Mid Week Market Summary - Crude Oil, Natural Gas, Gold

November crude oil closed higher on Wednesday. The high range close sets the stage for a steady to higher opening when Thursday's night session begins. Stochastics and the RSI are turning neutral to bullish signaling that sideways to higher prices are possible near term. Closes above the reaction high crossing at 95.07 are needed to confirm that a low has been posted. If November resumes the decline off June's high, the 50% retracement level of the 2009-2011 rally crossing at 85.77 is the next downside target. First resistance is last Tuesday's high crossing at 94.12. Second resistance is the reaction high crossing at 95.07. First support is is the 38% retracement level of the 2009-2011 rally crossing at 90.75. Second support is the 50% retracement level of the 2009-2011 rally crossing at 85.77.

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November natural gas closed higher on Wednesday as it consolidated some of the decline off last week's high. The high range close sets the stage for a steady to higher opening when Thursday's session begins trading. Stochastics and the RSI are turning neutral to bullish signaling that sideways to higher prices are possible near term. Closes above the late August high crossing at 4.163 are needed to confirm an upside breakout of the late summer trading range. If November extends the decline off last week's high, July's low crossing at 3.786 is the next downside target. Closes below July's low crossing at 3.786 would confirm a downside breakout of the late summer trading range. First resistance is last Wednesday's high crossing at 4.100. Second resistance is the late August high crossing at 4.163. First support is the reaction low crossing at 3.812. Second support is July's low crossing at 3.786.

Here's Proof You Are Trading Like a Drooling Dog

December gold closed lower on Wednesday. The low range close sets the stage for a steady to lower opening when Wednesday's night session begins trading. Stochastics and the RSI are oversold but remain neutral to bearish signaling that sideways to lower prices are possible near term. If December extends the decline off July's high, the December 2013 low crossing at 1185.00 is the next downside target. Closes above the 20 day moving average crossing at 1247.90 are needed to confirm that a short term low has been posted. First resistance is the 10 day moving average crossing at 1228.00. Second resistance is the 20 day moving average crossing at 1247.90. First support is Monday's low crossing at 1208.80. Second support is the December 2013 low crossing at 1185.00.

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Where's the Growth?

By John Mauldin

In 1633 Galileo Galilei, then an old man, was tried and convicted by the Catholic Church of the heresy of believing that the earth revolved around the sun. He recanted and was forced into house arrest for the rest of his life, until 1642. Yet “The moment he [Galileo] was set at liberty, he looked up to the sky and down to the ground, and, stamping with his foot, in a contemplative mood, said, Eppur si muove, that is, still it moves, meaning the earth” (Giuseppe Baretti in his book the The Italian Library, written in 1757).

Flawed from its foundation, economics as a whole has failed to improve much with time. As it both ossified into an academic establishment and mutated into mathematics, the Newtonian scheme became an illusion of determinism in a tempestuous world of human actions. Economists became preoccupied with mechanical models of markets and uninterested in the willful people who inhabit them….

Some economists become obsessed with market efficiency and others with market failure. Generally held to be members of opposite schools – “freshwater” and “saltwater,” Chicago and Cambridge, liberal and conservative, Austrian and Keynesian – both sides share an essential economic vision. They see their discipline as successful insofar as it eliminates surprise – insofar, that is, as the inexorable workings of the machine override the initiatives of the human actors. “Free market” economists believe in the triumph of the system and want to let it alone to find its equilibrium, the stasis of optimum allocation of resources. Socialists see the failures of the system and want to impose equilibrium from above. Neither spends much time thinking about the miracles that repeatedly save us from the equilibrium of starvation and death.

– George Gilder, Knowledge and Power: The Information Theory of Capitalism and How It is Revolutionizing Our World

And to that stirring introduction let me just add a warning up front: today’s letter is not exactly a waltz in the park. Longtime readers will know that every once in a while I get a large and exceptionally aggressive bee in my bonnet, and when I do it’s time to put your thinking cap on. And while you’re at it, tighten the strap under your chin so it doesn’t blow off. There, now, let’s plunge on.

Launched by Larry Summers last November, a meme is burning its way through established academic economic circles: that we have entered into a period of – gasp! – secular stagnation. But while we can see evidence of stagnation all around the developed world, the causes are not so simple that we can blame them entirely on the free market, which is what Larry Summers and Paul Krugman would like to do: “It’s not economic monetary policy that is to blame, it’s everything else. Our theories worked perfectly.” This finger-pointing by Keynesian monetary theorists is their tried and true strategy for deflecting criticism from their own economic policies.

Academic economists have added a great deal to our understanding of how the world works over the last 100 years. There have been and continue to be remarkably brilliant papers and insights from establishment economists, and they often do prove extremely useful. But as George Gilder notes above, “[As economics] ossified into an academic establishment and mutated into mathematics, the Newtonian scheme became an illusion of determinism in a tempestuous world of human actions.”

Ossification is an inherent tendency of the academic process. In much of academic economics today, dynamic equilibrium models and Keynesian theory are assumed a priori to be correct, and any deviation from that accepted economic dogma – the 21^st century equivalent of the belief by the 17^th century Catholic hierarchy of the correctness of their worldview – is a serious impediment to advancement within that world. Unless of course you are from Chicago. Then you get a sort of Protestant orthodoxy.

It’s About Your Presuppositions

A presupposition is an implicit assumption about the world or a background belief relating to an utterance whose truth is taken for granted in discourse. For instance, if I asked you the question, “Have you stopped eating carbohydrates?” The implicit assumption, the presupposition if you will, is that you were at one time eating carbohydrates.

Our lives and our conversations are full of presuppositions. Our daily lives are based upon quite fixed views of how the world really works. Often, the answers we come to are logically predictable because of the assumptions we make prior to asking the questions. If you allow me to dictate the presuppositions for a debate, then there is a good chance I will win the debate.

The presupposition in much of academic economics is that the Keynesian, and in particular the neo-Keynesian, view of economics is how the world actually works. There has been an almost total academic capture of the bureaucracy and mechanism of the Federal Reserve and central banks around the world by this neo-Keynesian theory.

What happens when one starts with the twin presuppositions that the economy can be described correctly using a multivariable dynamic equilibrium model built up on neo-Keynesian principles and research founded on those principles? You end up with the monetary policy we have today. And what Larry Summers calls secular stagnation.

