- How Could the Fed Protect Us from Economic Waves?
by Keith Weiner
Mainstream economists tell us that the Federal Reserve protects us from economic waves, indeed from the business cycle itself. In their view, people naturally tend to go overboard and cause wild swings in both directions. Thus, we need an economic central planner to alternatively stimulate us and then take away the punch bowl.
Prior to the global financial crisis of 2008, a popular term described the supposed benefits created by the Fed. The Great Moderation referred to the reduced volatility of the business cycle. For example, I have written before about economist Marvin Goodfriend, who asserted that the Fed does better than the gold standard.
(Credit: Greg Ziegerson and Keith Weiner)This belief is inherent in the Fed’s very mandate from Congress. The Fed states its three statutory objectives as, “maximum employment, stable prices, and moderate long-term interest rates.” These terms are Orwellian. Maximum employment means five percent of able-bodied adults can’t find work. Stable prices are actually rising relentlessly, at two percent per year. The
meaning of moderate long-term interest rates must be changing, because rates have been falling for a third of a century.That aside, the basic idea is that the Fed has both the power and the knowledge to somehow deliver an economic miracle. However, we know that central planning never works, even for simple things such as wheat production. Communist states have invariably failed to produce the food to keep their people alive. Stalin, Mao, and other communist dictators have deliberately starved off segments of their populations that they couldn’t feed.
The business cycle is vastly more complicated than the crop cycle. It plays out over decades. It involves every participant in the economy. It affects every price, including, especially, the price of money. It causes changes in how people coordinate in the present and how they plan for the future. And, there are feedback loops. Changes in one variable cause changes in others, which come back to affect the first variable. The very idea of centrally planning money and credit boggles the mind.
This should not be controversial. Yet, even those who know why government food planners fail, somehow retain their faith in central planning of the economy as a whole. Marvin Goodfriend—who spoke in favor of free markets, by the way—called his faith in central banking, “optimism.”
Is it true that the Fed is actually somehow providing stability, or even improving on a free market? Let’s look to the interest rate on the 10-year Treasury bond. The rate of interest is a key economic indicator.
(sources: National Bureau of Economic Research 1800-2001, US Treasury 2002-2014)With that giant peak on the right side of the graph, we can immediately reject all claims to Fed-imposed stability. Now let’s label a few key dates.
The pre-Fed period is pretty stable. Two spikes occur due to wars that we know disrupted the economy—and they’re pretty small, considering. Interest declines to a lower level when the government was paying down its war debt. Things remain stable until the creation of the Fed.
After that, we get a rise, a protracted fall, an incredible and truly massive rise, and an endless freefall. Both rising and falling interest make it more difficult to run a business that depends on credit, such as manufacturing, banking, or insurance. The post-Fed period is a lot less stable than the pre-Fed.
A feature of the free market and its gold standard is interest rate stability. The rate can vary between the marginal time preference and marginal productivity. This tends to be a stable and narrow range.
Fed apologists argue that the economy would be even more unstable, if we had no monetary central planner. However, the fact is that it became a lot less stable after the Fed was created.
This article is from Keith Weiner’s weekly column, called The Gold Standard, at the Swiss National Bank and Swiss Franc Blog SNBCHF.com.
- "Ukrainians Have Been Dispossessed" Paul Craig Roberts Warns "Americans Are Next"
Submitted by Paul Craig Roberts,
Over the last 15 months Ukrainians have paid for Washington’s overthrow of their elected government in deaths, dismemberment of their country, and broken economic and political relationships with Russia that cost Ukraine its subsidized energy. Now Ukrainians are losing their pensions and traditional support payments. The Ukrainian population is headed for the graveyard.
On June 1 the TASS news agency reported that Ukraine has stopped payments to pensioners, World War II veterans, people with disabilities, and victims of Chernobyl. According to the report, Kiev has also “eliminated transport, healthcare, utilities and financial benefits for former prisoners of Nazi concentration camps and recipients of some Soviet-era orders and titles. Compensations to families with children living in the areas contaminated by radiation from the Chernobyl accident will be no longer paid either. Ukraine’s parliamentary opposition believes that the Prosecutor General’s Office should launch an investigation against Prime Minister Arseniy Yatsenyuk who actively promoted the law on the abolition of privileges.”
Notice that this is a yank of the blanket from under the elderly in Ukraine. “Useless eaters,” they are assigned to the trash can. How do the deceived Maiden student protesters feel now that they are culpable in the destruction of their grandparents’ support systems? Do these gullible fools still believe in the Washington-orchestrated Maiden Revolution? The crimes in which these stupid students are complicit are horrific.
Yatsenyuk, or Yats as Victoria Nuland calls him, is the Washington stooge that the US State Department selected to run the puppet government established by Washington. Yats sounds like a right-wing Republican when he refers to pensions, compensations, and social services as “privileges.” This is the Republican view of Social Security and Medicare, programs paid for by the payroll tax over the working lives of Americans. The Republicans stole the payroll revenues and spent them on their wars that enrich Wall Street and the military/security complex, and now blame “welfare handouts” for America’s fiscal plight.
Is Monsanto’s right to turn Ukraine into GMO food production a privilege? ls VP Biden’s son’s right to destroy Ukraine’s surface and underground water in fracking operations a privilege? Are the external costs imposed on Ukrainians by these looting activities a privilege? Of course not! These are not privileges. This is the operation of free market economics creating the greatest good for the greatest number. (As many Americans will not realize that I am engaging in satire, I would like to affirm that I am.)
The news report does not say whether the abolished “privileges” are one part of a reform that will replace the terminated “privileges” with a new social support system. Possibly this is the case, but as the termination of pensions and payments was triggered by the coming into effect of Yat’s law to “stabilize the financial condition of Ukraine,” the purpose of the termination of Ukraine’s social welfare system might be to free up money to hand over to the IMF and Western banks. In Ukraine, as in Greece, the gullible and naive population that saw salvation in unity with the West will be driven into the ground.
Russia, of course, will be blamed. I can already write the New York Times and Washington Post editorials and the words that will come from Obama, CNN, and Fox “News.” In fact, so can my intelligent readers.
The same looting is underway in Great Britain, Italy, Spain, Portugal, and the United States. In Great Britain everything achieved by the Labour Party over many decades has been taken away, and not only by the Conservatives but by Labour leader Tony Blair himself.
Tony Blair sold out his constituents for money and is now among the One Percent. Bill Clinton did the same thing. Bill and Hillary were able to spend $3 million on their daughter’s wedding, almost a world record, dwarfing many Hollywood weddings. Obama is not even out of office and is already rich. America’s faithful vassals–Merkel, Hollande, and Cameron–can look forward to equal riches.
Karl Marx was correct when he said that money corrupts all. Everything becomes a commodity that is bought and sold for money.
When money becomes the measure of a person, people have become corrupted. And that is the plight of the Western world.
Where in the West is your wealth, small or large, safe? Nowhere. Washington has destroyed financial privacy everywhere in the West. Washington even forced Switzerland to violate its own laws in order to comply with Washington’s insistence on the absence of any financial privacy.
For decades Americans with foreign bank accounts have been required to report them on their income tax returns. Now if an American owns a gold coin in a vault overseas, this must be reported to Washington.
Once Washington knows the location of your assets, the assets can be confiscated at will. Washington only has to make some declaration or accusation or the other, and your wealth is gone.
As Washington has run the printing presses hard in order to serve a handful of banks that control the US Treasury and the Federal Reserve, unless China and Russia acquiesce to becoming Washington’s vassals, at some point the dollar’s value is going to slide downward. When that happens, the Federal Reserve cannot continue to create new money to meet Washington’s needs.
Where will the money come from? It will come from Americans’ pensions.
Pensions accumulate tax free, and this accumulation will be confiscated in whole or part to make up for the failure to tax, another “privilege.”
That confiscation works that year. But what happens the next year when the dollar is reeling on foreign exchange markets from over-supply?
The answer is that another chunk of American pensions, and I am speaking of private pensions, will be confiscated “in order to stabilize the financial system.” Social Security will be long gone by this time.
Alicia Munnel, who was my replacement as Assistant Secretary of the Treasury for Economic Policy in the Clinton regime, advocated many years ago a confiscation of private pensions, including your IRAs and 401Ks, in order to compensate the US government for their non-taxed status.
Alicia has a sinecure at an Eastern university where she continues to advocate against your pension. The joint attack by Clinton Democrats on private pensions and by Conservative Republicans on public pensions means that no American can look forward to having a pension. Americans are only one presidential election away from the loss of their pensions, and it doesn’t matter who they vote for.
Economic security is a thing of the past. Security was a product of the US being the only extant economy following World War II. In those days corporations believed, as did Washington, that companies had obligations not only to shareholders but to employees, customers, and the communities in which they were located.
This meant prosperity for all, not merely, as is the case today, for corporate management and shareholders.
Apologists for exploitation claim that the rich are richer because they are smarter. But the stupidity of the rich is everywhere visible. The greedy fools have destroyed their domestic US market. Really, how stupid can you be? How do Americans buy when they are forced by offshoring out of well paid manufacturing and software engineering jobs into being waitresses, bartenders, retail clerks and part-time Walmart workers in order that corporate bottom lines improve? Who buys the stuff that sustains the profits? Not Americans who no longer have the incomes to do so.
The belief spread by Wall Street and “shareholder advocates” that corporations only have responsibility to their owners and managers has destroyed the American economy.
By locating production offshore, corporations have destroyed the incomes that supported the American consumer market. For example, the incomes associated with the production of Apple computers, I-Pads, and I-Phones are in China. Apple’s American customers do not have the incomes associated with the production of the products that Apple markets to them.Americans are already dispossessed of their livelihoods and careers and their pensions are next. Wherever we look, the fate of populations under Western influence are the same. The Ukrainians are exploited, the Greeks, the British, the Americans.
Wherever the West has an imprint, the populations are exploited. Exploitation of the many for the few is the Hallmark of the West, a decrepit, corrupt, and collapsing entity.
- Japanese "Over-Confidence & Complacency" Proved Deadly In Fukushima, IAEA Chief Blasts
In a stunning report by The International Atomic Energy Agency (IAEA), Director General Yukiya Amano fingers Japanese over-confidence and complacency among the main reasons why the country was unprepared to the Fukushima Daiichi disaster of 2011. As Sputnik News reports, Amano exclaimed “there was a widespread belief in Japan that Japanese nuclear power plants are very safe and there would never be a severe accident. This belief was one of the reasons why Japan was not well prepared for severe accident.” Four years later, he hopes many have learned the painful lesson that “there can be no grounds for complacency about nuclear safety in any country.”
The 240-page report assesses the causes and consequences of the accident triggered by a huge tsunami that followed a massive earthquake on 11 March 2011. It was the worst emergency at a nuclear plant since the Chernobyl disaster a quarter of a century earlier.
The preparation of the report on the Fukushima Daiichi accident, which is scheduled to be made public at the IAEA General Conference this September, involved some 180 experts from 42 IAEA Member States and several other organizations.
“The report represents an authoritative, factual and balanced assessment of what happened at Fukushima Daiichi that should also be accessible for a non-technical audience,” Mr Amano said.
“There can be no grounds for complacency about nuclear safety in any country. Some of the factors that contributed to the Fukushima Daiichi accident were not unique to Japan,” the Director General added.
“Continuous questioning and openness to learning from experience are key to safety culture and are essential for everyone involved in nuclear power. Safety must always come first.”
“Before the Fukushima Daiichi accident there was a widespread belief in Japan that Japanese nuclear power plants are very safe and there would never be a severe accident. This belief was one of the reasons why Japan was not well prepared for severe accident,” Yukiya Amano said at a press conference on the sidelines of the meeting of the Agency’s board of governors that kicked off Monday.
During the meeting, the IAEA governors are due to hear the final report on the Fukushima accident which is scheduled to be made public at the IAEA General Conference in September 2015.
Amano added that prior to the Fukushima disaster, the zones of responsibility of Japan’s nuclear regulative body and various relevant government offices were vague and often duplicated one another.
“After the Fukushima Daiichi accident there was a reform of the regulative body and the responsibility is more clearly defined. And the regulative authority is making the Japanese safety standards better meet the international standard,” Amano said.
He expressed hope that the governments of all the IAEA member states will draw lessons from the report on Japan’s nuclear disaster.
* * *
Perhaps most stunningly, especially for those heading to the Tokyo Olympics in just a few years, according to Japanese authorities, cleanup efforts around Fukushima could take up to 40 years.
