Warren Buffett is referred to as “the legendary investor Warren Buffett” or “the sage of Omaha”. The success of his Berkshire Hathaway fund is remarkable. He is also a pretty nice guy, and every year writes (with help, I’m sure) a letter describing the activities of his fund, along with general observations on investing and the economy. His letter covering 2022 was published two weeks ago.
Buffett noted that he and his team invest in companies in two ways: by buying shares to become a partial “owner” along with thousands of other shareholders, and also by buying ownership of the whole company. They aim to hold American companies that have a good business model, and will keep growing profits for years or decades. They look for great businesses at great prices, but they would rather buy a great business at a good price, than to buy a (merely) good business at a great price.
He was refreshingly honest about his overall stock picking record:
In 58 years of Berkshire management, most of my capital-allocation decisions have been no better than so-so. In some cases, also, bad moves by me have been rescued by very large doses of luck. (Remember our escapes from near-disasters at USAir and Salomon? I certainly do.) Our satisfactory results have been the product of about a dozen truly good decisions – that would be about one every five years – and a sometimes-forgotten advantage that favors long-term investors such as Berkshire.
In 1994 they bought a then-huge stake ($ 1.3 billion) in Coca-Cola, and another $1.3 billion stake in American Express. As it turned out, these two companies had the staying power that Buffet had anticipated, and have grown enormously in value over the past three decades.
In addition to their wholesome stock-picking philosophy, the “secret sauce” of Berkshire Hathaway is having the available funds to make those great investments in those great companies. These funds came large from the “float” from their insurance businesses. In Buffett’s words:
In 1965, Berkshire was a one-trick pony, the owner of a venerable – but doomed – New England textile operation. With that business on a death march, Berkshire needed an immediate fresh start. Looking back, I was slow to recognize the severity of its problems. And then came a stroke of good luck: National Indemnity became available in 1967, and we shifted our resources toward insurance and other non-textile operations.
The insurance business is interesting, in that clients pay in money “now”, but it does not get paid out until “later”. The insurance company has the money to own and manage until there is some claim event (e.g., someone dies or gets their home flooded) perhaps many years later. The traditional, conservative way for insurance companies to manage this float money was to invest it in low-paying but ultra-safe investment grade bonds.
Buffett’s key secret to success was to realize that he could invest at least part of these float funds in stocks, which would (hopefully!) over time make much more money than bonds. That gave him the cash to make those great investments in Coke and Amex. And his fund continues to have billions in hand to make strategic investments. He has made a bundle bailing out good companies that fell into short term difficulties. In his words:
Berkshire’s unmatched financial strength allows its insurance subsidiaries to follow valuable and enduring investment strategies unavailable to virtually all competitors. Aided by Alleghany, our insurance float increased during 2022 from $147 billion to $164 billion. With disciplined underwriting, these funds have a decent chance of being cost-free over time. Since purchasing our first property-casualty insurer in 1967, Berkshire’s float has increased 8,000-fold through acquisitions, operations and innovations. Though not recognized in our financial statements, this float has been an extraordinary asset for Berkshire.
You, too, can participate in Buffett’s investing magic, by buying shares in Berkshire Hathaway. The stock symbol is BRK.B. (Disclosure: I own a few shares). Buffett has been skeptical of flashy tech stocks, and so BRK.B’s performance lagged the S&P 500 fund SPY in 2020-2021, but over the long term Berkshire (orange line in chart below) has crushed the S&P:
I keep reading about how inflation has peaked (even peaked many months ago) and so any minute now the Fed will relent on raising interest rates, and will in fact start reducing them. Every data point that seems to support an early Fed pivot and a gentle “soft landing” for the economy is greeted with optimistic verbiage and a rip higher in stocks.
Except – – other meaningful data points regularly appear which show that inflation (especially core inflation) is remaining stubbornly high. The Personal Consumption Expenditures (PCE) Index is the Fed’s preferred way to track core inflation. It did peak in early 2022, and is falling, but very slowly and fitfully. Just when it seems like it is about to cascade downward, along comes another uptick. The latest report for 02/24/23 showed the PCE index (excluding the volatile categories of food and energy) increasing 0.6 percent during the month of January, which translated to a 4.7 percent year-on-year gain. That was considerably higher than the 0.4 percent monthly gain (4.3 percent year-on-year) that economists expected.
The chart below illustrates the chronic tendency of the economists at the Fed to lowball the estimates of future inflation. Each of the ten bars depicts quarterly projections of what inflation would be for 2023, starting back in September 2020 (first, green bar). No one in the craziness of 2020 could be held particularly responsible back then for accurately projecting 2023 conditions. But the Fed embarrassed themselves badly into late 2021 by airily dismissing inflation as “transitory”, due mainly to supply chain constraints that would quickly pass. (See towards the middle of the chart, yellow Sept 2021 and blue Dec 2021 bars projecting a mere 2.2% inflation for 2023.)