First, let’s acknowledge what we do know. The US economy is not growing as fast as anyone thinks it should be. Sluggish is a word that is used. And even our woeful economic performance is far superior to what is happening in Europe and Japan. David Beckworth (an economist and a professor, so there are some good guys here and there in that world) tackled the “sluggish” question in his Washington Post “Wonkblog”:

The question, of course, is why growth has been so sluggish. Larry Summers, for one, thinks that it’s part of a longer-term trend towards what he calls “secular stagnation.” The idea is that, absent a bubble, the economy can’t generate enough spending anymore to get to full employment. That’s supposedly because the slowdowns in productivity and labor force growth have permanently lowered the “natural interest rate” into negative territory. But since interest rates can’t go below zero and the Fed is only targeting 2 percent inflation, real rates can’t go low enough to keep the economy out of a protracted slump.

Rather than acknowledge the possibility that the current monetary and government policy mix might be responsible for the protracted slump, Summers and his entire tribe cast about the world for other causes. “The problem is not our theory; the problem is that the real world is not responding correctly to our theory. Therefore the real world is the problem.” That is of course not exactly how Larry might put it, but it’s what I’m hearing.

Where’s the Growth?

It’s been more than five years since the global financial crisis, but developed economies aren’t making much progress. As of today, the United States, Canada, Germany, France, Japan, and the United Kingdom have all regained their pre-crisis peaks in real GDP, but with little else to show for it.



Where orthodox neo-Keynesian policies like large-scale deficit spending and aggressive monetary easing have been resisted – as in Japan years ago or in the Eurozone debtor countries today – lingering depressions are commonly interpreted as tragic signs that “textbook” neo-Keynesian economic policy could have prevented the pain all along and that weak economic conditions persist because governments and central banks are not doing enough to kick-start aggregate demand and stimulate credit growth at the zero lower bound.

In places like the United States and Japan, where neo-Keynesian thought leaders have already traded higher public debt levels and larger central bank balance sheets for unspectacular economic growth and the kinds of asset bubbles that always lead to greater instability in the future, their policies have failed to jump-start self-accelerating recoveries. Even in the United States, when QE3 has been fully tapered off, I would expect to see the broader economy start to lose momentum once again.

We’ve tried countercyclical deficit spending to resist recessions, procyclical (and rather wasteful) deficit spending to support supposed recoveries, and accommodative monetary easing all along the way (to lower real interest rates and ease the financing of those pesky deficits); but growth has been sluggish at best, inflation has been hard to generate, and labor market slack is making it difficult to sustain inflation even when real interest rates are already negative.

Call me a heretic, but I take a different view than the economists in charge. To my mind, the sluggish recovery is a sign that central banks, governments, and, quite frankly, the “textbook” economists (despite their best intentions) are part of the problem. As Detlev Schlichter commented in his latest blog post (“Keynes was a failure in Japan – No need to embrace him in Europe”), “To the true Keynesian, no interest rate is ever low enough, no ‘quantitative easing’ program ever ambitious enough, and no fiscal deficit ever large enough.” It’s apparently true even as debt limits draw closer.

While the academic elites like to think of economics as a reliable science (with the implication that they can somehow control a multi-trillion-dollar economy), I have repeatedly stressed the stronger parallel of economics to religion, in the sense that it is all too easy to get caught up in the dogma of one tradition or another. And all too often, a convenient dogma becomes a justification for those in power who want to expand their control, influence, and spending.

Whereas an Austrian or monetarist approach would suggest less government and a very light handle on the monetary policy tiller, Keynesian philosophy gives those who want greater government control of the economy ample reasons to just keep doing more.

Schlichter expands his critique of the logic of pursuing more of the same debt-driven policies and highlights some of the obvious flaws in the pervasive Keynesian thinking:

Remember that a lack of demand is, in the Keynesian religion, the original sin and the source of all economic troubles. “Aggregate demand” is the sum of all individual demand, and all the individuals together are not demanding enough. How can such a situation come about? Here the Keynesians are less precise. Either people save too much (the nasty “savings glut”), or they invest too little, maybe they misplaced their animal spirits, or they experienced a Minsky moment, and took too much risk on their balance sheets, these fools. In any case, the private sector is clearly at fault as it is not pulling its weight, which means that the public sector has to step in and, in the interest of the common good, inject its own demand, that is [to] “stimulate” the economy by spending other people’s money and print some additional money on top. Lack of “aggregate demand” is evidently some form of collective economic impotence that requires a heavy dose of government-prescribed Viagra so the private sector can get its aggregate demand up again.

Generations of mismanagement have left major economies progressively weaker, involving

1. dysfunctional tax/regulatory/entitlement/trade policies created by short-sighted and corrupt political systems,
2. private-sector credit growth encouraged by central bank mismanagement, and
3. government expansion justified in times of crisis by Keynesian theory.

But rather than recognizing real-world causes and effects, neo-Keynesian ideologues are making dangerous arguments for expanding the role of government spending in places where government is already a big part of the problem.

We are going to delve a little deeper into this thesis of “secular stagnation” posited last year by Larry Summers and eagerly adopted by Paul Krugman, among others; and then we’ll take a trip around the rich world to assess the all-too-common trouble with disappointing growth, low inflation, and increasingly unresponsive labor markets. Then I’ll outline a few reasons why I think the new Keynesian mantra of “secular stagnation” is nothing more than an excuse for more of the same failed policies.

I think we’ll see a consistent theme: fiscal and monetary stimulus alone cannot generate “financially stable growth with full employment.” In fact, such policies only make matters worse. And funny things happen in the Keynesian endgame.

USA: Secular Stagnation or Public Sector Drag?

This latest theory – “secular stagnation” – argues that powerful and inherently deflationary forces like shrinking populations…...



… and potentially slowing productivity growth (as posited by Northwestern University professor Bob Gordon)…...



 … are adding to the deleveraging headwinds that always follow debt bubbles. According to the “stagnation” theory, structural forces have been bearing down on the natural rate of interest and weighing on the full-employment level of economic growth since the early 1980s; but the slowdown in trend GDP growth has been masked by a series of epic bubbles in technology stocks and housing.



Even before the 2008 crisis, the argument goes, the real interest rate required to restart the business cycle had been trending lower and lower for years, and the average level of growth experienced during business cycles has fallen.

Moreover, it has taken longer and longer to recoup the jobs that were lost in each of the last three recoveries.



It’s hard to argue with the data, but it’s really a matter of how we interpret it. While the five-year-old “recovery” is still the weakest business cycle in modern US history…..



