to control the situation.

If you or I have a debt issue, the solution is very simple: balance our family budget. But it is manifestly more difficult, politically and otherwise, for a major developed country to balance its budget than it is for your average household to do so. There are no easy answers. Cutting spending is a short-term drag on the economy and is unpopular with those who lose their government funding. Raising taxes is both a short term and a long-term drag on the economy.

The best way to get out of debt is to simply hold spending nominally flat and eventually grow your way out of the deficit, as the United States did in the 1990s. Who knew that 15 years later we would be nostalgic for Clinton and Gingrich? But governments almost never take that course, and eventually there is a crisis. As we will see in a moment, Japan elected to deal with its deficit and debt issues by monetizing the debt.

Meanwhile, in Europe, the ECB had to step in to save Italy and Spain; Greece, Ireland, and Portugal were forced into serious austerities; and Cyprus was just plain kicked over the side of the boat.



There is currently a lull in the level of concern about government debt, but given that most developed countries have not yet gotten their houses in order, this is a temporary condition. Debt will rear its ugly head again in the not too distant future. This year? Next year? 2016? Always we pray the prayer of St. Augustine: "Lord, make me chaste, but not today."

Deleveraging and Deflation – They Are Just No Fun
At some point, when you have accumulated too much debt, you just have to deal with it. My associate Worth Wray forwarded the following chart to me today. There is no better explanation as to why the current recovery is the weakest in recent history. Deleveraging is a b*tch. It is absolutely no fun. Looking at this chart, I find it rather remarkable and somewhat encouraging that the US has done as well as it has the past few years.



As I've outlined at length in other letters and in Code Red, central banks can print far more money than any of us can imagine during periods of deleveraging and deflation. For the record, I said the same thing back in 2010 when certain hysterical types were predicting hyperinflation and the end of the dollar due to the quantitative easing of the Federal Reserve. I remain actively opposed to the current level of quantitative easing, not because I'm worried about hyperinflation but for other reasons I have discussed in past letters. As long as the velocity of money keeps falling, central banks will be able to print more money than we would have thought possible in the '70s or '80s. And seemingly they can get away with it – in the short term. Of course, payback is a b*tch. When the velocity of money begins to rise again for whatever unknown reason, central banks had better have their ducks in a row!

Deflationary conditions make debt worse. If you borrow money at a fixed rate, a little inflation – or even a lot of inflation – helps a great deal. To think that even conservative Republican leaders don't get that is naïve. Certainly it is understood in Japan, which is why the success of Abenomics is dependent upon producing inflation. More on that below.

For governments, there is more than one way to deleverage. You can default on your payments, like Greece. We're going to see a lot more of that in the next five years – count on it. Or you can get your central bank to monetize the debt, as Japan is doing. Or get the central bank to convert your debt into 40-year bonds, as Ireland did. (Brilliant move, by the way, for tiny Ireland – you have to stand back and applaud the audacity. I wonder how much good Irish whiskey it took to get the ECB to agree to that deal?)

Inflation is falling almost everywhere today, even as central banks are as accommodative as they have ever been. Deflation is the default condition in a deleveraging world. It can even create an economic singularity.
Singularity was originally just a mathematical term for a point at which an equation has no solution. Then, in astrophysics, it was proven that a large enough collapsing star would become a black hole so dense that its own gravity would cause a singularity in the fabric of space time, a point where many standard physics equations suddenly have no solution.

Beyond the "event horizon" of the black hole, the physics models no longer work. In terms of general relativity, an event horizon is a boundary in space time beyond which events cannot affect an outside observer. In a black hole it is "the point of no return," i.e., the point at which the gravitational force becomes so large that nothing can escape.

Deflation and collapsing debt can create their own sort of black hole, an economic singularity. At that point, the economic models that we have grown comfortable with no longer work. As we approach a potential event horizon in a deflationary/deleveraging world, it can be a meaningless (and extremely frustrating) exercise to try to picture a future that is a simple extension of past economic reality. Any short term forecast (less than one or two years) has to bear that fact in mind.

We Are in a Code Red World
We need to understand that there has been a complete bureaucratic and academic capture of central banks. They are all run by neo-Keynesians. (Yes, I know there are some central bankers who disavow the prevailing paradigm, but they don't have the votes.) The default response of any present day central banker faced with a crisis will be massive liquidity injections. We can argue with the tide, but we need to recognize that it is coming in.

When there is a recession and interest rates are at or close to the zero bound, there will be massive quantitative easing and other, even more creative injections of liquidity into the system. That is a reality we have learned to count on and to factor into our projections of future economic possibilities. But as to what set of econometric equations we should employ in coming up with accurate, dependable projections, no one, least of all central bankers, has a clue. We are in unknown territory, on an economic Star Trek, with Captain Bernanke about to turn the helm over to Captain Yellen, going where no reserve currency printing central bank has gone before. This is not Argentina or Zimbabwe we are talking about. The Federal Reserve is setting its course based on economic theories created by people whose models are demonstrably terrible.

Will we have an outright recession in the US this year? I currently think that is unlikely unless there is some kind of external shock. But short term interest rates will stay artificially low due to financial repression by the Fed, and there will be an increased risk of further monetary creativity from a Yellen led Fed going forward. Stay tuned.
 
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The Unintended Consequences of ZIRP

By John Mauldin

Yellen's coronation was this week. Art Cashin mused that it was a wonder some senator did not bring her a corsage: it was that type of confirmation hearing. There were a few interesting questions and answers, but by and large we heard what we already knew. And what we know is that monetary policy is going to be aggressively biased to the easy side for years, or at least that is the current plan. Far more revealing than the testimony we heard on Thursday were the two very important papers that were released last week by the two most senior and respected Federal Reserve staff economists. As Jan Hatzius at Goldman Sachs reasoned, it is not credible to believe that these papers and the thinking that went into them were not broadly approved by both Ben Bernanke and Janet Yellen.

Essentially the papers make an intellectual and theoretical case for an extended period of very low interest rates and, in combination with other papers from both inside and outside the Fed from heavyweight economists, make a strong case for beginning to taper sooner rather than later, but for accompanying that tapering with a commitment to an even more protracted period of ZIRP (zero interest rate policy). In this week's letter we are going analyze these papers, as they are critical to understanding the future direction of Federal Reserve policy. Secondly, we'll look at what I think may be some of the unintended consequences of long-term ZIRP.

