The Last Straw

Bloomberg news had an interesting article in their February 17th magazine titled, “Selling Private Equity (PE) at The Superstore.” Yes, that sector of the market reserved for the very rich may soon be available as an ETF or mutual fund or both by VanGuard.  Isn’t that wonderful!  The retail investor will be able to put a few thousand dollars in PE that used to require $millions or $Billions.  That begs the question, who’s selling?  Wasn’t it just last year that I read about the hoards of cash PE companies were holding because they couldn’t find any worth while investments?  Some were even returning cash to shareholders.

My 60 years in the investment business tells me, anytime the institutional investors are selling something previously not available to retail investors, I should not be buying and neither should you.  You might say, If it is good enough for Warren Buffett to buy GEICO and Sees Candy and bring them private, why shouldn’t I get in on it?  Because you’re not Buffett and that was then and now is now. Also, last year Buffett warned:

“We have seen a number of proposals from private equity funds where the returns are really not calculated in a manner that I would regard as honest,” Buffett said Saturday at Berkshire Hathaway Inc.’s annual meeting. “If I were running a pension fund, I would be very careful about what was being offered to me.”

This is another indicator of a top in the market and a signal to stop buying equities and take profits.  To support this view, I provide the following update on some software my Colleague, Hal Forsey and I developed to provide a picture of the uncertainty you are facing in the stock market:

This may be a strange shape in Figure 1 for some of you. It is not bell shaped.  A bell shape implies you could lose an infinite amount of money and you cannot.  The Fed will make some banks bail you out like they did with AIG and Portfolio Insurance.  The bell shape calls for measuring risk as deviations about the mean and assumes volatility above the average return is just as risky as deviations below the mean.

We believe the mean is the wrong location point and deviations about the mean is the wrong measure of risk.[1]

                                                        Figure 1 

The shape in Figure 1 is a lognormal, given our inputs at the bottom of the graph. This version of the lognormal was developed by two professors at Cambridge University, Aitchison and Brown, and it allows the distribution to be flipped so that it is negatively skewed, as it would be at a top in the market.  I believe this is one of the greatest advancements in describing uncertainty yet devised. So, let’s flip it.

                                                     Figure 2

Only the sign of the extreme value has changed from negative to positive, causing the skewness toward negative returns. Now we measure reward and risk in terms of dispersion above and below the DTR, not the mean.  The DTR chosen is 8%, the most frequently used actuarial return by defined benefit plans.  Returns above this DTR will fund their plan within their cost constraints while returns below will cause them to be underfunded.  Risk and reward are thus directly related to the DTR, which cannot be said for standard deviation.  A DTR can be calculated for anyone investing to achieve a specified payout at a specified time.

We use Dr. Peter Fishburn’s proposed measure of downside risk (below target deviations) and measure reward (Upside potential) relative to the DTR in a ratio we developed with Professor van der Meer and his colleagues at Groningen University.  Here is how to interpret the ratio of upside potential to downside risk shown in Figure 2 above: 5.5% divided by 9.7% = .56, meaning, there is 44% more downside risk than upside potential.  Compare this to the Upside potential ratio in Figure 1 of .92, indicating only 8% more downside risk than upside potential and you see the difference between believing the outlook is positively skewed and believing it is negatively skewed.

Now, suppose you think the market will be more volatile than normal.  We accomplish this in Figure 3 by simply increasing volatility to 25%.

                                                       Figure 3

Note: The extreme kurtosis (pointiness) results in a 75.3% chance the return will be greater than the DTR, producing the potential to exceed the DTR by 8% for a total return of 16%.  Sounds even better than Figure 2?

That is a misleading statistic unless it is adjusted for risk as shown in the Upside potential ratio which has now dropped to .35.  Meaning, if volatility increases to recent levels, we are now facing 65% more downside risk than upside potential.

Conclusions:

Figure 1 represents my opinion of a best-case scenario.  If you truly believe these are normal times, don’t panic and sell positions you may never be able to restore at these levels. The almost equal trade-off between downside risk and upside potential indicates you are risk neutral, not, risk averse if you accept this trade-off. in that case a buy-hold strategy is appropriate.

