Category Archives: Manias

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.

Same Old

The Fed is making clear that it is having a change of heart and rate increases are on hold for the time being.

Does this mean the all clear, the bull market can resume? No. This is not good news. It means that even the Fed can now see the recession coming and is trying to avoid the blame. The recession itself is inevitable. The light at the end of the tunnel is a train and no amount of panicking will change that.

Powell was the last hope for a truly independent Fed. Well forget that. It turns out he’s just another politician. Go back to your cherished memory of Paul Volcker and resume dreaming. I quote the IMF, which may not know economics but does know accounting:

“Global debt has reached an all-time high of $184 trillion in nominal terms, the equivalent of 225 percent of GDP in 2017. On average, the world’s debt now exceeds $86,000 in per capita terms, which is more than 2½ times the average income per-capita.”

This catastrophe belongs entirely to the world’s central bankers and the governments that have failed to constrain them.

The Tide Is Falling

As I have expected and warned, successful attacks on “crypto” networks are now occurring. They are moving up the food chain to the larger networks, now Ethereum has been compromised. At this point, it is just a matter of time before Bitcoin is the victim, probably through one of the smaller forks. The tide is falling, exposing more and more naked swimmers.

Unlike economics, there is a solid mathematical foundation behind computation. The general problem of consistently obtaining reliable consensus in an untrusted distributed database network has been proven to be unsolvable. Simplifying assumptions are required. The blockchain system assumptions (consensus is not required; a majority vote within a time limit is good enough) are clearly inadequate in the face of deliberate attack.

The teaching of computer science in schools is pretty much a joke from what I see. Teaching Word and Excel is not teaching computer science. It seems that a weird variation of Gresham’s law is in operation these days, where bad science drives out good.

Note: At least 3m+1 generals are required to cope with m traitors. But the open blockchain networks have no constraint on the number of traitors other than what it costs to add “traitorous” nodes. Blockchain could work within an organization where the network is tightly controlled. But then the performance issues….

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.

Here We Go Again

Recurring economic crises are nothing but the consequence of attempts, despite all the teachings of experience and all the warnings of the economists, to stimulate economic activity by means of additional credit. […]

And although the conclusion to which my investigations lead, that expansion of credit cannot form a substitute for capital, may well be a conclusion that some may find uncomfortable, yet I do not believe that any logical disproof of it can be brought forward.

— Ludwig von Mises, The Theory of Money and Credit, 1934, 2009 edition

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.

Nothing New Under The Sun

“Trouble arises from misuse of term “investment” to cover the crassest and most unrestrained speculation. The difficulty could be cured by re-adopting the old time, clean-cut distinctions between speculation and investment”

Benjamin Graham and David Dodd, Security Analysis,1934

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.