… I quite frankly still believe the effects on growth are temporary. Difficult and long-lasting, for sure (as Jonathan Tepper and I outlined in our books Endgame and Code Red), but temporary nonetheless as private-sector deleveraging continues. We have encountered a massive debt crisis and still have a long way to go in dealing with the sovereign debt bubbles that are being created in Europe and Japan – with the potential of one’s ballooning out of control in the US unless we turn ourselves around.



It may take a crisis, but the forces that plague rich-world economies will eventually shake out and usher in a new era of technology-driven growth. In other words, this too shall pass… but continuing with the same old policies is highly likely to create another crisis through which we all must pass first.

Yes, shrinking workforces, private-sector debt overhangs, and technological innovation are making it difficult to achieve “financially stable growth with full employment” (quoting Summers); but governments and central banks are themselves becoming an increasing drag on rich-world economies. Our governments have saddled us with excessive public debt, onerous overregulation, oppressive tax codes, and their attendant distorted market signals; while our central banks have engaged in currency manipulation and monetary-policy overmanagement. Those in power who rely on Keynesian policies almost always find it inconvenient to cut back in times of relative economic strength (as Keynes would have had them do). And if, according to their arguments, the economy is still too weak even in periods of growth to enable the correction of government balance sheets, then perhaps their reluctance has something to do with debt piling up, market signals being distorted, and governments being empowered to encroach on every aspect of the lives of their productive citizens .

My friend Grant Williams used this chart in a speech yesterday. It shows that we have come to need ever more debt just to produce the same amount of GDP. With a deleveraging in the private sector underway, it is no wonder that growth is under pressure.



Debt is simply future consumption brought forward. Another way to think about it is that debt is future consumption denied. But there comes a point when debt has to be repaid, and by definition, from that point forward there is going to be a period of slower growth. I have called that point the Endgame of the Debt Supercycle, and it was the subject of my book Endgame.

As a result of central bank and governmental machinations, Keynesian growth is ultimately debt-fueled growth (either through the swelling of public debt via deficit spending or the accumulation of private debt via credit expansion); and eventually, public and private balance sheets run out of room to expand anymore. It has taken decades for cracks to show up in the prevailing theory, but now the cracks are everywhere.

One place where the crack-up is especially evident is Japan, where an uber-Keynesian combination of aggressive fiscal deficits and a planned doubling in the monetary base started to lift real GDP and inflation numbers last year before falling back into a deflationary trap. Yet the Japanese experience has seemingly convinced ECB President Mario Draghi that similar policies should be implemented across the Eurozone.
Last quarter, the Japanese economy shrank by an annualized 7.1%; business investment fell by 5.1%; and residential spending was down 10%. This is after one of the most massive Keynesian quantitative easing efforts in the history of the world.

So, let’s go to Japan, which may now have to retitle itself “the land of the setting sun,” since it is facing the steepest expected decline in population and in workforce-to-population ratio on the planet.

Land of the Setting Sun

Japan’s long-awaited “recovery” is already losing steam without the effective implementation of Prime Minister Shinzo Abe’s “third arrow” of structural reform, which to my mind was always the most critical element of his entire “Abenomics” project (and of course the most politically difficult). Despite massive fiscal and monetary stimulus and a desperate attempt to boost tax revenues by hiking the sales tax this past April, Japanese GDP collapsed in Q2:



Let’s review how Japan got there.

Prime Minister Abe took office in late December 2012 and, together with his (initially reluctant) colleagues at the Bank of Japan, quickly fired the first two fiscal and monetary policy arrows, which aimed to propel the world’s third-largest economy out of its deflationary trap. The third arrow has yet to fly.

Source: Wall Street Journal, March 2013

Since January 2013 the Bank of Japan has expanded its balance sheet by 78% (42% on an annualized basis)…



… and pushed the USD/JPY exchange rate to a six-year low of a fraction under 109 yen per dollar as of the market close yesterday.



In true Keynesian form, the Japanese government ran a massive fiscal deficit in 2013, equivalent to 8.4% of GDP. This was its 22^nd consecutive year of deficit spending, starting in mid-1992…



… despite the fact that the Japanese public-sector debt-to-GDP ratio is quickly approaching 250%:



While inflation has popped to its highest level since the early 1990s…..



… headline CPI has been decelerating since May and could quickly revert to deflation in the event of continued economic weakness, as was the case after the 1997 tax hike… which would then bring on even more “money-financed” deficit spending.

Abe advisor Etsuro Honda was very clear on this point: “Regardless of the next sales tax hike, it could be that additional monetary easing might be called for if inflation and demand fail to pick up and the output gap doesn’t narrow…. I can fully see the possibility that such a situation will occur.”

Of course, the party cannot go on forever. More than twenty years of constant deficit spending and public-sector debt growth have finally led to a situation where debt service and entitlements are crowding out the government’s general budget.



And now the situation is turning dangerous. Japan has been flirting with current account deficits for the past few years, and the trend looks decidedly negative over the coming decade. That, in turn, could force the Abe administration to look for foreign investment to fund its ongoing operations, pushing interest rates up dramatically to the point that debt service and entitlements could consume more than half the annual operating budget.



Bottom line: Abenomics has delivered a bounce in economic growth and inflation, but it’s failing to push Japan into a self-sustaining recovery. Without a detour through structural reforms (which would be quite painful), this road leads to higher public debt balances and even more dysfunction in the medium term, leaving Japan only a shock away from disaster. As predicted here three years ago, I continue to believe that the yen will be over 200 to the dollar by the end of the decade, and possibly much sooner.



Keynesians argue that Abe had the right idea, he just didn’t spend enough and will need to spend a lot more in the near future. In other words, fiscal and monetary stimulus can lift inflation and boost growth in the short term… but the problem is that you can’t have that stimulus if you want to consolidate the national debt and boost tax revenues at the same time.

Some economists would argue that Abe’s policies don’t necessarily have to add to the debt load, as long as the government has a firm commitment from the central bank to monetize the debt along the way. The fact that that would destroy the buying power of the yen doesn’t seem to be a consideration for them. The elderly on fixed incomes might disagree.

So with their highly leveraged banking system and already crushing sovereign debt loads, why wouldn’t the Europeans embrace the same model?

Draghi’s Turn at Abenomics?

I’ve written extensively on the Eurozone in recent months, so I will keep this section brief.