- If Your BS Detector Is Not Screaming, It's Broken
Submitted by Charles Hugh-Smith of OfTwoMinds blog,
Wishing it was true doesn't make it true–it makes you a chump who fell for the con.
Once upon a time in America, no adult could survive without possessing a finely tuned BS detector. Herman Melville masterfully captured America's fascination with cons and con artists in his 1857 classic The Confidence-Man, which I discussed in The Con in Confidence (October 4, 2006).
An essential component of the American ethos is: don't be a chump. Don't fall for the con. And if you do, it's your own fault. The Wild West wasn't just thieves shooting people in the back (your classic "gunfight" in the real West)–it was a simmering stew of con artists, flim-flammers and grifters exploiting the naive, the trusting and the credulous.
We now inhabit a world where virtually everything is a con. That "organic" produce from some other country–did anyone test the soil the produce grew in? It could be loaded with heavy metals and be certified "organic" because no pesticides were used during production. But what about last year? And the year before? What's in the water used to irrigate the crops?
The employment/unemployment statistics are obviously BS. 93 million people aren't even counted any more–they're statistical zombies, no longer among the living workforce. If the unemployment rate were calculated on the number of full-time jobs and the true workforce (everyone ages 18 – 70 that isn't institutionalized or in prison), the unemployment rate would not be the absurdly delusional 5.6% claimed by the bureaucratic con artists.
The corrupts-everything-it-touches bribe vacuum known as Hillary Clinton is still disgracing the national stage, 24 years after she first displayed her con-artist colors. Hillary's most enduring accomplishment is the Clinton Foundation–a glorification of bribery, chicanery, flim-flam and cons so outrageously perfected that it serves up examples of every con known to humanity in one form or another.
And as she learned from hubby Bill–if the smarmy charm-con fails, quickly revert to veiled threats. "You'll never work in this town again!"
Hillary would fit right into Melville's river boat teeming with con-artists. The accent she uses on the marks–oops, I mean audience–changes as readily as the camouflage on a chameleon. Upper Midwest, Noo Yawk, Fake-Southern–what you hear depends on the credulity of her marks.
The entire American political system is a con, a sleazy mix of legalized bribes, auctioning off of favors, revolving doors between government agencies and the corporations they enrich and the blatant hypocrisy of snake-oil salespeople who know the marks (voters) face a false choice between two parties that are the same poison sold under different labels.
Which brings us to China, one of the greatest credit bubble and financial cons ever. Please examine this chart of the Shanghai Stock Exchange (SSEC). Clearly, there is no upper limit to the Chinese stock market: 5,000 today, 10,000 next week, 50,000 the following month and 100,000 shortly thereafter. The sky's the limit, Baby!
That China's credit machine is now dependent on a stock market bubble for its very survival speaks volumes about the true health of China's economy. This dependence was recently explained in Why China Is So Desperate To Blow The Most Epic Stock Bubble.
Everybody who thinks China's economy is healthy because its stock market is soaring has been suckered. Every good con-man/ con-woman knows that the con only works if the chump/mark wants to believe the impossible is true–that the snake-oil remedy will actually cure their ailments, that the "hope" candidate will actually change the corrupt system from the inside (ha-ha, they fell for it), and that China's economy is on its way to becoming the world leader in everything.
Many people want to believe this fantasy because it suits their agenda: For American pundits, China isn’t a country. It’s a fantasyland.
But wishing it was true doesn't make it true–it makes you a chump who fell for the con. We want to believe our political system isn't an unreformable cesspool, that our economy is a vibrant creator of new middle class jobs and that China will manage the greatest credit bubble in history without a hitch. But these are all cons put over to protect the wealth and power of those benefiting from the con.
If your BS detector isn't shrieking, it's broken. You've been conned. Wake up.
- Former CIA Director: We're Not Doing Nearly Enough To Protect Against The EMP Threat
Last week we were reminded of what Elliott Management's Paul Singer highlighted as the "one risk that stands way above the rest in terms of the scope of potential damage adjusted for the likelihood of occurrence" – an electromagnetic pulse (EMP). Specifically, we covered the release of an open letter written to President Obama on the country's concerning level of vulnerability to a natural or man-made EMP. What is stunning about the former CIA Director's comments below is not just the carnage an EMP could wreak, but the apparent rabid intransigence with which the electrical power lobby is fighting any responsibility for defending against one.
Submitted by Adam Taggart via PeakProsperity.com,
On Monday we covered the release of an open letter written to President Obama, issued by a committee of notable political, security and defense experts — which includes past and present members of Congress, ambassadors, CIA directors, and others — on the country's concerning level of vulnerability to a natural or man-made Electro-Magnetic Pulse (EMP).
An EMP has very real potential for crippling much of our electrical grid instantaneously. Not only would that immediately throw the social order into chaos, but the timeline to repair and restart the grid in most estimated scenarios would take months to a year or more. Those curious on learning exactly how devastating an EMP can be can read our report on the topic from last summer.
This week, we've been fortunate enough to get several of the authors of that open letter to join us and explain in depth what they conclude needs to be done to protect against the EMP risk: former CIA Director and current Ambassador James Woolsey, Executive Director of the EMP Task Force Dr Peter Pry, and security industry entrepreneur Jen Bawden.
What's frightening in this story is not just the carnage an EMP could wreak, but the apparent rabid intransigence with which the electrical power lobby is fighting any responsibility for defending against one:
Chris Martenson: Now, we’ve had a commission to assess the threat to the United States from an EMP attack, which delivered a report back in 2008. In fact, I found no less than two congressional commissions, a National Academy of Science report, other U.S. government sponsored studies, including your own. All have raised heightened concerns about this issue. All have found, all of them, that the EMP threat poses a significant and existential threat to the United States, and yet here we are still talking about this. Why is that?
Dr. Pry: Well, the short answer to that is it’s called the North American Electric Reliability Corporation. They used to be a trade association or a lobby for the 3,000 electric utilities that exist in this country. And, their relationship with the federal government, with the U.S. Federal Energy Regulatory Commission, is a 19th century-type relationship. There is no part of the U.S. government that has the legal powers to order them to protect the grid. This is unusual, because in the case of every other critical infrastructure, there’s an agency in the U.S. government that can require them to take actions for public safety. For example, the Food & Drug Administration can order certain medicines kept off shelves to protect the public safety. The Federal Aviation Administration can ground aircraft and require protective devices, put locks on aircraft doors, for example, to protect people from having the aircrafts hijacked by terrorists.The U.S. Federal Energy Regulatory Commission doesn’t have those legal powers or authorities.
And, the NERC, which owns half of K Street and has got very deep pockets, has been successful in lobbying against legislation like the Grid Act and the SHIELD Act, both bipartisan bills supported almost unanimously by Democrats and Republicans. They’ve been able to stall for years and keep these bills held up. One time when we got a bill passed: the Grid Act actually, in 2010, unanimously passed the House. Everybody supported it. But Washington is so broken, one senator put a hold on a bill—if they know which senator to buy, they can buy that one senator and the person can put a hold on the bill so it can’t come to the floor for a vote and they can do it anonymously. The senator doesn’t have to identify themselves. So, you never know who stopped the bill.
And, that’s been the problem in Washington. We’ve been trying to overcome resistance by the electric power lobby to try to protect the grid.
They’ve basically been successful in stymying efforts at the federal level. Now, we’ve got another bill, Critical Infrastructure Protection Act, that we’re hoping will pass this year. Again, we’ve got a lot of support, but it’s already under attack by the utilities. And, they’re trying to change the language of the bill to basically gut the bill.
Ambassador Woolsey: And, when NERC is studying a problem, it doesn’t exactly operate at breakneck speed. After the ’03 outage in Cleveland that started with a tree branch touching a power line and took out the electricity for several days of Eastern Canada and much of the northeastern United States, NERC was finally prevailed upon to do a study. And, they did one and focused entirely on how to cut tree branches so that they won’t interfere with electric power lines. And, that tree branch study took them three years and eight months. What’s interesting about that lapse of time is three years and eight months is exactly the amount of time the United States was engaged in World War II, from beginning to end. So, one wonders how many wars worth of time it would take NERC to deal with a more complicated problem such as say, squirrels.
Chris Martenson: I understand that NERC is against this and they think this is overbearing regulation and they don’t want to be more highly regulated. I think possibly understandable concerns from any industry, but in this case, what kind of money are we talking about here? How much would it take to really begin to remedy this issue and how much time would it take? What is NERC fighting here?
Dr. Pry: Sure. Interesting question, because there are different numbers, depending upon how much security you want to buy. One of my colleagues on the, who served on the EMP Commission, had a plan that would cost $200 million. That’s not billions, but millions with an ‘m’. Now, that would be a very minimalist plan, and it would just protect the extra high voltage transformers that service the major metropolitan areas. It would by no means—we would still be at a very high level of risk, but it would at least give us something like a fighting chance to save all those people in the big cities, in the hundred largest big cities from starving to death, if you just invested $200 million.
At this point, as I recently testified to Congress, I think the U.S. FERC is so broken and untrustworthy that we probably need to scrap the regulatory system we’ve got now and go to something completely different. I think what you’ve got is a situation of what’s called regulatory capture. You’ve got a rotating door between FERC and NERC and these guys are basically in cahoots with the electric power industry .
Click the play button below to listen to Chris' interview with Dr. Peter Pry, Jen Bawden, and Ambassador James Woolsey (48m:35s)
- This Time Is Different: Miami Condo Prices Flatline For First Time In Six Years
Back in March we suggested that slower price appreciation in 2014 might be the proverbial canary in the coal mine for a Miami condo market that has, in recent years, benefited from an influx of foreign buyers. Here’s a look at the trend:
While it’s still “up and to the right” so to speak, the growth rate fell to 16% in 2014 from 20%+ in the two previous years. Cooling prices are in large part attributable to dollar strength, which has hit demand from wealthy South American buyers especially hard.
As Miami’s Downtown Development Authority noted:
“The primary driver for the Downtown Miami Condominium market is foreign investment. At the early stages of this cycle, South American capital was extremely strong versus the dollar and represented significant purchasing power for South American buyers using foreign currency to purchase pre-sale units that were being sold in U.S. Dollars. In addition to the favorable currency exchange rates, South American buyers are typically hedging against their own economies, which experience significant fluctuations due to political turbulence.
Due to the recent advance of the U.S. Dollar vs. most South American and European currencies, the advantageous buying power of foreign investors has been diminished significantly since 2011 (with the exception of China). While the Euro has not diminished as much as the South American currencies, its slide vs. the U.S. Dollar has only recently started and is expected to continue to decrease over the next 6-12 months.”
The trend has continued in recent months and as Bloomberg reports, many developers are now having a difficult time locating buyers as “whole countries” are priced out of the market.
Via Bloomberg:
Downtown Miami’s luxury-condo boom — fueled by buyers from Latin America and Europe willing to pay half the purchase price up front — is becoming a casualty of the year-long climb in the U.S. dollar.
Diminished purchasing power and rising prices are holding back the overseas investors that make up the bulk of sales at new towers, cooling a frenzied market.
In response, developers are delaying projects, lowering down-payment requirements and turning their focus to Americans.
“We’ve seen a very strong shift in the last year in the dollar — it has literally pushed whole countries out of the marketplace,” said Kevin Maloney, founder and principal of Property Markets Group, which is developing Echo Brickell, a 57-story luxury tower that will have a shark tank in the lobby.
“We look around as real estate guys and say, ‘Jeez, who is our buyer?’” he said.
When last we discussed prevailing market conditions, we also mentioned that even as demand abates, construction and land costs are rising, pinching developer margins. According to the Miami DDA’s most recent quarterly report, this dynamic has continued to conspire with slumping foreign demand to create a drag on the market:
As land pricing and construction costs continue to increase, either increased end-unit pricing and/or a decrease in required developer/investor returns will be required to achieve financial feasibility of future condo projects. IRR-Miami projects that a number of recent and pending land sales are being made by long-term investors with plans to sell or develop the site in 5-10 years after the current pipeline has been absorbed.
As was noted in the February 2015 report by IRR-Miami, the Miami economy and the growth of the real estate market are not driven solely by local job and wage growth. The continued growth in the Downtown Miami real estate market remains largely-dependent on foreign capital participation.
The decline in foreign currencies compared to the U.S. Dollar over the past 18 months has narrowed the buyer pool. Several brokers have expressed concern regarding the closing ability of mid-level buyers that may not be fully denominated in U.S. currency. There have been early reports of buyers seeking approval for the assignment of their contract to a 3rd party.