We are going to start with an analysis by Gavyn Davies of the Financial Times. He writes on macroeconomics and is one of the more of the astute observers I read. I commend his work to you. Today, rather than summarize his analysis, I feel it is more appropriate to simply quote parts of it. (I will intersperse comments, unindented.) The entire piece can be found here.

While the markets have become obsessively focused on the date at which the Fed will start to taper its asset purchases, the Fed itself, in the shape of its senior economics staff, has been thinking deeply about what the stance of monetary policy should be after tapering has ended. This is reflected in two papers to be presented to the annual IMF research conference this week by William English and David Wilcox, who have been described as two of the most important macro-economists working for the FOMC at present. At the very least, these papers warn us what the FOMC will be hearing from their staff economists in forthcoming meetings.

The English paper extends the conclusions of Janet Yellen's "optimal control speeches" in 2012, which argued for pre-committing to keep short rates "lower-for-longer" than standard monetary rules would imply. The Wilcox paper dives into the murky waters of "endogenous supply", whereby the Fed needs to act aggressively to prevent temporary damage to US supply potential from becoming permanent. The overall message implicitly seems to accept that tapering will happen broadly on schedule, but this is offset by super-dovishness on the forward path for short rates.

The papers are long and complex, and deserve to be read in full by anyone seriously interested in the Fed's thought processes. They are, of course, full of caveats and they acknowledge that huge uncertainties are involved. But they seem to point to three main conclusions that are very important for investors.

1. They have moved on from the tapering decision.

Both papers give a few nods in the direction of the tapering debate, but they are written with the unspoken assumption that the expansion of the balance sheet is no longer the main issue. I think we can conclude from this that they believe with a fairly high degree of certainty that the start and end dates for tapering will not be altered by more than a few months either way, and that the end point for the total size of the balance sheet is therefore also known fairly accurately. From now on, the key decision from their point of view is how long to delay the initial hike in short rates, and exactly how the central bank should pre-commit on this question. By omission, the details of tapering are revealed to be secondary.

Yellen said as much in her testimony. In response to a question about QE, she said, "I would agree that this program [QE] cannot continue forever, that there are costs and risks associated with the program."
The Fed have painted themselves into a corner of their own creation. They are clearly very concerned about the stock market reaction even to the mere announcement of the onset of tapering. But they also know they cannot continue buying $85 billion of assets every month. Their balance sheet is already at $4 trillion and at the current pace will expand by $1 trillion a year. Although I can find no research that establishes a theoretical limit, I do believe the Fed does not want to find that limit by running into a wall. Further, it now appears that they recognize that QE is of limited effectiveness with market valuations where they are, and so for practical purposes they need to begin to withdraw QE.

But rather than let the market deal with the prospect of an end to an easy monetary policy (which everyone recognizes has to draw to an end at some point), they are now looking at ways to maintain the illusion of the power of the Federal Reserve. And they are right to be concerned about the market reaction, as was pointed out in a recent note from Ray Dalio and Bridgewater, as analyzed by Zero Hedge:

"The Fed's real dilemma is that its policy is creating a financial market bubble  that is large relative to the pickup in the economy that it is producing," Bridgewater notes, as the relationship between US equity markets and the Fed's balance sheet (here and here for example) and "disconcerting disconnects" (here and here) indicate how the Fed is "trapped." However, as the incoming Yellen faces up to her "tough" decisions to taper or not, Ray Dalio's team is concerned about something else – "We're not worried about whether the Fed is going to hit or release the gas pedal, we're worried about whether there's much gas left in the tank and what will happen if there isn't."

Dalio then outlines their dilemma neatly. "…The dilemma the Fed faces now is that the tools currently at its disposal are pretty much used up, in that interest rates are at zero and US asset prices have been driven up to levels that imply very low levels of returns relative to the risk, so there is very little ability to stimulate from here if needed. So the Fed will either need to accept that outcome, or come up with new ideas to stimulate conditions."

The new ideas that Bridgewater and everyone else are looking for are in the papers we are examining. Returning to Davies work (emphasis below is mine!):

2. They think that "optimal" monetary policy is very dovish indeed on the path for rates.

Both papers conduct optimal control exercises of the Yellen-type. These involve using macro-economic models to derive the path for forward short rates that optimise the behaviour of inflation and unemployment in coming years. The message is familiar: the Fed should pre-commit today to keep short rates at zero for a much longer period than would be implied by normal Taylor Rules, even though inflation would temporarily exceed 2 per cent, and unemployment would drop below the structural rate. This induces the economy to recover more quickly now, since real expected short rates are reduced.

Compared to previously published simulations, the new ones in the English paper are even more dovish. They imply that the first hike in short rates should be in 2017, a year later than before. More interestingly, they experiment with various thresholds that could be used to persuade the markets that the Fed really, really will keep short rates at zero, even if the economy recovers and inflation exceeds target. They conclude that the best way of doing this may be to set an unemployment threshold at 5.5 per cent, which is 1 per cent lower than the threshold currently in place, since this would produce the best mix of inflation and unemployment in the next few years. Such a low unemployment threshold has not been contemplated in the market up to now.

3. They think aggressively easy monetary policy is needed to prevent permanent supply side deterioration.

This theme has been mentioned briefly in previous Bernanke speeches, but the Wilcox paper elevates it to center stage. The paper concludes that the level of potential output has been reduced by about 7 per cent in recent years, largely because the rate of productivity growth has fallen sharply. In normal circumstances, this would carry a hawkish message for monetary policy, because it significantly reduces the amount of spare capacity available in the economy in the near term.

However, the key is that Wilcox thinks that much of the loss in productive potential has been caused by (or is "endogenous to") the weakness in demand. For example, the paper says that the low levels of capital investment would be reversed if demand were to recover more rapidly, as would part of the decline in the labour participation rate. In a reversal of Say's Law, and also a reversal of most US macro-economic thinking since Friedman, demand creates its own supply.