Much of Southern Europe has been mired in depression, with hopelessly slow or negative growth rates, low inflation or outright deflation, and extremely high levels of unemployment (especially among young workers), for several years.

It’s a toxic situation for a multi-country monetary system that still lacks the underpinning of banking or fiscal unions. Demonstrations in the Catalonia region of Spain, inspired by this week’s Scottish referendum, reveal the very real political risks that are only growing with voter frustration.

Perhaps it was just talk, but Mario Draghi laid out a three-point plan similar to Abe’s in his presentation at the recent Jackson Hole meeting of central bankers. It quickly acquired the sobriquet “Draghinomics.”
Draghi recently cut the ECB’s already-negative interest rates and has promised a large round of quantitative easing. But the core problems facing Europe are not interest rates or a lack of liquidity but rather a structurally unwieldly labor market, too many regulations being dreamed up in Brussels, a lack of capital available to small businesses, and major regulatory headwinds for business startups.

Compound all that with the significant structural imbalances between Northern and Southern Europe, dramatically overleveraged banks, and an obvious sovereign debt bubble, and you have all the elements of a major crisis in the making.

That the Eurozone is a fragile and politically unstable union will come as no surprise to Thoughts from the Frontline readers who have been diligently perusing my letters for the past several years, but it is a critical point that we cannot ignore. How, I wonder, can Draghi even hope for a successful European implementation of a three-point plan like Japan’s – where a leader who started with very strong approval ratings has burned through most of his political capital before structural reforms have even gotten off the ground?

Draghi simply does not have the political power to make the changes that are necessary. All he can do is prop up a failing system with liquidity and low rates, which will ultimately create even more serious problems.

The Failure of Monetary Policy

There are many economists, with Paul Krugman at their fore, who believe that Keynesian monetary policy is responsible for the United States doing better than Europe. I beg to differ. The United States is outshining Europe due to the combined fortuitous circumstances of massive new discoveries of unconventional oil and gas, new technologies, and an abundance of risk-taking entrepreneurs. Indeed, take away the oil boom and the technology boom centered in Silicon Valley, and the US would be as sclerotic as Europe is.

None of the above has anything to do with monetary policy. In fact, I would argue that current monetary, fiscal, and regulatory policy is getting in the way of that growth.

Robert A. Hefner III, chairman of The GHK Companies and the author of The Grand Energy Transition: The Rise of Energy Gases, Sustainable Life and Growth, and the Next Great Economic Expansion, wrote a wonderful piece in last month’s Foreign Affairs, entitled “The United States of Gas” (hat tip, Dennis Gartman).

Consider how much can change in one year alone. In 2013, on properties in Oklahoma in which the GHK Companies hold interests covering 150 square miles, one large U.S. independent company drilled and completed over 100 horizontal wells. Had those wells been drilled vertically, they would have exposed only about 1,000 feet of shale, whereas horizontal drilling allowed nearly 100 miles to be exposed. And rather than performing the 100 injections of fracking fluid that a vertical well would have made possible, the company was able to perform between 1,000 and 2,000 of them. The company’s engineers also tinkered with such variables as the type of drill bits used, the weight applied while drilling, the rotation speed of the drill, and the size and number of fracking treatments.

Thanks to that continuous experimentation, plus the savings from scale (for example, ordering tubular steel in bulk), the company managed to slash its costs by 40 percent over 18 months and still boost its productivity. The result: in 2014, six or seven rigs will be able to drill more wells and produce as much oil and gas as 12 rigs were able to the year before. Since the shale boom began, over a decade ago, companies have drilled about 150,000 horizontal wells in the United States, a monumental undertaking that has cost approximately $1 trillion. The rest of the world, however, has drilled only hundreds of horizontal wells. And because each borehole runs horizontally for about one mile (and sometimes even two miles) and is subjected to ten or more fracking injections, companies in the United States have fracked about 150,000 miles of shale about two million times. That adds up to around a thousand times as much shale exposed inside the United States as outside it.

There is a divide in the United States, and indeed in the world, between those who believe (and the emphasis is on believe) that government in all its various shapes and sizes is the font of all growth and progress and those who believe that it is individual effort and free markets that “move the ball down the field” of human progress. Count me in the latter group.

Government is necessary to the extent that we need to maintain a level playing field and proper conduct, but with the recognition that wherever government is involved there are costs for that service that must be paid by the private market and producers. For example, almost everyone thinks that the government’s being involved in student loans is a public good. We should help young people with education, right? Except that John Burns released a report this week that shows that student loans will cost the real estate industry 414,000 home sales. Young people are so indebted they can’t afford to buy new homes. Collateral damage?



The unintended consequences of government policies and manipulation of the markets are legendary. But often unseen.

Monetary policy as it is currently constructed is only marginally helping private markets and producers. Monetary policy as it is currently practiced is an outright war on savers, which sees them as collateral damage in the Keynesian pursuit of increased consumer demand.

It is trickle-down monetary policy. It has inflated the prices of stocks and other income-producing securities and assets, enriching those who already have assets, but it has done practically nothing for Main Street. It has enabled politicians to avoid making the correct decisions to create sustainable growth and a prosperous future for our children, let alone an environment in which the Boomer generation can retire comfortably.

It is a pernicious doctrine that refuses to recognize its own multiple failures because it starts with the presupposition that its theory cannot fail. It starts with the presuppositions that final consumer demand is the end-all and be-all, that increased indebtedness and leverage enabled by lower rates are good things, and that a small room full of wise individuals can successfully direct the movement of an entire economy of 300 million-plus people.

The current economic thought leaders are not unlike the bishops of the Catholic Church of 16^th-century Europe. Their world was constructed according to a theory that they held to be patently true. You did not rise to a position of authority unless you accepted the truth of that theory. Therefore Galileo was wrong. They refused to look at the clear evidence that contradicted their theory, because to do so would have undermined their power.

Current monetary and fiscal policy is leading the developed world down a dark alley where we are all going to get mugged. Imbalances are clearly building up in almost every corner of the market, encouraged by a low-interest-rate regime that is explicitly trying to increase the risk-taking in the system. Our Keynesian masters know their policies and theories are correct – we must only give them time to more perfectly practice them. That the results they’re getting are not what they want cannot be their fault, because the theory is correct. Therefore the problem has to lie with the real world, full of imperfect people like you and me.
What our leaders need is a little more humility and a little less theory.