But perhaps most telling, is the following updated version of the chart shown above.
As you can see, price appreciation has leveled off for the first time in at least six years.
And here’s a table which clearly shows that average lease prices are increasing at a far slower rate than they have in the past. Indeed it certainly looks as though overall price appreciation is likely to flatline in the not-so- distant future, having fallen to just 2% from 5% in the previous two years.
From the report:
According to leasing statistics from the MLS, approximately 350 to 400 units are leased every month, a contraction of the rental market since Q2 2014. This number could be skewed by the significant number of units that are leased every month outside of the MLS, either as renewals or between parties in off-market transactions. Lease rates in the greater Downtown Miami continue to increase with annual lease pricing increasing over 5% per year on average (2012-2013), and 5% per year (2013-2014). Since the beginning of 2015, rental price appreciation has slowed to about 2% annualized.
Despite all of the evidence above, and despite the strong dollar’s effect on demand from South America and Russia, some developers say there’s nothing to worry about, because after all, “corrections” are always portrayed as “healthy” in the beginning and this time is always different…
Anthony Graziano, senior managing director at Integra Realty Resources Inc. (which prepared the above cited report for the DDA):
“We’re basically going to be in a period of slower growth for the next year, year-and-a-half while the market stabilizes. I characterize it as a healthy correction.“
Carlos Rosso, president of Related Group of Florida:
“Everybody is looking at Miami and saying when is something bad going to happen? I say this is a different market. You’re not going to have a bubble burst.”
- The Sick Man Of Asia – China's Looming Health Disaster
Submitted by Charles Hugh-Smith of OfTwoMinds blog,
That the China Story is going to implode is already baked into the public health catastrophe that will unfold with a vengeance in the coming decade.
The financial pundits gushing over "The China Story" – that the Middle Kingdom's industrialization is a permanent boon to the global economy and China's poor – never calculate the human cost of that runaway industrialization and the vast inequalities it has unleashed.
The human cost is staggering: at least half the population is suffering from chronic lifestyle/environmental-related illnesses and 225 million suffer from mental disorders. For context, the population of China is estimated to be 1.39 billion, roughly 4.4 times the U.S. population of 317 million, and about 20% of the total global population.
Here are some estimates of China's public health problems: (source links below)
— Half the population is estimated to be prediabetic (suffering from metabolic syndrome/diabesity).
— 12% of the populace now has diabetes, roughly 115 million people.
— An estimated 70% of China's diabetics are undiagnosed; only 25% are receiving any treatment and of the 25%, the disease is only being controlled in 40% of those getting treatment.
— Noncommunicable diseases–cardiovascular disease, chronic respiratory diseases and cancer, account for 85% of total deaths in China today — much higher than the global average of 60%.
— Mental disorders rose by more than 50 percent between 2003 and 2008. An estimated 17.5% of the population (225 million) suffers from some form of mental problem, one of the highest rates in the world.
— More than 300 million people in China — roughly equivalent to the entire U.S. population of 317 million — smoke tobacco.
— 200 million workers are directly exposed to occupational hazards.
— Informal estimates suggest a large percentage of the urban population suffers from lung/pulmonary diseases. Over the last 30 years, deaths ascribed to lung cancer have risen by a factor of five in China.
— 160 million Chinese adults have hypertension (high blood pressure).
— In 2006, 80 percent of China’s health budget was spent on just 8.5 million government officials.
— Tthe rate of health-care coverage is high, but the level of benefits is still very low. 836 million rural residents who were officially covered by the government's plan still had to pay the lion’s share of their medical bills. The government coverage paid a mere 8.6% of rural residents' total healthcare expenditures.
Sources:
Reliable statistics are hard to come by for a number of reasons. Authorities in China avoid quantifying China's public health realities because it detracts from the glowing "China Story" they promote.
The rural population (still 55% of the total populace) often has little access to health care and statistics are sketchy.Preconditions that lead to disease (for example, prediabetes and early-stage COPD (chronic obstructive pulmonary disease) are not accurately monitored.
The standard Western proponent of the China Story spends a few days in a fancy Shanghai hotel and then repeats glowing (and dodgy) economic statistics, as if that's the whole story. Western pundits don't visit rural village stripped of working-age adults, where grandparents are struggling to raise the children who resent their factory-worker parents' absence.
Proponents don't spend time with those on the bottom of the urban "growth story," the millions living in makeshift hovels who receive no state aid due to their status as "illegal residents" in urban zones.
The mental health issues arising from dislocated families, uprooted workers and grinding poverty in the midst of a society dominated by an Elite that drives super-sports cars and owns lavish homes in the West are ignored by the mainstream Western media.
The rapid ageing of the Chinese populace is exacerbating an already immense public health crisis. It's estimated that by 2040 there will be more people with Alzheimer’s disease in China than in all the developed countries combined.
Ill health and chronic disease are undercutting the economic growth everyone is focusing on. Whatever the metric used–hours of labor lost to illness, years of labor lost to early retirement due to ill-health, etc.–the costs of China's environmental damage, disrupted social order and low investment in public health are weighing heavily on output.
The rise in health-related costs going forward will not be linear but geometric.Linear increases in pollution, diabesity, etc. can yield a ten-fold increase in diseases that require costly treatments.
Every nation, developed and developing alike, has public health challenges. What's different about China (and India) is the scale is just so enormous: 740 million Chinese are regularly exposed to second-hand smoke, for example, and ten of millions of urban dwellers are exposed to air pollution that is said to rival smoking three packs of cigarettes a day in its negative impact on pulmonary health.
It's all well and good to toss around grandiose plans for new Silk Roads, aircraft carriers and islands constructed in disputed seas, but where is the money and labor going to come from when the health problems of hundreds of millions of workers and retirees come due and payable? How many more trillions of yuan can local governments borrow once the credit bubble in China deflates, as all financial bubbles eventually do?
Apologists and cheerleaders will naturally claim these estimates are exaggerated, and that China is aggressively tackling its immense environmental and public-health problems. The Chinese excel at the Soviet model of showcase trials and projects staged for propaganda, and officials regularly present Potemkin-Village pollution clean-ups. But if you try to come back a year later and check on the progress, you will find it isn't possible–and insisting might get you arrested.
What's being exaggerated is China's response to the unfolding environmental and public health catastrophe. The Chinese government's priorities are tightening control of its domestic society and extending hegemony in the South China Sea. Public health receives lip service and a marginal slice of state funding and focus. The money flows to care for the elites, and the peasantry gets next to nothing.
That the China Story is going to implode is already baked into the public health catastrophe that will unfold with a vengeance in the coming decade.
- What Can Possibly Go Wrong: The "Flash Boys" Arrive In China
In a market where the Virtus of the world have, through outright manipulation, achieved trading perfection, it’s rare than a carbon-based lifeform bests a vacuum tube. Despite the odds, humans have scored two decisive victories YTD over the machines.
One came in mid April when Colorado Springs resident Lucas Hinch took his Dell in the back alley and executed it with a handgun.
The second came later that month when China’s millions of newly-minted ‘investors’ traded so much that they literally overwhelmed the software that tracks volume on the SHCOMP. Here’s what Reuters said at the time:
The exchange’s trading turnover exceeded 1 trillion yuan ($161.28 billion) for the first time on Monday, but the data could not be properly displayed because its software was not designed to report numbers that high.
Now, China’s legions of day-trading retail investors with be forced to contend with ‘slightly’ more advanced software because as Reuters reports, The Flash Boys are coming:
The rapid liberalisation of Chinese derivatives markets has attracted a new breed of creative traders employing complex trading strategies that can generate quick profits – and an extra dollop of risk – in China’s runaway stock boom.
Brokerages and fund managers are investing in mathematics whizzes and hardware, and moving servers onto trading floors to gain precious microseconds dealing in new options and futures contracts, helping China’s CSI300 index become the world’s most traded equity futures contract in May.
The introduction of new derivative products is intended to help investors hedge risk, but it also gives rise to the kind of sophisticated trading strategies that have made quick-trading “flash boys” notorious in the United States and Europe.
For the most part the strategies and the traders employing them are untested in China, where the derivatives market barely existed five years ago, and slick automated trading strategies can produce horrific crashes when they go wrong.
As we’ve been at pains to explain for years — and as the rest of the world is slowly realizing on the heels of last October’s Treasury flash crash — stop-hunting, hair trigger HFT algos help create the conditions for harrowing bouts of volatility and considering the number of inexperienced (and possibly illiterate) traders that have entered the Chinese equity markets over the past several months, combined with the amount of leverage these traders have employed on the way to driving the SHCOMP to historic highs and pushing valuations on the Shenzhen to a median of 108X, it would seem that adding automated trading to the mix is just about the worst thing that could possibly happen in terms of stability. Here’s more from Reuters:
The risk is amplified by a triple-digit percentage leap in the SCI. Chinese bourses have already seen three panics that have driven major indexes down about 6 percent in short order. On Thursday afternoon benchmark indexes suddenly plunged over 5 percent, wiping out 3.4 trillion yuan ($548 billion) of market value, only to turn positive again by the close.
(Thursday’s turbulece visualized)
Analysts blame the new volatility on the preponderance of retail investors in the Chinese market – unlike in the West, where institutions dominate – and to the fact that many Chinese traders are highly leveraged, which tends to amplify movements.
(“That aint no margin debt, THIS is margin debt”)
As for the traders themselves, the opportunity to test can’t-lose strategies in the hottest market on the planet is too enticing to resist:
That has already attracted overseas returnees like Wang Feng, a physics graduate from University of Michigan and former Wall Street trader, who finally sees an opportunity to apply scientific methods in China’s stock and futures markets.
“Theoretically, we hope to achieve the same speed as in U.S. markets, transactions occurring in microseconds,” Wang said.
And for all of China’s rabid, day-trading housewives, security guards, and banana vendors, prepare yourself because the challenge has been issued:
“China’s market is highly inefficient, which means it’s relatively easy to produce absolute returns,” said Ken Zhu, Chairman and CEO of hedge fund firm Scientific Investment. “Chinese retail investors don’t have any advantage over us.”
- Student Debt Cancellations Begin: Government To "Forgive" $3.6 Billion After Corinthian Closure
In late April, we asked if for-profit college closures would represent the next multi-billion dollar taxpayer-funded bailout. While the country’s $1.3 trillion student debt bubble represents a very real risk to taxpayers over time, for-profit institutions pose a more immediate threat.
From a ‘big picture perspective, the push for student loan forgiveness and “debt-free” higher education is certainly kicking into high gear, with the likes of Elizabeth Warren and Bernie Sanders pushing ideas such as a tax on stock transactions to fund college education in America. Meanwhile, The White House is exploring more “efficient” ways for students to discharge debt in bankruptcy and the “cancel all student debt” calls have begun in earnest. That said, any kind of sweeping overhaul will likely take years to implement, but in the mean time, IBR repayment programs allow students whose post-graduation disposable income isn’t deemed sufficient, to simply pay nothing on the way to total debt forgiveness in 25 years. Clearly, many borrowers will, at some point in their lives, make enough to pay something each month, but the point is that the government is now actively promoting the fact that the full principal needn’t be repaid and this, in turn, has led to the proliferation of IBR plans and rising default risk for student loan-backed ABS.
So that’s the long-term outlook, and as we’ve said repeatedly, this likely won’t end well for taxpayers. But there’s a more immediate threat and it comes from for-profit college closures.
To recap, the for-profit sector has been under intense government scrutiny for years due to, among other things, deceptive recruiting strategies and fabricated data on post-graduation job placement rates. These institutions rely heavily on federal student loans for their very existence, even as many are publicly traded and pay their CEOs millions. In addition, tuition rates at for-profit colleges are, on average, double the rates charged by large public universities, a fact which explains why nearly 90% of students at for-profit schools have taken out loans to pay for their education.
As we discussed a few months back, the delinquency and default problem that hangs over the student debt bubble is far worse for loans extended to students that attend for-profit colleges than for those who attend or have attended public institutions (note the discrepancy in share of enrollment versus share of defualts):
This, along with poor graduation rates and allegations of deceptive marketing practices, has led to increased government scrutiny of the for-profit sector, scrutiny which ultimately caused Corinthian Colleges to wind down operations last year amid allegations it falsified job placement rates.
The company — which is publicly traded — received nearly $1.5 billion per year in financial aid funding from the government, meaning the US taxpayer was subsidizing federal loans to students who very well may have been getting a subpar education and were thus even more likely to get behind on their loans and eventually default.