Figure 2 is my most likely scenario.  The already dangerous levels of debt are bound to get higher in response to the corona virus impact on world trade and it is an election year and Bernie Sanders is leading the Democratic race.  Even Fareed Zakaria says, the worst outcome may be if he is elected President and is allowed by a Democratic Congress to implement his platform.  One thing both parties agree on is: the tech industry needs to be regulated and downsized. Therefore, the returns are probably skewed to the downside and the proper strategy would be to take some profits in tech stocks and put them in short term treasuries.

Figure 3 is my worst-case scenario.  Just like 2007 when people thought they could flip houses forever and the bull got killed after goring several financial matadors.  We all knew it would eventually happen but most (not me) believed it was far off.

 

You can download the “Forsey-Sortino” software free and change the inputs as you wish at:

https://drive.google.com/open?id=1j-lL2Y33dqHFBLdXfvNuKHZXtPvV7RxM

Instructions are provided in the readme file included in the download.

[1] For papers and books supporting this view see past postings on the right-hand side of this page.

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Then and Now

Remember when President Trump said: “I could stand in the middle of Fifth Avenue and shoot somebody and wouldn’t lose any voters, okay?” Well, he just shot a foreign general with a rocket in a foreign country and then lied to congress about why he did it and guess what? The stock market is up over 100 points and Bloomberg posted this:

WOW!  Things are better than the best of times? What was going on in October of 2000?

Oh yes, the S&P index crashed for 3 years and didn’t fully recover until 2007.  And then we had the great real estate bubble! But that was then and now things are different.

This looks even worse to me! This time it is tech stocks and real estate. How did we get here?  We are $20 trillion in debt and our budget deficit is growing at a trillion dollars a year.  The result is, you can still buy the same house and the same stocks now as in 2000, it just takes 100 times more worth-less dollars. When I left the investment business and went back to UC Berkeley and then U of Oregon to get a PhD in finance, I was told that budget deficits were bad and trade wars were bad.  Now there is a new theory, MMT, that says they are good.

Hmmm, I remember back in October of 2000 I published a report in Pensions and Investments magazine that said, in effect,  get out! As of last month, I am taking that advice again.  I am out of the stock market, out of debt and into short term treasuries.

My best wishes to the twenty somethings who believe in MMT. I respect you, but not your theory. I didn’t write this for you. I wrote this out of concern for old people like me who are retired and won’t be able to replace the assets they are living off now.  Investing for us should not be exciting. Peace of mind is worth its weight in profits.

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The Final Solution

The only thing standing in the way of President Trump using the Federal Reserve to bankroll his real estate empire or a Democratic congress using the Fed to provide massive infrastructure and universal health care without raising taxes is…Nothing and Nobody!

How this is going to happen is explained in a paper by Charles Plosser at the Hoover institute at their 2018 Monetary Policy Conference. The entire book covering the conference, “The Structural Foundations of Monetary Policy . Hoover Institution Press. Kindle Edition” can be purchased at Amazon for $2. I have copied and pasted excerpts from Plosser’s presentation below.  The bold highlights are the parts that support my outrageous opening remarks.

………………………………………………………………………………………………………………………….

The Risks of a Fed Balance Sheet Unconstrained by Monetary Policy                                                                                    Charles I. Plosser

My focus today is on the Fed’s balance sheet and how institutions, and the incentives they create, matter for how it is managed. Since 2006, the balance sheet of our central bank has grown about fivefold, primarily because of the Fed’s unconventional policies during the financial crisis and subsequent recession.

Regardless of the rationale, the actions amounted to debt-financed fiscal policy and a form of credit allocation. Thus, such changes in the mix of assets held by the Fed are frequently referred to as credit policy. Prior to the crisis, the Fed operated with a relatively small balance sheet. Its size was determined by the demand for currency and the demand for required reserves. That is, it expanded or shrank reserves in the banking system

to achieve its funds rate target. This operating procedure required the Fed to increase or decrease its balance sheet accordingly. The size of the balance sheet was integral to setting the instrument of monetary policy—the fed funds rate.

Several economists (including former Fed My focus today is on the Fed’s balance sheet and how institutions, and the incentives they create, matter for how it is managed. Since 2006, the balance sheet of our central bank has grown about fivefold, primarily because of the Fed’s unconventional policies during the financial crisis and subsequent recession. Once the Fed had reduced the targeted fed funds rate to near zero in December 2008, it embarked on a program of large-scale asset purchases. Initially, those purchases were motivated by a desire to provide liquidity and maintain financial market stability. Those goals were largely achieved by mid-2009, yet quantitative easing (QE) continued and expanded. It was justified not on the grounds of financial market dysfunction but as a means to provide more monetary accommodation to speed up the recovery.