Washington DC, Dallas, Chicago, Athens (Texas), and Boston

I find myself in the Hill Country north of San Antonio, Texas, attending the Casey Research Summit, where I speak tomorrow. I’m surrounded by many friends in very pleasant circumstances. And when I hit the send button, I will have two days of fascinating conversations ahead of me. I am doing a number of videos with various interesting personalities, which we will post on the Mauldin Economics site in the coming weeks. More on that later.

On Monday I fly back to Dallas, where I will stay until the end of the month, then head off to Washington DC. In the middle of October I’ll visit Chicago, Athens (Texas), and Boston, all in one week.

I can't hit the send button without noting that Jack Ma, the Chinese ultra-billionaire founder of Alibaba, was at the New York Stock Exchange for the launch of his IPO and sought out my friend Art Cashin, saying “I can't leave without a picture with Art Cashin.” As one of Art's friends subsequently wrote on our round-robin group email, Jack is clearly a man who understands who is really running things. The incident also shows that anyone can be a groupie. But what really intrigues me is that here is one of the richest men in the world, a force in China, obsessively focused on creating a merchandising machine, and yet he is so in touch with the world of investment and business that he watches CNBC enough to know who Art is. And to appreciate the character and class that Art has shown us for years – and want to meet him. Jeff Bezos may have his work cut out for him in the coming years.

Have a great week and tell a struggling businessman that you appreciate his work.

Your ready for some fun conversations analyst,

John Mauldin

The article Thoughts from the Frontline: Where’s the Growth? was originally published at mauldineconomics.com.

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How You Can Tell When a Company’s P/E is All Flash

By Andrey Dashkov

College reunions are toxic. Except for the few precious moments of genuine human connection, these parties are nothing but status pageants. Suits and watches are inconspicuously glanced at, vacation photos (carefully selected the night before) are passed around; compensations guesstimated; Platinum Master Cards flashed (“Oh no, let me take care of this round!”); spouses evaluated based on trophy-worthy qualities… and inconspicuously glanced at.

It’s hard to tell true, praiseworthy success from carefully crafted smoke and mirrors. Your college friend may have rented that car, watch, suit—and even his “spouse.” In fact, there are escort agencies out there that provide “dates” for single men to social occasions. Don’t ask me how I learned about it.

The point is, both people and companies like to project high status and success to the public. Not only do your friends from Beta Phi Delta want to look alpha (pun intended), but companies, too, often want you to think they earn more than they actually do.

There are many incentives to do that: management’s compensation may be tied to earnings-per-share (EPS) goals; the company may be trying to maintain an image of rapid growth; or it could be attempting to raise funds by issuing debt or shares. Higher EPS would benefit the company and the team at the helm in all of these cases.

The Illusory P/E Ratio

Another reason why companies try to massage their earnings is that millions of investors pay attention to the price-to-earnings ratio (P/E). It is one of the most intuitive financial metrics. Potential investors see it all across the Internet, on free finance sites and many trading platforms. However, despite its popularity, I’d argue that it’s one of the most illusory financial metrics that exists, and the blame is on the denominator, earnings. Let’s see how we can make better use of it.

“E” in the P/E ratio stands for earnings per share, which is a ratio itself. EPS is the company’s net income for the reported 12-month period (or forecasted net income for the next 12 months) divided by its shares outstanding. Without going into too much detail, here are some of the potential issues with the usefulness of reported historical, or trailing, earnings per share for investors:

• Seasonality. Earnings of a lot of companies fluctuate due to seasonal buying activity, weather, and other factors. In these cases, quarter-to-quarter comparisons are meaningless, and it’s necessary to understand the company’s operating cycles (annual, based on contract renewals, etc.) to make use of the reported earnings.

• Dilution. There are two broad measures of shares outstanding: basic (or common) and diluted. Diluted shares outstanding include common shares, options, warrants, convertible preferred shares, and convertible debt. All of these can potentially be converted to common stock and result in lower earnings per share because of the higher denominator in the EPS ratio. However, when you look at a P/E ratio on the Internet, it’s not always clear whether it was based on basic or diluted shares. The latter is more conservative, and we pay more attention to it than to the basic EPS.

• Accruals-based accounting, in which revenues are recognized at the moment they’re earned, and expenses are recognized when they’re incurred. In contrast, under cash-based accounting, revenues are recognized when cash is collected, and expenses are recognized when cash is paid.
  
  Accruals-based accounting has its advantages:

*  It allows the company to match revenues to expenses in time more closely (for example, the cost of a piece of equipment is depreciated over its useful life to match the revenues this equipment generates); and

*  It provides the market with information about the company’s operations as soon as it has enough objective evidence that the transaction will be fulfilled. For example, when a company sends an invoice to a customer, it records a receivable, which sends a signal to the market that a sale took place. We don’t need to wait until the actual funds are deposited in the company’s bank account, which may take a month or more, to become aware of this sale.

However, accrual accounting has two major drawbacks for analysts and investors:

*  Reported income and expenses do not mirror actual cash inflows and outflows; and

*  Management can accelerate or postpone recognition of revenue and expenses, which makes reported net income figures less reliable.

Consider a real-world example. A friend of mine—let’s call him Steven—spent several years as a credit manager. One of his responsibilities was to expense a “reserve” for anticipated credit losses. The first time he was about to charge the expenses, he estimated them realistically and quickly realized that it wouldn’t work. The reserve wasn’t there to cover the related losses calculated fairly and correctly.

After a discussion with the corporate accounting department (his superior), if they needed to find more profit to make their numbers, Steven would lower his reserve estimates. If they were having a good year, he was told to increase the reserve write-off to provide a cushion for the next quarter.

The beauty of it was that such draws and deposits are almost impossible to catch unless the amounts are outrageous, so any auditor would overlook them. Steven and his team were safe legally, but the practice misrepresented his company’s financial performance nevertheless.

When I asked another friend—let’s call him Jack—to share any stories about his company’s creative accounting, he said he too would get calls from the corporate accounting department at the end of each quarter. Another easy target to massage is insurance costs. To get the lowest prices, many of its insurance policies were paid annually, and the premium period did not correspond with the accounting year. If the company was having a good quarter or year, he was encouraged to write off the entire annual premium in that accounting period. Conversely, if it was struggling to make its numbers, the team would show the premiums for future months as “prepaid insurance,” effectively delaying the expense until the next accounting period.

The effect, as with our first example, was to smooth out period-to-period fluctuations to keep stockholders happy by “making their numbers” or beating them by a little bit. The justification was that they weren’t really manipulating profits—“in the long run, it all comes out in the wash.”