This concept is key to understanding current economic thinking. The belief is that it is demand that is the issue and that lower rates will stimulate increased demand (consumption), presumably by making loans cheaper for businesses and consumers. More leverage is needed! But current policy apparently fails to grasp that the problem is not the lack of consumption: it is the lack of income. Income is produced by productivity. When leverage increases productivity, that is good; but when it is used simply to purchase goods for current consumption, it merely brings future consumption forward. Debt incurred and spent today is future consumption denied. Back to Davies:

This new belief in endogenous supply clearly reinforces the "lower for longer" case on short rates, since aggressively easy monetary policy would be more likely to lead to permanent gains in real output, with only temporary costs in higher inflation. Whether or not any of this analysis turns out to be justified in the long run, it is surely important that it is now being argued so strongly in an important piece of Fed research. 

            Read that last sentence again. It makes no difference whether you and I might disagree with their analysis. They are at the helm, and unless something truly unexpected happens, we are going to get Fed assurances of low interest rates for a very long time. Davies concludes:

The implication of these papers is that these Fed economists have largely accepted in their own minds that tapering will take place sometime fairly soon, but that they simultaneously believe that rates should be held at zero until (say) 2017. They will clearly have a problem in convincing markets of this. After the events of the summer, bond traders have drawn the conclusion that tapering is a robust signal that higher interest rates are on the way. The FOMC will need to work very hard indeed to convince the markets, through its new thresholds and public pronouncements, that tapering and forward short rates really do need to be divorced this time. It could be a long struggle.

On a side note, we are beginning to see calls from certain circles to think about also reducing the rate the Fed pays on the reserves held at the Fed from the current 25 basis points as a way to encourage banks to put that money to work, although where exactly they put it to work is not part of the concern. Just do something with it. That is a development we will need to watch.

The Unintended Consequences of ZIRP

Off the top of my head I can come up with four ways that the proposed extension of ZIRP can have consequences other than those outlined in the papers. We will look briefly at each of them, although they each deserve their own letter.

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Thoughts from the Frontline: A Code Red World

By John Mauldin

I wasn't the only person coming out with a book this week (much more on that at the end of the letter). Alan Greenspan hit the street with The Map and the Territory. Greenspan left Bernanke and Yellen a map, all right, but in many ways the Fed (along with central banks worldwide) proceeded to throw the map away and march off into totally unexplored territory. Under pressure since the Great Recession hit in 2007, they abandoned traditional monetary policy principles in favor of a new direction: print, buy, and hope that growth will follow. If aggressive asset purchases fail to promote growth, Chairman Bernanke and his disciples (soon to be Janet Yellen and the boys) respond by upping the pace. That was appropriate in 2008 and 2009 and maybe even in 2010, but not today.

Consider the Taylor Rule, for example – a key metric used to project the appropriate federal funds rate based on changes in growth, inflation, other economic activity, and expectations around those variables. At the worst point of the 2007-2009 financial crisis, with the target federal funds rate already set at the 0.00% – 0.25% range, the Taylor Rule suggested that the appropriate target rate was about -6%. To achieve a negative rate was the whole point of QE; and while a central bank cannot achieve a negative interest-rate target through traditional open-market operations, it can print and buy large amounts of assets on the open market – and the Fed proceeded to do so. By contrast, the Taylor Rule is now projecting an appropriate target interest rate around 2%, but the Fed is goes on pursuing a QE-adjusted rate of around -5%.



Also, growth in NYSE margin debt is showing the kind of rapid acceleration that often signals a drawdown in the S&P 500. Are we there yet? Maybe not, as the level of investor complacency is just so (insert your favorite expletive) high.



The potential for bubbles building atop the monetary largesse being poured into our collective glasses is growing. As an example, the "high-yield" bond market is now huge. A study by Russell, a consultancy, estimated its total size at $1.7 trillion. These are supposed to be bonds, the sort of thing that produces safe income for retirees, yet almost half of all the corporate bonds rated by Standard & Poor's are once again classed as speculative, a polite term for junk.

Central Bankers Gone Wild

But there is a resounding call for even more rounds of monetary spirits coming from emerging-market central banks and from local participants, as well. And the new bartender promises to be even more liberal with her libations. This week my friend David Zervos sent out a love letter to Janet Yellen, professing an undying love for the prospect of a Yellen-led Fed and quoting a song from the "Rocky Horror Picture Show," whose refrain was "Dammit, Janet, I love you." In his unrequited passion I find an unsettling analysis, if he is even close to the mark. Let's drop in on his enthusiastic note:

I am truly looking forward to 4 years of "salty" Janet Yellen at the helm of the Fed. And it's not just the prolonged stream of Jello shots that's on tap. The most exciting part about having Janet in the seat is her inherent mistrust of market prices and her belief in irrational behaviour processes. There is nothing more valuable to the investment community than a central banker who discounts the value of market expectations. In many ways the extra-dovish surprise in September was a prelude of so much more of what's to come.

I can imagine a day in 2016 when the unemployment rate is still well above Janet's NAIRU estimate and the headline inflation rate is above 4 percent. Of course the Fed "models" will still show a big output gap and lots of slack, so Janet will be talking down inflation risks. Markets will be getting nervous about Fed credibility, but her two-year-ahead projection of inflation will have a 2 handle, or who knows, maybe even a 1 handle. Hence, even with house prices up another 10 percent and spoos well above 2100, the "model" will call for continued accommodation!! Bond markets may crack, but Janet will stay the course. BEAUTIFUL!

Janet will not be bogged down by pesky worries about bubbles or misplaced expectations about inflation. She has a job to do – FILL THE OUTPUT GAP! And if a few asset price jumps or some temporary increases in inflation expectations arise, so be it. For her, these are natural occurrences in "irrational" markets, and they are simply not relevant for "rational" monetary policy makers equipped with the latest saltwater optimal control models.

The antidote to such a boundless love of stimulus is of course Joan McCullough, with her own salty prose:

And the more I see of the destruction of our growth potential … the more convinced I am that it's gonna' backfire in spades. Do I still think that we remain good-to-go into year end? At the moment, sporadic envelope testing notwithstanding, the answer is yes. But I have to repeat myself: The data has stunk for a long time and continues to worsen. And the anecdotes confirming this are yours for the askin'. The only question remaining is for how long we can continue to bet the ranch on wildly incontinent monetary policy while deliberately opting to ignore the ongoing disintegration of our economic fabric?"