Only as of December 2022 did estimates of inflation jump up to 3.1% for 2023, and that estimate will surely get revised upward even further.
Many factors probably went into this systematic failure on the part of the Fed economists. There are probably political reasons for erring on the rosy optimistic side, which I will not speculate on here.
One factor in particular was mentioned in the Minutes of the Jan 31/Feb 1 Fed meeting that I thought was significant:
A few participants remarked that some business contacts appeared keen to retain workers even in the face of slowing demand for output because of their recent experiences of labor shortages and hiring challenges.
Jeremy LaKosh notes regarding this feature, “If true across the economy, the idea of keeping employees for fear of facing the labor force shortage would represent a fundamental shift in the employment market. This shift would make it harder for wage increases to mitigate towards historical norms and keep upward pressure on prices.”
This all rings true to my anecdotal observations. In bygone days, when business slowed down, factories would lay off or furlough workers, with the expectation on all sides that they would call the workers back (and the workers would come back) when conditions improved. However, employers have had to struggle so hard this past year to find willing/able workers, that employers are loath to let them go, lest they never get them back. I have read that even though homebuilders are not sure they can sell the houses they are building, they are so worried about losing workers that they are keeping them on the payroll, building away.
Other inflation data points show big decreases in prices for goods (and energy), but not for services. Wages, of course, are the big driver for service costs.
So the inflation story in 2023 seems to come down largely to a labor shortage. This is a large topic cannot be fully addressed here. I will mention one factor for which I have anecdotal support, that the enormous benefits (stimulus money plus enhanced unemployment) paid out during 2020-2021 set up a large number of baby boomers to leave the workforce early and permanently. Studies show that this is a major factor in the drop in workforce participation rate post-Covid. Maybe some of those folks had not planned ahead of time for such early retirement, but they got a taste of the good life (NOT getting up and going to work every day) in 2020-2021 along with the extra cash to pad their savings, and so they decided to just not return to work. That exodus of trained and presumably productive workers has left a hole in the labor force which now manifests as a labor shortage, which drives up wages and therefore inflation and therefore interest rates, which will eventually crater the economy enough that struggling firms will finally lay off enough workers to mitigate wage gains.
I wonder if this unhappy scenario could be staved off with increased legal migration of targeted skilled workers from other countries to alleviate the labor shortage. Dunno, just a thought.
This post is to share some observations that may be helpful to readers who, like me, were rudely surprised by the simultaneous steep decline in both bonds and stocks in the past year.
Bonds and Stocks Are No Longer Inversely Correlated
Back in the day before routine, massive Federal Reserve interventions, say before the 2008 Great Recession, there was a more or less routine business cycle. In an expansionary phase, GDP would increase, there was greater demand for loans, company profits would rise and so would stock prices and interest rates. When interest rates go up, bond prices go down. When the cycle rotated to the recessionary downside, all this would reverse. Stocks would go down, interest rates would decline and investors would flee to bonds, raising their prices.
Thus, bonds served as a good portfolio diversifier, since their prices tended to move inversely to stocks. Hence, the traditional 60/40 portfolio: 60% stocks, 40% bonds, with periodic rebalancing between the two classes.
This approach still worked sort of OK from 2008-2021 or so. The Fed kept beating interest rates lower and lower, and so bond prices kept (fitfully) rising. But at last we hit the “zero bound”. Short- and long-term interest rates went to essentially zero in the U.S. (and actually slightly negative in some other developed countries). Rates had nowhere to go but up, and so bond prices had no place go but down, no matter how stocks performed.
Trillions of dollars of federal deficit spending to pay out various COVID-related benefits in 2020-2021, along with supply chain interruptions, ignited raging inflation in 2022, which the Fed belated addressed with a series of rapid rate hikes and reductions in its bond holdings. The end of easy (nearly no-interest) money and the prospect of a recession knocked stock prices down severely in 2022. However, the rise in both short term and long term interest rates also cratered bond prices. The traditional 60/40 portfolio was decimated. Thus, in an inflationary environment with active Fed intervention, bonds are much less useful as a portfolio diversifier.
Both the stock and bond markets seem to be now driven less by real-world considerations and more by expectations of Fed (and federal government) reactions to real-world occurrences. Pundits have noted the “bad news is good news” effect on stock prices: if GDP dips or unemployment rises (which used to be considered recessionary bad news), the markets cheer, assuming that if any real economic pain occurs, the federal government will flood us with benefits and the Fed will lower rates and buy bonds and otherwise facilitate the renewed deficit spending. (See The Kalecki Profit Equation: Why Government Deficit Spending (Typically) MUST Boost Corporate Earnings for an explanation of why deficit spending normally causes a rise in corporate profits, and hence in stock prices.)