Part of Jack’s annual performance review was “being a good team player.” Helping the corporate team was part of that evaluation.

Other common revenue and expense “management” techniques include adjustments to how depreciation expense is calculated, which is doable within limits under generally accepted accounting principles (GAAP), and can affect net income as desired; and adjustments to revenue recognition policies that technically comply with GAAP but distort the underlying economic reality to artificially boost the top line and thereby juice earnings.

Normalization Helps Solve the Numbers Game

The first two issues with earnings—seasonality and dilution—can be addressed simply: instead of looking at price to reported earnings per share, pay attention to P/E calculated from normalized earnings based on diluted shares outstanding. Normalization takes care of seasonality and some of the nonrecurring revenue and cost items. Using diluted share count instead of basic will return a more conservative number, because it assumes that all options, warrants, and convertible debt are converted into common shares. The more common shares there are, the lower the EPS.

As shareholders, we need those conservative estimates. Our returns (share price appreciation and dividend income) aren’t based on management achieving arbitrary earnings targets that can be fiddled with, but on how the company functions as a business. To get a clearer picture, using normalized diluted EPS should help.
Note that I wrote “clearer” but not “clear,” “true,” or “objective.” The reason we stay away from such absolutes is that it’s prohibitively difficult to say what’s going on with any company’s earnings with 100% accuracy.

One simple tip can help you make better use of P/E: use normalized earnings and diluted shares. These numbers are often available on free websites or in SEC filings.

Now I’ll go ahead and clear my browser history. Although reading about escort services for college reunions is a great study of the human condition, I’ll have a hard time explaining to my lovely wife why I need to do it for work.

And speaking of the work I do… you can receive more unique insights on better investing strategies by signing up for our free, retirement-focused e-letter, Miller’s Money Weekly.

The article How You Can Tell When a Company’s P/E is All Flash was originally published at millersmoney.com.

Make sure to check out our "Beginners Guide to Trading Options"....Just Click Here!

The Truth About Today’s Market

No doubt, we both understand the agony of making trading decisions. Especially when the market is moving in a way we have never seen before.

Want to know what I’m talking about?

You see, Doc Severson compiled research from the last 100 years to show the market is moving in a way that’s never happened – EVER - throughout history.

This little-known shift began in early 2013 ... and is creating lots of frustration for traders today.

Here’s the bottom line:

If you’ve been using strategies that worked in the past… and NOW aren’t seeing the profits you want, it isn’t your fault.

Watch this.

Could the right strategies from years past now be the wrong approach?

After watching this video, I think it’s possible.

See for yourself

And we'll see you in the markets!
Ray C. Parrish
aka The Crude Oil Trader


Make sure to check out our "Beginners Guide to Trading Options"....Just Click Here!

Thoughts from the Frontline: What’s on Your Radar Screen?

By John Mauldin

Toward the end of every week I begin to ponder what I should write about in the next Thoughts from the Frontline. Much of my week is spent in front of my iPad or computer, consuming as much generally random information as time and the ebb and flow of life will allow. I cannot remember a time in my life after I realized you could read and learn new things that that particular addiction has not been my constant companion.

As I sit down to write each week, I generally turn to the events and themes that most impressed me that week. Reading from a wide variety of sources, I sometimes see patterns that I feel are worthy to call to your attention. I’ve come to see my role in your life as a filter, a connoisseur of ideas and information. I don’t sit down to write with the thought that I need to be particularly brilliant or insightful (which is almighty difficult even for brilliant and insightful people) but that I need to find brilliant and insightful, and hopefully useful, ideas among the hundreds of sources that surface each week. And if I can bring to your attention a pattern, an idea, or thought stream that that helps your investment process, then I’ve done my job.

What’s on Your Radar Screen?

Sometimes I feel like an air traffic controller at “rush hour” at a major international airport. My radar screen is just so full of blinking lights that it is hard to choose what to focus on. We each have our own personal radar screen, focused on things that could make a difference in our lives. The concerns of a real estate investor in California are different from those of a hedge fund trader in London. If you’re an entrepreneur, you’re focused on things that can grow your business; if you are a doctor, you need to keep up with the latest research that will heal your patients; and if you’re a money manager, you need to keep a step ahead of current trends. And while I have a personal radar screen off to the side, my primary, business screen is much larger than most people’s, which is both an advantage and a challenge with its own particular set of problems. (In a physical sense this is also true: I have two 26-inch screens in my office. Which typically stay packed with things I’m paying attention to.)

So let’s look at what’s on my radar screen today.

First up (but probably not the most important in the long term), I would have to say, is Scotland. What has not been widely discussed is that the voting age was changed in Scotland just a few years ago. For this election, anyone in Scotland over 16 years old is eligible. Think about that for a second. Have you ever asked 16-year-olds whether they would like to be more free and independent and gotten a “no” answer? They don’t think with their economic brains, or at least most of them don’t. If we can believe the polls, this is going to be a very close election. The winning margin may be determined by whether the “yes” vote can bring out the young generation (especially young males, who are running 90% yes) in greater numbers than the “no” vote can bring out the older folks. Right now it looks as though it will be all about voter turnout.

(I took some time to look through Scottish TV shows on the issue. Talk about your polarizing dilemma. This is clearly on the front burner for almost everyone in Scotland. That’s actually good, as it gets people involved in the political process.)

The “no” coalition is trying to talk logic about what is essentially an emotional issue for many in Scotland. If we’re talking pure economics, from my outside perch I think the choice to keep the union (as in the United Kingdom) intact is a clear, logical choice. But the “no” coalition is making it sound like Scotland could not make it on its own, that it desperately needs England. Not exactly the best way to appeal to national instincts and pride. There are numerous smaller countries that do quite well on their own. Small is not necessarily bad if you are efficient and well run.

However, Scotland would have to raise taxes in order to keep government services at the same level – or else cut government services, not something many people would want.
There is of course the strategy of reducing the corporate tax to match Ireland’s and then competing with Ireland for businesses that want English-speaking, educated workers at lower cost. If that were the only dynamic, Scotland could do quite well.

But that would mean the European Union would have to allow Scotland to join. How does that work when every member country has to approve? The approval process would probably be contingent upon Scotland’s not lowering its corporate tax rates all that much, especially to Irish levels, so that it couldn’t outcompete the rest of Europe. Maybe a compromise on that issue could be reached, or maybe not. But if Scotland were to join the European Union, it would be subject to European Union laws and Brussels regulators. Not an awfully pleasant prospect.