And thus we come to the heart of this week's letter, which is the introduction of my just-released new book, Code Red. It is my own take (along with co-author Jonathan Tepper) on the problems that have grown out of an unrelenting assault on monetary norms by central banks around the world.

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Earnings Growth to Ramp Up? Call Me a Skeptic

By Sheraz Mian

Stocks have performed impressively this year and have largely been able to hold on to the gains despite monetary and fiscal uncertainties and the less than inspiring economic and earnings pictures. In a price-earnings framework for the market, most of the gains this year have resulted from investors’ willingness to pay a higher multiple for pretty much the same, or even lower, earnings.

Reasonable people can disagree over the extent of the Fed’s role in the market’s upward push, but few would argue that the Bernanke Fed’s easy money policy has been a key, if not the only, driver of this trend. If nothing else, the Fed policy of deliberately low interest rates pushed investors into riskier assets, including stocks.

But with the Fed getting ready to institute changes to its policy, investors will need to go back to fundamentals to keep pushing stocks higher.

We don’t know when the Fed will start ‘Tapering’ its bond purchases, but we do know that they want to get out of the QE business in the "not too distant" future. What this means for investors is that they will need to pay a lot more attention to corporate earnings fundamentals than has been the case thus far.

The overall level of corporate earnings remains quite high. In fact, aggregate earnings for the S&P 500 reached an all-time record in 2013 Q2 and are expected to be not far from that level in the ongoing Q3 earnings season as well. There hasn’t been much earnings growth lately, but investors are banking on material growth resumption from Q4 onwards. This hope is reflected in current consensus expectations for 2013 Q4 and full year 2014.

I remain skeptical of current consensus earnings expectations and would like to share the basis for my skepticism with you. The goal is to convince you that current earnings expectations remain vulnerable to significant downward revisions.

Negative estimate revisions haven't mattered much over the last few quarters as the Fed's generous liquidity supply helped lift all boats. But if the Fed is going to be less of a supporting actor going forward, then it's reasonable to expect investors to start paying more attention to fundamentals. It is in this context that the coming period of negative revisions could potentially result in the market giving back some, if not all, of its recent gains.

This discussion is particularly timely as we are in the midst of the 2013 Q3 earnings season that will help shape consensus estimates for Q4 and beyond. In the following sections, I will give you an update on the Q3 earnings season and critically review consensus expectations for Q4 and beyond.

The Q3 Scorecard

 

As of Monday, October 21st, we have Q3 results from 109 companies in the S&P 500 that combined account for 31.6% of the index’s total market capitalization. Total earnings for these 109 companies are up +7.5% year over and 63.3% of companies beat earnings expectations with a median surprise of +2.1%. Total revenues are up +2.1%, with 45.9% of the companies beating top line expectations and median revenue surprising by +0.02%.

The table below presents the current scorecard for Q3



Note: One sector, Aerospace, has not reported any Q3 results yet. NRPT means ‘no reports’; NM means ‘not meaningful’. 

With results from more than 30% of the S&P 500’s total market capitalization already out, we are seeing the Q3 earnings picture slowly emerge. This is particularly so for the Finance sector, where 51.8% of the sector’s total market cap has already reported. Other sectors with meaningful sample sizes include Transportation (47.3%), Consumer Staples (40.4%), Technology (36.9%) and Medical (25.2%).

Finance has been a steady growth driver for the last many quarters and is diligently playing that role this time around as well despite anemic loan demand, wind-down of the mortgage refi business and weak capital markets activities, particularly on the fixed income side. Outside of Finance, total earnings are up +4.4% for the companies that have reported already.

How do the 2013 Q3 results thus far compare with the last few quarters?

The short answer is that they are no better than what we have seen from this same group of 109 companies in recent quarters. In fact, on a number of counts the results thus far do not compare favorably to either the preceding quarter (2013 Q2), or the 4-qurater average, or both.

Specifically, the earnings and revenue growth rates and revenue beat ratio are tracking lower, while the earnings beat ratio is about in-line



The charts below compare the beat ratios for these 109 companies with what these same companies reported in Q2 and the 4-quarter average (beat ratio is the % of total companies coming ahead of consensus expectations).



The trends we have seen thus far will shift to some extent as the rest of the reporting season unfolds, but not by much. A composite look at the Q3 earnings season, combining the actual results from the 109 companies with estimates for the 391, is for +2.1% earnings growth on +0.8% higher revenues, as the summary table below shows.

 

Earnings growth rate has averaged a little over +3% over the first two quarters of the year and will likely stay at or below that level in Q3 as well. With respect to beat ratios, roughly two-thirds of the companies come ahead of expectations in a typical quarter and the Q3 ratio will likely be in that same vicinity.

The ‘Expectations Management’ Game

 

In the run up to the start of the Q3 earnings season, consensus earnings estimates came down sharply. The primary reason for the estimate cuts – guidance from management teams. Companies guided lower for Q3 while reporting Q2 results, a trend that has remained in place for more than a year now.
The chart below does a good job of showing the evolving Q3 earnings expectations over the last few months.



The Q3 estimate cuts weren’t unusual or peculiar to the quarter, as we have been seeing this trend play out repeatedly for more than a year now. The chart below compares the trends in earnings estimate revisions in the run up to the Q3 and Q2 reporting seasons



These expectations mean that Q3 wouldn't be materially different from what we have become accustomed to seeing quarter after quarter, with roughly two-thirds of the companies beating consensus earnings estimates. This game of under-promise and over-deliver by management teams has been around long enough that it has likely lost most of its value in investors’ eyes.

Beat ratios may not carry as much informational value this time around, but what will be particularly important is company guidance for Q4 and beyond. Guidance is always very important, but it has assumed added significance this time around given the elevated hopes that Q4 represents a material earnings growth ramp up after essentially flat growth over the last many quarters.

Evaluating Expectations for Q4 & Beyond

 

Let's take a look at how consensus earnings expectations for 2013 Q3 compare to what companies earned in the last few quarters and what they are expected to earn in the coming quarters.
The chart below shows the expected Q3 total earnings growth rate for the S&P 500 contrasted with the preceding two and following two quarters. (Please note that the Q3 growth rate is for the composite estimate for the S&P 500, combining the 109 that have reported with the 391 still to come)



The Finance sector has been a big earnings growth driver for some time. Outside of the Finance sector, total earnings growth for the S&P 500 was in the negative in 2013 Q2 and is expected to be no better in Q3. But the high hopes from Q4 and beyond reflect a strong turnaround in growth outside of Finance.
The chart below shows the same data as the one above, but excludes the Finance sector.