In 2022, there was practically no place to hide from investment losses. Petroleum-related stocks furnished one of the few bright spots, but that was partly a function of economies recovering that year from COVID lockdowns. There is no particular reason to believe that petroleum stocks will rise in the next market downturn. Oil and gas stocks, along with gold and other commodities, might offer a certain degree of diversification, but none of these can be assumed to normally rise (or even stay steady) when the general stock market falls.
Managed Futures Funds as Portfolio Diversifiers
It turns out that there is one class of investable assets that does tend to rise during an extended market downturn, while typically rising slowly or at least staying level during stock bull markets. That is managed futures funds. These funds observe pricing trends across a wide range of commodities and currencies and bond markets, and buy or sell futures to try to profit. If they (or their algorithms) guess right, they make steady, small gains. If there is a new, strong trend that they can buy into, they can make a lot of money quickly. Such was the case for most of 2022. It was obvious that the Fed was going to raise rates heavily that year, which would drive up interest rates and the value of the dollar versus other currencies, and would crush bond prices. The managed futures funds shorted the Euro and bonds, and made a ton of money January-November last year. Investors who held these funds were glad they did. Charts to follow.
The first chart here shows the total returns for the S&P 500 stock index (blue) and a general bond fund, BND (purple), for the past three years, ending Feb 13, 2023. (Ignore the orange curve for the moment). This chart captures the short but very sharp drop in stock prices in early 2020, as COVID lockdowns hit, but government aid was promised. Bonds did not greatly rise as stocks fell then, although after a bit of wobble they stayed fairly steady in early 2020. However, when stocks slid down and down during most of 2022, bonds went right down with them (purple drawn-in arrow), giving no effective diversification. Both stocks and bonds rose in early 2023, showing what is now a positive correlation between these two asset classes.
The next chart (below) omits the bonds line, showing just the blue stocks curve and the orange curve, which is for a managed futures fund, DBMF. The drawn-in red arrows show how DBMF only dipped a little during the COVID crash in early 2020, and it rose greatly in 2022, as stocks (blue arrow) collapsed. This shows the power of managed futures for portfolio diversification.
There was a surprising break in futures trends in November, 2022, as markets suddenly started pricing in an early Fed pivot towards easing in 2023, and so interest rates rose, and bonds and the U.S. dollar tumbled. All the managed futures funds took a sharp hit Nov-Dec 2022; some of them recovered better than DBMF, which kept drifting down for the next few months. Without getting too deep in the weeds, DBMF is an exchange-traded fund (ETF) with favorable fees and taxation aspects for the average investor. However, its holdings are chosen by observing the recent (past few weeks) behavior of other, primary managed futures funds, and trying to match the average performance of these funds. Some of these other, similar funds are EBSIX, PQTNX, GIFMX and AMFNX. These are mutual funds, rather than ETFs, with somewhat higher fees and higher minimum purchases, depending on which “class” of these funds you go with (A, C, or I).
This average matching technique is good, because the performance of any single one of the major managed futures funds can be really good or really any particular year. Some of these individual funds have done consistently horribly, so you’d be in bad shape if you happened to pick one of those. But the average of all those funds, as quantified by a relevant index, does OK and so does DBMF. However, as observed by Seeking Alpha author Macrotips Trading, because of its backwards-looking matching methodology, DBMF can be appreciably slower than other funds to adjust its positions when trends change. KMLM is another managed futures ETF, which tends to be more volatile than DBMF; higher volatility may be desirable for this asset class.
One Fund to Rule Them All
A recommended application of these managed futures funds is to replace maybe a third of your 40% bond holdings with them. Back testing shows good results for say a 15 managed futures/25 bonds/ 60 stocks portfolio, which is periodically rebalanced.
What if there was a fund which combined stocks and managed futures under one wrapper? There is one I have found, called REMIX. It has an “institutional” class, BLNDX, with higher minimum purchase and slightly lower fees, which I have bought into. The chart below shows the past three years of performance for the hybrid REMIX (orange) compared to stocks (blue) and the managed futures-only fund DBMF. We can see that REMIX stayed fairly flat during the COVID blowout in 2020, and it rose along with stocks in 2021, and went roughly flat in 2022 instead of dropping with stocks (see thick drawn-in yellow arrows). The performance of REMIX is actually better than a plain average of stocks (blue curve) and DBMF (purple), so this is an attractive “all-weather” fund. A similar hybrid (multi-asset) fund is MAFCX, which has higher fees but perhaps slightly higher returns to date. MAFCX buys stock (S&P500) futures rather than the stocks themselves, which is a leveraged play – – so for $100 investment in MAFCX you get effectively $100 worth of managed futures plus $50 worth of stock investment.