Corinthian was able to sell off many of its campuses in November and although the writing has been on the wall for quite sometime, the company closed its remaining physical campus in late April without notice to students or faculty.
As we noted when the doors were shut, for-profit students won’t have a particularly easy time transferring their credits (meaning they would have to start over at another school if they wanted to complete their degrees), and so will likely seek to take advantage of their ‘right’ to have their debt discharged. Fast forward to late May and sure enough, the government was scrambling to figure out what to do after Secretary of Education Arne Duncan received a group request from 78,000 students requesting loan forgiveness.
At the time, Reuters said that because the government had never used its authority to cancel student debt on a large scale, the Department of Education was “unsure how it would work,” to which we responded as follows:
Well Department of Education, allow us to tell you how the debt “relief” will work. You will end up being forced to write it off because you closed down the school.
And while your decision to shutter the college was likely the right move given the for-profit industry’s reputation for absurdly predatory recruiting practices, you have no one to blame but yourself for allowing these institutions to live off of billions in federal loans for years (while their CEOs pulled in millions in compensation), when you likely knew that in the end, they would have to be closed down once Congress got wind of how they went about luring students.
Sure enough, The Department of Education now says it will forgive federal student loans made to Corinthian students who can prove they were victims of fraud. The potential cost to taxpayers: nearly $4 billion. And that is for just one for-profit school. AP has more:
The federal government will erase much of the debt of students who attended the now-defunct Corinthian Colleges, officials announced Monday, as part of a new plan that could cost taxpayers as much as $3.6 billion.
Corinthian Colleges was one of the largest for-profit schools when it nearly collapsed last year and became a symbol of fraud in the world of higher education and student loans. According to investigators, Corinthian schools charged exorbitant fees, lied about job prospects for its graduates and, in some cases, encouraged students to lie about their circumstances to get more federal aid.
In a plan orchestrated by the Department of Education, some of the Corinthian schools closed while others were sold before the chain filed for bankruptcy this spring. The biggest question has been what should happen to the debt incurred by students whose schools were sold. The law already provides for debt relief for students of schools that close, so long as they apply within 120 days.
The latest plan expands debt relief to students who attended a now-closed school as far back as a year ago. And it streamlines the process for students whose schools were sold but believe they were victims of fraud.
“We will make this process as easy as possible for them, including by considering claims in groups wherever possible, and hold institutions accountable,” Education Secretary Arne Duncan said in a statement.
As an example, the department said it has already found that many programs at a California subsidiary of Corinthian Colleges, known as Heald College, were “misrepresented” to students. So any student enrolled in that school between 2010 and 2015 would likely qualify for relief.
The amount of debt relief could be staggering. Officials estimate that some 40,000 borrowers at the Heald College alone took on more than $540 million in loans that potentially qualify for debt relief.
But the final amount could climb significantly when looking across all Corinthian Schools, which include Everest and WyoTech. In all, the department estimates that about $3.6 billion in federal loans was given to Corinthian students.
This precedent set by this decision is precisely what we warned about nearly two months ago. In essence, this means that if the government continues to crack down on for-profit schools, the ensuing debt cancellations will run into the tens, if not hundreds of billions.
WSJ has more on the fallout:
Officials said that under the emerging plan, the government will consider forgiving any loans made directly by the government—those held by the majority of the 43 million Americans with student debt—so long as the borrower can document a school persuaded him or her to take out the loan under conditions that would violate state laws.
The Education Department plans to use a provision of a decades-old federal law that allows borrowers to have loans discharged if they can prove their schools broke a state law—such as by using false advertising or other deception—to lure them to apply and borrow funds.
Federal officials acknowledged the potentially high cost of the policy. In the case of Corinthian alone, the Education Department said 350,000 Americans who owe roughly $3.5 billion in loans could be eligible for forgiveness. In all, Americans owe more than $1.2 trillion in outstanding student debt.
Federal officials declined to disclose the potential total amount of loans that could be eligible for forgiveness.
Under Secretary of Education Ted Mitchell said the agency realized the move could invite applications from across higher education, whether from community college students or law-school graduates. The agency said it would hire a “special master” to figure out many of the details, including what standards the department should use to determine whether a school had violated state law. The department also would likely hire additional personnel to handle the applications.
Mr. Duncan, the education secretary, said Corinthian won’t be the last company to come under close government scrutiny. “There may be more,” he said.
Various arms of the federal government have become more aggressive in pursuing for-profit schools for misrepresentations. Ashworth College, an online college based in Norcross, Ga., agreed late last month to settle Federal Trade Commission allegations that the school misrepresented how well it prepared students for certain vocational licenses and whether students could transfer credits from Ashworth to other schools.
Meanwhile, the Securities and Exchange Commission announced in May that it had brought fraud charges against ITT Educational Services Inc. and two of its top executives, alleging they misled investors about the financial prospects of some internal student-loan programs.
We’ll close with what we said last month when we last discussed the idea of debt discharge for Corinthian students because, frankly, our assessment proved extremely prescient.
The real question now is whether continued pressure on for-profit colleges will result in further closures and more petitions from hundreds of thousands of students with hundreds of billions of loans they now know can be legally discharged. Note that we have not used the term “canceled”, because as we like to remind readers, liabilities are never “canceled”, they are simply written off by the person for whom they are an asset.
- How To "Measure" Risk
Excerpted from Oaktree Capital Management's Howard Marks letter to investors,
Risk Revisited Again…
What Risk Really Means
In [my] book, I argued against the purported identity between volatility and risk. Volatility is the academic’s choice for defining and measuring risk. I think this is the case largely because volatility is quantifiable and thus usable in the calculations and models of modern finance theory. In the book I called it “machinable,” and there is no substitute for the purposes of the calculations.
However, while volatility is quantifiable and machinable – and can be an indicator or symptom of riskiness and even a specific form of risk – I think it falls far short as “the” definition of investment risk. In thinking about risk, we want to identify the thing that investors worry about and thus demand compensation for bearing. I don’t think most investors fear volatility. In fact, I’ve never heard anyone say, “The prospective return isn’t high enough to warrant bearing all that volatility.” What they fear is the possibility of permanent loss.
Permanent loss is very different from volatility or fluctuation. A downward fluctuation – which by definition is temporary – doesn’t present a big problem if the investor is able to hold on and come out the other side. A permanent loss – from which there won’t be a rebound – can occur for either of two reasons: (a) an otherwise-temporary dip is locked in when the investor sells during a downswing – whether because of a loss of conviction; requirements stemming from his timeframe; financial exigency; or emotional pressures, or (b) the investment itself is unable to recover for fundamental reasons. We can ride out volatility, but we never get a chance to undo a permanent loss.
Of course, the problem with defining risk as the possibility of permanent loss is that it lacks the very thing volatility offers: quantifiability. The probability of loss is no more measurable than the probability of rain. It can be modeled, and it can be estimated (and by experts pretty well), but it cannot be known.
…
If you accept that the underlying processes affecting economics, business and market psychology are less than 100% dependable, as seems obvious, then it follows that the future isn’t knowable. In that case, risk can be nothing more than the subject of estimation – Keynes’s “intuition or direct judgment” – and certainly not reliably quantified.
* * *
The Unknowable Future
It seems most people in the prediction business think the future is knowable, and all they have to do is be among the ones who know it. Alternatively, they may understand (consciously or unconsciously) that it’s not knowable but believe they have to act as if it is in order to make a living as an economist or investment manager.
On the other hand, I’m solidly convinced the future isn’t knowable. I side with John Kenneth Galbraith who said, “We have two classes of forecasters: Those who don’t know – and those who don’t know they don’t know.”…
Given the near-infinite number of factors that influence developments, the great deal of randomness present, and the weakness of the linkages, it’s my solid belief that future events cannot be predicted with any consistency. In particular, predictions of important divergences from trends and norms can’t be made with anything approaching the accuracy required for them to be helpful.
* * *
Coping with the Unknowable Future
Here’s the essential conundrum: investing requires us to decide how to position a portfolio for future developments, but the future isn’t knowable.
Taken to slightly greater detail:
- Investing requires the taking of positions that will be affected by future developments.
- The existence of negative possibilities surrounding those future developments presents risk.
- Intelligent investors pursue prospective returns that they think compensate them for bearing the risk of negative future developments.
- But future developments are unpredictable.
How can investors deal with the limitations on their ability to know the future? The answer lies in the fact that not being able to know the future doesn’t mean we can’t deal with it. It’s one thing to know what’s going to happen and something very different to have a feeling for the range of possible outcomes and the likelihood of each one happening. Saying we can’t do the former doesn’t mean we can’t do the latter.
The information we’re able to estimate – the list of events that might happen and how likely each one is – can be used to construct a probability distribution. Key point number one in this memo is that the future should be viewed not as a fixed outcome that’s destined to happen and capable of being predicted, but as a range of possibilities and, hopefully on the basis of insight into their respective likelihoods, as a probability distribution.
There’s little I believe in more than Albert Einstein’s observation: “Not everything that counts can be counted, and not everything that can be counted counts.” I’d rather have an order-of-magnitude approximation of risk from an expert than a precise figure from a highly educated statistician who knows less about the underlying investments. British philosopher and logician Carveth Read put it this way: “It is better to be vaguely right than exactly wrong.”
We can’t know what will happen. We can know something about the possible outcomes (and how likely they are). People who have more insight into these things than others are likely to make superior investors. As I said in the last paragraph of The Most Important Thing:
Only investors with unusual insight can regularly divine the probability distribution that governs future events and sense when the potential returns compensate for the risks that lurk in the distribution’s negative left-hand tail.
In other words, in order to achieve superior results, an investor must be able – with some regularity – to find asymmetries: instances when the upside potential exceeds the downside risk. That’s what successful investing is all about.
* * *
Thinking in Terms of Diverse OutcomesIt’s the indeterminate nature of future events that creates investment risk. It goes without saying that if we knew everything that was going to happen, there wouldn’t be any risk.
…
To oversimplify, investors in a given company may have an expectation that if A happens, that’ll make B happen, and if C and D also happen, then the result will be E. Factor A may be the pace at which a new product finds an audience. That will determine factor B, the growth of sales. If A is positive, B should be positive. Then if C (the cost of raw materials) is on target, earnings should grow as expected, and if D (investors’ valuation of the earnings) also meets expectations, the result should be a rising share price, giving us the return we seek (E).
We may have a sense for the probability distributions governing future developments, and thus a feeling for the likely outcome regarding each of developments A through E. The problem is that for each of these, there can be lots of outcomes other than the ones we consider most likely. The possibility of less-good outcomes is the source of risk. That leads me to key point number two, as expressed by Elroy Dimson, a professor at the London Business School: “Risk means more things can happen than will happen.” This brief, pithy sentence contains a great deal of wisdom.
People who rely heavily on forecasts seem to think there’s only one possibility, meaning risk can be eliminated if they just figure out which one it is. The rest of us know many possibilities exist today, and it’s not knowable which of them will occur. Further, things are subject to change, meaning there will be new possibilities tomorrow. This uncertainty as to which of the possibilities will occur is the source of risk in investing.
* * *
Even a Probability Distribution Isn’t Enough
I’ve stressed the importance of viewing the future as a probability distribution rather than a single predetermined outcome. It’s still essential to bear in mind key point number three: Knowing the probabilities doesn’t mean you know what’s going to happen. For example, all good backgammon players know the probabilities governing throws of two dice. They know there are 36 possible outcomes, and that six of them add up to the number seven (1-6, 2-5, 3-4, 4-3, 5-2 and 6-1). Thus the chance of throwing a seven on any toss is 6 in 36, or 16.7%. There’s absolutely no doubt about that. But even though we know the probability of each number, we’re far from knowing what number will come up on a given roll.
Backgammon players are usually quite happy to make a move that will enable them to win unless the opponent rolls twelve, since only one combination of the dice will produce it: 6-6. The probability of rolling twelve is thus only 1 in 36, or less than 3%. But twelve does come up from time to time, and the people it turns into losers end up complaining about having done the “right” thing but lost. As my friend Bruce Newberg says, “There’s a big difference between probability and outcome.” Unlikely things happen – and likely things fail to happen – all the time. Probabilities are likelihoods and very far from certainties.
It’s true with dice, and it’s true in investing . . . and not a bad start toward conveying the essence of risk. Think again about the quote above from Elroy Dimson: “Risk means more things can happen than will happen.” I find it particularly helpful to invert Dimson’s observation for key point number four: Even though many things can happen, only one will.
…
I always say I have no interest in being a skydiver who’s successful 95% of the time.