What this means is that quarterly earnings growth was +3.4% in the first two quarters of the year, is expected to be 2.1% in Q3, but accelerate to a +9.4% pace in Q4. And not all of the expected Q4 growth is coming from the Finance sector, as the rest of the corporate world is expected to reverse trend and start contributing nicely from Q4 onwards.

The chart below shows the same data, but this time on a trailing 4-quarter basis. The way to read this chart of steadily rising expectations is that total earnings for the S&P 500 are on track to be up +3.8% year over year in the four quarters through Q3, but accelerate to +4.5% in Q4 and +5.6% in 2014 Q1. Consensus expectations are for total earnings growth of +11.8% in calendar year 2014.



The two charts below show earnings for the S&P 500; not EPS, but total earnings. The first chart shows quarterly totals, while the second one presents the same data on a trailing 4-quarter basis. As you can see, the 'level' of total earnings is very high. In fact, quarterly earnings have never been this high - the 2013 Q2 total of $260.3 billion was an all-time quarterly record.




The data in this chart reflects current consensus estimates. This shows that consensus is looking for new all-time record quarterly totals in the coming two quarters. The high expected growth rates in Q4 and beyond are more than just easy comparisons, they represent material gains in total earnings.
The record level of current corporate profits is also borne by the very high level of corporate profits as a share of nominal GDP, which has never been this high ever. The chart below, using data from the BEA, of corporate profits as a share of nominal GDP clearly shows this.




Where Will the Growth Come From?


There is some truth to the claim that the current record level of corporate profits, whether in absolute dollar terms or as a share of the GDP, does not mean that earnings have to necessarily come down. But earnings don’t grow forever either as current consensus expectations of double-digit growth next year and beyond seem to imply.

After all, earnings in the aggregate can grow only through two avenues - revenue growth and/or margin expansion.

Revenue growth is strongly correlated with 'nominal' GDP growth. If the growth outlook for the global economy is positive or improving, then it’s reasonable to expect corporate revenues to do better as well. But the global economic growth outlook is at best stable, definitely not improving as the recent estimate cuts by the IMF shows.

The U.S. economic outlook has certainly stabilized and GDP growth in Q4 is expected to be modestly better than Q3’s growth pace. The expectation is for growth to materially improve in 2014, with consensus GDP growth estimates north of +3% for 2014 and even higher the following year. Europe isn’t expected to become an engine of global growth any time soon, but the region’s recession has ended and its vitals appear to be stabilizing. The magic of Abenomics is expected to revitalize Japan, but it’s nothing more than a hope at this stage. In the emerging world, sentiment on China has improved, but India, Brazil, Turkey and other former high flyers appear to be struggling.

All in all, this isn’t a picture to get overly excited about. But with almost 60% of the S&P 500 revenues coming from the domestic market, the expected GDP ramp up next year should have a positive effect on corporate revenues, which are expected to increase by +4.2% in 2004. But in order to reach the expected +11.8% total earnings growth in 2014, we need a fair amount of expansion in net margins to compliment the +4.2% revenue growth.

Can Margins Continue to Expand?

 

The two charts show net margins (total income/total revenues) for the S&P 500, on a quarterly and trailing 4-quarter basis. For both charts, the data through 2013 Q2 represents actual results, while the same for Q3 and beyond represent net margins implied by current consensus estimates for earnings and revenues.



The chart below shows net margins the same data for a longer time span on a calendar year basis – from 2003 through 2014.



As you can see margins have come a long way from the 2009 bottom and by some measures have already peaked out.

Margins follow a cyclical pattern. As the above chart shows, they expand as the economy comes out of a recession and companies use existing resources in labor and capital to drive business. But eventually capacity constraints kick in, forcing companies to spend more for incremental business. Input costs increase and they have hire more employees to produce more products and services. At that stage, margins start to contract again.

We may not be at the contraction stage yet, but given the current record level of margins and how far removed we are from the last cyclical bottom, we probably don’t have lot of room for expansion. The best-case outcome on the margins front will be for stabilization at current levels; meaning that companies are able to hold the line on expenses and keep margins steady. We will need to buy into fairly optimistic assumptions about productivity improvements for current consensus margin expansion expectations to pan out.

So What Gives?

 

What all of this boils down to is that current consensus earnings estimates are high and they need to come down - and come down quite a bit. I don't subscribe to the view held by some stock market bears that earnings growth will turn negative. But I don't buy into the perennial growth story either.

So what's the big deal if estimates for Q4 come down in the coming days and weeks? After all, estimates have been coming down consistently for more than a year and the stock market has not only ignored the earnings downtrend, but actually scaled new heights.

A big reason for investors' disregard of negative estimate revisions has been that they always looked forward to a growth ramp up down the road. In their drive to push stocks to all-time highs in the recent past, investors have been hoping for substantial growth to eventually resume. The starting point of this expected growth ramp-up kept getting delayed quarter after quarter. The hope currently is that Q4 will be the starting point of such growth.

Guidance has overwhelmingly been negative over the last few quarters. But if current Q4 expectations have to hold, then we will need to see a change on the guidance front; we need to see more companies either guide higher or reaffirm current consensus expectations. Anything short of that will result in a replay of the by-now familiar negative estimate revisions trend that we have been seeing in recent quarters.

Will investors delay the hoped for earnings growth recovery again this time or finally realize that the period of double digit earnings growth is perhaps behind us for good? Hard to tell at this stage, but we will find out soon enough. My sense is that markets can buck trends in aggregate earnings for some time, as they have been doing lately. But expecting the trend to continue indefinitely may not be realistic.

220 Stocks To Sell Now

 

No matter where the market is headed, one fact is obvious: You should not buy and hold stocks unless they offer good prospects for profit. I can help you weed out many of the ones that don't make the grade. That is because my company, Zacks Investment Research, is releasing to the public its list of 220 Stocks to Sell Now.