Managed futures put in an outstanding performance in 2022 because there was a well-telegraphed trend (Fed raising interest rates) in place for many months, which allowed them to make easy profits at the same time that stocks were crashing. But we cannot assume that managed futures will always go up when stocks go down. That said, managed futures will likely be reasonable diversifiers, since they should at least stay roughly level when stocks go down. The trick is to not grow impatient and dump them if their prices stagnate during a long bull stock market phase. Holding them in the form of a multi-asset fund like REMIX may help investors hang in there, since it should go up in a bull market (due to its stock component), while offering protection in a bear.
For instance, below is a five-year chart of a managed futures fund ( EBSIX, purple line ), the S&P 500 stock index (blue line), and a multi-asset fund that combines stocks and managed futures ( MAFIX, orange line. This is the institutional version of MAFCX). The charting program did not account properly for the Dec 2022 dividend of MAFIX, so I extended its curve with a short red line at the right-hand side to show what it should look like if plotted on a consistent total return basis.
With perfect hindsight, I chose a managed futures fund (EBSIX) which has performed among the best over the years; many other such funds would have looked far worse. There was a period of nearly two years (mid-2020 -early 2022) when this fund lagged far behind stocks. It was only when the 2022 catastrophe arrived that the managed future fund EBSIX proved its worth and shot up. The multi-asset fund MAFIX, which is similar to REMIX but with higher fees, basically kept up with stocks in their bull phase, then held more or less steady for 2022, and ended much higher over five years than either SP500 or the plain EBSIX.
The stock market drools and rips higher at the slightest sign that inflation is abating, since that portends rate cuts instead of rate hikes by the Fed, and a return to the golden days of easy money. But what do the latest data show? Here I’ll show several charts to show what we know so far.
The last couple months’ data points in the lower chart show that inflation (as estimated by CPI) has essentially leveled out and may be starting to decline a little. That is fine but it still leaves inflation far above the Fed’s 2% target. Victor defines a Fed “pivot” not as actually cutting rates, but simply a halt to raising them. By that somewhat anemic definition, sure, a Fed pivot could well come in the next few months. But that leaves rates still very high by recent standards. The real question is when will inflation come down low enough to justify significant rate cuts. The Fed screwed up so abysmally last year with its ridiculous “this inflation is only transitory supply chain issues” that they really cannot afford to relent too soon, and let inflationary psychology take hold.
Side comment: the big “blowout” jobs number for January (last bar on the right, on the top chart above) caused a huge buzz. But there are strong reasons to discount it as an artifact of “ revisions, adjustments, control factors, and recoding “, per Jeffrey Snider.
On the other side of the bull/bear divide, Wolf Richter published a glass-half-empty article noting how the Bureau of Labor Statistics recently revised its CPI numbers, and the changes shifted the numbers so as to undermine the argument that inflation has started to drop rapidly:
The chart above with revisions (red line) shows core CPI barely declining over the past 9 months or so, and no trend for an acceleration in that decline. The chart below shows CPI for Services (where we consumers spend most of our money, and which is closely correlated to wages) is holding nearly steady around a red-hot 0.55%/month or about 6.6% annualized. It could be longer than the market thinks before there are substantial rate cuts.
And from the Eurozone, there is this chart, courtesy of Bloomberg via Yahoo, depicting the results of polling economists as to the future course of inflation there:
The consensus view is that inflation in Europe will not approach the 2% target until well into 2024. The European Central Bank is expected to hike by 0.5% in March, followed by another 0.25% to reach 3.25%. (This is much lower than the Fed’s interest rates, but that is probably because the U.S. is still working off the orgy of COVID-related payments that dumped trillions in peoples’ pockets here in 2020-2021). Cuts by the ECB are not expected until the second quarter of 2024.
THIS JUST IN: The January CPI data just came out today (2/14), and pretty much matches up with the picture presented above. Inflation is falling, but ever so slowly, and so it becomes more likely that the Fed will keep its rates higher for longer:
“The Consumer Price Index (CPI) for January showed a 0.5% increase in prices over the past month, an acceleration from the prior reading, government data showed Tuesday. On an annual basis, CPI rose 6.4%, continuing a steady march down from a 9.1% peak last June. Economists had expected prices to climb 6.2% over the year and jump 0.5% month-over-month, per consensus estimates from Bloomberg. …
Core CPI, which strips out the volatile food and energy components of the report, climbed 5.6% year-over-year, more than expected, and 0.4% over the prior month. Forecasts called for a 5.5% annual increase and 0.4% monthly rise in the core CPI reading.”
(For another recent take on the inflation picture, see James Bailey’s The Murky Macro Picture, on this blog).
I just ran across the 1Q2023 “Guide to Markets” issued by J. P. Morgan Asset Management. This compendium of financial data is issued by a large team of their Global Market Insights Strategy Team. It consists of some seventy pages of data-packed charts, covering through December 2022. This information is selected to be of use to investors, both individual and institutional.