While I think that Scotland would initially have a difficult time making the transition, the Scots could figure it out. The problem is that Scottish independence also changes the dynamic in England, making it much more likely that England would vote to leave the European Union. Then, how would the banks in Scotland be regulated, and who would back them? Markets don’t like uncertainty.

And even if the “no” vote wins, the precedent for allowing a group of citizens in a country within the European Union to vote on whether they want to remain part of their particular country or leave has been set. The Czech Republic and Slovakia have turned out quite well, all things considered. But the independence pressures building in Italy and Spain are something altogether different.

I read where Nomura Securities has told its clients to get out of British pound-based investments until this is over. “Figures from the investment bank Société Générale showing an apparent flight of investors from the UK came as Japan’s biggest bank, Nomura, urged its clients to cut their financial exposure to the UK and warned of a possible collapse in the pound. It described such an outcome as a ‘cataclysmic shock’.” (Source: The London Independent) The good news is that it will be over next Thursday night. One uncertainty will be eliminated, though a “yes” vote would bring a whole new set of uncertainties, as the negotiations are likely to be quite contentious.

One significant snag is, how can Scottish members of the United Kingdom Parliament continue to vote in Parliament if they are leaving the union?

I admit to feeling conflicted about the whole thing, as in general I feel that people ought have a right of self-determination. In this particular case, I’m not quite certain of the logic for independence, though I can understand the emotion. But giving 16-year-olds the right to vote on this issue? Was that really the best way to go about things? Not my call, of course.

Emerging Markets Are Set Up for a Crisis

We could do a whole letter just on emerging markets. The strengthening dollar is creating a problem for many emerging markets, which have enough problems on their own. My radar screen is full of flashing red lights from various emerging markets. Brazil is getting ready to go through an election; their economy is in recession; and inflation is over 6%. There was a time when we would call that stagflation. Plus they lost the World Cup on their home turf to an efficient, well-oiled machine from Germany. The real (the Brazilian currency) is at risk.

Will their central bank raise rates in spite of economic weakness if the US dollar rally continues? Obviously, the bank won’t take that action before the election, but if it does so later in the year, it could put a damper on not just Brazil but all of South America. Take a look at this chart of Brazilian consumer price inflation vs. GDP:

Mbeki

Turkey is beginning to soften, with the lira down 6% over the last few months. The South African rand is down 6% since May and down 25% since this time last year. I noted some of the problems with South Africa when I was there early this year. The situation has not improved. They have finally reached an agreement with the unions in the platinum mining industry, which cost workers something like $1 billion in unpaid wages, while the industry lost $2 billion. To add insult to injury, it now appears that a Chinese slowdown may put further pressure on commodity-exporting South Africa. And their trade deficit is just getting worse.

Who’s Competing with Whom?

We could also do a whole letter or two on global trade. The Boston Consulting Group has done a comprehensive study on the top 25 export economies. I admit to being a little surprised at a few of the data points. Let’s look at the chart and then a few comments.



First, notice that Mexico is now cheaper than China. That might explain why Mexico is booming, despite the negative impact of the drug wars going on down there. Further, there is now not that much difference in manufacturing costs between China and the US .
Why not bring that manufacturing home – which is what we are seeing? And especially anything plastic-related, because the shale-gas revolution is giving us an abundance of natural gas liquids such as ethane, propane, and butane, which are changing the cost factors for plastic manufacturers. There is a tidal wave of capital investment in new facilities close to natural gas fields or pipelines. This is also changing the dynamic in Asia, as Asian companies switch to cheaper natural gas for their feedstocks.

(What, you don’t get newsfeeds from the plastic industry? Realizing that I actually do makes me consider whether I need a 12-step program. “Hello, my name is John, and I’m an information addict.”)

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: What’s on Your Radar Screen? was originally published at mauldineconomics.com.

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Top Dividend Plays – Profit in a Bull Market, Protect Yourself in a Bear Market and Collect Dividends Along the Way!

When your babysitter knows that the market is on a roll, there is no question it’s a bull market! It may also be time to keep an eye out for a correction. No one knows when a correction will take place and you don’t want to miss gains in a bull market.

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Ray C. Parrish [aka the Crude Oil Trader] here…...  I hope you were one of the lucky ones that made it on John Carters webinar on Tuesday because I know that a lot of you tried, but weren't able to.   How do I know? I'm basing that on the number of support tickets John received from people that got locked out begging for a chance to see it.  As a result, John is hosting an encore presentation TONIGHT at: 8:00pm Eastern 7:00pm Central 6:00pm Mountain 5:00pm Pacific Secure your spot here.....  www.SimplerOptions.com/optionswebinar  Seriously, the feedback on this has been great. See you there,  Ray C. Parrish Options Trading Made Easy

Floating Rate Funds Poised to Profit as Interest Rates Rise

By Andrey Dashkov

Money can’t be this cheap forever. In other words, one of the most likely scenarios the U.S. economy faces is rising interest rates. The current low interest rate climate is simply unsustainable. At some point—as it always does—the trend will turn around. We want to be prepared for that turn, and the right floating-rate fund can help.

A floating rate loan is a bank loan with interest that’s tied to some benchmark rate, often the London Interbank Offer Rate (LIBOR). When the LIBOR changes, so does the loan’s coupon. The rate is adjusted every 30 - 90 days. Floating rate funds are pools of capital that invest in these loans, earn variable-rate interest, and pay dividends that are themselves flexible.

Variable Dividends Boost Immunity

Variable dividends are the key feature of floating rate funds. They’re what separate floating rate funds from the rest of the debt market. Flexible dividends make shares of the bond funds immune to rising interest rates; the prices of the bonds and the fund’s shares don’t get punished when rates go up. What the investor sees is higher dividends; his principal is safe.

A note of caution is in order here: Even though floating rate bonds don’t have the same inverse price-yield relationship as fixed rate debt instruments, their prices can still go down. Although the automatic coupon adjustments mostly eliminate the first major risk of any debt instrument—interest-rate risk—floating-rate funds still hold the other major risk: credit risk. As a reminder, credit risk is the risk that the borrower won’t make payments on time or will default on the debt entirely.

The credit risk of floating rate loans is high because the companies that borrow under these conditions are usually rated below investment grade. They can’t go to capital markets for money because fixed rate loans would be too expensive, so they turn to banks that provide funds on floating rate terms.