…
Investment performance (like life in general) is a lot like choosing a lottery winner by pulling one ticket from a bowlful. The process through which the winning ticket is chosen can be influenced by physical processes, and also by randomness. But it never amounts to anything but one ticket picked from among many. Superior investors have a better sense for what’s in the bowl, and thus for whether it’s worth buying a ticket in a lottery. But even they don’t know for sure which one will be chosen. Lesser investors have less of a sense for the probability distribution and for whether the likelihood of winning the prize compensates for the risk that the cost of the ticket will be lost.
* * *
Risk and Return
We hear it all the time: “Riskier investments produce higher returns” and “If you want to make more money, take more risk.”
Both of these formulations are terrible. In brief, if riskier investments could be counted on to produce higher returns, they wouldn’t be riskier. Misplaced reliance on the benefits of risk bearing has led investors to some very unpleasant surprises.
This is the essence of investment risk. Riskier investments are ones where the investor is less secure regarding the eventual outcome and faces the possibility of faring worse than those who stick to safer investments, and even of losing money.
* * *
The Many Forms of RiskThe possibility of permanent loss may be the main risk in investing, but it’s not the only risk. I can think of lots of other risks, many of which contribute to – or are components of – that main risk.
In the past, in addition to the risk of permanent loss, I’ve mentioned the risk of falling short. Some investors face return requirements in order to make necessary payouts, as in the case of pension funds, endowments and insurance companies. Others have more basic needs, like generating enough income to live on.
Some investors with needs – particularly those who live on their income, and especially in today’s low-return environment – face a serious conundrum. If they put their money into safe investments, their returns may be inadequate. But if they take on incremental risk in pursuit of a higher return, they face the possibility of a still-lower return, and perhaps of permanent diminution of their capital, rendering their subsequent income lower still. There’s no easy way to resolve this conundrum.
There are actually two possible causes of inadequate returns: (a) targeting a high return and being thwarted by negative events and (b) targeting a low return and achieving it. In other words, investors face not one but two major risks: the risk of losing money and the risk of missing opportunities. Either can be eliminated but not both. And leaning too far in order to avoid one can set you up to be victimized by the other.
Potential opportunity costs – the result of missing opportunities – usually aren’t taken as seriously as real potential losses. But they do deserve attention. Put another way, we have to consider the risk of not taking enough risk.
These days, the fear of losing money seems to have receded (since the crisis is all of six years in the past), and the fear of missing opportunities is riding high, given the paltry returns available on safe, mundane investments. Thus a new risk has arisen: FOMO risk, or the risk that comes from excessive fear of missing out. It’s important to worry about missing opportunities, since people who don’t can invest too conservatively. But when that worry becomes excessive, FOMO can drive an investor to do things he shouldn’t do and often doesn’t understand, just because others are doing them: if he doesn’t jump on the bandwagon, he may be left behind to live with envy.
…
There are many ways for an investment to be unsuccessful. The two main ones are fundamental risk (relating to how a company or asset performs in the real world) and valuation risk (relating to how the market prices that performance). For years investors, fiduciaries and rule-makers acted on the belief that it’s safe to buy high-quality assets and risky to buy low-quality assets. But between 1968 and 1973, many investors in the “Nifty Fifty” (the stocks of the fifty fastest-growing and best companies in America) lost 80-90% of their money. Attitudes have evolved since then, and today there’s less of an assumption that high quality prevents fundamental risk, and much less preoccupation with quality for its own sake.
On the other hand, investors are more sensitive to the pivotal role played by price. At bottom, the riskiest thing is overpaying for an asset (regardless of its quality), and the best way to reduce risk is by paying a price that’s irrationally low (ditto). A low price provides a “margin of safety,” and that’s what risk-controlled investing is all about. Valuation risk should be easily combatted, since it’s largely within the investor’s control. All you have to do is refuse to buy if the price is too high given the fundamentals. “Who wouldn’t do that?” you might ask. Just think about the people who bought into the tech bubble.
Fundamental risk and valuation risk bear on the risk of losing money in an individual security or asset, but that’s far from the whole story. Correlation is the essential additional piece of the puzzle. Correlation is the degree to which an asset’s price will move in sympathy with the movements of others. The higher the correlation among its components, all other things being equal, the less effective diversification a portfolio has, and the more exposed it is to untoward developments.
An asset doesn’t have “a correlation.” Rather, it has a different correlation with every other asset. A bond has a certain correlation with a stock. One stock has a certain correlation with another stock (and a different correlation with a third). Stocks of one type (such as emerging market, high-tech or large-cap) are likely to be highly correlated with others within their category, but they may be either high or low in correlation with those in other categories. Bottom line: it’s hard to estimate the riskiness of a given asset, but many times harder to estimate its correlation with all the other assets in a portfolio, and thus the impact on performance of adding it to the portfolio. This is a real art.
* * *
To move to the biggest of big pictures, I want to make a few over-arching comments about risk.
The first is that risk is counterintuitive.
- The riskiest thing in the world is the widespread belief that there’s no risk.
- Fear that the market is risky (and the prudent investor behavior that results) can render it quite safe.
- As an asset declines in price, making people view it as riskier, it becomes less risky (all else being equal).
- As an asset appreciates, causing people to think more highly of it, it becomes riskier.
- Holding only “safe” assets of one type can render a portfolio under-diversified and make it vulnerable to a single shock.
- Adding a few “risky” assets to a portfolio of safe assets can make it safer by increasing its diversification. Pointing this out was one of Professor William Sharpe’s great contributions.
The second is that risk aversion is the thing that keeps markets safe and sane.
- When investors are risk-conscious, they will demand generous risk premiums to compensate them for bearing risk. Thus the risk/return line will have a steep slope (the unit increase in prospective return per unit increase in perceived risk will be large) and the market should reward risk-bearing as theory asserts.
- But when people forget to be risk-conscious and fail to require compensation for bearing risk, they’ll make risky investments even if risk premiums are skimpy. The slope of the line will be gradual, and risk taking is likely to eventually be penalized, not rewarded.
- When risk aversion is running high, investors will perform extensive due diligence, make conservative assumptions, apply skepticism and deny capital to risky schemes.
- But when risk tolerance is widespread instead, these things will fall by the wayside and deals will be done that set the scene for subsequent losses.
Simply put, risk is low when risk aversion and risk consciousness are high, and high when they’re low.
The third is that risk is often hidden and thus deceptive. Loss occurs when risk – the possibility of loss – collides with negative events. Thus the riskiness of an investment becomes apparent only when it is tested in a negative environment. It can be risky but not show losses as long as the environment remains salutary. The fact that an investment is susceptible to a serious negative development that will occur only infrequently – what I call “the improbable disaster” – can make it appear safer than it really is. Thus after several years of a benign environment, a risky investment can easily pass for safe. That’s why Warren Buffett famously said, “. . . you only find out who’s swimming naked when the tide goes out.”
Assembling a portfolio that incorporates risk control as well as the potential for gains is a great accomplishment. But it’s a hidden accomplishment most of the time, since risk only turns into loss occasionally . . . when the tide goes out.
The fourth is that risk is multi-faceted and hard to deal with. In this memo I’ve mentioned 24 different forms of risk: the risk of losing money, the risk of falling short, the risk of missing opportunities, FOMO risk, credit risk, illiquidity risk, concentration risk, leverage risk, funding risk, manager risk, over-diversification risk, risk associated with volatility, basis risk, model risk, black swan risk, career risk, headline risk, event risk, fundamental risk, valuation risk, correlation risk, interest rate risk, purchasing power risk, and upside risk. And I’m sure I’ve omitted some. Many times these risks are overlapping, contrasting and hard to manage simultaneously. For example:
- Efforts to reduce the risk of losing money invariably increase the risk of missing out.
- Efforts to reduce fundamental risk by buying higher-quality assets often increase valuation risk, given that higher-quality assets often sell at elevated valuation metrics.
At bottom, it’s the inability to arrive at a single formula that simultaneously minimizes all the risks that makes investing the fascinating and challenging pursuit it is.
The fifth is that the task of managing risk shouldn’t be left to designated risk managers. I’m convinced outsiders to the fundamental investment process can’t know enough about the subject assets to make appropriate decisions regarding each one. All they can do is apply statistical models and norms. But those models may be the wrong ones for the underlying assets – or just plain faulty – and there’s little evidence that they add value. In particular, risk managers can try to estimate correlation and tell you how things will behave when combined in a portfolio. But they can fail to adequately anticipate the “fault lines” that run through portfolios. And anyway, as the old saying goes, “in times of crisis all correlations go to one” and everything collapses in unison.
“Value at Risk” was supposed to tell the banks how much they could lose on a very bad day. During the crisis, however, VaR was often shown to have understated the risk, since the assumptions hadn’t been harsh enough. Given the fact that risk managers are required at banks and de rigueur elsewhere, I think more money was spent on risk management in the early 2000s than in the rest of history combined . . . and yet we experienced the worst financial crisis in 80 years. Investors can calculate risk metrics like VaR and Sharpe ratios (we use them at Oaktree; they’re the best tools we have), but they shouldn’t put too much faith in them. The bottom line for me is that risk management should be the responsibility of every participant in the investment process, applying experience, judgment and knowledge of the underlying investments.
The sixth is that while risk should be dealt with constantly, investors are often tempted to do so only sporadically. Since risk only turns into loss when bad things happen, this can cause investors to apply risk control only when the future seems ominous. At other times they may opt to pile on risk in the expectation that good things lie ahead. But since we can’t predict the future, we never really know when risk control will be needed. Risk control is unnecessary in times when losses don’t occur, but that doesn’t mean it’s wrong to have it. The best analogy is to fire insurance: do you consider it a mistake to have paid the premium in a year in which your house didn’t burn down?
Taken together these six observations convince me that Charlie Munger’s trenchant comment on investing in general – “It’s not supposed to be easy. Anyone who finds it easy is stupid.” – is profoundly applicable to risk management. Effective risk management requires deep insight and a deft touch. It has to be based on a superior understanding of the probability distributions that will govern future events. Those who would achieve it have to have a good sense for what the crucial moving parts are, what will influence them, what outcomes are possible, and how likely each one is. Following on with Charlie’s idea, thinking risk control is easy is perhaps the greatest trap in investing, since excessive confidence that they have risk under control can make investors do very risky things.
Thus the key prerequisites for risk control also include humility, lack of hubris, and knowing what you don’t know. No one ever got into trouble for confessing a lack of prescience, being highly risk-conscious, and even investing scared. Risk control may restrain results during a rebound from crisis conditions or extreme under-valuations, when those who take the most risk generally make the most money. But it will also extend an investment career and increase the likelihood of long-term success. That’s why Oaktree was built on the belief that risk control is “the most important thing.”
Lastly while dealing in generalities, I want to point out that whereas risk control is indispensable, risk avoidance isn’t an appropriate goal. The reason is simple: risk avoidance usually goes hand-in-hand with return avoidance. While you shouldn’t expect to make money just for bearing risk, you also shouldn’t expect to make money without bearing risk.
* * *
At present I consider risk control more important than usual. To put it briefly:
- Today’s ultra-low interest rates have brought the prospective returns on money market instruments, Treasurys and high grade bonds to nearly zero.
- This has caused money to flood into riskier assets in search of higher returns.
- This, in turn, has caused some investors to drop their usual caution and engage in aggressive tactics.
- And this, finally, has caused standards in the capital markets to deteriorate, making it easy for issuers to place risky securities and – consequently – hard for investors to buy safe ones.
Warren Buffett put it best, and I regularly return to his statement on the subject:
. . . the less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.
While investor behavior hasn’t sunk to the depths seen just before the crisis (and, in my opinion, that contributed greatly to it), in many ways it has entered the zone of imprudence. To borrow a metaphor from Chuck Prince, Citigroup’s CEO from 2003 to 2007, anyone who’s totally unwilling to dance to today’s fast-paced music can find it challenging to put money to work.
It’s the job of investors to strike a proper balance between offense and defense, and between worrying about losing money and worrying about missing opportunity. Today I feel it’s important to pay more attention to loss prevention than to the pursuit of gain. For the last four years Oaktree’s mantra has been “move forward, but with caution.” At this time, in reiterating that mantra, I would increase the emphasis on those last three words: “but with caution.”