These Strong Sells are sinister portfolio killers because many have good fundamentals and seem like good buys.   But something important has happened to each of them that greatly lowers their odds of success. Historically, such stocks perform 6 times worse than the market.

I invite you to examine this list for free and make sure no stock you own or are considering is on it. Today you are welcome to see it and other time-sensitive Zacks information at no charge and with no obligation to purchase anything.

See Zacks’ “220 Stocks to Sell Now” list for Free.

Best,
Sheraz Mian
Sheraz Mian is the Director of Research for Zacks and manages its award-winning Focus List portfolio. 
 
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Busting Economic and Natural Resource Myths

By The Gold Report

The Gold Report: Why is the theory of tapering or turning quantitative easing (QE) off a myth, and who really benefits from QE?


Rick Rule: My view—as an investor, not an economist—is that QE is misnamed. I think it's another way of saying counterfeiting. It exists in large measure because we're running a trillion-dollar deficit and, while we can hoodwink investors into funding two-thirds of it, we need to print away the last third.

TGR: What are the consequences of turning off QE?

Louis James: Federal Reserve Chairman Ben Bernanke said himself that he had certain criteria he wanted to see before tapering—employment in particular. Those have not been met. Employment figures have improved, but only in—I guess the technical term would be "crappy" jobs. Long-term employment, the middle class' bread and butter, is not better.

TGR: Rick, you defy common sense and argue that bull markets are bad and bear markets are good, but it doesn't feel that way.

RR: JT, at the risk of being sexist, women are normally more rational shoppers than men. Think about the stock market as a mall.

In the mall, the store on the left-hand of the entrance has a big flashing sign that says, "Bear Market Merchants All Goods 70% Off, No Reasonable Offer Refused, Come Back Tomorrow—Prices May Be Lower." The store on the right-hand side has a tiny sign that says, "Bespoke Bear Market Merchants, No Deals Ever, High Margin for Merchants, Don't Even Think About Asking for a Deal, Prices May Be Higher Next Week."

If you're going to buy a pair of shoes, which store would you go to? This is a no-brainer. When people buy physical goods, they act rationally. When they buy financial goods, they want to overpay. It's totally irrational, and it's extraordinarily common. If you want to become wealthier, why wouldn't you buy financial assets when they're on sale?

TGR: Staying with the mall analogy, does that suggest that people are afraid stocks will be on even deeper sale tomorrow?

Marin Katusa: You have to look at the timeframe. This is a great market if you're an accredited investor and have an account with someone like Rick Rule or you subscribe to the International Speculator and follow the right management teams. Today, you can invest in deals with five-year full warrants that would not have been available three years ago. Rick and I have been in meetings where the venture teams laughed at me when I requested full warrants. Rick just said, "Bite your lip, smile, and wait." And he was right.
If you're buying stock today in hopes that the market will go up the next day, you'll be in a lot of pain. But if you have a two- to five-year timeframe, you can get guys like Bob Quartermain and Lukas Lundin on sale.

LJ: What would you give to go back in time and buy Apple just after the Apple II came out? Or to buy Microsoft when DOS was new?

Over the course of the last decade—what I think of as the first half of this great bull cycle—billions of dollars have gone into the ground and done good work.

Companies with 10 million ounces of high grade gold in a safe mining jurisdiction are on sale below IPO prices. Some companies with excellent management and assets in hand are selling for less than cash value. You can buy these companies now, instead of looking for the next Apple or Microsoft.

RR: Words like "want" and "hope" in speculation are truly four-letter words, profanities. Having a stock in your portfolio that cost $200,000 and has a current market valuation of $40,000 is unfortunate, but irrelevant. Investors need to take advantage of their education and do their best with the situation at hand. Right now, things are cheap. When things are cheap you're supposed to buy. In bull markets, when things are expensive, you're supposed to sell.

Right now, buying is easy because you have no competitors. In a bull market, selling is easy because everybody is a buyer. If the market is desperately looking for bids and you are scared to death because your stocks can't catch bids, you have to bid. They say the market was desperate for asks, but this market is desperate for bids.

TGR: Some have said this the end of the commodity supercycle. Is that a myth? And is it more or less of a myth in some sectors than others?

RR: The narrative that existed in 2009-2010, when the commodity supercycle was the currency of all financial thinking, is unchanged. The first part of that narrative was founded on the idea that world population growth was taking commodity consumption higher. World population growth is not over.

The second part of the narrative was that as poor people gained more freedom, they got richer and consumed more. Political liberalization in emerging frontier markets has continued, and people are wealthier and are consuming more.

A third part of the narrative was that Western consumers had lived beyond their means and as a consequence were debasing the denominators, the fiat currencies. If you debase the denominator, the nominal value of stuff would go up. We have not stopped debasing the denominator.

The entire narrative associated with the resource-industry bull market is intact. Nothing has changed except the price. A cyclical decline in a secular bull market is a different way of describing a spectacular sale, for people who understand that the narrative hasn't changed.

TGR: Are there some sectors that still feel as if it's a commodity supercycle?

MK: Definitely. Look at oil.

RR: But your readers don't want to look for hot sectors, because they are overpriced. They want to look for cold sectors. They want to find the sector, management team, or the company that's going to be hot.

TGR: If oil is hot right now, what is going to be hot?

MK: From the energy side, I think within three years uranium will be hot.

TGR: Why the three-year timeline?

MK: There are three major catalysts. First is the end of the US-Russia Highly Enriched Uranium Purchase Agreement (HEU). The last shipment will happen at the end of 2013.

Second is the transitional agreement, in which the Russians will provide up to 50% of the uranium on a new pricing metric than the HEU agreement. Only this time, the Russians have new dance partners: Saudi Arabia, China, India, Korea, even France. The reality is the Americans will have to pay more for uranium from the Russians.

Third, nuclear reactors are not all being taken down; they're being built. Japan plans to bring its reactors back online, just not on the timeframe the junior resource sector wants them to. The Japanese cannot afford to pay the most expensive electricity prices in the world and stay competitive. They have no choice but to move forward with nuclear power.

TGR: Is the end of HEU already priced in to uranium?

MK: Yes, both because the market is determining what it's worth today and because Japan shut down 40 nuclear reactors. That's a black-swan game-changer that shifted everything.