I was like a kid in a candy store, scrolling from one page of eye candy to the next. Without further ado, I will paste in some charts with minimal commentary.
One thing that caught my attention here was the persistence overestimation of earnings by Wall Street analysts. “Why do they keep doing that?” I wondered. A brief search led me to a 2017 article on Seeking Alpha by Lance Roberts titled “The Truth About Wall Street Analysis”.
It is a pleasure to be able to report on a successful microfinance outfit that helps the poorest of the poor. I heard a talk recently from Dale Stanton-Hoyle, CEO of the Five Talents organization. (He is as nice in person as he looks in this photo).
This group was birthed at Truro Anglican Church, in Fairfax, Virginia. An Anglican bishop from Tanzania noted that he had many thousands of people under his care who were suffering so much from hunger and other concomitants of poverty that they had little inclination or energy to listen to elevating spiritual messages. As he put it, “An empty stomach has no ears.”
Inspired by Jesus’ parable of the talents, where servants were each entrusted with some large sum of money (expressed in “talents”) and were expected to multiply that money productively, a group was formed in 1998 to help people living in the most extreme poverty to build productive enterprises.
Their approach would be classified as micro-credit, which nowadays is well-known and well-regarded approach. The modern stream of micro-credit, which is a subset of microfinance, has its roots In the Grameen Bank of Bangladesh, founded by micro-finance pioneer Mohammed Yunus in the 1970s.
A micro-enterprise development organization that helps the world’s most vulnerable families escape poverty. Partnering with local churches around the world, we train men and women, mostly women living in extreme poverty, to form savings groups, take out loans, and build their own businesses. It may seem surprising, but even those living in extreme poverty can save a little each week, start a tiny business, and fulfill their God-given potential.
In general, Five Talents does not give handouts. They support a limited number of full-time trainers, who in turn train local volunteer trainers, who do most of the actual organizing and leading. They found that when Western sources provided the initial seed capital, the money was not valued as much, and the loan payback rates were unsustainably low, around 60% or so.
So their model is to form a group of 20 or more people, and have them save their own money for at least six months. This develops tremendous accountability for borrowed funds. You are borrowing precious money from your group of friends and associates, and they all have a stake in helping your business succeed so you can repay it.
During those initial 6 to 12 months, the organization provides training: first, basic literacy (many are illiterate) and math skills which are essential for running a small business. Then, they provide training for more specific business planning and operation. This graphic depicts the process:
A typical loan might be $30-$150. This might be used to buy a goat to raise, or some beans to sell in the market. The local people can be creative in coming up with enterprises. The speaker told of a woman who was stuck in a refugee camp, who had been beaten up by life and was bitter and hopeless. All she could see were wretched poor people, and not much else. But the trainer persisted in asking her, “But what has God blessed you with?” The subsequent conversation went something like this: “Well there is this large river nearby. And…there are unemployed men in the camp who used to have skilled jobs. I could probably pay some of them to make me a dugout canoe, then I could ferry people across the river for a fee. And…there are all these ragged children running around underfoot… I could probably buy them some fishing gear and pay them to catch me fish in the river, that I could sell in the market.” So this insightful local person was able to identify two completely new business ideas that the trainer had not thought of.
Some 80% of their participants are women. These women get a huge boost in self-confidence and community status, as well as income and food for their families.
Five Talents typically operates in concert with the local Anglican church in a country, which gives them some credibility and support and structure to start with. They are currently active in nine countries, mainly in central and eastern Africa along with Bolivia and Myanmar. They aim for countries with largest numbers of people living in extreme poverty. There is a wide range of development among so-called Third World countries. Many African countries already have a nascent middle class economy, so Five Talents directs its effort elsewhere.
According to their tracking, they have developed some 95,000 businesses so far, with a total of 1.4 million family members supported. They currently train about 10,000 people a year, and hope to increase that to 20,000 people. As with most development NGOs, the ultimate holy grail is to have your development project become independent and self-sustaining. Happily, Five Talents reports a great deal of success in getting groups to become self-funding after about one and a half years.
We have all seen the decline in consumer usage of physical currency. The trend has been going on for some years, with folks finding it more convenient to whip out a credit card or just wave their phone in order to make a purchase. The drop in cash use was dramatically accelerated during COVID when we avoided physical contact with anyone and anything outside our homes, preferring contactless payments or just ordering stuff on line.
The Federal Reserve has since 2016 run an annual survey of households to track trends in payments. This data set shows the big drop in cash use in 2020, with a corresponding increase in payments by credit cards and mobile apps:
Share of payments use for all payments, from Federal Reserve’s “Diary of Consumer Choice” , 2022 edition.
Similar trends hold for the U.K.; the main alternative to cash there seems to be debit cards:
Cash use continues to decline but the rate of decline seems to be slowing. Among other things, some twenty-somethings have been inspired by social media discussions to practice budgeting by using physical envelopes of physical cash for specified categories of spending.