Economic and company fundamentals in the U.S. are fine today, and asset prices – while full – don’t seem to be at bubble levels. But when undemanding capital markets and a low level of risk aversion combine to encourage investors to engage in risky practices, something usually goes wrong eventually. Although I have no idea what could make the day of reckoning come sooner rather than later, I don’t think it’s too early to take today’s carefree market conditions into consideration. What I do know is that those conditions are creating a degree of risk for which there is no commensurate risk premium. We have to behave accordingly.
- Obama Goes Full Stalin: Tells Secret Court To Ignore Law He Signed 4 Hours Earlier, Extend Illegal NSA Surveillance
Just when we thought the absurdity that marks every single day of Obama’s reign could not possibly be surpassed, we learned that 4 hours (3 hours and 47 minutes to be precise) after the US president vowed to sign a new law banning bulk data collection by the NSA (named, for purely grotesque reasons, the “USA Freedom Act“), the Obama administration asked the secret Fisa surveillance court to ignore a federal court that found bulk surveillance illegal and to once again grant the National Security Agency the power to collect the phone records of millions of Americans for six months.
Or, as the Guardian’s Spencer Ackerman, who spotted this glaring page out of Josef Stalin’s playbook, summarized it:
June 2, 6:03pm: Obama says he’ll sign law banning bulk collection.
June 2 9:50pm: DOJ asks secret court for 180 more days of bulk collection— Spencer Ackerman (@attackerman) June 8, 2015
According to Ackerman, this latest travesty by the administration “suggests that the administration may not necessarily comply with any potential court order demanding that the collection stop.”
Or, in other words, the administration “may” give orders that openly flaunt US laws. From the Guardian:
US officials confirmed last week that they would ask the Foreign Intelligence Surveillance court – better known as the Fisa court, a panel that meets in secret as a step in the surveillance process and thus far has only ever had the government argue before it – to turn the domestic bulk collection spigot back on.
This is a problem because Justice Department national security chief John A Carlin cited a six-month transition period provided in the USA Freedom Act – passed by the Senate last week to ban the bulk collection – as a reason to permit an “orderly transition” of the NSA’s domestic dragnet. However, Carlin “did not address whether the transition clause of the Freedom Act still applies now that a congressional deadlock meant the program shut down on 31 May.”
So after the second circuit court of appeals already ruled NSA surveillance illegal, and after Congress officially shut down NSA’s bulk data collection in its current form, Obama’s DOJ decided to singlehandedly order that NSA spying on Americans be extended for at least another 6 months.
Follow the details of how the US Department of “Justice” crushes every semblance thereof:
Carlin asked the Fisa court to set aside a landmark declaration by the second circuit court of appeals. Decided on 7 May, the appeals court ruled that the government had erroneously interpreted the Patriot Act’s authorization of data collection as “relevant” to an ongoing investigation to permit bulk collection.
Carlin, in his filing, wrote that the Patriot Act provision remained “in effect” during the transition period.
“This court may certainly consider ACLU v Clapper as part of its evaluation of the government’s application, but second circuit rulings do not constitute controlling precedent for this court,” Carlin wrote in the 2 June application. Instead, the government asked the court to rely on its own body of once-secret precedent stretching back to 2006, which Carlin called “the better interpretation of the statute”.
The punchline:
The second circuit court of appeals is supposed to bind only the circuit’s lower courts. But the unique nature of the Fisa court – whose rulings practically never became public before whistleblower Edward Snowden’s revelations – has left ambiguous which public court precedents it is obliged to follow.
Said otherwise, the NSA’s espionage activity is above the law, any law.
Amusingly, some still harbor hope that “justice” is still a viable concept in the United States, such as the FreedomWorks conservative group, which is asking the Fisa court to essentially disband itself:
On Friday, the conservative group FreedomWorks filed a rare motion before the Fisa court, asking it to reject the government’s surveillance request as a violation of the fourth amendment’s prohibition on unreasonable searches and seizures. Fisa court judge Michael Moseman gave the justice department until this coming Friday to respond – and explicitly barred the government from arguing that FreedomWorks lacks the standing to petition the secret court.
Which, incidentally, is like asking Wall Street to police itself. A quick reminder of what happened there: after gross market manipulation was taking place for years involving trillions of interest-rate products, the person who witnessed it every single day called it, don’t laugh, a “conspiracy theory.”
Incidentally, “conspiracy theorists” is precisely what all those who accused the NSA of engaging in mass illegal surveillance even before the Snowden revelations, were branded as. And, we are confident, before all is said and done, the “conspiracy theorists” who dare speak the truth against the surreal Orwellian state that the US finds itself in, will be crushed by the administration, both the current and the one that will replace it, whose every day modus operandi is taken straight out of the Stalin memoirs.
- Idaho School Arms Its Teachers As Defense Against Violent Criminals
In the aftermath of the 2012 Shady Hook elementary school shooting, the Obama administration did everything in its power to impose even further Second Amendment limitations on general principles. It failed. Instead, what has happened over the past year is a documented series of lethal (and in many cases brutal) gun violence by those tasked to uphold and preserve the law, and who have been specifically instructed how to use weapons: the US police force.
And in a world in which violence is constantly on the rise yet the police can not be relied on to “protect and to defend”, one Idaho school has decided to take matters into its own hands.
According to the Guardian, the small Garden Valley School district in Idaho has purchased firearms and trained a handful of staff to use them should the same school shooting rampage that has occurred across the country take place.
The stated reason for this decision, which will surely infuriate anti-gun activists, is that the school is far removed from law enforcement, that it takes the police at least 45 minutes to reach the school district. Furthermore, due to limited funds, the school is unable to afford hiring police officers to patrol the building during school hours.
The solution: the school board approved this month purchasing guns to remain locked inside the school and trained six employees to use the weapons in an emergency. A school board member said that the school has spent roughly $3,500 to purchase ammunition and train six school employees to handle the weapons while the rest of the arsenal was donated by the community.
Truly a novel concept: being prepared for violence instead of leaving your fate in the hands of some (potentially irresponsible) other person, and since the mere preparation will be a sufficient enough deterrent once it is public knowledge – the very same principle behind the concept of Mutual Assured Destruction – the probability of an armed assailant breaching the sanctity of the Garden Valley School district is virtually nil.
“I hope we never have to use them,” said Alan Ward, a school board member who has been discussing this option with the school for two years. “But in the event something did happen, we wanted to be prepared.”
The surprising move has been long coming: in 2013, an eastern Idaho school district approved installing gun safes in its high schools and middle schools in order for school resource officers to have easy access to rifles if needed – the same year the Idaho School Board Association rejected a plan to set up gun training for education staff and teachers. In 2014, state lawmakers approved allowing guns on college campuses.
So far it has worked: according to the Idaho department of education, school districts statewide reported less than 10 weapon-related incidents over the past two years. This includes reports about guns, knives and explosives to schools.
And yet, despite the Idaho’s track record of school violence, there are those who promptly brought up hypothetical strawman arguments against the school’s chosen path:
Even with training, there is no guarantee teachers and staff will prevent fatalities in a high-stakes situation, said Allison Anderman, a staff attorney with Law Center to Prevent Gun Violence, a nonprofit opposed to arming teachers.
She added that housing guns in schools could create a chilling effect for students who may be less inclined to speak out knowing that the teacher could be armed. “Just having people armed doesn’t make a school safer,” Anderman said.
Judging by empirical evidence, it does, as does the whole concept of “defense” because knowing one may be potentially met with lethal force will make one far less willing to engage in lethal threats in the first place. It is called deterrence for a reason.
As for students not speaking up over fears of being shot, questions emerge about what traumatic events may have defined Ms. Anderman own personal upbringing.
We conclude with a summary by John Vibes, whose recent takes on guns and school violence has been spot on:
As many of you who follow my regular work are already aware, I am an advocate of unschooling and homeschooling. I feel that the kind of schooling that we have today is counterproductive and oppressive, so I don’t feel that children should be forced to go to public school to begin with.
There may be a lot of great teachers out there, who care about what they do and have very good intentions, like the world famous educator John Taylor Gatto. But even he found the top down structure of the school system and the curriculum provided is very damaging to the minds of children.
He left public schools by writing his resignation letter in the op-ed pages of the Wall Street Journal, starting the letter off by saying that he “refuses to continue hurting children.” He then went on to start an incredible career in writing, researching and speaking out about the dangers of compulsory schooling.
This element is important because the public school system combined with other forms of child abuse has worked to create the kind of violent and angry culture that we see today. When you treat people like prisoners and second class citizens for the most vital developmental years of their lives, you are going to create confused, bitter and deranged people. There is still value in group learning settings, and there is still value in teachers, but what we have today is indoctrination, not education.
With that being said, whether we are talking about a place of voluntary group learning in a free society or the compulsory public schools that we see today, the administrators should be armed. A convenience store clerk protects his store with a gun, and by the same logic a teacher or administrator should be able to protect the lives of children with a gun as well.
Which makes sense, and which probably explains why the administration will fight too and nail to prevent the case study of the Garden Valley School district from going national.
- Corporate Buybacks: Connecting The Dots To The F-Word
Submitted by Michael Lebowitz via 720Global.com,
Over the course of history in the financial markets, Wall Street has continuously invented increasingly creative ways to peddle its wares under the guise of meeting investors’ “needs”. The modern era of financial alchemy began quietly enough with index investing in the early 1970’s, followed by portfolio insurance in the 1980’s (the cause of Black Monday 1987), progressed to the advent of the exchange-traded fund (ETF) and credit-default swaps (CDS) in the early to mid-1990’s, trailed by internet stocks in the late 1990’s (bubble #1). The 2000’s saw more than its fair share of ingenuity including toxic triple-A rated sub-prime mortgage-backed securities and CDO-Squared structures (bubble #2).
The latest craze in financial engineering plays to the theme of “less is more”. Share buybacks, whereby a publicly-traded company repurchases its own stock in the open market, are driving the stock market to previously unimaginably rich valuations despite weak economic growth and a lack of supporting fundamentals. Share buybacks are being conducted in record amounts without regard for whether a company actually has the cash to spend on such a plan and worse, at prices well-above intrinsic value for those shares.
The Federal Reserve (Fed) has been complicit creating this environment through not only their zero interest rate policy but indirectly via the euphoric markets which are partially the result of such policy. The instant gratification that share buybacks offer shareholders, including insiders, in combination with “free” money are so irresistible that companies are more than willing to borrow cash and exchange prudence for the gratuitous short-term pleasure of watching their stock climb on the news. Even if the Fed were to follow through with recently threatened interest rate hikes, markets are clearly not worried that the proverbial monetary stimulus punch bowl will be removed anytime soon. By maintaining crisis policy for nearly seven years and refusing to allow normal market discipline to reassert itself, the Fed has once again laid the groundwork for the third financial market bubble in only the last 15 years.
With the Fed and other government authorities providing cover and Wall Street endorsing the approach, share buybacks are being driven by a desire to both manipulate stock prices in the short term and increase already egregious executive pay. Share buybacks are the mechanism by which value creation is being buried by corporate executives seeking value extraction.
Finance and Accounting 101
A share buyback is exactly what the name suggests. At some point in the past a company issued equity to capitalize the corporation. The repurchase, or buyback, is simply buying some of those shares back either as a tender offer to specific shareholders or in the open market, effectively returning capital and leaving remaining ownership in fewer hands. Most share repurchases today occur in the open market.
From an accounting perspective a company’s true value or net worth before and after a buyback is identical. As the number of shares decrease, earnings per share (EPS) increase proportionately, seemingly making remaining ownership more valuable. However the benefits to remaining shareholders are perfectly offset by the loss of cash used to conduct the buyback. Accounting 101 teaches that assets minus liabilities equals owners’ equity. A cash buyback does nothing more than decrease the assets and the owners’ equity accounts equally, keeping the equation in the same state of equilibrium and leaving the remaining shareholders with the same amount of owners’ equity as prior to the exercise. This accounting identity is among the most basic in corporate finance and accounting.
Because of historically low interest rates, debt-funded buybacks are especially popular today. Unlike cash buybacks which produce neither an accounting benefit nor impairment, buybacks supported by the issuance of new debt have an adverse effect on the bottom line. In a debt-funded buyback the asset side of the balance sheet is untouched, however the liability side increases while owners’ equity drops an equal amount. The end result is the company now owes the principal on the money borrowed as well as a series of future interest payments against which future earnings are reduced.
Increased interest expenses with no change to cash flows or earnings negatively affects a company’s credit rating, which in turn increase future borrowing costs and limits future borrowing capacity. Rating agencies have warned that buybacks, especially those fueled with debt, increase the odds of credit downgrades.