Yet, the long-term price is 50% higher than the spot price, and more than 90% of the uranium being consumed and traded is based on the long-term price. That's the equivalent of saying gold today is $1,300/ounce, but if you want to take delivery in three or four years—which is what nuclear utilities do for uranium—you have to pay $1,900/oz. Or copper at $4.50/pound if you want delivery in five years. That's the situation in uranium today.

TGR: Louis, which sector are you looking forward to?

LJ: There's talk on the streets about helium, although I'm not sure I want to move in that direction. I'm happier focusing on something right in front of me and that I understand. Finding a company that has a multimillion-ounce, high-grade deposit and is on sale at half price is similar to going into the supermarket and finding the thickest, most beautifully marbled T-bone steak, fresh cut today, on sale for half off. Why bother with hamburger of unknown quality?

TGR: We keep hearing that we've hit a bottom, which would imply that the market is moving up. However, Rick, you have described it as a bifurcated market in which the bad stocks will continue to sink, which would be a good thing. How do we know which companies will sink and which will revive?

RR: That's a critical question. Before your readers classify stocks, they need to classify themselves. Are they the type of person who will put enough time and attention into securities analysis to compete on their own? Or do they need other people to help them compete?

While securities analysis and stock selection in the junior market is imperfect, it can be done. It requires understanding the stock. If you're not willing to understand the stock, you need an advisor.

TGR: How many hours does that work take? What questions should investors be asking?

RR: Speculators running their own portfolios without advice should limit the number of stocks in the portfolio to the number that they can spend two or three hours a month working on. That means reading every press release, proxy, quarterly, and annual report. Read the president's message and measure it against what he said the company would accomplish over the year.

Speculators unwilling to do that need to hire somebody who will. That may mean subscribing to one of the trading services offered by Casey or hiring an organization like Sprott to be a broker or a manager.
Getting to bifurcation and stock selection, if 15% of the stocks are moving higher, 85% are moving lower. You won't be able to concentrate 100% in either camp, but if you get more right than wrong, you'll make so much money that the outliers will be irrelevant. If you get it wrong, you'll lose so much money that you ought to be in some other business.

TGR: Are there fewer brokers walking the streets of Vancouver these days?

MK: Definitely, also fewer analysts and fewer corporate development positions and many fewer investor relations people.

There are more BMWs, Mercedes, and Ferraris on sale, and now more offices becoming vacant.

TGR: Does that mean only the best are left?

MK: Not necessarily.

RR: But it does reduce the population. To be a responsible analyst, you once had to look in a cursory fashion at 4,000 companies. Today, having only 3,000 companies to look at is an advantage.

The three of us look at data in a summary fashion to try and dispose of a company. You look for something to kill your interest. The good news is that the population of timewasters is down by at least a third. That's unfortunate for their shareholders, but that's their problem, not ours. Our job is to look after our subscribers or clients.

TGR: Let's talk about regions. Is it true that the Yukon is remote?

LJ: It's no more remote now than it was last year. You can't write off the Yukon or anywhere without looking at and understanding the specifics of individual opportunities. Miners with remote projects that have high enough margins are able to barge or truck diesel fuel in and run gen-sets, etc. If Canadians can mine diamonds in the Arctic Circle, they can mine gold in the Yukon.

Remoteness by itself is not the issue. The issue is margin. If you're in the Yukon and you've got something low grade, with low recoveries and complex metallurgy—don't call us, we'll call you. If you have something high grade, open pit, that leaches, tell me more.

TGR: Rick, in your presentation, you talked about platinum and palladium. Is that an area where the supercycle needs to whip things up?

RR: I don't think it even requires a supercycle. With platinum and palladium, I can look empirically at simple supply and demand. On a global basis, the platinum and palladium industry doesn't earn its cost of capital. That means one of two things will happen: The price of platinum and palladium will increase, or there won't be enough platinum and palladium to supply current demand.

In the context of supply, you don't have to worry about investor inventories because there are almost none. The world supply of existing, finished platinum and palladium is less than one year's fabrication demand.
The consequence of the industry not earning its cost of capital is that production has fallen by 19% over six years. New mine supply is falling. South Africa itself accounts for 70% of world platinum production and 39% of world palladium production.

In South Africa, the industry has deferred $5 billion in sustaining capital investments; workers are dying and infrastructure is more and more decrepit.

A skilled worker crouching 7,000 feet underground in 105-degree heat in two inches of water makes $700 per month. An unskilled worker who mucks the material on his hands and knees 400 meters from the mine face to the adit makes $200 a month. A migratory worker sustaining a family in the homeland is probably sustaining another family at the mine face. Wages have to go up, but they can't because the companies don't earn their cost of capital.

According to the majority of South Africans, social take—taxes and royalties—has to go up, but can't because companies don't earn their cost of capital.

Prices have to go up. Platinum and palladium prices can go up because their utility to users is so high. It goes into high-carat jewelry. Platinum goes up a smokestack. Mostly, it goes out a tailpipe.

It costs $200—the cost of a catalytic converter in a new car—to give us the air quality we enjoy today. There's a social consensus in favor of stricter air-quality standards. If the price of platinum and palladium doubled, the catalytic converter would cost $400 in a $27,000 new car; the demand impact would be de minimus.

LJ: We all know the often-quoted phrase that most of the gold ever mined in the world is still sitting in purified form on the surface in one form or the other. Platinum and palladium are different; they are consumed. I agree with Rick.

I would go one step further regarding South Africa. It's not just the economics that don't work; it's the country itself. It's a balloon resting on pins. I see platinum and palladium as speculation on South Africa going up in flames, which is an easy bet to take now. I'm sorry for the South Africans, but it's a bad situation with no easy way out.

TGR: There's been a lot of talk about the dearth of young, qualified people coming up to take a place in management teams. Has the next generation of managers—and investors, for that matter—left the sector? If so, what will happen?

MK: There's a significant age gap in our industry. When I was taking geology courses at university, our professor would ask why we were taking this class. There were no jobs. He recommended we go into computers, and a lot of people did.

Unfortunately, good management teams are very difficult to come by. Only 1 in 3,000 projects ever becomes an economic mine, and I'd say investing in the right people is more important than any other factor.