Currently, the Fed’s balance sheet is roughly $4.5 trillion, compared to about $850 billion prior to the financial crisis. The composition of the balance sheet is also quite different today than it was prior to the crisis. In 2006, the asset side of the balance sheet was predominately US Treasury securities. Today, approximately 40 percent of the balance sheet is composed of mortgage-backed securities (MBS), while Treasuries account for most of the rest. In addition, at various points during the crisis the Fed held hundreds of billions of dollars of other private-sector securities or loans, although most of these private-sector securities have rolled off the balance sheet, leaving primarily Treasuries and MBS. The liability side of the balance sheet also reflects the impact of QE. In 2006, currency accounted for more than 90 percent, or $785 billion, of the $850 billion, and bank reserves just about 2 percent, or $18 billion, almost all of which were required reserves. Today, currency represents about $1.5 trillion, or just 33 percent of the balance sheet, while reserves have risen to about $2.6 trillion, or about 60 percent of the balance sheet, of which only $180 billion are required.2 So there is about $2.4 trillion in excess reserves today compared to zero in 2006.

chair Ben Bernanke, now at the Brookings Institution, and John Cochrane at the Hoover Institution) have argued that since the Fed now has the ability to pay interest on bank reserves, it is possible, desirable, and perhaps more efficient to maintain a large balance sheet and use the interest rate paid on reserves (IOR) as the instrument of monetary policy rather than the fed funds rate. The basic idea is that by setting the interest rate it pays on bank reserves, the Fed establishes a floor for short-term risk-free rates.

Who will determine the amount of excess reserves created and how will they do it, since the monetary policy instrument will be the IOR? Unfortunately, there is little discussion or analysis of how to determine the appropriate amount of excess reserves that should be created. Is it $10 billion, $100 billion, or $1,000 billion? First and foremost, an operating regime where the Fed’s balance sheet is unconstrained as to its size or holdings is ripe for misuse, if not abuse. A Fed balance sheet unconstrained by monetary policy becomes a new policy tool, a free parameter if you will. Congress would be free to lobby the Fed through political pressure or legislation to manage the portfolio for political ends. Imagine Congress proposing a new infrastructure bill where the Fed was expected, or even required, to buy designated development bonds to support and fund the initiative so taxes could be deferred. This would be very tempting for Congress. More generally, the temptation would be to turn the Fed’s balance sheet into a huge hedge fund, investing in projects demanded by Congress and funded by forcing banks to hold vast quantities of excess reserves on which the central bank pays the risk-free rate.

Recall that in 2015 Congress raided the Fed’s balance sheet to help fund a transportation bill. In 2010, the resources for the Consumer Financial Protection Bureau were found in Fed revenues. These were all efforts to exploit the central bank for fiscal policy purposes. Imagine the political debates over appointments to the Board of Governors. Hearings might focus on the nominees’ views on the investment policy for the balance sheet rather than monetary policy. Political pressure to purchase various forms of securities to support favored projects or initiatives could be enormous and fraught with controversy.

I have other concerns surrounding the implementation of monetary policy under a big-balance-sheet regime. The evidence accrued to date suggests that the IOR does not provide a firm floor for the funds rate or other short-term rates. One way the Fed has sought to address these problems is by increasing its interventions into the short-term money markets. This program is the reverse repo program, or RRP. This program allows non-depository institutions to borrow Treasury securities from the Fed overnight (which soaks up reserves) with an agreement that the Fed will repurchase the securities the next day.

Thus, we have some evidence that the floor system currently in place does not provide a firm floor and must be supported by the RRP program, which effectively drains reserves from the banking system on an ongoing basis.

The Fed has become a larger and more deeply embedded participant in the short-term financial markets than ever before. This is a worrisome development, as RRPs give large financial firms a safe and reliable place to flee in times of volatility—and making it easy to do so may increase systemic risk rather than reduce it. The instrument of monetary policy in a floor system is the interest paid on reserves. Unlike the funds rate, the IOR is an administered rate rather than a market rate. Under current law, the IOR is set by the Board of Governors, not the FOMC. In other words, it is the Board of Governors rather than the FOMC that technically determines monetary policy. Under a pure floor system, the FOMC would become irrelevant. Gutting the FOMC’s role in monetary policy would undermine independence and result in monetary policy becoming far more political.