Our discussion so far has mainly dealt with retail purchases by consumers. However, there is another dimension of cash use. As pointed out by Andy Serwer, there has been a steady surge in international demand for the largest denomination of U.S. currency, which is the $100 bill. This chart from the Fed shows that the dollar value of U.S. dollars in circulation has roughly doubled in the past decade:
Nearly all this rise is due to the insatiable demand for $100 bills, and the vast majority of that new demand is from overseas. Some of those Benjamins may be innocently sitting in foreign central bank vaults, but it is understood that many (perhaps most) of them are used by arms and drug dealers and other criminals. Cash is used way more than cryptocurrencies for criminal activity. According to Serwer:
A million dollars in $100 bills, in case you’re wondering, weighs about 22 pounds, they say. A double stack would be about 21.5 inches high by 12.28 inches by 2.61 inches. You could carry it in a big briefcase, or as I suggested, a satchel.
Gordon starts by recapping four recent financial bubbles:
The commercial real estate bubble of the mid-1980s
The internet stock craze of the late 1990s (with the highest price/earnings valuations ever – – e.g., a startup called Netbank possessed nothing but a website, yet was valued at ten times book value; and went bankrupt a few years later)
The mid-00s housing bubble.
The 2020/2021 COVID bubble: “The trifecta of a ‘disruptive business model’ stock bubble, SPACs and crypto. You know how this story is ending.”
Gordon then presents an explanation of why humans keep doing financial bubbles, despite the experiences of the past. He suggests that there are both bubble addicts, who have a need to chase bubbles and therefore create them, and bubble enablers who are only too happy to make money off the addicts.
THE BUBBLE ADDICTS
The greedy. Some of us just think we deserve more. I think of an acquaintance who said he was approached to invest with Bernie Madoff, who famously promised steady 10% returns. My friend turned down the offer because he required 15% returns.
Pension funds. This $30 trillion pool of investment dollars targets about a 7% return in order to meet future pension obligations. If pension fund managers can’t consistently earn at least 7%, they have to go to their sponsor – a state government, a corporate CEO, etc. – and ask for more money, or for pension benefits to be cut. And probably lose their job in the process.
Back in the day, bonds were the mainstay pension fund investment. But over the past 20 years, bond yields haven’t gotten the pensions anywhere close to 7%. So increasingly they have invested in stocks and alternative investments like private equity, as this chart shows:
And venture capital fundraising, in large part from pension funds, has soared since the pandemic…
How many great new ideas are out there for venture capitalists to invest in? [Obviously, not an unlimited number]. So their investments are by necessity getting riskier. But if the pension funds back away from the growing risk, they have to admit they can’t earn that 7%. Then bad things happen, to retirees and to pension plan sponsors and then to pension fund managers. So pension fund managers are pretty much addicted to chasing bubbles.
The relatively poor. The “absolutely poor” have income below defined poverty levels. The “relatively poor” feel that they should be doing better, because their friends are, or their parents did, or because the Kardashians are, or whatever. Their current income and prospects just aren’t getting them to the lifestyle they aspire to. [Gordon provides example of folks chasing meme stocks and crypto, and getting burned]. …But can the relatively poor just walk away from chasing bubbles? Not without giving up dreams of better lifestyles.
THE BUBBLE FEEDERS
Bubbles don’t just spontaneously occur; they require skilled hands to shape them. And those skilled hands profit handsomely from their creations. Who are these feeders?
Private equity and venture fund managers. They typically earn a 2% management fee plus 20% of profits earned. That adds up fast. A $10 billion venture fund could easily generate $400 million a year in income, spread among a pretty small group of people. VC News lists 14 venture capitalists who are billionaires.
SPAC sponsors. [ A SPAC (Special Purpose Acquisition Company) is a shell corporations which raises money through stock offerings, for the purpose of going out and buying some existing company. SPAC sponsors make a bundle, and so are motivated to promote them. SPACs proliferated in 2020-2021, and for a while pumped money into acquiring various small-medium “growth” companies. But now it is clear that there are not a lot of great underpriced companies out there for SPACs to buy, so SPACs are fizzling]
Wall Street earns fees from (A) raising funds for private equity, venture capital and SPACs, (B) buying and selling companies, (C) trading bubble stocks, crypto, etc., and (D) other stuff I’m not thinking of right now.
The Federal Reserve. Part of the Federal Reserve’s mandate is to reduce unemployment. Lowering interest rates increases stock values, which creates wealth, which drives the “wealth effect”. The wealth effect is the estimate that households increase their spending by about 3% as their wealth increases. More spending increases GDP, which reduces unemployment, which makes the Fed happy, and politicians happy with the Fed.
In my view, the wealth effect is why the supposed economic geniuses at the Fed never figure out that bubbles are occurring, so they never take steps to minimize them.