From a valuation perspective there is little doubt that buybacks, over the past few years, have led to increases in share prices in the equity market. However, analysts and investors who argue for buybacks on the premise that somehow those actions add real intrinsic value to a company are misguided. These advocates are correct that earnings per shares are increased, but they fail to factor in the negative effects on future earnings when cash is used to buy back stock instead of invested in the company’s future.
When cash or debt is used to perform a buyback, then by definition those dollars cannot be used for other purposes. The question that must be answered is, “What gets sacrificed”?
A company has two options to consider when deploying capital:1. It can reinvest that money by expanding employee skills, increasing pay and benefits, hiring more people, creating new products and services or making other capital investments that make the company more profitable and competitive.
2. It can repurchase its own shares and/or pay cash dividends to shareholders – “capital return”.
Deploying capital via share buybacks or dividends diminishes the ability of a company to invest in itself. The recent meteoric growth of returning capital to shareholders simply means far less capital is being deployed by corporations for reinvestment purposes. Prior to the 1980’s, major U.S. corporations employed a “retain and reinvest” approach to resource allocation in order to enhance both operational and human capital. This approach contributed to equitable, stable economic growth in the years to follow. Throughout the 1980s and 1990s however, the focus of corporate leadership shifted. In order to satisfy Wall Street’s demanding requirements for ever-higher quarterly earnings per share, executives lost sight of the long-term objectives and began using stock repurchases and other shortsighted ideas to manipulate EPS and ultimately their stock price.
This behavior ensures the seeds of future earnings growth, re-investment, are being sacrificed for current benefits. While the economic costs of this strategy may not be well publicized, they are palpable. Productivity growth for instance slowed to a paltry .10% in 2014, continuing a slowing trend of the last 30 years. New highs in stock market indices may temporarily mask important economic factors such as the lack of productivity growth, sub-trend economic growth, income disparity and an ever growing debt burden, but the costs of misallocating corporate capital are significant and will be increasingly felt for years to come.
Rational for buybacks
Corporate executives offer three main reasons for share repurchases:
1. Buybacks are investments in our undervalued shares signaling our confidence in the company’s future.
2. Buybacks allow the company to offset the dilution of EPS when employee stock options are exercised or stock is granted to employees.
3. The company is mature and has limited investment opportunities, therefore we are obligated to return unneeded cash to shareholders.
The logic behind each of these explanations is in the vast majority of cases is flawed, to be kind, and deceptive to be blunt. In a letter to shareholders fifteen years ago, Warren Buffett explicitly addressed the topic of share repurchases through the following direct and critical explanations:
- “Now, repurchases are all the rage, but are all too often made for an unstated and, in our view, ignoble reason: to pump or support the stock price.”
- “Usually, of course, chicanery is employed to drive stock prices up, not down.”
- “The shareholder who chooses to sell today, of course, is benefitted by any buyer, whatever his origins or motives. But the continuing shareholder is penalized by repurchases above intrinsic value.”
- “Buying dollar bills for $1.10 is not good business for those who stick around.”
- “Sometimes too, companies say they are repurchasing shares to offset the shares issued when stock options granted at much lower prices are exercised. This “buy high, sell low” strategy is one many unfortunate investors have employed – but never intentionally! Managements, however, seem to follow this perverse activity very cheerfully.”
Despite The Oracle’s sensible take, many “sophisticated” investors have opted to ignore the deception involved in buybacks and take part in the cheerleading. Rick Rieder, the Chief Investment Officer of BlackRock, the world’s largest asset management firm, recently stated “why risk cap-ex when the bar here is low and the results instantaneous?” The “low bar” and “instantaneous” results referring to the benefits of buybacks.
On the other hand, across the hall in the executive suite, BlackRock’s CEO Laurence Fink had this to say: “More and more corporate leaders have responded with actions that can deliver immediate returns to shareholders, such as buybacks or dividend increases, while underinvesting in innovation, skilled workforces or essential capital expenditures necessary to sustain long-term growth.”
For the record, we concur with Mr. Fink.
Two important facts bear emphasis:
1. Stock buybacks do not increase the value of the company from an accounting perspective and when buybacks are done via borrowed money, there is a negative effect.
2. Stock buybacks have an often overlooked cost of reducing corporate investment which is not being factored into earnings projections and valuations. By exchanging future earnings growth for hollow short-term stock price gains, CEO’s are having a deleterious effect on productivity and ultimately earnings potential.
There is a reason for everything, for everything there is a reason
So if share repurchases do not in any way enhance the intrinsic value of a company, the logic and rationale offered by executives is faulty and/or deceptive and the action itself is viewed as “chicanery”, then why are so many executives and board of directors authorizing them? What are the real reasons?
The answer, as it so often does, lies in the incentives.
Citing from his book The Practice of Management, Peter Drucker wrote “There is only one valid definition of a business purpose: to create a customer.”
In the mid-1970’s Michael Jensen and William Meckling, Finance Professors at the University of Rochester, proposed in an article published in the Journal of Financial Economics that, contrary to Drucker’s philosophy, the singular goal of a company should be to maximize the return to shareholders. The professors argued that in efforts to re-prioritize the objective of maximizing shareholder value ahead of executives’ self-interest, executive incentives should be altered through stock-based compensation. Unfortunately, this concept ultimately became the conventional wisdom of the last 35 years.
In a 2009 article in the Financial Times, Former GE CEO Jack Welch said “On the face of it, shareholder value is the dumbest idea in the world. Shareholder value is a result, not a strategy… your main constituencies are your employees, your customers and your products. Managers and investors should not set share price increases as their overarching goal.”
In a 2011 Forbes article The Dumbest Idea in the World: Maximizing Shareholder Value, author Steve Denning highlights that between “1960 and 1980, CEO compensation per dollar of net income earned for the 365 biggest publicly traded American companies fell by 33 percent. By contrast, in the decade from 1980 to 1990, CEO compensation per dollar of net earnings produced doubled. From 1990 to 2000 it quadrupled.”
As an important side-bar the Securities Exchange Commission in 1982, allowed companies to buy back their own shares with virtually no regulatory oversight.
Corporate executive compensation has become much more dependent on current EPS and ultimately stock prices as an incentive metric with stock option grants and outright stock awards increasing dramatically. In 2012, average CEO pay for S&P 500 companies was $30 million of which 83% was comprised of stock options and awards as shown below.
As executive compensation has soared, the reasons for buybacks becomes more apparent. First, buybacks allow companies to manipulate their stock price in the short term to please investors and analysts. Second, they are a means of increasing pay for top executives resulting in their personal financial gain at the expense of innovation, employees and job creation.
- The PetroYuan Is Born: Gazprom Now Settling All Crude Sales To China In Renminbi
Two topics we’ve deemed critically important to a thorough understanding of both global finance and the shifting geopolitical landscape are the death of the petrodollar and the idea of yuan hegemony.
Last November, in “How The Petrodollar Quietly Died And No One Noticed,” we said the following about the slow motion demise of the system that has served to perpetuate decades of dollar dominance:
Two years ago, in hushed tones at first, then ever louder, the financial world began discussing that which shall never be discussed in polite company – the end of the system that according to many has framed and facilitated the US Dollar’s reserve currency status: the Petrodollar, or the world in which oil export countries would recycle the dollars they received in exchange for their oil exports, by purchasing more USD-denominated assets, boosting the financial strength of the reserve currency, leading to even higher asset prices and even more USD-denominated purchases, and so forth, in a virtuous (especially if one held US-denominated assets and printed US currency) loop.
The main thrust for this shift away from the USD, if primarily in the non-mainstream media, was that with Russia and China, as well as the rest of the BRIC nations, increasingly seeking to distance themselves from the US-led, “developed world” status quo spearheaded by the IMF, global trade would increasingly take place through bilateral arrangements which bypass the (Petro)dollar entirely. And sure enough, this has certainly been taking place, as first Russia and China, together with Iran, and ever more developing nations, have transacted among each other, bypassing the USD entirely, instead engaging in bilateral trade arrangements.
Falling crude prices served to accelerate the petrodollar’s demise and in 2014, OPEC nations drained liquidity from financial markets for the first time in nearly two decades:
By Goldman’s estimates, a new oil price “equilibrium” (i.e. a sustained downturn) could result in a net petrodollar drain of $24 billion per month on the way to nearly $900 billion in total by 2018. The implications, BofAML notes, are far reaching: “…the end of the Petrodollar recycling chain is said to impact everything from Russian geopolitics, to global capital market liquidity, to safe-haven demand for Treasurys, to social tensions in developing nations, to the Fed’s exit strategy.”
Shifting to the idea of yuan hegemony, China is aggressively pushing its Silk Road Fund and Asian Infrastructure Investment Bank.
The $40 billion Silk Road Fund is backed by China’s FX reserves, the Export-Import Bank of China, and China Development Bank and seeks to increase ROIC for Chinese SOEs by investing in infrastructure projects across the developing world, while the $50 billion AIIB is funded by 57 founding member countries (the US and Japan have not joined) and will serve to upend traditionally dominant multilateral institutions which have failed to respond to the rising influence and economic clout of their EM membership. China will push for the yuan to play a prominent role in the settlement of AIIB transactions and may look to establish special reserves in both the AIIB and Silk Road fund to issue yuan-denominated loans.
Back in early November, SWIFT data showed that 15 new countries had joined a list of nations settling more than 10% of their trade deals with China in yuan. “This is a good sign for [yuan] adoption rates and internationalisation. In particular, Canada’s [yuan] usage for payments, which has increased greatly over this period, is very interesting since we have not seen strong adoption of the [yuan] from North America to date,” Astrid Thorsen, Swift’s head of business intelligence said.
Earlier that month, China and Russia indicated that going forward, more trade between the two countries would be settled in yuan. From Reuters, last November:
Russia and China intend to increase the amount of trade settled in the yuan, President Vladimir Putin said in remarks that would be welcomed by Chinese authorities who want the currency to be used more widely around the world.Spurred on by their often testy relations with the United States, Russia and China have long advocated reducing the role of the dollar in international trade.
Curtailing the dollar’s influence fits well with China’s ambitions to increase the influence of the yuan and eventually turn it into a global reserve currency. With 32 percent of its $4 trillion foreign exchange reserves invested in U.S. government debt, China wants to curb investment risks in dollar.
The quest to limit the dollar’s dominance became more urgent for Moscow this year when U.S. and European governments imposed sanctions on Russia over its support for separatist rebels in Ukraine.
“As part of our cooperation with this country (China), we intend to use national currencies in mutual transactions.The initial deals for rouble and yuan are taking place. I want to note that we are ready to expand these opportunities in (our) energy resources trade,” Putin said at the time, suggesting that going forward, Russia may look to settle sales of oil in yuan.
Sure enough, Gazprom has confirmed that since the beginning of the year, all oil sales to China have been settled in renminbi. From FT:
Russia’s third-largest oil producer, is now settling all of its crude sales to China in renminbi, in the most clear sign yet that western sanctions have driven an increase in the use of the Chinese currency by Russian companies.
Russian executives have talked up the possibility of a shift from the US dollar to renminbi as the Kremlin launched a “pivot to Asia” foreign policy partly in response to the western sanctions against Moscow over its intervention in Ukraine, but until now there has been little clarity over how much trade is being settled in the Chinese currency.
Gazprom Neft, the oil arm of state gas giant Gazprom, said on Friday that since the start of 2015 it had been selling in renminbi all of its oil for export down the East Siberia Pacific Ocean pipeline to China.
Russian companies’ crude exports were largely settled in dollars until the summer of last year, when the US and Europe imposed sanctions on the Russian energy sector over the Ukraine crisis…
Gazprom Neft responded more rapidly than most, with Alexander Dyukov, chief executive, announcing in April last year that the company had secured agreement from 95 per cent of its customers to settle transactions in euros rather than dollars, should the need to do so arise.
Mr Dyukov later said the company had started selling oil for export in roubles and renminbi, but he did not specify whether the sales were significant in scale.
According to Gazprom Neft’s first-quarter results issued last month, the East Siberian Pacific Ocean pipeline accounted for 37.2 per cent of the company’s crude oil exports of 1.6m tonnes in the three months to March 31.
With that, the “PetroYuan” has officially been born and while FT notes that “other Russian energy groups have been more reluctant to drop the dollar for settlement of oil sales,” the fact that Russian producers are now openly considering a shift at the same time that officials in the US and Europe are openly discussing stepped up economic sanctions suggests renminbi settlements may become more commonplace going forward.
