Category Archives: Asset Classes

Caveat Emptor

Bond guru Jeff Gundlach observed that the stock market has become a market for high-risk CDO residuals.

I must admit that I had not thought about this but he is exactly correct. CDOs (Collateralized Debt Obligations) were at ground zero in the last financial crisis. A CDO is constructed from a collection of assets, for example mortgages, and is divided into slices (“tranches”) which receive income in a priority sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. So for example, if $100 comes in, then slice 1 may be entitled to the first $25, slice 2 the next $25 and so on. But if only $10 comes in, slice 1 gets it all and nobody else gets any money. The last or lowest priority slice is called the residual, which receives whatever is left over after the other slices with fixed entitlements have been satisfied.

Gundlach’s point is that companies which have bought back shares with debt now have a capital structure essentially identical to that of a CDO, where the debt obligations have first claim on the company’s income and the equity investors must be satisfied with the crumbs. They are in the same position as the owner of the residual tranche of a CDO. So long as earnings are high and interest rates are low, all is well and there will be yachts and jets. But when the tide goes out, there will be naked swimmers as the ugly side of leverage becomes visible. Read Jeff’s piece and be very very scared.

Loose Cannons

In the days of fighting sail, the ship’s main armament typically consisted of rows of cannons lined up on each side of the ship. These cannons fired through ports in the side of the hull and were mounted on wheels so that they could be pointed and able to recoil when fired. Normally, they were constrained by heavy ropes. But from time to time one or more would get loose. Each cannon could weigh as much as three tons and would then roll around the gun deck as the ship pitched and rolled, crushing anything or anybody in its way. The gundeck would be crowded most of the time – each gun on a large ship had a crew of 14 men who not only worked but ate and slept near their gun. Needless to say, a loose cannon could do much more damage than any broadside from an enemy ship.

In the market, the black boxes or “algos” are the equivalent of the loose cannons of yore. They are out of control and roll around in herds, as many of them share similarly programmed rules. You can watch the “herding” in the stock market by watching the “Tick” as it moves to extremes in both directions – that’s the herd. You hear about “flash crashes” – that’s a herd of algos running over some security or asset class. They pose a huge danger to the financial system, and need to be reined in. The mistake that the regulators make is to only consider them as single entities, without comprehending the emergent phenomena arising from unintentional herding behavior.

Crispin’s Day (Not Henry V)

Crispin Odey, who runs the most bearish hedge fund and needless to say has done rather well this year, writes in his recent manager’s letter:

I have a lot of sympathy for your position, sitting on the other side of the desk.

This is late cycle economics. Consumers are sated and over-borrowed. Companies have extracted all the margin they can and have leveraged themselves as well. Cheap money has spawned competition. Populism risks playing about with prices and property ownership. Recessions will not be altogether unwelcome given that they deal with the problem of rich and poor and young and old. The rich lose money which pleases the poor. The old lose their jobs and the young are the first to be reemployed. Without recessions this redistribution has to be done through taxation and legal theft.

Too Tight?

Reportedly, President Trump is considering firing Fed chair Powell, blaming him for the recent stock market declines.

Ironically, in Sept 2016, Trump accused the the Fed of “keeping the rates artificially low so the economy doesn’t go down so that Obama can say that he did a good job. They’re keeping the rates artificially low so that Obama can go out and play golf in January and say that he did a good job. It’s a very false economy. We have a bad economy, everybody understands that but it’s a false economy.”

Of course, he then adopted the “false economy,” even though he apparently well knew that it was a bubble, going on to extend it with spending increases and tax cuts. Of course, this simply increased government’s value destruction and we will all reap the consequences. In my mind, this is the biggest disappointment of Trump’s presidency – that he knowingly continued to inflate the bubble.

Yellen was “too short.” It seems Powell is “too tight.” Firing Powell would probably precipitate a crash.

The right thing to do is to acknowledge that the Fed’s ability to control the economy is a myth. Their attempts just lead to an endless series of booms and busts, as anyone who has the least understanding of control systems theory could predict.

Volatility In 2019?

2019 could be like 2008, which featured nine rallies of at least 9.5% of which three were greater than 20%, totaling 142%. The corresponding declines totaled 158%. The total opportunity, if you like, was 300%. Not that it would have been possible to catch the spikes perfectly, but….

The top top to bottom bottom was a mere -50.3%.

The Tilted Playing Field

The stock market is supposed to be a level playing field for all participants. But it clearly isn’t, and the referee, the SEC, doesn’t care and actively favors the tilters.

Understanding the issue is straightforward. If, every morning, you got the day’s closing prices, do you think you could make money? Of course, it would be a no-brainer.

How about an hour from now’s prices? Or a minute? Same answer, although you’d have to be quick. If you’re a computer, you could be quick enough.

Well, the favored few have computers, and no they don’t get a day or even a whole minute but they do get fractions of a second and that’s plenty for a computer capable of billions of instructions in a second. They are allowed direct connections to the exchange computers and are often only a few feet away to minimize any network delays. So they see prices before you do, and can respond before you can. Making money consistently is easy-peasy. They do pay the exchanges for the privilege, but that’s nothing in comparison to the profits they reap at your and my expense.

What can you do about it? Not much. Just remember the SEC is the retail investors enemy. Like many government employees, SEC personnel are corrupted by the promise of lucrative sinecures after their stay at the SEC. It’s called regulatory capture.

So they go after visible but harmless and relatively defenseless prey like Martha Stewart.

Chunky Monkey

Thanks to zero hedge, of course.

Deflation Watch

ECRI chimes in – I told you so.

The plunge in oil prices, which dropped below $50 this week, blindsided many businesses and investors. But the inevitable decline was foreshadowed months ago by a downturn in commodity prices, as measured by ECRI’s Industrial Price Index (IPI) which was previously known as the JoC-ECRI IPI*…….

…..Oil price inflation has now plummeted to a 32-month low – its worst reading since early 2016 (bottom line). But industrial commodity price inflation, as measured by the IPI, has already dropped to a 33-month low, and is still falling (top line), signaling continued downside risk for oil price inflation.

Deflation Watch

Crude Oil (WTI) is through $50/bbl to the downside.

Only two prices matter; energy and labor.

I assume Powell knows this and that’s why he goosed markets yesterday. He’s worried that he’s broken something. He has.

Is The Crypto Romance Over?

Bitco(i)n is down again today, now off about 80% from its peak. A Veblen asset?

Are the HODLers still holding on?

This has been quite the gem of speculative lust overcoming rational thought. The blockchain technology is flawed in both performance and integrity, and then the Bitcoin application has compounded those flaws. I don’t think it was an intentional scam, at least in the beginning, but more the product of naïveté.