A large Fed balance sheet that is untethered to the conduct of monetary policy creates the opportunity and incentive for political actors to exploit the Fed and use its balance sheet to conduct off-budget fiscal policy and credit allocation. Such actions would undermine Fed independence and politicize the Fed to a far greater degree than it currently is. Without changes in the Federal Reserve Act, it would shift the conduct of monetary policy to a more politicized Board of Governors and away from the FOMC. Finally, it seems to require that the Fed play a much larger, directive role in the functioning of short-term money markets, potentially reducing the traditional role of market forces. For these reasons, I think the economy would be better served if the Fed returned to an operating regime based on a smaller footprint, where the balance sheet is more directly linked to the conduct of monetary policy. (It ain’t going to happen but Trump will stack the board with incompetents who will do his bidding and Democrats will create bigger entitlement programs and neither will want to pay for it by increasing taxes. But don’t worry, the stock market will probably go up…until it doesn’t)

Source of quotes

The Structural Foundations of Monetary Policy (pp. 15-16). Hoover Institution Press. Kindle Edition.

 

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Cryptocurrency versus the Dollar

The first question to Fed Chairman Powell today in his meeting with congress was about a new cryptocurrency called “Libra” and its possible impact on monetary policy. Also, President Trump invited all but one leader of Silicon Valley tech companies to meet with him today.  That leader was Zuckerberg of Facebook. My response to these developments begins with a quote from Ahamed Liaquat’s, “Lords of Finance: The Bankers Who Broke the World”. Penguin Publishing Group. Kindle Edition.

“Before WW I Britain was the world’s banker. No other financial center—neither Berlin nor Paris, certainly not New York—came close to matching London’s standing as the hub of international finance.

The war had changed the balance of financial power, and the New York Times correspondent in Paris reported that “ninety out of a hundred regard Uncle Sam as selfish, as heartless, as grasping. The great majority of the British people have made up their minds that American policy is selfish, sordid and contemptible.”

The consequences were: the British pound was replaced as the exchange currency of the world by the dollar and London was replaced by New York as the hub of international finance. Now, America is engaged in a trade war to keep that position of world dominance and it is America calling China, selfish, sordid and contemptible as they threaten to replace us. The major factor cited by Ahamed in “Lords of Finance” for England’s decline was the decision to go on the Gold Standard. America had more gold than all the allies put together.

The major factor regarding the outcome of America’s Trade Wars may also involve money. Only this time, it may be a Cryptocurrency that changes the world order financially. I encourage everyone to read a white paper by Facebook at this link Libra Association website. Click on White Paper. The following is my interpretation of a few of the claims in this white paper:

  1. Libra is fully funded by multiple marketable assets denominated in multiple currencies. This should provide a relatively stable price.
  2. It operates on a blockchain system that could provide control over funds. being siphoned of to a hacker rather than the intended receiver.
  3. Libra uses a new programing language that also enhances security.
  4. It is governed by a group of expert IT firms, not just Facebook.
  5. It could provide more than a 2% return on assets to founding members and investors according to a Fortune magazine article.
  6. Allows for cross-border transfers of funds at much lower costs than currently available.
  7. All the user needs is a cell phone.
  8. It could dramatically reduce the ability of drug traffickers to move money.

The following is a well-reasoned opposing point of view by a respected source:

Hello Frank,

I think the position of the dollar as the reserve currency has only strengthened over time, particularly in recent years.  A currency functions as a medium of exchange and a store of value.  Over the years, the dollar has overtaken every government currency in the world and gold too in both functions.  It is the preferred reserve holding by central banks around the world.  It engenders confidence around the world through the two main institutions of the US Federal Reserve and the US Treasury (which issues default free debt-by definition).  We may criticize these two institutions domestically, and accuse them of political expediency and other things, but they remain the most solid institutions of their kind in the world – by far.  The ability of any cryptocurrency to dethrone the dollar, due to technological advances, is highly improbable in my opinion.

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AlgoDynamix Webinar

I had the pleasure of attending a webinar on June 13th by AlgoDynamix. The management team are physicists who met at Cambridge University. Instead of using historic return data, like I do, they look at behavioral characteristics of clusters they develop from a limit order book, as shown below:

I remember back when I was an allied member of the NYSE, it was believed if one could get a peek at the specialist’s books, one would be able to determine which way the market was going.  Perhaps AlgoDynamix is getting that peek with an insight into their behavior.