Social media and CNBC certainly benefit from more viewers while bubbles are blowing up [i.e., inflating].
INVESTING IN CURRENT MARKET ENVIRONMENT
Gordon sees us still in recovery from the recent bubble of “disruptor companies” and crypto, and so the market may have more than the usual choppiness in the next year. So he advises being nimble to trade in and out, and not mindlessly commit to being either long or short. “Value stocks are probably the best near-term bet, even if they can’t offer the adrenaline jolt offered by bubble stocks.”
Seventy trillion dollars is a lot of money. It is nearly three times the size of the U.S. GDP, and approaches total global GDP (around $100 trillion). That is the amount of funds that are missing from normally reported financial statistics, according to a December, 2022 report from the Bank for International Settlements. That report caused a bit of a flurry in financial circles.
It’s not that this money has been stolen, it’s just that it is not publicly known exactly where it is, i.e., how much money that which parties owe to whom. Here is the Abstract of this paper:
FX swaps, forwards and currency swaps create forward dollar payment obligations that do not appear on balance sheets and are missing in standard debt statistics. Non-banks outside the United States owe as much as $25 trillion in such missing debt, up from $17 trillion in 2016. NonUS banks owe upwards of $35 trillion. Much of this debt is very short-term and the resulting rollover needs make for dollar funding squeezes. Policy responses to such squeezes include central bank swap lines that are set in a fog, with little information about the geographic distribution of the missing debt.
Much of this money is in the form of currency swaps, especially foreign exchange (FX) swaps. Even though the U.S. economy no longer dominates the whole world, the U.S. dollar remains the premier basis for international trade and even more for foreign exchange:
As a vehicle currency, the US dollar is on one side of 88% of outstanding positions – or $85 trillion. An investor or bank wanting to do an FX swap from, say, Swiss francs into Polish zloty would swap francs for dollars and then dollars for zloty.
Who cares? Well, the incessant demand for dollars periodically leads to a dollar funding squeeze in international trade, which in turn reverberates into world GDP.
Currency Swaps as Lending Events
In many cases these currency swaps effectively amount to short-term lending /borrowing (of dollars). Much of the financial world is utterly dependent on smoothly flowing short-term funding to cover longer term debt or investments. Borrowing short-term (at usually lower interest rates) and investing or lending out longer-term (at higher rates) is how many institutions and funds exist. For instance, depositors at banks effectively lend their deposits to the bank (short-term), in return for some pitiful little interest on their checking or savings accounts, while the banks turn around and make say 5 year or 30-year loans to businesses or home-buyers. Banks earn profits on the spread between the interest rates they receive on the funds they loan out, and the typically lower rates on the short term funds they “borrow” from their depositors.
This “mismatch” between the maturities of borrowed funds (especially dollars) and invested funds can cause a complete melt-down of the financial system if holders of dollars stop being willing to lend them out, or to lend them out at less than ruinous interest rates:
The very short maturity of the typical FX swap/forward creates potential for liquidity squeezes. Almost four fifths of outstanding amounts at end-June 2022 in Graph 1.B matured in less than one year. Data from the April 2022 Triennial Survey show not only that instruments maturing within a week accounted for some 70% of FX swaps turnover, but also that those maturing overnight accounted for more than 30%. When dollar lenders step back from the FX swap market, the squeeze follows immediately.
Financial customers dominate non-financial firms in the use of FX swaps/forwards. Non-bank financial institutions (NBFIs), proxied by “other financial institutions” in Graph 1.C, are the biggest users of FX swaps, deploying them to fund and hedge portfolios as well as take positions. Despite their long-term foreign currency assets, the likes of Dutch pension funds or Japanese life insurers roll over swaps every month or quarter, running a maturity mismatch. For their part, dealers’ non-financial customers such as exporters and importers use FX forwards to hedge trade-related payments and receipts, half of which are dollar-invoiced. And corporations of all types use longer-term currency swaps to hedge their own foreign currency bond liabilities .
It is really bad if pension funds or insurance companies get starved of needed ongoing funding. Central banks, especially the dollar-rich Fed, have had to repeatedly jump in and spray dollar liquidity in all directions to mitigate these “dollar squeezes”. The BIS authors’ main concern is that these big public policy decisions are currently made in absence of data on what the actual needs and issues are. Hence, “Policy responses to such squeezes include central bank swap lines that are set in a fog.”
This all is part of the murky “Eurodollar” universe of dollar-denominated bank deposits circulating outside the U.S. (more on this some other time). Investing adviser Jeffery Snider offers the “Eurodollar University” on podcasts and on YouTube, in which he explores the many dimensions of the Eurodollar scene. He likens the Eurodollar system to a black hole: we cannot observe it directly, but we can estimate its size by its effects.