Since the companies borrowing these funds are below investment grade, their default rates are close to those of speculative grade bonds. Vanguard Research reports that the average annual default rate from 1996 to 2012 for speculative grade bonds was 4.5%; for senior floating-rate loans, it was 3.4%. Better, but still much higher than investment-grade bonds at 0.1%.

High Post - Default Recovery Rates

Does this mean that you should avoid floating rate loans in favor of AAA-rated debt? No. First, floating-rate loans are high in a companies’ debt structure, which means that if the borrower defaults, investors holding floating rate debt have a priority claim on the company’s assets. This leads to very high recovery rates for senior floating rate loans in the event of default: 71.1%, or more than 70 cents on the dollar. Compare that to the next class of loans, senior secured, which are recovered at a rate of 56.8%.

Second, floating rate loans outperform both high yield loans and the aggregate U.S. bond market. According to Vanguard, during the last three rising rate periods (January 1994-February 1995, June 1999-May 2000, and June 2004-June 2006) floating rate bonds outperformed high yield instruments by 2.5 percentage points (pp) and the aggregate bond market by 4.3 pp.

After the rising rate periods end, however, floating rate funds tend to underperform both high yield instruments and the overall bond market. This is why we’re buying them now, when rates have nowhere to go but up. We don’t know when that will happen, but when it does, we want to be positioned to profit.
In addition to their excellent performance in rising interest rate periods, floating rate funds are good for diversification. Their correlation with the overall US bond market is close to zero, which makes them especially good for a portfolio focused on fixed-rate US bonds. However, they also belong in our retirement portfolio—the Money Forever portfolio—where we use them to diversify our allocation across various debt instruments and to make sure we are well positioned to profit from rising interest rates.

Entrée into the World of Big Money

To sum it up, floating rate funds provide a way to diversify into an investment class that is almost immune to rising interest rates. Like business development companies, floating rate funds offer retail investors entrée into an area of finance usually reserved for big money and institutions. In exchange for these opportunities, investors accept credit risk due to the low credit ratings of the borrowing companies. With that in mind, we pay close attention to the sectors of the funds we consider investing in, and prefer more defensive and crisis-resistant industries.

At Miller’s Money we closely monitor the bond market, constantly scouting out the best options for seniors and savers. Learn more need to know information about bonds and the role they play in today’s low-interest rate environment by downloading our free special report, Bond Basics today.

The article Floating-Rate Funds Poised to Profit as Interest Rates Rise was originally published at Millers Money

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aka The Crude Oil Trader

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What Chimpanzees Can Teach Us about Convertible Bonds

By Dennis Miller

In a renewed commitment to finally learn Spanish, one of my colleagues spent quite a bit of time this week awkwardly saying, “Qué es eso?” into the headset Rosetta Stone provides with its language learning programs. Translation: “What’s that?”

Here in the US, the 10,000 or so people reaching retirement age each day often find themselves asking the same question—though maybe not out loud—when advisors use terms of art or casually mention sophisticated investment options. What’s that? Most of these folks didn’t earn their living in the financial services sector, so they don’t speak the language—nor should they feel embarrassed about it.

That said, no one—particularly risk-adverse retirees—should ever invest in something they don’t understand. So let me add one more type of investment to your “I know about that” toolbox: convertible bonds. Despite their obscurity, they’re not the least bit complicated.
Put simply, convertible bonds:

• have, as a rule of thumb, two-thirds of the upside of common stock and one-third of the downside; and
• can be an excellent way to diversify your portfolio.

Convertible bonds are bonds an investor (let’s say it’s you) can convert into common stock of the issuing company under certain circumstances. Imagine, for example, that Rosetta Stone wants to finance a new project—maybe it’s doing R&D on how to teach humans to speak the language of chimpanzees (hey, this is purely hypothetical). So Rosetta Stone (RST), which has a current stock price of about $8.80, issues a convertible bond and sets the conversion rate so that it’s not profitable to convert your bonds unless the stock price rises, say to $11.

Then more people start to feel a burning need to learn Spanish—or Mandarin, or Farsi—and RST’s price passes $11. At that point, you can convert your bonds into shares of RST worth more than the stream of payments from the bond alone. You own bonds with upside potential.

If RST’s price goes up, the value of your convertible bond goes with it. If it goes down, the discounted stream of underlying cash flows (the bonds’ coupon payments plus return of the principal at maturity) act as a price floor.

Now imagine that speaking multiple languages goes out of vogue, and instead of rising past $11.00, RST drops to $4.00. You’ll still receive interest and principal—meaning your convertible bonds can’t be worth less than those payments.

Of course, there’s always the threat of default. Say Rosetta Stone goes bankrupt for one reason or another (maybe it overspent on the chimp project, and it failed). The silver lining is that you’ll have a better chance of getting some money back than if you owned common stock.

What You Trade for the Option to Convert

As with any investment, there are trade offs: convertible bonds have slightly lower yields. The company pays a lower interest rate, and in exchange you have the option to convert your bonds. Also, convertible bonds often fall into the high yield/junk-bond category.

What’s more, it’s often only feasible for individuals to invest in convertible bonds through convertible bond funds. And you know what that means: fees. With an average expense ratio of 1.25%, fund managers have to get past that hurdle before they can start making you money.

With that, why would anyone want to buy a convertible bond fund? In a word, diversification. We hold one convertible bond fund in our retirement-specific portfolio for downside protection and the diversification it provides. With a gross expense ratio of 0.4% and one-third of its holdings in investment-grade bonds, this particular fund avoids the major pitfalls of most convertible bond funds.

Less common investments are worth knowing about, but understanding them doesn’t mean you should jump in whole hog—particularly when you’re investing your retirement nest egg. And that’s our focus at Miller’s Money: plain-English financial education and smart retirement investing. Read our free weekly e-letter, Miller’s Money Weekly every Thursday by signing up here.

The article What Chimpanzees Can Teach Us about Convertible Bonds was originally published at millers money

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Europe Takes the QE Baton

By John Mauldin

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

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

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

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

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

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

The Age of Deleveraging

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

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

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

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

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

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

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

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

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

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

How Bizarre Is It?

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

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



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



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



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

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

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



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



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



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



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



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

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



Time to Ramp up the Currency War

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

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

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



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

Europe Takes the Baton

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

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


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

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

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

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

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

Introducing Tony Sagami

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

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

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

San Antonio, Washington DC, Chicago, and Boston

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

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

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

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

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

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

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

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