I believe this could be a major improvement over the methodology I developed. While my February 6th posting warned against having more than 40% in equities,  AlgoDynamix raised a red flag for a downturn in the market, which occurred in April, with a subsequent flag indicating an end to the downturn. In the past year that I have been observing their flags for ups, downs and endings, their methodology appears to have had predictive powers worth looking into.

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What Kind of Game Are We Playing?

In his book, The Seventh Sense: Power, Fortune, and Survival in the Age of Networks, Joshua Ramo asks: “Do you believe the spread of democracy is inevitable? Or do you think we live in an age of global chaos and American decline?”  He goes on to say, “The world is not one big, flat equally connected topology. It is filled with closed and gated worlds. By “gates,” I mean not only in-and-out passages but also protocols, languages, block chains. Whatever binds and shapes a topology is a gate.” Ramo concludes: “The critical question is: Who will be the gatekeepers of finance, biology, trade, and pretty much every other source of power?”

Among those who believe this is the critical question of our times there seems to be general agreement the winner will either be America or China. Perhaps the following articles provide a clue.

  1. Bloomberg (Huawei Reprieve: U.K., Italy and Germany Reject US Boycott)

Last year Huawei surpassed Ericsson to become the world’s largest telecoms equipment manufacturer and trailed only Samsung for smartphone sales. CEO Guo Ping said: “We are working with our partners to serve global customers with 37 availability zones across 22 regions.” Built on the success of networking equipment and now devices, Huawei has grown its revenues fivefold in less than a decade: around $20 billion in 2009 to around $110 billion last year.

  1. Victor Hanson in his book: The Case for Trump had this to say about Trump’s role in this ongoing collapse of established ideas and institutions: “Trump’s sometimes scary message was that what could not be fixed could be dismantled.” Hanson then quotes Kissinger as saying: “I think Trump may be one of those figures in history who appears from time to time to mark the end of an era to force it to give up its old pretense.”
  2. Fareed Zakaria on May 25th said Trump’s actions may usher in a “Sputnik moment” for China where it surges ahead of America just like America did to Russia.

The stock market is viewed by many as an unbiased, objective indicator in that money has no philosophy and knows no borders.  If that is true, what does the following chart have to say about who is winning and who is losing?

Looks to me like the world has been the biggest loser and US high-tech, the big winner. China high-tech is down about 50% from its high but up from its lowest point. So, I accept this as evidence that America has fared better than China and the world X America.  However,  I also agree with the weak form test of the Efficient Markets Hypothesis that a time series of past prices does not predict future prices.

Checkmate or Surrounded With Nowhere to GO?

While the Trump administration is focusing on trade wars as a solution to stimulating our economy, China is focusing on inviting our former allies into their Gateland via their 21st century opening of the silk road called the “Belt and Road” Initiative. Xi Jinping claims China has signed up $64 billion in contracts during the current conference in Beijing.

Peter Frankopan in his book: “The Silk Road, A New History of the World,” says China’s One Belt One Road initiative, which is both a land and maritime Silk Road seeking to connect East Asia, Central Asia, the Middle East, Africa, and Europe, is,  the driving force of 21st century geopolitics. If, as some observers say, Xi is playing a game of GO, where the winner surrounds his opponent leaving nowhere to GO, while Trump is playing chess.  Trump may claim stock market results as, check, but not checkmate; while Xi closes the gate and puts a 5G lock on it.

It seems that Trump and his supporters believe in the stock market while Xi and his people believe in China. If Trump succeeds in telling the rest of the world who they can do business with and weakens China’s lead in the 5G race, is that checkmate? No

If China succeeds in forming a Gateland with SE Asia, central Asia, Europe, Russia and South America, where would that leave America and the rest of the world? Probably worse off.

One point that I have left out is the future role of the dollar in the global economy.  This past year China has been the world’s largest purchaser of gold and has been steadily decreasing its holdings in U.S. Treasuries.  China has been testing an electronic currency and is one of those countries calling for a replacement of the dollar as the exchange rate currency.  That would be….Goodbye Camelot, I’m glad I knew you.

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Market Truths

A Truth that’s told with bad intent

Beats all the Lies you can invent

William Blake

 

We’re told trade wars are good

And debt of nations, states and you.

Even better if it’s B or  below

But Prized above all are concept woes.

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