LJ: This scarcity makes the investor's job a little easier. Just type the CEO's name in Google and look up his history. Has he done this before? Has he succeeded? Was he an accountant or a used car salesman? Google is one of our primary triage tools.

People is the first of Doug Casey's famous Eight Ps. If I hear about a story that fits our general criteria, the first thing I look at is management and directors. If I recognize the name of someone who has lied to me or whom I don't trust, I don't even look at the project.

TGR: New people coming up need to get experience by being in a successful project. Are there enough successful projects that they're learning how to do it?

LJ: I don't necessarily agree with that angle. All experience is good experience. A person can learn a lot from working for a company that does something wrong. It's having lots of experience, both good and bad, that is so important. The problem is that, unless you get very lucky, you need to have experience to really call shots well, and there are not enough people out there with the decades of experience needed.

On the bright side, because there is money in the field now, geology departments are no longer shutting down; enrollment is up. Supply is improving, but it will be another 5 to 10 years before the supply of highly experienced personnel really improves.

RR: Let's personalize it for your readers. There are three analysts in the room: an old one and two young ones. I guarantee you that, as a consequence of the bear market they just experienced, the two younger analysts will make their readers more money with less risk in the next bull market.

Youth isn't enough. You need to have a decade under your belt so that you have lived through the changes. Marin and Louis just lived through the kind of challenges I lived through in the 1980s. They now have the two things needed to survive in this racket: legs and scars.

MK: He's not joking about the scars.

RR: The transfer of the mantle from the Doug Caseys and Rick Rules of the world to the Marin Katusas and Louis Jameses is under way. The batons are being passed.

TGR: Is the bear market making a better generation of investors? Will they be more patient, have more perspective given what they've been through?

MK: If they stick with it. It's all about timeframe and perspective. The bear market will wash out a lot of investors; do not allow yourself to become a victim. But as Rick said, investors have to mitigate risk to stay alive until the next leg in the bull market.

RR: You're wrong there, Marin. You have to thrive. The year 2000, which was the market bottom, was one of the best investment years of my life. And 2001 was even better, as was 2002.

A bear market is when you make your money. You don't get to put it in your pocket until things turn, but you make your money by thriving in bear markets. You don't thrive in bull markets. You cash the checks. It's very different.

LJ: I expect this will be a painful experience for a lot of people. Some will learn a lesson, but it will be the wrong lesson. The lesson will be: Don't invest in commodities; they're too risky. That lesson will stick until the prices go bananas again, when they'll give it another try and get taken to the cleaners again.

To buy low and sell high, investors have to be able to sell high, which means they are expecting people to act irrationally when prices are very high—which means they didn't learn the lesson. It's unfortunate for our world that human nature is so, but it is so, and investors who ignore the opportunities this creates don't do anyone any favors.

TGR: Marin, going back to energy, there's been a lot in the media about the International Energy Agency (IEA) report about energy independence in North America. Will we be the Saudi Arabia of natural gas?

MK: North America is already the Saudi Arabia of natural gas. Unfortunately, so are the Russians.

The report said that if these eight assumptions happen the way we hope, America will become almost energy independent. The media forgot about the eight assumptions, and they got rid of the word "almost."
The US has done a great job of bringing North American innovation to the shale industry, but the industry has many other challenges to work through.

TGR: Is Saudi Arabia still the Saudi Arabia of oil? Its wells are getting long in the tooth, and the country is building nuclear plants for domestic use.

MK: We're all asking that question. The Ghawar oil field has been producing oil since before Elvis hit the scene and today produces about half of Saudi Arabia's oil. There is significant risk in relying on these old elephant deposits that have been producing for more than 50 years.

RR: I agree. What has happened in the US, and to a lesser degree Canada, is unique because our competitive markets still work. For example, 50 or 60 competitors at Eagle Ford tried and failed using various completion techniques, each time getting better and better. Ultimately, Eagle Ford was an extremely messy success.

In most of the world, there's one quasi-state oil company looking at a basin. There's no competition trying different solutions. Exporting American or Canadian technology doesn't work without exporting the messiness of the North American energy-exploration business.

Marin, would exporting technology from Eagle Ford work in Argentina's Vaca Muerta Shale?

MK: It would take billions of dollars to make it work at Vaca Muerta. A junior company with a $10 million market cap and $500,000 to make management's salary and payment on their BMWs will never be able to develop this billion-dollar shale potential. It will require a big company, like a Chevron.

TGR: We heard a lot about the potential for crowdfunding to save the resource sector by funding more companies. True?

MK: I'd like to make sure that all of your readers stay the hell away from crowdfunding for the resource sector. I've heard it works OK in the tech sector and among the let's-make-a-movie crowd, where all that is needed is to raise $150,000 for something that may or may not work.

In the resource sector, real exploration cannot be done for $2-3 million. If people want to invest in the sector, go to someone with a track record, someone who knows what he's doing. Subscribe to Louis' newsletter and educate yourself. Stay the hell away from crowdfunding for the resource sector.

RR: The last thing the sector needs is more companies. The idea that the crowd would invest $3 million in a de novo project when there are companies out there that have spent $80 million on an existing project, yet have a $6 million market cap is the most counterproductive activity that one could imagine. If there are 3,000 public companies doing exploration on a global basis, we don't need another 300. We need 2,000 fewer.

LJ: It's one thing to go directly to the masses with an art project that some snob at the National Endowment for the Arts turned down, but entirely another to do so for a mine project no knowledgeable investor will touch.

TGR: What myth would you want our readers to stop believing in?

LJ: I would like to dethrone the "grade is king" myth. It's not grade; it's margin. You can have an exceptionally high-grade deposit in an exceptionally expensive, difficult, or kleptocratic jurisdiction, and it won't work. You could have a water table that's so fluid that you spend more money pumping water than mining. There are so many things that can go wrong or add to costs. Too many people believe if a project is high grade, it has to make money. No, it doesn't. High margin is paramount, not grade.

MK: I think the myth that the commodity bull market is over is insane. We're nowhere near being over. This is the opportunity of a lifetime. This is when you start doing your homework and investing money.

RR: The idea that bear markets are bad and bull markets are good is bullshit. It's the other way around. Bear markets are good. Bull markets are bad.

LJ: Bullshit is a technical term.

TGR: I enjoyed talking with the three of you. Thanks.

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