In his YouTube talk on this BIS paper, among other things Snider notes that this short-term lending associated with currency swaps functions much like repo borrowing, except the currency swaps (unlike repo) do not appear on bank or other balance sheets as assets/liabilities. That is part of the attraction of these swaps, since they are effectively invisible to regulators and are not constrained by e.g., capital requirements.
What the Fed does in a dollar squeeze is largely lend dollars to large dealer banks. But unless those other banks then lend those dollars out into the private marketplace of manufacturers and shippers and pension funds, having trillions of dollars in central bank reserves has little effect. It is not the case that “the Fed floods the world with dollars” — actually, mainstream banks get those dollars, and then lend out at high rates to the dollar-starved rest of financial world, where they can actually do something.
The result, according to Snider, is that the Eurodollar is the only functional reserve currency in existence. This is the real, effective banking system (not “reserves” sitting on some bank’s balance sheet), even though the current accounting system doesn’t show it.
Finnish crisis researcher Tuomas Malinen has for some time been predicting the collapse of the Western financial system, starting with the melt-down of the European Central Bank. Malinen, an associate professor of economics at the University of Helsinki, offers his views on his substack and elsewhere. He correctly warned in early/mid 2021 of coming inflation, which would present central bankers with severe challenges.
Among other things, by raising interest rates (to counter inflation), the banks necessarily cause the value of bonds to drop. However, a lot of the assets of the central banks consist of medium and long term bonds, especially those issued by sovereign governments. We have come to the point where some central banks are technically insolvent: the current cash value of their liabilities exceed their assets.
Is that a problem? Most authors I found did not seem to think so. For a normal private bank, as soon as the word got out that it was insolvent, customers would rush to withdraw their funds, in a classic “run on the bank”. Customers who waited too late to panic would simply lose their money, since there would not be enough assets on the bank’s balance sheet to cover all withdrawals.
However, no one seems to be in a hurry to beat down the doors of the Fed and demand their money. Most of the liabilities of the Fed are (a) paper currency in circulation, and (b) “Reserve” accounts of major banks at the Fed.
Bandyopadhyay, et al. note that negative equity in central banks (including those of smaller countries) is not uncommon; at any given time, about one out of seven central banks worldwide in the 2014-2017 timeframe suffered operating losses, some of which were large enough to wipe out their capital. However, most central banks are owned by, or have some other synergistic relationship to , the governments of their respective countries. For instance, there is a standard contractual relationship between the Bank of England (BOE) and the British government. Thus, when the BOE recently fell into arrears, the government provided them with additional funds. This was apparently a routine non-event. (I don’t know where the government came up with those additional funds; did they just issue more bonds, which in turn were purchased by the BOE?)
The Fed, as a privately-owned public/private hybrid, technically has a more arms-length distancing from the U.S. Treasury. For instance, the Fed is not supposed to buy government bonds directly from the government. Rather, the government sells them to large banks, who in turn sell them to the Fed (if the Fed is buying). It is possible for the U.S. Treasury to transfer funds to the Fed to recapitalize it; but for now, the Fed is just booking losses as a “deferred asset”. Voila, the magic of central bank accounting. The presumption is that sometime in the future, the Fed will receive enough net income to overcome these losses.
The biggest debate is over the fate of the European Central Bank (ECB). Its relation to sovereign governments is even more arms-length; it is difficult to see all the European countries, with their own budget issues, agreeing to cough up money to give to ECB. As Malinen sees it, this likely leads to the “deferred asset” accounting scheme to handle negative equity for the ECB. He worries, “Will the markets or the banks trust the ECB after losses starts to mount forcing the Bank to operate with (large) negative equity? We simply do not know.” This is a weighty issue. As we noted earlier, “money” is in the end a social construct, an item of trust among parties for future payments of value. Central banks are the lenders of last resort, the source of money when it has dried up elsewhere; they regularly have to step into financial liquidity crises to inject more money to keep the system going. If people stopped accepted the keystroke-created money from central banks, the whole economy could freeze up.
A more sanguine view of central bank negative equity issues from MMT proponent Bill Mitchell. In his “Central banks can operate with negative equity forever” Mitchell heaps scorn on the very idea that central banks could run into solvency problems. He states that a “government bailout” is an inconsequential paper operation, merely transferring money from the left pocket to the right pocket of the government/central bank joint entity (as he views it). Furthermore, central banks have the capability of creating money out of thin air, so they can always meet their obligations and therefore can never be deemed insolvent:
The global press is full of stories lately about how central banks are taking big losses and risking solvency and then analysing the dire consequences of government bailouts of the said banks. All preposterous nonsense of course. It would be like daily news stories about the threat of ships falling off the edge of the earth. But then we know better than that. But in the economic commentariat there are plenty of flat earthers for sure. Some day, humanity (if it survives) will look back on this period and wonder how their predecessors could have been so ignorant of basic logic and facts. What a stupid bunch those 2022 humans really were.
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