To understand why and to what extent this is significant in the current environment, consider the following from WSJ:
Officials of the Organization of the Petroleum Exporting Countries, which declined to cut oil production last year, reasoned that maintaining high production levels would protect market share in crucial importing nations.;
But Chinese customs data released Friday show that China’s crude imports from some big OPEC nations have plummeted, while imports from Russia surged 36% in 2014. Meanwhile, imports from Saudi Arabia fell 8% and those from Venezuela dropped 11%.
To summarize: Western economic sanctions on Russia have pushed domestic oil producers to settle crude exports to China in yuan just as Russian oil is rising as a percentage of total Chinese crude imports. Meanwhile, the collapse in crude prices led to the first net outflow of petrodollars from financial markets in 18 years, and if Goldman’s projections prove correct, the net supply of petrodollars could fall by nearly $900 billion over the next three years. All of this comes as China is making a concerted push to settle loans from its newly-created infrastructure funds in renminbi.
Putting it all together, the PetroYuan represents the intersection of a dying petrodollar and an ascendant renminbi.
- MSCI "On Track" For China Inclusion But Warns Liquidity Remains An Issue
MSCI has not decided to include China stocks in its index yet – as opposed to what mainstream media believes. MSCI instead says the inclusion is “on track” for inclusion but there remains three significant hurdles including liquiidty restrictions.
Full MSCI Statement on China inclusion:
MSCI, the premier provider of global equity indexes, announced today that it expects to include China A?shares in its global benchmarks after a few important remaining issues related to market accessibility have been resolved. MSCI and the China Securities Regulatory Commission (CSRC) will form a working group to contribute to the successful resolution of these issues.
“Substantial progress has been made toward the opening of the Chinese equity market to institutional investors,” said Remy Briand, MSCI Managing Director and Global Head of Research. “In our 2015 consultation, we learned that major investors around the world are eager for further liberalization of the China A?shares market, especially with regard to the quota allocation process, capital mobility restrictions and beneficial ownership of investments.”
Briand continued, “Because MSCI’s client base is so large and diverse, we have a strong interest in ensuring that remaining issues are addressed in an orderly and transparent way. We are honored that the CSRC has recognized MSCI’s expertise regarding the requirements of international institutional investors. We look forward to a fruitful collaboration that will contribute to the further opening of the China A?shares markets to international investors and the inclusion in the MSCI Emerging Markets Index.”
MSCI stated that it may announce the decision to include China A?shares in the MSCI Emerging Markets Index as soon as the issues it has outlined are resolved. This may happen outside the regular schedule of its annual Market Classification Review.
China A?shares
MSCI will collaborate with the CSRC over coming months to facilitate discussions designed to lead to the implementation of policies that effectively resolve the remaining accessibility issues in the China A?shares market.
Since its 2014 Annual Market Classification Review, MSCI has continued to observe significant positive market?opening developments in the Chinese capital market. These developments include the successful launch of the Shanghai?Hong Kong Stock Connect program (“Stock Connect”), the expansion of RQFII program from four cities to 12 cities and the clarification of the capital gains tax. In addition, the imminent launch of the Shenzhen?Hong Kong Stock Connect program and potential further liberalization of the QFII program should further improve the accessibility of the China A?shares market.
The working group aims to facilitate discussion and understanding of accessibility concerns and potential solutions that were highlighted by international institutional investors in MSCI’s 2015 consultation. The concerns include, but are not limited to, the quota allocation process, capital mobility restrictions and beneficial ownership of investments.1. Quota allocation process. Global investors told MSCI that having reliable access to quota is a critical requirement. They believe that large investors should be given access to quota commensurate with the size of their assets under management. This is especially important for passive investors, whose investment processes replicate benchmarks. In addition, all investors said that they need sufficient flexibility and assurance to secure additional quota should the need arise. Most international investors have indicated a preference for a more streamlined, transparent and predictable quota allocation process.
2. Capital mobility restrictions. Liquidity is a critical component of the investment process. Regardless of the channel they use, investors say that they need access to daily liquidity. They believe that this access should apply to all investment vehicles, including open?ended funds, ETFs and separate accounts. Some investors have continued to express concerns about restrictions on capital lock?up and the limit on the amount of repatriation. Finally, in the context of Stock Connect, investors feel that the daily limit imposed on the “northbound access” (access to Shanghai?listed A?shares through the Hong Kong Stock Exchange) should be lifted because it is a great source of trading uncertainty for passive investors, who typically trade on market close.
3. Beneficial ownership. MSCI applauds CSRC’s recent clarification on the Stock Connect beneficial ownership issue. MSCI expects this clarification to make international investors more confident in using the Stock Connect scheme. Time and actual experience, however, are needed for investors to provide their final assessments. A large number of asset owners invest through separate accounts. Because they typically delegate investment and operational decisions to their fund managers, recognizing clear title to ownership for the ultimate beneficial owners is a crucial concern.
Recognizing the significant progress to date and ongoing reform efforts, China A?shares will remain on the 2016 review list for potential inclusion into Emerging Markets.
MSCI has updated the consultation document that describes the proposed index inclusion roadmap for China A?shares in the MSCI Emerging Markets Index. This roadmap, which was introduced in March 2014, proposes to partially include China A?shares in the pro forma MSCI China Index and its corresponding composite indexes, including the MSCI Emerging Markets Index, at 5% of its FIF?adjusted market capitalization.
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For the cynics among you, we wonder (out loud) if the push for inclusion of Chinese stocks is preparation for a full-blown Chinese QE which, if unleashed, will send Chinese Stocks soaring and implicitly lift all MSCI boats on the back of it, thus enabling a far greater “wealth creation” channel effect to the world (multiplier) than if China was absent… but that would just be conspiracy theory wonkishness.
- Leaking Las Vegas
What happens in Vegas, stays in Vegas… apart from the water. As the following interactive chart from ProPublica shows, water usage in the greater Las Vegas region has more than doubled in the last 40 years and with the drought conditions, every reservoir is near record lows. Welcome To Las Vegas (while water supplies last).
Click here for large interactive version
Vegas Water History
1905 The Las Vegas Land and Water Company is formed to build and operate groundwater wells which the city then depended on for decades.
1922 The seven basin states sign the Colorado River Compact, estimating the river’s annual supply at 18 million acre-feet of water and dividing 15 million acre-feet between the northern and southern states. The river would eventually prove to flow with just 14.8 million acre-feet a year.
1928 The Boulder Canyon Project Act authorizes construction of the Hoover Dam and split the water shares up between states. Nevada only gets 97.8 billion gallons, while California is given 1.4 trillion gallons, an imbalance that complicates relations to this day.
1941 A pipeline is constructed by Basic Management Inc., to take water from the Colorado River in Lake Mead and deliver it to Las Vegas for the first time.
1956 Congress passes the Colorado River Storage Project, authorizing the construction of some of the largest dams on the river, including Glen Canyon, Flaming Gorge, New Mexico’s Navajo and Colorado’s Aspinall Unit.
1963 Supreme Court settles Arizona vs. California, deciding a key aspect of Western water law and allowing Arizona, Nevada and California to withdraw unlimited water from their tributary rivers without counting it against their share of the Colorado River, further straining the system’s supply.
1971 The first phase of construction on the Southern Nevada Water System is completed, enhancing Las Vegas’ reliance on the Colorado River for its water.
1989 Seeking more water to support growth, Pat Mulroy and the Las Vegas Valley Water District quietly file 148 applications for water rights in rural counties north of Las Vegas.
1990 Las Vegas’ daily water demand exceeds 300 million gallons per day.
1991 The Las Vegas Valley Water District receives a report warning the area will run out of water within five years. Pat Mulroy temporarily puts a moratorium on new building projects. Later that year the Southern Nevada Water Authority is formed, combining seven water districts in the Las Vegas Valley.
1992 The Water Authority gets permission from the U.S. Secretary of Interior to temporarily use extra water from the river, which for a few years flowed with more water than the states had divided up.
1994 Nevada’s state engineer allows the Water Authority to take additional water from the Virgin River, water which would have otherwise flowed into Lake Mead.
1998 The Southern Nevada Public Lands Management Act is passed, giving Nevada a say in how federal lands are sold and allowing Las Vegas to rapidly expand. The Water Authority gets a 10 percent stake in land sales, tying its revenues directly to growth.
1999 Las Vegas’ maximum daily demand exceeds 400 million gallons.
2001 A year into the start of the drought, California, Nevada and Arizona agree to divide up surplus water from the Colorado River.
2002 The Water Authority completes a $2.1 billion tunnel to double the amount of water it can take from Lake Mead. That same year, drought ravages the basin. The Colorado flows at 25 percent of normal. Pat Mulroy throws out her 50-year water plan.
2003 Mulroy’s water authority pays Las Vegas residents up to $2 per square foot to rip out front lawns.
2005 SNWA decides to build a third, lower intake tunnel from Lake Mead to ensure it can, as Mulroy said recently, “take the last drop” when water levels fall.
2007 As drought drags on, the Colorado River basin states reach an agreement to divide water shortfalls between them in case water levels in Lake Mead drop below 1,075 feet, a trigger that signals a water emergency.
2012 The United States reaches an agreement with Mexico, which has long been entitled to nearly 489 billion gallons from the river, to allow Mexico to store some of its water for future use in Lake Mead. That same year the U.S. Bureau of Land Management comes out in support of the Water Authority’s proposal to build a water pipeline from rural Nevada to Las Vegas.
2014 Pat Mulroy retires after 26 years as Las Vegas’ top water official and having added significantly more water to the city’s annual supply. But the city is in its 15th year of drought, and the Water Authority projects its water demand will continue to rise beyond what the city is currently capable of providing.
Sources: USGS, NASA/USGS Landsat, Google, U.S. Census, Las Vegas Valley Water District, Southern Nevada Water Authority, U.S. Bureau of Reclamation, Department of Justice, State of Nevada Division of Water Resources, Wyoming State Water Plan, U.S. Department of the Interior Bureau of Land Management, Clark County Office of Public Communication.
- Stocks Slide To Weakest Consecutive Close Since October's Bullard Bounce
Summing up today (and every day) on the AAPL infotainment channel, we thought the following brief clip would clarify our perspective…
Before we start, something just does not add up here… Stocks (admittedly starting to catch down) have decoupled from relative volume pressures…
h/t @Not_Jim_Cramer
And Stocks have broken the uptrend heading back towards fundamentals…
but still CNBC claims "you have nothing to worry about in the equity markets, credit is the bubble"
* * *
Having got that off our chests…
Trannies were suffering more than the rest until late in the day panic buying lifted them up to Small Caps… S&P managed a tiny gain…
Futures markets show the V-Shaped recovery from early Europe-driven losses… (this is post Payrolls)
Since Friday's close, Trannies are ugly but notably the higher beta stock indices are not generasting the kind of momo oomph one would expect…
Notably, the S&P rallied all the way back up to its 100DMA then sold off again – this is the first consecutive close below the 100DMA since October's Bullard bounce…
AAPL's ramp was all about stop runs from yesterday's WWDC presentation...(AAPL bounced perfectly off its 100DMA at 125.37 and tested up to its 50DMA at 128.06 also)
The Dollar had a modestly volatile day but ended unch…
Treasury yields rose notably into the European close then rallied modestly into the US close…
Gold and Copper rose gently, silver was flat, but crude just did its thing…
Another day in the quiet world of crude oil… MidEast re-turmoiled – Saudi airstrikes in Yemen (and some claim that China will uptick its imports… because it just plunged them?)…
Charts: Bloomberg
Bonus Chart: Target was buyback spoofed…
1. Issue press release about massive buyback
2. Watch stock.
3. If stock does not surge, retract press release
- Crude Oil Jumps After API Reports Significant Inventory Draw
While API and DOE data has not exactly been consistent recently, the fact that API reported a huge 6.7 million barrel inventory draw for the last week is significant. Of course, all eyes will be focused on production data tomorrow but for now, WTI prices are up at the highs of the day.
WTI loves the news…
For some context on the size of the draw…
Charts: Bloomberg
- Why Adding China To The MSCI Indices Could Be A Disaster (In 1 Simple Chart)
Chinese stocks are around 4 times more volatile than the current MSCI World index… in other words, if asset allocators maintain current equity weightings then portfolio risks will soar (if China is added). But given that most risk budgets are fixed, rising volatility in the equity portion of portfolios (from adding China) will require rotation out of equities and into bonds (or lower vol assets) in order to maintain VaR limits.
Be careful what you wish for…
In English – Adding China to MSCI is like adding a powder keg of volatility into an illiquid global correlation nest.
Charts: Bloomberg
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